Madawalabu University, School of Business and Economics, Accounting Department Nov.

2010

CHAPTER TWO
PROFESSIONAL ETHICS
AND
LEGAL RESPONSIBILITIES AND LIABILITIES OF
AUDITORS
2.1 PROFESSIONAL ETHICS AND RULES OF PROFESSIONAL CONDUCT

INTRODUCTION
All recognized professions have recognized the importance of ethical behavior and have
developed codes of professional ethics. The fundamental purpose of such codes is to
provide members with guidelines for maintaining a profession attitude and conduct them
in a manner that will enhance the professional stature of their discipline. Our purpose in
this chapter is to discuss the nature of professional ethics, to present and discuss the
AICPA code professional conduct, and auditors’ legal liabilities and responsibilities

WHAT ARE ETHICS?

Ethics can be broadly defined as a set of moral principles or values. Each of us has such
set of values, even though we may or may not have considered them explicitly.
Philosophers, religious organizations, and other groups have defined in various ways
ideal sets of moral principles or values. Examples of prescribed sets of moral principles
or values at the implementation level include: laws and regulations, church doctrine,
codes of business ethics for professional groups like CPAs, and codes of conduct within
individual organizations.

It is common for people to differ in their moral principles and values and the relative
importance they attach to these principles. These differences reflect life experiences,
successes and failures, as well as the influences of parents, teachers, and friends.

Ethical Dilemmas- ethical dilemma is a situation that an individual faces involving a

decision about appropriate behavior. A simple example of an ethical dilemma is
presented below
Assume that a student at Madawalabu University finds a lost mobile in the University
compound while he is going to his auditing class. What action, if any, does the student
take to find the original owner?

Ethical dilemmas generally involve situations in which the welfare of one or more other
individuals is affected by the results of the decision. In the dilemma presented above, the
welfare of the original owner of the lost mobile is affected by the student’s decision.

Ethical dilemmas faced by auditors often have an effect on the welfare of a large member
of individuals or groups. For example, if an auditor made an unethical decision about the
content of an audit report, the welfare of thousands of investors, creditors and other
members of the society would be affected.
It is therefore essential for professions to have ethical and moral standards in addition to
other professional and technical standards so that the profession can provide quality
services that can properly address the interest and welfare of its users.

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NEED FOR ETHICS IN AUDITING

Ethical behavior is necessary for a society to function in an orderly manner. It can be
argued that ethics is the glue that holds a society together. Imagine, for instance, what
would happen if couldn’t depend on the people we deal with to be honest. If parents,
teachers, employers, co-workers, and friends all consistently lied, it would be almost
impossible for effective communication to occur.

The public attaches a special meaning to the term professional. Professionals are
expected to conduct themselves at a higher level than most other members of society. For
example, when it is reported that a physician, clergyperson, or CPA has committed
crime, most people fell more disappointment than when the same thing happened by
people who are not labeled as professional.

The underlining reason for high level of professional conduct by any profession is the
need for public confidence in the quality of services provided by the profession,
regardless of the individual providing it. For the CPA, it is essential that the client and
external financial statements users have confidence in the quality of audits and other
assurance services. If the users of these services do not have confidence in professionals,
the need of the users for the services provided by professionals is diminished.

It is not practical for users to evaluate the quality of the performance of most professional
services because of the complexity. A patient cannot be expected to evaluate whether an
operation was properly performed or not. Similarly, a financial statements user cannot be
expected to evaluate audit performance. Most users have neither the competence nor the
time for such an evaluation. Public confidence in the quality of professional services is
enhanced when the profession encourages high standards of performances and conduct
on the part of all practitioners.

CPA firms have a different relationship with users of financial statements than most other
professionals have with the users of their services. Attorneys, for instance, are typically
engaged and paid by a client and have primary responsibility to be an advocate for that
client. CPA firms are engaged and paid by the company issuing the financial statements,
but the primary beneficiaries of the audit are the users of these financial statements.
Often, the auditor does not know or have contact with the statement users but has
frequent meetings and ongoing relationships with client personnel.

