the expectation gap and auditors' responsibilities

[VOL. 20

THE EXPECTATION GAP AND AUDITORS' RESPONSIBILITIES

MICHAEL MILLS*

INTRODUCTION

In 1983 Judge Schrieber of the New York Supreme Court observed in Rosenblum Inc u Alder:

At one time the audit was made primarily to inform management of irregularities and inefficiencies in the business .... That function remains one of the principle - -

reasons for the audit. Gradually a need for independent audits was generated by public ownership of business enterprises and by requirements of the stock exchanges ... investors, investment specialists, stockholders and lenders de- manded more reliable information. It is now well recognised that the audited statements are made for the use of third parties who have no contractual relationship with the auditor. Moreover, it is common knowledge that companies use audits for many proper business purposes, such as submission to banks and other lending institutions that might advance funds and to suppliers of services and goods that might advance credit .... The auditor's function has expanded from that of a watchdog for management to an independent evaluator of the adequacy and fairness of financial statements issued by management to stockholders, creditors and othe IS... ?

Nor is such an expectation confined to the United States. On 30th November 1989 The Australian Financial Review reported that:

When a company collapses unexpededly, the first thought of those caught in the wreckage is to blame the company's auditors for not warning them ... the public and sometimes even the professionals see the auditor's job as giving an early warning of corporate t ro~bles .~

* Partner, Phillips Fox, Perth. I am indebted to David Boymal of Messrs Ernst & Young for checking and commenting on the practical auditing asp& of this paper.

1. 461 A 2d 138,149 (1983). 2. M Lawson "It's not our job to read the entrails: Auditors" The Australian Financial

Review 30 November 1989.27.

THE EXPECTATION GAP

Auditors maintain their responsibdities do not extend that far. Rather, their principal responsibility is to report on whether the accounts of the c mpany are "true and fair" and present fairly the company's financial position and the results of its operation^.^ As has also been said:

The problem is, most of the users of financial statements - the investing public - have been led to believe that the auditor's signature on an annual report means the books are a totally accurate reflection of the corporation's financial status. At the very least, they are confident that a Big Eight stamp of approval means the company has been investigated for fraud and that it has been found free of any trace of wrongdoing. How shocked the "little old widow" would be to find that auditors point to fraud as one of the factors they provide little insurance against. Insisting that they are not policeman, auditors state that they are, instead, management's partners in the audit process and not their overseers. They do not set out to catch management with its hand in the till but look to management to co-operate with the audit team.j

The fact that the public's perception of the role and responsibilities of an external auditor differ from the accountancy profession's has been well documented elsewhere and does not appear to be di~puted.~ The parameters of this disparity in perception are more uncertain. However, it is not the purpose of this article to evaluate the so called "expectation

- -

gap" between what the public believes, and auditors understand, to be their responsibilities. Suffice to say, in a general sense the expectation gap exists in respect of the extent to which the public expect an auditor to: be suspicious; detect fraud; provide a certificate of good health for the audited company; and independently exercise these responsibilities for the benefit of the public as well as the audited company and shareholders.

Legally the concern for auditors is that the "expectation gap" has, andfor will be, filled by more extensive and onerous responsibilities being imposed on independent auditors by the courts andlor legislation. Translated into legal tenns, whether recent developments have imposed greater responsibilities on auditors is principally a question of the extent

3. G Gay and G Pound "The Role of the Auditor in Fraud Detection and Reporting" (1989) 7 C S U 116,117.

4. R Baxt "The Modern Company Auditor: A Bloodhound Without Teeth or a Watch- dog Without Eyes?" (1986) 24 Osgoode Hall Law Journal 667,697 citing M Stevens The Big Eight (New York: MacMillan, 1981) 98.

5. J Westlake "Auditors -Your Liability is Unlimited Law Society of NSW, Sydney (NSW) September 1987; D Boymal "Implications forAuditorsn in Legal Liability ofAuditors (Melbourne: BLEC, 1989) 118; supra n 3,116 n 1.

540 WESTERN AUSTFk%IAN LAW REVIEW [VOL. 20

to which the applicable standard of care has increased and a duty of care is owed to third parties?

It is not possible within the scope of this article to adequately assess an auditor's present responsibilities, particularly from an auditor's per- spective. Rather, what is proposed, in the context of the expectation gap outlined above, is to assess the recent cases on auditors' liability to evaluate the degree, if any, to which an external auditor's responsibilities have increased.

STANDARD OF CARE As recent cases have again shown: the decisions, and in particular

several passages, of Lords Justices Lindley and Lopes almost a century ago in In Re London and General Bank (No .i?)7 ("London") and In Re Kingston Cotton Mill Company (No 2)8 ("Kingston") must be the starting point of any discussion about auditors' responsibilities.

In London Lord Justice Lindley said an auditor's duty: ... is to ascertain and state the true financial position of the company at the time of the audit, and his duty is confined to that. But then comes the question. How is he to ascertain that position? The answer is, by examining the books of the company. But he does not discharge his duty by doing this without inquiry and without taking any trouble to see that the books themselves shew the company's true position. He must take reasonable care to ascertain that they do so. Unless he does this his audit would be worse than an idle farce ... [Hlis first duty is to examine the books, not merely for the purpose of ascertaining what they do shew, but also for the purpose of satisfying himself that they shew the true financial position of the company .... An auditor, however, is not bound to do more than exercise reasonable care and skill in making inquiries and investigations. He is not an insurer; he does not guarantee that the books do correctly shew the true position of the company's affairs; he does not even guarantee that his balance sheet is accurate according to the books of the company. If he did, he would be responsible for error on his part, even if he were himself deceived without any want of reasonable care on his part, say, by the fraudulent concealment of a book from him. His obligation is not so onerous as this. Such I take to be the duty of the auditor: he must be honest - ie, he must not certify what he does not believe to be true, and he must take reasonable care and skill before he believes that what he certifies is true. What is reasonable care in any particular case must depend upon the circumstances of that case. Where there is nothing to excite suspicion

6. BGJHoldings Pty Ltd u Touche Ross & Co (1987) 12 ACLR 481 ("BGJHoldingsn) Pacific Acceptance Corporation Ltd u Forsyth (1970) 92 WN (NSW) 25 ("Pacific").

7. [I8951 2 Ch 673. 8. [I8961 2 Ch 279.

19901 THE EXPECTATION GAP 541

very little inquiry will be reasonably sufficient .... Where suspicion is aroused more care is obviously necessary; but, still, an auditor is not bound to exercise more than reasonable care and skill, even in a case of suspicion ... ?

In Kingston Lord Justice Lindley approved the test propounded in London.l0 Lord Justice Lopes did likewise and said:

It is the duty of an auditor to bring to bear on the, care and caution which a reasonably competent, careful, and cautious auditor would use. What is reasonable skill, care, and caution must depend on the particular circumstances of each case. An auditor is not bound to be a detective, or, as was said, to approach his work with suspicion or with a foregone conclusion that there is something wrong. He is a watch-dog, but not a bloodhound. He is justifled in believing tried servants of the company in whom confidence is placed by the company. He is entitled to assume that they are honest, and to rely upon their representations, provided he takes reasonable care. If there is anything calculated to excite suspicion he should probe it to the bottom; but in the absence of anything of that kind he is only bound to be reasonably cautious and careful."

These general principles are as true today as they were then. But just as modern cases are quick to approve these principles, it is either expressed or implied in the judgments that the standards of reasonable care and skill which auditors are expected to exercise are much more onerous and exacting now than they were in 1896. This raises the question whether in order to achieve reasonable care and skill, and therefore avoid any liability for negligence, auditors are in fact expected to be suspicious and or be much more vigorous in their verification of the company's accounts? This in turn leads to the issue of how onerous is the current standard of "reasonable care and skill'?

Watchdogs or bloodhounds?

The extent to which auditors are expected to be suspicious and exercise their responsibilities has been debated in many cases since Kingston and fell to be considered in two recent decisions in Australia.

In BGJ holding^,'^ a case decided by Justice Marks of the Victorian Supreme Court in 1987, the plaintiff company had lost in excess of four million dollars as a result of foreign currency transactions entered into by the managing director in breach of company policy.

