Accountants' Liability in China

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The role of the auditor is vital to achieving good corporate governance. Impartial assessment of a company's finances by an auditor can provide important peace of mind to the company's board of directors and to third parties including business partners, investors and regulators. However, an auditor faces a dilemma where conflicts arise due to the client's desire for his/her stamp of approval despite the existence of problems with the client's financial books.

Under the common law, accountants have a direct contractual relationship with clients. An accountant's liability occurs when an accountant fails to perform as agreed under the contract. While a normal audit is not intended to uncover excessive fraud, shortages, or irregularities in financial statements, the level of standards may be questionable. Signing-off on a financial statement with irregularities that a routine audit should have detected constitutes a failure by an accountant to perform under the contract. Such failure could amount to a breach of contract, negligence, gross negligence or even fraud, exposing the accountant to potential claims by the client and possibly other affected parties such as investors and lenders. If the accountant is found liable for a breach of contract or negligence, he/she may be responsible for losses that reasonable use of care would have avoided.

In the US, the main statutory laws affecting accountants are the Securities Act of 1933 (1933 Act) and the Securities and Exchange Act of 1934 (1934 Act). Under the 1933 Act, it is unlawful for audited financial statements included in initial securities registration to contain false material or omissions of material facts. In order to prove innocence, accountants must demonstrate that they have exercised due diligence. The 1934 Act regulates the trading of securities subsequent to their initial offering. Accountant civil liability under this Act makes it unlawful for accountants to defraud, make untrue statements of, or omit material facts, or commit fraud or deceit in connection with purchase or sale of securities. The burden of proof is on the plaintiff to prove that damage incurred from reliance on the financial information and the existence of the intent to deceive, manipulate or defraud.

Particularly in China, international auditors face varied challenges. As business practices and accounting rules in China strive towards international standards, auditors face difficulties in discovering the fair value of a firm's assets and maintaining independence in an environment where corruption is widespread and transparency is lacking. A shortage of qualified personnel means that a majority of auditors are overworked and projects are often turned down or delayed because accounting firms are backlogged. Additionally, auditors dealing with listed companies in China must also observe multiple sets of rules depending on whether the company is listed domestically or on various offshore bourses.

Further complicating matters, the liability provisions under the new PRC Securities Law (Securities Law) (中华人民共和国証券法)and the shareholder activism that the new PRC Company Law (中华人民共和国公司法)appears to encourage, together with the possibility of PRC courts beginning to entertain class-action suits, have created new pitfalls for international accounting firms operating in China. Similar to its US counterparts, the Securities Law requires that the issuers of audit reports in connection with securities offering, listing or trading must examine and verify the truthfulness, accuracy and completeness of their reports, and bear corresponding civil liability in respect of their work. In the case of intentionally giving false statements or misleading information, an auditor may be subject to both civil liability and criminal sanctions. So far there has been no judicial guidance as to how such liability provisions may be interpreted or applied in practice.

Since the introduction of the Securities Law, some of the Big Four accounting firms have seen 'feeler' litigation in PRC courts. The most prominent case involved a shareholder of a major listed Chinese home appliance manufacturer taking the manufacturer's auditor to court for negligence, on grounds that the auditor's 2003 unqualified opinion of the manufacturer's financial accounts failed to uncover massive abnormal cash flows between the company and its controlling shareholder, resulting in losses to the investor. The plaintiff's claim for damages was based on allegations of breach of the PRC Certified Public Accountants Law (which traditionally governs the accounting profession), as well as the Securities Law. A Shanghai court declined to hear the case in April 2006, citing a 2001 notice of the Supreme People's Court that ordered local courts not to accept securities-related claims. However, the plaintiff's counsel indicated that his client would appeal the ruling to a higher court. Moreover, the shareholder's counsel also indicated that the plaintiff would attempt to gather other shareholders and file a class action suit. Meanwhile, the China Securities Regulatory Commission (CSRC) has begun hearings on whether to discipline the auditor. Based on a 2002 Supreme People's Court's notice, once the CSRC has issued an administrative penalty, a court may then hear the case and award civil damages.

Given their lack of experience in dealing with such types of cases, it is likely that PRC courts will take a relatively cautious approach in the early stages of the Securities Law's enactment and take on a more subordinate role behind regulators, such as the CSRC, in the protection of investors' interests. Consequently, it is unlikely that there would be a flood of securities-related litigation and claims against auditors in the near future. For China's accounting profession, however, it may be a race against time to foster a greater degree of professional competence, ethics and independence, before investors begin to take advantage of available recourses against accountants and other professional advisors in order to recover their lost investments.