Learning Outcomes
After studying this article, you will be able to explain when and why auditors may be liable to third parties for negligent audit work. You will understand the legal principles of negligence, key legal tests for establishing a duty of care to non-clients, and the impact of major court cases. You will also be able to apply these concepts in exam scenarios and identify ways to reduce audit risk in relation to third-party claims.
ACCA Foundations in Audit (FAU) Syllabus
For ACCA Foundations in Audit (FAU), you are required to understand when auditors are liable to third parties. This article addresses the following syllabus points:
- The meaning and scope of auditor liability to third parties
- Principles of negligence as applied to auditors
- Legal tests for establishing duty of care to third parties
- Key case law affecting auditor duties
- Practical implications for audit practice
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.
- On what basis can a non-client (such as a lender or investor) bring a claim against an auditor?
- What three elements must a claimant prove to succeed in a negligence action against an auditor?
- Which famous case introduced the modern legal test for duty of care to third parties in English law?
- True or false? Auditors always owe a duty of care to anyone who relies on audited financial statements.
Introduction
Auditors are appointed by a company and owe a clear duty to their client under contract law. However, third parties such as investors, lenders or suppliers may also rely on audited financial statements. If these individuals suffer financial loss because of a negligent audit, can they hold the auditor liable? This article explores the principles defining when, and to whom, auditors owe a duty of care beyond their direct client, and how courts decide such cases.
Negligence and Auditor Liability
Auditor liability for negligence means being legally responsible for loss caused by audit work that falls below the required standard of skill and care.
Key Term: negligence
Failure to exercise the level of skill and care expected of a reasonably competent auditor, resulting in loss to another person.
If an auditor fails to perform to acceptable professional standards and this causes loss, a claim may arise. For clients, liability is straightforward due to the contractual relationship. For third parties, the legal position is more complex.
Establishing Auditor Liability to Third Parties
A third party (not the audit client) can only claim against an auditor in the law of tort—not contract—on the grounds of negligence.
To succeed in a negligence claim, the claimant must prove:
- The auditor owed them a duty of care.
- The auditor breached that duty by failing to act with reasonable skill and care.
- The claimant suffered a loss as a direct result.
Key Term: duty of care
A legal obligation requiring a person to take reasonable care to avoid causing harm to others who may foreseeably suffer loss as a result of their actions.Key Term: tort
A civil wrong not arising from contract, giving rise to a claim for damages.
Most disputes centre on the first element—whether a duty of care existed between the auditor and the third party.
Duty of Care: Legal Principles and Tests
Courts consider whether an auditor owed a duty of care to a third party based on several factors, established in precedent cases. The critical question: "Should the auditor have reasonably foreseen that this person would rely on the audited information, and is it fair, just and reasonable to impose liability?"
The modern approach is set out in the Caparo test (from Caparo Industries plc v Dickman [1990]), which requires:
- Foreseeability of loss: Was it predictable that the third party would rely on the audit report?
- Proximity: Was there a close relationship between auditor and third party?
- Fairness: Is it fair and reasonable to impose a duty in the circumstances?
Auditors are generally liable only where the third party was a known user (or belonged to a known class of users) and the auditor was, or should have been, aware that their work would be relied upon for a specific purpose.
Key Term: Caparo test
A three-part test for establishing duty of care: foreseeability of harm, proximity between parties, and whether it is fair, just, and reasonable to impose a duty.
Key Case Law Influencing Auditor Liability
Several landmark cases have shaped auditor liability to third parties:
- Hedley Byrne & Co Ltd v Heller & Partners Ltd [1964]: Introduced the idea that a duty of care may arise when a professional knows their work will be relied upon by a third party.
- JEB Fasteners Ltd v Marks Bloom & Co [1983]: Duty of care was owed where the auditor knew who would rely on the accounts for a specific transaction, but claim failed as plaintiff had not relied solely on the auditor’s work.
- Caparo Industries plc v Dickman [1990]: Established the three-part test above; held that auditors generally owe duties to the company as a whole, not to individual shareholders or the investing public.
- Barings v Coopers & Lybrand [2002]: Confirmed that auditors may owe a duty where they provide confirmation directly to a third party for a specific purpose.
Limiting Factors and Practical Implications
Auditors do not owe a duty of care to all possible users of audited financial statements. Claims by the general public or anonymous potential investors are unlikely to succeed. Similarly, if a disclaimer is included in an auditor’s report or advice, courts may be less willing to find liability (as in Hedley Byrne).
Worked Example 1.1
A local authority invests in Alpha plc after reading its audited financial statements. The auditor made errors and Alpha plc collapses, causing the local authority to lose its investment. Can the local authority sue the auditor for negligence?
Answer:
The auditor did not know, nor could reasonably predict, that this specific local authority (or class of investors) would rely on the accounts for investment. There is no sufficient proximity, so no duty of care is likely to be found under the Caparo test. The claim would probably fail.
Worked Example 1.2
MegaBank requests an audit firm to confirm the financial position of client XYZ Ltd as part of a loan approval process. The audit firm contacts MegaBank directly and provides a written summary which turns out to be incorrect. XYZ Ltd defaults and MegaBank suffers a loss. Does the auditor owe MegaBank a duty of care?
Answer:
Here, the auditor provided information to the third party (MegaBank) for a specific transaction. There is foresight, proximity, and it is just and reasonable to impose liability—so a duty of care likely exists. If negligence is proven, there could be liability.
Exam Warning
A common error is to assume that any user of audited accounts can bring a negligence claim if an audit error causes loss. In practice, only those within a sufficiently close relationship—where reliance was foreseeable and intended—are owed a duty.
Summary
Auditors may be liable in negligence for losses suffered by non-clients, but only if all legal requirements are met. Successful claims require a proven duty of care, a breach of that duty, and actual loss resulting from reliance on the auditor’s work. The scope of an auditor’s duty to third parties is strictly limited by court decisions.
Key Point Checklist
This article has covered the following key knowledge points:
- Distinguish between contractual and tortious liability for auditors
- List the three elements needed for a negligence claim by a third party
- Explain the legal tests applied by courts to decide when an auditor owes a duty of care to non-clients
- Identify the main cases shaping auditor liability to third parties
- Recognise circumstances where liability is unlikely (e.g., general investors or unknown parties)
- Understand practical steps to limit auditor exposure to third party claims (such as use of disclaimers)
Key Terms and Concepts
- negligence
- duty of care
- tort
- Caparo test