Ethics and Legal Responsibilities
Auditors’ Responsibility to Society The three areas of responsibility to society. 1. Moral Responsibilities. • Text: “A public accountant should be upright, not kept upright. ” 2. Professional Responsibilities. 3. Legal Responsibilities. 2
Ethics Professional responsibilities • The rules and principles Professional ethics are necessary for a number or reasons: • • Obtain respect Distinguish professional To achieve order Provide a means of 3
Overview • Ethics: “that branch of philosophy which is the systematic study of reflective choice, • There is always a possibility that a professional accountant will encounter an ethical problem Ethical problem: • 4
• Ethical behaviour: That which produces the greatest good, or that which conforms to rules and principles. • Ethics are involved in decision making • Why do we need a code of ethical conduct? • A code serves as a 5
Ethics refer to the role of the decision maker as mentioned. In addition, the professional accountant serves other roles: • • • Spectator Advisor Instructor Judge Critic What is ethical behaviour? 6
An Ethical Problem In your work as an auditor, you discover that the cashier, who has custody over the petty cash fund, has forged several payment records in order to cover innocent mistakes and to make the fund balance each month when it is replenished. Your investigation reveals that the amount involved during the year is $240. the cashier is a woman, age 55, and the president of the company is a man who can tolerate no mistakes, intentional or otherwise, in the accounting records. In fact, he is unyielding in this respect. He asks you about the results of your audit. Not doubting that the cashier would be fired if the forgeries were known, should you remain silent and thus not tell the truth? 7
Ethical Decision Process 1. 2. 3. 4. 5. 6. Recognize a decision problem. Collect evidence. Think about rules of behaviour. Considering probable outcomes. Analyze the situation. Take action. 8
Professional Scepticism An inclination to question all material assertions made by management whether oral, written, or contained in the accounting records. • Results from the potential conflict of interest 9
Codes of Professional Ethics Each CPA institute in the provinces has its own rules of professional conduct. Typical framework follows: • • • Introduction and purpose Fundamental principles and standards General rules Specific rules Discipline Interpretations of the rules 10
Fundamental Principles 1. The member should act to maintain 2. The member should use and maintain his/her If engaged to express an opinion the member should maintain 3. 4. 5. 6. as well as so as not to impair professional judgment and objectivity. The member should The member practice should based on his/her reputation The member should show to other members at all times. 11
Framework for a Code of Conduct Objective: to serve the public interest. Principles necessary to attain objective: • • • Integrity Objectivity Professional Competence and due care Confidentiality Professional behaviour Conformity is achieved by identifying, evaluating, and controlling threats to non-conformity to an acceptable level 12
Rules of Professional Conduct The Rules of Professional Conduct derive their authority from the bylaws of the profession. • • Rules apply to members and all persons associated in public practice including employees and partners. Certain principles apply to all professional accountants. • • • 100 – General 200 – Standards Affecting the Public Interest 300 – Relations with Other Members or Firms 400 – Organization and Conduct of a Professional Practice 500 – Rules of Professional Conduct Applicable only to firms 13
Serving the Public Interest The single most important principle is that accountants must serve the public interest. The profession must maintain a good reputation at all time. • Rule 205 – auditor must not be associated with misleading information. A very important rule. 14
Integrity is the duty to be honest and conscientious in performing professional services. 15
Independence and Objectivity Rule 204 • A member shall be free from any influence which would impair their ability to perform their professional responsibilities Independence and objectivity are closely related terms. Objectivity: • Member in public practice Independence: • This means that there must be objectivity Independent in fact and in appearance 16
Canadian Business Corporations Act, Section 161. (2) Independence – For the purpose of this section, a) independence is a b) a person is deemed not to be independent if he or his business partner III. has been within two years of his proposed appointment as auditor of the corporation. (3) Duty to resign. – An auditor who becomes disqualified under this section 17
Independence Standards The CPA Canada has an independence standard framework based on five threats to independence. 1. 2. 3. 4. 5. self-review threat, self-interest threat, advocacy threat, familiarity threat, and intimidation threat. 18
