Liabilities of a Statutory Auditor | Company | Auditing

The liability of a statutory auditor may be charted as under:

1. Contractual Liability:

The Statutory Auditor is liable for nonfulfillment of the terms and conditions of an agreement between him and the company who appoints him. He may be held responsible under the Contract Act ‘in failing to perform the duties’ as laid down in agreement. In the absence of any written agreement or contract, he is expected to perform a complete audit. He may conduct partial audit at his own risk. Even if he does not issue an audit certificate, it does not relieve him from incurring liability. He is also liable for breach of fiduciary relationship by disclosing confidential matters.

2. Criminal Liability:

Indian Penal Code imposes a criminal liability on the auditor. The I.P.C. states that whosoever issues or signs any certificate required by law to be given or signed or relating to any fact which such certificate is by law admissible in evidence, knowing or believing that such certificate is false in any material point, shall be punishable in the same manner as if he gives a false evidence’.

The Statutory Auditor’s criminal liability may be of three categories:

(a) Falsification of books (Sec 539 of Companies Act.):

He shall be punishable with imprisonment shall also be liable to a fine if, with the intent to defraud or deceive any person, the auditor:

(1) Destroys, mutilates, alters, falsifies, or secrets or is privy to the destruction, mutilation, alteration, falsification or secreting of any books, papers or securities; and

(2) Makes or is privy to the making of any false or fraudulent entry in any register, books of account or document belonging to the company.

(b) Giving False Statement (Sec. 628 of Companies Act):

If in any return, report, certificate or other document, he makes a statement:

(1) Which is false in any material fact knowing it to be a material and

(2) Which omits any material fact knowing it to be a material, he shall be punishable with imprisonment for a term which may extend to two years and shall also be liable to a fine.

(c) Giving False Evidence:

The auditor who intentionally gives false evidence:

(1) Upon any examination, upon oath or solemn affirmation; or

(2) In any affidavit, deposition or solemn affirmation in or about the winding up of any company shall be punishable with imprisonment for a term which may extend to seven years and shall also be liable to a fine.

3. Liability Arising from Negligence:

The auditor may be held liable for the damages if he fails to perform his duties with reasonable skill and care, i.e., arising out of his negligence. He is liable to make good the loss or damage resulting from negligence on his part to detect defalcations or discover errors which may have caused loss to the company.

4. Liability Arising from Misfeasance:

The auditor may be held liable for breach of trust or responsibility and for wilful misconduct and default, depending on the circumstances of each case.

5. Liability to the Professional Body:

The auditor may be held liable for his professional misconduct if he violates the professional code of conduct as instituted by the Chartered Accountants Act, 1949. He is liable if he acts as an auditor without holding a valid certificate of practice from the Institute.

6. Liability to Third Parties:

There are several conflicting judgements over the auditor’s liability to third parties, i.e., the persons other than the client (e.g. investors, creditors, bankers, tax departments, etc.). However, in the context of Indian legislation, the auditor can be held liable for damages if he has authorised the issue of such a prospectus which contains misleading information.

Generally, the persons other than the client rely on the audited financial statements for various purposes (such as sanction of loan, purchase of shares or debentures, etc.), and so it appears that the auditor may be held liable to all parties in general who are interested in the affairs of the business.

Some important audit case laws relating to the liabilities of a statutory auditor.

1. Derry Vs. Peck (1889):

It was held that the auditor is liable in tort to third parties, if the under mentioned points are proved by the plaintiffs:

(a) The auditor’s statement was untrue in fact;

(b) The auditor failed to exercise reasonable skill and care to ascertain the truth (a part of his duty) knowing that the statement was untrue;

(c) The auditor’s statement was intended that the plaintiff should act on it with sound belief; and

(d) The plaintiff suffered damages by relying on the auditor’s statement.

2. Fairdeal Corporation Vs. Gopalakrishnan:

It was decided that an auditor remains liable to carry out his audit function with reasonable skill and care, even if his appointment is honorary. Duty of care and diligence is important for an auditor though there is no remuneration for him.

