Auditor’s Legal Liability

Lawsuits typically faced by auditors

Alleged misstatements
– Improper or inadequate disclosure
– Inappropriate valuation
Non-discovery of fraud resulting from
negligence
Delayed completion of audit
Inappropriate withdrawal from an audit
 Expectation Gap
Auditors guarantee the accuracy of
financial statements
Auditors guarantee the financial viability of
the business
 PSA 250
Consideration of Law and Regulations in an
Audit of FS
Auditor should recognize that non-
compliance by the entity with laws and
regulations may affect the FS.
“Non compliance” are acts of omission or
commission by the entity being audited,
either intentional or unintentional which
are contrary to prevailing laws or
regulations.
 PSA 250
Consideration of Law and Regulations in an
Audit of FS - Auditor’s Responsibility
Auditor should recognize that non-
compliance by the entity with laws and
regulations may affect the FS.
“Non compliance” are acts of omission or
commission by the entity being audited,
either intentional or unintentional which
are contrary to prevailing laws or
regulations.
 PSA 250
Consideration of Law and Regulations in an
Audit of FS - Auditor’s Responsibility
Noncompliance is a legal determination
beyond the auditor’s professional
competence
Laws and regulations vary considerably in
their relation to the FS
Auditor’s responsibility for Fraud is
provided in PSA 240
Indications of Noncompliance
Government investigation
Payment for unspecified services
Excessive sales commissions and agent’s
fees
Purchases significantly below or above
market price
Unusual cash payments
Unusual transactions with companies in
tax havens
Indications of Noncompliance
Payments other than to the country of
origin of goods
Payments with lacking documentation
Accounting systems without adequate
audit trail
Unauthorized or improperly recorded
transactions
Media comment
Management’s Responsibility
Monitoring legal requirements
Instituting & operating appropriate IC
systems
Code of Conduct (creation, employee
training, monitoring)
Engaging legal advisors
Maintaining a register of significant laws
Auditor’s procedures for obtaining a
general understanding of laws &
regulations affecting the client

Knowledge of industry & business

Inquiry & discussion with management
 Considerations when auditor
detects noncompliance
Potential financial consequences
Whether the fncl consequences needs
disclosure
Whether the fncl consequences are so
serious to question the fair presentation of
the FS.
document findings and discuss with
management
 Reporting of noncompliance
To management
To the users of the auditor’s report on the
financial statements
To regulatory and enforcement authorities

Withdrawal from the engagement

• When entity does not take remedial action
 Legal Concepts Related to
Auditor’s Liability
Due Professional Care
– Prudent person concept
Sources of Responsibility
– Common law -> laws that have been
developed through court decisions rather than
government statutes
– Statutory law -> laws passed by legislative
bodies
 Legal Concepts Related to
Auditor’s Liability
Degree of Wrongdoing

Degree of wrongdoing

None Negligence Gross Fraud

(Ordinary) negligence or
Constructive
Fraud
Auditors Auditors did not Auditors Auditors issue
perform do what a consistently fail report on
appropriate reasonably to follow the financial
audit and issue prudent auditor standards of statements with
appropriate would do profession on the intent to
report an engagement deceive
 Legal Concepts Related to
Auditor’s Liability
Lack of privileged communication
– Under common law, information obtained by a
CPA from a client is not privileged. Court may
subpoena these information.
Liability for acts of others
– Partners are jointly liable for civil actions
– Partners are also liable for work of others like
employees, other CPA Firms and specialists
Legal Liability of the Independent
Auditor

Liability to clients
Liability to 3rd parties
Liability of the CPA under the NIRC
Section 321 C
Legal Liability of the Independent
Auditor
Liability to clients
- obliged to exercise due professional care
during the engagement including adherence to
professional standards and ethics.
- failure to exercise this degree of care may
constitute negligence and breach of contracts to
render professional service.
-Honest errors does not constitute negligence so
long as he exercised due professional care.
Legal Liability of the Independent
Auditor
Liability to clients
-undetected widespread fraud not detected by
auditors
- inadequate procedures were performed
- auditor is negligent
- client is entitled to recover any losses to which
the auditor’s negligence is the proximate cause
- client may also recover the audit fee for
auditor’s breach of contract.
Legal Liability of the Independent
Auditor
Liability to third parties
– Auditors are liable to all foreseeable third
parties for losses which are caused by the
auditor’s fraud or gross negligence.
Legal Liability of the Independent
Auditor
Liability of the CPA under the NIRC
– Ensure client pays the right kind and proper
amount of tax
– Second responsibility – interest of the govt.
(BIR)
– Not obliged to investigate info. Provided by
taxpayer but cant just disregard clues that
cast doubt on the accuracy of these data.
Legal Liability of the Independent
Auditor
Liability of the CPA under the NIRC Section 321 C
– Wilfully falsify report
– Certifies FS containing essential misstatement of facts
or omission of transaction –taxable income,deduction,
exemption of client
– Not being an independent CPA doing the examination
and audit of taxpayers’ books
Penalty:
- Fine of not exceeding P5000 and imprisonment of not
less than 2 years, plus cancellation of CPA license.
 Limitation on Auditor’s
Responsibility
If circumstances indicate the possible
existence of fraud & errors, the auditor
should consider the potential effect on the
financial information.
If material, auditor should perform
appropriate modified and additional
procedure to confirm or dispel such
suspicion

(Based on PSA 240)

 Limitation on Auditor’s
Responsibility
The auditor should communicate his
findings to management on a timely basis
if:
– He believes fraud may exist even if potential
effect is immaterial, or
– Fraud or significant error is actually found to
exist

(Based on PSA 240)

 Auditor’s Defenses

Against client lawsuits

Against 3rd party lawsuits
 Auditor’s Defenses
Against client lawsuits
1) lack of duty to perform the service
2) performed with reasonable care or lack
of reasonable care did not cause damages
3) absence of causal connection
4) contributory negligence
5) statute of limitations has expired.
 Auditor’s Defenses
Against 3rd party lawsuits
1) Non-negligent performance
2) Privity of contract
3) Absence of causal connection
4) Statute of limitations has expired.
Minimizing exposure to legal liability

Emphasize compliance with ISAs, Code of

Prof. Ethics and IFRS.
Thoroughly investigate prospective clients
Avoid companies where risk of litigation is
so high
Exercise extreme care in the audit of
clients w/ financial difficulties
Establish and follow QC procedures
Minimizing exposure to legal liability
Use clear engagement letters –scope &
responsibilities
Conduct audit w/ prof. skepticism
Provide opportunity for auditors to consult
with more experienced auditors about
difficult issues
Maintain professional liability insurance
coverage
Seek legal counsel whenever serious
problems occur.