The Auditing Profession

Chapter 2
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 Chapter Objectives
After completing this chapter, you should be able
to:
 define ethics
 describe the purpose of professional ethics in
auditing
 identify the characteristics of a profession
 identify the basic principles of ethics in general
and auditing professional ethics in particular
 discuss rules of professional conduct
 discuss the legal liability of auditors
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 Nature of Ethics
• What is ethics?
 Ethics refers to standards or codes of behavior
expected by the group to which the individual
belongs.
 Ethics is the study of moral problems which seeks to
discover how one ought to act, not how one does in
fact act or how one thinks one should act
 Ethics may include political ethics, social ethics,
company ethics, professional ethics etc

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 Basic ethics principles
- be honest
- have integrity
- keep your promises
- be faithful and loyal
- be fair
- care for others
- respect others
- be a responsible citizen
- pursue excellence
- be accountable
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 Characteristics of a profession
1. Specialized body of knowledge
2. Standard of qualification for admission
3. Standard of conduct of behavior
4. Level of status recognition
5. Acceptance of social responsibility &
legal liability

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 Characteristics of a profession
Special Body of Knowledge
 A highly developed profession has a very highly
specialized written body of knowledge.
Standard of Qualification for Admission
 A profession to be a profession must have well-
recognized and accepted predetermined criteria of
qualification for admission into the profession.
Standard Conduct of Behavior
• A profession has a standard conduct of behavior to be
observed by the professional through prescribed code of
ethics that attempt to enforce general rules of conducts, and
maximum and minimum rules of competence and
responsibility to client and colleagues. 6
 Characteristics of a profession
Level of Status Recognition
The quality and level of professional
services demanded by society determines
the level of status recognition to the
profession.
Acceptance of Social Responsibility
A profession to be a profession must
accept responsibility for the consequences
of its action.
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 PROFESSIONAL QUALIFICATION
REQUIREMENTS
 The professional qualification requirements for
auditors or qualified public accountants (CPA) in
various countries is more or less the same. The
most common elements in are:
1. minimum educational background which
nowadays is being pushed higher and higher
2. completion of required specialized body of
knowledge as prescribed by the profession and
proved through the passing of qualifying
examinations

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 PROFESSIONAL QUALIFICATION
REQUIREMENTS
3. fulfillment of prescribed practical
experience
4. moral and ethical requirements invoked
through character reference
5. age limit for determining legal personality
and responsibility.

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Generally Accepted Auditing
Standards (GAAS)

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 Nature of GAAS
 are those guidelines which auditors must adhere
to while conducting an audit of a company's or
government entity's financial statements.
 have been required since 1941 after the
investigation of a large drug company,
McKesson & Robbins, Inc., which had had funds
embezzled by its president and his three
brothers. Neither the internal controls or the
independent auditors detected the
embezzlement
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 Nature of GAAS
 Provide a measure of audit quality and
the objectives to be achieved in an audit.
 the foundation of all auditing theory
and practice

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 GAAS Setting Bodies
• The International Federation of Accountants
(IFAC) through its International Auditing and
Assurance Standards Board (IAASB)
– Issues International Standards on Auditing (ISA)
 Each country has its own authoritative body. e.g.
a. USA: American Institute of Certified Public
Accountants (AICPA)
b. Canada: Canadian Institute of Certified Accountants
(CICA)

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 Main Areas of Auditing Standards
1) General Standards
2) Standards of Fieldwork, and
3) Standards of Reporting

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 General Standards (1)
1. Training and proficiency: The audit is
to be performed by a person or
persons having adequate technical
training and proficiency as an auditor
 Educational requirement
 Uniform examination requirement
 Experience requirement

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 General Standards (2)
2. Independence: The auditor must maintain
independence in mental attitude in all matters
relating to the audit.
 The most important attribute of an auditor
 Independence is the cornerstone to
professional audit
 Independence is an attitude of mind i.e. working
in unbiased & objective manner
 An auditor must remain independent of the
client at all times and avoid all situations that
may jeopardize his independence

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General Standards (2 Cont’d…)
Two aspects of independence:
a. Independence in fact (or of mind):
working in unbiased and objective
manner
b. Independence in appearance: avoiding
the circumstances that might cause the
third party to conclude that the integrity
and objectivity of the auditor has been
compromised
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General Standards (2 Cont’d…)
• When is independence of the auditor
impaired?
 Financial relationship
 Employment relationship
 Business relationship
Non-attest services provided by the auditor to
the audit client
 Receipt of contingent fees etc