9. Supra n 7,682-683. 10. Supra n 8,284. 11. Ibid, 288-289. 12. Supran6.

542 WESTERN AUSTRALIAN LAW REVIEW [VOL. 20

There was no allegation that the audit was defective or failed to correctly verify the true financial position, except for the omission of the losses as an extraordinary item. Rather, the principal claim against the auditors, in contact and in tort, was that the auditors had not alerted the directors to these transactions. The facts revealed the auditors had raised this with the managing director and other directors and senior executives.

Leaving aside an auditor's duty to comment on business decisions, the issue was whether it was sufficient for the auditors to tell senior management about their suspicions and to raise this in a letter of recommendation, without vevlfylng the nature of the company's policy and the number of foreign exchange transactions entered into in breach of that policy.

On the facts and no doubt buoyed by the absence of allegations of fkaud and defective audit, Justice Marks concluded the auditors had done all that was required in raising this with management in the way they had.

Even more recently the Full Court of the Western Australian Supreme Court in Arthur Young & Co u WA Chip & Pulp Co Pty Ltd13 (r'WA Chip & Pulp") had to consider the extent to which auditors should go in order to satisfy suspicions.

The plaintiff company's senior officers had drawn money to his own account without authority. The auditors had become aware of this, but accepted the officer's and the subordinate accountant's explanation. The officer subsequently disappeared and the company sued the auditors on the basis that if the auditors had carried out their duties properly, the unauthorised drawings would have been deteded at an early stage and the subsequent losses avoided.

It was held the auditors were negligent. Once put on enquiry, as the auditors had been, their suspicions should only have been satisfied by the making of enquiries at the appropriate level about the use of funds. The appropriate level was a company officer more senior than the employee.

13. [I9891 WAR 100. The case at first instance WA Chip & Pulp Co Pty Ltd u Arthur Young & Co is reported at (1987) 5 ACLC 1002.


The outcomes in these two recent cases do not indicate a fundamental change in the role of an auditor to that of a bloodhound. Even more sigdicantly, both cases relied heavily on the traditional principles of an auditor's role as enunciated in the 19th century authorities ofLono!on and Engston.l4

Although the auditor's role in principle may have remained the same, whether an auditor has made sufficient enquiry in the first place is a question of whether "reasonable care and skill" was exercised in the circumstances. As the following instances show, in practical terms this test has become more onerous and consequently, the circumstances in which an auditor is expected to become suspicious have increased. Correspondingly, there is then a greater obligation for auditors to probe that suspicion "to the bottom".15

As WA Chip & Pulp illustrates, auditors need to be careful about the information and people on whom they rely to conclude their enquiries. This was also borne out by Justice Roger's comments on the auditor's responsibilities following the collapse of Cambridge Credit in Cam- bridge Credit Corporation Ltd u Hutcheson Wambndge Credit"). It was noted the auditor should have been conscious of the need to carefully scrutinise the transactions engaged in by Cambridge Credit and evaluate with a proper degree of skepticism the actions and promises of Cam- bridge Credit directors, rather than accepting them at face value.16

Similarly, one of the points to emerge from the Interim Report of the National Companies and Securities Commission ("NCSC") into the collapse of the merchant bank Rothwells Limited was the need for auditors to resist pressure from directors and maintain a healthy skepticism in dealing with them. This may also require an evaluation of the independence and conflicts of interest of people involved in related companies. Although an auditor is justified in believing tried servants of the company and "to assume that they are honest, and to rely on their

14. RBaxtAuditors and Accountants: Their Role, Liabilities and Duties 3rd edn (North Ryde: CCH Australia Ltd, 1980) 21 ("A ancl A ) ; Baxt "Auditor Watchdogs and Bloodhounds" (1988) vol58 no 7 The Chartered Accountant in Australia 66,68.

15. Supra n 8 Lopes U, 290. 16. (1985) 9 ACLR 545,557. This decision was notable for its reminder that an auditor

is only liable, particularly for a corporate collapse, if there is a direct causal link between the auditor's negligence and the corporate collapse.


representations, provided he takes reasonable care",17 the prudent auditor should not blindly do so and if there is any suspicion, should check the position to the auditor's own satisfaction.

If an auditor is uncertain or suspicious about a breach of law of relevance to the accounts, he is under an obligation to obtain legal advice, according to Justice Rogers in Cambridge Credit.18 In that case, the auditor was found to be negligent for failing to seek legal advice as to whether any part of a loan was unenforceable at law. The ramifications of this are that an auditor may need an extensive knowledge of the law before he can know there may be a legal problem which requires legal advice.lg

Of course an auditor is already statutorily required to be aware of and to report to the Commission any contravention of or failure to comply with the provisions of the Companies (Western Australian) Code20 ("Code"). A breach of sub-section 285(10) of the Code need not be reported unless the auditor feels the matter will not be adequately dealt with by comment in his report on the accounts. One possible benefit of section 285(10) of the Code is it may, in certain instances, relieve the auditor of the burden of investigating andlor reporting to management a possible breach of the Code by referring it to the NCSC.

If an auditor has uncovered some illegal activity and takes no action to report that, it may constitute misprision of felony. At least one commentator has even gone hrther than this and suggested auditors should have an even more extensive role in the detection of crime.21 If this were to occur, an auditor would be a police bloodhound. It may satisfy public expectations in this regard, but as has been recognised, auditors cannot be expected to assume onerous responsibilities for detection or disclosure of a client's breach of the law, for their training, role and experience are basically

Gauging by the Statement ofAuditing Practice ("AUP"), with one exception, auditors' perception of their role and responsibilities are not

17. Supra n 8 Lopes LJ, 289. 18. Supra n 16,563. 19. This problem was argued and rejected in Cambridge Credit supra n 16. 20. (WA) Companies (Western Australia) Code 1981 sub-ss 285(9)-(10); (Cth) Corpo-

rations Act 1989 sub-ss 332 (9)-(10). 21. N Milne "Recent Developments in Auditors Liability Claims"inLega1 Liabilities of

Auditors (Melbourne: BLEC, 1989) 21. 22. Supran4.


too different from the above. For example, auditors accept they should plan and perform the audit "with an attitude of professional skepticism", recognising there may be fraud or errors and the need to warn management of this.23 Similarly, a responsibility to warn management of an irregularity or breach of company policy and to detect and report any illegal act which has a material effect on the accounts, are in line with paragraph 18(a) AUP 16.24 The exception is the need to detect and report all illegal acts. The auditing profession, nor the courts, are yet to embrace this responsibility in such broad terms.

Modem responsibility to detect fraud

The extent to which an external auditor is responsible for a failure to detect fraud is probably the classical example of the gap between what an auditor sees as the auditor's responsibility and what company directors, shareholders and even the public expect of an auditor.25

AUP 16 states in two parts: The objective of an audit of financial information is to enable an auditor to express an opinion on such financial information.

The responsibility for the prevention and detection of fraud and error rests with management through the application and continued operation of an adequate system of control.

As such, AUP 16 addresses material misstatements of the accounts resulting from fraud, rather than the fraud itself. The implication, therefore, of AUP 16, is although the auditor should plan the audit with a reasonable expectation of detecting if fraud does not cause a material misstatement, then the auditor will not necessarily have a duty to uncover it.

These statements ge erally accord with the principles set out in London and Kingston. Similarly, in the Australian landmark decision on auditors' responsibilities in Pacific, Justice Moffitt concluded there was not a general duty to detect all fraud and said:

An auditor pays due regard to the possibility of fraud or error by framing and carrying out his procedures, having in mind the general and particular possibili- ties that exist, to the extent that if a substantial or material error or fraud has crept

23. Paras 8 and l8(a) AUP 16. 24. Boymal supra n 5,124. 25. Supran3. 26. Para 5 AUP 16.

546 WESTEFW AUSTFULIAN LAW REVIEW [VOL. 20

into the affairs of the company he has a reasonable expectation that it will be re~ea led .~

Moreover, Justice Moffitt recognised "the legal responsibility for safeguardmg a company's assets falls primarily on the directors and that a company's own system of internal control provides the most effective safeguard for the early detection of fraud.28

Justice Moffitt's general approach seems to have been that an auditor's duty was verification and not detedion. In carryingout this task, the auditor should approach it with an inquiring mind and as such, investigate any suspicious circumstances to the auditor's satisfaction and, if necessary, warn management.

