The expectation is that an auditor should be held responsible for the quality of his/her work. This is because a major error or omission by the auditor can result in a false opinion. Auditors have a moral, professional and legal responsibility. In the Companies Act 2006, Section 507 prevents auditors knowingly or recklessly causing an audit report to include any matter that is “misleading, false or deceptive in a material way”. To be proved in cases of civil liability Mr Justice Woolf in the case Lloyd Cheyham v Littlejohn (1985) established the 4 issues of duty of care, negligence, causation and quantum.
The duty of care issue asks whether the defendants owe the plaintiffs a duty of care. The law is built on a series of important cases. The high profile case Caparo Industries plc v Dickman & Others (House of Lords 1990) originated when Caparo, an existing shareholder, made a successful take-over bid for Fidelity. Caparo alleged that the bid was made in reliance of misleading accounts and that if the true facts had been known, it would not have bid. It alleged fraud against the directors (Dickman) and negligence against the auditors (Touche Ross).
However, the House of Lords were unanimous that auditors do not have a duty of care to individual shareholders or future investors. Although, Caparo went on to successfully pursue their action for damages against the directors of Fidelity. Lord Bridge of Harwich said that the auditor owed a duty of care if he/she was fully aware of the nature of the transaction and knew it was likely the plaintiff would rely on it in deciding whether to engage in the transaction.
Thus, auditors owe a duty of care to the company’s shareholders as a group and not individual shareholders in order provide accurate financial information especially when investors are reliant on it to make decisions, but then privity would need to be established. Next is the negligence issue which asks were the defendants negligent in their audit of the accounts. The earliest explanation of negligence is “the omission to do something which a reasonable man would do or doing something which a prudent and reasonable man would not do” (Mr Justice Alderson, 1865).
From the Bolam v Friern Hospital Management committee (1957) it was established that surgeons will not be negligent if they act in accordance with a practice accepted at the time as correct, even if there is a body of professional opinion that adopts a different technique. The surgeon would be negligent if he carried out an operation on a patient, found a cancerous tumour and made no attempt to remove or draw attention towards it. Similarly, a negligent audit would mean the failure to acknowledge or knowingly approve of accounting practice that a reasonable professional would not.
However, E&Y’s acceptance of Lehman’s use of Repo 105 was not negligent as the accounting manoeuvre was legal despite the questionable classification. In the case Lloyd Cheyham v Littlejohn (1985), Mr Justice Woolf said that financial reporting standards “are not rigid rules, they are very strong evidence as to what is the proper standard which should be adopted and a departure will be regarded as constituting a breach of duty. ” A negligent audit can be hard to justify given no strict rulings, but it’s clear that doing something a reasonable auditor would not do under the standards would be and is not to be confused with fraud.
Therefore, company’s can exploit the loopholes in the law due to there not being specific rulings on acceptable practice and had led to high profile cases where inappropriate but legal actions have been taken to represent an untrue financial performance and approved by their auditors. In particular, Enron’s “special purpose entities”, although Andersen was not negligent as they facilitated the fraud. Another issue is the causation issue which asks, if the defendants were negligent, did the plaintiffs suffer loss in consequence because of their reliance on the audited accounts.
The plaintiffs have to prove that the negligent audit caused their losses, because they would not have acted as they did if they had been presented with a true audit report. In the case JEB Fasteners Ltd. v Marks Bloom & Co. (1981) it was found that the auditors owed a duty of care and were negligent. Although, Mr Justice Woolf was of the opinion that JEB Fasteners did not rely on the accounts and that they would have acted in the same way even if the accounts has shown an accurate picture. This view was confirmed by The Appeal Court.
Thus, auditors will be held accountable if plaintiffs suffer due to inaccurate audits, but it can be difficult to prove whether or not they relied on the information to make a decision. The final issue is the quantum issue which asks what the amount of loss suffered by the plaintiffs was. In another case Twomax Ltd and Goode v Dickson et al (1983) the company went into liquidation and the plaintiffs lost their entire investment. The plaintiffs claimed that the accounts were false and misleading and if they had known the true position, they would never have invested.
The plaintiffs were awarded the amount of their investment plus interest at 11% from the investment date. However, auditors can limit their liability by forming a Limited Liability Partnership which reduces personal responsibility for business debts to the disadvantage of the plaintiff when pursuing a case against them. The LLP itself is responsible for any debts that it runs up, not the individual partners, and required to provide financial information equivalent to that of companies.
Limited Liability Agreements were the result of extensive lobbying by the Big Four firms who claimed to face potential extinction as a result of large claims against them. The Companies Act 2006 allows auditors to limit their liability annually, although the amount of such limitation must be fair and reasonable in all the circumstances. Any LLA must be approved by a shareholders resolution and must be disclosed. There is an inverse relationship between the liability limit and audit quality, which is the higher the liability limit, the higher the audit quality.
This is because a higher liability limit means the firm is more confident that the audit quality is good and will not receive legal cases against them due to negligent or fraudulent auditing practice. In conclusion, auditors can be criminally liable if they make false or misleading statements that cause people to invest. There are four issues which must be considered in claims for negligence against auditors. Is a duty of care owed to the plaintiffs by the auditors?
Did the auditors perform a negligent audit through following professional standards? Did the plaintiffs suffer a loss due to reliance on the detective audit reported? How great was the loss caused by the detective audit report? However, auditors benefit from limited liability which reduces their individual responsibility and could hinder the plaintiff’s case when taking the issue to court. In addition, the confidence put in auditors has diminished and made outsiders suspicious of the activities carried out by big firms.