Topic 15: Auditors Liability Auditing, EC – July-Dec 2007

Legal liabilities of auditors

Auditors are supposed to perform their work in an honest and careful manner since they can be held
liable for negligence in the following ways:
a) They don’t carry out their work as required by the ISA
b) They fail in the duty of protecting the interest of the various users of the financial statements
i.e. any person who relies on his work.
c) They don’t carry out their work with due care and skill i.e. what an ordinary skilled man or
woman would do in that circumstance.

N.B. The auditor’s liability falls under three categories:

i) To their clients (company itself)
ii) To third parties in case of negligence
iii) Civil and criminal liabilities

CIVIL LIABILITY UNDER THE STATUTE

All auditors can be sued in a civil court when they have breached their position of trust e.g. if an
auditor uses information acquired during the course of the audit to make financial gain , then in such a
case he or she can be sued for breaching his position of trust and confidentiality.

CRIMINAL LIABILITY UNDER THE STATUTE

Section 46 of the Companies Act provide that an auditor shall be criminally liable if he willingly
makes a material false statement in any report, certification or in the financial statement with the
intention to deceive and mislead. Examples of criminal liabilities include:
i) The auditor accepts appointment when he is ineligible to do so or continue in office after
becoming ineligible.
ii) The auditor obtains the advantage of deception.
iii) The auditor falsifies accounting records or documents.
iv) When the auditor publishes misleading statements intended to deceive members.
v) When an auditor misappropriates a clients’ property.
vi) When the auditor destroys, defaces or conceals any account record or document made or
required for any accounting purpose.

LIABILITY UNDER THE LAW OF CONTRACT

There is a contractual relationship between the auditor and his client .Under this contract it is implied
that the auditor will carry out the work with a reasonable degree of skill and care. The degree of care
and skill required will mainly depend on the nature of work undertaken. Generally if the auditor has
complied with ISA it is difficult to prove that he was negligent. In the absence of suspicious
circumstances the auditor will not be liable for failing to uncover fraud and error which could not be
discovered by exercise of normal skill and care. The auditor can be accused of negligence if:
• He fails to detect fraud or error that he could have reasonably detected i.e. material
misstatement
• He fails to comply with the Generally Accepted Auditing Standards (GAAS) and practices e.g.
attending stock take, circularizing debtors, writing to the bank etc.
Topic 15: Auditors Liability Auditing, EC – July-Dec 2007

N.B. For the client to succeed in a claim for financial loss he must satisfy the court in relation to three
matters:
i) That there existed a duty of care enforceable by the law
ii) That where the duty existed the auditor was negligent in the performance of that duty
judged by acceptable professional standards
iii) That the client suffered some financial loss as a direct consequence of the auditor’s
negligence.

LIABILITITY TO THIRD PARTIES (USERS OF FINANCIAL STATEMENTS)

An auditor may be liable for negligence not only under the law of contract but also in the law of tort
i.e. if a person to whom he owed a duty of care has suffered financial loss as a result of the auditor’s
negligence. For the third party to succeed he must prove the following:
• The auditor owed him a duty of care
• The auditor was negligent
• He has suffered financial loss resulting from the auditor’s negligence.

DUTY OF CARE
In Hedley Byrne V. Heller
A duty of care exists where there is a special relationship between the parties i.e. where the auditor
knows or ought to have known that the audited accounts would be made available to and would be
relied on by a particular person. Accountants owe a duty of care if the following conditions are met:
• He is fully aware of the nature of transactions which the plaintiff had in contemplation e.g.
during the issue of prospectus.
• He knew that the advice or information would be communicated to the plaintiff either directly
or indirectly
• He knew that it was very likely that the plaintiff would rely on that advice or information in
deciding whether or not to engage in the transaction in contemplation.

The Caparo case:

The facts of this case were that Caparo Industry Public Limited Co. purchased shares in Fidelity Public
Limited Co. from June 1984 and subsequently made a successful take over bid for Fidelity. Caparo
alleged that purchase of most of the shares were made on reliance of fidelity accounts for the year to
31st March 1884 which had been credited by Touché Ross and that those accounts were inaccurate i.e.
sold at a profit of 1.3 Million instead of a loss of 0.4 Million. Caparo alleged that if the true facts had
been known they would not have made a bid. The decision was that in the circumstances the auditor
owed no duty of care to the shareholders either actual or potential in respect to investment decisions.

Kingston Cotton Mill Company

In this case, auditors accepted the certificate of the manager, a person of acknowledged competence
and high reputation to the value of stock in trade. The stock was grossly over estimated for several
years in the balance sheet as a result of which dividends were paid out of capital .The auditors did not
examine the books, if they had done so and compared the amount of stock at the beginning of the year
with the purchase and sales during the year they would have seen that the valuation required
explanation. It was held that the auditors were not liable i.e. it is not the auditor’s duty to take stock
and he does not guarantee the discovery of all frauds .It was stated that the auditor is a watchdog but
not a blood hound.