Chapter Three: professional Ethics and Legal liability of auditors

3.1: Introduction
3.2: What is professional ethics
3.3: Need for ethics and ethical dilemmas
3.4: Special need for ethical conduct for Auditing
profession
3.5: AICPA code of professional conduct
3.6: Audit Committes
3.7: Legal Liability of Auditors
3.8: Legal terms affecting auditors liability
3.9: Major Sources of Auditors liability
3.10: Auditors defense against clients and third parties
professional Ethics

 There are a number of ethical matters that are extremely important

for auditors to consider when performing their work. It is vital to the
public image and credibility of the profession that the auditor is
seen to be behaving in an acceptable manner in addition to actually
complying with the ethical requirements.
 It is important to recognize that many groups in society rely on
accountant/auditors work and an accountant/auditor therefore
has a public accountability.
professional Ethics

Introduction
 professional ethics refers 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.
 Professional ethics in public accounting as in other professions,
have been developed gradually and are still in a process of change
as the practice of accounting it self changes.
 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 status of
their discipline
professional Ethics

The AICPA Code of Conduct: The Code of Ethics for Professional Auditors establishes
ethical requirements for professional auditors and provides a conceptual framework for all
professional auditors to ensure compliance with the following fundamental principles of professional
ethics. These principles are:
1. Independence
2. Integrity,
3. Objectivity,
4. Professional competence and due care,
5. Confidentiality, and
6. Professional behavior
7. Technical Standards
professional Ethics
The SEC adopted rules to strengthen independence with respect to a
number of issues between CPA and client:
 Financial interests--the issue is whether a material direct investment

by an auditor in an auditee, or indirect investment by a family

member of an auditor compromises independence;
Former practitioners who may have a relationship with the auditee;
 Loans between an auditing firm and its client;
professional Ethics
 Financial interests of close family members;
 Joint investor or investee relationship with a client;
 Membership on the board of directors of the auditee;
 Litigation involving a CPA firm and its client may serve to limit
independence as well.
 Consulting and other non-audit services provided to the client.
 Unpaid fees that the client owes to the CPA.
professional Ethics

Integrity
 A professional accountant should be straightforward and honest in all professional
and business relationships.
 The principle of integrity imposes an obligation on all professional accountants to be

straightforward and honest in professional and business relationships. Integrity also

implies fair dealing and truthfulness.
 A professional accountant should not be associated with reports, returns,

communications or other information where they believe that the information:

(a) Contains a materially false or misleading statement;
(b) Contains statements or information furnished recklessly; or
(c) Omits or obscures information required to be included where such
omission or obscurity would be misleading
professional Ethics
Objectivity
 A professional accountant should not allow bias, conflict of interest or

undue influence of others to override professional or business judgments.

 The principle of objectivity imposes an obligation on all professional

accountants not to compromise their professional or business judgment

because of bias, conflict of interest or the undue influence of others.
 A professional accountant may be exposed to situations that may impair

objectivity. It is impracticable to define and prescribe all such situations.

Relationships that bias or unduly influence the professional judgment of
the professional accountant should be avoided.
professional Ethics
Professional Competence and Due Care
A professional accountant has a continuing duty to maintain
professional knowledge and skill at the level required to ensure
that a client or employer receives competent professional service
based on current developments in practice, legislation and
techniques.
A professional accountant should act diligently and in accordance
with applicable technical and professional standards when
providing professional services.
professional Ethics
 The principle of professional competence and due care imposes the
following obligations on professional accountants:
(a) To maintain professional knowledge and skill at the level required
to ensure that clients or employers receive competent professional
service; and
(b) To act diligently in accordance with applicable technical and
professional standards when providing professional services.
professional Ethics
 Competent professional service requires the exercise of
sound judgment in applying professional knowledge
and skill in the performance of such service.
Professional competence may be divided into two
separate phases:
(a) Attainment of professional competence; and
(b) Maintenance of professional competence.
professional Ethics
 The maintenance of professional competence requires a continuing
awareness and an understanding of relevant technical professional
and business developments. Continuing professional development
develops and maintains the capabilities that enable a professional
accountant to perform competently within the professional
environments.
 Diligence encompasses the responsibility to act in accordance with
the requirements of an assignment, carefully, thoroughly and on a
timely basis.
professional Ethics
 A professional accountant should take steps to ensure that
those working under the professional accountant’s authority
in a professional capacity have appropriate training and
supervision.
 Where appropriate, a professional accountant should make

