CASE STUDY (5-17, page 125) a. The non-negligent performance defense would work for Azman Yusof & Co. The company followed all the auditing standards. In most circumstances it would not be necessary to physically count all inventory at different locations on the same day. There is no set procedure that states when inventory needs to be counted. For non-negligent performance in an audit, the audit firm claims that the audit was performed in accordance with auditing standards. Even if there were undiscovered misstatements, the auditor is not responsible if the audit was conducted properly. The prudent person concept establishes in law that the audit firm is not expected to be infallible. Similarly, auditing standards make it clear that an audit is subject to limitations and cannot be relied on for complete assurance that all misstatements will be found. Requiring auditors to discover all material misstatements would, in essence, make them insurers or guarantors of the accuracy of the financial statements. The courts do not require that. The contributory negligence would also work. The management that was involved in the cover up went to great lengths to hide their activity. The fraud perpetuated by Diddy was a reasonably complex one and difficult to uncover except by the procedures suggested by Azman Yusof & Co. A defense of contributory negligence exists when the auditor claims the client’s own actions either resulted in the loss that is the basis for damages or interfered with the conduct of the audit in such a way that prevented the auditor from discovering the cause of the loss. Suppose a client claims that an audit firm was negligent in not uncovering an employee’s theft of cash. F the audit firm had notified the client (preferably in writing) of a deficiency in internal control that would have prevented the theft but management did not correct it, the audit firm would have a defense of contributory negligence. Or, suppose an audit firm failed to determine that certain accounts receivable were uncollectible and, in reviewing collectability, the auditors were lie to and given false documents by the credit manager. In this circumstance, assuming the audit of accounts receivable was 1 the auditor can claim a defense of contributory negligence. There is evidence of that through his signed statement. when it came to counting inventory. Even though the bank was known as a third party. b. However. the president of the company also added and contributed to the failure of finding the fraud by not listening to the suggestions of Azman Yusof & Co. Privity once meat that a contract between the third party and auditor was required before any liability could exist. First. There are two defences Azman Yusof & Co. there is a lack of privity of contract. it does not necessarily mean that there is any duty to that party in this situation. That defense is unlikely to be successful in most jurisdictions today. depending on which state law applies. 2 . should use in a suit by First City National Bank. There are three basic approaches to third-party liability. Furthermore. without giving much weight to traditional provity. courts now overlook traditional privity and apply legal approaches referred to as “near privity” as well as other approaches.done in accordance with auditing standards. After the audit report is issued. is more likely to be successful with is more likely to be successful with is that the firm followed auditing standards in the audit of inventory. the auditor knows the bank is the client’s principal lender and is aware of the bank’s reliance on the financial statements. a third party must be in privity or near privity with an auditor to recover for ordinary negligence. The client subsequently goes bankrupt and defaults on the loan. The second defense which Azman Yusof & Co.The first approach is called the privity-of-contract approach. the auditor must be aware that a known third party intended to rely upon the audit information provided to the client for a particular purpose. In such a case. The bank alleges that the auditor failed to communicate about the inadequacy of the client’s internal recordkeeping and inventory control. can argue that they followed all of the auditing standards. 3 . For this to happen. It is because the certified public accounting firm did not uncover the fraud and did not have responsibility for it. particularly the valuation of inventory or accounts receivable. Based on this case. the bank and auditor have direct oral and written communication during the lending period and even meet to discuss the client’s financial statements. Additionally. the bank would have standing to sue the auditor even though there wasn’t a formal contract between the auditor and the bank. Just like with the suit by Diddy. Audits will not always uncover fraud. Ordinarily. including the employment of due care. Under the privity-of-contract approach. The management that was involved in the cover up went to great lengths to hide their activity. Azman Yusof & Co. the bank discovers that the client’s inventory or accounts receivable were overstated. There also has to be conduct by the auditor linking it to a third party’s reliance. it is unreasonable to expect a certified public accounting firm to find such an unusual problem in the course of an ordinary audit. the owners are not viewed as having privity of contract with the auditors. as a “legal person. The company has responsibility for instituting adequate internal controls. The