Liabilities of Auditor under Common law and Statutory law

Liabilities of Auditor

The importance of functions performed by an auditor has increased a lot during the past centuries. This has resulted in the auditor’s legal liability being established not only to the shareholders/clients but also to third parties. The liabilities of the auditor of a company in relation to his work have been expressly specified in several statutes including the Companies Act 2013 and are also recognized by pronouncements of the Courts. The liability concepts under common law are evolved through court decisions. Statutory law, on the other hand, refers to laws enacted by the legislature.

Hence, the liabilities of an auditor can be classified into two broad categories:

  • Civil Liabilities of Auditor under common law
  • Civil and Criminal Liabilities of Auditor under statutory law

It’s difficult to draw a clear distinction between criminal and civil liability. Criminal liability, in general, occurs when a person commits an act that is seen to be detrimental to society. Fines, imprisonment, or both can be imposed on the guilty. The violation of a specific party’s rights is the basis for civil liability, and the punishment is in the form of payment of damages.

Civil Liability under Common law for negligence towards clients

The word ‘negligence’ refers to the failure of an auditor to apply reasonable care and skill when performing an audit. What constitutes ‘reasonable care and skill’ in each case is determined by the facts of the specific case. In general, he will be held accountable for his acts of omission and commission, such as failing to discover defalcations, relying on certification as to stock valuation provided by management when adequate grounds existed to raise auditor’s suspicion, and so on.

However, a client can sue the auditor for negligent discharge of his duties and claim damages from him when the following conditions are satisfied:

  • The auditors owed a duty of care to the aggrieved party like there is a contractual relationship with the client.
  • There’s been a failure to conform to the standard of reasonable care and skill as expected from the auditor.
  • The aggrieved party has suffered an actual loss because of such negligence.

A sample case law in this regard is as follows:

London Oil Storage Co. Limited. v. Seear, Hasluck & Co. (1904)

The amount of petty cash in hand claimed to be £796 in the accounts was not verified by the auditor. This money had been misappropriated by the company secretary, and just £30 existed in actuality. The auditors were judged to be incompetent and were found guilty of negligence. It was decided that the auditor’s responsibility to check the existence of assets stated in the balance sheet is extremely critical and that the auditor should be held accountable for any damage caused to the firm as a result of his failure to verify such assets.

Civil Liability under Common law for negligence towards third parties

An auditor’s liability for negligence against shareholders stems from his contractual connection with them. He is appointed by the shareholders, and he reports to them. Apart from shareholders, various interested parties, including creditors, bankers, possible investors, and so on, also rely on the auditor’s report to make significant decisions. Hence, where any fraudulent representation or negligence on the part of the auditor results in damage to third parties, several Courts have taken the view that the auditor shall be held accountable to pay damages suffered by third parties.

A significant case in this regard is given below:

Hedley Byrne & Co. Ltd. V. Heller and Partners Ltd. (1963)

The case did not involve auditors, but rather a credit report issued by a bank on which a third party trusted and lost its investment. By inference, the court extended the auditor’s duty of reasonable care to a limited class of third parties, such as a bank that has loans outstanding with the client at the balance sheet date.

There is a duty even if no contractual relationship exists between the auditor and the third party (bank). This is so because banks extend loans to clients based on audit reports. And by relying on false audit reports, banks may suffer a loss of their investments if the concerned company subsequently goes into liquidation, of which the audit report did not express clear facts. The Courts held if a person holds out that he possesses certain skills and makes other people rely upon him or where he knows that his information or advice would be relied upon by others, then he must exercise reasonable care in discharging his duties.

However, it may be noted that the law relating to the liability of an auditor towards third parties is judged in accordance with various court decisions taken previously and the Courts may, depending upon the circumstances, also take a different view.

Civil Liabilities of Auditor under Companies Act 2013

Misstatements in Prospectus

Section 35 establishes the civil liability of promoters, directors, and other people authorizing the issuance of a prospectus, including auditors, in regard to misstatements in the prospectus. Here, the auditor shall be obligated to indemnify the aggrieved party for all losses, charges, and expenses incurred as a result of reliance on such false statements. However, if certain stated grounds are proven, the auditor can avoid such liability.

