SECTION THREE

1
SECTION THREE

• Legal Liability

2
The Auditors Legal Liability

• A litigious society
• The cost to accounting firms
• Awareness
• Common law
• Statute law

3
Common Law vs Statute Law

• The main difference
• Common Law
• clients
• third parties
• Statute Law

4
Common Law Liability to Clients

• Clients suit against an auditor, two categories
• Client action can be based upon
• breach of contract
• tort

5

• Is an auditor infallible?

• Errors of judgement and negligence
• innocence
• error of judgement
• negligence
• gross negligence
• fraud
• constructive fraud

6
Burden of Proof

• Auditor accepted duty of care
• Auditor breached duty of care
• Client suffered a loss
• Close causal relationship between 2 3

7
Defenses Used by the Auditor

• Reasonable care and skill
• Clients own negligence
• No causal relationship

8
1136 Tenants v Max Rothenberg and Company (1967)

• Cooperative apartments

• MR engaged to prepare F/S, tax returns, and a
  schedule for real estate taxes

• F/S unaudited

• Tenants sued firm for failure to find fraud

• Manager of management firm was embezzling funds

9

• Two main issues

• 1.
• 2.
• Some auditing procedures were done
• A worksheet was entitled
• Missing Invoices

10
Fund of Funds Limited v Arthur Andersen (1982)

• FF paid King Resources 90M for oil gas reserves

• 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

• FF did not determine this higher profit until
  much later on
• Said that AA had a duty to inform FF or resign

• AA defense was based on the rules of conduct

11
Consolidata Services Inc. v Alexander Grant
Co. (1981)

• CS a payroll company

• AG did tax work
• also recommended CS payroll services to its
  clients

• Meeting between CS and AG showed that CS was
  insolvent

• 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

12
H.E. Kane Agencies v. Coopers Lybrand (1983)

• Kane an agent for a national airline
• Airline supposed to be promptly paid for tickets
• Kanes 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 CL. Said they should have done a year
  end cutoff of sales

• CL claimed they were not obligated to advise on
  business matters
• Judge found CL 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

13
Liability to Third Parties

• Most frequent common law action
• Typical circumstances
• Third party then claims
• Third party must prove same elements previously
  seen

14
Third Party Damage Recovery

• Gross negligence or fraud is straightforward
• Negligence is more complex
• until late 1960s
• only to clients
• privity of contract

15
Ultramares Corp. vs Touche, Niven Co. (1931)

• Ultramares, a finance company is 3rd. party

• Auditors client, Fred Stern borrowed money from
  Ult.

• TN did not know this

• Ult. relied upon Fred Sterns audited F/S

• Stern declared bankruptcy

• Ult. Said that F/S were false and TN were
  negligent

• Court said that F/S were not prepared for the
  express benefit of Ultramares

• Thus TN not negligent

16
Ultramares Doctrine

• If an auditors 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?

17
Hedley Byrne Co. v Heller Partners Ltd. (1963)

• HB received a credit rating from HP, the banker
  of the client

• House of Lords

• Client in serious financial difficulty and
  subsequently could not pay

• HB thus incurred a loss

• 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

18
Gordon T. Haig v Ralph L. Bamford et al.(1976)

• SF needed more funds. Their auditor was RB

• GH approached manager of SEDCO for investment
  advice. SEDCO had already advanced funds to
  Scholler Furniture

• SF told RB they need audited F/S for their bank
  and an unknown investor

• 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

19

• From Haig v. Bamford

• Tests for duty of care to third parties
• Forseeability of the use of the F/S and client
  reliance thereon.
• Actual knowledge of the limited class of F/S
  user.
• Actual knowledge of specific plaintiff using the
  F/S

20
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

• Thus Thorne had prior knowledge

• A TIH partner talked to a Thorne partner about
  this

• Court said F/S did present fairly but that Thorne
  were negligent due to poor audit procedures

• TIH sued Thorne for negligence. Said F/S did not
  present fairly

• 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

21
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.

• Court ruled that auditors were negligent. They
  owed a duty of care to prospective investors

• AD was able to prove reliance on F/S

• Appears to broaden auditors liability

• But not heard at Supreme Court, and did not refer
  to Haig v Bamford

22
Dixon v Deacon,Morgan,McEwan, Easson (1989)

• BC case

• Fraudulent overstatement of sales. Not disclosed
  in F/S

• Dixon purchased 1.2 M in shares of National
  Business Systems Inc.

