Datasets:

kothasuhas
/

accounting-textbooks-15

Dataset card Viewer Files Files and versions Community

Split (1)

train · 10.3k rows

text stringlengths 27 15.8k	textbook_name stringclasses 15 values
Auditing Standards? 2-12 (Objective 2-7) What is meant by the term quality control as it relates to a CPA ﬁrm? 2-13 (Objective 2-7) The following is an example of a CPA ﬁrm’s quality control procedure requirement: “Any person being considered for employment by the ﬁrm must have completed a basic auditing course and have been interviewed and approved by an audit partner of the ﬁrm before he or she can be hired for the audit staff.” Which element of quality control does this procedure affect and what is the purpose of the requirement? 2-14 (Objective 2-7) State what is meant by the term peer review. What are the implications of peer review for the profession? 2-15 (Objective 2-7) What are the two AICPA resource centers to which CPA ﬁrms may belong? What are the primary purposes of the two centers? Apago PDF Enhancer MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS 2-16 (Objective 2-6) The following questions deal with auditing standards. Choose the best response. a. International Standards on Auditing are established by the (1) International Accounting Standards Board. (2) International Auditing and Assurance Standards Board. (3) Auditing Standards Board. (4) Global Auditing Standards Board. b. Which of the following best describes what is meant by U.S. generally accepted auditing standards? (1) Acts to be performed by the auditor. (2) Measures of the quality of the auditor’s performance. (3) Procedures to be used to gather evidence to support ﬁnancial statements. (4) Audit objectives generally determined on audit engagements. c. The general group of U.S. generally accepted auditing standards includes a requirement that (1) ﬁeld work be adequately planned and supervised. (2) the auditor’s report state whether or not the ﬁnancial statements conform to generally accepted accounting principles. (3) due professional care be exercised by the auditor. (4) informative disclosures in the ﬁnancial statements be reasonably adequate. Chapter 2 / THE CPA PROFESSION 41 d. What is the general character of the three generally accepted auditing standards classiﬁed as standards of ﬁeld work? (1) The competence, independence, and professional care of persons performing the audit. (2) Criteria for the content of the auditor’s report on ﬁnancial statements and related footnote disclosures. (3) The criteria of audit planning and evidence gathering. (4) The need to maintain an independence in mental attitude in all matters pertaining to the audit. 2-17 (Objective 2-7) The following questions concern quality control standards. Choose the best response. a. A CPA ﬁrm is reasonably assured of meeting its responsibility to provide services that conform with professional standards by (1) adhering to generally accepted auditing standards. (2) having an appropriate system of quality control. (3) joining professional societies that enforce ethical conduct. (4) maintaining an attitude of independence in its engagements. b. The nature and extent of a CPA ﬁrm’s quality control policies and procedures depend on (1) (2) (3) (4) The CPA Firm’s Size The Nature of the CPA Firm’s Practice Cost-benefit Considerations Yes Yes Yes No Yes Yes No Yes Yes No Yes Yes c . Which of the following are elements of a CPA ﬁrm’s quality control that should be considered in establishing its quality control policies and procedures? Apago PDF Enhancer Human Resources Monitoring Engagement Performance (1) (2) (3) (4) Yes Yes No Yes Yes Yes Yes No No Yes Yes Yes d. One purpose of establishing quality control policies and procedures for deciding whether to accept a new client is to (1) enable the CPA firm to attest to the reliability of the client. (2) satisfy the CPA firm’s duty to the public concerning the acceptance of new clients. (3) provide reasonable assurance that the integrity of the client is considered. (4) anticipate before performing any field work whether an unqualified opinion can be issued. DISCUSSION QUESTIONS AND PROBLEMS 2-18 (Objectives 2-2, 2-7) The following comments summarize the beliefs of some practitioners about the Sarbanes–Oxley Act and the PCAOB.	Alvin
The Sarbanes–Oxley Act is unnecessary regulation of the profession. The costs of require ments such as reporting on the effectiveness of internal control over ﬁnancial reporting greatly exceed the beneﬁts. These increased costs will discourage companies from issuing publicly traded stock in the United States. The regulation also gives a competitive advantage to national CPA ﬁrms because they are best prepared to meet the increased requirements of the Act. Three things already provide sufﬁcient assurance that quality audits are performed without PCAOB oversight. They are competitive pressures to do quality work, legal liability for inadequate performance, 42 Part 1 / THE AUDITING PROFESSION and a code of professional conduct requiring that CPA ﬁrms follow generally accepted auditing standards. a. State the pros and cons of those comments. b. Evaluate whether the Sarbanes–Oxley Act and PCAOB regulation are worth their Required cost. 2-19 (Objective 2-7) For each of the following procedures taken from the quality control manual of a CPA ﬁrm, identify the applicable element of quality control from Table 2-4 on page 38. a. Appropriate accounting and auditing research requires adequate technical reference materials. Each ﬁrm professional has online password access through the ﬁrm’s Internet Web site to electronic reference materials on accounting, auditing, tax, SEC, and other technical information, including industry data. b. Each office of the firm shall be visited at least annually by review persons selected by the director of accounting and auditing. Procedures to be undertaken by the reviewers are illustrated by the office review program. c. All potential new clients are reviewed before acceptance. The review includes consultation with predecessor auditors, and background checks. All new clients are approved by the firm management committee, including assessing whether the firm has the technical competence to complete the engagement. d. Each audit engagement must include a concurring partner review of critical audit decisions. e. Audit engagement team members enter their electronic signatures in the firm’s engagement management software to indicate the completion of specific audit program steps. At the end of the audit engagement, the engagement management software will not allow archiving of the engagement file until all audit program steps have been electronically signed. f . At all stages of any engagement, an effort is made to involve professional staff at appropriate levels in the accounting and auditing decisions. Various approvals of the manager or senior accountant are obtained throughout the audit. Apago PDF Enhancer g. No employee will have any direct or indirect financial interest, association, or rela - tionship (for example, a close relative serving a client in a decision-making capacity) not otherwise disclosed that might be adverse to the firm’s best interest. h. Individual partners submit the nominations of those persons whom they wish to be considered for partner. To become a partner, an individual must have exhibited a high degree of technical competence; must possess integrity, motivation, and judgment; and must have a desire to help the ﬁrm progress through the efﬁcient dispatch of the job responsibilities to which he or she is assigned. i . Through our continuing employee evaluation and counseling program and through the quality control review procedures as established by the ﬁrm, educational needs are reviewed and formal staff training programs modiﬁed to accommodate changing needs. At the conclusion of practice ofﬁce reviews, apparent accounting and auditing deﬁciencies are summarized and reported to the ﬁrm’s director of personnel. j . The firm’s mission statement indicates its commitment to quality, and this commit - ment is emphasized in all staff training programs. 2-20 (Objectives 2-2, 2-3, 2-6) The Howard Mobile Home Manufacturing Company is audited by Olson and Riley, CPAs. Howard Mobile Home has decided to issue stock to the	Alvin
public and wants Olson and Riley to perform all the audit work necessary to satisfy the requirements for ﬁling with the SEC. Olson and Riley has never had a client go public before. a. What factors should Olson and Riley consider before accepting the engage ment? b. List additional issues confronting auditors of companies that ﬁle with the SEC as Required compared to dealing with a private company audit client. Chapter 2 / THE CPA PROFESSION 43 2-21 (Objective 2-6) Ray, the owner of a small company, asked Holmes, a CPA, to conduct an audit of the company’s records. Ray told Holmes that an audit was to be completed in time to submit audited ﬁnancial statements to a bank as part of a loan application. Holmes immediately accepted the engagement and agreed to provide an auditor’s report within 3 weeks. Ray agreed to pay Holmes a ﬁxed fee plus a bonus if the loan was granted. Holmes hired two accounting students to conduct the audit and spent several hours telling them exactly what to do. Holmes told the students not to spend time reviewing internal controls but instead to concentrate on proving the mathematical accuracy of the ledger accounts and summarizing the data in the accounting records that support Ray’s ﬁnancial statements. The students followed Holmes’s instructions and after 2 weeks gave Holmes the ﬁnancial statements, which did not include footnotes. Holmes reviewed the statements and prepared an unqualiﬁed auditor’s report. The report did not refer to generally accepted accounting principles or to the consistent application of such principles. Required Brieﬂy describe each of the 10 generally accepted auditing standards and indicate how the action(s) of Holmes resulted in a failure to comply with each standard. Organize your answer as follows:* Brief Description of GAAS Holmes’ Actions Resulting in Failure to Comply with GAAS 2-22 (Objective 2-5) For each engagement described below, indicate whether the engage - ment is likely to be conducted under international auditing standards, U.S. generally accepted auditing standards, or PCAOB auditing standards. a. An audit of a U.S. private company with no public equity or debt. b. An audit of a German private company with public debt in Germany. c. An audit of a U.S. public company. d. An audit of a United Kingdom public company that is listed in the United States and whose financial statements will be filed with the SEC. Apago PDF Enhancer e. An audit of a U.S. not-for-profit organization. f . An audit of a U.S. private company to be used for a loan from a publicly-traded bank. g. An audit of a U.S public company that is a subsidiary of a Japanese company that will be used for reporting by the parent company in Japan. h. An audit of a U.S. private company that has publicly-traded debt. INTERNET PROBLEM 2-1: INTERNATIONAL AUDITING AND ASSURANCE STANDARDS BOARD International Standards on Auditing (ISAs) are issued by the International Auditing and Assurance Standards Board (IAASB). Use the IAASB web site (http://www.ifac.org/IAASB/) to learn more about the IAASB and its standard-setting activities. Required a. What is the objective of the IAASB? Who uses International Standards on Auditing? b. Summarize the due process followed by the IAASB in setting standards. c. How is the IAASB committed to transparency in the standard-setting process? *AICPA adapted. 44 Part 1 / THE AUDITING PROFESSION C H A P T E R 3 AUDIT REPORTS The Audit Report Was Timely, But At What Cost? Halvorson & Co., CPAs was hired as the auditor for Machinetron, Inc., a company that manufac tured high-precision, computer-operated lathes. The owner, Al Trent, thought that Machinetron was ready to become a public company, and he hired Halvorson to conduct the upcoming audit and assist in the preparation of the registration statement for a securities offering. Because Machinetron’s machines were large and complex, they were expensive. Each sale was negotiated individually by Trent, and the sales often transpired over several months. As a result, improper recording of	Alvin
one or two machines could represent a material misstatement of the ﬁnancial statements. The engagement partner in charge of the Machinetron audit was Bob Lehman, who had signiﬁcant experience auditing manufacturing companies. He recognized the risk for improper recording of sales, and he insisted that his staff conﬁrm all receivables at year-end directly with customers. Lehman conducted his review of the Machinetron audit ﬁles the same day that Trent wanted to ﬁle the company’s registration statement for the initial public stock offering with the SEC. Lehman saw that a receivable for a major sale at year-end was supported by a fax, rather than the usual written conﬁrmation reply. Apparently, relations with this customer were “touchy,” and Trent had discouraged the audit staff from communicating with the customer. Apago PDF Enhancer L E A R N I N G O B J E C T I V E S After studying this chapter, you should be able to 3-1 Describe the parts of the standard unqualiﬁed audit report. 3-2 Specify the conditions required to issue the standard unqualiﬁed audit report. 3-3 Understand reporting on ﬁnancial statements and internal control over ﬁnancial reporting under Section 404 of the Sarbanes–Oxley Act. 3-4 Describe the ﬁve circumstances when an unqualiﬁed report with an explanatory paragraph or modiﬁed wording is appropriate. 3-5 Identify the types of audit reports that can be issued when an unqualified opinion is not justified. 3-6 Explain how materiality affects audit reporting decisions. 3-7 Draft appropriately modiﬁed audit reports under a variety of circumstances. At the end of the day, there was a meeting in Machinetron’s ofﬁce. It was attended by Lehman, Trent, the underwriter of the stock offering, and the company’s attorney. Lehman indicated that a better form of conﬁr mation would be required to support the receivable. After hearing this, Trent blew his stack. Machinetron’s attorney stepped in and calmed Trent down. He offered to write a letter to Halvorson & Co. stating that in his opinion, a fax had legal substance as a valid conﬁrmation reply. Lehman, feeling tremendous pressure, accepted this proposal and signed off on an unqualiﬁed audit opinion about Machinetron’s ﬁnancial statements. 3-9 Understand proposed use of international accounting and auditing standards 3-8 Determine the appropriate audit report for a given audit situation. Six months after the stock offering, Machinetron issued a statement indicating that its revenues for the prior year were overstated as a result of improperly recorded sales, including the sale supported by the fax conﬁr mation. The subsequent SEC investigation uncovered that the fax was returned to the audit ﬁrm by Trent, not the customer. Halvorson & Co. recalled their unqualiﬁed audit report, but this was too late to prevent the harm done to inves tors. Halvorson & Co. was forced to pay substantial damages, and Bob Lehman was forbidden to prac tice before the SEC. He subsequently left public accounting. Reports are essential to audit and assurance engagements because they communicate the auditor’s ﬁndings. Users of ﬁnancial statements rely on the auditor’s report to provide assurance on the company’s ﬁnancial statements. As the story at the beginning of this chapter illustrates, the auditor will likely be held responsible if an incorrect audit report is issued. The audit report is the ﬁnal step in the entire audit process. The reason for studying it now is to permit reference to different audit reports as we study the accumulation of audit evidence throughout this text. These evidence concepts are more meaningful after you understand the form and content of the ﬁnal product of the audit. We begin by describing the content of the standard auditor’s report. STANDARD UNQUALIFIED AUDIT REPORT Parts of Standard Unqualified Audit Report OBJECTIVE 3-1 Describe the parts of the standard unqualiﬁed audit report. To allow users to understand audit reports, AICPA professional standards provide uniform word ing for the auditor’s report, as illustrated in the auditor’s standard	Alvin
unqualiﬁed audit report in Figure 3-1. Different auditors may alter the wording or presentation slightly, but the meaning will be the same. The auditor’s standard unqualiﬁed audit report contains seven distinct parts, and these are labeled in bold letters in the margin beside Figure 3-1. 1. Report title. Auditing standards require that the report be titled and that the title include the word independent. For example, appropriate titles include “independent auditor’s report,” “report of independent auditor,” or “independent accountant’s opinion.” The requirement that the title include the word independent conveys to users that the audit was unbiased in all aspects. 2. Audit report address. The report is usually addressed to the company, its stockholders, or the board of directors. In recent years, it has become customary to address the report to the board of directors and stockholders to indicate that the auditor is independent of the company. Apago PDF Enhancer 3. Introductory paragraph. The ﬁrst paragraph of the report does three things: First, it makes the simple statement that the CPA ﬁrm has done an audit. This is intended to distinguish the report from a compilation or review report. The scope paragraph (see part 4) clariﬁes what is meant by an audit. Second, it lists the ﬁnancial statements that were audited, including the balance sheet dates and the accounting periods for the income statement and statement of cash ﬂows. The wording of the ﬁnancial statements in the report should be identical to those used by management on the ﬁnancial statements. Notice that the report in Figure 3-1 is on com - parative ﬁnancial statements. Therefore, a report on both years’ state ments is needed. Third, the introductory paragraph states that the statements are the responsibility of management and that the auditor’s responsibility is to express an opinion on the statements based on an audit. The purpose of these statements is to communicate that management is responsible for selecting the appro priate accounting principles and making the measurement decisions and disclosures in applying those principles and to clarify the respective roles of management and the auditor. 4. Scope paragraph. The scope paragraph is a factual statement about what the auditor did in the audit. This paragraph ﬁrst states that the auditor followed U.S. generally accepted auditing standards. For an audit of a public company, the paragraph will indicate that the auditor followed standards of the Public Company Accounting Oversight Board. Because ﬁnancial statements prepared in accordance with U.S. accounting principles and audited in accordance with U.S. auditing standards are available throughout the world on the Internet, the country of origin of the accounting principles used in preparing the ﬁnancial statements and auditing standards followed by the auditor are identiﬁed in the audit report. The scope paragraph states that the audit is designed to obtain reasonable assurance about whether the statements are free of material misstatement. The inclusion of the word 46 Part 1 / THE AUDITING PROFESSION FIGURE 3-1 Standard Unqualiﬁed Report on Comparative Statements for a U.S. Public Company ANDERSON and ZINDER, P.C. Certified Public Accountants Suite 100 Park Plaza East Denver, Colorado 80110 303/359-0800 Independent Auditor’s Report To the Stockholders General Ring Corporation We have audited the accompanying balance sheets of General Ring Corporation as of December 31, 2011 and 2010, and the related statements of income, retained earnings, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.	Alvin
An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. Report Title Audit Report Address Introductory Paragraph (Factual Statement) Scope Paragraph (Factual Statement) In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of General Ring Corporation as of December 31, 2011 and 2010, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. Opinion Paragraph (Conclusions) ANDERSON AND ZINDER, P.C., CPAs Apago PDF Enhancer Name of CPA Firm February 15, 2012 Audit Report Date (Date Audit Field Work Is Completed) material conveys that auditors are responsible only to search for signiﬁcant misstatements, not minor misstatements that do not affect users’ decisions. The use of the term reasonable assurance is intended to indicate that an audit cannot be expected to completely eliminate the possibility that a material misstatement will exist in the ﬁnancial statements. In other words, an audit provides a high level of assurance, but it is not a guarantee. The remainder of the scope paragraph discusses the audit evidence accumulated and states that the auditor believes that the evidence accumulated was appropriate for the circumstances to express the opinion presented. The words test basis indicate that sampling was used rather than an audit of every transaction and amount on the statements. Whereas the introductory paragraph of the report states that management is responsible for the preparation and content of the ﬁnancial statements, the scope paragraph states that the auditor evaluates the appropriateness of those accounting principles, estimates, and ﬁnancial statement disclosures and presentations given. 5. Opinion paragraph. The ﬁnal paragraph in the standard report states the auditor’s conclusions based on the results of the audit. This part of the report is so important that often the entire audit report is referred to simply as the auditor’s opinion. The opinion paragraph is stated as an opinion rather than as a statement of absolute fact or a guarantee. The intent is to indicate that the conclusions are based on professional judgment. The phrase in our opinion indicates that there may be some information risk associated with the ﬁnancial statements, even though the statements have been audited. Chapter 3 / AUDIT REPORTS 47 EU REQUIRES AND PCAOB CONSIDERS AUDIT PARTNER’S PERSONAL SIGNATURE ON AUDIT REPORT While some countries in continental Europe already required that the personal signature of the engagement partner be included in the audit report, the passage of The European Union’s Eighth Company Law Directive in 2006 made it mandatory for all EU member states. The 2008 ﬁnal report of the U.S. Department of Treasury’s Advisory Commit - tee on the Auditing Profession urged the PCAOB to consider mandating the engagement partner’s signature on the auditor’s report. In 2009 the PCAOB issued and received comments on “Concept Release on Requiring the Engagement Partner to Sign the Audit Report.” Proponents argue that the requirement would increase the partner’s sense of accountability to users and it would increase trans - parency about who is respon sible for performing the audit. Opponents note that only including the audit ﬁrm signature signals to users that the entire audit ﬁrm stands behind the opinion. Source: “Concept Release on Requiring the Engagement Partner to Sign the Audit Report,” PCAOB Release No. 2009-005, July 28, 2009, PCAOB Rulemaking Docket Matter No. 29 (www.pcaobus.org). The opinion paragraph is directly related to the ﬁrst and fourth generally accepted	Alvin
auditing reporting standards listed on page 35. The auditor is required to state an opinion about the ﬁnancial statements taken as a whole, including a conclusion about whether the company followed U.S. generally accepted accounting principles or the International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB). One of the controversial parts of the auditor’s report is the meaning of the term present fairly. Does this mean that if generally accepted accounting principles are followed, the ﬁnancial statements are presented fairly, or something more? Occa - sionally, the courts have concluded that auditors are responsible for looking beyond generally accepted accounting principles to determine whether users might be misled, even if those principles are followed. Most auditors believe that ﬁnancial statements are “presented fairly” when the statements are in accordance with generally accepted accounting principles, but that it is also necessary to examine the substance of trans - Apago PDF Enhancer actions and balances for possible misinformation. 6. Name of CPA ﬁrm. The name identiﬁes the CPA ﬁrm or practitioner who performed the audit. Typically, the ﬁrm’s name is used because the entire CPA ﬁrm has the legal and professional responsibility to ensure that the quality of the audit meets professional standards. 7. Audit report date. The appropriate date for the report is the one on which the auditor completed the auditing procedures in the ﬁeld. This date is important to users because it indicates the last day of the auditor’s responsibility for the review of signiﬁ - cant events that occurred after the date of the ﬁnancial statements. In the audit report in Figure 3-1 (p. 47), the balance sheet is dated December 31, 2011, and the audit report is dated February 15, 2012. This indicates that the auditor has searched for material unrecorded transactions and events that occurred up to February 15, 2012. The standard unqualiﬁed audit report is issued when the following conditions have been met: 1. All statements—balance sheet, income statement, statement of retained earnings, and statement of cash ﬂows—are included in the ﬁnancial statements. 2. The three general standards have been followed in all respects on the engage ment. 3. Sufﬁcient appropriate evidence has been accumulated, and the auditor has conducted the engage ment in a manner that enables him or her to conclude that the three standards of ﬁeld work have been met. 4. The ﬁnancial statements are presented in accordance with U.S. generally accepted accounting prin ciples. This also means that adequate disclosures have been included in the footnotes and other parts of the ﬁnancial statements. 5. There are no circumstances requiring the addition of an explanatory paragraph or modiﬁcation of the wording of the report. Conditions for Standard Unqualiﬁed Audit Report OBJECTIVE 3-2 Specify the conditions required to issue the standard unqualiﬁed audit report. 48 Part 1 / THE AUDITING PROFESSION FIGURE 3-2 Four Categories of Audit Reports Standard Unqualified The five conditions stated on page 48 have been met. Unqualified with Explanatory Paragraph or Modified Wording A complete audit took place with satisfactory results and financial statements that are fairly presented, but the auditor believes that it is important or is required to provide additional information. Qualified Adverse or Disclaimer The auditor concludes that the overall financial statements are fairly presented, but the scope of the audit has been materially restricted or applicable accounting standards were not followed in preparing the financial statements. The auditor concludes that the financial statements are not fairly presented (adverse), he or she is unable to form an opinion as to whether the financial statements are fairly presented (disclaimer), or he or she is not independent (disclaimer). When these conditions are met, the standard unqualiﬁed audit report, as shown in Figure 3-1, is issued. The standard unqualiﬁed audit report is sometimes called a clean	Alvin
opinion because there are no circumstances requiring a qualiﬁcation or modiﬁcation of the auditor’s opinion. The standard unquali ﬁed report is the most common audit opinion. Sometimes circumstances beyond the client’s or auditor’s control prevent the issuance of a clean opinion. However, in most cases, companies make the appropriate changes to their accounting records to avoid a qualiﬁcation or modiﬁcation by the auditor. Apago PDF Enhancer If any of the ﬁve requirements for the standard unqualiﬁed audit report are not met, the standard unqualiﬁed report cannot be issued. Figure 3-2 indicates the categories of audit reports that can be issued by the auditor. The departures from a standard unqualiﬁed report are considered increasingly severe as one moves down the ﬁgure. Financial statement users are normally much more concerned about a disclaimer or adverse opinion than an unqualiﬁed report with an explanatory paragraph. These other categories of audit reports are discussed in following sections. REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING UNDER SECTION 404 OF THE SARBANES–OXLEY ACT As discussed in Chapter 1, Section 404(b) of the Sarbanes–Oxley Act requires the auditor of a public company to attest to management’s report on the effectiveness of internal control over ﬁnancial reporting. Since 2004, larger public companies (known as accelerated ﬁlers) have been required by the SEC to annually obtain an auditor’s report on internal controls over ﬁnancial reporting. As noted in Chapter 1, non- accelerated ﬁlers have been exempt from this requirement and the passage by Congress of the 2010 ﬁnancial reform legislation made that exemption permanent for non- accelerated ﬁlers. PCAOB Auditing Standard 5 requires the audit of internal control to be integrated with the audit of the ﬁnancial statements. However, the auditor may choose to issue separate reports, such as the separate report on internal control over ﬁnancial OBJECTIVE 3-3 Understand reporting on ﬁnancial statements and internal control over ﬁnancial reporting under Section 404 of the Sarbanes–Oxley Act. Chapter 3 / AUDIT REPORTS 49 FIGURE 3-3 Separate Report on Internal Control over Financial Reporting Introductory Paragraph Scope Paragraph Definition Paragraph REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders of Westbrook Company, Inc.: We have audited Westbrook Company, Inc.’s internal control over financial reporting as of December 31, 2011, based on criteria established in Internal Control−Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Westbrook Company, Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. financial reporting and the preparation of A company’s internal control over financial reporting is a process designed to provide reasonable	Alvin
assurance regarding the reliability of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Apago PDF Enhancer Inherent Limitations Paragraph Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Opinion Paragraph In our opinion, Westbrook Company, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2011, based on the COSO criteria. Cross Reference Paragraph We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Westbrook Company, Inc. as of December 31, 2011 and 2010, and the related consolidated statements of income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2011 of Westbrook Company, Inc. and our report dated February 11, 2012 expressed an unqualified opinion thereon. reporting shown in Figure 3-3, or in a combined report. The combined report on ﬁnancial statements and internal control over ﬁnancial reporting addresses both the ﬁnancial statements and management’s report on internal control over ﬁnancial reporting. While the combined report is permitted, the separate report on internal control over ﬁnancial reporting is more common and includes these elements: • The introductory, scope, and opinion paragraphs describe that the scope of the auditor’s work and opinion is on internal control over ﬁnancial reporting, and the introductory paragraph highlights management’s responsibility for and its separate assessment of internal control over ﬁnancial reporting. • The introductory and opinion paragraphs also refer to the framework used to evaluate internal control. 50 Part 1 / THE AUDITING PROFESSION • The report includes a paragraph after the scope paragraph deﬁning internal control over ﬁnancial reporting. • The report also includes an additional paragraph before the opinion that addresses the inherent limitations of internal control. • Although the audit opinion on the ﬁnancial statements addresses multiple reporting periods, the auditor’s opinion about the effectiveness of internal control is as of the end of the most recent ﬁscal year. • The last paragraph of the report includes a cross-reference to the auditor’s separate report on the ﬁnancial statements. The separate report in Figure 3-3 is an unqualiﬁed opinion on the effectiveness of internal control over ﬁnancial reporting prepared in accordance with PCAOB Auditing Standard 5. The auditor may issue a qualiﬁed opinion, adverse opinion, or disclaimer of opinion on the operating effectiveness of internal control over ﬁnancial reporting. Conditions that require the auditor to issue a report other than an unqualiﬁed	Alvin
opinion on the operating effectiveness of internal control are discussed in Chapter 10, along with the effects of these conditions on the wording of the auditor’s report on internal control over ﬁnancial reporting. Auditor reporting on internal controls for private companies is covered in Chapter 25. UNQUALIFIED AUDIT REPORT WITH EXPLANATORY PARAGRAPH OR MODIFIED WORDING Apago PDF Enhancer The remainder of this chapter deals with reports, other than standard unqualiﬁed reports, on the audit of ﬁnancial statements. In certain situations, an unqualiﬁed audit report on the ﬁnancial statements is issued, but the wording deviates from the standard unqualiﬁed report. The unqualiﬁed audit report with explanatory paragraph or modiﬁed wording meets the criteria of a complete audit with satisfactory results and ﬁnancial statements that are fairly presented, but the auditor believes it is important or is required to provide additional information. In a qualiﬁed, adverse, or disclaimer report, the auditor either has not performed a satisfactory audit, is not satisﬁed that the ﬁnancial statements are fairly presented, or is not independent. The following are the most important causes of the addition of an explanatory paragraph or a modiﬁcation in the wording of the standard unqualiﬁed report: • Lack of consistent application of generally accepted accounting principles • Substantial doubt about going concern • Auditor agrees with a departure from promulgated accounting principles • Emphasis of a matter • Reports involving other auditors The ﬁrst four reports all require an explanatory paragraph. In each case, the three standard report paragraphs are included without modiﬁcation, and a separate explana - tory paragraph follows the opinion paragraph. Only reports involving the use of other auditors use a modiﬁed wording report. This report contains three paragraphs, and all three paragraphs are modiﬁed. The second reporting standard requires the auditor to call attention to circumstances in which accounting principles have not been consistently observed in the current period in relation to the preceding period. Generally accepted accounting principles require that changes in accounting principles or their method of application be to a preferable principle and that the nature and impact of the change be adequately disclosed. When a material change occurs, the auditor should modify the report by adding an explanatory OBJECTIVE 3-4 Describe the ﬁve circumstances when an unqualiﬁed report with an explanatory paragraph or modiﬁed wording is appropriate. Lack of Consistent Application of GAAP Chapter 3 / AUDIT REPORTS 51 FIGURE 3-4 Explanatory Paragraph Because of Change in Accounting Principle INDEPENDENT AUDITOR’S REPORT (Same introductory, scope, and opinion paragraphs as the standard report) Fourth Paragraph— Explanatory Paragraph As discussed in Note 8 to the financial statements, the Company changed its method of computing depreciation in 2011. paragraph after the opinion paragraph that discusses the nature of the change and points the reader to the footnote that discusses the change. The materiality of a change is evaluated based on the current year effect of the change. An explanatory paragraph is required for both voluntary changes and required changes due to a new accounting pronouncement. Figure 3-4 presents such an explanatory paragraph. It is implicit in the explanatory paragraph in Figure 3-4 that the auditor concurs with the appropriateness of the change in accounting principles. If the auditor does not concur, the change is a violation of generally accepted accounting principles, and his or her opinion must be qualiﬁed. Consistency Versus Comparability The auditor must be able to distinguish between changes that affect consistency and those that may affect comparability but do not affect consistency. The following are examples of changes that affect consistency and therefore require an explanatory paragraph if they are material: 1. Changes in accounting principles, such as a change from FIFO to LIFO inven -	Alvin
tory valuation in combined ﬁnancial statements 2. Changes in reporting entities, such as the inclusion of an additional company Apago PDF Enhancer 3. Corrections of errors involving principles, by changing from an accounting principle that is not generally acceptable to one that is generally acceptable, including correction of the resulting error Changes that affect comparability but not consistency and therefore need not be included in the audit report include the following: 1. Changes in an estimate, such as a decrease in the life of an asset for depreciation purposes 2. Error corrections not involving principles, such as a previous year’s mathe - matical error 3. Variations in format and presentation of ﬁnancial information 4. Changes because of substantially different transactions or events, such as new endeavors in research and development or the sale of a subsidiary Items that materially affect the comparability of ﬁnancial statements generally require disclosure in the footnotes. A qualiﬁed audit report for inadequate disclosure may be required if the client refuses to properly disclose the items. Even though the purpose of an audit is not to evaluate the ﬁnancial health of the busi - ness, the auditor has a responsibility under auditing standards to evaluate whether the company is likely to continue as a going concern. For example, the existence of one or more of the following factors causes uncertainty about the ability of a company to continue as a going concern: 1. Signiﬁcant recurring operating losses or working capital deﬁciencies 2. Inability of the company to pay its obligations as they come due 3. Loss of major customers, the occurrence of uninsured catastrophes such as an earthquake or ﬂood, or unusual labor difﬁculties Substantial Doubt About Going Concern 52 Part 1 / THE AUDITING PROFESSION FIGURE 3-5 Explanatory Paragraph Because of Substantial Doubt About Going Concern INDEPENDENT AUDITOR’S REPORT (Same introductory, scope, and opinion paragraphs as the standard report) The accompanying financial statements have been prepared assuming that Fairfax Company will continue as a going concern. As discussed in Note 11 to the financial statements, Fairfax Company has suffered recurring losses from operations and has a net capital deficiency that raise substantial doubt about the company’s ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 11. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Fourth Paragraph— Explanatory Paragraph 4. Legal proceedings, legislation, or similar matters that have occurred that might jeopardize the entity’s ability to operate The auditor’s concern in such situations is the possibility that the client may not be able to continue its operations or meet its obligations for a reasonable period. For this purpose, a reasonable period is considered not to exceed 1 year from the date of the ﬁnancial statements being audited. When the auditor concludes that there is substantial doubt about the entity’s ability to continue as a going concern, an unqualiﬁed opinion with an explanatory paragraph is required, regardless of the disclosures in the ﬁnancial statements. Figure 3-5 provides an example in which there is substantial doubt about going concern. Auditing standards permit but do not require a disclaimer of opinion when there is substantial doubt about going concern. The criteria for issuing a disclaimer of opinion instead of adding an explanatory paragraph are not stated in the standards, and this type of opinion is rarely issued in practice. An example for which a disclaimer might be issued is when a regulatory agency, such as the Environmental Protection Agency, is considering a severe sanction against a company and, if the proceedings result in an unfavorable outcome, the company will be forced to liquidate. Apago PDF Enhancer Rule 203 of the AICPA Code of Professional Conduct states that in unusual situations, a	Alvin
departure from a generally accepted accounting principle may not require a qualiﬁed or adverse opinion. However, to justify an unqualiﬁed opinion, the auditor must be satisﬁed and must state and explain, in a separate paragraph or paragraphs in the audit report, that adhering to the principle would produce a misleading result in that situation. Under certain circumstances, the CPA may want to emphasize speciﬁc matters regard - ing the ﬁnancial statements, even though he or she intends to express an unquali ﬁed opinion. Normally, such explanatory information should be included in a separate paragraph in the report. Examples of explanatory information the auditor may report as an emphasis of a matter include the following: • The existence of signiﬁcant related party transactions • • The description of accounting matters affecting the comparability of the Important events occurring subsequent to the balance sheet date ﬁnancial statements with those of the preceding year • Material uncertainties disclosed in the footnotes When the CPA relies on a different CPA ﬁrm to perform part of the audit, which is common when the client has several widespread branches or subdivisions, the princi - pal CPA ﬁrm has three alternatives. Only the second is an unqualiﬁed report with modiﬁed wording. 1. Make No Reference in the Audit Report When no reference is made to the other auditor, a standard unqualiﬁed opinion is given unless other circumstances Auditor Agrees with a Departure from a Promulgated Principle Emphasis of a Matter Reports Involving Other Auditors Chapter 3 / AUDIT REPORTS 53 require a departure. This approach is typically followed when the other auditor audited an immaterial portion of the statements, the other auditor is well known or closely supervised by the principal auditor, or the principal auditor has thoroughly reviewed the other auditor’s work. The other auditor is still responsible for his or her own report and work in the event of a lawsuit or SEC action. 2. Make Reference in the Report (Modiﬁed Wording Report) This type of report is called a shared opinion or report. A shared unqualiﬁed report is appropriate when it is impractical to review the work of the other auditor or when the portion of the ﬁnancial statements audited by the other CPA is material in relation to the whole. An example of an unqualiﬁed shared report is shown in Figure 3-6. Notice that the report does not include a separate paragraph that discusses the shared responsi bility, but does so in the introductory paragraph and refers to the other auditor in the scope and opinion paragraphs. The portions of the ﬁnancial statements audited by the other auditor can be stated as percentages or absolute amounts. 3. Qualify the Opinion A qualiﬁed opinion or disclaimer, depending on materiality, is required if the principal auditor is not willing to assume any responsibility for the work of the other auditor. The principal auditor may also decide that a qualiﬁcation is required in the overall report if the other auditor qualiﬁed his or her portion of the audit. Qualiﬁed opinions and disclaimers are discussed in a later section. FIGURE 3-6 Unqualiﬁed Shared Report INDEPENDENT AUDITOR’S REPORT Stockholders and Board of Directors Washington Felp Midland, Texas Apago PDF Enhancer Introductory Paragraph— Modified Wording Scope Paragraph— Modified Wording We have audited the accompanying consolidated balance sheets of Washington Felp as of July 31, 2011 and 2010, and the related consolidated statements of income, retained earnings, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We did not audit the financial statements of Stewart Pane and Lighting, a consolidated subsidiary in which the Company had an equity interest of 84% as of July 31, 2011, which statements reflect total assets of $2,420,000 and $2,237,000 as of July 31, 2011 and 2010,	Alvin
respectively, and total revenues of $3,458,000 and $3,121,000 for the years then ended. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Stewart Pane and Lighting, is based solely on the report of the other auditors. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion. Opinion Paragraph— Modified Wording In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Washington Felp as of July 31, 2011 and 2010, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. September 16, 2011 Farn, Ross, & Co. Certified Public Accountants Dallas, Texas 54 Part 1 / THE AUDITING PROFESSION DEPARTURES FROM AN UNQUALIFIED AUDIT REPORT OBJECTIVE 3-5 Identify the types of audit reports that can be issued when an unqualiﬁed opinion is not justiﬁed. Qualified Opinion It is essential that auditors and readers of audit reports understand the circumstances when an unqualiﬁed report is inappropriate and the type of audit report issued in each circumstance. In the study of audit reports that depart from an unqualiﬁed report, there are three closely related topics: the conditions requiring a departure from an unqualiﬁed opinion, the types of opinions other than unqualiﬁed, and materiality. First, the three conditions requiring a departure are brieﬂy summarized. Each is discussed in greater depth later in the chapter. 1. The Scope of the Audit Has Been Restricted (Scope Limitation) When the auditor has not accumulated sufﬁcient appropriate evidence to conclude whether ﬁnancial statements are stated in accordance with GAAP, a scope restriction exists. There are two major causes of scope restrictions: restrictions imposed by the client and those caused by circumstances beyond either the client’s or auditor’s control. An example of a client restriction is management’s refusal to permit the auditor to conﬁrm material receivables or to physically examine inventory. An example of a restriction caused by circumstances is when the auditor is not appointed until after the client’s year-end. It may not be possible to physically observe inventories, conﬁrm receivables, or perform other important procedures after the balance sheet date. 2. The Financial Statements Have Not Been Prepared in Accordance with Generally Accepted Accounting Principles (GAAP Departure) For example, if the client insists on using replacement costs for ﬁxed assets or values inventory at selling price rather than historical cost as required by generally accepted accounting principles, a departure from the unqualiﬁed report is required. When U.S. generally accepted accounting principles or international ﬁnancial reporting standards are referred to in this context, consideration of the adequacy of all informative dis - closures, including footnotes, is especially important. Apago PDF Enhancer 3. The Auditor Is Not Independent Independence ordinarily is determined by Rule 101 of the rules of the Code of Professional Conduct. Auditor independence requirements and the Code of Professional Conduct are further discussed in Chapter 4.	Alvin
