A revisitation of the "audit expectations gap": judicial and practitioner views on the role of...

A good deal was said in these judgments about "reasonable care and skill". Well that is a very elastic phrase. It is a phrase I suppose that must be ultimately defined by a Judge of the court in which such cases are decided. An auditor may have his own ideas, and a client may have his own ideas as to what is "reasonable care and skill", and a Judge on the bench may have somewhat different ideas from either.

Mather(1896)1

It has never yet been decided what is the exact character, nature, and extent of the duties of an auditor.

Cohen QC, Cozens-Hardy QC and Whinney (1895)2

Introduction

Mid-to-late Victorian England was a time of fundamental change, a time when the country's industrial power was at its zenith3 and empire at full stretch. Major changes were occurring in the way in which business was organised and conducted, prosperity was spreading, with an already wealthy aristocracy, burgeoning upper and middle classes4 and an emerging professional class.5 These changes were accompanied by an explosion in the number of businesses operating together with the promulgation of a series of statutes governing various types of business entities. The economy was populated by a variety of organisational entities including companies originally incorporated under Royal Charter in the sixteenth and seventeenth centuries and the Joint Stock companies of the seventeenth and eighteenth centuries.6 To these were added a plethora of "registered limited companies (as known today) formed as a result of a succession of Acts7 from 1844 onwards" (Rehaag, 1994, p. 16). As a consequence of these profound changes, investing opportunities were constantly available to an ever-increasing proportion of society with resources to invest.

One important dimension to these changes, among others, was the notion of audit and its role within the commercial affairs of the country. This was complicated by the fact that, although audit was emerging as an important element in the economy, there appeared to be little agreement as to what might be expected of, or the benefit(s) accruing from, such a process. In a climate of profound structural change, both social and economic, the paucity of direction through "regulation" (both statutory and professional), facilitated the emergence of important gaps in the expectations of a variety of parties to the audit. According to Mills (1990), the existence and de facto recognition, of long-standing divergence between auditors' perceptions of their duties and those held by non-auditors "does not appear to be disputed" (p.539). Against this background, a steady stream of case law emerged from the courts, in the first instance adjudicating disputes as they arose and secondly (and possibly by default), addressing the problems arising as a result of shortcomings in extant statutes and a lack of professional codes.

This paper renders an account of how inconsistencies within case law and inconsistent reactions by the profession, together with disagreements between the judiciary and the profession provided a confused basis for early auditing development. In more recent times similar inconsistencies have been characterised as gaps and are styled collectively as the "audit expectations gap". This phenomenon, identified for the first time in the scholarly literature by Liggio (1974)8 pays particular attention to the expectations of users of financial statements (for example, investors) and practitioner-auditors. The critical parties of interest, however, in mid-to-late Victorian England were the emerging audit-practitioners and the judiciary, each of whom are the focus of this paper. The paper extends the notion of the audit expectations gap, demonstrating, by means of an extensive use of case law and contemporary academic and professional literature, significant, and for the times, troubling gaps within the profession, within the judiciary and between the profession and the judiciary.

In addition to the trio of differences identified between the two critical participants, a further important difference identified between mid-to-late Victorian England and more recent times is the existence or non-existence of audit expectations. Modern day audit expectations gap analysis9 is premised solidly on a body of knowledge and measurable practitioner performance criteria that had not evolved in earlier times. Indeed Victorian England is characterised as a time of evolution and formulation in terms of expectations. At the start of this period, there was little accepted doctrine; however, by the end of the same period much had changed but a great deal of inconsistent attitude and application remained to be clarified. Whilst "gaps" existed in the nineteenth century, they were not so much about expectations but a series of inconsistencies as to what expectations might or should be.

The paper also highlights, for the first time, reported interactions between existing members of the profession and prospective (student) members. The extant literature is replete with reports and transcripts of lectures delivered early in the period under review and open discussion forums conducted later in the period. The content and character of these occasions is shown to change significantly as the issues became more acute for the profession.

To establish the existence of these "gaps" in the period under review, two data sources are utilised. A series of judicial decisions is reviewed, each of which has an audit issue at its core. An extensive range of additional case law material from a range of jurisdictions is introduced to complement and support key Victorian-era cases. The decisions cover the period 1859 to 1896 with the initial (and earliest) related case being Royal British Bank [1859], known as Nicol's case.10 The appeal court decision in Kingston Cotton Mill (No 2) [1896]11 draws the review period to a close. As a counterpoint to these judgements, extensive use is made of practitioner reactions reported in the professional literature of the day12 together with commentary from the extant academic literature. These provide the means to contrast the reaction of the profession to the judgement of the bench and to assess subsequent disparities. Additionally, it is also possible to contrast material and to highlight inconsistencies within the judgement material and the writings of the profession. Whilst it is reasonable to expect consistency within case law judgements and to expect the profession to speak with a united voice, records from the time suggest otherwise.