auditor’s best defence is to demonstrate that at least one of the preceding elements is missing. In the case of auditors. The most significant source of liability to auditors. however.” has to claim any damages. for example. an auditor (the first party) owes the client (the second party) a duty of care due to privity of contract. Thus. 4 . there must be a breach in that duty. there must be a reasonably proximate connection between the breach of duty and the resulting damage. only the corporation has privity of contract. The engagement letter is critical in specifying the contractual obligations. Negligence is the failure to perform a duty to a standard of care. there must be proof that damage resulted. There must be a legal duty of care to the plaintiff. shareholders can take action only as third parties. is from these third parties. Most auditor legal liability arises from the law of negligence. a part of the common law known as the law of torts. He is likely to be successful in her defense against the client because of the contributory negligence. The auditor may also argue that the plaintiff contributed to his own loss by. not correcting internal control weaknesses. The president’s statement that it was impractical to count all inventories on the same day because of personnel shortages and customer preferences puts considerable burden on the company for its own loss. The corporation itself. In a contract. Under common law all of the following four elements of negligence must be established by the plaintiff if he is to successfully sue the auditor.c. negligent for the suit to be successful. there is unlikely to be a claim of extreme negligence. In this case.The primary defence against a negligence claim is to offer evidence that the audit had been conducted in accordance with GAAS with due professional care. page 126) 5 . It is unlikely that First City National Bank will be successful in a suit. A good example is a bank. Therefore. Their decision to extend a loan is very often based on considerations quite apart the opinion of the customer’s auditors. The fact that there was not a count for all inventories on the same date is unlikely to be sufficient for a successful suit. Banks usually have available to them not only their customers’ financial statements but a great deal of other information as well. CASE STUDY (5-19. In several Canadian cases. The success of Azman Yusof & Co. it would be required for the court to both ignore the privity of contract precedence and find Azman Yusof & Co.’s defences is also heavily dependent upon the jurisdiction’s attitude about privity of contract. the auditors successfully argued that clients should not have relied on the financial statements to make their decision. The court is likely to conclude that Azman Yusof & Co. followed due care in the performance of his work. Ordinary negligence is the lowest standard of negligence due to auditor failure to conduct “reasonable investigation”. The second one is gross negligence. In practices. Thompson is not being able to recover his loss if he allege and prove the negligence on the part of the auditors. False. because of the complexity of auditing. or oversight. Thompson trying to allege and prove the negligence in term of ordinary negligence on behalf of Wong and Jensen so that he can recover his loss. The first one is ordinary negligence. It is recognised in this case that the audit made by Wong and Jensen has failed to uncover material misstatements and the wrong type of audit opinion based on Regal Jewellery Sdn Bhd’s financial statements. legal precedent makes it difficult to determine who has the right to expect the benefit of an audit and recover losses in the event of an 6 . In cases of audit failure. it is difficult to determine when the auditor has failed to use due care. There was no privity of contract between Thompson and Wong and Jensen. it is unintentional. Negligence is a careless mistake. It is the judgement of errors resulting from a lack of experience. training. tantamount to reckless behaviour that can be expected of a person. So. Gross negligence is lack of even slight care. For auditors. Also. ordinary negligence will usually not be sufficient for a recovery. it is in terms of what other competent auditors would have done in the same situation. In this question. In ordinary negligence cases you should have privity of contract between the auditors and the third party. Ordinary negligence is the absence of reasonable care that can be expected of a person in a set of circumstances. therefore.a. Some states do not distinguish between ordinary and gross negligence. There are two types of terms related to negligence that will affect auditor’s liability. the law often allows parties who suffered losses to recover some or all of the losses caused by the audit failure. Wong and Jensen in term of ordinary negligence. True. b. that ordinary negligence is insufficient for liability to third parties because of the lack of privity of contract between the third party and the auditor. Nevertheless. when appropriate. Wong and Johnson are not liable to the Thompson because Thompson were not their primary beneficiary. commonly called the Ultra-mares doctrine. Negligence is a careless mistake. This case established a precedent.audit failure. primary beneficiary is one about whom the auditor was informed before conducting the audit. the court held that although the auditors were negligent. an auditor’s failure to follow due care