When any of the three conditions requiring a departure from an unqualiﬁed report exists and is material, a report other than an unqualiﬁed report must be issued. Three main types of audit reports are issued under these conditions: qualiﬁed opinion, adverse opinion, and disclaimer of opinion. A qualiﬁed opinion report can result from a limitation on the scope of the audit or failure to follow generally accepted accounting principles. A qualiﬁed opinion report can be used only when the auditor concludes that the overall ﬁnancial statements are fairly stated. A disclaimer or an adverse report must be used if the auditor believes that the condition being reported on is highly material. Therefore, the qualiﬁed opinion is considered the least severe type of departure from an unqualiﬁed report. A qualiﬁed report can take the form of a qualiﬁcation of both the scope and the opinion or of the opinion alone. A scope and opinion qualiﬁcation can be issued only when the auditor has been unable to accumulate all of the evidence required by generally accepted auditing standards. Therefore, this type of qualiﬁcation is used when the auditor’s scope has been restricted by the client or when circumstances exist that prevent the auditor from conducting a complete audit. The use of a qualiﬁcation of the opinion alone is restricted to situations in which the ﬁnancial statements are not stated in accordance with GAAP. When an auditor issues a qualiﬁed report, he or she must use the term except for in the opinion paragraph. The implication is that the auditor is satisﬁed that the overall ﬁnancial statements are correctly stated “except for” a speciﬁc aspect of them. Examples Chapter 3 / AUDIT REPORTS 55 Adverse Opinion Disclaimer of Opinion MATERIALITY OBJECTIVE 3-6 Explain how materiality affects audit reporting decisions. of this qualiﬁcation are given later in this chapter. It is unacceptable to use the phrase except for with any other type of audit opinion. An adverse opinion is used only when the auditor believes that the overall ﬁnancial statements are so materially misstated or misleading that they do not present fairly the ﬁnancial position or results of operations and cash ﬂows in conformity with GAAP. The adverse opinion report can arise only when the auditor has knowledge, after an adequate investigation, of the absence of conformity. This is uncommon and thus the adverse opinion is rarely used. A disclaimer of opinion is issued when the auditor has been unable to satisfy himself or herself that the overall ﬁnancial statements are fairly presented. The necessity for disclaiming an opinion may arise because of a severe limitation on the scope of the audit or a nonindependent relationship under the Code of Professional Conduct between the auditor and the client. Either of these situations prevents the auditor from expressing an opinion on the ﬁnancial statements as a whole. The auditor also has the option to issue a disclaimer of opinion for a going concern problem. The disclaimer is distinguished from an adverse opinion in that it can arise only from a lack of knowledge by the auditor, whereas to express an adverse opinion, the auditor must have knowledge that the ﬁnancial statements are not fairly stated. Both disclaimers and adverse opinions are used only when the condition is highly material. Materiality is an essential consideration in determining the appropriate type of report for a given set of circumstances. For example, if a misstatement is immaterial relative to the ﬁnancial statements of the entity for the current period, it is appropriate to issue an un - qualiﬁed report. A common instance is the immediate expensing of ofﬁce supplies rather than carrying the unused portion in inventory because the amount is insigniﬁcant. Apago PDF Enhancer The situation is totally different when the amounts are of such signiﬁcance that the ﬁnancial statements are materially affected as a whole. In these circumstances, it is necessary to issue a disclaimer of opinion or an adverse opinion, depending on whether	Alvin
a scope limitation or GAAP departure is involved. In situations of lesser materiality, a qualiﬁed opinion is appropriate. Levels of Materiality The common deﬁnition of materiality as it applies to accounting and therefore to audit reporting is as follows: A misstatement in the ﬁnancial statements can be considered material if knowledge of the misstate - ment will affect a decision of a reasonable user of the statements. In applying this deﬁnition, three levels of materiality are used for determining the type of opinion to issue. Amounts Are Immaterial When a misstatement in the ﬁnancial statements exists but is unlikely to affect the decisions of a reasonable user, it is considered to be im - material. An unqualiﬁed opinion is therefore appropriate. For example, assume that management recorded prepaid insurance as an asset in the previous year and decides to expense it in the current year to reduce record-keeping costs. Management has failed to follow GAAP, but if the amounts are small, the misstatement is immaterial and a standard unqualiﬁed audit report is appropriate. Amounts Are Material but Do Not Overshadow the Financial Statements as a Whole The second level of materiality exists when a misstatement in the ﬁnancial statements would affect a user’s decision, but the overall statements are still fairly stated 56 Part 1 / THE AUDITING PROFESSION and therefore useful. For example, knowledge of a large misstatement in ﬁxed assets might affect a user’s willingness to loan money to a company if the assets were the collateral. A misstatement of inventory does not mean that cash, accounts receivable, and other elements of the ﬁnancial statements, or the ﬁnancial statements as a whole, are materially incorrect. To make materiality decisions when a condition requiring a departure from an unqualiﬁed report exists, the auditor must evaluate all effects on the ﬁnancial statements. Assume that the auditor is unable to satisfy himself or herself whether inventory is fairly stated in deciding on the appropriate type of opinion. Because of the effect of a misstatement in inventory on other accounts and on totals in the statements, the auditor needs to consider the materiality of the combined effect on inventory, total current assets, total working capital, total assets, income taxes, income taxes payable, total current liabilities, cost of goods sold, net income before taxes, and net income after taxes. When the auditor concludes that a misstatement is material but does not over - shadow the ﬁnancial statements as a whole, a qualiﬁed opinion (using “except for”) is appropriate. Amounts Are So Material or So Pervasive That Overall Fairness of the Statements Is in Question The highest level of materiality exists when users are likely to make incorrect decisions if they rely on the overall ﬁnancial statements. To return to the previous example, if inventory is the largest balance on the ﬁnancial statements, a large misstatement would probably be so material that the auditor’s report should indicate the ﬁnancial statements taken as a whole cannot be considered fairly stated. When the highest level of materiality exists, the auditor must issue either a disclaimer of opinion or an adverse opinion, depending on which conditions exist. When determining whether an exception is highly material, the extent to which the exception affects different parts of the ﬁnancial statements must be considered. This is called pervasiveness. A misclassiﬁcation between cash and accounts receivable affects only those two accounts and is therefore not pervasive. On the other hand, failure to record a material sale is highly pervasive because it affects sales, accounts receivable, income tax expense, accrued income taxes, and retained earnings, which in turn affect current assets, total assets, current liabilities, total liabilities, owners’ equity, gross margin, and operating income. Apago PDF Enhancer As misstatements become more pervasive, the likelihood of issuing an adverse opinion rather than a qualiﬁed opinion increases. For example, suppose the auditor	Alvin
decides a misclassiﬁcation between cash and accounts receivable should result in a qualiﬁed opinion because it is material; the failure to record a sale of the same dollar amount may result in an adverse opinion because of pervasiveness. Regardless of the amount involved, a disclaimer of opinion must be issued if the auditor is determined to lack independence under the rules of the Code of Professional Conduct. This strict requirement reﬂects the importance of independence to auditors. Any deviation from the independence rule is therefore considered highly material. Table 3-1 (p. 58) summarizes the relationship between materiality and the type of opinion to be issued. In concept, the effect of materiality on the type of opinion to issue is straightforward. In application, deciding on actual materiality in a given situation is a difﬁcult judgment. There are no simple, well-deﬁned guidelines that enable auditors to decide when something is immaterial, material, or highly material. The evaluation of materiality also depends on whether the situation involves a failure to follow GAAP or a scope limitation. Materiality Decisions—Non-GAAP Condition When a client has failed to follow GAAP, the audit report will be unqualiﬁed, qualiﬁed opinion only, or adverse, depending on the materiality of the departure. Several aspects of materiality must be considered. Materiality Decisions Chapter 3 / AUDIT REPORTS 57 TABLE 3-1 Relationship of Materiality to Type of Opinion Materiality Level Signiﬁcance in Terms of Reasonable Users’ Decisions Immaterial Material Users’ decisions are unlikely to be affected. Users’ decisions are likely to be affected only if the information in question is important to the speciﬁc decisions being made. The overall ﬁnancial statements are presented fairly. Highly material Most or all users’ decisions based on the ﬁnancial statements are likely to be signiﬁcantly affected. Type of Opinion Unqualiﬁed Qualiﬁed Disclaimer or Adverse Note: Lack of independence requires a disclaimer regardless of materiality. Dollar Amounts Compared with a Base The primary concern in measuring materiality when a client has failed to follow GAAP is usually the total dollar mis statement in the accounts involved, compared with some base. A $10,000 misstatement might be material for a small company but not for a larger one. Therefore, mis statements must be compared with some measurement base before a decision can be made about the materiality of the failure to follow GAAP. Common bases include net income, total assets, current assets, and working capital. For example, assume that the auditor believes there is a $100,000 overstatement of inventory because of the client’s failure to follow GAAP. Also assume recorded inventory of $1 million, current assets of $3 million, and net income before taxes of $2 million. In this case, the auditor must evaluate the materiality of a misstatement of inventory of 10 percent, current assets of 3.3 percent, and net income before taxes of 5 percent. Apago PDF Enhancer To evaluate overall materiality, the auditor must also combine all unadjusted misstatements and judge whether there may be individually immaterial misstatements that, when combined, signiﬁcantly affect the statements. In the inventory example just given, assume the auditor believes there is also an overstatement of $150,000 in accounts receivable. The total effect on current assets is now 8.3 percent ($250,000 divided by $3,000,000) and 12.5 percent on net income before taxes ($250,000 divided by $2,000,000). When comparing potential misstatements with a base, the auditor must carefully consider all accounts affected by a misstatement (pervasiveness). For example, it is important not to overlook the effect of an understatement of inventory on cost of goods sold, income before taxes, income tax expense, and accrued income taxes payable. Measurability The dollar amount of some misstatements cannot be accurately measured. For example, a client’s unwillingness to disclose an existing lawsuit or the acquisition of	Alvin
a new company subsequent to the balance sheet date is difﬁcult if not impossible to measure in terms of dollar amounts. The materiality question the auditor must evaluate in such situations is the effect on statement users of the failure to make the disclosure. Nature of the Item The decision of a user may also be affected by the kind of misstate - ment. The following may affect a user’s decision and therefore the auditor’s opinion in a different way than most misstatements: 1. Transactions are illegal or fraudulent. 2. An item may materially affect some future period, even though it is immaterial when only the current period is considered. 3. An item has a “psychic” effect (for example, the item changes a small loss to a small proﬁt, maintains a trend of increasing earnings, or allows earnings to exceed analysts’ expectations). 4. An item may be important in terms of possible consequences arising from contractual obligations (for example, the effect of failure to comply with a debt restriction may result in a material loan being called). 58 Part 1 / THE AUDITING PROFESSION Materiality Decisions—Scope Limitations Condition When there is a scope limitation in an audit, the audit report will be unqualiﬁed, qualiﬁed scope and opinion, or disclaimer, depending on the materiality of the scope limitation. The auditor will consider the same three factors included in the previous discussion about materiality decisions for failure to follow GAAP, but they will be considered differently. The size of potential misstatements, rather than known misstatements, is important in determining whether an unqualiﬁed report, a qualiﬁed report, or a disclaimer of opinion is appro - priate for a scope limitation. For example, if recorded accounts payable of $400,000 was not audited, the auditor must evaluate the potential misstatement in accounts payable and decide how materially the ﬁnancial statements could be affected. The pervasiveness of these potential misstatements must also be considered. It is typically more difﬁcult to evaluate the materiality of potential misstatements resulting from a scope limitation than for failure to follow GAAP. Misstatements resulting from failure to follow GAAP are known. Those resulting from scope limitations must usually be subjectively measured in terms of potential or likely misstatements. For example, a recorded accounts payable of $400,000 might be understated by more than $1 million, which may affect several totals, including gross margin, net earnings, and total assets. DISCUSSION OF CONDITIONS REQUIRING A DEPARTURE OBJECTIVE 3-7 Draft appropriately modiﬁed audit reports under a variety of circumstances. Auditor’s Scope Has Been Restricted You should now understand the relationships among the conditions requiring a departure from an unqualiﬁed report, the major types of reports other than unquali - ﬁed, and the three levels of materiality. This part of the chapter examines the conditions requiring a departure from an unqualiﬁed report in greater detail and shows examples of reports. Apago PDF Enhancer Two major categories of scope restrictions exist: those caused by a client and those caused by conditions beyond the control of either the client or the auditor. The effect on the auditor’s report is the same for either, but the interpretation of materiality is likely to be different. When there is a scope restriction, the appropriate response is to issue an unqualiﬁed report, a qualiﬁcation of scope and opinion, or a disclaimer of opinion, depending on materiality. For client-imposed restrictions, the auditor should be concerned about the possibility that management is trying to prevent discovery of misstated information. In such cases, auditing standards encourage a disclaimer of opinion when materiality is in question. When restrictions result from conditions beyond the client’s control, a qualiﬁcation of scope and opinion is more likely. Two restrictions occasionally imposed by clients on the auditor’s scope relate to the observation of physical inventory and the conﬁrmation of accounts receivable, but	Alvin
other restrictions may also occur. Reasons for client-imposed scope restrictions may be a desire to save audit fees and, in the case of conﬁrming receivables, to prevent possible conﬂicts between the client and customer when amounts differ. The most common case in which conditions beyond the client’s and auditor’s control cause a scope restriction is when the auditor is appointed after the client’s balance sheet date. The conﬁrmation of accounts receivable, physical examination of inventory, and other important procedures may be impossible under those circum - stances. When the auditor cannot perform procedures he or she considers desirable but can be satisﬁed with alternative procedures that the information being veriﬁed is fairly stated, an unqualiﬁed report is appropriate. If alternative procedures cannot be performed, a qualiﬁed scope and opinion or disclaimer of opinion is necessary, depending on materiality. Chapter 3 / AUDIT REPORTS 59 FIGURE 3-7 Qualiﬁed Scope and Opinion Report Due to Scope Restriction INDEPENDENT AUDITOR’S REPORT (Same introductory paragraph as standard report) Scope Paragraph— Qualified Except as discussed in the following paragraph, we conducted our audit . . . (remainder is the same as the scope paragraph in the standard report). Third Paragraph— Added We were unable to obtain audited financial statements supporting the Company’s investment in a foreign affiliate stated at $475,000 or its equity in earnings of that affiliate of $365,000, which is included in net income, as described in Note X to the financial statements. Because of the nature of the Company’s records, we were unable to satisfy ourselves as to the carrying value of the investment or the equity in its earnings by means of other auditing procedures. Opinion Paragraph— Qualified In our opinion, except for the effects of such adjustments, if any, as might have been determined to be necessary had we been able to examine evidence regarding the foreign affiliate investment and earnings, the financial statements referred to above present fairly, in all material respects, the financial position of Laughlin Corporation as of December 31, 2011, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. A restriction on the scope of the auditor’s examination requires a qualifying paragraph preceding the opinion to describe the restriction. In the case of a disclaimer, the entire scope paragraph is excluded from the report. For example, the report in Figure 3-7 is appropriate for an audit in which the amounts were material but not pervasive and the auditor could not obtain audited ﬁnancial statements supporting an investment in a foreign afﬁliate and could not Apago PDF Enhancer satisfy himself or herself by alternate procedures. When the amounts are so material that a disclaimer of opinion rather than a qualiﬁed opinion is required, the auditor uses only three paragraphs. The ﬁrst (introductory) paragraph is modiﬁed slightly to say “We were engaged to audit . . ..” The second paragraph is the same as the third paragraph in Figure 3-7. The scope paragraph is deleted, and the ﬁnal (opinion) paragraph is changed to a disclaimer. The reason for deleting the scope paragraph is to avoid stating anything that might lead readers to believe that other parts of the ﬁnancial statements were audited and therefore might be fairly stated. Figure 3-8 shows the audit report assuming the auditor had concluded that the facts in Figure 3-7 required a disclaimer rather than a qualiﬁed opinion. FIGURE 3-8 Disclaimer of Opinion Due to Scope Restriction INDEPENDENT AUDITOR’S REPORT Introductory Paragraph— Modification of Standard Report We were engaged to audit . . . (remainder is the same as the introductory paragraph in the standard report) Second Paragraph—Added (Same wording as that used for the third paragraph in Figure 3-7)	Alvin
Opinion Paragraph—Disclaimer Because we were unable to obtain audited financial statements supporting the Company’s investment in a foreign affiliate and we were unable to satisfy ourselves as to the carrying value of the investment or the equity in its earnings by means of other auditing procedures, the scope of our work was not sufficient to enable us to express, and we do not express, an opinion on these financial statements. 60 Part 1 / THE AUDITING PROFESSION When the auditor knows that the ﬁnancial statements may be misleading because they were not prepared in conformity with GAAP, and the client is unable or unwilling to correct the misstatement, he or she must issue a qualiﬁed or an adverse opinion, depending on the materiality of the item in question. The opinion must clearly state the nature of the departure from accepted principles and the amount of the misstatement, if it is known. Figure 3-9 shows an example of a qualiﬁed opinion when a client did not capitalize leases as required by GAAP. Statements Are Not in Conformity with GAAP FIGURE 3-9 Qualiﬁed Opinion Report Due to Non-GAAP INDEPENDENT AUDITOR’S REPORT (Same introductory and scope paragraphs as the standard report) The Company has excluded from property and debt in the accompanying balance sheet certain lease obligations that, in our opinion, should be capitalized to conform with U.S. generally accepted accounting principles. If these lease obligations were capitalized, property would be increased by $4,600,000, long-term debt by $4,200,000, and retained earnings by $400,000 as of December 31, 2011, and net income and earnings per share would be increased by $400,000 and $1.75, respectively, for the year then ended. In our opinion, except for the effects of not capitalizing lease obligations, as discussed in the preceding paragraph, the financial statements referred to above present fairly, in all material respects, the financial position of Ajax Company as of December 31, 2011, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. Third Paragraph—Added Opinion Paragraph—Qualified When the amounts are so material or pervasive that an adverse opinion is required, the scope is still unqualiﬁed and the qualifying paragraph can remain the same, but the opinion paragraph might be as shown in Figure 3-10. Apago PDF Enhancer FIGURE 3-10 Adverse Opinion Due to Non-GAAP INDEPENDENT AUDITOR’S REPORT (Same introductory and scope paragraphs as the standard report) (Same third paragraph as that used for the third paragraph in Figure 3-9) Third Paragraph—Added In our opinion, because of the effects of the matters discussed in the preceding paragraph, the financial statements referred to above do not present fairly, in conformity with accounting principles generally accepted in the United States of America, the financial position of Ajax Company as of December 31, 2011, or the results of its operations and its cash flows for the year then ended. Opinion Paragraph—Adverse When the client fails to include information that is necessary for the fair presen - tation of ﬁnancial statements in the body of the statements or in the related footnotes, it is the auditor’s responsibility to present the information in the audit report and to issue a qualiﬁed or an adverse opinion. It is common to put this type of qualiﬁcation in an added paragraph preceding the opinion (the scope paragraph will remain unqualiﬁed) and to refer to the added paragraph in the opinion paragraph. Figure 3-11 (p. 62) shows an example of an audit report in which the auditor considered the ﬁnancial statement disclosure inadequate. Rule 203 Reports Determining whether statements are in accordance with GAAP can be difﬁcult. Rule 203 in the Code of Professional Conduct permits a departure from	Alvin
Chapter 3 / AUDIT REPORTS 61 FIGURE 3-11 Qualiﬁed Opinion Due to Inadequate Disclosure INDEPENDENT AUDITOR’S REPORT (Same introductory and scope paragraphs as the standard report) Third Paragraph—Added On January 15, 2011, the company issued debentures in the amount of $3,600,000 for the purpose of financing plant expansion. The debenture agreement restricts the payment of future cash dividends to earnings after December 31, 2011. In our opinion, disclosure of this information is required to conform with accounting principles generally accepted in the United States of America. Opinion Paragraph—Qualified In our opinion, except for the omission of the information discussed in the preceding paragraph, the financial statements referred to above present fairly . . . (remainder is the same as the opinion in the standard report). generally accepted accounting principles when the auditor believes that adherence to these would result in misleading ﬁnancial statements. When the auditor decides that adherence to GAAP would result in misleading statements, there should be a complete explanation in a third paragraph. The paragraph should fully explain the departure and why GAAP would result in misleading state - ments. The opinion paragraph should then be unqualiﬁed except for the reference to the third paragraph. As discussed earlier in the chapter, this is called an unqualiﬁed audit report with an explanatory paragraph. Lack of Statement of Cash Flows The client’s unwillingness to include a statement of cash ﬂows is speciﬁcally addressed in auditing standards. When the statement is omitted, there must be a third paragraph stating the omission and an “except for” opinion qualiﬁcation. Apago PDF Enhancer If the auditor is not independent as speciﬁed by the Code of Professional Conduct, a disclaimer of opinion is required even though all the audit procedures considered necessary in the circumstances were performed. The wording in Figure 3-12 is recom - mended when the auditor is not independent. Auditor is Not Independent The lack of independence overrides any other scope limitations. Therefore, no other reason for disclaiming an opinion should be cited. There should be no mention in the report of the performance of any audit procedures. As a result, it is a one- paragraph audit report. FIGURE 3-12 Disclaimer Due to Lack of Independence We are not independent with respect to Home Decors.com, Inc., and the accompanying balance sheet as of December 31, 2011, and the related statements of income, retained earnings, and cash flows for the year then ended were not audited by us. Accordingly, we do not express an opinion on them. Note: When the auditor lacks independence, no report title is included. AUDITOR’S DECISION PROCESS FOR AUDIT REPORTS OBJECTIVE 3-8 Determine the appropriate audit report for a given audit situation. Auditors use a well-deﬁned process for deciding the appropriate audit report in a given set of circumstances. The auditor must ﬁrst assess whether any conditions exist requiring a departure from a standard unqualiﬁed report. If any conditions exist, the auditor must then assess the materiality of the condition and determine the appropriate type of report. 62 Part 1 / THE AUDITING PROFESSION TABLE 3-2 Audit Report for Each Condition Requiring a Departure from a Standard Unqualiﬁed Report at Different Levels of Materiality Level of Materiality Material Unqualiﬁed report, explanatory paragraph Unqualiﬁed report, explanatory paragraph Unqualiﬁed report, explanatory paragraph Unqualiﬁed report, explanatory paragraph Unqualiﬁed report, modiﬁed wording Immaterial Unqualiﬁed Unqualiﬁed Unqualiﬁed Unqualiﬁed Unqualiﬁed Condition Requiring an Unqualified Report with Modiﬁed Wording or Explanatory Paragraph Accounting principles not consistently applied* Substantial doubt about going concern† Justiﬁed departure from GAAP or other accounting principle Emphasis of a matter Use of another auditor Condition Requiring a Departure from Unqualiﬁed Report Scope restricted by client	Alvin
or other conditions Immaterial Unqualiﬁed Level of Materiality Material, But Does Not Overshadow Financial Statements as a Whole So Material That Overall Fairness Is in Question Qualiﬁed scope, additional paragraph, and qualiﬁed opinion (except for) Disclaimer Financial statements not prepared Unqualiﬁed Additional paragraph and qualiﬁed Adverse in accordance with GAAP‡ The auditor is not independent opinion (except for) Disclaimer, regardless of materiality * If the auditor does not concur with the appropriateness of the change, the condition is considered a violation of GAAP. † The auditor has the option of issuing a disclaimer of opinion. ‡ If the auditor can demonstrate that GAAP would be misleading, an unqualiﬁed report with an explanatory paragraph is appropriate. Apago PDF Enhancer Determine Whether Any Condition Exists Requiring a Departure from a Standard Unqualiﬁed Report The most important of these conditions are identiﬁed in Table 3-2. Auditors identify these conditions as they perform the audit and include information about any condition in the audit ﬁles as discussion items for audit reporting. If none of these conditions exist, which is the case in most audits, the auditor issues a standard unqualiﬁed audit report. Decide the Materiality for Each Condition When a condition requiring a departure from a standard unqualiﬁed opinion exists, the auditor evaluates the potential effect on the ﬁnancial statements. For departures from GAAP or scope restrictions, the auditor must decide among immaterial, material, and highly material. All other conditions, except for lack of auditor independence, require only a distinction between immaterial and material. The materiality decision is a difﬁcult one, requiring considerable judgment. For example, assume that there is a scope limitation in auditing inventory. It is difﬁcult to assess the potential misstatement of an account that the auditor does not audit. Decide the Appropriate Type of Report for the Condition, Given the Materiality Level After making the ﬁrst two decisions, it is easy to decide the appro - priate type of opinion by using a decision aid. An example of such an aid is Table 3-2. For example, assume that the auditor concludes that there is a departure from GAAP and it is material, but not highly material. Table 3-2 shows that the appropriate audit report is a qualiﬁed opinion with an additional paragraph discussing the departure. The introductory and scope paragraphs will be included using standard wording. Write the Audit Report Most CPA ﬁrms have computer templates that include precise wording for different circumstances to help the auditor write the audit report. Also, one or more partners in most CPA ﬁrms have special expertise in writing audit reports. These partners typically write or review all audit reports before they are issued. Chapter 3 / AUDIT REPORTS 63 More Than One Condition Requiring a Departure or Modification Number of Paragraphs in the Report Auditors often encounter situations involving more than one of the conditions requiring a departure from an unqualiﬁed report or modiﬁcation of the standard unqualiﬁed report. In these circumstances, the auditor should modify his or her opinion for each condition unless one has the effect of neutralizing the others. For example, if there is a scope limitation and a situation in which the auditor is not independent, the scope limitation should not be revealed. The following situations are examples when more than one modiﬁcation should be included in the report: • The auditor is not independent and the auditor knows that the company has not followed generally accepted accounting principles. • There is a scope limitation and there is substantial doubt about the company’s ability to continue as a going concern. • There is a substantial doubt about the company’s ability to continue as a going concern and information about the causes of the uncertainties is not adequately disclosed in a footnote. • There is a deviation in the statements’ preparation in accordance with GAAP	Alvin
and another accounting principle was applied on a basis that was not consistent with that of the preceding year. Many readers interpret the number of paragraphs in the report as an important “signal” as to whether the ﬁnancial statements are correct. A three-paragraph report ordinarily indicates that there are no exceptions in the audit. However, three-paragraph reports are also issued when a disclaimer of opinion is issued due to a scope limitation or for an unqualiﬁed shared report involving other auditors. More than three paragraphs indicates some type of qualiﬁcation or required explanation. An additional paragraph is added before the opinion for a qualiﬁed opinion, an adverse opinion, and a disclaimer of opinion for a scope limitation. This results in a four-paragraph report, except for the disclaimer of opinion for a scope limitation. A disclaimer due to a scope limitation results in a three-paragraph report because the scope paragraph is omitted. A disclaimer due to a lack of independence is a one- paragraph report. Apago PDF Enhancer When an unqualiﬁed opinion with explanatory paragraph is issued, an explana- tory paragraph usually follows the opinion. No explanatory paragraph is required for an unqualiﬁed shared report involving other auditors, but the wording in all three paragraphs is modiﬁed. Table 3-3 summarizes the types of reports issued for the audit of ﬁnancial state - ments, the number of paragraphs for each type, the standard wording paragraphs modiﬁed, and the location of the additional paragraph. The table excludes a disclaimer for a lack of independence, which is a special, one-paragraph report. TABLE 3-3 Number of Paragraphs, Standard Wording Paragraphs Modiﬁed, and Location of Additional Paragraph for Audit Reports Type of Report Standard unqualiﬁed Unqualiﬁed with explanatory paragraph Unqualiﬁed shared report with other auditors Qualiﬁed—opinion only Qualiﬁed—scope and opinion Disclaimer—scope limitation Adverse Number of Paragraphs Standard Wording Paragraphs Modiﬁed Location of Additional Paragraph 3 4 3 4 4 3 4 None None All three paragraphs Opinion only Scope and opinion None After opinion None Before opinion Before opinion Introductory and opinion paragraphs Before opinion modiﬁed; scope paragraph eliminated Opinion only Before opinion 64 Part 1 / THE AUDITING PROFESSION RESEARCH UNDERWAY ON AUDIT REPORT The AICPA’s Auditing Standards Board (ASB) and the International Auditing and Assurance Standards Board (IAASB) have partnered to commission academic research to study the effectiveness of communications provided by auditors in the audit report. Anecdotal evidence suggests that ﬁnancial statement users may not consistently understand the information contained in the auditor’s report, including the nature of the ﬁnancial statement audit process and the level of assurance provided. For example, users of the audit report sometimes believe that an auditor’s unqualiﬁed opinion provides an indication that a company’s business model is sound or a user may conclude that the opinion provides absolute assurance that the ﬁnancial statements are accurate. This research is being conducted with audit report users in the United States and internationally. Research ﬁndings will be used by the ASB and IAASB as they evaluate the effectiveness of audit reporting guidance in auditing standards. Source: AICPA and IFAC, “Auditing Standards Board and International Auditing and Assurance Standards Board Request for Proposals for Research on Unqualiﬁed Auditor’s Report Communications” (www.ifac.org). INTERNATIONAL ACCOUNTING AND AUDITING STANDARDS OBJECTIVE 3-9 Understand proposed use of international accounting and auditing standards by U.S. companies. The increasing globalization of the world’s capital markets and the expanding presence of business operations in multiple countries are leading to calls for the establishment of a single set of accounting standards to be used around the world. IFRS is increasingly accepted worldwide as the basis of accounting used to prepare ﬁnancial statements in other countries.	Alvin
Currently, U.S. public companies are required to prepare ﬁnancial statements that are ﬁled with the Securities and Exchange Commission (SEC) in accordance with generally accepted accounting principles in the United States. The SEC is developing a work plan to determine whether to incorporate IFRS into the U.S. ﬁnancial reporting system. Approval of the work plan could lead to the use of IFRS by U.S. public companies as early as 2015. Apago PDF Enhancer An auditor may be engaged to report on ﬁnancial statements prepared in accordance with IFRS. When the auditor reports on ﬁnancial statements prepared in conformity with IFRS, the auditor refers to those standards rather than U.S. generally accepted accounting principles as follows: In our opinion, the ﬁnancial statements referred to above present fairly, in all material respects, the ﬁnancial position of Carlos Incorporated as of December 31, 2011 and 2010, and the results of its operations, comprehensive income, changes in equity, and its cash ﬂows for the years then ended in con- formity with International Financial Reporting Standards as issued by the International Accounting Standards Board. As discussed in Chapter 2, the International Auditing and Assurance Standards Board (IAASB) issues International Standards on Auditing (ISAs). Auditing standards in the United States now allow an auditor to perform an audit of ﬁnancial statements of a U.S. entity in accordance with both generally accepted auditing standards in the U.S. and the ISAs. The auditor’s scope paragraph is modiﬁed to indicate that the audit was conducted in accordance with auditing standards generally accepted in the United States of America and in accordance with International Standards on Auditing. This chapter described the auditor’s standard unqualiﬁed audit report, as well as reports on internal control over ﬁnancial reporting under Section 404 of the Sarbanes–Oxley Act. The four categories of audit reports and the auditor’s decision process in choosing the SUMMARY Chapter 3 / AUDIT REPORTS 65 appropriate audit report to issue were then discussed. In some circumstances, an explana - tory paragraph or modiﬁcation of the unqualiﬁed report is required. When there is a material departure from GAAP or a material limitation on the scope of the audit, an unqualiﬁed report cannot be issued. The appropriate report to issue in these circum stances depends on whether the situation involves a GAAP departure or a scope limitation, as well as the level of materiality. ESSENTIAL TERMS Adverse opinion—a report issued when the auditor believes the ﬁnancial state - ments are so materially misstated or misleading as a whole that they do not present fairly the entity’s ﬁnancial posi - tion or the results of its operations and cash ﬂows in conformity with GAAP Combined report on ﬁnancial statements and internal control over ﬁnancial reporting—audit report on the ﬁnancial statements and the effectiveness of internal control over ﬁnancial reporting required for larger public companies under Section 404 of the Sarbanes–Oxley Act Disclaimer of opinion—a report issued when the auditor is not able to become satisﬁed that the overall ﬁnancial state - ments are fairly presented or the auditor is not independent Apago PDF Enhancer statements are fairly stated but that either the scope of the audit was limited or the ﬁnancial data indicated a failure to follow GAAP Separate report on internal control over financial reporting—audit report on the effectiveness of internal control over financial reporting required for public companies under Section 404 of the Sarbanes–Oxley Act that cross-references the separate audit report on the financial statements Standard unqualiﬁed audit report—the report a CPA issues when all auditing conditions have been met, no signiﬁcant misstatements have been discovered and left uncorrected, and it is the auditor’s opinion that the ﬁnancial statements are fairly stated in accordance with GAAP Material misstatement—a misstatement in the ﬁnancial statements, knowledge of	Alvin
which would affect a decision of a reason - able user of the statements Qualiﬁed opinion—a report issued when the auditor believes that the overall ﬁnancial Unqualiﬁed audit report with explanatory paragraph or modiﬁed wording—an unquali ﬁed report in which the ﬁnancial statements are fairly presented, but the auditor believes it is important, or is required, to provide additional infor - mation REVIEW QUESTIONS 3-1 (Objective 3-1) Explain why auditors’ reports are important to users of ﬁnancial statements and why it is desirable to have standard wording. 3-2 (Objective 3-1) List the seven parts of a standard unqualiﬁed audit report and explain the meaning of each part. How do the parts compare with those found in a qualiﬁed report? 3-3 (Objective 3-1) What are the purposes of the scope paragraph in the auditor’s report? Identify the most important information included in the scope paragraph. 3-4 (Objective 3-1) What are the purposes of the opinion paragraph in the auditor’s report? Identify the most important information included in the opinion paragraph. 3-5 (Objective 3-1) On February 17, 2012, a CPA completed all the evidence gathering procedures on the audit of the financial statements for the Buckheizer Technology Corporation for the year ended December 31, 2011. The audit is satisfactory in all respects except for the existence of a change in accounting principles from FIFO to LIFO inventory 66 Part 1 / THE AUDITING PROFESSION valuation, which results in an explanatory paragraph on consistency. On February 26, the auditor completed the tax return and the draft of the financial statements. The final audit report was completed, attached to the financial statements, and delivered to the client on March 7. What is the appropriate date on the auditor’s report? 3-6 (Objective 3-2) What ﬁve circumstances are required for a standard unqualiﬁed report to be issued? 3-7 (Objective 3-3) Describe the information included in the introductory, scope, and opinion paragraphs in a separate audit report on the effectiveness of internal control over ﬁnancial reporting. What is the nature of the additional paragraphs in the audit report? 3-8 (Objectives 3-4, 3-7) What type of opinion should an auditor issue when the ﬁnancial statements are not in accordance with GAAP because such adherence would result in misleading statements? 3-9 (Objectives 3-4, 3-5) Distinguish between an unqualiﬁed report with an explanatory paragraph or modiﬁed wording and a qualiﬁed report. Give examples when an explanatory paragraph or modiﬁed wording should be used in an unqualiﬁed opinion. 3-10 (Objective 3-4) Describe what is meant by reports involving the use of other auditors. What are the three options available to the principal auditor and when should each be used? 3-11 (Objective 3-4) The client has restated the prior-year statements because of a change from LIFO to FIFO. How should this be reﬂected in the auditor’s report? 3-12 (Objective 3-4) Distinguish between changes that affect consistency and those that may affect comparability but not consistency. Give an example of each. 3-13 (Objective 3-5) List the three conditions that require a departure from an unqualiﬁed opinion and give one speciﬁc example of each of those conditions. 3-14 (Objective 3-5) Distinguish between a qualiﬁed opinion, an adverse opinion, and a disclaimer of opinion, and explain the circumstances under which each is appropriate. Apago PDF Enhancer 3-15 (Objective 3-6) Deﬁne materiality as it is used in audit reporting. What conditions will affect the auditor’s determination of materiality? 3-16 (Objective 3-6) Explain how materiality differs for failure to follow GAAP and for lack of independence. 3-17 (Objective 3-7) How does the auditor’s opinion differ between scope limitations caused by client restrictions and limitations resulting from conditions beyond the client’s control? Under which of these two will the auditor be most likely to issue a disclaimer of opinion? Explain. 3-18 (Objective 3-5) Distinguish between a report qualiﬁed as to opinion only and one	Alvin
with both a scope and opinion qualiﬁcation. 3-19 (Objectives 3-6, 3-7) Identify the three alternative opinions that may be appropriate when the client’s ﬁnancial statements are not in accordance with GAAP. Under what circumstance is each appropriate? 3-20 (Objective 3-8) When an auditor discovers more than one condition that requires departure from or modiﬁcation of the standard unqualiﬁed report, what should the auditor’s report include? 3-21 (Objective 3-9) The ISAs allow an auditor to include either of the following phrases in the auditor’s opinion paragraph: (1) “The financial statements present fairly in all material respects . . .” or (2) “The financial statements give a true and fair view of . . .”. Discuss whether the ASB should adopt a similar option for U.S. audit standards. 3-22 (Objective 3-9) Discuss why the adoption of international accounting and auditing standards might be beneficial to investors and auditors. Chapter 3 / AUDIT REPORTS 67 MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS 3-23 (Objectives 3-1, 3-2, 3-3, 3-4, 3-8) The following questions concern unqualiﬁed audit reports. Choose the best response. a. Which of the following statements about a combined report on the ﬁnancial state - ments and internal control over ﬁnancial reporting is correct? (1) The auditor’s opinion on internal control is for the same period of time as the opinion on the ﬁnancial statements. (2) The report includes additional paragraphs for the deﬁnition and limitations of internal control. (3) The introductory, scope, and opinion paragraphs are unchanged from a report for an audit of the ﬁnancial statements only. (4) GAAP is the framework used to evaluate internal control. b. The date of the CPA’s opinion on the ﬁnancial statements of the client should be the date of the (1) closing of the client’s books. (2) finalization of the terms of the audit engagement. (3) completion of all important audit procedures. (4) submission of the report to the client. c. If a principal auditor decides to refer in his or her report to the audit of another auditor, he or she is required to disclose the (1) name of the other auditor. (2) nature of the inquiry into the other auditor’s professional standing and extent of the review of the other auditor’s work. (3) portion of the ﬁnancial statements audited by the other auditor. (4) reasons for being unwilling to assume responsibility for the other auditor’s work. Apago PDF Enhancer 3-24 (Objectives 3-4, 3-8) The following questions concern unqualiﬁed audit reports with an explanatory paragraph or modified wording. Choose the best response. a. An entity changed from the straight-line method to the declining-balance method of depreciation for all newly acquired assets. This change has no material effect on the current year’s ﬁnancial statements but is reasonably certain to have a substantial effect in later years. If the change is disclosed in the notes to the ﬁnancial statements, the auditor should issue a report with a(n) (1) qualiﬁed opinion. (2) unqualiﬁed opinion with explanatory paragraph. (3) unqualiﬁed opinion. (4) qualiﬁed opinion with explanatory paragraph regarding consistency. b. When the financial statements are fairly stated but the auditor concludes there is sub - stantial doubt whether the client can continue in existence, the auditor should issue a(an) (1) adverse opinion. (2) qualiﬁed opinion only. (3) unqualiﬁed opinion. (4) unqualiﬁed opinion with explanatory paragraph. c. The introductory paragraph of an auditor’s report contains the following: “We did not audit the financial statements of EZ Inc., a wholly owned subsidiary, which statements reflect total assets and revenues constituting 27 percent and 29 percent, respectively, of the consolidated totals. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for EZ Inc., is based solely on the report of the other auditors.” These sentences (1) indicate a division of responsibility.	Alvin
(2) assume responsibility for the other auditor. (3) require a departure from an unqualiﬁed opinion. (4) are an improper form of reporting. 68 Part 1 / THE AUDITING PROFESSION 3-25 (Objectives 3-5, 3-7, 3-8) The following questions concern audit reports other than unqualiﬁed audit reports with standard wording. Choose the best response. a. The annual audit of Midwestern Manufacturing revealed that sales were accidentally being recorded as revenue when the goods were ordered, instead of when they were shipped. Assuming the amount in question is material and the client is unwilling to correct the error, the CPA should issue: (1) an unqualified opinion or adverse opinion. (2) a qualified “except for” opinion or disclaimer of opinion. (3) a qualified “except for” opinion or adverse opinion. (4) an unqualified opinion with an explanatory paragraph b. Under which of the following circumstances would a disclaimer of opinion not be appropriate? (1) The auditor is unable to determine the amounts associated with an employee fraud scheme. (2) Management does not provide reasonable justification for a change in accounting principles. (3) The client refuses the auditor permission to confirm certain accounts receivable or apply alternative procedures to verify their balances. (4) The chief executive officer is unwilling to sign the management representation letter. c. The opinion paragraph of a CPA’s report states: “In our opinion, except for the effects of not capitalizing certain lease obligations, as discussed in the preceding paragraph, the financial statements present fairly,” in all material respects, . . . This paragraph expresses a(an) (1) Unqualified opinion. (2) Unqualified opinion with explanatory paragraph. (3) Qualified opinion. (4) Adverse opinion. Apago PDF Enhancer DISCUSSION QUESTIONS AND PROBLEMS 3-26 (Objective 3-1) A careful reading of an unqualiﬁed report indicates several important phrases. Explain why each of the following phrases or clauses is used rather than the alternative provided: a. “The ﬁnancial statements referred to above present fairly in all material respects the ﬁnancial position” rather than “The ﬁnancial statements mentioned above are correctly stated.” b. “In conformity with accounting principles generally accepted in the United States of America” rather than “are properly stated to represent the true economic conditions.” c. “In our opinion, the ﬁnancial statements present fairly” rather than “The ﬁnancial statements present fairly.” d. “Brown & Phillips, CPAs (ﬁrm name),” rather than “James E. Brown, CPA (individual partner’s name).” e. “We conducted our audit in accordance with auditing standards generally accepted in the United States of America” rather than “Our audit was performed to detect material misstatements in the ﬁnancial statements.” 3-27 (Objectives 3-1, 3-2, 3-4, 3-6, 3-7) Patel, CPA, has completed the audit of the ﬁnancial statements of Bellamy Corporation as of and for the year ended December 31, 2011. Patel also audited and reported on the Bellamy ﬁnancial statements for the prior year. Patel drafted the following report for 2011. We have audited the balance sheet and statements of income and retained earnings of Bellamy Corporation as of December 31, 2011. We conducted our audit in accor- Chapter 3 / AUDIT REPORTS 69 dance with generally accepted accounting standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the ﬁnan- cial statements are free of misstatement. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the ﬁnancial statements referred to above present fairly the ﬁnan- cial position of Bellamy Corporation as of December 31, 2011, and the results of its operations for the year then ended in conformity with generally accepted auditing standards, applied on a basis consistent with those of the preceding year. Patel, CPA (Signed) Other Information • Bellamy is presenting comparative ﬁnancial statements. • Bellamy does not wish to present a statement of cash ﬂows for either year.	Alvin