3. Ultramares Corporation Vs. Touche, Niven & Co., (1923):

The auditors knew that creditors of certain type would use the balance sheet, but they were not aware of the specific creditors. The creditor-banker lent the firm about $ 165,000, based on the audited balance sheet which showed the assets at $ 2, 50,000 and the net worth at $ 1, 00,000. In reality, the company net worth was ‘Nil’ and most of the overstatement was due to a large block of fictitious accounts receivable.

The auditors confined their scrutiny to the evidence created and/ or held by the client, such as sales invoices and did not ask for direct confirmation of accounts balance from the customers. When the overstatement was discovered, the banker (third party creditor) sued the auditors for both negligence and fraud. The judge, in the original trial, disallowed the charge of negligence as there was a lack of contractual relationship between the auditor and the third party creditor. He also disallowed the charge of fraud.

The judge, in the appeals trial, upheld the negligence charge and ordered “If liability for negligence exists, the failure to detect a theft or forgery beneath the cover of deceptive entries may expose accountants to liability in an indeterminate amount for an indeterminate time to an indeterminate class.” On the charge of fraud, the judge opined that the negligence might be so serious as to constitute a form of fraud.

This case ultimately ended indecisively, but the following auditing implications were established:

(i) An auditor is liable to the client and known third parties for ‘ordinary negligence’ and to unknown third parties for ‘gross negligence’.

(ii) The person, not parties to the original contract, cannot ordinarily recover damages in respect of an auditor’s negligence.

4. Le Lievere and Dennes Vs. Gould (1893):

The decision was – “The question of liability for negligence cannot arise at all until it is established that the man who has been negligent owed some duty to the person who seeks to make him liable for his negligence. What duty is there when there is no relation between the parties by contract? A man is entitled to be as negligent, as he pleases towards the whole world if he owes no duty to them. “Thus, it appears that the auditor, in the absence of fraud,-does not incur liability to third parties who suffered damages for the former’s negligence.

5. Candler Vs. Crane, Christmas & CO. (1951):

In this case Mr. Candler, the plaintiff, claimed that he suffered a loss of investment in shares of the company as he relied on the ‘draft accounts’ which, without any change, was certified by the auditors. He, therefore, sued the auditors for compensation against damages sustained. Mr. Justice Denning gave a verdict that the auditors were not liable to the third parties in absence of any contractual relationship between them. It is interesting to note that this judgment was however, overridden by the House of Lords in 1964 in their decisions in another landmark case, Hedley Byrne & Co. Ltd. Vs. Heller & Partners Ltd.

6. Hedly Byrne & Co. Ltd. Vs. Heller & Partners Ltd. (1964):

The brief outline of the case is that the advertising agents (the plaintiffs) entered into a contract with their party and made a reference to the merchant bankers (the defendants) for obtaining information as to the financial position of the party who also happened to be the client of the merchant bankers. The bankers furnished the information without assuming any responsibility. The plaintiffs suffered a loss due to inaccurate and misleading information furnished by the bankers, and so, filed a damage suit for negligence in the Court.

It was held by the House of Lords that:

(i) There existed a general relationship as banker and customer, not as Solicitor and client;

(ii) The bankers disclaimed liability under reference in clearly expressed words to the customer; and

(iii) The bankers should, therefore, be exonerated from their liability for damages arising out of negligence.

In course of the judgment Lord Morris remarked: “If someone possessed of special skill undertakes, quite irrespective of contract, to apply that skill for the assistance of another person who relies on such skill a duty of care will arise”.

The noticeable feature of this legal decision and its practical application in auditing scene is that the Institute of Chartered Accountants in England and Wales came out with the following two statements concerning the auditor’s liability to third parties:

(1) Statement no. V.8.: Accountants Liability to Third parties – The Hedly Byrne Decision.

