Audit Practice II - Week 3: Ethics and Reports

Audit Practice and Procedures II - Week Three

• Topic: Legal Liability; Audit Responsibility and Objectives

Second Class Recap

• Audit Report: Definition of an audit report
• Types of Audit Reports: Four types of audit reports and the situations under which each one is issued
• Materiality and Opinion: Relationship between materiality and the type of audit opinion
• Ethics: Definition of ethics, code of professional conduct, six core values/principles
• Unethical Behavior: Reasons behind unethical behavior
• Ethical Dilemmas: Examples and analysis of ethical dilemmas

Fundamental Concepts

• Business Failure: A business is unable to meet financial obligations due to economic conditions (recession), poor management, or unexpected competition.
• Audit Failure: Auditors issue an incorrect audit opinion due to failure in complying with auditing standards, possibly resulting in assigning unqualified assistant(s) who fail to recognize material misstatements.
• Audit Risk: The possibility that the financial statements may be materially misstated even after an adequate audit; unavoidable due to testing inherent limitations and concealing fraudulent activities.

Accounting and Legal Professionals Perspectives on CPA Firm Lawsuits

• Understanding Business Failures and Audit Failures: Financial statement users often misunderstand the distinction between a business failure and an audit failure, leading to lawsuits against CPA firms.
• Understanding Audit Failures and Audit Risk: The distinction between an audit failure and audit risk is essential for understanding the validity of legal claims against accounting firms.

Liability to Clients

• Common Source of Lawsuits: The most frequent source of lawsuits against CPAs are from clients, including issues like failing to complete engagements on the agreed date, inappropriate withdrawal, failing to detect embezzlement, or violating confidentiality.
• Relatively Small Amounts: These lawsuits usually involve smaller amounts, unlike third-party cases that can have significant publicity.
• Audit Negligence: Typical cases against clients involves claims auditors failed to identify employee theft due to negligence in the audit process.
• Contract Breach: Actions can be pursued for breaches of contracts, or audit negligence/breaches and professional misconduct.
• Severity of Negligence: Tort actions (ordinary/gross negligence, fraud) are more common than contract actions since compensation amounts are typically higher, and can be determined based on negligence, gross negligence, or fraudulent behavior.

Legal Terms Affecting CPAs' Liability

• Ordinary Negligence: Lack of reasonable care expected based on the circumstances of a situation.
• Gross Negligence: A complete lack of care; significantly worse than ordinary negligence.
• Constructive Fraud: Deliberate negligence, without intent to deceive, resulting in an inadequate audit.
• Fraud: Making a false statement with the intent to deceive.

Auditor's Defenses Against Client Suits

• Lack of Duty: Refuting an implied or expressed contract for audit services.
• Nonnegligent Performance: Arguing that the audit was conducted in accordance with auditing standards despite misstatements.
• Contributory Negligence: Client actions that resulted in losses or hindered the audit.
• Absence of Causal Connection: Claims that there isn't a direct, clear connection between the alleged audit failure and reported damages.

Liability to Third Parties under Common Law

• Third Parties: Include stockholders, vendors, bankers, creditors, employees, and customers.
• Loss Incurred through Reliance: Third-party liability may arise if a loss is incurred due to relying on misleading financial statements.
• Specific Legal Claims: (Example) Banks suing for not discovering that a borrower's financial statements are materially misstated.

Civil Liability Under Federal Securities Law

• Growth in CPA Liability: Increased litigation against CPAs for issues related to financial statements under Federal Securities Laws.
• Class-Action Litigation: This aspect facilitates the possibility of significant damages for the plaintiff.
• Strict Liability Standards: Some sections of securities laws have strict liability standards, which courts often favor plaintiffs in lawsuits.
• Recent Tort Reform: More recent attempts at tort reform may lessen negative outcomes for accounting firms within these particular courts.

Criminal Liability

• Criminal Liability for Accountants: CPAs may face criminal charges under federal and state laws, including those similar to SEC rules (Uniform Securities Acts), fraudulent reporting (1933 & 1934 securities acts), federal mail fraud, and false statements.
• Notable Criminal Case Examples: (Example) United States v. Simon, 1969, illustrating a case of criminal action against CPAs.

Minimizing Liability Factors for Practicing Auditors

• Integrity-Focused Client Selection: Auditors should primarily focus on engaging with high integrity clients to mitigate legal risks.
• Maintaining Independence: Auditor independence extends beyond financial and encompasses a commitment to maintaining an attitude and appropriate conduct separate from the client's interests.
• Understanding Client Business: Possessing sufficient knowledge of the client's business operations and industry standards helps auditors identify potential misstatements.
• Quality Audits: Encompasses obtaining necessary evidence, exercising adequate judgment and appropriately documenting audit activities.
• Professional Skepticism: Demonstrating a cautious approach to assess misstatements within financial reporting.

Audit Report Objectives & Phases

• Auditing Objective: Provide an opinion on whether the financial statements are fair, reflecting compliance with applicable financial accounting frameworks; notifying users if there are significant misstatements or uncertainty.
• Developing Audit Objectives: Steps for developing audit objectives: Understanding objectives and responsibilities, dividing financial statements into cycles, knowing management assertions, and knowing specific audit objectives.
• Phases of a Financial Statement Audit: Four sequential phases of the audit process--planning, tests of controls, substantive procedures and completing the audit and issuing the report.

Management's Responsibilities

• Policy and Control: Management is responsible for implementing sound accounting principles, proper internal controls, and accurate representation in financial statements, since they have day-to-day management responsibility over the business.
• Statements' Integrity and Accuracy: Management is in charge of financial statement integrity and determining required presentations/disclosures. If they insist on financial statements the auditor believes are unacceptable, the auditor can issue an adverse/qualified opinion, or withdraw from the engagement.

Auditor's Responsibilities

• Reasonable Assurance: Auditors pursue "reasonable," but not absolute, assurance about material misstatements, recognizing limitations in their scope and the potential for undetected errors/fraud.
• Material versus Immaterial Misstatements: Auditors focus on material misstatements, as those would likely change the decisions of a rational financial statement user, rather than immaterial errors.
• Assurance for Several Reasons: Factors like sampling, making judgment calls (timing, scope, etc), and fraud inherent complexity make a complete assurance practically unachievable.

Management Assertions

• Implied and Expressed: Management representations, implied or expressed, regarding transactions and disclosures, directly related to financial reporting standards.
• Categories: Assertions grouped into three categories: Transactions and Events, Account Balances and Presentation & Disclosure.
• Importance for Audit: Understanding these assertions is critical for auditors.

This quiz covers key topics from Week Three of the Audit Practice and Procedures II course. Focus areas include legal liability, types of audit reports, the relationship between materiality and audit opinions, and ethics in auditing. Test your understanding of these essential audit concepts and ethical dilemmas.