Gavin Howe
Auditors are subject to a variety of laws and regulations, and can be held liable for both criminal and civil offences. Auditors may be sued by clients or third parties for negligence, breach of contract, and fraud. Common law liability arises from negligence, breach of contract, and fraud, whereas statutory law liability is based on specific statutes or laws applied to society. The two most important laws relating to auditors' liability are the Securities Act of 1933 and the Securities Exchange Act of 1934. Auditors are responsible for gathering sufficient and appropriate audit evidence to ensure compliance with laws and regulations, particularly those that have a direct effect on financial statements.
| Characteristics | Values |
|---|---|
| Common law liability arises from | Negligence, breach of contract, and fraud |
| CPAs must exercise | Due professional care |
| CPAs are liable for damages based on | Common law, statutory law, or both |
| Common law theories of liability | May evolve or change over time |
| Interpretation and application | May differ between jurisdictions |
| CPAs must also be concerned with the application of | The Racketeer Influenced and Corrupt Organizations Act (RICO) |
| CPAs are bound by the laws in the countries in which they operate | Yes |
| CPAs could be prosecuted for acts such as | Fraud and insider trading |
| CPAs are responsible for | Detection of non-compliance with laws and regulations |
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What You'll Learn
- Common law liability arises from negligence, breach of contract, and fraud
- Common law theories of liability may evolve or change over time
- Third parties can sue auditors for fraud
- Auditors are liable for both criminal and civil offences
- Auditors must obtain sufficient evidence of compliance with laws and regulations
Common law liability arises from negligence, breach of contract, and fraud
Common law liability in auditing arises from negligence, breach of contract, and fraud. Certified Public Accountants (CPAs) have a duty of care to their clients and can be held liable for negligence if they fail to perform their duties professionally or make errors that cause harm to their clients. CPAs can also be sued for breach of contract if they fail to fulfil the terms of their engagement letter with their clients.
Negligence in auditing occurs when CPAs violate their duty of care to their clients, resulting in harm or loss. To win a negligence claim, plaintiffs must prove duty, breach of duty, causation, scope of liability, and damages. In the context of auditing, this could involve CPAs providing inaccurate financial information or failing to modify financial statements that are materially misstated, leading to losses for investors and firm creditors.
Breach of contract in auditing refers to the violation of the terms agreed upon in the engagement letter between CPAs and their clients. For example, if a CPA fails to provide the agreed-upon services or does not perform within the scope of the contract, they may be liable for breach of contract.
Fraud is another aspect of common law liability in auditing. Third parties can sue auditors for fraud, but a contract (privity) is usually necessary. To prevail in a fraud case, third parties must prove that the auditor had a duty to exercise due care, knowingly breached that duty, and that the breach directly resulted in a loss for the third party.
It is important to note that common law theories of liability may vary across jurisdictions and can evolve or change over time. CPAs and accounting firms often carry professional liability insurance to protect themselves from legal claims and lawsuits arising from common law liability.
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Common law theories of liability may evolve or change over time
The evolution of common law theories of liability is a dynamic process influenced by various factors, including societal changes, legal precedents, and new interpretations of existing laws. As society progresses and new issues emerge, the application of common law theories must adapt to address these evolving challenges. For example, in the 19th century, during the Industrial Revolution, the law prioritised protecting new industries from damage recoveries, whereas in the 20th and 21st centuries, the focus shifted to imposing liability standards on industries due to increased consumer protection needs.
One notable aspect of the evolution of common law theories of liability is the development of various legal approaches to address specific scenarios. For instance, in the context of auditor liability, several approaches have been established to determine an auditor's liability to third parties. These include the privity approach, the near privity approach, the foreseen or "Restatement Standard" approach, and the reasonably foreseeable approach. Each of these approaches provides a framework for determining an auditor's liability based on factors such as the existence of a contract, direct communication, and the foreseeability of reliance by third parties.
The flexibility of common law theories allows them to adapt to changing social and economic landscapes. As new situations arise, common law theories can be interpreted and applied differently to ensure justice and accountability. This adaptability ensures that the law remains relevant and effective in addressing emerging issues and complexities in areas such as manufacturing, auditing, and commercial transactions.
However, it is important to recognise that while common law theories of liability may evolve, they are also subject to jurisdictional interpretations. The specific application of these theories can vary across different legal systems, reflecting the unique cultural, historical, and legal contexts of each jurisdiction. This variation highlights the dynamic nature of common law and its ability to adapt to local circumstances while maintaining a consistent framework for determining liability and accountability.
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Third parties can sue auditors for fraud
Common law liability in auditing arises from negligence, breach of contract, and fraud. Certified Public Accountants (CPAs) have an obligation to their clients to exercise due professional care and to act independently of their clients. CPAs can be held liable for damages based on common law, statutory law, or both, depending on the jurisdiction.
Auditors are responsible for the reliability of financial statements for external users and can face liabilities if they fail to perform their duties with professional competence and due care. They can be held liable for negligence or breach of contract, resulting in lawsuits from clients or third parties. To successfully sue an auditor for negligence, the plaintiff must prove four criteria: the auditor owed a duty of care, breached that duty, the plaintiff suffered a real loss, and there was a causal connection between the auditor's negligence and the loss.
There are different legal approaches to determining an auditor's liability to third parties. The Privity approach states that an auditor is liable to a third party if a contract exists. The "near privity" approach, established in Credit Alliance Corp. v. Arthur Andersen & Co., holds auditors liable for ordinary negligence if a third party is known to be using the financial statements and there has been direct communication between them. The "reasonably foreseeable" approach, stemming from Rosenblum v. Adler, is broader and holds auditors liable to all third parties relying on financial statements. The "foreseen" or "Restatement Standard" approach, established by the American Law Institute, states that auditors are liable to all third parties whose reliance on the financial statements could be foreseen, even if the auditor doesn't know the third party.