(a) The extent to which an auditor accepts responsibility should be made clear beyond the scope of misunderstanding;

(b) Where an auditor specifically restricts the scope of his report or expresses appropriate reservations in a note attached to and referred to in the financial statements he has prepared or the report which he has made thereon, this can constitute a disclaimer which will be effective against any action for negligence brought against him by third parties;

(c) Where an individual shareholder uses the audited annual accounts for investment decisions no action would lie against the auditor as the accounts are not normally prepared for this purpose;

(d) Where the audited accounts would be used for tax assessment purposes by the Revenue Department, no action would lie in case of reliance upon accounts negligently prepared since in fact the failure to recover tax is attributable to the death or insolvency or decamping of the taxpayer, not to the negligence of the auditor;

(e) The third parties entitled to recover damages will be limited to those who by reason of accountants’ negligence in preparing reports, accounts, or financial statements on which the third parties place reliance suffer financial loss in circumstances where the accountants knew or ought to have known that the reports, accounts, and the financial statements in question were being prepared for the purpose specifically or transaction which gave rise to the loss and that they would be shown to and relied on by third parties in that particular connection.

(2) Statement no. V.18.: Professional Liability of Accountants and Auditors.

(i) Liability to Clients: Action for negligence can be-

(a) In contract, by persons to whom the accountant owes a contractual duty of care;

(b) In tort, by persons with whom the accountant is not in a contractual relationship but to whom the accountant owes a duty in accordance with the Hedley Byrne decision.

The opinions expressed or the advice given by an auditor will not be liable to action for negligence merely because, in the light of later events, they prove to have been mistaken.

(ii) Liability to third parties:

Such liability is signified where no direct contractual liability exists.

The accountant, under the Hedly Byrne Doctrine, may incur liability in the following occasions:

(a) Preparing financial statements or reports for a client when it is known or expected that they are intended to be shown to and relied upon by a third party, even if the identity of the third party is not disclosed ;

(b) Giving reference regarding a client’s credit­worthiness;

(c) Allowing the use of the auditor’s name indiscriminately;

(d) Accepting the work which is beyond the professional competence, or not obtaining the specialist advice where the report may have to include opinions of a nature outside the field of the auditor’s professional work.

7. London and General Bank (1895):

The brief outline of the case was that the bank advanced considerable amounts to its customers on loan and current accounts although the securities held were insufficient. The bank credited its profit and loss account with interest on such advances pending actual realisation and did not provide for bad debts either. As a result, the accounts had shown unrealized profits.

Consequently, dividends were paid out of capital (not out of realised profits) in pursuance of a resolution of the shareholders based upon the directors’ recommendation and upon balance sheet certified by the auditor. The auditor, in his report to the shareholders, merely stated that the value of the assets as shown by the balance sheet was dependent upon realisation without any comment as to the insufficiency of security. Subsequently, the auditor was held guilty of misfeasance and was ordered to pay the Official Receiver the dividends plus interests thereon.

Lord Justice Lindley, in the course of his judgment, made the following remarks which have a direct bearing to the auditors’ responsibilities:

(1) It is no part of an auditor’s duty to give advice either to directors or shareholders as what they ought to do. He has nothing to do with the prudence or imprudence of making loans with or without security. It is nothing to him whether the business of a company is being conducted prudently or imprudently, profitably or unprofitably. It is nothing to him whether dividends are properly or improperly declared provided he discharges his own duty to the shareholders.

(2) It is the auditor’s duty to ascertain and state the true financial position of the company, at the time of audit, by actually examining the books of the company. He does not discharge his duty without inquiry and without taking any trouble to see that the books of the company themselves show the company’s true position. He must take reasonable care to ascertain. Unless he does this, his duty will be worse than a farce.

(3) An auditor is not bound to do more than exercise reasonable care and skill in making inquiries and investigation. He is not an insurer and does not guarantee that the books do correctly show the true position of the company’s affairs or that the balance sheet is accurate according the books of the company. He must be honest. He must not certify what he does not believe to be true. He must take reasonable care and skill before he believes that what he certifies is true.

(4) An auditor need not be unnecessarily suspicious where there is nothing to excite suspicions. Where there is nothing to excite suspicion, very little inquiry will be reasonable and sufficient. When suspicion is aroused, more care is obviously necessary. But still an auditor is not bound to exercise more than reasonable care and skill even in a case of suspicion, and he is perfectly justified in acting on the opinion of an expert where special knowledge is required.

(5) The duty of an auditor is to convey information and not means of information. Information and means of information are not equivalent terms. A person whose duty is to convey information to others does not discharge that duty by simply giving them so much information as is calculated to induce them, or some of them, to ask for more. An auditor who adopts such a course does so at his peril, and runs a very serious risk of being held judicially to have failed to discharge his duty.

