Lesson 2 Professional Ethics, Audit Responsibilities, and Client Acceptance (chap 3, 4 & 6).docx

Chapter 3: Professional Ethics and Legal Liability Canadian code prohibits members in public practice from disclosing any confidential information without the consent of the client -> if such information used for trading = insider trading Independence and integrity of public accountants. Profess...

Chapter 3: Professional Ethics and Legal Liability Canadian code prohibits members in public practice from disclosing any confidential information without the consent of the client -> if such information used for trading = insider trading Independence and integrity of public accountants. Professional Ethics and Public Accountants Characteristics of public accountants: integrity, competence, professional skepticism, and independence. Ethics = set of moral principles or values -> to guide us on how we should act Professional ethics = standards of conducts that apply to the member of a profession. Can be shared between professions. Responsibility of public accountant = protection of the public interest Structure of the auditor–client relationship has an inherent conflict of interest in that the company that issues the financial statements pays the public accountant (PA) yet the primary beneficiaries of the PA’s services (the audit opinion) are the financial statement users. Based on CPA code of conduct, 5 fundamental ethical principles: Professional behaviour: maintain good reputation Integrity and due care: honest and fair Objectivity: does not allow professional judgement to be compromised Professional competence: maintain a high level of competence Confidentiality: duty of confidentiality A Framework for Ethical Reasoning Ethical dilemma—a situation in which a decision must be made about the appropriate behaviour. Framework for ethical decision-making—a methodological approach to resolving an ethical dilemma. Obtain relevant facts and identify the issues Identify the ethical issues Identify who is affected and how each is affected Consider and evaluate courses of action: test course of action (Would a similar course of action be used in a similar situation? Would the course of action stand up to the scrutinity of peers?) Implement the course of action Ethical Blind Spots A blind spot tends to eliminate ethics from the decision. Ethical blind spot – unconscious tendency that can affect the ethical of the decision making process or cause the decision maker to not recognize the ethical dimension of a choice. Rationalization: people will try to explain or justify their behaviour with logical reasons, even if they are not appropriate Professional Guidance on Ethical Conduct Auditor’s decisions are made with consideration of the rules of professional conduct. Provincial accounting bodies determine the rules of professional conduct for members and students. Harmonized the same rules to all PAs. CPA code applies to all members and firms irrespective of the type of services provided. Professional code of conduct in Canada is principles-based and compliance-based. Compliance based Advantage: enforce minimum behaviour and performance standards Disadvantage: define the rules as maximum rather than minimum standards + if some action is not prohibited, it must be ethical Public protection Section 200 of the Code of Professional Conduct: protect the public interest and maintain the profession’s reputation Rule 201 – Maintenance of good reputation of the profession Require to behave in the best interests of their profession and the public interest -> accountants should not take advantage of the trust placed in them. Do not publicly critic a colleague without giving the chance to explain first Do not voluntarily resign from an audit engagement without good and sufficient reason (loss of trust in the client, auditor’s independence or objectivity could be questioned, client pressures the client to perform illegal/fraudulent acts) Rule 202 – Integrity, due care, and objectivity Integrity is one of the hallmarks (poincons, marque) of the profession. Reputation for honesty is one of the most important asset for the accountant profession. Objectivity is a state of mind. Independence is not only a state of mind; it also includes the appearance of independence, in the view of a reasonable observer. Rule 203 – Professional competence Professional accountants are required to attend a certain number of continuing professional education courses a year. Rule 204 – Independence The value of auditing depends on the public’s perception of the independence of auditors -> unbiased point of view from the auditor. PAs must be free of any influence, interest, or relationship that impairs professional judgment or objectivity. Independence—impartiality in performing professional services. Independence = independence in fact + independence in appearance Independence in fact = auditor is able to maintain an unbiased attitude during the audit Independence in appearance = other people interpretation of his unbiased attitude Rule 205 – False and misleading documents and oral representations No members can sign or associate with false or misleading information (this includes letters, reports, and written or oral statements) or fail to reveal material omissions from FS. Rule 206 – Compliance with professional standards PAs are required to comply with professional standards when preparing and auditing financial statements: accounting standards + GAAS as set out in CPA Canada handbook Rule 208- Confidentiality of information Not disclose any confidential client information or employer information without the consent. Rules also prohibit using confidential or inside information to earn profits Confidential or inside information—client information that may not be disclosed without the specific consent of the client except under authoritative professional or legal investigation. Permission is not required from the client if the working papers are subpoenaed (= assigné a comparaitre) by a court, or are used as part of practice inspection or in connection with a disciplinary hearing. Rule 210 – Conflicts of interest If auditors have clients who are competitors -> must obtain consent from each client + procedure in place to protect confidential information Access to confidential information can create conflicts of interest. Rule 211 – Duty to report breaches of the CPA code If aware about a breach from another member -> have to report to the profession’s discipline committee after first advising the member of the intent to make a report => give opportunity to mitigate the circumstances Rule 214 – Fee quotations and billings Members must obtain adequate information before providing a fee quotation: assessment of accounting