Module 2: Professional Standards, Ethics, and Legal Liabilities

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Module 2: Professional standards, ethics, and legal liabilities

Overview
In this module, you learn about professional audit standards and the ethical and legal environment in which a CGA in public
practice operates. You examine the general standard, examination standards, and reporting standards that make up GAAS.
You also learn about CGA-Canada’s Code of Ethical
Principles and Rules of Conduct (CEPROC)
and Independence standards, which every CGA member
must follow.
This module also offers you the opportunity to apply what you have learned about professional ethics by using the
Ethics Reading Handbook (ERH) in resolving ethical dilemmas. After
completing this module, you should understand the legal relationship between auditors and their clients and the legal
liabilities of a professional auditor in public practice.
Assignment reminder: Assignment 1 (see Module 5) is due at the end of Week 5 (see the Course Schedule). You may wish
to take a look at it now in order to familiarize yourself with the requirements and to prepare for any necessary work in
advance.
Test your knowledge
Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study
required.
Learning objectives
2.1 Professional standards State the generally accepted auditing standards

(GAAS) and describe their implications for auditors.
(Level 1)
2.2 Assurance standards, generally accepted audit Differentiate between assurance standards, generally
standards, and audit procedures accepted auditing standards, and auditing
procedures. (Level 1)
2.3 Professional ethics Define ethics, describe the accounting profession’s

ethical concerns, and explain the fundamental
principles in accounting codes of conduct in relation
to the CGA-Canada Code of Ethical Principles and
Rules of Conduct. (Level 1)
2.4 Independence Explain the importance of independence for a CGA,

and evaluate situations that may threaten
independence. (Level 1)
2.5 An ethical case study Resolve ethical dilemmas using a case analysis
approach. (Level 1)
2.6 Legal liability and ethical responsibility Describe the relationship between legal liability and
ethical responsibility. (Level 2)
2.7 Liability to clients and third parties Identify the parties to which an auditor owes a duty
of care, and describe the circumstances under which
liability to third parties arises. (Level 2)
2.8 Responding to legal liability Describe how an auditor’s negligence is established,

and explain how an auditor can respond to legal
liability. (Level 2)
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Module summary
Print this module
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2.1 Professional standards
Learning objective
● State the generally accepted auditing standards (GAAS) and describe their implications for auditors. (Level 1)
Required reading
● Chapter 2, pages 30–41 and 53–57

● CAS 200 (CICA Handbook — Assurance ,
section 5100)
LEVEL 1
In this topic, you turn from the basic elements of assurance engagements to the more specific generally accepted auditing
standards (GAAS) used in external auditing. GAAS summarize most of what you need to know about auditing. This topic
outlines GAAS and relates them to other professional standards.
The Canadian Auditing and Assurance Standards Board (AASB) has adopted International Standards on Auditing (ISA) issued
by the International Auditing and Assurance Standards Board (IAASB). Handbook sections dealing with the audit of financial
statements have all been replaced and will now be called Canadian Auditing Standards (CAS). The layout of the new
Canadian Assurance Handbook is as follows:
● Canadian Standards on Quality Control

● Canadian Auditing Standards
● Other Canadian Standards (those standards which do not specifically relate to the audit of financial statements)
● Assurance and Related Services Guidelines
Throughout the module notes, all references will refer to Canadian Auditing Standards (CAS) dealing with the audit of
financial statements. The sections superseded by CAS are also referenced in the module notes. Refer to the inside front cover
of your textbook for a table which cross references the new CAS sections to the superseded Assurance Handbook sections.
All changes to the Handbook have been incorporated into Part I of the Assurance Handbook.
Generally accepted auditing standards (GAAS)
GAAS are the Assurance Handbook recommendations that govern the activities of external auditors. They relate to the
auditor’s qualifications, the performance of the auditor’s examination, and the preparation of the auditor’s report. A good
description is provided on text pages 30–36; pages 37–40 describe how accounting principles (GAAP) affect the auditor’s
report.
Here are the various sources of GAAS available to practitioners:
● CICA Handbook — Assurance, Part I

