Reading...
Play button
Play button
Use LEFT and RIGHT arrow keys to navigate between flashcards;
Use UP and DOWN arrow keys to flip the card;
H to show hint;
A reads text to speech;
156 Cards in this Set
- Front
- Back
|
Chapter 4
|
Professional Ethics
|
|
|
What are Ethics? What are Morals?
|
Ethics: Objective sense; Set of rules you have to follow
Morals: Personal sense; What you're thinking about |
|
|
Explain the scope of conduct?
|
e.g., Law does not govern many aspects of "personal" life, your mental state.
|
|
|
Explain positive vs negative code of conduct?
|
Positive code promotes good behavior.
The law is a negative code of conduct because it prohibits you from doing something. |
|
|
Explain professional ethics vs personal ethics?
|
There are lots of standards in accounting, and the ethical standards we are facing are complex.
A lot of accountants that go to jail are great people (personal ethics) but they cant handle the pressure faced in the office (professional ethics). |
|
|
What are the 2 biggest types of Independence?
|
1. Independence in fact
2. Independence in appearance |
|
|
What is Independence in fact?
|
Also called Independence in mind.
Mental attitude; Are you actually independent in your mind? It reflects the auditor's state of mind that permits the audit to be performed with an unbiased attitude. |
|
|
What is Independence in appearance?
|
Independence in perception.
-Rules -Most important rule is that an Auditor can not own stock in the client company. -Perception may not be reality (i.e. hiring your own brother despite him being the best candidate). It is the result of others' interpretations of this independence. If auditors are independent in fact but users believe them to be advocates for the client, most of the value of the audit function is lost. |
|
|
Explain professional judgement?
|
Professional judgement can be a moral issue.
Use professional judgement, especially when auditing accounts receivable and allowance for doubtful accounts. |
|
|
What are the 4 parts of the Code of Professional conduct?
|
1. Principles
2. Rules of conduct 3. Interpretations of the rules of conduct 4. Ethical rulings |
|
|
Explain the Principles section of the Code of Professional Conduct?
|
It is ideal standards of ethical conduct stated in philosophical terms. They are NOT enforceable.
|
|
|
What are the 6 ethical principles?
|
1. Responsibilities
2. The Public Interest 3. Integrity 4. Objectivity and Independence 5. Due Care 6. Scope and Nature of Services (Applies only to members in public practice) |
|
|
Explain the Rules of Conduct section of the Code of Professional Conduct?
|
Minimum standards of the ethical conduct stated as specific rules.
This is the only section that IS enforceable. Because of this it is stated in more precise language. This part of the Code includes the explicit rules that must be followed by every CPA in the practice of public accounting. |
|
|
What is the difference in the Standards of Conduct between the Principles and the Rules of Conduct?
|
The Principles are set extremely high (the ideal conduct by practitioners) so that the Rules of Conduct can be set lower (at a minimum level of conduct by practitioners).
|
|
|
Explain the Interpretations of Rules of Conduct?
|
Interpretations of the rules of conduct by the AICPA Division of Professional Ethics.
They are not enforceable, but a practitioner must justify departure. Needed for when there are frequent questions from practitioners about a specific rule. Interpretations are not officially enforceable, but a departure from the interpretations is difficult if not impossible for a practitioner to justify in a disciplinary hearing. |
|
|
Explain the Ethical Rulings?
|
Published explanations and answers to questions about the rules of conduct submitted to the AICPA by practitioners and others interested in ethical requirements.
They are not enforceable, but a practitioner must justify departure. Rulings are explanations by the executive committee of the professional ethics division of specific factual circumstances. |
|
|
How do rules on ethics differ from rules of conduct?
|
Rules on ethics are not as high of authority as rules of conduct.
|
|
|
What are the 9 services prohibited by the Sarbanes-Oxley Act? Who are they prohibited from?
|
1. Bookkeeping and other accounting services
2. Financial information systems design and implementation 3. Appraisal and valuation services 4. Actuarial services 5. Internal audit sourcing 6. Management or human resource functions 7. Broker or dealer or investment adviser or investment banker services 8. Legal and expert services unrelated to the audit 9. Any other service that the PCAOB determines by regulation is impermissible. CPA firms are not prohibited from providing these services to private companies and public companies that are not audit clients. In addition, CPA firms may still provide other services that are not prohibited for public company audit clients. |
|
|
What are the 4 categories of fees that must be reported?
|
1. Audit fees
2. Audit-related fees 3. Tax fees 4. All other fees |
|
|
What are audit-related fees?
|
Audit-related fees are for services such as comfort letters and reviews of SEC filings that can only be provided by CPA firms.
|
|
|
What do companies do for "other fees"?
|
Companies are required to provide further breakdown of the "other fees" category and to provide qualitative information on the nature of the services provided.
|
|
|
What are the rules on Ownership Interests?
|
SEC rules on financial relationships take an engagement perspective and prohibit ownership in audit clients by those persons who can influence the audit.
The rules prohibit any ownership by covered persons and their immediate family, including (a) members of the audit engagement team, (b) those in a position to influence the audit engagement in the firm chain of command, (c) partners and managers who provide more than 10 hours of non audit services to the client, and (d) partner in the office of the partner primarily responsible for the audit engagement. |
|
|
What is Rule 101?
|
Independence:
It says that CPA firms are required to be independent for certain services that they provide, but not for others. The last phrase in rule 101 "as required by standards promulgated by bodies designated by council" is a convenient way for the AICPA to include or exclude independence requirements for different types of services. |
|
|
What are the interpretations of Rule 101?
|
They prohibit covered members from owning any stock or other direct investment in audit clients because it is potentially damaging to actual audit independence (independence of mind), and it certainly is likely to affect users' perceptions of the auditors' independence (independence in appearance).
