Jimmy Farnham is the external auditor for Aussie Outback Tours Ltd, a company which promotes tours to the Australian outback and owns a chain of souvenir shops. Jimmy has been auditing the company since it was listed on the Australian Securities Exchange 7 years ago. Although the financial statements of the company have never received a qualified audit report, Jimmy is aware that the company has been making losses for the past 2 years as a result of short-term cash flow difficulties influenced by the global financial crisis. The company has no long-term loans and the bank overdraft is near its limit at the end of the current financial year.

During the current financial year, the company upgraded its accounting system to a computer database. An IT consultant was contracted to assist in the correct changeover of files for this system. At year-end, this new system had been in place for 6 months, and the directors have advised Jimmy they are happy with the way it is operating. Jimmy does not have the expertise to review and evaluate the database management system, so he asks an independent expert to undertake this role. This person concludes that the system appears reliable and that the changeover was correctly carried out. Jimmy has never before audited this type of system, so he attends some courses to familiarise himself with its features. His accounting firm has a standard work program that he uses to test the internal controls operating within the new system.

In Jimmy's review of the minutes of the board of directors' meetings, he becomes aware that the company's major shareholder (which currently owns 35 per cent of the shares of the company) is considering making an offer to purchase the remaining shares. This is because the company's share price is trading well below its net asset backing.

After the company's audited financial statements for the current year are published, the takeover offer from the company's major shareholder proceeds on the basis of an offer price equivalent to the net asset backing of $2.20 per share (as determined from the financial statements). The takeover offer results in acceptances from 94 per cent of the company's other shareholders and compulsory acquisition proceedings have been instituted for the other 6 per cent.

While these compulsory acquisition proceedings are being instituted, it is discovered that there were errors in the changeover of the computer system, which resulted in the year-end inventory at the souvenir stores being materially overstated. After the subsequent write-down of inventory, the correct net asset backing of $1.40 per share is calculated. The major shareholder commences legal action against Jimmy for alleged negligence for its loss of $0.80 per share.

Required:

Explain whether you believe the major shareholder would be successful in the legal action for negligence against Jimmy Farnham. In doing so, you should discuss and apply each of the four criteria/tests listed on p. 209 of the Leung et al textbook, as well as potential defences that could be used by Jimmy including contributory negligence.