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
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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.
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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. Audting Part I By: Yetnayet Ayele, AAUSC, 2015 6 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.
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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.
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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. Auditing part I By: Yetnayet Ayele, AAUSC, 2012 9 …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.
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…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. Auditing part I By: Yetnayet Ayele, AAUSC, 2012 11 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 Auditing part I By: Yetnayet Ayele, AAUSC, 2012 12 ..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
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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. Auditing part I By: Yetnayet Ayele, AAUSC, 2012 14 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. Auditing part I By: Yetnayet Ayele, AAUSC, 2012 15 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.
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……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. Auditing part I By: Yetnayet Ayele, AAUSC, 2012 17 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 Audting Part I By: Yetnayet Ayele, AAUSC, 2015 18 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.
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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).
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…..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. . Audting Part I By: Yetnayet Ayele, AAUSC, 2015 22 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.
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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. Audting Part I By: Yetnayet Ayele, AAUSC, 2015 24 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. Audting Part I By: Yetnayet Ayele, AAUSC, 2015 25 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.
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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. Audting Part I By: Yetnayet Ayele, AAUSC, 2015 27 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 Audting Part I By: Yetnayet Ayele, AAUSC, 2015 28 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 Audting Part I stature By: Yetnayet Ayele, AAUSC, 2015 29 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 Audting Part I By: Yetnayet Ayele, AAUSC, 2015 30 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 Audting Part I By: Yetnayet Ayele, AAUSC, 2015 31 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. Audting Part I By: Yetnayet Ayele, AAUSC, 2015 33 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 Audting Part I By: Yetnayet Ayele, AAUSC, 2015 34 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. Audting Part I By: Yetnayet Ayele, AAUSC, 2015 35 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. Audting Part I By: Yetnayet Ayele, AAUSC, 2015 36 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 Audting Part I By: Yetnayet Ayele, AAUSC, 2015 37 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). Audting Part I By: Yetnayet Ayele, AAUSC, 2015 38 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. Audting Part I By: Yetnayet Ayele, AAUSC, 2015 39 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
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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
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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. By: Yetnayet Ayele, AAUSC, 2015 42 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.
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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). Audting Part I By: Yetnayet Ayele, AAUSC, 2015 44 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. Audting Part I By: Yetnayet Ayele, AAUSC, 2015 45 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 Audting Part I By: Yetnayet Ayele, AAUSC, 2015 46 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
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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: Audting Part I By: Yetnayet Ayele, AAUSC, 2015 49 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
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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. Audting Part I By: Yetnayet Ayele, AAUSC, 2015 51 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.
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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. .
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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. Audting Part I By: Yetnayet Ayele, AAUSC, 2015 55 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.
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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. Audting Part I By: Yetnayet Ayele, AAUSC, 2015 57 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
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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).
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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.
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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.
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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. Audting Part I By: Yetnayet Ayele, AAUSC, 2015 62 . 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 Audting Part I By: Yetnayet Ayele, AAUSC, 2015 63 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
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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.
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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. Auditing part I By: Yetnayet Ayele, AAUSC, 2012 66 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 Auditing part I By: Yetnayet Ayele, AAUSC, 2012 67 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
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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. Auditing part I By: Yetnayet Ayele, AAUSC, 2012 69 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 Auditing part I By: Yetnayet Ayele, AAUSC, 2012 70 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
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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. Auditing part I By: Yetnayet Ayele, AAUSC, 2012 72 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 Auditing part I By: Yetnayet Ayele, AAUSC, 2012 73 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.
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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
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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. Auditing part I By: Yetnayet Ayele, AAUSC, 2012 76 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
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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. Auditing part I By: Yetnayet Ayele, AAUSC, 2012 78 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)
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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 Auditing part I By: Yetnayet Ayele, AAUSC, 2012 80 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 Auditing part I By: Yetnayet Ayele, AAUSC, 2012 81 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)
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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, ) Auditing part I By: Yetnayet Ayele, AAUSC, 2012 83 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 part I By: Yetnayet Ayele, AAUSC, 2012 84 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 By: Yetnayet Ayele, AAUSC, 2012 85 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
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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 Auditing part I By: Yetnayet Ayele, AAUSC, 2012 87 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) Auditing part I By: Yetnayet Ayele, AAUSC, 2012 88 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.
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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 Auditing part I By: Yetnayet Ayele, AAUSC, 2012 90 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
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