LEGAL LIABILITY SECTION 3 Legal Liability and

LEGAL LIABILITY SECTION 3

Legal Liability and Auditors Responsibilities • Auditors are liable in law for their professional conduct • Failure to exercise due care • Legal liability evolves over time

Common Law • Case law or unwritten law • Auditor may be liable for damages sufferd by clients or third parties

• Four conditions: 1. Legal duty of care 2. Breach of the duty 3. Damages 4. Reasonable proximate connection

Duty of Care • English courts • London and General Bank, 1895 • Must exercise reasonable care and skill • A definition of reasonable care • Where there is nothing to excite suspicion • Where suspicion is aroused

Pacific Acceptance v Forsyth, 1970 • Duty of care still remains • Reasonable skill and care calls for changed standards • Standards more exacting • How did the auditing profession deal with this?

Liability to Clients • If accountant agrees to perform services • An engagement letter • Privity of contract • Auditors Liability for negligence 1. Internal control weaknesses 2. Insufficient reliable audit evidence 3. Too much reliance on management representations

• Types of Action by the client • Breach of contract • A tort action

• Auditor's defences • Lack of duty • Absence of misstatement • Absence of negligence • Contributory negligence • No damages • Absence of causal connection

1136 Tenants Corp v Max Rothenberg & Co, 1971 • TC owned a cooperative apartment house • MR failed to discover an embezzlement of more than $100, 000 • Facts: • TC booked fee as audit expense • MR marked each page of F/S as unaudited • A letter of transmittal with F/S stated: 1. Prepared from books and records. 2. No independent verification taken. • But MR did not disclaim an opinion

• Court found that MR was engaged to perform an audit 1. MR did perform some limited auditing procedures 2. MR included in working papers “missing invoices” • MR ruled negligent • The appellate court affirmed the decision • MR had a duty to inform TC of known wrongdoing • MR worksheets indicted some auditing procedures

Italian Gifts v Dixon (2000) • Review engagement • Did not detect an under remittance of sales taxes with a corresponding over remittance of income taxes • IG claiming damages • Two lower courts rejected the claim 1. No duty owed 2. Nature of the review engagement 3. Bookkeeping function • Ontario Court of Appeal overturned this rejection • Contributory negligence

H. E. Kane Agencies v Coopers & Lybrand, 1983 • A Canadian case on contributory negligence • Facts: • Kane, an agent for a Air Canada • Kane’s son concealed the extension of credit to customers • Airline should have been promptly paid for the tickets • Air Canada eventually caught on to the deception and Kane had to pay $250, 000 representing the outstanding sales • Sued auditor because Kane could not recover from their customers

• Kane said the C&L should have done a year end cutoff of sales • Judge found that auditor did fail to detect the extension of credit • But lack of supervision of the son by Kane

Liability to Third Parties • Individuals who are not party to the contract – Typically include actual and potential shareholders, vendors, creditors, banks • Must prove the same four points • The same defences are also available

Ultramares Corporation v Touche, 1931 • Major influence • Prior to this case, only fraudulent conduct • Facts: • Fred Stern and Company audited by Touche, Niven • Ultramares extended a large loan to Fred Stern • Unknown to Ultramares and Touche, Stern’s balance sheet contained large errors • Stern declared bankruptcy

• Ultramares filed suit against Touche alleging that the accounting firm should have discovered the errors • Fraud charges dismissed • But Touche found negligent • Trial judge reversed the decision • Appellate court reversed the trail judge’s decision • New York court of appeal issued final judgment in favour of Touche • Primary beneficiary

Hedley Byrne & Co. Ltd. v Heller & Partners, 1963 • Established the principle that there could be a liability to third parties • Facts: • HB, an advertising agency, asked for and received a credit rating for one of their clients • • • HP, the bankers of HB, did the credit rating along with a disclaimer Client went into liquidation The Lords indicated that there could be a liability to a third party if the giver of the advice knew or ought to have known that the receiver was going to rely on the advice