This approach not only appears to accord with current auditing principles, but also still represents the law as exemplXed in WA Chip & Pulp where Pacifi was generally approved. Justice Wallace rejected the auditor's submission that an auditor's duties do not include the detection of fraud and pointed out a failure to report it promptly to directors or senior management constitutes negligence. He said: 'This surely was the case of the dog sniffing around and being required to follow up the scent and keep its eyes and nose open".29

Whether it is a primary or incidental duty of auditors to detect fraud is legally irrelevant. Either way an auditor will be liable for failure to detect fraud only in "so far as he has been negligent in determining the scope and character of his examination or in the conduct of such examinati~n".~

It is one thing though for the cases and AUP to say an auditor should detect fraud and report it or any irregularity to senior management. The cases recognise this does not mean all fraud.31 Therefore it is a question of degree and this will have be decided on the facts of each case. This interpretation is dependant on the application of the standard of"reasonable care and skill", which has been consistently in~reasing.~~ Therefore

27. Supra n 6,65. 28. Ibid. 29. Supra n 13,107. 30. Pacific supra n 6,65. 31. Ibid, 62-67; D Williams "The Auditor's Responsibility for the Detection of Fraud"

(1987) Professional Negligence 9 argues it is unrealistic to expect an auditor to uncover frauds.

32. In re Thomas Gerrard & Son Ltd [I9681 Ch 455,475; Pacific supra n 6,74.


an auditor is at risk because, despite compliance with the usual auditing standards and practices, a court may conclude the auditor's judgement on the degree of inquiry to be made fell short of the "reasonable care and skill" expected at that time.33

Audit of business decisions?

Several recent, spectacular corporate collapses have again revealed the public expectation that an unqualified audit means a "financially clean bill of health" for the audited company, whilst auditors are quick to stress that is not the role of the audit.34

In BGJHoldings Justice Marks, in relation to the audited company's foreign exchange losses, commented:

In my opinion, contractual duty to use reasonable care and skill (that is, not to be negligent) does not involve the defendant being obliged to investigate and report on the prudence or imprudence of entry into speculative currency transactions or transactions which expose the company to risk of exchange rate changes affecting cost of overseas purcha~es.3~

But again it is all a matter of degree. Justice Marks, continued: On the other hand, facts and circumstances arising out of the conduct of the audit may give rise to a duty of the auditor in tort (ifnot in contract) to take action about the existence of some such exposure if he comes to know about

I do not preclude this duty arising in the absence of a policy or knowledge of it. It may well be that an auditor merely learns in the course of an audit that the company has entered into transactions which on their face are so imprudent that the law would impose on him a duty to inform the directors, if he thinks they might not know. ~Bss-e, without deciding, the existence of that duty and that the speculative hedge contracts here had that degree of impr~dence.~~

On one interpretation this judgment would accord with current auditing practice, if it means auditors are not responsible for management decisions concerning the management of the company, but an auditor is certainly responsible for the appropriateness of management decisions relating to the preparation of the accounts. These decisions will relate to

33. D Gwilliam "Fraud: A Recent Legal Interpretation" (1988) vol58 no 10 The Chartered Accountant in Australia 48.

34. Supra n 2. 35. Supra n 6,484-485. 36. Ibid, 485. 37. Ibid. 487.


the recoverability of receivables, saleability of stock, useM Life of assets, recoverability of carrying values and likelihood of outcome of certain hture events.

Alternatively, the above observations in BGJHoldings may mean that even in the absence of suspicion of fraud, an auditor has a responsibility to report to management any suspected breach of company policy or irregularity that may expose the client to some risk. Once it is so reported, and it is appropriately reflected in the accounts, the auditor is not under a duty to stop the practice.

At this level, this decision appears to be inconsistent with Lord Justice Lindley's statement inLondon that:

It is no part of an auditor's duty to give advice, either to directors or shareholders, as to what they ought to do. An auditor has nothing to do with the prudence of making loans with or without security. It is nothing to him whether the business of a company is being conducted prudently or imprudently, profitably or unprof- itably.%

This may only go again to demonstrate how the standard of care of auditors is increasing. Conversely, it may be a judicial reaction to the public, if not business, expectations that an audit will give an early warning of corporate troubles?

As Boymal has recently commented, "[olne of the most common causes for negligence claims against auditors is where a business fails soon after its financial statements receive a clean opinion".39 Moreover, in the United States, in response to the sort oflegal claims and expectations outlined above, a number of auditing standards were revised in 1988.40 AAS 59 addresses this particular expectation and "reflects the belief that auditors can and should take more responsibility for assessing the ability of their clients to continue as going concerns.'"l

38. Supran7,682. 39. Supra n 5,127. 40. Ibid, 122. 41, Ibid, 128.

THE EXPECTATION GAP

"Reasonable care and skill"

The benchmark for whether an auditor has discharged tortious, ifnot contractual, responsibilities is whether "reasonable care and skill" has been exercised. As Justice Moffitt put it in Pacific:

The legal duty, namely, to audit the accounts with reasonable skill and care, remains the same, but reasonableness and skiU in auditing must bring to account and be directed towards the changed circumstances referred to. Reasonable skill and care calls for changed standards to meet changed conditions or changed understan- of dangers andin this sense standards are more exacting today than in 1896. This the audit profession has rightly accepted ... It is not a question of the court requiring higher standards because the profession has adopted higher standards. It is a question of the court applying the law, which by its content expects such reasonable standards as will meet the circumstances of today, including modern conditions of business and knowledge concerning themA2

In other words, the standard of care expected of an auditor is the skill and care of the reasonable auditor. As such, the law normally reflects the hgher standards and modern procedures of the profession. As previously noted, it is not the purpose of this article to review the practical areas in which an auditor's responsibilities have increased.43 Suffice to say the standard of care has increased. The following are several further examples in relation to the positive and active vouchmg of information now required of auditors:

- If a document is material to the audit, the duty of the auditor acting reasonably is to check the document personally unless there is a good reason not to;@

- This duty of an auditor to check material documents personally has meant, as Pacific and WA Chip &&Pulp illustrate, less scope for certificate evidence and reliance on management's representations;

- Similarly, as Cambridge Credit demonstrates, auditors need to remain independent and skeptical of assurances and explanations provided by company directors; and

42. Supra n 6,74. 43. D Gwilliam "Reasonable Skill and Care - The Interpretation of the Courts" (1989)

vol58 no 7 Chartered Accountant in Australia 52. 44. Pacific supra n 6,70.

550 WESTERN AUSTRALIAN LAW REVIEW WOL. 20

- An auditor is not to be confined to the mechanics of checking vouchers and making arithmetical computations. Rather, the vital task is to take care to see that errors are not made, be they errors of computation, or downright untruths. This requires an inquiring mind.45

Consequently, auditors need to be very thorough in their substantia- tion of the accounts and the facts and documents which support those accounts. Nor can auditors afford not to adopt an "inquiring mind" and to accept explanations of management without checking material matters for themselves. This may require auditors to take a positive, if not aggressive role with the audit company and its officers to achieve that objective. Also, "reasonable care and skill" is, in this context, a dual standard and once suspicion is aroused, greater care is necessary. Pacific, Cambrdge Credit and WA Chip &Pulp all illustrate how much care is now required to probe that suspicion "to the bottom".

But as Justice Moffitt observed in Pacific, it is not just a matter of the courts reflecting the profession's standards. For it must be remembered the common law of negligence is an aspect of the law of torts and the law of torts relates to civil wrongs. Consequently, in an ad hoc way, the common law of negligence has regulated conduct which falls below the standard regarded as normal or desirable in a given community. Thus, historically, negligence is the failure to exercise that standard of care for the safety of others which the communityAaw requires under the circum- s tance~.~~

In legal tenns this is the answer to the current expectation gap and, in a sense, "watchdog" debate. In the past the responsibilities and standard of care expectedof auditors have dramatically increased, no doubt in part at least, in response to community expectati~ns.~~ Similarly, in the future it will not be surprising if the "reasonable care and skill" expected of auditors will reflect, within reason, the community's expectations of auditors, albeit as perceived by the courts.

