UNIT 2: THE AUDITING PROFESSION

Contents
2.0 Aims and Objectives
2.1 Introduction
2.2 Independence
2.3 What Makes a Profession a 'Profession'?
2.4 Professional Qualification Requirements
2.5 Generally Accepted Auditing Standards
2.5.1 General Standards of Qualification and Conduct
2.5.2 Standards of Field Work
2.5.3 Standards of Reporting
2.6 Professional Ethics
2.6.1 Independence, Integrity and Objectivity
2.6.2 General and Technical Competence
2.6.3 Responsibility to Clients
2.7 Legal Liability and Responsibility
2.8 Summary
2.9 Answer to Check Your Progress Exercises

2.0 AIMS AND OBJECTIVES

After you have completed this unit, you should be able to:
- explain what a profession means
- describe and explain GAAS
- describe the principles of professional conduct and ethics auditors follow
- describe potential factors that can bring about legal liability on auditors and what
auditors can do to avoid legal liability.

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2.1 INTRODUCTION

The work of an independent auditor is to express an objective opinion on financial statements

of an organization. To have this objectivity an auditor needs to have an independent physical
and mental attitude at all time in his work. This is one of the major ethical issues that auditors
have to deal with and need guidance on.

This unit looks at the principles and guidelines that auditors frequently refer to when
conducting their audit work. Auditors can be charged or sued because of their work. This unit
also looks at why auditors can be charged and how they can avoid legal liability. In addition,
the auditing professional view on many aspects of the audit will be discussed.

2.2 INDEPENDENCE

The development of auditing as a profession is tied to the involvement of the importance of

independence in audit. Independence is the key stone to professional audit. Thus, the reason
for naming professional auditing as independent audit.

Why Do Auditors Need Independence?

The very demand for audit calls for integrity objectivity in the person who is to be creditable
by all those who put trust and confidence in him and his work. How can independence,
integrity and objectivity be best provided or guaranteed in the auditor's function or personality
is a constant challenge of the profession. The auditing profession has tried to delineate these
within the framework of professional qualification, ethics and legal liability and responsibility
requisites.

2.3 WHAT MAKES A PROFESSION A 'PROFESSION'?

A profession is characterized by the following elements.

- Specialized body of knowledge
- Standard of qualification for admission
- Standard of conduct of behavior
- Level of status recognition
- Acceptance of social responsibility

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Special Body of Knowledge
A highly developed profession has a very highly specialized written body of knowledge. The
more the profession is highly developed the more specialized the body of knowledge and
voluminous requiring longer period of time to absorb. The body of knowledge is dynamic and
in constant development and growth and not static.

Standard of Qualification for Admission

A profession to be a profession must have well-recognized and accepted predetermined
criteria of qualification for admission into the profession. The standards include educational
requirement as well as other moral and legal criteria fulfillment. The education requirements
are composed of theoretical knowledge and practical experience. Usually the fulfillment of
these requirements is measured through tests of qualifying examinations to prove the
consumption of the accumulated body of knowledge that exist in the profession and
competence in it.

Standard Conduct of Behavior

A profession has a standard conduct of behavior to be observed by the professional through
prescribed code of ethics that attempt to enforce general rules of conducts, and maximum and
minimum rules of competence and responsibility to client and colleagues. Good example of
such code of conduct is the 'Oath of Hypocratus', which is sworn by medical doctors at their
graduation.

Level of Status Recognition

The quality and level of professional services demanded by society determines the level of
status recognition to the profession. The level of status and recognition earned in a society is a
function of the quality of professional service rendered which in turn is a function of the
standard of professional qualification and the degree of the social, moral, and legal
responsibility assumed. The more rigorous are the standards of qualification and code of
ethics needed for rendering the professional services, the higher will be the level of status and
recognition given to the profession.

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Acceptance of Social Responsibility
A profession to be a profession must accept responsibility for the consequences of its action.
Not only legal responsibility, which arises out of the contractual obligation, but also moral
responsibility to the profession itself has a responsibility to assure the society of the quality of
services demanded and accept sanction for failure to do so.

We can find these characteristics in different stages of growth and development in various
profession. Some professions more than others seem to have attempted to fulfill some
elements better. The role of professional associations in the development of these is crucial.
An association is a body of professionals and it is this body that plays important role in
prescribing the professional standards and policing their implementability.

2.4 PROFESSIONAL QUALIFICATION REQUIREMENTS

The professional qualification requirements for auditors or qualified public accountants

(CPA) in various countries is more or less the same. The most common elements in are:
- minimum educational background which nowadays is being pushed higher and higher
- completion of required specialized body of knowledge as prescribed by the profession
and proved through the passing of qualifying examinations
- fulfillment of prescribed practical experience
- moral and ethical requirements invoked through character reference
- age limit for determining legal personality and responsibility.