Indirect investments, such as ownership of stock in a client's company by an auditor's grandparent, are also prohibited, but only if the amount is material to the auditor. |
|
|
Rule 101 applies to covered members in a position to influence an attest engagement. Who are considered covered members?
|
1. Individuals on the attest engagement team
2. An individual in a position to influence the attest engagement, such as individuals who supervise or evaluate the engagement partner. 3. A partner or manager who provides nonattest services to the client. 4. A partner in the office of the partner responsible for the attest engagement. 5. The firm and its employee benefit plans 6. Any entity that can be controlled by any of the covered members listed above or by two or more of the covered individuals or entities operating together. These independence rules also generally apply to the covered member's immediate family, which is defined as spouse, spousal equivalent, or dependent. |
|
|
What is Direct Financial Interest?
|
The ownership of stock or other equity shares and debt securities by members of their immediate family is called a direct financial interest.
|
|
|
What is an Indirect Financial Interest?
|
An indirect financial interest exists when there is a close, but not a direct, ownership relationship between the auditor and the client.
An example of an indirect ownership interest is the covered member's ownership of a mutual fund that has an investment in a client. |
|
|
Explain Material or Immaterial in Rule 101?
|
Materiality affects whether ownership is a violation of Rule 101 only for indirect ownership. Materiality must be considered in relation to the member person's wealth and income.
For example, if a covered member has a significant amount of his or her personal wealth invested in a mutual fund and that fund has a large ownership position in a client company, a violation of the Code is likely to exist. |
|
|
What is the rule about Financial Interests and Employment of Immediate and Close Family Members in Rule 101?
|
The financial interests of immediate family members (spouse or dependent) are ordinarily treated as if they were the financial interest of the covered member.
Ownership interest of close family members (parent, sibling, or nondependent child) do not normally impair independence unless the ownership interest is material to the close relative. |
|
|
What is Rule 102?
|
Integrity and Objectivity
In the performance of any professional service, a member shall maintain objectivity and integrity, shall be free of conflicts of interest, and shall not knowingly misrepresent facts or subordinate his or her judgement to others. |
|
|
What is Rule 201?
|
General Standards
|
|
|
What is Rule 202?
|
Compliance with Standards
|
|
|
What is Rule 203?
|
Accounting Principles
|
|
|
Explain the Rules 201, 202, 203?
|
They are grouped together and considered "Technical Standards".
The primary purpose of the requirements of Rules 201 to 203 is to provide support for the ASB, PCAOB, FASB, IASB, and other technical standard-setting bodies. |
|
|
Explain Rule 301?
|
Confidential Client Information
A member in public practice shall not disclose any confidential client information without the specific consent of the client. |
|
|
What are the 4 exceptions to confidentiality?
|
1. Obligations related to technical standards (misstated financial report on first opinion, CPA must issue new opinion)
2. Subpoena or summons and compliance with laws and regulations 3. Peer review (client permission to examine the audit documentation is not needed during a peer review) 4. Response to ethics division (If a practitioner is charged with inadequate technical performance by the AICPA Ethics Division trial board under any of Rules 201 to 203, board members are likely to want to examine audit documentation. This exception prevents a CPA firm from denying the inquirers access to audit documentation by saying that it is confidential information) |
|
|
What is Rule 302?
|
Contingent Fees
To help CPAs maintain objectivity in conducting audits or other attestation services, basing fees on the outcome of engagements is prohibited. It is also a violation of Rule 302 for members to prepare an original or amended tax return or a claim for tax refunds for a contingent fee. The only exception to the contingent fee rule is: Soley for purposes of this rule, fees are not regarded as being contingent if fixed by courts or other public authorities, or, in tax matters, if determined based on the results of judicial proceedings or the finding of government agencies. CPA firms are allowed to charge contingent fees for NONATTESTATION services, unless the CPA firm is also performing attestation services for the same client. I.E. it is not a violation for a CPA to charge fees as an expert witness determined by the amount awarded to the plaintiff or to base consulting fees on a percentage of a bond issue, assuming no attestation services are done for the client. |
|
|
What is Rule 501?
|
Acts Discreditable
A member shall not commit an act discreditable to the professions. Rule 501 applies to all CPAs, even those not in public practice. Discreditable acts are not clearly defined, but 4 crimes are listed in specific. |
|
|
What are the 4 crimes that the by laws state that they can terminate any membership in the AICPA without a hearing for judgement? (Part of Rule 501)
|
1. A crime punishable by imprisonment for more than 1 year.
2. The willful failure to file any income tax return that the CPA, as an individual tax payer, is required to file. 3. Filing of a false or fraudulent income tax return on the CPA's or clients behalf. 4. The willful aiding in the preparation and presentation of a false and fraudulent income tax return of a client. *Note that 3 of these deal with income tax matters of the member or client. |
|
|
What is Rule 502?
|
Advertising and Other Forms of Solicitation
To encourage CPAs to conduct themselves professionally, the rules also prohibit advertising or solicitation that is false, misleading, or deceptive. Solicitation consists of the various means that CPA firms use to engage new clients other than accepting new clients who approach the firm. Examples include take prospective clients to lunch to explain the CPA's services, offering seminars on current tax law changes to potential clients, and advertising on an internet site. The last example is advertising, which is only one form of solicitation. A CPA firm cant do any of those forms of soliciting/advertising |
|
|
What is Rule 503?
|
Commissions and Referral Fees
Restrictions on commissions are similar to the rules on contingent fees. CPAs are prohibited from receiving commissions for a client who is receiving attestation services from the CPA firm. Commissions are permissible for other clients, but they must be disclosed. Referral fees for recommending or referring the services of another CPA are not considered commissions and are not restricted. However, any referral fees for CPA services must also be disclosed. The rules for commissions and referral fees means that a CPA does not violate AICPA rules of conduct if it sells such things as real estate, securities, and entire firms on a commission basis if the transaction does not involve a client who is receiving attestation services from the same CPA firm. This rule enables CPA firms to profit by providing many services to nonattestation services clients that were previously prohibited. |
|
|
What is the reasoning for the AICPA to prohibit contingent fees (rule 302) and commissions (rule 503)?
|
Independence and objectivity.
