AUDITING: Auditors' Liability

Professional liability of accountants and auditors

The “responsibility of the auditor (an independent person) to the client and third parties relying on the accountant's work. Accountants can be sued for fraud and negligence in performance of duties”.^[1]

Certified Public Accountants (CPAs) opinions affect their clients and their judgments can further affect investors, stockholders, firm creditors, or even partners. Large public accounting firms perform thousands of audits annually. Ultimately they will find unmodified reports on financial statements that could appear to be misleading. If CPAs fail to modify the audit report on financial statements that are materially misstated, investors and firm creditors may experience substantial losses.

As a result of litigation against public accounting firms, amounts in excess of $300 million have been awarded to these parties.^[2] Even with professional liability insurance to cover such losses, occasionally the total amounts granted to plaintiffs have surpassed the maximum amounts the insurance can or will cover. If investors sustain losses they will attempt to recover them as long as the price to bring suit is low and there is a chance for recovery. Any public accounting firm may find itself in litigation no matter how careful the CPAs were. CPAs are often required to make further payments for investors and creditors uninsured losses. The firm itself can make these payments, as can personnel who have worked on the engagement.

CPAs have common law liability and statutory law liability. Common law liability arises from negligence, breach of contract, and fraud. Statutory law liability is the obligation that comes from a certain statute or a law, which is applied, to society. Recoveries from these liabilities vary by their source or “theory”. Some of these theories are:

• Privity: CPAs and their clients enter into a contract with an agreement to perform certain services. Liability occurs when there is a breach of contract.^[3] This applies to the CPA if they don’t perform what they stated in the engagement letter and the client suffers damages.
• Negligence: Negligence may be viewed as “failure to exercise due professional care".^[4] Both clients and third parties can sue CPAs for the tort of negligence, which is a wrongful act, injury, or damage for which a civil action can be brought. Negligence can be referred to as ordinary negligence and gross negligence. Ordinary negligence is defined as failure of duty in accordance with applicable standards, and gross negligence is the lack of concern for the likelihood that injuries will result.^[5]
• Fraud: Fraud is defined to be a misrepresentation of a material fact by a person who is aware of his or her actions, with the intention of misleading the other party with the other party injured as a result.
• Statutory liability: CPAs have statutory liability under both federal and state securities laws. Statutory liability provides cover for defense costs, fines and penalties charged against the firm. Under statutory law, an auditor can be held civilly or criminally liable.^[6]

CPAs have an obligation to their clients to exercise due professional care. With an engagement letter, it provides the client and other third parties with rights of recovery. Therefore if the CPAs are not performing within the agreement set forth in the contract this will be considered a breach of contract. The clients may also claim negligence against the CPAs if the work was performed but contained errors or was not done professionally. This is considered a tort action.

In order to recover from an auditor under common law, the client must prove:^[7]

• Duty
• Breach of Duty
• Losses
• Causation

CPAs may defend against a breach of contract if they can prove that the client’s loss occurred because of factors other than negligence by the auditors. If the auditor proves the loss resulted from causes other than the auditor’s negligence, a client may be accused of contributory negligence. If a state follows the doctrine of contributory negligence, the auditor may eliminate their liability to the client based on contributory negligence by the client. Many states do not follow this doctrine.^[8] Most states permit a jury to assess the fault and apply the correct percentage of fault to the parties involved. This is called comparative negligence.

TYPES OF LIABILITY

Auditors are potentially liable for both criminal and civil offences. The former occur when individuals or organisations breach a government imposed law; in other words criminal law governs relationships between entities and the state. Civil law, in contrast, deals with disputes between individuals and/or organisations.

Criminal offences
Like any individual or organisation auditors are bound by the laws in the countries in which they operate. So under current criminal law auditors could be prosecuted for acts such as fraud and insider trading.

Audit is also subject to legislation prescribed by the Companies Act 2006. This includes many sections governing who can be an auditor, how auditors are appointed and removed and the functions of auditors.

One noteworthy offence from the Companies Act is that of ‘knowingly, or recklessly causing a report under section 495 (auditor’s report on company’s annual accounts) to include any matter that is misleading, false or deceptive in a material particular’ (s.507).

This means that auditors could be prosecuted in a criminal court for either knowingly or recklessly issuing an inappropriate audit opinion.

Civil offences

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.

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.