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 Threats to Independence of an Auditor
i) Undue dependence on an audit client
• Objectivity may be threatened by undue dependence on any
audit client or group of connected clients. The recurring work
paid by one client or group of connected clients should not
exceed 15% of the gross practice income.
i) Overdue fees
• The existence of significant overdue fees from an audit client or
group of association clients can be a threat to objectivity akin to
that of a loan. Audit firms must therefore ensure that overdue
fees, along with fees from current work, could not be construed
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as a loan.
iii)Actual or threatened litigation
A firm's objectivity may be threatened or appear to be threatened
when it is involved in, or even threatened with litigation in relation
to a client. Litigation of certain sorts will represent a 'breakdown of
the relationship of trust' between auditor and client. This would
impair the independence of the auditor or cause the directors of
the client to become unwilling to disclose information to the
auditor.
iv)Family or other personal relationships
An auditor's objectivity may be threatened as a consequence of a
family or other close personal or business relationship.
v)Beneficial interest in shares and other investments
An auditor's objectivity may be threatened where he/she holds a
beneficial interest in the shares or other forms of investment in a
company upon which the practice reports.
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vi) Loans
Objectivity may be threatened by a loan to or from an audit client.
No loans or guarantees should be undertaken unless they are with client
financial institutions in the normal course of the business
vii)Goods and Services Hospitable
Objectivity may be threatened by acceptance of goods, services or hospitality
from an audit client. Acceptance on normal commercial terms, or with only
modest benefit, is acceptable.
vii Provision of other services to audit clients
•There are occasions where objectivity may be threatened or appear to be
threatened by the provision to an audit client of services other than the audit.
Care must taken to avoid performing executive functions or making executive
decisions.

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 General Standards (3)
3.Due professional care: Due professional care is
to be exercised in the performance of the audit and
the preparation of the report
 Concerns audit quality:
 Completeness of work papers
 Sufficiency & appropriateness of evidence,
 Appropriate report
 working carefully and being willing to take
responsibility for the accuracy of his/her work
 Court precedents form" prudent practitioner;”
i.e., what a competent practitioner would do

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General Standards (3Cont’d…)
• Some indicators of due professional care;
– Observe technical and ethical standards
– Strive continually to improve competence &
quality of services
– Discharge professional responsibility to the
best of his/her ability etc

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 Standards of Fieldwork
1. Adequate planning and supervision: The
work is to be adequately planned & executed
using sufficient knowledge of the business.
Assistants, if any, are to be properly supervised.
 Planning: needed to schedule personnel, & to
determine the type and timing of tests
 Supervision: needed because of assistants’ lack
of experience
 Knowledge about the client’s business: needed
for planning & supervision

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 Standards of Fieldwork
2. A sufficient understanding of internal control
is to be obtained to plan the audit
 Internal control is a process designed by the
entity’s board and management to provide
reasonable assurance regarding the
achievement of the following objectives:
a. Reliability of financial reporting
b. Compliance with applicable laws & regulations
c. Effectiveness and efficiency of operations

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 Standards of Fieldwork
• The degree to which the auditor relies on
the client’s internal control directly affects
the nature, timing, & extent of the work
performed by the independent auditor

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 Standards of Fieldwork
3. Sufficient appropriate audit evidence:
Sufficient appropriate audit evidence is to be
obtained through inspection, observation,
enquiry, confirmation, computation &
analysis, to afford a reasonable basis for an
opinion regarding the financial statements
under audit

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 Standards of Reporting
1. Conformity with GAAP: Whether financial
statements are presented in accordance
with GAAP
2. Consistency in the application of GAAP:
Whether GAAP are consistently applied
3. Completeness of disclosures: Whether all
informative disclosures have been made
4. The auditor must either express the opinion
regarding the financial statements, taken as
a whole, or state that an opinion can not be
expressed , in the auditor’s report.