Liability for Misfeasance

Misfeasance is defined as a ‘breach of duty or trust’. The auditor of a company would be guilty of misfeasance if he has committed a breach of trust or was negligent in performing his duties, resulting in a loss or damage to the company or its property. It is a specific remedy under the Act and it can only be invoked when the company is being liquidated. Negligence procedures under the common law, on the other hand, can be initiated at any time against the auditor. In numerous cases, the auditor has been held accountable for misfeasance under Section 340 of the Companies Act.

An important case in this regard is as follows:

The London and General Bank Ltd. (1895)

The bank had advanced loans based on insufficient collateral. There was no provision for bad debts created around these loans. As a result, the profit and loss account did not accurately reflect the genuine profit earned as a result of operations. The auditors informed the directors of this fact in a separate report but did not disclose anything about it expressly in the report to the shareholders. On the basis of the audited Profit and Loss Account and Balance Sheet, the directors paid dividends to the shareholders. Because profits were insufficient, dividends were paid out of capital. The auditors were held financially responsible to make good the company’s loss.

Criminal Liabilities of Auditor under Companies Act 2013

Some of the sections under which an auditor can be held accountable for criminal liability are given below. Remember, these sections are applicable to all officers, managers, directors, etc. (including auditors) of a company who are at default.

Section 34: If a prospectus includes any untrue statement, the auditor authorizing the issue of such prospectus can be punishable with imprisonment (which may extend to 10 years) and with a fine not less than the sum involved in fraud (which may extend to 3 times the sum involved in fraud) [Section 447].

Section 147:If the auditor of a company contravenes with any of the provisions laid down in Sections 139, 144, or 145 relating to the signing of an audit report, rendering prohibited services, etc., he shall be liable for a fine as well as imprisonment (he will be imprisoned if the contravention is done willfully).

Section 217: In case the auditor fails to produce documents or give assistance to an inspector appointed by the Central Government for the investigation of a company’s affairs, he shall be punishable with imprisonment and fine.

Section 299: During the process of winding up of a company, if the auditor fails to appear before the National Company Law Tribunal if he has been asked to, he shall be held criminally liable.

Section 448: If any person (including the company’s auditor) deliberately omits a material fact or makes a false statement in any return, certificate, report, financial statement, or other documents as may be required under the Act, he shall be held liable for punishment under Section 447.

Some cases in which an auditor has been held for criminal liability are as follows:

Dumbell Banking Co. Ltd. (1900)

In this case, the directors and auditors were charged under Section 221 of the Criminal Code of 1872, which is similar to Section 143 of the Companies Act of 2013, for participating in the issuance of false balance sheets, knowing that they were false in material particulars, with the intention to deceive and defraud the company’s shareholders.

The accounts were not just incorrect, but materially false, based on the facts presented; letters from the auditors to the managers demonstrated that the auditors thought that overdrafts were bad even though they were taken in as good. They had told the managers that they had strong opinions about the overdraft, but they did not express those opinions in the certificates issued to the shareholders. All of the defendants (including the auditors) were found guilty by the jury and were sentenced to terms of imprisonment.

Farrow’s Bank Ltd. (1921)

In this instance, there had been a significant write-up of assets, presumably to indicate earnings available for dividends. In one instance, a £5,500 property was written up to £7,80,000. The auditor was a regular employee of the corporation, working as its accountant. He was convicted on several charges of conspiracy and fraud in connection with the bank’s published accounts and was sentenced to 12 months in prison.

Note: Liabilities of Auditor under the Income Tax Act, 1961

A Chartered Accountant quite often acts as the authorized representative of his clients in proceedings under the Income Tax Act, 1961, and appears before an Income Tax Authority or the Appellate Tribunal. He also has a few liabilities under the said Act by virtue of Section 288, Section 278, Rule 12A of the Income Tax Rules, and Section 271J.

Conclusion

An auditor of a company has civil and criminal liabilities. Under common law, he has civil liabilities both towards the client as well as third parties, and under various statutes including the Companies Act, 2013, in addition to civil liability, he has criminal liabilities as well.


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By Ruchi Gandhi

The author enjoys to write informational content in the domain of company law and allied laws. She takes interest in doing thorough and analytical research on legal topics. She is a CA along with MBA (Fin) and M. Com.

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