It is essential that users regard CPA firms as competent and unbiased. If users believe
that CPA firms do not perform a valuable service (reduce information risk), the value of
CPA firms’ audit and other attestation reports is reduced and the demand for audits will
thereby also be reduced. Therefore, there is considerable incentive for CPA firms to
conduct themselves at high professional level.

CHARACTERISTICS OF A PROFESSION
The development of audit as a profession is tied to the involvement of the importance of
independence in audit. Thus, this is the reason for naming professional auditing as
independent audit. All of the generally recognized professions such as auditing,
medicine, engineering, theology, architecture and the like are characterized by the
following elements/ features/.

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a. Specialized body of knowledge- A highly developed profession has a very

highly specialized written body of knowledge. The body of knowledge is dynamic
and in continuous development and growth and not static. The body of knowledge
here goes far beyond general education knowledge. Always, there is need for
technical competence and familiarity with current/contemporary/ standards of
practice that might be embodied in the code of professional conducts.
b. Standards of qualification for admission- A profession to be a profession must
have well recognized and accepted predetermined criterion of qualification for
admission into the profession. The standards include educational requirements as
well as other moral and legal criteria fulfillment. The educational requirement is
composed of theoretical knowledge and practical experience. Thus, attaining a
license to practice as a certified public accountant requires an individuals or group
members, to meet minimum standards of education and experience.
c. Standards of conduct of behavior- A profession has a standard of conduct of
behavior to be observed by the professionals through prescribed code of ethics
that attempt to enforce general rules of conducts, and maximum and minimum
rules on competence and responsibility to client and colleagues.
d. Level of status recognition- The quality and level of professional services
demanded by society determines the level of status and recognition to the
profession. The level of status and recognitions earned in a society is a function of
the quality of professional services rendered which in turn is a function of the
standards of profession qualification and the degree of the social, moral, and legal
responsibility assumed. (They have direct relationship). Thus, careless work or
lack of integrity on part of any auditor(s) may lead the public to negative view
towards the entire profession. Accordingly, reasonable level of competence to
practice their service as required by standards and to give clients and the public an
assurance that the profession intends to maintain high standards and enforce
compliance by individual member broads the reputation of the profession.
e. Acceptance of social responsibility/ Responsibility to serve the public/ – A
professional to be a profession must accept responsibility for the consequence of
its action. Not only legal responsibilities which arises out of contractual
obligation, but also moral responsibility to the profession itself and to the society
at large. Accordingly, auditors are representatives of the public-creditors,
stockholders, consumers, employees, and others-in the financial reporting
process. The role of the independent auditors is to ensure that financial statements
are fair to all parties and not biased to benefit one group at the at the expense of
another. This responsibility to serve the public interest must be a basic motivation
for the professional.
Significance of professional ethics in accounting- Careless work or lack of integrity on
the part of any public auditor is a reflection upon the entire profession. Consequently, the
members of the public accounting profession / auditing profession/ have acted in unison
through the certain appropriate code of conduct such as the AICPA code of conduct. This
code provides practical guidance to the individual members in maintaining a professional
attitude. In addition, this code gives assurance to clients and to the public that the
profession intends to maintain high standards and to enforce compliance by individual
members.

Evidence that public accounting has achieved the status of a profession is found in the
willingness of its members to accept voluntarily standards of conduct more rigorous than
those imposed by law. These standards of conduct set forth the basic responsibilities of

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auditors to the public, clients and fellow practitioners. To be effective, a body

professional ethics must be attainable and enforceable; it must be consists not merely of
abstract ideals but of attainable goals and practical working rules that can be enforced.

2.2 THE AICPA CODE OF PROFESSIONAL CONDUCT

The AICPA code of professional conduct is designed to provide a framework for

expanding professional services and responding to other changes in the profession, such
as the increasingly competitive environment.

The AICPA code of professional conduct consists of two sections. These are:
Section-1: Principles- is a goal oriented, positively stated discussion of the profession’s
responsibilities to the public, clients and fellow practitioners. It provides overall frame
work for the rules.

Section- 2: Rules- are enforceable applications of the principles. They define acceptable
behavior and identify sources of authority for performance standards.

