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Auditing Theory

Notes liability could be incurred for a negligent misstatement made by one person to another, even in
the absence of any contractual or fiduciary relationship. The parameters of such responsibility
were limited by the “neighbourhood principle” laid down by Lord Atkin in Donaghue v. Stevenson.
In Jeb Fastners v. Marks Bloom & Co., the appropriate test for establishing whether a degree of care
exists was laid down to be whether the defendant knew or reasonably should have foreseen at
the time the accounts were audited that a person might rely upon those accounts for the purpose
of deciding whether or not to take over the company and, therefore could suffer a loss if the
accounts were inaccurate. Firstly, they must have relied upon the accounts and secondly, they
must have done so in circumstances where either the auditor’s knew they would, or ought to
have known, that they might. The decision in Hedley Byrne v. Heller held that liability for
negligent statements resulting in the financial loss is not limited only to cases where there is an
existing contractual or fiduciary relationship. This raised the question of the limits of such
liability. The test of a reasonable man would not make the auditors liable. The rule thus was that
the auditors would not be liable to third parties unless the facts of the case showed otherwise.
Thus, in Candler v. Crane, Christmas and Co, where the accounts were prepared specifically for the
purpose of inducing the plaintiff to invest in the company, to the knowledge of the auditors,
there was a duty of care even though the plaintiffs were not members or shareholders of the
company. This can however, be negated by a clear clause expressly disclaiming liability. There
are recent cases which state that the auditors should have foreseen that the accounts may be
relied on by future investors for the purpose of making decisions regarding their investments.

Caselet Report by London Economics on Auditor’s Liability

n independent study prepared by London Economics at the request of the European
Commission summarized the auditors’ liability and the impact of the community
Aregulations related to the conditions of liability insurance in the member states.
The study, which was published in October, highlights that the current regulations related
to liability involve system risk and predicts that within five years after Arthur Andersen’s
downfall due to the Enron scandal, another Big4 will follow the same fate as AA. Such an
event would have unpredictable consequences on world economy and on the stock markets.
It would probably result in capacity gap and in the considerable increase of the service
prices, due to which large companies may not be able to comply with their reporting
requirements. The situation would shake the investors’ confidence and would probably
cause the dissolution of further audit firms.
The Commission presented four options to the member states on the basis of the London
Economics study: According to the first option, there would be one single monetary cap
with respect to the indemnification payable by auditors (there is such a cap in 5 member
states: it is EUR 12 million in Belgium and Austria, EUR 4 million in Germany, and EUR
150 thousand in Slovenia; according to the Greek regulation, the cap corresponds to either
a year’s audit fee or to five times the salary of the head of the supreme court). According
to the second option, the cap would depend on the audited company’s size (as measured
by its market capitalization). In the third option, the cap would be a multiple of the audit
fees charged to the company. The fourth option follows the principle of proportionate
liability, which means that each party is liable only for the portion of loss that corresponds
to the party’s degree of responsibility. It is possible that Brussels will not enact a law the
scope of which applies to all member states but will leave it to the member states to define
the means and extent of restricting the liability. Our experts do not know about plans in
Hungary to limit the auditors’ liability.

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