John Mutiso bought shares of Sh.2 million six months ago in Kenya Company Limited which has since gone into liquidation. He intends to sue XYZ & Co. Certified Public Accountants for the imminent loss of Sh. 2 million which he is likely to suffer. XYZ & Co. had audited the Kenya Company Ltd. The previous year and issued an unqualified report. John Mutiso claims that he solely relied on the audit report when he took that investment decision.
a) Do the auditors, XYZ & Co. have any liability to Mr. John Mutiso? (4 marks)
b) What circumstances must Mr. John Mutiso demonstrate if he has to succeed against the auditors? (6 marks)
c) State the measures XYZ & Co. should undertake to minimize potential liability for professional negligence. (10 marks)
(Total: 20 marks)
A shareholder cannot sue the auditor individually if he relied solely on audited financial statements as a basis for investing in a company.
However the auditor could be liable if he knew that his report would be used to make
investment decision ‗Hedley Byrne principle‘
―Third parties entitled to recover damages under this principle are be limited to those who reason of the accountants negligence in preparing reports, accounts or financial statements suffered financial loss and where the accountant knew or ought to have known that the report, accounts or financial statements in question were being reported for specific purpose or transactions which gave rise to the loss or that they will be shown to, and relied upon third parties in that particular connection.
This position was supported the decision In Re: Candler Vs Crank Christmas & Co(UK case)
Candler was induced to invest money in a company on the strength of audited financial statements and subsequently he lost his investment when the company wound up.
Lord Denning stated that, ― accountants owe their duty of course, to their employer or clients and also, I think to any 3rd person to whom they themselves show the accounts or to whom the know their employer is going to show the accounts so as to induce him to invest money or take some action on them. I do not think, however, the duty can be extended still
further so as to include strangers of whom they have heard nothing and to whom their
employer without their knowledge may choose to show the accounts‖
This judgment appears to imply that various users of audited financial statements such as creditors, potential investors e.t.c may not be able to sue the auditor for negligence virtue of their placing reliance on audited financial statements.
Basing on this judicial precedence it appears that John Mutiso cannot successfully sue XYZ certified accountants.
b) Mr. Mutiso must prove that: –
i That XYZ company indeed carried out the audit work negligently
ii That as a direct consequence of XYZ‘s negligence he suffered financial loss
iii That XYZ knew or ought to have known that the accounts will be relied upon for investment decisions John Mutiso i.e prove that XYZ Co. owed him a duty of care.
iv That Mr. Mutiso actually relied on the report. No other external auditors whatsoever influenced his decision making but just that of the audit report.
The auditor should ensure that he is competent enough to carry out the audit assignment in order to be able to carry it out according to the professional standards. He should also ensure that he actually conducts this audit in accordance to the standards set both professional and ethical bodies and in utmost care. By doing so, he will be able to prove that the audit was not carried out negligently.
The audit should be carried out in detail and every aspect of it taken seriously. If the information necessary in one area are unavailable. The auditor should obtain a letter of representation in order to ensure that he makes an informed decision and he can be able to prove so, if the need arises.
The auditor can enter into an agreement with his client that his report should not be used another person apart from the client.
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‖
Taking professional indemnity insurance cover.