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 Professional Ethics in Auditing
• The purpose of professional ethics in auditing is
to:
 build public confidence
 judge the quality of audit work
 Means of grounding guidance for practitioners
• Professional ethics is the function of the
following:
– Nature of the profession
– Collective morals
– Regulatory & legal constraints
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Rules of Professional Conduct/Ethics
1. Independence
A member in public accounting must be
independent in the performance of certain
professional services (audits, reviews, other
attestation functions; not tax returns,
compilations, management consulting).
Auditor’s independence should be both in fact
and in appearance. Independence in fact exists
when the auditor is actually able to maintain an
unbiased attitude throughout the audit, whereas
independence in appearance is the result of
others' interpretations of this independence
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Rules of Professional Conduct/Ethics
2. Confidential client information
A member in public practice shall not
disclose any confidential client (or
employer) information without the
specific consent of the client (or
employer). Confidential / inside
information can’t be used to benefit the
member. Exceptions: Court, disciplinary
hearings, & practice inspections

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 Rules of Professional Conduct/Ethics

3. Integrity, objectivity, and Due Care

In the performance of any professional
service, a member shall maintain integrity
(reputation for honesty), objectivity (free from
bias) and use due care (application of
appropriate level of care and skill for
comparable trained professional).

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 Rules of Professional Conduct/Ethics

4. Competence
A member shall maintain his / her
professional competence. Undertake only
those professional services that the
member or the member’s firm can
reasonably expect to be completed with
professional competence

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 Rules of Professional Conduct/Ethics
5. Adherence to GAAS & GAAP
A member shall comply with the professional standards
and shall not be associated with false or misleading
financial information.
6. Advertising & Solicitation
A member in public practice shall not seek to obtain
clients by advertising or other forms of solicitation in a
manner that is false, misleading, or deceptive.
Solicitation by the use of coercion, overreaching, or
harassing conduct is prohibited.
Acceptable advertising include types of services offered,
certificates & degrees of members, fess charged for
service etc

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 Rules of Professional Conduct/Ethics

7. Contingent Fees
A member in public practice shall not
charge a fee contingent on the outcome of
an audit, review or compilation.
8. Communication with Predecessor
Auditor
A member shall communicate with the
predecessor auditor prior to accepting
an appointment.
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Auditor’s Responsibilities &
Legal Liability

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 Auditor’s Responsibilities
• Auditors take responsibility for detecting material
misstatements in financial statements but they are
very cautious about taking responsibility for
detecting all manner of fraud
• Independent auditors have the responsibility to:
(1) assess the risk that errors and irregularities may
cause a client's financial statements to be
materially misstated, and
(2) design the audit to provide reasonable assurance
of detecting errors and irregularities material to the
financial statements

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 Who might sue an auditor and why?
Plaintiff Reason Type of liability
Client for failing to discover a common law
defalcation, inappropriate liability to client
withdrawal from an audit, breaching

the confidentiality requirements

Third party for failing to discover common law liability

misstatements to third parties
Combined not discovering materially common law liability
group of misstated financial to third parties
shareholders statements
Government for knowingly issuing an criminal liability
incorrect audit report

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 Legal concepts apply to auditor
liability
1. The prudent person concept
An auditor is expected to conduct the audit with
due care but the auditor is not expected to be
perfect.
2. Liability for the acts of others
The partners of a partnership are jointly liable for
civil actions of a partner. Partners may also be
liable for work of others such as employees,
other public accounting firms, and specialists.

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Legal concepts apply to auditor
liability
3. Lack of privileged communication
In general, auditors do not have the right
under common law to withhold
information from the courts on the
grounds that the information is privileged

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Legal concepts applying to auditor
liability
4. Negligence: Absence of reasonable care
 Plaintiff must prove:
 defendant owed duty of care
 defendant was negligent
 plaintiff suffered a loss
 connection exists between defendant’s
negligence and plaintiff’s loss

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Legal Concepts applying to auditor
liability
5. Tort action for negligence
Failure to meet social or professional
obligations which caused an injury to another
party
6. Fraud: a false assertion made knowingly or
recklessly
7. Constructive fraud
Existence of such recklessness that even
though there was no intent to deceive or do
harm, court will impute fraud

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Legal Concepts applying to auditor
liability
8. Breach of contract: failure of one or both parties
in a contract to fulfill the requirements of the
contract
9. Common law: laws that have been developed
through court decisions rather than through
government statutes
10. Statutory law: laws that have been passed by
the government
11. Contributory negligence: when plaintiff also
partly caused his or her loss or injuries

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Auditor’s Defenses Against Client Suits
1. Lack of Duty
The auditor claims that there was no implied or
expressed contract. A common way for an
auditor to demonstrate a lack of duty to perform
is by use of an engagement letter.
2. Absence of Negligence
The auditor claims that the audit was performed
in accordance with GAAS. Even if there were
undiscovered errors or irregularities, the auditor
is not responsible if the audit was properly
conducted.

