Understanding Audit Legal Implications
Inaccurate or erroneous financial information can cause audit legal implications. Auditors are responsible for making sure that all line items on financial statements are presented fairly. The audit reports ultimately affect business decisions of banks, government, investors, and other business-related entities. Auditors are required by law to report fairly their opinion on client companies. Otherwise, they can be subjected to lawsuits and other audit legal implications.
One of the most important professional standards that an auditor must follow is the notion of due professional care. The concept of due professional care is stated in general auditing standards and is also required by most codes of professional conduct issued by an accounting body. Due care is a technical legal term and, in the context of an auditor, it means that the auditor must be diligent in applying technical standards and must document each stage of the audit process thoroughly. Due professional care implies that:
- The auditor must possess the required skills to do the audit.
- There is a duty to approach the task with care and diligence.
- The auditor is expected to act in good faith and integrity, however, is not expected to be infallible.
- An auditor is liable for negligence or dishonesty but not for mere errors of judgment.
Sources of Legal Liability
Let’s take a closer look at all the involved parties here. Consider the triangular relationship between the users of financial information, a client company, and the auditor. Auditors can be sued not only by client companies but also by other parties.
|Who Might Sue?||Why Sue?|
|Client||Breach of contract|
|Users||Failure to identify a misstatement|
|Government||Fraud (Issuing an incorrect audit report intentionally)|
In summary, clients can sue auditors if there is a breach of contract between the two entities. Users may sue auditors if the latter fails to identify a material error that ultimately ends up influencing the users’ investment decisions. Finally, the government plays a large role in accounting scandals that deal with fraud.
Despite the potential for lawsuits against auditors, many lawsuits by third parties are unjustified. For example, if a third party (i.e., user) sues the auditor because the client (the company being audited) is no longer a viable company, that is not justified, because the auditor is not responsible for making sure that the company can continue operating in the long term. The auditor is solely responsible for ensuring that financial statements are presented fairly against the appropriate evaluation criteria.
In addition, unjustified lawsuits may also involve the phenomenon of audit risk. Audit risk is the risk that an auditor will express an inappropriate audit opinion on the financial statements. Essentially, these situations deal with errors in the financial statements that may exist even after following the relevant auditing rules. These are simply unfortunate situations when an auditor, for example, decides to pick a sample to audit that is not representative of the entire population of data. If, however, an auditor were to not comply with general auditing standards outlined by the governing accounting body, that is called audit failure and is valid grounds for a lawsuit.
Successful Lawsuits Against Auditors
In order for a third party or a client to successfully sue an auditor, the plaintiff must prove the following four criteria:
- Auditor owed a duty of care to the plaintiff – There are few possible users that an auditor owes a duty of care to. The user must be a known or foreseeable user of the financial statements
- Auditor breached that duty of care – For example, a situation of audit failure as described above, where the auditor fails to comply with the auditing rules specified by the governing accounting body
- Plaintiff suffered a loss – The plaintiff must prove that there was an actual, tangible loss. An opportunity cost, such as missing out on shares increasing in price, is not sufficient.
- Connection between Auditor’s negligence and Plaintiff’s loss – The plaintiff needs to prove that they actually suffered a loss directly as a result of relying on the auditor’s evaluation of the financial statements
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