2.5 GENERALLY ACCEPTED AUDITING STANDARDS

Auditing standards are measures of the quality of the auditor's performance. The American
Institute of Certified Public Accountants (AICPA) first issued the ten generally accepted
auditing standards (GAAS) in 1947 and has periodically modified them to meet changes in
the auditor's environment. The GAAS are composed of three categories of standards: general
standards of qualification and conduct and standards of fieldwork and standards of reporting.

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 Table 2.1
Generally Accepted Auditing Standards
General Standards of Qualification and Conduct
1. The audit is to be performed by a person or persons having adequate technical training
and proficiency as an auditor.
2. An auditor must maintain an independent physical and mental attitude.
3. An auditor must exercise due professional care in his work.
Standard of Fieldwork:
1. Auditor's work must be properly planned and supervised.
2. Auditor's must study and evaluate internal control.
3. Auditor must gather sufficient and competent evidence.
Standards of Reporting:
1. The audit report must state whether financial statements have been prepared in
accordance with Generally Accepted Accounting Principles (GAAP).
2. The audit report must state whether the GAAP has been consistently applied wit that
of the preceding period.
3. The audit is to be presumed to have adequate information disclosure unless and
otherwise stated so.
4. The audit report must maintain an expression of opinion on the financial statements as
a whole or an explanation for not expressing an opinion.

2.5.1 General Standards of Qualification and Conduct

The three general standards are concerned with the auditor's qualification and the quality of
his or her work. The first general standard recognizes that an individual must have adequate
training and proficiency as an auditor. This is gained through formal education, continuing
education programs, and experience. It should be recognized that this training is on going
with a requirement on the part of the auditor to stay up to date with current accounting and
auditing pronouncements. Auditors should also be aware of developments in the business
world that may affect the auditing profession.

The second general standard requires that the auditor always maintain an attitude of
independence on an engagement. Independence precludes relationships that may impair the
auditor's objectivity. A distinction is often made between independence in fact and

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independence in appearance. An auditor must not only be independent in fact but also avoid
actions that may appear to affect independence. If an auditor is perceived as not being
independent, users may lose confidence in the auditor's ability to report truthfully on financial
statements. Public confidence is impaired if an auditor is found to lack independence.

Due professional case is the focus of the third general standard. In simple terms, due care
means that the auditor performs his or her duties with a degree of skill commonly possessed
by others in the profession. The third general standard imposes an obligation on the members
of the audit team to observe the standards of field work and reporting, and to perform the
work at the same level as any other professional auditor who offers such services to clients.

2.5.2 Standards of Field Work

The standards of fieldwork relate to the actual conduct of the audit. These three standards
provide the conceptual background for the audit process. The first standard of fieldwork deals
with planning and supervision. Proper planning can lead to a more effective audit that is more
likely to detect material misstatements if they exist. Proper planning also assists in completing
the engagement in a reasonable amount of time. Additionally, the standard requires that
assistants on the engagement be properly supervised.

The second standard of fieldwork requires that the auditor gain sufficient understanding of the
auditee's internal control to plan an audit. Internal control is a process, effected by an entity's
board of directors, management and other personnel, that is designed to provide reasonable
assurance regarding the achievement of the following objectives: (1) reliability of financial
reporting, (2) compliance with applicable laws and regulations, and (3) effectiveness and
efficiency of operations. The degree to which the auditor relies on the auditee's internal
control directly affects the nature, timing, and extent of the work performed by the
independent auditor.

Sufficient, competent evidence is the focus of the third fieldwork standard. Most of the
auditor's work involves the search for and evaluation of evidence to support management's
assertions in the financial statements. The auditor uses various audit procedures to gather this
evidence.

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2.5.3 Standards of Reporting
The four standards of reporting require that the auditor consider each of the following issues
before rendering an audit report: (1) the financial statement are presented in accordance with
generally accepted accounting principles, (2) those principles are consistently applied, (3) all
informative disclosures have been made and (4) what degree of responsibility the auditor is
taking and the character of the auditor's work.

2.6 PROFESSIONAL ETHICS

The purpose of professional ethics in the auditing profession as well as in other professions is
to build the public confidence, to judge the quality of audit work and means of producing
guidance of conduct for practitioner. The advantages of prescribing professional ethics is to
emphasize positive activity and encourage high level of performance while preventing mal-
practices. However, there is difficulty in concretizing them. First they can only be prescribed
in general terms to avoid prescribing unacceptable behavior, and it is difficult to enforce
general ideas of behavior. Second it is difficult to interpret behavior withhold reference to
specific situation at which point it requires interpretation to rulings according to
circumstances.

Important parts of ethics in auditing are in relation to:

- maintenance of mental and physical independence
- general competence and technical standards
- responsibility to client and colleague
- other responsibility and practices that have bearing on ethical conduct include acts
discreditable to the profession, i.e., commission, incompatible occupation, soliciting,
etc.