Additional Interpretations-provide guidelines as to the scope and

guidance applications of rules to particular
issued by factual circumstances
AICPA Ethical Rulings-summarizes applications of rules and
interpretations to particular
factual circumstances

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The relationships among the principles, Rules, interpretations and Ethical rulings is
summarized in the following figures

Principles-provide
overall frame
work for rules
Code of professional
Conduct
Rules- govern performance of
professional services

Interpretations-provide guideline as to
the scope and application of rule
Additional
Guidance Ethics rulings-summarize application of rules and
interpretations to particular factual
circumstance

Fig 2.1: AICPA professional Ethics

Section-I: Principles
These principles of AICPA express the profession’s recognition of its responsibilities to
the public to clients, and to colleges. They guide members in the performance of their
professional responsibilities and express the basic tenets of the ethical and professional
conduct. The principles call for an unlimited commitment to honorable behavior, even at
the sacrifice of personal advantages. These principles are explained below article by
article.

Article-I: Responsibilities
In carrying out their responsibilities as professionals, members should exercise
sensitive professional and moral judgments in all their activities.

Article-II: 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

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A distinguishing mark of a profession is acceptance of its responsibilities to the public.

The accounting profession’s public consists of clients, credit grantors, governments,
employers, investors, the business and financial community and others who rely on the
objectivity and integrity of certified public accountants to maintain the orderly
functioning of their business.

The public interest is thus defined as the collective well being of the community of
peoples and institutions the profession serves. Those who rely on certified public
accountants expect them to discharge their responsibilities with integrity, objectivity,
due professional, and a genuine interest in serving the public i.e. they are expected to
provide quality services, enter into fee arrangements, and offer a range of services- all in
a manner that demonstrates a level of professionalism consistent with these principles of
the code of professional conduct.

Article-III: Integrity1
To maintain and broaden public confidence, members should perform all professional
responsibilities with the highest sense of integrity, i.e. a member shall be free of conflict
of interest, and /or not deliberately misrepresent facts or subordinate his/ her judgments
to others.

Article-IV: 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.

Article-V: Due professional care

A member should observe the professions technical and ethical standards, strive
continually to improve competence and the quality of services, and discharge
professional responsibilities to the best of the member’s ability.

Article-VI: Scope and Nature of services

A member in public practice should observe the scope and nature of services to be
provided.
Each of these principles should be considered by members in determining whether or
not to provide specific services in individual circumstances. As there is no hard- and-fast
rules that can be developed to help members reach these judgments, they must be sure
whether they are satisfied that they are meeting the spirit of the principles in this regards.

Section-II-Rules
Applicability-the bylaws of AICPA require that members adhere to the rules of the code
of professional conduct. Members must be prepared to justify departures from these
rules.
Rule -101: Independence
A member in public practice shall be independent in the performance of professional
services as required by standards promulgated by bodies designated by council.
Interpretation 101-1 of the code contains examples of transactions, interests, and
relationships that result in lack of independency during the period covered by financial

1
Be principled, honourable, upright, courageous, and do not be two-faced

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statements, during the period of professional engagements, and / or at the time of

expressing opinion. These circumstances include the following:

1) If a member or member’s firm had or was committed to acquire any direct

financial interest such as investment in the client ( owning capital stock) and/
or acquire any material indirect financial interest (direct and indirect financial
interest)
2) If a member or member’s firm was a trustee of any trust or executor or
administer of any estate if such trust or estate, had or was committed to
acquire any direct or material indirect financial interest in the enterprise to be
audited.
Independency of partners and staff requires partners (or stockholders),
managerial employees and all professional staff be free from any interest of
the client enterprise. Thus, not all employees of an audit firm are required to
be independent.
3) If a member or member’s firm had any joint, closely held business investment
with the enterprise or with any officer, director, or principal stockholders
thereof that was material in relation to the member’s net worth, or to the net
worth of the member’s firm.
4) If a member or member’s firm had any loan to or from the enterprise or any
officer, director, or principal stockholders to the enterprise.
5) If a member or members firm was connected with the enterprise as promoter,
underwriter, or voting trustee, a director or officer or in any capacity
equivalent to that of a member of management or of an employee.
6) If a member or member’s firm was a trustee for any pension or profit-sharing
trust of the enterprise.