45. Ibid, 64 approving Fomento (Sterling Area) Ltd v Selsdon Fountain Pen Co Ltd [I9581 1 W L R 45 Lord Denning, 51.

46. Pacific supra n 6,73-74. 47. Supra n 3,119 and 129; supra n 43.


In short, the basic responsibility and limit of an auditor's promise is to use "that degree of skill and care as is reasonable in the circumstances as they then exist9'.* But the problem for the auditing profession is to be able to monitor the circumstances so they can accurately gauge "the reasonable skill and care"requjred and the responsibilities which they are legally required to discharge. As such, the public's expectation of the auditors' role and their responsibilities and the judiciary's on-going evaluation of those expectations are crucial to the auditor.

Other developments

Recent developments in auditors' responsibilities have not been confined to the common law. Therefore, it is necessary to briefly touch on the extent to which other recent legal developments indicate greater accountability of auditors in line with increased public expectations.

Most audits are required by reason of statute and the minimum responsibilities for the auditor so appointed are set out in the statute. An example is section 285 of the Code, which in part requires an auditor to report whether the accounts are drawn up in accordance with the provisions of the Code and applicable approved accounting standards.49 Consequently, if there is a gap between the public's expectation of an audit and the auditor's understanding of that role, it is open to the legislature to endeavour to plug that gap by imposing more onerous statutory responsibilities so audits, and auditors, meet the public's expectations.

The Commonwealth Trade Practices Ad 1974 ("TPA"), and section 52 in particular, has been a constant source of comment and speculation as to its potential scope and ramifications. It can only be a matter of time before a plaintiff, possibly in order to circumvent common law proof of a failure to exercise reasonable care and skill, brings an action against an auditor for "deceptive or misleading conduct" pursuant to section 52 of the TPA, or its State equivalent, the Western Australian Fair Tradmg Ad 1987.50

48. Pacific supra n 6,60. 49. (WA) Companies (Western Australia) Code s 285(3)(a)(ii) and (iii); (Cth) Corpora-

tions Act 1989 s 332(3)(a)(ii) and (iii). 50. Auditors and Accountants supra n 14,107-109.

552 WESTERN A U S m I A N LAW REVIEW [VOL. 20

Most actions against auditors cry out for a defence of contributory negligence, particularly ifthe loss has arisen due to imprudent business decisions by the directors or management of a company. As Justice Rogers remarked in Brown & Hatton Pty Ltd v National Australia Bank Ltd:

I think I should make it clear that it is a matter of profound concern that directors should bear their proper share of responsibility with respect to losses suffered by their company. It is socially and commercially unjust and inappropriate that diredors should escape liability completely and that fdl burden of responsibility should rest on auditors.51

However, Australian cases have largely denied this defence to auditors, of which Dominion Freeholders Ltd v Aird; Spargo (Third Party)52 and Simonius Vischer & Co v Holt & Thomp~on~~ ("Simonius Vischer") are two examples.

The most recent decision, WA Chip &Pulp, was no exception but still did not conclusively resolve the issue." Justice Brinsden concluded that the wording and history of the Western Australian Law Reform (Con- tributory Negligence and Tortfeasors' Contribution) Act 1947 ("the Ad") meant "it cannot be applied to a claim arising under contract, even for breach of duty coincident with a duty imposed upon the defendant by common law."55 Justice Wallace reached a similar conclu~ion.~~

Chief Justice Burt did not have this problem and found, in a dissenting judgment on this point, a claim for concurrent liability in tort and contract was "founded on an allegation of negligence" within the mean- ing of the Act. However, Chief Justice Burt held the defence of contributory negligence was not available for the reasons expressed by the President ofthe New South Wales Court ofAppeal, Justice Moffitt inSi- monius Vis~her.~~

51. Brown & Hatton Pty Ltd v National Australia Bank Ltd (unreported) Supreme Court of New South Wales 12 February 1987.

52. [I9661 2 NSWR 293. 53. [I9791 2 NSWLR 322. 54. See C Lockhart "Contributory Negligence As A Defence To A Claim For Breach of

Contract: Arthur Young & Co u WA Chip &Pulp Co Pty Ltd" (1989) 19 UWAL Rev 411.

55. Supranl3,115. 56. Ibid, 108. 57. Ibid, 104.


Therefore as the law stands, in Western Australia the defence of contributory negligence is not available in an action for damages for breach of contract. Otherwise, whether a claim for contribution is available seems unlikely, but still uncertain. Although the sentiment expressed by Justice Rogers in Brown & Hatton is attractive, the reasoning of Justice Moffitt in Pacific and Simonius Vischer seems likely to be more persuasive. Or as Professor Baxt put it:

There seems little point in heralding the auditor as the champion of the shareholders if the onus to seek recovery of damages could be so easily diverted by the auditor to the shareholders by a separate action against the directors. Let the auditors seek recovery from the directors in a separate action! In my view, Justice Moffitt was right in denying apportionment in a number of cases.58

Lastly in this respect, it has been suggested by auditors that the engagement letter should stress the inherent limitations of an audit, without of course endeavouring to disclaim liability in breach of section 237 ofthe Code.59 Conversely, ifthe company management or shareholders wanted to impose greater responsibilities on the company audit, such as to provide a certificate of corporate health, this can always be contractually imposed. Whether the auditor would agree or the company would be prepared to meet the additional fee may of course prove to be a different issue.

DUTY OF CARE The debate as to the expectation gap should not be confined to the

nature of responsibilities owed by auditors. In recent times, a possibly more important issue has been to which, if any, third parties are those responsibilities are owed to?

Traditionally, the primary purpose of the engagement of an auditor was to prepare a report to shareholders. Even in 1951, the Court of Appeal in Candler v Crane, Christmas & Cow ("Candler") the Court of Appeal, held that accountants, in the absence of a contractual or fiduciary relationship, did not owe the investorlthird party a duty of care.

58. Supra n 4,695. 59. (Cth) Corporations Act 1989 s 241. 60. [I9511 2 KB 164. Denning W dissented.


However, since then and in particular since the decision in 1964 of Hedley Byrne & Co Ltd u Heller & Partners LtdG1 ("Hedley Byrne"), the law has developed rapidly. Courts have much more readily recognised claims for negligent misstatement and pure economic loss by third parties against auditors and other professionals. These developments have been such that if Candler had been litigated twenty years later, the investor would probably have succeeded.62

Recent history - towards indeterminate liability?

These developments had an immediate impact on auditom because the test of reasonable foreseeability for duty of care, coupled with the law's recognition of claims for negligent misstatement and economic loss, meant:

- a greater potential for damages and number of possible claims; d

- auditors owed a duty of care to a much greater range of potential plaintiffs than the shareholders as a class of the audited company.

The legal ramifications of these developments for auditors were illustrated by the Canadian decision ofHaig u B a r n f ~ r d ~ ~ ("Hazg"), the New Zealand decision of Scott Group Ltd u M ~ F a r l a n e ~ ~ ("Scott") and the English decision of JEB Fasteners Ltd u Marks, Bloom & Co (a firm)65 ("JEB). The fads of each case were similar because in each case a third party sued the auditors concerning allegedly incorrect accounts on which the third party plaintiff had relied to its loss.

Importantly, in Haig the trial judge found that prior to the accountants' completing the audited financial statement of the company, they knew the statement would be used by the company's bank and a potential investor.

On appeal to the Supreme Court of Canada, the crucial issue was whether the plaintiff, as an unknown potential investor, could recover his loss kom the accountants. Justice Dickson, whose judgment was in effect

61. [I9641 AC 465. 62. For example Dimond Manufacturing Company Limited u Hamilton [I9691 NZLR

609. There a n investor who relied on negligently prepared accounts recovered damages against the accountants.

63. (1977) 72 DLR (3d) 68. 64. [I9781 1 NZLR 553. 65. [I981 I 3 All ER 289.

THE EXPECTATION GAP

the judgment of the Court, in answer to this question quoted with approval Lord Justice Denning's dissenting judgment in Candler.

They owe the duty, of course, to their employer or client, and also, I think, to any third person to whom they themselves show the accounts, or to whom they know their employer is going to show the accounts so as to induce him to invest money or take some other action on them. I do not think, however, the duty can be extended still further so as to include strangers of whom they have heard nothing and to whom their employer without their knowledge may choose to show their accounts.

