Wk 6 Notes- ACT 4070

THE AUDITOR AND LIABILITY

Because of inherent limitations of the audit profession the auditor cannot eliminate
audit risk altogether. There will always be some chances of legal suits against the
auditor possibly resulting into damages or even imprisonment.
Factors that explain increased litigation against the auditor include the following;

Increased user awareness of the possibilities and reward of litigation

Increase complexity of audit leading to increased audit risk

Joint and several liability which increases the financial base for compensation

Pressure to reduce audit fees and at the same time improve the quality of
services- this means more resources are used yet there isnt enough fees to cover
cost so some aspects may be overlooked

Punitive damages

Who can successfully sue the auditor?

Generally anyone who can support a case against the auditor could sue him. This
covers both the client and other users of the audited report including the following;

Client

Clients guarantors

Government

Employees of client

Social activists

The business and financial community

USA audit literature places a significant emphasis on the foresee-ability of other users
observing that the burden of proof by the plaintiff depends on the likelihood that an
auditor could reasonably foresee that a particular user might rely on audited financial
statements

Litigation against auditors

Auditors liability can be categorized under the following;
1. Liability under statute, including civil and criminal
2. Negligence under common law- to clients under contract law and to third
parties under law of tort

1. Liability under statute

Civil Liability- The Bankruptcy Act in the laws of Kenya provides that officers
including auditors may be liable for financial damages in respect of civil
offences and breach of trust
Criminal Liability- Sect 46 of the Companys Act states that an auditor shall be
criminally liable if he willfully makes a false statement in any report, certificate or
financial statement. Willfully implies fraudulent intention and can be difficult to
prove. The most commonly used section is Sec 17 of the Theft Act which states
that a person commits an offense if he dishonestly with a view to gain for himself
or another causes loss to another. This covers the following;
1. Destroys, defaces, conceals or falsifies any account or any record or
document made or required for any accounting purpose- or
2. In furnishing information for any purpose produces or makes use of any
account or any such record or document aforesaid which to his
knowledge is or may be misleading, false or deceptive
In the banking act, any person who:
1. Makes a statement, promise or forecast which he knows to be misleading
, false or deceptive, or dishonest or
2. Recklessly makes dishonestly or otherwise a statement, promise or forecast
which is misleading, false or deceptive is guilty of an offence if such
statement, promise or forecast conceals the facts for the purpose of

inducing a person to enter into or refrain from entering into an investment

agreement or to exercise of refrain from exercising and rights conferred
by an investment.

2 a). Negligence under common law

Liability in negligence is twofold:

to clients under contract law

To third parties under law of tort

For any person to maintain an action against the auditor in negligence, he must
prove that:
i.

The auditor owed him a duty of care

Judge Lope L J in Re Kingston Cotton Mills (1896) illustrated a duty of care

enforceable in law when he declared:
It is the duty of an auditor to bring to bear on the work he has to perform that
skill, care and caution which reasonable competent careful and cautious
auditors would use. What is reasonable skill care and caution must depend on
the circumstances of each case.
ii.

The auditor was negligent

Where a duty of care exists, the plaintiff must prove negligence on the part of
the auditor. Auditors are judged by accepted professional standards in force.
This concept was tested in the case of Wilde& Other v Cape & Dalgleish (1897)
the auditors were found to be negligent in failing to detect defalcations since
they did not examine the bank passbooks contrary to generally accepted bank
practice.

iii.

They suffered loss as a result

The client must demonstrate that he suffered some pecuniary( economic/

financial) loss as a direct consequence of the negligence of the auditor

2.b) Negligence under contract law;

When auditors accept an appointment, they enter into a contract with the
client that imposes certain obligations upon them. These obligations arise from
the terms of the contract which are either express or implied.
Express terms- will be significant if the auditor and the client agree that auditor
responsibilities should be extended beyond those set out by the companies Act
Implied terms- refer to terms left unstated because they are too obvious to
express but nevertheless impact the contract- example the auditor has a duty to
exercise reasonable care and expediency and should also expect a reasonable
remuneration for work done.
Breach of contract will occur in case of poor performance or non-performance
of the terms of the contract. Possible legal bases include suing the auditor for:

Violation of client confidentiality

Failure to provide the report on time

Failure to observe due care- example in detecting error where it was

ordinarily possible to do so

Withdrawing from an engagement without justification

Duty to Client in Tort

Laws of TortsA body of rights, obligations, and remedies that is applied by courts in civil proceeding
s to provide relief for persons who have suffered harmfrom the wrongful acts of others.

Lord Denning in the case of Esso Petroleum v Marden (1976) said In the case of
a professional man, the duty of reasonable care arises not only in contract but is
also imposed by the law apart from contract and is therefore actionable in tort
Liability to Third Parties
This is one of the most controversial and hotly debated areas in auditing today.
Caparo Industries plc v Dickman& Other (1990): Facts of the case
In 1984 Caparo Industries purchased 100,000 Fidelity shares on the open market.
On June 12 1984, the date on which the accounts were published, they
purchased a further 50,000 shares and relying on information in the accounts
further shares were acquired. By October Caparo had acquired control of
Fidelity. Caparo alleged that the accounts on which they had relied were
misleading in that an apparent pre-tax profit of some 1.3 million pounds should
in fact have been shown as a loss of 40,000 pounds. The Plaintiff argues that the
auditor owed duty of care to investors and potential investors.
The House of Lords declared that the auditors of a public companys accounts
owed no duty of care to members of the public at large who relied upon the
accounts in deciding to buy shares in the company. Further the House of Lords
held that for one to maintain an action against the auditor, such a person must
be a member of the company instituting the lawsuit. Moreover, it is a basic
maxim that the company is all members acting as a body; hence individual
members cannot sue the auditor successfully.
This landmark decision drastically reduced the groups of people who could sue
auditors to only members acting jointly.

Measures adopted by auditors to reduce Legal liability

1. Adequate planning and discharge of his duties- if an auditor proves that
audit work was carried out with due professional care, and that he
planned and executed the audit in accordance with professional
judgment he may escape legal liabilities on the premise that the auditing
profession suffers inherent limitations which the client and other users knew
or ought to have known and assumed the risk voluntarily
2. Quality control procedures: This is a preventive measure in that
adherence to quality and peer review may help the auditor avoid
litigation
3. Issuing proper disclaimer on who may use the audit report
4. Thorough client screening, so as to take on work for which he has
capacity and also understand the clients business
5. Settlement out of court- this saves time and cost and safeguards the
professional firms reputation.
6. Professional indemnity insurance( insurance against civil claims made by
users of a professionals work)- the auditor transfers the risk to an insurer
7. Limited liability partnership-this gives limited liability to partners
8. Maintenance of accurate and complete documentations- such as audit
files that can support defense against legal suits
9. Sign a clear letter of engagement that details what is expected from you
and the clients role in the audit