Audit Practice II - Week 3 Overview

Audit Practice and Procedures II - Week Three

• Legal Liability; Audit Responsibility and Objectives is the topic for Week Three.

Second Class Recap

• What is an Audit Report? - Basic definition.
• The Four Types of Audit Reports and when/why they are issued. - Describes the different audit report types and their context.
• Relationship between materiality and the type of opinion. - Explains how the significance of a finding relates to the audit report.
• What is Ethics; Code of Professional Conduct; The six (6) core value ethical values/principles. - Definition and examples of ethical codes and values in professional conduct.
• Why are people unethical? - Possible reasons behind unethical behavior.
• Ethical Dilemmas. - Cases that put moral principles at odds with personal gain.

Three Fundamental Concepts

• Business Failure: Inability to meet debt obligations due to factors like poor management, economic downturns, or market competition.
• Audit Failure: The auditor issues an incorrect opinion due to inadequate standards compliance, or overlooking material issues and misstatements.
• Audit Risk: The possibility of an auditor concluding that financial statements are fairly stated while they are, in fact, materially misstated. This is an unavoidable aspect of auditing.

Accounting and Legal Liability

• Professionals believe that a significant cause of lawsuits against accounting firms is a lack of understanding about business failure and audit failure, differentiating between the two.
• The difference between audit failure and audit risk is also a key area of concern.

Sources of Legal Liability

• Liability to clients: suits range widely from not completing the work on time to failure to recognize fraudulent activity.
• Liability to third parties under common law: When third parties (like investors or lenders) suffer financial losses due to reliance on misstatements in financial statements prepared by a CPA firm. This is particularly relevant when banks or other creditors experience difficulties collecting loans from firms because of incorrect or misleading information.
• Civil liability under federal securities laws: Liability arising from violations of federal securities laws.
• Criminal liability: Liability arises when the auditor knowingly and intentionally misrepresents information.

Auditor's Defenses Against Client Suits

• Lack of Duty: The CPA firm claims no contractual obligation to perform the service in question
• Nonnegligent Performance: The audit was conducted properly according to auditing standards, and any misstatements discovered, were not the firm's fault.
• Contributory Negligence: The client's actions either led to losses or prevented the auditor from finding the issue.
• Absence of Causal Connection: The loss suffered by the client was not caused by the auditor's failure.

Liability to Third Parties

• Auditors may be liable to third parties under common law when misstatements in financial statements cause losses to those who relied on these statements.
• Third parties commonly include investors and creditors.
• The defenses available to an auditor in third-party suits are similar to those in client-side suits.

Civil Liability Under Federal Securities Law

• Federal securities laws lead to many claims against accountants. Claims arise from significant damages and class-action suits.
• Strict liability standards in securities laws make courts more inclined towards favoring plaintiffs in such lawsuits.

Criminal Liability

• CPAs can experience criminal liability for accountants if found guilty of fraudulent or intentionally misleading financial statements.
• This relates to the Federal Mail Fraud Statute and other relevant laws and regulations.
• One notable case is United States v. Simon where CPAs face prosecution and criminal liability for filing false statements with the government.

Minimizing Liability

• Deal only with clients with a reputation of integrity.
• Maintain independence in thought and action, separating auditor interests from client interests.
• Understand the business operations and industry practices of the client.
• Maintain professional skepticism.
• Properly document the audit work.
• Perform quality audits.

Audit Responsibility and Objectives - Chapter 6

• Objective of Conducting an Audit of Financial Statements: The goal of an audit is to provide an opinion on whether financial statements fairly represent the entity's financial position, in accordance with applicable financial accounting frameworks.
• Steps to Develop Audit Objectives: Understand objectives and responsibilities of the audit, divide financial statements into cycles, know management assertions about financial statements, and know specific audit objectives for classes of transactions, accounts, and disclosures.
• Management's Responsibilities: Management is responsible for adopting sound accounting policies, maintaining adequate internal control, and presenting financial statements fairly. They are responsible for the completeness, accuracy, and validity of the company's financial information and internal controls.
• Auditor's Responsibilities: The auditor must obtain reasonable assurance about whether the financial statements are free from material misstatements, due to error or fraud. Auditing standards require that the auditor issues a report on the financial statements and communicates their findings.
• Material Versus Immaterial Misstatements: Misstatements are considered material if the combined uncorrected errors and fraud would influence the decisions of a reasonable user of the financial statements. The auditor is responsible for reasonable, but not absolute, assurance of detecting material misstatements.
• Reasonable Assurance: Assurance isn't absolute, meaning it can, but does not guarantee that material misstatements will always be caught during an audit.
• Reasons for not absolute assurance: Audit sampling, risk of undetected misstatements, estimates, and complex financial situations.

Management Assertions

• Management makes representations or assertions about transactions, account balances, and disclosures in financial statements.
• Auditors must understand the assertions to properly perform their audits. AICPA and International Auditing Standards classify the assertions into three categories.

Phases of a Financial Statement Audit

• Phase I: Plan and design an audit approach
• Phase II: Perform tests of controls and substantive tests of transactions
• Phase III: Perform analytical procedures and tests of details of balances
• Phase IV: Complete the audit and issue an audit report

Explore the key concepts of legal liability, audit responsibility, and ethical considerations in auditing from Week Three. This quiz covers audit reports, their types, materiality, and the importance of professional ethics. Test your knowledge on the relationship between ethics and auditing as well as the factors leading to unethical behavior.