Liabilities of an auditor, professional ethics and professional misconduct

1. Civil liability for negligence

The auditor is liable in damages to his client if he fails to exercise the reasonable care and skill that an ordinary competent auditor would exercise in the circumstances, and the client suffers loss as a result. The liability arises in contract (the engagement) and in tort. The plaintiff must show: the auditor owed a duty, he was negligent in performing it, and the loss was caused by that negligence.

• Re London and General Bank (No. 2) (1895): the auditor is not an insurer and does not guarantee that the books are correct, but must use reasonable care and skill; he must report the true position to the shareholders, not merely hint at it. The auditor who knew the loans were inadequately secured and did not say so plainly was liable for the dividends paid.
• Re Kingston Cotton Mill Co. (No. 2) (1896): the auditor is “a watchdog, but not a bloodhound”; he may rely on the certificate of a trusted official as to stock when there is nothing to arouse suspicion.
• Leeds Estate, Building and Investment Co. v. Shepherd (1887): the auditor had not read the articles, which made dividends payable only out of profits; dividends were paid out of capital on accounts he certified. He was liable: an auditor must know the constitution of the company.
• Re City Equitable Fire Insurance Co. (1925): securities said to be held by the company’s stockbrokers were not there. The auditor should have inspected them or obtained a certificate from a responsible custodian; reliance on a stockbroker’s certificate was not enough (though the auditors escaped liability under an indemnity clause in the articles).
• Re Thomas Gerrard & Son Ltd. (1967): once suspicion is aroused, the auditor must probe the matter to the bottom; accepting the managing director’s explanation for altered invoices was negligence.

Under section 147(3) of the Companies Act 2013, an auditor convicted under section 147(2) must refund the remuneration received and pay damages to the company, statutory bodies or other persons for loss arising out of incorrect or misleading statements in his report. Where an audit firm acted fraudulently or abetted fraud, the firm and the concerned partners are jointly and severally liable (s.147(5)).

2. Liability for misfeasance

Misfeasance is a breach of duty causing loss to the company’s property. In the winding up of a company, the Tribunal may, on the application of the liquidator, a creditor or a contributory, order any officer, including the auditor, who has misapplied or retained money or property of the company, or been guilty of misfeasance or breach of trust, to repay or restore it with interest or contribute compensation (section 340 of the Companies Act 2013). Paying dividends out of capital on the strength of a negligent audit is the classic example (London and General Bank, Leeds Estate).

3. Liability to third parties

Banks, investors and creditors who rely on audited accounts have no contract with the auditor. In Candler v. Crane, Christmas & Co. (1951) the majority held there was no duty to them, but Denning L.J. dissented. In Hedley Byrne & Co. v. Heller & Partners (1964) the House of Lords accepted that a duty of care can arise for a negligent statement where there is a special relationship and the maker knows the statement will be relied on. In Caparo Industries plc v. Dickman (1990) it held that the auditors of a company owe no duty to members of the public who buy shares in reliance on the accounts, and no duty to an existing shareholder buying more shares; the statutory audit is for the members as a body to supervise the management. A duty arises only where the auditor knew that the statement would be given to a particular person for a particular purpose and relied on. An auditor named as an expert in a prospectus is also liable to persons who subscribe on the faith of an untrue statement in his report (sections 35 and 26).

4. Criminal liability

• Section 147(2): an auditor who contravenes sections 139, 143, 144 or 145 is punishable with fine of not less than Rs. 25,000, extending to Rs. 5 lakh or four times his remuneration, whichever is less. If he does so knowingly or wilfully with intent to deceive the company, its shareholders, creditors or tax authorities, he is punishable with imprisonment up to one year and fine of not less than Rs. 50,000, extending to Rs. 25 lakh or eight times his remuneration, whichever is less.
• Section 448: any person who, in any return, report, certificate, financial statement, prospectus or other document required by the Act, makes a statement false in any material particular knowing it to be false, or omits a material fact knowing it to be material, is liable under section 447.
• Section 447 (fraud): imprisonment from six months to ten years and fine not less than the amount involved, extending to three times that amount; where the fraud involves public interest, the minimum imprisonment is three years.
• Section 34 (untrue statement in a prospectus) and section 36 (fraudulently inducing persons to invest).
• Where the auditor joins in falsifying accounts, he may also be prosecuted under the general criminal law (the Bharatiya Nyaya Sanhita 2023 provisions on cheating, forgery and falsification of accounts, and criminal breach of trust), and for false certificates under tax laws.

5. Disciplinary liability

Under the Chartered Accountants Act 1949, a member guilty of professional or other misconduct may be reprimanded, have his name removed from the register for a period, or be fined, by the Board of Discipline (for First Schedule matters) or the Disciplinary Committee (Second Schedule matters). For listed and large companies, NFRA has the power to investigate and penalise auditors (s.132).

Examples of professional misconduct

• First Schedule, Part I (members in practice): allowing a non-member to practise in his name; sharing fees with non-members; soliciting clients or advertising beyond what ICAI permits; accepting an audit previously held by another chartered accountant without first communicating with him in writing (clause 8); accepting an appointment as company auditor without ascertaining that the requirements of sections 139 and 140 have been complied with (clause 9); charging fees as a percentage of profits; engaging in another business without permission.
• Second Schedule, Part I: disclosing client information without consent or legal requirement; certifying a report without examining the records; failing to disclose a material fact known to him; failing to report a material misstatement; being grossly negligent in his professional duties; failing to obtain sufficient information to warrant an opinion; failing to invite attention to any material departure from generally accepted procedure of audit.

6. Professional ethics

The ICAI Code of Ethics, based on the international code, sets five fundamental principles:

1. Integrity: straightforward and honest in all professional relationships;
2. Objectivity: no bias, conflict of interest or undue influence;
3. Professional competence and due care: keep knowledge up to date and act diligently in accordance with standards;
4. Confidentiality: not disclose client information without authority, nor use it for personal advantage;
5. Professional behaviour: comply with law and avoid conduct that discredits the profession.

In addition the auditor must be independent in mind and in appearance. The threats to independence are self-interest (fees, loans, shares), self-review (auditing his own accounting work), advocacy, familiarity (long association, which rotation addresses) and intimidation. The Companies Act gives these rules legal force through the disqualifications of section 141, the prohibited services of section 144 and rotation under section 139(2). SA 200 requires the auditor to comply with the relevant ethical requirements, including independence, and to maintain professional scepticism throughout the audit.

How this is examined

“In what circumstances is an auditor criminally liable?” (April 2021, 10 marks): section 4. “Civil liability of an auditor” (April 2021, short note): sections 1 to 3 with cases. “Duties and liabilities of an auditor” (June 2025): the duties from the previous note in brief, then this note. Short notes: liabilities (2019), professional misconduct (November 2021), professional ethics (October 2023, August 2024, June 2025).