Case name: Kingston Cotton Mills Co.,  2 Ch. 279 (Court of Appeal)
Jurisdiction: The Court of Appeal
The learned judge: Lord Justice Lopes L.J.
More than a century has passed since the Court of Appeal in England gave a landmark judgment in the Kingston Cotton Mills case. The case is well known for describing an auditor’s duty with regard to valuations done by the client’s management.
Facts of the case
In the instant case, the managing director of Kingston Cotton Mills, who later confessed to the frauds he committed, had manipulated the accounts of the company. For many years, the quantities and values of the company’s stock had been manipulated, but there was nothing apparent in the accounts that could raise suspicion. Particularly, the values of stock were overstated to fraudulently inflate the company’s profits. Later, the true financial position of the company was revealed when it failed to pay off its debts.
The auditor relied on the certificate of stock valuation issued by the managing director and ensured that the figures appearing in the accounts were consistent with the certificate. He neither verified the stock physically nor checked the values of individual items of stock.
It was recommended to the Court that the auditor should not have relied merely on the representation of the managing director and should have conducted additional research on the matter.
Hence, the auditor was sued for failing to detect the fraud.
Judgment of the Courts in Kingston Cotton Mills
Three Lord Justices gave a unanimous decision in the favour of the auditor.
The following judgment was given:
“It is the duty of an auditor to bring to bear on the work he has to perform that skill, care, and caution which a reasonably competent, careful, and cautious auditor would use. 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 watchdog, but not a bloodhound. Auditors must not be made liable for not tracking out ingenious and carefully laid schemes of fraud, when there is nothing to arouse their suspicion …So to hold would make the position of an auditor intolerable.”
– Quoted by Lord Justice Lopes
What conclusions were drawn?
It was held that as long as the auditor exercises reasonable care and skill, he is justified in relying upon management representations. He is not needed to be a detective. Unless there are circumstances that arouse suspicion, he need not investigate in detail. He should only be reasonably cautious and careful.
Moreover, what constitutes “reasonable care and skill” depends upon the circumstances of each case.
The case decided that it was appropriate for the external auditor of Kingston Cotton Mills Co. to rely on a management representation of inventory balances, and the auditor was not held accountable for failing to discover a misrepresentation or fraud.
Another case that made audit norms stricter
Pacific Acceptance Corporation Ltd v. Forsyth (1970)
The Pacific Acceptance Corporation case eventually put an end to the narrow interpretation of the Kingston Cotton Mills case regarding the extent of audit practices.
The Pacific Acceptance Corporation case showed that the expectations in respect of an auditor’s responsibility are changing and so the standard of reasonable care is also being raised. It noticed that audit standards should become more stringent than they were in 1896. Hence, “reasonable care and skill” calls for broadening the scope of the auditor’s duties to meet the changing conditions and demands of the profession.
Generally speaking, auditors are expected to take care of the following:
- When carrying out audit procedures, keep the possibility of material fraud or error in mind.
- Supervise and evaluate the work of inexperienced staff.
- Clearly describe audit procedures in a written audit program that will be revised as the audit work progresses.
- Carry out proper and objective auditing procedures.
Are the views given in the Kingston Cotton Mills case still relevant?
According to the Kingston Cotton Mills case, an auditor is not always answerable for mistakes if he or she acts with the competence and care of a reasonably competent and well-informed member of the profession. Nonetheless, an overly literal interpretation of the Kingston Cotton Mill case has been criticized for delaying the development of better auditing techniques.
Back then in 1896, Lord Justice Lopes, though unintentionally, influenced the profession of audit for the next century. With the watchdog mindset, a passive approach was seen to be adopted in the audit work. It was presumed that the representations made by management could be and in fact, should be relied upon.
But whatever may be the scenario back then, the audit profession has increasingly been surrounded by instances of failure to meet the public interest in the last few years. Corporate scams and the failures of audit firms indicate that relying barely on the watchdog philosophy is not enough.
Over recent years, the view regarding dependence on management representations has undergone a change. Many professional standards and code of conduct principles are also laid down by accounting & auditing bodies.
Further, the liabilities of an auditor, if he is found negligent in his duties, are also provided in various laws.
The profession has started to identify that auditors’ responsibilities should be broadened and that they should consider the possibility of fraud in financial statements. International, as well as Indian Auditing Standards, require that an auditor should maintain an “attitude of professional skepticism” to recognize that a material misstatement due to fraud could occur. Even though this principle does not require an auditor to be a bloodhound, it still goes beyond the parameters of just being a watchdog.
Moreover, before relying on valuation certificates issued by management, it is expected of auditors that they check whether valuation has been done properly and in accordance with widely accepted accounting principles. He should take all reasonable steps to ensure that assets appearing on the Balance Sheet actually exist. He should see that an appropriate basis for valuation has been adopted and charges for depreciation, etc. are accounted for well.
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