The reason for the AICPA continuing to prohibit commissions for any attestation service client is the need to ensure that the CPA firm is independent. This requirement and the reasons for it are the same as those for contingent fees. |
|
|
What is Rule 505?
|
Form of organization and name
A member may practice public accounting only in a form of organization permitted by state law or regulation whose characteristics conform to resolutions of Council and shall not practice public accounting under a firm name that is misleading. |
|
|
Rule 505 permits practitioners to organize in any of six forms, as long as they are permitted by state law. What are the 6 forms?
|
1. Proprietorship
2. General partnership 3. General corporation 4. Professional corporation (PC) 5. Limited Liability Company (LLC) 6. Limited Liability Partnership (LLP) |
|
|
Chapter 5
|
Legal Liability
|
|
|
Business Failure
|
• A business failure occurs when a business is unable to repay its lenders or meet the expectations of its investors because of economic or business conditions, such as a recession, poor management decisions, or unexpected competition in the industry.
|
|
|
Audit Failure
|
• Audit failure occurs when the auditor issues an incorrect audit opinion because it failed to comply with the requirements of auditing standards.
• Example: A firm assigning unqualified assistants to perform certain audit tasks where they failed to notice material misstatements in the client’s records that a qualified auditor would have found. |
|
|
Audit Risk
|
• Audit risk represents the possibility that the auditor concludes after conducting an adequate audit that the financial statements were fairly stated when in fact, they were materially misstated.
• Audit risk is unavoidable, because auditors gather evidence only on a test basis and because well-concealed frauds are extremely difficult to detect. • An auditor may fully comply with auditing standards and still fail to uncover a material misstatement due to fraud. |
|
|
Prudent Person Concept
|
• The auditor is expected only to conduct the audit with due care, and is not expected to be perfect; this standard of due care is often called the prudent person concept.
• The CPA “undertakes for good faith and integrity, but not for infallibility, and he is liable for negligence, bad faith, or dishonesty, but not for losses consequent upon pure errors of judgment.” |
|
|
o Ordinary Negligence
|
Absence of reasonable care that can be expected of a person in a set of circumstances. For auditors, it is in terms of what other competent auditors would have done in a similar situation.
|
|
|
o Gross Negligence
|
Lack of even slight care, equivalent in seriousness to reckless behavior, that can be expected of a person. Some stated do not distinguish between ordinary and gross negligence.
|
|
|
o Constructive Fraud
|
Existence of extreme or unusual negligence even though there was no intent to deceive or do harm. Constructive fraud is also termed recklessness. Recklessness in the case of an audit is present if the auditor knew an adequate audit was not done but still issued an opinion, even though there was no intention of deceiving statement users.
|
|
|
o Fraud
|
Occurs when a misstatement is made and there is both the knowledge of its falsity and the intent to deceive.
|
|
|
• Terms related to Contract Law:
|
Breach of Contract
Third-Party Beneficiary Common Law Statutory Law |
|
|
Breach of Contract
|
Failure of one or both parties in a contract to fulfill the requirements of the contract. An example is the failure of a CPA firm to deliver a tax return on the agreed-upon date. Parties who have a relationship that is established by a contract are said to have privity of contract.
|
|
|
Third-Party Beneficiary
|
A third party who does not have privity of contract but is known to the contracting parties and is intended to have certain rights and benefits under the contract. A common example is a bank that has a large loan outstanding at the balance sheet date and requires and audit as a part of its loan agreement. While the contract for the audit engagement is between the client and the audit firm, both parties are aware the bank will be relying on the audited financial statements.
|
|
|
Common Law
|
Laws that have been developed through court decisions rather than through government statutes.
|
|
|
Statutory Law
|
Laws that have been passed by the U.S. Congress and other governmental units. The Securities Acts of 1933 and 1934 and Sarbanes-Oxley Act of 2002 are important statutory laws affecting auditors.
|
|
|
o Joint and Several Liability
|
The assessment against a defendant of the full loss suffered by a plaintiff, regardless of the extent to which other parties shared in the wrongdoing. For example, if management intentionally misstates financial statements, an auditor can be assessed the entire loss to shareholders if the company is bankrupt and management is unable to pay.
|
|
|
Separate and Proportionate Liability
|
The assessment against a defendant of that portion of the damage caused by the defendant’s negligence. For example, if the courts determine that an auditor’s negligence in conducting an audit was the cause of 30% of a loss to a defendant, only 30% of the aggregate damage will be assessed to the CPA firm. (Private Securities Litigation Reform Act of 1995)
The passage of the Private Securities Litigation Reform Act of 1995 (The Reform Act) and the Securities Litigation Uniform Standards Act of 1998 significantly reduced potential damages in federal securities-related litigation by providing for proportionate liability in most cases. |
|
|
The 4 Sources of Auditor’s Legal Liability
|
• Liability to clients (i.e. Client sues auditor for not discovering a material fraud during the audit)
• Liability to third parties under common law (i.e. Bank sues auditor for not discovering that a borrower’s financial statements are materially misstated) • Civil liability under the federal securities laws (i.e. Combined group of stockholders sues auditor for not discovering materially misstated financial statements) • Criminal liability (Federal government prosecutes auditor for knowingly issuing an incorrect audit report) |
|
|
Liability to Clients
|
• The most common source of lawsuit against CPAs is from clients.
• Typically, the amount of these lawsuits is relatively small, and they do not receive the publicity often given to suits involving 3rd parties. • The lawsuit can be for breach of contract, a tort action for negligence, or both. • Tort actions are more common because the amounts recoverable under them are normally larger than under breach of contract. • Tort actions can be based on ordinary negligence, gross negligence, or fraud. • The principal issue in cases involving alleged negligence is usually the level of care required. • In audits, failure to meet auditing standards is often conclusive evidence of negligence. • CPA firms and clients typically sign engagement letters, which are required for audits, to formalize their agreements about the services to be provided, fees, and timing. • Privity of contract can exist without a written agreement, but an engagement letter defines the contract more clearly. |
|
|
o Lack of Duty to Perform the Service
|
The CPA firm claims that there was no implied or expressed contract. The CPA’s use of an engagement letter provides a basis to demonstrate a lack of duty.
|
|
|
o Nonnegligent Performance
|
The CPA firm claims that the audit was performed in accordance with auditing standards. The prudent person concept establishes in law that the CPA firm is not expected to be infallible.
|
|
|
o Contributory Negligence
|
A defense of contributory negligence exists when the auditor claims the client’s own actions either resulted in the loss that is the basis for damages or interfered with the conduct of the audit in such a way that prevented the auditor from discovering the cause of the loss.
