Topic 3 - LearnObj - Professional Responsibilities of Auditors

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The SEC prohibits these types of relationships between auditor and client (4 categories)

*(1) Employment relationships.* For example, a company faces some limitations on being able to hire individuals formerly employed by its auditors. Such cases require a one-year cooling off period before the individual can occupy certain positions in the company. *(2) Contingent fee relationships.* In other words, auditors cannot be paid based on the outcome of the audit engagement. *(3) Direct or material indirect business relationships.* Auditors can't have direct or material indirect business relationships with the company, its officers or directors, or with significant shareholders. *(4) Certain financial relationships.* Some financial relationships between the auditor and his client are prohibited by the SEC. For example, direct or material indirect financial interests in the client, debtor/creditor relationships, and banking relationships are prohibited.

1.520 - Commissions and Referral Fees

A member in public practice shall not for a commission recommend or refer to a client any product or service, or for a commission recommend or refer any product or service to be supplied by a client, or receive a commission, when the member or the member's firm also performs for that client 1. an audit or review of a financial statement; or 2. a compilation of a financial statement when the member expects, or reasonably might expect, that a third party will use the financial statement and the member's compilation report does not disclose a lack of independence; or 3. an examination of prospective financial information.

1.800 - Form of Organization and Name

A member may practice public accounting only in a form of organization permitted by law or regulation whose characteristics conform to resolutions of Council. A member shall not practice public accounting under a firm name that is misleading. Names of one or more past owners may be included in the firm name of a successor organization. A firm may not designate itself as "Members of the American Institute of Certified Public Accountants" unless all of its CPA owners are members of the Institute.

Covered Member - According to ET Section 0.400.12

According to ET Section 0.400.12, a covered member is: an individual on the attest engagement team; an individual in a position to influence the attest engagement; a partner, partner equivalent or manager who provides non-attest services to the attest client beginning once he or she provides ten hours of non-attest services to the client within any fiscal year and ending on the later of the date (i) the firm signs the report on the financial statements for the fiscal year during which those services were provided or (ii) he or she no longer expects to provide ten or more hours of non-attest services to the attest client on a recurring basis; a partner or partner equivalent in the office in which the lead attest engagement partner or partner equivalent primarily practices in connection with the attest engagement; the firm, including the firm's employee benefit plans; or an entity whose operating, financial, or accounting policies can be controlled by any of the individuals or entities described in the previous descriptions of a covered member or by two or more such individuals or entities if they act together.

LO 6 Discuss audit firms' legal liability risks and factors influencing their litigation exposure

Auditors face the risk of litigation from users of financial statements. also auditor's clients can sue for failure to perform agreed-upon services in a professional manner. In addition, the auditor may be sued by the board of directors who hired the auditor for failing to detect the material misstatement. Investors or the client may allege the auditor was negligent, grossly negligent or even fraudulent in performing the audit. Negligence refers to a lack of due care in the conduct of the audit. Gross negligence goes a step further alleging that the auditor had a reckless disregard for the truth or that they failed to excercise even the slightes amount of care in conducting the audit. Fraud refers to the auditor taking actions with the intent to deceive. (in other words) an auditor who is accused of fraud is accused of purposely allowing management's misstatement to occur in order to mislead investors.

How do auditors limit litigation exposure?

Auditors seek to limit litigation exposure by doing each of the following: Selectively reviewing potential clients prior to accepting an audit engagement Establishing and following stringent firm guidance and policies to ensure compliance with auditing standards and to promote high-quality audits Perform client retention evaluations following each engagement to remove high-risk audit engagements from the firm's portfolio of clients Lobby lawmakers for liability restrictions in both federal and state securities litigation laws

LO 5 Describe the SEC's and AICPA's rules regarding auditor independence. *(4 SEC principles)*

Because auditor independence is such a critical issue, the SEC and the AICPA have principles and detailed rules relating to auditor independence for SEC registrants (synonymous with public company) In general auditors are thought to lack independence if the service performed by the auditor:* *4 SEC Principles* *1. creates a mutual or conflicting interest with their audit client; *2. places them in the position of auditing their own work; *3. results in their acting as management or an employee of the audit client; or *4. places them in a position of being an advocate for the audit client.

Non-Audit Services Prohibited from being performed by the external auditor

Bookkeeping or other services relating to the accounting records or financial statements of the audit client; Financial information systems design and implementation; Appraisal or valuation services, fairness opinions, or contribution-in-kind reports; Actuarial services; Internal audit outsourcing services; Management functions or human resources; Broker or dealer, investment adviser, or investment banking services; Legal services and expert services unrelated to the audit; and Any other services that the Board determines, by regulation, is impermissible.

1.400 - Acts Discreditable

deals with acts discreditable (an action taken by CPAs that cause harm to the reputation of the profession. A member shall not commit an act discreditable to the profession. Several examples include: Failure to return client-provided documents at their request Discrimination or harassment Failure to follow regulations Negligence in preparation of financial statements Failure to file a tax return or pay a tax liability Failure to maintain confidentiality of client's info Using false or deceptive practices in marketing professional services Using CPA credential contrary to acceptable practices Solicitation or disclosure of CPA exam questions and answers.

