Auditing CH 2 The Auditing Profession

Learning Objectives
 Identify Characteristics of a Profession

 Explain the Generally Accepted Auditing Standards (GAAS)
 Define Ethics, and describe the Purpose of Professional Ethics in Auditing
 Identify the Basic Principles of Ethics in General and Auditing Professional Ethics in
Particular
 Distinguish ethical from unethical behavior in personal and professional contexts.
 Resolve ethical dilemma using ethical framework
 Explain the importance of ethical conduct for the accounting profession.
 Discuss Rules of Professional Conduct
 Discuss why auditor’s responsibility to safeguard public interest has increased
 Discuss the Legal environment in which CPAs practice
 Differentiate between business failure, audit failure and audit risk
 Describe the primary legal concepts and terms related to legal liability of auditors
 Describe auditors legal
Audtingliability
Part I to clientsAyele,
By: Yetnayet andAAUSC,
third 2015
parties and related defense 1
Chapter 2 : The Auditing Profession
 What makes a profession Different from a vocation?

 All of the recognized professions (eg. medicine, engineering,
accounting, etc) have the following common characteristics:
A responsibility to serve the public
A complex body of knowledge
Standards of admission to the profession
A need for public confidence
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 A responsibility to serve the public
 The term professional represents a responsibility
that extends beyond satisfying personal interest
 It extends beyond the requirements of the society’s
laws and regulations.
 A CPA, as a professional is the representative of the
public-creditors, stockholders, consumers, employees,
and others in the financial reporting process, as his/her
role is to assure that financial statements are fair to all
parties and not biased to benefit one group at the
expense of another.
 A complex body of knowledge
 A profession, consists different but interrelated concepts,
standards and is a complex body of knowledge
 Professionals are required to update their knowledge
through continuing education, this is a requirement
 For audit professionals, the need for technical
competence and familiarity with current standards of
practice is embodied in the Code of Professional
Conduct

 Standards of admission to the profession
 In order to attain a license to serve as a CPA, it
essential for the public accountant:
 to attain minimum standards of education and
experience
 pass the uniform CPA examinations showing the
mastery of the common body of knowledge.
 Once licensed, a CPA must adhere to the ethics of
the profession, if not disciplinary actions will be
taken.

 A need for public confidence
 Physicians, lawyers, CPAs and all other professionals must have
the confidence of the public to be successful.
 If users of services do not have confidence in physicians, judges,
or CPAs, the ability of those professionals to serve clients and the
public effectively is diminished.
 To the CPA, public confidence has special significance, because:
 CPAs product is credibility. The value of audit report and the demand for
audit services depend on public confidence in the independence and
integrity of CPAs
 Thus, for the CPA, it is essential that the client and external financial
statement users have confidence in the quality of audits and other services.
 Without public confidence on the attester, the attest function serves no
useful purpose.
The two pillars up on which the Auditing
Profession Stands:
 The trustworthiness of the profession of auditing
is supported by two pillars:
1. GAAS, which deals with how the work is done,
2. The auditor’s standard of personal conduct, of person an
auditor should be, there is some overlap between GAAS and
the code of ethics.

 Auditing standards:
 are general guidelines to aid auditors in fulfilling their
professional responsibilities in the audit of financial statements.
 include considerations of professional qualities such as
competence and independence, reporting requirements and
evidence.
 are used in measuring the quality of performance of auditing
profession.
 are used as a benchmark based on which auditors performance
is checked,
Thus auditors have to perform their duties in accordance with
these standards, and this in turn will rise the prestige of the
profession.
Auditing part I By: Yetnayet Ayele, AAUSC, 2012 8

 GAAs is set by the AICPA, and it falls in to three categories:
1. General Standards
2. Standards of Field work
3. Reporting standards
2.1.1. General Standards

1. The examination is performed by person or persons having
adequate training and proficiency as an auditor
2. Independence in mental attitude is to be maintained by auditors in
all matters related to the examination
3. Due professional care is exercised in the performance of the
examination and the preparation of the report.
…2.1.1. General Standards
 General standards relate to the training and proficiency of auditors, the
need for independence and due care in the audit profession.
Training and Proficiency- The standard requires CPA’s to have:
 College or university education in accounting and auditing,
 Substantial public accounting experience,
 Ability to use procedures suitable for computer-based systems, and
 Participation in continuing education programs.
 A technical knowledge of the industry in which the client operates is
also part of the personal qualifications of the auditor.
 This standard requires that a CPA firm should not accept engagement
without having a staff members with the needed technical proficiency
that enable them to function effectively in the particular industry.

…2.1.1. General Standards
 The standard also requires auditors to be independent, ie,
 Free from conditions that threaten objectivity or the appearance of objectivity.
 Mental independence of the auditor in all aspect of the examination is the most
important factor in the existence of a public accounting profession.
 A CPA should avoid any relationship with the client organization to avoid doubts
on its independence to maintain public trust on its activities.
 Independence is needed because an opinion by an independent public accountant
as to the fairness of the financial statement has no value if independence is
impaired
 Due Professional Care
 This requires auditors to perform each activity diligently and alertly.
 Full compliance to this standard would prevent a neglect acts or material
omissions by the auditor.
2.1.2 Standards of Field work
1. The work is to be adequately planned and assistants if
any are to be properly supervised
2. A sufficient understanding of internal control structure
is to be obtained to plan the audit and to determine the
nature, timing, and extent of tests to be performed.
3. Sufficient competent evidential matter is to be
obtained through inspection, observation, inquires, and
confirmations to afford a reasonable basis for opinion
regarding the financial statements under examination
..2.1.2 Standards of Field work
 The standards of field work relate to accumulating
and evaluating evidence sufficient for the auditors
to express an opinion on the financial statements
 Adequate Planning and Supervision of the audit
 Sufficient Understanding of Internal Control
 Sufficient Competent Evidential Matters

