BCom 3rd Year Liabilities of an Auditor Notes Study Material
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BCom 3rd Year Liabilities of an Auditor Notes Study Material
A company auditor is appointed under the Companies Act, 2013, and hence, his position differs from that of one appointed by a private concern. His appointment, remuneration, rights and duties, liabilities and responsibilities, etc., are defined and laid down by the Companies Act. His liabilities can be classified under the following heads:
I. CIVIL LIABILITY
1. Liability for Negligence
An auditor appointed by a company is expected to safeguard the interests of the shareholders and, as such, he performs his duties as an agent of the shareholders. He must exercise reasonable care and diligence in the performance of his duties as laid down under the statute. If he fails to do so and as a consequence thereof, the principal suffers a loss, the auditor is held liable to make good the loss under the Law of the Agency. Thus, he can be compelled to compensate the loss caused to the company resulting from his negligence.
But it has to be remembered that the auditor cannot be held responsible to compensate the loss if his negligence is proved without, in any way, causing loss to the company. He is liable for damages if the company has suffered any loss due to his negligence in the performance of his duties as was held in the case of Liverpool & Wigan Supply Association Ltd. (1907). The situation can be briefly put as given hereunder:
(1) Leeds Estate Building & Investment Society vs. Shepherd (1887)
It was held in this case that if an auditor is found negligent in the performance of his duties as an auditor, he is liable for damages. In this case, the auditor failed to see that:
- The Articles of Association had not been fully complied with, and
- Dividends had been paid out of capital.
Decision. “It is the duty of an auditor not to confine himself merely to ascertaining the arithmetical accuracy of the Balance Sheet, but to see that it is a true and accurate representation of the company’s affairs. It was no excuse that the auditor had not seen the Articles when he knew of their existence. The Statute of Limitations had been pleaded on his behalf, and the plea had not been resisted so that his liability would be limited to the dividends paid within six years of the commencement of the action.”
(2) Irish Wollen Company Ltd. vs. Tyson and Others (1900)
In this case, it was held that an auditor who by reasonable care and skill could detect falsification of accounts is liable for dividends paid out of capital due to such falsification. (BCom 3rd Year Liabilities of an Auditor Notes Study Material)
Decision. In the course of his judgment, Holmes. Lord Justice said: “There is no doubt that both the suppression and carrying over of invoices would have been detected if the auditor had called for the creditors’ Statement of Accounts upon which payment was ordered, and compared them with the Ledger…I do not understand how the carrying over of the invoices could have escaped detection by the accountant, who should have used due care and skill and who was not a mere machine. The invoices carried over were ultimately posted to the Ledger.
If they were posted to their true dates, it would be at once apparent that they were not entered in at the proper time. If they were posted under false dates, why was this not detected when the Ledger Accounts were checked with the invoices… For these reasons, I am of the opinion that if due care and skill had been exercised, the carrying over and suppression of invoices would have been discovered and the auditor is liable for any damage, the company has sustained from the under-statement of liabilities in the balance sheet….”
(3) London Oil Storage Co. vs. Seear Hasluck & Company (1904)
It was held that an auditor who fails to verify the existence of assets as shown in the Balance Sheet of the company is liable for damages but the assessment of such damage is dependent on how far the negligence of the administration is contributory to such loss.
Alberstone, C. J. observed:
“The plaintiffs must satisfy you that the damage has been occasioned to whatever extent you think it was occasioned, by the breach of duty on the part of an auditor. You must not put upon him the loss by reason of theft occurring afterward or before but you must put upon him such damages as you consider in your opinion were really caused by his duty as an auditor of the company.
(4) Arthur E. Green & Company vs. The Central Advance & Discount Corporation Ltd. (1920)
It was held that an auditor is guilty of negligence, if he fails, to detect time-barred debts within the schedule of debtors.
An auditor may, thus, be liable for the previous losses, and he may also be held responsible for the consequential losses. In fact, damages which are the direct result of negligence are only recoverable. Remote damages are not recoverable.
On the question of consequential damages. the Accountant of England referring to the Armitage vs. Brewer & Knott wrote: “The case gives a footing disadvantage to the profession in applying the principle of consequential damages to audit claims… Thus, if an auditor omits to detect the defalcation by an employee and in the following year before there is a chance of any further audit, the employee emboldened by having escaped detection embezzles a larger sum, the auditor is liable both for the original embezzlement which he failed to detect and for the subsequent losses to the employer as well?”
