Your firm of certified accountants, in common with many other firms of accountants and auditors, issues to its staff an audit manual which contains, among other matters, recommended procedures to be adopted in carrying out audits. A number of these recommended procedures relate to physical observation of inventory counts and review of count instructions.

Owing to pressure of work, you neglected to arrange for the physical observation of inventories at the premises of Leesmoor Limited at 31 March 2018, but your review of the inventory count instructions suggested that company procedures appeared to be in order. You decided to accept the amount at which inventories were stated in the financial statements at 31 March 2018 on the grounds that:

(i) the inventory count instructions appeared to be satisfactory

(ii) no problems had arisen in determining physical quantities in previous years (iii) the figures in the financial statements generally ‘made sense’.
You issued your unqualified audit report on 28 May 2018 and, unbeknown to you, Leesmoor used the financial statements and audit report for the purpose of obtaining material additional finance from a third party in the form of an unsecured long-term loan. Unfortunately, in October 2018 the company ran into financial difficulties and was forced into liquidation, as a result of which the provider of the long-term loan lost the amount of their loan. During the liquidation proceedings it became clear that inventory quantities at 31 March 2018 had been considerably overstated.

Required:

(a) Explain the probable legal position of your firm in respect of the above matter commenting specifically on the following:
• the possibility of demonstrating your firm was negligent • the fact that the inventory figure in the financial statements apparently ‘made sense’
• the fact that a loss was made by the longterm loan holder • the fact that you were not informed that the financial statements and your audit report were to be used to obtain additional finance.

(b) Describe the reasonable steps your firm should take to avoid a re-occurrence of a matter such as that described above.