CHAPTER 2: ETHICS, LEGAL LIABILITY, AND CLIENT ACCEPTANCE

Fundamental Principles of Professional Ethics

All professional accountants in Canada must abide by a code of professional conduct
These principles are to act with:

 Professional behaviour
 Integrity and Due Care
 Professional competence
 Confidentiality
 Objectivity
Professional behaviour
o Comply with rules and regulations and do not harm reputation of the profession
o Be honest in representations to current and prospective clients
o Do not claim to provide services they cannot provide, or qualifications they do not possess, or
experience they do not have
o Do not undermine reputation of, or quality of work produced by, others

Integrity and Due Care

o To be straightforward and honest
o Act diligently, taking care to complete each task thoroughly, document all work, finish on a
timely basis
Professional competence
o Maintain knowledge and skill at a level required by the professional body
o Keep up-to-date with changes in regulations and standards
o Continue education and work experience

Confidentiality
o Refrain from disclosing information to people outside the workplace that is learned as a result
of employment
o Exception: if legal requirement to disclose
o Not allowed to use confidential information to their advantage or advantage of another person

Objectivity
o Not allow personal feelings or prejudices to influence professional judgement
o Be unbiased
o Not allow conflict of interest or influence of others to impair decision process
Professional Judgement and Professional Scepticism
 Just like analyzing ethical issues, auditors use a framework when making professional
judgements
 The Centre for Audit Quality suggests a five-step process as follows:

Improving Professional Scepticism

 Being alert to contradictory evidence, evidence that may suggest fraud, or evidence that could
be altered
 Awareness of unconscious cognitive biases such as:
o Availability bias
o Confirmation bias
o Overconfidence bias
o Anchoring bias

Independence
 Independence is the ability to act with integrity, objectivity, and with professional scepticism
(questioning mind)
 Lack of auditor independence impacts on credibility and reliability of the financial statements
 The auditor must be, and be seen to be, independent

Auditor Independence
 Independence in fact
o ability to act independently with integrity, objectivity and professional scepticism
o ability to make a decision free from bias, personal belief, and client pressures
 Independence in appearance
o belief that independence of mind has been achieved
 Threats to independence
o Self-interest
o Self-review
o Advocacy
o Familiarity
o Intimidation

Self-interest threat
- Can occur if the audit firm or its staff have financial interest in audit client
 - Examples:
+ Bank account held with the client
+ Shares owned in the client
+ A loan to or from the client
+ Fee dependence, where the fees from a client form a significant proportion of all
fees of the firm
+ Close business relationship with the client
Self-review threat
- Can occur when the assurance team need to form an opinion on their own work or work
done by others in their firm
- Examples:
+ Assurance team member has recently been an employee or director of the client
+ Preparing information for the client that is then assured
+ Performing services for the client that are then assured
Advocacy threat
- Can occur when an audit firm or assurance staff act, or is believed to act, on behalf of
assurance client
- Can lead to questioning of auditor’s objectivity
- Examples:
+ Encouraging others to buy client’s shares or bonds
+ Representing client in negotiations with third party
+ Representing the client in a legal dispute
Familiarity threat
- Can occur when close relationship exists or develops between assurance firm or its staff
and client, or firm and client personnel
- Assurance staff can become too sensitive to needs of client and lose objectivity
- Examples:
+ Long association between assurance firm and client
+ Long association between assurance firm and client personnel
- Former partner of assurance firm holding senior position at the client
- Acceptance of gifts by members of assurance team from their client (other than minor
tokens)
- Acceptance of hospitality by members of assurance team from client (other than minor
gestures)
Intimidation threat
- Can occur when member of assurance team feels threatened by the client’s staff or
directors
- Assurance team member unable to act objectively, fearing negative consequences
- Examples:
 + Threat that client will use different assurance firm next year
+ Undue pressure to reduce audit hours to reduce fees paid
 Additional requirements for public companies with market capitalization and a book value of
total assets great than $10 million include:
o Mandatory partner rotated
o Audit committee must pre-approve all services provided to the client
o Audit partners not to be directly compensated for selling non- assurance services to
client
 Additional requirements:
o Auditor cannot perform certain prohibited services– examples include actuarial, human
resources, and tax calculations
o If engagement team member accepts employment in financial reporting role with client,
firm refrains from being the auditor of client for one year from last filing of financial
statements
 Safeguards to independence
o Created by profession, legislation, or regulation
- Quality control standards
- Education and Code of ethics
- Legislative requirement to be independent
o Created by clients and accounting firms
- Created by clients
+ Corporate governance
+ Policies and procedures
- Created by accounting firms
+ Quality control procedures and education
+ Client acceptance and continuance

