AUDITING AND ASSURANCE SERVICES (See attachment) Essay Example

Auditing 9

Auditing and Assurance Services


Question A

The audit firm of King and Queen will not be liable to the finance company Easy Finance Limited (EFL) because the company is a third party, which does not have any business dealings with the audit firm. This comes down to the concept of Privity of contract whereby auditors would be liable for a duty of care to third parties only if there is some privity between them and the non-clients (Campbell & Houghton 2005, p. 20). This implies that before the existence of any liability, there has to be a contract that subsists between the auditor and the third party (Campbell & Houghton 2005, p. 20). For Easy Finance Limited to recover for ordinary negligence, it has to be in privity with King and Queen where the auditors would have the knowledge that the third party (EFL) would rely on the provided audit information. Some specific case references whose rulings have enforced this concept of duty of care and privity of contract. Such ruling can be applied in this case of EFL v King and Queen under judicial precedent or stare decisis.

MAN Nutzfahrzeuge AG v Freightliner Ltd [2005] EWHC 2347

The case involved fabrication of financial information by the financial controller of ERF, which was an affiliate of Freightliner that had been subsequently sold to MAN. He later discovered after the acquisition that ERF was in fact insolvent and sued Freightliner for deceit. Subsequently, Freightliner submitted reports shifting the blame to its external auditors (Ernst & Young) for breaching their duty of care and contributed to the suffered losses. On October 28th, Lord Justice Moore –Bick ruled that the claims of Freightliner went beyond the duties of the auditors and they had no duty of care towards MAN hence not liable for the losses. The claim was dismissed.

Caparo Industries plc v Dickman [1990] 2 AC 605

The facts underlying this case were that Caparo Industry as a public Limited Company acquired shares in Fidelity Company, manufactures electrical equipment and made a successful takeover bid. Caparo claimed that most of the shares were acquired on reliance of Fidelity accounts for the year 31st March 1884. According to the auditors of Fidelity Company, Touche Ross, the accounts were inaccurate as they showed that the Company sold at a profit of 1.3 million in preference to a loss of 0.4 Million. Caparo alleged that they would not have made the bid if the exact financial position of Fidelity Company had been established through the company’s financial statements. The majority of Court of Appeal (O’Connor LJ, Bingham LJ and Taylor LJ) ruled that the auditors had no duty of care towards the shareholders either potential or actual in respect to the corresponding investment decisions. O’Connor used an example of a shareholder and his friend who are looking at account reports and thought that if they had both invested, the friend who does not have previous shareholding will certainly lack any proximate relationship with the negligent auditor.

In another approach, King and Queen will be liable to the finance company if it was brought to their attention that their audited financial statements would be fully relied on by the company before granting any loan or financial services. This is a legal approach that has been overlooked by modern courts and referred to as”near privity”. Under this approach, a third party client may have a standing to sue the auditor notwithstanding the fact that there has not been any formal contract between the auditor and the client (Singleton & Singleton 2010, p.303). However, this was not the case and therefore, cannot form sufficient ground under which King and Queen could be liable. In addition, the company act has introduced Liability Limitation Agreements (LLA) where auditors can now limit the liability they own to clients.

These provisions are found in part 16 of the Companies act which was brought into force on 6th April 2008. The Liability Limitations agreements outline that liability can only be limited to what is “fair and reasonable” even though it does not pin point what exactly may be termed as “fair and reasonable”. A limited liability agreement cannot apply to a period that exceeds more than one financial year of auditing and must therefore specify the specific year with which it relates (Campbell & Houghton 2005, p. 23).

Under the law of torts, an auditor’s liability will arise when it is reasonable that the third party relied on the audited financial information and has a result suffered financial loss or proved the auditor’s negligence. Even when the auditor has not been informed of the particular parties that are most likely to use the audited financial statements, it will be prudent to consider whether this might be the case (Brooks & Dunn 2010, p.453). Where the auditor is aware of the purpose of financial Information and the third parties to whom the information will be shown, the auditor will have a duty of care to that third party.

An example of a similar circumstance would be involvement in production of projections or management accounts for bank presentations to support loan application or any financial services. Easy Finance Limited will therefore have to prove that the auditor was negligent in preparing the financial statements and that they suffered financial loss because of negligence of King and Queen. There are those prior cases whose ruling has been in line with similar principles. These are;

Henderson v Merrett Syndicates Ltd [1995] 2 AC 145;

The case involved the eminent downfall of Lloyd’s in London, which is an insurance market in a period when the effects of hurricanes in America on property holdings were immense. Shareholders were then called upon to indemnify the losses. Litigation followed where the names sued all those who were running the underwriting agents on the grounds of poor misrepresentation and negligently managing the investment funds. The Court ruling established liability on the part of Merrett Syndicate to all shareholders with the existence of foresee-ability to extend the loss likely to be incurred by the third parties. The ruling affirmed that a duty of care may only be established in cases where services are rendered negligently and the plaintiff has suffered a substantial loss as a result (Singleton & Singleton 2010, p.307).