2.1.3 Standards of Reporting
1.The reports shall state whether the financial statements are
prepared as per GAAPs
2. The report shall identify those circumstance in which such
principles have not been consistently observed in the current
period in relation to the preceding period
3. Informative disclosures in the financial statements are to be
regarded as adequate unless it is stated differently in the report
4. The report shall either contain an expression of opinion regarding
the financial statements taken as a whole, or an assertion to the
effect that an opinion cannot be expressed. When an overall
opinion cannot be expressed, the reasons therefore should be
stated, in all cases when an auditors name is associated with
financial statements, the report should contain a clear-cut
indication of the character of the auditor’s examination, if any,
and the degree of responsibility he is taking.
Application of Auditing Standards
 The 10 standards set forth by the AICPA include
such subjective terms of measurement as
 adequate planning,
 sufficient understanding of the internal control structure,
 sufficient competent evidential matters and adequate
disclosure.
So, auditors exercise professional judgment to determine
what is adequate, sufficient, and competent under each
audit.
 Statements on Auditing Standards (SAS)
 SASs are pronouncements issued by the Auditing Standards Board.
 The SASs are considered to be interpretations of the 10 GAASs.
 The term Auditing standards is often used in practice to refer to the
SASs, GAASs or both.
 The authoritative status of SASs is derived from the AICPA code of
professional conduct (Rule 202).
 The code recognizes SASs as interpretations of GAASs and require
auditors to adhere to these pronouncements.
 A CPA firm must be prepared to justify any departure from the SASs.

……Statements on Auditing Standards (SAS)
 Though it is specific and detailed than GAASs,
SASs do not prescribe specific auditing procedures
to be followed.
 For specific audit problems, auditors can refer to the
Industry Audit Guides and Audit procedure Studies
issued by AICPA, auditing text books, and articles in
journals such as the Accounting review Journal.
 It is evident that compliance with SASs does not
represent an ideal of audit performance, but rather a
minimum standard for all audit engagements.
 Ethics
 Ethics can be defined broadly as a set of moral principles
or values
 Honesty, integrity, Trustworthiness, Responsibility,
Caring, Respect, Fairness and Citizenship are attributes
of ethical behaviors.
 Philosophers, religious organizations, and other groups
have defined in various ways (Laws and regulations,
church doctrine, code of ethics etc), ideal sets of moral
principles or values, which indicates the importance of
ethics in society
 Ethics Distinguished from Laws
 Ethical behavior goes beyond legal behavior
 The law defines the minimum standard of behavior that
society considers acceptable.
 Ethical behavior rises to a higher level.
 Ethics is not just a definition of the lowest acceptable
behavior; it is a search for the highest attainable
behavior
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Need for Ethics
 Ethical behavior is needed for a society to function in an
orderly manner.
 Ethics is glue that holds a society together. If there is no
ethics, for example if everyone lied, there will be no effective
communication, a state of chaos will be created.
 Since ethics is very important for effective functioning of the
society, commonly held ethical values are incorporated into
laws.

 Unethical behavior- is an act which is against the moral
principles of the society
 People differ in their moral principles due to the difference in
their background
Two Reasons for Why People act Unethically
1. The person’s ethical standards are different from those of
society as a whole.
In some unethical acts those who commit feel no guilt when
they are arrested because their ethical standards differ from
those of the society as a whole (Eg extreme cases such as
drug dealers, bank robbers).

…..Two Reasons for Why People act
Unethically
2. The person chooses to act selfishly- (selfish
behavior)
Here, a person purposely act selfishly, he/she knows
what the appropriate behavior is, but selfishness
makes them to behave unethically.
Eg. tax evaders, people engaged in corrupted acts are
motivated by personal financial greed; acts of people
who cheat on exams are caused by laziness.
.
Ethical Dilemmas
 An ethical dilemma is a situation a person faces in which a
decision must be made about appropriate behavior.
 Auditors, accountants, and other businesspeople face many
ethical dilemmas in their business careers.
 Dealing with a client who threatens to seek a new auditor unless an unqualified
opinion is issued presents an ethical dilemma if an unqualified opinion is
inappropriate.
 Deciding whether to confront a supervisor who has materially overstated
departmental revenues as a means of receiving a larger bonus is an ethical
dilemma.
 Continuing to be a part of the management of a company that harasses and
mistreats employees or treats customers dishonestly is an ethical dilemma,
especially if the person has a family to support and the job market is tight.

Methods of Resolving Ethical Dilemmas
1. By Rationalizing Unethical Behavior
There are attempts to resolve ethical dilemmas by rationalizing
unethical behavior, but this is not advisable since it results in
unethical conduct
1. Everybody Does It, so why not me?
2. If it’s legal, it’s ethical
3. Likelihood of discovery and consequences
Eg.
1. Everybody Does It, so why not me?
Bad behaviors such as to falsify tax returns, cheat on
exams, or sell defective products are commonly the result
of the rationalization that everyone else is doing it and
therefore it is normal.
2. If it is legal, it is ethical: Using the argument that all legal
behavior is ethical relies heavily on the perfection of laws.
Under this philosophy, one would have no obligation to return a lost
object unless the person could prove that it was his or hers.
3. Likelihood of Discovery and Consequences
 This philosophy relies on evaluating the likelihood that someone else
will discover the behavior.
 The person also assesses the severity of the penalty (consequences) if
there is a discovery.
Eg. in deciding whether to correct an unintentional overbilling to a
customer when the customer has already paid the full amount. If the
seller believes that the customer will detect the error and respond by not
buying in the future, the seller will inform the customer now; otherwise,
the seller will wait to see if the customer complains.
Formal frameworks with six-step have been developed to
help people resolve ethical dilemmas:
1. Obtain the relevant facts.
2. Identify the ethical issues from the facts.
3. Determine who is affected by the outcome of the
dilemma and how each person or group is affected.
4. Identify the alternatives available to the person who
must resolve the dilemma.
5. Identify the likely consequence of each alternative.
6. Decide the appropriate action.

