Chapter 8

Auditor’s Legal Liability

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 Introduction to Auditor’s Legal Liability

When investors and creditors suffer losses from a bankrupt entity, they
look for “deep pockets”, those who have the ability to pay for their lo
sses if ordered to do so by a court. Investors and creditors often con
sider accounting firms deep pockets.
Lawsuits against auditors typically involve alleged misstatements that t
he auditors did not detect in the FS. These misstatements are:
(1) an improper or inadequate disclosure; or
(2) an inappropriate valuation

The expectation gap often results in unwarranted lawsuits which had c

aused significant increases in both litigation costs and liability insura
nce premiums among the public practitioners.

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 Auditor’s Responsibility
Philippine Standard on Auditing (PSA) 250 (Redrafted), “Consideration of Laws and
Regulations in an Audit of FS”, establishes standards and provides guidance
on the auditor’s responsibility to consider laws and regulations in an audit of F
S.

Auditor’s Responsibility
PSA 250 (Redrafted) provides the following guidelines:
(a) When planning and performing audit procedures and evaluating and reporting the result
s thereof, the auditor should recognize that noncompliance by the entity with laws and r
egulations may affect the FS.
(b) The term “noncompliance” as used in this PSA refers to acts of omission or commission
by the entity being audited, either intentional or unintentional, which are contrary to the
prevailing laws or regulations.
(c ) Whether an act constitutes noncompliance is a legal determination that is ordinarily bey
ond the auditor’s professional competence. The determination as to whether a particula
r act constitutes or is unlikely to constitute noncompliance is generally based on the adv
ice of an informed expert qualified to practice law but ultimately can only be determined
by a court of aw.
(d) Laws and regulations vary considerably in their relation to the FS. Noncompliance with l
aws and regulations could result in financial consequences for the entity such as fines, l
itigations, etc.
(e) Guidance on the auditor’s responsibility to consider fraud and errors in an audit of FS is
provided in PSA 240 (Redrafted), “The Auditor’s Responsibility to Consider Fraud and E
rror in an Audit of FS.” 3
Responsibility of Management for the Compl
iance with Laws and Regulations
• Monitoring legal requirements and ensuring that operating procedur
es are designed to meet these requirements.
• Instituting and operating appropriate system of internal control.
• Ensuring employees are properly trained and understand the Code
of Conduct.
• Monitoring compliance with the Code of Conduct and acting appropr
iately to discipline employees who fail to comply with it.
• Engaging legal advisors to assist in monitoring legal requirements.
• Maintaining a register of significant laws with which the entity has to
comply within its particular industry and a record of complaints.

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Procedures used by the auditor to obtain general u
nderstanding of the laws and regulations

• Use the existing knowledge of the entity’s industry and business.

• Inquire of management concerning the entity’s policies and procedur
es regarding compliance with laws and regulations.
• Inquire of management as to the laws and regulations that may be e
xpected to have a fundamental effect of the operations of the entity.
• Discuss with management the policies or procedures adopted for ide
ntifying, evaluating and accounting for litigation claims and assessm
ents.
• Discuss the legal and regulatory framework with auditors of subsidia
ries in other countries.

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 Procedures When Noncompliance is Discovered

To Management:
• When the auditor becomes aware of information concerning a possible insta
nce of noncompliance, the auditor should obtain an understanding of the nat
ure of the act and the circumstances in which it has occurred, and sufficient
other information to evaluate the possible effect on FS.
• The auditor, as soon as practicable, either communicate with the audit com
mittee, the board of directors and senior management, noncompliance that
comes to the auditor’s attention.
• If the auditor suspects that members of the senior management, including m
embers of the board of directors, are involved in noncompliance, the auditor
should report the matter to the next higher level of authority at the entity.
• When no higher entity exists, or if the auditor believes that the report may n
ot be acted upon or is unsure as to the person to whom to report, the audito
r would consider seeking legal advice.

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Procedures When Noncompliance is Discovered (c
ontinued…)

To the Users of the Auditor’s Report on FS:

• If the auditor concludes that the noncompliance has a material effect on the
FS, and has not been properly reflected in the FS, the auditor should expres
s a qualified or adverse opinion.
• If the auditor is precluded by the entity from obtaining sufficient appropriate
audit evidence to evaluate whether noncompliance that may be material to t
he FS, has, or is likely to have, occurred, the auditor should express a qualif
ied opinion or a disclaimer opinion on the FS on the basis of a limitation on t
he scope o the audit.
• If the auditor is unable to determine whether noncompliance has occurred b
ecause of limitations imposed by the circumstances rather than by the entity
, the auditor should consider the effect on the auditor’s report.

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Procedures When Noncompliance is Discovered (c
ontinued…)

To Regulatory and Enforcement Authorities:

The auditor’s duty of confidentiality would ordinarily preclude reporting noncom
pliance to a third party. However, in certain circumstances, the duty of confi
dentiality is overridden by statute, law or by courts of law.