The paper reviews critical cases as documented in the law reports and reactions to these cases as recorded in professional and academic literature of the day. Primary source law report material is used to review transcripts of judicial judgements and primary source material is also utilised in regard to professional commentary and debate of the time.13 This examination, which recognises broader economic, legal and social settings,14 reveals evolving attitudes and views of the auditor's role to be associated with changing economic conditions as well as differences of opinion and lack of consensus between, as well as among, the key participants in the events of the day.

Initial developments

According to Godsell (1990, p.70), one of the first judicial decisions concerning the standard of skill and care expected of professional persons generally, consistent with those executing specialised work such as auditing, is Lanphier ? Phipos [1838]15 where Tindall, CJ., directed the jury that everyone performing such tasks does not:

undertake to use the highest possible degree of skill. There may be persons who have higher education and greater advantages than he has but he undertakes to bring a fair, reasonable and competent degree of skill (p.422).

Both Godsell (1990) and Baxt (1987) observe that the notion of "reasonableness" undeipins negligence cases to this day, particularly where there is an apparent or alleged failure to meet minimum-conduct criteria required by Common Law16 where no specific standards exist, either through private agreement or legislation.17 The latter is said to be true of auditors because, from the earliest companies legislation18 the precise role of the auditor remained largely undefined (Chandler, 1997, p.63).19 Watts and Zimmerman (1983) conclude that auditing was not a phenomenon to emerge solely within nineteenth century England,20 but suggest its manifestation at this time was simply the most recent phase in a long, evolutionary process. As audit has been a shifting paradigm through the ages it was inevitable that auditors' responsibilities particularly, would be swept up within a gradually evolving framework which was being applied generally to a range of existing and nascent professions.

Jurists' perceptions of auditors' duties

The earliest reported case concerning auditors' duties is Nicol's case [1859]. Denying relief to the plaintiff (a holder of partly-paid shares in the bank) from the collapsed bank's creditors, Turner, LJ., concluded that knowledge of fraudulent misrepresentations in the bank's accounts could be imputed to him as these were discoverable by the auditors. According to Lee (1979, p. 154), this "was the starting point of fraud as a major audit objective for the next 80 years or so", as, by implication, the judgement intimated it was reasonable for auditors to detect the fraud.21 Sterling J., subsequently affirmed the fraud-discovery notion in Leeds Estate [1887],22 stating:

It was in my view the duty of the auditor not to confine himself merely to the task of verifying the arithmetical accuracy of the balance sheet, but to inquire into its substantial accuracy and to ascertain that it contained the particulars specified in the articles of association (and consequently a proper income and expenditure account) and was properly drawn up so as to contain a true and correct representation of the company's affairs (p.802).

His honour's view was that it would be negligent on the part of the auditor if he were to only look for calculation errors in the implicit belief that preparers of financial statements would ensure themselves that "the books themselves do correspond with the facts" (Whinney, 1888, p.696).

The emphasis on auditors detecting fraud is consistent with Yamey's (1962, pp.429-30) observation that contemporary jurists considered it important that stakeholders (in particular creditors and debt-holders) be protected from the consequences of opportunistic behaviour by company servants,23 an approach particularly understandable in the context of the many spectacular corporate collapses of the time.24 Brown (1905), Todd (1932-1933, p.46), Shannon (1933, p.290) and Robb (1992, pp. 12-22) each attribute the high company-failure-rate in part to fraudulent practices. Registrar Emden in Liberator Permanent [1893],25 viewed audits as in a way offering investors protection from such actions26 whereas Romer, J., stressed specifically in Kemp [1895]27 that frauds might have been discovered earlier had auditors shown "greater care ... and not trusted" (p.94), as they have done. However, the fraud-focus emphasis was not accepted universally, as evidenced by Lord Chelmsford's28 remark in Spackman [1868]29 that the auditor's responsibility was not "to inquire into the validity of any transactions appearing in the accounts" (p.236). The narrower verification role his Lordship envisaged accords generally with their lordships' later conclusions in Irish Woollen Company [1900]30 that reasonable auditors should be more focussed on the legality of the ascertainment of company profit.

Both Chandler (1997) and Lobban (1996) intimate that the lack of any evolving consistency of approach to this issue by the courts in late-Victorian England should be of no surprise. At the height of the Industrial Revolution - a time of profound change in investing, reporting and accountability - courts were dispensing justice in individual circumstances characterised by innovative commercial activity, rather than pursuing some larger purpose of coherent, consistent regulation (Lobban, 1996, p.288). Lobban further intimates that:

Courts (like the legislature) reacted to economic change in an ad hoc, unsystematic way. They were in effect always reacting to the last crisis; but they were often caught out by the fact that they were unprepared for the next one. In solving problems before them, courts were not guided by a consistent view informed by economic goals, rather in reconciling these factors, they attempted to provide answers which seemed most just in the cases before them.