Lack of independency may also arise from financial interests that may result from past
employment relationship with the client, interest of a close relatives of an auditor such as
her or his spouse and dependents. Other situations that may impair independency of
auditor are past due fees, gifts from client, and client auditor or CPA litigation if any.

Two distinct ideas are involved in the concept of independency. These are:
1) Independence in fact- A CPA (auditor) must in fact be independent of any
enterprise for which they provide attestation services i.e. an auditor must be able
to maintain an objective and impartial mental attitude throughout the engagement.
2) Independent in appearance- The relationship between the CPAs and their client
must be such that the auditor will appear independent to third party i.e. an auditor
must be able to maintain an objective and impartial mental attitude throughout the
engagement.

NB. The independency rule does not apply to all services performed by public auditor(s).
Services in which the client is a major beneficiary such as management consultancy
service, tax services, accounting/compilation/ service and the like do not require
independency.
The independency rule applies to auditing, and other attestation services such as review
of financial statements, examination of financial forecasts, performance of agreed up on
procedures and the like.
Independency - a matter of degree i.e. the concept of independency is not absolute; no
CPA/auditor/ can claim complete independence of a client. Rather, independence is

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relative i.e. a matter of degree. Thus, CPAs must strive for the greatest degree of
independence consistent with this business environment.

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/her professional judgments to others.
Interpretation 102-1 states that a CPA or auditor(s) will be found to have knowingly
misrepresented facts in violation of rule102, when he/she knowingly:
 Makes, or permits or directs another to make, materially incorrect entries in a
client’s financial statements or records.
 Fail to correct financial statements that are materially false or misleading when
the member has such authority.
 Signs or permits or directs another to sign, a documents containing materially
false and misleading information.
Objectivity means impartiality in performing all services. For example, assume that an
auditor believes that accounts receivable may not be collectible, but accepts
management’s opinion without an independent evaluation of collectability. The auditor
has subordinated his/her judgment and thereby lacks objectivity.
Free from conflicts of interest means the absence of relationships that might interfere
with objectivity or integrity. For example, it would be inappropriate for an auditor who is
also an attorney to represent a client in legal matters. The attorney is an advocate for the
client, whereas the auditor must be impartial.

Rule-201: General standards

A member shall comply with the following standards and with any interpretations
thereof by bodies designated by council.
a) Professional competence- undertakes only those professional services that the
member or member’s firm can reasonably expect to be completed with
professional competence.
b) Due professional care- Exercise due professional care in the performance of
professional services.
c) Planning and supervision- adequately plan and supervise the performance of
professional services.
d) Sufficient relevant data- Obtain sufficient relevant data to afford a reasonable
basis for conclusions or recommendations in relation to any professional
services performed.

Rule-202: Compliance with standards

A member who performs auditing, review, compilation, management consultancy, tax
return preparation, or other professional services shall comply with standards
promulgated by bodies designated by council.

Rule-203: Accounting principles

A member shall not (1) express an opinion or state affirmatively that the financial
statements or other financial data of any entity are presented in conformity with GAAP
or (2) state that he/she is not aware of any material modification that should be made to
such statements or data in order for them be in conformity with GAAP, if such statements

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or data contain any departure from accounting principles promulgated by bodies

designated by council.
If however, the statements or data contain such departure and the members can
demonstrate that due to unusual circumstance, the financial statements or data would
otherwise have been misleading, the members can comply with the rule by describing the
departure, its approximate effects, if practicable; and the reasons why compliances with
the principle would result in misleading statements.

Rule-304: Confidential client information

A member in public practice shall not disclose any confidential client information
without the specific consent of the client.
This rule shall not be construed:
(1) To relieve a member of the member’s professional obligations under rule 202
and 203 presented above.
(2) To affect in any way the member’s obligation to comply with a validity issued
and enforceable subpoena or summons
(3) To prohibit review of a member’s professional practice under AICPA or state
CPA society authorization, or
(4) To preclude a member from initiating with or responding to any inquiry by a
recognized investigative or disciplinary bodies.
Thus, except for the above mentioned circumstances and other related interpretation,
members of a recognized investigative or disciplinary bodies and professional
practice reviewers shall not use to their own advantage or disclose any member’s
confidential client information that comes to their attention in carrying out their
professional responsibilities.

