Solutions Manual Audit and Assurance: 1st Edition

Solutions manual
to accompany
Audit and assurance

1st edition
by
Leung et al.
© John Wiley & Sons Australia, Ltd 2019

Chapter 3: Professional ethics, regulation and liability
Review questions
3.11 How does ethics apply to auditors?
Ethics are concerned with the evaluation of choices where the options are not clear or
where there is no absolute right or wrong answer. The study and practice of ethics are
important to enable accountants to examine critically a situation in which there is a
conflict of loyalties and interests, involving issues that relate to roles and
responsibilities, both as an individual and a professional. The practice of ethical
behaviour requires an understanding of ethical issues, a framework within which a
responsible decision can be made, and awareness of the consequences of such
decisions. Ethics therefore not only encompasses professionalism and the code of
professional conduct which accountants should adhere to, it relates to the numerous
decisions accountants make, as a professionally responsible accountant, safeguarding
the public interest, and the underpinning system which helps the accountant to manage
difficult situations. Ethics consists of moral principles and standards of conduct,
which includes professional and organisational ethics. They include standards of
behaviour for professional accountants and are incorporated into the Code of Ethics
for Professional Accountants (APES110) issued by the Accounting Professional
Ethics Standards Board established by the CPA Australia and The Institute of
Chartered Accountants in Australia.
In regard to auditors, there is an additional requirement that they must also comply
with the Auditing Standards in relation to audit independence, quality control
procedures and ensuring that the audit engagements are carried out objectively.
Auditors are also expected to comply with various requirements of common law
where the duty of care and diligence is applied to their professional services.
© John Wiley & Sons Australia, Ltd 2019 3.2

Solutions manual to accompany Audit and assurance 1e by Leung et al.
3.12 Identify the five types of ethical threats to professional

independence and give a specific example of each.
Threats Examples
Self-interest threats  Financial interests, loans or guarantees such as a
bank account held with the client or a loan to or
from the client
 Incentive schemes entitlements
 Concern over the security of the employment
 Inappropriate personal use of corporate assets
 Commercial pressure from outside the employing
organisation
Self-review threats  Business decisions or data subject to review or

justification by the same person responsible for
the decision such as performing services for the
client that are then assured
Advocacy threats  Commenting publicly on future events where

outcomes are doubtful or information is
incomplete
 Acting publicly as an advocate for a position
where bias may arise such as representing the
client in a legal dispute
 Encouraging others to buy shares or bonds being
sold by the client
.
Familiarity threats  A person who can influence financial or non-
financial reporting decisions having a relationship
with someone who may benefit from the
influence
 Long association with business contacts
influencing decisions
 Acceptance of gifts or preferential treatment
unless the value is clearly insignificant
Intimidation threats  Threats of dismissal or replacement due to

disagreement about an accounting treatment
 A dominant personality attempting to influence
business decisions
 Undue pressure to reduce audit hours to reduce
fees paid

3.13 What are the main ways in which the profession ensures the quality
of audit services?
The main ways include:

 Requiring Continuous Professional Education and development to ensure audit
skills are relevant and up to date;
 Peer review systems such as practice reviews on quality control procedures
within firms;
 Promoting audit research and dissemination of relevant information;
 Requiring compliance of auditing standards and developing relevant auditing
standards and guidelines;
 Ensuring audit independence procedures are practised within firms;
 Developing comprehensive Code of Ethics for Professional Accountants
including Independence guidelines;
 Engaging in Corporate Governance reforms.
3.14 Describe what is meant by independence in mind and independence

in appearance.
Independence of mind relates to the state of mind that permits the expression of a
conclusion without being affected by influences that compromise professional
judgement. It requires the professional accountant to exercise scepticism and act with
integrity and objectivity.
Independence in appearance means avoiding situations and facts that are so significant
that a reasonable person, knowing all relevant facts and having considered the
safeguards in place, would reasonably conclude that a firm’s or a professional
accountant’s integrity and objectivity had been impaired.
3.15 Discuss the safeguards which would eliminate or reduce the threat to
independence created by providing non-assurance services.
The following are safeguards that can be applied:

· Policies and procedures to prohibit professional staff from making
management decisions for the assurance client
· Identifying responsibility for provision of non-assurance services by the firm
· Involving an additional professional accountant to advise on the potential
impact of the non-assurance engagement on the independence of the member
of the assurance team and the firm
· Involving an additional professional accountant to provide assurance on a
discrete matter of the assurance engagement
· Obtaining the assurance client’s acknowledgement of responsibility for the
results of the work performed by the firm
· Making arrangements so that personnel providing non-assurance services do
not participate in the assurance engagement

3.16 Discuss the key factors attributable to the increase in professional

indemnity insurance and the impacts this has had.
Australia is experiencing a hard insurance market, where risk selections by insurers

are tough. This is brought about by many factors, and has raised the professional
indemnity insurance premiums. Factors that have contributed to this phenomenon
include:
 Recent corporate collapses where accountants and auditors were alleged to
have failed leading to substantial law suits;
 Inadequate insurance coverage to meet some of the claims;
 Large excess payments and some areas of self-insurance as a result of gaps in
cover;
 Increasing risk profile of the profession, which is exposed to significant
personal liability of firms;
 Increasing internationalisation of the profession where any negligent claim
against an affiliated firm may impact on the entire group;
 The growth and complexity of multi-disciplinary practices where insurance
coverage for the partnerships are complex.
Impacts of this phenomenon include:
 Auditing firms spending more resources to strengthen their own legal support
system;
· Specialisation in a particular field to maximise competitive advantages and
utilisation of resources;
· Substantial increase in premiums leading to fee increases;
· Lack of availability of appropriate insurance coverage leading to some
structural changes within the firms;
· Larger excess payments and some areas of self-insurance increased.
3.17 How did the key principles of ‘due care’ develop through the
Kingston Cotton Mill Co. case, the London and General Bank case
and the Pacific Acceptance case?
In the Kingston Cotton Mill Co. case the auditors were judged to have exercised their
reasonable care under the circumstances, where management representation was
acceptable and that an auditor is not bound to be a detective to seek out fraudulent
activities. The auditor was said to be a watchdog and not a bloodhound. What is
reasonable skill, care and caution must depend on the particular circumstances of the
case.
In London and General Bank, it was no part of the auditors’ duty to give advice either
to the directors or shareholders as to what they ought to do. He is not an insurer and
he does not guarantee that the books do correctly show the true and fair position of the
company. The auditor must be honest, and must not certify what he does not believe
to be true, and he must take reasonable care and skill before he believes that what he
certifies is true.

