Audit Principles I Hand Out

Chapter Two
1.1 Auditor’s Professional Ethics

Ethics – can be defined broadly as a set of moral principles or values. Each of us has a set of
values, although we may not have considered them explicitly. Philosophers, religious
organizations and other groups have defined in various ways the idea sets of moral principles and
values. Examples of prescribed sets of moral principles or values at the implementation level
include laws and regulations, church doctrine, codes of business ethics for professional groups
such as CPAs, and codes of conduct within individual organizations.

Ethical behavior is necessary for a society to function in an orderly manner. The underlying
reason for a high level of professional conduct by any profession is the need for public
confidence in the quality of services rendered by the professions.

Most people define unethical behavior, as a conduct that differs from what they believe would
have been appropriate given circumstances. It is believed that there are two primary reasons why
people act unethically: the reasons are first when the person’s ethical standards are different from
those of society as a whole or second when the person chooses to act selfishly. The typical
examples for the former include drug dealers, bank robbers. The later behavior marks a
considerable proportion; examples include political power desire, cheating taxes.

An example of a prescribed set of principles that was developed by the Josephson Institute for
Advancement of Ethics. The Josephson Institute was established as a not-for-profit foundation to
encourage ethical conduct of professionals in the fields of government, law, medicine, business,
accounting, and journalism. The ten prescribed ethical principles are:

a. Honesty f. Caring for others

b. Integrity g. Respect for others
c. Promise keeping h. Responsible citizenship
d. Loyalty (fidelity) i. Pursuit of excellence
e. Fairness j. Accountability

The following are six core ethical values that the Josephson Institute associates with ethical
behavior.

A. 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
organization.

B. Respect includes notions such as civility, courtesy, dignity, tolerance, and acceptance.
A respectful person treats others with consideration and accepts individual differences and
benefits without prejudice.

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C. Responsibility means being accountable for one’s actions and exercising restraints.
Responsibility also means pursuing excellence and leading by example, including perseverance
and engaging in continuous improvement.

D. Fairness and justice include issues of equality, impartiality, proportionality, openness, and
due process. Fair treatment means that similar situations are handed consistently.

E. Caring means being genuinely concerned for the welfare of others and includes acting
altruistically and showing benevolence.

F. Citizenship includes obeying laws and performing one’s share to make society work,
including such activities as voting, serving on juries, and conserving resources.

Ethical Dilemmas

An ethical dilemma is a situation a person faces in which a decision must be made about the
appropriate behavior. A simple example include, finding a diamond ring, which necessitates
deciding whether to attempt to find the owner or to keep it, accepting money informally as a tip
of corruption, killing or keeping alive the patient who is in agony.

Auditors, accountants, and other business people face many ethical dilemmas in their business
careers. Dealing with a client who threatens to seek a new auditors unless an unqualified opinion
(auditor’ opinion for those organizations present their financial statements fairly) is issued
presents a serious 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 large bonus is difficult ethical dilemma. Continuing to be a part of the management
of a company that harasses and mistreats employees or treats customers dishonestly is a moral
dilemma, especially of the person has a family to support and the job market is tight.

The common rationalizations of ethical dilemmas include:

1. Everybody does it – the argument that it is acceptable to falsify things because it is done
by everybody. Examples include, falsify tax returns, cheat on exams, or sell defective
products.

2. If it’s Legal, it’s 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 other person could prove that it was his or hers. Example,
abortion.

3. Likelihood of Discovery and Consequences – this philosophy relies on evaluating the

likelihood that someone else will discover the behavior. Typically, the person also
assesses the severity of the penalty (Consequence) if there is a discovery. An example is
deciding whether to correct an unintentional over billing to a customer when the
customer has already paid the full billing. 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 he/she will wait to see if the customer complains.
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Resolving Ethical Dilemmas

In recent years, formal frameworks have been developed to help people resolve ethical
dilemmas. The purpose of such a framework is in identifying the ethical issues and deciding on
an appropriate course of action using the person’s own values. The six-step approach that
follows is intended to be a relative simple approach to resolve ethical dilemma.

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.

Importance of ethical conduct in professions

The term profession means a responsibly for conduct (behavior) that extends beyond discharging
own responsibilities and beyond the requirements of society’s laws and regulations. This may
involve personal sacrifices. The central rationale behind code of conduct is getting Public
Confidence. Public confidence is more important for CPAs than other professions in that unlike
other professions, users of CPAs works are the general public even though they get their fees
from their clients.

1.1.1 Code of Professional Conduct

A code of conduct can consist of general statements of ideal conduct or specific rules that define
unacceptable behavior. The advantage of general statements is the emphasis on positive The
American Institute of Certified Public Accountants (AICPA) code of professional conduct
provides both general standards of ideal conduct and specific enforceable rules of conduct. There
are four parts to the code:

a- Principles In order of increasing

b- Rules of conduct specificity.
c- Interpretations of the rules of conduct
d- Ethical rulings

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Code of Professional Conduct.

Ideal standards of ethical conduct stated in philosophical terms.

Principles
They are not enforceable

Minimum standards of ethical conduct stated as specific rules.

Rules of Conduct
They are enforceable

Interpretations of the rules of conduct by the AICPA division of Professional

Ethics.
Interpretation of the
Rules of Conduct They are not enforceable, but a practitioner must
justify departure.

Published explanations and answers to questions about the rules of conduct

submitted to the AICPA by practitioners and others interested in ethical
Ethical Rulings requirements.

They are not enforceable, but a practitioner must

justify departure.

