TUTORIAL 2_PROFESSIONAL LIABILITY

1.What are the potential causes of action against an auditor under a breach of contract lawsuit?

The potential causes for action against the auditor for breach of contract includeViolating client confidentiality.Failing to provide the audit report on time.Failing to discover a material error or employee fraud.Withdrawing from an audit engagement without justification.

2.What defenses might an auditor use in successfully defending:

a.Suit brought about because of breach of contract?

b.Suit brought under statutory law?

3.An auditor issued an unqualified opinion on financial statements that failed to disclose that a significant portion of the accounts receivable was uncollectible. The auditor also failed to follow professional auditing standards with respect to inventory. The auditor knew that the financial statements would be used to obtain a loan. The client subsequently declared bankruptcy. Under what concepts might a creditor, who loaned money to the client on the basis of financial statements, recover losses from the auditor?

4.An investor is suing an auditor for issuing an unqualified opinion on the financial statements of Duluth Industries, which contained a material error. The auditor was negligent in performing the audit. The investor had reason to believe that statements were wrong prior to purchasing stock in the company. In the subsequent period, Duluth Industries sustained operating losses, the stock price went down by 40%, and the investor sold the stock at loss. During the period that the investor held this stock, the Dow Jones Industrial Average declined 10%. What defenses might the auditor use against the investor's lawsuit to recover losses?

5.A client applied for a bank loan from First Bank. In connection with the loan application, the client engaged an auditor to audit its financial statements, and the auditor issued an unqualified opinion. On the basis of those statements, First Bank loaned money to the client. Shortly thereafter, the client filed for bankruptcy, and First Bank sued the auditor for damages. The audit documentation showed negligence and possible other misconduct in performing the audit.

a.Under what circumstances is First Bank an identified user?

b.What exceptions to the identified user test might First Bank argue?

6.Compare an auditor's liability to third parties for negligence under Ultramares, Credit Alliance, 1965 Restatement (Second) of Torts and Rosenblum. Then indicate which approach you think auditors prefer and why? Which approach do you think is best for society? Why? (January 2019)

7.East Factory is a company operating in the manufacturing industry and is led by its managing director, Mr Leong. The company had enjoyed a rapid growth in the previous year due to the following reasons:

a)Mr Leong had been falsifying the sales records of the company by creating several fictitious sales agents who were responsible for 30% of the company's revenue.

b)25% of the cost of sales was capitalized by falsification of purchase invoices with the co-operation of the supplier companies.

c)The directors of the company were rewarded lucrative bonus plans linked to the reported profits. Hence the directors did not query the abnormal rapid growth of the company and were unaware of the fraud committed by Mr Leong.

Mr Leong spent large sums of money in creating false records and bribing accomplices in order to conceal the fraud from auditors. He insisted that the auditor should sign a "confidentiality" agreement which effectively precluded the auditors from corroborating sales with independent third parties and from examining the service contracts of the directors. This agreement had the effect of preventing the auditor from discussing the affairs of the company with the sales agents.

The fraud was discovered when an unsatisfied director wrote an anonymous letter to the Stock Exchange concerning the reasons for East Factory's growth. The auditors were subsequently sued by a major bank that had granted a loan to East Factory on the basis of interim accounts. These accounts had been reviewed by the auditor and a review report was issued.

Required:

a)Discuss whether the auditors are guilty of professional negligence in not detecting the fraud.

b)Explain how can an audit firm minimize its potential for paying damages in cases involving torts?