 SOME ETHICAL VIOLATIONS ARE MORE
SEVERE THAN OTHERS
Eg. Look at the following unethical act
Tom is much busy in a social life to work overtime. To make certain
that work does not interfere with his social life, he tests only part of
the assigned sample. For example, if he is asked to test 25 cash
disbursement transactions, he tests the first 15 but indicates that
he has tested all 25. A supervisor, curious about Tom’s amazing
ability to beat the time budget, decides to carefully review Tom’s
work. When the firm discovers that Tom is signing off procedures
without completing them, he is dismissed that day—no counseling
out, no 2 weeks’ notice.
Special Need for Ethical Conduct in Professions
 The society has attached a special meaning to the term
professional.
 Professionals are expected to conduct themselves at a
higher level than most other members of society.
 For example, when the press reports that a physician,
clergyperson, a Lawyer, or CPA has been indicted for a
crime, most people feel more disappointment than when
the same thing happens to people who are not labeled as
professionals.
 Professional Ethics is one pillar up on which the audit
profession stands
 Code of professional ethics is necessary in that:
 It is not practical for most customers to evaluate the quality of the
performance of professional services because of their complexity.
Eg. A patient cannot be expected to evaluate whether an operation was
properly performed.
A financial statement user cannot be expected to evaluate audit
performance. Most users have neither the competence nor the time for
such an evaluation. Public confidence in the quality of professional
services is enhanced when the profession encourages high standards
of performance and conduct on the part of all practitioners.
Thus, Code of professional ethics
 is a means of self regulation by imposing the codes in addition to the
rule of the land and other rules and regulations by which we have to
abide by whether we like it or not .
 is a means of recognition as a profession.
 enhances the profession’s
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 The most important factors that encourage CPAs
to conduct themselves appropriately and perform
high-quality audits and related services include:
 Applications of the GAAS and their interpretations,
 The CPA examination,
 Quality control,
 Peer review requirements,
 Regulations by different bodies eg. SEC,
 Continuing education.
 The existence of legal liability of CPA firms
 The AICPA Code of Professional Conduct provides both general
standards of ideal conduct and specific enforceable rules of conduct.
 It provides a standard of conduct for all members of the AICPA.
 There are four parts to the code:
1. Principles,
2. Rules of conduct,
3. Interpretations of the rules of conduct, and
4. Ethical rulings.
The parts are listed in order of increasing specificity:
 The principles provide ideal standards of conduct, they are not enforceable
 Rules of conduct, are minimum standards of ethical conduct stated as
specific rules, they are enforceable
 Interpretations of Rules of conduct they are not enforceable but the
practitioner must justify departure
 Ethical rulings are highly specific, they are not enforceable but the
practitioner must justify departure
Ethical Principles
Article 1. Responsibilities: In carrying out their responsibilities as professionals, members
should exercise sensitive professional and moral judgments in all their activities.
Article 2. The Public Interest: Members should accept the obligation to act in a way that will
serve the public interest, honor the public trust, and demonstrate commitment to
professionalism.
Article 3. Integrity: To maintain and broaden public confidence, members should perform all
professional responsibilities with the highest sense of integrity.
Article 4. Objectivity and Independence: A member should maintain objectivity and be free of
conflicts of interest in discharging professional responsibilities. A member in public practice
should be independent in fact and appearance when providing auditing and other attestation
services.
Article 5. Due Care: A member should observe the profession’s technical and ethical standards,
strive continually to improve competence and quality of services, and discharge professional
responsibility to the best of the member’s ability.
Article 6. Scope and Nature of Services: A member in public practice should observe the
principles of the Code of Professional Conduct in determining the scope and nature of
services to be provided. Audting Part I By: Yetnayet Ayele, AAUSC, 2015 32
 Article 1: Responsibilities
 CPAs (Audit firms) have responsibility to all who use their service
 Thy have to provide the service with highest level of integrity
 Members have to cooperate each other to improve the art of the service and
maintain public confidence
In general they are responsible to the following groups:
 To the society or the public in general. (to those that relies on audited
financial statements. )
 To the clients. Specifically, the CPA owes it to his client to be competent,
honest, loyal, independent, and solicitous. The auditor should not disclose
this information to others, without the consent of the client. (Example:
Officer’s salaries, engineering specifications of a new type of computer).
 To fellow practitioners. Colleagues norms help build and maintain internal
cohesion within a profession. The advancement of a profession is dependent
upon goodwill and mutual trust among practitioners. The auditor should
promote cooperation and good relations among other members of the
profession.
 Article 2: Public interest
 The distinguishing feature of a profession is acceptance of
its responsibility to the public.
 The accounting profession’s public consists of clients, credit
grantors, governments, employers, investors, the business
and financial community
 The public interest is the collective well-being of the
community of people and institutions the profession serves
including all who rely on the objectively verified financial
information for the orderly function of commerce
 Thus those in the profession are required to commit
themselves for public interest
Article 3: Integrity
 Integrity means that the auditor will give his own honest
opinion, in spite of what the consequences might be. It
requires the auditor to be impartial.
Article 4: Objectivity and Independence
 Independence and objectivity are very closely bound
together.
 If the auditor is not independent, it is almost impossible for
him to be objective.
 Independence is said to be the cornerstone of the auditing
profession.
 It is because the auditor is expected to be independent, that
third parties believe that his report will be unbiased, or
objective.
 Article 5: Due Care
 Due Care is a standard for competence and technical
standards
 According to this standard, the auditor should not
accept an engagement unless he is certain that he has
the essential skills to do the work well, including a
thorough knowledge of GAAP.
 Then, having accepted the engagement, the auditor is
required to work carefully, including planning and
supervising the work of staff members.
 Finally, the auditor is required to do the work
completely, accumulating and examining a sufficient
amount of evidence to support his opinion.
Article 6: Scope and Nature of Service
 This rule can be considered as a constraint on the
nature of the non audit service that may be rendered
to the client
 The rule requires members:
 to practice in firms that have in place internal quality-
control procedures, to ensure that services are competently
delivered and adequately supervises
 To determine, in their individual judgments, whether the
scope and nature of other services provided to an audit
client would create a conflict of interest in the
performance of the audit function for that client
 Asses in their own judgments, whether an activity is
consistent with their role as professional
Rules of Conduct
 This part of the Code includes the explicit rules that must be
followed by every CPA in the practice of public accounting.
 Those individuals holding the CPA certificate but not
practicing public accounting must follow most, but not all
requirements.
 Because the section on rules of conduct is the only
enforceable part of the code, it is stated in more precise
language than the section on principles.
 Because of their enforceability, many practitioners refer to
the rules as the AICPA Code of Professional Conduct.
(Note: Since this Section II, the rules of conducts (Rule
101-505) are enforceable, they will be discussed in this
chapter, after the nature of interpretations and ethical rulings
are highlighted).
Interpretations of Rules of Conduct
 The need for published interpretations of the rules of conduct
arises when there are frequent questions from practitioners
about a specific rule.
 The Professional Ethics Executive Committee of the AICPA
prepares each interpretation based on a consensus of a
committee made up principally of public accounting
practitioners.
 Before interpretations are finalized, they are issued as exposure
drafts to the profession and others for comment.
 Interpretations are not officially enforceable, but a departure
from the interpretations is difficult if not impossible for a
practitioner to justify in a disciplinary hearing.
 The most important interpretations are discussed as a part of
each section of the rules.
Ethical Rulings
 The AICPA also issues Ethical rulings
 Ethical Rulings explain the application of the
Rules and Interpretations to specific factual
circumstances involving professional ethics
 Ethical rulings are highly specific, they are not
enforceable but the practitioner must justify
departure