Withdrawal from the Engagement

The auditor may conclude that withdrawal from the engagement is necessary w
hen the entity does not take the remedial action that the auditor considers n
ecessary in the circumstances, even when the noncompliance is not materi
al to the FS.

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Legal Concepts Related to Auditor’s Liability
a) Due Professional Care
Auditors are not guarantors of the statements’ accuracy. Auditors are not infallible
and can make errors in judgment but auditors are expected to exercise the same r
easonable care with which others in the profession would perform in similar circum
stances. This is referred to as due professional care. The standard of due care to
which the auditor is expected to be held is often referred to as the prudent person
concept.
b) Sources of Responsibility
The auditor’s legal responsibilities to others are established by either common law
or statutory law.
Common laws are laws that have been developed through court decisions rather t
han through government statutes. Ex: an auditor’s liability to a bank related to the
auditor’s failure to discover material misstatements in financial statements that wer
e relied on in issuing a loan.
Statutory law refer to the body of laws passed by legislative bodies such as Congr
ess. Ex: auditors for an entity selling securities under the Securities Act owe a stat
utory duty to a purchaser of those securities.

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Legal Concepts Related to Auditor’s Liability
(continued…)

c) Degree of Wrongdoing
The courts have identified two degrees of wrongdoing:
1. Ordinary negligence implies the absence of reasonable care that can be expected of a person i
n a set of circumstances. Auditors are guilty of ordinary negligence if they do not do what reasona
bly prudent auditors should do in the circumstances.
2. Auditors are guilty of gross negligence if they consistently fail to follow the standards of the prof
ession on an engagement.

d) Lack of Privileged Communication

Generally, CPAs shall not disclose any confidential client information without the specific consent
of the client. Permission however is not required from the client if the working papers are subpoen
aed by the court.

e) Liability for Acts of Others

The partners in a CPA firm are jointly liable for civil actions against a partner. They are also liable f
or the work of others such as their employees, other CPA firms engaged to do part of the work an
d specialists called upon to provide technical information.

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 Responsibility in Tax Practice
The CPAs as tax advisers has a primary responsibility to client; that is, to e
nsure that the client pays the right kind and proper amount of tax.

Liability of the CPA under the National Internal Revenue Code Sections 321 (c):
Any CPA employed exclusively to examine and audit books of taxpayers or any person under
his direction who:
1. willfully falsifies any report or statement bearing on any examination or audit or renders
a report on statements which have not been verified by him personally or under his supervi
sion or by a member of his firm in accordance with sound auditing practices; or
2. certifies FS of a business enterprise containing an essential misstatement of facts or om
ission in respect to the transaction, taxable income, deduction and exemption of is client; o
r
3. not being independent CPA examine and audits books of taxpayers.
shall be punished by a fine of not exceeding, five thousand pesos and imprisonment of not les
s than two years. The CPA’s certificate shall also be automatically revoked or cancelled.
Section 290.180 of the Revised Code of Ethics for Professional Accountants in the Philippines states the pro
vision to taxation services to FS clients.

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 Guidelines in Dealing with “Tentative FS”
The salient features of PAPS 1001 Ph are:
• The purpose of this Philippine Auditing Practice Standards (PAPS) is to pro
vide practical guidance to auditors in dealing with what is currently referred t
o as “tentative financial statements”. This term is generally used at present t
o refer to a set of incomplete or unaudited FS accompanied by a report of a
n external auditor who has not yet completed his audit of such FS.
• Companies in the Philippines are required to file FS with regulatory agencie
s such as the Securities and Exchance Commission (SEC), the Bureau of In
ternal Revenue (BIR) and the Bangko Sentral ng Pilipinas (BSP), among ot
hers.
• Except for the BR and the Board of Contractors, government agencies do n
ot accept, as part of a company’s annual filing or as one of the requirements
for bidding purposes by contractors, tentative FS.

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 Responsibility over Financial Statements

a. As provided in PSA 200, Objectives and General Principles Governin

g on Audit of Financial Statements, the responsibility for preparing a
nd presenting the FS is that of the management of the entity. The au
dit of the FS does not relieve the management of its responsibility.
b. The responsibility of management cited above applies whether the F
S are considered incomplete or unaudited or final audited FS.
c. On the other hand, an auditor, based on the terms of a regular audit
engagement, is responsible for forming and expressing an opinion o
n the FS

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Handling of Incomplete or Unaudited FS (PA
PS1001 Ph)
PSA 200 (Revised and Redrafted) provides that an audit in accordance with PSAs is desi
gned to provide assurance that the FS taken as a whole are free from material missta
tements.
PSA 500 (Redrafted), Audit Evidence provides that the auditor shall obtain sufficient appr
opriate audit evidence to be able to draw reasonable conclusions on which to base th
e audit opinion. Sufficiency is the measure of the quantity of audit evidence. Appropri
ateness is the measure of quality of audit evidence; that is, its relevance and its reliab
ility in providing support for, or detecting misstatements in, the classes of transactions
, account balances, and disclosures and related assertions.
Under the circumstances whereby incomplete or unaudited FS are drawn up, the auditor
has not yet obtained sufficient appropriate audit evidence to be able to draw a conclu
sion.
Accordingly, the auditor shall not be associated with incomplete or unaudited FS, he shall
not issue a report on the incomplete or unaudited FS or consent to the use of his nam
e in connection with such FS. This is to avoid any risks on the part of the auditor that
may arise from being associated with a client’s preliminary figures that may eventuall
y differ materially from the final figures determined at the completion of his audit.

