eMESER Liabilities of An Auditor — 9 1h this chapter. we will be covering: #911 Liability of An Auditor in case of Sole Proprietorship or Partnership. ++ 9.2 Liabilities of an Auditor Appointed by the Company or Under The Companies Act $9.3 Civil Libity : + 94 Criminal Liebility Under The Companies Act $95 Penalties to Auditors The liabilities of an auditor may be studied from legal-and practical point of view in the following ways: (a) When he is appointed by a private concern, ie sole proprietary or partnership firm. (b) When he is appointed by a Joint stock Company under the Companies Act, 2013 LIABILITY OF AN AUDITOR IN CASE OF SOLE PROPRIETORSHIP OR PARTNERSHIP In case of private concerns, there is no statutory obligation to get the accounts audited. His duties, rights, and liabilities would depend upon the agreement, entered between him and the appointing authority. His scope of duties will be decided from the agreement between the client and the auditor. I he fails to perform the duties as discussed by the chest which result into negligence and consequent loss to the client, he may be held responsible for it In Maritime Insurance Company Lid, vs William Fortune & sons (1931) the company had sustained loss by reason of defalcation of a trysted mplayer, who covered up the ‘frauds’ by omitting to enter in the books of accounts the receipt of considerable sums in cash and cheque. The question at issue was whether the auditors should have discovered the fraud? It was held that the auditors were not engaged to carry out a full audit and they had properly carried out the work they contracted to do. From this case, it is clear that the auditors shall not be liable for any loss suffered by his dient duc ta.the non-performance of that work which he was not vauked te do fo do under the Sgeeea ee ZZLiabilities of An Auditor LIABILITIES OF AN AUDITOR APPOINTED BY THE COMPANY OR UNDER THE COMPANIES ACT The duties and liabilities of an auditor of a public company are laid down under the Companies Act, 2013. If he fails to perform the duties in accordance to the provisions of the Companies Act, he is held liable. The liabilities of professional auditor for not performing their duties or responsibilities broadly fall under the following heads: (1) Civil liability for Negligence (2) Civil liability for Misfeasance (statute) (3) Civil liability for negligence towards third parties (A) Civil lability Under the Companies Act. (5) Criminal Liability of an auditor under the Companies Act. Dee ace Be acess Pit se mec teams ater, em ncn sa mom CIVIL LIABILITY 1 Under these liabilities, if the auditor is found guilty, he shall have to pay damages. (i) Liability for Negligence An auditor in case of company is appointed by the shareholders and he is expected to safeguard the interest of the shareholders. In this case, liability of an auditor arises where it is proved that his clients have suffered loss due to professional negligence. The Negligence is breach of the “duty to take care”, It means failure to exercise reasonable skill and care, which is expected from the auditor, while conducting an audit. When negligence of an auditor is being evaluated, it is in terms of what other competent auditors would have done in the same situation. Liability for Damages for Negligence In order to hold auditor liable for negligence three conditions are must.( Liver Pool and Wigan Supply Association Ltd.,1907) " (a) Existence of duty or responsibility owed by one party to.another to perform some act with certain degree of care and competence (b)_Negligence in the performance of duties. (0) Loss to the client as a result of his professional negligence. JE MR‘Audting and Secretarial Practice nce o negligence without loss is not All the factors should be present. Loss without negli capable of making the auditor liable. Existence of reach of Loss or Duty or Duy Damage Responsibility Legal decisions Lead Estate Building and development Go. vs Shepherd: In this case, the company has suffered a loss,but even then, directors of the company has received remuneration and declared dividends, in contravention to the provisions of Articles of Association. The auditor failed to detect ultravires transactions and certified the accounts to be true and fair. Justice Sterling, holding the auditor guilty of negligence, held him liable to damages. London Oil Storage Ltd vs Sear Hasluck & Co. In this case, the auditor was held guilty of negligence due t the failure on his part to check petty cash transactions. Due to the negligence of the auditor a defalcation of pound 766 by the petty cashier could not be detected. Thus the failure to exercise reasonable skill and care will make auditor responsible to pay damages. Irish woollen Mills Co. vs ‘Tyson and Others: In this case, accounts of the company were falsified by overvaluing stock-in-trade and book debts and understating liabilities. As a result dividend was paid out of capital of the company. Despite this fact, they failed to qualify, the Teport. Justice Holmes in his decision observed that had the auditor been not negligent and worked intelligently to detect errors and frauds, damages could have been prevented. Thus, the auditor was held guilty and was asked to pay damages to the company. ( ities for Misfeasance lia The term “misfeasance” means “breach of trust or breach of duty” imposed by law or negligence in the performance of his duties, which has resulted in loss or damage to the company or its property: There is a difference between negligence and misfeasance. In negligence work is completed but not with due caution and honesty, whereas in case of misfeasance the work is totally or partially not completed, The company can file a suit against the auditor for misfeasance only during its lifetime, and if the company is being liquidated, then the liquidator, or any creditor or member of the company can file a suit against the auditor for misfeasance. In order to prove the