There are two pieces of civil law of particular significance to the audit profession; contract law and the law of tort. These establish the principles for auditor liability to clients and to third parties, respectively. Under contract law parties can seek remedy for a breach of contractual obligations. Therefore shareholders can seek remedy from an auditor if they fail to comply with the terms of an
engagement letter. For example; an auditor could be sued by the shareholders, which was the case in the PwC settlement to Tyco shareholders referred to above.
Under the law of tort auditors can be sued for negligence if they breach a duty of care towards a third party who consequently suffers some form of loss.
Civil liabilities of an auditor
They are briefly explained under the following:
1. Liability of negligence
An auditor is expected to perform his duties with reasonable care and skill. Of course, no person can promise to always use highest degree of skill and display extraordinary knowledge while discharging their duties.
An auditor is liable to the following persons for negligence while discharging his duties.
- To his client, with whom he has contractual relationship.
- To Third parties, if the auditor knows or had reasonable opportunity to know that he (the third party) is relying on the skill and judgment of the auditor.
- However, in case of Fraud, the auditor is liable to all persons.
Consequences of negligence
Compensatory Damages
- The auditor has to pay damages for the loss resulting directly out of negligence on the part of the auditor.
- Such compensatory damages are not called for, if any remote or indirect loss is suffered by the client.
Special Damages
If the auditor has agreed to be liable at the time of entering into a contract and has had knowledge of the prevailing circumstances, special damages can be claimed for his negligence.
2. Liability of companies act
The court may summon and examine the auditor (or any officer of the company) and order him to produce books or documents of the company that are kept under his custody. This power is enforceable only after the appointment of liquidator or passing of winding up order of the company. When a company is wound up by the order of the court and if the Official Liquidator is of the opinion that a fraud has been committed and has made a report thereon, the court may examine the auditor (or any officer of the company) in public on an appointed day.
Misfeasance
Misfeasance implies breach of duty or negligence in the performance of duties. The liability for misfeasance arises only if any loss is suffered due to negligence or breach of duty. If no loss is suffered due to misfeasance, liability does not arise. Action for misfeasance
can be initiated within 5 years –
- from the date of order of winding up.
- from the first appointment of the liquidator or
- of the cause of action having arisen, whichever is longer.
Action for misfeasance can be initiated only when the company is being wound up. Compensatory damages can be claimed from all the officers of the company, including an auditor, for the loss suffered due to misfeasance.
Misstatement in Prospectus
A prospectus is an invitation extended to subscribe for shares in or debentures of a company. An auditor becomes liable if, he had made an untrue statement as an expert and a person has relied on the statement made by the auditor and subscribed for any shares or debentures and incurred loss or damages as a result.
However an auditor is no liable
- if he can prove that the prospectuses was issued without his knowledge or consent and on becoming aware of the same, he has issued a public notice that it was issued without his knowledge or consent or
- if he withdrew his consent in writing before the delivery of the prospectus for registration or
- after delivery of the prospectus for registration but before allotment of shares, on becoming aware of the untrue statement, if he withdrew his consent in writing and gives reasonable public notice of his consent in writing and gives reasonable public
notice of his reasons for withdrawal or - if he has reasonable grounds to believe that the statement was true and did believe the statement was true up to the date of allotment of the shares or debentures.
3. Liability under consumer protection act
The following points should be borne in mind:
1. The auditor gives his opinion or advice on payment of fees. Therefore, they come under the purview of Consumer Protection Act.
2. If any chartered accountant gives opinion or advice contrary to the provisions of law or any opinion not supported by any judicial decisions, he may be called upon to compensate by paying damages for the loss suffered as a result of his opinion or advice.
4. Liability for unaudited statements
A chartered accountant may accept assignments other than his audit work. For example, a chartered accountant may accept to write the books of accounts and prepare the financial statements for a client. He may not have actually audited the client‘s accounts.
However, since he has associated himself in the preparation of financial statements, there is every possibility of a third party to presume that he is the auditor of the company to which he had prepared financial statements and that the books of accounts were duly audited.
In such an event, a chartered accountant becomes liable. However, to avoid such misinterpretations, the chartered accountant should be very careful while entering into a contract/ agreement with a client. Actually, when he is not required to audit the books of
accounts, or where he is not required to perform a complete audit, such facts should be clearly stated in the letter of appointment.
Precautions to be taken by an auditor for unaudited statements When an auditor gives a report on certain specific matters, where his scope of engagement is quite limited, he is advised to take the following precautions while reporting to avoid liability.
1. The title of the report should clearly state the purpose/scope of report.
2. Ambiguous terms such as review, general review, or check should not be used in describing his engagement.
3. In his correspondence with the firm or in any other document, the auditor should not use the term audit or audit fee.
4. The report should clearly state that the books of accounts are unaudited.
5. Liability for negligence of assistants.
An auditor is entitled to rely on the work performed by the assistants. But he should ensure that his assistants are not negligent and the audit is conducted with due care and skill. However, he will continue to be responsible for forming and expressing his opinion on the financial information.
