NOT WHAT THE DOCTOR ORDERED: SCOPE OF AUDITOR’S DUTIES

Legal Directions

Cam & Bear Pty Ltd v McGoldrick [2016] NSWSC 1894

Introduction

While the preparation of the financial statements of a Self-Managed Superannuation Fund (SMSF) is the responsibility of the trustee and/or its manager, the fund’s auditor owes a duty to ensure that the financial report presents a fair description of the circumstances described in the report. A decision of the NSW Supreme Court in Cam & Bear Pty Ltd v McGoldrick – delivered on 3 May 2017 – considered the scope of that duty. The Court found that the auditor had breached his duty of care, but that it was not causative of any loss.

Background

The plaintiff was the corporate trustee of a SMSF (the Fund). The Fund’s investments were managed by a finance business owned by Mr Lewis, a close friend of a director of the plaintiff, Dr Bear. Contributions to the Fund by the trustee were transferred to a company, LSL Holdings, in which Lewis held an interest. Another company, in which Lewis also held an interest, administered the Fund and prepared its financial accounts. Unbeknown to the plaintiff and its directors, who believed that the funds were being held in cash, LSL Holdings was using the funds for unsecured loans. The Fund’s accounts described those assets held by LSL Holdings as ‘cash to LSL Holdings’.

The auditor dealt solely with the Fund’s manager and its principal (Lewis), who was also the principal of LSL Holdings. At no stage did he deal with the plaintiff or its principals, or ensure that the audited accounts were provided to them. He had been engaged by and communicated only with those people associated with receipt of the funds from the Fund, being the same people who managed the Fund and compiled their books.

Claim by the plaintiff

In 2008, LSL Holdings was placed into voluntary administration and subsequently, liquidation. The plaintiff sued the auditor of the Fund, alleging that he was negligent and that his unqualified audit of the Fund misrepresented the nature of the Fund’s assets.

Decision on breach of duty

The Court discussed the principles applicable to a claim for negligence by an auditor and considered what a competent, reasonable auditor would have done to avoid a foreseeable risk of harm. The experts called by each party agreed that the financial statements were the responsibility of the trustees and of the management company, and that the function of the auditor is to ensure that the financial report of the Fund is presented fairly. However, the Court stated that an auditor owed a duty to exercise reasonable care, skill and diligence to ensure that the financial report presented a fair description of the circumstances described in it. The Court found that the amounts described in the Fund’s accounts as cash’ did not fairly represent those amounts, in circumstances where that description was inconsistent with both the description of cash’ in the auditor’s note to the accounts, and with the definition of cash’ in the relevant Accounting Standard.

The Court also found that the auditor had breached his duty of care to the plaintiff. Although he realised the difficulties associated with the description of cash, he sought to satisfy those concerns by a conversation with Lewis, a principal of LSL Holdings, without any independent documentary verification.

Both parties’ experts agreed that there was no obligation to consider the financial condition of LSL Holdings, as a decision about what procedures an auditor undertakes is a matter of professional judgment. However, the Court accepted the opinion of the plaintiff’s expert that, given the materiality of the balance held in LSL Holdings and the risk of valuation misstatement associated with balance held with related parties, it was probable that a competent auditor would have considered the financial condition of LSL Holdings in order to form an opinion about whether the funds fell within the relevant definition of cash. It said that the auditor should have sought the financial statements of LSL Holdings which, if provided, would have disclosed the deficiency in assets and if not provided, would have caused concern as to the lack of transparency and/or availability of assets to underpin the liability.

The Court also found that the statement by the auditor to the effect that the statements by the Fund manager and/or Lewis that the amounts were cash’ fairly represented the state of affairs of the Fund, was a misrepresentation and was false and misleading.

Causation

However, notwithstanding the Court’s finding that the defendant’s conduct was negligent, it found that the negligence was not causative of any loss. The Court held that even if the assets had been correctly stated in the accounts, it would have made no difference to Dr Bear in terms of the future investments that were made. This was because the level of trust reposed by him in Lewis, together with his conceded lack of understanding as to the difference between the description cash – LSL Holdings’ and ‘loans – LSL Holdings’, led to the necessary conclusion that this description in the financial statements was not the cause, nor a contributing factor, to the losses incurred. Rather, the losses were occasioned by an inappropriate level of trust in Lewis, and an inappropriate arm’s length relationship between the trustees and Lewis, which trust was misplaced and/or abused.

Comment

SMSF audits can be a risky area for auditors and their insurers; in part, because clients can have expectations that the audit will be conducted for a modest fee and SMSF trustees can be financially unsophisticated. This decision serves as a warning to auditors of SMSFs of the need to undertake proper enquiries to satisfy the duty owed to ensure that the financial report is presented fairly. It is also a reminder that careful analysis is required before bringing a claim as to whether, even if negligent conduct can be established, such conduct was in fact causative of loss or damage.

Authored by Greg King, Special Counsel, Melbourne


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