Auditing: The Art and Science of Assurance Engagements

Chapter 4: Legal Liability

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 Auditing, Canadian Eleventh Edition

Chapter 4 Learning Objectives

1. Identify the public accountant’s sources of legal
liability.
2. Explain why the accountant does not have the right
of privileged communication.
3. Describe the groups of individuals or organizations,
in addition to the client, who can sue the auditor.
4. Examine conditions where the auditor may consider
disclosure of confidential information.
5. Identify the actions that accountants should take to
determine which legislation has an impact on their
work.

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Sources of Auditor’s Legal
Liability

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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
• Audit failure: when the auditor issues an incorrect
audit opinion (e.g. an unqualified opinion when it
should be qualified)

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Think of an example …

• Think of a recent business failure that was publicized

in your area.
• Were the auditors sued?
• If so, do you think that it was a business failure, or an
audit failure, or both?
• Was fraud involved?

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Role of Audit Risk

• The auditor uses audit risk to help decide how much

evidence to collect.
• Audit risk is the risk that the auditor will conclude that
the financial statements are fairly stated, when they
are not (For example, if the auditor chooses audit risk
of 3%, there is a 3% risk of material error in the
financial statements).

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Expectation Gap

• There is an expectation gap when two different

groups expect different outcomes in a particular
situation.
• Here, we use the term ‘expectation gap’ to refer to
the difference between what users actually expect
and what the audit report actually provides.

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What do Users Expect?

• Think about the different users of financial

statements.
• What might the difference in expectations be among
these users with respect to the auditor’s report?

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Prudent Person

• The auditor is not expected to be perfect.

• How is the standard of performance set?
• According to the courts it is based upon “reasonable
care and diligence in the performance of obligations”
– this means that the auditor does his/her best given
the training and experience required.

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Joint and Several Liability

• The partner in charge of an audit engagement is

responsible for his/her employees, other partners on
the engagement, as well as work performed by other
audit firms, internal auditors or specialists.
• Limited liability could be present if the firm formed a
limited liability partnership.

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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.

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Review Question 4-4, p. 101

• Think about the typical accounting firm.

• Think of as many specific examples as you can –
who would the partner in the public accounting firm
be held liable for?

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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, Bangladesh Revenue Board or other
creditors
– Customers
– Employees, etc.

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Six Possible Defences against
Third-Party Suits

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Lack of Duty of Care

• The auditor claims that there was no duty to the party
that is suing.
• Also called “lack of duty to perform”.
• There is a duty of reasonable care to the client.
• An engagement letter helps identify that there is no
duty of care to find fraud.

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Discussion Problem 4-13, p. 102

• The bank lent some more money

• After relying upon the financial statements
• Lo, and behold, the company went bankrupt
• And the bank sued the auditors (of course?)
• So are the auditors liable?

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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.

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Non-negligent Performance

• 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 used to
support this defence.

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Absence of Causal Connection

• 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.

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Contributory Negligence

• The auditor accepts partial blame, 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.

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No Damages

• There is one additional defence that arises from the

definition of a tort action for negligence , and it is
simply: “No damages”
• This defence is simply the fact that the plaintiff did
not lose any money by relying upon the financial
statements.

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Practice Problem 4-18, p. 103

• Deliberate fraud on the part of the client

• Overstatement of accounts receivable and inventory
• Is the auditor liable?
• Why or why not?
• What defence would be used?

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Preventing Excess Legal Costs

• Both the accounting profession and the individual

practitioner need to respond to the potential of legal
liability.

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The Profession’s Response to
Legal Liability
• Conduct research in auditing
• Set standards and rules
• Set requirements to protect auditors
• Establish practice inspection requirements
• Defend unjustified lawsuits
• Educate users
• Sanction members for improper conduct or
performance
• Lobby for changes in laws

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The Individual Practitioner’s
Response to Legal Liability
• Deal only with clients possessing integrity
• Hire qualified personnel and train and supervise them
properly
• Follow the standards of the profession
• Maintain independence
• Understand the client’s business
• Perform quality audits

(Continued)

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The Individual Practitioner’s
Response to Legal Liability
(Continued)
• Document the work properly
• Obtain an engagement letter and a management
representation letter
• Maintain confidential relations
• Seek legal counsel (when warranted)

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Discussion Problem 4-16, p. 103

• It is important to follow up all errors

• This practice problem looks at a firm’s internal quality
control and supervision processes

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