While third parties can sue auditors for fraud, not all lawsuits are justified. For example, if a company becomes unviable after an audit, the auditor is not necessarily responsible, as their role is to ensure financial statements are fairly presented against evaluation criteria. Additionally, audit risk refers to the possibility that an auditor follows the rules but still expresses an inappropriate opinion on financial statements. Disclaimers of liability in audit reports can reduce the scope for courts to assume liability to third parties, although critics argue that this reduces the incentive for good-quality audits.
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Auditors are liable for both criminal and civil offences
In the United Kingdom, the Companies Act 2006 includes sections governing who can be an auditor, how auditors are appointed and removed, and the functions of auditors. An important offence outlined in the Companies Act is 'knowingly, or recklessly causing a report under s.495 (auditor’s report on company’s annual accounts) to include any matter that is misleading, false or deceptive in a material particular'.
Auditors can also be prosecuted in a criminal court for either knowingly or recklessly issuing an inappropriate audit opinion. Civil law, on the other hand, includes contract law and the law of tort, which establish the principles for auditor liability to clients and third parties, respectively. Under contract law, 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 shareholders, as 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, resulting in some form of loss for the third party. Auditors are generally responsible to two groups of third parties:
- Known users of the financial statements, such as shareholders and creditors of the company.
- A limited class of foreseeable users, such as potential investors or creditors, who will rely on the audited financial statements.
While auditors can face liability for their actions, many lawsuits by third parties are unjustified. For instance, if a company is no longer viable, the auditor cannot be held responsible as their sole responsibility is to ensure that financial statements are presented fairly against appropriate evaluation criteria. Additionally, the phenomenon of audit risk comes into play, where an auditor may still express an inappropriate audit opinion despite following all auditing rules.
To successfully sue an auditor for negligence, a third party or client must prove the following four criteria:
- The auditor owed a duty of care as a known or foreseeable user.
- The auditor breached that duty of care (audit failure).
- The plaintiff suffered a real loss.
- There was a causal connection between the auditor's negligence and the plaintiff's loss.
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Auditors must obtain sufficient evidence of compliance with laws and regulations
Auditing is a field that requires professionals to adhere to strict standards and legal frameworks to ensure the accuracy and integrity of financial statements and compliance with laws and regulations. Auditors play a crucial role in evaluating entities' financial activities and providing assurance that these activities are lawful and accurately represented. In this context, "common law" refers to the legal liability of auditors, encompassing negligence, breach of contract, and fraud. Understanding common law in auditing is essential for auditors to navigate their legal responsibilities and potential liabilities.
Auditors have a critical responsibility to obtain sufficient evidence of compliance with laws and regulations during their audits. This involves gathering appropriate audit evidence to ensure that the entity being audited has complied with relevant laws and regulations, particularly those with a direct effect on financial statements. Obtaining such evidence is essential to mitigate the risk of non-compliance, which could result in fines or misstated financial statements.
For example, when auditing payroll, an auditor must gather sufficient evidence to ensure that tax legislation has been correctly applied. This may include reviewing documentation, performing substantive tests, and seeking explanations from management to ensure compliance with tax laws. By doing so, auditors can identify potential misstatements or irregularities and provide reasonable assurance that the financial statements are accurate and compliant with the applicable laws and regulations.
To achieve this, auditors must exercise professional judgment and maintain professional scepticism throughout the audit process. They should identify and assess the risks of material misstatement, whether due to fraud or error, and design and perform appropriate audit procedures to obtain the necessary evidence. This includes evaluating the overall presentation, structure, and content of the financial statements to ensure they accurately reflect the underlying transactions and events.
In cases of suspected non-compliance or instances where fraud and money laundering are involved, auditors must remain vigilant and follow specific procedures. They must notify those charged with governance while exercising caution if those individuals are implicated in any way. Additionally, auditors should be mindful of “tipping off" perpetrators of money laundering about their suspicions or knowledge, as this is an offence. Overall, auditors play a crucial role in upholding compliance with laws and regulations, and their diligence in obtaining sufficient evidence helps maintain the integrity of financial reporting.
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Frequently asked questions
Common law in auditing refers to the body of law that deals with the legal liability of auditors and accounting firms. Common law liability arises from negligence, breach of contract, and fraud.
Statutory law consists of written laws created by legislative bodies. Lawsuits brought against auditors based on statutory provisions differ from those under common law. Common law theories of liability may evolve or change over time, and their interpretation and application may differ between jurisdictions, while statutory law is more constrained by the text of the underlying statute.
Some common law theories of liability in auditing include the "privity" approach, the “near privity” approach, the "foreseen" or "Restatement Standard" approach, and the "reasonably foreseeable" approach.
Auditors can purchase professional liability insurance to protect themselves from legal claims and lawsuits arising from common law liability. Additionally, they can include disclaimers of liability to third parties in audit reports to reduce their exposure to litigation, as seen in the Bannerman case.
Auditors need to comply with various laws and regulations, including the Companies Act 2006, the Sarbanes-Oxley Act of 2002, and ISA 250, which outlines the objectives of the auditor in gathering evidence regarding compliance with relevant laws and regulations. Auditors are also subject to criminal and civil law, with potential offences including fraud, insider trading, and issuing misleading or deceptive reports.
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