Haig v Bamford, 1972 • A key Canadian case • Facts: • Haig wanted to invest funds • Asked advice from the manager of the Saskatchewan Economic Development Corporation (SEDCO) • SEDCO had invested funds in a small manufacturing firm • The small manufacturing firm advised their accountants (Bamford) that they needed audited F/S • Haig advanced funds

• The small manufacturing firm incurred significant loses • Haig advance more funds • The small manufacture intimately wound up • Haig sued Bamford for negligence • Supreme Court ruled that the accountants were negligent • Several possible tests 1. Forseeability of the use of the F/S and the auditor’s report by the plaintiff and reliance thereon. 2. Actual knowledge of the limited class of the user of the F/S. 3. Actual knowledge of the specific plaintiff using the F/S.

Criminal Liability • An allegation of fraud • • • Possibility of civil action Also criminal action An essential element • intent

US v Simon, 1969 • Simon (includes three CPA partners) was the auditor of Continental Vending loans to X Valley Commercial Corporation Y loan to (to finance stock market T/As) X -pledged Y as collateral Mr. Roth President of Continental Vending -not respected in the business community -had served time in jail Y -secured by common stock of Roth

• Misleading footnote 1. Continental’s footnote did not show Roth received the money 2. The nature of the collateral was not disclosed • Defence: • Note in conformity with GAAP • The Court: • Critical test – did the B/S present fairly the financial position • The jury: • Balance sheet did not present fairly • US Court of appeal refused to reverse the decision

Avoidance of Litigation 1. Make a thorough investigation of prospective clients 2. Use engagement letters for all professional services 3. Hire qualified individuals 4. Independence and Objectivity

5. Understand the clients business 6. Comply fully with professional standards 7. Establish and maintain high standards of quality control 8. Exercise caution involving clients in financial difficulty 9. Emphasize quality of service

10. Documentation and evidence 11. Confidential relations 12. Insurance coverage 13. Legal advice

Federal Legislation in Canada • The vast majority of audits are • Canada Business Corporations Act • Section 149 – directors to provide shareholders with F/S within six months of fiscal year end • Section 152 – specifies the contents of the F/S • Section 156 – the size of the companies that require an audit

• Section 156 – the appointment of the auditor • Section 155 – independence • A question of fact • Section 161 – auditors rights and duties • Section 164 – access to client information • Section 44 – CICA Handbook

Legislation in the United States • Why do we look at this? The Securities Act of 1933 • Auditors who express an opinion are liable to nay person purchasing the securities if the F/S contain “an untrue statement of material fact or omitted to state a material fact required to be stated therein”. • Due diligence defence

Escott v Barchris Construction, 1968 • Barchris in continual need of cash • Peat, Marwick, Mitchell & Co. • A registration statement pertaining to bond issue • Performed a subsequent events review (S 1 review) • Barchris declared bankruptcy and the bond purchasers filed suit • Court concluded PMM in accordance with GAAS • But S 1 review was unsatisfactory

The Securities Act of 1934 • Every company whose securities are traded on national markets or over-the-counter is required to file annual and quarterly reports and other information with the SEC • Fund of Funds Limited v Arthur Andersen, 1982 • FF audited by AA • AA did not disclose irregularities to FF when the engagement letter contained specific representation that any irregularities would be revealed • Jury found AA liable for aiding and abetting violation of the security laws and common law fraud for failing to disclose these irregularities

The Foreign Corrupt Practices Act of 1977 • Illegal to offer bribes to foreign officials with the intention of maintaining or increasing business • Also companies must have accurate records and adequate system of internal controls • Alexander Grant & Co. and ESM Government Securities, 1986 • A partner and principle charged with complicity in a scheme to defraud saving and loan institutions and municipalities out of many millions of dollars • ESM collapsed in 1984 • Out of court settlements of $175 million

Corporate Governance • Definition • Use of corporate governance structure • Monitoring

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

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

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

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

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

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

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

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 Small’s 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 firm’s 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.

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

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

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