Auditors’ Liability
1 Introduction
Auditors’ and accountants’ liability can arise from three branches of the law:
Statute: for example if the accountant has been appointed as a liquidator of a company they can be regarded as officers of the company and could be subject to criminal proceedings. This is rare.
Contract law: the letter of engagement sets out what the auditors and the client will do. For example the auditors undertake to give reasonable assurance about the financial statements. If the auditors carry out their work with due care and skill they will not be liable under contract law.
Tort law: the tort of negligence allows any injured party, not necessarily a party who has a contractual relationship with the auditor, to pursue the auditor for damages if they have suffered loss caused by the auditor’s negligence. This is the area where there is potentially most difficulty.
2 The tort of negligence
An injured party has to show three things if the tort of negligence is to be proved:
That a duty of care exists. The act of the accountant must be sufficiently close to the damage (proximity). This is presumed to exist between an auditor and the audit client. However, with other relationships this is more difficult to establish.
That the duty of care was breached.
That the breach caused financial loss.
3 The duty of care
For a duty of care to be owed by an auditor to a third party, a 'three-fold test' must be satisfied:
The auditor knew or should have known that that person would rely on the auditor’s work (ie damage was foreseeable).
The third party has sufficient proximity (effectively, ‘close enough’ to reasonably rely on the auditor’s work).
It must be ‘fair, just and reasonable’ to impose a liability on the auditor.
Some cases illustrate these principles:
Caparo Industries v Dickman (1990)
Caparo sued an auditor after buying shares in a company they claimed was overvalued because of inaccurate financial statements. They claimed that the auditor owed potential investors a duty of care.
The claim was unsuccessful as it was held by the House of Lords that the financial statements are prepared for existing shareholders, as a class, and that the auditor has no common law duty to individual investors (whether existing or prospective).
Royal Bank of Scotland v Bannerman (2002)
Bannerman was the auditor and issued ‘clean’ auditor's reports for a client. The client was a customer of the Royal Bank of Scotland and used the financial statements to support a successful loan application. The financial statements greatly overstated the company's assets and profitability as the result of alleged fraud.
The claim was successful. The court held that the auditor knew that the bank would rely on the accounts for lending decisions and therefore owed the bank a duty of care. The court stated that if the auditor's report had contained a disclaimer warning that only members of the company should rely on it then there would be no duty of care to third parties.
4 Conclusion
The courts have been reluctant to extend the concept of duty of care to third parties such as suppliers, lenders and potential investors.
Auditors will have exercised sufficient professional care if:
They keep up to date with current approaches to auditing.
They apply ISAs and ethical standards and safeguards.
They comply with the terms of the engagement letter.
They apply an adequate system of quality management: assignment of staff, direction of staff, review of work.
They undergo adequate supervision and education and training.
Since the Bannerman case it has become routine for audit firms in the UK to include a disclaimer clause in their reports. For example:
"This report is made solely to the company's members, as a body, in accordance with [Companies Act 2006]. Our audit work has been undertaken so that we might state to the company's members those matters we are required to state to them in an auditors report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the company and the company's members as a body, for our audit work, for this report, or for the opinions we have formed."
However, there is criticism of disclaimer clauses because they can be seen as devaluing the auditor's report:
How can it be that the financial statements "present fairly ..." to the shareholders but to no one else?
If the disclaimer clause reduces the chance of litigation, auditors might not take as much care whilst performing the audit.
5 Ways to restrict liability
In addition to the measures set out above, the following may restrict liability:
Professional indemnity insurance (PII). This will pay compensation to injured parties in cases of negligence.
Fidelity Guarantee insurance (FGI): Insures against the dishonesty of staff or partners. Both PII and FGI may be mandatory (eg to obtain an ACCA licence to practice).
Incorporation: Instead of being a normal partnership where the partners have unlimited liability, the firm becomes a limited liability partnership. The partners’ personal wealth is protected.
Liability limitation agreements. The engagement letter includes a cap on the amount of compensation payable to clients. This gives no protection against third party claims. An agreement is only valid if it is:
fair and reasonable
for the current year only
approved by the shareholders.
Proportional liability. Under this system the auditor and the client would share the burden of paying compensation to injured third parties according to blame - not ability to pay