Question

B. PricewaterhouseCoopers (PwC), the global auditor was facing a class action from bondholders of its collapsed audit client Assess today over allegations of shoddy accounting work by the big four consultancy. (Financial Review, 2020)
Required:

i. Explain In the context of auditors’ liability, the following terms: (6 MARKS )
a. Privity of contract
b. Ordinary negligence
c. Professional indemnity insurance

ii. Differentiate the auditors’ liability under Common Law and Statutory Law.

C. Critically discuss the types of fees that can be charged by auditors as prescribed under
Section 240 of the By-Laws on Professional Ethics.

Answer 1

HISTORICAL PERSPECTIVE: COMMON LAW LIABILITY- ULTRAMARES AND THE PRIVITY BAR

Based on the economic and commercial realities of the audit function and the role of the auditor, several schools of thought have emerged with respect to an accountant's liability as an auditor. Jurisdictions apply one of three rules to determine whether nonclients can sue an auditor for negligently preparing financial statements:

(1) the privity rule, which generally allows only clients to recover;"

(2) the foreseeability approach, which allows any reasonably foreseeable party who relies on the audit to recover and (3) the approach embodied in section 552 of the Restatement (Second) of Torts, allowing only intended beneficiaries to recover, provided that the auditor had knowledge of the intended beneficiaries." While various jurisdictions have followed the privity rule,  relatively few jurisdictions follow the foreseeability approach.The majority of jurisdictions, however, have adopted the Restatement, finding that it strikes an equitable balance between foreseeability and privity.

Historical Background of Privity

The "privity" doctrine developed in England at common law as early as the 1840s when the Court of Exchequer presided over the case of Winterbottom v. Wright. In that case, the defendant had violated a contract to keep a mail coach in repair." The court held that the defendant was not liable to a third party who had suffered injuries caused by the mail coach's latent defects. The court reasoned, "Unless we confine the operation of such contracts as this to the parties who entered into them, the most absurd and outrageous consequences, to which I can see no limit, would ensue.  Because the plaintiff was not in privity of contract with the defendant, the court concluded that no liability existed. From this holding, the general rule of privity developed.

• Privity: CPAs and their clients enter into a contract with an agreement to perform certain services. Liability occurs when there is a breach of contract.This applies to the CPA if they don’t perform what they stated in the engagement letter and the client suffers damages.

b. Negligence: Negligence may be viewed as “failure to exercise due professional care".Both clients and third parties can sue CPAs for the tort of negligence, which is a wrongful act, injury, or damage for which a civil action can be brought. Negligence can be referred to as ordinary negligence and gross negligence. Ordinary negligence is defined as failure of duty in accordance with applicable standards, and gross negligence is the lack of concern for the likelihood that injuries will result.

C. Professional indemnity insurance, often referred to as professional liability insurance or PI insurance, covers legal costs and expenses incurred in your defence, as well as any damages or costs that may be awarded, if you are alleged to have provided inadequate advice, services or designs that cause your client to lose money.

A graphic designer was briefed by their client to provide price tags that would fit round the stem of Christmas trees. The tags would need to withstand exposure to the elements and stay fitted to the tree while it grew. The tags did not survive the test of time; the ink ran, rendering them useless to the client. The client lost money due to this oversight and took legal action against the graphic designer for professional negligence. The graphic designer's professional indemnity insurance policy covered their legal costs and compensation payments to the client, a total cost of over £3,000. The client didn't pursue their claim for the full cost of the labels; if they had, the claim could have cost as much as £100,000.

Ans ii:-

Liability under common law originates from the judgements passed by the jury pertaining to various cases solved. These judgments given on precedent cases will be the base and will be applied to cases that are heard after the precedent judgement is passed, if the facts and circumstances of the latter are similar to the former. These liabilities are generally civil and not criminal in nature.
Liability under statutes arise from statutes/acts imposed by the government. They may be civil or criminal in nature. Auditors are likely to be held for negligence if duty if they do not abide the Generally Accepted Audit Standards or any rules of the statute they are auditing under.

his section is quite dense.

Start with understanding the difference between common-law liability and statutory liability. Common-law liability are legal opinions issued by judges in deciding cases. They become legal precedents & guide other judges in deciding on similar cases in the future. Common law cases are civil cases.

Statutory liability reflects legislation passed at the state or federal level. Can result in either civil liability or criminal liability. Statutory law can be interpreted differently by different people.