Rule 101: Independence
Rule 102: Integrity and Objectivity
Rule 201: General Standards
Rule 202: Compliance with Standards
Rule 203: Accounting Principles
Rule 301: Confidential Client Information
Rule 302: Contingent fees
Rule 501: Acts discreditable
Rule 502: Advertizing and other forms of Solicitation
Rule 503: Commissions
Rule 505: Form of practice and Name

Independence
 Rule 101: states that “A member in public practice shall be
independent in the performance of professional services as
required by standards promulgated by bodies designated by
council”.
 Independence, because of its importance, is the first rule of conduct.
 It deals with independence in an audit and non-audit context.
 The value of auditing depends heavily on the public’s perception
of the independence of auditors. Independence is the cornerstone of
the auditing profession. The reason that many diverse users are
willing to rely on CPA’s reports is their expectation of an unbiased
viewpoint.
 This rule requires that the auditors of historical financial statements
and other types of attestation (review services and audit of
prospective financial statements) be independent.
 For working on tax returns and management services, the auditor
can provide suchAudting
services
Part I
without being independent.
 The AICPA Code of Professional Conduct and the IESBA
Code of Ethics for Professional Conduct both define
independence as consisting of two components:
 Independence of mind (independence in fact) and
 Independence in appearance.
Independence of mind (independence in fact) reflects the auditor’s
state of mind exists when the auditor is actually able to maintain an
unbiased attitude throughout the audit.
Independence in appearance is the result of others’ interpretations of
this independence.
 If auditors are independent in fact but users believe them to be
advocates for the client, most of the value of the audit function is lost.

 The following are threats that impair independence:
 Ownership in audit client by the CPA firm
 Ownership in audit client by the CPA close family like non dependent
children, spouse brother, sister grand parents ,parents and parents in law
and other family members
 Loans that are not under normal lending procedures
 Material gift
 Actual or potential litigation between the auditor and the client
 Unpaid fee for more than a year.
 Thus, in dealing with this rule, auditors preserve independence:
 By avoiding financial connections that make it appear that the auditor’s
wealth depends upon the outcome of the audit.
 By avoiding managerial connections that make it appear that the auditor
is involved in management decisions of the audit client (thus auditing
their own work).
Integrity and Objectivity
Rule 102: states that, “In the performance of any professional
service, a member shall maintain objectivity and integrity; shall
be free of conflicts of interest, and shall not knowingly
misrepresent facts or subordinate his or her judgment to
others”.
 Integrity means impartiality in performing all services.
 This rule apply not only to CPAs in public practice, but also to
CPAs working in government and industry.
 The rule requires integrity and objectivity in all kinds of
professional work - tax practice and consulting practice as well as
audit practice for public accountants and all kinds of accounting
work performed by CPAs employed in corporations, not for profit
organizations, government and individual practices.
 The rule of integrity and objectivity, also emphasizes
the need to,
 Be free from conflict of interest between CPA and others,
 Be truthful in representation of facts in reports and
discussions, and
 Not allow other peoples to dictate or influence the CPA’s
judgment and professional decisions.
 This rule prohibits the misrepresentation of facts to
the client or to other third parties.
 In addition, the judgment of the auditor should not
be subordinated to others. This holds true for any
aspect of auditor work, whether audit work, tax
work or management services
The following are threats to Integrity and Objectivity:
a. Undue Dependence on an Audit Client
b. Family and other Personal Relations
c. Beneficial Interest in Shares or Other Investment
d. Loans
e. Goods and Services Hospitality
f. Provision of Other services to Audit Clients
g. Overdue fees
h. Actual or Threatened Litigation
i. Associated Firms: influences Outside the practice
j. Voting on Audit Appointment
Links Ch 3\Ch 3 Link 4 Threats to Integrity and
Objectivity.docx