I. Ethical principles
There are six principles of professional conduct.
1. Responsibilities – in carrying out their responsibilities as professionals, auditors should
exercise sensitive professional and moral judgment in all their activities.
2. The public interest – Auditors should accept the obligation to act in a way that will
serve the public interest, honor the public trust, and demonstrate commitment to
professionalism.
3. Integrity – To maintain and broaden public confidence, members should perform all
professional responsibilities with the highest sense of integrity.
4. Objectivity & Independence – An Auditor 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.
5. Due Care – An Auditor should observe the professional’s technical and ethical
standards, strive, and discharge professional responsibility to the best of the member’s
ability.
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.

The first five principles apply to all members of the AICPA auditors, both internal & external
and accountants; while the last one is applicable to those who make public practice.

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II. Rules of Conduct and their Interpretations

III. Ethical Rulings

Are published explanations and answers to questions about the rules of conduct submitted to the
AICPA by practitioners and other interested in ethical requirements. They are not enforceable,
but a practitioner must justify departure.

1.2 Audit Objectives & Responsibilities

1.2.1 Audit Responsibilities
The objective of the ordinary audit of financial statements by the independent auditor is the
expression of an opinion on the fairness with which they present fairly, in all material respects,
financial position, results of operations, and its cash flows in conformity with GAAP. This
emphasis on opinion of financial statements is outlined in SAS (Statements of Auditing
Standard)

Although the auditor is not an insurer or a guarantor of the fairness of the presentations, he/she
has considerable responsibility for notifying users whether the statements are properly stated. In
case when situations make difficult to draw conclusions, the auditor has the responsibility to
notify the users through the report.

Steps to develop specific audit Objectives

Understand objectives and responsible for the audit

Divide financial statements into cycles

Know management assertions about accounts

Know general audit objectives for classes of

Transactions and accounts

Know specific audit objectives for classes of

Transactions and account

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Legal Liabilities

Legal liabilities are the professional’s obligation under the law to provide a reasonable level of
care while performing work for those he or she serves.

Audit professionals are liable to their clients for negligence, breach of contract, fail to perform
services or not exercise due care in their performance. Many accounting and legal professionals
believe that a major cause of lawsuits against CPA firms is lack of understanding by financial
statement users of the difference between a business failure and an audit failure and between an
audit failure and audit risk. These three cases help in answering the questions of legal liability.

A business failure – occurs when a business is unable to repay its lenders or meet the
expectations of its investors because of economic or business conditions, such as
recession, poor management decision, or unexpected competition in the industry.
Audit failure – 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).
e.g. assigning unqualified assistants to perform audit tasks who then fail to find
material misstatements that qualified auditor would discover.
Audit risk – represents the risk that the auditor will conclude that the financial
statements are fairly stated and unqualified opinion can be issued when, in fact, they are
materially misstated, even if GAAS is applied.

Legal Concepts
There are several legal concepts apply to lawsuits against CPAs.

1. Prudent Person Concept – the legal that a person has a duty to exercise reasonable care
and diligence in the performance of his/her obligations to another.
2. Liabilities for the acts of others – generally, the partners, or shareholders in the case of
a professional corporation, are jointly liable for the civil actions against owners.

e.g. if an employee performs improperly in doing an audit, the partners can held liable for
the employee’s performance.
3. Lack of Privileged communication – the CPA do not have the right under common law
to withhold information from the court on the grounds that the information is privileged,
including confidential discussions with the client.

Sources of legal Liabilities

There are four sources of auditor’s legal liability.

1. Liability to client under common law – these are the most common sources of lawsuits
against CPAs. They include:
 Failure to complete a non audit engagement on the agreed upon date
 Inappropriate withdrawal from audit
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 Failure to discover defalcations (theft of assets)
 Breaching the confidentiality requirements of CPA
 Negligence performance etc…

2. Liability to the third party under common law – this arises when third part suffers a
loss due to reliance on misleading financial statements. The auditor is liable to the
primarily stated beneficiary of the audit opinion, to foreseen (auditors aware of users)
etc… Third party includes vendors, actual & potential investors, employees bankers &
other creditors, customers etc…
3. Civil liability under the federal law – the auditor can be liable for breaching of federal
security laws and strict standards under the federal laws.
4. Criminal liability – if the auditor knowingly conceals material frauds, he/she faces trial
against criminal law.

Auditor’s Defenses against client’s suits

The CPA firm normally uses one or a combination of four defenses when there are legal claims
by clients.

a- Lack of duty – means that the CPA firm claims that there was no implied or expressed
contract.
e.g. for suits against uncovered misstatements, the CPA firm might claim that the firm
did a review service not an audit.
A common way for a CPA firm to demonstrate a lack of duty to perform is by use of an
engagement letter.
b- Non-negligent Performance – for non-negligent performance in an audit, the CPA firm
claims that the audit was performed in accordance with GAAS.
The Statements of Auditing Standards (SAS) make it clear that an audit in accordance
with GAAS is subject to limitation and cannot be relied on for complete assurance that
misstatements will be found.
c- Contributory Negligence – Exists when the client’s own action either resulted in the loss
that is the basis for damages or interfered with the conduct of the audit in such a way that
prevented the auditor from discovering the cause of the loss.
e.g. when false documents were given by the credit manager.
d- Absence of causal connection – an auditor’s legal defense under which the auditor
contends that the damages claimed by client were not brought about by any act of the
auditor.

Auditor’s Defenses against third-party suits

Three of the four defenses available to auditors in suits by clients are also available in third-party
lawsuits. Contributory negligence is ordinarily not available because a third party is not in a
position to contribute to misstatement of financial statements.

The preferred defense against third-party suits is non-negligence performances.

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