“A mere mistake will not render a professional man liable for the consequence, but if the negligence was of the type where omission was to detect a fraud which by the exercise of a reasonable care an accountant would have detected, then we are inclined to think that a jury would take into account the consequential losses in their award of damages. On the other hand, if the auditor’s failure to detect defalcation was not blameworthy, and he could not reasonably be expected to detect such a defalcation, he might not, in our opinion, be liable.”
Thus, to hold the auditor liable for negligence, the following three things must be proved:
- That he was negligent,
- As a result of his negligence, the client suffered a loss, and
- That the loss was suffered by the person to whom the auditor owed a duty.
The company may indemnify the auditor for any expense that he incurs in defending himself provided the judgment was in his favour.
2. Liability for Misfeasance
As an auditor is held responsible for damages caused to a company on account of his negligence. He will similarly be held liable if, he is negligent in the performance of his duties or commits misfeasance, i.e., a breach of trust or duty. Misfeasance implies a wrong done. If an auditor does something wrongfully in the performance of his duties resulting in a financial loss to the company, he is guilty of misfeasance. The Directors, Managing Agents, and other officials of a company may also be held liable for misfeasance.
About experts’ Statement in the prospectus. Where the consent of a person is required to the issue of a prospectus and he has given such consent, he shall not be liable as a person who has authorized the issue of the prospectus if his opinion is honest. However, he remains liable in respect of an untrue statement, if any, purporting to be made by him as an expert. As such the expert remains liable for untrue statements made by him and included in the prospectus with his consent as if he had authorized the issue of the prospectus.
Company Law provides for the Civil liability of an auditor and also for misstatements in the prospectus of the company.
Negligence in winding-up. If in the course of the winding up of a company, it appears that any officer (including the auditor) of the company has misapplied or retained or become liable for any money or property of the company or has been guilty of any negligence or breach of trust in relation to the company, he can be held liable for damages caused to the company.
(1) London and General Bank Case (1895)
An auditor is liable for misfeasance if he fails to bring to the notice of the shareholders in clear terms, the unsatisfactory state of affairs of the company when he himself had not been satisfied.
In the course of the judgment, Lindley, L.J. said:
“It is no part of an auditor’s duty to give advice either to Directors or Shareholders as to what they ought to do. His business is to ascertain and state the company’s true financial position at the time of the audit, and his duty is confined to that. But then comes the question: How is he to ascertain such a position? The answer is: By examining the books of the company…He must take reasonable care to ascertain that they do. Unless he does this, his duty will be worse than a farce….”
“Such I take to be the duty of the auditor: he must be honest, that is, he must not certify what he does not believe to be true and he must use reasonable care and skill before he believes what he certifies is true….”
(2) Kingston Cotton Mill Co. Ltd. (1896)
An auditor is not liable if, in the absence of suspicious circumstances, he relies on trusted officials of the company.
In the course of the judgment, Lopes, L. J. remarked:
“An auditor is not bound to be a detective or, as was said, to approach his work with suspicions or with a foregone conclusion that there is something wrong. He is a watchdog and not a blood-hound. He is justified in believing tried servants of the company in whom confidence is placed by the company…Auditors must not be made liable for not tracking out ingenious and carefully laid schemes of fraud, when there is nothing to arouse their suspicion and when these frauds are perpetuated by tried servants of the company and are undetected for years by the Directors.”
(3) The City Equitable Fire Insurance Co. Ltd. (1924)
It was held that an auditor is liable for misfeasance if he omits to verify investments and accepts the certificate of a stockbroker in lieu. An auditor is liable only when he accepts the certificate for investments from persons who are not in the usual course of their business to hold others’ securities and are not trustworthy, irrespective of the fact that they are Bankers, Sale-Deposit Companies, or Stock-Brokers.
(4) Republic of Bolivia Exploration Syndicate Ltd. (1913)
It was held in the case that it is the duty of the auditors to ascertain the scope of their work from the Articles and the statutes, and in case of damages suffered by the company on account of misleading Balance Sheet, the onus to show that the damage is not caused by their negligence is on the auditor. The auditors are prima facie responsible for a such loss but its extent depends on the circumstances of each case. (BCom 3rd Year Liabilities of an Auditor Notes Study Material)
(5) The Westminster Road Construction & Engineering Co. Ltd. (1932)
If an auditor fails to utilize the evidence reasonably available from which the overvaluation of work-in-progress could be detected, he is liable for negligence. He must make full use of the evidence available and the acceptance of the certificate without question in such a case is amounting to negligence. (BCom 3rd Year Liabilities of an Auditor Notes Study Material)
(6) Union Bank (in liquidation), Allahabad (1925)
It was held that the Directors, who have trusted a dishonest Manager, were guilty of misfeasance and an auditor was similarly held liable.
