Chapter Two

Auditors Ethical, Legal and

Professional Responsibilities
Chapter Outline
▫ Professional ethical responsibilities
▫ Statutory responsibilities and rights
▫ Key responsibilities derived from International
Standards on Auditing (ISAs)
▫ Auditor’s responsibility in relation to fraud and for
the entity’s compliance with laws and regulations
▫ Auditor’s responsibilities defined by case law
arising from alleged negligence (financial
statements misstated) and related exposure and
consequences
▫ Pre-appointment procedures
Professional Ethical Responsibilities
 Why do auditors need codes of ethics?
 To maintain respect and confidence of
public
 To distinguish the professional from the
general public
 To maintain order within the profession
and provide guidance to professionals
 Provide a means of self-policing the
profession
 Format of code of ethics
• General rules: Encourage high standard of
behavior, but vague and difficult to enforce.
• Specific rules: Sets out only minimum
standards, but easier to observe and thus to
enforce.
• Interpretations: Even more specific. Not
specifically enforceable, but practitioner must
justify departures.
 Fundamental Principles
• The member should
▫ act to maintain the profession’s reputation
▫ Act to serve the public interest
▫ Act with integrity and due care
▫ maintain independence in fact and in
appearance
▫ preserve client’s confidentiality
▫ show professional courtesy to other
members at all times
 Independence
• Audit must be performed with an objective
state of mind
• This is facilitated by independence in fact:
▫ Investigative independence:
 Sufficient time and resources
 Sufficient access
▫ Reporting independence
 Free to report honestly, without undue
influence
• However, independence in fact is impossible to
observe and thus difficult to enforce
 Independence in appearance
• Specific rules regarding prohibited relationships
between auditor and client
• Minimum standard, but visible and enforceable
• Rules reflect 2 general insights:You’re not
independent if:
▫ You’re evaluating your own work/decisions (or
that of someone close to you)
▫ You (or someone close to you) are better off
under certain outcomes
• Eg. Can’t be employee, owner, manager or
shareholder of auditee, or closely related to owner,
manager or shareholder of auditee
Independence in appearance vs. Independence in
fact
• Independence in appearance facilitates but does not
guarantee independence in fact
• Can have one without the other
• Even if you have independence in fact, if you don’t
have independence in appearance your credibility
will be undermined.
• If you have independence in appearance without
independence in fact, you may be conforming to the
letter of the rules of p.c. but you are violating the
spirit.
 Other Rules
• Confidentiality
▫ Members shall not disclose confidential info about
client or employer without specific consent OR
unless ordered by courts
• Act with integrity and due care
• Competence
▫ Must have necessary technical training, knowledge
of business and industry to perform audit
• Adhere to GAAP and GAAS
 Other Rules
• Advertising and Solicitation
▫ Can’t solicit another auditor’s client (but can respond to
a request for info)
▫ Can’t claim superior skills or being a “specialist”
▫ Must be in good taste
• Contingent Fees
▫ Can’t charge fee that is a function of the outcome
• Communication with predecessor auditor
▫ Must communicate with predecessor before accepting
engagement
• Association with false or misleading information
▫ Auditor cannot be associated with info that s/he knows
or should know is false or misleading.
 Ethical principles (AICPA)
• 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.
 Ethical principles (AICPA)
• Objectivity and independence: free of conflicts of
interest in discharging professional responsibilities and
independent in fact and appearance.
• Due care: observe the profession’s technical and ethical
standards, strive continually to improve competence and
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.
IFAC Code of Ethics for Professional Accountants
 Code of Ethics for Authorized Auditors and
Accountants
• In 2009 the Office of the Federal Auditor General issued
‘Ethiopian Code of Ethics for Professional Accountants’
including Professional Auditors
• Currently, the Accounting and Auditing Board of Ethiopia
(AABE) can establish, publish and review a Code of
Professional Conduct and Ethics for certified public
accountants and certified auditors, which shall be
consistent with that of the International Federation of
Accountants or its successors as per Regulation
No.332/2014
 Code of Ethics for Authorized Auditors and
Accountants
• International Federation of Accountants (IFAC) being the
leading international body in the accountancy profession
promulgates various pronouncements to be applied by
member countries in the world.
• In addition the United Nations arm in accountancy, the
International Organization of Supreme Audit Institutions
(INTOSAI) has also being a member of IFAC has developed
various rules and standards to be adapted by members.
• Both the international Codes of ethics enacted by IFAC and
INTOSAI serves as a model on which the national ethical
standards based.
 Code of Ethics for Authorized Auditors and
Accountants
• It was under this auspices of IFAC and INTOSAI code of ethics that
OFAG took the initiative and developed tailored made ethical
standards to be followed by all authorized auditors, authorized
accountants and employed professional accountants in both in private
and public sector.
• Authorized auditors and accountants have an important role in
society.
▫ Investors, creditors, employers and other sectors of the business
community, as well as the government and the public at large rely
on professional accountants for sound financial accounting and
reporting, effective financial management and competent advice on
a variety of business and taxation matters.
 Code of Ethics for Authorized Auditors and
Accountants
• All authorized accountant and auditors should follow the
technical and professional standards promulgated by:
▫ IFAC’s International Standard on Auditing and
▫ IASB’s International Financial Reporting Standards, if they
opt for this or
▫ Generally accepted accounting and auditing standards as
currently applicable in the country and
▫ Relevant Government legislation in Ethiopia
 Threats to Professional Ethics
• Competition
▫ Temptation to cut corners, let problems slide, accept
unsuitable clients
• Merger mania
▫ Difficult to maintain culture, internal policies,
independence issues
• Non-audit services
▫ Auditing own work
▫ Pressure on audit partners to “keep client happy” to
maintain lucrative non-audit work
• Financial Dependence
• Opinion Shopping
▫ Puts pressure on both new and incumbent auditors to
accept questionable accounting treatment
 Solving Ethical Dilemmas
1) Obtain relevant facts
2) Identify the ethical issues
3) Determine stakeholders affected and how
they are affected
• Don’t forget the public at large
4) Identify the alternatives
5) Identify likely consequences
6) Decide appropriate action
Statutory responsibilities and rights
 Auditors and the Law
• Professionals must fulfill implied or express
contracts with reasonable level of care
• Powerful force exerted on auditors, getting
stronger
▫ Increased volatility, losses, complexity
▫ Deep pockets
▫ Out of court settlements
▫ “expectations gap”
 Expectations Gap
• Public believes a clean audit opinion means:
▫ F/S are free of error
▫ No fraud has occurred
▫ Business is in sound health
• Importance of clear audit reports, engagement
letters, public education, clear standards
 Sources of Auditor Liability
• Auditors can have liability under:
▫ Statutory law
 Responsibilities under constitution
▫ Contract law
 Responsibility by virtue of contracts with
client
▫ Common law
 Law developed through past court decisions
▫ Criminal law
 Responsibility under Criminal Code of
Ethiopia
 Key elements of liability
• To be successful:
▫ Duty of Care
▫ Breach of duty
▫ Loss
▫ Causal link between breach of duty and loss
 Auditor Liability to Clients
• Generally through contract law.
• Client generally asserts auditor was negligent in
performance of duties
 Defenses against Client Claims
• Lack of Duty
• Absence of Misstatement
• Absence of Negligence
• Contributory Negligence
• No damages
• Absence of Causal Connection
 Liability to Third Parties
• Liability under common law
• Most common defense is that there is no duty
of care (=lack of privity)
 Are auditors liable?
• Smith v. London Assurance Corp (1905)
▫ first American case involving an auditor: held liable
towards their client for failing to audit a branch office
as stipulated in the engagement contract and failing to
detect an embezzlement
• Ultramares Corporation v. Touche (1931)
▫ if negligence were so great as to constitute gross
negligence, might conclude that auditor had engaged
in constructive fraud and could be liable to third parties
▫ actual fraud = intentional act to deceive, mislead or
injure the rights of another person.
▫ Auditors not liable for ordinary negligence in USA for
the next 35 years
 Due Care to whom?
• Foss v Harbottle (1842)
▫ no duty to financial stakeholders
• Heaven v. Pender (1883)
▫ duty to 3rd parties for physical damage only
• Ultramares v. Touche (1931)
▫ duty to 3rd parties for gross negligence but not
ordinary negligence
• Headley Byrne v. Heller (1964)
▫ duty to 3rd party the auditor knows or should
know will rely
 Due Care to whom?
• Haig v. Bamford (1976) and Toromont v. Thorne
(1975)
▫ duty to known third parties or known limited
class of third parties
• Dupuis v. Pan American Mines (1979)
▫ duty to recipients of prospectus
• Caparo Industries Plc. V. Dickman (1989)
▫ duty only to known 3rd parties of sufficient
proximity if fair and reasonable
Recent developments: Auditors Not Legally Liable to
Investors,Top Court Rules
• Hercules Management Ltd v. Ernst and Young
• An auditor who signs a company's financial
statements has no legal liability to shareholders or
investors
• The court’s concern is to protect auditors (for
public policy reasons) from unlimited liability to
thousands of investors who may use the audit
opinion for many different purposes
Liability to 3rd parties: Causal Connections