• During 2011, Bellamy changed its method of accounting for long-term construction contracts and properly reﬂected the effect of the change in the current year’s ﬁnancial statements and restated the prior year’s statements. Patel is satisﬁed with Bellamy’s justiﬁcation for making the change. The change is discussed in footnote 12. • Patel was unable to perform normal accounts receivable conﬁrmation procedures, but alternative procedures were used to satisfy Patel as to the existence of the receivables. • Bellamy Corporation is the defendant in a litigation, the outcome of which is highly uncertain. If the case is settled in favor of the plaintiff, Bellamy will be required to pay a substantial amount of cash, which might require the sale of certain ﬁxed assets. The litigation and the possible effects have been properly disclosed in footnote 11. • Bellamy issued debentures on January 31, 2010, in the amount of $10 million. The funds obtained from the issuance were used to ﬁnance the expansion of plant facilities. The debenture agreement restricts the payment of future cash dividends to earnings after December 31, 2015. Bellamy declined to disclose this essential data in the foot- notes to the ﬁnancial statements. Apago PDF Enhancer of the auditor’s report. a. Identify and explain any items included in “Other Information” that need not be part b. Explain the deﬁciencies in Patel’s report as drafted.* 3-28 (Objectives 3-4, 3-5, 3-6, 3-7, 3-8) For the following independent situations, assume that you are the audit partner on the engagement: 1. During your audit of Raceway.com, Inc., you conclude that there is a possibility that inventory is materially overstated. The client refuses to allow you to expand the scope of your audit sufﬁciently to verify whether the balance is actually misstated. 2. You complete the audit of Munich Department Store, and in your opinion, the ﬁnancial statements are fairly presented. On the last day of the audit, you discover that one of your supervisors assigned to the audit has a material investment in Munich. 3. Auto Delivery Company has a ﬂeet of several delivery trucks. In the past, Auto Delivery had followed the policy of purchasing all equipment. In the current year, they decided to lease the trucks. The method of accounting for the trucks is therefore changed to lease capitalization. This change in policy is fully disclosed in footnotes. 4. You are auditing Deep Clean Services for the ﬁrst time. Deep Clean has been in business for several years but over the last two years has struggled to stay afloat given the economic conditions. Based on your audit work, you have substantial doubt that Deep Clean will be in business by the end of its next fiscal year. 5. One of your audit clients has a material investment in a privately-held biosciences company. Your audit firm engaged a business valuation specialist to assist in evaluating the client’s estimation of the investment’s fair value. You conclude that the valuation specialist’s work provides sufficient appropriate audit evidence. 6. Four weeks after the year-end date, a major customer of Prince Construction Co. declared bankruptcy. Because the customer had conﬁrmed the balance due to Prince Required *AICPA adapted. 70 Part 1 / THE AUDITING PROFESSION at the balance sheet date, management refuses to charge off the account or otherwise disclose the information. The receivable represents approximately 10% of accounts receivable and 20% of net earnings before taxes. For each situation, do the following: Required a. Identify which of the conditions requiring a modiﬁcation of or a deviation from an unqualiﬁed standard report is applicable. b. State the level of materiality as immaterial, material, or highly material. If you cannot decide the level of materiality, state the additional information needed to make a decision. c. Given your answers in parts a and b, state the type of audit report that should be issued. If you have not decided on one level of materiality in part b, state the	Alvin
appropriate report for each alternative materiality level. 3-29 (Objectives 3-4, 3-5, 3-6, 3-7, 3-8) For the following independent situations, assume that you are the audit partner on the engagement: 1. In the last 3 months of the current year, Oil Reﬁning Company decided to change direction and go signiﬁcantly into the oil drilling business. Management recognizes that this business is exceptionally risky and could jeopardize the success of its exist- ing reﬁning business, but there are signiﬁcant potential rewards. During the short period of operation in drilling, the company has had three dry wells and no suc- cesses. The facts are adequately disclosed in footnotes. 2. Your client, Harrison Automotive, has changed from straight-line to sum-of-the- years’ digits depreciation. The effect on this year’s income is immaterial, but the effect in future years is likely to be material. The facts are adequately disclosed in footnotes. 3. Toronto Technology Corporation has prepared ﬁnancial statements but has decided to exclude the statement of cash ﬂows. Management explains to you that the users of their ﬁnancial statements ﬁnd this statement confusing and prefer not to have it included. 4. Marseilles Fragrance, Inc. is based in New York but has operations throughout Europe. Because users of the audited financial statement are international, your audit firm was engaged to conduct the audit in accordance with U.S. auditing standards and International Standards on Auditing (ISAs). Apago PDF Enhancer 5. The controller of Brentwood Industries, Inc. will not allow you to conﬁrm the receivable balance from two of its major customers. The amounts of the receivables are material in relation to Brentwood Industries’ ﬁnancial statements. You are unable to satisfy yourself as to the receivable balances by alternative procedures. 6. Approximately 20% of the audit of Lumberton Farms, Inc. was performed by a different CPA ﬁrm, selected by you. You have reviewed their audit files and believe they did an excellent job on their portion of the audit. Nevertheless, you are unwilling to take complete responsibility for their work. For each situation, do the following: Required a. Identify which of the conditions requiring a modiﬁcation of or a deviation from an unqualiﬁed standard report is applicable. b. State the level of materiality as immaterial, material, or highly material. If you cannot decide the level of materiality, state the additional information needed to make a decision. c. Given your answers in parts a and b, state the appropriate audit report from the following alternatives (if you have not decided on one level of materiality in part b, state the appropriate report for each alternative materiality level): (1) Unqualiﬁed—standard wording (2) Unqualiﬁed—explanatory paragraph (3) Unqualiﬁed—modiﬁed wording (4) Qualiﬁed opinion only (5) Qualiﬁed scope and opinion (6) Disclaimer (7) Adverse* *AICPA adapted. Chapter 3 / AUDIT REPORTS 71 d. Based on your answer to part c, indicate which paragraphs, if any, should be modiﬁed in the standard audit report. Also indicate whether an additional paragraph is necessary and its location in the report. 3-30 (Objectives 3-4, 3-5, 3-7, 3-8) Several types of opinions are described in a. through i. below. For each opinion, select the appropriate description of that opinion from the list numbered 1 through 9 below that corresponds with the type of opinion. Types of Opinion a. Unqualified opinion with an explanatory paragraph for change in consistency b. Disclaimer of opinion due to scope limitation c. Qualified opinion due to inadequate disclosure; report includes a going concern explanatory paragraph d. Shared report with other auditors e. Standard unqualified (“clean”) opinion f. Qualified opinion due to a scope limitation g. Adverse opinion for departure from accounting standards h. Disclaimer of opinion due to lack of independence i. Unqualified opinion with an explanatory paragraph for a change in consistency and an explanatory paragraph for an emphasis of a matter	Alvin
Description of Opinions (each item in list can be used only once) 1. One paragraph report containing the words “we do not express an opinion” 2. Three paragraph report with no changes in wording 3. Three paragraph report; the wording in all three paragraphs has been modified 4. Three paragraph report in which the opinion includes “we do not express an opinion” 5. Four paragraph report in which the explanatory fourth paragraph precedes the opinion; opinion includes “except for the effects of such adjustments, if any, as might have been determined had we been able to examine” Apago PDF Enhancer opinion; opinion includes “financial statements do not present fairly” 6. Four paragraph report in which the explanatory fourth paragraph precedes the 7. Four paragraph report in which the explanatory fourth paragraph follows the opinion 8. Five paragraph report with explanatory paragraphs preceding and following the opinion 9. Five paragraph report with two explanatory paragraphs following the opinion 3-31 (Objective 3-4) Various types of “accounting changes” can affect the second reporting standard of the generally accepted auditing standards. This standard reads, “The auditor must identify in the auditor’s report those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period.” Assume that the following list describes changes that have a material effect on a client’s ﬁnancial statements for the current year: 1. Correction of a mathematical error in inventory pricing made in a prior period. 2. A change from deferring and amortizing preproduction costs to recording such costs as an expense when incurred because future beneﬁts of the costs have become doubtful. The new accounting method was adopted in recognition of the change in estimated future beneﬁts. 3. A change from the completed-contract method to the percentage-of-completion method of accounting for long-term construction contracts. 4. A change in the estimated useful life of previously recorded ﬁxed assets based on newly acquired information 5. A change to including the employer share of Social Security (FICA) taxes as “retirement beneﬁts” on the income statement from including it with “other taxes.” 6. A change from prime costing to full absorption costing for inventory valuation. 7. A change from presentation of statements of individual companies to presentation of consolidated statements. 8. A change from the FIFO method of inventory pricing to the LIFO method of inventory pricing. 72 Part 1 / THE AUDITING PROFESSION Identify the type of change described in each item above, and state whether any modi - ﬁcation is required in the auditor’s report as it relates to the second standard of reporting. Organize your answer sheet as shown. For example, a change from the LIFO method of inventory pricing to the FIFO method of inventory pricing would appear as shown. Required Assume that each item is material.* Item No. Example Type of Change An accounting change from one generally accepted accounting principle to another generally accepted accounting principle Should Auditor’s Report Be Modiﬁed? Yes 3-32 (Objectives 3-1, 3-2, 3-4) The following tentative auditor’s report was drafted by a staff accountant and submitted to a partner in the accounting ﬁrm of Better & Best, CPAs: AUDIT REPORT To the Audit Committee of American Broadband, Inc. We have examined the consolidated balance sheets of American Broadband, Inc. and subsidiaries as of December 31, 2011 and 2010, and the related consolidated state- ments of income, retained earnings, and cash ﬂows for the years then ended. These ﬁnancial statements are the responsibility of the Company’s management. Our respon- sibility is to express an opinion on these ﬁnancial statements based on our audits. Our audits were made in accordance with auditing standards generally accepted in the United States of America as we considered necessary in the circumstances. Other auditors audited the ﬁnancial statements of certain subsidiaries and have furnished us	Alvin
with reports thereon containing no exceptions. Our opinion expressed herein, insofar as it relates to the amounts included for those subsidiaries, is based solely upon the reports of the other auditors. As fully discussed in Note 7 to the ﬁnancial statements, in 2011, the company extended the use of the last-in, ﬁrst-out (LIFO) method of accounting to include all inventories. In examining inventories, we engaged Dr. Irwin Same (Nobel Prize win- ner 2009) to test check the technical requirements and speciﬁcations of certain items of equipment manufactured by the company. Apago PDF Enhancer In our opinion, the ﬁnancial statements referred to above present fairly the ﬁnan- cial position of American Broadband, Inc. as of December 31, 2011, and the results of operations for the years then ended, in conformity with accounting principles gener- ally accepted in the United States of America. To be signed by Better & Best, CPAs March 1, 2012 Identify deﬁciencies in the staff accountant’s tentative report that constitute departures from the generally accepted standards of reporting.* Required 3-33 (Objectives 3-1, 3-9) The following is an auditor’s report prepared in accordance with International Standards on Auditing (ISAs) issued by the International Auditing and Assurance Standards Board (IAASB): INDEPENDENT AUDITOR’S REPORT To the Shareholders of Les Meridian, Inc. We have audited the accompanying financial statements of Les Meridian, Inc., which comprise the statement of financial position as of December 31, 2011, and the statement of comprehensive income, statement of changes in equity and statement of cash flows for the year then ended, and a summary of significant accounting policies and other explanatory notes. *AICPA adapted. Chapter 3 / AUDIT REPORTS 73 Management’s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these financial statements in accordance with International Financial Reporting Standards, and for such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error. Auditor’s Responsibility Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with International Standards on Auditing. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstate- ment of the financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presenta- tion of the financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the financial statements give a true and fair view of the financial Apago PDF Enhancer position of Les Meridian, Inc. as of December 31, 2011, and of its financial perfor- mance and cash flows for the year then ended in accordance with International Financial Reporting Standards. Bergen and Bergen, CPAs February 20, 2012 19 Rue de Bordeaux Marseille, France Required a. For each of the seven distinct parts of the standard unqualified report prepared in	Alvin
accordance with generally accepted auditing standards in the United States, describe whether key elements of each of those seven parts are present in the audit report based on International Standards on Auditing for Les Meridian’s financial statements. b. Describe elements in the audit report based on International Standards on Auditing that are more extensive than an audit report based on U.S. auditing standards. INTERNET PROBLEM 3-1: RESEARCH ANNUAL REPORTS The U.S. Securities and Exchange Commission (SEC) is an inde pendent, nonpartisan, quasi-judicial regulatory agency with responsibility for adminis tering the federal securities laws. Publicly traded companies must electronically ﬁle a variety of forms or reports with the SEC (for example, annual ﬁnancial statements). The SEC makes most of these electronic documents available on the Internet via EDGAR. EDGAR stands for Electronic Data Gathering, Analysis, and Retrieval system. The primary purpose for EDGAR is to increase the efﬁciency and fairness of the securities market for the beneﬁt of investors, corporations, and the economy by accelerating the receipt, acceptance, dissemination, and analysis of time-sensitive corporate information ﬁled with the agency. 74 Part 1 / THE AUDITING PROFESSION a. Visit the SEC’s website (www.sec.gov) and review the information under the link to “Descriptions of Forms” to find the definitions for these forms: 8-K, 10-K, 10-Q, and DEF-14a. Required b. Visit the link to “Search for Company Filings” and locate the Form 10-K filing for Google Inc. for the year ended December 31, 2009 to answer the following questions: 1. Who was Google’s auditor? 2. Did the audit firm issue a combined or separate report(s) on the financial state - ments and on internal controls over financial reporting? 3. What type of audit opinion did the auditor provide for the financial statements? 4. What was the auditor’s opinion about internal controls over financial reporting? c. Search for the Form 10-K filing for Yahoo Inc. for the year ended December 31, 2009 to answer the following questions: 1. What type of audit opinion did Yahoo’s auditor provide for the financial state - ments and for internal controls over financial reporting? 2. How does the Yahoo auditor’s report on the financial statements differ from the audit report related to Google’s financial statements? Apago PDF Enhancer Chapter 3 / AUDIT REPORTS 75 This page intentionally left blank Apago PDF Enhancer C H A P T E R 4 PROFESSIONAL ETHICS The Value Of The Audit Depends On Auditor Independence Bruce Smith works on the audit of the U.S. subsidiary of Ultimate Networks, an audit client in his ﬁrm’s Hong Kong ofﬁce. Bruce has watched the stock of Ultimate Networks soar for the past 6 months. Ultimate Networks is gaining market share, and he knows that their sales will continue to soar with the new technology they have in the pipeline. Finally, he can’t resist any longer. He calls his stockbroker, John Rizzo, and places an order for 200 shares of Ultimate Networks’ stock. “Are you sure this is okay?” asked Rizzo. “I thought Ultimate Networks was your client.” Rizzo knows about professional responsibilities because he worked with Bruce at the CPA ﬁrm before becoming a stockbroker, and they remained friends. “Why don’t you check it out and get back to me?” Rizzo added. The next morning, Bruce is glad that he has John Rizzo for a stockbroker. The SEC just announced that they had uncovered numerous independence violations at another CPA ﬁrm. The ﬁrm had to recall several audit reports, and a few partners and audit staff were terminated for making stock investments similar to the investment that Bruce contemplated the day before. As he thinks about the requirement that he not own stock in an audit client, he con cludes, “There must be other good investments out there.’’ Apago PDF Enhancer L E A R N I N G O B J E C T I V E S After studying this chapter, you should be able to 4-1 Distinguish ethical from 4-2 4-3 unethical behavior in personal and professional contexts.	Alvin
Resolve ethical dilemmas using an ethical framework. Explain the importance of ethical conduct for the accounting profession. 4-4 Describe the purpose and content of the AICPA Code of Professional Conduct. 4-5 Understand Sarbanes–Oxley Act and other SEC and PCAOB independence requirements and additional factors that inﬂuence auditor independence. 4-6 Apply the AICPA Code rules and interpretations on independence and explain their importance. 4-7 Understand the require ments of other rules under the AICPA Code. 4-8 Describe the enforcement mechanisms for the rules of conduct. In preceding chapters, audit reports and the demand for audit and other assurance services were discussed. The value of the audit report and the demand for audit services depend on public conﬁdence in the independence and integrity of CPAs. This chapter discusses ethics and the independence and other ethical requirements for CPAs, including the AICPA Code of Professional Conduct. We begin the chapter with a discussion of general ethical principles and their application to the CPA profession. WHAT ARE ETHICS? OBJECTIVE 4-1 Distinguish ethical from unethical behavior in personal and professional contexts. Need for Ethics Ethics can be deﬁned broadly as a set of moral principles or values. Each of us has such a set of values, although 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 include laws and regulations, church doctrine, codes of business ethics for professional groups such as CPAs, and codes of conduct within organizations. An example of a prescribed set of principles is included in Figure 4-1. These principles were developed by the Josephson Institute of Ethics, a nonproﬁt member - ship organization for the improvement of the ethical quality of society. 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 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 example, what would happen if we couldn’t depend on the people we deal with to be honest. If parents, teachers, employers, siblings, coworkers, and friends all consistently lied, it would be almost impossible to have effective communication. Apago PDF Enhancer The need for ethics in society is sufﬁciently important that many commonly held ethical values are incorporated into laws. However, many of the ethical values found in Figure 4-1, such as caring, cannot be incorporated into laws because they cannot be deﬁned well enough to be enforced. That does not imply, however, that the principles are less important for an orderly society. Why People Act Unethically Most people deﬁne unethical behavior as conduct that differs from what they believe is appropriate given the circumstances. Each of us decides for ourselves what we consider FIGURE 4-1 Illustrative Prescribed Ethical Principles The following are the six core ethical values that the Josephson Institute associates with ethical behavior: Trustworthiness includes honesty, integrity, reli- ability, and loyalty. Honesty requires a good faith intent to convey the truth. Integrity means that the person acts according to conscience, regard- less of the situation. Reliability means making all reasonable efforts to fulfill commitments. Loyalty is a responsibility to promote and protect the interests of certain people and organizations. Respect includes notions such as civility, courtesy, decency, dignity, autonomy, tolerance, and accep- tance. A respectful person treats others with consideration and accepts individual differences and beliefs without prejudice.	Alvin
Responsibility means being accountable for ones actions and exercising restraint. Responsibility also means pursuing excellence, self-restraint, and leading by example, including perseverance and engaging in continuous improvement. Fairness and justice include issues of equality, impartiality, proportionality, openness, and due process. Fair treatment means that similar situ- ations are handled consistently. Caring means being genuinely concerned for the welfare of others and includes acting altruis- tically and showing benevolence. Citizenship includes obeying laws and per- forming one’s fair share to make society work, including such activities as voting, serving on juries, conserving resources, and giving more than one takes. 78 Part 1 / THE AUDITING PROFESSION unethical behavior, both for ourselves and others. It is important to understand what causes people to act in a manner that we decide is unethical. There are two primary reasons why people act unethically: The person’s ethical standards are different from those of society as a whole, or the person chooses to act selﬁshly. Frequently, both reasons exist. Person’s Ethical Standards Differ from General Society Extreme examples of people whose behavior violates almost everyone’s ethical standards are drug dealers, bank robbers, and larcenists. Most people who commit such acts feel no remorse when they are apprehended because their ethical standards differ from those of society as a whole. There are also many far less extreme examples when others violate our ethical values. When people cheat on their tax returns, treat other people with hostility, lie on resumes and employment applications, or perform below their competence level as employees, most of us regard that as unethical behavior. If the other person has decided that this behavior is ethical and acceptable, there is a conﬂict of ethical values that is unlikely to be resolved. The Person Chooses to Act Selﬁshly The following example illustrates the difference between ethical standards that differ from general society’s and acting selﬁshly. Person A ﬁnds a briefcase in an airport containing important papers and $1,000. He tosses the briefcase and keeps the money. He brags to his family and friends about his good fortune. Person A’s values probably differ from most of society’s. Person B faces the same situation but responds differently. He keeps the money but leaves the briefcase in a conspicuous place. He tells nobody and spends the money on a new wardrobe. It is likely that Person B has violated his own ethical standards, but he decided that the money was too important to pass up. He has chosen to act selﬁshly. A considerable portion of unethical behavior results from selﬁsh behavior. Political scandals result from the desire for political power; cheating on tax returns and expense reports is motivated by ﬁnancial greed; performing below one’s competence and cheating on tests typically arise from laziness. In each case, the person knows that the behavior is inappropriate but chooses to do it anyway because of the personal sacriﬁce needed to act ethically. Apago PDF Enhancer ETHICAL DILEMMAS OBJECTIVE 4-2 Resolve ethical dilemmas using an ethical framework. An ethical dilemma is a situation a person faces in which a decision must be made about the appropriate behavior. A simple example of an ethical dilemma is ﬁnding a diamond ring, which necessitates deciding whether to attempt to ﬁnd the owner or to keep it. A far more difﬁcult ethical dilemma to resolve is the following one, taken from Easier Said Than Done, a publication dealing with ethical issues. It is the type of case that might be used in an ethics course. • In Europe, a woman was near death from a special kind of cancer. There was one drug that the doctors thought might save her. It was a form of radium that a druggist in the same town had recently discovered. The drug was expensive to make, but the druggist was charging ten times what the drug cost him to make. He paid $200 for the radium and charged $2,000 for a small dose of the drug.	Alvin
The sick woman’s husband, Heinz, went to everyone he knew to borrow the money, but he could only get together about $1,000, which is half of what it cost. He told the druggist that his wife was dying and asked him to sell it cheaper or let him pay later. But the druggist said: “No, I discovered the drug and I’m going to make money from it.” So Heinz got desperate and broke into the man’s store to steal the drug for his wife. Should the husband have done that?1 1Norman Sprinthall and Richard C. Sprinthall, “Value and Moral Development,” Easier Said Than Done (Vol. 1, No. 1, Winter 1988); p. 17. Chapter 4 / PROFESSIONAL ETHICS 79 Auditors, accountants, and other businesspeople face many ethical dilemmas in their business careers. Dealing with a client who threatens to seek a new auditor unless an unqualiﬁed opinion is issued presents an ethical dilemma if an unqualiﬁed opinion is inappropriate. Deciding whether to confront a supervisor who has materially overstated departmental revenues as a means of receiving a larger bonus is an ethical dilemma. Continuing to be a part of the management of a company that harasses and mistreats employees or treats customers dishonestly is an ethical dilemma, especially if the person has a family to support and the job market is tight. Rationalizing Unethical Behavior There are alternative ways to resolve ethical dilemmas, but care must be taken to avoid methods that are rationalizations of unethical behavior. The following are rationaliza - tion methods commonly employed that can easily result in unethical conduct: Resolving Ethical Dilemmas Ethical Dilemma Everybody Does It The argument that it is acceptable behavior to falsify tax returns, cheat on exams, or sell defective products is commonly based on the rationalization that everyone else is doing it and therefore it is acceptable. If It’s Legal, It’s Ethical Using the argument that all legal behavior is ethical relies heavily on the perfection of laws. Under this philosophy, one would have no obligation to return a lost object unless the other person could prove that it was his or hers. Likelihood of Discovery and Consequences This philosophy relies on evaluating the likelihood that someone else will discover the behavior. Typically, the person also assesses the severity of the penalty (consequences) if there is a discovery. An example is deciding whether to correct an unintentional overbilling to a customer when the customer has already paid the full amount. If the seller believes that the customer will detect the error and respond by not buying in the future, the seller will inform the customer now; otherwise, the seller will wait to see if the customer complains. Apago PDF Enhancer Formal frameworks have been developed to help people resolve ethical dilemmas. The purpose of such a framework is to help identify the ethical issues and decide an appropriate course of action using the person’s own values. The six-step approach that follows is intended to be a relatively simple approach to resolving ethical dilemmas: 1. Obtain the relevant facts. 2. 3. Determine who is affected by the outcome of the dilemma and how each Identify the ethical issues from the facts. person or group is affected. Identify the alternatives available to the person who must resolve the dilemma. Identify the likely consequence of each alternative. 4. 5. 6. Decide the appropriate action. An illustration is used to demonstrate how a person might use this six-step approach to resolve an ethical dilemma. Bryan Longview has been working 6 months as a staff assistant for Barton & Barton CPAs. Currently he is assigned to the audit of Reyon Manufacturing Company under the supervision of Charles Dickerson, an experienced audit senior. There are three auditors assigned to the audit, including Bryan, Charles, and a more experienced assistant, Martha Mills. During lunch on the ﬁrst day, Charles says, “It will be necessary for us to work a few extra hours on our own time to make sure we come in	Alvin
on budget. This audit isn’t very proﬁtable anyway, and we don’t want to hurt our ﬁrm by going over budget. We can accomplish this easily by coming in a half hour early, taking a short lunch break, and working an hour or so after normal quitting time. We just won’t enter that time on our time report.” Bryan recalls reading the ﬁrm’s policy that working hours and not charging for them on the time report is a violation of Barton & Barton’s employment policy. He also knows that seniors are paid bonuses, instead of overtime, whereas staff are paid for overtime but get no bonuses. Later, 80 Part 1 / THE AUDITING PROFESSION when discussing the issue with Martha, she says, “Charles does this on all of his jobs. He is likely to be our ﬁrm’s next audit manager. The partners think he’s great because his jobs always come in under budget. He rewards us by giving us good engagement evaluations, especially under the cooperative attitude category. Several of the other audit seniors follow the same practice.’’ Relevant Facts There are three key facts in this situation that deal with the ethical issue and how the issue will likely be resolved: 1. The staff person has been informed that he will work hours without recording Resolving the Ethical Dilemma Using the Six-Step Approach them as hours worked. 2. Firm policy prohibits this practice. 3. Another staff person has stated that this is common practice in the ﬁrm. Ethical Issue The ethical issue in this situation is not difﬁcult to identify. • Is it ethical for Bryan to work hours and not record them as hours worked in this situation? Who Is Affected and How Is Each Affected? There are typically more people affected in situations in which ethical dilemmas occur than might be expected. The following are the key persons involved in this situation: Who Bryan Martha Charles Barton & Barton How Affected Being asked to violate ﬁrm policy. Hours of work will be affected. Pay will be affected. Performance evaluations may be affected. Attitude about ﬁrm may be affected. Same as Bryan. Success on engagement and in ﬁrm may be affected. Apago PDF Enhancer Hours of work will be affected. Stated ﬁrm policy is being violated. May result in underbilling clients in the current and future engagements. May affect ﬁrm’s ability to realistically budget engagements and bill clients. May affect the ﬁrm’s ability to motivate and retain employees. Staff assigned to Reyon Manufacturing in the future May result in unrealistic time budgets. May result in unfavorable time performance evaluations. Other staff in ﬁrm Following the practice on this engagement may May result in pressures to continue practice of not charging for hours worked. motivate others to follow the same practice on other engagements. Bryan’s Available Alternatives • Refuse to work the additional hours. • Perform in the manner requested. • Inform Charles that he will not work the additional hours or will charge the additional hours to the engagement. • Talk to a manager or partner about Charles’s request. • Refuse to work on the engagement. • Quit working for the ﬁrm. Each of these options includes a potential consequence, the worst likely one being termination by the ﬁrm. Chapter 4 / PROFESSIONAL ETHICS 81 SOME ETHICAL VIOLATIONS ARE MORE SEVERE THAN OTHERS Bryan Longview’s ethical dilemma involves a situation in which he is asked to work without recording the time, which is sometimes called kitchen-tabling or eating time. One of the concerns with kitchen-tabling is that it can lead to a more severe problem known as premature signoff, in which a staff person signs off as having completed work without performing the necessary procedures. Tom Holton has far too busy a social life to work overtime. To make certain that work does not interfere with his social life, he tests only part of the assigned sample. For example, if he is asked to test 25 cash disbursement transactions, he tests the ﬁrst 15 but indicates that he has tested all 25. A supervisor, curious about Tom’s amazing ability to beat the time budget, decides to carefully review Tom’s work. When the ﬁrm	Alvin
discovers that Tom is signing off procedures without completing them, he is dismissed that day—no counseling out, no 2 weeks’ notice. Consequences of Each Alternative In deciding the consequences of each alterna - tive, it is essential to evaluate both the short- and long-term effects. There is a natural tendency to emphasize the short term because those consequences will occur quickly, even when the long-term consequences may be more important. For example, consider the potential consequences if Bryan decides to work the additional hours and not report them. In the short term, he will likely get good evaluations for cooperation and perhaps a salary increase. In the longer term, what will be the effect of not reporting the hours this time when other ethical conﬂicts arise? Consider the following similar ethical dilemmas Bryan might face in his career as he advances: • A supervisor asks Bryan to work 3 unreported hours daily and 15 unreported hours each weekend. • A supervisor asks Bryan to initial certain audit procedures as having been performed when they were not. • Bryan concludes that he cannot be promoted to manager unless he persuades assistants to work hours that they do not record. • Management informs Bryan, who is now a partner, that either the company gets Apago PDF Enhancer an unqualiﬁed opinion for a $40,000 audit fee or the company will change auditors. • Management informs Bryan that the audit fee will be increased $25,000 if Bryan can ﬁnd a plausible way to increase earnings by $1 million. Appropriate Action Only Bryan can decide the appropriate option to select in the circumstances after considering his ethical values and the likely consequences of each option. At one extreme, Bryan can decide that the only relevant consequence is the potential impact on his career. Most of us believe that Bryan is an unethical person if he follows that course. At the other extreme, Bryan can decide to refuse to work for a ﬁrm that permits even one supervisor to violate ﬁrm policies. Many people consider such an extreme reaction naive. SPECIAL NEED FOR ETHICAL CONDUCT IN PROFESSIONS OBJECTIVE 4-3 Explain the importance of ethical conduct for the accounting profession. Our society has attached 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 the press reports that a physician, clergyperson, U.S. senator, or CPA has been indicted for a crime, most people feel more disappointment than when the same thing happens to people who are not labeled as professionals. The term professional means a responsibility for conduct that extends beyond satisfying individual responsibilities and beyond the requirements of our society’s laws and regulations. A CPA, as a professional, recognizes a responsibility to the public, to the client, and to fellow practitioners, including honorable behavior, even if that means personal sacriﬁce. The reason for an expectation of a high level of professional conduct by any profession is the need for public conﬁdence in the quality of service by the profession, 82 Part 1 / THE AUDITING PROFESSION Difference Between CPA Firms and Other Professionals Ways CPAs Are Encouraged to Conduct Themselves Professionally regardless of the individual providing it. For the CPA, it is essential that the client and external ﬁnancial statement users have conﬁdence in the quality of audits and other services. If users of services do not have conﬁdence in physicians, judges, or CPAs, the ability of those professionals to serve clients and the public effectively is diminished. It is not practical for most customers to evaluate the quality of the performance of professional services because of their complexity. A patient cannot be expected to evaluate whether an operation was properly performed. A ﬁnancial statement 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	Alvin
professional services is enhanced when the profession encourages high standards of performance 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 their customers. Attorneys, for example, are typically engaged and paid by a client and have primary responsibility to be an advocate for that client. CPA ﬁrms are usually engaged by management for private companies and the audit committee for public companies, and are paid by the company issuing the ﬁnancial statements, but the primary beneﬁciaries of the audit are ﬁnancial statement users. Often, the auditor does not know or have contact with the ﬁnancial 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 these services will thereby also be reduced. Therefore, there is considerable incentive for CPA ﬁrms to conduct themselves at a high professional level. Figure 4-2 summarizes the most important ways in which CPAs can conduct them - selves appropriately and perform high-quality audits and related services. We discussed in Chapter 2 GAAS and their interpretations, the CPA examination, quality control, peer review requirements, PCAOB and SEC, AICPA audit practice and quality centers, and continuing education. The legal liability of CPA ﬁrms also exerts considerable inﬂuence on the way in which practitioners conduct themselves and audits, and this topic is examined in Chapter 5. Apago PDF Enhancer In the United States, the two most inﬂuential factors—shown shaded in Figure 4-2—are the AICPA Code of Professional Conduct and the PCAOB and SEC. The Code FIGURE 4-2 Ways the Profession and Society Encourage CPAs to Conduct Themselves at a High Level CPA examination Auditing standards and interpretations Quality control Peer review PCAOB and SEC Conduct of CPA firm personnel Code of Professional Conduct Continuing education requirements Legal liability AICPA practice and quality centers Chapter 4 / PROFESSIONAL ETHICS 83 of Professional Conduct is meant to provide a standard of conduct for all members of the AICPA. The PCAOB is authorized to establish ethics and independence standards for auditors of public companies, and the SEC also plays a signiﬁcant role in estab - lishing independence standards for auditors of public companies. At the international level, the International Ethics Standards Board for Accountants (IESBA), an inde - pendent standards setting body within the International Federation of Accountants (IFAC), establishes ethical standards and guidance and fosters international debate on ethical issues faced by accountants through its Code of Ethics for Professional Accountants. While CPAs in the United States must follow the AICPA Code, the AICPA’s Pro - fessional Ethics Executive Committee closely monitors IESBA activities to converge the U.S. guidance, where appropriate, to guidance in the IESBA’s Code. As a member body of IFAC, the AICPA agrees to have ethics standards that are at least as stringent as the IESBA’s ethics standards. The remainder of this chapter addresses the AICPA Code and related PCAOB and SEC requirements. CODE OF PROFESSIONAL CONDUCT OBJECTIVE 4-4 Describe the purpose and content of the AICPA Code of Professional Conduct. The AICPA Code of Professional Conduct provides both general standards of ideal conduct and speciﬁc enforceable rules of conduct. There are four parts to the code: principles, rules of conduct, interpretations of the rules of conduct, and ethical rulings. The parts are listed in order of increasing speciﬁcity; the principles provide ideal standards of conduct, whereas ethical rulings are highly speciﬁc. The four parts are summarized in Figure 4-3 and discussed in the following sections. A few deﬁnitions, taken from the AICPA Code of Professional Conduct, must be	Alvin
understood to help interpret the rules. • Client. Any person or entity, other than the member’s employer, that engages a Apago PDF Enhancer member or a member’s ﬁrm to perform professional services. • Firm. A form of organization permitted by law or regulation whose characteristics conform to resolutions of the Council of the American Institute of Certiﬁed Public Accountants that is engaged in the practice of public accounting. Except for the purposes of applying Rule 101, Independence, the ﬁrm includes the individual partners thereof. FIGURE 4-3 Code of Professional Conduct Ideal standards of ethical conduct stated in philosophical terms. Principles They are not enforceable. Rules of conduct They are enforceable. Minimum standards of ethical conduct stated as specific rules. Interpretations of the rules of conduct Interpretations of the rules of conduct by the AICPA Division of Professional Ethics. They are not enforceable, but a practitioner must justify departure. Ethical rulings Published explanations and answers to questions about the rules of conduct submitted to the AICPA by practitioners and others interested in ethical requirements. They are not enforceable, but a practitioner must justify departure. 84 Part 1 / THE AUDITING PROFESSION Institute. The American Institute of Certiﬁed Public Accountants. • • Member. A member, associate member, or international associate of the American Institute of Certiﬁed Public Accountants. • Practice of public accounting. The practice of public accounting consists of the performance for a client, by a member or a member’s ﬁrm, while holding out as CPA(s), of the professional services of accounting, tax, personal ﬁnancial plan - ning, litigation support services, and those professional services for which standards are promulgated by bodies designated by Council. Ethical Principles 1. Responsibilities In carrying out their responsibilities as professionals, members should exercise sensitive professional and moral judgments in all their activities. 2. 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. 3. Integrity To maintain and broaden public conﬁdence, members should perform all professional responsibilities with the highest sense of integrity. 4. 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. 5. Due Care A member should 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. 6. 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. The section of the AICPA Code dealing with principles of professional conduct includes a general discussion of characteristics required of a CPA. The principles section consists of two main parts: six ethical principles and a discussion of those principles. The ethical principles are listed in the box above. Discussions throughout this chapter include ideas taken from the principles section. Apago PDF Enhancer The ﬁrst ﬁve of these principles are equally applicable to all members of the AICPA, regardless of whether they practice in a CPA ﬁrm, work as accountants in business or government, are involved in some other aspect of business, or are in education. One exception is the last sentence of objectivity and independence. It applies only to members in public practice, and then only when they are providing attestation services such as audits. The sixth principle, scope and nature of services, applies only to members in public practice. That principle addresses whether a	Alvin
practitioner should provide a certain service, such as providing personnel consulting when an audit client is hiring a chief information ofﬁcer (CIO) for the client’s IT function. Providing such a service can create a loss of independence if the CPA ﬁrm recommends a CIO who is hired and performs incompetently. Principles of Professional Conduct GUIDANCE FOR MEETING OBJECTIVES OF PRINCIPLES Speciﬁc threats to a CPA’s ability to meet the objectives of the six principles may arise when providing professional services to clients and employers. Because it is impossible to address in the Code every potential threat, the AICPA’s Profes - sional Ethics Executive Committee (PEEC) issued a non-authoritative Guide for Complying with Rules 102–505 to assist all members, including those in business and government, with meeting the objectives of the six ethical principles when facing circumstances not explicitly addressed by the Code. Similar to the International Ethics Standards Board’s (IESBA’s) Code of Ethics for Professional Conduct, the guide contains a risk-based framework that outlines categories of potential threats to compliance with the principles and includes suggested safeguards to prevent noncompliance. Although use of the guide is not required, it can assist members in complying with the rules. Therefore, members should refer to the framework when making decisions on ethical matters not explicitly addressed in the Code. Source: “Guide for Complying with Rules 102–505,” (www.aicpa.org). Chapter 4 / PROFESSIONAL ETHICS 85 Rules of Conduct Interpretations of Rules of Conduct Ethical Rulings FIGURE 4-4 Standards of Conduct Ideal conduct by practitioners Minimum level of conduct by practitioners Principles Rules of conduct Substandard conduct This part of the Code includes the explicit rules that must be followed by every CPA in the practice of public accounting.2 Those individuals holding the CPA certiﬁcate but not practicing public accounting must follow most, but not all requirements. Because the section on rules of conduct is the only enforceable part of the code, it is stated in more precise language than the section on principles. Because of their enforceability, many practitioners refer to the rules as the AICPA Code of Professional Conduct. The difference between the standards of conduct set by the principles and those set by the rules of conduct is shown in Figure 4-4. When practitioners conduct themselves at the minimum level in Figure 4-4, this does not imply unsatisfactory conduct. The profession has presumably set the standards sufﬁciently high to make the minimum conduct satisfactory. At what level do practitioners conduct themselves in practice? As in any profession, Apago PDF Enhancer the level varies among practitioners. Most practitioners conduct themselves at a high level. Unfortunately, a few conduct themselves below the minimum level set by the profession. The activities designed to encourage CPAs to conduct themselves at a high level described in Figure 4-2 (p. 83) help minimize any substandard practice. The need for published interpretations of the rules of conduct arises when there are frequent questions from practitioners about a speciﬁc rule. The Professional Ethics Executive Committee of the AICPA prepares each interpretation based on a consensus of a committee made up principally of public accounting practitioners. Before interpretations are ﬁnalized, they are issued as exposure drafts to the profession and others for comment. Interpretations are not ofﬁcially enforceable, but a departure from the interpretations is difﬁcult if not impossible for a practitioner to justify in a disci - plinary hearing. The most important interpretations are discussed as a part of each section of the rules. Rulings are explanations by the executive committee of the professional ethics division of speciﬁc factual circumstances. A large number of ethical rulings are published in the expanded version of the AICPA Code of Professional Conduct. The following is an example (Rule 101—Independence; Ruling No. 16):	Alvin
