LEGAL ASPECTS OF AUDIT
- Appointment of an auditor
- Rights and duties of an auditor
- Law of contract and the auditor
- Tort law
- Auditor’s liability
- Money laundering and whistle blowing
- Unlawful acts of clients and their staff
By the end of this chapter students should be able to:
- Outline the process of obtaining an audit engagement.
- State the contractual requirements between the auditor and other parties in the engagement.
- State the qualifications requirement under the Companies Act and the Public Accountants and Auditors Act for a person or a firm to be engaged to carry out a statutory audit.
- State the auditor’s and entity directors or management respective duties and rights during the engagement as provided for by the Companies Act.
- Explain the auditors’ contractual performance expectations and resulting liability for negligence.
- Explain the auditors’ responsibility and liability with respect to money laundering and other illegal acts or non-compliance with other relevant laws and regulations.
The chapter covers appointment of an auditor, qualification and process of audit engagement, duties and rights of the auditor as an expert, resignation and dismissal and associated rights and duties. These are covered by the Malawi Companies Act.
Contract law, law of tort and criminal law have also been discussed and the chapter ends with a discussion of money laundering and unlawful acts of clients.
- Legal aspects
- Appointment of an auditor (Section 191)
The Act requires every company to appoint an auditor. The auditors will be appointed by the following persons.
- Appointment of the auditors by the members
The company shall at each general meeting, at which financial statements are presented (usually at each Annual General Meeting (AGM), appoint an auditor. Note that it is the company (i.e. shareholders) who appoint the auditor. The appointment is for the period of time known as tenure of office and is from the conclusion of the meeting to the conclusion of the following annual general meeting at which financial statements are laid.
- Appointment of auditors Directors of company
In exceptional circumstances the directors of the company can appoint auditors either to;
- Fill a casual vacancy, for example when the existing auditor resigns
- Appoint the first auditor between the date of incorporation and the first AGM or if the company qualifies to have an audit, before the next AGM
As noted above, however, in both cases the members must then reappoint the auditors at the next AGM, by ordinary resolution.
- Appointment of auditors by Registrar of Companies
In very rare circumstances, where the auditor has not been appointed at the appropriate time the Registrar of Companies will then appoint auditors.
- Qualification of an auditor (Section 192)
A person is eligible for appointment as a company’s auditor if is qualified under the Public Accountants and Auditors Act. The auditors must be members of a Recognized Supervisory Body and if the auditor is the firm, the firm must be controlled by members of the Recognized Supervisory Body. In Malawi, the Recognized Supervisory Body is the Malawi Accountants Board (MAB).
The following cannot act as auditors;
- An officer or an employee of a company
- A shareholder of the company
- A partner or employee of such a person
- A partner in a partnership in which such a person is a partner
- Ineligible by the above for appointment as auditor of any directly connected companies.
- A person disqualified from acting as an auditor to any other corporate body within the same group.
It is an offence for a person to act as a company auditor if he/she is ineligible and requires vacation of office if he becomes ineligible. A second audit is requested if the first one was carried out by an ineligible auditor.
- Remuneration of an auditor
Remuneration refers to earnings generated through provision of goods and services. Auditor’s remuneration is fixed by those who appoint him, that is, the shareholders or directors. Sometimes it is fixed in such a manner as the company thinks fit, this is usually the basis taken in practice.
The auditors’ remuneration shall be stated in a note in the company’s accounts. This is disclosable for auditing services only and must include sums paid in respect of expenses and the money value and nature of any benefit in kind. Disclosure in the accounts must also be made of remuneration including benefits in kind paid to the auditor for non-audit work.
- Resignation of auditors
An auditor has a right to resign if he wishes. Resignation is one of the rights of an auditor and this brings further rights to the auditor.
1.4.1 Why auditors resign
The following are the factors that can cause the auditor to resign.
- Poor health: Sickness may cause the auditor fail to execute his/her duties.
- Growth in the size of the audit firm such that the fee is inadequate.
- Restriction to the extent of audit work: This is where the auditor concludes that because of fraud or other irregularity the accounts do not show a true and fair view and there is no immediate opportunity to report to the members.
