Business School

Auditing and Assurance

Professional EthicsAuditors Legal Liability

Audit Quality

The University of Sydney Business School

WELCOME ACCT3014 - Auditing and Assurance

Semester 1, 2013

Week 2 LectureThe Professional Auditor

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Multiple Choice1. Which body has a mission ‘to develop, in the public interest, high-quality auditing and

assurance standards and related guidance to enhance the relevance, reliability and timeliness of information provided to users of audit and assurance services’? a. the IAASB. b. the AASB. c. the AUASB. d. the FRC.

2. The term audit expectation gap refers primarily to differences in expectations between:

a. auditors and users of audited financial reports. b. auditors and their clients. c. CPA Australia/ICAA and the ASIC. d. auditors and the ASIC.

3. Investors shift financial responsibility for audited financial information to the auditor in order to lower the expected loss from litigation or related settlements. This describes which theory of auditing?

a. explanatory. b. agency. c. information hypothesis. d. insurance hypothesis.

4. The best test to decide if audits provide good value is:

a. by examining how often audits are associated with company failure b. by examining whether the audit report is correct c. by examining the premium the market places on a share price for independently

audited information d. it is not possible to designate any one test as being the best to decide if audits provide

good value 2

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Lecture Outline• Purpose of the Code of Ethics

• Audit Quality-where does it fit in?

• Legal Liability of Auditorsto clientsto third parties.

• The Auditor and Fraud

Compliments Google Images 28/2/2012

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• makes explicit the values implicitly required• indicates how members should act toward one

another• provides basis for sanctions

Ethics requires knowledge of moral principles, and skills in applying them to problems and decisions. Code of Ethics — formal, systematic statement of rules and principles developed by community to promote its well-being and sanctions for undermining behaviour. Therefore:

Purpose of Code of Ethics

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The Accounting Professional and Ethical Standards Board (APESB)

› Established jointly by CPA Australia and ICAA in late 2005

› APESB members appointed in early 2006

› Issued Standards as at September 2006

› APESB standards currently fall into the following four categories:

› Code of Ethics for Professional Accountants (‘APES 100’ series)

› Professional standards applicable to all members (‘APES 200’ series)

› Professional standards applicable to members in public practice

(‘APES 300’ series)

› Professional standards applicable to members in business (‘APES 400’ series)

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“Code of Ethics for Professional Accountants” (APES 110)

APES 110 was reissued in December 2010, effective from 1 July 2011, to bring it into line with the amended Code of Ethics issued by the International Ethical

Standards Board for Accountants.

Mandatory for all members and failure to observe code can result in disciplinary procedures.

Members are expected to comply with the spirit as well as the letter of the code.

› General Application of the Ethics Code:

Section 100 Introduction and Fundamental Principles Section 110 Integrity Section 120 Objectivity Section 130 Professional Competence and Due Care Section 140 ConfidentialitySection 150 Professional Behaviour

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APES 110: Part A Section 100 - Fundamental Principles

Integrity – to be straightforward and honest in all professional and business relationships

Objectivity – to not allow bias, conflict of interest or undue influence of others to override professional or business judgments.

Professional competence and due care – to maintain professional knowledge and skill at the level required to ensure that a client or employer receives competent Professional Services based on current developments in practice, legislation and techniques and act diligently and in accordance with applicable technical and professional standards.

Confidentiality – to respect the confidentiality of information acquired

Professional behaviour – to comply with relevant laws and regulations and avoid any action that discredits the profession.

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APES 110: Part B – Members in Public Practice

PART B—MEMBERS IN PUBLIC PRACTICE Section 200 IntroductionSection 210 Professional AppointmentSection 220 Conflicts of InterestSection 230 Second OpinionsSection 240 Fees and Other Types of RemunerationSection 250 Marketing Professional ServicesSection 260 Gifts and HospitalitySection 270 Custody of client AssetsSection 280 Objectivity – All Services

Example: Conflicts of Interest 220.1 A Member in Public Practice shall take reasonable steps to identify circumstances that could pose a conflict of interest. Such circumstances may create threats to compliance with the fundamental principles. For example, a threat to objectivity may be created when a Member in Public Practice competes directly with a client or has a joint venture or similar arrangement with a major competitor of a client.