Compared to shareholders in the relatively smaller but proliferating industrial and manufacturing enterprises, a paradigm shift was occurring in respect of banking, insurance and railway companies. Investors in these classes of companies were more likely to view themselves as investors per se rather than shareholders/owners and as such the maximisation of investment returns emerged as the superior incentive. Their information requirements were more readily met by reports on financial performance than those concentrating on management honesty. Additionally an auditor-verification role applied to financial statements that confirmed company performance offered greater utility than any fraud detection role (Chandler et al., 1993, p.444). Arguably, this view appealed to and could be extended to encompass jurists who generally hailed from the wealthier sections of society (Chisholm & Nettheim, 1992, p.79)31 and were therefore more likely to participate in investment opportunities themselves.32

Auditors' understandings of their own role

Inconsistent judicial expectations as to what constituted reasonable audit standards are also not surprising when auditors themselves showed little unanimity on the issue. Parliament's silence regarding precisely what audits should entail meant that courts did not always share auditors' (albeit varied) perceptions, as the judiciary had no substantive direction with which to work. The views of the law-maker bodies had not yet formalised sufficiently to provide such guidance. In Leeds Estate [1887J the defendant clerk viewed the auditor's duty merely:

to see that the balance sheet represented and was a true result of what appeared in the books of the company, and his certificate goes no further than that ... . The auditor cannot go behind the books of the company. The inconvenience of requiring more from an auditor is obvious (pp.795-6).

This mechanical bookkeeping and arithmetical audit role, in Chandler's (1997) words, a "non-audit" (p.61),33 was rejected in Leeds Estate [1887] and subsequent cases34 despite representations from highly respected professionals who defended this as "standard practice".35 In New Oriental Bank [1892], company law expert Williams J., specifically challenged the opinion of one expert witness,36 noting he:

... did not agree with certain views, which he gathered Mr Welton entertained as to the duties of an auditor. ... did not think it was taking the true view of the duties of an auditor, to arrive, from conversations with directors, at a conclusion whether a balance sheet fairly represented the state of the bank's affairs (p. 167).

This superficial auditing approach was discouraged by auditing authorities such as Pixley (1881, p.687), Merritt Wade (1894, p.575) and Spicer and Pegler (1911, p.4), who believed a fraud-detection role could not be fulfilled with mere bookkeeping audits. However, other contributors such as Griffiths (1885, p.9) disagreed with this perception of auditors' responsibility, claiming:

It appears to be the rooted opinion ... that an auditor must have failed in his duty if a fraud has been effected whether it is eventually discovered or not... . The auditor, by some magic or by some other means ... is to prevent any evil result occurring ... .37

The "great diversity of opinion" on the auditor's role is amply illustrated by Dicksee (1892, p.7), who observed that some:

... claim an auditor's duty is confined to a comparison of the Balance Sheet with the books, while others assert that it is the auditor's duty to trace every transaction back to its source. Between these two extremes every shade of opinion may be found and among others, the opinion of most practical men.38

A further dimension of auditors' views is evident in Spackman [1868], Leeds Estate [1887] and The Liberator Permanent [1893] particularly in respect to whom auditors considered they were reporting and to whom they were ultimately responsible. In Spackman [1868], Lord Chelmsford made the observation, based on earlier testimony, that "auditors are not the agents of the shareholders."39 This point was further illustrated in Leeds Estate [1887] by Decimus Sturges, counsel for the defendant auditor Locking.40 When summarising evidence provided earlier by his client, he stated that "Locking was a mere servant of the directors, employed at an annual fee ..." (p.795). Not surprisingly, counsel for the company (and by extension the members) Horace Davey, adopted a contrarian view asserting, "Locking, the auditor was not the servant of the directors, but of the company. According to his own admission he never looked at the articles of association ..." (p.802). Davey went on to amplify his claim quoting the appropriate article, Article 101, and informing the court that, "auditors shall make a report to the members on the balance sheet and accounts" (p.790).

A similar attitude to "responsibility" was evident six years later when William Theobald, auditor-defendant in the The Liberator Permanent [1893] attested that "he was appointed directors' auditor in 1868 and continued in that position to June 1886" (p.74). Further, "he considered it his duty to protect the directors mainly, being the directors' auditor; but at the same time he should not sign accounts that were inaccurate" (p.75). At a later stage in the proceedings Theobold reiterated his view under cross-examination from the bench, making a slight concession in so doing. He testified again that "... he still maintained his duty was mainly to the directors, but he had a duty to the shareholders which he thought he did not neglect" (p.76). Testimony in these cases on this aspect of the auditor's role is premised on events that occurred years earlier and generally fall within the mid 1860s to the late 1880s. Clarification of primary responsibility would evolve subsequently and would not be of major concern in later cases.41

A number of factors apparently contributed to the inconsistencies in views that had developed. Lee (1979) observed that the auditing profession was in its infancy at this point (p. 160). The 1854 petitions for Royal Charters by The Society of Accountants in Edinburgh and the Society of Accountants and Actuaries in Glasgow, the 1867 petition by the Society of Accountants in Aberdeen and the 1880 granting of a Royal Charter to the Institute of Chartered Accountants in England and Wales42 highlight the emerging professionalising of accounting and auditing. The audit function had not yet become the sole preserve of professional accountants and regulatory capture was still a long way off. Shareholder audits were not uncommon, particularly as many of the small industrial and manufacturing companies predominating in the economy were audited by shareholder-auditors. It is both understandable and not surprising that a frauddetection emphasis was supported by certain jurists and auditors. However the lack of a uniform approach to auditing generally and the amateurish nature of many shareholder-auditors meant that establishing broad standards for auditing was destined to be a slow process.

