Session 3

LEGAL LIABILITY
OF AUDITORS
By

Misbahul Munir

Distinction among
Business Failure, Audit Failure, and
Audit Risk (1)
Business Failure
occurs when a business is unable to
repay its lenders or meet the
expectation of investors because of
economic and business conditions,
such
as
a
recession,
poor
management decisions, or unexpected
competition in the industry

Distinction among
Business Failure, Audit Failure, and
Audit Risk (2)
Audit Failure
occurs when auditor issue an erroneous
audit opinion resulted from the failure to
comply with the requirements of GAAS
(SPAP)
Example :

Assigning
unqualified
assistants
to
perform audit tasks who then fail to find
material misstatements that qualified
auditors would discover

Distinction among
Business Failure, Audit Failure, and
Audit Risk (3)
Audit Risk
represents the risk that the auditors
will conclude that the financial
statements are fairly stated and an
unqualified opinion can be issued
when, in fact, they are materially
misstated that cannot be discover even
though auditors in the audit have
complied with GAAS.

Distinction among
Business Failure, Audit Failure, and
Audit Risk (3)
Audit Risk
This is because

auditors are able to gather evidence

only on a test basis, and detecting wellconcealed frauds can be extremely
difficult,
there is always some risks that the
auditors will not uncover a material
misstatement due to fraud even though
the auditor complied with GAAS

Legal Concepts
Affecting Liability
Prudent Person Concept
Public assumes that CPA shall perform the
task successfully and without fault or error.
He undertakes for good faith and integrity

Liability for the Acts of Others

Generally, the partners in professional
Corporation (CPA) are jointly liable for the
civil action against any owner. Except, if
the corp. is run as limited
liability of
partnership or company.

Legal Concepts
Affecting Liability
Lack of Privileged Communication
CPAs do not have the right, under
common law to withhold information
from the courts on the ground that
information is privileged.

Terms Related Negligence and

Fraud
Ordinary Negligence
Absence of reasonable care that can
be expected of a person in a set of
circumstances

Gross Negligence
Lack of even slight care, similar as
reckless behavior, that can be
expected of a person

Terms Related Negligence and

Fraud(2)
Constructive Fraud
Existence of extreme or unusual negligence
even though there was no intent to deceive or
do harm.
Example: The auditor knew an adequate audit
was not done but still issued an opinion, even
though there was no intention of deceiving
statement users

Fraud
A misstatement is made and there is both the
knowledge of its falsity and intent to deceive

Terms Related to Contract Law

Breach of Contract
Failure of one or both parties in a contract
to fulfill the requirements of the contract.
Exc. To fulfill the date line

Third-party Beneficiary
A third party not having previlages
(legally
recognized
relationship)
of
contract but have a right and benefit
under the contract of auditee-auditors.
Exc. Bank having a large amount of loan
outstanding

Other Terms
Common Law
Laws having been developed through
court decision rather than through
government statutes.

Statutory Law
Laws having been passed by Congress
(DPR).
Examples:
UU Pasar Modal, UU Penggunan Gelar
Akuntan, UU Keu. Negara.

Other Terms
(2)

Joint and Several Liability

The auditor can be sued for not
discovering
intentionally
misstated
financial
statements
made
by
management.

Separated and Proportionated Liability

The auditor can be sued for the
negligence causing the loss of other
parties using the reckless audit report.

Four Major Sources

of Auditors Legal Liability
Client
Liability to Client under Common Law
for not discovering a material fraud

Third Party
Liability to third parties (Bank) under
common law for not discovering that a
borrowers Financial Statements are
materially misstated

Four Major Sources

of Auditors Legal Liability
Liability under UU Pasar Modal
Combined group of stockholders sue
auditor for not discovering materially
misstated financial statements

Criminal Liability
Government prosecutes auditor for
knowingly issuing an incorrect audit
report.

Auditors Defenses
against Client suits
Lack of Duty to Perform
Review Service vs Audit Service

Non-negligent Performance
Auditor had performed the audit in
accordance with GAAS (SPAP).

Contributory Negligence
The weakness of IC
Management provides fake documents

Absence of Causal Connection

The loss is resulted from other causes not as
of audit reports

The Professions Response

to Legal Liability
Research in Auditing
Standard and Rule Setting
Set Requirement to Protect Auditors

Mgt Representation Letter

Establish Peer Review

Oppose Lawsuit
Education of Users
Sanction Members for Improper Conduct
and Performance
Lobby for Changes in Laws

Protecting Individual CPA from

Legal Liability
Deal only with Client possessing
Integrity
Hire Qualified Personnel and Train and
Supervise Them Properly
Follow the Standards of the Profession
Maintain Independence
Understand the Client Business
Perform Quality audit

Protecting Individual CPA from

Legal Liability
Document the Work Properly
Obtain an engagement letter and a
Representation Letter
Maintain Confidential Relations
Carry Adequate Insurance
Seek Legal Council
Choose a Form of Organization with
Limited Liability
Exercise Professional Skepticism