AUDITOR’S LEGAL LIABILITY AND RESPONSIBILITY

Potential litigation is a major concern to auditors. Professionals have always a duty to provide
reasonable level of care while performing work for those they serve. Audit professionals have a
responsibility under law to fulfil expressed and implied contracts with clients. They are liable to
their clients for negligence and breach of contracts should they fail to provide the services or not
exercise due care in their performance.

When investors and creditors suffer losses from a bankrupt entity, they look for deep pockets,
those who have the ability to pay for their losses if ordered to do so by a court. Accounting firms
are often considered deep pockets because they are composed of a number of partners each
of whom is personally liable for the firm’s actions and carries professional liability insurance.

Lawsuits against auditors typically involve alleged misstatements that the auditors did not detect
in the financial statements. Other typical lawsuits brought by clients against CPA firms involve
claims that the auditor:

A. Did not discover an employee defalcation as a result of negligence in the conduct of the
audit.

B. Did not complete the audit on the agreed date.

C. Inappropriate withdrawal from an audit.

LEGAL CONCEPTS RELATED TO AUDITOR’S LIABILITY

A. Due professional care.

There is an agre ement within the profession and the courts that the auditor is not a guarantor
of the statement’s accuracy. Auditors are not infallible and can make errors in judgment. But
auditors are expected to exercise the same reasonable care with which others in the profession
would perform in similar circumstances.

B. Sources of responsibility.

The auditor’s legal responsibilities to others are established either by:

Common laws – those that have been developed through court decisions rather than
government statutes.

Statutory laws – those bodies of laws passed by legislative bodies such as the Congress.

C. Degree of wrongdoing.

At one end, the auditor commits no wrongdoing. The auditor performed an appropriate audit
and issued an appropriate report. On the other end, the auditor commits fraud. The auditor issues
a report on the financial statements with the intent to deceive. Despite knowing that the financial
statements are misstated, the auditor did not take appropriate action to report the
misstatements.

Courts have identified two other degrees of wrongdoing. Ordinary negligence or simply
negligence implies the absence of reasonable care that can be expected of a person in a set
of circumstances. Auditors are guilty of negligence if they do not do what reasonably prudent
auditors should do in the circumstances. Auditors are guilty of gross negligence if they
consistently fail to follow or recklessly disregard standards of the profession on an engagement.
Gross negligence is also known as constructive fraud.

Courts distinguish between these four degrees of wrongdoing depending on the particular
circumstances of the case or the pertinent legal precedent.
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 working papers are
subpoenaed by the court. Under common law, information obtained by a CPA from a client is
not privileged. Information is privileged if legal proceedings cannot require a person to provide
the information even if there is a subpoena. Confidential discussions between client and auditor
cannot be withheld from courts.

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
for the work of others such as their employees, other CPA firms engaged to do part of the work
and specialists or experts called upon to provide technical information.

LEGAL LIABILITY OF THE INDEPENDENT AUDITOR

A. Auditor’s liability to his clients.

A CPA is obliged to exercise due professional care during the engagement including adherence
to professional standards and ethics. Failure by the CPA to exercise this degree of care may
constitute negligence and breach of contracts to render professional service. An honest error
doesn’t constitute negligence on the part of CPA so long as he has exercised due professional
care.
If an undetected fraud is so widespread and of such magnitude as to cause the financial
statements to be materially misstated, the argument may be advanced that the auditor’s
procedures were clearly inadequate and that the auditor was negligent. In the event that the
auditor is found negligent, a client is entitled to recover any losses to which the auditor’s
negligence was proximate cause. The client may also recover the audit fee because of the
auditor’s breach of contract.

B. Auditor’s liability to third parties.

Creditors, investors and other third parties also rely upon the auditor’s work when they place their
confidence in audited financial statements. Independent auditors are liable to all foreseeable
third parties for losses which are caused by the auditor’s fraud or gross negligence. Auditor’s
expression of an opinion on financial statement when, in fact, he has no basis for an opinion is
considered gross negligence.

C. CPA’s responsibility in tax practice.

The CPA as tax advisers has a primary responsibility to the client to ensure that the client pays
the right kind and proper amount of tax. As a tax adviser, the CPA may properly resolve
questionable issues in favor of the client but at the same time must adhere to the same standards
of trust and personal integrity in tax work as in all other professional services.

A CPA on tax engagements has a secondary responsibility to the public whose interests are
represented by the government, specifically the BIR. To meet this responsibility, CPAs must
observe the client’s declarations on tax returns they prepare. Though not required to investigate,
CPA should not disregard any clues that cast doubt on the accuracy of information provided by
taxpayers.
In addition, CPAs should look into the series of pronouncements, rules and regulations on tax
matters issued by the Department of Finance as follows:

BIR Revenue Regulation No. 3 – 90.

Defenses against Client Suits

B. The audit was performed using reasonable care or the lack of reasonable care did not cause
the damage.

C. The reliance on the financial statements did not cause the loss. This is also referred to as
absence of causal connection.

D. In cases in which a tort is involved, auditors in some jurisdiction can claim contributory
negligence. This means that the client’s own actions contributed to the loss.

E. The statute of limitations on the action has expired.

Defenses against Third Party Lawsuits

A. The preferred defense in third party lawsuits is non-negligent performance. If the audit was
conducted in accordance with GAAS, the other defenses are unnecessary.

B. A lack of duty can also be used. This defense contends the lack of privity of contract which
limits the liability to the parties of a given contract. Under privity, the auditor is not liable to third
parties for ordinary negligence.

C. The auditor may use the absence of causal connection. The third party must be able to prove
that there is a close causal connection between the auditor’s breach of the standard of due
care and the damages suffered by the third party. This could be construed as non-reliance on
the financial statements by the user.

D. The statute of limitations on the action has expired.

Contributory negligence is not available in third party lawsuits because third parties are not in a
position to contribute to misstated financial statements.

MINIMIZING EXPOSURE TO LEGAL LIABILITY

In the light of auditor’s extensive exposure to obligation, public accounting firms must take
positive action to withstand the threat of legal liability. These actions include:

A. Emphasize compliance with GAAS, the Code of Ethics for Professional Accountants and where
appropriate GAAP.
B. Avoid companies and industries in which the risk of litigation is high.
C. Thoroughly investigate prospective clients. Avoid taking on clients when there are indications
of deliberate management misrepresentation.
D. Exercise extreme care in the audit of clients in financial difficulties.
E. Establishing and following appropriate quality control procedures over all audit work.
F. Use engagement letters which clearly point out to the client the scope of auditor’s services
and responsibilities on a particular engagement.
G. Conduct the audit with appropriate professional skepticism.
H. Provide the opportunity for auditor to consult with more experienced auditors about difficult
issues.
I. Maintain adequate professional liability insurance coverage. This is however no a common
practice in the Philippines.
J. Seek legal counsel whenever serious problem occur.