● CGA-Canada’s Public Practice Manual, Volumes I and II (Vol.
II contains the CGA-Canada Auditing Guidelines )
● CGA-Canada’s Code of Ethical Principles
and Rules of Conduct (CEPROC)
Quality control standards
To make sure GAAS are adhered to, it is necessary to develop mechanisms to monitor and enforce GAAS. Such monitoring
and enforcement mechanisms ensure that all accounting services are performed with due care.
The Auditing and Assurance Standards Board (AASB) issued two standards relevant to quality control at both the firm level
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(CSQC 1, formerly GSF-QC) and assurance engagement level (CAS 220; CICA Handbook
section 5030). The firm standard, Quality control for firms that perform audits and reviews of financial statements and other
assurance engagements, establishes a framework and provides guidance on quality-control policy and procedures. The
engagement standard, CAS 220, Quality Control for an audit of financial statements (CICA
Handbook section 5030, Quality control procedures for assurance engagements other than audits of
financial statements and other historical financial information), establishes standards and provides guidance on the specific
quality-control procedures to be performed by the practitioner.
There are several ways of regulating adherence to GAAS:
● Have a set of principles or code of conduct for guiding professional practice.

● Have in place a system of quality control in professional practice within each public accounting firm.
● Through various types of monitoring mechanisms called “audits of the auditors.” The most common type in Canada is
the practice inspection approach, which stresses the educational aspect of the monitoring process rather than the
disciplinary aspect.
● A final, extreme form of enforcing GAAS is through litigation to enforce the auditor’s legal responsibilities.
The following background on standard setting is provided for your information and is not examinable.
Standard setting
The text reading provides a brief background on the standard-setting process, which will help you to understand why and
how GAAS have evolved, how the process can be time consuming, and the cost involved to complete the process. The
significant point is that standards derive much of their credibility and authority from the process used in creating them. Since
the process must be seen as fair and responsive to user needs, it is essential to get input from all those affected, including
regulators (such as the provincial securities commissions), management, users, and public accountants.
In Canada, you are guided by the recommendations and guidelines in the CICA Handbook
— Assurance . CGA-Canada is also a member of the International Federation of Accountants (IFAC)
and responds to all proposals and recommendations.
Since the mid-1970s, CGA-Canada has published a practice engagement manual, the Public
Practice Manual , which contains accounting and auditing guidelines for CGAs. This
manual was originally issued by the CGA-Canada Practice Committee, but is now produced by CGA-Canada’s Research and
Standards department. The current version contains four volumes: Volumes I-A and I-B and Volumes II-A and II-B. In 2008,
CGA-Canada issued Public Practice Entrance Standards that set out the education and experience requirements that must be
satisfied by CGAs who wish to engage in public practice.

2.2 Assurance standards, generally accepted audit standards, and audit

procedures
Learning objective
● Differentiate between assurance standards, generally accepted auditing standards, and auditing procedures. (Level 1)
Required reading
● Chapter 2, pages 48–53

● CICA Handbook — Assurance, paragraphs 5025.16-.80
LEVEL 1
The Assurance Handbook section 5025, Standards for assurance engagements, outlines a framework for any type of
assurance engagement other than an audit of financial statements or other historical information. In an assurance
engagement, a practitioner is called to provide assurance regarding a subject matter in the context of an accountability
relationship between two parties (the accountable/responsible party and the user). As this section can apply to any of type of
assurance engagement, the standards are very general. Refer to page 53 for various examples of assurance engagements
that can be provided within the section 5025 standard. Notice how some of the assurance engagements listed do not always
provide assurance on financial information.
GAAS are standards developed specifically and only for the audit of financial statements. Auditing procedures are the specific
activities that auditors perform in order to collect sufficient and appropriate evidence.
Review Exhibit 2-6 on textbook pages 50-51, which compares GAAS to assurance standards. The exhibit highlights the
similarities and differences between GAAS and assurance standards.
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2.3 Professional ethics
Learning objective
● Define ethics, describe the accounting profession’s ethical concerns, and explain the fundamental principles in
accounting codes of conduct in relation to the CGA-Canada Code of Ethical
Principles and Rules of Conduct . (Level 1)
Required reading
● Chapter 4, pages 94–95, 101–103, and 110–118