NOT AVAILABLE TO THE OTHER 3 SOURCES OF LIABILITIES |
|
|
o Absence of Casual Connection
|
To succeed in an action against the auditor, the client must be able to show that there is a close casual connection between the auditor’s failure to follow auditing standards and the damages suffered by the client. Assume that an auditor failed to complete an audit on the agreed upon date. The client alleges that this caused a bank not to renew an outstanding loan, which caused damages. A potential auditor defense is that the bank refused to renew the loan for other reasons, such as the weakening financial condition of the client. This defense is called an absence of casual connection.
|
|
|
Liability to Third Parties Under Common Law
|
• Third parties include actual and potential stockholders, vendors, bankers and other creditors, employees, and customers.
• A CPA firm may be liable to third parties if a loss was incurred by the claimant due to reliance on misleading financial statements. ULTRAMARES DOCTRINE |
|
|
3 types ofinterpretations for Foreseen Users
|
Credit Alliance
Restatement of Torts Foreseeable Users |
|
|
Credit Alliance
|
Credit Alliance v. Arthur Andersen & Co. (1986).
The New York State Court of Appeals upheld the basic concept of privity established by Ultramares and stated that to be liable (1) an auditor must know and intend that the work product would be used by the third party for a specific purpose, and (2) the knowledge and intent must be evidenced by the auditor’s conduct. |
|
|
Restatements of Torts
|
The rule followed by most states is to apply the rule cited in the Restatement of Torts, an authoritative set of legal principles.
The Restatement Rule is that foreseen users must be members of a reasonably limited and identifiable group of users who have relied on the CPA’s work, such as creditors, even though those persons were not specifically known to the CPA at the time the work was done. Rusch Factors v. Levin |
|
|
Foreseeable Users
|
The broadest interpretation of the rights of third-party beneficiaries is to use the concept of foreseeable users.
Under this concept, any users who the auditor should have reasonably been able to foresee as likely users of the client’s financial statements have the same rights as those with privity of contract. These users are often called an unlimited class. Although a significant amount of states followed this approach in the past, it is now only used in two states. |
|
|
Civil Liability Under the Federal Securities Laws
|
• The greatest growth in CPA liability litigation has been under the federal securities laws.
• Litigants commonly seek remedies because of the availability of class-action litigation and the ability to obtain significant damages from defendants. Securities Acts of 1933 and 1934, and the SOX Act. |
|
|
Securities Act of 1933
|
• Burden of proof is on the auditor.
• Deals only with the reporting requirements for companies issuing new securities, including the information in registration statements and prospectuses. • The only parties who can recover from the auditors under the 1933 act are the original purchasers of securities. • The amount of the potential recovery equals the original purchase price less the value of the securities at the time of the suit. (If the securities have been sold, users can recover the amount of the loss incurred) • The 1933 act is the only common or statutory law where the burden of proof is on the defendant. • Registration statement. • Users must only prove that the audited financial statements contained a material misrepresentation or omission. • The auditor has the burden of demonstrating that (1) an adequate audit was conducted or (2) all or a portion of the plaintiff’s loss was caused by factors other than misleading financial statements. |
|
|
Securities Exchange Act of 1934
|
• The liability of auditors under the Securities Exchange Act of 1934 often centers on the audited financial statements issued to the public in annual reports submitted to the SEC as a part of annual Form 10-K reports.
• Every company with securities traded on national or over-the-counter exchanges is required to submit audited statements annually. • Obviously, a much larger number of statements fall under the 1934 act than the 1933 act. • Auditors also face potential legal exposure for quarterly information (Form 10-Q) or other reporting information filed with the SEC, such as n unusual event filed in a Form 8-K. • The auditor must perform a review of the Form 10-Q before it is field with the SEC, and the auditor is frequently involved in reviewing the information in other reports, and , therefore, may be legally responsible. • However, few cases have involved auditors for reports other than reports on annual audits. |
|
|
Rule 10b-5 of the Securities Exchange Act of 1934
|
• The principal focus on CPA liability litigation under the 1934 act is Rule 10b-5.
• Section 10 and Rule 10b-5 are often called the antifraud provisions of the 1934 act, as they prohibit any fraudulent activities involving the purchase or sale of any security. • Numerous federal court decisions have clarified that Rule 10b-5 applies not only to direct sellers but also to accountants, underwriters, and others. • Generally, accountants can be held liable under Section 10 and Rule 10b-5 if they intentionally or recklessly misrepresent information intended for third-party use. • In 1976, in Hochfelder v. Ernst & Ernst, known both as a leading securities law case and as a CPA liabilities case, the U.S. Supreme Court ruled that scienter, which is knowledge and intent to deceive, is required before CPAs can be held liable for violation of Rule 10b-5. • The view that appears to be winning favor in courts currently is that poor judgment isn’t proof of fraud. |
|
|
Sarbanes-Oxley Act of 2002
|
• The Sarbanes-Oxley Act greatly increases the responsibilities of the public companies and their auditors.
• The Act requires the CEO and CFO to certify the annual and quarterly financial statements filed with the SEC. • In addition, management must report its assessment of the effectiveness of internal control over financial reporting, and for accelerated filers, the auditor must provide an opinion on the effectiveness of internal control over financial reporting. • As a result, auditors may be exposed to legal liability related to their opinions on internal control. • The PCAOB also has the authority to sanction registered CPA firms for violations of the Act. • The Act made it a felony (criminal liability) to destroy or create documents to impede or obstruct a federal investigation, which is punishable by fine or imprisonment of up to 20 years. |
|
|
Criminal Liability
|
• A fourth way CPAs can be held liable is under criminal liability for accountants.