The test of proximity in these cases is: Did the accountants know that the accounts were required for submission to the plaintiff and use by h imF

On this reasoning, it was concluded the plaintiffwas a member of a limited class, namely, potential investors, who the accountants knew would use and rely on the statement and therefore the investor recovered damages from the negligent accountants.

In Scott, the extent of the duty of care of auditors was raised in relation to the appellant company which, in reliance on audited accounts which it had examined at the Companies m c e , made a successful take- over of the audited company. However, the audit had been negligently prepared by the respondent and consequently the assets had been over- stated.

In contrast to Haig, the auditors had no knowledge of a take-over or a limited class of investors who could rely on the audited statements.

The appellant company failed in its action against the auditors. Of the majority, Justice Richmond did not believe the necessary special relationship had been proved between the appellant and the Al- though Justice Cooke considered a duty of care was owed, he did not consider damage had been established.@

Justice Woodhouse, who dissented, did not base his judgment on the test of a special relationship, but on the two-stage test of reasonable foreseeability as enunciated by Lord Wilberforce in Anns v Merton London Borough Council6g ("Arms").

66. Supra n 63,75. 67. Supra n 64,566. 68. Ibid, 583 and 585. 69. [I9781 AC 728.


On this basis, Justice Woodhouse found there was a prima facie duty of care as the auditors gave professional advice which they must have realised would be relied on by others, such as in respect of a take-over. Nor were there any considerations to negate that

In a subsequent commentary on Scott it was suggested that Justice Woodhouse's judgment was the first to find a duty of care existed between an accountant and the investing p ~ b l i c . ~ It was also suggested that on this reasoning, any member ofthe public who relies on the public accounts of a company and invests may be owed a duty by the company's

Lastly in JEB, Justice Woolf applied the reasoning of Lord Justice Denning in Candler and Justices Cooke and Woodhouse in Scott concerning their application of Lord Wilberforce's two-stage test in Anns. Consequently, Justice Woolfconsidered whether the auditors owed a duty of care to the plaintiffwhich had taken over the audited company was a question of whether the auditors knew or ought reasonably to have foreseen at the time of preparing the accounts, persons such as the plaintiff might rely on the accounts? As a matter of fact it was held they should, because, accordmgto the headnote, the auditors knew the audited company needed outside financial help and it was therefore foreseeable that a take-over was a means of obtaining this finance and such a person as the plainwmight rely on the audited accounts.73 However, it was also held the plaintiffs reliance on the accounts was not a cause of the loss.74

An even more graphic and frightening example of auditors' potential liability was provided in 1984 by the decision in Cambridge Credit" that the company, through its liquidators, and the trustee for the debenture holders had proved their claim for a minimum of 145 million dollars.

70. Supra n 64,574-575. 71. A Khan and A Davidson "Auditors and Third Parties" (1979) N Z W 257. 72. R Baxt "Recent Cases" (1979) 53 ALJ 582; see also G Masel Professional Negli-

gence oflawyers, Accountants, Bankers &Brokers (North Ryde: CCH Australia Ltd, 1981) 214-215 andAuditors and Accountants supra n 14,64-65,94,97.

73. Supra n 65,289. 74. Ibid, 290. 75. Supra n 16.

19901 THE EXF'ECTATION GAP 557

As ifthat was not enough, by then it was becoming apparent there had been a substantial change in the business and social climate whereby people who felt aggrieved were ready to resort to litigation, particularly against professionals and other advi~ers.7~ The potential for a si@cant gap between the public's and auditors' perception of the auditors' responsibilities and to whom they were owed was also provided at this time by two judicial comments in the United States.

Firstly, there was the view quoted at the outset of this paper, which was endorsed and even enhanced by the United States Supreme Court in United States u Arthur Young & Co that an accountant:

assumes a public responsibility transcenhng any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as the investing public. The public watch dog h c t i o n demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust. To insulate from disclosure a certified public accountant's interpretations of the client's financial statements would be to ignore the sigmficance of the accountant's role as a disinterested analyst charged with public obligation^.^^

In fact, by 1984 it must have seemed to auditors that the famous warning of Justice Cardozo in 1931 had not been heeded and auditors indeed faced a potential liability for "an indeterminate amount for an indeterminate time to an indeterminate class".78

76. Whitehouse u Jordan (1980) 1 All ER 650 Lord Denning MR, 658. 77. 104 S Ct 1495 (1983). 78. Ultramares Corporation u Touche 174 N E 441,444 (1931).


Duty of care - a control mechanism

But just as Justice Cardozo had become concerned over f3ty years earlier about the possibility of indeterminate liability for auditors, so by 1984 the English and Australian courts had generally recognised the recent expansion of liability for negligence, particularly for negligent misstatement and economic loss, had produced a need for a control mechanism on the potential liability for negligen~e.~~

Two recent observations by the High Court of Australia and English Court ofAppeal respectively illustrate the reasoning behind this judicial attitude:

The recovery of economic loss has traditionally excited an apprehensio~l that it will give rise to indeterminate liability. And there is also an apprehension that the application of the standard of reasonable foreseeability may allow recovery of economic loss of such magnitude and in such circumstances as to provoke doubts about the justice of imposing liability for it on the defendant.

It was with a view to diminishing that risk that the High Court ... in Cultex sought to limit the persons, or class of persons, to whom a duty of care may be owed in respect of economic loss.80

Lord Justice Taylor aptly noted last year in respect of auditors: The principal concern in this class of case is that casting too wide a duty on a potential defendant may result in a liability which is intolerably onerous. The courts have therefore been reluctant to extend the scope of liability for economic loss arising from negligent mis~tatement.~

79. Supra n 61 Lord Reid, 482; Lord Pearce, 534; Caltex Oil (Australia) Pty Limited u The Dredge "Willemstad" (1976) 136 CLR 529 Stephen J , 574-575 ("Caltex"); supra n 69 Lord Wilberforce, 751-752; Junior Books Ltd v Veitchi Co Ltd [I9831 AC 520 Lord Fraser, 532-533; Lord Keith, 536-537; Lord Roskill, 539-546; Jaensch u Coffey (1984) 155 CLR 549 Deane J , 583 ("Jaensch"); and for subsequent confir- mation see Sun Sebastian Pty Ltd v Minister Administering the Environmental Planningand Assessment Act 1979 (1986) 162 CLR 341 Gibbs CJ, Mason, Wilson and Dawson JJ, 354 ("Sun Sebastian"); Caparo Industries PLC u Dickman and Others [I9891 QB 653 Taylor U, 696-697 ("Caparo"); Smith v Eric S Bush [I9891 2 WLR 790 Lord Griffiths, 816; Governors of the Peabody Donation Fund u Parkinson [I9851 AC 210 Lord Keith, 240-241 ("Peabody"); The Council of The Shire ofSutherland u Heyrnan (1985) 157 CLR 424 Deane J, 498 ("Sutherland Shire Council"); Candlewood Navigation Corporation Ltd v Mitsui OSKLines Ltd [I9861 1 AC l , 25 ; Leigh and Sillavan Ltd u Aliakman Shipping Co Ltd [I9861 1 AC 785 Lord Brandon, 815-817;Al Saudi Banque v Clark Pixley (a firm) [I9891 3 All ER 361 Millett J, 366 ("A1 Saudi Banque").

80. Sun Sebastian ibid, 354. 81. Caparo supra n 79 Taylor LJ, 696-697. See also United States u Benjamin 328 F 2d

854 Friendly J, 863 (1964).

19901 THE EXF'ECTATION GAP 559

Given there was a concern about the expansion of liability for negligence, it was both natural and logical that the courts turned to the concept of duty of care to limit this expansion.

