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SECTION THREE
Legal Liability
The Auditor’s Legal Liability
• A litigious society
• The cost to accounting firms
• Awareness
• Common law
• Statute law
Common Law vs Statute Law
• The main difference
• Common Law
• clients
• third parties
• Statute Law
Common Law Liability to Clients
• Clients suit against an auditor, two categories
• Client action can be based upon
• breach of contract
• tort
• Is an auditor infallible?
• Errors of judgement and negligence
» innocence
» error of judgement
» negligence
» gross negligence
» fraud
» constructive fraud
Burden of Proof
• Auditor accepted duty of care
• Auditor breached duty of care
• Client suffered a loss
• Close causal relationship between 2 & 3
Defenses Used by the Auditor
• Reasonable care and skill
• Clients own negligence
• No causal relationship
1136 Tenants v Max Rothenberg and
Company (1967)
• Cooperative apartments
• F/S unaudited
• Tenants sued firm for
failure to find fraud
• MR engaged to prepare
F/S, tax returns, and a
schedule for real estate
taxes
• Manager of management
firm was embezzling
funds
• Two main issues:
1.
2.
• Some auditing procedures were done
• A worksheet was entitled
» “Missing Invoices”
Fund of Funds Limited v Arthur Andersen
(1982)
• FF paid King Resources
$90M for oil & gas reserves
• FF did not determine this
higher profit until much
later on
• Said that AA had a duty
to inform FF or resign
• Properties supposed to be
sold at arms length
• AA auditor of FF and KR
• AA noticed that sales at
much higher profit than
to other KR customers
• Not reported to FF
• AA defense was based
on the “rules of conduct”
Consolidata Services Inc. v Alexander
Grant & Co. (1981)
• CS a payroll company
• Meeting between CS and
AG showed that CS was
insolvent
• AG did tax work
• also recommended CS
payroll services to its
clients
• AG requested CS to notify
CS customers
• CS refused
• AG informed CS that it
would inform all AG
customers
• CS requested a 10 day wait
• AG called its customers
• CS sued AG for negligence
and breach of contract
H.E. Kane Agencies v. Coopers & Lybrand
(1983)
• Kane an agent for a
national airline
• Airline supposed to be
promptly paid for tickets
• Kane’s son extended credit
on these sales. Delayed
recording of sales
• Airline caught on and Kane
had to pay $250,000 for
outstanding sales
• Kane sued C&L. Said they
should have done a year
end cutoff of sales
• C&L claimed they were not
obligated to advise on
business matters
• Judge found C&L failed to
detect the extension
• But also that Kane had lack
of supervision and willful
concealment of unreported
sales
• Thus company contributed
to its own loss
Liability to Third Parties
• Most frequent common law action
• Typical circumstances
• Third party then claims
• Third party must prove same elements
previously seen
Third Party Damage Recovery
• Gross negligence or fraud is straightforward
• Negligence is more complex
– until late 1960’s
• only to clients
• privity of contract
Ultramares Corp. vs Touche, Niven &
Co. (1931)
• Ultramares, a finance
company is 3rd. party
• Auditor’s client, Fred Stern
borrowed money from Ult.
• Ult. relied upon Fred Sterns
audited F/S
• TN did not know this
• Ult. Said that F/S were false
and TN were negligent
• Stern declared bankruptcy
• Court said that F/S were not
prepared for the express
benefit of Ultramares
• Thus TN not negligent
Ultramares Doctrine
• If an auditor’s conduct is more serious than a
mere error of judgement, but not gross
negligence or fraud, a third-party who is
identified or qualifies as a primary third-party
beneficiary may recover, but other third
parties may not.
• Ordinary negligence?
• Privity of contract?
Hedley Byrne & Co. v Heller &
Partners Ltd. (1963)
• House of Lords
• HB received a credit rating
from HP, the banker of the
client
• HB thus incurred a loss
• Client in serious financial
difficulty and subsequently
could not pay
• HB sued HP to recover
• HP had issued a disclaimer
for responsibility
• Thus House ruled in HPs
favour
• House indicated that there could
be liability if giver of advice
knew or ought to have known
that the receiver was going to rely
on it
• No privity, but a special
relationship established
Gordon T. Haig v Ralph L. Bamford et
al.(1976)
• GH approached manager
of SEDCO for investment
advice. SEDCO had
already advanced funds to
Scholler Furniture
• SF needed more funds.