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Auditor’s Defenses Against Client Suits

3. Contributory Negligence
The auditor claims that if the client had
performed certain obligations, the loss
would not have occurred.
4. Absence of causal connection
The auditor claims that there is a lack of a
close causal connection between the
auditor’s breach of the due care standard
and the damages suffered by the client.
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What can the auditing profession do to
reduce auditors’ exposure to lawsuits?
 encourage auditing research regarding litigation
and improvements in auditing practice
 establish standards and rules that meet the
changing needs of auditing
 establish requirements that protect auditors
 establish practice inspection requirements
 oppose unwarranted lawsuits
 educate financial statement users about auditing
and the auditor’s opinion
 sanction auditors for improper conduct
 lobby for changes in laws

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What can individual public accountants do to
reduce their exposure to lawsuits?
- deal only with clients possessing integrity
- hire, train, and supervise qualified personnel
- follow the standards of the profession
- maintain independence
- understand the client’s business
- perform quality audits
- document the work properly
- obtain an engagement letter and a representation
letter
- maintain confidential relations
- carry adequate insurance
- seek legal counsel

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 Appointment of Auditors
• First auditor: According to the Commercial code of
Ethiopia (1960), the appointment of the first auditor for a
newly established share company is done by the
meeting of subscribers who represent at least 20% of the
capital. This auditor will stay in office until the first annual
general meeting of the shareholders. At this meeting, the
general assembly may decide to continue with this
auditor or appoint another auditor.
• Other auditor: The general assembly takes the
responsibility to appoint the auditor other than the first
auditor. This auditor may hold office for up to three
years.

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 Remuneration of Auditors
• The remuneration of the auditor is
normally fixed by the general assembly
based on the scope of the audit work.
• If the general assembly failed to agree, the
relevant government ministry (e.g. Ministry
of Trade) will decide the auditor’s
remuneration.

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 Removal of Auditors
• The auditor may leave the office due to
various reasons: Some of them are;
– End of the term of engagement
– Disagreement between the auditor and the
client
– Resignation by the auditor

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Client Acceptance and continuance
procedures (1)
1. Objectives:
 To reduce the risk of accepting inappropriate
auditor. The auditor is required to have
insight in to the prospective client’s past
business practice, integrity of management
team, and identify any issues that may
create a breach of professional obligations.
 To ensure the quality of audit work
 To comply with GAAS

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Client Acceptance and continuance
procedures (2)
2. Factors to be considered
a. Frequent changes of auditor: Could mean the
firm is opinion shopping
b. Poor financial history: Could mean high
chance for the fraud to exist in the financial
statements
c. Work/business history: Unstable address
d. Overly litigious as a plaintiff or defendant:
signals for party who is not afraid to sue (a risk
of non-payment) or who may not honor its
agreements

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Client Acceptance and continuance
procedures (3)
e. High turnover in top management: Indication of
lack of internal stability
f. Reluctance to provide references: Unwillingness
to have a look at its background
g. Pressure to get deal quickly: Unwillingness to
have a look at its background
h. Regulatory actions: Indication of poor controls or
a management team ignoring internal controls

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Client Acceptance and continuance
procedures (4)
• Sources of information:
– Predecessor auditor
– Inquiry of banks, legal counsel
– Background searches of relevant database

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 Engagement Letter (1)
• An agreement between the auditor and the client
with the purpose of avoiding misunderstanding
with respect to the engagement
• Contents of an engagement letter:
– Objective of the audit
– Management responsibility for financial statement
– The applicable financial reporting framework
– The scope of the audit
– The form of any report
– Unrestricted access to any records, documents &
other information
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 Engagement Letter (2)
– The fact that some material misstatements may not
be discovered due to the nature of the tests and the
inherent limitations of internal controls
– Management’s responsibility for establishing and
maintaining internal controls
– Bases of fee computation
– Expectation of receiving written confirmation from
management
– Description of letters to be issued by the auditor to the
client
– Arrangements concerning the involvement of the
internal auditor and other client staff
– Arrangements to be made with the predecessor
auditor etc

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