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Chapter 3 – Audit – Legal Liability

Litigation is a major risk for the audit profession.

Auditors legal environment

The auditing profession is facing growing litigation. Some reasons are stated below:

 Growing awareness of the responsibilities of Pas by users of financial statements

 Increased consciousness on the part of provincial securities commissions for their responsibility
for protecting investors interests
 Increasing omplexity of auditing and accounting
 Tough economic tines resulting in individuals wanting to pursue restitiution
 Deep pockets
 Desire to settle

Auditor Litigation

Audit failure is when the auditor issues an innapropriate opinion because of failing to comply with the
requirements of GAAS. These parties that suffered losses are allowed to recover some or all of the
losses. It is difficult to determine if due care hasn’t been performed. Also legal precedent makes it
difficult to determine who has the right to expect of an audit and recover losses. Connection between
audit failure and liability is not straightforward.

Bussiness failure is when a business is unable to repay its lenderos or meet expections of investors. So
financial statements may be materially misstated despite an audit done in accordance with GAAS. This is
called audit risk which is when financially statements are fairly stated when in fact they were materially
misstated. It is avoidable as well concealed frauds are hard to detct.

The underlying cause of conflit between statement users and auditors is called the expectations gap.
There is a difference in expectations between auditors role and responsibilities.

Major Sources of Auditor Liability

They have legal liability to their clients for negligence or breach of contract should they fail to provide
the services or should they fail to exercise due care. They will be held under common law tort of
negligence or provincial securities.

The issue here is standard of care. Failure to meet GAAS is evidence of negligence. Under tort law if
auditor is negligent they will be sued. Four things need to be satisfied.

 Auditor owed duty of care to the plaintiff

 Auditor breached the duty of care
 Plaintiff suffered a loss
 The loss was attributed to the auditors breach of duty.

Liability to clients

The most common source of lawsuits is clients. Duty of care isn’t an issue here. More so over not
completing contractual obligations.
Liability to third parties under common law.

Certain cases you may be liable to third parties including actual and potential shareholders, vendors,
bankers, and other creditors etc. since there is no contract they rely on tort law. They have to first argue
a duty of care.

Ultramares corp v touche

Auditors are not liable for ordinary negligence to those that they don’t have a contractual relationship.

Hedley byrne

Forseeable third parties, says that auditors are liable if they know beforehand that the third parties
would be relying on their audit report.

Gordon t haig

Foreseeable third parties duty of care was present


Duty of care is present when the auditor had knowledge of the specific third party or a narrow class of
third parties and the specific third party or limited class relied upon the financial statements for the
purpose of the transaction it was prepared for.

Liability to third parties under securities law

Securities legislation gives investors the right to sue auditors for misrepresentation in their audit report.
Duty of care of Hercules doesn’t apply here.

Criminal liability

Can face criminal liability, but these are rare. They can face criminal and quasi criminal liability for
breaches of securities legislation, in which the regulator makes allegations.

Auditors defense

PA typically rely on five defenses when clients or third parties make claims of negligence.

 Lack of duty of care

o Lack of duty of care is cited. A well written engagement letter is the most important
means by which they can avoid claims
 Absence of misstatements
o Financial statements are in accordance with applicable accounting framework, even if
they were irrelevant. Must present fairly the economic events. They can’t hide behind
technical interpretations
 Absence of negligence
o Audit was conducted in accordance with GAAs. Auditor not responsible even if
misstatements exst. The standard of due care is referred to as the prudent person
concept. You have to exercise reasonable care and diligence.
 Absence of Causal connection
o The plaintiff has to prove that there is a close causal connection between auditors
breach of due care and damages suffered by the client. The damaes were not brought
by any act of the professional.
 Contributory Negligence
o Part of or all of the loss arose because of the claimants own negligence. In order to
reduce an auditors liability they should
 Deal with clients possessing integrity,
 Maintain independence
 Understand clients business, knowing industry practices and client operations
have been a major factor in uncovering misstatements.
 Perform quality audits, obtain appropriate evidence and make appropriate
judgements about the evidence.
 Document the work properly
 Exercise and maintain professional skepticism