Lesson 4 Auditors Liability

AUDITORS RESPONSIBILITY
Negligence in General ( auditors liability)

There is no recorded case in Kenya against auditors and this makes it difficult to be precise as to where the
auditor’s legal liability falls. We need therefore to refer to decided cased in other countries. But even in
those countries there are in fact very few decided cases against auditors. In those countries, the vast
majority of actions against auditors are settled out of court. This saves what could otherwise be very
expensive court costs. It is also significant to note that this saves dragging the professional firm's name
through the courts and most likely through the newspapers. Firms are of course anxious to avoid such bad
publicity.
It is however generally known that the auditor's liability falls under three specific headings:
(a) To his clients under contract law;

(b) To third parties under the law of tort;
(c) Civil and criminal liability under statute law
and we will deal with each in turn:
To his clients: The auditor is under duty to report to the members in general meetings on all
accounts examined by him and laid before them. His contract is therefore with the company as a
whole and not with individual shareholders. The auditor can therefore be accused of negligence if:
(a) he fails to detect fraud or error which he should reasonably have detected;
(b) if he fails to comply with generally accepted auditing standards and practices.
However, it is also generally held that for an auditor to suffer actual financial loss, the following
conditions must be met.
i. he must be proved to have been negligent;

ii. the complainant must have suffered a loss;
iii. the loss must be as a direct consequence of his reliance on the auditor's report and the auditors
negligence.
Therefore if the auditor fails to detect a fraud which is immaterial to the accounts and unless there are
suspicious circumstances which he had noticed or should reasonably have noticed, it is unlikely that
he will be held negligent.
Even if the fraud was material to the accounts, he may still escape liability if detection could not
reasonably have been achieved using normal audit procedures. It must be admitted however this is a
very dubious area of law.
The auditor has no duty to individual shareholders. A shareholder who makes an investment decision
by relying on the auditor's report and suffers loss cannot claim under the law of contract. Only if the
company as a whole has suffered, can the whole body of shareholders claim from the auditor.
In a number of cases it appears that claims have arisen as a result of some misunderstanding as to the
degree of responsibility which the accountant was expected to take in giving advice or expressing an
opinion. It is therefore important, to distinguish between disputes arising from misunderstanding
regarding the duties assumed, and negligence in carrying out agreed terms.
The Use of Engagement Letters
There is a contractual relationship between an accountant and his client. The accountant should therefore
ensure that at the time he agreed to perform certain work for the client, the scope of his responsibilities is
made clear preferably in writing, in that the terms of his contract with his client are properly defined. Where
possible a letter of engagement should be prepared setting out in detail the actual services to be performed,
and the terms of engagement should be accepted by the client so as to minimise the risk of disputes
regarding the duties assumed.
Liability to third parties

For a long time liability to third parties existed only in respect to physical injury. Liability for financial loss
is a recent development. Examples of occasions when an accountant may run the risk of insuring a liability
to third parties may include the following:
(a) Preparing financial statements or reports for a client when it is known or ought to be known
that they are intended to be shown to and relied upon by a third party even if the identity of the
third party is not disclosed.
(b) Giving references regarding a client's credit worthiness or an assurance as to his capacity to
carry out the terms of a contract or giving any other reference on behalf of the client.
Again, it must be shown that the accountant was negligent, third parties suffered a financial loss, the
financial loss occurred as a result of the accountant's negligence and that the accountant knew the purpose
for which his report or accounts were to be used.
Liability under statute

Civil liability: Section 206 of the Companies Act provides that officers of the company and for these
purposes auditors are considered as officers, may be liable for financial damages in respect of the
civil offences of misfeasance and breach of trust. This section which is only relevant to winding up
refers to a situation where officers have misused their position of authority for the purposes of
personal gain.
Criminal liability: Section 46 of the Companies Act states that an auditor shall be criminally liable if
he wilfully makes a materially false statement in any report, certificate, financial statement etc.
Wilfully implies fraudulently and can be difficult to prove. Whereby, it is held that where an officer
of a body corporate with intent to deceive members or creditors, publishes or concurs in publishing a
written statement of account which to his knowledge is or may be misleading, false or deceptive in a
material particular he shall on conviction be liable to imprisonment for a term not exceeding 7 years.
Other relevant issues to be considered under this section include:

• The auditor with errors and irregularities;
• The auditor with illegal acts by client or client's staff;
• Questionable payments;
ILLEGAL ACTS
Auditors may uncover criminal offences committed by a client or an employee of the client. This puts them
in a difficult position, but the auditor should act carefully and correctly and if necessary, take legal advice.
The auditor must not commit a criminal offence himself. It is felt that he would have committed a criminal
offence if:
(a) He advises his client to commit a criminal offence;

(b) Aids the client in devising or examining a crime;
(c) If he agrees with a client to conceal or destroy evidence or mislead the police with false
statements;
(d) If he knows that his client has committed an arrest able offence and tries to impede his arrest
and prosecution. Impede does not include refusing to answer questions or refusing to produce
documents without the client's consent;
(e) If he knows that his client has committed an offence and agreed to accept consideration to
withhold information;
(f) If he knows that the client has committed treason and fails to report the offence to the proper
authority.
Discovery of unlawful acts

When an auditor discovers unlawful acts, usually he is not expected to disclose to the police or other
authorities unless:
i. The client authorises disclosure;

ii. That disclosure is compelled by process of law for example, a court order;
iii. That disclosure is required in the auditor's own defence;
iv. The circumstances are such that the auditor has a public duty to disclose, for example, when
the client has committed a serious crime or his act is treasonable.
Therefore to summarise, the auditor on discovery of an unlawful act should do nothing positively to assist in
the offence or to prevent its disclosure. He must bring all offences of employees to the notice of his clients.
If the offence is such that its non-disclosure means that the accounts are not showing a true and fair view,
then the auditor must insist on disclosure or qualify his audit report. Discovery of material defects in
previous accounts should be pointed out to the client with recommendation for disclosure.
Questionable Payments
In some countries, business is often gained by bribing ministers or public officials or officers of companies
or firms with whom one wishes to do business. Indeed bribery and corruption are a way of life in some
business communities. This is the general area of questionable payments, which may include
"commissions, usually based on the amount of business placed". When an auditor discovers such payments,
he has to consider what course of action to take. In general, the following conduct by the auditor is
acceptable.
(a) He should satisfy himself that the payment is as stated and that he has been told the whole
story;
(b) He should satisfy himself that the payments were genuinely made in furtherance of the client's
business;
(c) He has to satisfy himself that all directors of the company were aware of the payment and its
purposes;
(d) He has to obtain a letter of representation, signed by all the directors to confirm (c);
(e) If the client is a subsidiary, then he has to ensure that the holding company and the primary
auditors are aware of the payment and;
(f) He has to consider whether disclosure is required. Generally disclosure is not necessary
because such payments are rarely material in the context of the company' accounts as a whole
and usually a true and fair view is given without disclosure.

Lesson 4 Auditors Liability

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AUDITORS RESPONSIBILITY

Negligence in General ( auditors liability)

(a) To his clients under contract law;

and we will deal with each in turn:

i. he must be proved to have been negligent;

Liability to third parties

Liability under statute

Other relevant issues to be considered under this section include:

(a) He advises his client to commit a criminal offence;

Discovery of unlawful acts

i. The client authorises disclosure;

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