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The Issue of Limiting Auditor’s Liability

Executive Summary

The liability of auditors has been a subject of debate in the recent past. The company law, international auditing Standards and the International Financial Reporting Standards stipulate the need for auditors work in the financial reports of companies. In addition, these bodies plus the statutory legislations of different countries indicate the level at which the auditor is liable to the users of his reports

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The claims against auditors in the few past years have been massive and with disastrous results as evidenced by the collapse of two giant audit firms, Arthur Andersen and Enron. This has raised debate among the accountants pushing for the limitation of auditor’s liability (Dyer, 1993). However, holding auditors liable may benefit the users of auditors’ reports, who suffer loss or damage due to negligence of the auditor in preparing such reports. In addition, various legislations have been passed aimed at protecting the auditors from further demise (Murphy, 2009). This is due to the realization that extensive fall out of audit firms will create a situation of compromised audit work that will have a direct effect on the confidence of investors and subsequently the growth strategies of the companies.

As accounting firms continue to face ever present litigations for damage, reforms in auditing are overdue. Limiting auditors’ liability through various alternatives that include liability capping, proportionate liability, limited liability partnerships and limited liability corporations is important. These alternatives are all directed towards ensuring that the auditors are not exploited by the opportunistic litigators as well as enhancing the overall performance of auditors.

Introduction

The concept of auditor liability has been a controversial one in the last few years. Auditor liability may be described as holding the auditor accountable for the losses or damages incurred by the users of information prepared by the auditor, who may have done so negligently (either simple or gross). From one point of view, auditors have been seen to have caused a lot of losses to stakeholders of the company audited leading to massive litigations for damages.

This has led to the escalation of financial and legal risks of the audit firms, a scenario that has witnessed the collapse of two big players in the audit industry. On the other side, there has been massive lobbying for reforms in auditing liability to protect the survival of the audit industry. The lobbyists claim that any further collapse of a large audit firm will not only lead to the demise of the industry but also to compromise of audit quality, whose effect will even be more severe.

The importance of auditor’s liability can be evidenced by the fact that it protects the users of the auditor’s information from possible losses caused by relying on such information which may be misstated. An auditor has a duty of care to the users of the audit information and therefore they should exercise reasonable care and skills that will not inflict any harm to his clients or other users. Moreover, Sealy and Worthington (2007, p. 73) claim that the auditor should be criminally litigated for providing misleading reports. The aggrieved party may petition the auditor for damages under civil law for simple negligence or under tort law for gross negligence.

Limiting auditor’s liability

Holding auditors liable for damages in every case of negligence or otherwise is likely to be detrimental to the audit work in general. Due to the importance of the audit work, it becomes important to establish a limitation of auditor’s liability that will enhance the protection of the overall audit profession. According to Hodge (2009), lack of limitation on auditor’s liability will lead to a collapse of more audit firms; quality of audit work will be compromised, and the companies are likely to lose in terms of growth as existing investors will lose confidence and dump the companies’ stocks.

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Reasons for limiting auditor’s liability

The effect of auditor’s negligence may inflict damage to the users of information presented by the auditors, but the implication of abuse of such liability may be detrimental to the survival of the auditors in the accounting industry. This can also be emphasized by the collapse of Arthur Andersen and Enron, the two largest audit firms following excessive claims of damage against them. This has seen stimulated the remaining giant firms to campaign for limitation of auditors’ liability. Moreover, common law legislation does not hold that the auditors necessarily have a duty of care against the shareholders of a company; it is not sufficient to claim that auditors report is a sufficient indicator of the financial risk of the company, yet there are other indicative factors available.

Limiting auditor’s liability will also enhance the growth of the audit industry as it will create confidence to other smaller audit firms to expand their operation with an assurance that the profession is safe (Taub, 2005) – they fear excessive litigations for damages against them.

According to Gray and Manson (2007, p. 763), the excessive litigations on the auditors make them financially strained due to the high cost of indemnity insurance compared to the revenues they make, thus affecting their overall profit margin. The consequences of this liquidity problem are severe and discouraging for the expansion and growth of the accounting industry.

Reasons against limiting auditor’s liability

Although it may be important to protect the audit profession from oblivion, there are severe consequences that can not go unpunished especially when the issue of negligence comes in. In the economic sense, the cost of litigation may not be so prohibitive compared to the revenues generated by the audit firms and therefore, since they are in business, they should strive to protect their business by providing accurate and well-intended reports. Moreover, Clark, Dean and Oliver (2003, p. 322) claim that the auditors should not expect to earn huge revenues at expense of users of their information and walk scot-free; that would be tantamount to impunity.