• Market price went from 12.89 to 3.50

• Dixon sued auditors to recover loss

• Court ruled there was no proximity of
  relationship between investor and shareholder

• Case dismissed

23
Caparo Industries PLC v Dickman (1990)

• House of Lords

• Accounts negligently prepared by Dickman

• Caparo relied upon accounts prepared by Dickman.
  Prepared for management purposes

• Engagement letter showed auditor had a duty of
  care

• House ruled that Caparo could not recover either
  as an investor or shareholder

• 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

24
McGauley et al v British Columbia (1990)

• Depositors in a failed Co-op advanced the claim

• Court ruled that there was no duty owed

• Claimed that auditors should have warned about
  the lack of deposit insurance

• 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

25
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

• Thus auditors knew that debentures could not be
  issued without audited F/S

• Court said SCU was entitled to rely on F/S. A
  duty of care was therefore owed

26
Kripps v Touche Ross et al (1990)

• Investors purchased Victoria Mortgage Corporation
  debentures based on an issued prospectus

• Court concluded that auditors should have been
  aware of the class of persons investing

• VMC Collapsed and investors sued auditors for
  negligent preparation of F/S

• Prospectus needed audited F/S

• Thus duty of care was owed

• This and previous cases Show that the purpose of
  the F/S is crucial to the outcome

27
Hercules Management v Ernst Young (1997)

• HM and others sued EY

• Case dismissed at two Manitoba courts

• Plaintiff argued that

• Supreme Court

• General principle

28
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

29
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

30
United States v Simon (1969)
Continental Vending
Valley Commercial Corp (an affiliate of CV)

• To finance stock market TAs

Mr. Roth, President of Continental Vending

• Not respected in the community
• Had served a jail term

31

• 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

32
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

33
ESM Government Securities v Alexander Grant Co.
(1986)

• Losses from securities trades were concealed by
  intercompany transactions
• Losses gt 300M
• AG partner convicted of being party to the
  concealment

34
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)

35
Liability for Unaudited Statements

• Due care
• How?
• By adherence to standards
• Material error?
• Engagement letter
• 1136 Tenants v Max Rothenberg

36
Preventing Legal Actions

• Areas of high audit risk
• Errors and irregularities
• Supervision
• Initial engagements
• Ethical behaviour

37
Corporate Governance

• Definition
• Use of corporate governance structure
• Monitoring

38

• Parties to corporate governance
• All parties have interest in effective corporate
  performance

39

• Principles
• Rights and equitable treatment of shareholders
• Interests of other stakeholders
• Role and responsibilities of the board
• Integrity and ethical behaviour
• Disclosure and transparency

40

• Mechanisms and controls
• Internal corporate governance controls
• External corporate governance controls

41

• Systemic problems of corporate governance
• Supply of accounting information
• Demand for information
• Monitoring costs

42

• Role of the accountant
• Accountants and auditors
• Accounting firm area of concern
• Enron collapse

43

• Regulation
• Self-Regulation
• Rules versus principles
• Enforcement

44

• Attention to corporate governance
• Issues are receiving greater attention
• High-profile cases
• Widely studied

45
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 nations
capital markets by, among other things,
strengthening corporate accounting controls.
46
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.
47

• 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
  Smalls 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 firms 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.

48

• 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 in-charge accountant. Relying on prior
  experience with the client, the in-charge
  accountant disregarded Sharpes comments, and
  nothing further was done about the exceptions.
• Subsequently, it was learned that one of the
  clients 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.

49

• Problem 3
• In confirming accounts receivable on December
  31, 2001, the auditor found 15 discrepancies
  between the customers 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
  bookkeepers report indicated that the errors
  were caused by timing differences in the client's
  and customers 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
  auditors December 31, 2001, accounts receivable
  working papers, which were subpoenaed by the
  court, indicated that one of the explanations in
  the bookkeepers 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 bookkeepers theft.
• Required
• What are the legal issues involved in this
  situation? What should the auditor use as a
  defence in the event that she is sued?
• What was the public accountants deficiency in
  conducting the audit of accounts receivable?

50

• 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
• Describe the role of Payley and Karson, and
  discuss the apparent conflict on interest in this
  situation.
• 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?

51
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-Westerns practice to let
each shopping centre manager negotiate that
centres 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-Weste
rn 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?