• Question—A member serves on the board of directors of a nonproﬁt social club. Is the independence of the member considered to be impaired with respect to the club? • Answer—Independence of the member is considered to be impaired because the board of directors has the ultimate responsibility for the affairs of the club. 2The AICPA Code of Professional Conduct is applicable to every CPA who is a member of the AICPA. Each state also has rules of conduct that are required for licensing by the state. Many states follow the AICPA rules, but some have somewhat different requirements. 86 Part 1 / THE AUDITING PROFESSION IESBA CODE OF ETHICS FOR PROFESSIONAL CONDUCT The International Ethics Standard Board for Accountants (IESBA) Code of Ethics for Professional Conduct is also a principles-based framework consisting of three parts. Part A establishes the ﬁve fundamental principles related to integrity, objectivity, professional competence and due care, conﬁdentiality, and professional behavior. Part A also provides a conceptual framework that accountants can apply to identify threats to compliance with the fundamental principles, evaluate the signiﬁcance of identiﬁed threats, and apply safeguards, when necessary, to eliminate the threat or reduce the threat to an acceptable level. Parts B and C of the IESBA Code describe how the conceptual framework applies in certain situations, including examples of safeguards and descriptions of situations where safeguards are not available to address threats. Part B applies to professional accountants in public practice while Part C applies to professional accountants in business. Source: International Ethics Standards Board for Accountants, Code of Ethics for Professional Accountants, (www.ifac.org). Applicability of the Rules of Conduct The rules of conduct in the AICPA Code of Professional Conduct apply to all AICPA members for all services provided, whether or not the member is in the practice of public accounting, unless the code speciﬁcally states otherwise. Table 4-1 (p. 102) indicates whether the rule applies to all members or only to members in public practice. Each rule applies to attestation services, and unless stated otherwise, it also applies to all services provided by CPA ﬁrms such as taxes and management services and to CPAs who are employees who prepare ﬁnancial statements for their employer organi - zations. The most notable exception is Rule 101—Independence that requires inde - pendence only when the AICPA has established independence requirements through its rule-setting bodies, such as the Auditing Standards Board. The AICPA requires independence only for attestation engagements. For example, a CPA ﬁrm can perform management services for a company in which the partner owns stock. Of course, if the CPA ﬁrm also performs an audit, that violates the independent requirements for attestation services. Apago PDF Enhancer It is a violation of the rules if someone does something on behalf of a member that is a violation if the member does it. An example is a banker who puts in a newsletter that Johnson and Able CPA ﬁrm has the best tax department in the state and con - sistently gets large refunds for its tax clients. That is likely to create false or unjustiﬁed expectations and is a violation of Rule 502 on advertising. A member is also responsible for compliance with the rules by employees, partners, and shareholders. INDEPENDENCE OBJECTIVE 4-5 Understand Sarbanes–Oxley Act and other SEC and PCAOB independence requirements and additional factors that inﬂuence auditor independence. Independence, because of its importance, is the ﬁrst rule of conduct. Before we discuss the speciﬁc independence requirements, we ﬁrst discuss external factors that may inﬂuence auditor independence. The value of auditing depends heavily on the public’s perception of the independ - ence of auditors. The reason that many diverse users are willing to rely on CPA’s reports is their expectation of an unbiased viewpoint. The AICPA Code of Professional Conduct and the IESBA Code of Ethics for Professional Conduct both deﬁne independence as	Alvin
consisting of two components: independence of mind and independence in appearance. Independence of mind reﬂects the auditor’s state of mind that permits the audit to be performed with an unbiased attitude. Independence of mind reﬂects a long-standing requirement that members be independent in fact. Independence in appearance is the result of others’ interpretations of this independence. If auditors are independent in fact but users believe them to be advocates for the client, most of the value of the audit function is lost. The following sections discuss SEC and related PCAOB independence rules, including those required by the Sarbanes–Oxley Act. Organizations and standards Chapter 4 / PROFESSIONAL ETHICS 87 Sarbanes–Oxley Act and SEC Provisions Addressing Auditor Independence other than the AICPA Code of Professional Conduct that inﬂuence auditor independ - ence are also described. The SEC adopted rules strengthening auditor independence consistent with the requirements of the Sarbanes–Oxley Act. The SEC rules further restrict the provision of nonaudit services to audit clients, and they also include restrictions on employment of former audit ﬁrm employees by the client and provide for audit partner rotation to enhance independence. The PCAOB has also issued additional independence rules related to the provision of certain tax services. Nonaudit Services The Sarbanes–Oxley Act and the revised SEC rules further restrict, but do not completely eliminate, the types of nonaudit services that can be provided to publicly held audit clients. Many of these services were prohibited under existing SEC rules on independence. The revised rules clarify many of the existing prohibitions and expand the circumstances in which the services are prohibited. The following nine services are prohibited: Internal audit outsourcing 1. Bookkeeping and other accounting services 2. Financial information systems design and implementation 3. Appraisal or valuation services 4. Actuarial services 5. 6. Management or human resource functions 7. Broker or dealer or investment adviser or investment banker services 8. Legal and expert services unrelated to the audit 9. Any other service that the PCAOB determines by regulation is impermissible CPA ﬁrms are not prohibited from performing these services for private companies and for public companies that are not audit clients. In addition, CPA ﬁrms may still provide other services that are not prohibited for public company audit clients. For example, SEC and PCAOB rules allow CPAs to provide tax services for audit clients, except for tax services for company executives who oversee ﬁnancial reporting, and tax avoidance planning services. Nonaudit services that are not prohibited by the Sarbanes– Oxley Act and the SEC rules must be preapproved by the company’s audit committee. In addition, a CPA ﬁrm is not independent if an audit partner receives compensation for selling services to the client other than audit, review, and attest services. Apago PDF Enhancer Companies are required to disclose in their proxy statement or annual ﬁlings with the SEC the total amount of audit and nonaudit fees paid to the CPA ﬁrm for the two most recent years. Four categories of fees must be reported: (1) audit fees, (2) audit- related fees, (3) tax fees, and (4) all other fees. Audit-related fees are for services such as comfort letters and reviews of SEC ﬁlings that can only be provided by CPA ﬁrms. Companies are also required to provide further breakdown of the “other fees” category and to provide qualitative information on the nature of the services provided. Audit Committees An audit committee is a selected number of members of a company’s board of directors whose responsibilities include helping auditors remain independent of management. Most audit committees are made up of three to ﬁve or sometimes as many as seven directors who are not a part of company management. In response to the Sarbanes–Oxley Act requirement that all members of the audit committee be independent, the national stock exchanges amended their listing rules to reﬂect the	Alvin
provision. Now, with very limited exceptions, public company audit committees should be comprised solely of independent members, and companies must disclose whether or not the audit committee includes at least one member who is a ﬁnancial expert. The Sarbanes–Oxley Act further requires the audit committee of a public company to be responsible for the appointment, compensation, and oversight of the work of the auditor. The audit committee must preapprove all audit and nonaudit services, and is responsible for oversight of the work of the auditor, including resolution of disagree - ments involving ﬁnancial reporting between management and the auditor. Auditors 88 Part 1 / THE AUDITING PROFESSION are responsible for communicating all signiﬁcant matters identiﬁed during the audit to the audit committee. For public companies, PCAOB rules require a CPA ﬁrm, before its selection as the company’s auditor, to describe in writing and document its discussions with the audit committee about all rela tionships between the ﬁrm and the company, including executives in ﬁnancial reporting positions, to determine whether there is any impairment of the CPA ﬁrm’s independence. If selected as the auditor, these communications are to be made at least annually. These provisions increase the independence and role of the audit committee. The requirements enhance auditor independence by effectively making the audit com - mittee the client for public companies, rather than management. Conﬂicts Arising from Employment Relationships The employment of former audit team members with an audit client raises independence concerns. Consistent with the requirements of the Sarbanes–Oxley Act, the SEC added a one-year “cooling off ” period before a member of the audit engagement team can work for the client in certain key management positions. This has important implications for an auditor working for a CPA ﬁrm who receives an employment offer from a publicly held client for a position as a chief executive ofﬁcer, controller, chief ﬁnancial ofﬁcer, chief accounting ofﬁcer, or equivalent position. The CPA ﬁrm cannot continue to audit that client if the auditor accepts the position and has participated in any capacity in the audit for one year preceding the start of the audit. This has no effect on the CPA ﬁrm’s ability to continue the audit if the former auditor accepts a position such as assistant controller or accountant without primary accounting responsibilities. Apago PDF Enhancer Under SEC rules existing before the Sarbanes–Oxley Act and continuing, a CPA ﬁrm is not independent with respect to an audit client if a former partner, principal, shareholder, or professional employee of the ﬁrm accepts employment with a client if he or she has a continuing ﬁnancial interest in the CPA ﬁrm or is in a position to inﬂuence the CPA ﬁrm’s operations or ﬁnancial policies. Partner Rotation As required by the Sarbanes–Oxley Act, the SEC independence rules require the lead and concurring audit partner to rotate off the audit engagement after ﬁve years. (The concurring partner is not involved with the actual performance of the audit and reviews the work at the completion of the audit.) Although not addressed in the Sarbanes–Oxley Act, the SEC requires a ﬁve-year “time-out” for the lead and concurring partners after rotation before they can return to that audit client. Addi - tional audit partners with signiﬁcant involvement on the audit must rotate after seven years and are subject to a two-year time-out period. Ownership Interests SEC rules on ﬁnancial relationships take an engagement perspective and prohibit ownership in audit clients by those persons who can inﬂuence the audit. The rules prohibit any ownership by covered persons and their immediate family, including (a) members of the audit engagement team, (b) those in a position to inﬂuence the audit engagement in the ﬁrm chain of command, (c) partners and managers who provide more than 10 hours of nonaudit services to the client, and (d)	Alvin
partners in the ofﬁce of the partner primarily responsible for the audit engagement. These rules are designed to provide workable rules that still safeguard independence. Both management and representatives of management, such as investment bankers, often consult with other accountants on the application of accounting principles. Although consultation with other accountants is appropriate, it can lead to a loss of independence in certain circumstances. For example, suppose one CPA ﬁrm replaces the existing auditors on the strength of accounting advice offered but later ﬁnd facts and circumstances that require the CPA ﬁrm to change its stance. It may be difﬁcult for the new CPA ﬁrm to remain independent in such a situation. Auditing standards set forth requirements that must be followed when a CPA ﬁrm is requested to provide a written or oral opinion on the application of accounting principles or the Shopping for Accounting Principles Chapter 4 / PROFESSIONAL ETHICS 89 type of audit opinion that would be issued for a speciﬁc or hypothetical transaction of an audit client of another CPA ﬁrm. The purpose of the requirement is to mini - mize the likelihood of management following the practice commonly called opinion shopping and the potential threat to independence of the kind described. Primary among the requirements is that the consulted CPA ﬁrm should communicate with the entity’s existing auditors to ascertain all the available facts relevant to forming a professional judgment on the matters on which the ﬁrm has been requested to report. Can an auditor be truly independent in fact and appearance if the payment of the audit fees is dependent on the entity’s management? There is probably no satisfactory answer to this question, but it does demonstrate the difﬁculty of assuring that auditors are independent. The alternative to engagement of the CPA ﬁrm by the audit committee and payment of audit fees by management is probably the use of either government or quasi-government auditors. All things considered, it is questionable whether the audit function would be performed better or more cheaply by the public sector. Engagement and Payment of Audit Fees by Management INDEPENDENCE RULE OF CONDUCT AND INTERPRETATIONS OBJECTIVE 4-6 Apply the AICPA Code rules and interpretations on independence and explain their importance. Financial Interests The previous section discussed the importance of auditor independence. It is not surprising that independence is the ﬁrst subject addressed in the rules of conduct. 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. CPA ﬁrms are required to be independent for certain services that they provide, Apago PDF Enhancer but not for others. The last phrase in Rule 101, “as required by standards promulgated by bodies designated by Council” is a convenient way for the AICPA to include or exclude independence requirements for different types of services. For example, the Auditing Standards Board requires that auditors of historical ﬁnancial statements be independent. Rule 101 therefore applies to audits. Independence is also required for other types of attestations, such as review services and audits of prospective ﬁnancial statements. However, a CPA ﬁrm can do tax returns and provide management services without being independent. Rule 101 does not apply to those types of services. There are more interpretations for independence than for any of the other rules of conduct. Some of the more signiﬁcant issues and interpretations involving independ - ence are discussed in the following sections. Interpretations of Rule 101 prohibit covered members from owning any stock or other direct investment in audit clients because it is potentially damaging to actual audit independence (independence of mind), and it certainly is likely to affect users’ percep - tions of the auditors’ independence (independence in appearance). Indirect investments,	Alvin
such as ownership of stock in a client’s company by an auditor’s grandparent, are also prohibited, but only if the amount is material to the auditor. The ownership of stock rule is more complex than it appears at ﬁrst glance. A more detailed examination of that requirement is included to aid in understanding and to show the complexity of one of the rules. There are three important distinctions in the rules as they relate to independence and stock ownership. Covered Members Rule 101 applies to covered members in a position to inﬂuence an attest engagement. Covered members include the following: Individuals on the attest engagement team 1. 2. An individual in a position to inﬂuence the attest engagement, such as individuals who supervise or evaluate the engagement partner 90 Part 1 / THE AUDITING PROFESSION 3. A partner or manager who provides nonattest services to the client 4. A partner in the ofﬁce of the partner responsible for the attest engagement 5. The ﬁrm and its employee beneﬁt plans 6. An entity that can be controlled by any of the covered members listed above or by two or more of the covered individuals or entities operating together For example, a staff member in a national CPA ﬁrm could own stock in a client cor - poration and not violate Rule 101 if the staff member is not involved in the engagement. However, if the staff member is assigned to the engagement or becomes a partner in the ofﬁce of the partner responsible for the attest engagement, he or she would have to dispose of the stock or the CPA ﬁrm would no longer be independent of that client. These independence rules also generally apply to the covered member’s immediate family. The interpretations of Rule 101 deﬁne immediate family as a spouse, spousal equivalent, or dependent. Some CPA ﬁrms do not permit any ownership by staff of a client’s stock regardless of which ofﬁce serves the client. These ﬁrms have decided to have higher requirements than the minimums set by the rules of conduct. Direct Versus Indirect Financial Interest The ownership of stock or other equity shares and debt securities by members or their immediate family is called a direct ﬁnancial interest. For example, if either a partner in the ofﬁce in which an audit is conducted or the partner’s spouse has a ﬁnancial interest in a company, the CPA ﬁrm is prohibited by Rule 101 from expressing an opinion on the ﬁnancial statements of that company. An indirect ﬁnancial interest exists when there is a close, but not a direct, owner - ship relationship between the auditor and the client. An example of an indirect ownership interest is the covered member’s ownership of a mutual fund that has an investment in a client. Apago PDF Enhancer Material or Immaterial Materiality affects whether ownership is a violation of Rule 101 only for indirect ownership. Materiality must be considered in relation to the member person’s wealth and income. For example, if a covered member has a signiﬁcant amount of his or her personal wealth invested in a mutual fund and that fund has a large ownership position in a client company, a violation of the Code is likely to exist. Several interpretations of Rule 101 deal with speciﬁc aspects of ﬁnancial relationships between CPA ﬁrm personnel and clients. These are summarized in this section. Related Financial Interest Issues Former Practitioners In most situations, the interpretations permit former partners or shareholders who left the ﬁrm due to such things as retirement or the sale of their ownership interest to have relationships with clients of the ﬁrm of the type that are normally a violation of Rule 101, without affecting a ﬁrm’s independence. A violation by the ﬁrm would occur if the former partner was held out as an associate of the ﬁrm or took part in activities that are likely to cause other parties to believe the person is still active in the ﬁrm. Normal Lending Procedures Generally, loans between a CPA ﬁrm or covered members and an audit client are prohibited because it is a ﬁnancial relationship. There	Alvin
are several exceptions to the rule, however, including automobile loans, loans fully collateralized by cash deposits at the same ﬁnancial institution, and unpaid credit card balances not exceeding $10,000 in total. It is also permissible to accept a ﬁnancial institution as a client, even if covered members of the CPA ﬁrm have existing home mortgages, other fully collateralized secured loans, and immaterial loans with the institution. No new loans are permitted, however. Both the restrictions and exceptions are reasonable ones, considering the trade-off between independence and the need to permit CPAs to function as businesspeople and individuals. Chapter 4 / PROFESSIONAL ETHICS 91 Financial Interests and Employment of Immediate and Close Family Members The ﬁnancial interests of immediate family members, deﬁned as a spouse, spousal equivalent, or dependent, are ordinarily treated as if they were the ﬁnancial interest of the covered member. For example, if the spouse of a professional on the audit engagement team owns any stock in the client, Rule 101 is violated. Independence is also impaired if an immediate family member holds a key position such as ﬁnancial ofﬁcer or chief executive ofﬁcer with the client that allows them to inﬂuence accounting functions, preparation of ﬁnancial statements, or the contents of the ﬁnancial statements. Ownership interests of close family members, deﬁned as a parent, sibling, or nondependent child, do not normally impair independence unless the ownership interest is material to the close relative. Imagine the potential difﬁculty in maintaining independence and objectivity if the ﬁrm is asked to audit a client where the parent of the audit partner is chief executive ofﬁcer and has a signiﬁcant ownership interest in the client. For individuals on the engagement team, independence is impaired if a close relative has a key position with the client or has a ﬁnancial interest that is material to the close relative or enables the relative to exercise signiﬁcant inﬂuence over the client. Immaterial ownership interests of close family members, deﬁned as a parent, sibling, or nondependent child, do not normally impair independence. Independence is also not impaired if the covered member is not aware of the close relative’s ownership interest. Similar rules apply to other individuals in a position to inﬂuence the audit engagement or partners in the audit-engagement ofﬁce. However, in these cases, the ownership interest does not impair independence unless the ownership interest is material to the close relative and allows the close relative to exercise signiﬁcant inﬂuence over the audit client. Joint Investor or Investee Relationship with Client Assume, for example, that a CPA owns stock in a nonaudit client, Jackson Company. Frank Company, which is an audit client, also owns stock in Jackson Company. This may be a violation of Rule 101. Interpretation 101-8 addresses situations where the client is either an investor or investee for a nonclient in which the CPA has an ownership interest. Apago PDF Enhancer 1. Client investor. If the client’s investment in the nonclient is material, any direct or material indirect investment by the CPA in the nonclient investee impairs independence. If the client’s investment is not material, independence is impaired only if the CPA’s investment is material. 2. Client investee. If investment in a client is material to a nonclient investor, any direct or material indirect investment by the CPA in the nonclient impairs independence. If the nonclient’s investment in the client is not material, independence is not impaired unless the CPA’s investment in the nonclient allows the CPA to exercise signiﬁcant inﬂuence over the nonclient. Director, Ofﬁcer, Management, or Employee of a Company If a CPA is a member of the board of directors or an ofﬁcer of a client company, his or her ability to make independent evaluations of the fair presentation of ﬁnancial statements is affected.	Alvin
Even if holding one of these positions did not actually affect the auditor’s inde - pendence, the frequent involvement with management and the decisions it makes is likely to affect how statement users perceive the CPA’s independence. To eliminate this possibility, interpretations prohibit covered members, partners, and professional staff in the ofﬁce of the partner responsible for the attest engagement from being a director or ofﬁcer of an audit client company. Similarly, the auditor cannot be an underwriter, voting trustee, promoter, or trustee of a client’s pension fund, or act in any other capacity of management, or be an employee of the company. Independence can also be impaired when a former partner or member of the audit ﬁrm leaves the ﬁrm and is employed by the client in a key position, unless certain conditions are met. For example, the audit engagement team may need to modify audit 92 Part 1 / THE AUDITING PROFESSION procedures to reduce the risk that the former employee has knowledge of the audit plan, and the ﬁrm will need to evaluate whether members of the engagement team can maintain an effective level of professional skepticism when evaluating audit infor mation and other representations provided by the former ﬁrm member. Independence can also be impaired when a member of the audit team discusses potential employment or receives an offer of employment from the audit client. In those situations, inde pendence can be preserved if the individual promptly reports the offer to appropriate ﬁrm personnel and is removed from the engagement until the offer is accepted or rejected. Interpretations permit CPAs to do audits and be honorary directors or trustees for not-for-proﬁt organizations, such as charitable and religious organizations, as long as the position is purely honorary. To illustrate, it is common for a partner of the CPA ﬁrm doing the audit of a city’s United Fund drive to also be an honorary director, along with many other civic leaders. The CPA cannot vote or participate in any management functions. When there is a lawsuit or intent to start a lawsuit between a CPA ﬁrm and its client, the ability of the CPA ﬁrm and client to remain objective is questionable. The interpretations regard such litigation as a violation of Rule 101 for the current audit. For example, if management sues a CPA ﬁrm claiming a deﬁciency in the previous audit, the CPA ﬁrm is not considered independent for the current year’s audit. Similarly, if the CPA ﬁrm sues management for fraudulent ﬁnancial reporting or deceit, independence is lost. The CPA ﬁrm and client company or management may be defendants in a suit brought by a third party, such as in a securities class action. This litigation in itself does not affect inde - pendence. However, independence may be affected if cross-claims between the auditor and client are ﬁled that have a signiﬁcant risk of a material loss to the CPA ﬁrm or client. Litigation by the client related to tax or other nonaudit services, or litigation against both the client and the CPA ﬁrm by another party, does not usually impair independence. The key consideration in all such suits is the likely effect on the ability of client, management, and CPA ﬁrm personnel to remain objective and comment freely. Apago PDF Enhancer If a CPA records transactions in the journals for the client, posts monthly totals to the general ledger, makes adjusting entries, and subsequently does an audit, there is some question as to whether the CPA can be independent in the audit role. The inter - pretations permit a CPA ﬁrm to do both bookkeeping and auditing for a private company audit client. The AICPA’s conclusion is presumably based on a comparison of the effect on independence of having both bookkeeping and auditing services performed by the same CPA ﬁrm with the additional cost of having a different CPA ﬁrm do the audit. There are three important requirements that the auditor must satisfy before it is acceptable to do bookkeeping and auditing for the client:	Alvin
1. The client must accept full responsibility for the ﬁnancial statements. The client must be sufﬁciently knowledgeable about the enterprise’s activities and ﬁnancial condition and the applicable accounting principles so that the client can reasonably accept such responsibility, including the fairness of valuation and presentation and the adequacy of disclosure. When necessary, the CPA must discuss accounting matters with the client to be sure that the client has the required degree of understanding. 2. The CPA must not assume the role of employee or of management conducting the operations of an enterprise. For example, the CPA cannot consummate transactions, have custody of assets, or exercise authority on behalf of the client. The client must prepare the source documents on all transactions in sufﬁcient detail to identify clearly the nature and amount of such transactions and maintain accounting control over data processed by the CPA, such as control totals and document counts. 3. The CPA, in making an audit of ﬁnancial statements prepared from books and records that the CPA has maintained completely or in part, must conform to Litigation Between CPA Firm and Client Bookkeeping and Other Services Chapter 4 / PROFESSIONAL ETHICS 93 auditing standards. The fact that the CPA has processed or maintained certain records does not eliminate the need to make sufﬁcient audit tests. The ﬁrst two requirements are often difﬁcult to satisfy for a smaller company with an owner who may have little knowledge of or interest in accounting or processing transactions. The AICPA independence rules require members to adhere to more restrictive independence rules of other regulatory bodies, such as the SEC. As a result, it is not permissible for an audit ﬁrm to provide bookkeeping services to a public company audit client under both SEC rules and the AICPA rules on independence. Consulting and Other Nonaudit Services CPA ﬁrms offer many other services to attest clients that may potentially impair independence. Such activities are permissible as long as the member does not perform management functions or make management decisions. For example, a CPA ﬁrm may assist in the installation of a client’s information system as long as the client makes necessary management decisions about the design of the system. Subject to some restrictions, CPA ﬁrms may also provide internal auditing and other extended auditing services to their clients as long as management maintains responsibility for the direction and oversight of the internal audit function. The CPA ﬁrm must assess the client’s willingness and ability to perform all management functions related to the engagement and must document the under - standing with the client. The understanding should include a description of the services, the engagement objectives, any limitations on the engagement, the member’s responsibilities, and the client’s agreement to accept its responsibilities. As indicated in the discussion of bookkeeping services, the more restrictive SEC independence rules concerning provision of nonaudit services apply to AICPA members when providing services to public company audit clients. As a result, providing nonaudit services that are prohibited by the SEC to a public company audit client would be a violation of AICPA rules as well as PCAOB and SEC rules. These Apago PDF Enhancer prohibited nonaudit services were listed on page 88. Under Rule 101 and its rulings and interpretations, independence is considered impaired if billed or unbilled fees remain unpaid for professional services provided more than 1 year before the date of the report. Such unpaid fees are considered a loan from the auditor to the client and are therefore a violation of Rule 101. Unpaid fees from a client in bankruptcy do not violate Rule 101. Audit ﬁrms frequently join larger groups or associations of other ﬁrms to enhance their capabilities to provide professional services. When they share certain characteristics, such as a common brand name, common control, common business strategy, common	Alvin
quality control procedures, or they share in proﬁts, costs, or professional resources, the network ﬁrm is required to be independent of audit and review clients of other network ﬁrms. While the guidance contained in Rule 101 and related interpretations address many speciﬁc circumstances that may impair independence, CPAs are likely to face other circumstances that may threaten independence. To assist CPAs in evaluating indepen - dence issues, the Professional Ethics Executive Committee developed an independence conceptual framework consistent with a similar framework in the IESBA Code that provides a risk-based approach to analyzing independence matters. This risk- based approach involves a three-step process for assessing whether independence is impaired: 1. Identify and evaluate circumstances that might threaten independence. For example, a CPA ﬁrm’s reliance on revenue from a single audit client may be sig - niﬁcant, posing a potential threat to the ﬁrm’s independence from that client. 2. Determine whether safeguards are already in place or can be implemented that elimi - nate or sufﬁciently mitigate the threat. For example, to address the threat associated Unpaid Fees Network of Firms Independence Conceptual Framework 94 Part 1 / THE AUDITING PROFESSION with the excessive reliance on revenues from a single audit client, the CPA ﬁrm has established policies to closely monitor the ﬁrm’s reliance on a single client’s revenue and those policies include speciﬁc actions that prevent excessive reliance. 3. Conclude that independence is impaired if no safeguards are available to eliminate an unacceptable threat or reduce it to an acceptable level. In making this judgment, the CPA considers whether the circumstance would lead a reasonable person aware of all the relevant facts to conclude that there is an unacceptable threat to the CPA’s independence. The independence framework outlines seven broad categories of threats to independence, explores common issues associated with these kinds of threats, and describes examples of the types of safeguards that can be used to mitigate or eliminate threats to independence. OTHER RULES OF CONDUCT Although independence is critical to public conﬁdence in CPAs, it is also important that auditors adhere to the other rules of conduct listed in Table 4-1 (p. 102). We begin by discussing the rules for integrity and objectivity. Integrity means impartiality in performing all services. Rule 102 on integrity and objectivity is presented below: Integrity and Objectivity OBJECTIVE 4-7 Understand the require ments of other rules under the AICPA Code. 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 or her judgment to others. Apago PDF Enhancer To illustrate the meaning of integrity and objectivity, assume the auditor believes that accounts receivable may not be collectible but accepts management’s opinion without an independent evaluation of collectibility. The auditor has subordinated his or her judgment and thereby lacks objectivity. Now assume a CPA is preparing the tax return for a client and, as a client advocate, encourages the client to take a deduction on the returns that the CPA believes is valid, but for which there is some but not complete support. This is not a violation of either objectivity or integrity, because it is acceptable for the CPA to be a client advocate in tax and management services. If the CPA encourages the client to take a deduction for which there is no support but has little chance of discovery by the IRS, a violation has occurred. That is a misrepresentation of the facts; therefore, the CPA’s integrity has been impaired. Audit staff members should not subordinate their judgment to supervisors on the audit. Staff auditors are responsible for their own judgments documented in the audit ﬁles and should not change those conclusions at the request of supervisors on the	Alvin
engagement unless the staff auditor agrees with the supervisor’s conclusion. Firm procedures should allow assistants to document situations where they disagree with a conclusion involving a signiﬁcant matter. Freedom from conﬂicts of interest means the absence of relationships that might interfere with objectivity or integrity. For example, it is inappropriate for an auditor who is also an attorney to represent a client in legal matters. The attorney is an advo - cate for the client, whereas the auditor must be impartial. An interpretation of Rule 102 states that apparent conﬂicts of interest may not be a violation of the rules of conduct if the information is disclosed to the member’s client or employer. For example, if a partner of a CPA ﬁrm recommends that a client have the security of its Internet Web site evaluated by a technology consulting ﬁrm that is owned by the partner’s spouse, a conﬂict of interest may appear to exist. No violation Chapter 4 / PROFESSIONAL ETHICS 95 of Rule 102 occurs if the partner informs the client’s management of the relationship and management proceeded with the evaluation with that knowledge. The interpreta - tion makes it clear that the independence requirements under Rule 101 cannot be eliminated by these disclosures. Rule 102 also applies to CPAs who are not in public practice. For example, a CPA who, as an employee of an entity, makes false or misleading entries or representations in ﬁnancial statements is in violation of Rule 102. Technical Standards The next three standards of the Code relate to the auditor’s adherence with the require - ments of technical standards. The following are the requirements of the technical standards: 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. Undertake only those professional services that the member or the 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 consulting, tax, or other professional services shall comply with standards promulgated by bodies designated by Council. Apago PDF Enhancer 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 generally accepted accounting principles or (2) state that he or she is not aware of any material modiﬁcations that should be made to such statements or data in order for them to be in conformity with generally accepted accounting principles, if such statements or data contain any departure from an accounting principle promulgated by bodies designated by Council to establish such principles that has a material effect on the statements or data taken as a whole. If, however, the statements or data contain such a departure and the member can demonstrate that due to unusual circumstances the ﬁnancial statements or data would otherwise have been misleading, the member can comply with the rule by describing the departure, its approximate effects, if practicable, and the reasons why compliance with the principle would result in a misleading statement. The primary purpose of the requirements of Rules 201 to 203 is to provide support for the ASB, PCAOB, FASB, IASB, and other technical standard-setting bodies. In May 2008 the AICPA designated the IASB as the body to establish professional standards with respect to international ﬁnancial accounting and reporting principles under Rule 202 of the Code.	Alvin
Notice that requirements A and B of Rule 201 are the same in substance as general auditing standards 1 and 3, and C and D of Rule 201 have the same intent as ﬁeld work standards 1 and 3. The only difference is that Rule 201 is stated in terms that apply to all types of services, whereas auditing standards apply only to audits. Rule 202 makes it clear that when a practitioner violates an auditing standard, the rules of conduct are also automatically violated. It is essential that practitioners not disclose conﬁdential information obtained in any type of engagement without the consent of the client. The speciﬁc requirements of Rule 301 related to conﬁdential client information are shown in the box on the following page. Confidentiality 96 Part 1 / THE AUDITING PROFESSION Need for Conﬁdentiality During audits and most other types of engagements, practitioners obtain considerable conﬁdential information, including ofﬁcers’ salaries, product pricing and advertising plans, and product cost data. If auditors divulge this information to outsiders or to client employees who have been denied access to the information, their relationship with management can be seriously strained, and in extreme cases, the client can be harmed. The conﬁdentiality requirement applies to all services provided by CPA ﬁrms, including tax and manage ment services. Ordinarily, the CPA’s audit ﬁles can be made available to someone else only with the express permission of the client. This is the case even if a CPA sells the practice to another CPA ﬁrm or is willing to permit a successor auditor to examine the audit docu - mentation prepared for a former client. Rule 301—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 his or her professional obligations under Rules 202 and 203, (2) to affect in any way the member’s obligation to comply with a validly issued and enforceable subpoena or summons, or to prohibit a member’s compliance with applicable laws and government regulations, (3) to prohibit review of a member’s professional practice under AICPA or state CPA society or Board of Accountancy authorization, or (4) to preclude a member from initiating a complaint with, or responding to any inquiry made by, the professional ethics division or trial board of the Institute or a duly constituted investigative or disciplinary body of a state CPA society or Board of Accountancy. Members of any of the bodies identiﬁed in (4) above and members involved with professional practice reviews identiﬁed in (3) above shall not use to their own advantage or disclose any member’s conﬁdential client information that comes to their attention in carrying out those activities. This prohibition shall not restrict members’ exchange of information in connection with the investigative or disciplinary proceedings described in (4) above or the professional practice reviews described in (3) above. Exceptions to Conﬁdentiality As stated in the second paragraph of Rule 301, there are four exceptions to the conﬁdentiality requirements. All four exceptions concern responsibilities that are more important than maintaining conﬁdential relations with the client. Apago PDF Enhancer 1. Obligations related to technical standards. Suppose that 3 months after an unqualiﬁed audit report was issued, the auditor discovers that the ﬁnancial statements were materially misstated. When the chief executive ofﬁcer is confronted, he responds that even though he agrees that the ﬁnancial state - ments are misstated, conﬁdentiality prevents the CPA from informing anyone. Rule 301 makes it clear that the auditor’s responsibility to discharge professional standards is greater than that for conﬁdentiality. In such a case, a revised, correct audit report must be issued. Note, however, that the conﬂict seldom occurs. 2. Subpoena or summons and compliance with laws and regulations. Legally,	Alvin
information is called privileged information if legal proceedings cannot require a person to provide the information, even if there is a subpoena. Information communicated by a client to an attorney or by a patient to a physician is privileged. Information obtained by a CPA from a client generally is not privileged. Exception (2) of Rule 301 is therefore needed to put CPA ﬁrms in compliance with the law. 3. Peer review. When a CPA or CPA ﬁrm conducts a peer review of the quality controls of another CPA ﬁrm, it is normal practice to examine several sets of audit ﬁles. If the peer review is authorized by the AICPA, state CPA society, or state Board of Accountancy, client permission to examine the audit docu - mentation is not needed. Requiring permission from each client may restrict access of the peer reviewers and would be a time burden on all concerned. Chapter 4 / PROFESSIONAL ETHICS 97 Naturally, the peer reviewers must keep the information obtained conﬁdential and cannot use the information for other purposes. Access to ﬁles for PCAOB inspections is also allowed to comply with the requirements of the Sarbanes–Oxley Act. As noted earlier, access to audit ﬁles is allowed to comply with laws and regulations. 4. Response to ethics division. If a practitioner is charged with inadequate technical performance by the AICPA Ethics Division trial board under any of Rules 201 to 203, board members are likely to want to examine audit documentation. Exception (4) in Rule 301 prevents a CPA ﬁrm from denying the inquirers access to audit documentation by saying that it is conﬁdential information. Similarly, a CPA ﬁrm that observes substandard audit documentation of another CPA ﬁrm cannot use conﬁdentiality as the reason for not initiating a complaint of substandard performance against the ﬁrm. Contingent Fees To help CPAs maintain objectivity in conducting audits or other attestation services, basing fees on the outcome of engagements is prohibited. The requirements of Rule 302 related to contingent fees are shown below. Rule 302—Contingent Fees 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 member’s ﬁrm performs: (a) an audit or review of a ﬁnancial statement; or (b) 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 (c) 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 Apago PDF Enhancer client. The prohibition in (1) above applies during the period in which the member or the member’s ﬁrm is engaged to perform any of the services listed above and the period covered by any historical ﬁnancial statements involved in any such listed services. Except as stated in the next sentence, a contingent fee is a fee established for the performance of any service pursuant to 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 service. Solely for purposes of this rule, fees are not regarded as being contingent if ﬁxed by courts or other public authorities, or, in tax matters, if determined based on the results of judicial proceedings or the ﬁndings of governmental agencies. A member’s fees may vary depending, for example, on the complexity of services rendered. To illustrate the need for a rule on contingent fees, suppose a CPA ﬁrm was per - mitted to charge a fee of $50,000 if an unqualiﬁed opinion was provided but only $25,000 if the opinion was qualiﬁed. Such an agreement may tempt a practitioner to issue the wrong opinion and is a violation of Rule 302. It is also a violation of Rule 302 for members to prepare an original or amended tax return or a claim for tax refunds	Alvin