● ERH, Unit C1: The Marks of a Profession
● ERH, Unit C3: Introduction (the opening commentary)
● ERH, Unit C4: “Accountants, Full Disclosure, and Conflicts of Interest” and “Auditors and Deceptive Financial
Statements”
● ERH , Unit C3: CGA Canada’s Code of Ethical
Principles and Rules of Conduct
(CEPROC)
(Note: For all ethics-related readings in this course, you are required to be familiar with Section A of the ERH , as
mentioned in the course introduction. ERH readings can be found under the Resources tab.)
LEVEL 1
Requiring adherence to a professional code of conduct is one way of assuring that GAAS are followed. Such a code is
especially useful in helping the auditor identify actions that satisfy the general standard of GAAS.
Underlying a code of conduct are more general standards of right action or ethical conduct. These are described in detail in
Section A of the Ethics Reading Handbook (ERH). Included here are
standards such as honesty, integrity, promise keeping, trustworthiness, and commitment to the public good; these standards
are central to the development of specialized ethical standards for accounting and auditing.
Such standards, as well as the reasons for them, are studied in ethics. Ethics or moral philosophy is the systematic study of
human conduct and moral judgment. It includes business and professional ethics, which are both relevant to accounting.
Moral behaviour involves more than competent moral reasoning and making good moral judgments; it involves acting on
those judgments. So professional ethics, which deals with proper conduct in one’s professional life, has both an intellectual
aspect (making ethically good judgments) and a choice aspect (doing what is right).
Rules of professional and ethical conduct
As a CGA, you are considered by society to be a professional and as such, the first obligation you have is to society. The
underlying reason for a high level of professional conduct is because CGAs need to ensure that society has confidence in the
services that the profession provides. The overall success of the profession depends on our clients having the utmost
confidence and respect for the services we provide.
As a CGA, your reputation will be your most important asset; it is the reputation of the members of the CGA profession that
creates a demand for their services. This is why maintaining a good reputation should be considered the single most
important ethical principle. In addition to technical skills, it is the CGA’s concern for integrity that is the basis for that
reputation.
Activity 2.3-1
What are some important ethical concerns covered in the CGA-Canada Code?

Solution 1
In an audit, who is to blame for deceptive financial statements?
Solution 2
Both readings from ERH Unit C4 are intended to provide insights into important ethical issues facing auditors in their
specialized role as independent and reliable information providers.
The code of ethics of a professional group provides several important advantages for both its members and the public. What
are these advantages and what are the implications of this Code for CGA members and students?
Solution 3
As a professional, you will be called on to resolve issues that have ethical implications. Topic 2.4 introduces you to a case
analysis framework that will help you deal with the ethical dilemmas you may face in your business and personal life.
Code of Ethical Principles and Rules of Conduct
The CGA-Canada Code of Ethical Principles and

Rules of Conduct (CEPROC) presents the standards of conduct that apply to all CGA
members, although some relate specifically to members providing professional services. In addition, the Preamble points out
that rules apply to members and students alike, except where the rules specifically state they apply only to members. Each
provincial association has the power to supplement the CGA-Canada rules. The Code has two sections:
● Code of Ethical Principles

● Rules of Conduct
Professional codes of conduct can only provide a partial guide to professional ethical behaviour; there is considerable room
left for good judgment. For this reason, a substantial part of the Code consists of principles for good behaviour rather than
detailed rules of conduct.
The Code of Ethical Principles enunciates the six principles on which the Rules of Conduct are built. The second last
paragraph of the Preamble points out that the Code of Ethical Principles is the most important part of the Code, providing
ethical standards on which accountants should base their professional judgment. The Code is structured so that the principles
are relatively general and only rarely subject to review. The six principles are the foundation for the more specific Rules of
Conduct.
The Rules of Conduct provide clear statements of required or prohibited behaviour in specific situations and are subject to
amendment as warranted. They are organized under the headings of the six ethical principles.
● Responsibilities to Society (R101 to R107) explains how a CGA who is trustworthy and acts with integrity and
objectivity protects and advances the interests of society and of her or his colleagues.
● Trust and Duties (R201 to R204) explains the rules that guide CGAs so that they will act “in the interest of their
clients, employers, and interested third parties.” A significant portion of these rules addresses the issue of
confidentiality and conflict of interest.
● Due Care and Professional Judgment (R301 to R305) explains the rules covering a CGA’s technical competence,
continuing professional development, and adherence to the standards of the profession.
● Deceptive Information (R401 to R404) cautions a CGA about being associated with false or misleading information.
● Practice of the Profession (R501 to R520) explains the rules under which CGAs “act openly and fairly towards
others in the profession.”
● Responsibilities to the Profession (R601 to R614) enunciates rules that govern the behaviour of CGAs such that
their behaviour “will enhance the image of the profession and the Association.”