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APES 110 Provision Examples

290.151 In respect of an audit of a Public Interest Entity, an individual shall not be a Key Audit Partner for more than seven years.

After such time, the individual shall not be a member of the Engagement Team or be a Key Audit Partner for the client for two years. .......a Key Audit Partner may remain on the Audit Team for up to one additional year in circumstances where, due to unforeseen events, a required rotation was not possible, as might be the case due to serious illness of the intended Engagement Partner.

290.144 If, during the period covered by the audit report, a member of the Audit Team had served as a Director or Officer of the Audit Client, or was an employee in a position to exert significant influence over the preparation of the client’s accounting records or the Financial Statements on which the Firm will express an Opinion, the threat created would be so significant that no safeguards could reduce the threat to an Acceptable Level. Consequently, such individuals shall not be assigned to the Audit Team.

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Auditing as a ‘Quality Control’ device

› Quality control over the over the ‘quality’ of information reported by management.

› The auditing function provides credibility to the accounts

› Financial reports are ‘fit for purpose’ or serviceable› Fit to use information for decision making

› Audits are a form of testing or checking› What is tested is the ‘result’ or output

› All testing is a form of quality control

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Drivers of Audit Quality?

‘Undertaking a quality audit involves obtaining sufficient and appropriate audit evidence to support the conclusions on which the audit report is based and making objective and

appropriate audit judgements… A quality audit [also] involves appropriate and complete reporting by the auditors which enables the Audit Committee and Board to discharge their

responsibilities.’ (June 2005) UK FRC

The five drivers of audit quality

The culture within an audit firm

The skills and personal qualities of audit partners and staff

The effectiveness of the audit process

Factors outside of the control of auditors

The reliability and usefulness of audit reporting

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Auditors’ Legal Liability

› Who are auditors responsible to? › What is their liability legally?

› There are five ways that an auditor can suffer a legal sanction

- Breaches of the Crimes Act

- Breaches of the Corporations Act

- Breach of contract

- Tort of negligence

- Breaches of the Trade Practices Act

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Terminology

› What is a tort?

› What is reasonable care and skill?

› What are damages?The Australian November 2012:

THE corporate watchdog has issued an enforceable undertaking against the PricewaterhouseCoopers auditor who signed off on shopping centre Centro Property's

error-riddled 2007 accounts. Stephen Cougle, a partner at the accounting firm, will be not allowed to act as an auditor for

the next two and a half years as per the undertaking that was issued by the Australian Securities and Investment Commission (ASIC) today.

The misclassification of billions of dollars of Centro's short-term debt in its 2007 set in train a series of events that left the company teetering on the brink of collapse for nearly five years.

It also led to a class action being brought against the company and PwC over the accounting mistakes and the subsequent loss of investor value, which PwC and

Centro settled for $200 million this year.

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Auditor must exercise reasonable care and skill expected of a professional.

Requires adherence to professional standards in all aspects of an audit.

“The professional man owes a duty to exercise that standard of skill and care appropriate to his professional status” (Caparo, 1990) p217.

Reasonable Care and Skill

"It is the duty of an auditor to bring to bear on the work he has to perform that skill, care and caution which a reasonably careful, cautious auditor would use. What is reasonable skill, care and caution must depend on the particular circumstances of each case. An auditor is not bound to be a detective, or, as was said to approach his work with suspicion, or with a forgone conclusion that there is something wrong. He is a watchdog, not a bloodhound. He is justified in believing tried servants of the company in whom confidence is placed by the company. He is entitled to assume that they are honest and rely upon their representations, provided he takes reasonable care.“

Kingston Cotton Mill Case

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Any conduct which is careless or unintentional in nature and

entails a breach of any contractual duty or duty of care intort owed to another person or persons.

Elements the plaintiff must prove: duty was owed to plaintiff by defendant; a breach of the duty of care (negligent conduct

occurred); loss or damage was suffered by plaintiff and links to the

breach of duty of care; and that a causal relationship existed between breach of

duty by defendant and harm suffered by plaintiff.