General Standards
Rule 201: states that “A member shall comply with the following standards and
with any interpretations there of by bodies designed by Council.”
A. Professional Competence. CPAs should only undertake work for which they can
reasonable expect to complete with professional competence. Undertaking work
for which they are not competent will bring discredit both to themselves and to the
entire profession. CPAs initially may feel they have the competence to complete a
particular engagement. However, during the course of their engagement they may
find that they must do additional research or consultation with others in particular
areas. This does not signify any lack of competence
B. Due professional care. A CPA should exercise due professional care in the
performance of professional service (in any engagement).
C. Planning and supervision. The engagement should be adequately planned and
supervised
D. Sufficient relevant data. The conclusion and /or recommendations that result from
any professional accounting engagement should be based on sufficient and relevant
data.
This rule of the code relates to the general standards that are applicable to all areas of
public accounting Audting Part I By: Yetnayet Ayele, AAUSC, 2015 48
Compliance with Standards
Rule 202: states that “A member who performs auditing,
review, compilation, management advisory, tax or other
professional services, shall comply with standards
promulgated by bodies designated by the council”
 This rule requires CPAs to adhere to professional
standards issued by other technical bodies.
 The following are bodies that are given the authority to set
various standards, and CPAs are required to be familiar
with them and apply in their engagements:
Technical Body Authority Pronouncement
Auditing Standards Board Prescribes standards for Statements on Auditing
Audit of F/S and Standard (SAS)
supplementary inform.
required by FASB
Management Advisory Prescribes standards for Statements on standards
Service Committee Management services for Management services
Auditing and Review Prescribes standards for Statements on Standards
Service Unaudited information for Auditing and Review
service for non public Service
Entities
Financial Accounting Prescribes disclosure Statements of Financial
Standards Board standards for accounting Standards and
supplementary inf. Outside Related interpretations
the F/S

Accounting Principles
Rule 203: States that: A member shall not
(1) express an opinion or state affirmatively that the financial statements
or other financial data of any entity are presented in conformity with
generally accepted accounting principles or
(2) state that he or she is aware of any material modifications that should
be made to such statements or data in order for them to be in
conformity with generally accepted accounting principles, if such
statements of data contain any departure form an accounting principle
promulgated by bodies designated by council to establish such
principles that has a material effect on statements or data taken as
whole. If however, the statements or data contain such a departure
and the member can demonstrate that due to unusual circumstances
the financial statements or data would otherwise have been
misleading, the member can comply with the rule by describing the
departure, its approximate effects, if practicable, and the reasons why
compliance with the principle would result in a misleading statement.
 Rule 203 recognizes the authority of designated bodies
to issue accounting principles
 Under this rule the AICPA has designated FASB, its
predecessor the APB, and the GASB as primary sources
of GAAPs.
 It requires CPAs not to issue an unqualified opinion on a
set of financial statements that materially depart from
one of these pronouncements, except in rare cases in
which application of the pronouncements would result in
misleading financial statements.

Confidential Client Information
Rule 301: States that: “A member in Public Practice shall not
disclose any confidential client information without the specific
consent of the client”.
 Confidential information is information that should not be disclosed to
outside parties unless demanded by a court or an administrative body
having subpoena or summon power.
 Privileged information, on the other hand, is information that cannot be
even be demanded by a court. Eg. communication between the
penitent and confessor father, doctor and patient, and plaintiff
defendant and lawyer are examples of privileged information
 In all the recognized privilege relationships, the professional person is
obligated to observe the privilege, which can be waived only by the
client, patient, or penitent. (These persons are known as the holders of
the privilege).
 The rules of privileged and confidential communications are based on
the belief that they facilitate a free flow of information between parties
to the relationship.Audting Part I By: Yetnayet Ayele, AAUSC, 2015 53
 The nature of auditors work makes it necessary for them to
have access to their client’s most confidential information
including financial data like previous year’s earnings and non-
financial information like client trade secrets.
 Managers would be less likely to reveal such information if
they could not trust the accountant to keep it confidential.
 If the accountants were to reveal such information, the
resultant reduction of the information flow might be
undesirable, so no accountant should break the confidentiality
rule without a good reason
 Society has given certain professions like medicine and law the
right of privileged communication, however, the accounting
profession does not have this right.
.

 Thus information obtained during auditing is confidential but not
privileged.
 Consequently, auditors may be compelled to disclose their
communications with their clients in certain types of court
proceedings
 Though confidential information shall not be disclosed to any
body without the consent of the client, there are exceptions. For
example, difficult problems arise over auditor’ obligations to
“blow the whistle” about clients’ shady or illegal practices.
 However, the confidential relationship between the CPA and the
client is never a justification for the CPA to cooperate in any
deceitful act. The personal integrity of the CPA is essential to the
performance of the attest function.
 In general, information is not considered confidential if
disclosure of it is necessary to make financial statements
not misleading.
 Exceptions to confidentiality: There are four exception
concerning responsibilities that are more important than
confidential relations with the client.
 Obligations to related to technical standards
 Subpoena or summons
 Peer review
 Response to ethics division.

Contingent Fees
 Rule 301: States that: “Professional services shall not be offered or
rendered under an arrangement where by no fee will be charged
unless a specified finding or result is attained. Or where the fee is
contingent up on the findings or results of such services. However, a
member’s fees may vary depending on, for example, the complexity
of services rendered. ”.
 Fees are not regarded as being contingent if fixed by courts or other
public authorities.
 Thus, this rule prohibits public accountants to perform services on fee
basis. Eg. A company in need of audit report to support its application
for a bank loan might offer to make the auditor’s fee contingent up on
approval of the loan by the bank. This arrangement could create
undesirable temptation for the auditor on his independence.
 So, fees could be contingent upon time, qualification, court rulings,
complexity of work etc. but should not be contingent upon outcome
(audit report) of audit engagement.
Acts Discreditable
Rule 501: States that:” A member shall not commit an act discreditable to
the profession”.
 This rule is not specific as to what constitutes a discreditable act; it is
subject to interpretation
 In past, the following acts were considered as violation of rule or as
discreditable acts:
 Signing a false or misleading opinion or statements (failure to follow professional
standards, government regulations),
 Committing felony,
 engaging in discriminatory employment practices (by sex, religion etc),
 failure to return clients records, a situation that arise when the CPA have been
discharged and not paid for their services,
 Solicitation or disclosure of CPA exams questions and answers without the approval
of AICPA Solicit
This rule permits the disciplining of those members who act in a manner damaging to
the reputation of the profession

