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Auditor’s liability – explained

Auditor’s liability is a legal liability that can face auditor when he breaches the engagement contract, or he breaks country’s law. In other words, we can say that auditor’s liability arises when auditor performs the audit negligently or breaks the law.

Auditor’s liability can arise under two circumstances, one when The auditor performs the work negligently and two when the auditor performs his duties contrary to the provisions of the law. The liability arising from performing the audit work negligently is called civil liability because it arises from a civil case where the auditor causes financial loss to an individual or company. Liability caused by the auditor breaking the law is called criminal liability because the auditor has broken the criminal code of the country.

Criminal liability is initiated by government and it may lead to auditor paying fines or being imprisoned. Example of criminal liability is when auditor takes the audit engagement while not having the qualification stipulated in the law or when auditor destroys the documents before the time stipulated in the law.

Civil liability can arise under two circumstances. First it can occur when auditor has breached the engagement contract causing the financial loss to the owner of the entity. Auditor when he sign an engagement letter which is a contract between him and the client he is obliged to conduct the audit according to the terms in the engagement letter. So if he breaches the terms of the engagement letter and cause the financial loss to the shareholders then he may be sued under law of contract. The second circumstance which can lead to civil liability is when third party other than those who have entered into contract with the auditor sue the auditor for performing the audit negligently and causing them financial loss. The civil case under this circumstance is done under the law of tort.

For anyone to successful sue the auditor and recover his loss, he must prove in front of the court the following three points:

That he had the proximity to the auditor when the auditor was engaged in the audit. This means that the auditor knew that the plaintiff was going to use the audited financial statements. For shareholders, it is easy to prove proximity because they already have contract with auditor but for another third party it is somehow difficult to the proximity, but general principle is that, if auditor did know when performing the audit that the third party was going to use the financial statement for decision-making then there is proximity between the auditor and the third party.

That the auditor had performed the audit negligently. This means that auditor did not follow audit standards and did not perform his duties with due care.

That he has suffered financial loss due to auditor’s negligence.

It is very important for the auditor to be aware of circumstances that can lead to auditor’s liability. This is because the liabilities have sucked millions of dollars from audit firms around the world, for example, PWC paid $229 as lawsuit settlement payment to shareholders of Tyco in 2007. The other reasons besides financial implications that make auditor’s liability important include:

Auditor’s liability reduces the competition in the auditing professional because only audit firm with a big check to pay for insurance premium for possible liabilities are left to audit large companies.

Auditor’s liabilities makes auditing expensive due to the fact that audit firms have to pay the insurance premiums to guard themselves against possible liabilities.

Audit liabilities tarnish the image of the audit profession since any successful lawsuit against the audit firm portray that the firm did not perform the audit with due care.

There are several measures which countries government, professional bodies around the world have taken in order to reduce auditor’s liability. The measures include:

Allowing the audit firm to include third party disclaimer in the audit report;

Performing audit quality control to audit firm to ensure that all audit firms perform their activities up to required standards;

Some government such as Germany, have agreed to put the cap (limit) to the amount the audit firm can pay as audit liability.

Some countries such as the UK has agreed to allow the audit firm to form limited liability partnership in order to limit audit partners liability

However, no matter what the government and the professional bodies will do to minimize audit liability, the key to solving the problems lays with the audit firm themselves. All auditors’ liability comes from auditors failing to maintain audit quality to the required standards. As we have seen earlier it is difficult for the auditor to lose in the court if he did perform the audit with due care. So in order to reduce auditor’s liability audit firms must make sure that they implement quality control systems as per ISQC 1 and ISA 220, and they should always perform the audit with attitude of professional skepticism.

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5 thoughts on “Auditor’s liability – explained”

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