MA506 Business and Company Law: Legal Liability of Audit Firms Report

This report, prepared for the Business and Company Law course (MA506), examines the legal liabilities faced by audit firms. It begins by outlining the auditor's duty of care, as defined by the Corporations Act 2001, and the potential for legal action from clients, third parties, and the government. The report details the circumstances under which an audit firm can be held liable, including breach of contract, negligence, and fraud, referencing relevant case law such as Esanda Finance v Peat Marwick Hungerfords. It then explores factors that limit auditor liability, such as proving a duty of care, breach, and tangible loss. The importance of the engagement letter, particularly the inclusion of exclusion of liability clauses, is highlighted, along with the benefits of operating as a limited liability partnership. The report concludes by emphasizing the need for auditors to exercise professional due care, while acknowledging that legal implications can be minimized through a strong understanding of the relevant laws and proactive risk management strategies.

Running Head: Legal Liability; Audit Firms 1
Business and Company Law: Legal Liability of Audit (Partnership Firms).
Student’s Name
Institutional Affiliation

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The duty of ensuring that financial items are presented fairly and accordingly is
entrusted upon the auditors, as stated in s336 of Corporations Act (2001). Due professional
care requires that the auditing task be carried out by one who possesses the standard auditing
skills, and that care and diligence be applied in the approach of the task, as illustrated
Moroney, Campbell and Hamilton (2012). This paper will be advice on the legal risks that an
audit firm could suffer and the potential solutions to avoid liability.
The auditing reports and statements could be relied upon by the clients, the
government and third parties and they are, therefore, the sources of legal risks. The client
could sue for breach of a contract that existed between him and the auditor. Salzedo and
Singla (2016) stated that the third party could sue for negligence and the failure of the auditor
to notice a misguided statement in the audit reports. In the case of Re Lowe Lippmann Figdor
& Franck (1992) it was held that auditors do not owe a duty of care to a third party creditor.
However, the third party can only sue when s/he relied on the statement to make an
investment decision as in Esanda Finance v Peat Marwick Hungerfords (1997). The
government could sue on grounds of fraud or gross negligence where there is intentional
issuance of an incorrect audit report (Miller, 2016).
Despite being susceptible to these legal implications, there are several factors that will
limit the liability of the auditor. First, for a lawsuit instigated against the auditor to be
successful, there has to be proof that the auditor owed a duty of care to the plaintiff (Chung,
Farrar, Puri, & Thorne, 2010). Where it is proved that a duty of care exists, the plaintiff is
tasked with proving that the auditor breached the duty of care.
In addition, after proof of breach of a duty of care, the plaintiff must show that s/he
suffered a tangible loss as noted in Segenhoe Ltd. v. Akins & Ors., Supreme Court of New
South Wales (1990) 1 ACSR 691. The nature of the loss should be quantifiable and should
have already happened, not anticipatory loss. A nexus has to be proven to exist between the
plaintiff’s loss and the auditor’s negligence. The loss suffered by the plaintiff has to be shown
to be as a result of the auditor’s inaccurate information; had the plaintiff not relied upon the
auditor’s information, the loss would not have been suffered. In instances where the
plaintiff’s loss was inevitable despite the auditor’s information, the liability on the auditor
will be minimized (Giove, 2015).
The wording in the engagement letter with the client is also very crucial in matters
liability (McLaren, 2018). To avoid the risk of encountering potential legal implications, the

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auditor should avoid ambiguous terms and seek to make the terms as clear as possible. Clarity
of the letter will minimize chances of future misunderstandings that would have lead to
lawsuits. A very significant clause in the engagement letter is the exclusion from liability
clause. The addition of this clause in the engagement letter will clarify on the extent of legal
liability that the auditor is willing to be exposed to and it will guide the client or third party
before filing suits in court.
Another way to minimize legal liability is to operate under a limited liability
partnership (Gay, & Simnett, 2018). Here, the partners have limited liability and they are not
responsible for the negligence or misconduct of others.
In conclusion, auditors are required by law to exercise professional due care and the
concept of the prudent person. However, seeing as no one is infallible, they are to be liable
for negligence and dishonesty but not when it resulted purely from misjudgement (no
tangible loss), third parties, engagement letters and when operating under a limited liability
partnership. A rich knowledge of the relevant laws, nevertheless, would minimize the legal
implications.

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References
Books, Articles & Reports
Chung, J., Farrar, J., Puri, P., & Thorne, L. (2010). Auditor liability to third parties after
Sarbanes-Oxley: An international comparison of regulatory and legal
reforms. Journal of International Accounting, Auditing and Taxation, 19(1), 66-78.
doi: 10.1016/j.intaccaudtax.2009.12.005
Gay, G., & Simnett, R. (2018). (7th edn) Auditing and assurance services in Australia.
McGraw-Hill Education Australia.
Giove, F., C. (2015). Auditing Essentials (Essentials Study Guides) Research & Education
Association
McLaren, T., (2018) Engagement Letters: Why bother? What to include? (With 12 Samples).
Practice Ignition. Retrieved 18 May 2019, from
https://www.practiceignition.com/blog/engagement-letter.
Miller, R. L. (2016). Business Law Today, Comprehensive. Cengage learning.
Moroney, R., Campbell, F., & Hamilton, J. (2012). Auditing, Google eBook: A Practical
Approach. John Wiley & Sons.
Salzedo, S, Singla, T., (2016). Accountants’ Negligence and Liability. Bloomsburg
Publishing Plc
Legislation
Corporations Act 2001 (Cth)
Cases
Esanda Finance v Peat Marwick Hungerfords (1997) (1997) 188 CLR 241
Re Lowe Lippmann Figdor & Franck (1992) 2 VR 671
Segenhoe Ltd. v. Akins & Ors., Supreme Court of New South Wales (1990) 1 ACSR 691