Advertizing and other forms of Solicitation
Rule 502: States that:” A member in public practice shall
not seek to obtain clients by advertizing or other forms of
solicitation in a manner that is false, misleading, or deceptive.
Solicitation by the use of coercion, overreaching, or harassing
conduct is prohibited. ”.
 Advertising - messages designed to attract business that are
broadcast widely to an undifferentiated audiences (e.g print,
radio, television, billboards). The guidelines basically prohibit
false, misleading, and deceptive messages.
 Solicitation – is more of a direct contact type (e.g in person,
mail, telephone) with a specific potential client. In regard to
solicitation, the rule basically prohibits extreme bad behavior
(coercion, overreaching, or harassing conduct).

 Most CPAs carryout only modest advertising efforts,
and many do no advertizing at all.
 Public practice is generally marked by dignity and a
sense of good taste.
 In earlier times, advertizing by CPAs was strictly
forbidden, most CPAs considered advertizing in any
form to be unprofessional
 However, now, they can advertize their services so long
as the advertizing is not false, misleading, or deceptive.
 The danger in bad advertising lies in getting the images
of a professional huckster, which may backfire on
efforts to build a practice.

Unethical Advertizing Acceptable Advertizing
Advertizing that creates unjustified Advertizing which is informative and
expectations of favorable results based on verifiable facts
Advertizing that consists of self Indications of the type of services offered,
laudatory statements that are not based certificates and degrees of members of the
on verifiable facts firm, and fees for services
Advertizing that makes incomplete
Inclusion of policy or position statements
comparisons with other CPAs in which
relating to public accounting or subject of
the facts are not verifiable.
public interest such as a statement may be
made by a firm or a member of a firm.
Advertizing that indicates an ability to
influence a court or other official body
Thus, Advertising should at all times be in good taste - in fairly moderate and professional in tone.

Commissions
Rule 503: States that:” The acceptance by a member in public practice of a
payment for the referral of products or services of others to a client is
prohibited. Such action is considered to create a conflict of interest that
results in a loss of objectivity and independence”.
 A commission is generally defined as a percentage fee charged for
professional services in connection with executing a transaction or performing
some other business activity. Examples are insurance sales commissions, real
estate commissions, and securities sales commissions.
 CPAs can earn commissions except in connection with any client for whom
the CPA performs attest services.
 The rule treats commissions as an impairment of independence just like the
rule on contingent fees. Thus, a member shall not make a payment to obtain a
client.
 When CPA is involved in an attest engagement with a client, the CPA cannot
receive a commission from anyone for
1. referring a product or service to the client, or
2. referring to someone else a product or service supplied by the client.
It does not matter which party actually pays the commission.
.
 However, the role permits commissions, provided the
engagement that does not involve attestation services and also
require CPA to disclose to clients an arrangement to receive
commission
 This rule shall not prohibit payments for the purchase of an
accounting practice or retirement payments to individuals
formerly engaged in the practice of public accounting or
payments to their hires or estates.
 Commissions and fee splitting are not usually in the best interest
of the clients. In addition, such fees are often charged back to
the client, either directly or indirectly.
 Consequently, the code prohibits a practitioner from paying a
commission to another CPA. However, interpretation allows a
CPA to compensate another CPA for services provided to the
client
For example:
 Assume that X audit firm agreed to provide audit service to
client Y and after performing some tasks, the firm faced
some difficulties of completing the audit service for client
Y (eg. lack of specialized skill in client Y’s business) and
suggests Y to communicate with Auditor Z who has the
competence to perform the assignment.
 In this case, Z may compensate X audit firm for the portion
of tasks performed earlier to client Y, so this is not a
violation of this rule; However, if firm X demanded a
compensation for the referral and received payment for this
act, it is considered as a violation of this rule

Rule 504:(Deleted)
Forms of Practice and Name

Rule 505: States that:” A member shall not practice
public accounting under a firm name that is misleading”.
 A member (an audit firm) may practice public accounting in the
form of Proprietorship, General partnership, General Corporation,
Professional corporation, Limited Liability Company and Limited
liability partnership.
 A firm may not designate itself as” Member of AICPA” unless all
of its owners are members of the institute.

 Legal liability of Auditors
 It refers to auditor’s litigation in which persons with real or
fancied grievances are likely to take their grievances to court
OR
 the possibility of court action that auditors expect if they do
not adhere to GAAS and to the code of ethics
 The Legal Environment in Which Audit professionals
Operate:
 The legal environment is changing, audit professionals have
a responsibility under common law to fulfill implied or
expressed contracts with clients.
Thus, when CPAs take any engagement, they are
obliged to render the service with due
professional care, this obligation exists whether
it is written in the contract or not.
Auditors are liable to their clients for negligence
and/or breach of contract if they fail to provide the
services or fail to exercise due care in their
performance.
Based on precedents in common law, clients and
third parties have the right to recover damages
caused by auditors for ordinary negligence
 Potential liability of CPAs due to improper professional
practices is considered to be higher as compared to the case in
other professions. Why?
 The parties that will be injured is larger in the case of
improper practices of CPAs
 Eg: Physician/attorney- the injured parties could be the
client
 If CPAs are negligent in expressing opinions on financial
statements – millions of investors could sustain losses
 Trends show that legal liability of auditors are increasing

