LEGAL LIABILITY AND QUALITY

CONTROL
 LEARNING OBJECTIVES
• Understand the legal environment for auditors
• Learn the definitions of key legal terms
• Identify the types of litigations against auditor
• Know the auditor’s liability to client under
common law
• Know the auditor’s liability to third parties
under common law
 LEARNING OBJECTIVES
• Understand the conditions for tort of
negligence under common law
• Know the auditor’s legal duties to report
breaches of laws under various statutes
• Identify action to minimise legal liability
• Learn the elements of quality control for audit
and assurance services
 THE LEGAL ENVIRONMENT
• Before 1970s
• After 1970s – exposure of legal systems and
litigious climate, large insurance coverage,
deep pocket theory.
• In 1990s – litigation reform acts were lobbied,
provide limits to auditor liability, more difficult
to sue auditors.
• In 2002 – the collapse of Enron and WorldCom
and by conviction of Arthur Anderson.
 TYPES OF LITIGATION
• Common Law – represents case law developed
over time by judges who issue legal opinions
when deciding a case. The legal principles
announced in these cases become precedent for
judges deciding similar cases in the future.
• Statutory Law – written law enacted by the
legislative arm of the government that establish
certain courses of conduct that must be adhered
to by covered parties.
 TYPES OF LITIGATION
• Under Common Law an auditor can be held
liable to clients for breach of contract,
negligence, gross negligence and fraud.
• Liability to clients – breach of contract
• Liability to clients and third parties -
negligence
 KEY LEGAL TERMS
• Privity of contract
• Breach of contract
• Tort
• Ordinary negligence
• Gross negligence
• Fraud
• Joint and several liability
• Proportionate liability
 LIABILITY TO CLIENTS – BREACH OF
CONTRACT
• When an auditor fails to carry out contractual
arrangements with the client, he may be held
liable for breach of contract and/or negligence.
• The auditor need not to guarantee his work but
need to perform his professional services with
due care.
• Due care standard requires the auditor to
perform his professional services with the same
degree of skill, knowledge, and judgment
possessed by other members of the profession.
 LIABILITY TO CLIENTS AND THIRD
PARTIES-NEGLIGENCE
• If the audit engagement has been performed
without due care, the auditor may be held
liable for an actionable tort in negligence.
• It can be brought by the client or third parties.
 LIABILITY TO CLIENTS AND THIRD
PARTIES-NEGLIGENCE
The plaintiff must prove:
• The auditor owed a duty of care to the
plaintiff
• There is a failure to act in accordance with
that duty of care
• There is causal relationship or connection
between the auditor’s negligence and the
plaintiff damage.
• The plaintiff suffered actual loss or damage.
 DUTY OF CARE
• Arises in situations when a person’s
relationship to another is such that his actions
or omissions could reasonably be expected to
cause injury to the other person.
• In an audit engagement, the auditor always
owes a duty of care to the client.
 DUTY OF CARE TO THIRD PARTIES
• Actions can be brought by non-client third
parties against the auditors for tort in
negligence.
• However, this area of liability is complex, and
court rulings are not always consistent across
different judicial jurisdictions.
• The main difficulty is proving that the
auditor’s duty to exercise due care is extended
to them.
 BREACH OF THE STANDARD OF CARE
• The second condition in a tort of negligence is
to establish that the person who owned the
duty of care has breached the duty of care.
• For a professional person such as an auditor,
the standard of care is that of the reasonable
skill and care of another skilled person
carrying out the same assignment.
 LEGAL STANDARD OF CARE AND
PROFESSIONAL STANDARDS
• The judge’s watchdog analogy in particular, has
often been quoted in cases against the auditors
for failure to detect fraud.
• Current auditing standards require the auditor to
approach his work with professional scepticism.
• Professional scepticism means that the auditor
must maintain an objective and critical
questioning mind and should not assume that
management is either honest or dishonest.
 LEGAL STANDARD OF CARE AND
PROFESSIONAL STANDARDS
• In determining what constitute reasonable
standard of care in particular circumstances, the
court is likely to refer to the professional
standards and the prevalent accounting practice.
• Therefore essential for accountants to regard
professional standards as minimum standards of
performance since failure to adhere to codified
standards would give the court an easier ground
to infer negligence when errors and omissions
occur.
 DUTY TO DETECT FRAUD
• Basically the auditor is not responsible to detect
fraud.
• However, an auditor’s failure to probe to the
bottom when suspicion has been aroused is often
difficult to defend in a case of negligence.
• Similarly, it would be difficult to claim that the
auditor had exercised reasonable skill and care if
the auditor failed to detect fraud as a result of
failure to observe generally accepted auditing
standards.
 CAUSAL RELATIONSHIP OR
CONNECTION
• The third element in the tort of negligence is
the proof of causation or connection between
the plaintiff’s loss and the act of negligence.
• To succeed in their claim, the plaintiffs must
demonstrate that the loss is the consequence
of the breach in the duty of care and at the
time the breach was committed, the loss was
reasonably foreseeable as a consequence.
 DAMAGES
The common types of claims for economic
losses resulted from an auditor’s negligence
include:
• Loss of investment
• Overpayment for investment
• Loss due to defalcation by management or
employees
• Overpayment of dividends
 DUTIES TO REPORT BREACHES OF
LAWS
• Play an action as whistle blower
• Duty to report and not to detect
• Companies Act 1965, Securities Commision
Act 1993, BAFIA 1989, An-Money Laundering
Act 2001,
 APPROACHES TO MINIMISING LEGAL
LIABILITY – professional level
• Establishing stronger auditing and assurance
standards
• Continually updating the code on professional
ethics and sanctioning members who do not
comply with it
• Educating users
 APPROACHES TO MINIMISING LEGAL
LIABILITY – firm level
• Instituting sound quality control and review
procedures
• Ensuring that members of the firm are
independent
• Following sound client acceptance and
retention procedures
• Being alert to risk factors that may result in
lawsuits
• Performing and documenting work diligently.