Their auditor was RB
• GH advanced funds based on
the F/S
• SF foundered
• GH invested more funds
• SF wound up their operations
• GH sued RB for negligence
• Supreme Court found that
accountants were negligent
• SF told RB they need
audited F/S for their bank
and an unknown investor
• From Haig v. Bamford
• Tests for duty of care to third parties
1 Forseeability of the use of the F/S and client
reliance thereon.
2 Actual knowledge of the limited class of F/S
user.
3 Actual knowledge of specific plaintiff using the
F/S
Toromont Industrial Holdings Ltd. v
Thorne et al. (1975)
• TIH wanted to acquire all shares
of CIMCO for cash plus TIH
shares
• Thorne were the auditors of
CIMCO
• A TIH partner talked to a
Thorne partner about this
• Thus Thorne had prior
knowledge
• TIH sued Thorne for
negligence. Said F/S did not
present fairly
• Court said F/S did present
fairly but that Thorne were
negligent due to poor audit
procedures
• Showed that TIH did have
right of action against Thorne
since Thorne knew TIH
would rely on F/S
• But case was dismissed
because no damages were
suffered
Albert Dupuis v Pan American Mines
et al. (1979)
• AD bought shares of PA
• Prospectus for a share
offering. Thorne expressed
clean opinion on F/S.
• Stock was delisted. AD sued
to recover loss.
• AD was able to prove
reliance on F/S
• Court ruled that auditors were
negligent. They owed a duty
of care to prospective
investors
• Appears to broaden auditor’s
liability
• But not heard at Supreme
Court, and did not refer to
Haig v Bamford
Dixon v Deacon,Morgan,McEwan,
Easson (1989)
• BC case
• Dixon purchased $1.2 M in
shares of National Business
Systems Inc.
• Fraudulent overstatement
of sales. Not disclosed in
F/S
• Dixon sued auditors to
recover loss
• Market price went from
$12.89 to $3.50
• Court ruled there was no
proximity of relationship
between investor and
shareholder
• Case dismissed
Caparo Industries PLC v Dickman
(1990)
• House of Lords
• Caparo relied upon accounts
prepared by Dickman.
Prepared for management
purposes
• Accounts negligently
prepared by Dickman
• House ruled that Caparo
could not recover either as an
investor or shareholder
• Engagement letter showed
auditor had a duty of care
• But no specific duty of care
to investors or shareholders
• Auditors only liable to third
parties if third parties used
them for the purpose for
which they were prepared
McGauley et al v British Columbia
(1990)
• Depositors in a failed Co-op
advanced the claim
• Claimed that auditors should
have warned about the lack of
deposit insurance
• Court ruled that there was
no duty owed
• If any depositor had shown
specific reliance, there may
have been a duty of care
• Purpose of F/S was not to
warn depositors about
financial affairs of the Co-op
Surrey Credit Union v Wilson (1990)
• SCU invested $7.5M in a
Northland Bank debenture
• Northland bank subsequently
collapsed
• SCU sued auditors for
negligent preparation of F/S
• Auditors said the F/S were
for Northland Bank, not for
investors
• But the court noted that there
had been a prospectus issued
• Court said SCU was entitled
to rely on F/S. A duty of care
was therefore owed
• Thus auditors knew that
debentures could not be
issued without audited F/S
Kripps v Touche Ross et al (1990)
• Investors purchased Victoria
Mortgage Corporation
debentures based on an issued
prospectus
• VMC Collapsed and
investors sued auditors for
negligent preparation of F/S
• Court concluded that auditors
should have been aware of
the class of persons investing
• Prospectus needed audited
F/S
• This and previous cases
Show that the purpose of the
F/S is crucial to the outcome
• Thus duty of care was owed
Hercules Management v Ernst &
Young (1997)
• HM and others sued EY
• Plaintiff argued that
• Case dismissed at two
Manitoba courts
• Supreme Court
• General principle
Summary of Liability to Third Parties
• If statements are prepared for a specific
purpose and this is known to the auditors
• duty of care is owed
• If F/S prepared to assist shareholders in
assessing management of company
• If F/S included in a prospectus
Criminal Liability
• Very often State v. Defendant
• Means of punishing and deterring
• Fraud is typical example
• F/S known to be materially misstated or false
United States v Simon (1969)
loans to
Continental Vending
Valley Commercial Corp
(an affiliate of CV)
X
Y
X
Pledged
Y
as collateral
Secured by common stock of Roth
•
To finance stock
market TAs
Mr. Roth, President of
Continental Vending
•
•
Y
loans to
Not respected in the community
Had served a jail term
• The court decision said that the
footnote regarding this transaction
was presented in an obscure manner
• Convicted two partners of fraud
• Key question from this case
» can auditors defend themselves by demonstrating
compliance with GAAP
United States v. Weiner (1978) or The
Equity Funding Case
• The F/S were manipulated by a
massive overstatement of net
income and assets
• Finding against auditors was
largely circumstantial
• But the magnitude was so
large and over a long period
of time
• auditors knew of the fraud
and performed acts in
furtherance of the fraud
• This case illustrates the risk
when auditors perform
sloppy work
• Best defense is to perform a
thorough audit
ESM Government Securities v
Alexander Grant & Co. (1986)
• Losses from securities trades were concealed
by intercompany transactions
• Losses > $300M
• AG partner convicted of being party to the
concealment
Summary of Sources and Types of
Liability
• Liability to clients
– under contract law for
• ordinary negligence
• gross negligence
• fraud
• Liability to third parties
– under common law for
• fraud
• gross negligence
• ordinary negligence (limited class)
Liability for Unaudited Statements
• Due care
• How?