Independence The Canadian Business Corporations Act • • Many other services offered by public accountants also require independence. A member is considered to be in public practice if he or she: The concept of independence is critical to the public accounting profession. • Not only must an accountant • • Independence in fact Independence in appearance is governed 19
Professional Competence and Due Care Professional competence and due care principles are • Professional competence • Due care 20
Compliance with Professional Standards Rule 206 - PAs shall perform professional services in accordance with generally accepted standards of practice for the profession. • • • An extension and refinement of Practical effect of the rule is to make noncompliance The failure to follow auditing standards, accounting and review standards, and assurance, compilation and professional conduct standards 21
Some Common Rules - examples General Rules Rule 101: Must comply with the bylaws, regulations, and rules of the Institute Rule 102: If convicted of, or pleaded guilty to, any criminal or similar offence, any also be charged with Rule 103: When applying for admission, or readmission, shall not provide Rule 104: Shall promptly reply to any letter from the Institute which specifically requests for one
Standards of Conduct Affecting the Public Interest Rule 201: Conduct oneself at all times in a manner which will maintain the good reputation of the profession Rule 202: Perform services with integrity and due care Rule 203: Sustain professional competence by keeping informed of developments in the field
Rule 209 -210: Confidential information No member shall • Use of confidential information about clients • Disclosure of confidential information Rule 215: Contingency fees • What are contingency fees? Rule 217: Advertising and soliciting Professional excellence
Relations with Fellow Members Rule 301: Solicitation • Direct or Indirect Rule 302: Change of auditor by a client • Act with courtesy and consideration • Communicate with previous public accountant • Advise client to notify the incumbent
Organization and Conduct of Professional Practice Rule 401 and 403: Practice names • Misleading names • Composition of the name • Surname(s) of present owners or partners • Using the term “Chartered Accountant” or “Public Accountant”
• Federal and Provincial legislation contain statement preventing specified individual acting as auditors • Family members • Investors • Normal commercial transactions • Trustee in bankruptcy – two year rule
Problem 3 -1, Page 89 For each case, state whether or not the action or situation shows violation of the rules of professional conduct, explain why, and cite the relevant rule or interpretation. a. R. Stout, PA, performs the audit of the local symphony society. Because of her good work, she was elected an honorary member of the board of directors. b. N. Wolfe, a retired partner of your PA firm, has just been appointed to the board of directors of Palmer Corporation, your firm’s client. Wolf is also an ex officio member of your firm’s income tax advisory committee, which meets monthly to discuss income tax problems of the partnership’s clients, some of which are competitors of Palmer Corporation. The partnership pays Wolfe $100 for each committee meeting attended and a monthly retirement benefit, fixed by a retirement plan policy, of $100. c. Archie Goodwin, PA, performs significant day-to-day bookkeeping services for Harper Corporation and supervises the work of one of part-time bookkeeper employed by Marvin Harper. This year, Marvin wants to engage PA Goodwin to perform an audit. d. PA Fritz’s wife owns 20% of the common shares of Botacel Company, which wants Fritz to perform the audit for the calendar year ended December 31, 20 X 4. e. Fritz’s wife gave her shares to their 10 -year-old daughter on July 1, 20 X 4. f. Fritz’ s daughter, acting through an appropriate custodian, sold the shares to her grandfather on August 1, 2007. His purchase, as an accommodation, took one-half of his retirement savings. g. Fritz’s father managed to sell the shares on August 15 to his brother, who lives in Brazil. The brother fled there 20 years ago and has not returned. 28
h. i. j. Clyde Brenner is a manager in the Regina office of a large national PA firm. His wife, Bonnie, is assistant controller in ATC Corporation, a client of the firm whose audit is performed by the New York office. Bonnie and Clyde live in Rhode Island commute to their respective workplaces. Clyde Brenner just received word that he has been admitted to the partnership. The Rockhard Trust Company, a client of your firm, privately told your local managing partner that a block of funds would be set aside for home loans for qualified new employees. Rockhard’s president is well aware that your firm experiences some difficulty hiring good people in the midsize but growing community and is willing to do what he can to help while mortgage money is so tight. Several new assistant accountants obtained home loans under this arrangement. (AICPA Adapted) 29