often results in liability and. the certified public accountant firm can and probably will be held liable for losses to third parties. In this context. For auditors. damages against the accounting firm. Thompson will be able to recover his loss. Ordinary negligence is the absence of reasonable care that can be expected of a person in a set of circumstances. Thus. unless the third party is a primary beneficiary. which is also known as a third party. The second one is gross negligence. There are two types of terms related to negligence that will affect auditor’s liability. If gross negligence is proven by Thompson on the part of Wong and Jensen. Gross negligence is lack of even slight care. it is in terms of what other competent auditors would have done in the same situation. tantamount to 7 . The first one is ordinary negligence. However. in this case. Even if there were undiscovered misstatements. reporting. Recklessness in the case of an audit is present if the auditor knew an adequate audit was not done but still issued an opinion. Thompson can recover his loss in terms of gross negligence because it is the auditor reckless disregards in establish accounting. Lastly. Wong and Jensen are most likely liable to third parties under common law. The third defense is contributory negligence. In terms of gross negligence. The second defence when they are legal claims by clients is non-negligent performance. The lack of duty to perform the service means that the audit firm claims that there was no implied or expressed contract. not an audit. the fourth defense is absence of causal connection. Thompson trying to allege and prove the negligence in term of constructive fraud or gross negligence on behalf of Wong and Jensen so that he can recover his loss. the auditors.reckless behaviour that can be expected of a person. For non-negligent performance in an audit firm claims that the audit was performed in accordance with auditing standards. The audit firm normally uses one or a combination of four defense when there are legal claims by clients. It is a defense of contributory negligence exists when the auditor claims the client’s own actions either resulted I the loss that is the basis for damages or interfered with the conduct of the audit in such a way that prevented the auditor from covering the cause of the loss. First one is lack of duty to perform the service. They are liable for constructive fraud based on reckless disregard of the truth. the client must be able to show that there is a close 8 . the auditor is not responsible if the audit was conducted properly. Auditing standards make it clear that an audit is subject to limitations and cannot be relied on for complete assurance that all misstatements will be found. To success in an action against the auditor. and auditing standards. The audit firm might claim that misstatement were not uncovered because the firm did a review service. Some states do not distinguish between ordinary and gross negligence. In this question. even though there was no intention of deceiving statement users. which is also known as a third party. There is no privity contract between them. This relationship is necessary in contracts. True. unless the third party is a primary beneficiary. Privity of contract is the relationship that exists between the parties to an agreement. you were both involved in the contract and had an established contractual relationship.causal connection between the auditor’s failure to follow auditing standards and the damages suffered by the client. primary beneficiary is one about whom the auditor was informed before conducting the audit. Thompson does not have a contract with Wong and Jensen. Wong and Johnson are not liable to the Thompson because Thompson were not their primary beneficiary. that ordinary negligence is insufficient for liability to third parties because of the lack of privity of contract between the third party and the auditor. This case established a precedent. If you want to file a lawsuit involving a contract. 9 . commonly called the Ultramares doctrine. you therefore need to show that you and the other person were in privity of contract. In this context. c. In other words. To not be held responsible for the damages defense must show that the auditor exercised a reasonable level of care. These circumstances include car accidents. False. Reasonable care is a term that refers to how a person with an ordinary degree of reason. and medical professional negligence. but another person can still claim you were grossly negligent. social responsibility and/or care would have acted in the same situation. In any negligence situation (whether gross or not). legal malpractice. slip-and-fall cases. Gross negligence is a legal concept which means serious carelessness. they may not have purposely intended on causing harm. The standard of ordinary negligence is what conducts deviates from the proverbial "reasonable person”.d. In fact. The auditor needs to prove that they did not breach a duty. or being careful. Secondly. Victim may claim gross negligence in any case where harm is caused if the victim believes the auditor acted unreasonably. in terms of duty of care. and damages. auditor legal case will have to respond to the four factors such as duty of care. Gross negligence (constructive fraud) is treated as actual fraud in determining who may recover from the certified public accountant. causation. Breaching a duty means failed to exercise reasonable care to avoid injuring someone or damaging property. breach of duty of care. The specifics of auditor’s defense will vary based on the terms of the personal injury lawsuit. Negligence is the opposite of diligence. the auditor must prove they behaved reasonably given the circumstances of the event. 