(6) The duty of an auditor is to convey in direct and express terms to the members any information which he thought proper to be communicated. It is not his duty to consider what is good or what is bad policy. He has to examine facts and see that the members have his opinion as to the balance sheet showing the state of affairs of the company.

Summary: An auditor was guilty of misfeasance as he gave only the ‘means of information’ and not the ‘information’ to the shareholders in respect of the untrue and incorrect state of affairs of the company.

8. City Equitable Fire Insurance Co. Ltd. (1924):

This is a case in which the directors and auditors of the company were sued by the Official Receiver (as liquidator) for damages arising out of negligence and breach of duty.

The charges were that:

(a) The debts due to the company, from Ellis and Co. (the stockbrokers of the company) and its General Manager were mis-described and shown under wrong account head, viz. Loans at call or short notice, and the part of Ellis & Co.’s debt was wrongly included under ‘Cash at Bank and in hand, and the auditor did not disclose these debts to the shareholders.

(b) Larger sums were due from Ellis & Co. at the date of each balance sheet than was so included – which the auditor failed to disclose.

(c) The existence of a large number of the company’s securities, which were in Ellis & Co’s custody and had been pledged by that firm to its customers (i.e. third parties), was not brought to light and reported by the auditors to the shareholders.

According to Mr. Justice Romer (in Chancery Division):

It was held in respect of the first charge that:

(i) It was no part of the auditor’s duty to bring to the notice of the directors and shareholders about the mis-description of the debts;

(ii) Such mis-description did not involve any damage to the company;

(iii) The auditor need not specifically draw the attention of the shareholders of loans given to the brokers or others; and

(iv) There was nothing to arise in the auditor’s mind any doubt as to the goodness of the debt.

As regards the second and third charges, the Court held that the transactions involved ‘window dressing’ operations effected by “a pretended purchase of treasury bonds just before the balance sheet date, followed by a pretended sale just after that date” by Ellis & Co.

The company, in this way, materially reduced the debt due from Ellis & Co. and correspondingly increased the gilt-edged Securities in the balance sheet. The Court held that the auditors were not guilty of negligence for not inspecting the securities as such fraud might not have been detected in view of their actual knowledge of the state of affairs at the time of each audit.

As regards the third charge, the court held that:

(i) The auditors should have asked for the Securities instead of accepting the certificate of the Company’s stockbrokers;

(ii) The fraud must have been detected had the auditors asked for the securities – which could not have been produced by Ellis & Co.- as the same were charged to brokers against the loan by them to Ellis & Co. ; and

(iii) The auditors on this ground are guilty of negligence. But the Court could not pass a decree for damages as the Company’s Articles of Association provided for a protection to the auditors.

According to the Master of the Rolls (Appeal Case):

The decision of Mr. Justice Romer was appealed against by the Official Receiver in the Court of Appeal. This Appeal was dismissed by the Court with cost. The Master of the Rolls, in the course of the judgment, said that “the auditor must take a certificate from a person who is in the habit of dealing with, and holding Securities and who he, on reasonable grounds, rightly believes to be, in the exercise of the best judgment, a trustworthy person to give such a certificate.”

Summary:

(1) An auditor is liable where assets are mis-described in the balance sheet if the Company incurs damage as a result of such mis-description.

(2) An auditor is liable if he does not inspect the securities which are in the hands of third party in whose custody such assets are not ordinarily kept.

(3) An auditor is liable for misfeasance if he does not verify investments and accepts the certificate of a stockbroker instead.

(4) An auditor is liable only when he accepts the certificate for investments from persons who are not expected to hold other’s securities and are not trustworthy, irrespective of their status as bankers or stockbrokers.

9. The Westminster Road Construction Co. Ltd. (1932):

This case is also known as Smith Vs. Offer and Others.