Problem 3 -3, page 90 Required: For each of the following completely independent situations, describe the rules of professional conduct that are relevant. Have they been violated? Support your conclusion. Situation A Randi Woode, PA, was working on the year-end audit of her client, Pads N’ Pens (PNP). PONP is an office stationery retailer with a July 31 year-end. She was having difficulty completing the audit because some accounting records for the months of April and May had been destroyed in a fire. She told the owner-manager of PNP, Joe Smith, that she might have to qualify her audit report because of her inability to substantiate some of the balances on the financial statements. Joe pointed out that he had been her client for eight years and that she knew him to honest and trustworthy. He also said a qualified report would harm his negotiations with the bank for additional loans. After considering PNP’s need for additional financing as well as their long standing relationship, Randi agreed to issue an unqualified report. Situation B Lori Wilkes is an audit senior with a large PA firm in Toronto. She has learned that one of her largest clients, Superior Motors Ltd. (SML), is planning to acquire Steelco Inc. SML is Canada’s largest automobile manufacturer, and Steelco is one of SML’s biggest steel suppliers. Lori is confident that SML’s acquisition of Steelco will reduce SML’s costs dramatically, and that, as a result, SML’s share price will rise. She has, therefore, encouraged her boyfriend, Tom, to buy some shares while being careful not to divulge the real reasons behind her recommendations. Situation C After obtaining his PA designation, Larry Wilde decided to set up his own public accounting practice. He reasoned that naming his practice “Quality Chartered Accounting Services” would best attract new clients. (ICAO Adapted) 30
Legal Liability Record-setting damages have been awarded and professional liability insurance premiums have increased dramatically. • Accountants are potentially liable • Class action suits 31
Auditors are exposed to liability for: 1. 2. 3. 4. Failure to report Failure to conduct Failure to detect Being party 32
Audit Responsibilities Users of audit reports expect auditors will detect fraud, theft, and illegal acts and report them publicly. But: • Auditors take responsibility An expectation gap exists: Users can expect a different level of diligence versus the diligence auditors are able to accept. 33
Common Law and Statutory Law Common law is based on precedents and past decisions in the courts. • • • Common law is Statutory law In the US, prior to Enron, the major source of liability for accountants was common law. In the post-Enron world this appears to be changing. 34
Liability Under Common Law Legal liabilities of PAs may arise from the law of contracts or as tort actions for negligence. • Breach of contract is a claim that • The rule of the law of torts is to compensate victims for 35
Characteristics of Common Law Actions Burden of proof on the plaintiff. Plaintiff must prove all the following: • • • That there was a That financial statements were That the financial statements That the accountant was 36
Characteristics of Common Law Actions Clients: May bring a lawsuit for breach of contract. • • The relationship of direct involvement between parties to a contract is known as A fiduciary duty • Auditors have a fiduciary duty to their clients 37
H. E. Kane Agencies v. Coopers & Lybrand (1983) – Canadian Case • • • Kane an agent for a national airline Airline supposed to be promptly paid for tickets Kane’s son extended credit on these sales. Delayed recording of sales Airline caught on and Kane had to pay $250, 000 for outstanding sales Kane sued C&L. Said they should have done a year end cutoff of sales • C&L claimed they were not obligated to advise on business matters • Judge found C&L failed to detect the extension • But also that Kane had lack of supervision and willful concealment of unreported sales • Thus company contributed to its own loss
Third parties: May file a lawsuit under the tort law of negligence. • • Negligence is failure to perform a duty with requisite standard care. Plaintiff must demonstrate: • • • There is a There must be a Haig v. Bamford • Canadian case for Third Party Liability 39
Gordon T. Haig v Ralph L. Bamford et al. (1976) • GH approached manager of SEDCO for investment advice. SEDCO had already advanced funds to Scholler Furniture • GH advanced funds based on the F/S • GH invested more funds • GH sued RB for negligence • SF needed more funds. Their auditor was RB • SF told RB they need audited F/S for their bank and an unknown investor • SF foundered • SF wound up their operations • Supreme Court found that accountants were negligent
• From Haig v. Bamford • To which third parties does the auditor owe a duty of care: • Supreme Court said that there were three possible situations: Called a test for duty of care to third parties 1 Foreseeability of the use of the F/S and client reliance thereon. 2 Actual knowledge of the limited class of F/S user. 3 Actual knowledge of specific plaintiff using the F/S • Which one applies?