In addition, the massive litigations will act as deterrence of the auditors to be careful in their reports as well as influence the accounting body to institute new all-inclusive and comprehensive standards that will improve the quality of audit work – it will serve as a means of modernization of the accounting and auditing profession. Furthermore, although an auditor may be adhering to the International Accounting Standards, this does not preempt him from making additional disclosures that are of importance in making decisions by the user of the audit report (Squires, 2003, p. 68).

Although limiting auditor liability may be claimed to enhance the quality of audit, the reverse may also be true given that, protected auditors may not act seriously with the belief that they will not be held accountable. Moreover, the opponents of reform in legal liability claim that, by so doing, there will be a reflection of discrimination against other professions (Aisbit and Evans, 2004, p.455).

Impact of Limiting auditors’ liability

Limiting the auditor’s liability may have various impacts on the client, the society and the auditor. It involves providing a liability cap on the auditors that mitigates their financial and legal risks. This means that the personal assets or possessions of the auditor will be protected especially where there is a limited liability partnership or corporation. In addition, limiting the auditor’s liability will enhance the growth of smaller audit firms who are always hindered by the financial and legal risks associated with litigations for indemnity (Potdevin, 2008). Moreover, Marianne (2009) claims that limiting the liability will not only enhance the performance of the auditors but also create harmonization.

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This will also benefit the shareholders as the auditor will have a conducive playfield to enhance their efficiency of reporting. However, disadvantages always arise where the shareholders are left exposed to the potential negligence of the auditors. Limiting their liability will neutralize the civil law of joint and several liabilities on the auditors, thus denying the shareholders compensation for the injuries and damages caused by the use of the auditor’s information.

Protection of auditors will ensure continuity of financial scrutiny of large corporations that affect society. The current accounting policies require companies to report not only on financial matters but also on social responsibility, which may be overlooked where auditors are not involved. Indeed Bilek (1986) holds that the accountants (auditors) should be held liable to third parties for injuries arising from their negligence of care.

Auditors Legal Liability

The company law stipulates the duties, rights and liabilities of the auditor when preparing his/her report; he is liable to stakeholders of the company he audits, who rely on his report to make financial decisions (Clickeman, p. 9). The statutory also have legislations that govern the conduct of auditors, the breach of which he may face legal redress; this makes the auditor be ensuring his report portrays a true and accurate representation of the client’s financial affairs and that he applied reasonable care and skills that are required of a person of his calibre under the circumstances (Dicksee, p. 326). However, where the accounts of the company audited by the auditors are not true (there has been embezzlement of funds) yet the auditor did fail to discover such fraud due to negligence, the auditor may be held liable for damages (Gormley, 1984, p. 531).

However, the claim of damages will only hold if the court establishes with certainty that the plaintiff suffered loss or damage, the financial statements contained material misstatements or omissions (contained false information) and that the plaintiff relied on the statement to make decisions that led to the damage (Whittington and Delany, 2008, p. 85). In addition, for the plaintiff to have a successful claim of damage against the auditor, he must prove beyond doubt that the auditor had a duty of care against him, that the auditor was negligent and that he suffered a loss due to the negligence of the auditor. However, the auditor is liable where the user was not the intended user (Hocking, 1999, p. 166).

Limiting Liability Alternatives

Auditor liability capping

Capping of auditor’s liability is a statutory obligation that involves setting a limit up to which an auditor can be held liable for damages on his/her negligence (Free, 1999). Capping is usually based on the balancing effect of the cost to be charged on damages and the revenues generated by the auditor in carrying out the audit work whose information caused damage or injury. According to Free (1999), this may push the audit fees charged down as auditors tend to limit the number of fees charged on the damages. Different countries have different legislations related to the amount of capping and the limit of liability that the auditor is entitled to.

Proportionate liability

Proportionate liability refers to a scheme to provide a compromising situation on the claim of damages where the auditor (defendant) becomes insolvent and is unable to cover all the claims, with the aggrieved party (plaintiff) covering the remainder. In this case, the auditors will not be held jointly and severally liable for the claims if one of them is insolvent, especially in cases of the tort of negligence. However, Free (199) claims that the scheme of proportionate liability may not be effective as the plaintiff bears the burden which he/she was not part of and proposes the insurance of directors to mitigate the risk.

Further, since the auditor relies on the information provided by the company to prepare his report, the burden of negligence should fall partly on the auditor and partly on the directors on the company audited. However, according to Melzer, Weinberger, Zinman, Symposium of Science and Modern Democracy (1999, p. 335) the fact that there is sharing of liability where the auditor is unable to pay damages leads to inequitable since the victim is made to incur financial loss, yet the failure was on the side of the company.