Consider particularly R202.1 (Independence in Assurance or Specified Auditing Procedures Engagements) and R301 to R305
(under the section Due Care and Professional Judgment), which form part of the general standard of GAAS (CAS 200;
formerly CICA Handbook , paragraph 5100.02). All prospective CGAs should know and
understand the Rules of Conduct. They embody statements with respect to confidentiality (R201), independence (R202), and
due care and competence (R301 to R305), all of which should be part of the values of a professional accountant or a person
who aspires to become one.

2.4 Independence
Learning objective
● Explain the importance of independence for a CGA, and evaluate situations that may threaten independence. (Level 1)
Required reading
● Chapter 4, pages 104–110

● ERH , Unit C3: Code of Ethical Principles
and Rules of Conduct , R202 Independence
● ERH , Unit C3: CGA-Canada's Independence Standard
LEVEL 1
Activity 2.4-1: Concept of independence
Independence is a major attribute of the CGA in public practice. Why is independence such an important concept?
Solution
Two concerns related to the potential loss of independence arise because the auditor is paid by the audit client and because
the auditor sometimes provides non-audit services to audit clients. Note that independence
requires a) independence in mind, and b) independence in appearance. These issues have been the subject of thought and
research over the years.
Recent pronouncements in the United States, Canada, and elsewhere have limited significantly the range of non-audit
services that public accounting firms may provide to audit clients whose securities are traded in public markets. While such
limitations have not been imposed with respect to non-listed clients, public accountants have become more aware of the
need to self-assess independence with respect to every audit client every year.
Independence is more than just an issue for a profession’s code of ethics. Note the explanation on pages 105 and 106
regarding the CICA, CGA-Canada, and IFAC framework for independence (reread pages 12–14). The
Sarbanes-Oxley Act of 2002 (SOX) has had an impact that extends far
beyond U.S. borders.
The following background article on the effects of the collapse of Enron is provided for your information, and is not
examinable.
As background information on this topic, read “The auditing environment after Enron,” which discusses the auditing
profession in the post-Enron era. Independence is a special condition of objectivity that applies to audit engagements as
specified in the codes or their interpretations (or as interpreted by the courts, because it is also a legal term in Canada).

2.5 An ethical case study
Learning objective
● Resolve ethical dilemmas using a case analysis approach. (Level 1)
Required reading
● How to analyze a case (under the Resources tab)
LEVEL 1
This topic gives you an opportunity to practise resolving an ethical dilemma. Consider the ethical principles described in Topic
2.2 and review “How to analyze a case” under the Resources tab. Then read the case details and work through the notes
provided for each of the steps that is relevant to this case.
Activity 2.5-1: Johnny Keems case
Johnny Keems is not yet a CGA but is doing quite well in his first employment with a large public accounting firm. He has
been on the job for two years and has become a good staff accountant (junior auditor). If he passes his last CGA exam next
month, he will be promoted to a senior accountant (in-charge accountant).
This month, during the audit of Row Lumber Company, Johnny told the controller that he is remodelling an old house. The
controller likes Johnny and had a load of needed materials delivered to his house, billing Johnny at a 70% discount — saving
him over $300 above the normal cash discount. Johnny was happy to have the materials, which he otherwise would not have
been able to afford on his meagre salary.
What should Johnny do?
Case analysis approach
The relevant steps are evaluated below.
Step 3. Identify problems and issues.

