What is Legal Liability of Auditors?
Concerns about the legal liability of auditors continue to grow every day. Auditors are highly important people because, ultimately, they are responsible for enhancing the reliability of financial statements for all kinds of external users. Like other professionals, they can face civil and criminal liability in the performance of their duties.
Without independent and competent auditors, many fraud cases worldwide would’ve gone unnoticed, notwithstanding all the other cases that are still undiscovered. The code of professional conduct states that auditors must go about their business with due care. Due care is the “prudent person” concept.
Due care generally implies four things:
- The auditor must possess the requisite skills to evaluate financial statements
- The auditor has a duty to employ such skill with reasonable care and diligence
- The auditor undertakes his task(s) with good faith and integrity but is not infallible
- The auditor may be liable for negligence, bad faith, or dishonesty, but not for mere errors in judgment
Sources of Legal Liability for an Auditor
Let us consider the possible entities that may sue an auditor and the possible reasons for a lawsuit.
The Legal Liability of Auditors to Third Parties
By reading this article, one question that might arise is who exactly are auditors responsible to? Can any third party sue an auditor? Or is there a certain class of parties? It is generally known that auditors are responsible to two groups of third parties: 1) Known users of the financial statements, and 2) A limited class of foreseeable users who will rely on the financial statements.
Known users of the financial statements consist of the actual shareholders and creditors of the company. Usually, the company maintains a full list of all these individuals by name. The second group pertaining to foreseeable users requires a bit of judgment.
For example, if the company is trying to issue new equity or get a loan from a bank, these potential investors and the potential creditor (i.e., a bank) will fall under the class of foreseeable users. Therefore, even though the auditor does not know the specific user, the auditor is aware that the client will be using the financial statements to raise bank financing or issue new shares – thus, they know the type of user.
Despite all the potential for lawsuits against auditors, many lawsuits by third parties are unjustified. For example, if a third party sues the auditor because the client (i.e., 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 is viable and can continue operating in the long-term. The auditor is solely responsible for making sure that the financial statements are presented fairly against the appropriate evaluation criteria. In addition, unjustified lawsuits also may involve the phenomenon of audit risk.
Audit risk is the risk that an auditor does everything correctly/to the best of his/her ability, but may still express an inappropriate audit opinion on the financial statements. Essentially, the situation deals with errors in financial statements that can remain even after the auditor has followed the auditing rules provided by the governing body.
There are simply bad luck situations when an auditor, for example, decides to pick a sample to audit which is not representative of the entire population of data. The errors originate from unfortunate situations and are not the auditor’s responsibility. If, however, an auditor were not to comply with the general auditing standards outlined by the governing accounting body, that would be a justified reason for a lawsuit, a situation called audit failure.
Successful Lawsuits Against Auditors
In order for a third party or a client to successfully sue an auditor under negligence, it is not sufficient to just come up with some evidence and file a court case. The plaintiff must prove the following four criteria:
Thank you for reading this guide to better understanding the legal liability of auditors. CFI is the official global provider of the Financial Modeling & Valuation Analyst (FMVA)® and on a mission to help anyone in the world advance their career in the financial industry. To continue learning, these free CFI resources will helpful: