External Auditor's Legal Accountability In Fraud Detection Essay.

To what extent should external auditors be legally accountable for the consequences of client fraud where they negligently fail to detect it?

 
• What is the current stance on auditors' accountability? Are they legally accountable

• Find the regulations on audit liability

• Look at the historical developments of the laws around this area

• Try to provide a balanced argument of more legal responsibility or less

• Find examples of where auditors have been sued in fraud cases 

The auditors are currently responsible for both the civil as well as the criminal offences. The criminal offences takes place when the companies breaches the rules and the regulations that have bene imposed by the government. There are mainly 2 types of laws, one being criminal which deals with the transactions between the entity and the state and the civil law that deals with the transactions between the individual and the company.

The criminal offences takes place when the auditors follow different laws that exists in the other countries. These laws confer to the countries in which these companies operate. Therefore, the auditors are held accountable for the acts of fraud and insider trading.

This include various sections that governs the fact of who could be an auditor and the way in which these auditors are appointed and the way in which they could be removed and also include the functions and the duties of the auditors.

One of the most important offence under the companies Act is the section 495 which deals with the fact of knowingly or recklessly causing a report which includes any matter which could be misleading or is false or is deceptive in any manner.

Civil offences on the other hand include 2 pieces of civil law. The first piece being contract law and the other being law of tort. Both of these pieces deals with the liability of the auditor to the clients and also to the third parties.

Under the law of contract, the party could ask for remedy in case the contractual obligations have not been fulfilled. Hence, the shareholders could seek remedy in case an auditor fails to comply with the terms that were stated in the letter of engagement. In order to illustrate, an auditor was sued by the shareholders of the Tyco Company. Whereas under the law of tort, the auditors could be sued for any negligence in case there is any breach of care wherein a third party has suffered some loss (ACCA Global, 2018).

The most notable of these include the case of Caparo Industries Plc v Dickman and the Royal Bank of Scotland vs Bannerman Johnstone MacLay. The first case deals with the purchase of the shares of another company. It was realised later on that the shares of the company were purchased on the basis of inaccurate valuation details of the other company. The shareholders also stated the fact that the auditors did not carry on their duty of care. But then the claim was not successful.

Current stance on auditor's accountability

There are some of the landmark judgments in the cases of Caparo Industries Plc (Caparo) v Dickman (1990) and Royal Bank of Scotland (RBS) vs Bannerman Johnstone MacLay (Bannerman) (2002). The House of Lords concluded the case by saying that the books of accounts were prepared by the auditors without having any knowledge about the purposes to which the accounts would be put to use.

This was the case which throws light on the duty of care that exists between an auditor and the third party. Hence, this ruling laid down the following:

• It is due to the conduct of the defendant that the company has suffered a loss
• There is a relationship that exists between the defendant and the pursuer
• The imposition of liability is just, fair and reasonable

In yet another case, RBS held APC Ltd of losing £13m on account of overdraft facilities that were not paid. The facility was given to APC on account of the true financial statements that were applied. In this case, the court held that the auditor owed no duty since there was no sort of disclaimer given to the third parties.

The liability was joint. The fact that an auditor could be prone to either criminal or civil law is highly uncontroversial and is also clear. But the fact of the penalty being the same is still very much debatable.

Auditors were found to be liable in the cases wherein the auditor had breached the responsibilities for the work that has been performed with an utmost professional competence and also independent of the client. It is due to this reason that the auditors must face the penalty or the repercussions of the acts that have bene suffered by them and the parties that have been aggrieved due to their failures be compensated for the same (the Australian government, 2018).

But it is also true that these system have been criticised on the grounds that the amount of the penalty imposed are very high. This is in the sense that in case, there are multiple culpable parties, even then the plaintiff could sue any one party and seek entire amount of the damages (Hein online, 2018). In order to illustrate this, in case, the director used the financial statements in the wrong manner and the management of the company was not able to detect the poor controls, then the auditor would perform an inadequate audit leading to an expression of a wrong audit opinion. This is due to the mistake on the part of a third party. The shareholders in such cases would try and recover the full amount of loss that has been incurred from any one of the parties. It is mainly due to the reasons like these that the penalties are criticised.

Regulations on audit liability and historical developments in law

The history behind the introduction of these rules is the fact that the authors had started to take their work for granted or they were not carrying on their duties with utmost diligence. This led to many audit reports of being reported as clean when they should have been qualified. This resulted in companies crashing since the books of accounts misled the investors and the company falsified their books of accounts to report profits. But ultimately these companies fell and went bankrupt. This all would not have happened if the auditors would have been vigilant enough in carrying on their duties. It was due to these reasons that the relevant authorities decided to impose penalties and impeach the auditors when they were found guilty of misconduct. These events led to the introduction of the rules and regulations such as have been mentioned in this report.