As the considerable questioning and re-evaluation of duty of care as a control mechanism over the last decade revealed, the problem was not so much the modern "neighbour" test for duty of care established by Lord Atkin in Donoghue u Steuem0n,8~ as its application. For, by and large, the test for duty of care has become reasonable f~reseeability.~~

Relationship of proximity

It was due to a recognition ofthese problems that in a series of recent casess4 the High Court ofAustralia has endeavoured to establish its own overall test for duty of care derived from Lord Atkin's neighbour test. Now reasonable foreseeability is no longer the sole determinant of duty of care and is limited by the requirement that there be a sufficient relationship of proximity between the

In contrast to reasonable foreseeability, proximity "involved both an evaluation ofthe closeness ofthe relationship and a judgment ofthe legal consequences ofthat eval~ation."~~

The importance ofthe considerations relevant to proximity will vary dependmg on the category ofthe case and "may involve value judgments on matters of policy and degree". Similarly it may vary depending upon the content ofthe criteria or rules which reflect the duty requirement in developing areas of the law, such as economic loss and negligent misstatement."7

82. 119321 AC 562,580. 83. San Sebastian supra n 79 Brennan J, 367. 84. Caltex supra n 79 Stephen 4 Jaeasch supra n 79; Hackshaw u Shaw (1984) 155 CLR

614; San Sebastian supra n 79; Stevens u Brodribb Sawmilling Company Proprie- tary Limited (1986) 160 CLR 16; Sutherland Shire Council supra n 79; Cook u Cook (1986) 162 CLR 376; Hawkins u Clayton (1988) 164 CLR 539 ("Hawkins").

85. In the context of this article it is inappropriate to outline, in detail, the recent developments and intricacies of this relationship of pmximity; but see S Quudan and D Gardiner "New Developments with &sped To the Duty of Care in Tort" (1988) 62 ALJR 347.

86. Jaensch supra n 79,580. 87. bid, 585. English decisions in the 1980s also recognised the "reasonable foreseea-

bility" and two-stage test in Anns supra n 69 was "not to be regarded in all circumstances as a suitable guide to the existence of a duty of care": Yuen Kun Yeu u Attorney-General ofHong Kong [I9881 AC 175, 94.


The above approach to proximity has been reflected in subsequent decisions of the High Court.s8 Proximity's conceptual role as a limitation on reasonable foreseeability and therefore duty of care is reasonably clear. However, the manner in which proximity is to be applied to particular facts as a determinant of duty of care is still uncertain, particularly in cases concerning negligent misstatement and economic

Caparo

The importance of these developments for auditors' duty of care to third parties has been emphasised in two of the most recent English decisions, Caparogo andA Saudi Banqz~e.~~

The facts of Caparo were that the plaintiffs were shareholders of Fidelity Plc and once the audited accounts had been published, launched a successful takeover of Fidelity Plc. It then discovered the reported profit of 1.3 million pounds should have been a loss of 0.46 million pounds. Caparo sued two directors for fraud and the auditors for negligence, claiming the auditors owed current and prospective shareholders a duty of care, as both sets of investors had relied on the accuracy of the accounts in purchasing shares.

At first instance on the preliminary issue of whether the auditors owed a duty of care to the shareholders as individuals and to prospective shareholders, it was held no such duty was owed. On appeal a majority of the Court of Appeal, Lord Justices Bingham and Taylor, held the auditors owed a duty of care to individual shareholders but not prospective shareholders or investors.

In an unanimous judgmentg2 the House of Lords held the auditors owed no duty of care to individual or prospective shareholders.

These facts highlight the problems, importance and probably the grey area of the duty of care concept. But before turning to the House of Lord's decision in Caparo, the decision should be put into its proper judicial context.

88. Supra n 79. 89. For example, Hawkins supra n 84. 90. Supra n 79. 91. Supra n 79. 92. [I9901 2 WLR 358.


In Smith u Eric S Bushg3 ("Bush") the House of Lords had occasion to consider a valuer's liability to a third party, the purchaser of the valued house, for negligent misstatement. The House of Lords held the valuer owed the prospective mortgagor a duty of care, subject to any disclaimer of liability, if the valuer was aware the mortgagor would probably purchase the house in reliance on the valuation without an independent survey.

The extent to which duty of care with the limitation of a reasonably proximate relationship can limit the categories of case in which an auditor owes a duty of care to third parties was provided in A1 Saudi Banque.

The defendants were auditors of a company, GCL Ltd, and the plaintiff banks made advances to the company in 1981 and 1982. The plaintiffs claimed that they did so in reliance on the audited accounts of the company. Seven of the banks were existug creditors at the date of the auditor's report and three were new creditors. In January 1983 the company was wound up with no assets and owed 8.6 million pounds to unsecured creditors.

The banks sued the auditors in negligence and alleged the accounts failed to show the company was insolvent and did not reflect a true and fair view of the company's affairs. Furthermore, the plaintiffs contended that the auditors ought to have been aware that the company's business was dependent on bank finance and they ought reasonably to have foreseen that the banks providmg such hance would rely on the audited accounts.

On the trial of the preliminary issue whether the auditors owed a duty of care to the banks, it was acknowledged for a duty of care to exist in a claim for negligent misstatement:

[Tlhree requirements must be satisfied: (i) it must be reasonably foreseeable by the defendant that the statement will be relied on by the plaintiff, (ii) there must exist the relevant degree of proximity between the parties, and (iii) it must be just and reasonable in all the circumstances to impose a duty of care on the part of the defendant to the plaintiff?

93. Supra n 79. 94. A1 Saudi Banque supra n 91,365.


Justice Millett reviewed and approved the reasoning of the Court of Appeal in C a p a r ~ , ~ ~ but prophetically considered that it marked the fluthest limit for duty of care for negligent misstatement in England.% The subsequent House of Lords decision in Bush adopted a more strin- gent test that the defendant should know the advice is to be provided to the plaintiff.

Thus the plaintifps contentions that where there is a high foreseeability of reliance, this is sufficient to satisfy the requirement of proximity, andlor the requirement of proximity had been relaxed in the even more recent House of Lords decision in Bush, were rejected.97

Accordingly, in relation to the three new creditor banks, they were treated as comparable to the potential investors in Caparo. There was no close or direct relationship with the auditors and the element of proximity was lacking. As to the existing seven banks at the time of the au&t, there was also not sufficient proximity to establish a duty of care. Justice Millett did not consider the existing banks' position was comparable to the existing shareholders in Caparo. They did not appoint the auditors, the auditors had no statutory obligation to report to them, nor did they or the company send the audited accounts to the banks. In short, there was no relationship between the auditors and the banks and reasonable foreseeability of reliance was not enough to establish proximity, even where it may be just and reasonable to impose a duty of care.98

Against this background the House of Lords heard the appeal from the Court of Appeal's decision in Caparo, which Lord Bridge categorised as:

Molding that, whilst there was no relationship between an auditor and a potential investor sufficiently proximate to give rise to a duty of care at common law, there was such a relationship with individual shareholders, so that an individual shareholder who suffered loss by acting in reliance on negligently prepared accounts, whether by selling or retaining his shares or by purchasing additional shares, was entitled to recover in tort.%

95. Ibid, 367. 96. Ibid, 371. 97. Ibid, 370. 98. bid, 370-371. 99. Supra n 92,363.


It is difficult to extract a ratio from the various judgments of the House of Lords, but the following points were commonly accepted:

1. The extension of the concept of negligence for economic loss not resulting from physical damage since Hedley Byrne "has given rise to considerable and as yet unsolved difficulty of definition".lm

2. The extent of the liability of professional people, especially accountants, for allegedly negligent statements is an important and vexed question.lOl

3. The suggestion that a duty of care was owed to people who it may reasonably be foreseen would suffer harm102 or who rely on the advice or statement to their detriment was considered to be untenable.lo3

4. The duty of care in tort depends not solely upon the existence of the essential ingredient of the foreseeability of damage to the plaintiff but upon its coincidence with a hrther ingredient to which has been attached the label "proximity'"04 and 'Sust and reasonable.'"05

5. It was expressly or implicitly recognised that it was reasonably foreseeable that investors who rely on negligently audited accounts would suffer loss, as in this case. However, reasonable foreseeability of itself is not enough and therefore the requirement of further proximity was the crucial issue.lo6

6. Following a review of the authorities, in particular, Cann v Will~on,'~~ Lord Justice Denningin Candler, Hedley Byrne and Bush, the common view of the "test of proximity in these cases is: did the accountants know that the accounts were required for submission to the plaintiff and use by him?'"Os

100. Ibid Lord Oliver, 378. 101. Ibid Lord Roskill, 374. 102. Ibid Lord Oliver, 379. 103. Ibid Lord Bridge, 363; Lord Roskill, 375. 104. Ibid Lord Oliver, 378. 105. Ibid Lord Bridge, 365. 106. Ibid, Lord Oliver, 379. 107. (1888) 39 Ch 39. 108. Supra n 92, Lord Jauncey, 401; Lord Oliver, 383-384.


