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9.401 Auditing. Chapter 4 Legal Liability. Auditors and the Law. Professionals must fulfill implied or express contracts with reasonable level of care Powerful force exerted on auditors, getting stronger Increased volatility, losses, complexity Deep pockets Out of court settlements

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9.401 Auditing

Chapter 4

Legal Liability


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Auditors and the Law

  • Professionals must fulfill implied or express contracts with reasonable level of care

  • Powerful force exerted on auditors, getting stronger

    • Increased volatility, losses, complexity

    • Deep pockets

    • Out of court settlements

    • “expectations gap”


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Expectations Gap

  • Public believes a clean audit opinion means:

    • F/S are free of error

    • No fraud has occurred

    • Business is in sound health

  • Importance of clear audit reports, engagement letters, public education, clear GAAS


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Sources of Auditor Liability

  • Auditors can have liability under:

    • Statutory law

      • Responsibilities under CBCA etc.

    • Contract law

      • Responsibility by virtue of contracts with client

    • Common law

      • Law developed through past court decisions

    • Criminal law

      • Responsibility under Criminal Code of Canada


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Key elements of liability

  • To be successful:

    • Duty of Care

    • Breach of duty

    • Loss

    • Causal link between breach of duty and loss


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Auditor Liability to Clients

  • Generally through contract law.

  • Client generally asserts auditor was negligent in performance of duties


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Defenses against Client Claims

  • Lack of Duty (eg. Review vs. Audit: see next slide)

  • Absence of Misstatement

  • Absence of Negligence

  • Contributory Negligence

  • No damages

  • Absence of Causal Connection


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Audits vs. Review vs. Compilation

  • Progressively lower levels of assurance, less work done by auditor, less responsibility

    • Audit: “f/s present fairly…”

    • Review: “nothing has come to our attention”

    • Compilation: “we do not express an opinion..”


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Liability to Third Parties

  • Liability under common law

  • Most common defense is that there is no duty of care (=lack of privity)


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Are auditors liable?

  • Smith v. London Assurance Corp (1905)

    • first American case involving an auditor : held liable towards their client for failing to audit a branch office as stipulated in the engagement contract and failing to detect an embezzlement

  • Ultramares Corporation v. Touche (1931)

    • if negligence were so great as to constitute gross negligence, might conclude that auditor had engaged in constructive fraud and could be liable to third parties

    • actual fraud = intentional act to deceive, mislead or injure the rights of another person.

    • Auditors not liable for ordinary negligence in USA for the next 35 years


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Due Care to whom?

  • Foss v Harbottle (1842)

    • no duty to financial stakeholders

  • Heaven v. Pender (1883)

    • duty to 3rd parties for physical damage only

  • Ultramares v. Touche (1931)

    • duty to 3rd parties for gross negligence but not ordinary negligence

  • Headley Byrne v. Heller (1964)

    • duty to 3rd party the auditor knows or should know will rely


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Due Care to whom?

  • Haig v. Bamford (1976) and Toromont v. Thorne (1975)

    • duty to known third parties or known limited class of third parties

  • Dupuis v. Pan American Mines (1979)

    • duty to recipients of prospectus

  • Caparo Industries Plc. V. Dickman (1989)

    • duty only to known 3rd parties of sufficient proximity if fair and reasonable


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Recent developments: Auditors Not Legally Liable to Investors, Top Court Rules

  • Hercules Management Ltd v. Ernst and Young

  • An auditor who signs a company's financial statements has no legal liability to shareholders or investors

  • The court’s concern is to protect auditors (for public policy reasons) from unlimited liability to thousands of investors who may use the audit opinion for many different purposes


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Liability to 3 Investors, Top Court Rulesrd parties: Causal Connections

  • Causality may be disproved if:

    • User did not rely on f/s to make decision

    • Event gives rise to loss, not f/s


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Liability to 3 Investors, Top Court Rulesrd parties: Confidentiality

  • Confidentiality may conflict with not associating with false and misleading

    • Consolidata Services v. Alexander Grant(1981) should have maintained confidentiality

    • Fund of Funds v Auther Anderson (1982) should have broken confidentiality to avoid misleading statements

    • Transamerica vs. Dunwoody (1996): auditor was correct in maintaining confidentiality


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Criminal Liability Investors, Top Court Rules

  • Generally rare. Occurs if:

    • Gross negligence

    • Deliberate

  • Proceeds of Crime Legislation:

    • Guilty if auditor accepts property if they know or should know that property was obtained illegally

    • Participating in money laundering is illegal


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Canadian Trends in legal liability Investors, Top Court Rules

  • Ontario Securities Commission interested in increasing auditors liability to shareholders by revising securities legislation

  • Charter of Rights and Freedoms may move the Canadian system closer to the USA

  • Class Action suits allowed in Quebec (1979), Ontario (1993) and British Columbia (1995)

  • Contingency fees for lawyers being considered

  • PA firms are finding it difficult to acquire adequate insurance

  • Limited liability partnerships

  • Proportionate liability


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Is there an auditor liability crisis in Canada? Investors, Top Court Rules

  • Jury trials in USA - Judge in Canada

  • Punitive damages rare in Canada

  • Unsuccessful party must pay 50 to 60 % of the legal fees of the opposing side and other costs in Canada

  • Class actions are rare in Canada

  • nothing comparable to SEC in Canada