• CPAs can be found guilty for criminal action under both federal and state laws. • Under state law, the most likely statutes to be enforced are the Uniform Securities Acts, which are similar to parts of the SEC rules. • The more relevant federal laws affecting auditors are the 1933 and 1934 securities acts, as well as the Federal Mail Fraud Statute and the Federal False Statements Statute. All make it a criminal offense to defraud another person through knowingly being involved with false financial statements. • In addition, the Sarbanes-Oxley Act made it a felony to destroy or create documents to impede or obstruct a federal investigation • Under Sarbanes-Oxley, a person may face fines or imprisonment of up to 20 years for altering or destroying documents. |
|
|
Ultramares Doctrine part 1
|
• The leading precedent-setting auditing case in third-party liability was Ultramares Corporation v. Touche (1931), which established the Ultramares Doctrine.
• In this case, the court held that although accountants were negligent, they were not liable to the creditors because the creditors were not a primary beneficiary. • The court held that the accounts had been negligent, but ruled that accountants would not be liable to third parties for honest blunders beyond the bounds of the original contract unless they were primary beneficiaries. The court held that only one who enters into a contract with an accountant for services can sue if those services are rendered negligently. • In this context, a primary beneficiary is on about whom the auditor was informed before conducting the audit (a known third party). • This case established a precedent, commonly called the Ultramares Doctrine, that ordinary negligence is insufficient for liability to third parties because of the lack of priv |
|
|
Ultramares Doctrine part 2
|
• This case established a precedent, commonly called the Ultramares Doctrine, that ordinary negligence is insufficient for liability to third parties because of the lack of privity of contract between the third party and the auditor, unless the third party is a primary beneficiary.
• However, in a subsequent trial of the Ultramares case, the court pointed out that had there been fraud or gross negligence on the part of the auditor, the auditor could be held liable to third parties who are not primary beneficiaries. |
|
|
The major conclusion of the 1931 Ultramares case was that:
|
ordinary negligence is insufficient for liability to third parties.
|
|
|
Chapter 7
|
Audit Evidence
|
|
|
What are the 4 Audit Evidence Decisions to make?
|
1. Which audit procedure to use (Audit procedure)
2. What sample size to select from a given procedure (Sample size) 3. Which items to select from the population (Items to select) 4. When to perform the procedures (Timing) |
|
|
What is an Audit Procedure?
|
An audit procedure are the detailed steps, usually written in form of instructions, for the accumulation of the eight types of audit evidence.
It is commonly written in great detail. Audit procedures often incorporate sample size, items to select, and timing into the procedure. |
|
|
What is the Sample Size?
|
Once an audit procedure is selected, auditors car vary the sample size from one to all the items in the populations being tested (i.e. 50 of the 6,000 checks recorded).
Auditor makes the decision on the sample size individually for each audit procedure. |
|
|
What is the Items to Select?
|
After determining the sample size for an audit procedure, the auditor must decide when items in the population check.
I.E. (1) randomly select 50 checks, (2) choose the 50 largest checks, (3) choose the 50 checks the auditor thinks is most suspicious, (4) select the first 50 checks written in a random week, or a combination of these methods. |
|
|
What is the Timing?
|
When you are going to perform the audit procedures to collect the audit evidence.
An audit of financial statements usually covers a span of a year. Can do the audit months after the financial year end. Client usually wants the audit completed in 1 - 3 months after financial year end. SEC requires audited financial statements 2-3 months after financial year end depending on the size of the company. |
|
|
What is an Audit Program?
|
The list of audit procedures for an audit area or an entire audit is called an Audit Program.
It always includes a list of the audit procedures and it usually includes sample sizes, items to select, and the timing of the tests. Normally there is an audit program, including several audit procedures, for each component of the audit (i.e. an audit program for accounts receivable, one for sales, and so on). |
|
|
What are the 2 words used by the AICPA to describe the type of audit evidence that needs to be collected?
"The two determinants of the persuasiveness of evidence are..." |
"Appropriate & Sufficient"
Audit standards require the auditor to accumulate sufficient appropriate evidence to support the opinion issued. |
|
|
What are the 2 subcategories of Appropriateness of evidence?
|
Relevance of the Evidence
Reliability of the Evidence |
|
|
What is the Appropriateness of Evidence?
|
It is a measure of the quality of evidence, meaning its relevance and reliability in meeting audit objectives for classes of transactions, account balances, and related disclosures.
Appropriateness of evidence deals only with the audit procedures selected. Appropriateness cannot be improved by selected a larger sample size or different population items. It can only be improved by selecting audit procedures that are more relevant or provide more reliable evidence. |
|
|
What is Relevance of Evidence?
|
Evidence must pertain or be relevant to the audit objective that the auditor is testing before it can be appropriate.
A relevant procedure is to trace a sample of shipping documents to related duplicate sales invoices to determine whether each shipment was billed (completeness objective). Relevance can be considered only in terms of specific audit objectives, because evidence may be relevant for one audit objective but not for a different one. Most evidence is relevant for more than one, but not all, audit objectives. |
|
|
What is Reliability of Evidence?
|
It refers to the degree to which the evidence can be believable or worthy of trust.
|
|
|
Reliability, and therefore appropriateness, depends on which 6 characteristics of reliable evidence?
|
1. Independence of provider
2. Effectiveness of client's internal controls 3. Auditor's direct knowledge 4. Qualifications of individuals providing the information 5. Degree of objectivity 6. Timeliness |
|
|
1. Independence of provider
|
Evidence obtained for a source outside the entity is more reliable than that obtained from within.
|
|
|
2. Effectiveness of client's internal controls
|
When a client's internal controls are effective, evidence obtained is more reliable than when they are not effective.
|
|
|
3. Auditor's direct knowledge
|
Evidence obtained directly by the auditor though physical examination, observation, recalculation, and inspection is more reliable than information obtained indirectly.
|
|
|
4. Qualifications of individuals providing the information
|
Although the source of information is independent, the evidence will not be reliable unless the individual providing it is qualified to do so.