10 . Firstly. breach of duty of care. but refused to 11 . e.Third is causation. emotional and financial losses incurred as a result of the breach of duty. and therefore negligent actions could not have caused the damages. False. Damages are the actual physical. Thompson is an unknown third party and will probably be able to recover damages only in the case of gross negligence or fraud. Lastly are damages. A defense against gross negligence will try to show that auditor should not be held responsible for the damages because they exercised reasonable duty of care. Auditor must prove that they did not breach their duty. Contributory negligence used in legal liability of auditors is a defense used by the auditor when he or she claims the client or user also had a responsibility in the legal case. An example is the claim by the auditor that management knew of the potential for fraud because of weaknesses in internal control. Without an engagement letter. the terms of the engagement are easily disputed. The auditor may also use this as an opportunity to inform the client that the responsibility for the prevention of fraud is that of the client. In recent years some courts have interpreted Ultramares more broadly to allow recovery by third parties if those third parties were known and recognized to be relying upon the work of the professional at the time the professional performed the services (foreseen users or beneficiaries). there is a legal responsibility to pay damages. An engagement letter from the auditor to the client specifies the responsibilities of both parties and states such matters as fee arrangements and deadlines for completion. In some jurisdictions the precedence of Ultramares is still recognized whereas in others there is no significant distinction between liability to third parties and to clients for negligence. The liability to third parties under common law continues in a state of uncertainty. Under 12 . A well-written engagement letter can be useful evidence in the case of a lawsuit. Traditionally the distinction between privity of contract with clients and lack of privity of contract with third parties was essential in common law. usually has the same rights as the party that is privy to the contract. An unknown third party usually has fewer rights. Liability to clients under common law has remained relatively unchanged for many years.correct them. given that the letter spells out the terms of the engagement agreed to by both parties. Others have rejected the Ultramares doctrine entirely and have held the CPA liable to anyone who relies on the CPA’s work. under common law. If a CPA firm breaches an implied or expressed contract with a client. In recent years the auditor's liability to a third party has become affected by whether the party is known or unknown. The lack of privity of contract with third parties meant that third parties would have no rights with respect to auditors except in the case of gross negligence. if that work is performed negligently. The approach followed in most states is the Restatement of Tortsapproach to the foreseen users concept. That precedent was established by the Ultramares case. Now a known third party. The auditor thereby claims that the client contributed to the fraud by not correcting material weaknesses in internal control. however. 13 . foreseen users must be members of a reasonably limited and identifiable group of users that have relied on the CPA’s work. courts have decided that poor judgment doesn’t necessarily prove fraud on the part of the accountant. The differences between the auditor's liability under the securities acts of 1933 and 1934 are because the 1933 act imposes a heavier burden on the auditor. third party users do not have the burden of proof that they relied on the financial statements or that the auditor was negligent or fraudulent in doing the audit. Besides that. They must only prove that the financial statements were misleading or not fairly stated. The liability of auditors under the 1934 act is not as harsh as under the 1933 act. but merely made poor judgments. accountants generally can only be held liable if they intentionally or recklessly misrepresent information intended for third-party use.the Restatement of Torts approach. The principal focus of accountants’ liability under the 1934 act is on Rule 10b-5. Under Rule 10b-5. In conjunction with these third party rights. and the user did not incur the loss because of misleading financial statements. the auditor has a greater burden in that he or she must demonstrate that the statements are not materially misstated. Third party rights as presented in the 1933 act are any third party who purchases securities described in the registration statement may sue the auditor. In recent years. even though those persons were not specifically known to the CPA at the time the work was done. Many lawsuits involving accountants’ liability under Rule 10b-5 have resulted in accountants being liable when they knew all of the relevant facts. an adequate audit was conducted. In this instance. the burden of proof is on third parties to show that they relied on the statements and that the misleading statements were the cause of the loss.