In summary
· The auditor does not guarantee the financial report is fairly presented.
· The auditor is only expected to exercise the skill and care of a reasonably
competent and well-informed member of the profession.
· The auditor is not liable for the detection of fraud where his or her suspicion
has not been aroused.
It has been suggested that there has been a too literal interpretation of these cases,
which has retarded the development of the profession of auditing. Such a narrow
view was laid to rest by the Pacific Acceptance case in 1970, which
comprehensively evaluated auditing practices at the time and led to the development
of a number of auditing standards.
The Pacific Acceptance case (1970) is probably the most significant, as it was the first
major case to review auditing under modern concepts with respect to what is
reasonable due care and diligence. The auditor was found to be liable to exercise care
to competently carry out his audit. The judgement has been wide ranging and requires
several matters to be attended to by the auditor.
These include:
 Paying due regard to the possibility of material fraud or error in framing the
audit procedures;
 Promptly report fraud or warn of possibility of fraud;
 Closely supervise and review the work of inexperienced staff;
 Carry out proper objective auditing procedures; and
 Recommendations regarding the standards of auditing to be performed.
The Pacific Acceptance case calls for a changed standard to be met where the
conditions or understanding of dangers is changed. The audit profession has accepted
a change in emphasis in procedures and acknowledged a different approach to the
exercise of due skill and care.
3.18 The Esanda case established the elements that would be necessary
for a third party to succeed in an action of negligence against the
auditor due to reliance on the audited accounts. Identify what these
elements are.
In order for a third party to succeed they would have to establish:

 The report was prepared on the basis that it would be conveyed to a third
party
 The report would be conveyed for a purpose that was likely to be relied on
by that party
 The third party would be likely to act in reliance on that report, thus running
the risk of suffering the loss if the statement was negligently prepared.

3.19 Discuss some of the legal reforms in relation to audit legal liability
have been implemented in Australia?
Following numerous public debate, the federal government’s Treasury Legislation

Amendment (Professional Standards) Bill 2003 was passed by Senate on 24 June
2004.
Thus, the liability reforms supported by the federal, state and territory governments
are:
· A nationally consistent system of PSL
· The replacement of Joint and Several Liability with a national model of
proportionate liability
In practice, PSL allows occupational schemes to be registered, and if approved by the

state government, members of the schemes must comply with certain requirements
including a minimum level of Professional Indemnity insurance cover of $500,000.
The state ministers agreed that any legislation and schemes being developed should be
flexible enough to meet the concerns of large purchasers of professional services.
Subsequently, the New South Wales Professional Standards Act 1994 and the
Victorian Professional Standards Act 2003 (with amendments as at 12 December
2005) were then amended to take into account such flexibility and differences. The
following are the general thrust of these legislations are:
· The occupational association within the schemes include members of
associations that belong to more than one occupational groups, and also
officers and employees of corporations that are members of the occupational
association;
· Limitation caps are calculated with reference to a multiple of fees charged. A
scheme may also specify a multiple, monetary ceiling or minimum cap for the
purposes of the Scheme by way of a formula.
· Conditions of application include that the person has business assets the net
current market value of which is not less than the amount of the monetary
ceiling specified in the Scheme in relation to the class of person and the kind
of work related to the cause of action; and that there is adequate insurance
cover.
· The cap does not apply to liability arising from claims for death, personal
injury or any conduct involving a breach of trust, fraud or dishonesty
(Victoria);
· A minimum cap of $500,000 applies but can vary within and between
occupational groups;
· Risk management strategies must be in place which include Codes of Practice,
Codes of Ethics and Quality Management.
· Members of a professional standards scheme is voluntary but the limitation of
liability must be disclosed to a customer or potential customer.

3.20 What is a privity letter? How should an auditor respond to a request

for a privity letter?
A privity letter is one issued by an auditor, acknowledging a third party’s reliance on

an audited financial report. The purpose of the letter is to establish a relationship with
required foreseeability and proximity and thus a duty of care by the auditor to the third
party. A decision to issue such a letter is an individual business risk and management
decision. Auditors should be cautious when such a letter is requested.

