Liability of Auditors

Liability of Auditors in the Common Law System – Australian Position 

By Serge Perkovic on 12 November 2020

We briefly examine liabilities of auditors under the Australian Law.

Onus of Proof

 If it is shown that the audited financial statements do not show the true financial condition of the company and that damage has resulted, the onus is upon the auditors to show that this is not the result of any breach of duty on their part. (In re Republic of Bolivia Exploration Syndicate, Limited [1914] 1 Ch 139).

Size of Transaction

 Standard of care is not dependent on value of transaction. In Cook and Another v Green and Others (Unreported, May 2008) (Chancery Division, UK) in defence of claim, the auditors claimed that the degree of care that they exercised in conducting their task was commensurate with the size of the ensuing transaction. The Chancery Division nevertheless rejected that argument on the basis that the standard of care had to be determined by reference to generally applicable auditing standards and not according to the transaction’s value.

Standard of Care

 In most Australian jurisdictions, the standard of care for auditors, like other professionals, will firstly be determined by the Civil Liability Acts

 The section 5O of the Civil Liability Act 2002 (NSW) states:

CIVIL LIABILITY ACT 2002 - SECT 5O

Standard of care for professionals

5O Standard of care for professionals

(1) A person practising a profession  

("a professional" ) does not incur a liability in negligence arising from the provision of a professional service if it is established that the professional acted in a manner that (at the time the service was provided) was widely accepted in Australia by peer professional opinion as competent professional practice.

(2) However, peer professional opinion cannot be relied on for the purposes of this section if the court considers that the opinion is irrational.

(3) The fact that there are differing peer professional opinions widely accepted in Australia concerning a matter does not prevent any one or more (or all) of those opinions being relied on for the purposes of this section.

(4) Peer professional opinion does not have to be universally accepted to be considered widely accepted.

Duties of Auditor can not be Limited by Retainer so to Exclude Common Law and Statutory Obligations

 In  Pacific Acceptance Corporation Ltd v Forsyth & Ors (1970) 92  WN (NSW) 29 at 65–69 Moffitt J examined the basis of the duty owed by the auditors under the terms of the audit engagement which they had signed with the company. The contractual obligation under the terms of the audit engagement may add to the duties owed under the statute but cannot subtract from the obligations owed by the auditor.

 This approach was endorsed in WA Chip & Pulp Co Pty Ltd v Arthur Young & Co (1987) 5 ACLC 1,002 (appeal dismissed in Arthur Young & Co v WA Chip & Pulp Co Pty Ltd (1989) 7 ACLC 496).

Common Law Duties

          Standard of Care   

Auditors must exercise reasonable care and skill. What that requires of an auditor has been examined in great many decisions since the judgment of the Court of Appeal In Re Kingston Cotton Mill Co (No 2) (1896) 2 Ch. 279. where Lopes LJ observed at 289 and 290 that an auditor is a watchdog, but not a bloodhound.

However, his Lordship Pennycuick J pointed out at p 475 in  In Re Thomas Gerrard & Son Ltd (1968) 1 Ch. 455. that the standards of reasonable care and skill are more exacting today than those which prevailed in 1896. 

The “watchdog-bloodhound” analogy made in the Kingston Cotton Mill case may no longer represent the modern standard of care and skill expected of auditors:

a) Moffitt J observed in Pacific Acceptance Corporation v. Forsyth (1970) 92 WN (NSW) 29 at 65): 'If fraud has taken place and is undetected by the auditor he is blameworthy in the eyes of the law [but] only so far as he has been negligent in determining the scope and character of his examination' (see further BGJ Holdings Pty Ltd and Anor v. Touche Ross and Co and Ors (1988) 12 ACLR 481 and WA Chip and Pulp Co Pty Ltd v. Arthur Young and Co (1987) 12 ACLR 25

b) The level of skill expected is not that of a reasonable person but of an expert: Pacific Acceptance Corporation Ltd v Forsyth & Ors (1970) 92 WN (NSW) 29 at 65–69:  “In principle an auditor is really in no different position from any skilled inquirer. To the inquirer in any field to know by direct examination is surer proof than to believe on the hearsay of others or by inference.”