for a contingent fee. CPA ﬁrms are permitted to charge contingent fees for nonattestation services, unless the CPA ﬁrm is also performing attestation services for the same client. For example, it is not a violation for a CPA to charge fees as an expert witness determined by the amount awarded to the plaintiff or to base consulting fees on a percentage of a bond issue if the CPA ﬁrm does not also do an audit or other attestation for the same client. Prohibiting contingent fees for attestation services and tax return preparation is important because of the importance of independence and objectivity. Because CPAs compete when providing other services with other professions who do not have contingent fee restrictions, it would be unfair to prohibit CPAs from providing these services on the same basis. When these nonattestation services are provided for a 98 Part 1 / THE AUDITING PROFESSION client receiving attestation services, the need for independence and objectivity prevails and the auditor is not allowed to provide the services on a contingent fee basis. Because of the special need for CPAs to conduct themselves in a professional manner, the Code has a speciﬁc rule prohibiting acts discreditable to the profession. Although a discreditable act is not well deﬁned in the rules or interpretations, some of the requirements are discussed below. Discreditable Acts Rule 501—Acts Discreditable A member shall not commit an act discreditable to the profession. Do excessive drinking, rowdy behavior, or other acts that many people consider unprofessional constitute a discreditable act? Probably not. Determining what con - stitutes professional behavior continues to be the responsibility of each professional. For guidance as to what constitutes a discreditable act, the AICPA bylaws provide clearer guidelines than the AICPA Code of Professional Conduct. The bylaws state that membership in the AICPA can be terminated without a hearing for judgment of convic - tion for any of the following four crimes: (1) a crime punishable by imprison ment for more than 1 year; (2) the willful failure to ﬁle any income tax return that the CPA, as an individual taxpayer, is required by law to ﬁle; (3) the ﬁling of a false or fraudulent income tax return on the CPA’s or client’s behalf; or (4) the willful aiding in the preparation and presentation of a false and fraudulent income tax return of a client. Observe that three of these deal with income tax matters of the member or a client. Interpretations of Rule 501 identify several acts that are considered to be discredit - able. For example, it is discreditable to retain a client’s records after a demand is made for them or whenever a member is found to have violated any federal, state, or local antidiscrimination laws. The solicitation or disclosure of the Uniform CPA examination Apago PDF Enhancer questions and answers without permission of the AICPA is also not permitted. Rule 501 applies to all CPAs, even those not in public practice. For example, a member is considered to have committed an act discreditable if by his or her negli gence others are made or permitted or directed to make materially false and misleading entries in the ﬁnancial statements and records of an entity, the member fails to correct ﬁnancial statements that are materially false and misleading, or the member signs or permits or directs another to sign a document containing materially false and misleading information. Also, if a member prepares ﬁnancial statements or related information for reporting to governmental bodies, commissions, or regulatory agencies, the member should follow the requirements of such organizations in addition to requirements of accounting standards. Other interpretations of Rule 501 describe additional acts considered to be discreditable: 1. Compliance with standards on government audits and requirements of government bodies and agencies. Audits of government units and federal grant recipients must be done in compliance with government auditing standards, in addition	Alvin
to GAAS. When a member accepts an engagement that involves reporting to a regulatory agency such as the SEC, the member must follow the additional requirements of the regulatory agency, in addition to auditing standards. If the additional requirements are not followed, the reasons should be noted in the report. Inclusion of indemniﬁcation clauses in engagement letters. Certain governmental bodies, such as federal banking regulators, state insurance commissions, and the SEC prohibit entities they regulate from including certain types of indem - niﬁcation and limitation of liability provisions in agreements related to the performance of audit or other attest services. Members violate Rule 501 if they include such provision in their engagement letters related to the performance of audit or attest services for these entities. 2. Chapter 4 / PROFESSIONAL ETHICS 99 Advertising and Solicitation To encourage CPAs to conduct themselves professionally, the rules also prohibit advertising or solicitation that is false, misleading, or deceptive. Commissions and Referral Fees 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 solicitation in a manner that is false, misleading, or deceptive. Solicitation by the use of coercion, overreaching, or harassing conduct is prohibited. Solicitation consists of the various means that CPA ﬁrms use to engage new clients other than accepting new clients who approach the ﬁrm. Examples include taking prospective clients to lunch to explain the CPA’s services, offering seminars on current tax law changes to potential clients, and advertising in the Yellow Pages of a phone book. The last example is advertising, which is only one form of solicitation. Many CPA ﬁrms have developed sophisticated advertising for national journals read by businesspeople and for local newspapers. It is common for CPA ﬁrms to identify potential clients being serviced by other CPA ﬁrms and make formal and informal pre - sentations to convince management to change CPA ﬁrms. Price bidding for audits and other services is now common and often highly competitive. As a result of these changes, some companies now change auditors more often than previously to reduce audit cost. Has the quality of audits become endangered by these changes? Although there have been several recent high-proﬁle cases involving apparent audit failures, the existing legal exposure of CPAs, peer review requirements, and the potential for interference by the SEC and government has kept audit quality high. Commissions are compensation paid for recommending or referring a third party’s product or service to a client or recommending or referring a client’s product or service to a third party. Restrictions on commissions are similar to the rules on contingent fees. CPAs are prohibited from receiving commissions for a client who is receiving attestation services from the CPA ﬁrm. Commissions are permissible for other clients, but they must be disclosed. Referral fees for recommending or referring the services of another CPA are not considered commissions and are not restricted. However, any referral fees for CPA services must also be disclosed. Apago PDF Enhancer Rule 503—Commissions and Referral Fees A. Prohibited commissions. 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: (a) an audit or review of a ﬁnancial statement; or (b) 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 (c) an examination of prospective ﬁnancial information. This prohibition applies during the period in which the member is engaged to perform any of the	Alvin
services listed above and the period covered by any historical ﬁnancial statements involved in such listed services. B. Disclosure of permitted commissions. A member in public practice who is not prohibited by this rule from performing services for or receiving a commission and who is paid or expects to be paid a commission shall disclose that fact to any person or entity to whom the member recommends or refers a product or service to which the commission relates. C. Referral fees. Any member who accepts a referral fee for recommending or referring any service of a CPA to any person or entity or who pays a referral fee to obtain a client shall disclose such acceptance or payment to the client. The rule for commissions and referral fees means that a CPA ﬁrm does not violate AICPA rules of conduct if it sells such things as real estate, securities, and entire ﬁrms 100 Part 1 / THE AUDITING PROFESSION Form of Organization and Name on a commission basis if the transaction does not involve a client who is receiving attestation services from the same CPA ﬁrm. This rule enables CPA ﬁrms to proﬁt by pro - viding many services to nonattestation services clients that were previously prohibited. The reason for the AICPA continuing to prohibit commissions for any attestation service client is the need to ensure that the CPA ﬁrm is independent. This requirement and the reasons for it are the same as those discussed under contingent fees. The Board of Accountancy in the state in which the ﬁrm is licensed may have more restrictive rules than the AICPA’s. The CPA ﬁrm must follow the more restrictive requirements if different rules exist. The organizational structure of CPA ﬁrms was ﬁrst discussed in Chapter 2. The rules of conduct restrict the permissible forms of organization and prohibit a member from practicing under a ﬁrm name that is misleading. Rule 505 permits practitioners to organize in any of six forms, as long as they are permitted by state law: proprietorship, general partnership, general corporation, profes - sional corporation (PC), limited liability company (LLC), or limited liability partnership (LLP). Each of these forms of organization was discussed in Chapter 2 (pp. 28–29). Rule 505—Form of Organization and Name A member may practice public accounting only in a form of organization permitted by state 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. Ownership of CPA ﬁrms by non-CPAs is allowed under the following conditions: Apago PDF Enhancer • CPAs must own a majority of the ﬁrm’s ﬁnancial interests and voting rights. • A CPA must have ultimate responsibility for all ﬁnancial statement attest, compilation, and other services provided by the ﬁrm that are governed by Statements on Auditing Standards or Statements on Standards for Accounting and Review Services. • Owners must at all times own their equity in their own right. • The following rules apply to all non-CPA owners: 1. They must actively provide services to the ﬁrm’s clients as their principal occupation. 2. They cannot hold themselves out as CPAs but may use any title permitted by state law such as principal, owner, ofﬁcer, member, or shareholder. 3. They cannot assume ultimate responsibility for any ﬁnancial statement attest or compilation engagement. 4. They are not eligible for AICPA membership but must abide by the AICPA Code of Professional Conduct. A recent development has been the acquisition of CPA ﬁrms by corporate entities. In such instances, the CPA ﬁrm may form a subsidiary to provide attest services to clients. These alternative practice structures are permissible, but an AICPA Council resolution makes it clear that to protect the public interest, CPAs have the same responsibility for	Alvin
the conduct of their attest work as they have in traditional practice structures. A CPA ﬁrm may use any name as long as it is not misleading. Most ﬁrms use the name of one or more of the owners. It is not unusual for a ﬁrm name to include the names of ﬁve or more owners. A CPA ﬁrm can use a trade name, although this is unusual in practice. Names such as Marshall Audit Co. or Chicago Tax Specialists are permissible if they are not misleading. A summary of the rules of conduct is included in Table 4-1. Chapter 4 / PROFESSIONAL ETHICS 101 TABLE 4-1 Summary of Rules of Conduct Rules of Conduct Applicability Summary of Rules Number Topic All Members Members in Public Practice 101 Independence x A member in public practice shall be independent in the 102 Integrity and objectivity 201 General standards 202 Compliance with standards 203 301 Accounting principles Conﬁdential client information 302 Contingent fees x x x x performance of professional services as required by standards promulgated by bodies designated by Council. In performing 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 or her judgment to others. For all services, a member shall comply with the following professional standards and interpretations thereof by bodies designated by Council: (1) undertake only those professional services that the member can reasonably expect to complete with professional competence, (2) exercise due professional care, (3) adequately plan and supervise all engagements, and (4) obtain sufﬁcient relevant data to afford a reasonable basis for all conclusions or recommendations. A member who performs auditing, review, compilation, management consulting, tax, or other professional services shall comply with standards promulgated by bodies designated by Council. A member shall follow the professional audit reporting standards promulgated by bodies designated by Council in issuing reports about entities’ compliance with generally accepted accounting principles. Apago PDF Enhancer x A member in public practice shall not disclose any conﬁdential client information without the speciﬁc consent of the client, except for the four speciﬁc situations included in Rule 301. x x x x A member in public practice shall not perform for a contingent fee any professional service if the member also performs for the client an audit, review, or certain compilations of ﬁnancial statements, or an examination of prospective ﬁnancial statements. A member in public practice should also not prepare an original or amended tax return or claim for a tax refund for a contingent fee for any client. A member shall not commit an act discreditable to the profession. 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, overreaching, or harassing conduct is prohibited. A member in public practice shall not receive or pay a commission or referral fee for any client if the member also performs for the client an audit, review, or certain compilations of ﬁnancial statements, or an examination of prospective ﬁnancial statements. For nonprohibited commissions or referral fees, a member must disclose the existence of such fees to the client. A member may practice public accounting only in a form of organization permitted by state law or regulation whose characteristics conform to resolutions of Council and shall not practice public accounting under a ﬁrm name that is misleading. 501 502 503 Acts discreditable x Advertising and other forms of solicitation Commissions and referral fees 505 Form of organization and name 102 Part 1 / THE AUDITING PROFESSION Failure to follow the rules of conduct can result in expulsion from the AICPA. This by itself does not prevent a CPA from practicing public accounting, but it is an important social sanction. In addition to the rules of conduct, the AICPA bylaws	Alvin
provide for automatic suspension or expulsion from the AICPA for conviction of a crime punishable by imprisonment for more than 1 year and for various tax-related crimes. The AICPA Professional Ethics Division is responsible for investigating violations of the Code and deciding disciplinary action. The division’s investigations result from information obtained primarily from complaints of practitioners or other individuals, state societies of CPAs, or governmental agencies. A member can be automatically sanctioned without an investigation if the member has been disciplined by govern - mental agencies or other organizations that have been granted the authority to regulate accountants, such as the SEC and PCAOB. There are two primary levels of disciplinary action. For less serious, and probably unintentional violations, the division limits the discipline to a requirement of remedial or corrective action. An example is the unintentional failure to make sure that a small audit client included all disclosures in its ﬁnancial statements, which violates Rule 203 of the rules of conduct. The division is likely to require the member to attend a speciﬁed number of hours of continuing education courses to improve technical competence. The second level of disciplinary action is action before the Joint Trial Board. This board has authority to suspend or expel members from the AICPA for various violations of professional ethics. Typically, action by the board is reported in the Disciplinary Actions sections of the AICPA’s Web site, including the name and location of the person suspended or expelled and reasons for the action. Apago PDF Enhancer Even more important than expulsion from the AICPA are the rules of conduct, similar to the AICPA’s, that have been enacted by the Board of Accountancy of each of the 50 states. Because each state grants the individual practitioner a license to practice as a CPA, a signiﬁcant breach of a state Board of Accountancy’s code of conduct can result in the loss of the CPA certiﬁcate and the license to practice. Although it rarely happens, the loss removes the practitioner from public accounting. Most states adopt the AICPA rules of conduct, but several have more restrictive codes. For example, some states have retained restrictions on advertising and other forms of solicitation. In recent years, an increasing number of states have adopted codes of conduct more restrictive than the AICPA’s. ENFORCEMENT OBJECTIVE 4-8 Describe the enforcement mechanisms for the rules of conduct. Action by AICPA Professional Ethics Division Action by a State Board of Accountancy SUMMARY The demand for audit and other assurance services provided by CPA ﬁrms depends on public conﬁdence in the profession. This chapter discussed the role of ethics in society and the unique ethical responsibilities of CPAs. The professional activities of CPAs are governed by the AICPA Code of Profes sional Conduct, and auditors of public companies are also subject to oversight by the PCAOB and SEC. Foremost of all ethical responsibilities of CPAs is the need for inde pendence. The rules of conduct and interpretations provide guidance on permissible ﬁnancial and other interests to help CPAs maintain independence. Other rules of conduct are also designed to maintain public conﬁdence in the profession. The ethical responsibilities of CPAs are enforced by the AICPA for members and by state boards of accountancy for licensed CPAs. Chapter 4 / PROFESSIONAL ETHICS 103 ESSENTIAL TERMS Audit committee—selected members of a client’s board of directors whose respon - sibilities include helping auditors to remain independent of management Conﬁdential client information—client information that may not be disclosed without the speciﬁc consent of the client except under authoritative professional or legal investigation Direct ﬁnancial interest—the owner - ship of stock or other equity shares by members or their immediate family Ethical dilemma—a situation in which a decision must be made about the appro -	Alvin
priate behavior Ethics—a set of moral principles or values Independence appearance—the in auditor’s ability to maintain an unbiased viewpoint in the eyes of others Independence of mind—the auditor’s state of mind that enables an unbiased viewpoint in the performance of pro - fessional services; also described as “independence in fact” Indirect ﬁnancial interest—a close, but not direct, ownership relationship between the auditor and the client; an example is the ownership of stock by a member’s grandparent Privileged information—client infor - mation that the professional cannot be legally required to provide; information that an accountant obtains from a client is conﬁdential but not privileged REVIEW QUESTIONS 4-1 (Objective 4-1) What are the six core ethical values described by the Josephson Institute? What are some other sources of ethical values? Apago PDF Enhancer 4-2 (Objective 4-2) Describe an ethical dilemma. How does a person resolve an ethical dilemma? 4-3 (Objective 4-3) Why is there a special need for ethical behavior by professionals? Why do the ethical requirements of the CPA profession differ from those of other professions? 4-4 (Objective 4-4) List the four parts of the Code of Professional Conduct, and state the purpose of each. 4-5 (Objective 4-4) What organization is responsible for developing ethics standards at the international level? What are the fundamental principles of the international ethics standards? 4-6 (Objective 4-5) Distinguish between independence of mind and independence in appearance. State three activities that may not affect independence of mind but are likely to affect independence in appearance. 4-7 (Objective 4-5) Why is an auditor’s independence so essential? 4-8 (Objective 4-5) What consulting or nonaudit services are prohibited for auditors of public companies? What other restrictions and requirements apply to auditors when providing nonaudit services to public companies? 4-9 (Objective 4-6) Explain how the rules concerning stock ownership apply to partners and professional staff. Give an example of when stock ownership would be prohibited for each. 4-10 (Objective 4-5) Many people believe that a CPA cannot be truly independent when payment of fees is dependent on the management of the client. Explain two approaches that could reduce this appearance of lack of independence. 4-11 (Objective 4-7) After accepting an engagement, a CPA discovers that the client’s industry is more technical than he realized and that he is not competent in certain areas of the operation. What are the CPA’s options? 104 Part 1 / THE AUDITING PROFESSION 4-12 (Objective 4-7) Assume that an auditor makes an agreement with a client that the audit fee will be contingent upon the number of days required to complete the engagement. Is this a violation of the Code of Professional Conduct? What is the essence of the rule of professional ethics dealing with contingent fees, and what are the reasons for the rule? 4-13 (Objective 4-7) The auditor’s audit ﬁles usually can be provided to someone else only with the permission of the client. Give three exceptions to this general rule. 4-14 (Objective 4-7) Identify and explain factors that should keep the quality of audits high even though advertising and competitive bidding are allowed. 4-15 (Objective 4-7) Summarize the restrictions on advertising by CPA ﬁrms in the rules of conduct and interpretations. 4-16 (Objective 4-7) What is the purpose of the AICPA’s Code of Professional Conduct restriction on commissions as stated in Rule 503? 4-17 (Objective 4-7) State the allowable forms of organization a CPA ﬁrm may assume. MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS 4-18 (Objective 4-6) The following questions concern independence and the Code of Professional Conduct or GAAS. Choose the best response. a. What is the meaning of the generally accepted auditing standard that requires the auditor be independent? (1) The auditor must be without bias with respect to the client under audit.	Alvin
(2) The auditor must adopt a critical attitude during the audit. (3) The auditor’s sole obligation is to third parties. (4) The auditor may have a direct ownership interest in the client’s business if it is not material. Apago PDF Enhancer b. The independent audit is important to readers of ﬁnancial statements because it (1) determines the future stewardship of the management of the company whose ﬁnancial statements are audited. (2) measures and communicates ﬁnancial and business data included in ﬁnancial statements. (3) involves the objective examination of and reporting on management-prepared statements. (4) reports on the accuracy of all information in the ﬁnancial statements. c. An auditor strives to achieve independence in appearance to (1) maintain public conﬁdence in the profession. (2) become independent in fact. (3) comply with the generally accepted auditing standards of ﬁeld work. (4) maintain an unbiased mental attitude. 4-19 (Objective 4-7) The following questions concern possible violations of the AICPA Code of Professional Conduct. Choose the best response. a. In which one of the following situations would a CPA be in violation of the AICPA Code of Professional Conduct in determining the audit fee? (1) A fee based on whether the CPA’s report on the client’s ﬁnancial statements results in the approval of a bank loan. (2) A fee based on the outcome of a bankruptcy proceeding. (3) A fee based on the nature of the service rendered and the CPA’s expertise instead of the actual time spent on the engagement. (4) A fee based on the fee charged by the prior auditor. b. The AICPA Code of Professional Conduct states that a CPA shall not disclose any conﬁdential information obtained in the course of a professional engagement except with the consent of the client. In which one of the following situations would disclosure by a CPA be in violation of the code? Chapter 4 / PROFESSIONAL ETHICS 105 (1) Disclosing conﬁdential information in order to properly discharge the CPA’s responsibilities in accordance with the profession’s standards. (2) Disclosing conﬁdential information in compliance with a subpoena issued by a court. (3) Disclosing conﬁdential information to another accountant interested in pur - chasing the CPA’s practice. (4) Disclosing conﬁdential information during an AICPA authorized peer review. c. A CPA’s retention of client records as a means of enforcing payment of an overdue audit fee is an action that is (1) not addressed by the AICPA Code of Professional Conduct. (2) acceptable if sanctioned by the state laws. (3) prohibited under the AICPA rules of conduct. (4) a violation of generally accepted auditing standards. DISCUSSION QUESTIONS AND PROBLEMS 4-20 (Objectives 4-5, 4-6) The following situations involve the provision of nonaudit services. Indicate whether providing the service is a violation of AICPA rules or SEC rules including Sarbanes–Oxley requirements on independence. Explain your answer as necessary. a. Providing bookkeeping services to a public company. The services were preapproved by the audit committee of the company. b. Providing internal audit services to a public company that is not an audit client. c. Implementing a ﬁnancial information system designed by management for a private company. d. Recommending a tax shelter to a client that is publicly held. The services were pre - e. Providing internal audit services to a public company audit client with the preapproval approved by the audit committee. Apago PDF Enhancer of the audit committee. f . Providing bookkeeping services to an audit client that is a private company. 4-21 (Objectives 4-6, 4-7) Each of the following situations involves a possible violation of the AICPA’s Code of Professional Conduct. For each situation, state the applicable section of the rules of conduct and whether it is a violation. a. Emrich, CPA, provides tax services, management advisory services, and bookkeeping services and conducts audits for the same nonpublic client. Because the ﬁrm is small, the same person often provides all the services.	Alvin
b. Franz Marteens is a CPA, but not a partner, with 3 years of professional experience with Roberts and Batchelor, CPAs. He owns 25 shares of stock in an audit client of the ﬁrm, but he does not take part in the audit of the client, and the amount of stock is not material in relation to his total wealth. c. A nonaudit client requests assistance of M. Wilkenson, CPA, in the installation of a local area network. Wilkenson had no experience in this type of work and no knowledge of the client’s computer system, so he obtained assistance from a computer consultant. The consultant is not in the practice of public accounting, but Wilkenson is conﬁdent of his professional skills. Because of the highly technical nature of the work, Wilkenson is not able to review the consultant’s work. d. In preparing the personal tax returns for a client, Sarah Milsaps, CPA, observed that the deductions for contributions and interest were unusually large. When she asked the client for backup information to support the deductions, she was told, “Ask me no questions, and I will tell you no lies.” Milsaps completed the return on the basis of the information acquired from the client. e. Roberta Hernandez, CPA, serves as controller of a U.S. based company that has a significant portion of its operations in several South American countries. Certain 106 Part 1 / THE AUDITING PROFESSION government provisions in selected countries require the company to file financial statements based on international standards. Roberta oversees the issuance of the company’s financial statements and asserts that the statements are based on inter - national financial accounting standards; however the standards she uses are not those issued by the International Accounting Standards Board. f . Steve Custer, CPA, set up a casualty and ﬁre insurance agency to complement his auditing and tax services. He does not use his own name on anything pertaining to the insurance agency and has a highly competent manager, Jack Long, who runs it. Custer often requests Long to review the adequacy of a client’s insurance with management if it seems underinsured. He believes that he provides a valuable service to clients by informing them when they are underinsured. g. Seven small Seattle CPA ﬁrms have become involved in an information project by taking part in an interﬁrm working paper review program. Under the program, each ﬁrm designates two partners to review the audit ﬁles, including the tax returns and the ﬁnancial statements of another CPA ﬁrm taking part in the program. At the end of each review, the auditors who prepared the working papers and the reviewers have a conference to discuss the strengths and weaknesses of the audit. They do not obtain authorization from the audit client before the review takes place. h. Archer Ressner, CPA, stayed longer than he should have at the annual Christmas party of Ressner and Associates, CPAs. On his way home he drove through a red light and was stopped by a police officer, who observed that he was intoxicated. In a jury trial, Ressner was found guilty of driving under the inﬂuence of alcohol. Because this was not his ﬁrst offense, he was sentenced to 30 days in jail and his driver’s license was revoked for 1 year. 4-22 (Objectives 4-6, 4-7) Each of the following situations involves possible violations of the AICPA’s Code of Professional Conduct. For each situation, state whether it is a violation of the Code. In those cases in which it is a violation, explain the nature of the violation and the rationale for the existing rule. Apago PDF Enhancer a. The audit firm of Miller and Yancy, CPAs has joined an association of other CPA firms across the country to enhance the types of professional services the firm can provide. Miller and Yancy share resources with other firms in the association, including audit methodologies and audit manuals, and common IT systems for billing and time reporting. One of the partners in Miller and Yancy has a direct financial interest in the audit client of another firm in the association.	Alvin
b. Bruce Sullivan, CPA, is the audit partner on the engagement of Xylium Corporation, which is a public company. In structuring the agreement with the audit committee for the audit of Xylium’s financial statements, Sullivan included a clause that limits the liability of Sullivan’s firm so that shareholders of Xylium are prohibited from suing Sullivan and the firm for performance issues related to the audit. c. Jennifer Crowe’s audit client has a material investment in Polex, Inc. Jennifer’s non- dependent parents also own shares in Polex and Polex is not an attest client of Jennifer’s firm. The amount of her parent’s ownership in Polex is not significant to Jennifer’s net worth. d. Joe Stokely is a former partner in Bass and Sims, CPAs. Recently, Joe left the firm to become the chief operating officer of Lacy Foods, Inc., which is an audit client of Bass and Sims. In his new role, Joe has no responsibilities for financial reporting. Bass and Sims made significant changes to the audit plan for the upcoming audit. e. Odonnel Incorporated has struggled financially and has been unable to pay the audit fee to its auditor, Seale and Seale, CPAs, for the 2009 and 2010 audits. Seale and Seale is currently planning the 2011 audit. f . Connor Bradley is the partner in charge of the audit of Southern Pinnacle Bank. Bradley is in the process of purchasing a beach condo and has obtained mortgage financing from Southern Pinnacle. g. Jessica Alma has been serving as the senior auditor on the audit of Carolina BioHealth, Inc. Because of her outstanding work, the head of internal audit at Carolina BioHealth Chapter 4 / PROFESSIONAL ETHICS 107 extended her an offer of employment to join the internal audit department as an audit manager. When the discussions with Carolina BioHealth began, Jessica informed her office’s managing partner and was removed from the audit engagement. h. Lorraine Wilcox is a CPA and professor of accounting at a major state university. One of her former students recently sat for the Audit section of the CPA exam. One day, the student dropped by Lorraine’s office and told her about many of the questions and simulation content on the exam. Lorraine was grateful for the information, which will be helpful as she prepares the course syllabus for the next semester. i . Audrey Glover is a financial analyst in the financial reporting department of Technologies International, a privately held corporation. Audrey was asked to prepare several journal entries for Technologies International related to transactions that have not yet occurred. The entries are reflected in financial statements that the company recently provided to the bank in connection with a loan outstanding due to the bank. j . Austin and Houston, CPAs, is performing consulting services to help management of McAlister Global Services streamline its production operations. Austin and Houston structured the fee for this engagement to be a fixed percentage of costs savings that result once the new processes are implemented. Austin and Houston perform no other services for McAlister Global. 4-23 (Objective 4-5) The national stock exchanges require listed companies to have an independent audit committee. a. Describe an audit committee. b. What are the typical functions performed by an audit committee? c. Explain how an audit committee can help an auditor be more independent. d. Describe the nature of the audit firm’s communications with the audit committee regarding independence issues. e. Some critics of audit committees believe that they bias companies in favor of larger Apago PDF Enhancer and perhaps more expensive CPA ﬁrms. These critics contend that a primary concern of audit committee members is to reduce their exposure to legal liability. The committees will therefore recommend larger, more prestigious CPA ﬁrms, even if the cost is somewhat higher, to minimize the potential criticism of selecting an unquali - ﬁed ﬁrm. Evaluate these comments. Required 4-24 (Objectives 4-5, 4-6) The following relate to auditors’ independence: Required	Alvin
a. Why is independence so essential for auditors? b. Compare the importance of independence of CPAs with that of other professionals, such as attorneys. c. Explain the difference between independence in appearance and of mind. d. Assume that a partner of a CPA ﬁrm owns two shares of stock of a large audit client on which he serves as the engagement partner. The ownership is an insigniﬁcant part of his total wealth. (1) Has he violated the Code of Professional Conduct? (2) Explain whether the ownership is likely to affect the partner’s independence of mind. (3) Explain the reason for the strict requirements about stock ownership in the rules of conduct. e. Discuss how each of the following could affect independence of mind and inde- pendence in appearance, and evaluate the social consequence of prohibiting auditors from doing each one: (1) Owning stock in a client company (2) Having bookkeeping services for an audit client performed by the same person who does the audit (3) Having the annual audit performed by the same audit team, except for assistants, for 5 years in a row (4) Having the annual audit performed by the same CPA ﬁrm for 10 years in a row 108 Part 1 / THE AUDITING PROFESSION (5) Having management select the CPA ﬁrm (6) Recommending adjusting entries to the client’s ﬁnancial statements and preparing ﬁnancial statements, including footnotes, for the client (7) Having management services for an audit client performed by individuals in a department that is separate from the audit department f . Which of (1) through (7) are prohibited by the AICPA Code of Professional Conduct? Which are prohibited by the Sarbanes–Oxley Act or the SEC? 4-25 (Objective 4-6) Marie Janes encounters the following situations in doing the audit of a large auto dealership. Janes is not a partner. 1. The sales manager tells her that there is a sale (at a substantial discount) on new cars that is limited to long-established customers of the dealership. Because her ﬁrm has been doing the audit for several years, the sales manager has decided that Janes should also be eligible for the discount. 2. The auto dealership has an executive lunchroom that is available free to employees above a certain level. The controller informs Janes that she can also eat there any time. 3. Janes is invited to and attends the company’s annual Christmas party. When presents are handed out, she is surprised to ﬁnd her name included. The present has a value of approximately $200. Use the three-step process in the AICPA’s independence conceptual framework to assess whether Janes’ independence has been impaired. Required a. Describe how each of the situations might threaten Janes’ independence from the auto dealership. b. Identify a safeguard that Janes’ firm could impose that would eliminate or mitigate the threat of each situation to Janes’ independence. c. Assuming no safeguards are in place and Janes accepts the offer or gift in each situation, discuss whether she has violated the rules of conduct. d. Discuss what Janes should do in each situation. Apago PDF Enhancer 4-26 (Objective 4-6) Ann Archer serves on the audit committee of JKB Communications, Inc., a telecommunications start-up company. The company is currently a private company. One of the audit committee’s responsibilities is to evaluate the external auditor’s inde - pendence in performing the audit of the company’s ﬁnancial statements. In conducting this year’s evaluation, Ann learned that JKB Communications’ external auditor also performed the following IT and e-commerce services for the company: 1. Installed JKB Communications’ information system hardware and software selected by JKB management. 2. Supervised JKB Communications’ personnel in the daily operation of the newly installed information system. 3. Customized a prepackaged payroll software application, based on options and speci - ﬁcations selected by management. 4. Trained JKB Communications’ employees on the use of the newly installed informa - tion system. 5. Determined which JKB Communications’ products would be offered for sale on the	Alvin
company’s Internet Web site. 6. Operated JKB Communications’ local area network for several months while the company searched for a replacement after the previous network manager left the company. Consider each of the preceding services separately. Evaluate whether the performance of each service violates the AICPA’s Code of Professional Conduct. Required 4-27 (Objectives 4-6, 4-7) The following are situations that may violate the Code of Professional Conduct. Assume, in each case, that the CPA is a partner. CASES Chapter 4 / PROFESSIONAL ETHICS 109 1. Contel, CPA, advertises in the local paper that his ﬁrm does the audit of 14 of the 36 largest community banks in the state. The advertisement also states that the average audit fee, as a percentage of total assets for the banks he audits, is lower than any other CPA ﬁrm’s in the state. 2. Davis, CPA, sets up a small loan company specializing in loans to business executives and small companies. Davis does not spend much time in the business because he spends full time with his CPA practice. No employees of Davis’s CPA ﬁrm are involved in the small loan company. 3. Elbert, CPA, owns a material amount of stock in a mutual fund investment company, which in turn owns stock in Elbert’s largest audit client. Reading the investment company’s most recent ﬁnancial report, Elbert is surprised to learn that the company’s ownership in his client has increased dramatically. 4. Able, CPA, owns a substantial limited partnership interest in an apartment building. Frederick Marshall is a 100% owner in Marshall Marine Co. Marshall also owns a substantial interest in the same limited partnership as Able. Able does the audit of Marshall Marine Co. 5. Baker, CPA, approaches a new audit client and tells the president that he has an idea that could result in a substantial tax refund in the prior year’s tax return by appli - cation of a technical provision in the tax law that the client had overlooked. Baker adds that the fee will be 50% of the tax refund after it has been resolved by the Internal Revenue Service. The client agrees to the proposal. 6. Finigan, CPA, does the audit, tax return, bookkeeping, and management services work for Gilligan Construction Company. Mildred Gilligan follows the practice of calling Finigan before she makes any major business decision to determine the effect on her company’s taxes and the ﬁnancial statements. Finigan attends continuing education courses in the construction industry to make sure that she is technically competent and knowledgeable about the industry. Finigan normally attends board of directors meetings and accompanies Gilligan when she is seeking loans. Mildred Gilligan often jokingly introduces Finigan with this statement, “I have my three business partners— Apago PDF Enhancer my banker, the government, and my CPA, but Finny’s the only one that is on my side.’’ Required Discuss whether the facts in any of the situations indicate violations of the Code of Professional Conduct. If so, identify the nature of the violation(s). 4-28 (Objectives 4-2, 4-7) Barbara Whitley had great expectations about her future as she sat in her graduation ceremony in May 2010. She was about to receive her Master of Accountancy degree, and next week she would begin her career on the audit staff of Green, Thresher & Co., CPAs. Things looked a little different to Barbara in February 2011. She was working on the audit of Delancey Fabrics, a textile manufacturer with a calendar year-end. The pressure was enormous. Everyone on the audit team was putting in 70-hour weeks, and it still looked as if the audit wouldn’t be done on time. Barbara was doing work in the property area, vouching additions for the year. The audit program indicated that a sample of all items over $20,000 should be selected, plus a judgmental sample of smaller items. When Barbara went to take the sample, Jack Bean, the senior, had left the client’s ofﬁce and couldn’t answer her questions about the appropriate size of the judgmental sample. Barbara forged ahead with	Alvin
her own judgment and selected 50 smaller items. Her basis for doing this was that there were about 250 such items, so 50 was a reasonably good proportion of such additions. Barbara audited the additions with the following results: The items over $20,000 contained no misstatements; however, the 50 small items contained a large number of misstatements. In fact, when Barbara projected them to all such additions, the amount seemed quite signiﬁcant. A couple of days later, Jack Bean returned to the client’s ofﬁce. Barbara brought her work to Jack in order to apprise him of the problems she found and got the following response: “Gosh, Barbara, why did you do this? You were only supposed to look at the items over $20,000 plus 5 or 10 little ones. You’ve wasted a whole day on that work, and we can’t afford to spend any more time on it. I want you to throw away the schedules where you tested the last 40 small items and forget you ever did them.” 110 Part 1 / THE AUDITING PROFESSION When Barbara asked about the possible audit adjustment regarding the small items, none of which arose from the ﬁrst 10 items, Jack responded, “Don’t worry, it’s not material anyway. You just forget it; it’s my concern, not yours.’’ a. In what way is this an ethical dilemma for Barbara? b. Use the six-step approach discussed in the book to resolve the ethical dilemma. Required 4-29 (Objectives 4-1, 4-2, 4-3) In 2006, Arnold Diaz was a bright, upcoming audit manager in the South Florida ofﬁce of a national public accounting ﬁrm. He was an excellent technician and a good “people person.” Arnold also was able to bring new business into the ﬁrm as the result of his contacts in the rapidly growing Hispanic business community. Arnold was assigned a new client in 2007, XYZ Securities, Inc., a privately held broker–dealer in the secondary market for U.S. government securities. Neither Arnold nor anyone else in the South Florida ofﬁce had broker–dealer audit experience. However, the AICPA and Arnold’s ﬁrm had audit aids for the industry, which Arnold used to get started. Arnold was promoted to partner in 2007. Although this was a great step forward for him (he was a new staff assistant in 1998), Arnold was also under a great deal of pressure. Upon making partner, he was required to contribute capital to the ﬁrm. He also thought he must maintain a special image with his ﬁrm, with his clients, and within the Hispanic community. To accomplish this, Arnold maintained an impressive wardrobe, bought a BMW and a small speedboat, and traded up to a nicer house. He also entertained freely. Arnold ﬁnanced much of this higher living with credit cards. He had six American Express and banking cards and ran up a balance of about $40,000. After the audit was completed and before the 2008 audit was to begin, Arnold contacted Jack Oakes, the CFO of XYZ Securities, with a question. Arnold had noticed an anomaly in the ﬁnancial statements that he couldn’t understand and asked Oakes for an explanation. Oakes’s reply was as follows: “Arnold, the 2007 ﬁnancial statements were materially misstated and you guys just blew it. I thought you might realize this and call me, so here’s my advice to you. Keep your mouth shut. We’ll make up the loss we covered up last year, this year, and nobody will ever know the difference. If you blow the whistle on us, your ﬁrm will know you screwed up, and your career as the star in the ofﬁce will be down the tubes.” Apago PDF Enhancer Arnold said he’d think about this and get back to Oakes the next day. When Arnold called Oakes, he had decided to go along with him. After all, it would only be a “shift” of a loss between two adjacent years. XYZ is a private company and no one would be hurt or know the difference. In reality, only he was the person exposed to any harm in this situation, and he had to protect himself, didn’t he? When Arnold went to XYZ to plan for the 2008 audit, he asked Oakes how things were going, and Oakes assured him they were ﬁne. He then said to Oakes, “Jack, you guys are in the money business, maybe you can give me some advice. I’ve	Alvin
run up some debts and I need to reﬁnance them. How should I go about it?” After some discussions, Oakes volunteered a “plan.” Oakes would give Arnold a check for $15,000. XYZ would request its bank to put $60,000 in an account in Arnold’s name and guarantee the loan security on it. Arnold would pay back the $15,000 and have $45,000 of reﬁnancing. Arnold thought the plan was great and obtained Oakes’s check for $15,000. During 2008 through 2010, three things happened. First, Arnold incurred more debts and went back to the well at XYZ. By the end of 2010, he had “borrowed” a total of $125,000. Second, the company continued to lose money in various “off-the-books” investment schemes. These losses were covered up by falsifying the results of normal operations. Third, the audit team, under Arnold’s leadership, “failed to ﬁnd” the fraud and issued unqualiﬁed opinions. In 2009, Oakes had a tax audit of his personal 2008 return. He asked Arnold’s ﬁrm to handle it, and the job was assigned to Bob Smith, a tax manager. In reviewing Oakes’s records, Smith found a $15,000 check payable from Oakes to Diaz. Smith asked to see Diaz and inquired about the check. Arnold somewhat broke down and conﬁded in Smith about his problems. Smith responded by saying, “Don’t worry Arnold, I understand. And believe me, I’ll never tell a soul.” Chapter 4 / PROFESSIONAL ETHICS 111 In 2010, XYZ’s continuing losses caused it to be unable to deliver nonexistent securities when requested by a customer. This led to an investigation and bankruptcy by XYZ. Losses totaled in the millions. Arnold’s ﬁrm was held liable, and Arnold was found guilty of conspiracy to defraud. He is still in prison today. Required a. Try to put yourself in Arnold’s shoes. What would you have done (be honest with yourself now) when told of the material misstatement in mid-2008? b. What do you think of Bob Smith’s actions to help Arnold? c. Where does one draw the line between ethical and unethical behavior? 4-30 (Objective 4-2) Frank Dorrance, a senior audit manager for Bright and Lorren, CPAs, has recently been informed that the ﬁrm plans to promote him to partner within the next year or two if he continues to perform at the same high-quality level as in the past. Frank excels at dealing effectively with all people, including client personnel, professional staff, partners, and potential clients. He has recently built a bigger home for entertaining and has joined the city’s most prestigious golf and tennis club. He is excited about his future with the ﬁrm. Frank has recently been assigned to the audit of Machine International, a large wholesale company that ships goods throughout the world. It is one of Bright and Lorren’s most prestigious clients. During the audit, Frank determines that Machine International uses a method of revenue recognition called “bill and hold” that has been questioned by the SEC. After considerable research, Frank concludes that the method of revenue recognition is not appropriate for Machine International. He discusses the matter with the engagement partner, who concludes that the accounting method has been used for more than 10 years by the client and is appropriate, especially considering that the client does not ﬁle with the SEC. The partner is certain the ﬁrm would lose the client if the revenue recognition method is found inappropriate. Frank argues that the revenue recognition method was appropriate in prior years, but the SEC ruling makes it inappropriate in the current year. Frank recognizes the partner’s responsibility to make the ﬁnal decision, but he feels strongly enough to state that he plans to follow the requirements of auditing standards (AU 311) and include a statement in the audit ﬁles that he disagrees with the partner’s decision. The partner informs Frank that she is unwilling to permit such a statement because of the potential legal implications. However, she is willing to write a letter to Frank stating that she takes full responsibility for making the ﬁnal decision if a legal dispute ever arises. She	Alvin