Professional application questions
 BASIC |  MODERATE |  CHALLENGING
3.21 Professionalism 
Brenda Jones is a newly qualified accountant who is carrying out her first audit
as the in-charge auditor for a construction company client that is engaged in a
range of long-term contracts. Brenda has little experience of these types of clients
and the accounting requirements in relation to long-term contracts. John Bull is
the CFO of the client, he is a busy man and has a notorious reputation for being
unfriendly to auditors. You are Brenda’s supervisor and it has become apparent
that she has not got to grips with the accounting issues involved and has avoided
asking the necessary questions of John Bull to gain an understanding of the
company’s transactions and the necessary audit work required to obtain
evidence on the long-term contract transactions.
Required
Explain to Brenda the importance of professionalism, using the Code
of Ethics for Professional Accountants and particularly referring to its
guidance on competence and give advice as to how she should
proceed.
The importance of a profession is evident in its attributes, which include, (1) a

systematic body of theory, (2) authority, (3) community sanction, (4) ethical codes
and (5) culture. It is acknowledged that non-professionals to a lesser degree also
possess these attributes. Professional organisations differentiate themselves by
emphasising the community sanction that they strive so hard to achieve. Professionals
would also claim that they benefit society by their superior performance in fulfilling a
highly competent and sophisticated role.
The accounting professional bodies have implemented a built-in regulatory code to

compel ethical behaviour on the part of its members. The profession would see this
regulatory code as a key way of differentiating itself from other organisations.
Through its ethical code, the profession’s commitment to social welfare becomes a
matter of public interest, thereby helping to ensure the continued confidence of
society. Self-regulatory codes are characteristic of all occupations. However, a
professional code is more explicit, systematic, and binding: it possesses altruistic
overtones and is more public service orientated. The code also provides the principles
of competence and due care, and guidelines where accountants and auditors should
avoid performing tasks, which they are not competent in.
Brenda should be advised that the exercise of due care and diligence is part of the duty
of auditors. Where there are doubts relating to the tasks, she should raise it with her
seniors and seek independent advice if necessary. She should be advised that it is not
uncommon for auditors to consult others. Section 130 of the Code of Ethics for
Professional Accountants (APES110) refers to the requirement to maintain adequate
professional knowledge and technical skills regarding professional competence.

Brenda should take responsibility for making sure that she has the skills necessary to
carry out her work and consult with others and request the necessary training where
there are gaps. I would discuss with her the steps to complete the current audit,
assisting her in establishing steps to complete the necessary audit work and I would
also supervise her closely to ensure that her work is monitored and she has the support
she needs in order to not be afraid to ask questions, seek advice from others and ask
for training to fill her knowledge and skills gaps.
3.22 Conflict of interests 

Your firm, Earnest, Devoid and Couples, has been the auditor for many years of
Barley Gordon Ltd, which operates a large chain of electrical goods retailers
across Australia and New Zealand. The electrical goods retailing business is
dominated by two major players in the market, Barley’s, as they are
affectionately known by the buying public, and Duck Guys Ltd, or Duckies as
they are known.
The market is very competitive with both companies engaged in significant
television advertising, price competition and other marketing activities in order
to gain market share, largely by attracting the customers from the other
company.
You have recently been approached by the CFO of Duckies to carry out its year-
end audit. Duckies was attracted to your firm because of your extensive
experience in the industry.
Required
Explain the safeguards that could be put in place in relation to the
conflict of interest arising from the above.
Barley Gordon Ltd and Duck Guys Ltd should be advised that the firm would be
acting for both parties. It is likely that Duckies is aware of the existing relationship
with Barley’s but this will still need to be formally confirmed. As a part of this
disclosure the companies should be advised to seek independent advice so that they
aware of any implications.
In order to alleviate any worries that sensitive information could be passed from one
company to another the firm can implement the following processes:
 Separate engagement teams for each audit including different engagement

partners, this would include one team member not being allowed to transfer the
other audit team for future audits (a time limit may be set after which a transfer
could be done)
 Maintaining control over security and access to audit files to prevent
information leaking between teams
 Staff training will be required to remind them of their responsibility for
confidentiality, this includes non-disclosure to those within the firm that are
not directly connected with the audit - this may include all staff signing
confidentiality agreements

 These processes should be reviewed annually, before the commencement of

the next year’s audit work, by a senior member of the audit firm not connected
to either client
3.23 Ethical issues 

You are Mark Ouse, an audit senior with the firm Pull, Lift, Tug & Co. You are
planning the financial report audit of Nestree Ltd, a manufacturer of
confectionery. The following issues have arisen:
1. Arthur Stick, the Finance Manager of Nestree, was ill for three months of the
year and Eloise Lift, the engagement partner, received a request from
Nestree to supply a member of staff on secondment until Arthur was well.
Eloise was only too happy to help and Daisy Flute, a member of Pull, Lift,
Tug & Co’s audit staff was seconded to Nestree for three months. Nestree
was happy with this arrangement and Eloise enjoyed the additional fees this
created for the firm. As a result of Daisy’s secondment and the knowledge
she now has about Nestree, Eloise is suggesting that she will be a valuable
member of the audit team for the current financial year’s audit.
2. From the review of the draft financials that Mark has received, Nestree
appears to take an optimistic approach to its valuation of development
expenditure capitalised in intangible assets. Executive remuneration includes
a profit-related bonus.
3. Staff of Nestree are entitled to visit the company shop where defective
confectionery products or ‘seconds’ that do not make it past the company’s
quality control processes are available for purchase at a significant discount
to normal retail prices. Nestree has in the past invited the audit team to enjoy
this benefit while it is attending the company during its audit visit.
4. You are aware that Nestree’s Finance Director, Barbara Polo, plays on the
same softball team as Eloise Lift and recently spent a week with the team on
a tour of Vanuatu.
Required
Explain the ethical threats above and identify how they might be avoided.
1. (a) This is a self-review threat which might compromise the objectivity

and independence of Daisy in her role as an auditor.
(b) The guidelines in APES 110 permit the provision of write-up services
to proprietary company audit clients and, in exceptional circumstances only,
which may be the case here, to public company audit clients. However, it is
important that the service does not require any member of the practice to make
executive decisions on behalf of the client. A fundamental ethical requirement
is that, if Daisy is to be assigned to the job, she must be competent to provide
the required service. It is advised that the firm should have safeguards
regarding its policies to maintain independence.
2. (a) The ethical issue relates to the confidentiality of information acquired

in the course of providing professional services to a client and an intimidation
threat towards independence. It is however required that an auditor should
inform the authorities should there be a breach of the law.