policies and internal controls to estimate a fee Rule 215 – Contingent fees Contingent fees (= frais conditionnels) are prohibited for audits, reviews, compilation engagements, and any other engagements that require the auditor to be objective. Rule 217 – Advertising, solicitation, and endorsements The professional accounting bodies in Canada prohibit solicitation of another PA’s client and advertising not align with profession’s high standards. Rule 218 – Retention of documentation and working papers Need to retain documentation for a reasonable period of time: in case of litigation, practice inspection, disciplinary hearings. Some documentation needs to be retained indefinitely (=permanent file): financial statements, contracts, leases, tax returns. Professional Colleagues = Client interests are placed ahead of the interest of member or firm and that professional courtesy and cooperation are expected all times. Rule 302 – Communication with predecessor If new successor auditor -> prior to accepting the appointment as auditor, needs to communicate with previous auditor to inquire if he is aware of any circumstances that might prevent the successor from accepting the appointment. Successor would ask the client to authorize the incumbent (=titulaire, predecessor) to provide the information requested. IF client refuses -> successor should be reluctant to accept the appointment because it is possible that the client is hiding something. Communication between predecessor and successor must be candid. In short, the required communication protects prospective successors, and thus the profession, from getting involved with undesirable clients. Rule 303 – Provision of client information A predecessor should supply reasonable information to the successor about the client: prior year’s financial statement and tax returns. Allow the successor to review the working papers and answer the questions -> meet the CPA Canada Handbook that the auditor obtain information related to opening balances. The independence standard for assurance engagements Rule 204: principle-based framework to assess independence for assurance engagements -> what is acceptable as auditor-client relationship? Standard to determine if the service is prohibited: Are there any prohibitions that would stop undertaking or completed the engagement? Identify the threats Evaluate the significance of the threat Determine if any safeguards can be applied For each insignificant safeguard, document the rational Identify threats PA needs to identify whether the service creates a threat to independence. 5 threats: Self-interest: PA has a financial interest in the client or in the financial results of the client. Revenue of the firm comes from only one client Self-review: PA is having to audit his own work or system during the audit Advocacy: PA promotes client’s position (resolving a dispute with a creditor of the client or promoting sale of shares) Familiarity: occurs when it is difficult to behave with professional skepticism because PA knows the client well Intimidation: client intimidates the PA firm regarding the content of the FS or the conduct of the audit, preventing objective completion (threaten to replace the audit firm) Evaluate the significance of the threat PA needs to evaluate if there are any safeguards that will eliminate or reduce the threat to an acceptable level => independence is not compromised Identify and apply safeguards Required or prohibited actions and internal controls can serve as safeguards to eliminate or reduce threats to independence: Created by the profession (education and training), legislation or securities regulation: rotation of partners on the engagement, limits on percentage of firm revenue from one client, independent reviews provided by CPAB Provided by the client: qualified independent audit committee Safeguards within the firm’s systems and procedures: policies and procedures to promote awareness and independence, rotation of seniors, training programs Audit committee—a committee of the board of directors that is responsible for auditor (internal and external) oversight. It is an objective and independent liaison between auditors, management, and the board of directors. Publicly accountable enterprises (e.g., universities, large hospitals) and companies listed on stock exchange (3 independent directors who are financially literate) are required to have an audit committee. The external auditor has the right to attend meetings of the audit committee. At least annually, the auditor should inform the audit committee of the following items: the level of the auditor’s independence; all relationships between the auditor and his or her related business or practice and the entity and its related entities; and the total fees charged (separating out audit and non-audit services). For each identified threat, document how it was resolved Independence threat analysis—assessment of independence threats for a particular engagement. This formal independence threat analysis forms part of the documentation for the engagement. The documentation should include the threat, a description of the safeguard to eliminate or reduce the threat to an acceptable level, and how that safeguard eliminates or reduces that threat to an acceptable level. => if no safeguards => decline or discontinue the assurance engagement, or the non insurance service created the threat Prohibitions for ALL Assurance Engagements Prohibitions serve as an effective means to prevent independence threats. Does not mean that the firm cannot take on the engagement; rather, it means that the individual affected cannot take part in the engagement. The following are prohibitions applicable to all assurance engagements: Members of the engagement team may not have a direct or material indirect financial interest in the entity subject to the assurance engagement Not have a loan form or a loan guaranteed by the entity Firm and members cannot have a close business relationship with the entity May not have an immediate family member who is an officer or director of the client, who has a significant affluence A member of the engagement team must not serve as a director or officer during the period covered by the assurance report Members of the engagement team must obtain client approval for making journal entries and accounting classifications. Not accept significant gifts or hospitality from the assurance client Key audit partners cannot be evaluated or compensated based on selling non-assurance services A member or firm cannot charge a fee that is significantly lower than market Firms cannot provides the following services to their assurance clients: Accounting and bookkeeping, Valuation services, Internal audit services, legal