Hedley Byrne & Co Ltd v Heller & Partners Ltd [1964] AC 465

Hedley (the appellants in this case) were an advertising agency that made an advertising contract with Easipower. Hedley was accountable for any amount not remitted by Easipower because they had to pay for all the advertising orders. Hedley become suspicious about Easipower’s financial position and needed to know whether the company would honor its accruals when Hedley makes credit advertisements for them. Easipower’s bank (the defendant) handed over a report that outlined the financial position of Easipower implying that the Company has enough resources to cater for all the ordinary business proceedings. Hedley added more advertising orders for Easipower based on the report the respondents provided. Later on, the Company was not in a position to cover all the accruals with its resources and meant a loss of £17,000. Hedley sued the bank for damages under tort of negligence. However, the court established a duty of care based on the existence of a proximate relationship between the parties in the case. The disclaimer was sufficient to discharge the duty Heller’s actions created. The appeal was dismissed as the respondents did not undertake any duty to uphold care while giving their replies and the appellants could not clearly pin point the actual loss they suffered.

The two cases lay emphasis on tort law, contract law, third party rights and negligence of auditors as stipulated in the Company’s Act. Therefore, Easy Finance Limited may be accorded some form of compensation or hold King and Queens’s audit firm liable only if they can be in a position to prove that the auditors were negligent while preparing financial statements and that they suffered some particular loss which was a result of the auditors negligence (Singleton & Singleton 2010, p.305).

Question B

If EFL had written to the auditors of King and Queen notifying them of their willingness to go ahead and grant a loan to impulse in reliance with the audited financial statements, then this would pose a different contractual relationship. This is because according to section 628 of the companies act, the auditors may be fined or imprisoned for a period not exceeding two years if they make false statements that are known to be false or deliberately omits a material fact (Macmillan 2010, pp. 147-154). Under section 68, the auditors will also be liable if they fraudulently induce financial companies or investors to either invest or lend their money to the company. This is as per the Criminal liability, which is under the statue.

In addition, contract law provides third parties with some rights including the rights to enforce a contract as per their intentions even though the intentions shall be strictly determined from the terms of the contract (Sherer & Turley 2007, p.151 ). Provisions in a contract supporting allocation of certain benefits or implying such terms form a strong basis for establish an intent. This means that third parties have rights to enforce contracts between two parties only if the intention of granting either party some benefit has been outlined in the terms of the contract documents. For this reason, King and Queen will be liable because they are aware of the benefit (Loan) that is to be granted to Impulse Pty Ltd. Before an audit firm enters in any engagement to provide some financial information to any third parties, it should carefully consider its position in light to ethical requirements for statements because its responsibilities to the lender and the client maybe presented with conflict of interest in some circumstances.

For enforcement of a duty of care towards the third parties, the auditors should be fully aware of the fact that the financial information prepared got the attention of the third parties and that the third party would fully rely on that information in contemplation or deciding whether to engage in any transactions (Campbell & Houghton 2005, p. 18). For this reason, lenders have come up with strategies to establish a direct relationship in order to be able utilize information or facts contained in the financial statements prepared for use for legal references. As such, King and Queen would be held liable for the financial statements they may prepare for the purposes of being used by the EFL financial Company. There are those prior cases that have enforced the theoretical aspect of third party rights. An example is;

Re: Kingston Cotton Mills Co. (1896),

In this case, the auditors accepted the manager’s certificate that had vast knowledge in the field of stock trading. The stock was being over estimated in the balance sheet, which meant that dividends were to be paid out from capital. The auditors had not examined the stock books hence failed to compare the opening stock with the sales and purchases in the course of the year. The court ruling established lack of liability on the part of the auditors based on the circumstances surrounding the case, and an auditor cannot be expected to assume the role of a detector or draw suspicion in their work as independent auditors. In addition, auditors should only play the role of a watchdog and blow the whistle whenever they discover financial malpractices in the undertakings of their employer or contractor and as such, cannot be expected to demonstrate care and reason in their activities.

This therefore implies that auditors ought to carry out their work with reasonable skill and care and in accordance with the Generally Accepted Auditing Standards (GAAP). This is an implied term under the contract Law (Macmillan 2010, p. 140). King and Queen will therefore be Liable to Easy Finance Limited (EFL) for acting negligently bearing in mind that their audited financial information will be relied on in granting Impulse Pty Ltd a loan.


American Institute of Certified Public Accountants 1963, Auditing standards and procedures, New York, American Institute of Certified Public Accountants

Brooks, L, J & Dunn, P 2010, Business & professional ethics for directors, executives, & accountants, Cengage Learning, Mason, OH

Campbell, T & Houghton, K, A 2005, Ethics and auditing, ANU E Press, Canberra.

Macmillan, F 2010, International Corporate Law, Volume 1, Hart Pub, Oxford.

Singleton, T & Singleton, A, J 2010, Fraud auditing and forensic accounting, Hoboken, N.J

Tomasic, R, Bottomleys, S & McQueen, 2002 Corporations law in Australia, Sydney, Federation Press.

Sherer, M & Turley, S 2007, Current issues in auditing, Chapman Pub, London.