concludes by saying, “Frank, partners must act like partners, not like loose cannons trying to make life difﬁcult for their partners. You have some growing up to do before I would feel comfortable with you as a partner.’’ Apago PDF Enhancer Required Use the six-step approach discussed in the book to resolve the ethical dilemma. INTERNET PROBLEM 4-1: IESBA CODE OF ETHICS Required The International Ethics Standards Board for Accountants (IESBA) Handbook of the Code of Ethics for Professional Accountants is available for free download from the IFAC website (www.ifac.org). Similarly, the AICPA’s Code of Professional Conduct is searchable at the AICPA’s website (www.aicpa.org). a. Locate both the IESBA Code and the AICPA Code on the respective websites. b. Compare the six Principles in the AICPA Code with the five Fundamental Principles in the IESBA Code. Evaluate where there are similarities and differences in concepts across the principles. c. One of the Principles in the AICPA Code is “public interest.” Describe how the IESBA Code addresses the concept of “public interest.” d. Compare the organizational structure of the AICPA Code with the IESBA Code. e. Identify where in the IESBA Code issues related to independence are addressed. 112 Part 1 / THE AUDITING PROFESSION C H A P T E R 5 LEGAL LIABILITY It Takes The Net Profit From Many Audits To Offset The Cost Of One Lawsuit Orange & Rankle, a CPA ﬁrm in San Jose, audited a small high-tech client that developed software. A signiﬁcant portion of the client’s capital was provided by a syndicate of 40 limited part ners. The owners of these interests, including several lawyers, were knowledgeable business and professional people. Orange & Rankle audited the company for 4 consecutive years, from its inception, for an average annual fee of approximately $66,000. The audits were well done by competent auditors. It was clear to the ﬁrm and to others who subsequently reviewed the audits that they complied with auditing standards in every way. In the middle of the ﬁfth year of the company’s existence, it became apparent that the marketing plan it had developed was overly optimistic and the company was going to require additional capital or a signiﬁcant strategy change. The limited partners were polled and refused to provide the capital. The company folded its tent and ﬁled bankruptcy. The limited partners lost their investment in the company. They subsequently ﬁled a lawsuit against all parties involved in the enterprise, including the auditors. Apago PDF Enhancer Over the next several years, the auditors proceeded through the process of preparing to defend themselves in the lawsuit. They went through complete discovery, hired an expert witness on auditing-related issues, ﬁled motions, and so forth. They attempted a settlement at various times, but the plaintiffs would not agree to a reasonable amount. Finally, during the second day of trial, the plaintiffs settled for a nominal amount. L E A R N I N G O B J E C T I V E S After studying this chapter, you should be able to 5-1 Understand the litigious environment in which CPAs practice. 5-2 Explain why the failure of ﬁnancial statement users to differentiate among business failure, audit failure, and audit risk has resulted in lawsuits. 5-3 Use the primary legal concepts and terms concerning accountants’ liability as a basis for studying legal liability of auditors. 5-4 Describe accountants’ liability to clients and related defenses. 5-5 Describe accountants’ liability to third parties under common law and related defenses. 5-6 Describe accountants’ civil liability under the federal securities laws and related defenses. 5-7 Specify what constitutes criminal liability for accountants. 5-8 Describe how the profession and individual CPAs can reduce the threat of litigation. It was clear that the plaintiffs knew the auditors bore no fault but kept them in the suit anyway. The total out-of-pocket cost to the audit ﬁrm was $5 million, not to mention personnel time, possible damage to their reputation, and general stress and strain. Thus, the cost of this suit, in which the auditors	Alvin
were completely innocent, was more than 75 times the average annual audit fee earned from this client. As the auditors at Orange & Rankle learned the hard way, legal liability and its consequences are significant. Although firms have insurance to help alleviate the impact of assessed damages, the premiums are high and the policies available to the firms require large deductibles. The amount of these deductibles is such that large firms are essentially self-insured for losses of many millions of dollars. This chapter on legal liability and the preceding one on professional ethics highlight the environment in which CPAs operate. These chapters provide an overview of the importance of protecting the profession’s reputation of high ethical standards, highlight consequences accountants face when others believe they have failed to live up to those standards, and show how CPAs can be held legally liable for the professional services they provide. In this chapter we focus on legal liability for CPAs both on a conceptual level and in terms of specific legal suits that have been filed against CPAs. We also discuss actions available to the profession and individual practitioners to minimize liability while, at the same time, maintaining high ethical and professional standards and meeting the needs of society. CHANGED LEGAL ENVIRONMENT OBJECTIVE 5-1 Understand the litigious environment in which CPAs practice. Professionals have always been required to provide a reasonable level of care while performing work for those they serve. Under common law, audit professionals have a responsibility to fulﬁll implied or expressed contracts with clients. Should auditors fail to provide the services or not exercise due care in their performance, they are liable to their clients for negligence and/or breach of contract, and, in certain circumstances, to parties other than their clients. Although the criteria for legal actions against auditors by third parties vary by state, the auditor generally owes a duty of care to third parties who are part of a limited group of persons whose reliance is “foreseen” by the auditor. In addition to common law liability, auditors may be held liable to third parties under statutory law. The Securities Act of 1933, the Securities Exchange Act of 1934, and the Sarbanes–Oxley Act contain provisions that serve as a basis for legal action against auditors. In rare cases, auditors have even been held liable for criminal acts. A criminal conviction against an auditor can result when plaintiffs demonstrate that the auditor intended to deceive or harm others. Apago PDF Enhancer Despite efforts by the profession to address legal liability of CPAs, both the number of lawsuits and sizes of awards to plaintiffs remain high, including suits involving third parties under both common law and the federal securities acts. No simple reasons explain this trend, but the following factors are major contributors: • Growing awareness of the responsibilities of public accountants by users of ﬁnancial statements • An increased consciousness on the part of the Securities and Exchange Commis - sion (SEC) for its responsibility for protecting investors’ interests • The complexity of auditing and accounting functions caused by the increasing size of businesses, the globalization of business, and the complexities of business operations • The tendency of society to accept lawsuits by injured parties against anyone who might be able to provide compensation, regardless of who was at fault, coupled with the joint and several liability doctrine (often called the deep-pocket concept of liability) • Large civil court judgments against CPA ﬁrms awarded in a few cases, en - couraging attorneys to provide legal services on a contingent-fee basis, which offers the injured party a potential gain when the suit is successful, but minimal losses when it is not • Many CPA ﬁrms being willing to settle legal problems out of court in an attempt to avoid costly legal fees and adverse publicity, rather than pursuing resolution	Alvin
through the judicial process • The difﬁculty judges and jurors have understanding and interpreting technical accounting and auditing matters 114 Part 1 / THE AUDITING PROFESSION INTERNATIONAL AFFILIATIONS BRING LEGAL EXPOSURE In the wake of a major accounting fraud in 2003 that exceeded $9 billion at Italian dairy giant Parmalat, CPA ﬁrms are reviewing the structure of their international afﬁliations to protect themselves from legal exposure for the actions of their international afﬁliates. Italy’s Grant Thornton SpA, a small member ﬁrm of Grant Thornton International, was the accounting ﬁrm most directly associated with the accounting scandal. The Italian member ﬁrm of Deloitte International was also involved in the audit of Parmalat. Following disclosure of the fraud and alleged audit deﬁciencies, Grant Thornton International expelled its Italian afﬁliate. Grant Thornton also declared that the fraud occurred only within the Italian afﬁliate, and that it should not be legally liable for Grant Thornton SpA’s actions. However, Grant Thornton and Deloitte International, as well as their U.S. member ﬁrms, were forced to defend themselves in lawsuits related to Parmalat. The legal concept that makes one party potentially responsible for the conduct of another is known as “vicarious liability.” In response, both the International Federation of Accountants (IFAC) and AICPA have taken actions to more clearly set out to deﬁne a “network” compared to an “association” as it relates to accounting ﬁrms. An association ensures strict independence among the member ﬁrms, and does not have a common naming structure or operating manuals. In contrast, a network structure includes common ownership or control, and does allow for common naming and operating procedures. Sources: Adapted from 1. Kevin Mead, “Find the Membership Group that’s Right for Your Firm,” Accounting Today (July 21, 2008) (www.webcpa.com); 2. Richard I. Miller, “Liability for Someone Else’s Sins: The Risks of Accounting Firm Alliances,” Journal of Accountancy (December 2006) pp. 30–32. Litigation costs for accountants are a concern because they are borne by all members of society. In recent years, legislative efforts have attempted to control litigation costs by discouraging nonmeritorious lawsuits and by bringing damages more in line with relative fault. Nevertheless, accountants’ liability remains burden some and is a major consideration in the conduct of a CPA ﬁrm’s professional practice. Apago PDF Enhancer DISTINGUISHING BUSINESS FAILURE, AUDIT FAILURE, AND AUDIT RISK OBJECTIVE 5-2 Explain why the failure of ﬁnancial statement users to differentiate among business failure, audit failure, and audit risk has resulted in lawsuits. Many accounting and legal professionals believe that a major cause of lawsuits against CPA ﬁrms is ﬁnancial statement users’ lack of understanding of two concepts: 1. The difference between a business failure and an audit failure 2. The difference between an audit failure and audit risk A business failure occurs when a business is unable to repay its lenders or meet the expecta tions of its investors because of economic or business conditions, such as a reces sion, poor management decisions, or unexpected competition in the industry. Audit failure occurs when the auditor issues an incorrect audit opinion because it failed to comply with the requirements of auditing standards. An example is a ﬁrm assigning unqualiﬁed assistants to perform certain audit tasks where they failed to notice material misstatements in the client’s records that a qualiﬁed auditor would have found. Audit risk represents the possibility that the auditor concludes after conducting an adequate audit that the ﬁnancial statements were fairly stated when, in fact, they were materially mis stated. Audit risk is unavoidable, because auditors gather evidence only on a test basis and because well-concealed frauds are extremely difﬁcult to detect. An auditor may fully com ply with auditing standards and still fail to uncover a material misstatement due to fraud.	Alvin
Accounting professionals tend to agree that in most cases, when an audit has failed to uncover material misstatements and the wrong type of audit opinion is issued, it is appropriate to question whether the auditor exercised due care in performing the audit. In cases of audit failure, the law often allows parties who suffered losses to recover some or all of the losses caused by the audit failure. In practice, because of the complexity of auditing, it is difﬁcult to determine when the auditor has failed to use due care. Also, legal precedent makes it difﬁcult to determine who has the right to Chapter 5 / LEGAL LIABILITY 115 expect the beneﬁt of an audit and recover losses in the event of an audit failure. Nevertheless, an auditor’s failure to follow due care often results in liability and, when appropriate, damages against the CPA ﬁrm. As highlighted by the lawsuit against Orange & Rankle in the opening story, difﬁ - culties often arise when a business failure, not an audit failure, occurs. For example, when a company ﬁles for bankruptcy protection or cannot pay its debts, statement users commonly claim that an audit failure has occurred, especially when the most recently issued auditor’s report indicates that the ﬁnancial statements were fairly stated. Even worse, if a business failure happens and the ﬁnancial statements are later determined to have been misstated, users may claim the auditor was negligent even if the audit was conducted in accordance with auditing standards. This conﬂict between statement users and auditors often arises because of an “expectation gap” between users and auditors. Most auditors believe that the conduct of the audit in accordance with auditing standards is all that can be expected of auditors. However, many users believe that auditors guarantee the accuracy of ﬁnancial statements, and some users even believe that the auditor guarantees the ﬁnancial viability of the business. Fortunately for the profession, courts continue to support the auditor’s view. Nonethe - less, the expectation gap often results in unwarranted lawsuits. The profession must continue to educate statement users about the role of auditors and the differences between business failure, audit failure, and audit risk. However, auditors must recognize that, in part, the claims of audit failure result from the hope of those who suffer a business loss to recover from any source, regardless of who is at fault. LEGAL CONCEPTS AFFECTING LIABILITY OBJECTIVE 5-3 Use the primary legal concepts and terms con - cerning accountants’ liability as a basis for studying legal liability of auditors. Prudent Person Concept Apago PDF Enhancer A CPA is responsible for every aspect of his or her public accounting work, including auditing, taxes, management advisory services, and accounting and bookkeeping services. If a CPA failed to correctly prepare and ﬁle a client’s tax return, the CPA can be held liable for any penalties and interest that the client was required to pay plus the tax preparation fee charged. In some states, the court can also assess punitive damages. Most of the major lawsuits against CPA ﬁrms have dealt with audited or unaudited ﬁnancial statements. The discussion in this chapter is restricted primarily to those two aspects of public accounting. First, we examine several legal concepts pertinent to lawsuits involving CPAs. There is agreement within the profession and the courts that the auditor is not a guarantor or insurer of ﬁnancial statements. The auditor is expected only to conduct the audit with due care, and is not expected to be perfect. This standard of due care is often called the prudent person concept. It is expressed in Cooley on Torts as follows: • Every man who offers his service to another and is employed assumes the duty to exercise in the employment such skill as he possesses with reasonable care and diligence. In all these employments where peculiar skill is prerequisite, if one offers his service, he is understood as holding himself out to the public as	Alvin
possessing the degree of skill commonly possessed by others in the same employ - ment, and, if his pretensions are unfounded, he commits a species of fraud upon every man who employs him in reliance on his public profession. But no man, whether skilled or unskilled, undertakes that the task he assumes shall be performed successfully, and without fault or error. He undertakes for good faith and integrity, but not for infallibility, and he is liable to his employer for negligence, bad faith, or dishonesty, but not for losses consequent upon pure errors of judgment. Liability for the Acts of Others Generally, the partners, or shareholders in the case of a professional corporation, are jointly liable for the civil actions against any owner. It is different, however, if the ﬁrm 116 Part 1 / THE AUDITING PROFESSION operates as a limited liability partnership (LLP), a limited liability company (LLC), a general corporation, or a professional corporation with limited liability. Under these business structures, the liability for one owner’s actions does not extend to another owner’s personal assets, unless the other owner was directly involved in the actions of the owner causing the liability. Of course, the ﬁrm’s assets are all subject to the damages that arise. The partners may also be liable for the work of others on whom they rely under the laws of agency. The three groups an auditor is most likely to rely on are employees, other CPA ﬁrms engaged to do part of the work, and specialists called upon to provide technical information. If an employee performs improperly in doing an audit, the partners can be held liable for the employee’s performance. Under common law, CPAs do not have the right to withhold information from the courts on the grounds that the information is privileged. Conﬁdential discussions between the client and auditor cannot be withheld from the courts. (See page 97 in Chapter 4 on how auditor’s documentation can be subpoenaed by a court.) Several states have statutes that permit privileged communication between the client and auditor. Even then, the intent at the time of the communication must have been for the communication to remain conﬁdential. A CPA can refuse to testify in a state with privileged communications statutes. However, that privilege does not extend to federal courts. Before proceeding in the discussion of legal liability, we examine several common legal terms that affect CPAs’ liability. These terms are deﬁned in Table 5-1. Take a moment to review these deﬁnitions. When the auditor has failed to conduct an adequate audit, liability may depend on the level of negligence, which can range from ordinary negligence to fraud. Also note the distinction between joint and several liability and separate and proportionate liability, because the amounts assessed will likely vary greatly between these two approaches when courts assess damages. Generally, these Apago PDF Enhancer TABLE 5-1 Legal Terms Affecting CPAs’ Liability Legal Term Description Terms Related to Negligence and Fraud Lack of Privileged Communication Legal Terms Affecting CPAs’ Liability Ordinary negligence Absence of reasonable care that can be expected of a person in a set of circumstances. For auditors, it is in terms of what other competent auditors would have done in the same situation. Gross negligence Lack of even slight care, tantamount to reckless behavior, that can be expected of a person. Some Constructive fraud states do not distinguish between ordinary and gross negligence. Existence of extreme or unusual negligence even though there was no intent to deceive or do harm. Constructive fraud is also termed recklessness. Recklessness in the case of an audit is present if the auditor knew an adequate audit was not done but still issued an opinion, even though there was no intention of deceiving statement users. Fraud Occurs when a misstatement is made and there is both the knowledge of its falsity and the intent to deceive. Terms Related to Contract Law	Alvin
Breach of contract Third-party beneficiary Failure of one or both parties in a contract to fulfill the requirements of the contract. An example is the failure of a CPA firm to deliver a tax return on the agreed-upon date. Parties who have a relationship that is established by a contract are said to have privity of contract. A third party who does not have privity of contract but is known to the contracting parties and is intended to have certain rights and benefits under the contract. A common example is a bank that has a large loan outstanding at the balance sheet date and requires an audit as a part of its loan agreement. (continued on following page) Chapter 5 / LEGAL LIABILITY 117 TABLE 5-1 Legal Terms Affecting CPAs’ Liability (Cont.) Legal Term Other Terms Common law Statutory law Description Laws that have been developed through court decisions rather than through government statutes. Laws that have been passed by the U.S. Congress and other governmental units. The Securities Acts of 1933 and 1934 and Sarbanes–Oxley Act of 2002 are important statutory laws affecting auditors. Joint and several liability The assessment against a defendant of the full loss suffered by a plaintiff, regardless of the extent to which other parties shared in the wrongdoing. For example, if management intentionally misstates financial statements, an auditor can be assessed the entire loss to shareholders if the company is bankrupt and management is unable to pay. Separate and proportionate liability The assessment against a defendant of that portion of the damage caused by the defendant’s negligence. For example, if the courts determine that an auditor’s negligence in conducting an audit was the cause of 30% of a loss to a defendant, only 30% of the aggregate damage will be assessed to the CPA firm. damage approaches only apply in cases of liability to third parties under common law and under the federal securities laws. When lawsuits are ﬁled in state court, state laws determine which approach to damages applies. When lawsuits are brought under the federal securities laws, the separate and proportionate approach applies, except where it can be shown that the CPA defendant had actual knowledge of fraud or has participated in fraud, in which case joint and several liability applies. Under the federal statutes, the amount of damages under separate and proportionate liability can be increased to 150 percent of the amount determined to be proportionate to the CPA’s Apago PDF Enhancer degree of fault when the main defendant is insolvent. The remainder of this chapter addresses the four sources of auditor’s legal liability: 1. Liability to clients 2. Liability to third parties under common law 3. Civil liability under the federal securities laws 4. Criminal liability Figure 5-1 provides examples of each of these classiﬁcations of liability. Let’s examine each of these liability classiﬁcations in more detail. Sources of Legal Liability LIABILITY TO CLIENTS OBJECTIVE 5-4 Describe accountants’ liability to clients and related defenses. The most common source of lawsuits against CPAs is from clients. The suits vary widely, including such claims as failure to complete a nonaudit engagement on the agreed-upon date, inappropriate withdrawal from an audit, failure to discover an embezzlement (theft of assets), and breach of the conﬁdentiality requirements of CPAs. Typically, the amount of these lawsuits is relatively small, and they do not receive the publicity often given to suits involving third parties. A typical lawsuit brought by a client involves a claim that the auditor did not discover an employee theft as a result of negligence in the conduct of the audit. The lawsuit can be for breach of contract, a tort action for negligence, or both. Tort actions are more common because the amounts recoverable under them are normally larger than under breach of contract. Tort actions can be based on ordinary negligence, gross negligence, or fraud. Refer to Table 5-1 for distinctions among these three levels of negligent actions. 118	Alvin
Part 1 / THE AUDITING PROFESSION FIGURE 5-1 Four Major Sources of Auditors’ Legal Liability The principal issue in cases involving alleged negligence is usually the level of care required. Although it is generally agreed that no one is perfect, not even a professional, in most instances, any signiﬁcant error or mistake in judgment creates at least a presumption of negligence that the professional will have to rebut. In audits, failure to meet auditing standards is often conclusive evidence of negligence. Let’s examine a typical case that raised the question of negligent performance by a CPA ﬁrm: Cenco Incorporated v. Seidman & Seidman. The case, which is described in more detail in Figure 5-2, involved alleged negligence by the auditor in failing to ﬁnd fraud. In the legal suit by Cenco’s management, the auditor was able to successfully argue that it was not negligent and that the previous management team’s deceitful actions had prevented the auditor from uncovering the fraud. The question of level of care becomes more difﬁcult in the environment of a review or a compilation of ﬁnancial statements in which there are fewer accepted standards to evaluate performance. Figure 5-3 (p. 120) summarizes a widely known example of a lawsuit dealing with the failure to uncover fraud in unaudited ﬁnancial statements. Although the CPA was never engaged to conduct an audit for the 1136 Tenants Corporation, the CPA was found liable for failing to detect an embezzlement scheme conducted by one of the client’s managers. One of the reasons for this outcome was the lack of a clear understanding between the client and the CPA as to the exact nature of the services to be performed by the CPA. As noted in Figure 5-3, engagement letters between the client and the CPA ﬁrm developed as a result of this case. Now, CPA ﬁrms and clients typically sign engagement letters, which are required for audits, to formalize their agreements about the services to be provided, fees, and timing. Privity of contract Apago PDF Enhancer FIGURE 5-2 Cenco Incorporated v. Seidman & Seidman (1982) — Liability to Clients Between 1970 and 1975 Cencos managerial employees, ultimately including top management, were involved in a massive fraud to inflate the value of the company’s inventory. This in turn enabled the company to borrow money at a lower interest rate and to obtain higher fire insurance settlements than were proper. After the fraud was discovered by an employee of Cenco and reported to the SEC, a class action suit was filed by stockholders against Cenco, its management, and its auditors. The CPA firm settled out of court on the class action suit by paying $3.5 million. By now, new management was operating Cenco. They brought a second suit against the CPA firm on behalf of Cenco for breach of contract, professional negligence, and fraud. The primary defense used by the CPA firm was that a diligent attempt was made on the part of the auditors to follow up any indications of fraud, but the combined efforts of a large number of Cenco’s manage- ment prevented them from uncovering the fraud. The CPA firm argued that the wrongdoings of management were a valid defense against the charges. The Seventh Circuit Court of Appeals concluded that the CPA firm was not responsible in this case. The wrongdoings of Cenco’s management were considered an appropriate defense against the charges of breach of contract, negligence, and fraud, even though the management no longer worked for the company. Considering management’s involvement, the CPA firm was not deemed negligent. Chapter 5 / LEGAL LIABILITY 119 FIGURE 5-3 1136 Tenants v. Max Rothenberg and Company (1967) — Liability to Clients The 1136 Tenants case was a civil case concerning a CPA’s failure to uncover fraud as a part of unaudited financial statements. The tenants recovered approximately $235,000. A CPA firm was engaged by a real estate management agent for $600 per year to prepare financial statements, a tax return, and a schedule showing the apportionment of real estate	Alvin
taxes for the 1136 Tenants Corporation, a cooperative apartment house. The statements were sent periodically to the tenants. The statements included the words unaudited, and there was a cover letter stating that ‘‘the statement was prepared from the books and records of the cooperative and no independent verifications were taken thereon.’’ During the period of the engagement, from 1963 to 1965, the manager of the management firm embezzled significant funds from the tenants of the cooperative. The tenants sued the CPA firm for negligence and breach of contract for failure to find the fraud. There were two central issues in the case. Was the CPA firm engaged to do an audit instead of only accounting, and was there negligence on the part of the CPA firm? The court answered yes on both counts. The reasoning for the court’s conclusion that an audit had taken place was the performance of ‘‘some audit procedures’’ by the CPA firm, including the preparation of a worksheet entitled ‘‘missing invoices.’’ Had the CPA followed up on these, the fraud would likely have been uncovered. Most important, the court concluded that even if the engagement had not been considered an audit, the CPA had a duty to follow up on any potential significant exceptions uncovered during an engagement. Two developments resulted from the 1136 Tenants case and similar lawsuits concerning unaudited financial statements: • Engagement letters between the CPA and client were strongly recommended for all engage- ments, but especially for unaudited engagements. The letter should clearly define the intent of the engagement, the CPA’s responsibilities, and any restrictions imposed on the CPA. • The Accounting and Review Services Committee was formed as a major committee of the AICPA to set forth guidelines for unaudited financial statements of nonpublic companies. (see breach of contract in Table 5-1) can exist without a written agreement, but an Apago PDF Enhancer engagement letter deﬁnes the contract more clearly. The CPA ﬁrm normally uses one or a combination of four defenses when there are legal claims by clients: lack of duty to perform the service, nonnegligent performance, contributory negligence, and absence of causal connection. Lack of Duty The lack of duty to perform the service means that the CPA ﬁrm claims that there was no implied or expressed contract. For example, the CPA ﬁrm might claim that misstatements were not uncovered because the ﬁrm did a review service, not an audit. The CPA’s use of an engagement letter provides a basis to demonstrate a lack of duty to perform. Many litigation experts believe that a well-written engagement letter signiﬁcantly reduces the likelihood of adverse legal actions. Nonnegligent Performance For nonnegligent performance in an audit, the CPA ﬁrm claims that the audit was performed in accordance with auditing standards. Even if there were undiscovered misstatements, the auditor is not responsible if the audit was conducted properly. The prudent person concept (discussed on page 116) establishes in law that the CPA ﬁrm is not expected to be infallible. Similarly, auditing standards make it clear that an audit is subject to limitations and cannot be relied on for complete assurance that all misstatements will be found. Requiring auditors to discover all material misstate ments would, in essence, make them insurers or guarantors of the accuracy of the ﬁnancial statements. The courts do not require that. Contributory Negligence A defense of contributory negligence exists when the auditor claims the client’s own actions either resulted in the loss that is the basis for damages or interfered with the conduct of the audit in such a way that prevented the auditor from discovering the cause of the loss. Suppose a client claims that a CPA ﬁrm was negligent in not uncovering an employee’s theft of cash. If the CPA ﬁrm had notiﬁed the client (preferably in writing) of a deﬁciency in internal control that would	Alvin
Auditor’s Defenses Against Client Suits 120 Part 1 / THE AUDITING PROFESSION have prevented the theft but management did not correct it, the CPA ﬁrm would have a defense of contributory negligence. Or, suppose a CPA ﬁrm failed to determine that certain accounts receivable were uncollectible and, in reviewing collectibility, the auditors were lied to and given false documents by the credit manager. In this circumstance, assuming the audit of accounts receivable was done in accordance with auditing standards, the auditor can claim a defense of contributory negligence. Absence of Causal Connection To succeed in an action against the auditor, the client must be able to show that there is a close causal connection between the auditor’s failure to follow auditing standards and the damages suffered by the client. Assume that an auditor failed to complete an audit on the agreed-upon date. The client alleges that this caused a bank not to renew an outstanding loan, which caused damages. A potential auditor defense is that the bank refused to renew the loan for other reasons, such as the weakening ﬁnancial condition of the client. This defense is called an absence of causal connection. LIABILITY TO THIRD PARTIES UNDER COMMON LAW In addition to being sued by clients, CPAs may be liable to third parties under common law. Third parties include actual and potential stockholders, vendors, bankers and other creditors, employees, and customers. A CPA ﬁrm may be liable to third parties if a loss was incurred by the claimant due to reliance on misleading ﬁnancial statements. A typical suit occurs when a bank is unable to collect a major loan from an insolvent customer and the bank then claims that misleading audited ﬁnancial statements were relied on in making the loan and that the CPA ﬁrm should be held responsible because it failed to perform the audit with due care. Apago PDF Enhancer The leading precedent-setting auditing case in third-party liability was Ultramares Corporation v. Touche (1931), which established the Ultramares doctrine. Take a moment to read the summary of the case in Figure 5-4. OBJECTIVE 5-5 Describe accountants’ liability to third parties under common law and related defenses. Ultramares Doctrine In this case, the court held that although the accountants were negligent, they were not liable to the creditors because the creditors were not a primary beneﬁciary. In this context, a primary beneﬁciary is one about whom the auditor was informed before con - ducting the audit (a known third party). This case established a precedent, commonly called the Ultramares doctrine, that ordinary negligence is insufﬁcient for liability to third parties because of the lack of privity of contract between the third party and the auditor, unless the third party is a primary beneﬁciary. However, in a subsequent trial of the Ultramares case, the court pointed out that had there been fraud or gross negli - gence on the part of the auditor, the auditor could be held liable to third parties who are not primary beneﬁciaries. FIGURE 5-4 Ultramares Corporation v. Touche (1931) — Liability to Third Parties The creditors of an insolvent corporation (Ultramares) relied on the audited financials and subse- quently sued the accountants, alleging that they were guilty of negligence and fraudulent misrep- resentation. The accounts receivable had been falsified by adding to approximately $650,000 in accounts receivable another item of over $700,000. The creditors alleged that careful investigation would have shown the $700,000 to be fraudulent. The accounts payable contained similar discrepancies. The court held that the accountants had been negligent but ruled that accountants would not be liable to third parties for honest blunders beyond the bounds of the original contract unless they were primary beneficiaries. The court held that only one who enters into a contract with an accountant for services can sue if those services are rendered negligently.	Alvin
Chapter 5 / LEGAL LIABILITY 121 Foreseen Users In recent years, courts have broadened the Ultramares doctrine to allow recovery by third parties in more circumstances by introducing the concept of foreseen users, who are members of a limited class of users that the auditor knows will rely on the ﬁnancial statements. For example, a bank that has loans outstanding to a client at the balance sheet date may be a foreseen user. Under this concept, a foreseen user is treated the same as a known third party. Although the concept of foreseen users may appear straightforward, courts have generated several different interpretations. At present, the three leading approaches taken by the courts that have emerged are described as follows: Credit Alliance In Credit Alliance v. Arthur Andersen & Co. (1986) in New York, a lender brought suit against the auditor of one of its borrowers, claiming that it relied on the ﬁnancial statements of the borrower, who was in default, in granting the loan. The New York State Court of Appeals upheld the basic concept of privity established by Ultramares and stated that to be liable (1) an auditor must know and intend that the work product would be used by the third party for a speciﬁc purpose, and (2) the knowledge and intent must be evidenced by the auditor’s conduct. Restatement of Torts The approach followed by most states is to apply the rule cited in the Restatement of Torts, an authoritative set of legal principles. The Restatement Rule is that foreseen users must be members of a reasonably limited and identiﬁable group of users that have relied on the CPA’s work, such as creditors, even though those persons were not speciﬁcally known to the CPA at the time the work was done. A leading case supporting the application of this rule is Rusch Factors v. Levin, as presented in Figure 5-5. Foreseeable User The broadest interpretation of the rights of third-party bene - ﬁciaries is to use the concept of foreseeable users. Under this concept, any users that the auditor should have reasonably been able to foresee as likely users of the client’s ﬁnancial statements have the same rights as those with privity of contract. These users are often called an unlimited class. Although a signiﬁcant number of states followed this approach in the past, it is now used in only two states. Apago PDF Enhancer Table 5-2 summarizes the three approaches to third party liability taken by the courts under common law. There is confusion caused by these differing views of liability to third parties under common law, but the movement is clearly away from the foreseeable user approach, and thus toward the ﬁrst two approaches. For example, in Bily v. Arthur Young (1992), the California Supreme Court reversed a lower court decision against Arthur Young, clearly upholding the Restatement doctrine. In its decision, the court stated that “an auditor owes no general duty of care regarding the conduct of an audit to persons other than the client” and reasoned that the potential liability to auditors under the foreseeable user doctrine would be distinctly out of proportion to any fault. FIGURE 5-5 Rusch Factors v. Levin (1968) — Liability to Third Parties The plaintiff, Rusch Factors, a lender, asked the defendant auditor to audit the financial statements of a company seeking a loan. The auditor, Levin, issued an unqualified opinion on the financial statements, indicating that the company was solvent when, in fact, it was insolvent. The plaintiff loaned the company money, suffered a subsequent loss, and sued the auditor for recovery. The auditor’s defense in the case was based on the absence of privity on the part of Rusch Factors. The court found in favor of this plaintiff. Although the court could have found in favor of Rusch Factors under Ultramares in that it was a primary beneficiary, it chose to rely on the Restatement of Torts, stating that the auditor should be liable for ordinary negligence in audits where the financial statements are relied on by actually foreseen and limited classes of persons. 122	Alvin
Part 1 / THE AUDITING PROFESSION TABLE 5-2 Approaches Courts Take to Assign Third Party Liability Under Common Law Interpretation Approaches by Courts and Example Cases Definition of Third Party User Example Narrow Primary beneficiary/identified user Ultramares Corporation v. Touche (1931) Credit Alliance v. Arthur Andersen (1986) Auditor knows and intends that user will use audit report. Auditor is aware of bank loan agreement that requires audited financial statements. Foreseen user Rusch Factors v. Levin (1968) Foreseeable user Rosenblum, Inc. v. Adler (1983) Broad Reasonably limited and identifiable group of users who have relied on the auditor’s work. An unlimited class of users that the auditor should have reasonably been able to foresee as being likely users of the financial statements. Bank or trade creditors when the auditor is aware that the client has provided audited financial statements to such users. A trade creditor that has not previously conducted business with the client. That client has not furnished ﬁnancial statements to trade creditors in the past. Three of the four defenses available to auditors in suits by clients are also available in third-party lawsuits: lack of duty to perform the service, nonnegligent perfor - mance, and absence of causal connection. Contributory negligence is ordinarily not available because a third party is not in a position to contribute to misstated ﬁnancial statements. Auditor Defenses Against Third-Party Suits A lack of duty defense in third-party suits contends lack of privity of contract. The extent to which privity of contract is an appropriate defense and the nature of the defense depend heavily on the approach to foreseen users in the state and the judicial jurisdiction of the case. Apago PDF Enhancer If the auditor is unsuccessful in using the lack of duty defense to have a case dismissed, the preferred defense in third-party suits is nonnegligent performance. If the auditor conducted the audit in accordance with auditing standards, that eliminates the need for the other defenses. Unfortunately, nonnegligent performance can be difﬁcult to demonstrate to a court, especially in jury trials when laypeople with no accounting experience make up the jury. Absence of causal connection in third-party suits often means nonreliance on the ﬁnancial statements by the user. Assume that the auditor can demonstrate that a lender relied on an ongoing banking relationship with a customer, rather than the ﬁnancial statements, in making a loan. In that situation, auditor negligence in the conduct of the audit is not relevant. Of course, it is difﬁcult to prove nonreliance on the ﬁnancial statements. Absence of causal connection can be difﬁcult to establish because users may claim reliance on the statements even when investment or loan decisions were made without considering the company’s ﬁnancial condition. CIVIL LIABILITY UNDER THE FEDERAL SECURITIES LAWS Although there has been some growth in actions brought against accountants by clients and third parties under common law, the greatest growth in CPA liability litigation has been under the federal securities laws. Litigants commonly seek federal remedies because of the availability of class-action litigation and the ability to obtain signiﬁcant damages from defendants. Other factors also make federal courts attractive to litigants. For example, several sections of the securities laws impose strict liability standards on CPAs and federal courts are often likely to favor plaintiffs in lawsuits when there are strict standards. OBJECTIVE 5-6 Describe accountants’ civil liability under the federal securities laws and related defenses. Chapter 5 / LEGAL LIABILITY 123 Securities Act of 1933 However, fairly recent tort reform legislation may result in a reduction of negative outcomes for CPA ﬁrms in federal courts. The Securities Act of 1933 deals only with the reporting requirements for companies issuing new securities, including the information in registration statements and prospectuses. The only parties who can recover from auditors under the 1933 act are	Alvin
the original purchasers of securities. The amount of the potential recovery equals the original purchase price less the value of the securities at the time of the suit. (If the securities have been sold, users can recover the amount of the loss incurred.) The Securities Act of 1933 imposes an unusual burden on the auditor. Section 11 of the 1933 act deﬁnes the rights of third parties and auditors, which are summarized as follows: • Any third party who purchased securities described in the registration statement may sue the auditor for material misrepresentations or omissions in audited ﬁnancial statements included in the registration statement. • Third-party users do not have the burden of proof that they relied on the ﬁnancial statements or that the auditor was negligent or fraudulent in doing the audit. Users must only prove that the audited ﬁnancial statements contained a material misrepresentation or omission. • The auditor has the burden of demonstrating as a defense that (1) an adequate audit was conducted or (2) all or a portion of the plaintiff ’s loss was caused by factors other than the misleading ﬁnancial statements. The 1933 act is the only common or statutory law where the burden of proof is on the defendant. Furthermore, the auditor is responsible for making sure that the ﬁnancial state ments are fairly stated beyond the date of issuance, up to the date the registration statement becomes effective, which can be several months later. Assume that the audit report date for December 31, 2010 ﬁnancial statements is February 10, 2011, but the registration statement is dated November 1, 2011. In a typical audit, the auditor must review trans - actions through the audit report date, February 10, 2011. In statements ﬁled under the 1933 act, the auditor is responsible for reviewing transactions – for almost nine additional months – through the registration statement date, November 1, 2011. Apago PDF Enhancer FIGURE 5-6 Escott et al. v. BarChris Construction Corporation (1968) — Securities Act of 1933 BarChris filed an S-1 registration statement with the SEC in 1961 for the issuance of convertible subordinated debentures, thereby subjecting the company to the Securities Act of 1933. Approxi- mately 17 months later, BarChris filed for bankruptcy. The purchasers of the debentures filed suit against the CPA firm under the 1933 act. The most significant issue of the case, especially to audit staff personnel, was the matter of the review for events subsequent to the balance sheet, called an S-1 review for registration state- ments. The courts concluded that the CPA firm’s written audit program was in conformity with auditing standards in existence at that time. However, they were highly critical of the auditor conducting the review, who was inexperienced in audits of construction companies, for the failure to appropriately follow up on answers by management. The following is an important part of the court’s opinion in the case: • Accountants should not be held to a higher standard than that recognized in their profession. I do not do so here. Richard’s review did not come up to that written standard. He did not take the steps which the CPA firm’s written program prescribed. He did not spend an adequate amount of time on a task of this magnitude. Most important of all, he was too easily satisfied with glib answers to his inquiries. This is not to say that he should have made a complete audit. But there were enough danger signals in the materials which he did examine to require some further investigation on his part. . .. It is not always sufficient merely to ask questions. (Italics were added and the name used in the case was changed.) The CPA firm was found liable in the case on the grounds that they had not established due diligence required under the 1933 securities act. 124 Part 1 / THE AUDITING PROFESSION Securities Exchange Act of 1934 Although the burden may appear harsh to auditors, there have been relatively few	Alvin