services, Litigation support services, Corporate finance services, Tax planning and advisory services. Prohibitions specific to listed entities Listed entities—entities whose debts or shares are listed on a recognized stock exchange (in Canada and elsewhere) and that have market capitalization and total assets greater than $10 million. A member or a firm cannot perform an audit if a person who would participate in the audit is an officer or director or is in a financial reporting oversight role of the entity (unless a year has elapsed) The firm cannot perform an audit if the chief executive officer (CEO) of the audit firm is an officer or director or is in a financial reporting oversight role of the entity (unless a year has elapsed) Key audit partners must leave the audit team after seven years, and must wait until 2 years have elapsed. Lead partners cannot participate in the engagement for that company until 5 years have elapsed. Unless specific measures are taken, firms are prohibited from performing the financial statement audit if 15% of the firm’s total revenue comes from a listed entity for 2 consecutive years. Firms cannot provide actuarial or human resources services, and cannot provide tax calculations for purposes of preparing audit entries. Enforcement of the code of Professional conduct Rules of conduct for CPA -> administered provincially => upgrade skills, fine, expulsion, publication of the violator and the nature, increase frequency of peer review, suspension of designation. Disciplinary process includes layperson (=profane) on disciplinary committees and being transparent about disciplinary process. The expectations gap and auditor litigation Audit failure—a situation in which the auditor issues an erroneous audit opinion as the result of an underlying failure to comply with the requirements of generally accepted auditing standards (GAAS). In practice, because of the complexity of auditing, it is difficult to determine when the auditor has failed to use due care. Due care—completing the audit with care, diligence, and skill. When an auditor fails to exercise due care, it often results in audit liability. Business failure—the situation when a business is unable to repay its lenders or meet the expectations of its investors because of economic or business conditions. Audit risk—the risk that the auditor will conclude that the financial statements are fairly stated and an unqualified opinion can therefore be issued when, in fact, they are materially misstated. Audit risk is unavoidable, because auditors gather evidence on a test basis and because well-concealed frauds are extremely difficult to detect. Not detect a fraud does not mean that there was an audit failure. The underlying cause of conflict between statement users and auditors is often attributed to the expectations gap. Expectations gap—the gap between public expectations of the auditor’s role and responsibilities and the auditor’s responsibilities per GAAS. Major sources of auditor liability Legal liability—the professional’s obligation under the law to provide a reasonable level of care while performing work for those they serve. They have legal liability to their clients for negligence and/or breach of contract. Auditors may also be held liable under the common law tort of negligence or provincial securities acts to parties other than their clients in certain circumstances. Failure to meet GAAS is often strong evidence of negligence. Under tort law, if an auditor is considered negligent, clients and third parties may sue the auditor. In order to prove negligence, the plaintiffs (clients or third parties) must satisfy the following tests: The auditor owed a duty of care to the plaintiff. The auditor breached the duty of care. The plaintiff suffered a loss. The plaintiff’s loss resulted, in part or wholly, from the auditor’s breach of duty. 4 mains sources of legal liability: Common law liability to client Most common source of lawsuits against CPAs is clients because they have a contractual relationship. Breach of confidentiality, inappropriate withdrawal from an audit, failure to discover a theft of asset by employee, negligence. Tort actions are more common because the amounts recoverable under them are normally larger than under breach of contract. Common law liability to third parties Potential shareholders, vendors, bankers and other creditors or investors, employees, and customers. Since there is no contract, third parties must rely upon tort law: auditor owed duty of care. Liability under provincial securities law to third parties Securities legislation gives investors the right to sue auditors (in their role as expert) for misrepresentation in their audit report. Because the investors do not have to prove that they relied upon the representation, the duty of care restrictions from Hercules do not apply. If company is not solvent, auditors become the target => deep pockets theory Criminal liability Convicted of criminal charges related to fraudulent financial statements and possible civil action => rare case Auditors can also face criminal and quasi-criminal liability for breaches of securities legislation, in which the securities regulator makes the allegations: misleading or untrue statement or omission in any document required to be filed or submitted to the regulator => $5 million and/or prison up to 5 years less 1 day. The profession’s response to legal liability To reduce practitioners’ exposure to lawsuits: Standard setting: IAASB and CPA must constantly set standards and revise them. Oppose lawsuits: must oppose unwarranted lawsuits even the cost is greater than the cost of settling Educate users: large expectations gap regarding auditor’s responsibilities. Reduce this gap by educating investors who read FS. People outside the profession need to understand that accounting and auditing are arts, not sciences. Sanction members for improper conduct and performance Accountants to minimize their liability: Deal only with clients possessing integrity: PA firms need procedures to evaluate the integrity of clients Maintain independence: The auditor must maintain an attitude of professional skepticism. Understand the client business: lack of understanding of the client’s business and its practices. Perform quality audits: obtain appropriate evidence and make appropriate judgments about the evidence. Document the work properly: preparation of good audit documentation helps the auditor perform quality audits. Should include an engagement letter and a representation letter that define the respective obligations of the client and the auditor. Exercise and maintain professional skepticism: maintain a healthy level of skepticism, one that keeps them alert to potential misstatements.