• By adherence to standards
• Material error?
• Engagement letter
• 1136 Tenants v Max Rothenberg
Preventing Legal Actions
• Areas of high audit risk
• Errors and irregularities
• Supervision
• Initial engagements
• Ethical behaviour
Corporate Governance
• Definition
• Use of corporate governance structure
• Monitoring
• Parties to corporate governance
• All parties have interest in effective
corporate performance
• Principles
– Rights and equitable treatment of shareholders
– Interests of other stakeholders
– Role and responsibilities of the board
– Integrity and ethical behaviour
– Disclosure and transparency
• Mechanisms and controls
– Internal corporate governance controls
– External corporate governance controls
• Systemic problems of corporate governance
– Supply of accounting information
– Demand for information
– Monitoring costs
• Role of the accountant
– Accountants and auditors
– Accounting firm area of concern
– Enron collapse
• Regulation
– Self-Regulation
– Rules versus principles
– Enforcement
• Attention to corporate governance
– Issues are receiving greater attention
– High-profile cases
– Widely studied
Sarbanes –Oxley Act 2002
Also known as the ‘Public Company Accounting Reform and Investor Protection
Act’ (in the Senate) and ‘Corporate and Auditing Accounting and Responsibility
Act’ (in the house).
The bill was enacted as a reaction to a number of major corporate and accounting
scandals including those affecting Enron, Tyco International, Adelphia, Peregrine
Systems and WorldCom. These scandals, which cost investors billions of dollars
when the share prices of affected companies collapsed, shock public confidence
in the nation's securities’ markets.
It does not apply to privately held companies.
It created a new, quasi-public agency, the Public Company Accounting Oversight
Board, or PCAOB, charged with overseeing, regulating, inspecting and
disciplining accounting firms in their roles as auditors of public companies.
Has played a useful role in restoring public confidence in the nation’s capital
markets by, among other things, strengthening corporate accounting controls.
Canada – Bill 198
An Ontario legislative bill effective April 7, 2003, which provides for regulation of
securities issued in the province of Ontario.
To protect investors by improving the accuracy and reliability of corporate
disclosures.
Bill 198 amends Part XXIII of the Ontario Securities Act.
In June 2003, all Canadian Securities Commissions (except BC) issued three
regulations for public comment designed to build on Bill 198.
In Canada we now have the Canadian Public Accountability Board (CPAB)
incorporated in 2003 under the Canada Corporation Act.
The mission: To contribute to the public confidence in the integrity of financial
reporting issuers in Canada by promoting high quality, independent auditing.
Problem 1:
The public accounting firm of Andre, Mathieu & Paquette (AMP) was
expanding very rapidly. Consequently, it hired several junior accountants,
including Jim Small. The partners of the firm eventually became dissatisfied with
Small’s production and warned him that they would be forced to discharge him
unless his output increased significantly.
At that time, Small was engaged in audits of several clients. He decided that
to avoid being fired, he would reduce or omit entirely some of the standard
auditing procedures listed in audit programs prepared by the partners. One of the
public accounting firm’s clients, Newell Corporation, was in serious financial
difficulty and had adjusted several of the accounts being audited by Small to
appear financially sound. Small prepared fictitious working papers in his home at
night to support purported completion of auditing procedures assigned to him,
although he in fact did not examine the adjusting entries. The public accounting
firm rendered an unqualified opinion on Newell's financial statements, which
were grossly misstated. Several creditors, relying on the audited financial
statements, subsequently extended large sums of money to Newell Corporation.
Required:
Would the public accounting firm be liable to the creditors who extended the
money because of their reliance on the erroneous financial statements if Newell
Corporation should fail to pay them? Explain.