Negligence

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Auditor’s Liability

› Two broad categories- Liability to clients- Liability to third parties

› The type of liability is dependent on the legal relationship› A duty of care arises in both contract and tort› The Auditor’s Duty

- Society imposes a duty to exercise reasonable care and skill in two ways:

- Contractual (including statutory) relationship;

- Special relationship between two parties.

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Liability to Clients

› Auditors liability to clients arises generally from failing to perform their duties with due care- Difficulty in establishing appropriate level of due care (reasonable person test?)- Failure to follow prevailing auditing standards has often served as conclusive evidence that level of care is deficient› Liability to clients arises both in contract and in the tort of negligence.- Distinction between the type of action brought is related to the type of remedy sought

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Exposition of auditor’s duties and responsibilities: duty to use reasonable care and skill; duty to check and see for themselves; ASA 500 appropriately supervise and review; ASA 220 properly document procedures; ASA 230 reliance can be placed on internal controls ASA 315; ASA 330 duty to warn and inform appropriate level of management; ASA

260 duty to take further action where suspicion is aroused; ASA 240 expectation of discovering material error or fraud; ASA 240 professional auditing standards provide a guide. (from 1/7/06

have ‘force of law’ status)

Liability to Clients — Pacific Acceptance (expanding on what ‘reasonable care and skill’ means for an auditor)

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More recently - HIHRC

Report of Justice Owen described the auditors duty highlighting:- Fiduciary nature- Auditor to exercise skill and judgement to reach conclusions- Company, users and regulatory bodies rely on integrity of auditors- Auditors have an obligation to maintain high standards of honesty and

probity- Act in the interests of shareholders (to whom they report)- Exercise independence in mind- To ensure financial reports provide a “TRUE and FAIR VIEW” of the

financial position and performance

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History of auditors’ duties

› Auditors duties established:

- London and General Bank (1895) p203 – duty to report to shareholders (not directors) and reasonable care and skill. Duty to be honest and independent!

- Kingston Cotton Mill (1986) p202 – auditor is a “watch-dog, but not a bloodhound” – perform duties with “that skill, care and caution which a reasonably competent, careful and cautious auditor would use”

› Auditors duties extended:

› Thomas Gerrard & Son (1967) – standards of reasonable care and skill “more exacting” in 1967 compared to KCM (1896) – auditors have special skills – change in audit standards may add to the auditors legal liability

› Pacific Acceptance ( see earlier slide No. 18)

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Other duties to clients› Duty to inform management (AUS710)

- AWA (1992) p210 – auditors negligent not to advise board over irregularities relating to forex dealings – this was important as it extended the auditor’s duty to inform to include system deficiencies.

- WA Chip & Pulp Co (1987) – Auditors failed in their duty of care and were negligent in not bringing to the attention of GM loans not properly authorised and relying on verbal assurances from person authorising loans (this case seemed to modify Pacific Acceptance Case by extending duty to non-material irregularities)

› Auditors duty is to clients- Segenhoe (1990) p209 – clarified that the auditors responsibility is also

to client company due to Separate Legal Enitity doctrine- Galoo (1994) p 209– must establish a causal relationship between

negligence and loss (continued trading mgmt decisions)

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Exists where the plaintiff fails to exercise the required standard of care, thus contributing to its own loss. Prior to AWA p210, such a defence by auditors was unsuccessful

AWA — losses suffered by company due to internal control weaknesses over foreign exchange.

Auditor liable for failure to report to board of directors. Company contributed to loss by officers not reporting to board of

directors, and failure to put in place adequate internal control system. Contributory negligence established.