The emerging profession's approach to its future members is also particularly apposite. The extant practitioner literature reports a stream of lectures43 delivered by eminent members of different accounting bodies to members of various student societies.44 Occasionally the topic ventured into the realm of auditing and invariably the title of the lecture was "duties of auditors", or words to that effect. The earlier lectures (Pixley, 1883, Chadwick, 1883 and Welton, 1883) were styled in this manner but, besides extolling the virtues of auditing, inevitably became detailed, prosaic dissertations of procedural issues associated with fieldwork. Occasional commentary included more substantive statements such as Pixley's (1883) view that "an auditor ... is a critic of the bookkeeper's work" (p.7). The somewhat pedestrian approach to addressing and engaging accountancy students continued until the urgency that emerged immediately following the London and General Bank (No 2) [1895] and Kingston Cotton Mill (No 2) [1896] decisions of the mid 189Os. A shift in the tenor and content of the material is abundantly clear from the substantial article appearing in The Accountant of 21 March 1896 reporting an open discussion of the "Present Position of Accountancy in View of Recent Legal Decisions". This was the first instance in the auditing domain of a joint meeting and open forum discussion involving practising accountants (Manchester Society of Chartered Accountants) and prospective members (Manchester Students Society). Whilst no students are reported to have spoken or contributed at the forum, the extant conditions had precipitated a major direction shift in regard to material that should be presented not only to members but aspiring members.

Practitioner engagements, which typically occurred in the more demanding large banking, insurance and railway companies arguably compounded the problem, creating two different auditor groups performing essentially similar tasks but on entities with different characteristics and audit demands. Auditors' different attitudes regarding their duties are therefore not surprising given the variation that existed in the degree of skill and expertise brought to the task. Jurists attempting to deliver justice in variable circumstances with decisions based mainly on the circumstances of the case before them, may also have had different views of auditors' roles. This was compounded by the possibility of fieldwork being conducted either by practitioners from the newly emerging group professing to be auditing specialists or alternatively (and possibly more likely initially) by the older and increasingly anachronistic amateur shareholder-auditors. Whilst the judiciary could invoke precedence, the number of cases and the limitations of each specific case impinged on their capacity to make judgements that developed, incrementally, more precise guidelines for audit practice. Judges' and auditors' ad hoc views of what could reasonably be required of auditors meant that gaps developed and expanded within both the judiciary and audit "community" as well as between the former and latter. Chandler (1997, p.64) believes these gaps developed on an entirely inconsistent basis. In an attempt to dispel confusion as to the criteria governing a "reasonable" audit, practitioner-writers of the time, such as Carter and Pixley, called on the Council of the Institute of Chartered Accountants in England and Wales to formulate a set of authoritative statements on audit practice (Chandler, 1997, p.74). However, the lack of action on the part of the Institute is attributed by Chandler et al. (1993, p.452) to beliefs that auditors':

judgement should not be supplanted by "rules"; an inability to reach agreement concerning the means of carrying out an audit; and ... simply an unwillingness to interfere in matters which should be left to the accountant "in the field".

This inertia also led other practitioners such as Whinney, Price and Robertson45 to advocate definition through more judicial rulings although such views, in Chandler's (1997) words, "invited judicial interference in professional practice" (p.74). The real fear and risk was that developments such as these might not necessarily be in the best financial interest of the emerging practitioner auditors. Regulation and maintenance from within was seen by many as the best approach.

Commercial issues were never far from the surface as instanced by the reaction to the words of Field, J., in Field [1885]46 who regarded the auditor's duty "to check and verify ... every item" (p. 13). This was supported by leading practitioners such as Quilter47 and writers like Pixley, but Griffiths and The Accountant's leader-writer decried this approach as economic imprudence (Chandler et al., 1993, p.450). A frank admission as to the commercial imperatives underpinning accounting firm operations was made by one of the founders of Grace, Derbyshire & Todd, a medium-size West Country firm, who characterised the firm's approach as throwing "our net... wherever ... it would catch fish, or ... money".48 Within profit-motivated professional practices, cost pressures rendered it virtually impossible for individual audit principals to perform personally, all work on all audits for which they were principals. The dramatic changes occurring in practice naturally altered operational procedures within firms, however either the accompanying commercial realities of these changes escaped jurists or they remained unconvinced of the consequences being wrought by such developments. This was evident in The Liberator Permanent [1893] when the bench, (Registrar Emden), expressed incredulity at the auditor's admission that he had signed his report without seeing all evidence available (p.80).

