Question

What does a third-party user of financial statements have to prove under common law in a suit against an auditor for the auditor’s negligence? Illustrate each item with an example.

Answer 1

Solution:

Use of financial statements by third parties:

Investors, shareholders, bank, government etc use the financial statements to analyse the business of the company. Any outsider who use the financial statement in analysing the credit worthiness of the company to make investment, lend loan, or calculate the tax is third party. The financial statement gives the material aspect, financial position, result of operation of the company in accordance with the generally accepted accounting principles.

Auditors Responsibilities:

An independent auditor responsibility is to express opinion in his report, the presentation of the financial statement in all the aspects. The financial statements are prepared by the management and the misstatement in the financial statement can be due to error or fraud by the management. The auditor’s responsibility is to plan and perform audit so that there is no material misstatement in the financial statement presented by the management.

Auditor’s negligence:

When an auditor fails to find the material misstatement in the financial statement presented, then it is considered as negligence of an auditor. The negligence of the auditor is classified as. The requirement of due care, competence and independence of the auditor is primary for generally accepted auditing standard.

• Failure in the part of auditor to do audit with due care. (Due Care)
• Ordinary negligence in the part of auditor. (Competence)
• Gross negligence in the part of the auditor. (Independence of the auditor)

Negligence to audit with due care:

It is the responsibility of an auditor to perform his duty with due care. Negligence to audit with due care is a situation where an auditor omits to perform his duty, or lack of due care to perform a duty which a reasonable person will not fail to perform.

The third-party user of the financial statement has to prove that there is potential risk which an auditor is aware and it is duty of the auditor to conduct audit with due care.

Example: There is potential risk in the misrepresentation of the cost of goods sold and inventory valuation in the business. It is the duty of the auditor to value the inventory and the cost of goods sold with due care so that the operating profit of the business is not misrepresented.

Ordinary negligence:

Ordinary negligence arises due to the auditor’s failure in showing competence and lack of experience in handling a situation. Such as auditor’s failure in foreseeability and understanding the public policy in influencing the auditor’s decision.

Example: In the case of Stephens Industries, Inc. v. Haskins & Sells, 438 F.2d 357 (10th Cir. Colo. 1971), The court held that the auditor is liable to the third party who acted upon the financial statement presented by company. It was held that the auditor was negligent when there is misrepresentation in the financial statement presented by the company.

Gross negligence:

Gross negligence is a conscious and a voluntary disregard by the auditor to use reasonable care while auditing the financial statement. It is a situation where an auditor fails to take even little care and disregard his professional responsibility.

Example: Failure in the part of auditor to follow Generally Accepted Auditing Standard.