auditor guilt of misfeasance the company has to prove three facts against the auditor: The auditor has a duty towards the client; | He did not perform his duty properly; © Asa result of misfeasance, the company (Plaintiff) has suffered a loss. However, under Section 633 of the companies Act, a person charged with misfeasance ca apply to the court for relief Legal decisions The important legal decisions related to misfeasance or breach of trust on the part of the auditor are as follows: , iLiabilities of An Auditor Union Bank of Allahabad: In this case, the manager of the bank had borrowed large sums of money from the company for himself and his relatives on inadequate securities. The auditor of the company blindly signed the balance sheet, trusting a dishonest manager, without examining them. The court held that, auditor is guilty of misfeasance since, he had not made any efforts to find out the true position. He should not depend upon the officials of the company. Hence, the auditor was held to make good all the funds misappropriated by the dishonest manager. The Westminster Road Construction Co. Ltd. (1932) In this case, the auditors did not report to the shareholders of the company about the overstatement of work in progress and understatement of liabilities. As a result the profits of the company were inflated and dividend was paid out of capital. The auditor was held guilty of misfeasance, even though there was adequate evidence, they didn’t took any steps to detect the overstatement of profits. Hence, it was held that the auditor should make good the capital distributed as dividend with interest. The City Equitable Fire Insurance Co. Itd (1924) The company was doing re-insurance business. The company went into liquidation and the official receiver as liquidator of the company brought an action against the directors and auditors for damages arising out of misfeasance. The charge against the auditors was that balance sheet of the company contained misdescription of debts due by the company’s brokers and manager. In this case, justice Romar said “ that it is the duty of an auditor in general to satisfy himself that the securities of the compa fact exist and are in safe custody cannot be gained”. An auditor is not in my judgement ever justified in omitting to make personal inspection of securities that are in the custody of a person or a company with whom it is not proper that they should be left with company’s brokers are not he proper people to have the custody of securities, however, respectable and responsible those /prokers may be”. The London and General Bank (1895) The auditors neglected to bring to the notice of jharcholders the fact that assets shown in the balance sheet of the company were overvalued ‘and as a result dividends were paid out of capital. The Court observed that the duty of the auditor was to convey information and not to arouse enquiry and held that the auditor, by way of damages, was liable to refund the amount of the second dividend (declared in 1892) on the ground that he was aware of the critical position of the affairs and thus had acted negligently in not reporting the facts to the shareholders although he had reported them to directors. As regards, the first divi idend (declared in 1891), the auditor not held liable, as it was of the ‘that the evidence was not sufficiently strong to establish a case of misfeasance against ‘ough he was guilty of an error of judgement. ( Re: Kingston Cotton Mills Co. Ltd. (1896), held - That its not the duty of the auditor pobddstock and that he is not guilty of negligence if the certificate of a responsible official is Fépted in the absence of suspicious circumstances. In this case, the profits of the company had been inflated fictitiously by the deliberate anipulation of the quantities and values of stock:in-tade. The auditors had certified the \ (valance sheet on the basis of the certificate of the manager as to the correctness of the stoc trade without checking the stock in detail and this fact was shown on the fact of the balance sheet. Lopes LJ, exonerating the auditors of the charge of negligence, in the course of judgement, made remarks to the following effect: It is the duty ofan auditor to bring to by A year on the work, he has to perform the skill, care and caution which a reasonably competent, careful and cautious auditor ordinarily would use, What se reavonable skill, care and caution is a matter which must be judged on consideration of the specfal cireumstances W\ A not bound to act as a detective, or as had been‘Auting and Secretarial Practice . ; is somethin, said to approach his work with suspicion or with a foregone conclusion that there is something wrong. ‘He isa watch dog, but nota blood hound’. He is entitled to rely on the representation made to him by the tried servants of the company in whom confidence has been plied by the company, believing them to be honest and truthful. He must, however, take reasonable care to find that the representations made by them are not palpably false. If any mati is Observed which is calculated to excite suspicion, he should probe it to the bottom, but in the absence of anything of that kind he is only bound to be reasonable, cautious and careful. Damages must be suffered: In the various cases considered, it will be observed that when an auditor has been found guilty of professional negligence and a loss has been suffered, the Courts have held that the amount of loss should be made good by the auditor. For instance, in the case of Leeds Estate Building and Investment Co. Ltd. vs. Shepherd, under a civil action by the liquidator, the auditor was held liable to make good, jointly with directors, the dividend paid out of capital Where, however, the loss has been occasioned through negligence of directors, the fault of the auditor in failing to verify the asset has been considered to be only technical and only nominal penalty has been imposed. For instance, in