In other instances however, sympathetic consideration was given to the impact of commercial considerations on some audit work. The Lord Mayor in Schultz and Comins [1899]49 described as "scandalous"50 the bank's request that the auditors sign their report despite having been paid only 5 5s as the fee for the audit. A similar, albeit earlier, approach occurred in Westmoreland v Watson [1895]51 when Lawrence, J. permitted the auditors to persuade the jury that for "trumpery remuneration of 10"52 they should not be expected to monitor the plaintiff's friend and trusted servant who ultimately ended up stealing from his employer.

A contrarian and less accommodating view is apparent in the conclusion of Wills, J., in Lister Lea and Son [1884]53 who stated that if "... a man undertakes to ... work and is paid ... he must do it faithfully and properly" (p. 11). In Ross & Co. [1896],54 another employee-fraud case, a similar view was expressed when Fitzgibbon, LJ., directed jury members that "... if a man chose to ... do a thing cheaply he was not to do it badly ... a man was not to give bad goods because he was not getting a good price" (p. 106). This less than sympathetic approach is in a sense understandable from the perspective of a permanently tenured judge concerned with purity of legal reasoning.55

The variation in approach to these commercial aspects was reflectively summed up by Price (1896, p.615), a Manchester practitioner, who noted that an accountant's business is:

mainly, often primarily to gather shekels; and it is perhaps but natural that they should consider the relationship between the fees received and the services rendered. Hence it has happened and will happen again, that work which has been undertaken at unremunerative rates has been "scamped" to make it pay.

Watershed legal and auditing views on auditors' responsibilities

Against this background of differing inconsistent expectations by the judiciary and the auditing profession, the UK Court of Appeal delivered two significant judgements within a short space of time; London and General Bank (No 2) [ 1895] and Kingston Cotton Mill (No 2) [1896]. Each represented a "landmark in ... auditor's responsibilities" (Godsell, 1990, pp.72-3) and both provoked much comment at the time. As precedent decisions, they have been relied upon on many occasions since (Jackson & Powell, 1997, p.862; Godsell, 1990, pp.72-3) and in a number of jurisdictions.56

London and General Bank (No 2) [1895] -Appeal Court decision57

At a meeting called to discuss the ramifications of each of these decisions, W.H. Nairne, President of the Manchester Society of Chartered Accountants referred to the appeal decision in London and General Bank (No 2) [1895], as the profession's "Magna Charta" (p.240). The case, concerning (i) the adequacy of security on bank loans; (ii) whether shareholders had been deceived as to the condition of the company; and (iii) whether dividends had thus been paid out of capital and not profits available (p.67), had gone against the defendants, one of whom was the auditor. In his report to shareholders, the auditor had made no comment on loan valuations or of the need to recognise doubtful debts on the loans and interest. He merely stated that "the value of the assets as shown on the balance sheet is dependent upon realisation" (p.67). Whilst this may have appeared to be a somewhat innocuous confession and entirely appropriate accounting approach on the part of the auditor, the bench took gross exception to the inclusion of this phrase in the auditor's report. The auditor's position was in no way helped by the fact that his confidential report to directors had called their attention to the "insufficiency of the securities on which the capital of the company was invested" (p.67). As demonstrated by the severity of the judgement and the severity of the commentary, the bench was in no mind to accept, prima facie, such an approach.

Lindley LJ.'s reaction (with the concurrence of his fellow judges, Lopes LJ. and Rigby LJ.), is contained in his often-quoted58 passages where he outlined his view that the auditor's duty:

... is to ascertain and state the true financial position of the company at the time of the audit .... By examining the books .... But he does not discharge his duty by doing this without taking any inquiry and without taking 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. What is reasonable care in any particular case must depend on the circumstances ... . He does not guarantee that the books do correctly shew the true position of the company's affairs; he does not guarantee that the balance-sheet is accurate. It is a mere truism to say that the value of loans and securities depends upon their realisation ... the duty of an auditor is to convey information not to arouse inquiry and although an auditor might infer from an unusual statement that something was seriously wrong, it by no means follows that ordinary people would have their suspicious aroused ... if as in this case, its language expresses no more than an ordinary person would infer without it (pp.682-3 and 685).

This pronouncement firmly established the notion of the substantive, "complete" audit as first enunciated in Leeds Estate [1887], putting an end to the notion of the "biscuit and sherry" (Robb, 1992, p. 129) arithmetic audit tolerated previously.59 Rigby LJ., made particular comment concerning the report, taking particular exception to certain words contained therein. He observed that:

The words "shewn by the books of the company" seem to be introduced to relieve the auditors from any responsibility as to affairs of the company kept out of the books and concealed from them .... A full and fair balance sheet must convey a truthful statement as to the company's position (p.692).

His Lordship appeared to be in no mood to allow the auditor use of these words in order to escape responsibility or reduce duty. The upshot of the decision effectively meant that auditors should address the issue of valuation in their audit work.