Confidential vs. privileged communications-The communication between CPAs

and their clients are confidential, but not privileged. This is because; legally
privileged communications cannot be required by a subpoena or court order. Thus,
CPAs may be compelled to disclose their communication with clients in certain types
of court proceedings

Reporting illegal act – many countries have adopted laws that require members in a
public practice (auditors) to reports illegal acts committed by organizations whenever
they come across it if:
A) It has a material effect on the financial statements
B) Senior management and the board directors have not taken appropriate
remedial action
C) The failure to take remedial action is reasonably expected to warrant a
departure from standards of audit report or a resignation by the auditors.
Under such circumstances, the auditor must as soon as possible communicate
their conclusion directly to the client’s board of directors or if that is not possible
directly communicate the matter to the appropriate authoritative bodies.

Rule-302: Contingent fees

A member in public practice shall not perform for an contingent fee any professional
services for, or receive such a fee from a client for whom the member or member’s firm
performs services such as:
(a) An audit or review of financial statements

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(b) Compilation of financial information expected to be used by third party,

(c) An examination of prospective financial information or
(d) Prepare an original or amended tax return or claim for a tax refund.
A contingent fee is a fee established for the performance of any service pursuant, or an
arrangement in which no fee will be charged unless a specified finding or result is
attained, or in which the amount of the fee is otherwise dependent upon the finding or
result of such services.

Rule-501: Acts Discreditable

A member shall not commit an act discreditable to the profession.
Rule-501 gives the AICPA the authority to discipline those members who act in a manner
damaging to the reputation of the profession. The three circumstances outlined in
interpretation 101-1 presented above relating to misleading entries and financial
statements are considered discreditable acts
An interesting practices have been interpreted to be discreditable is failure to return client
records, may be when the auditors discharges their responsibilities and not been paid for
their services. To refuse to return a clients ledger or other records is clearly wrong but
refusing to return audit work papers needed by client is not constitutes acts discreditable,
because, audit work paper is the property of the auditors not the property of the client
company.

Rule-502: Advertising and other forms of solicitation

A member in public practice shall not seek to obtain clients by advertising or other forms
of solicitations in a manner that is false, misleading, or deceptive. Solicitation by the use
of coercion, overreaching or harassing conduct is prohibited.

Rule-503: Commission and Referral fees

1) Prohibited commissions- a member in public practice shall not for a commission

recommend or refer to 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,
services such as auditing and review of financial statements, a compilations of
financial statements and/ or examination of financial statements.

2) Disclosure of permitted commissions and referral fees- a member of CPA or

auditor who receive/or paid a permitted commission and/or referral fees shall
disclose such acceptance or payments to the client.

Rule-505: Form of organization and Name

A member may practice public accounting in a form of organization permitted by law or
regulation whose characteristics conform to resolution of council.
A member shall not practice public accounting under a firm name that is misleading.

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2-4: Legal liabilities and responsibilities of auditors

We live in an era of litigation in which persons with real or fancied grievances are likely
to take their complaints to curt. In this environment, investors and creditors who suffer
financial damages or reversals find CPAs, as well as attorneys and corporate directors,
tempting targets for lawsuits alleging malpractice.

Thus, CPAs must approach every engagement with the prospect that they may be
required to defend their work in court. Even if the court finds in favor of the CPAs, the
costs of defending a legal action can be very high. Moreover, lawsuits can be extremely
damaging to a professional’s reputation. In extreme cases, the CPA may even be held
criminal for professional malpractice. Thus, every member considering a career in public
accounting should be aware of the legal liability inherent in the practice of this profession
and should conduct the audit with reasonable skill and care. Though audit report is not a
guarantee that the figures are free from error, the auditor must conduct the audit that it
stands a reasonable chance of discovering a material error in the figure. It is difficult to
determine what is meant by reasonable skill and care. The auditors’ principal duties
center around the report on the truth and fairness of the financial statements. The
auditors are not required to make any positive statement if they are satisfied with the
audit matters. They must, however state any reservations in the audit report. There is
always a possibility that someone will disagree with some of the assumptions upon which
the figures have been based. The auditors are also required to form an opinion on several
matters ant properly report them in their report.

