Auditor’s are liable to third parties incase of negligence. They are liable in tort law and in contract law. Third parties such as investors and buyers suffer damages due to wrong audits done by auditors. Investors suffer damages in the secondary market and buyers make losses when buying shares. Liability of auditors to third parties can be described as liability for pure economic loss. Auditors are liable for negligence behavior if a misleading audit led to damages in the secondary market (Tubbs 1990, p. 453). They are also liable for simple negligence in the case of primary market audit.
The law of tort restricts and excludes the liability of an auditor for pure financial loss. However, contract law demands that pure economic losses must be compensated in the case of simple negligence. Damages that are caused to the shareholder, under an implied contract between the shareholder and the auditor, damages can be recovered because the auditor is liable for simple negligence. The auditor has violated a contractual duty to the shareholder negligently though the explicit contract was between the auditor and the company.
These damages under the law of contract are recoverable under the law of tort. However, compensation cannot be given to simple negligence since the damages are considered to be pure economic losses under the law of tort. Under common law auditors are liable to third parties incase of ordinary negligence. This paper describes various cases that are related to the auditor’s liability due to negligence. It also describes the changes in audit standards that describe the auditor’s obligations to identify and assess risks of material misstatements due to fraud.
It is the duty of an auditor to alert the audit team of any potential unsuitable behavior to facilitate the required planning and implementation of an effective audit (Holstrum et al, 1985, p. 104). Cases Ultramares Corporation v. Touche (1931) This is a land mark case in common law that established the liability of auditors to third party beneficiaries for ordinary negligence (Toba 1975, p. 13). This case also denotes that auditors are liable to other third parties for gross negligence. The case between Ultramares Corporation v.
Touche (1931) is a tort law case that was decided in the US for negligent misstatement by an auditor. The case was decided by Cardozo CJ who denoted that the law should not accept to a liability that involves an indeterminate amount for an indeterminate time and to an indeterminate class. The action is under the law of tort where damages were suffered due to misrepresentations by the accountants who were negligent and fraudulent. Facts of the case Touche, a firm of public accountants was employed by Fred Stern & Co to prepare and certify a balance sheet that would show its financial position at the end of 31st Dec 1923.
Fred Stern & Co. was a company that was dealing with importation and sale of rubber and required finances that would enable it to continue running. The company decided to borrow money from various financial institutions. The defendants (Touche) knew that, they should prepare a balance sheet that would be accepted by the financial institutions and lent money to Fred Stern & Co. they made up a balance sheet for the financial year and distributed 32 copies certified with serial numbers as counterpart originals to stern company.
The balance sheet was presented on Feb 26th 1924 with more assets of 2,550,671. 88 than liabilities of 1,479,956. 62 with a net worth of 1,070,715. 26. It was certified by the accountants as having a true and fair view of the company. Stern company borrowed money from the plaintiff using the balance sheet. On the faith of the balance sheet the plaintiff advanced a loan to stern company and other loans were given without or inadequate security. The plaintiff used the audited balance sheet and suffered losses (Waller et al 1984). Judgment The audit was confirmed with negligence and fraud.
The auditors did not communicate to the creditors of the wrong audit hence they were liable for negligence since they did not use reasonable and ordinary care. The judge Cardozo CJ held that auditors were not negligent to the plaintiff since they owe no duty of care to the plaintiff. The judge said that there was no sufficiently proximate relationship since the liability was for an indeterminate amount for an indeterminate time to an indeterminate class. The case laid down the privity of relationship and not for contract (Dye 1993, p. 889).