The response from the accounting profession was swift and predictable. Murray (1896, p.238) claimed that many auditors had reacted with alarm, thinking "they must at once give up their bank audits".60 Far from it being the portent of doom for these particular audit activities, Chandler et al. (1993, p.450) make the prescient observation, (albeit a century later), that the judicial views expressed in London and General Bank (No 2) [1895] were simply an affirmation of the audit approach "advocated by leading practitioners for some time".61 The divergence between auditing principle and practice is also arguably demonstrated by the defendant-auditor's earlier suggestion in The Liberator Permanent [1893] that his duty ended "not quite but pretty nearly when accounts agreed with the books" (p.83). An indication of the evolving attitude of the bench can be deduced from the judicial response to the defendant's view when Vaughan Williams J., also in The Liberator Permanent [1893], in a state of disbelief, drew attention to the inherent contradiction in the evidence given to the court and the defendant's claim, made in a speech to the society's twenty-second annual general meeting, that "he went through the accounts very carefully indeed" (p.83).

Kingston Cotton Mill (No 2) [1895]-first instance decision62

Within six months of the London and General Bank decision, Vaughan Williams J. delivered the first instance decision in Kingston Cotton Mill (No 2) [1895], a decision dealing again with valuation issues and having similar general consequences as with the appeal decision in London and General Bank. For years, the mill's manager, (who was also a director of the company), had exaggerated inventory quantities and values to fraudulently overstate profits. The fraudulent activity and the true financial position of the company emerged only when a major debt default occurred. Consistent with contemporary practice, the auditor had relied on managers' certificates attesting that inventory was as shown in accounts, did not conduct a physical observation of inventory, nor take steps to confirm valuation. Inventory was thus described in the statements as "per manager's certificate" (p.333), but a simple reconciliation of closing inventory with opening balances, purchases and sales would have revealed substantial "false and misleading entries" (p.343). Vaughan Williams J. consequently found the auditors (and directors) liable in respect of dividends paid from non-existent profits but denied damages sought in respect of resultant insolvency on the tortious grounds of remoteness (p.332).

Judging by the flood of articles in The Accountant questioning the basis of the verdict, (rather than the non-award of damages), the first-instance decision provoked outcry and a sense of disbelief from the profession, specifically over the key issue of inventory valuation.63 The chorus of objections emanated from a contemporary reluctance to adopt inventory valuation as a key audit responsibility as the profession felt this role was best left to management, which, in its view, were better placed and better qualified to discharge such duties. Primacy of the manager's certificate had grown from this position. As a leading article in The Accountant (4 January 1896, p.4) argued, valuation:

of a stock-in-trade is a matter which requires expert knowledge and it is a matter upon which the opinion of an expert in accounts is practically valueless. If, therefore, it is held that directors - who presumably have some special knowledge of the business carried on by the company - are not responsible for the valuation placed upon the stock-in-trade, by all laws of logic one would have thought that, a fortiori, the auditors were not responsible and we have searched Mr Justice Vaughan Williams' judgement in vain for any convincing argument to the contrary effect.

The willingness on the part of the profession to accept valuation certificates from parties perceived to be experts was the catalyst for the judgement in this case and the risk associated with assuming managers to be experts who were in reality, less-than-independent, was seriously exposed. The judgement cast serious doubt on the worth of managers' certificates particularly when the auditor made no attempt to prove veracity or cross-validate "numbers" using a standard reconciliation process apparently easily recognised by the bench. Failure to attend to this latter task provided Vaughan Williams J., with a convenient stick with which to beat the defendant, making the telling observation that if all that was done in this respect was to:

add to the stock-in-trade at the beginning of any year the purchases of raw materials in that year, and had deducted there-from, the sales, they must have seen that the statement of stock-in-trade at the end of the year was so remarkable as to call for explanation, and they called for none (p.350).

Kingston Cotton Mill (No 2) [1896] -Appeal Court decision

The concern felt by the profession following Vaughan Williams J.'s judgement in the first-instance decision did not last. In a unanimous verdict reversing the judgement six months later, the Court of Appeal without resorting to reliance on hindsight, adopted a more accommodating view of management and the level of reliance that auditors could rightly place thereon. In this judgement, Lopes L.J., used the (now) renowned "watchdog" metaphor, noting:

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. 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 watchdog but not a bloodhound. He is justified 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 (pp.288-9).

His honour also specifically commented on audit effort and fraud, noting:

the duties of auditors must not be rendered too onerous. Their work is responsible and laborious and the remuneration moderate. 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 and when those frauds are perpetrated by tried servants of the company and are undetected for years by the directors. So to hold would make the position of an auditor intolerable (p.291).

As regards inventory, Lindley L.J.'s remark was entirely in accord with his fellow judges when he observed:

I cannot see that their omission to check his returns was a breach of their duty to the company. It is no part of an auditor's duty to take stock. ....He must rely on other people for details of the stock-in-trade on hand (p.286).

The final member of the Appeal Bench, Kay LJ., restricted his comments to the issue of auditors' duties as he saw them in respect of managers' certificates and whether a process of examination should have been applied to them. He noted "the question is, was it their duty? Upon the best consideration I can give to the case, I come to the conclusion that this was not their duty" (p.294).