clients, employers or other users of the professional services

aware of limitations inherent in the services to avoid the
misinterpretation of an expression of opinion as an assertion
of fact.
professional Ethics
 Confidentiality
A professional accountant should respect the
confidentiality of information acquired as a result of
professional and business relationships and should not
disclose any such information to third parties without
proper and specific authority unless there is a legal or
professional right or duty to disclose.
Confidential information acquired as a result of
professional and business relationships should not be used
for the personal advantage of the professional accountant or
third parties.
professional Ethics
 The principle of confidentiality imposes an obligation
on professional accountants to refrain from:
(a) Disclosing outside the firm or employing
organization confidential information acquired as a
result of professional and business relationships
without proper and specific authority or unless there is
a legal or professional right or duty to disclose; and
(b) Using confidential information acquired as a result of
professional and business relationships to their
personal advantage or the advantage of third parties.
professional Ethics
 A professional accountant should maintain confidentiality
even in a social environment.
 The professional accountant should be alert to the possibility
of inadvertent disclosure, particularly in circumstances
involving long association with a business associate or a close
or immediate family member.
 A professional accountant should also maintain confidentiality
of information disclosed by a prospective client or employer.
A professional accountant should also consider the need to
maintain confidentiality of information within the firm or
employing organization.
professional Ethics
The following are circumstances where professional
accountants are or may be required to disclose
confidential information or when such disclosure may
be appropriate:
a) Disclosure is permitted by law and is authorized by
the client or the employer
b) Disclosure is required by law, for example:
(i) Production of documents or other provision of
evidence in the course of legal proceedings; or
(ii) Disclosure to the appropriate public authorities of
infringements of the law that come to light; and
professional Ethics
(c) There is a professional duty or right to disclose, when
not prohibited by law:
(i) To comply with the quality review of a professional
body;
(ii) To respond to an inquiry or investigation by a
regulatory body;
(iii) To protect the professional interests of a professional
accountant in legal proceedings; or
(iv) To comply with technical standards and ethics
requirements.
professional Ethics
 Professional Behavior: A professional accountant should
comply with relevant laws and regulations and should
avoid any action that discredits the profession.
 The principle of professional behavior imposes an
obligation on professional accountants to comply with
relevant laws and regulations and avoid any action that
may bring discredit to the profession.
 This includes actions which a reasonable and informed
third party, having knowledge of all relevant information,
would conclude negatively affects the good reputation of
the profession.
professional Ethics
 Technical Standards: Audit should be performed
by following certain standards, international or
national.
Ethical dilemmas

 Ethical situations often present conflicting

objectives, and it is sometimes tempting to
rationalize a particular course of action that is
unethical.
 Typical rationalizations for such behavior include:
1) everyone is doing it;
2) it is legal it must also be ethical; and
3) no one will know the difference.
Ethical dilemmas

A process for managing one's personal ethical

dilemmas is as follows:
 Obtain the facts;

 Identify the ethical issues;

 Examine the effects of various outcomes on each

participant;
 Identify alternatives;

 Look at the consequences of each alternative;

 Choose the appropriate action.

Legal Responsibility and Liability of Auditors

The potential liability of CPAs to parties who might be

injured as a result of improper professional practice greatly
exceeds that of other physicians or any group of
professionals.
One reason for this is the large potential number of injured
parties.
If a physician or an attorney is negligent, the injured party
usually consists only of the client.
If a CPA is negligent in expressing an opinion on financial
statements, literally millions of investors may sustain losses.
Legal responsibility and Liability of Auditors

Definition of Terms
 A discussion of auditors’ liability is best prefaced by a

definition of some of the common terms of business laws.

These are:
 Ordinary negligence is violation of a legal duty to exercise a

degree of care that any other prudent person would exercise

under similar circumstances. It is failure to perform a duty
in accordance with applicable professional standards. 
 Gross negligence: is the lack of even slight care. It is a

substantial failure on the part of the auditor to comply

with generally accepted auditing standards (GAAS).
Legal responsibility and Liability of Auditors

 Fraud: is defined as misrepresentation by a person of material

fact known by that person to be untrue or made with reckless
indifference as to whether the fact is true, with the intention of
deceiving the other party and with the result that the other party is
injured.
 Constructive fraud: differs from fraud in that constructive fraud
does not involve a misrepresentation with the intent to deceive the
other party. 
 Privity: is the relationship between parties to a contract. A CPA firm
is in privities with the client and any other third party beneficiary.
 Third party beneficiary: a person who is named in a contract or
intended by contracting parties to have definite rights and benefits
under the contract.
Legal responsibility and Liability of Auditors