1.4.2 Resignation procedures
An auditor may resign by depositing a notice of resignation to the registered (or head) office of the audit client. This notice must be accompanied by a statement of circumstances. A statement of circumstances is a description of matters which the auditor considers should be brought to the attention of members or creditors as well as the absence of such, for example, fraudulent trading.
The statement of circumstances is sent by the auditors to Registrar of companies within twenty-eight days. This statement can also be sent by the company to everyone entitled to receive a copy of accounts and a copy of the statement to Registrar of companies or otherwise face a fine within fourteen (14) days unless the company applies to court because the statement is defamatory.
The auditor can cease to be auditor by simply not seeking re-election. In that case, the auditor must still deposit a statement of circumstances. This statement must be sent to the company and the Registrar of companies.
1.4.3 Further rights and duties of the auditor on resignation
The auditor must deposit a notice of resignation and statement of circumstances and notice calling the company to call an extraordinary general meeting. The directors must call for meeting within twenty-one days and must send out copies of the statement of circumstances.
The auditor can receive all notices that relate to a general meeting where their term of office would have expired and a general meeting where causal vacancy caused by their resignation is to be filled. Auditors can speak at these meetings on any matter which concerns them as auditors. When the directors fail to send out copies of the statement of circumstances, the auditor can require that the statement be read at the meeting.
1.5 Dismissal (removal) of auditors
Company law takes the view that auditors must be capable of being changed or removed if the shareholders wish it but is designed:
- To give the auditors, who the directors would like to remove, every opportunity to state their case.
- To ensure maximum publicity is given to any proposed change of auditor so that members are aware of the matter and can make informed choices.
- To ensure that the auditors that are appointed by the shareholders, cannot be removed by the directors if the auditors disagrees with the directors
A company can remove an auditor before expiry of his tenure of office. The following requirements have to be followed.
First the company must pass an ordinary resolution at an extraordinary general meeting. Second, a special notice of dismissal must be given to the auditor within twenty-eight (28) days. This avoids the removal being done secretly without the auditor knowing.
If the auditor feels that his/her dismissal is unjustified, he has other statutory rights. The auditor has right to make representations which require the company to state that representations have been made by the auditor and notice given to the shareholders. If the representations are not sent to the shareholders the auditor may require them to be read out at meeting.
The representations need not be sent out nor be read out in a meeting if on application of either the company or any other person who claims to be aggrieved and the court is satisfied that the auditor’s right is being abused to obtain needless publicity for defamatory matter.
The auditor has also a right to receive notices of meeting. The auditor can attend a general meeting at which his/her term of office could have expired and also at which it is proposed to fill the casual vacancy caused by his/her removal. The auditor must also be heard at such meeting.
1.6 Duties and rights of an auditor
The Malawi Companies Act 1984 (section 194) lays out duties and rights of auditors as detailed below:
1.6.1 Duties of an auditor
To make a report to the members or shareholders on all financial statements laid before members in an annual general meeting.
To state in his report whether accounts comply with the requirements of the Act and that they show a true and fair view in his opinion.
- To report if proper accounting records have not been kept.
- To report if proper returns from branches not visited by the auditor have not been received.
- To report if financial statements are not in agreement with books of accounts.
- To consider if any information in the Director’s report is inconsistent with the accounts and to report any such instances.
- To investigate (this is an implied duty) if there are indications that material errors and fraud have occurred.
1.6.2 Rights of an auditor
The auditor has the following rights under the Companies Act 1984 (Section 194) in order to carry out the above duties.
- Right of access at all times to the books, accounts, vouchers or documents of the company.
- Right to require from directors, employees of the company any information which the auditor thinks necessary.
- Right to receive notices and attend meetings and to report on any matters concerning him as auditor.
- Right to make a report on his findings including failure of the directors to provide him with information and explanation which he deems necessary.
- Right to be heard when making a presentation during a meeting.
- Right to reasonable remuneration.
- Right of lien. A lien is right to hold or keep somebody’s property until that somebody settles a debt.
- Right to receive correct information
- False statements to auditors (Section 335)
An officer of a company commits an offence if he/she knowingly or recklessly makes to the company auditors a statement which the auditors require and is misleading, false or deceptive. The person guilty of this offence is liable to imprisonment or a fine or both.