Making rulings based on precedent in common law systems is beneficial when the meaning of the law is disputed.

Understand the difference between ordinary negligence, gross negligence & fraud.

Legal concepts of actually foreseen third-party users:   These users are a limited range of individuals or organizations that the client intends the information to benefit. The auditor doesn’t need to know the actual identify of the third party. There is a duty to persons who the professional knows will rely on the information.

Legal concepts of reasonably foreseeable third-party users:   This includes a limited class of potential users that the accountant could reasonably foresee (but may not be known to the auditor at the time) relying on the auditors’ work. Mississippi and Wisconsin are the only two states where this is used.

Legal basis for a cause of action against an auditor

1. CPA accepted a duty of professional care to exercise skill, prudence & diligence;
2. CPA breached his/her duty of due professional care through negligence
3. The client or third party suffered losses
4. The damages were caused by the CPAs negligence

The legal liability of accountants is not limited to auditors. On page 347 your book discusses the 1967 case 1136 Tenants Corp. v. Max Rothenberg & Co. The company was found negligent in doing “write up” work. The importance of engagement letters under SSARS is highlighted after that.

SECTION 240 Fees and Other Types of Remuneration

240.1 When entering into negotiations regarding professional services, a professional accountant in public practice may quote whatever fee deemed to be appropriate. The fact that one professional accountant in public practice may quote a fee lower than another is not in itself unethical. Nevertheless, there may be threats to compliance with the fundamental principles arising from the level of fees quoted. For example, a self-interest threat to professional competence and due care is created if the fee quoted is so low that it may be difficult to perform the engagement in accordance with applicable technical and professional standards for that price.

240.2 The significance of such threats will depend on factors such as the level of fee quoted and the services to which it applies. In view of these potential threats, safeguards should be considered and applied as necessary to eliminate them or reduce them to an acceptable level. Safeguards which may be adopted include: • Making the client aware of the terms of the engagement and, in particular, the basis on which fees are charged and which services are covered by the quoted fee. • Assigning appropriate time and qualified staff to the task.

240.3 Contingent fees are widely used for certain types of non-assurance engagements.1 They may, however, give rise to threats to compliance with the fundamental principles in certain circumstances. They may give rise to a self-interest threat to objectivity. The significance of such threats will depend on factors including: • The nature of the engagement. • The range of possible fee amounts. • The basis for determining the fee. • Whether the outcome or result of the transaction is to be reviewed by an independent third party.

240.4 The significance of such threats should be evaluated and, if they are other than clearly insignificant, safeguards should be considered and applied as necessary to eliminate or reduce them to an acceptable level. Such safeguards may include:

An advance written agreement with the client as to the basis of remuneration. • Disclosure to intended users of the work performed by the professional accountant in public practice and the basis of remuneration. • Quality control policies and procedures. • Review by an objective third party of the work performed by the professional accountant in public practice.

240.5 In certain circumstances, a professional accountant in public practice may receive a referral fee or commission relating to a client. For example, where the professional accountant in public practice does not provide the specific service required, a fee may be received for referring a continuing client to another professional accountant in public practice or other expert. A professional accountant in public practice may receive a commission from a third party (e.g., a software vendor) in connection with the sale of goods or services to a client. Accepting such a referral fee or commission may give rise to self-interest threats to objectivity and professional competence and due care.

240.6 A professional accountant in public practice may also pay a referral fee to obtain a client, for example, where the client continues as a client of another professional accountant in public practice but requires specialist services not offered by the existing accountant. The payment of such a referral fee may also create a self-interest threat to objectivity and professional competence and due care.

240.7 A professional accountant in public practice should not pay or receive a referral fee or commission, unless the professional accountant in public practice has established safeguards to eliminate the threats or reduce them to an acceptable level. Such safeguards may include: • Disclosing to the client any arrangements to pay a referral fee to another professional accountant for the work referred. • Disclosing to the client any arrangements to receive a referral fee for referring the client to another professional accountant in public practice. • Obtaining advance agreement from the client for commission arrangements in connection with the sale by a third party of goods or services to the client.

240.8 A professional accountant in public practice may purchase all or part of another firm on the basis that payments will be made to individuals formerly owning the firm or to their heirs or estates. Such payments are not regarded as commissions or referral fees for the purpose of paragraph 240.5−240.7 above.