The Appeal Court decision in Kingston Cotton Mill was a unanimous reversal of the lower court decision. Whilst the lower court had found a case of negligence against the auditor, the higher court judgement offered a complete vindication, rejection and reversal of the earlier decision. Understandably, the judgement was met with considerable relief throughout the auditing profession.64 However, any narrowing in the inconsistency as between jurist and auditor following the decision came about, apparently, not by design but rather by default. As Price (1896a) observed, in the aftermath of the first-instance decision in Kingston Cotton Mill [1896], a seemingly untenable situation had arisen for the profession, particularly in respect of the audit responsibilities attaching to valuation:

In the case of London and General Bank ... the auditor is not expected to be a valuer ... what then is the meaning of... Kingston ... which says that if he does not value he shall be held liable? ... those two statements stand in direct contradiction to each other and we must, before we can feel certain of our ground, have a decision that decides the difference between them (p.241).

As indicated earlier, the confusion was to be short-lived. It is arguable the final pronouncement in Kingston Cotton Mill (No 2) [1896] was driven more by the desire to maintain legal consistency than by any subjective judicial and auditor meeting of minds regarding auditors' duties.65 The disjoint between London and General Bank [1896] and the first-instance decision in Kingston Cotton Mill [1895] could not stand, and, as such, the Appeal Court decision can be viewed as correcting the inconsistency rather than a serious attempt to codify auditors' duties through case law.

Implications

The importance of these two cases cannot be overstated as Lee (1979, p. 156) observed:

these two cases, more than any other, established certain auditing standards centred on the accepted fraud and error objectives and served to put the nature of the then audit in perspective. The auditor was not expected to nose out every fraud but was required to use reasonable care and skill in his perusal of the relevant books and records. There was a recognition, implied in this, that the company auditor should be reasonably qualified to carry out this examination in a professionally expert manner.

A similar view is expressed by Gill and Cosserat (1996, p.4) who view these two cases as being:

of crucial importance in ... the recognition of auditing as a profession. The auditor does not guarantee that the financial report is fairly presented any more than the solicitor guarantees to win a case or the doctor to effect a cure. Neither does the auditor warrant to bring to bear the highest degree of skill in the performance of their duties since there may well be more skilful auditors ... within the profession. Neither is the auditor necessarily answerable for an error of judgement provided they exercise the skill and care of a reasonably competent and well-informed member of the profession.

Despite the fact that London and General Bank (No 2) [1895] (pp.682-3) and Kingston Cotton Mill (No 2) [1896] (pp.288-9) were endorsements of the "reasonableness" test that had been accepted judicially for the first time in respect of professional conduct in Lanphier [1838], the judgements were met with some consternation. This was particularly so as it became clearer that the test could be equally applied to auditing as any other area of professional endeavour. The primary concern however, was that the broad, relative nature of this "standard" (Gwilliam, 1988, p.52) provided no specific, absolute guidance as to what would constitute negligent auditing in any particular circumstance. Price (1896a, p.241) yearned for clarity and finality on this issue, musing:

I do hope ... that the time will come when the Council will upon both these points, see their way to carry the matter to the ultimate Court of Appeal in the House of Lords, so that we may know once and for all, and with absolute definiteness and certainty, what we have to expect.

A similar desperation for certainty is evident from practitioner Lancashire's (1896, p. 10) plea to the effect that, "if the law will only tell us in clear and exact terms what we are to do, then we will do it".

From the perspective of late Victorian England, the possibility that the "standard" would be relative and evolutionary had likely not yet dawned on the parties to the debate. Chandler's (1997) observation that "... over time, a more coherent vision of the audit concept was to develop" (p.64), was not obvious to those involved at the time. The conundrum as to where the notion was to go, was however, obvious to Nairne (1896, p.242) who asked:

What is reasonable care and skill in cases which are more difficult than ... and how far are we expected to go and how much is expected of us in the way of discovering these errors ... we are called upon to show that we used reasonable care and skill. But the danger is that different Judges may presume upon these decisions to come to different conclusions as to what is reasonable care and skill in varying cases and more specifically in more complicated cases.

What was particularly anathema to the profession was that their Lordships' approach, or simply the judicial system as it stood at the time, meant non-auditor judges and likely (non-auditor) lay juries, not the profession, would, to a significant extent determine what constituted "reasonable" auditing.66 Accountants recognised this posed a major threat to self-regulation expected of membership in their profession.67 Mather (1896, p.239) complained that:

... a good deal was said in these judegments about "reasonable care and skill". Well that is a very elastic phrase ... must be ultimately defined by a Judge ... . An auditor may have his own ideas, and a client may have his own ideas as to what is "reasonable care and skill", and a Judge on the bench may have somewhat different ideas from either.

From all this, Lancashire (1896, p. 10) remarked bleakly:

Is it not possible to ... protect ourselves absolutely against such a narrow definition of "reasonable care" as might mean utter ruin, both professionally and financially ... to keep myself clear of risk, I now need as it seems to me to be skilled accountant, lawyer, and High Court judge, all in one.

