Chapter three

Ethics and legal liability of auditors

 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’s work, not just the shareholders on
whose behalf the accountant is working. The
accountant 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

• Although professions are to some extent self-

regulating, guidance in ethical behavior is
provided by the AICPA Code of Conduct, as well
as PCAOB and the SEC.
The AICPA Code of Conduct
• The AICPA Code of Conduct contains four
parts--principles, rules of conduct,
interpretations of the rules, and ethical rulings.
 professional Ethics
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
five 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

• There are many stakeholders who rely on

audited financial statements: the client (with
which there is a privity relationship), actual and
potential stockholders, vendors, bankers
and other creditors, employees, customers, and
the government.
• Legal liability of the auditor to each
stakeholder varies from country to country,
district to district. This liability can generally
be classified as based on one or more of the
following: common law, civil liability under
statutory law, criminal liability under statutory
law, and liability as members of professional
accounting organizations.
 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

Write a note on the following topics

1. Auditing in Ethiopia,
2. Business entities required by law to produce
audited Financial Statements.
3. EDP/IS Auditing
 Assignments

4. Take any corporate business organization and consider its

audit reports of the last two years
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

5. Assume you are an independent auditor of ABC

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, ABC 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
ABC company has brought suit against you for the amount
of its losses in this cash fraud.
 Assignment

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 ABC 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

• All Assignments will be presented in the class

• All Assignments will be done in group
• Date of submission of the assignments Dec.
31/2016
 Liability Under Common Law

• Liability for auditors under common law generally falls in

two categories: liabilities to clients and third party liability.
1. Liability to Clients
• A typical civil lawsuit filed by a client involves a claim that
the auditor did not discover financial statement fraud or
employee fraud (defalcation) because the auditors showed
negligence in the conduct of an audit. The legal action can be
for breach of contract, or more likely, a tort action for
negligence. Tort actions are the most common, for
generally they generate larger monetary judgments than
breach of contract.
2. Liabilities to Third Parties
• Third parties include all stakeholders in an
audit other than the audit client. An audit firm
may be liable to third parties such as banks
who have incurred a loss due to reliance on
misleading financial statements.
Criminal Liability Under Statutory Law
• A professional accountant may be held
criminally liable under the laws of a country or
district that make it a criminal offense to
defraud another person through knowingly
being involved with false financial statements
Liabilities as Members of Professional
Accounting Organizations
• all national audit professions have some sort
of disc
• the court makes its judgment and determines
the sanction – if any – against the auditor. The
sanction may vary. It may be:diplinary court
• a fine;
• a warning (either oral or written);
• a suspension for a limited period of time (e.g.
six months); or
• a lifetime ban from the profession.
 Assignments

Write a note on the following topics

1. Auditing in Ethiopia,
2. Business entities required by law to produce
audited Financial Statements.
3. EDP/IS Auditing
 Assignments

4. Take any corporate business organization and consider its

audit reports of the last two years
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

5. Assume you are an independent auditor of ABC

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, ABC 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
ABC company has brought suit against you for the amount
of its losses in this cash fraud.
 Assignment

• All Assignments will be presented in the class

• All Assignments will be done in group
• Date of submission of the assignments Dec.
31/2016