Auditor engagement and liability - Liability under contract ...

Learning Outcomes

After studying this article, you will be able to explain how auditors may incur liability to clients under contract and negligence. You will understand the contractual relationship between auditor and client, the legal requirements for duty of care, and the key defences available to auditors. You will also be able to recognise how exam questions might test this area.

ACCA Foundations in Audit (FAU) Syllabus

For ACCA Foundations in Audit (FAU), you are required to understand the main legal and professional risks facing auditors in their engagements. In particular, you should be able to:

• Explain the contractual nature of the auditor-client relationship
• Outline the auditor’s duty of care under contract law
• Explain when an auditor could be negligent towards a client
• Identify the essential elements required to establish a claim for negligence
• Describe how professional standards and quality management reduce auditor liability
• List key defences and protections available to auditors

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which three elements must a client prove to succeed in a negligence claim against an auditor?
2. When can a client sue an auditor for breach of contract?
3. State one example of a defence an auditor might use if accused of negligence by a client.
4. True or false? An auditor is always strictly liable for any financial loss suffered by their client.

Introduction

Auditors face legal risks in every engagement they undertake. The main risk is that a client may pursue legal action if they believe the auditor has been careless or has breached the contract for audit services. Understanding the legal basis of an auditor’s liability to clients is essential for protecting yourself and for exam success. This article focuses on liability to clients, which is distinct from liability to third parties.

Key Term: contract
A legally binding agreement between two or more parties. In an audit context, the contract is formed by the engagement letter accepted by the client and the auditor.

LIABILITY UNDER CONTRACT

Auditors always have a direct contractual relationship with their clients. This contract is usually set out in an engagement letter. If the auditor fails to perform their responsibilities as agreed, the client may have a legal remedy.

The auditor’s main contractual obligation is to carry out the audit with reasonable care and skill and to deliver a report that meets the agreed scope and standards. If the auditor breaches these duties—such as abandoning work or failing to follow agreed standards—the client may sue for damages.

Key Term: breach of contract
Failure to perform an obligation required by a contract, giving the other party the right to claim damages or enforce performance.

NEGLIGENCE TO CLIENTS (TORT LAW)

In addition to contract law, auditors must also meet duties of care imposed by common law (tort of negligence). Even if all express contract terms are met, an auditor can still be liable if their work is careless and causes the client financial loss.

Three conditions must be satisfied for the client’s claim for negligence to succeed:

1. The auditor owed the client a duty of care (always true in the engagement)
2. The auditor breached that duty by falling below acceptable standards
3. The client suffered financial loss as a direct result

Key Term: negligence
Failure to exercise the level of care and skill that a reasonable professional would in similar circumstances, resulting in loss to another party.

Key Term: duty of care
The legal obligation to act towards others with the attention, caution, and prudence that a reasonable person in the profession would use.

Worked Example 1.1

An audit firm fails to perform critical audit procedures on ABC Ltd and overlooks a significant misstatement. The company later suffers financial losses due to undetected fraud. ABC Ltd claims the auditor is negligent.

Answer:

• ABC Ltd and the audit firm have a contractual relationship via the engagement letter, so there is a duty of care.
• If the auditor's work fell below accepted standards (e.g., missing basic tests required by ISAs), the duty has been breached.
• If the financial loss was caused by this failure, and not by unrelated factors, ABC Ltd may recover damages for negligence and breach of contract.

STANDARD OF CARE AND PROFESSIONAL JUDGEMENT

In both contract and negligence, the court asks: Did the auditor act as a reasonably competent auditor would? Following relevant auditing standards, professional guidance, and obtaining sufficient documentation are essential for demonstrating reasonable care. If auditors can show they performed an audit in line with International Standards on Auditing (ISAs) and maintained proper records, they are unlikely to be found negligent.

Exam Warning

A common exam mistake is to assume auditors are only liable if fraud is missed. In fact, auditors are liable for not detecting material misstatements due to any lack of reasonable care—even if caused by error, not fraud.

DEFENCES AND LIMITATION OF LIABILITY

An auditor can avoid or reduce liability if:

• The client’s loss was not caused by the auditor’s breach (no causation).
• The auditor followed all professional standards and guidance.
• The client’s actions contributed to the loss (contributory negligence).
• The claim is outside the statutory time limits.

Sophisticated engagement letters may include clauses limiting liability, but such terms must be reasonable and comply with the law.

Worked Example 1.2

Delta LLP conducts an audit in line with all ISAs and professional guidelines. Even so, the client suffers loss due to management’s deliberate false statements that were extremely well hidden. Delta LLP is sued for negligence.

Answer:

• Delta LLP is unlikely to be found negligent. They fulfilled their duty by exercising due skill and care, complied with professional standards, and could not have reasonably detected the fraud.
• Even with a loss, there is no breach of duty if reasonable care was taken.

PROFESSIONAL STANDARDS AND QUALITY MANAGEMENT

Implementing robust internal controls, staff training, quality reviews, and careful documentation helps reduce risk of negligence claims. Good quality management not only prevents errors but also provides evidence that care and skill were used, offering a strong legal defence if a claim is made.

Revision Tip

Always relate negligence claims to: (1) duty of care, (2) breach of duty, and (3) causation of loss. Knowing this structure is essential for ACCA exam questions on liability.

Summary

Auditors have contractual and common law duties to their clients. Breaching these duties by failing to perform audit work with reasonable care and skill can lead to liability for damages if loss results. Maintaining high professional standards, documenting work, and managing audit quality are key defences. Understanding the requirements and boundaries of auditor liability is essential for both exam and professional practice.

Key Point Checklist

This article has covered the following key knowledge points:

• The relationship between auditors and clients is governed by contract (engagement letter)
• Auditors owe a duty of care in contract and in tort (negligence) to clients
• For negligence, three elements must be proved: duty, breach, and loss caused by the breach
• Compliance with ISAs and documentation is essential to defend against negligence claims
• Clients may only recover losses directly caused by the auditor’s breach
• Engagement letters may limit liability, but only within legal boundaries

Key Terms and Concepts

• contract
• breach of contract
• negligence
• duty of care