- Law of contract and the auditor
Contract law is the law which regulates legally binding agreements.
The law of contract affects the auditor as follows.
- The auditor and the client agree on express terms of the contract set out in the engagement letter.
- The law may also impose implied terms into contractual agreements.
Implied terms are terms deemed to form part of a contract even though not expressly mentioned by the parties to the contract.
Examples of implied terms are:
- The auditors have a duty to exercise reasonable care and skill.
- The auditors have a duty to carry out the work required with reasonable expediency.
- The auditors have a right to reasonable remuneration.
Meaning of reasonable care
Reasonable care is the degree of care, diligence, or precaution that may fairly, ordinarily, and properly be expected or required in consideration of the nature of the action, the subject matter, and the surrounding events.
The following guidelines help to know when an auditor is said to have displayed reasonable care.
- Auditors should use generally accepted auditing techniques contained in auditing standards.
- If auditors’ suspicions are aroused (this is called being ‘put upon enquiry’), they must carry out investigations until they are satisfied as to what those suspicions mean.
- Auditors must act honestly and carefully when making judgements.
1.9 Auditor’s civil and criminal liability
- Civil liability
All auditors can be sued in a civil court when they have breached their position of trust e.g. if an auditor uses information acquired during the course of the audit to make financial gain ,then in such a case he or she can be sued for breaching his position of trust and confidentiality.
- Negligence liability
Negligence is an act or omission which occurs because the person concerned failed to exercise that degree of reasonable care and skill which is reasonably expected in the circumstances of the case. The degree of care and skill to be shown should be in terms of depth of the auditor’s investigation and the type of check to be made. Simply defined, negligence is the breach of the duty of care
Indications that negligence exists and results there of
- Failure to exercise sufficient skill and care.
- Failure to discover fraud or error when put upon enquiry. In the absence of suspicious events, the auditor is entitled to accept the work of a responsible company official. But once an auditor’s suspicions have been aroused there is a duty to probe the matter to the bottom.
As a result,
- Somebody who relies on the work of the auditor may lose money.
- There is loss of money flow from the failure of the auditor to do his/her job.
If the above are proved the auditor may have to make good from his own resources the loss suffered by another person.
Consequences of breach of implied duty of care by auditors
When the auditors breach their implied duty of care under the contract, the client may be entitled to bring a claim against the auditor.
In order for the claim to be successful, three things must be proved.
- There must have been a duty of care enforceable at law. (Always the case when there is a contract)
- The auditors are negligent in the performance of a duty judged by the accepted professional standards of the day.
- The client has suffered some monetary loss as a result of the auditors’ negligence.
Re Thomas Gerrard & Son 1968
The facts: The managing director of the company falsified the accounts to conceal company losses causing dividend to be paid either wholly or partially out of capital over a number of years. He had done this by including non-existing stock and altering invoices which the auditors discovered and pursued no further.
Decision: The court held that the discovery of the altered invoices put the auditors on enquiry; they were no longer entitled to rest content. The auditors were negligent.
1.9.3 Law of Tort
Tort law is a body of law that addresses and provides remedies for civil wrongdoings not arising out of contractual obligations. A person who suffers legal damage may be able to use tort law to receive compensation from someone who is legally responsible, or liable, for those injuries. Tort law involves the relationships between individual citizens or business entities. It is the legal mechanism, which is part of civil law, through which individuals can assert claims against others and have those rights adjudicated and enforced
An auditor to a limited company is an agent of the shareholders. He is required to exercise reasonable care and skill in the performance of the work entitled to him, and if he fails to do, then the question of his liability with reference to the negligence arises. This matter is discussed in the light of legal provisions as follows:
- Where an auditor is proved to be negligent but no loss is sustained by his client arising out of his negligence, he is not liable
- An auditor cannot restrict his liability by entering into an agreement as his duties are defined and laid down in the Companies Act, 1984, and therefore any such
agreement (if executed) would be against the law and will be void. He will be liable for damages in spite of such an agreement.
- An indemnity clause inserted in the articles of a company, by which the directors, managing agents, auditor and other officers of the company are relieved from liability has been declared void by Section 194. However, the court may relieve an auditor of liability for negligence, or misfeasance if it is proved that he acted honestly and reasonably.
