Topic 2 PDF

2
LIABILITY OF AUDITORS
Learning Outcomes
After studying this chapter, you should be able to:

 Explain auditor’s liabilities under the Companies Act
2016.
 Describe accountants’ liability to third parties under
common law and related defenses.
 Explain how audit firms can minimize their liability
to third parties.
 Describe how the profession and individual auditors
can reduce the threat of litigation.
FUNDAMENTALS OF AUDITING All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1– 2
Introduction
 The responsibility of public accountants to

safeguard the public’s interest has increased as the
number of investors has increased, as the
relationship between corporate managers and
stockholders has become more impersonal, and as
government increasingly relies on accounting
information.

Introduction (cont.)
 Factors that lead to increased litigation against

auditors include:
(a) Increased audit complexity caused by
computerized systems, new types of
transactions and operations, more complicated
accounting standards and more international
business.
(b) Pressures to reduce audit time and improve
audit efficiency.

Introduction (cont.)
(c) Misunderstanding by users that an unqualified

opinion is an insurance policy against misstatements
(expectations gap).
(d) The possibility of the plaintiff to claim 100% of their loss
against the auditor, if they were to win the case.

Types of Litigation
 Liability that affects public accounting firms is derived

from the following laws:
(a) Common law includes liability concepts which are
developed through court decisions based on negligence,
gross negligence, or fraud.
(b) Statutory law includes liability which is based on federal
securities laws or state statutes. Among the most
important of these statutes to the auditing profession in
Malaysia is the Companies Act 2016.

Liability under Common Law
 Causes of legal action against auditors under the

common law are:
(a) Breach of contract;
(b) Negligence - failure to exercise a reasonable level of
care that causes damage to another;
(c) Gross negligence - failure to exercise even a minimal
level of care (reckless disregard) but without intent to
harm or damage anyone; and
(d) Fraud - intentional concealment or misrepresentation of
material facts that cause damages to those deceived.

(cont.)
Breach of Contract
 A breach of contract occurs when an auditor fails to
perform a contractual duty.
 Breach actions include:
(a) Violating client confidentiality;
(b) Failing to provide the audit report on time;
(c) Failing to discover a material error or employee fraud; and
(d) Withdrawing from an audit engagement without
justification.
 Parties to the contract can file suit.

(cont.)
 Among the court remedies to a breach include:

(a) Requiring specific performance of the contract
agreement;
(b) Granting an injunction to prohibit the auditor from
doing certain acts, such as disclosing confidential
information; and
(c) Providing for recovery of amounts lost as a result
of the breach.

(cont.)
 In their defense, auditors may include the following:

(a) The auditor exercised due professional care in
accordance with the contract.
(b) The client was contributory negligent.
(c) The client’s losses were not caused by the breach.

(cont.)
Liability to Clients & Third Parties-NegligenceNegligence

 Tort- a wrongful act other than a breach of contract for
which civil action may be taken.
 Action for tort of negligence can be brought against
accountants by the client or by non-client third parties.
 To be liable for negligence, five conditions must be
fulfilled:
(a) The auditor owes a duty of care to the plaintiff to conform
to a required standard of care;
(b) Breach of duty of care to the plaintiff on the part of the
auditor;
(cont.)
(c) Causal relationship or connection between auditor’s

negligence and plaintiff damage;
(d) Plaintiff suffers actual loss or damage, and
(e) It is fair, just and reasonable for the court to
impose a liability on the auditor.

(cont.)
 Duty of care- obligation to exercise a level of

care, as is reasonable in all circumstances, in
carrying out professional work.
 In other words, the auditor is:
(a) Applying the most up-to date accounting and
auditing standards;
(b) Adhering to all standards of ethical behaviour
laid down by the relevant professional bodies;

(cont.)
(c) Being aware of the terms and conditions of the

appointment as set out in the engagement letter
and as implied by law; and
(d) Employing competent staff who are adequately
trained and supervised in carrying out their duties.

(cont.)
 To prevail in a negligence, a plaintiff must generally

prove that:
(a) They suffered a loss;
(b) The loss was due to reliance on misleading
financial statements; and
(c) The auditor knew, or should have known, that the
financial statements were misleading.

(cont.)
 The courts have ruled that auditors can be held

liable by clients and third parties who are
reasonably expected to rely on audited statements.
 Generally, courts have classified third-party users
into three groups:
(a) Identified users are specific individual users who

the auditor knows will use the statements to make a
specific decision.

(cont.)
(b) Foreseen users while not individually known,

belong to a specific group of users whom the
auditor knows will use the statements.
(c) Foreseeable users belong to a general class of
users whose members may or may not use the
financial statements.

(cont.)
 Cases:
– Cenco Incorp. v Seidman & Seidman (1982)
• Negligence to client
– Candler v Crane, Christmas & Co. (1951)
• Negligence to third party
– Caparo Industries PLC v Dickman & Others
(1990)

Liability Under Statutory Law
 Under US laws, auditor liability under Federal

statute was established by the Securities Act of
1933 and the Securities Exchange Act of 1934, and
most recently modified by Sarbanes/Oxley Act of
2002.
 Auditors found to be unqualified, unethical, or in
willful violation can be disciplined by the SEC.

