Chapter Two: The Auditing Profession

Good Auditing Includes Good Client Service

‘‘It had been a good week,” thought Jeanine Wilson, as she drove out of the parking lot of
Solberg Paints on Friday afternoon. Just a few months earlier, she graduated from State
University and sat for the CPA examination. Still, Jeanine did not think her transition to
professional life had been all that smooth, and she was surprised at how much there still was to
learn. But she had made great progress on the Solberg job. John Hernandez was the audit senior
on the Solberg Paints audit, and he had a reputation as a patient teacher and supervisor. Jeanine
was not disappointed. At the start of the engagement, John told her, “Don’t be afraid to ask
questions. If you see anything that seems unusual, let’s discuss it.
And most importantly, if you have any ideas that will help the client, bring them up. The client
expects us to deliver more than an audit report.’’
‘‘I’d say I delivered,” thought Jeanine. She found an error in the way the company had calculated
LIFO inventory that was going to save the client a significant amount of taxes. But her biggest
contribution almost did not happen. Jeanine read as much as she could about paint manufacturers
and learned about some new production control methods that seemed like they could apply to
Solberg. She was afraid to bring it up, thinking that she couldn’t possibly know any thing that the
client didn’t already know, but John encouraged her to discuss it with the client. The result was
that the client wanted to meet further with Jeanine’s firm to better understand how they could
improve their production processes.
Friday was the last day of field work on the audit, and the partner, Bill Marlow, was at the
client’s office to complete his review of the audit files. Jeanine was surprised to hear him say to
her, “What are you doing on the 15th? We’re going to meet with the client to discuss our audit
findings. You’ve made a real contribution on this audit, and I’d like you to be there.” Jeanine
tried not to show her excitement too much, but she couldn’t hide the smile on her face. “Yes, it
had been a good week.’’
We learned in the first chapter that auditing plays an important role in society by reducing
information risk and facilitating access to capital and that audit firms provide additional, value-
added service to their clients. As the opening story to this chapter demonstrates, audit
professionals at all experience levels serve as valued advisors to their clients. \
International Vs U.S auditing standards
Auditing standards are general guidelines to aid auditors in fulfilling their professional
responsibilities in the audit of historical financial statements. They include consideration of
professional qualities such as competence and independence, reporting requirements, and
evidence. The three main sets of auditing standards are International Standards on Auditing, U.S.
Generally Accepted Auditing Standards for entities other than public companies, and Public
Company Accounting Oversight Board (PCAOB) Auditing Standards.
International Standards on Auditing (ISAs) are issued by the International Auditing and
Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC).
IFAC is the worldwide organization for the accountancy profession, with 159 member
organizations in 124 countries, representing more than 2.5 million accountants throughout the
world. The IAASB works to improve the uniformity of auditing practices and related services
throughout the world by issuing pronouncements on a variety of audit and attest functions and by
promoting their acceptance worldwide.

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ISAs do not override a country’s regulations governing the audit of financial or other
information, as each country’s own regulations generally govern audit practices.
These regulations may be either government statutes or statements issued by regulatory or
professional bodies.
U.S. Generally Accepted Auditing Standards
Auditing standards for private companies and other entities in the United States are established
by the Auditing Standards Board (ASB) of the AICPA. These standards are referred to as
Statements on Auditing Standards (SASs). These Generally Accepted Auditing Standards
(GAAS) are similar to the ISAs, although there are some differences.
If an auditor in the United States is auditing historical financial statements in accordance with
ISAs, the auditor must meet any ISA requirements that extend beyond GAAS.
PCAOB Auditing Standards.
The PCAOB initially adopted existing auditing standards established by the ASB as interim audit
standards. In addition, the PCAOB considers international auditing standards when developing
new standards. As a result, auditing standards for U.S. public and private companies are mostly
similar. Standards issued by the PCAOB are referred to as PCAOB Auditing Standards in the
audit reports of public companies and when referenced in the text, and apply only to the audits of
public companies.
Generally Accepted Auditing Standards
The broadest guidelines available to auditors in the U.S. are the 10 generally accepted auditing
standards (GAAS), which were developed by the AICPA. Generally accepted auditing
standards fall into three categories:
 General standards
 Standards of field work
 Reporting standards
These standards are not sufficiently specific to provide any meaningful guide to practitioners, but
they do represent a framework upon which the AICPA can provide interpretations.