The facts of the case were that:

(1) The profit of the Company was inflated by (a) understating the company’s liabilities by suppression of purchase invoices and (b) overstating the value of work-in- progress;

(2) The dividend was paid out of such inflated profit which resulted in payment of dividend out of capital;

(3) The auditors also acted as accountants to the company;

(4) The company went into liquidation; and

(5) the Official liquidator brought on action against the directors and auditors of the Company alleging that they have failed to perform their duties and were, therefore, guilty of misfeasance.

Mr. Justice Bennett, in the course of his judgment, remarked the following:

(1) “An auditor did not discharge his duty if he merely saw that the balance sheet accurately represented what was shown by the books on the material date.

(2) “His duty with regard to the ascertainment of unrecorded liabilities must be determined by the nature of the business carried on.

(3) “If the auditor found that a company in the course of its business was incurring liabilities of a particular kind, and that the creditors sent in their invoices after an interval, and that the liabilities of the kind in question must have been incurred during the accountancy period under audit, and that when he was making his audit a sufficient time had not elapsed for the invoices relating to such liabilities to have been received and recorded in the Company’s books, it became his duty to make specific inquiries as to the existence of such liabilities and so, before he signed a certificate as to the accuracy of the balance sheet, to go through the invoice files of the company in order to see that no invoices relating to liabilities had not been omitted.”

(4) “With regard to the Over-Valuation of Work- in-progress, it was the duty of the auditor to check the figures at which work-in-progress was brought into the balance sheet. He had also to satisfy himself that all liabilities incurred by the Company in connection with the work so valued had been brought into account.”

Summary:

(1) An auditor is guilty of misfeasance if he fails to detect the omission of liabilities from the balance sheet even when such omission is apparent.

(2) An auditor is guilty of negligence if he fails to detect the over-valuation of work-in- progress when ample materials as evidence are available for testing the accuracy of the figures given to him.

10. London Oil Storage Co. Vs. Seear, Hasluck and Co. (1904):

The facts of the case were that:

(1) The clerk of the audit firm compared the petty cash book with the accounts and did not verify the balance of actual cash in hand;

(2) The petty-cashier misappropriated the differential amount between the actual cash that should have been and the physical cash balance in hand; and

(3) The company brought an action against the auditors for damages on the ground that the fraud could have been detected by the auditors had they verified the petty cash in hand.

The auditors denied the charge for negligence and put forth an argument that the alleged loss was the result of negligence on the part of the Company directors in entrusting so much money to the cashier and in not checking the petty cash from time to time.

The judge decided the case as follows:

(1) The directors of the company were guilty of gross negligence and were a contributor to the cause of the loss.

(2) The auditor’s committed a breach of duty by not verifying the petty cash in hand and hence were liable to pay damages of a nominal amount.

Summary:

It is the auditor’s duty to take appropriate steps for verification as to the existence of assets shown in the balance sheet. He remains liable for damages if he omits to verify the existence of assets.

11. Irish Woolen Co. Vs. Tyson and Others (1900):

The fact of the case was that the dividends were paid out of fake profit arrived at by the manipulation and falsification of the accounts of the Company with respect to the vital aspects, such as: Over­valuation of the Stocks and book debts, and under­valuation of trade liabilities by suppressing the purchase invoices and carrying them to the next period while including the goods in the Stock of the current period. The company also alleged that the auditor entrusted the major work to his assistant who did not exercise reasonable skill and care to the audit. As a result, the frauds of the aforesaid nature could not be detected during audit.

The judgment ultimately stated that:

(1) The auditor’s duty was not to take stock unless there was something to arouse his suspicion as was held in the case of Kingston Cotton Mills.

(2) The auditor was not supposed to do everything himself and could get the work done by his assistant.

(3) If the auditor has called for the creditors’ statement of accounts upon which the payment was ordered and compared them with the ledger, he would have detected the suppression and carrying over to invoices. 

(4) The auditor was liable for any damage that the Company sustained from the understatement of liabilities in the balance sheet.

Summary and Comments:

(1) The auditor is liable for damages by reason of falsification in the accounts which might have been detected by the exercise of reasonable care and skill.

(2) The plea that an auditor is not a stock-taker or valuer, or that he must rely upon the trusted official regarding the list of bad or doubtful debts does not hold good now a days in view of the exacting standard of audit work expected of an auditor.