Discussion of Auditors liabilities is best prefaced by a definition of some of the common

business law terms such as negligence, liability for gross negligence, liabilities for
fraud, and liabilities for constructive fraud.

Negligence- also referred to as ordinary or simple negligence is violation of a legal duty

to exercise a degree of care that an ordinary prudent person would exercise under similar
circumstances. For an auditor, negligence is failure to perform a duty in accordance with
applicable standards such as failure to exercise due professional care.

Gross Negligence- is the lack of even slight care, indicative of reckless disregards for
one’s professional responsibilities. Substantial failures on the part of an auditor to
comply with GAAS might be interpreted as gross negligence.

Fraud-is defined as misrepresentation by a person of a material fact, known by that

person to be untrue or made with reckless indifferences as to whether the fact is true with
the intention of deceiving the other party and with the result that the other party is
injured.

Constructive fraud- differs from fraud as defined above in that constructive fraud does
not involve a misrepresentation with intent to deceive. Gross negligence on the part of an
auditor as been interpreted by the courts is constructive fraud.
Privity- is the relationship between parties to contract. A CPA firm is in privity with the
client it is serving, as well as with any third party beneficiary.

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Breach of contract- is failure of one or both parties to a contract to perform in

accordance with the contacts provisions. For example, failure by auditors(s) to perform in
accordance with contractual specifications indicated in the engagement letter.

Proximate/immediate/ cause-exists when damage to another is directly attributable to a

wrong doer’s act. The issue of proximate cause may be raised as a defense in litigation
cases. Even though the CPA firm might have been negligent in rendering services, it will
not be liable for the plaintiff’s loss if its negligence was not the proximate cause of the
said loss.

Contributory negligence-is negligence on the part of the plaintiff that has contributed to
his or her having incurred loss.
Comparative negligence- is a concept used by courts to allocate damages between
negligent parties based on the degree to which each party is at fault. The allocation of
damages is also referred to as proportionate liabilities.

The plaintiff-is the party claiming damages and bringing suit against the defendant.

A third party beneficiary- is a person or institution not a contracting party who is

named in a contract or intended by the contracting parties to have definite rights and
benefits under the contract
. E.g. If W-Thomas audit firm is engaged to audit the financial statements of Shell-
Ethiopia and if it is indicated in the contract that a copy of the audit report will be sent to
Awash International Bank as a support for a loan, then, the bank is a third-third party
beneficiary under the contractual agreement between W-Thomas Audit firm and Shell-
Ethiopia company.

An engagement letter- is the written contract summarizing the contractual relationships

between the CPA and client. It typically specifies the nature and scope of professional
services to be rendered , expected completion date of the engagement, the amount of
audit fees, responsibility of auditors and responsibility of client/manager/ and other
related matters.

An auditor holds position of great responsibility and has to perform a given duties,
statutory or otherwise, allotted to him. In performance of his duties, he has to exercise
reasonable care and skill. His client expects him to follow generally accepted auditing
standards and he/she may be held liable in case he does not act with reasonable care and
skill required from him in the particular circumstances.

In other words, if his client suffers any loss due to his negligence or breach of trust or
duty and, the errors or frauds remain undetected, he would be held liable for the same and
may be called upon to pay the damages suffered by the client on account of his
negligence or breach of duty. The auditor may be penalized for failing to apply
reasonable care and skill. This could take the form of a disciplinary action by the
professional body or civil or criminal proceedings.

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Auditor’s liability can be classified as:

1. Auditor’s civil liability

The civil liability of an auditor can be for
a. Liability for negligence
b. Liability for Misfeasance.