- If the auditor fails to perform his job with reasonable care and skill and consequently his client suffers a loss due to his negligence, he is liable to make good the loss on an action being taken against him by the company.
1.9.4 Misfeasance liability
After a company has gone into liquidation, misfeasance proceedings can be instituted against the liquidator, creditor and a contributor of the company. The term ‘misfeasance’ means breach of duty involving the company in a loss. When a company is in liquidation, its past and present directors, promoters, managing agents and auditors are liable to make good all losses sustained by the company on account of negligence of duty or breach of trust if misfeasance proceedings are initiated against him within the prescribed time.
(iii) Legal liabilities of auditors
Auditors are supposed to perform their work in an honest and careful manner since they can be held liable for negligence in the following ways:
- They don’t carry out their work as required by the auditing standard.
- They fail in the duty of protecting the interest of the various users of the financial statements i.e. any person who relies on their work.
- They don’t carry out their work with due care and skill i.e. what an ordinary skilled person would do in that circumstance.
1.9.5 The auditor’s liability falls under three categories
- To their clients
- To third parties in case of negligence
- Civil and criminal liabilities
22.214.171.124 Liability under the law of contract (To the client)
There is a contractual relationship between the auditor and his client. Under this contract it is implied that the auditor will carry out the work with a reasonable degree of skill and care. The degree of care and skill required will mainly depend on the nature of work
undertaken. Generally if the auditor has complied with ISA it is difficult to prove that he was negligent. In the absence of suspicious circumstances the auditor will not be liable for failing to uncover fraud and error which could not be discovered by exercise of normal skill and care.
The auditor can be accused of negligence if:
- He fails to detect fraud or error that he could have reasonably detected i.e.
- He fails to comply with the Generally Accepted Auditing Standards (GAAS) and practices e.g. attending stock take, circularizing debtors, writing to the bank etc.
For the client to succeed in a claim for financial loss he must satisfy the court in relation to three matters:
- That there existed a duty of care enforceable by the law
- That where the duty did exist the auditor was negligent in the performance of that duty judged by acceptable professional standards.
- That the client suffered some financial loss as a direct consequence of the auditor’s negligence.
126.96.36.199 Liability to third parties
An auditor may be liable for negligence not only under the law of contract but also in the law of tort i.e. if a person to whom he owed a duty of care has suffered financial loss as a result of the auditor’s negligence. For the third party to succeed, he must prove the following:
- The auditor owed him a duty of care
- The auditor was negligent
- He has suffered financial loss resulting from the auditor’s negligence
1.10 Duty of care towards a third party
In third part negligence claims, the key issue is whether the auditor owed the third party a duty of care. As a general rule, judges do not think that auditors owe third parties a duty of care. This general rule was established in the landmark case of Caparo Industries v Dickman and Touche Ross and Co (1989).
The Caparo case is fundamental to understanding professional negligence. It was decided that auditors do not owe a duty of care to the public at large or to shareholders increasing their stakes.
The facts: Caparo, which already held shares in Fidelity plc, bought more shares and later made a takeover bid, after seeing accounts prepared by the defendants that showed a profit of £1.3m. Caparo claimed against the directors (the brothers Dickman) and the auditor for the fact that the accounts should have shown a loss of £400,000. The claimants argued that the auditors owed a duty of care to investors and potential investors in respect of the audit. They should have been aware that a press release stating that profits would fall significantly had made Fidelity vulnerable to a takeover bid and that bidders might well rely upon the accounts.
Decision: the auditor’s duty did not extend to potential investors or to existing shareholders increasing their stakes. It was a duty owed to the body of shareholders as a whole.
By the House of Lords, a duty was not owed to potential investors or takeover bidders for the company having regarded:
- The lack of proximity between auditor and potential investor
- The fact that it would not be just and reasonable to impose a duty on the auditor to such investors.
In the Caparo case, the House of Lords identified the auditors’ functions as being:
- To protect the company itself from errors and wrongdoing not its owners.
- To provide shareholders with information such that they can scrutinize the conduct of a company’s affairs and remove or reward those responsible, that is, the directors. This means that the auditor does not exist to aid investment decisions.