(cont.)
 Sanctions include:
(a) Temporarily or permanently revoking the firm’s
registration with the Public Company
Accounting Oversight Board;
(b) Civil penalties of up to USD 50,000 per
violation; and
(c) Require continuing education of firm personnel
 Investors in public companies may sue auditors
under the common law, statutory law, or both.

(cont.)
 In Malaysia, legal actions may be brought against

auditors for violating the Companies Act 2016.

(cont.)
Companies Act 2016

 Section 167 provides for civil liability for
misstatements in prospectus.
– An auditor, as an expert who authorizes and
causes the issue of the prospectus is liable to pay
compensation to persons who purchase shares
or debentures on the faith of the prospectus for
any loss sustained by reason of untrue
statements or wilful non-disclosure of any mater
which is material.
(cont.)
 Prospectus- includes both information describing

the entity and the securities offered and other
detailed information such as statement of financial
position and statements of earnings.

(cont.)
 However, they not liable if they can prove that:

(a) They have withdrawn their consent before the
prospectus was lodged with the SC.
(b) The prospectus was issued without their knowledge or
consent, or they have been given public notice after they
became aware of the issue.
(c) They have withdrawn their consent before the allotment
or sale of shares, after becoming aware of the untrue
statement, and have given public notice of the
withdrawal.
(d) They were competent in making the statement and have
reasonable grounds to believe that the statement is true.
(cont.)
Criminal Liability to Third Parties
 Auditor can also be subject to criminal proceedings
under the corporate or securities laws.
 Example:
– Failure to report non-compliance (Section 266(13)
of the Companies Act);
– Insider trading.
 Results in auditors being given large fines and
imprisonment.
 Criminal actions against auditors are rare.

Limitations of Liability
 Auditors and accountants can minimize their

potential liability in a number of ways:
(a) Periodic rotation of audit engagement partner
(b) Prohibit certain non-audit services for public
company audit clients
(c) Restrict other non-audit services for audit clients
(d) Firm policies including training programs that
emphasize auditor independence and requiring
each auditor to sign a statement of independence

Limitations of Liability (cont.)
(e) Other-control programs: The Sarbanes-Oxley

Act 2002 requires the PCAOB perform quality
reviews of registered public accounting firms
(f) Internal reviews: concurring partner reviews and
interoffice reviews

Limitations of Liability (cont.)
 There are other actions that firms can take to

ensure quality and minimize liability exposure
including:
(a) Issuing engagement letters;
(b) Making appropriate client
acceptance/continuance decisions;
(c) Evaluating the audit firm’s limitations; and
(d) Maintaining high-quality audit documentation


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2

After studying this chapter, you should be able to:

FUNDAMENTALS OF AUDITING All Rights Reserved

 The responsibility of public accountants to

FUNDAMENTALS OF AUDITING All Rights Reserved

 Factors that lead to increased litigation against

FUNDAMENTALS OF AUDITING All Rights Reserved

(c) Misunderstanding by users that an unqualified

FUNDAMENTALS OF AUDITING All Rights Reserved

 Liability that affects public accounting firms is derived

FUNDAMENTALS OF AUDITING All Rights Reserved

 Causes of legal action against auditors under the

FUNDAMENTALS OF AUDITING All Rights Reserved

FUNDAMENTALS OF AUDITING All Rights Reserved

 Among the court remedies to a breach include:

FUNDAMENTALS OF AUDITING All Rights Reserved

 In their defense, auditors may include the following:

FUNDAMENTALS OF AUDITING All Rights Reserved

Liability to Clients & Third Parties-NegligenceNegligence

(c) Causal relationship or connection between auditor’s

FUNDAMENTALS OF AUDITING All Rights Reserved

 Duty of care- obligation to exercise a level of

FUNDAMENTALS OF AUDITING All Rights Reserved

(c) Being aware of the terms and conditions of the

FUNDAMENTALS OF AUDITING All Rights Reserved

 To prevail in a negligence, a plaintiff must generally

FUNDAMENTALS OF AUDITING All Rights Reserved

 The courts have ruled that auditors can be held

(a) Identified users are specific individual users who

FUNDAMENTALS OF AUDITING All Rights Reserved

(b) Foreseen users while not individually known,

FUNDAMENTALS OF AUDITING All Rights Reserved

FUNDAMENTALS OF AUDITING All Rights Reserved

 Under US laws, auditor liability under Federal

FUNDAMENTALS OF AUDITING All Rights Reserved

FUNDAMENTALS OF AUDITING All Rights Reserved

 In Malaysia, legal actions may be brought against

FUNDAMENTALS OF AUDITING All Rights Reserved

Companies Act 2016

 Prospectus- includes both information describing

FUNDAMENTALS OF AUDITING All Rights Reserved

 However, they not liable if they can prove that:

FUNDAMENTALS OF AUDITING All Rights Reserved

 Auditors and accountants can minimize their

FUNDAMENTALS OF AUDITING All Rights Reserved

(e) Other-control programs: The Sarbanes-Oxley

FUNDAMENTALS OF AUDITING All Rights Reserved

 There are other actions that firms can take to

FUNDAMENTALS OF AUDITING All Rights Reserved

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