Question 3 Auditor\'s Legal Liability 120 marks the external auditor of Kiwi Aus

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Question 3 Auditor's Legal Liability 120 marks the external auditor of Kiwi Australia and owns a chain of duty-free shops. Y listed on the qualified, Tours Ltd, a company which promotes New Zealand tours to auditing the company since it was Australian Securities Exchange 10 years ago. Although the accounts have never been you are aware that the company has been making losses for the past 3 years as a result f short-term cash flow difficultie The company has no long-term loans and the bank overdraft is near its limit at the end of the financial year. During the financial year, the company upgraded its accounting system to a computer database. A consultant was hired to aid in the correct changeover of files for this system At year-end, this new system had been in place for 6 months, and the directors report they are happy with the way it is operating You do not have the expertise to review and evaluate the database management system, so you ask an independent expert to undertake this role. This person concludes that the system appears reliable and that the changeover was correctly carried out. You have never audited this type of system, so ou attend some courses program that you use to test the controls operating within the system In your review of the minutes of the board of directors' meetings, you become aware that the New Zealand parent company (which owns 40 per cent of the shares of the company) is considering making an offer for the remaining shares. This is because the company's share price is trading well to familiarise yourself with its features. Your firm has a standard work ts net asset backing. After your audited 30 June 2009 financial statements are published, the takeover offer from the New Zealand parent company proceeds on the basis of an offer price equivalent to the net asset backing of $1.10 per share (as determined from the financial statements) The takeover results in acceptances of 96 per cent of the issued capital, and compulsory acquisition proceedings have been instituted for the other 4 per cent While these compulsory acquisition proceedings are being instituted, it is discovered that there stores being materially misstated. After the subsequent write-down of inventory, a new asset backing of $0.70 per share is established. The New Zealand parent company is suing you for alleged negligence for its loss of $0.40 per share Required: (a) Decide what major questions must be answered to determine whether you have been negligent. You should support your answer by reference to case law and the auditing standards. (7 marks) the changeover of the computer system, which resulted in inventory at the duty free rro (b) Outline the major issues to be determined to decide whether the company is guilty of contributory negligence. (7 marks) (c) Assuming you were negligent, explain whether you owe a duty of care to the New Zealand parent company. (6 marks) THE END

Explanation / Answer

(a) The key issue in determining whether an auditor has acted with ‘due care’ or not is by looking at decided cases and the relevant professional standards. Cases such as Kingston Cotton Mill and London and General Bank have suggested that the auditor will have exercised due care if he or she exercises the skill and care of a reasonably competent member of the profession. The case of Pacific Acceptance did say that the courts would consider whether the auditor had followed the appropriate professional standards in determining whether he or she had acted with due care. Not complying with the professional standards would probably mean that the auditor had not acted with due care. Complying with the standards may or may not mean that the auditor had acted with due care.

The professional standards to consider in this case are as follows:

ASA 570 Going Concern states that the auditor should obtain sufficient appropriate audit evidence that it is appropriate, based on all reasonably foreseeable circumstances for the financial report to be prepared on a going concern basis.

In this case the onus will be on you to prove that you had reasonable grounds to believe that the company would continue as a going concern. Based on the facts that the company had been making losses for the last three years, had short term cash flow difficulties, and the bank overdraft was nearing its limit it looks as though some reference to going concern problems should have been disclosed.

ASA 315 and ASA 330 require an auditor to obtain an understanding of the control procedures sufficient to assess its effectiveness. This includes the use of information technology.

Although you went to a training course, it does not appear that you had a particularly good knowledge of the controls over the new computer system.

ASA 620 Using the Work of an Expert states that the auditor should assess the appropriateness of the expert’s work as audit evidence.

It does not appear that you have done anything to assess the work performed by the expert.

It appears that there may be a reasonable case of negligence against you for your work on this audit client.

(b) The principle of contributory negligence was introduced to the Australian legal environment by the AWA case (1992). Contributory negligence relates to the failure of the plaintiff to meet certain required standards of care that contribute to bring about the loss in question. In the AWA case the court accepted that the directors have a duty to establish a sound system of internal control to safeguard the company’s assets. Their failure to do so was held to be contributory negligence.

In this case the failure of the Kiwi Tours to implement proper controls over the changeover to its new computer system would be grounds for a claim of contributory negligence.

(c) The key case that is most relevant to the facts of this case is the Caparo case (1990). On appeal to the House of Lords it was found that a duty of care was owed only to third parties that were existing shareholders to whom the auditor knew their report would be sent and relied upon. This approach was recently endorsed by the High Court of Australia in 1997 in the Esanda case.

To owe a duty of care the following would have to be established according to Brennan, CJ, in Esanda Finance (on the appeal to the High Court in 1997):

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