2.6.1 Independence, Integrity and Objectivity

A members objectivity must be beyond question if he/she is to report as an auditor. That
objectivity can only be assured if the member is, and seen to be, independent. The threat to
independence may be reduced by the nature and extent of the precautions taken by the
practice to guard against loss of objectivity.

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An auditor must maintain an independent mental and physical attitude. He must be free from
any financial and positional interests, and family relation in assuming a position of an auditor
otherwise his independence will be impaired in terms of physical and mental attitude.

Threats to Independence of an Auditor

i) Undue dependence on an audit client
Objectivity may be threatened by undue dependence on any audit client or group of
connected clients. The recurring work paid by one client or group of connected clients
should not exceed 15% of the gross practice income.
ii) Overdue fees
The existence of significant overdue fees from an audit client or group of association
clients can be a threat to objectivity akin to that of a loan. Audit firms must therefore
ensure that overdue fees, along with fees from current work, could not be construed as a
loan.
iii) Actual or threatened litigation
A firm's objectivity may be threatened or appear to be threatened when it is involved in, or
even threatened with litigation in relation to a client. Litigation of certain sorts will
represent a 'breakdown of the relationship of trust' between auditor and client. This would
impair the independence of the auditor or cause the directors of the client to become
unwilling to disclose information to the auditor.
iv) Family or other personal relationships
An auditor's objectivity may be threatened as a consequence of a family or other close
personal or business relationship.

Problems arise if an officer or senior employee of an audit client is closely connected with
the partner or senior staff member responsible for the conduct of the audit. In this context,
closely connected people include adult children and their spouses, siblings and their
spouses, any relative to whom regular financial assistance is given or who is indebted to
the staff members or partner.

v) Beneficial interest in shares and other investments

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 An auditor's objectivity may be threatened where he/she holds a beneficial interest in the
shares or other forms of investment in a company upon which the practice reports.

Staff or partners should not have share holdings in client businesses. (This includes
beneficial shareholdings held by a spouse or minor children).

a) If share are acquired involuntarily (by marriage or inheritance) then they

should be disposed of at the earliest opportunity.
b) Where an act of parliament or the articles of the client company require the
auditor to be a share holder, then the auditor should hold only the minimum
number of shares and the holdings should not be disclosed in the accounts of
the client company.
vi) Loans
Objectivity may be threatened by a loan to or from an audit client.

No loans or guarantees should be undertaken unless they are with client financial
institutions in the normal course of the business.
vii) Goods and Services Hospitable
Objectivity may be threatened by acceptance of goods, services or hospitality from an
audit client. Acceptance on normal commercial terms, or with only modest benefit, is
acceptable.
viii) Provision of other services to audit clients
There are occasions where objectivity may be threatened or appear to be threatened by
the provision to an audit client of services other than the audit. Care must taken to
avoid performing executive functions or making executive decisions.

2.6.2 General and Technical Competence

An auditor must possess professional competence necessary to provide competent services
that meet clear and acceptable standards and avoid the use of his name in an unintended
activity, i.e., in preparation of technical statements, forecasting or issuance of unaudited
financial statements. Auditors should not accept or perform work, which they are not
competent to undertake unless they obtain such advice and assistance as will enable them
competently to carry out the work.

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2.6.3 Responsibility to Clients
An auditor is responsible for maintaining confidential information forwarded to him by a
client as a result of his privileged position. An auditor cannot provide his services on
contingent fee bases. In addition they include responsibility that were developed through
common law cases that relate to 'due professional care'.

Auditors must employ reasonable care in all they do, in particular:

a) Auditors must use generally accepted auditing techniques when seeking to satisfy
themselves that the matters upon which they reports accurately reflect the true
financial state of his client's business.
b) If auditors come across any matter, which puts them upon inquiry then they have a
duty to investigate such a matter until they are able to resolve it to their own
reasonable satisfaction. Auditors should not accept any explanation unless they have
first carried out such investigations as will enable them properly to assess whether the
explanation offered a reasonable one.

2.7 LEGAL LIABILITY AND RESPONSIBILITY

The auditor is responsible for his report; he is not responsible for the financial statements,
which are the representations of management. However, the auditor can be sued for causing
damage to users of his audit report if he doesn't carry out his work properly. In other words,
auditors face legal liability if they conduct their work negligently. Legal liability means the
probability that an auditor would be liable to a legal (court) action for not performing his
duties well.

In order to understand this section, you have to know the meaning of the following words as
they are used in the context of auditor's legal liability.

- Breach of Contract: when the auditor/client fails to meet the terms and obligations
stated in the contract for audit.