7. Lords Jauncey, Oliver and Bridge went even W h e r and said for a duty to arise the statement had to have been made available to the plaintifffor a particular purpose upon which he had relied and in this Lord Justice Denning's dissenting judgment in Candler was approved.

On the basis of this general approach, it was concluded the auditors owed no duty of care to individual shareholders. According to Lord Bridge previous cases justified the conclusion that auditors of a company owe no duty of care to members of the public who purchase shares in the company. Similarly, the duty of an auditor to an existing shareholder cannot extend beyond the value of the shares held to any further shares purchased in reliance on the auditor's report.lo9

Lord Oliver held that in ascertaining the extent of a duty of care, the purpose of an audit is a relevant consideration.l1° As to the existence of a duty of care, the most that can be attempted is a broad categorisation of the decided cases. It is therefore permissible to regard negligent statements or advice as a separate category displaying common features from which it is possible to find at least guidelines by which a test for the existence of the necessary relationship can be deduced?ll The auditor's statutory duty of care was "owed to the shareholders as a body and not to individual shareholder^".^^^

To widen the scope of the duty to include loss caused to an individual by reliance upon the accounts for a purpose for which they were not supplied and were not intended would be to extend it beyond the limits which are so far deducible from the decisions of this House?13

Lord Jauncey held that ifin any given circumstances a relationship of proximity is found to exist, consideration must still be given to the scope of the duty which arises therefrom?14 "In each of the decided cases where a duty of care has been held to exist, the statement in question has, to the knowledge of its maker, been made available to the plaintiff for a particular purpose upon which he has relied."l15 This purpose was ascertained by an examination of the United Kingdom Companies Act 1985 and like Lord Oliver, Lord Jauncey approved the dissenting judg-

109. Ibid 370,373-374. 110. Ibid, 376. 111. Ibid,381. 112. Ibid, 398. 113. Ibid. 114. Ibid, 400. 115. Ibid. 402.


ment of Lord Justice O'Connor in the Court ofAppeal that the statutory duty owed by auditors to shareholders is owed to them as a class, not as individuals?16

Lords Roskill and Ackner agreed with the above judgments.'17 The significance of the House of Lords decision in Caparo lies not

only in the more restrictive interpretation of an auditor's duty to third parties, but also in the approach to proximity which produced that result.

In the Court of Appeal Lord Justice Bingham, although recognising the elusiveness of the concept of proximity, carefully assessed the existence of such factors as voluntary assumption of responsibility and contractual relationship to determine the existence of proximity?ls In the House of Lords, such a detailed analysis of the "factors'q1g of proximity was not undertaken. Rather, a number ofjudgments not only recognised the concept of proximity was not susceptible to any precise definition,120 but that Justice Brennan may have been right in Sutherland Shire Council:

that the law should develop novel categories of negligence incrementally and by analogy with established categories, rather than by a massive extension of a prima facie duty of care restrained only by indefinable "considerations". ...Iz1

Consequently, this decision has heightened the uncertainty about the practical application of proximity and reflects the recent judicial trend that reasonable foreseeability of loss is not enough on its own to ground a duty of care to third parties. Such a limited duty of care to third parties is not only encouraging for auditors, but also all professionals and advisors, particularly if, as was suggested, an essential ingredient of proximity and therefore duty of care for negligent misstatement becomes that:

the defendant knew that his statement would be communicated to the plaintiff, either as an individual or as a member of an identifiable class, specifically in connection with a particular transaction or transactions of a particular kind ... and

116. Ibid, 406. 117. Ibid, Lord Roskill, 374; Lord Ackner, 375. 118. Caparo supra n 79,683-687. 119. Infra 568; supra n 79,678-679. 120. Supra n 92 Lord Bridge, 364; Lord Roskill, 374; Lord Oliver, 379; Lord Jauncey,

400. 121. Supra n 79,481. Quoted with approval supra n 92, Lord Bridge 365; Lord Roskill,

375; Lord Oliver, 379-380.


that the plaintiff would be very likely to rely on it for the purpose of deciding whether or not to enter upon that transaction or upon a transaction of that kind.'z

Of possibly equal comfort to auditors performing statutory audits were the comments that the statutory purpose of annual accounts so far as shareholders were concerned was:

[to] enable them to question the past management of the company, to exercise their votingrights, if so advised, and to influence future policy and management. Advice to individual shareholders in relation to present or future investment in the company is no part of the statutory purpose of the preparation and distribution of the accounts?23

This comment is particularly pertinent when it is coupled with the view that a common law duty additional to the statutory purpose should not be imposed without the knowledge of auditors.

In relation to the claim by Caparo Industries as prospective shareholders, it was argued that it was no part of the purpose of the preparation, certification and publication of the accounts of a public company to provide information for the guidance of predators in the market. Never- theless the auditors' knowledge that predators might well rely upon the accounts for this purpose sufficiently established between them and potential bidders that relationship ~Yproximity" on which was founded liability. As a natural extension of the above reasoning, this claim was rejected.

For Lord Oliver there was "no pressing reason of policy which would require such an extension [of the duty of care] and there seems to me to be powedid reasons against it."%

Similarly, upon a review of the authorities Lord Bridge concluded: These considerations amply justify the conclusion that auditors of a public company's accounts owe no duty of care to members of the public at large who rely upon the accounts in deciding to buy shares in the company. If a duty of care were owed so widely, it is difficult to see any reason why it should not equally extend to all who rely on the accounts in relation to other dealings with a company as lenders or merchants extending credit to the company. Aclaim that such a duty was owed by auditors to a bank lending to a company was emphatically and convincingly rejected by Millett J in A1 Saudi Banque L: Clark Pixley. . . .Iz5

122. Supra n 92, Lord Bridge, 368. 123. b id lord Jauncey, 406. 124. Ibid, 388. 125. bid, 370.


In both Caparo andAl Saudi Banque the apparent conflict with earlier decisions was noted. In Caparo Lord Justice Bingham, with whose analysis Lord Justice Taylor considered the most far reaching statement of principle in this field was Justice Woolf in JEB. Lord Justice Bingham doubted whether it was necessary in that case to apply the broad reasonable foreseeability test ofAnns because the auditors knew it was intended to show the accounts to the plaints, information was provided directly to the plaintiff and it was reasonably foreseeable the plaintiff would rely on the accounts.127 In the House of Lords a similar view was adopted?28 Similarly, Hag could be explained because the auditom knew the accounts were to be made available to the bank and a potential investor.129 In A1 Saudi Banque these explanations were adopted.130

As to Scott, Lords Bridge and Oliver conceded this decision offered the plaintiff the most assistance, but the more restrictive view of Presi- dent of the New Zealand Court of Appeal Justice Richmond was to be preferred as it was consistent with the principles to be derived from earlier cases.131

Post-Caparo

The decisions over the last twenty-five years have made it clear auditors can owe a duty of care to third parties. The current issue though is when and to what extent do auditors owe a duty of care to third parties? As the above cases show, whether such a duty is owed will often depend on whether the necessary relationship of proximity exists between the auditor and the third party.132

In general terms, the tests in England and Australia for duty of care are very similar. The judgments of Lord Bridge in Caparo and Justice Millett inAl Saudi Banque are almost the same as Justice Deane's in Jaensch that the relevant duty is:

owed by the defendant to the plaintiff to take reasonable care resulting from the combination of (a) reasonable foreseeability of a real risk that injury of the kind

126. Supra n 79,704. 127. Ibid, 692. 128. For example supra n 92,378. 129. Caparo supra n 79,693. 130. Supran 79,367,370. 131. Ibid, Lord Bridge, 370-371; Lord Oliver, 389-392. 132. Hawkins supra n 84,576.


sustained by the plaintiff would be sustained either by the plaintiff, as an identified individual, or by a member of a class which included the plaintiff, (b) existence of the requisite element of proximity in the relationship between the parties with respect to the relevant a d or omission and the injury sustained, and (c) absence of any statutory provision or other common law rule ... which operates to preclude the implication of such a duty of care to the plaintiff in the circumstances of the case.133

