The document discusses the ethical responsibilities and legal liabilities of professional accountants, emphasizing the importance of ethical behavior, integrity, and client relationships. It outlines the professional duties, standards of conduct, and potential threats to auditor independence, as well as the legal implications of negligence and the auditor's duty of care. Key cases and legal interpretations involving auditor liability are analyzed, highlighting evolving standards and the significance of maintaining high ethical standards within the profession.

1. Week 3 Ethics and
auditors' legal liability

2. Concept of a profession
Five attributes of a profession
1. A systematic body of theory
2. Authority
3. Community sanction
4. Ethical codes
5. A culture
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3. Concept of a profession
Professional characteristics:
Mastery of a particular skill
Adherence to a common code
of values and conduct
Acceptance of a duty to society
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4. Concept of a profession
Duties of a profession:
Competence in the field of
expertise
and knowledge
Integrity in client dealings
Objectivity in offering services
Confidentiality
Discipline
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5. Duties of a professional accountant
Duties to sustain a fiduciary relationship:
Behaviour that espouses responsible values.
Attention to requirements of clients and
stakeholders.
Acquire and maintain required skills and
knowledge.
Maintain credible reputation.
Maintain acceptable personal reputation.
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6. Duties of a professional accountant
Values required to carry out duties and maintain
rights includes:
Honesty
Integrity
Exercise of due care
Objectivity
Confidentiality
Competence
Assumes a commitment to put the public, the client,
the profession and employer ahead of any self-interest.
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7. Professional ethics and the accountant
Ethics is concerned with the evaluation of
choices where options are not clear, or where there is
no absolute right or wrong.
Study and practice of ethics are important to
enable an accountant to examine critically a
situation in which there is a conflict of loyalties
and interest.
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8. An understanding of ethics and ethical issues
The word ‘ethics’ is derived from the Greek
word ethos, meaning ‘character’.
Whereas morality focuses on the ‘good’ and
‘bad’ of human behaviour, ethics focuses on
what is ‘right’ and ‘wrong’, and how and why
people act in a certain manner.
Ethics focuses on a study of choices,
standards and behaviour.
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9. An understanding of ethics and ethical issues
The nature of ethics:
Teleology
Deontology
Virtue ethics
Ethical relativism
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10. Professional ethics for accountants
Include standards of behaviour for a
professional person.
Designed for practical and idealistic purposes.
Co-regulation of audit independence and
standard setting.
However, professional ethics has been left in
the hands of the profession.
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11. Code of Ethics for professional accountants
Issued in June 2006 by the Accounting
Professional and Ethical Standards Board
(APESB). Amended in 2011.
Part A – Fundamental principles
Part B - Members in public practice.
Part C – Members in business.
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12. Code of Ethics for professional accountants
Changes from 1 January 2011
Independence requirements extended.
Requirements for members joining public
interest audit clients.
Extending partner rotation.
Provisions regarding non-assurance services.
Pre or post issuance review.
Non-assurance services provided to clients.
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13. Fundamental principles
Public interest is the overriding responsibility
Integrity
Objectivity
Professional competence and due care
Confidentiality
Professional behaviour
For each principal, a conceptual framework is
used to identify possible threats and safeguards.
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14. Types of threats
Self-interest threats may occur as a
result of financial or other interests of a
member, or of an immediate or close
family member.
Self-review threats may occur when a
previous judgement needs to be re-
evaluated by the member responsible for
that judgement.
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15. Types of threats
Advocacy threats may occur when a
member promotes a position of opinion to
the point that subsequent objectivity may
be compromised.
Familiarity threats may occur when,
because of a close relationship, a
member becomes too sympathetic to the
interests of others.
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16. Types of threats
Intimidation threats may occur when a
member may be deterred from acting
objectively by actual or perceived threats.
Public practice behaviour threats may
occur as a result of inappropriate
marketing of professional services and
products.
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17. Safeguards
Safeguards may eliminate or reduce threats
to an acceptable level.
Two broad categories of safeguards:
Safeguards created by the
profession, legislation or regulation.
Safeguards created in the work
environment.
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18. Safeguards: examples
Safeguards created by the profession
legislation or regulation:
Continuing professional development
requirements.
Professional standards.
Corporate governance regulations.
Safeguards created in the work environment:
Leadership and transparency.
Recruitment procedures for high calibre staff.
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22. Liability to shareholders and auditees
In respect of the provision of
auditing services, an auditor is
liable to compensate a plaintiff
if:
a duty of care is owed to the plaintiff
and the audit is negligently performed;
and the plaintiff has suffered a loss as
a result of the auditor’s negligence
(where the causal relationship is
reasonably foreseeable)
and the loss must also be
quantifiable.

23. The following issues, therefore, need
to be considered and each dealt with
separately:
Due care;
Negligence;
Privity of contract;
Causal relationship;
Contributory negligence; and
Damages.

24. The auditor’s duty of care
The development of the concept of due
care, as applied to the performance of an
auditor’s duties, is considered by referring
to cases decided in UK and Australian
courts.
Consideration is also given to the
relevance of the profession’s auditing and
accounting standards.