the case of London Oil Storage Co. Ltd. vs Seear Husluck and Co., £ 5.5sh was awarded as damages against the auditor, although the loss ‘was much more, on the ground that professional negligence had not occasioned the loss. In the case of Artmitage vs. Brewer and Knot, the auditors were held responsible even for the amount of defalcations which has taken place subsequent to their failure to detect fraud with regard (0 petty cash in an earlier period. Tt is the only case in which the principle of consequential damages has been applied to audit claims, ie., if an auditor omits to detect a defalcation by an ‘employee and, in the following year, before there is a chance of any further audit, the employee emboldened by the non-detection of the defalcation, embezzles a larger sum, the auditor would be liable both for the original loss which he had failed to detect and the subsequent loss suffered by the employer Apart from the liability for professional negligenc may be penalised under Section 147 of the Compat of the provi company. in the discharge of duties an auditor also ‘Act, 2018 for failure to comply with any mns contained in Sections 143 and 145. He incurs such a liability as auditor of the jabilities under the Companies Act According to Section 35 of the Companies Act, ifthe auditor makes an untrue statement or misstatement in the prospectus of the company, he shall be liable for the same. An auditor has to pay compensation to every person who subscribes to any shares or debentures of the company on the faith of the prospectus, which contains an untrue statement made by him as an expert. Secondly, they must have sustained any loss or damage as a consequence of taking shares or debentures. ‘The auditor may, however, escape the liability if he proves that: (a) He withdrew his consent in writing, before the issue of the prospectus and that it was issued. without his authority or consent; or (b) That the prospectus was issued without his knowledge or consent, and that on becoming aware of its issue, he forthwith gave a reasonable public notice that it was issued without his knowledge or consent.bilities of An Audtor (©) When he became aware of untrue statement contained in the prospectus, he immediately issues a withdrawal of the same, and declares the true facts publicly. (a) He was competent to make the statement and that he had reasonable grounds to believe and continued to believe up to the time of allotment of shares or debentures that the statement was true. It should be remembered that an auditor cannot restrict his liability by entering into an agreement with the company. His duties are laid down in The Companies Act and an agreement against this law will be void. However, under Section 633 of the Companies Act, a person charged with misfeasance can apply to the court for relief. The court is empowered to relieve an auditor either wholly or partly from his liabilities as it may deem fit, under certain circumstances (he acted honestly or reasonably), The court would make an order against an auditor only when along with negligence, the client has suffered loss of assets also, Liabilities towards Third Parties: Can third parties such as creditors, bankers or potential investors who have relied up on auditor's report can hold the auditor responsible for negligence, if they have suffered a loss by relying on balance sheet or any statement signed by the auditor: It is generally argued that auditor does not owe any duty towards the third parties, since he has not been appointed by them. There is no Privity of contract between the auditor and the third parties and therefore he has nothing to do with such a party. Hence, in the absence of a contract between the two, why should the auditor be liable towards the third parties. However, it was held that if the auditor is guilty of fraud, he can be held liable for damages to third parties only when his report comes out to be of such a nature that it amounts to fraud. A third party can prove fraud on the auditor on the following grounds: (a) The Balance sheet and the Profit and Loss account certified by the auditor contains in accurate information, (b) The auditor knew that the statements were untrue or inaccurate, (©) That the third party, entered into the transactions relying on the aecoumts certified by the auditor, and, as a result suffered a loss, (d) That the auditor gave his consent for the inclusion of such a statement in the prospectus. In short, negligence alleged must be of an extremely gross and culpable nature. In this context, the case of Deere vs Peek is very relevant. All the above grounds should be present, in order to held the auditor guilty of fraud. If even one of the above facts cannot be proved, the {fan auditor being released by the courts is greatly increased. +r auditor liable towards the third Parties Not liable for negligence: The auditor cannot be held liable for negligence or misfeasance, if any third party suffers a loss, as there is no contract between the auditor and third patty Liable for fraud: The auditor cannot be held liable towards the third parties for negligence or misfeasance. However, ifhe is found guilty of fraud and any third party has suffered any loss, then the auditor shall be liable to make good such a loss. fan auditor wants to avoid his Fability to the third party, he may incorporate in his report a Disclaimer of Responsibility to the third party on the following lines “ This report (statement) has been prepared for the use of my client only. No responsibility to any third party is accepted.” In India, such @ disclaimer in the auditor's report is not considered good practice.