Also, evidence obtained directly by the auditor may not be reliable if the auditor lacks the qualifications to evaluate the evidence. |
|
|
5. Degree of objectivity
|
Objective evidence is more reliable than evidence that requires considerable judgement to determine whether it is correct.
When the reliability of subjective evidence is being evaluated, it is essential for auditors to assess the qualifications of the person providing the evidence. |
|
|
6. Timeliness
|
The timeliness of audit evidence can refer either to when it is accumulated or the period covered by the audit.
|
|
|
The ______ of evidence obtained determines its sufficiency.
|
quantity
|
|
|
What is Sufficiency of Evidence?
|
It is measured primarily by the sample size the auditor selects.
For a given audit procedure, the evidence obtained from a sample of 100 is ordinarily more sufficient than from a sample of 50. In addition to sample size, the individual items tested affect the sufficiency of evidence. Samples containing population items with large dollar values, items with a high likelihood of misstatement, and items that are representative of the population are usually considered sufficient. In contrast, most auditors usually consider samples insufficient that contain ONLY the largest dollar items from the population unless these items make up a large portion of the total population amount. |
|
|
Several factors determine the appropriate sample size in audits. What are the 2 most important ones?
|
1. The auditors expectation of misstatements
2. The effectiveness of the client's internal controls. |
|
|
The persuasiveness of evidence can be evaluated only after considering the...
|
combination of appropriateness and sufficiency, including the effects of the factors influencing appropriateness and sufficiency.
|
|
|
In making decisions about evidence for a given audit, both _____ and _____ should be considered.
Explain. |
persuasiveness and cost.
The persuasiveness and cost of all alternatives should be considered before selecting the best type or types of evidence. The auditors goal is to obtain and sufficient amount of appropriate evidence as the lowest possible total cost. However, cost is never an adequate justification for omitting a necessary procedure or not gathering an adequate sample size. |
|
|
Explain Types of Audit Evidence. What are the 7 types of audit evidence (7 categories of audit tests)?
|
In deciding which audit procedures to use, the auditor can choose from eight broad categories of evidence, which are called types of evidence.
Every audit procedure obtains one or more of the following types of evidence: 1. Physical Examination 2. Confirmation 3. Documentation (Inspection) 4. Analytical procedures 5. Inquiries of the client 6. Reperformance (Recalculation) 7. Observation |
|
|
Physical Examination
|
It is the inspection or count by the auditor of a tangible asset.
Most often associated with inventory and cash, but is also applicable to the verification of securities, notes receivable, and tangible fixed assets. If the object being examined has no inherent value, such as a sales invoice, the evidence is called documentation. Example: Before a check is signed, its a document, once it is signed it is an asset; and when it is cancelled, it becomes a document again. For correct auditing terminology, physical examination of the check can occur only when it is an asset. It is a direct means of verifying that an asset actually exists (existence objective) and to a lesser extent whether existing assets are recorded (completeness objective). |
|
|
Confirmation
|
It describes the receipt of a direct written response from a third party verifying the accuracy of information that was requested by the auditor.
The request is made to client, who then asks the third part to respond directly to the auditor. When practical and reasonable, U.S. auditing standards require the confirmation of a sample of accounts receivable. International auditing standards does not require this. |
|
|
What are the two types on documents (inspection/documentation)
|
Internal and External
|
|
|
Inspection/Documentation
|
Is the auditor's examination of the client's documents and records to substantiate the information that is, or should be, included in the financial statements.
External documents are considered more reliable. |
|
|
What are Internal documents?
|
An internal document has been prepared and used with the client's organization and is retained without ever going to an outside party.
EX: Duplicate sales invoices, employees' time reports, and inventory receiving reports. |
|
|
What are External documents?
|
An external document has been handled by someone outside of the client's organization who is a party to the transaction being documented, but which is either currently held by the client or readily accessible.
EX: Vendors' invoices, cancelled notes payables, insurance policies, title to land, indenture agreements, and contracts. |
|
|
What is vouching?
|
When auditors use documentation to support recorded transactions or amounts, the process is often call vouching.
EX: verifying the acquisitions journal by examining vendors' invoices and receiving reports thereby satisfying the occurrence objective. |
|
|
What is tracing?
|
If the auditor traces from receiving reports to the acquisition journal to satisfy the completeness objective, it is not appropriate to call it vouching. This process is called tracing.
I think vouching has to do with external documents and tracing has to do with internal documents, but im not sure. |
|
|
Analytical Procedures
|
Analytical procedures consist of evaluations of financial information through analysis of plausible relationships between financial and non financial data.
EX: An auditor may compare the gross margin percentage in the current year to the previous year's. Analytical procedures are used extensively in practice and are REQUIRED DURING THE PLANNING AND COMPLETION PHASES ON ALL AUDITS. They are used to: 1. Understand the client's industry and business. 2. ***** the entity's ability to continue as a going concern. 3. Indicate the presence of possible misstatements in the financial statements. 4. Reduce detailed audit tests. |
|
|
What is an unusual fluctuation?
|
Significant unexpected differences between the current year's unaudited financial data and other data used in comparisons are commonly called unusual fluctuations.
Unusual fluctuations occur when significant differences are not expected but do exist, or when significant differences are expected but do not exist. |
|
|
Inquires of the Client
|
Inquiry is the obtaining of written or oral information from the client in response to questions from the auditor.
It is not conclusive evidence because it is not from an independent source and may be biased. |
|
|
Recalculation
|
Recalculation involves rechecking a sample of calculations made by the client.
Testing the clients arithmetic accuracy. |
|
|
Reperformance
|
Reperformance is the auditors independent tests of client accounting procedures or controls that were originally done as part of the entity's acocunting and internal control system.