(b) In this situation, there is no direct action that Joyce and Mark could
take and Lola’s action certainly represents a conflict with the client’s interest,
leading to an ethical dilemma. The appropriate course of action would have
been for Lola to draw the matter to the attention of the partners in her firm,
who should attempt to persuade management to take corrective action.
Pressure could be applied by way of requiring that an appropriate contingent
liability for unpaid taxes be disclosed in the interim accounts. As a last resort,
the firm should consider the desirability of continued association with a client
in the light of doubts as to the integrity of management.
3. (a) The ethical issue here is that of whether the preferential treatment
offered to the audit team prejudices the appearance of independence. In APES
110 concerning gifts and preferential treatment, such offerings may create
threats to compliance with the fundamental principles and a familiarity threat
may result in compromising the standards.
(b) The preferential treatment should be considered whether, in the opinion

of a well-informed third party, that the preferential treatment was clearly
insignificant. The significance of the preferential treatment offered should
take into account the nature, value and intent behind the offer. It appears that
the client did not indicate an intent to influence decisions. It would not seem
to fall outside the level of normal social courtesies acceptable. The firm’s
policies regarding gifts and hospitality should be in place in order that Eloise
and her audit team are given the right guidance.
4. (a) This close relationship creates a familiarity threat which might

compromise the objectivity and independence of Eloise in her role as the
engagement partner.
(b) Procedures should be in place to prevent staff being assigned to

assurance clients when they have a close personal relationship with client
personnel. In addition, the audit team should be provided with education
regarding socialising with client personnel.

3.24 Code of Ethics for Professional Accountants 

The following circumstances raise questions about an auditor’s ethical conduct:
1. An auditor accepts an engagement knowing that she does not have the
specialist knowledge required.
2. A public accounting firm states in a newspaper that it has had fewer lawsuits
than its main competitors have had.
3. An auditor discloses confidential information about a client to a successor
auditor.
4. A public accountant pays a commission to a solicitor to obtain a client.
5. A public accountant agrees to be the committee chairperson for a local
fundraising activity.
6. An auditor accepts a Christmas gift from a client.
7. An auditor accepts a commission from an insurance company for
recommending it to one of its audit clients.
8. An auditor has a bank loan with a bank that is an audit client.
9. An auditor retains a client’s records as a means of enforcing payment of an
overdue audit fee.
Required
a. Discuss the fundamental principles of the Code of Ethics for
Professional Accountants in relation to the above.
b. Indicate in each of the above circumstances whether the
effect on professional ethics is (i) a violation; (ii) not a
violation or (iii) indeterminate, and explain.
The fundamental principles of the Code of Ethics for Professional Accountants are:
1.14a Integrity – should be straightforward and honest in all professional and
business relationships
1.14b Objectivity – not allow prejudice or bias, conflict of interest or undue
influence of others to override professional or business judgements.
1.14c Professional Competence and Due Care – a continuing duty to maintain
professional knowledge and skill at the level required of the professional
accountant.
1.14d Confidentiality – should respect the confidentiality of information acquired.
1.14e Professional Behaviour – should comply with relevant laws and regulations
and should avoid any action that discredits the profession.

Effect Rule Reason

1 Violation 1.14c An accountant should only undertake work
that he or she can expect to complete with
professional competence.
2 Indeterminate - Ensure the advertising is truthful and without
naming the competitor. Advertising should be
on the services provided.
3 Violation 1.14d Only when there is no consent from the client.
If client’s consent is obtained, it can be part of
the professional clearance procedures.
4 Violation - Any commission must be disclosed.
Solicitation of client should not normally be
allowed.
5 Not a - Does not constitute incompatible business.
violation
6 Not a - Reasonable courtesy or social commitments
violation can be allowed. Disclosure is required.
7 Not a - Commission should be disclosed. The client’s
violation consent must be in writing and the public
accountant must take care to ensure that the
advice is in the best interests of the client.
8 Not a - Normal course of event allowed. Violation
violation only if the loan is obtained using favourable
terms. (Note: The Corporations Act has a limit
of $5 000 on non-housing loans)
9 Not a - An accountant has a legal right of lien, under
violation certain conditions, over clients’ records in his
custody in the event of non-payment of fees.

3.25 Independence 
You are Margaret String, one of the partners in the accounting firm Bader,
String, Floss & Co. You have a large client, Drench Ltd, for which your firm has
carried out a range of taxation, consultancy, audit and other assurance services.
The firm now obtains significant fee income from Drench. An amount has to be
paid still for work carried out earlier in the year in relation to consulting advice
given to Drench about internal controls around its new purchase ledger system
that was implemented during the year.
The planning work for the year end is about to commence and this will be the
twelfth year that you have carried out the audit. The relationship between
Drench and the audit team is excellent and the same audit staff have been happy
to return to carry out the audit for the last five years, this consistency of staffing
has been welcomed by Drench’s accounting staff who feel this allows the audit to
be done quickly and efficiently.
Drench is very happy with the quality of the audit staff, in fact it recently offered
the role of Financial Controller to the audit team senior, Sally Bring. Sally
accepted and will be starting her new role before the year-end audit visit. Before
she leaves the firm, Sally has decided to take the audit team out for dinner, to say
goodbye and thank it for its work over the last five years.
Required
Identify the risks to independence arising from the above and suggest how these
threats might be mitigated.
Long-term client
Margaret String has been the audit partner for many years and this creates a
familiarity threat where it becomes difficult for the auditor to respond to changes in
the client and adjust the audit approach accordingly. The best way to prevent this is to
change to another audit partner. For listed companies audit partners should rotate after
five years.
Fee levels
High levels of fee income from one client create a reliance on that income and there is
therefore pressure not to do anything to upset the client for fear of losing their fee
income, this creates a self-interest threat and the potential for an intimidation threat.
The firm must monitor fee levels and ensure objectivity is not impaired.
Variety of engagement types