‘Auditing and Secretarial Practioe 1s Ltd., the House of Lords, dd that the auditor is mainly is responsibility towards the ers, lenders, etc., who enter In the case of Hedley Beyren & Co. Ltd. vs. Heller and Partne: supporting the above line of thinking observed, “it cannot be denies responsible towards his client, however, the auditor cannot ignore bi many people and organisations such as customers, employees, ban| into transactions based on the reports or certificates issued by him. Reporting Responsibilities | i) Considering specific requirements to prepare and audit CFS, the Companies Bill requires that the auditor of a holding company will have the right of access to the records of all its subsidiaries in so far as it relates to consolidation. (ii) The auditor's report will include the following key additional matters (compared to current reporting requirements), (a) Observations or comments on financial transactions or matters, which have any adverse effect on the functioning of the company. Also, such observationscomments will be read in the AGM and can be inspected by any member. Currently, the Companies Act requires the observations or comments of the auditors with any adverse effect on the functioning of the company to be given in bold/italic in the audit report. (b) Whether the company has adequate internal financial controls in place, and operating effectiveness of such controls, Currently, the requirement under the CARO to report on internal control matters is limited, It requires an auditor to comment on whether the company hasan adequate internal control system commensurate with the size of the company and the nature of its business, for the purchase of inventory and fixed assets and for the sale of goods and services. 1. In the existing Companies Act, auditors are required to report on fraud in the CARO report. The Bill also requires that if the auditor, in the course of audit, has reasons to believe that an offence involving fraud is being or has been committed against the company by the officers or employees. He will immediately report the matter to the Central Government within such time and manner as may be prescribed. 2. The requirement of confidentiality by auditors in respect to ¢lients matter does not apply to reporting matters under any regulations. 3. Currently, the Companies Act entitles but does not require an auditor to attend AGM. Under the Companies Bill, it will be mandatory for the auditor or its authorized representative who is also qualified to be appointed as an auditor, to attend the AGM, unless exempted by the company. CRIMINAL LIABILITY UNDER THE COMPANIES ACT ‘The circumstances in which an auditor can be prosecuted under the Companies Act, and the penalties to which he may be subjected are briefly stated below: (i) Criminal liability for Misstatement in Prospectus: As per Section 34 of the Companies Act, 2013, where a prospectus, issued, circulated or distributed includes any statement which is untrue or misleading in form or context in which it is included or where any inclusion or omission of any matter is likely to mislead, every person who authorises the issue of such prospectus shall be liable under section 447 This section shall not apply to a person if he proves that such statement or omission was immaterial or that he bad reasonable grounds to believe, and did up to the time of issue of the prospectus believe, that the statement was true or the inclusion or omission was necess2 iLiabilities of An Auditor (i) Punishment for false statement: According to Section 448 of The Companies Act, 2013 if in any return, report, certificate, financial statement, prospectus, statement or other document required by, or for, the purposes of any of the provisions of this Act or the rules made thereunder, any person makes a statement — (a) which is false in any material particulars, knowing it to be false; or (b) which omits any material fact, knowing it to be r 447. Punishment for Fraud - As per Section 447 of The Companies Act, 2013, without prejudice toany liability including repayment of any debt under this Act or any other law for the time being in force, any person who is found to be guilty of fraud, shall be punishable with imprisonment for a term which shall not be less than six months but which may extend to ten years and shall also be liable to fine which shall not be less than the amount involved in the fraud, but which may extend to three times the amount invotved in the fraud. It may be noted that where the fraud in question involves public interest, the term of imprisonment shall not be less than three years. rial, he shall be liable under Section PENALTIES TO AUDITORS (Han auditor of a company contravenes any of the requirements concerning appointment/ rotation, powers and duties, prohibited services or signing of audit report, the auditor will be punishett-withra fine of not less than 25 thousand but may extend (@& 5 lakh. (i) Ian auditor has contravened such provisions knowingly or willfully with the intention to deceive the company or its shareholders or creditors or tax authorities, he will be punishable with imprisonment for a term, which may extend to 1 year and fine not less than @ 1 lakh but which may extend to & 25 lakh. — Gi) Where an auditor has been convicted under point no. 2 above, he will be liable to: (a) Refund the remuneration received by him to the company, and (b) Pay for damages to the company, statutory bodies or authorities or to any other persons for loss arising out of incorrect or misleading statements of particulars made in his audit report. (iv) Where, in case of audit of a company being conducted by audit firm, it has been proved that the partner or partners of the audit firm has or have acted in fraudulent manner or abetted or colluded in any fraud by, or in relation to or by the company or its directors or officers, the liability, whether civil or criminal as provided in this Bill or in any other law for the time being in force, for such act will be of the partner or partners concerned of the audit firm and of the firm jointly or severally Your Understandins 1. “An Auditor is @ watch dog and not a blood hound”. In the light of this statement, narrate the duties of a company auditor. Also give some case laws.