Duties of Statutory Auditor

On July 19, 2021, the Supreme Court rendered a decision on the duties and responsibilities of a statutory auditor in a case where a company sued its statutory auditor for a $2 million embezzlement by its employee. This holding provides guidance on the duty of care a statutory auditor is required to provide in its audits. For statutory auditors, it has not been discussed in depth what the duty of care actually means. In this newsletter, we start with the background facts and summarize the holdings as this should be helpful for corporate executives serving as statutory auditors of Japanese corporations. 

Background facts

The company was a closed corporation and appointed an external accountant as its statutory auditor in 1967, who served until 2012. His duties were limited to accounting matters, excluding his monitoring duties on directors' activities ("Limited Auditor").

An employee in charge of bookkeeping started embezzling funds in 2007 and continued for ten years, transferring JPY235 million ($2 million) in total to his personal account. He did not enter the fund transfer in company books, having forged bank statements in annual audits to cover his false bookkeeping.

The statutory auditor reviewed company books through his associate and verified that the financial statements were consistent with the books from 2007 to 2012. Based on this review, he opined in his audit reports that the financial statements accurately represent the financial status of the company in material respects. His associate reviewed bank statements in the annual audits, but did not notice the forgery of the bank statements.

Holding by lower courts

The trial court held that the auditor was liable, finding that he did not request the originals of bank statements in his annual audits. Tokyo High Court reversed that decision, holding that he fulfilled his duty as it is sufficient for Limited Auditors to verify the consistency of company books and financial statements unless the books are obviously suspicious.

Under the Companies Act, the directors of a company are primarily responsible for preparing company books and financial statements. Statutory auditors are required to audit financial statements, but not company books per se. The High Court weighed this difference, holding that the auditor was not expected to ensure the accuracy of company books.

The Supreme Court holding

The Supreme Court remanded the case to the High Court, dissenting from its holding. The Court held that statutory auditors should not assume the accuracy of company books in their audits. Even if company books are not evident to be unreliable, statutory auditors should ask directors how they prepare the books or they should review source documents should circumstances require, in order to opine that financial statements accurately reflect the financial status of the company.

Comments

This is a key decision to understand the level of care a statutory auditor must exercise in annual audits. The High Court tried to differentiate the degree of care expected in a Limited Auditor and other statutory auditors. The Supreme Court denied this approach, holding that a Limited Auditor has the power to request directors to report on accounting matters and investigate the financial status of the company, just like other statutory auditors. 

The case is now pending at the High Court to find the statutory auditor’s negligence in the audits, but the auditor may no longer argue that he was not responsible for not noticing errors in company books. Even if the directors should be primarily responsible for managing their employees and thus take the blame for overlooking the bookkeeper’s embezzling funds for years, it is not good enough to vindicate the liability of the statutory auditor.

Disclaimer
The information contained in this newsletter is for informational purposes only and should not be construed as legal advice on any matter. The material herein may not reflect the most current legal developments. The content and interpretation of the law addressed herein is subject to revision. We disclaim all liability in respect to actions taken or not taken based on any or all the contents of this newsletter to the fullest extent permitted by law. Do not act or refrain from acting upon this information without seeking professional legal counsel.