Introduction

Over the last two decades, the auditing profession has suffered from various scandals such as Enron and other high-profile audit scam settlements. The involvement in PwC in the Satyam scandal has brought it to its knees in an operational environment in India.

Such is the scenario that once the auditor or firm is engaged in the scandal, their career is literally over. Audit liability has increased many folds since the scam of Enron.

The liabilities have also enhanced the audit quality and reputation of the profession. This has also created barriers to new entries within the core audit market in itself.

Auditors are required to show two major skills while carrying out activities as independence and competence.

Auditors should have the required skills to carry out their job with due care and fairly. An auditor is also expected to complete tasks in good faith and integrity.

The auditor’s liability represents the legal liability that is assumed when the auditor is performing professional duties.

The auditor is liable for client accounting misstatements in the financial statements. There is always the risk of fraud and material misstatement in financial statements.

This forces auditors to be professionally competent and employ all the auditing and accounting standards carefully.

The auditor who performs his duties negligibly can face suit from the company, its shareholders, or even creditors who rely on the work of auditors.

The auditor can be held responsible for financial disadvantage to the firm caused by incorrect representation of books of the company. This leads to the auditors to take out professional liability insurance.

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Types of Auditors liability

Auditors are potentially liable for both criminal and civil offenses. Criminal liabilities occur when the organization breaches the law or regulation.

On the other hand, disputes between individuals and/or organizations tantamount to civil liability.

Criminal offences

Auditors are bound by the laws and regulations of the state or countries they operate in. They are also bound the ethics applicable to them as issued by the auditing boards.

Auditors under criminal law can be prosecuted for acts such as frauds and insider trading.

The audit is subject to legislation as per the Companies Act of the country. This Act includes the sections on qualifications of auditors, how they can be appointed, and what would be their functions.

As per general law, the auditors can be prosecuted in criminal court for either knowingly or recklessly issuing an inappropriate audit opinion.

Civil offences

This relates to issues related to contract law and the law of tort. The contract law seeks parties for breach of contractual obligations.

That would mean the company can seek remedy from auditors only in the terms of the engagement letter.

The shareholders can, therefore, sue the auditors directly in terms of the letter of engagement for failing to handle work with due care.

Audit quality

Firms must manage their exposure to claims of intelligence. It means applying audit standards and code of ethics for auditors and also complying with terms and conditions as agreed in the letter of engagement.

The audit firms should also make the investment of time and money to make the improvements happen. The firm would improve audit only when it will lead to long term reduction of legal and insurance costs.

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Disclaimers of liability

Auditors can be exposed to litigation from third-person parties whom they have not disclaimed liability. Hence, it is necessary to include a disclaimer of liability in the workings of the audit reports.

Disclaimers can not be entirely reduced. Further, the laws provide no protection from threats from litigations under contract law.

Liability Limitation Agreements

Limited liability agreements have been used a lot in recent years to reduce threats of litigations from clients.

LLAs are simply included in terms of engagement that impose a certain threshold of the amount of compensation that can be collected from the auditor in case of litigation.

Such LLAs are to be approved by auditors annually and generally are to be ascertained fair and reasonable by the judges when the case rises.

It’s difficult to estimate fair and reasonable amount while setting letter of engagement. This is because threshold has to be estimated before any potential litigation known to auditor and client.

The level of compensation therefore would be very discretionary and sometimes open to court as well in extreme circumstances.

It has to be noted that litigations in the field of audit profession have been rapidly increasing. The potential costs and risks of auditing large corporates would increase for auditors outside the Big Four.

The brunt of penalties that auditor’s misdemeanors can attract may damage the capital markets. Until and unless things change, auditors should take bear of the burden of liability.