“….. It is nothing to him whether dividends are properly or improperly declared, provided he discharges his own duty to the shareholders. His business is to ascertain and state the company’s true financial position at the time of the audit, and his duty is confined to that…If he fails in his duty, he will be jointly and severally liable with those who are responsible for the management of the company, although he is not guilty of any dishonesty.”
(7) L. Hudson vs. Official Liquidator of Dehradun-Mussoorie Electric Tramway Co. (1930)
It was held that under the Act, where auditors pass over illegal payments without demanding an explanation and the facts disclose that there are deliberate abstentions from performing plain and manifest acts and there was an absolute duty cast upon them to enquire into the illegal payments and think over the real meaning of dubious transactions, they are guilty of misfeasance unless there is anything to the contrary in the Articles of Association. (BCom 3rd Year Liabilities of an Auditor Notes Study Material)
II. CRIMINAL LIABILITY
As stated earlier, an auditor is an officer of the company and in that capacity, he is liable for his acts of omission/commission which can be construed as an offense under the provisions of the Companies Act, Penalties for such offenses may be imprisonment and fine.
If there is an untrue statement in the prospectus. Where a prospectus includes any untrue statement, every person who authorized the issue of the prospectus shall be punishable with imprisonment for a term which may extend from 6 months to 10 years or with a fine which may not be less than the amount involved in the fraud or three times of it. or with both, (Section 447) unless he proves either that the statement was immaterial or that he had reasonable ground to believe, that the statement was untrue.
For the purpose of this section, an auditor may be punished if he authorized the issue of the prospectus.
If an Auditor’s Report is made, or any document of the company is issued or authenticated otherwise that in conformity with the requirements of sections 143 and 145, the auditor concerned, and the person, if any, other than the auditor, who signs the report or signs or authenticates the document, shall be punishable with fine which may extend to 5 lakh rupees, and imprisonment up to one year.
Failure to give assistance to inspectors. The auditor of a company is required to give assistance to an Inspector appointed by the Central Government to investigate the affairs of the company. If he does not do so, he is punishable with imprisonment of up to one year and with a fine of up to one lakh rupees. (BCom 3rd Year Liabilities of an Auditor Notes Study Material)
Assist in prosecution. When on the basis of the report submitted by an Inspector, the Central Government takes action and prosecutes any person connected with the affairs of the company, the auditor is required to assist the prosecution. If he does not do so, he is guilty of Contempt of Court and punishable. (BCom 3rd Year Liabilities of an Auditor Notes Study Material)
In the course of winding up of a company, the auditor is subject to a private examination by the Tribunal and is required to return to the Court any documents in his possession. If he fails to appear before the Court, he can be arrested.
The auditor of a company, on the application of the Official Liquidator, can be publicly examined by the Tribunal. The notes of examination shall be taken down and signed by an auditor. Such notes may be used as evidence against him in any civil or criminal proceeding.
If an auditor destroys, mutilates, alters, falsifies, or secrets or is privy to the destruction, mutilation, alteration, falsification or secreting of any books, papers, or securities or makes, or is privy to the making of any false or fraudulent entry in any register, book of account or document belonging to the company, he shall be punishable with imprisonment and shall also be liable to fine.
If found guilty of a criminal offense. The tribunal may direct the Liquidator of a company in winding up to prosecute the auditor if he is found guilty of any criminal offense in relation to the company. (BCom 3rd Year Liabilities of an Auditor Notes Study Material)
Making false statements in reports etc. If an auditor of a company makes a statement in any Return, Report, Certificate, Balance Sheet, Prospectus, etc., which is false in any material particular, knowing it to be false or omits any material fact knowing it to be material, he shall be punishable with imprisonment and shall also be liable to fine. (BCom 3rd Year Liabilities of an Auditor Notes Study Material)
False evidence. If any person (including an auditor) intentionally gives false evidence upon any examination on oath or solemn affirmation authorized under the Act; or in any affidavit, deposition, or solemn affirmation, in or about the winding up of any company under the Act or otherwise in or about any matter arising under the Act, he shall punishable with imprisonment and shall be liable to fine.
Under the Indian Penal Code
Section 197 of the Indian Penal Code (IPC) lays down: “whosoever issues or signs any certificate required by law to be given or signed or relating to any fact which such certificate is false in any material point shall be punishable in the same manner as if he gives a false evidence.”
Powers of the Court to grant relief to the Auditor
If it appears to the Court that an auditor is or may be liable in respect of the negligence, default, breach of duty, misfeasance, or breach of trust but that he has acted honestly and reasonably, it can relieve him either wholly or partly from his liability on such terms as it may think fit.