Thus to whom do auditors owe a duty of care? 1. 2. To the Contractual Party To the financial stakeholders. • The shareholders or owners Third Parties: Reasonably foreseeable third parties can sue in the case of negligence. Auditor liability is much broader if there has been Gross Negligence or Fraud. 42
The Meaning of Due Care Due care implies the careful application of all the standards of the profession. 43
Auditors’ Liability Under Statutory Law In the US the SEC laws give the SEC the legal right to decide what is GAAP. • Increasingly the OSC (Ontario Securities Commissions) and the Quebec regulators are seeking more enforcement power over professionals • Canadian statutory law is the 44
Some key Cases re Due Care: • London v. General Bank (1895) UK • 1136 Tenants v. Max Rothenberg (1967) US • Mc. Kesson Robbins (1939) US • • Influenced Handbook section CAS 501 – Audit Evidence Continental Vending (1969) US 45
Canada Business Corporations Act: • Sections of auditor importance • S 161 Conditions under which the auditor • S 162 and 163 Conditions of S 168 Auditors rights and responsibilities: • attend • provide • to make an audit examination unimpeded • • S 44 -47 Identify the financial statements subject to audit and specify that the financial statements must be in conformity 46
Foreign Corrupt Practices Auditors are responsible for detecting foreign bribes 47
Other Issues Legal liability implications for auditor practice: • • • Be wary of the type of clients being accepted. Know thoroughly the client’s business. Perform quality audits. 48
Problem 3 -5, page 91 Common Law Liability Exposure. Smith, PA, is the auditor for Juniper Manufacturing Corporation, a privately owned company that has a June 30 fiscal year. Juniper arranged for a substantial bank loan, which was dependent on the bank’s receiving, by September 30, audited financial statements showing a current ratio of at least 2 to 1. On September 25, just before the audit report was to be issued, Smith received an anonymous letter on Juniper's stationery indicating that a five-year lease by Juniper, as lessee, of a factory building that was accounted for in the financial statements as an operating lease was in fact a capital lease. The letter stated that there was a secret written agreement with the lessor modifying the lese creating a capital lease. Smith confronted the President of Juniper, who admitted that the secret agreement existed but said it was necessary to treat the lease as an operating lease to meet the current ratio requirement of the pending loan and that nobody would ever discover the secret agreement with the lessor. The President said that if Smith did not issue his report by September 30, Juniper would sue Smith for substantial damages that would result from not getting the loan. Under this pressure and because the working papers contained a copy of the five-year lease agreement supporting the operating lease treatment, Smith issued his report with an unqualified opinion on September 29. In spite of the fact that the loan was received, Juniper went bankrupt. The bank is suing Smith to recover its losses on the loan and the lessor is suing Smith to recover the uncollected rents. Required: Answer the following, setting forth reasons for any conclusions stated: a. Is Smith liable to the bank? b. Is Smith liable to the lessor? c. Was Smith independent? (AICPA adapted) 49
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