A. Liability for negligence: An auditor is appointed to perform certain specific duties

and in performing his duties he must exercise reasonable care and skill to perform his
duties for which he is employed. If he acts negligently on account of which the client
is made to suffer loss, the auditor may be held liable and may be called upon to make
good the damages, which the client suffered due to this negligence. The auditor can
be held liable if the following conditions are satisfied.

i. There should be sufficient ground for holding him liable for negligence. A general
charge will not be enough and the specific matter in respect of which he failed must
be indicated
ii. It must be proved that the client has suffered a loss on account of this negligence

The auditor cannot be held liable if there is loss to the client without his negligence or
there has been negligence of the auditor but it has not resulted into the loss to the client.
At the same time, it must be proved that the auditor has acted negligently, i.e. he did not
exercise the reasonable care and skill in the performance of his duties. What is
reasonable care and skill should be determined on the basis of the particular
circumstances of the each case. It should be largely determined by a comparison with
the standard, which the members in this profession generally observe. It may be noted
that the auditor does not act as an insurer and does not guarantee the accuracy of the
books of account

B. Liability for breach of contract /Misfeasance / The term misfeasance implies

breach of trust or breach of duty. An auditor has to perform certain duties, which may
arise out of the contract with the client as in the case sole proprietor or partnerships or
it may be statutory as laid down in the various statutes. If the auditor does not
perform his duties properly and as a result his client suffers a loss, he may be held
liable for misfeasance.

2. Auditor’s criminal liability: Criminal liability of an auditor arises because of

offences against the statutory provisions specifically laid down. In such cases, an
auditor is liable not only to the shareholders but also to the state. It may arise
because of some criminal at on his part or gross neglect of certain provisions of
the statute. In case of criminal liability, an auditor is punishable with fine or
imprisonment or both as might be provided in the relevant statute.

3. Auditor’s contractual liability: The contractual liability arises out of the

contract entered between the auditor and the client. This arises when there is no
statute governing the rights or duties of an auditor. Since there are no statutory
provisions, the question of liability has to be settled in accordance with the terms
and conditions settled by the auditor with his client in the agreement. Hence the

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agreement with the auditor has to be in written clearly specifying the terms of
duties, responsibilities and scope of the audit. The auditor will be liable if he does
not observe high standards of his profession and work honestly. Sometimes, the
auditor will be in a delicate situation because of the frauds or irregularities carried
on by the client’s parents or close relatives. In such cases, he must not give way to
emotions. He must honestly and truthfully report the matter to his client in clear
words without any hesitation, laying aside all other considerations. If he does not
do so, he fails in the performance of his duties and may be held liable for the
same.

Liabilities to clients from audits often arise from a failure to uncover an

embezzlement or defalcation being performed against the client by client employees
and also failure to provide reasonable assurance of detecting misstatements due to
errors and fraud that are material to the financial statements.

In general, to establish auditors’ liabilities, a client must prove

a) Duty- that the auditor(s) or audit firm accepted a duty of care to exercise skill,
prudence, and diligence.
b) Breach of duty- that the auditor(s) or audit firm breached his/her/its duty of
care through negligent performance.
c) Loss-that the client suffered a loss.
d) Proximate-cause- that the loss is resulted from the auditor(s) negligent act or
performance
 Auditors Defense against client Suits-As defendants, auditors’ basic defense is
ordinarily that the audit was performed with reasonable care and that they were
not negligent in the performance of their duties. Alternatively, they, might
attempt to prove that, regardless of whether negligence was involved, such
alleged negligence was not the proximate cause of the client loss. Moreover,
demonstrating contributory negligence by the client is one means of showing
that the auditors’ negligence was not the sole cause of the client’s loss.

4. Auditor’s third party liability- In addition to being sued by clients under

common law, auditors may be liable to third parties under common law. This is
due the fact that the audited financial statements are used be many people other
than the client. These users of financial statements may completely rely upon the
audited statements and enter into transactions with the company without any
further enquiry. This are known as third parities which includes individual and
group society members such as potential stockholders/investors/, venders,
bankers, and other creditors, employers, employees, and customers, tax
authorities and others.
An audit firm may be liable to such third parities if a loss was incurred by the
claimant due to reliance on misleading financial statements. A typical suit might
occur when a bank is unable to collect a major loan from an insolvent customer. The
bank may claim that the misleading audited financial statements were relied on in
making the loan and that the audit firm should be held responsible because it failed to
perform the audit with due care.
 Auditors Defense against Third Party Suits- Three of the four defenses available to
auditors in suits by client are also available in third party lawsuits. Contributory
negligence is ordinarily not available because a third party is not in a position to

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contribute to misstated financial statements. The preferred defense in third party suits
is no negligent performance. If the auditor performed the engagement in accordance
with GAAS, the other defenses are unnecessary.