 What increased auditors responsibility to
safeguard public interest ?
 The increase in the number of investors
 The increase in the number of corporate form of
businesses (where ownership is separated from
control),
 The increased need for independent financial
information by different parties, (eg. investors,
owners, govt.)
 The increase in the reliance of government on
accounting information.
 Studies show legal liability of auditors has increased
over time due to:
 Users growing awareness of the responsibility of auditors
 Governments increased awareness on the need for protection of
investor’s interests.
 Increased audit complexity caused by computerized systems, new
types of transactions and operations, more complicated
accounting standards, more international business
 More demanding audit standards for detection of errors and fraud
 Pressures to reduce audit time and improve audit efficiency
 Misunderstanding by users that an unqualified opinion is an
insurance policy against misstatements (Expectation gap) mainly
due to inability to distinguish between Business failure, Audit
failure, and Audit Risk
 Joint and several liability statutes that permit a plaintiff to collect
the full amount of the settlement from any defendant, even those
only partially responsible for the loss (i.e. deep pockets theory)
 Courts’ difficulties in understanding and interpreting accounting and
auditing matters.
 Contingent-fee-based compensation for law firms
Implications of increased legal liability of Auditors:
 The need to be aware of the legal liability inherent in the practice
before deciding to enter in the auditing profession
 Auditors must approach every engagement with the expectation
that they may appear in court to defend their work

 Many accounting and legal professionals believe that a
major cause of lawsuits against CPA firms is financial
statement users’ lack of understanding of two concepts:
1. The difference between a business failure
and an audit failure
2. The difference between an audit failure
and audit risk
 Business Failure: It occurs when a business is unable to
repay its lenders or meet the expectations of its investors
because of economic or business conditions.
 Some users believe that the auditor guarantees the financial
viability of the business (this is expectation Gap), but it is
wrong to expect this from auditors, however this expectation
gap is believed to be one of the reasons that increased
litigation.
 Audit Failure: It occurs when the auditor issues an erroneous audit opinion
as the result of an underlying failure to comply with the requirements of
generally accepted auditing standards (GAAS).
 It is a good reason for taking complaints to courts
 the law often allows parties who suffered losses to recover some or all of
the losses caused by the audit failure
 But, the complexity of the auditing process makes it difficult to easily
decide on the existence of failure to comply with GAAS
 Audit Risk: It represents the risk that the auditor will conclude that the
financial statements are fairly stated and an unqualified opinion can be issued
when, in fact, they are materially misstated.
 This is unavoidable, since audits are performed on test basis (sample);
 So, it may occur even if an audit is conducted as per GAAS.
 Auditors can not give guarantee that financial statements are accurate, they
can give only a reasonable assurance, but some users expect auditors to
give guarantee about the accuracy of financial statements (expectation
gap)-another cause for increased litigation
 Difficulties often arise when a business failure, not an audit failure,
occurs.
 Eg. A company is bankrupt or cannot pay its debts, but the most
recently issued auditor’s report indicates that the financial
statements were fairly stated. In this case, statement users
commonly claim that an audit failure has occurred, but actually this
is a business failure.
 some users even believe that the auditor guarantees the financial
viability of the business. (expectation gap)
 The situation will be even worse, if a business failure happens and
the financial statements are later determined to have been misstated,
users may claim the auditor was negligent even if the audit was
conducted in accordance with auditing standards (due to audit risk).
 This conflict between statement users and auditors often arises
because of an “expectation gap” between users and auditors.

What will happen if the trend is not changed?
 The cost of professional liability insurance will continue to
increase
▪ Not only the cost issue, but reputations of audit firms will also
be damaged
 Performing tasks with due care is essential to reduce the costs
and keep the image of the profession
 It is obvious that, no matter how careful a CPA firm is, it may
occasionally find it self as defendant in litigation, however:
▪ CPAs are never liable to any party, if they perform their
services with due professional care
▪ Having exercised due professional care (due diligence)
is a complete defense against any charge of improper conduct

Legal Concepts Pertinent to Auditors Liability
1. Prudent Person Concept
2. Liability for the Acts of Others
3. Lack of Privileged Communication
1. Prudent Person Concept : It is considered as a standard of due care. It
requires CPA firms:
 To exercise due diligence- Those who provide services should
have the required skills and competence, if this is not the case, it
is considered as fraud (deceiving others)
 To provide service in good faith and highest level of integrity It is
understood that auditors can provide only reasonable assurance,
not a guarantee about the accuracy of financial statements (It
means, errors may occur in the process since no one is perfect
(infallibility is not assumed). Negligence and dishonesty makes
auditors liable to others, but not an error occurred in providing
services in good faith.
2. Liability for the Acts of Others
 CPA firms provide service to others through their
employees, or may involve other CPA firms to do
part of the work, and may also invite specialists to
provide technical information
 Thus, if an employee performs improperly in doing
an audit, the partners can be held liable for the
employee’s performance.
 In general, partners of the CPA firms are liable for
the work of others on whom they rely

3. Lack of Privileged Communication
 Information is said to be privileged information if legal
proceedings cannot require a person to provide the
information, even if there is a subpoena.
 Information communicated by a client to an attorney or by
a patient to a physician is privileged.
 But Information obtained by a CPA from a client generally
are confidential but not privileged.
 They are confidential (are not revealed without the consent
of the client), but exceptionally they are communicated eg.
by court orders.
Civil and Criminal Liabilities
Civil Liability: occurs when the rights of a specific individual or group
have been violated (torts fall under the heading of civil liability)
 Tort – a private wrong other than contractual, i.e. personal injury or
property damage, resulting from negligence. The wronged (ill treated)
person may get redress (compensation) in a law court.
Auditors may be held civilly liable by clients and third parties who use
audited financial statements. This civil liability is based
 Contract law
 Common law
 Statute (statutory law)