The objectivity of the audit may be impaired where the firm carries out consulting and
other work whilst at the same time auditing the financial report. This is particularly
the case with giving advice on internal controls which will the subsequently be
reviewed at the year-end audit which creates a self-review threat. The types of
engagements should be reviewed to ensure the objectivity is not impaired. One
solution is to have different partners responsible for different types of engagements.
Outstanding fees
The client has some outstanding fees, if these are significant and long overdue this
could be seen as a type of loan from the firm to the company suggesting a self-interest

threat due to financial dependence. The firm should request the payment of the
outstanding fees before the start of the audit.
Celebration dinner
The offer of dinner from Sally could be seen to have an impact on the independence
of the audit team given her new role with Drench. The key consideration is how this
would be perceived by an independent observer. An obvious solution is for the dinner
invite to be declined, an alternative is that the firm pays for a dinner for all staff rather
than just the audit team. Another alternative is to prevent any of those attending the
dinner from being part of the Drench audit, given they have been the audit team for
some years a refreshing of the team would appear to appropriate in any event.

3.26 Due care 

As the audit senior for Lockerparts Hardware Ltd, you are happy with the
smoothness of the audit for the year ended 30 June 2019. Today, your audit
partner tells you that Lockerparts has just gone into liquidation. The financial
controller was diverting company funds into a Swiss bank account and has left
the country to live in Majorca. The lawyers for the creditors of Lockerparts are
taking action against the partner for not performing an appropriate audit. They
believe that a properly conducted audit should have detected such a fraud.
The fraud was substantial; however, it was not material from the company’s
point of view. You explain to the partner that the audit was performed in
accordance with all auditing standards and nothing was found to arouse
suspicion during the audit. The audit took the same amount of time as last year’s,
and all appropriate work steps were performed. Your work was reviewed by a
manager and the entire file was reviewed by the audit partner.
The audit partner is still concerned. He rings an audit partner in an associated
office of your accounting firm and asks her to review the audit file. She agrees
and spends a day reviewing the file. After completing her review, she is satisfied
that the audit was performed properly.
Required
· Explain whether your accounting firm has acted with due care.
What do you think will be the court's decision if the case goes to
trial?
· Even if the partner is convinced he acted with due care, explain
why he may offer Lockerparts a substantial settlement amount.
(a) The key issue in determining whether an auditor has acted with ‘due care’ or not is
done 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
stated 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.
In this case, it appears as though the audit firm has acted with due care. They have
followed all the appropriate work steps and have ensured that the audit was performed
in accordance with Auditing Standards. There has even been a subsequent review by
another audit partner in an associated firm who cleared the audit file.
The key auditing standard in this case that the audit firm should be concerned about is
compliance with ASA 240. That standard requires that the auditor should plan the
audit with an awareness of the possibility of fraud. It also requires that further work
should be performed when there is a suspicion of fraud.
The court’s decision would probably be in favour of the auditor in this case. (Note:
This would be unless the court decided to extend the duties of auditors with respect to
the detection of fraud).

(b) A large number of cases are settled before their ultimate conclusion. The high rate of
settlement before verdicts has encouraged a large number of frivolous claims to be made
against auditors. The reasons for settling include the following:
· litigation tends to be a lengthy and expensive process;
· bad publicity and reputation damage that will arise out of a court decision that goes
against the auditor;
· bad publicity and reputation damage that will arise out of a lengthy legal dispute.
It may make more economic sense to settle with Lockerparts Hardware Ltd.
3.27 Negligence, liability to third parties 

Sonny Manufacturing Ltd sought a $2 million loan from Bank of Australia. The
bank insisted that audited financial statements be submitted before it would
extend the credit. Sonny agreed to do this and also agreed to pay the audit fee.
An audit was performed by an independent qualified accountant who submitted
his report to Sonny to be used solely for the purpose of the loan negotiation with
the bank. The bank, after reviewing the audited financial statements, decided not
to extend the loan to Sonny. The bank had been using some ratios from the
financial statements and decided they were too low. Sonny used the financial
statements to obtain a loan from another financial institution. However, it was
subsequently discovered that the auditor had failed to detect a significant
embezzlement by a senior manager at Sonny.
Required
· What are the liabilities, if any, of the auditor? To whom is the
auditor liable?
· If the auditor did uncover the embezzlement, and noted it in the
notes to the financial statement, is he still liable and to whom?
· What factors should appropriately be considered before the
auditor’s liability is confirmed?
(a) The auditor is only liable when there is a duty of care proven towards the injured
party. In this case, the auditor has knowledge that the financial statements will be
used for the purpose of loan negotiation with the Bank of Australia. It is important to
examine the terms of the engagement and whether the Bank of Australia was named
as the only bank in the negotiations. For the other financial institution which
subsequently lent money to Sonny to establish a cause of action for negligence against
the auditors, it must prove that:
· The auditors owed a legal duty of care to the Financial Institution

