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AUDITING CHAPTER 4

AUDITING CHAPTER 4. Professional Ethics By David N. Ricchiute. TOPICS. General, professional ethics & collapse of Enron, Andersen AICPA Code of Professional Conduct AICPA Rules of Conduct; SEC Independence Rules Ethics enforcement PCAOB rules & AICPA practice monitoring system.

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AUDITING CHAPTER 4

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  1. AUDITINGCHAPTER 4 Professional Ethics By David N. Ricchiute

  2. TOPICS • General, professional ethics & collapse of Enron, Andersen • AICPA Code of Professional Conduct • AICPA Rules of Conduct; SEC Independence Rules • Ethics enforcement • PCAOB rules & AICPA practice monitoring system GBW 8th ed., Ch. 4

  3. GENERAL, PROFESSIONAL ETHICS • General ethics • Study of ideal conduct, behavior • Professional ethics • Applies general ethics to choices, consequences of a profession • Does not, cannot require ideal standards • Enforces minimum standards GBW 8th ed., Ch. 4

  4. ETHICAL REASONING • Opinion • Personal opinion absent self interest; neither right nor wrong • “What do I think?” • Self-interest • “What’s in it for me?” • Consequence • “What’s in it for everyone • Duty • “What is my duty?” • Character • “How will this reflect on me?” GBW 8th ed., Ch. 4

  5. ENRON, ANDERSEN FACTS • Enron • Once ranked 7th on Fortune 500 • Thousands of investors, retirees who invested heavily in Enron lost millions • Andersen • Big 5 auditor at the time GBW 8th ed., Ch. 4

  6. ENRONQuestionable Accounting • Deducting notes received for common stock from equity • Reporting inflated values for broadband assets & content-service businesses • Special purpose entities (SPE) • Enron off-loaded debt to SPEs • Enron recorded gains on sales to SPEs because not consolidated • Chewco, with <3% at risk not consolidated when should have been GBW 8th ed., Ch. 4

  7. ENRON QUOTE I am incredibly nervous that we will implode in a wave of accounting scandals. My 8 years of Enron work history will be worth nothing on my resume, the business world will consider the past successes as nothing but an elaborate accounting hoax. What form of ethical reasoning is this? New York Times, 1/16/02, p. A6. GBW 8th ed., Ch. 4

  8. ANDERSENQuestionable Auditing • Did not issue qualified opinion for unconsolidated Enron subsidiary, Chewco GBW 8th ed., Ch. 4

  9. ANDERSEN QUOTE I have not spoken to the Practice Director. I do not know if he knows how much we cannot support this. Where do we go from here? This is a big item and the team apparently does not want to go back to the client on this. What form of ethical reasoning did the team use? http://energycommerce.house.gov/107/News/04022002_527.htm GBW 8th ed., Ch. 4

  10. 1980’S CONSULTING, AUDITING • Conflict • Independence, objectivity • Solutions • Code Professional Conduct applies to all professional activities • Mandatory quality assurance program GBW 8th ed., Ch. 4

  11. 21st CENTURY CONSULTING & AUDITING: • SEC concerns • “Consulting . . . May shorten distance between auditor, management” • Big 5 clients paying more for consulting than auditing • POB concerns • Ratio accounting, auditing revenues to consulting revenues dropping to 1.5:1 GBW 8th ed., Ch. 4

  12. ETHICS VULNERABILITY RISK ASSESSMENT Assessment of risks bearing on corporate ethics • Sexual harassment • Environmental contamination • Antitrust infractions • Improper foreign payments • Fraudulent financial reporting GBW 8th ed., Ch. 4

  13. AICPA CODE OF PROFESSIONAL CONDUCT • Principles • Framework for Rules of Conduct • Unenforceable • Rules of Conduct • Govern performance AICPA members GBW 8th ed., Ch. 4

  14. PRINCIPLES OF PROFESSIONAL CONDUCT 1 • Responsibilities • Use moral judgment • Public interest • Honor public trust • Integrity GBW 8th ed., Ch. 4

  15. PRINCIPLES OF PROFESSIONAL CONDUCT 2 • Objectivity, independence • Free of conflicts of interest • Independence in fact & appearance when auditing • Due care • Observe technical, ethical standards & improve • Scope, nature of services • Observe Code Professional Conduct GBW 8th ed., Ch. 4

  16. INTERPRETATIONS & ETHICS RULINGS • Interpret scope, applicability of Rules of Conduct • Summarize applicability of Rules of Conduct, Interpretations to detailed fact situations GBW 8th ed., Ch. 4