What appears to have been unappreciated is the judiciary's treatment of "like cases alike"68 in extending the broad standard of conduct expected from other professionals such as physicians69 and attorneys70 to the emerging accounting profession. Further, jurists arguably did not see their role as remedying the infant profession's failure to formulate precise standards relating to audit conduct, because, theoretically, they were focusing on providing individualised justice in unique circumstances and applying the generic "reasonableness" test where appropriate because of its flexible character (Mather, 1896; Gwilliam, 1988, p.52). Contrast this with the relative "certainty" associated with trade and commerce over which auditors, in the words of Tinker, lord as "paper prophets",71 and a stronger understanding of the reasons for the inconsistency of views between the judiciary and practitioners regarding the auditor's role, arguably emerges.

The moderation of the expectations of fraud detection by "reasonable" auditors which began with London and General Bank (No 2) [1896] and Kingston Cotton Mill (No 2) [1896] can also be reconciled in the context of broader economic developments. Lee (1979, p.161) points out that growing company sizes inevitably meant auditors could not possibly, nor reasonably be expected to scrutinise the sheer volume of material available. Time and cost constraints, even at this early stage in the evolutionary process made full checking unrealistic and unacceptable to fee-conscious clients and providers alike.

Conclusion

The emergence of auditing as a significant element of commercial activity in lateVictorian England was accompanied by many of the teething problems associated with a nascent profession. The profession was struggling to assert itself in a landscape more akin to a wilderness than one in which the guide posts had been neatly laid out and in which there was little difficulty navigating the obstacles and avoiding the pitfalls. Of particular concern to many members of this new grouping were differences emerging between themselves and the judiciary as well as differences that existed amongst themselves when questions inevitably arose as to the duties and responsibilities of those participating in this form of activity. From time to time, alleged lapses in audit performance made their way to the courts where jurists, charged with the responsibility of adjudicating on an almost nonexistent set of expectations for the profession, effectively set the agenda through case law. With minimal direction given in statute, jurists wrote case law in response to specific claims brought before them. Not surprisingly, in instances where judgements were interpreted as unfavourable to auditing practitioners, considerable consternation was aired in public. The later years of the nineteenth century caused considerable uncertainty in the minds of auditors as this body of case law developed, sometimes quite at odds with professional thinking of the time.

Two important appeal court decisions towards the end of the century, In re London and General Bank (No 2) [1895] and In re Kingston Cotton Mill (No 2) [1896] combined to further exacerbate for the profession, the confusion that had flowed from a series of earlier decisions. The process to this point had produced a profession that was searching for some clarity as it had become somewhat derailed from earlier interpretations and decisions handed down by the judiciary. The aftermath of the appeal decision in Kingston Cotton Mill (No 2) [1896], whilst at odds with the decision in London and General Bank (No 2) [1895], was greeted with acclaim as it was to stand as the ranking precedent decision on the issue. Relative confidence appeared to have returned following the latter decision and the century drew to a close with considerable opportunity presenting itself for both the bench and the profession to enumerate more particularly the roles and responsibilities of auditors and to narrow the "gaps" which had developed between the two parties.

What was also becoming clear to the profession in the aftermath of these two decisions was the precarious position they were in regarding the setting of groundrules and benchmarks for "reasonable" auditing. At this potentially late stage it was gradually dawning on the profession that they needed to be much more pro-active in this regard lest the initiative continue with the judiciary and the making of case law. This would be a major imperative for the new century but its success would be dependent upon the capacity of the profession to speak with one voice rather than the fragmentation that was apparent from the lack of consensus at times on a number of sensitive issues in the previous century.

In a revisitation of the modern-day phenomenon known as the audit expectations "gap", this paper has taken a contextual approach to exploring jurists' and auditors' perceptions of the auditor's role in the latter half of the nineteenth century. An examination of the reasoning and outcome of leading cases supplemented by a wide-ranging inclusion of related case material, together with an extended consideration of practitioner reactions, shows that differences of opinion and inconsistencies developed regarding what reasonably may be expected of auditors. Judicial-professional divergences were of primary concern because judges, by virtue of their office, were in a position to penalise significantly practitioners for failing to deliver what was expected of them at law regardless of whether statute was explicit or silent. From the auditor's perspective, judicial standards were uncomfortably inconsistent due to wider societal developments and differences existing between individual judges. Auditors' and jurists' views of the auditor's role under these changing conditions differed also, due arguably to the different priorities and commercial realities faced. The profession's own lack of consensus as to what might reasonably taken to be their role made for further disagreement between jurists and practitioners. It is also shown that educational activities provided for prospective members were not structured with a deliberate intention to reduce the possibility of difference in the future, however approaches were inevitably varied late in the period as the gravity of the situation grew.

As the profession struggled to assert itself in late-Victorian England, it was confronted, not only by a lack of cohesion within its own ranks, but also by a lack of agreement between itself and the judiciary. This predicament was further exacerbated by an apparent confusing lack of consistency in case law emanating from the bench, coupled with an abject lack of guidance as to what expectations may be applied to audit practitioners.