Auditors may be liable to shareholders and other parties who may have relied on the financial statements upon which the auditors have expressed an opinion. This is because the auditors are generally taken as owing a ―duty of care‖ those parties and they could be liable in the tort of negligence if they failed that duty.
(a) With reference to the external audit assignment, explain the meaning if the term ―duty
of care‖ (4 marks)
(b) Briefly explain the auditors‘ general responsibility. With regard to the prevention and
detection of fraud and errors. (6 marks)
(c) State and briefly explain five possible measures that auditing firms should take in order to avoid legal actions for negligence against them.
a) You are required to explain the meaning of the term “duty of care” in reference to the external audit assignment
What constitutes duty of care is not defined, however we can derive this from decided cases.
According to case law a duty of care exists where there is a special relationship between the parties. (Re: Hedley Byrne)
When carrying out his work the auditor must exercise care and skill. As stated in Re:London and General Bank (UK case). ― An auditor is not bound to do more than exercise reasonable care and skill in making enquiries. He is not an insurer, he does not guarantee that the books do correctly show the true position of the company‘s affairs, he must be honest, he must not certify that he does not believe to be true, and he must take reasonable care and skill before he believes that what he certifies is true‖
In the absence of suspicious circumstances, the auditor would not be liable for failing to uncover fraud and falsities which could not be discovered exercise of normal skill an care. This was stated in Re: City Equitable Fire Insurance (UK case).
From these decided cases the duty of care refers to the responsibility that the auditor assumes towards the client and other third parties whenever they undertake an assignment. The auditor should carry out his work to the best quality standards possible to protect the interest of the parties who have appointed him.
b) You are required to explain the auditors’ general responsibility. With regard to the prevention and detection of fraud and errors.
The responsibility for the prevention and detection of fraud and errors rests with the management of the entity.
The auditor on his part seeks reasonable assurance that fraud or error, which may be material to the financial statements, has not occurred or if it has occurred, the effect is properly reflected in the financial statements. The auditor should plan his work so that he has reasonable expectation of detecting material misstatements in the financial information resulting from fraud and error.
The auditor is and cannot be held responsible for the prevention of fraud and error. However, if the auditor comes across any fraud or error regardless of the materiality he should:
Inform management as soon as possible;
Carry out further procedures to confirm whether the fraud was an isolated case or indicative of others that had taken place;
Evaluate whether the fraud could have an impact on his opinion.
If the error or fraud is material the auditor should consider whether management has adequately disclosed the effect in the financial statements. If there is adequate disclosure there will be no need to modify the opinion. However, if the effect has not been disclosed in the financial statements the auditor should express a qualified opinion as appropriate.
c) You are required to state and briefly explain five possible measures that auditing firms should take in order to avoid legal actions for negligence against them.
The auditor can undertake the following steps to reduce potential liabilities for negligence:
Undertaking measures to ensure that all assignments are performed to the highest quality standards. The auditor should ensure that the requirements of the International Standards on Auditing are adhered to in all assignments;
Proper planning of the audit work to ensure that all potential risks that could affect the financial statements are identified and appropriate audit procedures performed;
Putting in place appropriate quality control policies and procedures and monitoring their effectiveness;
Limit access to his work or reports, where possible;
Include a disclaimer of liability clause in the relevant document or report.
Example of such a clause would be ― while every care has been taken in the preparation of this document, it may contain errors for which we cannot be held responsible‖
When submitting un-audited accounts or other un-audited financial statements (where the auditor prepares accounts on behalf of the client) the auditor should ensure that the purpose for which the statements or reports have been prepared is properly explained on the face of the report.
Obtaining proper terms of engagement such that the auditor‘s roles and responsibilities are clearly laid out and the client understands his role in the engagement.