  17. AICPA RULES OF CONDUCT: Independence (101) • Applies to all practicing CPAs in audit, attest services • AICPA interpretations affecting independence • Litigation or intent to litigate by management for deficiencies in work • Litigation by auditor for fraud, deceit • Other material litigation GBW 8th ed., Ch. 4

  18. SEC’s AUDITOR INDEPENDENCE ISSUES • Whether a relationship or service • Is prohibited by Sarbanes-Oxley • Involves client who has hired former auditor within 1 year • Violates mandatory partner 5-year rotation rule • Audit committee pre-approval of services rule • Compensates audit partner for non-audit/attest services • Fees not disclosed if for services GBW 8th ed., Ch. 4

  19. SEC FINANCIAL INDEPENDENCE RULES • No direct or material indirect financial relationship • Joint, material closely held business investment with client • Loan from client out of ordinary course of business • Investment > 5% client’s equity securities • No business relationship • No bookkeeping • No operating, supervising client’s information system GBW 8th ed., Ch. 4

  20. SEC OTHER INDEPENDENCE RULES • Not supplying actuarial advisory services for policy reserves • Not supplying more than 40% internal audit hours • No management functions or decision making • No human resources or broker-dealer functions • No legal services GBW 8th ed., Ch. 4

  21. AICPA RULES OF CONDUCT: Integrity, Objectivity (102) • In any service, AICPA member shall • Be free of conflicts of interest and • Shall not knowingly • Misrepresent facts • Subordinate judgment GBW 8th ed., Ch. 4

  22. AICPA RULES OF CONDUCT: General Standards (201) • AICPA member shall comply with standards for • Professional competence • Due professional care • Planning & supervision • Obtaining sufficient relevant data GBW 8th ed., Ch. 4

  23. AICPA RULES OF CONDUCT: Compliance, Principles (202, 203) • AICPA member shall • Comply with standards promulgated by designated bodies • AICPA member shall not, if false • Express opinion in conformity with GAAP • State unaware of material modifications necessary to conform to GAAP • If GAAP misleading, AICPA member can describe necessary departure GBW 8th ed., Ch. 4

  24. GAAP HIERARCHY • FASB Statements, APB opinions, ARB’s • FASB Technical Bulletins, AICPA accounting, auditing guides, AICPA Statements of Position • AICPA accounting standards & practice bulletins • AICPA accounting interpretations, FASB implementation guides GBW 8th ed., Ch. 4

  25. AICPA RULES OF CONDUCT: Confidentiality (301) • AICPA member shall not • Disclose confidential client information without specific consent of client except under law or disciplinary body GBW 8th ed., Ch. 4

  26. AICPA RULES OF CONDUCT:Contingent Fees (302) • AICPA member shall not • Perform any service for a contingent fee for any audit, review or compilation client • Prepare tax return for contingent fee GBW 8th ed., Ch. 4

  27. AICPA RULES OF CONDUCT: Acts Discreditable (501) • 3 Interpretations • Working papers are accountant’s property • No discrimination based on race, color, sex, age, national origin in hiring, promotion, salary, other employment practices • Nondisclosure CPA exam questions, solutions after May 1996 GBW 8th ed., Ch. 4

  28. AICPA RULES OF CONDUCT: Advertising, Soliciting (502) • AICPA member shall not • Obtain clients by false, misleading, deceptive advertising • Use coercion, overreaching, harassing conduct in solicitation GBW 8th ed., Ch. 4

  29. AICPA RULES OF CONDUCT: Commissions, Referral Fees (503) • Prohibited commissions • Audit, review • Compilation • Examination prospective statements • Must disclose permitted commissions & referral fees GBW 8th ed., Ch. 4

  30. AICPA RULES OF CONDUCT: Form of Practice, Name (505) • Form of organization must be permitted by state law • Name shall not be misleading • May not designate itself as “Members of AICPA” unless all partners, shareholders are members of institute GBW 8th ed., Ch. 4

  31. MOINTORING PUBLIC ACCOUNTING FIRMS • For all firms • Quality control • Internal policies, procedures designed to assure consistent performance across engagements • Firms that audit public companies • PCAOB Rules for Inspection & AICPA Center for Public Company Audit Firms • Firms without public audit clients • Peer review • AICPA Peer Review Program GBW 8th ed., Ch. 4

  32. ELEMENTS OF QUALITY CONTROL POLICIES • Independence, integrity, objectivity • Personnel management • Acceptance, continuance of clients • Engagement performance • Monitoring GBW 8th ed., Ch. 4

  33. PCAOB RULES • Under authority of Sarbanes-Oxley • Regular inspections • Annually for firms auditing more than 100 public companies • Special inspections • Every 3 years for firms whose public audit clients number between 1 and 100 GBW 8th ed., Ch. 4