Auditor’s Relationships with Others

Shareholders

 Audit report addressed to them

 Attendance at AGM
 Formal responsibility for auditor appointment
Board of directors

 Represents shareholders
 Executive and non-executive directors
 Large companies have committees made up of several directors to deal with specific issues
Audit committee

 A special committee of the board of directors

 Acts on behalf of board in financial reporting and audit matters
  Canadian Securities Administrators require all listed companies must have an audit committee
 Aid to auditor independence
o Non-executive directors, majority independent
o At least three independent directors must be financially literate
o Meets with external and internal auditors
 Internal auditors
o Viewed by external auditor as part of client
o External auditor can modify the nature and timing of their procedures and reduce the
extent of their testing if there is an effective internal audit function (CAS 610)
o Modifications by external auditor depends on internal auditor’s:
- Objectivity
- Technical competence
- Due professional care
- Communication with external auditors

Legal Liability
 External auditor must exercise due care, be diligent in applying standards and documenting
work
 Auditor can be found negligent and liable for damages under tort law if it is established that:
o A duty of care was owed by the auditor
o There was a breach of the duty of care
o A loss was suffered as a consequence of that breach
 Legal liability to clients:
o Liability under either contract or tort law
o Negligence: failed in performance of audit by being careless and breaching duty of care
o Contract: failed to live up to their responsibilities agreeing to act as the auditor and
explicit in engagement letter
 Contributory Negligence
Where a plaintiff (party suing) and the defendant (the auditor) can be proven to have been
negligent, each party must be held responsible in proportion to their guilt
 Legal liability to third parties
o Third party = anyone other than the client and its shareholders who use the financial
information to make a decision
o No contract between auditor and third parties
o Need to establish that:
- a duty of care was owed to the third party and
- the auditor’s negligence was responsible for the third party’s loss
 Auditor can take steps to avoid litigation:
o Hire competent staff, regular training
o Comply with ethical and auditing regulations
o Implement policies and procedures:
 - Client acceptance
- Staff allocation
- Ethical and independence issue identification dealt with on a timely basis
- Adequate work documentation
- Gather adequate and appropriate evidence to support opinion
o Meet with client’s audit committee to discuss significant issues arising in audit
o Follow up any significant weaknesses in client’s internal control procedures from
previous year’s audit

Client Acceptance and Continuance

 The first stage in any audit is client acceptance or continuance decision
 Guidance provided in CSQC1
o Step 1: Assess client integrity
o Step 2: Assess audit firm’s ability to meet ethical requirements, service client
o Step 3: Prepare client engagement letter

Client integrity - Auditor should consider:

- Reputation of client, management, directors, key stakeholders
- Client’s reason for switching auditor
- Client’s attitude to risk exposure and management
- Client’s attitude to using internal controls to mitigate risk
- Appropriateness of the client’s interpretation of accounting rules
- Client’s willingness to allow auditor full access to information required to form an opinion
- Client’s attitude and willingness to pay fair amount for audit work
Auditor can obtain information from:
- Communication with prior auditor, client personnel, third parties, key competitors
- Review of press articles and internet or background search
- Review of prior period financial statements
Ethical requirements
- Consider if any threats to fundamental principles arise from appointment
- Auditor must ensure it has sufficient staff available with required knowledge to complete audit
(professional competence and due care)
- Consider potential safeguards and remedies
- Decline appointment if threat insurmountable
Engagement letter (CAS 210)
- Prepared by auditor, acknowledged by client (need to update each year)
- Explains scope of audit
- Summarizes the responsibilities of both management and the auditor
- Identifies the applicable financial reporting framework
- References the expected form/content of audit report
- See Figure 2.6 in text for example
For the following scenario, state the violation(s) to the Rules of Professional Conduct:
David Collier, CPA, obtained his designation in 2000. Since that time, he has built up a significant
tax practice. In late 2015, a new client approached David and asked him to perform an audit
engagement. Believing this could lead to a substantial amount of tax work in the future, David
agreed, even though he had not taken any accounting or assurance courses for many years. In
performing the audit engagement, David obtained an engagement letter, put the financial
statements together based on the clients trial balance, and attached a review engagement report.
The financial statements contained a material error.