cases tried under the 1933 act. One of the most signiﬁcant is Escott et al. v. BarChris Construction Corporation (1968). As noted in Figure 5-6, the CPA ﬁrm was held liable for a lack of due diligence required under the 1933 act when performing its review of events occurring subsequent to the balance sheet date. This case brought about two noteworthy consequences: 1. Auditing standards were changed to require greater emphasis on procedures that the auditor must perform for events subsequent to the balance sheet date. 2. A greater emphasis began to be placed on the importance of the audit staff understanding the client’s business and industry. The liability of auditors under the Securities Exchange Act of 1934 often centers on the audited ﬁnancial statements issued to the public in annual reports submitted to the SEC as a part of annual Form 10-K reports. Every company with securities traded on national and over-the-counter exchanges is required to submit audited statements annually. Obviously, a much larger number of statements fall under the 1934 act than under the 1933 act. Auditors also face potential legal exposure for quarterly information (Form 10-Q) or other reporting information ﬁled with the SEC, such as an unusual event ﬁled in a Form 8-K. The auditor must perform a review of the Form 10-Q before it is ﬁled with the SEC, and the auditor is frequently involved in reviewing the information in other reports, and, therefore, may be legally responsible. However, few cases have involved auditors for reports other than reports on annual audits. FIGURE 5-7 Hochfelder v. Ernst & Ernst (1976) — Securities Exchange Act of 1934 Apago PDF Enhancer The case involved the auditor’s responsibility for detecting fraud perpetrated by the president of the client firm. Lestor Nay, the president of First Securities Co. of Chicago, fraudulently convinced certain customers to invest funds in escrow accounts that he represented would yield a high return. There were no escrow accounts. Nay converted the customers’ funds to his own use. The transactions were not in the usual form of dealings between First Securities and its customers. First, all correspondence with customers was made solely with Nay. Second, checks of the customers were drawn payable to Nay and because of a mail rule that Nay imposed, such mail was opened only by him. Third, the escrow accounts were not reflected on the books of First Securities, or in filings with the SEC, or in connection with customers’ other investment accounts. The fraud was uncovered at the time of Nay’s suicide. Respondent customers originally sued in district court for damages against the auditors, Ernst & Ernst, as aiders and abettors under Section 10b-5. They alleged that Ernst & Ernst failed to conduct a proper audit that should have led them to discover the ‘‘mail rule’’ and the fraud. No allegations were made as to Ernst & Ernst’s fraudulent and intentional conduct. The action was based solely on a claim that Ernst & Ernst failed to conduct a proper audit. The district court dismissed the action but did not resolve the issue of whether a cause of action could be based merely on allegations of negligence. The court of appeals reversed the district court. The appeals court held that one who breaches a duty of inquiry and disclosure owed another is liable in damages for aiding and abetting a third party’s violation of Rule 10b-5 if the fraud would have been discovered or prevented had the breach not occurred. The court reasoned that Ernst & Ernst had a common-law and statutory duty of inquiry into the adequacy of First Securities’ internal control because it had contracted to audit First Securities and to prepare for filing with the commission the annual report of its financial condition. The U.S. Supreme Court reversed the court of appeals, concluding that the interpretation of Rule 10b-5 required the ‘‘intent to deceive, manipulate or defraud.’’ Justice Powell wrote in the	Alvin
Court’s opinion that • When a statute speaks so specifically in terms of manipulation and deception, and of imple- menting devices and contrivances—the commonly understood terminology of intentional wrongdoing—and when its history reflects no more expansive intent, we are quite unwilling to extend the scope of the statute to negligent conduct. The Court pointed out that in certain areas of the law, recklessness is considered to be a form of intentional conduct for purposes of imposing liability. This left open the possibility that reckless behavior may be sufficient for liability under Rule 10b-5. Chapter 5 / LEGAL LIABILITY 125 Rule 10b-5 of the Securities Exchange Act of 1934 Auditor Defenses — 1934 Act SEC Sanctions The principal focus on CPA liability litigation under the 1934 act is Rule 10b-5. Section 10 and Rule 10b-5 are often called the antifraud provisions of the 1934 act, as they prohibit any fraudulent activities involving the purchase or sale of any security. Numerous federal court decisions have clariﬁed that Rule 10b-5 applies not only to direct sellers but also to accountants, underwriters, and others. Generally, accountants can be held liable under Section 10 and Rule 10b-5 if they intentionally or recklessly misrepresent information intended for third-party use. In 1976, in Hochfelder v. Ernst & Ernst, known both as a leading securities law case and as a CPA liabilities case, the U.S. Supreme Court ruled that scienter, which is knowledge and intent to deceive, is required before CPAs can be held liable for violation of Rule 10b-5. A summary of Hochfelder is included in Figure 5-7 (p. 125). Many auditors believed the knowledge and intent to deceive requirement established in the Hochfelder case would signiﬁcantly reduce auditors’ exposure to liability. However, subsequent cases were brought arguing the knowledge and deceit standard was met in cases in which the auditor knew all the relevant facts but made poor judgments. In such situations, the courts emphasized that the CPAs had requisite knowledge. The Solitron Devices case, described in Figure 5-8, is an example of that reasoning. In that case, the court of appeals ruled that reckless behavior on the part of the auditor was sufﬁcient to hold the auditor liable for violation of Rule 10b-5. However, in subsequent suits under Rule 10b-5, Worlds of Wonder (1994) and Software Toolworks (1994), two key Ninth Circuit court decisions stated that poor judgment isn’t proof of fraud. This view appears now to be winning favor in the courts. Although Rule 10b-5 continues to be a basis for lawsuits against auditors, Hochfelder and subsequent court decisions have limited the liability somewhat. The same three defenses available to auditors in common-law suits by third parties are also available for suits under the 1934 act: nonnegligent performance, lack of duty, and absence of causal connection. As we just discussed, the use of the lack of duty defense in response to actions under Apago PDF Enhancer Rule 10b-5 has had varying degrees of success, depending on the jurisdiction. In the Hochfelder case, the court ruled that knowledge and intent to deceive were necessary for the auditor to be found liable. In other cases, negligent or reckless behavior was sufﬁcient for the auditor to be found liable. Continued court interpre tations are likely to clarify this unresolved issue. Closely related to auditors’ liability is the SEC’s authority to sanction. The SEC has the power in certain circumstances to sanction or suspend practitioners from doing audits for SEC companies. The SEC’s Rules of Practice permit them to temporarily or FIGURE 5-8 Howard Sirota v. Solitron Devices, Inc. (1982) — Securities Exchange Act of 1934 Solitron was a manufacturer of electronic devices, with its stock issued on the American Stock Exchange. It was involved in government contracts that subjected it to assessments on excess profits as determined by the Renegotiations Board. When the board determined that profits were	Alvin
excessive, management admitted that profits had been intentionally overstated to aid in acquiring new companies. It was subsequently shown in court, through an audit by another CPA firm, that earnings had been materially overstated by more than 30 percent in two different years, by overstating inventory. A jury trial found the auditor responsible for reckless behavior in the conduct of the audit. The trial judge overturned the jury verdict on the grounds that the CPA firm could not be held liable for damages under Rule 10b-5 unless there was proof that the CPA firm had actual knowl- edge of the misstatement. Reckless behavior was not sufficient for damages. On appeal, the Second Circuit Court of Appeals concluded that there had been sufficient evidence for the jury to conclude that the CPA firm had knowledge of the fraud. It therefore overturned the trial judge’s findings and affirmed the original jury’s guilty verdict. The court of appeals also stated that proof of recklessness may meet the requirement of intent in Rule 10b-5, but that it need not address whether there was sufficient recklessness in this case because the CPA firm had knowledge of the misstatement. 126 Part 1 / THE AUDITING PROFESSION permanently deny a CPA or CPA ﬁrm from being associated with ﬁnancial statements of public companies, either because of a lack of appropriate qualiﬁcations or having engaged in unethical or improper professional conduct. In recent years, the SEC has temporarily suspended a number of individual CPAs from doing any audits of SEC clients. It has similarly prohibited a number of CPA ﬁrms from accepting any new SEC clients for a period, such as six months. In some cases, the SEC has required an extensive review of a major CPA ﬁrm’s practices by another CPA ﬁrm, or made CPA ﬁrms make changes in their practices. Individual CPAs and their ﬁrms have also been required to participate in continuing education programs. Sanctions such as these are published by the SEC and are often reported in the business press, making them a signiﬁcant embarrassment to those involved. Another signiﬁcant congressional action affecting both CPA ﬁrms and their clients was the passage of the Foreign Corrupt Practices Act of 1977. The act makes it illegal to offer a bribe to an ofﬁcial of a foreign country for the purpose of exerting inﬂuence and obtaining or retaining business. The prohibition against payments to foreign ofﬁcials is applicable to all U.S. domestic ﬁrms, regardless of whether they are publicly or privately held, and to all foreign companies ﬁling with the SEC. The law also requires SEC registrants under the Securities Exchange Act of 1934 to meet additional requirements of reasonably complete and accurate records, plus an adequate system of internal control. The law signiﬁcantly affected all SEC companies, and potentially affected auditors because of their responsibility to review and evaluate systems of internal control as a part of the audit. Although the provisions of the Foreign Corrupt Practices Act remain in effect, the provisions related to accounting records and internal control are largely superseded by the more stringent requirements of the Sarbanes–Oxley Act of 2002. Apago PDF Enhancer The Sarbanes–Oxley Act greatly increases the responsibilities of public companies and their auditors. The Act requires the CEO and CFO to certify the annual and quarterly ﬁnan cial statements ﬁled with the SEC. In addition, as discussed in Chapter 3 (p. 49–51), management must report its assessment of the effectiveness of internal control over ﬁnancial reporting, and for accelerated ﬁlers, the auditor must provide an opinion on the effectiveness of internal control over ﬁnancial reporting. As a result, auditors may be exposed to legal liability related to their opinions on internal control. The PCAOB also has the authority to sanction registered CPA ﬁrms for any violations of the Act. Table 5-3 (p. 128) summarizes the sources of liability to clients and others for breach	Alvin
of contract under common law, liability to third parties under common law, and liability to third parties under the 1933 and 1934 Securities acts. The table illustrates the strict burden on auditors to defend themselves under the 1933 act. Liability to third parties under common law and the 1934 act depends on the degree of negligence. Liability to third parties under common law also depends upon the jurisdiction and whether the third party is a primary beneﬁciary or known user of the ﬁnancial statements. The defenses available to the auditor are summarized in Table 5-4 (p. 128). If the auditor is unable to prove a lack of duty to perform the service, the preferred defense is generally nonnegligent performance. Foreign Corrupt Practices Act of 1977 Sarbanes–Oxley Act of 2002 CRIMINAL LIABILITY A fourth way CPAs can be held liable is under criminal liability for accountants. CPAs can be found guilty for criminal action under both federal and state laws. Under state law, the most likely statutes to be enforced are the Uniform Securities Acts, which are similar to parts of the SEC rules. The more relevant federal laws affecting auditors are the 1933 and 1934 securities acts, as well as the Federal Mail Fraud Statute and the Federal False Statements Statute. All make it a criminal offense to defraud another OBJECTIVE 5-7 Specify what constitutes criminal liability for accountants. Chapter 5 / LEGAL LIABILITY 127 TABLE 5-3 Summary of Auditor Liability Alleged Auditor Action Breach of contract Negligence Gross Negligence Constructive fraud/ Recklessness Fraud Liability to Client Third Parties under Common Law Liability to Third Parties under 1933 Securities Act Liability to Third Parties under 1934 Securities Act Yes Yes Yes Yes Yes N/A Primary Beneficiary — Yes Other third parties — depends on jurisdiction Yes Yes Yes N/A N/A1 N/A N/A N/A N/A No Yes — likely Yes — likely Yes — likely “Yes” indicates that the auditor could be held liable to a client or third party for the alleged audit or action. “No” means the auditor would not be liable for the alleged action. “N/A” means that the alleged auditor action is not an available basis to seek liability from the auditor under common law or the securities acts. 1Material error or omission is required for liability under the 1933 act. person through knowingly being involved with false ﬁnancial statements. In addition, the Sarbanes–Oxley Act of 2002 made it a felony to destroy or create documents to impede or obstruct a federal investigation. Under Sarbanes–Oxley, a person may face ﬁnes and imprisonment of up to 20 years for altering or destroying documents. These provisions were adopted following the United States v. Andersen (2002) case described in Figure 5-9, in which the government charged Andersen with obstruction of justice for the destruction and alteration of documents related to its audit of Enron. Apago PDF Enhancer Unfortunately, a few notorious criminal cases have involved CPAs. Historically, one of the leading cases of criminal action against CPAs is United States v. Simon, which occurred in 1969. In this case, three auditors were prosecuted for ﬁling false ﬁnancial statements of a client with the government, and all three were held criminally liable. Three major criminal cases followed Simon: TABLE 5-4 Auditor Defenses Against Suits by Client, Third Parties Under Common Law, and Under the 1933 and 1934 Securities Acts Available Auditor Defenses Client Suits Third Parties Common Law 1933 Securities Act 1934 Securities Act Lack of duty to perform service Nonnegligent performance (audit in accordance with audit standards) Contributory negligence by client or third party Absence of causal connection (no reliance on financial statements) X X X X X X N/A X N/A X1 N/A N/A2 X X N/A X “X” indicates the auditor defense would be available. “N/A” indicates the defense generally would not be applicable. 1Under the 1933 Securities Act, the auditor must prove due diligence in the performance of the audit. 2Auditor may prove that the loss was not attributable to the misleading financial statements. 128 Part 1 / THE AUDITING PROFESSION	Alvin
FIGURE 5-9 United States v. Andersen (2002) — Criminal Liability In this case, the government charged Andersen with destruction of documents related to the firm’s audit of Enron. During the period between October 19, 2001, when Enron alerted Andersen that the SEC had begun an inquiry into Enron’s accounting for certain special purpose entities, and November 8, 2001, when the SEC served Andersen with a subpoena in connection with its work for Enron, Andersen personnel shredded extensive amounts of physical documentation and deleted computer files related to Enron. The firm was ultimately convicted of one count of obstruction of justice. The conviction was not based on the document shredding, but it was based on the alteration of a memo related to Enron’s characterization of charges as nonrecurring in its third quarter 2001 earnings release, in which the company announced a loss of $618 million. As a result of the conviction, Andersen was no longer able to audit publicly traded U.S. companies. The conviction was overturned by the U.S. Supreme Court in 2005 because the instructions provided the jury were too broad. The victory was largely symbolic since the firm effectively ceased operations after the original conviction. • • • In United States v. Natelli (1975), two auditors were convicted of criminal liability under the 1934 act for certifying ﬁnancial statements of National Student Marketing Corporation that contained inadequate disclosures. In United States v. Weiner (1975), three auditors were convicted of securities fraud in connection with their audit of Equity Funding Corporation of America. The fraud was so extensive and the audit work so poor that the court concluded that the auditors must have been aware of the fraud and were therefore guilty of knowing complicity. In ESM Government Securities v. Alexander Grant & Co. (1986), management revealed to the partner in charge of the audit of ESM that the previous year’s audited ﬁnancial statements contained a material misstatement. Rather than com plying with professional and ﬁrm standards, the partner agreed to say nothing in the hope that management would work its way out of the problem during the current year. The partner was convicted of criminal charges for his role in sustaining the fraud. Apago PDF Enhancer These cases teach several critical lessons: • An investigation of the integrity of management is an important part of deciding on the acceptability of clients and the extent of work to perform. Auditing guid ance for auditors in investigating new clients will be discussed in Chapter 8. • As discussed in Chapter 4, independence by all individuals on the engagement is essential, especially in a defense involving criminal actions. LESSONS LEARNED FROM AUDITOR LITIGATION As we consider the advisability of legislation for the reform of accountants’ liability, it is useful to review actual experiences with past accountants’ litigation. Accordingly, a review was conducted of 23 cases of alleged audit failure with which I have been involved as a litigation consultant and expert witness. Of these 23 cases, six were clearly without merit and should not have been brought on equitable grounds. Of the 17 that were with merit, 13 did, in fact, represent a real audit failure. Considering the nature of the failure in each case, the evidence that would lead the auditor to identify the misstatement was usually present. In other words, the problem was not any inadequacy in the audit process as presented by professional standards; it was a lack of professional skepticism on the part of the auditor. The auditor had evidence in his or her possession that indicated the problem, but did not see it as such. Source: Presentation by James K. Loebbecke at the Forum on Responsibilities and Liabilities of Accountants and Auditors, United Nations Conference on Trade and Development, March 16, 1995. Chapter 5 / LEGAL LIABILITY 129 • Transactions with related parties require special scrutiny because of the potential	Alvin
for misstatement. Auditing requirements for related-party transactions are discussed in Chapter 8. • Accounting principles cannot be relied on exclusively in deciding whether ﬁnancial statements are fairly presented. The substance of the statements, con - sidering all facts, is required. • The potential consequences of the auditor knowingly committing a wrongful act are so severe that it is unlikely that the potential beneﬁts can ever justify the actions. THE PROFESSION’S RESPONSE TO LEGAL LIABILITY OBJECTIVE 5-8 Describe how the profession and individual CPAs can reduce the threat of litigation. The AICPA and the profession as a whole can do a number of things to reduce practi - tioners’ exposure to lawsuits: 1. Seek protection from nonmeritorious litigation 2. Improve auditing to better meet users’ needs 3. Educate users about the limits of auditing Let’s discuss some speciﬁc activities brieﬂy: • Standard and rule setting. The IAASB, AICPA and PCAOB must constantly set standards and revise them to meet the changing needs of auditing. For example, changes in auditing standards on the auditor’s responsibility to detect fraud were issued to address users’ needs and expectations as to auditor performance. • Oppose lawsuits. CPA ﬁrms must continue to oppose unwarranted lawsuits even if, in the short run, the costs of winning are greater than the costs of settling. • Education of users. The AICPA, leaders of CPA ﬁrms, and educators should educate investors and others who read ﬁnancial statements as to the meaning Apago PDF Enhancer of an auditor’s opinion and to the extent and nature of the auditor’s work. In addition, users need to understand that auditors do not guarantee the accuracy of the ﬁnancial records or the future prosperity of an audited company. People outside of the profession need to understand that accounting and auditing are arts, not sciences. Perfection and precision are simply not achievable. • Sanction members for improper conduct and performance. A profession must police its own membership. The AICPA and the PCAOB have made progress in dealing with the problems of inadequate CPA performance, but more rigorous review of alleged failures is still needed. • Lobby for changes in laws. Since the 1990s several changes in state and federal laws have favorably impacted the legal environment for the profession. Most states have revised their laws to allow accounting ﬁrms to practice in different organizational forms, including limited liability organizations that provide some protection from litigation. The passage of the Private Securities Litigation Reform Act of 1995 (the Reform Act) and the Securities Litigation Uniform Standards Act of 1998 signiﬁ cantly reduced potential damages in federal securities-related litigation by providing for proportionate liability in most instances. The profession continues to pursue litigation reform at the state level, including application of a strict privity standard for liability to nonclients and proportionate liability in all cases not involving fraud. PROTECTING INDIVIDUAL CPAs FROM LEGAL LIABILITY Practicing auditors may also take speciﬁc action to minimize their liability. Some of the more common actions are as follows: 130 Part 1 / THE AUDITING PROFESSION • Deal only with clients possessing integrity. There is an increased likelihood of having legal problems when a client lacks integrity in dealing with customers, employees, units of government, and others. A CPA ﬁrm needs procedures to evaluate the integrity of clients and should dissociate itself from clients found lacking integrity. • Maintain independence. Independence is more than merely ﬁnancial. Independ ence requires an attitude of responsibility separate from the client’s interest. Much litigation has arisen from auditors’ too-willing acceptance of client representations or from client pressure. The auditor must maintain an attitude of healthy professional skepticism. • Understand the client’s business. In several cases, the lack of knowledge of industry	Alvin
practices and client operations has been a major factor in auditors failing to uncover misstatements. • Perform quality audits. Quality audits require that auditors obtain appropriate evidence and make appropriate judgments about the evidence. It is essential, for example, that the auditor understands the client’s internal controls and modify the evidence to reﬂect the ﬁndings. Improved auditing reduces the likelihood of failing to detect misstatements and the likelihood of lawsuits. • Document the work properly. The preparation of good audit documentation helps the auditor perform quality audits. Quality audit documentation is essential if an auditor has to defend an audit in court, including an engagement letter and a representation letter that deﬁne the respective obligations of the client and the auditor. • Exercise professional skepticism. Auditors are often liable when they are presented with information indicating a problem that they fail to recognize. Auditors need to strive to maintain a healthy level of skepticism, one that keeps them alert to potential misstatements, so that they can recognize misstatements when they exist. Apago PDF Enhancer It is also important for CPAs to carry adequate insurance and choose a form of organization that provides some form of legal liability protection to owners. In the event of actual or threatened litigation, an auditor should consult with experienced legal counsel. SUMMARY This chapter provides insight into the environment in which CPAs operate by high - lighting the significance of the legal liability facing the CPA profession. No reasonable CPA wants to eliminate the profession’s legal responsibility for fraudulent or incompetent performance. It is certainly in the profession’s best interest to maintain public trust in the competent perfor mance of the auditing profession, while avoiding liability for cases involving strictly business failure and not audit failure. To more effectively avoid legal liability, CPAs need to have an understanding of how they can be held liable to their clients or third parties. Knowledge about how CPAs are liable to clients under common law, to third parties under common law, to third parties under federal securities laws, and for criminal liability, provides auditors an awareness of issues that may subject them to greater liability. CPAs can protect themselves from legal liability in numerous ways, and the profession has worked diligently to identify ways to help CPAs reduce the profession’s potential exposure. It is necessary for the profession and society to determine a reasonable trade-off between the degree of responsibility the auditor should take for the financial statements and the audit cost to society. CPAs, Congress, the SEC, and the courts will all continue to have a major influence in shaping the final solution. Chapter 5 / LEGAL LIABILITY 131 ESSENTIAL TERMS Absence of causal connection—an auditor’s legal defense under which the auditor contends that the damages claimed by the client were not brought about by any act of the auditor Audit failure—a situation in which the auditor issues an incorrect audit opinion as the result of an underlying failure to comply with the requirements of auditing standards Audit risk—the risk that the auditor will conclude after conducting an adequate audit that the financial statements are fairly stated and an unqualified opinion can therefore be issued when, in fact, they are materially misstated Business failure—the situation when a business is unable to repay its lenders or meet the expectations of its investors because of economic or business conditions Lack of duty to perform—an auditor’s legal defense under which the auditor claims that no contract existed with the client; therefore, no duty existed to perform the disputed service Legal liability—the professional’s obliga - tion under the law to provide a reasonable level of care while performing work for those served Nonnegligent performance—an auditor’s	Alvin
legal defense under which the auditor claims that the audit was performed in accordance with auditing standards Private Securities Litigation Reform Act of 1995—a federal law passed in 1995 that significantly reduced potential damages in securities-related litigation Prudent person concept—the legal con - cept that a person has a duty to exercise reasonable care and diligence in the performance of obligations to another Apago PDF Enhancer Contributory negligence—an auditor’s legal defense under which the auditor claims that the client failed to perform certain obligations and that it is the client’s failure to perform those obli - gations that brought about the claimed damages Scienter—commission of an act with knowledge or intent to deceive Securities Act of 1933—a federal statute dealing with companies that register and sell securities to the public; under the statute, third parties who are original purchasers of securities may recover damages from the auditor if the financial statements are misstated, unless the auditor proves that the audit was ade - quate or that the third party’s loss was caused by factors other than misleading financial statements Securities Exchange Act of 1934—a federal statute dealing with companies that trade securities on national and over-the- counter exchanges; auditors are involved because the annual reporting require - ments include audited financial statements doctrine—a common-law approach to third-party liability, estab - lished in 1931 in the case of Ultramares Corporation v. Touche, in which ordinary negligence is insufficient for liability to third parties because of the lack of privity of contract between the third party and the auditor, unless the third party is a primary beneficiary Criminal liability for accountants— defrauding a person through knowing involvement with false financial state - ments Foreign Corrupt Practices Act of 1977—a federal statute that makes it illegal to offer a bribe to an official of a foreign country for the purpose of exerting influence and obtaining or retaining business and that requires U.S. companies to maintain reasonably complete and accurate records and an adequate system of internal control Foreseeable users—an unlimited class of users that the auditor should have reasonably been able to foresee as being likely users of financial statements Foreseen users—members of a limited class of users whom the auditor is aware will rely on the financial statements 132 Part 1 / THE AUDITING PROFESSION REVIEW QUESTIONS 5-1 (Objective 5-1) State several factors that have affected the incidence of lawsuits against CPAs in recent years. 5-2 (Objective 5-1) Lawsuits against CPA firms continue to increase. State your opinion of the positive and negative effects of the increased litigation on CPAs and on society as a whole. 5-3 (Objective 5-2) Distinguish between business failure and audit risk. Why is business failure a concern to auditors? 5-4 (Objective 5-3) How does the prudent person concept affect the liability of the auditor? 5-5 (Objective 5-3) Distinguish between “fraud” and “constructive fraud.” 5-6 (Objectives 5-1, 5-8) Discuss why many CPA firms have willingly settled lawsuits out of court. What are the implications to the profession? 5-7 (Objective 5-4) A common type of lawsuit against CPAs is for the failure to detect a fraud. State the auditor’s responsibility for such discovery. Give authoritative support for your answer. 5-8 (Objectives 5-3, 5-4) What is meant by contributory negligence? Under what con - ditions will this likely be a successful defense? 5-9 (Objective 5-4) Explain how an engagement letter might affect an auditor’s liability to clients under common law. 5-10 (Objectives 5-4, 5-5) Compare and contrast traditional auditors’ legal responsibilities to clients and third-party users under common law. How has that law changed in recent years? 5-11 (Objective 5-5) Is the auditor’s liability affected if the third party was unknown rather	Alvin
than known? Explain. 5-12 (Objective 5-6) Contrast the auditor’s liability under the Securities Act of 1933 with that under the Securities Exchange Act of 1934. 5-13 (Objectives 5-4, 5-5, 5-6, 5-7) Distinguish between the auditor’s potential liability to the client, liability to third parties under common law, civil liability under the securities laws, and criminal liability. Describe one situation for each type of liability in which the auditor can be held legally responsible. 5-14 (Objective 5-6) What potential sanctions does the SEC have against a CPA firm? 5-15 (Objective 5-8) In what ways can the profession positively respond to and reduce liability in auditing? Apago PDF Enhancer MULTIPLE CHOICE QUESTIONS FROM CPA EXAMINATIONS 5-16 (Objectives 5-4, 5-5) The following questions concern CPA firms’ liability under common law. Choose the best response. a. Sharp, CPA, was engaged by Peters & Sons, a partnership, to give an opinion on the financial statements that were to be submitted to several prospective partners as part of a planned expansion of the firm. Sharp’s fee was fixed on a per diem basis. After a period of intensive work, Sharp completed about half of the necessary field work. Then, because of unanticipated demands on his time by other clients, Sharp was forced to abandon the work. The planned expansion of the firm failed to materialize because the prospective partners lost interest when the audit report was not promptly available. Sharp offered to complete the task at a later date. This offer was refused. Peters & Sons suffered damages of $400,000 as a result. Under the circumstances, what is the probable outcome of a lawsuit between Sharp and Peters & Sons? (1) Sharp will be compensated for the reasonable value of the services actually performed. (2) Peters & Sons will recover damages for breach of contract. Chapter 5 / LEGAL LIABILITY 133 (3) Peters & Sons will recover both punitive damages and damages for breach of contract. (4) Neither Sharp nor Peters & Sons will recover against the other. b. In a common law action against an accountant, lack of privity is a viable defense if the plaintiff (1) is the client’s creditor who sues the accountant for negligence. (2) can prove the presence of gross negligence that amounts to a reckless disregard for the truth. (3) is the accountant’s client. (4) bases the action upon fraud. c. The 1136 Tenants case was important chiefly because of its emphasis on the legal liability of the CPA when associated with (1) an SEC engagement. (2) unaudited financial statements. (3) an audit resulting in a disclaimer of opinion. (4) letters for underwriters. 5-17 (Objective 5-6) The following questions deal with liability under the 1933 and 1934 securities acts. Choose the best response. a. Major, Major, & Sharpe, CPAs, are the auditors of MacLain Technologies. In connection with the public offering of $10 million of MacLain securities, Major expressed an unqualified opinion as to the financial statements. Subsequent to the offering, certain misstatements were revealed. Major has been sued by the purchasers of the stock offered pursuant to the registration statement that included the financial statements audited by Major. In the ensuing lawsuit by the MacLain investors, Major will be able to avoid liability if (1) the misstatements were caused primarily by MacLain. (2) it can be shown that at least some of the investors did not actually read the audited Apago PDF Enhancer (3) it can prove due diligence in the audit of the financial statements of MacLain. (4) MacLain had expressly assumed any liability in connection with the public financial statements. offering. b. Under the 1933 Securities Act, which of the following must be proven by the purchaser of the security? (1) (2) (3) (4) Reliance on the Financial Statements Yes Yes No No Fraud by The CPA Yes No Yes No c. Donalds & Company, CPAs, audited the financial statements included in the annual report submitted by Markum Securities, Inc. to the SEC. The audit was improper in several respects. Markum is now insolvent and unable to satisfy the claims of its	Alvin
customers. The customers have instituted legal action against Donalds based on Section 10b and Rule 10b-5 of the Securities Exchange Act of 1934. Which of the following is likely to be Donalds’ best defense? (1) They did not intentionally certify false financial statements. (2) Section 10b does not apply to them. (3) They were not in privity of contract with the creditors. (4) Their engagement letter specifically disclaimed any liability to any party that resulted from Markum’s fraudulent conduct. d. Which of the following statements about the Securities Act of 1933 is not true? (1) The third party user does not have the burden of proof that she/he relied on the financial statements. 134 Part 1 / THE AUDITING PROFESSION (2) The third party has the burden of proof that the auditor was either negligent or fraudulent in doing the audit. (3) The third party user does not have the burden of proof that the loss was caused by the misleading financial statements. (4) The auditor will not be liable if he or she can demonstrate due diligence in performing the audit. DISCUSSION QUESTIONS AND PROBLEMS 5-18 (Objectives 5-3, 5-4, 5-5, 5-6) Following are 8 statements with missing terms involving auditor legal liability. 1. Under the Ultramares Doctrine, an auditor is generally not liability for _____ to third parties lacking _____. 2. The auditor will use a defense of _____ in a suit brought under the 1933 Securities Act. 3. After passage of the Private Securities Litigation Reform Act, auditors generally have _____ liability in federal securities cases. 4. The broadest class of third parties under common law is known as _____. 5. Based on the ruling in Hochfelder v. Ernst & Ernst, an auditor generally must have knowledge and _____ to be found guilty of a violation of Rule 10b-5 of the 1934 Act. 6. Under the 1933 Act, plaintiffs do not have to demonstrate _____ , but need merely demonstrate the existence of a _____. 7. _____ is generally only available as a defense in suits brought by clients. 8. A third party lacking privity will often be successful in bringing a claim against the auditor if they can demonstrate_____ or _____. Terms a. Due diligence b. Reliance on the financial statements c. Fraud d. Ordinary negligence e. Separate and proportionate f. Contributory negligence Apago PDF Enhancer g. Intent to deceive h. Privity of contract i. Gross negligence j. Foreseen users k. Material error or omission For each of the 11 blanks in statements 1 through 8, identify the most appropriate term. No term can be used more than once. Required 5-19 (Objectives 5-4, 5-5) Lauren Yost & Co., a medium-sized CPA firm, was engaged to audit Stuart Supply Company. Several staff were involved in the audit, all of whom had attended the firm’s in-house training program on effective auditing methods. Throughout the audit, Yost spent most of her time in the field planning the audit, supervising the staff, and reviewing their work. A significant part of the audit entailed verifying the physical count, cost, and summari - zation of inventory. Inventory was highly significant to the financial statements, and Yost knew the inventory was pledged as collateral for a large loan to First City National Bank. In reviewing Stuart’s inventory count procedures, Yost told the president she believed the method of counting inventory at different locations on different days was highly undesirable. The president stated that it was impractical to count all inventory on the same day because of personnel shortages and customer preference. After considerable discussion, Yost agreed to permit the practice if the president would sign a statement that no other method was practical. The CPA firm had at least one person at each site to audit the inventory count procedures and actual count. There were more than 40 locations. Eighteen months later, Yost found out that the worst had happened. Management below the president’s level had conspired to materially overstate inventory as a means of covering up obsolete inventory and inventory losses resulting from mismanagement. The misstate -	Alvin
ment occurred by physically transporting inventory at night to other locations after it had Chapter 5 / LEGAL LIABILITY 135 been counted in a given location. The accounting records were inadequate to uncover these illegal transfers. Both Stuart Supply Company and First City National Bank sued Lauren Yost & Co. Required Answer the following questions, setting forth reasons for any conclusions stated: a. What defense should Lauren Yost & Co. use in the suit by Stuart? b. What defense should Lauren Yost & Co. use in the suit by First City National Bank? c. Is Yost likely to be successful in her defenses? d. Would the issues or outcome be significantly different if the suit was brought under the Securities Exchange Act of 1934? 5-20 (Objective 5-5) The CPA firm of Bigelow, Barton, and Brown was expanding rapidly. Consequently, it hired several junior accountants, including a man named Small. The partners of the firm eventually became dissatisfied with Small’s production and warned him they would be forced to discharge him unless his output increased significantly. At that time, Small was engaged in audits of several clients. He decided that to avoid being fired, he would reduce or omit some of the standard auditing procedures listed in audit programs prepared by the partners. One of the CPA firm’s clients, Newell Corporation, was in serious financial difficulty and had adjusted several of the accounts being audited by Small to appear financially sound. Small prepared fictitious audit documentation in his home at night to support purported completion of auditing procedures assigned to him, although he in fact did not examine the adjusting entries. The CPA firm rendered an unqualified opinion on Newell’s financial statements, which were grossly misstated. Several creditors, relying on the audited financial statements, subsequently extended large sums of money to Newell Corporation. Required Will the CPA firm be liable to the creditors who extended the money because of their reliance on the erroneous financial statements if Newell Corporation should fail to pay them? Explain.* Apago PDF Enhancer 5-21 (Objectives 5-3, 5-5) Doyle and Jensen, CPAs, audited the accounts of Regal Jewelry, Inc., a corporation that imports and deals in fine jewelry. Upon completion of the audit, the auditors supplied Regal Jewelry with 20 copies of the audited financial statements. The firm knew in a general way that Regal Jewelry wanted that number of copies of the auditor’s report to furnish to banks and other potential lenders. The balance sheet in question was misstated by approximately $800,000. Instead of having a $600,000 net worth, the corporation was insolvent. The management of Regal Jewelry had doctored the books to avoid bankruptcy. The assets had been overstated by $500,000 of fictitious and nonexisting accounts receivable and $300,000 of nonexisting jewelry listed as inventory when in fact Regal Jewelry had only empty boxes. The audit failed to detect these fraudulent entries. Thompson, relying on the audited financial statements, loaned Regal Jewelry $200,000. She seeks to recover her loss from Doyle and Jensen. Required State whether each of the following is true or false and give your reasons: a. If Thompson alleges and proves negligence on the part of Doyle and Jensen, she will be able to recover her loss. b. If Thompson alleges and proves constructive fraud (that is, gross negligence on the part of Doyle and Jensen), she will be able to recover her loss. c. Thompson does not have a contract with Doyle and Jensen. d. Unless actual fraud on the part of Doyle and Jensen can be shown, Thompson can not recover. e. Thompson is a third-party beneficiary of the contract Doyle and Jensen made with Regal Jewelry.* *AICPA adapted. 136 Part 1 / THE AUDITING PROFESSION 5-22 (Objectives 5-5, 5-6) In order to expand its operations, Barton Corp. raised $5 million in a public offering of common stock, and also negotiated a $2 million loan from First National Bank. In connection with this financing, Barton engaged Hanover & Co., CPAs to	Alvin
audit Barton’s financial statements. Hanover knew that the sole purpose of the audit was so that Barton would have audited financial statements to provide to First National Bank and the purchasers of the common stock. Although Hanover conducted the audit in conformity with its audit program, Hanover failed to detect material acts of embezzlement committed by Barton Corp.’s president. Hanover did not detect the embezzlement because of its inadvertent failure to exercise due care in designing the audit program for this engagement. After completing the engagement, Hanover issued an unqualified opinion on Barton’s financial statements. The financial statements were relied upon by the purchasers of the common stock in deciding to purchase the shares. In addition, First National Bank approved the loan to Barton based on the audited financial statements. Within sixty days after the sale of the common stock and the issuance of the loan, Barton was involuntarily petitioned into bankruptcy. Because of the president’s embezzlement, Barton became insolvent and defaulted on the loan from the bank. Its common stock became virtually worthless. Actions have been brought against Hanover by: • The purchasers of the common stock who have asserted that Hanover is liable for damages under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934. • First National Bank, based upon Hanover’s negligence. • Trade creditors who extended credit to Barton, based upon Hanover’s negligence. a. Discuss whether you believe Hanover will be found liable to the purchasers of common stock. b. Indicate whether you believe First National Bank will be successful in its claim against Hanover. c. Indicate whether you believe the trade creditors will be successful in their claim against Hanover.* Apago PDF Enhancer 5-23 (Objectives 5-4, 5-5, 5-7) Chen, CPA, is the auditor for Greenleaf Manufacturing Corporation, a privately owned company that has a June 30 fiscal year. Greenleaf arranged for a substantial bank loan that was dependent on the bank’s receiving, by September 30, audited financial statements that showed a current ratio of at least 2 to 1. On September 25, just before the audit report was to be issued, Chen received an anonymous letter on Greenleaf ’s stationery indicating that a 5-year lease by Greenleaf, as lessee, of a factory building accounted for in the financial statements as an operating lease was, in fact, a capital lease. The letter stated that there was a secret written agreement with the lessor modifying the lease and creating a capital lease. Chen confronted the president of Greenleaf, who admitted that a secret agreement existed but said it was necessary to treat the lease as an operating lease to meet the current ratio requirement of the pending loan and that nobody would ever discover the secret agreement with the lessor. The president said that if Chen did not issue his report by September 30, Greenleaf would sue Chen for substantial damages that would result from not getting the loan. Under this pressure and because the audit files contained a copy of the 5-year lease agreement that supported the operating lease treatment, Chen issued his report with an unqualified opinion on September 29. Despite the fact that the loan was received, Greenleaf went bankrupt within 2 years. The bank is suing Chen to recover its losses on the loan, and the lessor is suing Chen to recover uncollected rents. Required Answer the following questions, setting forth reasons for any conclusions stated: Required a. Is Chen liable to the bank? b. Is Chen liable to the lessor? c. Is there potential for criminal action against Chen?* *AICPA adapted. Chapter 5 / LEGAL LIABILITY 137 5-24 (Objective 5-6) Under Section 11 of the Securities Act of 1933 and Section 10(b), Rule 10b-5, of the Securities Exchange Act of 1934, a CPA may be sued by a purchaser of registered securities. The following items relate to what a plaintiff who purchased securities must prove in a civil liability suit against a CPA.	Alvin