The requirements of proximity are incapable of precise definition. There does appear to be a Merent emphasis and application of proximity principles between the recent English and Australian decisions. Only M h e r decisions ofEnglish courts will reveal whether the recent House of Lords decision in Caparo was an application of particular "proximity principles" to the facts of this case, or whether this decision marks a significant return to a traditional approach to duty of care. If the latter, and further English cases are decided by reference to a categorisation of previous cases rather than the application of a general duty of care, then the approaches of the English and Australian courts will again be substantially different?34

Caparo, Bush and Saudi all illustrate the English courts' current approach of assessing a variety of fadors to determine proximity. Indeed, in both C ~ p a r o l ~ and Bush;% it was pointed out that "voluntary assurnp- tion of responsibility" should not be treated as necessarily definitive of the requisite proximity and the same comment was made about foreseeability of reliance in A1 Saudi B a n q ~ e . l ~ ~ The House of Lords in Caparo also made it clear a possibility or probability of "reliance" will not of itself impose a duty.laAt the same time, it was recognised reliance was an important ingredient to establish proximity in this sphere?39

No doubt the High Court ofAustralia would agree with this approach as a matter of principle. However, without entering into the debate of whether voluntary assumption of responsibility now adds a n y t h g to the notion of reasonable reliance,140 recent High Court decisions make it

133. Supra n 79,586. 134. For example, San Sebastian supra n 79,354. 135. Supra n 92 Lord Roskill, 375; Lord Oliver, 383. 136. Supra n 93 Lord Griffiths, 813,815. 137. Supra n 91,367,369,370. 138. Supra n 92 Lord Bridge, 370. 139. Supra n 108. 140. F A Trindade and P Cane The Law of Torts in Australia (Melbourne: Oxford

University Press, 1985) 325.

THE EXPECTATION GAP

clear these factors, particularly reliance, play a central role in determining proximity and therefore duty of care when economic loss results from negligent misstatement. For example:

When the economic loss results from negligent misstatement, the element of reliance plays a prominent part in the ascertainment of a relationship of proxim- it^...?^^

In the same judgment reliance was treated as the "cornerstone of liability for negligent misstatement." It was also noted that the maker of a statement may come under a duty of care for various reasons, included in which was an assumption of responsibility for the statement's correct- n e ~ 5 . l ~ ~

Although the test for negligent misstatement has gone through various permutations in Australia, the test appears to be that:

whenever a person gives information or advice to another upon a serious matter in circumstances where the speaker realizes, or ought to realize, that he is being trusted to give the best of his information or advice as a basis for action on the part of the other party and it is reasonable in the circumstances for the other party to act on that information or advice, the speaker comes under a duty to exercise reasonable care in the provision of the information or advice he chooses to give?*

In Hawkins Justice Deane, with whose reasoning Chief Justice Gibbs and Justice Wilson agreed, albeit in dissent, said in special cases such as a claim for pure economic loss, the relationship of proximity will be:

characterised by some additional element or elements which will commonly (but not necessarily) consist of known reliance (or dependence) or the assumption of responsibility or a combination of the two: see, generally, Sutherland Shire Council u Heymn.lM

Similarly, a comparison of the factors used to determine proximity in the recent English decisions on economic loss and negligent misstatement and Hawkins illustrate the seemingly greater importance ofreliance and assumption of responsibility in Australia. In Caparo the Court of Appeal made reference to a number of factors, including the existence of

141. Sun Sebastian supra n 79,355. 142. Ibid, 357. 143. L Shaddock &Associates Proprietary Limited u The Council of the City of Par-

ramatta (Nol) (1981) 150 CLR 225 Mason J, 250. 144. Supra n 84,576; Sutherland Shire Council supra n 79,433-444,466-468,501-502.

See also Banque Keyser Ullmann SA u Skandia (UK) Insurance Co Ltd [I9891 3 WLR 25.

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a contractual relationship or statutory duty, assumption of responsibility, member of a determinate class and clear and close nexus between the parties. As a result of his review ofBush, Justice Millett added knowledge of identity and knowledge that the information is to be provided to the plaintiff6 and the House of Lords in Caparo agreed with this and emphasised the importance of the purpose of the ad~icelinformation.~~

Conversely, in Hawkins, Justice Deane in the context of a professional relationship, considered:

[Tlhe elements of assumption of responsibility and of reliance combine with that of the foreseeability of a real risk of economic loss to give the ordinary relationship between a solicitor and his client the character of one of proximity with respect to foreseeable economic loss?47

InSan Sebastian, the appellants argued that where intent to induce is established, this overrides many of the constraints otherwise existing against recovery for economic loss and in these circumstances, partial reliance is enough. In support of this proposition the appellants relied on a number of American authorities, including Rhode Island Hospital Trust u Swartz, Bresenoff, Yauner & Jacobs148 which concerned a claim for negligence by a third party bank against accountants who knew the plaintiffbank required the financial statements in relation to proposed loans to the audited company.

In this context the majority judgment in San Sebastian noted that: lWhere the defendant intends the statement to operate as a direct inducement to action, the reasonableness of the reliance will not be a critical factor, although in other cases the defendant's appreciation of the reasonableness of reliance will be relevant?49

Consistently with this reasoning, the High Court would arguably find an auditor owed a duty of care to any third party investor if the auditor knew his client wanted the accounts to induce the third party to invest. Such a result would be no different to Haig, JEB or Caparo and could be distinguished from Al Saudi Banque on the finding the auditors had no knowledge that the accounts would be communicated to the plaintiff banks?%

145. Supra n 103,370-371, 146. Supra n 92. 147. Supra n 84,578-579. 148. 455 F (2d) 847 (1972). 149. Supra n 79,358. 150. An approach not dissimilar to Lord Denning's in Candler supra n 60,180-181.


As these decisions stress, each case depends on its facts and the relative importance of the factors determinative of the necessary relationship of proximity vary in different categories of case. Nevertheless, on the above cases, it would seem the High Court would take a more liberal view than the House of Lords and conclude on the facts ofcaparo, as did the Court of Appeal, that the auditors owed a duty of care to individual shareholders, if not potential investors. Also, it would not be surprising ifthe facts ofAl Saudi Banque were to come before an Australian court, such that the auditors knew of the banks at the time of the audit and the foreseeability of economic loss when the banks relied on the audited accounts, for it to be held there was sufficient closeness or directness in the relationship to constitute proximity.

CONCLUSION

At worst, legal developments over the last five years reflect the historical trend for a greater range of responsibilities and standard of reasonable care to be required of auditors by the courts (and it would seem, the profession itself). To date, none of these developments indicate a fundamental change to the role of the auditor consistent with the public expectations outlined in this article. An auditor is not expected to be a bloodhound and detect every fraud and flaw in the company's books. Nor is an auditor exposed to indeterminate liability. To the contrary, the courts recognise the need to control the expansion of liability for negligent misstatement and economic loss, of which the recent decision in Caparo is a perfect example. The development of proximity of relationship as a limitation on duty of care is to be welcomed by auditors, although its practical application is still uncertain?51 Also uncertain is the extent to which the more restrictive approach of the House of Lords in Caparo will affect the Australian courts' approach to these cases.

Recent cases also emphasise that the law is not static, either in relation to the nature of auditors' responsibilities or to whom those responsibilities are owed. Although courts are conscious of the need not to expose auditors (and other advisers) to indeterminate liability, within

151. Federation General Insurance Co Ltd u AWKnott Becker Scott Ltd (unreported) Commercial Court of the United Kingdom 23 May 1989.

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reason, the law of negligence reflects community standards and, as such, community expectations. The harsh reality for auditors is public percep- tions, if not the commercial reality in Australia in 1990, is just as Justice Dickson noted for Canada in Scott in 1975: namely, commercial developments

have led to marked changes in the role and responsibilities of the accountant, and in the reliance which the public must place upon his work. The financial statements of the corporations upon which he reports can affect the economic interest of the general public as well as of shareholders and potential shareholders. With the added prestige and value of his services has come ... a concomitant and commensurately increased responsibility to the public. It seems unrealistic to be oblivious to these deve10pments.l~~

The issue then for the hture is that if present public expectations of auditors' responsibilities are perceived to be correct and continue, for how much longer will the courts, if not the legislature, ignore these expectations when ruling on auditors' responsibilities?

152. Supra n 63,74.

the expectation gap and auditors' responsibilities

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