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 Limitation on Auditor’s Responsibility

In the event that the auditor fails to detect fraud and is found negligent, a client i
s entitled to recover any losses occurring since the auditor’s negligence was
proximate cause. Also the client may recover the audit fee because of the a
uditor’s breach of contract.

It is true that the basic purpose of an audit is to render an opinion on the fairnes
s of the FS and not to detect fraudulent acts by employees. However, if an u
ndetected fraud is so widespread and such magnitude as to cause the FS to
be materially misstated, the argument may be advanced that the auditor’s pr
ocedures were clearly inadequate and that the auditor was negligent.

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 Auditor’s Defenses Against Client Suit

(1) The CPA firm can claim there was no implied or expressed contact to per
form the service. This is referred to as lack of duty to perform the service.
(2) The audit was performed using reasonable care or lack of reasonable car
e did not cause damages.
(3) The reliance on the FS did not cause the loss. This is also referred to as
absence of causal connection.
(4) In cases in which a tort is involved, auditors in some jurisdiction can claim
contributory negligence (that the client’s own actions contributed to the lo
ss)
(5) The statute of limitations on the action has expired.

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 Auditor’s Defenses Against Third-Party Law
suits
(1) The preferred defense in third-party suits in nonnegligent performance. If
the audit was conducted in accordance with Standards of Auditing, the ot
her defenses are unnecessary.
(2) A lack of duty defense can also be used. This defense contends lack of p
rivity of contract. Privity of contract means limitations of liability to the part
ies to a given contract. Under privity, the CPA is not liable to third parties
for ordinary negligence.
(3) Absence of causal connection. This means that third party must be able t
o prove that there is a close casual connection between the auditor’s bre
ach of the standard of due care and the damages suffered by the third pa
rty.
(4) The statute of limitations on the action has expired.

Activity: Watch a video on

1. “Satyam Scam: Auditors in the Line of Fire” – 3:26
2. “How Lehman Brothers Bank Collapses” – 2:50
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Auditor’s actions to minimize exposure to leg
al liability:
1. Emphasize compliance with standards of auditing, the Code of Professio
nal Ethics and where appropriate Financial Reporting Standards.
2. Thoroughly investigate prospective clients.
3. Avoid companies and industries in which the risk of litigation is high.
4. Exercise extreme care in the audit of clients in financial difficulties.
5. Establishing and following appropriate quality control procedures over all
audit work.
6. Use engagement letters which point out to the client the scope of the audi
tor’s services and responsibilities on a particular engagement.
7. Conduct the audit with appropriate professional skepticism.
8. Provide the opportunity for auditor to consult with more experienced audit
ors about difficult issues.
9. Maintain adequate professional liability insurance coverage.
10. Seek legal counsel whenever serious problems occur.

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PSA 260 (Revised and Redrafted), “Communicatio
n with Those Charged with Governance”

- deals with the auditor’s responsibility to communicate with those cha

rged with governance in relation to an audit of FS.

Objectives of the Auditor:

(a) Communicate clearly with those charged with governance the responsibilities of th
e auditor in relation to the FS audit, and an overview of the planned scope and timing
of the audit;
(b) Obtain from those charged with governance information relevant to the audit;
(c ) Provide those charged with governance with timely observations arising from the
audit that are significant and relevant to their responsibility to oversee the financial re
porting process; and
(d) Promote effective two-way communication between the auditor and those charged
with governance.

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 The Communication Process
Establishing the Communication Process
The auditor shall communicate with those charged with governance the form, timing and expected
general content of communication.

Forms of Communication
The auditor shall communicate in writing with those charged with governance regarding significant
findings from the audit when, in the auditor’s professional judgment, oral communication would not
be adequate.

Timing of Communication
The auditor shall communicate with those charged with governance on a timely basis.

Adequacy of the Communication Process

The auditor shall evaluate whether the two-way communication between the auditor and those ch
arged with governance has been adequate for the purpose of the audit.

Documentation
Where matters required by this PSA to be communicated are communicated orally, th
e auditor shall document them, and when and to whom they were communicated. Wh
en matters have been communicated in writing, the auditor shall retain a copy of the c
ommunication as part of the audit documentation.

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