General standards

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The general standards stress the important personal qualities that the auditor should possess.
 Adequate Technical Training and Proficiency: - The first general standard is normally
interpreted as requiring the auditor to have formal education in auditing and accounting,
adequate practical experience for the work being performed, and continuing professional
education. Recent court cases clearly demonstrate that auditors must be technically qualified
and experienced in those industries in which their audit clients are engaged. In any case in
which the CPA or the CPA’s assistants are not qualified to perform the work, a professional
obligation exists to acquire the requisite knowledge and skills, suggest someone else who is
qualified to perform the work, or decline the engagement.
 Independence in Mental Attitude:-The Code of Professional Conduct and SASs stress the
need for independence. CPA firms are required to follow several practices to increase the
likelihood of independence of all personnel. For example, there are established procedures on
larger audits when there is a dispute between management and the auditors.
 Due Professional Care: - The third general standard involves due care in the performance of
all aspects of auditing. Simply stated, this means that auditors are professionals responsible
for fulfilling their duties diligently and carefully. Due care includes consideration of the
completeness of the audit documentation, the sufficiency of the audit evidence, and the
appropriateness of the audit report. As professionals, auditors must not act negligently or in
bad faith, but they are not expected to be infallible.
Standards of Field Work
The standards of field work concern evidence accumulation and other activities during the actual
conduct of the audit.
 Adequate Planning and Supervision: - The first standard requires that the audit be
sufficiently planned to ensure an adequate audit and proper supervision of assistants.
Supervision is essential in auditing because a considerable portion of the field work is done
by less experienced staff members.
 Understand the Entity and its Environment, Including Internal Control: - To
adequately perform an audit, the auditor must have an understanding of the client’s business
and industry. This understanding helps the auditor identify significant client business risks
and the risk of significant misstatements in the financial statements. For example, to audit a
bank, an auditor must understand the nature of the bank’s operations, federal and state
regulations applicable to banks, and risks affecting significant accounts such as loan loss
reserves. One of the most widely accepted concepts in the theory and practice of auditing is
the importance of the client’s system of internal control for mitigating client business risks,
safeguarding assets and records, and generating reliable financial information. If the auditor
is convinced that the client has an excellent system of internal control, one that includes
adequate internal controls for providing reliable data, the amount of audit evidence to be
accumulated can be significantly less than when controls are not adequate. In some
instances, internal control may be so inadequate as to preclude conducting an effective audit.
 Sufficient Appropriate Evidence: - Decisions about how much and what types of evidence
to accumulate for a given set of circumstances require professional judgment. A major
portion of this book is concerned with the study of evidence accumulation and the
circumstances affecting the amount and types needed.

Standards of Reporting

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The four reporting standards require the auditor to prepare a report on the financial statements
taken as a whole, including informative disclosures. The reporting standards also require that the
report state whether the statements are presented in accordance with GAAP and also identify any
circumstances in which GAAP have not been consistently applied in the current year compared
with the previous one.
Summary of Generally Accepted Auditing Standards

Professional Ethics
Broadly defined, the term ethics represents the moral principles or rules of conduct recognized
by an individual or group of individuals. Ethics apply when an individual has to make a decision
from various alternatives regarding moral principles.
All recognized professions have developed codes of professional ethics. Professional ethics refer
to the basic principles of right action for the member of a profession. Professional ethics may be
regarded as a mixture of moral and practical concepts. Thus the professional ethics of an
accountant would signify his behavior towards his fellows in the profession and other
professions and towards members of the public.
The fundamental purpose of such codes is to provide members with guidelines for maintaining a
professional attitude and conducting themselves in a manner that will enhance the professional
stature of their discipline.
The AICPA code of professional conduct considers the following to be followed by auditors
(accountants) in the conduct of professional relations with others.
- Integrity: - An accountant should be straightforward, honest and sincere in his approach to
his professional work.

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- Objectivity: - An accountant should be fair and should not allow bias to override his
objectivity. When reporting on financial statements, which comes his review, he should
maintain an impartial attitude.
- Independence: - When in public practice, an accountant should both be and appear to be
free of any interest which might be regarded, whatever its actual effect, as being
incompatible with integrity and objectivity.
- Confidentiality:
Confidentiality: - A professional accountant should respect the confidentiality of
information acquired in the course of his work and should not disclose any such information
to a third party without specific authority or unless there is a legal or professional duty to
disclose.
- Technical standards: - An accountant should carry out his professional work in accordance
with the technical and professional standards relevant to that work.
- Professional competence: - An accountant has a duty to maintain his level of competence
throughout his professional career. He should only undertake works, which he or his firm
can expect to complete with professional competence.
- Ethical behavior: - An accountant should conduct himself with a good reputation of the
profession and refrain from any conduct, which might bring discredit to the profession.
- Contingent fees: - The AICPA code of professional conduct prohibits a CPA firm from
rendering any professional services on a contingent fee basis.
- Responsibilities to colleagues: - The auditor should promote cooperation and good relations
with other members of the profession.
- Advertising: - The advertising should not be false or misleading,” should not contravene
“professional good taste,” should not make “unfavorable reflection on the competence or
integrity of the profession,” and should not” involve a statement the contents of which”
cannot be substantiated.
The following are the six core ethical values that the Josephson Institute associates with ethical
behavior:
Trustworthiness includes honesty, integrity, reliability, and loyalty. Honesty requires good faith
intent to convey the truth. Integrity means that the person acts according to conscience,
regardless of the situation. Reliability means making all reasonable efforts to fulfill
commitments. Loyalty is a responsibility to promote and protect the interests of certain people
and organizations.
Respect includes notions such as civility, courtesy, decency, dignity, autonomy, tolerance, and
acceptance.
A respectful person treats others with consideration and accepts individual differences and
beliefs without prejudice.
Responsibility means being accountable for ones actions and exercising restraint. Responsibility
also means pursuing excellence, self-restraint, and leading by example, including perseverance
and engaging in continuous improvement.
Fairness and justice include issues of equality, impartiality, proportionality, openness, and due
process. Fair treatment means that similar situations are handled consistently.
Caring means being genuinely concerned for the welfare of others and includes acting
altruistically and showing benevolence.
Citizenship includes obeying laws and performing one’s fair share to make society work,
including such activities as voting, serving on juries, conserving resources, and giving more than
one takes

