The Hindu Business Line : Margin of error could grow thinner

WITH the arc lights firmly focussed on the auditors these days, it would be interesting to see whether it would be possible to pin down the responsibility on auditors for professional negligence. In India, the Institute of Chartered Accountants of India (ICAI) deliberates and decides cases of professional negligence of members. In some instances, the case travels up to the courts to decide the case. Of late, there have been many instances of senior members of the profession being given the guillotine — termination of membership. The law abroad is a bit more evolved and it would be of interest to auditors to mull over a couple of decided cases.

The Scottish Court of Session (Outer House) had to decide on the duty of care of an auditor to a bank in Royal Bank of Scotland plc vs Bannermann Johnstone Maclay (the firm) and Others (2002 Times Law Reports). The bank had advanced monies to a company forming a judgment on the basis of the audited financial statements given by the firm. The company later went bust and the bank had to appoint a receiver on account of which it suffered a loss which it wanted to recover from the auditor.

It was alleged that the case satisfied all the three ingredients of professional negligence: a) existence of a duty of care; b) breach of that duty; and 3) resulting damage. The third ingredient is what distinguishes these cases from one of breach of contract since in a breach of contract the courts tend to award nominal damages even though the claimant fails to prove a loss.

The auditors defended themselves saying that they did not owe a duty of care to the Bank since the axioms laid down in Galoo Ltd vs Bright Grahame Murray and Another (1994 1 WLR 1360) suggesting that in addition to knowledge of the user of the accounts there was a further requirement that the auditors must intend that the claimant should rely on the accounts was not satisfied in the instant case. They argued that the only intention they had was to carry out their duties under the Companies Act to audit the accounts.

The court disagreed with the view of the auditors and ruled that knowledge of the user and of the specific use to which the accounts information would be put formed the basis of a duty of care for those making information or advice available.

The auditors knew that the bank was entitled to see management accounts and audited accounts.

Hence, they owed a duty of care to the bank. However, in the case under question, the bank failed to prove that the audited accounts were prepared negligently. This saved the day for the auditors.

In another case, Barings Futures Singapore vs D&T Singapore (2002 All ER (D), the audit firm D&T was charged with preparing the accounts of a firm negligently. D&T took defence under the fact that it had relied on the representation letter given by the management and, hence, not liable for a penny. The law in this regard is called circuity of action — if the auditors are liable to the company it is liable to them correspondingly and one claim cancels the other.

The law in this case was one of wrong of deceit for which the deciding case law is Derry vs Peek, wherein it has been established that wrong of deceit consists in making a statement knowing it to be false or recklessly or not caring whether it is true or false.

The court was satisfied that the representation letters given by the management were material and inaccurate and D&T would not have signed the accounts without receiving the information in the representations. In signing the representation letters, the directors did intend to induce D&T to sign off the accounts.

However, D&T failed to show that the directors were recklessly fraudulent in signing off the letters and in case they had been found to be so, the company would also have been vicariously liable. In cases of wrong of deceit, one cannot plead contributory negligence.

Hence, the stand of D&T would not stand in a court of law. Duty of care. Wrong of deceit. These terms have till today not been heard of in India. But they sound dangerous enough to force auditors to tread the path of caution.

Both the cases show that there is a very thin margin of error given to the auditor to be held not guilty in a case of professional negligence. With times being as they are, just like the norm in cricket. "When in doubt, sweep," auditors could probably use the norm "When in doubt, report."

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