LO 4 Explain the SEC's principles relating to auditor independence.

Independence can be viewed in two ways: Independence in fact and independence in appearance. *Independence in fact:* Relates to the state of mind, or impartiality held by the auditor during the conduct during the audit. Investor: concerned with whether the auditor is truly exercising impartial judgment when auditing. In other words: Independence in fact is not observable to the investor. *Independence in appearance:* Relates to the nature of observed relationships between the auditor and the client. Relates to whether relationships exist that might lead outsiders (investors) to believe that the auditor is not independent or impartial when carrying out the audit. In closing: If an auditor lacks independence in fact, the likelihood of an audit failure increases due to the auditor being biased in his judgments and decisions made during the engagement.

LO 2 Describe the key requirements in the AICPA's code of professional conduct. (6)

Outlines six principles and many related rules prescribing how auditors carry out their professional services. Both members of the AICPA as well as CPAs who are not members of the AICPA are obligated to comply The six principles of professional conduct are listed below: *Responsibilities:* In carrying out their responsibilities as professionals, members should *exercise sensitive professional and moral judgments* in all their activities. *The Public Interest*: Members should accept the obligation to *act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism.* *Integrity*: *To maintain and broaden public confidence*, members *should perform all professional responsibilities with the highest sense of integrity.* *Objectivity and Independence:* A member *should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities.* A member in public practice should be independent in fact and appearance when providing auditing and other attestation services. *Due Care:* A member *should observe the profession's technical and ethical standards*, *strive continually to improve competence and the quality of services*, and discharge professional responsibility to the best of the member's ability. *Scope and Nature of Services:* A member in public practice *should observe the Principles of the Code of Professional Conduct in determining the scope and nature of services* to be provided. Each of these principles is followed by a more detailed description. For example, the "Public Interest" principle is followed by additional information including the definition of what is meant by public interest. The document states, "The public interest is defined as the collective well-being of the community of people and institutions the profession serves."

LO 3 Define professional skepticism and describe the auditor's responsibilities relating to professional skepticism.

Professional skepticism: An attitude that includes a questioning mind, being alert to conditions that may indicate possible misstatement due to fraud or error, and a critical assessment of audit evidence. The PCAOB issued a Staff Audit Practice Alert: This reminded auditors of their responsibility to apply professional skepticism and suggested that improvements in the application of professional skepticism could come through improvements in quality control and proper tone at the top, proper assignments of personnel to audit engagements, and appropriate audit documentation (especially with regard to issues involving significant judgments)

1.510 - Contingent Fees

Relates to contingent fees (is a fee that is dependent on the outcome of the audit); because the nature of the fee potentially impairs the auditor's objectivity and independence. for example auditors are not permitted to accept an audit fee that is dependent on a particular outcome or a fee where the amount is determined by the outcome of the audit (i.e. the auditor receives more money if she issues an unqualified opinion) A member in public practice shall not: 1. Perform for a contingent fee any professional services for, or receive such a fee from a client for whom the member or the member's firm performs, * an audit or review of a financial statement; or * a compilation of a financial statement when the member expects, or reasonably might expect, that a third party will use the financial statement and the member's compilation report does not disclose a lack of independence; or * an examination of prospective financial information; or 2. Prepare an original or amended tax return or claim for a tax refund for a contingent fee for any client.

1.700 - Confidential Client Information

Relates to the confidentiality of the client's information. A member in public practice shall not disclose any confidential client information without the specific consent of the client. What's allowed: For example, the auditor is required to disclose confidential client information when issued a *valid subpoena or court summons* or *when laws or regulations require disclosure of client information.* Other instances when client information would be shared with others include *peer quality control reviews*, PCAOB *inspections*, or *inquiries by the SEC* or *professional ethics division* of the AICPA.

Selected Rules from the AICPA's Code of Professional Conduct

Rule 1.700 - Confidential Client Information Rule 1.510 - Contingent Fees Rule 1.400 - Acts Discreditable Rule 1.600 - Advertising and other forms of Solicitation Rule 1.520 - Commissions and Referral Fees Rule 1.800 - Form of Organization and Name

Federal government and each state have different laws regarding who can bring a lawsuit against an auditor and for what reasons they can bring the lawsuit.

States have varying level of liability the auditor is exposed to. Some jurisdictions use Joint and Several liability laws: which state that if both the client and the auditor are at fault in an audit failure, both are 100% liabile for all damages. ( if one party cannot pay , the other party becomes responsible for payment of all damages. Proportional Liability laws: dictate that each party is only responsible for the percentage of *actual damages* that he or she is responsible fore causing for example: client was deemed 80% responsible for damages and the auditor was 20% at fault, the auditor would be liabile for no more than 20% of the damages. (regardless of whether or not the client were able to pay) Punitive damages: Can be assessed to the audtors as well as limitations on the client's ability to sue the auditor when the client has contributed to the audit failure in some way.