•Causality may be disproved if:

▫ User did not rely on f/s to make
decision
▫ Event gives rise to loss, not f/s
 Liability to 3rd parties: Confidentiality
• Confidentiality may conflict with not
associating with false and misleading
▫ Consolidata Services v. Alexander Grant
(1981) should have maintained
confidentiality
▫ Fund of Funds v Auther Anderson (1982) should
have broken confidentiality to avoid misleading
statements
▫ Transamerica vs. Dunwoody (1996): auditor was
correct in maintaining confidentiality
 Criminal Liability
• Generally rare. Occurs if:
▫ Gross negligence
▫ Deliberate
• Proceeds of Crime Legislation:
▫ Guilty if auditor accepts property if they
know or should know that property was
obtained illegally
▫ Participating in money laundering is illegal
Auditor’s responsibility in relation to fraud and for
the entity’s compliance with laws and regulations
• ISA 240
▫ An auditor conducting an audit in accordance with
ISAs is responsible for obtaining reasonable
assurance that the financial statements taken as a
whole are free from material misstatement,
whether caused by fraud or error.
▫ Owing to the inherent limitations of an audit, there
is an unavoidable risk that some material
misstatements of the financial statements may not
be detected, even though the audit is properly
planned and performed in accordance with the ISAs
Auditor’s responsibility in relation to fraud and for
the entity’s compliance with laws and regulations
▫ The risk of not detecting a material misstatement
resulting from fraud is higher than the risk of not
detecting one resulting from error.
• ISA 250
▫ The auditor is responsible to identify material
misstatement of the financial statements due to
noncompliance with laws and regulations.
▫ The auditor is not responsible for preventing non-
compliance and cannot be expected to detect non-
compliance with all laws and regulations
 Pre-appointment procedures

• ISA 210
▫ The auditor is to accept or continue an audit
engagement only when the basis upon which it is
to be performed has been agreed, through:
 Establishing whether the preconditions for an
audit are present; and
 Confirming that there is a common understanding
between the auditor and management and, where
appropriate, those charged with governance of the
terms of the audit engagement.
Chapter End!