2-5: Appointment, remuneration and removal of auditors

Appointment of auditors-
In most cases the audit of business concerns other than corporate entity is voluntary and
not compulsory. But with regard to corporate entities, many countries have set
laws that make their audit mandatory. Therefore, provisions regarding appointment of
auditors, his/her qualification, powers, duties etc are governed. To assure independence,
auditors are appointed by the highest body and are solely responsible to this body who
appoints them. In a corporation such responsibility is given to the stockholders meetings
or the board of directors at the suggestion to the management, and it is to this body that
the independent auditors submit his audit report for approval. This is to avoid
compromises; nowadays this function is one of the functions given to audit committees.
In principles, it is this body that should be responsible to determine or negotiate the fee
payable to independent auditors.

The primary objective of appointment of auditor(s) in a corporate entity is to safeguard

the interest of the absentee owner (shareholders) and investors as it is not possible for
every shareholder or investors to inspect the books of accounts of the company. Hence an
auditor is a representative of shareholders and work on their behalf. Company auditors
may by appointed by board of directors, shareholders, central government and /or by
other special resolutions.
Generally, auditors are appointed for a term of one year, although this is often extended.

Auditor’s remuneration
Many CPA codes of ethics prohibit independent auditor from basing his professional
audit fee on contingency fee basis. That is independent auditor’s remuneration should not
be attached to of investment or total value of audit under consideration or amount of
default findings, just like lawyers who base their fees on percentage of amounts involved
in lawsuit. This is done in order to prevent compromises in audit work and bias in mental
attitude. Customarily, audit fees are based either on number of man-hour required to
complete the audit at the rate payable to the quality of manpower used, or just on flat
lump sum fee agreed upon. The auditor’s remuneration is generally fixed with the
directors or the audit committee of the client, and the auditors have a contract with the
client

Auditor’s removal procedures

It is uncommon for auditors for reign, or to be removed by their client before the end of
the term of office. If auditors disagree with their client over fee or accounting policies,
they simply do not offer themselves for re-appointment when their contract is finished.

It is generally more difficult to remove auditors tan to appoint them as shareholders

and/or directors need to be properly informed as to the nature of the problem. A simple
majority, two-thirds, or 75% majority resolution of directors and/or shareholders is
usually required to remove auditors, along with some sort of special notice in writing to
those concerned. The auditor is sometimes given the right to make written representation

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and to speak at the meeting at which it is proposed to remove them. It is also common for
the auditor to be required to make some sort of statement, either orally or in writing to the
effect that there are no circumstances surrounding his/her removal that ought to be
brought to the attestation of the shareholders or others. If such circumstances exist,
where, for example, there is a severe disagreement over accounting policies or suspected
fraud, and then the auditor should say so! This is commonly referred to as a ‘Statement
of Circumstances’. Removals must usually be notified to regulatory authorities.

These provisions are necessary to ensure that auditors are not removed for improper
reasons without the knowledge of shareholders, and that auditors do not seek to avoid the
responsibilities by ‘going quietly’, where problems arise, without informing shareholders.

Auditor’s resignation procedures

Resignation usually requires written notice by the auditor to the client and to the
regulatory authorities. It also requires a statement of circumstances as discussed above
and the auditor is again, permitted to speak and communicate in writing with
shareholders and others. In some cases, he/she is also allowed to require the client to call
the meeting in order to discuss the reasons for his/her resignation. This time, it is the
auditor who may be breach of contract, and he may be sued by the client.

Both removal and resignation before the end of the audit contract indicates serious
disagreement between auditor and client and is often accompanied by litigation.

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