 Criminal liability – occurs when an act,
considered to be a wrong against society, is
committed
 Statutory laws provide for criminal actions
against auditors - guilty persons can be fined or
imprisoned.
 So, auditors can also be held with criminal
liability
 Knowing the following terms is helpful to
understand the discussions related to legal
liability Links Ch 3\Ch 3 Link 2 Definition of
terms.docx
 Auditors liabilities may arise from improper
performance of any type of engagement, ie.: an
audit, tax services, accounting services, or
management advisory services
 Terms related to negligence such as ordinary, gross
represent different degrees of improper performance
by the CPA.
 The extent to which the CPA’s services are found to
be improper determines the parties to whom the
CPAs are liable for losses caused by their improper
action.
 Ordinary (simple) negligence is a sufficient degree
of misconduct to make CPAs liable for damages
caused to their clients
How to determine the level of negligence as ordinary and
gross?
 Reference to Professional Stds (GAAS)
 CPA as an Expert Witness
Four Major Sources of Auditor’s Liability:
1. Clients-most common source of law suits against CPAs
2. Third party beneficiary
3. Federal Securities Law
4. Criminal Liability
Thus, the plaintiffs include clients, third party beneficiaries
and the Government (for violation of security laws)

Clients may sue the auditor mainly for the following:
For Breach of Contract: this occurs when auditor fails to
perform a contractual duty: Breach actions include:
 failing to complete the engagement within the agreed-upon
time (Eg. Late F.S. or Tax Returns),
 withdrawing from the engagement without sufficient
justification
 violating client confidentiality (Disclosure of Confidential
Information)
 failing to provide professional quality work (eg Failure to
detect Fraud, Errors in Proposed F.S. Adjustments, Errors
in Tax Returns, )
 Auditor’s Responsibility for the detection of errors
and irregularities:
 Failure to uncover an embezzlement/defalcation against
clients by client employees is one source of CPAs liability
to clients
Key factor in determining whether the auditor is liable/not:
 The key factor is not whether the auditor is unable to
uncover the fraud, but, the issue is whether this failure
stems from the auditor’s negligence
 What does Auditing Standards (SAS 53) states about
auditor’s responsibilities?
Auditing Standards (SAS 53) require auditors:
1. To design their audit to provide reasonable assurance of detecting errors
and irregularities that are material to the financial statements;
2. To exercise due care and professional skepticism in planning and
conducting their examinations
3.To communicate irregularities of any consequence and proposed audit
adjustments to the audit committee of the client’s board of directors.
So what does this standard imply?
 These requirements do not imply that auditors were negligent when ever
errors and irregularities are later found to exist in audited financial
statements
 An audit has certain limitation; for cost reason, it is conducted on test
(sample) basis, so can not provide absolute assurance that financial
statements are free from errors and irregularities (those that do not fall
in the sample (the parts no checked) may contain errors and irregularities )
 In addition, if collusions exist, errors and irregularities can be
skillfully/expertly concealed, and this creates difficulty to reveal errors
and irregularities by applying
Auditing part I
the normal auditing techniques
 The Burden of Proof Under Common Law
 Legal actions under common law require the
plaintiff to bear most of the burden of proof.
 Plaintiffs seeking damages from CPAs must prove
that they sustained losses, due to their reliance on
audited financial statements that were misleading,
and auditors were guilty of a certain degree of
negligence

 Thus the following proofs are required from
Clients:
 CPA Accepted Duty to Exercise Due Professional
Care (Level of care should be included in the engagement
letter - based on level of service.)
 Existence of Breach of Duty (through negligence)

 Existence of Loss Suffered by Client
 Proof that the Loss is Resulted due to CPA’s
Negligence
 Auditor's Defense: Auditors can refute by showing the
following:
▪ auditor did not breach the contract
▪ client was contributory negligent
▪ client losses were not caused by the breach
In sum, auditors defend that 1) they were not negligent in the
performance of their duties, 2) their negligence was not the
proximate cause for the client loss
▪ Eg by demonstrating the existence of contributory negligence (when client's
negligence contributes to the loss. Eg. a loss resulted from failure to
implement auditor’s recommendation)
▪ Contributory negligence may eliminate auditor’s liability or the concept of
comparative negligence may be applied to allocate the damage between the
auditor and the client (Read the illustrative case on Megs et al, 9th edition Page
33)
 When the auditor is found to breach the contract,
court remedies to a breach include
 order auditors to fulfill the contract (specific performance)
 issue injunction to prohibit the auditor from continuing the
breach
 order auditor to pay compensatory (actual) damages
 If the case falls under the criminal act- guilty persons, in this
case the auditors, can be fined or imprisoned.

Liability to third parties Under Common Law
Approaches and Cases used as Precedence
 Ultramares (Identified/Known User) Approach
 Auditors are Liable to Clients and Third-Party Beneficiaries (identified/known
third parties) for Ordinary (simple) Negligence
 Auditors are Liable to Other Third Parties (not mentioned user) only for Gross
Negligence
 Restatement of Torts (Foreseen User) Approach
 Auditors are Liable to Clients and Foreseen class(es) of Third Parties (expected
users, though names are not mentioned) for Ordinary (simple) Negligence
 Auditors are Liable to Other Third Parties only for Gross Negligence
 Rosenblum (Foreseeable User) Approach
 Auditors are Liable to Clients and All Foreseeable Third Parties (including for
those whose names are not mentioned) for Ordinary (simple) Negligence
Auditing Notes for Class 2012\Links Ch 3\Ch 3 Link 3 Approches and cases in
deciding auditors liability.doc
 Research in auditing standards and rule setting
 Use engagement letters for all financial statement and consulting
engagements
 Set Requirements to protect auditors
 Sanction members for improper conduct and performance
 Client screening
 Understand the client’s business
 Do not accept engagements for which the firm is not qualified
 Perform quality audits
 Maintain complete and accurate audit documentation
 Maintain confidential relations
 Seek legal counsel
 Choose a form of business with Limited liability
 Carry sufficient professional liability insurance
 Establish peer review requirements
 Lobby for changes in laws-Tort reform
 Exercise professional skepticism

Auditing CH 2 The Auditing Profession

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Learning Objectives

 Identify Characteristics of a Profession

 What makes a profession Different from a vocation?

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2.1.1. General Standards

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Forms of Practice and Name

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 Existence of Breach of Duty (through negligence)

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