 Engagement letter: is the written contract summarizing the contractual

relationship between auditor and client.
 Breach of contract: is failure of one or both parties to a contract to perform in
accordance with the contract’s provisions. 
 Proximate cause: exits when damage to another is directly attributable to a
wrongdoer’s act. The issue of proximate cause may be raised as a defense in
litigation. Even though a CPA firm might have been negligent in rendering
services, it will not be liable if its negligence was not the proximate cause of the
plaintiff’s loss.
 Plaintiff: is the party claiming damages and bringing suit against the defendant.
 Contributory negligence: is negligence on the part of the plaintiff that has
contributed to his or having incurred a loss. Contributory negligence may be used
as a defense, because the court may limit or bar recovery by a plaintiff whose
own negligence contributed to the loss.
 Comparative negligence: is a concept used by certain courts to allocate damages
between negligent parties based on the degree to which each part is at fault.
Legal responsibility and Liability of Auditors

 Notice that negligence, gross negligence and fraud each

represent different degrees of improper performance by the
CPA.
 The extent to which the CPAs services are found to be
improper determines the parties to whom the CPAs are liable
for losses proximately caused by their improper actions.
 CPAs are never liable to any party if they perform their
services with due professional care.
 Having exercised due professional care is a complete defense
against any charge of improper conduct.
Legal responsibility and Liability of Auditors

 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 and third party
beneficiaries for any losses proximately caused by
the CPAs failure to render due professional care .
 In short ordinary negligence is a sufficient degree of
misconduct to make CPAs liable for damages caused to
their clients.
Legal responsibility and Liability of Auditors

Auditors’ responsibility for detection of errors and irregularities

 Auditors’ liability to clients most often arises from the
CPAs’ failure to uncover an embezzlement or defalcation
being perpetrated against the client by clients’ employees.
A client who has sustained such losses may allege that the
auditors’ were negligent in not uncovering the scheme and
sue the auditors for the amount of the loss.
 The key factor in determining whether the auditors’ are
liable is not just whether the auditors failed to uncover the
fraud. Rather, the issue is whether this failure stems from
the auditors’ negligence.
Legal responsibility and Liability of Auditors

 When CPAs’ examination has been made in

accordance with generally accepted auditing standards,
the auditor should not be held liable for failure to
detect the existence of errors or irregularities.
 This is because an audit has certain limitations; it does
not involve a complete and detailed examination of all
records and transactions.
 Thus there can never be an absolute assurance that
errors and irregularities do not exist among the
transactions not included in the auditors’ tests.
Legal responsibility and Liability of Auditors

 To obtain a judgment against its auditors, an injured client must

prove that it sustained a loss as a result of the auditors’ negligence
and the auditors’ negligence is a proximate cause to sustain a
loss.
 As defendants, the auditors’ can refuse this claim by showing that
either they were not negligent in the performance of their duties or
their negligence was not the proximate cause of the client’s loss.
 Demonstrating contributory negligence by the client is one means
of showing that the auditors’ negligence was not the cause (or sole
cause) of the client’s loss.
 The concept of comparative negligence is used to allocate
damages between the client and the auditors based on the extent to
which each is at fault.
Legal responsibility and Liability of Auditors

 In general, the detection and prevention of errors and fraud is

the managements’ responsibility by designing and
implementing appropriate internal control systems.
 The auditor is not responsible for the prevention and
detection of errors 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.
Assignments

Prepare a term paper on the following topics on group basis

1. Auditing in Ethiopia (one group)
History, organization, current status, Business entities required by law
to produce audited Financial Statements in Ethiopia)
2. EDP/IS Auditing ( based on contents of unit seven)

3. Take any corporate business organization and consider its audit reports
of the last two years (two groups)
A. Identify the audited financial statements

B. Evaluate the components of the audit report in each year’s financial

statements
C. Critically examine the audit procedures followed by the audit and the

comments given by the auditor in each year

D. Identify the type of audited opinions given by the auditor and critically

examine the basis of issuing such audit opinion

Assignment

4. Assume you are an independent auditor of XYZ company. During the past three
audits, you have repeatedly warned the top management of the company about the
serious weakness of internal control over cash disbursements. However, management
has not taken any corrective action. Shortly after the audit, XYZ company learned that
two employees in its accounting department had been embezzling money for the last two
years. The embezzlement scheme involved authorizing cash disbursement in various
expense accounts and then arranging to have the checks cashed. The management of
XYZ company has brought suit against you for the amount of its losses in this cash
fraud.
Required:
A-Suggest at least three arguments that you as an auditor can defend your self to lessen or
eliminate the liability.
B-What arguments might XYZ company advance to indicate that you were negligent in
failing to discover the embezzlement scheme?
C-Briefly describe the auditors’ responsibility for the detection of errors and irregularities.
Assignment

5. Internal control system and Internal Audit in Ethiopia:

The Case of x Share Company(Two Groups)
6. Performance Audit in Ethiopia: The Case of x Share Company
7. Compliance Audit in Ethiopia: The Case of x Share Company

Note that
All Assignments will be presented in the class
 Date of submission of the assignments will be May 24,

2015