CHAPTER TWO

PROFESSIONAL RESPONSIBILITY AND

LIABILITIES OF AUDITORS

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 What Are Ethics?

Ethics can be defined broadly as

a set of moral principles or values.

Each of us has such a set of values.

We may or may not have considered

them explicitly.

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 Need for Ethics

Ethical behavior is necessary for a society

to function in an orderly manner.

The need for ethics in society is sufficiently

important that many commonly held
ethical values are incorporated into laws.

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 Why People Act Unethically

The person’s ethical standards are different

from those of society as a whole.

The person chooses to act selfishly.

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 A Person Chooses to
Act Selfishly – Example
Person A finds a briefcase containing
important papers and $1,000.

He tosses the briefcase and keeps the money.

He brags to his friends about his good fortune.

This action probably differs from most of society.

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 A Person Chooses to
Act Selfishly – Example
Person B faces the same situation but
responds differently.

He keeps the money but leaves the briefcase.

He tells nobody and spends the money.

He has violated his own ethical standards

and chose to act selfishly.

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 Ethical Dilemmas

An ethical dilemma is a situation a person

faces in which a decision must be made
about appropriate behavior.
A simple example of ethical dilemma is
finding a diamond ring which necessitates
deciding whether to attempt to find the owner
or to keep it.

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 Rationalizing unethical Behavior
There are alternative ways to resolve ethical dilemmas,
but care must be taken to avoid methods that are
rationalizations of unethical behavior. The following are
rationalization methods commonly employed that can
easily result in unethical conduct:
Everybody does It
If It’s Legal, It’s Ethical
Likelihood of Discovery and Consequences

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 Resolving ethical dilemmas
 Formal frameworks have been developed to help people
resolve ethical dilemmas.
 The purpose of such a framework is to help identify the
ethical issues and decide an appropriate course of
action using the person’s own values.
 The six-step approach to resolving ethical dilemmas:

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 Cont’d
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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 Special Need for Ethical Conduct in
Professions
Our 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.

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 Difference Between CPA Firms and
Other Professionals
CPA firms are engaged and paid by the
company issuing the financial statements.

Primary beneficiaries of the audit are

statement users.

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 Code of Professional Conduct

Ideal standards of ethical conduct

Principles stated in philosophical terms.
They are not enforceable.
Minimum standards of ethical
Rules of
conduct stated as specific rules.
conduct
They are enforceable.
Interpretation of the rules of conduct by
Interpretations
the AICPA Division of Professional Ethics.
of the rules
They are not enforceable, but a
of conduct
practitioner must justify departure.

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 Code of Professional Conduct

Published explanations and answers

to questions about the rules of
conduct submitted to the AICPA by
Ethical
practitioners and others interested
rulings
in ethical requirements.
They are not enforceable, but a
practitioner must justify departure.

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 Ethical Principles

1. Responsibilities:
Professionals should exercise sensitive and
moral judgments in all their activities.

2. The public interest:

Members should accept the obligation to act
in a way that will serve and honor the public.

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 Ethical Principles

3. Integrity:
Members should perform all responsibilities
with integrity to maintain public confidence.

4. Objectivity and independence:

Members should be objective, independent,
and free of conflicts of interest.

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 Ethical Principles

5. Due care:
Members should observe the profession’s
standards and strive to improve competence.

6. Scope and nature of services:

A member in public practice should observe
the Code of Professional Conduct.

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 Standards of Conduct
Ideal conduct
Principles
by practitioners

Minimum level
Rules of
of conduct by
conduct
practitioners Substandard
conduct

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 Independence

The value of auditing depends heavily

on the public’s perception of the
independence of auditors.

 Independence in fact

 Independence in appearance

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 Audit Committees

An audit committee is a selected number

of members of a company’s board of directors
whose responsibilities include helping
auditors remain independent of management.

Most audit committees are made up of three

to five or sometimes as many as seven
directors who are not a part of company
management.

