The duty of an auditor with regard to the detection and prevention of fraud and error has been a matter of discussion for a long time. It has been laid down by several legal decisions and has been considered in many professional pronouncements. In this blog, we are going to throw light on some of these decisions and discuss the meaning of the famous quote “Auditor is a watchdog, not a bloodhound”.
The legal perspective on “Auditor is a watchdog, not a bloodhound”
In the last century, the way an auditor’s duty is perceived with regard to the detection and prevention of fraud and error has undergone many changes. Initially, it was more to do with the decision given in the Kingston Cotton Mills Co. case (1896). In that case, the learned Judge Lopes categorically defined an auditor’s duty by stating that an auditor is a watchdog, but not a bloodhound. Unless doubtful situations are there, the auditor is totally justified in relying upon the management/employees of his client.
An auditor is not expected to act as a detective or approach his or her work with undue suspicion or having preconceived notions in mind. He is not a bloodhound, but he is a watchdog. This statement means the following:
- In the case of a limited company, an auditor is appointed by the company’s shareholders. He is expected to work on their behalf in the role of a watchdog and should look after their best interests.
- Unlike a bloodhound, the auditor’s main duty is towards verification of the client’s books rather than detection. During the course of his audit, if he finds something suspicious, he should extend his audit procedures to examine the matter in detail and should communicate the same to the shareholders. However, in the absence of any such suspicious circumstances, he is completely justified in relying upon the representations made by the client’s staff and management. When it comes to fraud and error, he has to exercise reasonable care only.
Later, in the case of Westminster Road Construction and Engineering Co. (1932), it was pointed out that an auditor should adopt necessary audit procedures to confirm the facts stated through management representations. Hence, it broadened the scope of an auditor’s duty with regard to the detection and prevention of fraud and error and provided stricter norms to be followed while exercising reasonable care.
Further, in some other cases, this scope was all the more extended to include the auditor’s accountability not only towards shareholders but also towards third parties provided that his negligence is proved. This means that in case an auditor is found negligible and fails to detect misstatements that he could have easily found had he exercised due care, he shall be held accountable. Since auditors play a major role in enhancing the creditability of financial statements, they are under societal pressure to take more responsibility for fraud detection. Hence, for the first time in the case of Hedley Byrne & Co Ltd v Heller & Partners Ltd (1963), the liability of auditors towards third parties was recognized. Also, a similar decision was taken in Caparo’s case (1990) wherein the principle of the auditor’s duty towards third parties was acknowledged in case he is found negligent to detect and prevent fraud and error.
SA 240 entitled “The Auditor’s Responsibility to Consider Fraud and Error in an Audit of Financial Statements” gives guidance on what ought to be the responsibility of an auditor for identifying fraud and error and reporting on them.
According to SA 240, an auditor conducts a financial audit of an entity in order to obtain a reasonable assurance (and not absolute assurance) that its financials are free from any fraud/error and material misstatements.
In addition, the auditor must approach the work with a certain degree of professional skepticism. He must always be alert to any signs of misstatement. If there are any doubtful situations, the auditor should extend his procedures to confirm or dispel that doubt.
When a misstatement is identified, the auditor has to evaluate whether such misstatement is indicative of fraud or not. He has to also consider whether the representations given by management in this regard are satisfactory or not. He should look for situations that may indicate fraud involving management, employees, or third parties. The possibility of such fraud and its implications for the audit must be evaluated well. However, it should be noted that he is not responsible for the subsequent discovery of frauds as long as he undertakes adequate audit procedures.
The auditor is liable for failure to detect fraud only when such failure is substantially due to a lack of reasonable care and skill being exercised on his part.
Status of the auditor: “Auditor is a watchdog, not a bloodhound”
The point now arises as to what an auditor’s true status in a corporation is. Clearly, an auditor has legal standing. To put it another way, a company auditor is a statutory auditor since he is appointed strictly according to the law’s regulations. The following principles determine the status of an auditor in a company:
An agent: The auditor is an agent of the company’s members assigned to execute tasks outlined in (a) the Companies Act, (b) the company’s Articles of Association, and (c) the audit engagement between the auditor and the client.
Not an advisor: An auditor is not a company advisor. It is not his responsibility to advise the board of directors or the shareholders.
Not a detective: An auditor is neither a detective nor a company employee. He (the auditor) is a watchdog, not a bloodhound. He does not need to be overly suspicious in his work.
Not to discover frauds: It is not the auditor’s responsibility to uncover scams that have been carefully planned and committed. He can rely on the honesty of the company’s employees, who have a high level of trust in the organization.
Not to guarantee: The opinion of an auditor on the financial statements of the company does not imply an inherent assurance of correctness of books of accounts.
An officer: Although an auditor is not an employee of a company, he is treated as an official of the company under many provisions of the Companies Act.
By combining the above legal and professional perspectives, it can be seen that the auditor’s roles and responsibilities have been extended and made stricter over time. He is required to maintain an attitude of professional skepticism at all times, should confirm the representations made by management, and remain alert to any signs of misstatement.
Also, even though he is not needed to provide absolute assurance, it is his duty to exercise all reasonable care to ensure that the financial statements are free from fraud. But unless he has been negligent in his approach, he can’t be held liable for non-detection of misstatements.
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