Provided that in a criminal proceeding under this rule, the Court shall have no power to grant relief from civil liability which may attach to an officer in respect of such negligence, default, breach of duty, misfeasance, or breach of trust.
LIABILITY OF AN AUDITOR TO THIRD PARTIES
So far we were discussing the liability of an auditor to the company, now we shift to another vital question as to how far he is liable to those who are creditors, bankers, lenders, debenture holders, and other persons or institutions having dealings with the company but are outsiders. If they suffer any loss by relying on the Balance Sheet or other Statements or Documents signed by him, can he be held liable for damages so caused to any of them?
The answer is obviously, ‘No’. An auditor is never appointed by a third party and as such, he has nothing to do with such a party. There is virtually no contract between the auditor and the third party. (BCom 3rd Year Liabilities of an Auditor Notes Study Material)
“The auditor owes no duty of care to anybody but his client and he cannot be held responsible for any loss suffered by third parties through reliance on accounts which have been audited by him, even though negligence may be proved.” -Candler vs. Crane, Christmas & Co. (1951)
According to the judgment given in the case of Le Lievre & Dennes vs. Gould (1893), it becomes clear that the Court cannot hold an expert responsible for negligence unless fraud is established against him.
It should first be proved that:
(i) the statement signed by him was untrue in fact;
(ii) the person making it knows that it was untrue or was recklessly and consciously ignorant of whether it was true or not;
(iii) the statement was made intentionally for the plaintiff to act upon it; and
(iv) the plaintiff acted in reliance on it and suffered damages.
Thus, only in case of fraud in the Court of Law against an auditor, he can be held liable for damages. Whatever the case, he should exercise reasonable skill, care, and tact. (BCom 3rd Year Liabilities of an Auditor Notes Study Material)
Briefly, it can be stated that an auditor owes no duty to third parties. He is liable only when he has knowingly committed some fraud and due to this, they are put to some damages. Under the Hedley Byrne case, it was indicated that actions for professional negligence may arise if the financial loss is suffered by third parties. (BCom 3rd Year Liabilities of an Auditor Notes Study Material)
However, the legal position in India on the issue of the liability of an auditor to third parties has changed under section 34 of the Companies Act, 2013. Under the circumstances, an auditor can be held liable for the damages to a third party if the auditor had authorized the issue of such a prospectus that contains a misleading statement. (BCom 3rd Year Liabilities of an Auditor Notes Study Material)
Conclusion. It would be needless to repeat and reproduce the decisions given above but it can be laid down here that there are no universal and firm norms or principles on the basis of which the liability of an auditor to third parties can be in particular defined and established. Circumstances differ, the regulations of the Articles of Association vary, and more so, the terms of the contract between an auditor and his client vary widely. Hence, it does not seem feasible to lay down uniform laws and rules in this regard.
However, to make an auditor liable for the loss suffered by any third party by relying on his report and taking action thereafter, some principles normally accepted can be enunciated and they are:
- It is proved that the auditor showed negligence in his duty and as a result, the third-party suffered a loss, and/or
- His report is fraudulent.
Thus, some liability may arise when the auditor performs his duty knowing that his work would be relied upon by some third party which may suffer financial loss as a result thereof. (BCom 3rd Year Liabilities of an Auditor Notes Study Material)
But it has always to be remembered that an auditor must be honest. He must exercise reasonable care, caution, and skill. Unless he is fully satisfied, he must not certify as correct the Profit & Loss Account or Balance Sheet or any other statement. What amount of care and skill will be reasonable will depend upon the circumstances of the individual case. It is certain that if the negligence is proved in Court and the company is put to a loss as an effect thereof, he will be liable for damages.
He must be honest and submit his report after proper scrutiny of accounts in a free and frank way. This is all that he can do.
Liability of an Honorary Auditor
So far as the liability of an honorary auditor (that of charitable or voluntary organizations) is concerned, he is equally well responsible for negligence or misfeasance as a salaried auditor. He cannot be relieved of his liability on the ground that the agreement between him and his chief was not supported by consideration and hence it was void. (BCom 3rd Year Liabilities of an Auditor Notes Study Material)
He should not undertake the work of an auditor if he wishes to be free from any sort of liability with his taking over the responsibility of audit work and submitting his report, he is as responsible for his acts as a paid auditor. On this issue, there is actually no difference between the two. -Fairdeal Corporation, Bombay vs. K. Gopal Krishna Rao (1957)
BCom 3rd Year Liabilities of an Auditor Notes Study Material