12. Leeds Estate Building and Investment Co. Ltd. Vs. Shepherd (1887):

The brief facts of the case are as follows:

(i) The Company’s Articles of Association provided for payment of bonuses to the directors in proportion to the dividends paid but such payments were to be paid only out of profits.

(ii) The Company’s Articles further provided that:

(a) The directors should cause true accounts to be maintained and statement of income and expenditure and balance sheet to be placed once a year before the company;

(b) the directors were authorised to declare dividend out of profits; and (c) the auditors should state whether balance sheet exhibited a true and fair view of the state of affairs of the business,

(iii) The Company made no profits during the whole period of its operation except in one year – the fact of which was discovered only during the course of liquidation proceedings. It was further, established that the balance sheet was entirely false by including fictitious items and designed to show fictitious profit with a view declaring dividends by the manager and that the same was certified by the auditor,

(iv) The Company directors pleaded ignorance as to the fact that dividends had been paid out of capital as they relied upon the auditor,

(v) The auditor put forth his argument that he was unaware of the articles and that the action was time-barred,

(vi) The liquidator argued that the auditor was negligent in his duties as he did not comply with the provisions laid down in the articles and as he certified a false balance sheet.

Mr. Justice Sterling, in his judgment remarked:

(1) It was the duty of the auditor not to confine himself merely to the task of ascertaining the arithmetical accuracy of the balance sheet, but to see that it was true and accurate representation of the company’s affairs. It was no excuse that the auditor had not seen the Articles when he knew of their existence.

(2) The directors were bound to make good the losses arising out of the payment of dividend out of Capital and to the like amount the auditor and manager were for damages caused to the business.

Summary:

An auditor, who fails to inquire into the substantial accuracy of the balance sheet and who fails to conclude that the transactions are ultra vires the company’s Articles, is negligent in the performance of his duties and therefore liable for damages.

13. Wilde and others Vs. Cape and Dalgleish (1897):

The brief fact of the case was that the cashier of the plaintiffs defalcated certain amount which the auditor failed to detect as he had not checked the pass book. The plaintiffs brought action against the auditor for breach of duty and negligence and also claimed damages. The auditor argued that the preparation of the profit and loss account and the balance sheet was the Contract and not anything else. The Judge held that the auditor was guilty of negligence for not performing his duties with reasonable skill and care.

Summary:

An auditor is liable to pay damages for loss to his client in the event of non-fulfillment of the contract.

14. Arther E. Green & Co. Vs. The Central Advance and Discount Corporation Ltd. (1920)

The brief facts of the case are as follows:

(i) The auditors sued the Corporation to recover the audit fees and the Corporation made a counter-suit claiming damages from the auditors for breach of duty and negligence.

(ii) The defendant contended that the auditors did not report about the insufficient provision for bad and doubtful debts which resulted in inflated profits and more commission paid to the manager. Further, the auditors failed to highlight that some of the debts were time-barred.

(iii) The auditors argued that “in a money lending business it did not matter how old the debts were, because in the long run people would come back and pay in order to be able to obtain further advances.” The Judge decided that the auditors were guilty of negligence in their duties for:

(a) Not reporting the insufficiency of the provision for bad and doubtful debts to the shareholders; and

(b) Accepting the incomplete schedule of bad debts given by the directors.

Summary:

The auditor is guilty of negligence of his duty if he fails to perform statutory duties in communicating the true position of accounts to the shareholders although such communication is made to the directors.

15. Republic of Bolvia Exploration Syndicate Ltd. (1913):

The facts of the case are as follows:

(i) The directors of the company made certain payments, such as (a) Commission for placing shares (not to a director) and (b) Costs and also a share of profit to a Solicitor-Director.

(ii) One of the Company directors did not account for the balance that he received from one of the Company’s suppliers.

(iii) The articles of the Company did not contain any provision authorising such payments, and therefore the Companies Act was applicable.

(iv) The Liquidator of the Company brought an action against the auditors alleging that the auditors were negligent as they certified the payments which were ultra vires.

Although all these payments were ultra vires, the Court was not convinced that the Company suffered damages due to the auditors’ default for not pointing out this fact in the report. The Court dismissed the case against the auditors without costs in consideration of the existence of special circumstances.

