Auditors’ liabilities are legal claims made against auditors for losses suffered as a result of negligent or careless auditing.
Legal claim can be made against auditor under two circumstances:
- Criminal Law
- Civil Law
An auditor may be criminally liable under any of the following circumstances:
- When they accept an appointment as an auditor under a statutory provision without being qualified to act.
- When they are involved in fraud, such as falsifying accounting documents or records.
- When they are guilty of ‘insider dealing.’ Insider dealing is prohibited under the IFAC and ICAN rules of professional conduct. The criminal law of many countries makes it an offense for a person with inside knowledge of price-sensitive information to use or pass on that information.
- Money laundering.
An auditor may face legal claims for losses suffered as a result of negligent auditing under two separate branches of Civil law: Law of Contract and the Law of Tort.
LAW OF CONTRACT
A contract is an agreement between two or more persons intended to be enforceable by law. A company has a contract with its external auditor for the provision of audit services. Therefore, the company can sue the auditor for breach of contract if the auditor is negligent in carrying out the terms of the contract.
Only the company can sue the auditor for a breach of contract. Other persons (third parties) who might want to sue an auditor, such as banks and creditors, do not have a contract with the auditor. Therefore, they cannot bring a legal action under the law of contract. When a legal action is brought against an auditor by a company for breach of contract (negligence), the action is usually initiated by the board of directors of the company.
LAW OF TORT
A tort can be defined as a ‘civil wrong’ other than that arising under contract law, giving rise to a claim for damages. A civil wrong is wrongdoing that is not a criminal offense but allows the injured person to bring an action in civil law against the wrongdoer.
Examples of other persons who may suffer loss because of an auditor’s negligence and rely on financial statements that do not give a true and fair view are:
- A bank that lends money to a company, and the company subsequently defaults and fails to make payments of interest or repayments of the loan principal.
- A supplier who has given credit to the company, whose debts have to be written off as bad.
- Another company that relies on the financial statements when deciding to make a takeover bid for the audited company.
- An investor who relies on the financial statements to buy shares in the company, and the share price falls when the true state of the company later becomes apparent.
SETTLEMENT OF AUDITOR’S LIABILITY
The settlement of an auditor’s liability can be determined by court judgment or out-of-court settlements.
Court settlement is the determination of the auditor’s liability by judgment made by court order.
Out-of-court settlement involves the parties in dispute reaching a negotiated settlement rather than taking their case to court.
ADVANTAGES OF OUT-OF-COURT SETTLEMENTS:
- It avoids the cost and time involved in a court case.
- It may avoid adverse publicity for the auditor.
- The final settlement may be lower because both sides save legal costs, and the plaintiff might agree to a lower settlement to avoid the cost and the risk of losing the case.
DISADVANTAGES OF OUT-OF-COURT SETTLEMENTS:
- The final responsibility may be left undecided, so the legal position remains unclear.
- It may encourage others to act against auditors.
- Insurance premiums may rise.
AVOIDING OR LIMITING LIABILITY
It is preferable to avoid claims arising from negligent auditing. Firms can minimize the risks of being sued by ensuring the following:
- Follow appropriate auditing standards.
- Use effective quality control procedures.
- Train staff to an appropriate level of knowledge and skill.
- Ensure that the firm is up-to-date with modern auditing methods.
- Include disclaimers of liability to parties other than the company and its shareholders in the auditors’ report.
In general, if the auditor has followed auditing standards and can demonstrate this in their working papers, they will not usually be found guilty of negligence. This is why it is so important for the auditor to ensure that they maintain adequate working papers and obtain sufficient, relevant, and reliable evidence to support their audit opinion.