Where is duty of care owed: Principles established in Hedley Byrne v Heller & Partners
A duty of care exists where there is a special relationship between the parties, that is, where the auditors knew or ought to have known that the audited accounts would be available and would be relied upon by a particular person or class of persons. An example is where the directors tell the auditors that the bank will rely on the accounts or if someone notifies the auditor that he will purchase new shares on the strength of the audited accounts.
The essence of Hedley Byrne v Heller & Partners case is that the third parties must have been identified in some way to the auditors.
Hedley Byrne v Heller & Partners
The facts: The plaintiff lost money when a bank reference from the defendant turned out to have been negligently produced. Basically the bank indicated that a mutual client was a good credit risk when this was not the case.
Decision: The court ruled that Hedley Byrne, although they did not have a contract with the bank Heller & Partners, could recoup their losses due to the negligence and loss involved. However, the bank did not have to pay any damages due to a general disclaimer in its letter absolving it from any liability.
The decision affected accountants in that if a third party can show that it relied on the work of an accountant which later turned out to be wrong, it can claim damages. However, this principle was only extended to plaintiffs whom the auditor actually knew by name. Unidentified third parties would still not be able to claim against the auditor.
A duty of care would exist where the third party has suffered a loss and that the auditors knew that third party by name. This was the situation in Jeb Fasteners v Marks Bloom, where it was stated that a duty of care will exist where the defendant auditors:
- Knew or reasonably should have foreseen at the time that the accounts were audited and that a person might rely on those accounts for the particular purpose; and
- That in all the circumstances it would be reasonable for such reliance to be placed on those accounts for that particular purpose.
The existence of the duty of care is irrelevant if the loss was not suffered as a direct result of the breach of duty, as in this case. The question that therefore arises from Jeb Fasteners is the possible liability of an auditor to a member of the general public who reads the accounts and then buys shares in the company in reliance on those accounts.
Jeb Fasteners v Marks Bloom
The facts: The plaintiff acquired the share capital of the company. The audited accounts, due to the negligence of the auditors, did not show a true and fair view of the state of affairs of the company. It was accepted that at the time of the audit the defendant auditors did know of the plaintiffs but did not know that they were contemplating a takeover bid.
Decision: Both at first instance and in the court of Appeal it was decided that the auditors were not liable because the plaintiff had not suffered any loss. It was proved on the evidence that the plaintiffs would have bought the share capital of the company at the agreed price whatever the accounts had said. Therefore, whether or not a duty of care existed was not directly relevant to the decision.
Arguments for and against extending auditors’ liability
Extending auditors’ liability means that auditors should be liable to anybody who uses audited accounts.
Arguments for extending liability
- Third parties do rely on the integrity of audited accounts and would seem right that a legal liability should reflect that.
- Professional people are paid and should therefore be accountable.
- Where the company suffers loss because of the auditors’ negligence then the current existing legal remedy by the company against the auditor is appropriate.
- If liability is not extended then the public may perceive that the auditor is liable to no-one; there is no need for the auditor to exercise skill and care and the accounts are not reliable and are of little benefit.
Arguments against extending liability
- It is unreasonable and unrealistic to say auditors have a liability in an indeterminate amount for indeterminate time to an indeterminate class.
- There are practical difficulties in deciding whether accounts were relied upon.
- The current legal framework sees the purpose of preparing and auditing accounts as assisting shareholders in assessing stewardship of the directors but not in assisting investors in their investments.
- Audit fees would be too high if full liability for investment decisions were taken into account.
- The legal responsibility for producing accounts rests with directors and it would seem inequitable if the liability arising out of incorrect accounts were transferred to auditors.
- The work required on an audit would need to be greatly extended at an enormous cost which on a welfare economics viewpoint would be a misuse of scare resources.
- (g)The company pays the auditors and consequently expects to recover damages if the company loses as a result of auditor negligence. However, investors do not pay the auditor and so should not expect to recover.
- Insurance cover for professional indemnity would be even more difficult and
188.8.131.52 Criminal liability
- An auditor shall be criminally liable if he willingly makes a material false statement in any report, certification or in the financial statement with the intention to deceive and mislead. Examples of criminal liabilities include:
- The auditor accepts appointment when he is ineligible to do so or continue in office after becoming ineligible.
- The auditor obtains the advantage of deception.