· The auditors breached the legal duty by failing to perform the audit with the due
care and competence expected of members.
· The auditor’s failure to detect the embezzlement is directly caused by a failure of
due care proximately caused the damages suffered by the Financial Institution;
· The Financial Institution suffered actual losses or damages.
The facts of this case do not establish that the auditors were negligent by not detecting
the embezzlement, because of its nature. However, the auditors will not be liable to
the Financial Institution for negligence because they owed no duty to them. This is the
case because the auditor was not in privity of contract with them, and the financial

statements were neither audited for the primary benefit of the Financial Institution, nor
was it within a known and intended class of third parties who were to receive the
audited financial statements. Although in the Columbia Coffee & Tea Case
(1992), the New South Wales Supreme Court held that it was not necessary to prove
that the audited financial statements were prepared for the purpose of the plaintiff or
the class of persons intended to rely upon the audit, the Lowe Lippman Figdor &
Frank v. AGC (1992), and Esanda Finance Corp Ltd v. Peat Marwick
Hungerfords (1994) endorsed the decision in the Caparo case that the defendant
did not owe the plaintiff a duty of care.
(b) It may however be stated that the auditor is likely to be liable to the Financial
Institution if it is proven that the audit has been done negligently, or that proper
auditing standards have not been followed. The auditors would have lacked
reasonable ground for the belief that the financial report was fairly presented if they
recklessly departed from standards of due care in that it failed to investigate
embezzlements, having the knowledge. The mere noting in the financial statements
does not necessarily mean the proper discharge of due care. The auditors intended
that others rely on the audited financial report. The Financial Institution justifiably
relied on the audited financial report in deciding to loan Sonny and, if damages
resulted from a negligently prepared financial report, the auditors will be liable.
(c) Factors to be considered before the auditor’s liability is confirmed:

 Establishment of due care to exist between the lender and the auditor,
proximity
 The audit has been negligently performed
 The causal relationship between the auditor’s negligence and the financial
injury.

3.28 Liability to third parties, privity letters 

You have been the auditor of SHF Ltd for several years. The auditor’s report for
the year ended 30 June 2019 was unqualified. In August 2019, SHF obtained a
large loan from a finance company, LRB Ltd, to provide additional working
capital. The company experienced severe trading problems and was placed in
receivership in May 2020.
LRB is taking action against your firm based on the audit of the 30 June 2019
accounts. It claims that the cause of SHF’s failure related to both the inadequate
allowance for doubtful debts and a fall in the value of inventories on hand, and
that these problems were apparent earlier than June 2019, but had not been
adequately dealt with in the financial statements. LRB also claims that it would
not have given the loan to SHF had those accounts been qualified.
Required
(a) Outline your defence against the action taken by LRB. Provide
specific case references to support your answer.
(b) Explain whether you would change your answer to part (a) if LRB
had written to your firm telling you that it intended to make a
loan to SHF and was relying on the audited financial statements
to assist in making its decision.
(a) The defence to the action would be based on reference to a number of cases.
Hedley Byrne & Co Ltd v. Heller and Partners (1963) 2 A11 ER 575.
In this case the principle of proximity was established. According to this principle, to
be liable the auditor, in response to a request for information, should have reasonably
known or ought to have known that the inquirer was relying on him or her.
Caparo Industries Pty Ltd v. Dickman (1990) 1A11 ER 568
This narrowed the reliance on audited accounts to existing shareholders that the
auditors knew their report would be sent and relied upon.
(b) A common reaction to the Caparo case by third parties was to request a letter
from the auditor, in which the auditor acknowledges the user’s reliance on the
audited financial report, thereby establishing the relationship with the required
foreseeability and proximity. Such letters are known as privity or comfort letters.
AGS 1014, Privity Letter Requests, provides guidance to auditors when asked to
provide such a letter. There is currently uncertainty surrounding the legal force of
these requests given the judgement in Esanda. The following is from AGS
1014:
.03 In Australia the common law concerning the nature and extent of an auditor’s
duty of care to third parties remains complex as judgments contain differences
of judicial opinion and interpretation. However, the judgment in Esanda was a
positive development for auditors because the court rejected the contention
that liability could be based on foreseeability of reliance alone. The High
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. This indicates that the auditor has to come into a real
relationship with the third party for liability to arise rather than just knowledge
of the third party’s existence as a theoretical possibility.
.04 However, even after Esanda, it remains difficult to predict exactly what
conduct or circumstance will expose auditors to this risk of undue reliance.
The High Court did not establish a single definitive test since the individual
judgments described various possibilities. The position is also complicated
because third party liability is part of the law of negligence, which is still
evolving. The applicability of the Esanda judgment may also be affected by
the legislation under which the audit is performed, the terms of the audit
engagement and the audit report itself.
In conclusion, it is uncertain whether the answer will change.

3.29 Negligence, liability to third parties 

Newsday Marketing Ltd’s financial statements for the year ended 30 June 2020
were audited by Brian Lung and Partners. The unqualified auditor’s report was
published alongside the directors’ statements on 20 August 2020. Stephen Maine,
a tycoon in the publishing industry, put forward a bid to take over Newsday at
$2.50 per share, based on the net asset value of the audited accounts (which also
showed a net profit for the year of $18 million). The takeover was finalised on 30
September 2020. In October, it was leaked to the press that the financial
statements of Newsday Marketing had excluded a significant legal liability on a
case, for a claim of $5 million. The case was being appealed by Newsday in June
2021. The outcome of the damages claim caused the company’s share price to
plummet. Stephen Maine was extremely annoyed, partly because he had
examined the accounts but overlooked the lawsuit. He decided to sue Brian Lung
for negligence and compensation for not including an estimate for the likely
damages.
Required
Analyse Brian Lung’s legal liability and the likelihood that Stephen
Maine may succeed in the action.
The first issue is whether Brian Lung and Partners were negligent or not. It is difficult
from the facts to determine whether they were or not. We do not have enough
information about the manner in which the audit was conducted. The fact that some
liabilities were not discovered does not mean that they were negligent.
The more pressing issue in this case is whether they have a duty of care to Stephen
Maine. 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):
 The report was prepared on the basis that it would be conveyed to a third party.
 The report would be conveyed for a purpose that was likely to be relied upon
by that third party.
There is no indication that there was any attempt by Stephen Maine to contact the
auditors. It is therefore very unlikely that Maine will win the case. Even if he did
contact the auditors, it would still be unlikely that he would win the case.