Summary:

The auditor is prima facie liable for ultra vires payments but the extent of his liability for not detecting such payments depends on the existence of special circumstances.

16. Union Bank of Allahabad (1925)

The facts of the case are as follows:

(i) The auditor blindly signed the false Balance Sheet having been influenced by the dishonest manager and the secretary of the bank.

(ii) The auditor confessed that – he would have discovered the criticality of the affairs of the bank and fraud connected with the depositors and creditors, had he examined the books and asked for an explanation. But he never asked a question and certified the accounts.

(iii) The directors trusted the dishonest manager for years and also the auditor’s report and declared dividends.

(iv) The Bank, thereafter, went into liquidation.

Mr. Justice Wallis, in his judgment, remarked the following:-

(1) “Unless the auditors are to be held strictly to their legal liability, the object of legislature in requiring a certificate from them is absolutely defeated. He was utterly reckless and indifferent in his conduct as an auditor. He was trusted to discharge his duty.”

(2) “An auditor is not merely an arithmetical machine to check the figures in the books. He should have satisfied himself not only that the accounts were correct but that the books represented the true state of affairs of the Bank.”

Summary:

An auditor is liable to be guilty of misfeasance for signing the balance sheet blindly and has to suffer the consequences if such balance sheet is found subsequently to be incorrect.

17. Superintendent and Remembrance of Legal Affairs, Bengal Vs. Akhil Bandhu Guha and Others (1936):

The facts of the case are as follows:

(1) The managing directors of Dhakeswari Cotton Mills Ltd. were also the managing directors of a newly formed company named East Bengal Jute and Cotton Mills Ltd.

(2) The amount against the item ‘Deposit by others’ shown in the balance sheet of the first Company was actually arrived at by deducting the loan amount advanced to the other new company. This loan was never separately shown in the balance sheet.

(3) The amount against the item ‘advances to Contractors and Others’ included the loans to the managing directors but such loans were not specifically disclosed in the balance sheet.

(4) The auditors certified the balance sheet as having been properly drawn up, and the majority of the directors adopted the balance sheet.

(5) One of the shareholders brought a criminal suit against the managing directors under Section 282 of the Companies Act 1913 (now Section 628 of Companies Act 1956 which states – Any person who makes a false statement in any returns, balance sheet, etc. is liable to be imprisoned upto two years and fined.) before the Magistrate.

(6) The Magistrate convicted all the directors and sentenced them with fine and imprisonment. But the respondents appealed before the District Judge who reversed the judgment stating that the criminal intention of the directors was not proved.

(7) The Govt. made an appeal in the court against the District Judge’s Order.

(8) The Court, in its judgment upheld the Magistrate’s order and held that the directors and the auditors were guilty of criminal liability.

In the course of his judgment, Mr. Justice Cunliffe remarked the following:

(1) “A balance sheet need not be, in fact it must not be a mere inventory. It is supposed to be a pictorial representation of the trading position of the Company, easily appreciated not by ignorant people but by persons who are reasonably able to understand commercial conditions.”

(2) “A loan and a deposit; being obviously items differing completely in principle from the balance sheet point of view, ought to appear on different sides, one as an asset and the other as a liability and that the act of consolidating the two and presenting them as one item in the balance sheet was a striking case of non­disclosure amounting to suppression of truth.”

18. Armitage Vs. Brewer and Knott (J932):

The facts of the case are as follows:

(1) The plaintiff appointed the auditors to have protection against the petty frauds that were suspected to be perpetrated by the book-keeper.

(2) There was no system of internal check. The book-keeper had complete charge of the books of account including the preparation of wages sheets and payments therefor.

(3) It was found that the book-keeper manipulated the wages sheets and embezzled money; but the auditors did not give due importance to the matter so as to bring it to the notice of the principal.

(4) As a result, the plaintiff claimed damages against the auditors for their failure to detect frauds.

Mr. Justice Talbot observed that:

(i) The audits differed greatly as to scope and special instruction and

(ii) The fraud must have been detected by a thorough examination of the wages sheets by the auditors. It was held that the auditors were guilty of negligence as they failed to detect frauds for which they were informed.