Contributory Negligence — AWA

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Special relationships …

› A duty is owed to any third party to whom the auditor shows accounts, or to whom the auditor knows the client is going to show accounts, so as to induce some action.- Hedley Byrne (1963) p213; established ‘special relationship’ (not audit

case)

- MLC v Evatt (1971) p214; audit case confirmed special relationship – experts – duty of care to those third parties is not to cause economic loss by careless words

- Shaddock & Associates (1979) p214; confirmed ‘reasonable forseeability’

- JEB Fasteners v Marks Bloom & Co (1981) p215; confirmed auditors have a liability to third parties, but circumstances in which it applies are not ‘clear cut’

- Twomax Ltd v Dickson, MacFarlane & Robinson (1983) p215 – confirmed liability on the basis of reasonable forseeability

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Liability to third parties – Landmark case

› Essential elements in negligence actions by third parties› Caparo (1990) p 217– UK case Limited Auditor Liability

- Duty of care to third parties exists when- Foreseeability of damage

- Proximity of relationship AND

- The duty is reasonable

- Caparo also established that the auditor’s duty of care is owed to a general body of shareholders (not individual)

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A number of cases have considered the auditor’s liability in relation to persons other than the immediate client.Must establish a reasonable degree of proximity between third party and auditor.

The current test - Esanda (1997) p 220 (restated limited liability of auditor)whether statement by the auditor was meant to induce thethird party to undertake specific actions

Would be hard to show that audits on general purpose financial reports were ever intended to induce third parties to undertake a specific course of action.

It is now difficult for third parties to sue auditors for negligence.

Liability to Third Parties - Esanda

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Liability to Third Party - Privity› refers to the contractual relationship that exists between two or more contracting

parties – typical auditing relationship › Under the contract only the directors (on behalf of the company) or more

commonly liquidator or receiver can bring an action against the auditor› Third parties now requesting ‘Privity letters’ from auditors to establish reliance on

audit or proximity (guidance AGS 1014.17).

› Real Life Case: June 2012: KPMG was already was in the process of auditing Papel Giftware's 1998 and 1999 financial statements when merger discussions began with Cast Art. KPMG argued, among other things, that Cast Art had not retained KPMG and was not its client,... the Supreme Court found that because Cast Art failed to establish that KPMG either "knew at the time of the engagement by the client," or later agreed Cast Art could rely on its work for Papel in proceeding with the merger, Cast Art failed to satisfy the prerequisites of the law.......on the topic of privity, the legal concept of what parties in a contract owe each other:: "To impose liability for negligence on an auditor in the absence of privity or an equivalent relationship, wrote Justice Cardozo, may expose accountants to a liability in an indeterminate amount for an indeterminate time to an indeterminate class." In brief, the court appeared to believe there was no issue of privity between KPMG and Cast Art.

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Lecture Discussion Questions

1. In his comprehensive judgement in Pacific Acceptance Corporation v Forsyth, Moffit J. set out the duties of the auditor. Briefly outline these duties.

2. Outline the significance of the AWA Limited v Daniels (trading as Deloitte, Haskins and Sells) and others decisions for the auditing profession.

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Other Considerations

Consideration needs to be given to the provisions of the Commonwealth

Trade Practices Act and state Fair Trading Acts:

- Acts prohibit misleading and deceptive conduct.

- It is possible that in issuing an inappropriate audit report, an auditor might be guilty of conduct that is misleading or deceptive.

ASIC Act - enables ASIC to commence proceeding for damages ‘in the public interest’

Criminal Liability

- Auditors can be subject to criminal prosecution.

- It is an offence under s. 1308(2) of Corporations Act to knowingly make or

authorise false and misleading statements. A penalty of $22,000 and/or five

years’ imprisonment exists.

- Criminal actions against auditors are rare.

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Recent changes

› Recent changes now allow:- Imposition of a statutory cap on liability (10 times fee up to

max of $75 million)- auditors to incorporate and form authorised audit companies

with adequate and appropriate professional indemnity insurance.

- apportionment between plaintiff and defendant according to blame, and proportionate liability if there are two or more defendants (contributory negligence and proportionate liability).

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Auditor’s Responsibility for Fraud

› Guidance: ASA 240

- Prevention of fraud is management’s responsibility.

› Auditor has responsibility to:

- Plan so they have reasonable expectation of detecting irregularities;

- Pursue any suspicions further; and

- Report fraud to appropriate level of management, irrespective of materiality to an appropriate level of management when suspicions are aroused.

- Auditor may have a mandatory responsibility to report fraud under the

Corporations Act or the Crimes Act.

- Auditor is protected by qualified privilege when reporting matters in good faith.

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