THE AUDITOR & LIABILITY

UNDER THE LAW

Liability of auditors

1
 Objectives
• Describe the auditors’ responsibilities under
criminal & civil law.
• Discuss the role of case law in defining
auditors responsibility to third parties.
• Apply case law decisions in assessing whether
the auditor may be guilty of negligence
• Outline the various alternatives that have
been proposed or implemented to reduce
auditors’ liability
2
 Introduction
• Consider the auditors criminal & civil liability
• Emphasis on civil liability – most important?
• Recently, prime concern of auditors in civil
liability cases – liability to third parties, why?
Cost of obtaining indemnity insurance
Many actions brought against auditors
Level of damages demanded by plaintiffs
Bad publicity on the audit profession

3
 Introduction…
• Case law used to show how auditors’ liability
to third parties has developed over a period of
approximately 60 years
• Conditions to be met before the court
determines that an auditor is responsible to a
third party

4
 Criminal liability
Person can be guilty of fraud in 3 ways:
1. Fraud by false representation
2. Fraud by failing to disclose
3. Fraud by abuse of position
Failure to provide certain circumstances as
required by the Companies Act
NB: Rare for auditors to face criminal charges
Why?

5
 Civil liability
• Auditors add credibility to financial statements
• If clean opinion given & then proved later that
fin stats were not true & fair, a user who loses
as a result of reliance on the statements may
blame the auditor for the loss.
• The auditors’ liability towards the client is
based on the contractual obligation per
contract signed by both parties

6
 Civil liability…
• Client just need to prove that the auditor did
not exercise ‘duty of care’ - delict
• No contract between the auditor & a third
party
• A client or third party, who relied on an audit
report may hold the auditor liable if it can be
proved that the auditor was negligent in the
performance of his duties

7
 Civil liability…
• Examples of such scandals include BCCI, Enron
and WorldCom
• Study the following case law decisions:
Donaghue vs Stevenson (1932) Scottish case
Candler vs Crane Christmas & co. (1951)
Hedley Byrne & Co. vs Heller and Partners Ltd (1963)
The JEB Fasters case
The Twomax Limited case
The Caparo Industrial case
AWA Ltd vs Daniels (1992)
8
 Circumstances that a client or third
party may hold auditor liable
• Proof the opinion expressed done maliciously,
fraudulently or pursuant to a negligent
performance by the auditor; and
• Financial loss was suffered; and
• Auditor knew, or could reasonably have been
expected to know, at the time of the issue of
the report, that:
• The client would use the report to induce a
third party to act in a certain manner, or
9
 Circumstances that a client or third
party may hold auditor liable…
• Third party was going to rely on the report &
• At the time auditor issued report as ‘correct’,
& auditor knew that it is not and the third
party uses the report to act the auditor can be
held for financial loss.
• Auditor can be held liable to any partner,
member, shareholder or investor of the co. if
he does not report a reportable irregularity

10
 Legal liability regimes & auditors’
exposure to litigation
• Vary between countries and jurisdictions
• Differ according to:
Which actions auditor can be held liable to
Which third parties auditors liable to
Joint or several liability or proportional liability
Existence of legal liability caps & allowance to
contract liability caps and
Rules for allocation of litigation costs between
parties

11
 Challenges for legislators’ decisions
• Strike a balance between need for well-
functioning audit market
• Fair compensation to damaged parties
• Maintain strong auditor incentives to provide
audit quality, including avoiding auditors’
negligence

12
Potential ways of reducing auditor liability

• Professional indemnity insurance – cost?

• Proportional liability – carry some risk?
• Legal and associated defence costs of any
action? – bad publicity; settle out of court
• Liability limitation agreement (2008)?
• Change form from partnerships to limited
liability companies (1989 Companies Act)? –
possible liquidation
13
END

14