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 Audit Committees

The Sarbanes-Oxley Act requires that all

members of the audit committee
be independent.

Companies must disclose whether or not

the audit committee includes at least
one financial expert.

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 Conflicts Arising from Employment
Relationships

The SEC has added a one year “cooling off ”

period before a member of the audit
engagement team can work for the
client in certain key management positions.

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 Partner Rotation

The Sarbanes-Oxley Act requires that

the lead and concurring audit partner
rotate off the audit engagement
after a period of five years.

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 Ownership Interests

SEC rules on financial relationships

take an engagement perspective.

SEC rules prohibit ownership in

audit clients by those persons
who can influence the audit.

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 Other Issues
 Shopping for accounting principles

 Engagement and payment of

audit fees by management

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 Rules of Conduct
 Rule 101 – Independence

A member in public practice shall be

independent in the performance of
professional services as required by
standards promulgated by bodies
designated by Council.

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 Financial Interests

Interpretations of Rule 101 prohibit

covered members from owning any
direct investments in audit clients.

 Covered members

 Direct versus indirect financial interest

 Material or immaterial

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 Related Financial
Interests Issues
 Former practitioners
 Normal lending procedures
 Financial interests and employment
of immediate and close family members
 Joint investor or investee relationship
with client
 Director, officer, management,
or employee of a company

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 Litigation Between CPA Firm
and Client
A lawsuit or intent to start a lawsuit between
a CPA firm and its client, the ability of the
CPA firm and client to remain objective
is questionable.

The interpretations regard such litigation as

a violation of Rule 101.

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 Bookkeeping and Other Services

The AICPA Code permits a CPA firm

to do both bookkeeping and auditing
for a nonpublic client.

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 Bookkeeping and Other Services

1. Client must accept full responsibility

for the financial statements.

2. The CPA must not assume the role

of employee or of management.

3. The audit must conform to use of auditing standards.

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 Bookkeeping and Other Services

The SEC and AICPA rules do not allow

audit firms to provide bookkeeping
services to public company audit clients.

 Consulting and other nonaudit services

 Unpaid fees

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 Auditors’ legal liabilities
 Professionals have always been required to provide a reasonable
level of care while performing work for those they serve.
 Under common law, audit professionals have responsibility to fulfill
implied or expressed contracts with clients.
 Should auditors fail to provide the services or not exercise due care
in their performance, they are liable to their clients for negligence
and/or breach of contract, and, in certain circumstances, to parties
other than their clients.

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 DISTINGUISHING BUSINESS FAILURE, AUDIT
FAILURE, AND AUDIT RISK
 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

A business failure occurs when a business is unable to repay its lenders

or meet the expectations of its investors.
Audit failure occurs when the auditor issues an incorrect audit opinion
because it failed to comply with the requirements of auditing
standards

Audit risk represents the possibility that the auditor concludes after
conducting an adequate audit that the financial statements were fairly
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stated when, in fact, they were materially misstated.
 Cont’d
 In cases of audit failure, the law often allows parties who suffered
losses to recover some or all of the losses caused by the audit failure

 The conflict between statement users and auditors often arises

because of an “expectation gap” between users and auditors.

 Most auditors believe that the conduct of the audit in accordance

with auditing standards is all that can be expected of auditors.

 However, many users believe that auditors guarantee the accuracy of

financial statements, and some users even believe that the auditor
guarantees the financial viability of the business.

 Fortunately for the profession, courts continue to support the

auditor’s view.
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 Legal concepts affecting liability
 A CPA is responsible for every aspect of his or her public
accounting work, including auditing, taxes, management advisory
services, and accounting and bookkeeping services.
 Legal concepts pertinent to lawsuits involving CPAs.
1. Prudent Person Concept
There is agreement within the profession and the courts that the auditor
is not a guarantor or insurer of financial statements. The auditor is
expected only to conduct the audit with due care, and is not expected
to be perfect. This standard of due care is often called the prudent
person concept.
2. Liability for the Acts of Others

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 2. Liability 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 a partner
or any owner. Professional corporation dos not have limited
liability.
 The partners may also be liable for the work of others on whom
they rely under the laws of agency.
 The three groups an auditor is most likely to rely on are employees,
other CPA firms engaged to do part of the work, and specialists
called upon to provide technical information.
 If an employee performs improperly in doing an audit, the partners
can be held liable for the employee’s performance.