Limited Liability Partnership

In normal partnership agreements, the partners are jointly and severally liable for damages caused as a result of their negligence. However, limited liability partnerships allow the liability of each partner to be limited up to the amount of contribution to the firm for each partner. According to Morse (2006, p. 434), the auditors agree to limit the amount of liability owed by each auditor in respect of negligence or a breach of duty or trust that may be incurred in course of their duties in the audit firm. This enhances the protection of innocent partners, who would otherwise suffer financial loss as a result of the negligence of other partners (s). In this case, the case of jointly and severally liable does not apply as partners have limited liability.

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Limited liability agreements effectively allow for fair and justifiable liability of the auditors putting in mind the role of each auditor, nature of the contractual obligation of the auditor and prevailing professional standards. In some situations, the amount of liability may be agreed to be lower than the fair and reasonable amount without taking account of matters arising post damage claim and the possibility of recovery of the amount from third parties liable in respect of the claimed damage.

Limited Liability Corporations

For many years, the company law and accounting legislation have restricted the incorporation of audit firms primarily due to the duty of care they hold on the companies’ stakeholders and the delicate liability they hold. The argument has been that the limited companies have legal authority separate from the owners and that the owners are not liable for damages claimed against the company. Moreover, it may be viewed that, incorporating the audit firms will ultimately undermine the credibility of the audit work, since the auditors themselves may compromise their work with the confidence that they have no liability for their negligence.

Conclusion

The role of the auditor is important in protecting the plight of the investors and other stakeholders on the company that is being audited by the auditor. In this case, limiting the auditors from massive litigations may aid in increasing the performance of the audit work. From the various alternatives available for limiting auditors’ liability, proportionate liability seems to be more favourable since, despite protecting the auditor from exploitative litigations, it also provides the auditor with the responsibility of abiding by the legal provision of audit, the terms of contract and professional standards expected of him. The issue of sharing liability with clients will influence both parties to be more careful in their decisions.

References

Aisbit, S. and Evans, L. (2004). Developments in country studies in international accounting—Europe. Cheltenham, Edward Elgar Publishing. Web.

Bilek, T. E. (1986). Accountants’ Liability to Third Party and Public Policy: A Calabresi Approach. Web.

Clark, F. L. et al. (2003). Corporate Collapse: Accounting, Regulatory and ethical Failure. Cambridge, Cambridge University Press. Web.

Clikeman, P. M. (2008). Called to Account: Fourteen Financial Frauds that Shaped the American Accounting Profession. London, Taylor & Francis. Web.

Dicksee, L. R. (2009). Auditing: A Practiccal Manua for Auditors. Charleston, BiblioBazaar LLC. Web.

Dye, R. A. (1993). Auditing Standards, Legal Liability, and Auditor Wealth. Journal of Political Economy. Web.

Free, C. (1999). Limiting Auditors’ Liability. Web.

Gormley, R. J. (1984). The Unforeseen, the Foreseeable, and Beyond – Accountants Liability to Nonclients. Web.

Gray, L. and Manson, S. (2007). The Audit Process: Principles, Practice and Cases. Andover, Cengage Learning EMEA. Web.

Hocking, B. (1999). Liability for Negligent Words. Annandale, Federation Press. Web.

Hodge, N. (2008) Limiting auditor liability. World Finance. Web.

Marriane, O. (2009). Limiting audit firms’ liability: A step in the right direction? (Proposals for a new audit liability regime in Europe revisited). Web.

Melzer, A. M. et al. (1999). Democracy and the Arts. Cornell University Press. Web.

Morse, G. (2007). Palmer’s company law: annotated guide to the Companies Act 2006. London, Sweet & Maxwell. Web.

Murphy, R. (2009). Company law: What is an Auditor’s Liability Limitation agreement? Web.

Potdevin, J. (2008). The EU Audit Agenda after the Statutory Audit Directive. Web.

Sealy, L. S. and Worthington, S. (2007). Cases and Materials in Company Law. Oxford, Oxford University Press. Web.

Squires, S. (2003). Inside Arthur Andersen: shifting values, unexpected consequences. NJ, FT Press. Web.

Taub, S. (2005). Support for limiting liability. Corporate Performance Management. Web.

Whittington, R. and Delaney, P. (2008). Wiley CPA Exam Review 2009: Regulation. NY, John Wiley and Sons. Web.

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