  34. JOINT ETHICS ENFORCEMENT • 3 Organizations enforce ethical conduct • AICPA • State societies of CPAs • State boards of accountancy • Penalties include • Suspension • Expulsion • License revocation GBW 8th ed., Ch. 4

  35. AUDITINGCHAPTER 5 Legal Liability By David N. Ricchiute

  36. TOPICS • Issues of liability to clients, 3rd parties • Common law liability to foreseen 3rd parties & Restatement of Torts • Auditors & the Securities Acts • Statutory liability to securities purchasers, sellers & securities litigation reform • Liability for criminal offenses • Responsibility to detect, report illegal acts • Minimizing risk of legal liability GBW 8th ed., Ch. 4

  37. ISSUES CONTRIBUTING TO LEGAL LIABILITY • Joint-and-several liability • Allowed plaintiffs to recover against auditor alone • Revised by Private Securities Litigation Reform Act of 1995 • Changed to proportionate liability, i.e., auditor’s share • Privity doctrine limits liability to parties to contract • Expanded to include certain 3rd parties GBW 8th ed., Ch. 4

  38. ISSUES IN CIVILITY LIABILITY • Source of law for suit • Who is plaintiff? • What is auditor’s potential liability • Who has the burden of proof, plaintiff or defendant? • Penalty is monetary damages GBW 8th ed., Ch. 4

  39. SUMMARY OF ISSUES:Sources of Law • Common law • Written opinions of prior courts • Statutory law • Written statutes established by Congress, state legislatures • Securities Act of 1933 • Securities Exchange Act of 1934 GBW 8th ed., Ch. 4

  40. SUMMARY OF ISSUES: Plaintiff • Under common law • Breach of contract • Client • 3rd party primary beneficiaries • Tort (wrongful act) • Foreseen 3rd parties • Foreseeable 3rd parties • Under Securities Act 1933 • Initial purchasers • Under Securities Exchange Act of 1934 • Subsequent purchasers, sellers GBW 8th ed., Ch. 4

  41. SUMMARY OF ISSUES: Auditor’s Potential Liability • Ordinary negligence • Lack of reasonable care in performing services • Departure from GAAS • Gross negligence • Lack of minimum care in performing services • Reckless departure from GAAS • Fraud • Intentional misstatement or omission of material fact • Constructive fraud lacks intent GBW 8th ed., Ch. 4

  42. SUMMARY OF ISSUES: Burden of Proof • Plaintiff had damage, loss • Materially misstated financial statements • Reliance on financial statements, advice • Deficient auditor conduct GBW 8th ed., Ch. 4

  43. COMMON LAW: Legal Action • Breach of contract • Allege violations of GAAS or confidentiality • Tort (wrongful act) • Allege injury due to negligence, gross negligence, fraud GBW 8th ed., Ch. 4

  44. COMMON LAWPrimary Beneficiaries • Specifically identified to auditors • Beneficiaries of services • Privity of contract • Breach of contract • Threshold for primary beneficiaries ordinary negligence GBW 8th ed., Ch. 4

  45. COMMON LAW: 3rd Parties • General identity, reliance on statements known • Foreseen 3rd parties • Not specifically identified though known • Creditors • Foreseeable 3rd parties • Bondholders, shareholders • Uses tort law • Threshold for 3rd parties gross negligence or fraud GBW 8th ed., Ch. 4

  46. RESTATEMENT OF TORTS • Accepted in majority of states • Establishes auditor’s liability to foreseen 3rd parties • Treats as primary beneficiaries • Report used to influence plaintiff who provided funding GBW 8th ed., Ch. 4

  47. PRIVITY DOCTRINE • Used in states that don’t accept Restatement of Torts • Established in Ultramares Corp v. Touche (1931) • Auditors liable to 3rd parties for fraud • Reaffirmed in Credit Alliance • Established linkage test to link auditor to plaintiff GBW 8th ed., Ch. 4

  48. LIABILITY TO FORESEEABLE 3RD PARTIES • Most liberal interpretation of culpability • Used only in Mississippi & Wisconsin GBW 8th ed., Ch. 4

  49. STATUTORY LAW Securities Act of 1933 • New issues of securities (IPO) • Registration statement (S-1) filed with SEC • Auditor’s involvement • Auditor of annual reports • Reviews statements • Reviews S-1 for consistency with statements • Issues “comfort letter’ to underwriters (SAS 72) GBW 8th ed., Ch. 4

  50. STATUTORY LAW:Securities Exchange of 1934 • Regulates trading of securities • Requires registration with SEC & periodic reporting (10-k, 10-q) • Antifraud provisions of Section 10(b) & Rule 10b-5 • Protect purchasers, sellers from manipulation, deception by auditor GBW 8th ed., Ch. 4

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