Whereas recalculation involves rechecking a computation, reperformance involves checking other procedures. EX: The auditor may compare the price on a invoice to an approved price list. |
|
|
Observation
|
Observation consists of looking at a process or procedure being performed by others.
EX: The auditor touring the plant to obtain a general impression of the client's facilities, or watching an accountant do his job to make sure he is doing a good job. |
|
|
Group the 8 types of evidence (assuming reperformance and recalculation are 2 different ones) by Most Expensive, Moderately Expensive, and Least Expensive.
|
Most Expensive: Physical examination and confirmation
Moderately Expensive: Inspection, Analytical procedures, and Reperformance Least Expensive: Observation, Inquiries of the Client, and Recalculation |
|
|
What is Audit Documentation?
|
Auditing standards state that audit documentation is the record of the audit procedures performed, relevant audit evidence, and conclusions the auditor reached.
Auditing documentation should include all the information the auditor considers necessary to adequately conduct the audit and to provide support for the audit report. The overall objective of auditing documentation is to aid the auditor in providing reasonable assurance that an adequate audit was conducted in accordance with auditing standards. More specifically, audit documentation provides: 1. A basis for planning the audit. 2. A record of the evidence accumulated and the results of the tests. 3. Data for determining the proper type of audit report. 4. A basis for review by supervisors and partners. Audit documentation perpared during the engagement, including schedules prepared by the client for the auditor, is the property of the auditor (confidentiality). |
|
|
How long must audit documentation be kept?
|
Auditing standards require that records for audits of private companies be retained for a minimum of 5 years.
The Sarbanes-Oxley Act requires that auditors keep the audit files and other information for public companies for a minimum of 7 years. Willful destruction of audit documentation within the 7 year period is punishable by financial fines and imprisonment of up to 10 years. |
|
|
What are permanent files?
|
Permanent files contain data of a historical or continuing nature pertinent to the current audit. These files provide a convenient source of information about the audit that is of continuing interest from year to year.
The permanent files typically include: -Extracts or copies of such company documents of continuing importance as the articles of incorporation, bylaws, bond indentures, and contracts. -Analyses from previous years of accounts that have continuing importance to the auditor. -Information related to understanding internal control and assessing control risk. -The results of analytical procedures from previous years' audits. |
|
|
What are current files?
|
The current files include all audit documentation applicable to the year under audit.
There is one set of permanent files for the client and a set of current files for each year's audit. Documenting analytical procedures, understanding of internal control, and assessing control risk are included in the current period files rather than in the permanent file by many CPA firms. |
|
|
What are types of information that are often included in the current file?
|
Audit Program
General information Working Trial Balance Adjusting and Reclassification Entries Supporting Schedules |
|
|
What is the working trial balance?
|
Because the basis for preparing the financial statements is the general ledger, the amounts included in that record are the focal point of the audit. As early as possible after the balance sheet date, the auditor obtains or prepares a listing of the general ledger accounts and their year-end balances. This schedule is the working trial balance. Software programs enable the auditor to download the client's ending general ledger balances into a working trial balance file.
The technique used by many firms is to have the auditor's working trial balance in the same format as the financial statements. |
|
|
What is a lead schedule?
|
Each line item on the trial balance is supported by a lead schedule, contained the detailed accounts for the general ledger making up the line item total. Each detailed account on the lead schedule is, in turn, supported by proper schedules supporting the audit work performed and the conclusions reached.
|
|
|
What is the primary purpose of audit documentation?
|
1. Support opinion
2. Provide evidence that the auditor performed a nonnegligent audit 3. Evaluate work of subordinates. |
|
|
What are supporting schedules?
|
The largest portion of an audit includes the detailed supporting schedules prepared by the client or the auditors in support of specific amounts on the financial statements.
Each detailed account of the lead schedule is supported by proper schedules supporting the audit work performed and the conclusions reached by the auditors. |
|
|
What are the 8 major types of supporting schedules?
|
1. Analysis
2. Trial Balance or list 3. Reconciliation of amounts 4. Tests of reasonableness 5. Summary of procedures 6. Examination of supporting documents 7. Informational 8. Outside documentation |
|
|
What are the 3 types of confirmations?
|
1. Positive - customer provides the balance
2. Positive - audit client provides the balance 3. Negative |
|
|
Chapter 8
|
Audit Planning and Analytical Procedures
|
|
|
What are the 3 main reasons why the auditor should properly plan engagements?
|
1. To enable the auditor to obtain sufficient appropriate evidence for the circumstances
2. To help keep audit costs reasonable 3, To avoid misunderstandings with the client |
|
|
What are the 2 risks that have to do with planning an audit?
|
1. Acceptable Audit Risk
2. Inherent Risk These two risks significantly influence the conduct and cost of audits. Much of the early plannings of audits deals with obtaining information to help auditors assess these risks. Assessing acceptable audit risk and inherent risk is an important part of audit planning because it helps determine the amount of evidence that will need to be accumulated and the experience level of staff assigned to the engagement. For example, if inherent risk for inventory is high because of complex valuation issues, more evidence will be accumulated in the audit of inventory and more experienced staff will be assigned to perform testing in this area. |
|
|
What is Acceptable Audit Risk?
|
It is a measure of how willing the auditor is to accept that the financial statements may be materially misstated after the audit is completed and an unqualified opinion has been issued.
When the auditor decides on a lower acceptable audit risk, it means that the auditor wants to be more certain that the financial statements are not materially misstated. Zero risk is certainty, and a 100 percent risk is complete uncertainty. Audits with a low acceptable audit risk will normally represent a higher cost of auditing since more evidence is needed, which should be reflected in higher audit fees. |
|
|
What is Inherent Risk?
|
It is a measure of the auditor's assessment of the likelihood that there are material misstatements in an account balance before considering the effectiveness of internal control.