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Legal Responsibility and Liability of Auditors
The auditor is responsible for his report. The auditor then has certain duties to fulfill to the users
of the financial statements that he reports on. Responsibilities impose liabilities if things go
wrong.
Liable for what?
The CPA can be sued under the following legal concepts.
(i) Prudent man concept: - The auditor is responsible for exercising due professional
care, and he is subject to lawsuit if he fails to do so.
(ii) Liable for acts of others: - The partners are jointly liable for civil actions against a
partner.
(iii) Lack of privileged communication: - CPAS do not have the right under common
law to withhold information from the courts on the grounds that the information is
privileged.
Definition of Terms
Negligence: is violation of legal duty to exercise a degree of care that an ordinary prudent
person would exercise under similar circumstances with resultant damages to another party.
Gross negligence: is lack of event slight care. Many jurisdictions consider gross negligence
equivalent to constructive fraud.
fraud.
Fraud: is defined a misrepresentation by a person of a material fact, known by that person to be
untrue.
Constructive fraud: differs from fraud as defined above in that constructive fraud does not
involve a misrepresentation with the intent to deceive.
Breach of contact: is failure of one or both parties to a contract to perform in accordance with
the contract’s provisions.
Proximate cause: exists when damage to another is directly attributable to a wrongdoer’s act.
Contributory negligence: is negligence on the part of the client that has contributed to his or her
having incurred a loss.
A. Auditors’ liability to their clients
When CPAs take on any type of engagement, they are obliged to render due professional care.
This obligation exists whether or not it is specifically set forth in the written contract with the
client. Thus, CPAs are liable to their clients for any losses proximately caused by the CPA’s
failure to exercise due professional care. That is to recover its losses; an injured client need only
prove that the auditors were guilty of negligence and that the auditors’ negligence was the
proximate cause of the client’s losses.
B. Auditors’ liability to third parties
Bankers and other creditors or investors who utilize financial statements covered by an audit
report can recover damages from the auditors if it can be shown that the auditors were guilty of
fraud or gross negligence in the performance of their professional duties.

Moreover, the auditors can be held liable for negligence to a limited class of third parties if the
auditors have actual knowledge of such third parties or if there exists a special relationship
between the auditors and the third parties.

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The clients (plaintiffs) must prove that they sustained losses that they relied on the audited
financial statements, which were misleading, that this reliance was the primate cause of their
losses, and that the auditors were negligent.
C. Auditors’ responsibility for the detection of fraud and error
The detection and prevention of error and fraud is the management’s responsibility by designing
and implementing appropriate internal control systems. The auditor is not responsible for the
prevention and detection of error and fraud. The auditor is responsible to design audit
procedures to reduce the risk of not detecting a material error or fraud, to an appropriate level to
provide reasonable assurance. Accordingly, the auditor must exercise due care in planning,
performing, and evaluating the results of audit procedures.

An ethical dilemma is a situation a person faces in which a decision must be made about the
appropriate behavior. A simple example of an ethical dilemma is finding a diamond ring, which
necessitates deciding whether to attempt to find the owner or to keep it. A far more difficult
ethical dilemma to resolve is the following one, taken from Easier Said Than Done, a publication
dealing with ethical issues. It is the type of case that might be used in an ethics course.
• In Europe, a woman was near death from a special kind of cancer. There was one drug that the
doctors thought might save her. It was a form of radium that a druggist in the same town had
recently discovered. The drug was expensive to make, but the druggist was charging ten times
what the drug cost him to make. He paid $200 for the radium and charged $2,000 for a small
dose of the drug. The sick woman’s husband, Heinz, went to everyone he knew to borrow the
money, but he could only get together about $1,000, which is half of what it cost.
He told the druggist that his wife was dying and asked him to sell it cheaper or let him pay later.
But the druggist said: “No, I discovered the drug and I’m going to make money from it.” So
Heinz got desperate and broke into the man’s store to steal the drug for his wife. Should the
husband have done that?

What are the steps to resolve ethical dilemma?

The six-step approach that follows is intended to be a relatively simple approach to resolving
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.