3.30 Ethical issues in auditing 

John, a young CPA and one of the audit team members for Moulberg Electrical
Appliances Ltd, has developed very good insights into the company’s systems in
the last 12 months and was asked by his partner, Chandler, to draft a report on
the reliability of the internal control at Moulberg for review. The report is to be
used as a part of a due diligence assurance engagement for Moulberg’s
prospectus. Moulberg wants to be listed on the Australian Securities Exchange
by next June.
In carrying out the review, John finds a number of matters that concern him. He
notices that the controls over inventory requisitions are very poor, leading to
numerous complaints from customers about delays and wrong deliveries, and
cancellations. Moreover, the inventory records do not show the history or the
values of the inventory, so that estimates were used to arrive at the year-end
inventory. He also noticed the poor standard of the appliances, with
manufacturers’ warranties long expired.
John completes his report, with details of the poor internal controls for his
partner’s review. However, his partner replaces his report with a very brief
summary, and a conclusion that the internal control systems are sound and
reliable.
John makes an appointment to see Chandler, but is worried as to how he should
approach him about Moulberg Electrical Appliances’ issues.
Required
Discuss the professional and ethical issues faced by John and
provide an analysis, which can help him deal with the matter with
Chandler.
Professional issues:
· The fact that John reports to Chandler who may have more experience and
knowledge about the client Moulberg Electrical Appliances Ltd. may mean
that John’s conclusion may be based on incomplete information.
· The extent of the firm’s, and John’s liability towards the report on internal
control is dependent on the terms of engagement.
· There is the argument that Chandler is being negligent in concealing the true
situation about internal control, leading to a misleading impression given on
the affairs of the company, which is to be listed.
· John should also satisfy himself with respect to the facts and significance of
the problem and that he should seek to discuss this with Chandler prior to
submission of the report.
Ethical issues:
· John’s loyalty to his supervisor Chandler v. his integrity in ensuring the report
is truthful and not misleading;
· Chandler’s responsibility to the public interest v. his disguise.
· Chandler’s responsibility to ensure that the due diligence report is properly
drawn up v. his desire to maintain the client’s business.
John should review the situation by:

· Ensuring all facts are supported and verified

· Document the weaknesses and consult the client regarding any plans for
improvements
· Consult Chandler
· Identify his choices of action i.e. To proceed with the truthful report, or to
follow Chandler’s action and remain silent, to inform the ASX, or to raise it
with another review partner.
· He should evaluate each course of action by reviewing his duty and other
ethical principles.

Case studies
3.31 Liability to shareholders and the company 

Maxref Ltd is a new dotcom company specialising in online trading in
multimedia items such as DVDs, music, online reports and celebrity
commodities. It has been listed on the Australian Securities Exchange since last
year. As auditor for Maxref’s first year’s financial statements for the year ended
30 June 2020, you note that the accounts show a turnover of about $10 million,
shareholders’ funds of $3 million, and a profit before tax of $ 250 000. During the
course of your audit you discover that the balance of the sales ledger control
account is $500 000 and that about 80 per cent of the accounts receivable are
from new customers who bought items online without full details of the banking
particulars. You further discover that all online transactions were reported and
executed without proper security checks. Moreover, half of the items listed as
stock for sale cannot be located. The share price of the company stands at $1.50.
You raise the issue with the director of Maxref and he tells you that this is not
uncommon with this type of e-business and that he is concerned only that the
Australian Securities Exchange allows it to go on trading. He assures you that
nothing major will happen; an unqualified auditor’s report is all that is
necessary. However, you are worried about your own liability.
Required
Discuss the potential liability of the auditor to:
(a) the shareholders
(b) the company.
You may refer to any relevant case law in your answer.
The auditor is equally liable to the general body of shareholders and the company.
In relation to the annual accounts, the auditor may be guilty of negligence for not
seeking further evidence to substantiate the accounts receivable and inventory. The
auditor is aware of the discrepancies in internal accounting systems in that they are
unreliable in terms of the sales ledge control accounts and the recording of the
inventory for sale. These are major items, which render the financial statements
misleading. As a listed company, the auditor should realise that misleading financial
statements may affect both the company and the shareholders concerned. When the
problem is brought to light, the explanations of management do not provide enough
support for the auditor to express an unqualified report.
In WA Chip & Pulp (1987), it was stated that irrespective of the materiality of the
irregularity, the auditors should report irregularities to management. ASA240 states
that if the auditor suspects irregularities he/she should report it to management
regardless of the materiality of the item. Furthermore, in the Caparo case, the auditor
may find himself liable to the general class of shareholders for a set of negligently
prepared financial reports and for a misleading audit report. The auditor is potentially
liable to both the shareholders and the company for not exercising due care and
diligence in support of his audit opinion, if he remains silent about the discrepancies.

3.32 Negligence, contributory negligence 

You are the external auditor of Kiwi Tours Ltd, a company which promotes New
Zealand tours to Australia and owns a chain of duty-free shops. You have been
auditing the company since it was listed on the Australian Securities Exchange 10
years ago. Although the accounts have never been qualified, you are aware that
the company has been making losses for the past 3 years as a result of short-term
cash flow difficulties. 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 before audited this type of system, so you attend some courses to
familiarise yourself with its features. Your firm has a standard work 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 below its net asset
backing.
After your audited 30 June 2019, financial statements are published, the takeover
offer from the New Zealand parent company proceeds based on 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 were errors in the changeover of the computer system,
which resulted in inventory at the duty-free 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.
(b) Outline the major issues to be determined to decide whether
the company is guilty of contributory negligence.
(c) Assuming you were negligent, explain whether you owe a duty
of care to the New Zealand parent company.
(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):
 The report was prepared on the basis that it would be conveyed to a third party.