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 - Ordinary Negligence: an absence of reasonable or due care in performing an audit.
An auditor is negligent when she fails to do what other professional accountants would
have done under similar circumstances.
Eg. Failure to detect that there was an error in computing depreciation.
- Gross Negligence: an extreme deviation from professional standards of due care.
Eg. Discovering but taking no action about management theft or fraud because of
carelessness.
- Fraud: wrongful actions taken with the intent of deceive client, the one whose
financial statements are being audited.
- Third Party: the contract for the audit is signed by the auditor and the client others
who have interest are referred to as third parties
Eg. Creditors, investors, potential investors etc

The following table summarized the auditor's legal liability.

The auditor can be charged by For
- Client - Breach of contract
- Negligence (gross and ordinary
negligence)
- A third party known to rely on the - Negligence (gross and ordinary
auditor's report for a particular purpose negligence)
- Fraud
- Foreseen third parties
- Gross negligence
- Fraud
- Reasonably foreseeable third parties
- Gross negligence
- Fraud

For any of the above parties to be able to successfully sue the auditor, they should be able to
show that:
1. The auditor had a duty to do something
2. He did not perform his duty
3. The plaintiff (person suing the auditor) relied on the work of the auditor.
4. The plaintiff suffered a loss as a result of relying on the auditor's work.

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Possible Changes by a Client
a) For breach of contract
The auditor would be seud for breach of contract if he fails to complete the service agreed
to in the contract with the client. Eg. If the auditor discontinues an audit without adequate
cause, or fails to submit the audit report before or on the deadline, he may be asked to
repay a part or the entire fee.
b) For ordinary or gross negligence
Auditors can be sued for negligence by their clients when they fail to show due care, i.e, a
level of carefulness usually possessed by others in the profession. For example, the client
may charge the auditor for not detecting a major fraud by one employee or for letting a
confidential information leak out.

Possible Charges by Third Parties

The auditor can be charged by third parties that the auditor knows would rely on his report for
negligence and fraud.

For example, Albo Co. engaged Bolke, a CPA, to audit its financial statements telling him
that they need the report to obtain a loan from a bank. In this case, Bolke can be held liable
for both ordinary and gross negligence to the bank in case the bank suffers a loss as a result of
relying on the auditor's opinion.

On the other hand, third parties that the auditor doesn't know would use his report can charge
the auditor and recover any losses only for gross negligence and fraud. But, the question
would be how is ordinary negligence differs from gross negligence?

Say financial statements have been deliberately overstated by management to deceive users.
The auditor has a duty to discover this. If the auditor applies GAAS properly and simply
doesn't suspect the fraud, he can only be accused of ordinary negligence. However, if the
auditor suspected that there was fraud but did not do additional investigation to try to uncover
the fraud, he can be accused of gross negligence.

If the auditor actually discovered the fraud and did not mention this in his audit report, in this
case he is participating in the fraud himself (i.e., constructive fraud).

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The Auditor's Responsibility for other Illegal Acts
The auditor has a duty to uncover and report on illegal acts committed by the client or any one
as long as they are related to the financial statements.

So the auditor can be charged for not reporting illegal acts unrelated to the financial statement
only he knows about them.

2.8 SUMMARY

- A person is ineligible to act as auditor if he is an employee or officer or has various

other close connections with the company.
- Recognized supervisory bodies must follow a number of procedures to ensure their
members are fit and proper and competent and that audit work is conducted properly.
- Accounting standards are set by the Accounting Standards Board and have a direct
impact on the accounts on which auditors are reporting.
- The Auditing practices Board takes account of standards set by the International
Auditing Practices Committee when setting Auditing standards.
- Independence and objectivity are the most important characteristics of auditors.
- Potential threats to objectivity include:
o Undue dependence, on audit client
o Family and other personal relationships
o Beneficial interests in shares
o Acceptance of hospitality
o Provision of other services
- Auditors have a professional duty of confidentiality. However, they may be compelled
by law or consider it desirable in the public interest to disclose details of client's affairs to
third parties.
- Auditors can be sued for causing damage to users of his audit report if he does not
carry out his work properly.

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Check Your Progress Exercise
1. What is the definition of closely connected persons?
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2. Under what circumstances is the auditor permitted to breach client confidentiality?
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3. List the characteristics that make a profession a profession?
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4. Why do Auditors need independence?
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5. What are the major professional qualification requirements of auditor?
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6. List the ten Generally Accepted Auditing Standards.
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7. What are the potential threats of objectivity?
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8. Under what circumstances the auditor can charged by (a) a client, (b) third party?
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2.9 ANSWER TO CHECK YOUR PROGRESS EXERCISE

1. Refer Section 2.6.1

2. Refer Section 2.6.3
3. Refer Section 2.3
4. Refer Section 2.2
5. Refer Section 2.4
6. Refer Section 2.5
7. Refer Section 2.6.1
8. Refer Section 2.7

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