LEGAL LIABILITY

Legal Liability

• Professionals have duty to provide reasonable level of care while performing work for those they serve
• Responsibility under common law to fulfill implied or expressed contracts with clients
• Liable for negligence and/or breach of contract should auditor fail to exercise due care or to provide services
• Auditor also has a duty of care to 3^rd parties who are part of a limited group of persons whom the auditor knows will use and rely on the audit

Confusing business and audit failure

• Business failure: when a business cannot repay its debts, perhaps due to poor management, a shift in demand, or economic factors (bankruptcy)
• Audit failure : when the auditor issues an incorrect audit opinion (e.g. an unqualified opinion when it should be qualified) based on not complying with GAAS

Audit Risk

• Auditor fails to use due care in conducting audit then audit failed

· Auditor can be sued for breach of duty (negligence)

• Difficult if business failure because users claim it is an audit failure

· Conflict “expectation gap” between users and auditors

· “expectation gap” refers to the difference between what users actually expect and what the audit report actually provides

· Auditor-conduct audit in accordance with GAAS-completed duty

· Users-believe that auditor has guaranteed accuracy of f/s and possibly the viability of the business

· Court follows auditor’s view

Role of audit risk

· The auditor uses audit risk to help decide how much evidence to collect

· Audit isk is the risk that the auditor will conclude that the financial statements are fairly stated, when they are not

· Auditing cannot be expected to uncover all material misstatements

· Limited by sampling

· Fraud normally well concealed

· There is always some risk that the audit will not uncover a material misstatement even when compiled with GAAS

Prudent person

• Must conduct audit with due care
• The auditor is not expected to be perfect
• According to the courts auditor needs to provide “reasonable care and diligence in the performance of obligations” – this means that the auditor does his/her best given the training and experience required

Joint and several liability

• If a lawsuit for negligence is brought against a partnership, each member may be held liable for the actions of other partners and employees
• In Ontario: Limited liability Partnerships (LLP), individual partners who had nothing to do with engagement/supervision of staff would not be liable on their personal assets

· Only person that did work or supervised staff and firm would be liable

Lack of privileged communication

• Lawyers may refuse to provide information to the courts that was given to them by their clients (called privileged communication)
• Accountants do not have this right
• They must provide information to the courts when subpoenaed

Who can sue the auditor?

• Clients (the business entity or organization that hired the auditor)
• Third parties: Owners or shareholders (existing or potential), Vendors, Bankers, Canada Revenue Agency or other creditors, Customers, Employees, etc.

Negligence

• Absence of reasonable care
• What competent auditors would have done in the same situation
• Tort Action for negligence

· Failure of a party to meet its social or professional obligation, contractual or otherwise, thereby causing injury to another party to whom a duty is owed

· Bank can claim a duty to uncover material errors that had been relied upon in making a loan

· Bank must prove: accountant owed a duty of care to the bank, Accountant was negligent in performing duty, Bank suffered a loss, Connection between accountant’s negligence and the loss (relied on f/s)

Fraud

• False assertion made knowingly, without belief in its truth, or recklessly without caring whether or not it is true
• Plaintiff must prove that accountant intended plaintiff to act on assertion, that plaintiff did act on the assertion, and that as a result the plaintiff suffered a loss

Breach of Contract

• Failure of party to fulfill requirements of contract
• Engagement letter formalized agreement about services to be provided, fees, and timing of services

Liability to Clients

• Client is company not the owners or shareholders
• Fail to complete audit on the agreed dates, inappropriate withdrawal from audit failure to discover fraud or breach of confidentiality
• Failure to meet GAAS is evidence of negligence

· Due care and type of evidence to be obtained are subjective

· Judge/jury would decide what average accountant would do and what accountant being sued should have done

Liability to 3^rd Party Under Common Law

• May be liable to 3^rd party if loss was incurred due to reliance on misleading info
• Ordinary negligence is insufficient for liability to 3^rd party (no contract between them)
• Need to have actual knowledge of 3^rd party relying on f/s (banks will be lending money)

Criminal Liability

• Possibility of being found guilty under criminal law; defrauding a person through knowing involvement with false f/s
• Also be a charge of criminal misconduct by professional association after conviction
• Fraud when auditor associated with f/s that he/she knows are materially misstated or false
• Few Canadian cases involving fraud

Possible defences

• Lack of duty of care
• Absence of misstatement
• Non-negligent performance
• Absence of causal connection
• Contributory negligence
• No damages
• Preferably used in the above order during a suit.

Lack of duty of care (also called “lack of privity”)

• The auditor claims that there was no duty to the party to perform the tasks that was negligently performed
• An engagement letter helps identify that there is lack of duty to perform

· Well worded decrease likelihood of adverse legal actions

Absence of misstatement

· The statements were in accordance with GAAP

· There were no material errors in the financial statements

· The financial statements accurately portray the financial statements of the organization

· No grounds for lawsuit because f/s appropriately reflect financial situation

· Even if auditor had been negligent the appropriate f/s would not have differed from those on which plaintiff relied

Absence of Negligence

· Evidence to refute claim: the audit was done in accordance with generally accepted auditing standards

· The auditors are not responsible for undiscovered errors or fraud because their audit was done appropriately

· CICA Assurance Handbook or expert witness (exercise of judgment) used to support this defence

Contributory negligence

The auditor accepts partial blame for the negligence, i.e. accepts that the audit was not conducted in accordance with GAAS. However, the auditor also places blame on the party that is suing the auditor, e.g. management did not correct internal control weaknesses

No damages

· “No damages”

· This defence is simply the fact that the plaintiff did not lose any money by relying upon the financial statements

· Possible f/s misstatement

· Audit negligently performed but plaintiff did not suffer any damages

Absence of causal connection

· To succeed must show a causal connection between breach of standard of due care and damages suffered by the client

· This defence claims that there is no connection between the auditor’s breach (i.e. an audit failure) and the client’s loss

· For example, the client relied upon others (such as a banker) or upon their own expertise when deciding to invest or lend money

The profession’s response to legal liability

· Conduct research in auditing

· Better ways to uncover material misstatements or fraud, communicate audit results, and make sure auditors are independent

· Set standards and rules

· Set and revise standards to meet changing needs

· Set requirements to protect auditors

· Certain requirements that practitioners follow

· Establish practice inspection requirements

· Periodic inspections to evaluate practitioners

· Identify firms not meeting standards

The individual practitioner’s response to legal liability

• Deal only with clients possessing integrity

· Look for risks

· Look at how the client deals with employees, customers, government…

• Hire qualified personnel and train and supervise them properly
• Follow the standards of the profession

· Implement procedures to make sure firm knows and follows GAAP, GAAS, rules of professional conduct, and other professional guidelines

• Maintain independence

· Don’t be too willing to accept client’s representations/pressures

The individual practitioner’s response to Legal liability

• Maintain confidential relations

· Can’t disclose client matters to outsiders

• Carry adequate insurance

· Need insurance in case sued

• Seek legal counsel (when warranted)

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