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Ch. 4: Professional Ethics Ch. 5: Legal Liability Ch. 11: Fraud Auditing

What is an ethical dilemma?

It is a situation a person faces in which a decision must be made about the appropriate behavior.

Why unethical behavior? (2 reasons)

1.ethical standards differ from society as a whole and/or 2. person chooses to act selfishly.

6 steps to resolve ethical dilemmas?

1. Obtain the relevant facts.
2. Identify the ethical issues from the facts.
3.Determine who is affected by the outcome of the dilemma and how each person or group is affected.
4. Identify the alternatives available to the person who must resolve the dilemma.
5. Identify the likely consequence of each alternative.
6. Decide the appropriate action

Professional

means a responsibility for conduct that extends beyond satisfying individual responsibilities and beyond the requirements of our society's laws and regulations.

Why is high level of professionalism expected?

high level of professional conduct by any profession is the need for public confidence in the quality of service by the profession, regardless of the individual providing it.

What 2 factors have considerable influence on the CPA profession?

1. AICPA Code of Professional Conduct
2. Rules set by the PCAOB and/or the SEC.

Code of Professional Conduct (AICPA)-4 parts are?

1.Principles
2.Rules of Conduct (RoC)
3.Interpretations of RoC
4.Ethical Rulings

Client (AICPA Def)

Any person or entity, other than the member's employer, that engages a member or a member's firm to perform professional services.

Firm (AICPA Def)

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.

Institute

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 planning, litigation support services, and those professional services for which standards are promulgated by bodies designated by Council.

6 Ethical Principles?

1.Responsibilities
2.The Public Interest
3. Integrity
4. Objectivity and Independence
5. Due Care
6. Scope of Nature of Services

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.

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.

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.

Rule 201

General Standards- A member shall comply with the following standards:
A. Professional Competence
B. Due Professional Care
C. Planning and Supervision
D. Sufficient Relevant Data

Rule 202

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.

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.

Exception to Rule 203

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.

Rule 301

Confidential Client Information- A member in public practice shall not disclose any confidential client information without the specific consent of the client.

Rule 301: exceptions

(1) Obligations related to technical standards
(2) Subpoena or summons and compliance with laws and regulations
(3) Peer Review
(4) Response to Ethics Division

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 client.

Rule 302: Exceptions

CPA firms are permitted to charge contingent fees for non-attestation services, unless the CPA firm is
also performing attestation services for the same client.

Rule 501

Acts Discreditable- A member shall not commit an act discreditable to the profession.

7 Discreditable Acts

1.) Retention of Client Records
2.) Discrimination & harassment in employment practices.
3.) Standards on gov't audits & req's of gov't bodies & agencies.
4.) Negligence in the prep of financial statements or records.
5.) Failure to follow req's of regulatory agencies.
6.) Solicitation or disclosure of CPA examination questions and answers.
7.) Failure to file tax return or pay tax liability.

Rule 502

Advertising & 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.

Rule 503

Commissions & Referral Fees- Sections:
A. Prohibited Commissions
B. Disclosure of permitted commissions
C. 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.

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.

Rule 505

Form of Organization & 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.

financial users 2 misunderstood concepts leading to CPA liability

1. Business failure vs. audit failure
2. audit failure vs. audit risk

Business Failure

occurs when a business is unable to repay its lenders or meet the expectations of its investors because of economic or business conditions

Audit Failure

occurs when the auditor issues an incorrect audit opinion because it failed to comply with the requirements of auditing standards

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 misstated

Prudent Person Concept

Auditor is expected only to conduct the audit with due care, and is not expected to be perfect

Fraud and Negligence Terms

1.Ordinary Negligence 2. Gross Negligence 3. Constructive Fraud 4. Fraud

1. Ordinary Negligence

Absence of reasonable care that can be expected of a person in a set of circumstances. (what other competent auditors would have done in the same situation)

2. Gross Negligence

Lack of even slight care, tantamount to reckless behavior, that can be expected of a person. Some states do not distinguish between ordinary and gross negligence

3. Constructive Fraud

Existence of extreme or unusual negligence even though there was no intent to deceive or do harm. Constructive fraud is also termed recklessness

4. Fraud

Occurs when a misstatement is made and there is both the knowledge of its falsity and the intent to deceive

Contract Law Terms

1. Breach of Contract
2. Third-party Beneficiary

1. Breach of Contract

Failure of one or both parties in a contract to fulfill the requirements of the contract.

Privity of Contract

Parties who have a relationship that is established by a contract

2. Third-party Beneficiary

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

Common Law

Laws that have been developed through court decisions rather than through government statutes

Statutory Law

Laws that have been passed by the U.S. Congress and other governmental units

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

Separate and Proportionate Liability

The assessment against a defendant of that portion of the damage caused by the defendant's negligence

4 Sources of 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

Auditors' Defense Against Client Suits

1. Lack of Duty to Perform
2. Non-negligent Performance
3. Contributory Negligence
4. Absence of Casual Connection

1. Lack of Duty to Perform

The CPA firm claims that there was no implied or expressed contract

2. Non-negligent Performance

The CPA firm claims that the audit was performed in accordance with auditing standards

3. Contributory Negligence

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

4. Absence of Casual 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

Third parties include?

Actual and potential stockholders, vendors, bankers and other creditors, employees, and customers

Ultramares Doctrine

A common-law approach to third-party liability, established 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

Foreseen Users

members of a limited class of users whom the auditor is aware will rely on the financial statements

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 adequate 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 requirements include audited financial statements

Section 10 and Rule 10b-5

(1934 Securities Act) Accountants can be held liable if they intentionally or recklessly misrepresent information intended for third-party use

Actions to minimize liability

1. Deal only with clients possessing integrity
2. Maintain Independence
3. Understand the client's business
4. Perform quality audits
5. Document the work properly
6. Exercise professional skepticism



Fraudulent Financial Reporting;An intentional misstatement or omission of amounts or disclosures with the intent to deceive users.

Misappropriation of Assets

fraud that involves theft of an entity's assets

3 Conditions for Fraud

1. Incentives/Pressures
2. Opportunities
3. Attitudes/Rationalization

1. Incentives/Pressures

Management or other employees have incentives or pressures to materially misstate financial statements

2. Opportunities

Circumstances provide an opportunity for management or employees to misstate financial statements

3. Attitudes/Rationalization

An attitude, character, or set of ethical values exists that allows management or employees to intentionally commit a dishonest act, or they are in an environment that imposes sufficient pressure that causes them to rationalize committing a dishonest act

Professional Skepticism

Neither assumes that management is dishonest nor assumes unquestioned honesty- "Trust but Verify"

5 Sources for info to assess fraud risks

1. Communications Among Audit Team
2. Inquiries of Management
3. Risk Factors
4. Analytical Procedures
5. Other Information

AICPA 3 elements to prevent, deter, and detect fraud

1. Culture of honesty and high ethics
2. Management's responsibility to evaluate risks of fraud
3. Audit Committee Oversight

Fraudulent Financial Reporting

An intentional misstatement or omission of amounts or disclosures with the intent to deceive users.

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