The perception of the public are greatly affected by the Generally Accepted Auditing Standards and the Statements on Auditing Standards since the effort and the work of the auditor is not observable. This is directly proportional to the penalties that are levied for non-compliance. The profession imposes the penalties of the auditors that are not capable of carrying on their duties with an utmost efficiency. But in the case, wherein the auditors had relied on the misstated reports were not prone to any monetary penalties. The connection between the legal liability and the professional standards are not important. This is in the sense that in the cases wherein a producer has supplied a defective product, whether he knew about the same or not was immaterial. Wherein there is a strict liability for the professional standards, there could be factors that could affect the legal liability to which the members are exposed. In contrast of thus, the liability of the auditors for the product wherein the opinion of the auditors is somewhat based upon the theory of negligence and is also limited to the cases wherein the audit was negligent in the carrying on his duties. Casual review of this is the fact that in the cases, wherein negligence based theories of liability are applied to the auditors, then the levels of the due care which are connected with the auditors are not clearly specified (AICPA, 2018).

None of these laws states the definition of due care which is expected of an auditor. Whet comprises of due care has changed over the period of time. The major proof of the negligence is the key to the liability of the auditors and also the violation of the auditing standards which are considered to be the prima facie of a negligent audit. Under a vague specification of due care, an auditor has some positive probability of being negligent at any level. The violation of the GAAS is the prima facie evidence of negligence. Therefore, by the way of increasing his expected liability for any effort which is below the standard would not mean much in the absence of the relevant standards. Viewing these professional standards as the signals with regard to the quality of the output is also not specific to the auditors (Schwartz, 1998).

Balanced argument for more or less legal responsibility

There was a company which entered into a facility agreement with the claimant bank by the name of Barclays for the loan facilities. The company went into administration leading Barclays to have substantial loss of about £45 million. Later on, Barclays sued Grand Thornton for their negligence in carrying on their duties and care since GT had provided non statutory reports to the third parties (Fee, 1999). The reports had failed to report the fact that the 2 employees of the company had reported false sales and expenses of the company which led to these losses and claims. The court held that the disclaimers which were included in the reports were not sufficient enough to preclude GT owing to a duty of care to the Barclays. It is due to this reason that there are some of the cases wherein the auditors owes their duty to the third parties, especially when the third parties did not contain such disclaimers (Davis, 1991).

The above stated case had caused an alarm for the profession of audit in the creation of the risk in the creation of the duty of care of the auditors of the company to the bank from which money has been lent, if they were of an opinion that the bank would consider the audited financial statements of the client and that they did not explicit disclaim liability (Mondaq, 2018).

In the above stated case, the house was of an opinion that planning to save taxes could form the part of the operations in the ordinary course of the business. There is a clear cut difference between the mitigation of general taxes and in the tax planning advice of taxes. The house in this case held that the accountant did not possess the apt knowledge about the minimisation of the taxes provisions and hence the same could not be taken up with the client (Corporate finance institute, 2018). But the outcome of this case is somewhat assuring. This is because it was found by the court of Appeal that the scope and the extent of the retainer of the adviser was somewhat confined to the letter of engagement. But there were certain exceptions and some of the implied terms that could exist but the court would not be prepared to demonstrate the duty of the accountants to give specialist tax planning advice when it came to an outside general expertise along with the scope of the retainer.

Conclusion:

In the nutshell, there have been many cases wherein the auditors have been found guilty since they did not exercise their duties with an utmost efficiency and care. It is due to cases like Enron etc. that the auditors are being questioned about their degree of care. And it is for these reason, that there have been penalties that have come into existence. These penalties include contract law, tory law, civil and criminal offences. But then it is also true that these are not always correct when levied.

Hence, the facts of each case have to be considered when levying penalties.

References:

An Analysis of the Auditors' Liability to Third Parties in Australia 37 Common Law World Review 2008. (2018). Retrieved from https://heinonline.org/HOL/LandingPage?handle=hein.journals/comlwr37&div=7&id=&page=

AU-C Section 250. (2018). Retrieved from https://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-C-00250.pdf

Ch 5 R. (2018). Retrieved from https://archive.treasury.gov.au/documents/403/HTML/docshell.asp?URL=Ch5.asp

Davis, M. (1991). The liability of auditors to third party in negligence. Retrieved from https://www.austlii.edu.au/au/journals/UNSWLawJl/1991/7.pdf

Fee, C. (1999). Limiting Auditors’ Liability. Retrieved from https://epublications.bond.edu.au/cgi/viewcontent.cgi?article=1161&context=blr

https://www.accaglobal.com, A. (2018). Auditor liability | ACCA Global. Retrieved from https://www.accaglobal.com/in/en/student/exam-support-resources/professional-exams-study-resources/p7/technical-articles/auditor-liability.html

Legal Liability of Auditors - Due Care & the Prudent Person Concept. (2018). Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/accounting/legal-liability-of-auditors/

Recent Key Cases On Accountants' Liabilities - Accounting and Audit - Worldwide. (2018). Retrieved from https://www.mondaq.com/uk/x/458826/Accounting+Standards/Recent+Key+Cases+On+Accountants+Liabilities

Schwartz, R. (1998). Auditors' Liability, Vague Due Care, and Auditing Standards. Retrieved from https://link.springer.com/article/10.1023/A:1008220317852