 c) The duty to enquire: the classic formulation cited above (Kiingston                

 Cotton Mill), to extent that it stands for the proposition that the auditor has a relatively passive role in relation to the discovery of fraud or error, and that the auditor is justified in relying on the representations of management, in the absence of suspicion, the classic formulation, no longer represents the duties expected of the modern auditor. To some extent, the views expressed in the classic formulation are also inconsistent with the auditing standards which consistently reinforce the notion that the auditor must approach the audit with a sense of “professional scepticism” (see below under breaches of auditing standards).

d) The audit should be designed to provide a reasonable assurance

that the financial report taken as a whole is free from material misstatement,  whether caused by fraud or error. The process of verification cannot properly be carried out unless the auditor’s procedure takes account of the possibility that the affairs examined  may not be true due to errors innocent or fraudulent. Based on those assessments, the auditor should design substantive procedures to reduce, to an acceptably low level, the risk that misstatements resulting from fraud or error that are material to the financial report, will not be detected.     

e) In relation to the duty to enquire, appropriate audit evidence should be obtained particularly with respect to existence, ownership and valuation of assets     

f) The auditor has a duty to inspect documents: for example, in order to discharge their duty, an auditor must ascertain who are the shareholders upon the register, prior to signing the balance-sheet (The Matlock Old Bath Hydropathic Company (Limited) (Wheatcroft’s case) (1873) 29 LT 324). See also below comments made by Romer J in Equitable Fire Insurance Co Ltd (1925) 1 Ch 407; (1924) All ER Rep 485.

g) The auditor can not delegate his work to an accountant. The auditor has an obligation to undertake an independent evaluation of the company’s records, its financial statements, and various books and records.  In Dominion Freeholders Ltd v Aird (1967) 2 SR (NSW) 150 at 157–158 (followed in Employers Corporate Investments Pty Ltd v Cameron & Ors (1977–1978) CLC ¶40-365), it was stated:

In Pacific Acceptance Corporation Ltd v Forsyth & Ors (1970) 92  WN (NSW) 29 the judgment referred specifically to the need for a written audit program, to undertake samples throughout the year, for the auditor to make sure that the evidence on which he bases his audit is authentic, adequate and independent. This approach reflects the exacting standards of modern auditing and the breach of duty of the auditor for BSF is obvious as there were no undertaken samples through the year, no subsequent events check and no adequate evidence to base the audit obtained, although it was inexpensive and relatively simple to request shares certificates,

Auditing and Accounting Standards

AUASB has issued auditing standards as legislative instruments  under the Corporations Act 2001 (the Act).

 For audits not conducted under the Corporations Act 2001, the auditing standards are enforced by the professional accounting bodies. This is particularly relevant for audits of superannuation funds (and other entities that do not come within the scope of the Corporations Act) as APES 410 “Conformity with Auditing and Assurance Standards”, issued by the Accounting Professional & Ethical Standards Board (APESB),requires members to apply the auditing standards.

Existing non-force of law auditing standards still mandatory.  APES 410 requires that members of the professional bodies continue to mandatorily comply with the former AUASB (non-Force of Law) Standards that have yet to be withdrawn or reissued by the AUASB. This is because “auditing and assurance standards” contained within APES 410 refers to those standards issued by the AUASB which have not yet been revised and reissued (whether as standards or as guidance) by the AUASB, to the extent that they are not inconsistent with the AUASB standards.

 Auditing standards and SIS financial audit and SIS compliance audit:  APRA and the ATO (as Regulators of the superannuation entities) have stated in their guidelines and

instructions for approved auditors that they expect audits to be carried out in accordance with auditing standards. The approved form of audit report issued by APRA and the ATO require the auditor to certify that the audit has been carried out according to those standards.

Causation Concerns

 Breach of the above duties may cause damages directly. 

 It often happens that auditors’  breaches of duty cause their clients  to: lose a chance to take steps to avoid a loss consequent upon the breaches of duty by the financial planners and accountant,  and lose the chance to take remedial action and demonstrate that the chance lost had an economic value. (Hotson v East Berkshire Area Health Authority [1987] 1 AC 750; Malec v JC Hutton Pty Ltd (1990) Aust Torts Reports ¶ 81-022; The Commonwealth of Australia v Amann Aviation Pty Limited (1991) 174 CLR 64). 

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