25. Implications of the Kingston Cotton Mill and the London and
General Bank cases
These two cases have formed the basis for
most subsequent decisions as to the
determination of auditor negligence.
The auditor is not necessarily answerable
for an error of judgement, provided he or
she exercises the skill and care of a
reasonably competent and well-informed
member of the profession.
Nevertheless, a too-literal interpretation of
the Kingston Cotton Mill case has been
criticised as retarding the development of
improved auditing practices.

26. Pacific Acceptance Corporation Ltd v. Forsyth
(1970)
The narrow interpretation of the Kingston
Cotton Mill case concerning some audit
practice was finally laid to rest by the
Pacific Acceptance case.
The Pacific Acceptance case showed the
changing expectations in respect of the
auditor’s responsibility, with the standard
of reasonable care also being raised.
‘Reasonable skill and care’ calls for
changed standards to meet changed
conditions or changed understanding of
dangers, and in this sense standards are
more exacting today than in 1896
(Kingston Cotton Mill case).

27. Due care further emphasised in:
The Royal Commission into HIH
Insurance
‘… auditors have an obligation to
ensure that they are, and are
seen to be, maintaining high
standards of honesty and probity,
acting in the interests of the
shareholders of the company … and
exercising independence of
mind …’
Stanilite Pacific Ltd & Anor v. Seaton
and Ors (2005) (trading as Price
Waterhouse)
the judgement referred to ‘… an
extension of the duty to exercise
reasonable skill and care in giving
consent for their report to be included
in a prospectus …’

28. Negligence
Negligence has been defined as any
conduct that is careless or unintentional in
nature and entails a breach of any
contractual duty or duty of care in tort (that
is, to those who the auditor could
reasonably foresee would rely on the
auditor’s report), owed to another person
or persons.
The auditor’s duty of care to a client thus
arises either in contract or in the tort of
negligence.

29. Subsequent to the Pacific Acceptance
case, the Australian accounting bodies
issued more comprehensive and specific
auditing standards and practice statements
concerning the conduct of the audit.
Disputes may still arise as to whether, in a
specific engagement, an auditor has
complied with the standards and thus has a
good defence against an action for
damages on the grounds of negligence.

30. Privity of
contract
The term privity of contract refers to the
contractual relationship that exists between
two or more contracting parties.
An audit is assumed to be performed in
accordance with professional standards
unless the contract (engagement
letter) contains specific wording to the
contrary.
Under contract, only the directors (on
behalf of the company) or, more commonly,
the liquidator or receiver, may sue the
auditor in respect of losses incurred by the
company arising from the auditor’s
negligence.
Individual shareholders, creditors,
employees etc. have no claim against the
auditor under contract.

31. Causal
relationship
A causal relationship exists between the
breach of duty by the defendant and the
loss or harm suffered by the plaintiff.
1.This relationship must have been
reasonably foreseeable and
2. It must be proven that the loss suffered
is attributable to the negligent conduct of
the auditor in a negligence case.

32. Privity of contract
Segenhoe Ltd v. Akins & Ors (1990)
The court held that where an auditor
has been negligent and the company
has been induced to pay a dividend
out of capital — relying on an
Incorrectly audited profit and loss
account — the auditor is liable
for the loss incurred.
Galoo Ltd v. Bright Graham Murray
(1994)
Reaffirmed the causation relationship
requirement to establish the liability of
the auditor.

33. Contributory negligence
Contributory negligence relates to the failure of
the plaintiff to meet certain required standards
of care.
Together with the defendant’s negligence, it
contributes to bringing about the loss in
question.
The judgement in the AWA case is the landmark
decision on contributory negligence in an
auditor–client relationship.

34. Damages
Where auditors fail in their duty to act with
reasonable care and skill, whether under
contract or in tort, a plaintiff is entitled to
recover any economic loss arising out of
such a breach of duty.
Two issues need to be considered:
Firstly, what is the purpose of
statements that may give rise to
reliance reasonably being placed on
them?
Secondly, to what extent may
responsibility for any loss be
assigned on the one hand to the
auditor’s negligence and, on the other,
to other causes and other parties?

35. Proximity and third party
liability
As a result of the reluctance of professional
indemnity insurers to allow cases to come
to court there are very few decided
Australian (or overseas) cases of
significance involving claims by third
parties against auditors.
Most of these cases involve action being
brought by companies relying on audited
accounts in making a takeover bid for
another company.
Proximity is held to arise through the fact
that where a company’s financial condition
is such that it is a likely takeover target,
auditors should be aware that potential
suitors will rely on the accounts and that a
duty of care thus arises.

36. The House of Lords in the Caparo case argued that the
purpose of the financial statements on which auditors
express an opinion is to assist the shareholders in their
collective function of scrutinising the company’s affairs.
It would be unreasonable, therefore, to hold the auditors
responsible for their use, by shareholders or others, for
any other purpose.
the judgement in the Esanda case was a
positive development for auditors because
the Court rejected the contention that
liability could be based on foreseeability of
reliance alone.
The Court found that there had to be
circumstances establishing a relationship
of proximity between the auditor and the
third party before a duty of care could be
said to exist.

37. Trade Practices
Legislation
Rights for individual investors.
S.52 prohibits misleading and deceptive
conduct and has been used as a basis
for successful actions by investors.