The plaintiff security purchaser must allege or prove: 1. Material misstatements were included in a filed document. 2. A monetary loss occurred. 3. Lack of due diligence by the CPA. 4. Privity with the CPA. 5. Reliance on the financial statements. 6. The CPA had scienter (knowledge and intent to deceive). Required For each of the items 1 through 6 listed above, indicate whether the statement must be proven under a. Section 11 of the Securities Act of 1933 only. b. Section 10(b) of the Securities Exchange Act of 1934 only. c. Both Section 11 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934. d. Neither Section 11 of the Securities Act of 1933 nor Section 10(b) of the Securities Exchange Act of 1934.* 5-25 (Objective 5-6) Gordon & Groton, CPAs, were the auditors of Bank & Company, a brokerage firm and member of a national stock exchange. Gordon & Groton audited and reported on the financial statements of Bank, which were filed with the Securities and Exchange Commission. Several of Bank’s customers were swindled by a fraudulent scheme perpetrated by Bank’s president, who owned 90% of the voting stock of the company. The facts establish that Gordon & Groton were negligent but not reckless or grossly negligent in the conduct of the audit, and neither participated in the fraudulent scheme or knew of its existence. Apago PDF Enhancer The customers are suing Gordon & Groton under the antifraud provisions of Section 10b and Rule 10b-5 of the Securities Exchange Act of 1934 for aiding and abetting the fraudulent scheme of the president. The customers’ suit for fraud is predicated exclusively on the nonfeasance of the auditors in failing to conduct a proper audit, thereby failing to discover the fraudulent scheme. Answer the following questions, setting forth reasons for any conclusions stated: Required a. What is the probable outcome of the lawsuit? b. What other theory of liability might the customers have asserted?* 5-26 (Objective 5-5) Sarah Robertson, CPA, had been the auditor of Majestic Co. for several years. As she and her staff prepared for the audit for the year ended December 31, 2010, Herb Majestic told her that he needed a large bank loan to “tide him over” until sales picked up as expected in late 2011. In the course of the audit, Robertson discovered that the financial situation at Majestic was worse than Majestic had revealed and that the company was technically bankrupt. She discussed the situation with Majestic, who pointed out that the bank loan will “be his solution”—he was sure he will get it as long as the financial statements don’t look too bad. Robertson stated that she believed the statements will have to include a going concern explanatory paragraph. Majestic said that this wasn’t needed because the bank loan was so certain and that inclusion of the going concern paragraph will certainly cause the manage - ment of the bank to change its mind about the loan. Robertson finally acquiesced and the audited statements were issued without a going concern paragraph. The company received the loan, but things did not improve as Majestic thought they would and the company filed for bankruptcy in August 2011. The bank sued Sarah Robertson for fraud. Required Indicate whether or not you think the bank will succeed. Support your answer. 138 Part 1 / THE AUDITING PROFESSION *AICPA adapted. CASE 5-27 (Objectives 5-5, 5-6) Part 1. Whitlow & Company is a brokerage firm registered under the Securities Exchange Act of 1934. The act requires such a brokerage firm to file audited financial statements with the SEC annually. Mitchell & Moss, Whitlow’s CPAs, performed the annual audit for the year ended December 31, 2011, and rendered an unqualified opinion, which was filed with the SEC along with Whitlow’s financial state ments. During 2011, Charles, the president of Whitlow & Company, engaged in a huge embezzlement scheme that eventually bankrupted the firm. As a result, substantial losses were suffered by cus - tomers and shareholders of Whitlow & Company, including Thaxton, who had recently	Alvin
purchased several shares of stock of Whitlow & Company after reviewing the company’s 2011 audit report. Mitchell & Moss’s audit was deficient; if they had complied with auditing standards, the embezzlement would have been discovered. However, Mitchell & Moss had no knowledge of the embezzlement, nor can their conduct be categorized as reckless. Answer the following questions, setting forth reasons for any conclusions stated: Required a. What liability to Thaxton, if any, does Mitchell & Moss have under the Securities Exchange Act of 1934? b. What theory or theories of liability, if any, are available to Whitlow & Company’s customers and shareholders under common law? Part 2. Jackson is a sophisticated investor. As such, she was initially a member of a small group that was going to participate in a private placement of $1 million of common stock of Clarion Corporation. Numerous meetings were held between management and the investor group. Detailed financial and other information was supplied to the participants. Upon the eve of completion of the placement, it was aborted when one major investor withdrew. Clarion then decided to offer $2.5 million of Clarion common stock to the public pursuant to the registration requirements of the Securities Act of 1933. Jackson subscribed to $300,000 of the Clarion public stock offering. Nine months later, Clarion’s earnings dropped significantly, and as a result, the stock dropped 20% beneath the offering price. In addition, the Dow Jones Industrial Average was down 10% from the time of the offering. Apago PDF Enhancer Jackson sold her shares at a loss of $60,000 and seeks to hold all parties liable who participated in the public offering, including Clarion’s CPA firm of Allen, Dunn, and Rose. Although the audit was performed in conformity with auditing standards, there were some relatively minor misstatements. The financial statements of Clarion Corporation, which were part of the registration statement, contained minor misleading facts. It is believed by Clarion and Allen, Dunn, and Rose that Jackson’s asserted claim is without merit. Answer the following questions, setting forth reasons for any conclusions stated: Required a. If Jackson sues under the Securities Act of 1933, what will be the basis of her claim? b. What are the probable defenses that might be asserted by Allen, Dunn, and Rose in light of these facts?* INTERNET PROBLEM 5-1: SEC ENFORCEMENT The SEC Enforcement Division investigates possible violations of securities laws, recom - mends SEC action when appropriate, either in a federal court or before an administrative law judge, and negotiates settlements. Litigation Releases, which are descriptions of SEC civil and selected criminal suits in the federal courts, are posted on the SEC web site (www.sec.gov/litigation/litreleases.shtml). Find Litigation Release No. 21532 dated May 25, 2010. a. What is the nature of the complaint underlying LR No. 21532? b. What sections of the federal securities laws is the individual involved accused of Required violating? *AICPA adapted. Chapter 5 / LEGAL LIABILITY 139 C H A P T E R S 6 – 13 T R A P 2 THE AUDIT PROCESS Part 2 presents the audit process in a manner that will enable you to apply the concepts developed in these chapters to any audit area. Because the planning concepts covered in these chapters will be used extensively throughout the rest of the book, it is essential for you to master this material and fully understand the importance of audit planning. audit objectives, and general concepts of evidence accumulation. • Chapters 6 and 7 deal with auditors’ and managements’ responsibilities, • Chapters 8 through 12 study various aspects of audit planning in depth, Apago PDF Enhancer including risk assessment and auditors’ responsibility for detecting fraud. • Chapter 13 summarizes and integrates audit planning and audit evidence. Throughout the remainder of the book, many of the concepts are illustrated with examples based on the Hillsburg Hardware Company. The ﬁnancial statements and other information from the company’s annual report are	Alvin
included in the glossy insert material to the textbook. C H A P T E R 6 AUDIT RESPONSIBILITIES AND OBJECTIVES Where Were The Auditors? Barry Minkow was a true “whiz kid.” He started ZZZZ Best Company, a high- ﬂying carpet cleaning company specializing in insurance restoration contracts, at the age of 16. In 1982, when Minkow started the business, it was run out of his garage, but a mere 5 years later he had taken the company public and it had sales of $50 million and earnings of more than $5 million. The market value of Minkow’s stock in ZZZZ Best exceeded $100 million. As it turned out, Minkow’s genius lay not in business but in deception. Instead of being a solid operating company, ZZZZ Best was an illusion. There were no large restoration jobs and no real revenues and proﬁts. They were only on paper and supported by an effective network of methods to deceive shareholders, the SEC, and the reputable professionals who served the company, including its auditors. Many, including members of Congress, asked, “How could this happen? Where were the auditors?” Apago PDF Enhancer When ZZZZ Best ﬁrst started to grow, Minkow ran into the common problem of needing credit. He devised a scheme with an insurance adjuster to validate nonexistent jobs to potential creditors. Minkow could then get large sums of cash on credit despite not doing any real work. The scam was broadened when ZZZZ Best started needing audits. To fool the auditors, the coconspirator insurance adjuster was kept busy running a company that generated false contracts for ZZZZ Best. When the auditors tried to check on those contracts, the adjuster conﬁrmed them. Minkow even went so far as taking auditors to real work sites, sites that weren’t actually his. He even leased a partially completed building and hired subcontractors to perform work on the site, all for the sake of a visit by the auditors. As incredible as the ZZZZ Best story may seem, when asked about it, most knowledgeable observers would answer: “It’s not the ﬁrst time, and it won’t be the last.” It is also not the last time people will ask, “Where were the auditors?” L E A R N I N G O B J E C T I V E S After studying this chapter, you should be able to 6-1 Explain the objective of conducting an audit of ﬁnancial statements and an audit of internal controls. 6-2 Distinguish management’s responsibility for the ﬁnancial statements and internal control from the auditor’s responsibility for verifying the ﬁnancial state - ments and effectiveness of internal control. 6-3 Explain the auditor’s responsi - bility for discovering material misstatements. 6-4 Classify transactions and account balances into ﬁnancial statement cycles and identify beneﬁts of a cycle approach to segmenting the audit. 6-5 Describe why the auditor obtains a combination of assurance by auditing classes of transactions and ending balances in accounts, including presentation and disclosure. 6-6 Distinguish among the three categories of management asser - tions about ﬁnancial information. 6-7 Link the six general transaction- related audit objectives to management assertions for classes of transactions. 6-8 Link the eight general balance- related audit objectives to management assertions for account balances. 6-9 Link the four presentation and disclosure-related audit objectives to manage ment assertions for presentation and disclosure. 6-10 Explain the relationship between audit objectives and the accumulation of audit evidence. The ZZZZ Best story illustrates failure by the auditors to achieve the objectives of the audit of the company’s ﬁnancial statements. This chapter describes the overall objectives of the audit, the auditor’s responsibilities in con - ducting the audit, and the speciﬁc objectives the auditor tries to accomplish. Without an understanding of these topics, planning and accumulating audit evidence during the audit has no relevance. Figure 6-1 summarizes the ﬁve topics that provide keys to understanding evidence accumulation. These are the steps used to develop speciﬁc audit objectives.	Alvin
OBJECTIVE OF CONDUCTING AN AUDIT OF FINANCIAL STATEMENTS OBJECTIVE 6-1 Auditing standards indicate Explain the objective of conducting an audit of ﬁnancial statements and an audit of internal controls. The purpose of an audit is to provide ﬁnancial statement users with an opinion by the auditor on whether the ﬁnancial statements are presented fairly, in all material respects, in accordance with the applicable ﬁnancial accounting framework. Understand objectives and responsibilities for the audit Divide financial statements into cycles Know management assertions about financial statements Know general audit objectives for classes of transactions, accounts, and disclosures Know specific audit objectives for classes of transactions, accounts, and disclosures Our primary focus is the section that emphasizes issuing an opinion on ﬁnancial statements. For some public companies, the auditor also issues a report on internal control over ﬁnancial reporting as required by Section 404 of the Sarbanes–Oxley Act. Auditors accumulate evidence in order to reach conclusions about whether the ﬁnancial statements are fairly stated and to determine the effectiveness of internal control, after which they issue the appropriate audit report. If the auditor believes that the statements are not fairly presented or is unable to reach a conclusion because of insufﬁcient evidence, the auditor has the responsi bility of notifying users through the auditor’s report. Subsequent to their issuance, if facts indicate that the statements were not fairly presented as in the ZZZZ Best case, the auditor will probably have to demonstrate to the courts or regulatory agencies that the audit was conducted in a proper manner and the auditor reached reasonable conclusions. Apago PDF Enhancer FIGURE 6-1 Steps to Develop Audit Objectives Understand objectives and responsibilities for the audit Divide financial statements into cycles Know management assertions about financial statements Know general audit objectives for classes of transactions, accounts, and disclosures Know specific audit objectives for classes of transactions, accounts, and disclosures 142 Part 2 / THE AUDIT PROCESS MANAGEMENT’S RESPONSIBILITIES OBJECTIVE 6-2 Distinguish management’s responsibility for the ﬁnancial statements and internal control from the auditor’s responsibility for verifying the ﬁnancial statements and effectiveness of internal control. The responsibility for adopting sound accounting policies, maintaining adequate internal control, and making fair representations in the ﬁnancial statements rests with management rather than with the auditor. Because they operate the business daily, a company’s management knows more about the company’s transactions and related assets, liabilities, and equity than the auditor. In contrast, the auditor’s knowledge of these matters and internal control is limited to that acquired during the audit. The annual reports of many public companies include a statement about manage - ment’s responsibilities and relationship with the CPA ﬁrm. Figure 6-2 presents selected sections of the report of management for International Business Machines (IBM) Corporation as a part of its annual report. Read the report carefully to determine what management states about its responsibilities. Management’s responsibility for the integrity and fairness of the representations (assertions) in the ﬁnancial statements carries with it the privilege of determining which presentations and disclosures it considers necessary. If management insists on ﬁnancial statement disclosure that the auditor ﬁnds unacceptable, the auditor can either issue an adverse or qualiﬁed opinion or withdraw from the engagement. The Sarbanes–Oxley Act requires the chief executive ofﬁcer (CEO) and the chief ﬁnancial ofﬁcer (CFO) of public companies to certify the quarterly and annual ﬁnancial statements submitted to the SEC. In signing those statements, management certiﬁes that the ﬁnancial statements fully comply with the requirements of the Securities Exchange Act of 1934 and that the information contained in the ﬁnancial statements fairly	Alvin
FIGURE 6-2 International Business Machines Corporation’s Report of Management Apago PDF Enhancer REPORT OF MANAGEMENT International Business Machines Corporation and Subsidiary Companies Management Responsibility for Financial Information Responsibility for the integrity and objectivity of the financial information presented in this Annual Report rests with IBM management. The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, applying certain estimates and judgments as required. IBM maintains an effective internal control structure. It consists, in part, of organizational arrange- ments with clearly defined lines of responsibility and delegation of authority, and comprehensive systems and control procedures. An important element of the control environment is an ongoing internal audit program. Our system also contains self-monitoring mechanisms, and actions are taken to correct deficiencies as they are identified. The Audit Committee of the Board of Directors is composed solely of independent, non- management directors, and is responsible for recommending to the Board the independent registered public accounting firm to be retained for the coming year, subject to stockholder ratification. The Audit Committee meets periodically and privately with the independent registered public accounting firm, with the company’s internal auditors, as well as with IBM management, to review accounting, auditing, internal control structure and financial reporting matters. Samuel J. Palmisano Chairman of the Board, President and Chief Executive Officer February 23, 2010 Mark Loughridge Senior Vice President Chief Financial Officer February 23, 2010 Chapter 6 / AUDIT RESPONSIBILITIES AND OBJECTIVES 143 present, in all material respects, the ﬁnancial condition and results of operations. The Sarbanes–Oxley Act provides for criminal penalties, including signiﬁcant monetary ﬁnes or imprisonment up to 20 years, for anyone who knowingly falsely certiﬁes those statements. AUDITOR’S RESPONSIBILITIES OBJECTIVE 6-3 Auditing standards state Explain the auditor’s responsibility for discovering material misstatements. The overall objectives of the auditor are: (a) To obtain reasonable assurance about whether the ﬁnancial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion whether the ﬁnancial statements are prepared, in all material respects, in accordance with an applicable ﬁnancial reporting framework; and (b) To report on the ﬁnancial statements, and communicate as required by auditing standards, in accordance with the auditor’s ﬁndings. This paragraph discusses the auditor’s responsibility for detecting material mis - statements in the ﬁnancial statements. When the auditor also reports on the effectiveness of internal control over ﬁnancial reporting, the auditor is also responsible for identifying material weaknesses in internal control over ﬁnancial reporting. The auditor’s respon - sibilities for audits of internal control are discussed in Chapter 10. This paragraph and the related discussion in the standards about the auditor’s responsibility to detect material misstatements include several important terms and phrases. Apago PDF Enhancer Material Versus Immaterial Misstatements Misstatements are usually considered material if the combined uncorrected errors and fraud in the ﬁnancial statements would likely have changed or inﬂuenced the decisions of a reasonable person using the statements. Although it is difﬁcult to quantify a measure of materiality, auditors are responsible for obtaining reasonable assurance that this materiality threshold has been satisﬁed. It would be extremely costly (and probably impossible) for auditors to have responsibility for ﬁnding all immaterial errors and fraud. Reasonable Assurance Assurance is a measure of the level of certainty that the auditor	Alvin
has obtained at the completion of the audit. Auditing standards indicate reasonable assurance is a high, but not absolute, level of assurance that the ﬁnancial statements are free of material misstatements. The concept of reasonable, but not absolute, assurance indicates that the auditor is not an insurer or guarantor of the correctness of the ﬁnan - cial statements. Thus, an audit that is conducted in accordance with auditing standards may fail to detect a material misstatement. The auditor is responsible for reasonable, but not absolute, assurance for several reasons: 1. Most audit evidence results from testing a sample of a population such as accounts receivable or inventory. Sampling inevitably includes some risk of not uncovering a material misstatement. Also, the areas to be tested; the type, extent, and timing of those tests; and the evaluation of test results require signiﬁcant auditor judgment. Even with good faith and integrity, auditors can make mistakes and errors in judgment. 2. Accounting presentations contain complex estimates, which inherently involve uncertainty and can be affected by future events. As a result, the auditor has to rely on evidence that is persuasive, but not convincing. 144 Part 2 / THE AUDIT PROCESS 3. Fraudulently prepared ﬁnancial statements are often extremely difﬁcult, if not impossible, for the auditor to detect, especially when there is collusion among management. If auditors were responsible for making certain that all the assertions in the state - ments were correct, the types and amounts of evidence required and the resulting cost of the audit function would increase to such an extent that audits would not be economically practical. Even then, auditors would be unlikely to uncover all material misstatements in every audit. The auditor’s best defense when material misstatements are not uncovered is to have conducted the audit in accordance with auditing standards. Errors Versus Fraud Auditing standards distinguish between two types of misstate - ments: errors and fraud. Either type of misstatement can be material or immaterial. An error is an unintentional misstatement of the ﬁnancial statements, whereas fraud is intentional. Two examples of errors are a mistake in extending price times quantity on a sales invoice and overlooking older raw materials in determining the lower of cost or market for inventory. For fraud, there is a distinction between misappropriation of assets, often called defalcation or employee fraud, and fraudulent ﬁnancial reporting, often called manage - ment fraud. An example of misappropriation of assets is a clerk taking cash at the time a sale is made and not entering the sale in the cash register. An example of fraudulent ﬁnancial reporting is the intentional overstatement of sales near the balance sheet date to increase reported earnings. Professional Skepticism Auditing standards require that an audit be designed to provide reasonable assurance of detecting both material errors and fraud in the ﬁnancial statements. To accomplish this, the audit must be planned and performed with an attitude of professional skepticism in all aspects of the engagement. Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. Auditors should not assume that management is dishonest, but the possibility of dishonesty must be considered. At the same time, auditors also should not assume that management is unquestionably honest. Apago PDF Enhancer Auditors spend a great portion of their time planning and performing audits to detect unintentional mistakes made by management and employees. Auditors ﬁnd a variety of errors resulting from such things as mistakes in calculations, omissions, misunder - standing and misapplication of accounting standards, and incorrect summarizations and descriptions. Throughout the rest of this book, we consider how the auditor plans and performs audits for detecting both errors and fraud. Auditing standards make no distinction between the auditor’s responsibilities for	Alvin
searching for errors and fraud. In either case, the auditor must obtain reasonable assurance about whether the statements are free of material misstatements. The standards also recognize that fraud is often more difﬁcult to detect because manage - ment or the employees perpetrating the fraud attempt to conceal the fraud, similar to the ZZZZ Best case. Still, the difﬁculty of detection does not change the auditor’s responsibility to properly plan and perform the audit to detect material misstatements, whether caused by error or fraud. Fraud Resulting from Fraudulent Financial Reporting Versus Misappro - priation of Assets Both fraudulent ﬁnancial reporting and misappropriation of assets are potentially harmful to ﬁnancial statement users, but there is an important difference between them. Fraudulent ﬁnancial reporting harms users by providing them incorrect ﬁnancial statement information for their decision making. When assets are misappropriated, stockholders, creditors, and others are harmed because assets are no longer available to their rightful owners. Auditor’s Responsibilities for Detecting Material Errors Auditor’s Responsibilities for Detecting Material Fraud Chapter 6 / AUDIT RESPONSIBILITIES AND OBJECTIVES 145 CABLE MOGULS ARRESTED FOR CORPORATE LOOTING Sometimes, misappropriation of assets involves signiﬁcant amounts and occurs at the very top of the organization. In 2002 the SEC charged former Adelphia CEO John Rigas and other Rigas family members with “rampant self dealing” at Adelphia Communications Corp. in what has been called one of the most extensive ﬁnancial frauds ever to take place at a public company. According to the SEC complaint, the Rigas family used Adelphia funds to ﬁnance open market purchases of stock, pay off margin loans and other family debts, purchase timber rights, construct a golf club, and purchase luxury condominiums in Colorado, Mexico, and New York City. In the criminal complaint, prosecutors charged that the Rigas family “looted Adelphia on a massive scale, using the company as the Rigas family’s personal piggy bank, at the expense of public investors and creditors.” After details of the misappropriations and fraudulent reporting in the company’s ﬁnancial statements became public, Adelphia ﬁled for bankruptcy, and its stock collapsed from a price of $20 per share to less than $1 per share. John Rigas was convicted and sentenced to 15 years in prison; his son Timothy, the company’s former CFO, was sentenced to 20 years in prison. Sources: 1. “Adelphia founder sentenced to 15 years” (money.cnn.com/2005/06/20/news/newsmakers/ rigas_sentencing/); 2. SEC press release 2002-110 (www.sec.gov/news/press/2002-110.htm). Typically, fraudulent ﬁnancial reporting is committed by management, sometimes without the knowledge of employees. Management is in a position to make accounting and reporting decisions without employees’ knowledge. An example is the decision to omit an important footnote disclosure about pending litigation. Usually, but not always, theft of assets is perpetrated by employees and not by manage - ment, and the amounts are often immaterial. However, there are well-known examples of extremely material misappropriation of assets by employees and management, similar to the Adelphia fraud described in the shaded box at the top of this page. arising from the theft of assets. Consider the following three situations: There is an important distinction between the theft of assets and misstatements Apago PDF Enhancer 1. Assets were taken and the theft was covered by misstating assets. For example, cash collected from a customer was stolen before it was recorded as a cash receipt, and the account receivable for the customer’s account was not credited. The misstatement has not been discovered. 2. Assets were taken and the theft was covered by understating revenues or overstating expenses. For example, cash from a cash sale was stolen, and the transaction was not recorded. Or, an unauthorized disbursement to an employee was recorded as a miscellaneous expense. The misstatement has not been discovered.	Alvin
3. Assets were taken, but the misappropriation was discovered. The income statement and related footnotes clearly describe the misappropriation. In all three situations, there has been a misappropriation of assets, but the ﬁnancial statements are misstated only in situations 1 and 2. In situation 1, the balance sheet is misstated, whereas in situation 2, revenues or expenses are misstated. Illegal acts are deﬁned as violations of laws or government regulations other than fraud. Two examples of illegal acts are a violation of federal tax laws and a violation of the federal environmental protection laws. Direct-Effect Illegal Acts Certain violations of laws and regulations have a direct ﬁnancial effect on speciﬁc account balances in the ﬁnancial statements. For example, a violation of federal tax laws directly affects income tax expense and income taxes payable. The auditor’s responsibility for these direct-effect illegal acts is the same as for errors and fraud. On each audit, therefore, the auditor normally evaluates whether or not there is evidence available to indicate material violations of federal or state tax laws. To do this evaluation, the auditor might hold discussions with client personnel and examine reports issued by the Internal Revenue Service after completion of an exami - nation of the client’s tax return. Auditor’s Responsibilities for Discovering Illegal Acts 146 Part 2 / THE AUDIT PROCESS Indirect-Effect Illegal Acts Most illegal acts affect the ﬁnancial statements only indirectly. For example, if the company violates environmental protection laws, ﬁnancial statements are affected only if there is a ﬁne or sanction. Potential material ﬁnes and sanctions indirectly affect ﬁnancial statements by creating the need to disclose a contingent liability for the potential amount that might ultimately be paid. This is called an indirect-effect illegal act. Other examples of illegal acts that are likely to have only an indirect effect are violations of insider securities trading regulations, civil rights laws, and federal employee safety requirements. Auditing standards state that the auditor provides no assurance that indirect-effect illegal acts will be detected. Auditors lack legal expertise, and the frequent indirect relationship between illegal acts and the ﬁnancial statements makes it impractical for auditors to assume responsibility for dis covering those illegal acts. Auditors have three levels of responsibility for ﬁnding and reporting illegal acts: Evidence Accumulation When There Is No Reason to Believe Indirect-Effect Illegal Acts Exist Many audit procedures normally performed on audits to search for errors and fraud may also uncover illegal acts. Examples include reading the minutes of the board of directors and inquiring of the client’s attorneys about litigation. The auditor should also inquire of management about policies they have established to prevent illegal acts and whether management knows of any laws or regulations that the company has violated. Other than these procedures, the auditor should not search for indirect-effect illegal acts unless there is reason to believe they may exist. Evidence Accumulation and Other Actions When There Is Reason to Believe Direct- or Indirect-Effect Illegal Acts May Exist The auditor may ﬁnd indi cations of possible illegal acts in a variety of ways. For example, the minutes may indicate that an investigation by a government agency is in process or the auditor may have identiﬁed unusually large payments to consultants or government ofﬁcials. When the auditor believes that an illegal act may have occurred, several actions are Apago PDF Enhancer necessary to determine whether the suspected illegal act actually exists: 1. The auditor should ﬁrst inquire of management at a level above those likely to be involved in the potential illegal act. 2. The auditor should consult with the client’s legal counsel or other specialist who is knowledgeable about the potential illegal act. 3. The auditor should consider accumulating additional evidence to determine	Alvin
whether there actually is an illegal act. Actions When the Auditor Knows of an Illegal Act The ﬁrst course of action when an illegal act has been identiﬁed is to consider the effects on the ﬁnancial statements, including the adequacy of disclosures. These effects may be complex and difﬁcult to resolve. For example, a violation of civil rights laws could involve signiﬁcant ﬁnes, but it could also result in the loss of customers or key employees, which could materially affect future revenues and expenses. If the auditor concludes that the dis closures relative to an illegal act are inadequate, the auditor should modify the audit report accordingly. The auditor should also consider the effect of such illegal acts on the CPA ﬁrm’s relation ship with management. If management knew of the illegal act and failed to inform the auditor, it is questionable whether management can be believed in other discussions. The auditor should communicate with the audit committee or others of equivalent authority to make sure that they know of the illegal act. The communication can be oral or written. If it is oral, the nature of the communication and discussion should be docu - mented in the audit ﬁles. If the client either refuses to accept the auditor’s modiﬁed report or fails to take appropriate remedial action concerning the illegal act, the auditor may ﬁnd it necessary to withdraw from the engagement. If the client is publicly held, the auditor must also report the matter directly to the SEC. Such decisions are complex and normally involve consultation by the auditor with the auditor’s legal counsel. Chapter 6 / AUDIT RESPONSIBILITIES AND OBJECTIVES 147 FINANCIAL STATEMENT CYCLES OBJECTIVE 6-4 Classify transactions and account balances into ﬁnancial statement cycles and identify beneﬁts of a cycle approach to segmenting the audit. Cycle Approach to Segmenting an Audit Audits are performed by dividing the ﬁnancial statements into smaller segments or components. The division makes the audit more manageable and aids in the assign - ment of tasks to different members of the audit team. For example, most auditors treat ﬁxed assets and notes payable as different segments. Each segment is audited separately but not on a completely independent basis. (For example, the audit of ﬁxed assets may reveal an unrecorded note payable.) After the audit of each segment is completed, including interrelationships with other segments, the results are combined. A con - clusion can then be reached about the ﬁnancial statements taken as a whole. There are different ways of segmenting an audit. One approach is to treat every account balance on the statements as a separate segment. Segmenting that way is usually inefﬁcient. It would result in the independent audit of such closely related accounts as inventory and cost of goods sold. A common way to divide an audit is to keep closely related types (or classes) of trans - actions and account balances in the same segment. This is called the cycle approach. For example, sales, sales returns, cash receipts, and charge-offs of uncollectible accounts are the four classes of transactions that cause accounts receivable to increase and decrease. Therefore, they are all parts of the sales and collection cycle. Similarly, payroll transactions and accrued payroll are parts of the payroll and personnel cycle. The logic of using the cycle approach is that it ties to the way transactions are recorded in journals and summarized in the general ledger and ﬁnancial statements. Figure 6-3 shows that ﬂow. To the extent that it is practical, the cycle approach combines transactions recorded in different journals with the general ledger balances that result from those transactions. The cycles used in this text are listed below and are then explained in detail. Note Apago PDF Enhancer that each of these cycles is so important that one or more later chapters address the audit of each cycle: FIGURE 6-3 Transaction Flow from Journals to Financial Statements TRANSACTIONS JOURNALS Sales Cash receipts Sales journal	Alvin
Cash receipts journal LEDGERS, TRIAL BALANCE, AND FINANCIAL STATEMENTS General ledger and subsidiary records Acquisition of goods and services Acquisitions journal Cash disbursements Cash disbursements journal Payroll services and disbursements Allocation and adjustments Payroll journal General journal General ledger trial balance Financial statements 148 Part 2 / THE AUDIT PROCESS • Sales and collection cycle • Acquisition and payment cycle • Payroll and personnel cycle Inventory and warehousing cycle • • Capital acquisition and repayment cycle Figure 6-4 (p. 150) illustrates the application of cycles to audits using the December 31, 2011, trial balance for Hillsburg Hardware Company. (The ﬁnancial statements pre pared from this trial balance are included in the glossy insert to the textbook.) A trial balance is used to prepare ﬁnancial statements and is a primary focus of every audit. Prior-year account balances are usually included for comparative purposes, but are excluded from Figure 6-4 in order to focus on transaction cycles. The letter repre senting a cycle is shown for each account in the left column beside the account name. Observe that each account has at least one cycle associated with it, and only cash and inventory are a part of two or more cycles. The accounts for Hillsburg Hardware Co. are summarized in Table 6-1 (p. 151) by cycle, and include the related journals and ﬁnancial statements in which the accounts appear. The following observations expand on the information contained in Table 6-1. • All general ledger accounts and journals for Hillsburg Hardware Co. are included at least once. For a different company, the number and titles of journals and general ledger accounts will differ, but all will be included. • Some journals and general ledger accounts are included in more than one cycle. When that occurs, it means that the journal is used to record transactions from more than one cycle and indicates a tie-in between the cycles. The most important general ledger account included in and affecting several cycles is general cash (cash in bank). General cash connects most cycles. Understand objectives and responsibilities for the audit Divide financial statements into cycles Know management assertions about financial statements Know general audit objectives for classes of transactions, accounts, and disclosures Know specific audit objectives for classes of transactions, accounts, and disclosures • The sales and collection cycle is the ﬁrst cycle listed and is a primary focus on most audits. Collections on trade accounts receivable in the cash receipts journal is the primary operating inﬂow to cash in the bank. Apago PDF Enhancer • The capital acquisition and repayment cycle is closely related to the acquisition and payment cycle. Transactions in the acquisition and payment cycle include the purchase of inventory, supplies, and other goods and services related to opera tions. Transactions in the capital acquisition and repayment cycle are related to ﬁnancing the business, such as issuing stock or debt, paying dividends, and repaying debt. Although the same journals are used for transactions in the acquisition and pay ment and capital acquisition and repayment cycles, it is useful to separate capital acquisition and repayment cycle transactions into a separate transaction cycle. First, capital acquisitions and repayments relate to ﬁnancing the business, rather than operations. Second, most capital acquisition and repayment cycle accounts involve few transactions, but each is often highly material and therefore should be audited extensively. Considering both reasons, it is more convenient to separate the two cycles. • The inventory and warehousing cycle is closely related to all other cycles, especially for a manufacturing company. The cost of inventory includes raw materials (acquisition and payment cycle), direct labor (payroll and personnel cycle), and manufacturing overhead (acquisition and payment and payroll and personnel cycles). The sale of ﬁnished goods involves the sales and collection cycle. Because inventory is material for most manufacturing companies, it is	Alvin
common to borrow money using inventory as security. In those cases, the capital acquisition and repay ment cycle is also related to inventory and warehousing. Inventory is included as a separate cycle both because it is related to other cycles and because for most manufacturing and retail companies inventory is usually highly material, there are unique systems and controls for inventory, and inventory is often complex to audit. Chapter 6 / AUDIT RESPONSIBILITIES AND OBJECTIVES 149 FIGURE 6-4 Hillsburg Hardware Co. Adjusted Trial Balance HILLSBURG HARDWARE CO. TRIAL BALANCE December 31, 2011 S,A,P,C S S S A,I A A A A A A A C P P C C A C A A C C C S S I P P A A A A A P P A A A A A A A A A S A A A A A A C C Cash in bank Trade accounts receivable Allowance for uncollectible accounts Other accounts receivable Inventories Prepaid expenses Land Buildings Computer and other equipment Furniture and fixtures Accumulated depreciation Trade accounts payable Notes payable Accrued payroll Accrued payroll taxes Accrued interest Dividends payable Accrued income tax Long-term notes payable Deferred tax Other accrued payables Capital stock Capital in excess of par value Retained earnings Sales Sales returns and allowances Cost of goods sold Salaries and commissions Sales payroll taxes Travel and entertainment—selling Advertising Sales and promotional literature Sales meetings and training Miscellaneous sales expense Executive and office salaries Administrative payroll taxes Travel and entertainment—administrative Computer maintenance and supplies Stationery and supplies Postage Telephone and fax Rent Legal fees and retainers Auditing and related services Depreciation Bad debt expense Insurance Office repairs and maintenance Miscellaneous office expense Miscellaneous general expense Gain on sale of assets Income taxes Interest expense Dividends Apago PDF Enhancer Debit $ 827,568 20,196,800 945,020 29,864,621 431,558 3,456,420 32,500,000 3,758,347 2,546,421 1,241,663 103,240,768 7,738,900 1,422,100 1,110,347 2,611,263 321,620 924,480 681,041 5,523,960 682,315 561,680 860,260 762,568 244,420 722,315 312,140 383,060 302,840 1,452,080 3,323,084 722,684 843,926 643,680 323,842 1,746,600 2,408,642 1,900,000 $237,539,033 Credit $ 1,240,000 31,920,126 4,719,989 4,179,620 1,349,800 119,663 149,560 1,900,000 795,442 24,120,000 738,240 829,989 5,000,000 3,500,000 11,929,075 144,327,789 719,740 $237,539,033 Note: Letters in the left-hand column refer to the following transaction cycles: S = Sales and collection A = Acquisition and payment P = Payroll and personnel I = Inventory and warehousing C = Capital acquisition and repayment 150 Part 2 / THE AUDIT PROCESS TABLE 6-1 Cycles Applied to Hillsburg Hardware Co. Cycle Sales and collection Acquisition and payment Journals Included in the Cycle (See Figure 6-3, p. 148) Sales journal Cash receipts journal General journal Acquisitions journal Cash disbursements journal General journal General Ledger Accounts Included in the Cycle (See Figure 6-4) Balance Sheet Income Statement Cash in bank Trade accounts receivable Other accounts receivable Allowance for uncollectible accounts Sales Sales returns and allowances Bad debt expense Cash in bank Inventories Prepaid expenses Land Buildings Computer and other equipment Furniture and ﬁxtures Accumulated depreciation Trade accounts payable Other accrued payables Accrued income tax Deferred tax AdvertisingS Travel and entertainmentS Sales meetings and trainingS Sales and promotional literatureS Miscellaneous sales expenseS Travel and entertainmentA Stationery and suppliesA PostageA Telephone and faxA Computer maintenance and suppliesA DepreciationA RentA Legal fees and retainersA Auditing and related servicesA InsuranceA Ofﬁce repairs and maintenance expenseA Miscellaneous ofﬁce expenseA Miscellaneous general expenseA Gain on sale of assets Income taxes Salaries and commissionsS Sales payroll taxesS Executive and ofﬁce salariesA Administrative payroll taxesA Payroll and personnel Payroll journal General journal Apago PDF Enhancer Cash in bank Accrued payroll Accrued payroll taxes Inventory and warehousing Capital acquisition and repayment Acquisitions journal Sales journal General journal Acquisitions journal Cash disbursements journal	Alvin
General journal Inventories Cost of goods sold Interest expense Cash in bank Notes payable Long-term notes payable Accrued interest Capital stock Capital in excess of par value Retained earnings Dividends Dividends payable S = Selling expense; A = general and administrative expense. Figure 6-5 (p. 152) illustrates the relationships of the ﬁve cycles and general cash. Note that cycles have no beginning or end except at the origin and ﬁnal disposition of a company. A company begins by obtaining capital, usually in the form of cash. In a manufacturing company, cash is used to acquire raw materials, ﬁxed assets, and related goods and services to produce inventory (acquisition and payment cycle). Cash is also used to acquire labor for the same reason (payroll and personnel cycle). Acquisition and pay ment and payroll and personnel are similar in nature, but the functions are sufﬁciently different to justify separate cycles. The combined result of these two cycles Relationships Among Cycles Chapter 6 / AUDIT RESPONSIBILITIES AND OBJECTIVES 151 FIGURE 6-5 Relationships Among Transaction Cycles General cash Capital acquisition and repayment cycle Sales and collection cycle Acquisition and payment cycle Payroll and personnel cycle Inventory and warehousing cycle is inventory (inventory and warehousing cycle). At a subsequent point, the inventory is sold and billings and collections result (sales and collection cycle). The cash generated is used to pay dividends and interest or ﬁnance capital expansion and to start the cycles again. The cycles interrelate in much the same way in a service company, where there will be billings and collections, although there will be no inventory. Transaction cycles are an important way to organize audits. For the most part, auditors treat each cycle separately during the audit. Although auditors need to consider the interrelationships between cycles, they typically treat cycles independently to the extent practical to manage complex audits effectively. SETTING AUDIT OBJECTIVES Apago PDF Enhancer OBJECTIVE 6-5 Describe why the auditor obtains a combination of assurance by auditing classes of transactions and ending balances in accounts, including presentation and disclosure. Auditors conduct ﬁnancial statement audits using the cycle approach by performing audit tests of the transactions making up ending balances and also by performing audit tests of the account balances and related disclosures. Figure 6-6 illustrates this concept by showing the four classes of transactions that determine the ending balance in accounts receivable for Hillsburg Hardware Co. Assume that the beginning balance of $17,521 (thousand) was audited in the prior year and is therefore considered fairly stated. If the auditor could be completely sure that each of the four classes of trans - actions is correctly stated, the auditor could also be sure that the ending balance of FIGURE 6-6 Balances and Transactions Affecting Those Balances for Accounts Receivable Accounts Receivable (in thousands) Beginning balance $ 17,521 Sales $144,328 $137,087 Cash receipts $ $ 1,242 Sales returns and allowances 3,323 Charge-off of uncollectible accounts Ending balance $ 20,197 152 Part 2 / THE AUDIT PROCESS $20,197 (thousand) is correctly stated. But it is almost always impractical for the auditor to obtain complete assurance about the correctness of each class of transactions, resulting in less than complete assurance about the ending balance in accounts receivable. In almost all audits, overall assurance can be increased by also auditing the ending balance of accounts receivable. Auditors have found that, generally, the most efﬁcient and effective way to conduct audits is to obtain some combination of assurance for each class of transactions and for the ending balance in the related accounts. For any given class of transactions, several audit objectives must be met before the auditor can conclude that the transactions are properly recorded. These are called transaction-related audit objectives in the remainder of this book. For example, there	Alvin