LO 2 - Continued

In addition to these six principles of professional conduct, the Code of Professional Conduct includes guidelines and rules with specific applications. These rules are divided into the following categories: Section 100: Independence, Integrity and Objectivity Section 200: General Standards Accounting Principles Section 300: Responsibilities to Clients Section 400: Responsibilities to Colleagues Section 500: Other Responsibilities and Practices

Sarbanes-Oxley Act of 2002

Established the PCAOB and granted it the authority to serve as the standard setter for audits of SEC registrants. SOX gave greater authority to companie's audit committees, making it clear that the audit committee is responsible for hiring and compensation regarding external auditors. Committee must pre-approve any non-audit services performed by the external auditor. SOX prohibits auditors from performing certain non-audit services for their audit clients. The auditor is also required to provide an audit report on the companies internal controls. Sarbanes-Oxley Act of 2002 Congress gave the PCAOB the means to carry out inspections of public company audits and to require public accounting firms to register with the PCAOB.

1.600 - Advertising and other forms of Solicitation

Expressly prohibited false, misleading, or deceptive advertising. A member in public practice shall not seek to obtain clients by advertising or other forms of solicitation in a manner that is false, misleading, or deceptive. Solicitation by the use of coercion, over-reaching, or harassing conduct is prohibited. The code defines false, misleading or deceptive advertising practices as activities that: 1. Create false expectations of favorable results. 2. Imply the ability to influence any court, tribunal, or regulatory agency. 3. Contain a representation that specific professional services in current or future periods will be performed for a stated fee. 4. Contain any other representations that would cause a reasonable person to misunderstand or be deceived. Rule 1.600 prohibits members from practicing public accounting under a firm name that is misleading. One example of this would be a firm that was organized as a Limited Liability Partnership (LLP) using the abbreviation "Inc." after its name. In this example, using "Inc." after the name gives the public the impression that the firm is a corporation when, in reality, it is an LLP. Another example prohibited by Rule 1.600 is a firm referring to itself as a collection of CPAs (e.g., Smith & Johnson, CPAs) when, in fact, not all of the principals of the firm are certified public accountants.

Securities Exchange Act of 1934

Section 4 of this act created the SEC, which exercises Congressional authority to oversee the PCAOB, regulate the securities markets, and enforce U.S. securities laws. The Securities Exchange Act of 1934 regulates the secondary trading of securities (i.e., sales of securities between members of the public) Requires companies to file continuing perioding reports (annual reports (10-Ks), quarterly reports (10-Qs) etc. Also this act prohibits fraud, manipulation of the financial statements, and insider trading.

LO1 Describe the key requirements in the 1933 and 1934 Securities Acts as well as the Sarbanes-Oxley Act of 2002.

Securities Act of 1933 Often referred to as the "truth in securities" law, the Securities Act of 1933 has two basic objectives: require that investors receive financial and other significant information concerning securities being offered for public sale; and prohibit deceit, misrepresentations, and other fraud in the sale of securities. Securities act of 1934 With this Act, Congress created the Securities and Exchange Commission. The Act requires a variety of market participants to register with the Commission, including exchanges, brokers and dealers, transfer agents, and clearing agencies. Registration for these organizations involves filing disclosure documents that are updated on a regular basis. Sarbanes-Oxley Act of 2002 The Act mandated a number of reforms to enhance corporate responsibility, enhance financial disclosures and combat corporate and accounting fraud, and created the "Public Company Accounting Oversight Board," also known as the PCAOB, to oversee the activities of the auditing profession.

LO 5 (AICPA Auditor Independence Rules)

The AICPA's independence rules relate to *covered members*, their immediate family members, and - in some cases - other close relatives. covered members - (A member of the CPA firm to which the independence rules apply) - key word attest According to ET Section 0.400.12, a covered member is: an individual on the attest engagement team; an individual in a position to influence the attest engagement; a partner, partner equivalent or manager who provides non-attest services to the attest client beginning once he or she provides ten hours of non-attest services to the client within any fiscal year and ending on the later of the date (i) the firm signs the report on the financial statements for the fiscal year during which those services were provided or (ii) he or she no longer expects to provide ten or more hours of non-attest services to the attest client on a recurring basis; a partner or partner equivalent in the office in which the lead attest engagement partner or partner equivalent primarily practices in connection with the attest engagement; the firm, including the firm's employee benefit plans; or an entity whose operating, financial, or accounting policies can be controlled by any of the individuals or entities described in the previous descriptions of a covered member or by two or more such individuals or entities if they act together.

The Securities Act of 1933

The Securities Act of 1933 Requires companies that wish to sell securities to the public to register with the SEC. Requires SEC registrants (registered companies) to provide a prospectus (that provides details about an investment offering for sale to the public.) This law represents the first time financial statement audits were required by law. If material misstatements go undetected by the auditor and an original investor in securities relies on the prospectus and audited financial statements, The burden of proof shifts from the plaintiff (i.e. the investor) tot he defendant (i.e., the auditor), in a negligence suit against the auditor.


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