If, for example, the auditor concludes that there is a high likelihood of material misstatement in accounts receivable due to changing economic conditions, the auditor concludes that inherent risk for accounts receivable is high. |
|
|
What are the 8 steps in planning an audit?
|
1. Accept client and perform initial audit planning
2. Understand the clients business and industry 3. Assess client business risk 4. Perform preliminary analytical procedures 5. Set materiality and assess acceptable audit risk and inherent risk 6. Understand internal control and assess control risk 7. Gather information to assess fraud risks 8. Develop overall audit strategy and audit program |
|
|
Initial audit planning involves what 4 things, which should all be done early in the audit?
|
1. The auditor decided whether to accept a new client or continue serving an existing one.
2. The auditor identifies why the client wants or needs an audit. 3. To avoid misunderstandings, the auditor identifies why the client wants or needs an audit. This information is likely to affect the remaining parts of the planning process. 4. The auditor develops an overall strategy for the audit, including engagement staffing and any required audit specialists. |
|
|
New Client Investigation / Accepting a new client; What things are considered?
|
Before accepting a new client, most CPA firms investigate the company to determine its acceptability.
Things to consider: 1. Reputation in the business community 2. Financial Stability (struggling companies have a higher fraud risk) 3. Relations with prior auditor (SAS 84 requires contact with prior auditor, with permission from potential client) 4. Management reputation 5. Meet with client to get a feel for management and situation - competitive bid |
|
|
What is the rule about the potential new auditor talking to the old auditor? Why is this a rule?
|
SAS 84 in the Code of Professional Conduct
The new auditor is required to talk to the old auditor to figure out if he should accept the engagement. The old auditor needs permission from the client before talking to the new auditor. |
|
|
What is opinion shopping?
|
When a client fires an auditor to get an easier one. This is illegal.
|
|
|
Retention of Client
|
Many CPA firms evaluate existing clients annually to determine whether there are reasons for not continuing to do the audit.
Things to consider: -Evaluate ongoing risk associated with the company -Future risk associated with the company -Consider previous conflicts with management and the resolution -Assess management integrity -All prior fees must be paid within the last year |
|
|
Planning the Audit
|
-Understand who the financial statement users are the their intended use for the financial statements (statements that are used extensively will likely require more evidence which means higher cost).
-Obtain understanding with client (engagement letter; signed by auditor and signed acceptance by client). -Select staff for the engagement -Evaluate need for outside specialist -Create initial audit program. |
|
|
Who hires the auditor for public companies? How about private companies?
|
For public companies, the Sarbanes-Oxley Act requires the audit committee to hire the auditor.
For private companies, management usually signs the engagement letter. |
|
|
What is the audit strategy?
|
After understanding the client's reasons for the audit, the auditor should develop and document a preliminary audit strategy that sets the scope, timing, and direction of the audit and that guides the development of the audit plan. This strategy considers the nature of the client's business and industry, including areas where there is greater risk of significant misstatements.
Then planned strategy helps the auditor determine the resources required for the engagement, including engagement staffing. |
|
|
Selecting the staff for the engagement
|
The auditor must assign the appropriate staff to the engagement to comply with auditing standards including engagement staffing.
"Auditors are responsible for having appropriate competence and capabilities to perform the audit". Because of this, the staff must therefore be assigned with that requirement in mind, and those assigned to the engagement must be knowledgeable about the client's industry. A major consideration of staffing is the need for continuity from year to year. |
|
|
Understanding the clients business
|
-Need to understand risks of company
-Need to understand risks of industry -Clients business may determine how transactions should be recorded (percentage of completion vs. completed contract) -Provide added value -Resources: 1. read trade journals 2. tour facility 3. read board minutes 4. attend conferences 5. talk with management |
|
|
What is a related party?
|
A related party is defined in auditing standards as an affiliated company, a principal owner of the client company, or any other party with which the client deals, where one of the parties can influence the management or operating policies of the other.
|
|
|
What is a related party transaction?
|
A related party transaction is any transaction between the client and a related party (i.e. parent company and subordinate company or between two companies that have the same owner).
Not an arms-length transaction. Most auditors assess inherent risks as high for related party transactions. Because all material related party transactions must be disclosed, all related parties need to be identified and included in the auditors permanent files early in the engagement. |
|
|
What are corporate minutes?
|
The corporate minutes are the official record of the meetings of the board of directors and the stockholders.
|
|
|
What is (Client) Business Risk?
|
The auditor uses knowledge gained from the understanding of the client's business and industry to assess client business risk, the risk that the client will fail to achieve its objectives (fail to exist or something will happen to hurt performance).
Client business risk can arise from any of the factors affecting the client and its environment. The auditors primary concern is the risk of material misstatements in the financial statements due to client business risk. |
|
|
What is Audit Risk?
|
Level of risk the auditor is willing to accept that the financial statements are materially misstated after a "clean" audit opinion has been issued.
|
|
|
Analytical procedures for business risk
|
Compare relationships between financial statements
Cash flows from operations between years Compare ratios to competitors and between years including (but not restricted to) -accounts receivable turnover -inventory turnover -debt to equity ratio -current ratio -gross profit In identifying areas of specific risk, the auditor is likely to focus on the liquidity activity ratios (Accounts receivable turnover, Days to collect accounts receivable, Inventory turnover, Days to sell inventory). |
|
|
What 3 times can/are analytical procedures be performed?
|
1. They are required in the planning phase to assist in determining the nature, extent, and timing of audit procedures.
2. They are often done during the testing phase of the audit as a substantive test in support of account balances. 3. They are also required during the completion phase of the audit. |
|
|
What are the 5 types of Analytical Procedures?
|
1. Compare the client and the industry data.
2. Compare the client with similar prior period data. 3. Compare client data with client-determined expected results. 4. Compare client data with auditor determined expected results. 5. Compare client data with expected results, using non-financial data |
|
|
Common analytical procedures; Explain the 5 main ones.
|
Analytical procedures create a picture of the conditions in order to think about management motivations and direct audit testing.
1. Compare balances 2. Inventory turnover (obsolete inventory) 3. Current Ratio (ability to pay short term obligations; going concern) 4. Debt to Equity (compliance with debt covenants) 5. Accounts receivable turnover (collectibility of receivables and information for allowance) |