Problem 2:
Jan Sharpe recently joined the public accounting firm of Spark, Watts, and
Wilcox. She quickly established a reputation for thoroughness and steadfast
dedication to following prescribed auditing procedures to the letter. On her third
audit for the firm, Sharpe examined the underling documentation of 200
disbursements as a test of purchasing, receiving, vouchers payable, and cash
disbursement procedures. In the process, she found 12 disbursements for the
purchase of materials with no receiving reports in the documentation. She noted
the exceptions in her working papers and called them to the attention of the incharge accountant. Relying on prior experience with the client, the in-charge
accountant disregarded Sharpe’s comments, and nothing further was done about
the exceptions.
Subsequently, it was learned that one of the client’s purchasing agents and a
member of its accounting department were engaged in a fraudulent scheme
whereby they diverted the receipt of materials to a public warehouse while
sending the invoices to the client. When the client discovered the fraud, the
conspirators had obtained approximately $70,000, $50,000 of which was
recovered after the completion of the audit.
Required:
Discuss the legal implications and liabilities to Spark, Watts, and Wilcox as a result
of the facts just described.
Problem 3:
In confirming accounts receivable on December 31, 2001, the auditor found 15
discrepancies between the customer’s records and the recorded amounts in the subsidiary
ledger. A copy of all confirmations that had exceptions was turned over to the company
controller to investigate the reasons for the difference. He, in turn, had the bookkeeper
perform the analysis. The bookkeeper analyzed each exception, determined its cause, and
prepared elaborate working papers explaining each difference. Most of the differences in the
bookkeeper’s report indicated that the errors were caused by timing differences in the client's
and customer’s records. The auditor reviewed the working paper and concluded that there
were no material exceptions in accounts receivable.
Two years subsequent to the audit, it was determined that the bookkeeper had stolen
thousands of dollars in the previous three years by taking cash and overstating accounts
receivable. In a lawsuit by the client against the public accountant, an examination of the
auditor’s December 31, 2001, accounts receivable working papers, which were subpoenaed
by the court, indicated that one of the explanations in the bookkeeper’s analysis of the
exceptions was fictitious. The analysis stated the error was caused by a sales allowance
granted to the customer for defective merchandise the day before the end of the year. The
difference was actually caused by the bookkeeper’s theft.
Required:
a. What are the legal issues involved in this situation? What should the auditor use as
a defence in the event that she is sued?
b. What was the public accountant’s deficiency in conducting the audit of accounts
receivable?
Problem 4:
In 1998, the Board of Directors of Lively Plays Inc. fired George Drewerson, the
co-founder and another senior management representative of the company
claiming that they had engaged in fraudulent financial activities and had defrauded
the company of $4 million. Payley and Karson, Chartered Accountants have been
the auditors of Lively Plays Inc. for many years, and have also been the personal tax
advisers of Mr. Drewerson during that time.
Lively Plays Inc. engaged personnel from another office of Payley and Karson
to conduct a forensic audit (a special investigation of the fraud). Mr. Drewerson
obtained a court injunction delaying the release of the report on the grounds that
Payley and Karson owed hi a fiduciary duty. Thus, Mr. Drewerson should have had
the right to review the special report before it was released to determine whether
any confidential information should be released.
Required:
a.
Describe the role of Payley and Karson, and discuss the apparent
conflict on interest in this situation.
b.
If Mr. Dewerson were found to be guilty of fraud, and had declared the
income from the fraud on his income tax return, what would be the
potential liability of Payley and Karson?
Problem 5:
Shen and Vetzel, a public accounting firm, were the auditors of South-Western
Development, Inc., a real estate company that owned several shopping centres in
south-western Ontario. It was South-Western’s practice to let each shopping centre
manager negotiate that centre’s leases; they felt that such an arrangement resulted
in much better leases because the local person did the negotiating.
Two of the centres managers were killed in a plane accident returning home from a
company meeting at the head office in Windsor. In both cases, the new managers
appointed to take their places discovered kickback schemes in operation; the
manager had negotiated lower rents than normal in return for kickbacks from the
tenants.
South-Western brought in a new public accounting firm, Jasper & Co., to investigate
the extent of the fraud at those two locations and the possibility of similar frauds at
other centres. Jasper & Co. completed their investigation and found four locations
were involved quite independently of each other and that the total loss over five
years was over $1,000,000.
South-Western sued Shen & Vetzel for negligence for $1,000,000 plus interest.
Required:
What defense would Shen & Vetzel use? What would they have to prove?