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 3. Lack of Privileged Communication
 Under common law, CPAs do not have the right to withhold
information from the courts on the grounds that the information is
privileged.
 Confidential discussions between the client and auditor cannot be
withheld from the courts

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 Definitions of legal terms
Ordinary negligence: Absence of reasonable care that can be
expected of a person in a set of circumstances. For auditors, it is in
terms of what other competent auditors would have done in the same
situation.
Gross negligence: Lack of even slight care, tantamount to reckless
behavior that can be expected of a person. Some states do not
distinguish between ordinary and gross negligence.
Constructive fraud: Existence of extreme or unusual negligence even
though there was no intent to deceive or do harm. Constructive fraud
is also termed recklessness.
Fraud: Occurs when a misstatement is made and there is both the
knowledge of its falsity and the intent to deceive
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 Cont’d
Breach of contract: Failure of one or both parties in a contract to
fulfill the requirements of the contract. An example is the failure of a
CPA firm to deliver a tax return on the agreed-upon date. Parties who
have a relationship that is established by a contract are said to have
privity of contract.
Third-party beneficiary: A third party who does not have privity of
contract but is known to the contracting parties and is intended to have
certain rights and benefits under the contract

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 Sources of Legal Liability
1. Liability to clients
2. Liability to third parties under common law
3. Civil liability under the federal securities laws
4. Criminal liability
1. Liability to clients
The most common source of lawsuits against CPAs is from clients.
The suits vary widely, including such claims as:
Failure to complete an non- audit engagement on the agreed-upon
date
Inappropriate withdrawal from an audit
Failure to discover an embezzlement (theft of assets), and
Breach of the confidentiality requirements of CPAs.

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 Cont’d
For a claim that the auditor did not discover an employee theft as a
result of negligence in the conduct of the audit.
For breach of contract, a tort action for negligence, or both.

Auditor’s Defenses against Client Suits

The CPA firm normally uses one or a combination of four defenses
when there are legal claims by clients:
1. Lack of duty to perform the service
2. Non-negligent performance
3. Contributory negligence, and
4. Absence of causal connection.
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 2. LIABILITY TO THIRD PARTIES UNDER COMMON LAW
 In addition to being sued by clients, CPAs may be liable to
third parties if a loss was incurred by the claimant due to
reliance on misleading financial statements.
 Third parties include actual and potential stockholders,
vendors, bankers and other creditors, employees, and
customers.
 A typical suit occurs when a bank is unable to collect a major
loan from an insolvent customer and the bank then claims that
misleading audited financial statements were relied on in
making the loan and that the CPA firm should be held
responsible because it failed to perform the audit with due
care.
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 Auditor defenses against third-party suits
 Three of the four defenses available to auditors in suits by clients
are also available in third-party lawsuits:
1. Lack of duty to perform the service
2. Non-negligent performance, and
3. Absence of causal connection.
 Contributory negligence is ordinarily not available because a third
party is not in a position to contribute to misstated financial
statements

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 3. CIVIL LIABILITY UNDER THE FEDERAL SECURITIES LAWS
 In addition to common law, auditors may be held liable to third
parties under statutory law.
Example: Combined group of stockholders sues auditors for not
discovering materially misstated financial statement
4. CRIMINAL LIABILITY
 In rare cases, auditors have even been held liable for criminal acts.
Example: Federal government prosecutes sue auditors for knowingly
issuing an incorrect audit report

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 End of Chapter Two

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