 The report would be conveyed for a purpose that was likely to be relied upon
by that third party.

Research questions
3.33 Auditors’ roles and liability

Consult the pronouncements of the Australian professional accounting bodies
and develop an argument whether, in your opinion, the auditor’s role and duties
to safeguard the integrity of financial reports have been maintained through the
extensive range of standards. Can the auditors still be liable for accounting
misstatements and should their liability be limited? What are the business risks
and threats to the auditors that might prevent them from providing the
assurance that is needed?
Students should develop an argument based on their opinion, referring to relevant

sections of the Code of Ethics, NOCLAR, CPA Australia’s Articles of Association
and CAANZ’s Supplemental Royal Charter to support their claims.
There is a growing concern that too often following a business failure and alleged
fraudulent financial reporting, the plaintiffs and their legal representatives prey on the
auditor regardless of degree of fault, simply because the auditor may be the only party
left with sufficient financial resources to indemnify the plaintiffs’ losses. The
requirement to hold a practising certificate imposes an obligation on auditors to carry
professional indemnity insurance for possible liability to their clients and members of
the public. This source of compensation creates a perception that auditors have ‘deep
pockets’ and, arguably, contributes to the extent of claims filed against them. There is
a presumption that the courts, finding this source of compensation to be a means of
spreading loss, are easily influenced by the arguments of the plaintiffs’ solicitors. The
Australian Federal Government and many states have agreed to introduce
Proportionate Liability to replace the application of the common law joint and several
liability. Proportionate liability is where the liability is proportioned amongst all the
concurrent wrongdoers and is limited to the amount of the economic loss attributable
to each party’s wrongdoings. However, 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 breach of duty.
Threats that may prevent auditors providing the level of assurance needed include:
self-interest, self-review, advocacy, familiarity and intimidation. Self-interest threats
may occur as a result of the financial or other interests of a professional accountant or
of an immediate or close family member. Self-review threats may occur when a
previous judgement needs to be re-evaluated by the professional accountant
responsible for that judgement. Advocacy threats may occur when a professional
accountant promotes a position or opinion to the point that subsequent objectivity may
be compromised. Familiarity threats may occur when, because of a close relationship,
a professional accountant becomes too sympathetic to the interests of others.
Intimidation threats may occur when an accountant may be deterred from acting
objectively by threats, actual or perceived.

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Audit and assurance

© John Wiley & Sons Australia, Ltd 2019

Chapter 3: Professional ethics, regulation and liability

3.11 How does ethics apply to auditors?

© John Wiley & Sons Australia, Ltd 2019 3.2

3.12 Identify the five types of ethical threats to professional

Self-review threats  Business decisions or data subject to review or

Advocacy threats  Commenting publicly on future events where

Intimidation threats  Threats of dismissal or replacement due to

© John Wiley & Sons Australia, Ltd 2019 3.3

The main ways include:

3.14 Describe what is meant by independence in mind and independence

The following are safeguards that can be applied:

© John Wiley & Sons Australia, Ltd 2019 3.4

3.16 Discuss the key factors attributable to the increase in professional

Australia is experiencing a hard insurance market, where risk selections by insurers

Impacts of this phenomenon include:

© John Wiley & Sons Australia, Ltd 2019 3.5

In order for a third party to succeed they would have to establish:

© John Wiley & Sons Australia, Ltd 2019 3.6

Following numerous public debate, the federal government’s Treasury Legislation

In practice, PSL allows occupational schemes to be registered, and if approved by the

© John Wiley & Sons Australia, Ltd 2019 3.7

3.20 What is a privity letter? How should an auditor respond to a request

A privity letter is one issued by an auditor, acknowledging a third party’s reliance on

© John Wiley & Sons Australia, Ltd 2019 3.8

Professional application questions

 BASIC |  MODERATE |  CHALLENGING

The importance of a profession is evident in its attributes, which include, (1) a

The accounting professional bodies have implemented a built-in regulatory code to

© John Wiley & Sons Australia, Ltd 2019 3.9

3.22 Conflict of interests 

 Separate engagement teams for each audit including different engagement

© John Wiley & Sons Australia, Ltd 2019 3.10

 These processes should be reviewed annually, before the commencement of

3.23 Ethical issues 

1. (a) This is a self-review threat which might compromise the objectivity

2. (a) The ethical issue relates to the confidentiality of information acquired

© John Wiley & Sons Australia, Ltd 2019 3.11

(b) The preferential treatment should be considered whether, in the opinion

4. (a) This close relationship creates a familiarity threat which might

(b) Procedures should be in place to prevent staff being assigned to

© John Wiley & Sons Australia, Ltd 2019 3.12

3.24 Code of Ethics for Professional Accountants 

© John Wiley & Sons Australia, Ltd 2019 3.13

Effect Rule Reason

© John Wiley & Sons Australia, Ltd 2019 3.14

Variety of engagement types

© John Wiley & Sons Australia, Ltd 2019 3.15

© John Wiley & Sons Australia, Ltd 2019 3.16

3.26 Due care 

© John Wiley & Sons Australia, Ltd 2019 3.17

3.27 Negligence, liability to third parties 

· The auditors owed a legal duty of care to the Financial Institution

© John Wiley & Sons Australia, Ltd 2019 3.18

(c) Factors to be considered before the auditor’s liability is confirmed:

© John Wiley & Sons Australia, Ltd 2019 3.19

3.28 Liability to third parties, privity letters 

Caparo Industries Pty Ltd v. Dickman (1990) 1A11 ER 568

© John Wiley & Sons Australia, Ltd 2019 3.20

© John Wiley & Sons Australia, Ltd 2019 3.21

3.29 Negligence, liability to third parties 