- The auditor falsifies accounting records or documents.
- When the auditor publishes misleading statements intended to deceive members.
- When an auditor misappropriates a clients’ property
- Money laundering and whistle blowing
- Money laundering
Money laundering is a process by which criminals try to make the proceeds of their crimes appear clean. The criminals use professionals like banks, accountants and lawyers to clean their dirty money.
Accountants or auditors should not assist others to retain the benefit of criminal conduct. Accountants must report knowledge or suspicion of money laundering relating to drug trafficking or terrorism. It is a crime not to report suspicions of money laundering to the relevant authorities. It is equally a crime to warm a client of the impending money laundering investigations (tipping off the client)
Audit partners and employees should be trained on how to recognize suspicious clients and transactions. Evidence of client’sidentity should be kept for at least five years and firms should have Money Laundering Reporting Officer to whom suspicions of money laundering must be reported.
- Whistle blowing
Whistle blowing means informing the proper authorities of some breach of law or regulation. The risk here is that the informer will suffer reprisals.
There are three issues for auditors:
- Breaches of law or regulation may have an impact on the truth and fairness of financial statements.
- Breaches of law or regulation may in certain circumstances need to be reported immediately to the proper authorities as a statutory requirement.
- Breaches of law or regulation may need to be reported to the proper authorities in the public interest.
Where the auditor comes across a situation where a breach of law or regulation has occurred and he feels that this should be reported to the proper authorities in the public interest but there is no specific statutory duty to report the auditor should:
- Take legal advice.
- Discuss the matter with the Board of Directors.
- Request that the Board disclose the matter to the proper authorities.
- Inform the proper authorities themselves, if the board of directors fails to do so.
3.3 Insider dealing
Insider dealing is described as dealing in securities(shares) whilst in possession of inside information as an insider, the securities being price-affected by the information ones possesses.
Insider dealing is illegal and it is also contrary to the ethical rule. People who during the course of their work come across unpublished price sensitive information are prohibited from dealing in securities to which that information relates. This prohibition applies to anyone who has a connection at present or any time in the previous six months and to any third person who the insider may wish to instruct.
4 Unlawful acts of clients and their staff
The auditor must act correctly and in accordance with the law when he/she discovers crimes committed by a client or members of the client staff.
Actions of the auditor
The auditor should do the following.
- Take legal advice if necessary.
- Read the guidance provided by the professional body and by the auditing standards.
An auditor/accountant must not himself commit a criminal offence. An auditor/accountant would have committed offence if he/she:
- Advises a client to commit a criminal offence.
- Aids a client in devising or executing a crime.
- Agrees with a client to conceal or destroy evidence or mislead the law enforcement agencies with untrue statements.
- Knows a client has committed an arrestable offence and acts with intent to impede his arrest or prosecution. Impede does not include refusing to answer questions or refusing to produce documents without the client’s consent.
- Knows the client has committed an offence and agrees to accept consideration for withholding information.
- Knows that the client has committed treason or terrorism offences and fails to report the offence to the proper authority.
- Deals in various activities in connection with money laundering.
4.1 Disclosure of unlawful acts
If an auditor discovers an unlawful act he/she will not usually disclose this to the police or other authority unless:
- The client authorizes disclosure.
- The disclosure is compelled by process of law.
- Disclosure is required in the auditor’s own interest, for example, in defending himself against civil or criminal actions.
- The circumstances are such that the auditor has a public duty to disclose. If he/she discovers an intention to commit a serious crime or tort for example.
- Disclosure is required in the circumstances envisaged by advice given on money laundering and disclosure to regulators in the financial sector.
The auditor on discovering an unlawful act should act as follows;
- The auditor must do nothing to assist in the offence or to prevent its disclosure.
- The auditor must bring all offences of employees to the notice of his client.
- If the offence is such that its non-disclosure means that the accounts do not show a true and fair view, the auditor must insist on disclosure or qualify the audit report.
- The auditor should point out to the client with a recommendation for disclosure of material defects in previous year’s accounts.
End of Chapter Questions
Dunde Plc was formed on 1 July 2000 to assemble minicomputers. The directors of the company do not know their responsibilities and the nature of their relationship with the
their accountability to the company and their relationship with the auditor.