The problem is whether it is ethical for someone doing an audit to accept a substantial benefit from
the firm being audited. The decision is whether or not to accept the extra discount being offered by
the controller. Johnny is the main decision maker.
Step 5. Generate alternatives.

Based on the case details, what are the two main alternatives?
Solution 1
Step 6. Select the decision criteria. What should Johnny’s decision between the two alternatives
be based on?
Hint: Review the six Ethical Principles. Which rule is the most relevant in this case?
Solution 2
Step 7. Analyze and evaluate the alternatives.

First alternative

On the first alternative — accepting the 70% discount — there are several factors and possible
outcomes. Can you identify the factors and possible outcomes?
Hints: First alternative
a. Will it compromise the appearance of auditor independence? (independence of mind)
b. Is the discount of significant benefit to Johnny?
c. Is it likely that someone (for example, Johnny’s firm) will find out about the discount? What
could be the possible consequence(s)? (independence in appearance)
d. What would happen if the provincial association discovered the gift?
e. What if Johnny feels a debt of gratitude to the controller and during the audit discovers some
questionable items in the lumber firm’s books?
Solution 3
Second alternative
On the second alternative — refusing the 70% discount — there are several factors and possible
outcomes.
Hints: Second alternative
a. Will Johnny be able to take advantage of the discount?
b. What will the controller’s reaction be if Johnny refuses to accept the discount? (The controller
could have both a negative and a positive reaction.)
c. How will Johnny himself feel?
Solution 4
Step 8. Make a recommendation or decision.
Hint: What is the ethically correct decision?
Solution 5

2.6 Legal liability and ethical responsibility
Learning objective
● Describe the relationship between legal liability and ethical responsibility. (Level 2)
Required reading
● ERH , Unit A7, Responsibility
LEVEL 2
Auditors have responsibilities to the public, to their peers and profession, and to their professional organization as set out in
the organization’s code of ethics. Failure to comply will result in censure by the professional organization; such censure may
range from a reprimand to expulsion.
Auditors’ statutory responsibilities are defined by statutes such as the Canada

Business Corporations Act and the various provincial
corporations acts. Auditors will also have contractual relationships with clients that define their legal responsibilities.
Relationship between legal liability and ethical responsibility
It is important to recognize that acting ethically may not be the same as acting legally; nor is acting legally necessarily acting
ethically. The reason ethical responsibility and legal liability do not always coincide is that ethical responsibility is judged by
ethical standards, and legal liability by legal standards for responsibility. The law may sometimes allow people to act
unethically.
For example, the senior executives of Enron were permitted to sell their stock options immediately upon receipt, while rank-
and-file employees were compelled to hold theirs for at least one year. As Enron’s stock fell in value, these senior employees
“cashed out,” while the rest watched their savings evaporate when Enron declared bankruptcy. The actions of these
executives were legal (the options granted to them permitted immediate sale), but they are obviously unethical. The senior
executives that had the greatest responsibility for the financial collapse of Enron were the least financially injured by their
own negligence (and in some cases malfeasance), while rank-and-file employees who had no responsibility for Enron’s
collapse lost their investments and company pensions.
Usually, there is a moral obligation to obey the law (unless the law affronts fundamental moral principles) because the law is
often based on moral principles (for example, don’t kill), or because the law states areas of significant social agreement
important for cooperative behaviour.
It is important to recognize that while legal liability is not the same as moral responsibility, there is generally a very close
relationship. ERH Unit A7 relates ethics and legal responsibility. (The McMullin Plumbing case, referred to in this
reading, can be found in Unit A1 of ERH .)

2.7 Liability to clients and third parties
Learning objective
● Identify the parties to which an auditor owes a duty of care, and describe the circumstances under which liability to
third parties arises. (Level 2)
Required reading
● Chapter 5, pages 136–157 (except page 140, Four Elements of Negligence, and page 152, Defences of the
Accountant)
LEVEL 2
Liability to clients
Because of the contractual relationship between the client and the auditor, auditors have a responsibility to perform their
duties “with due care” — that is, auditors must not be negligent in performing the audit. The text refers to this duty of care
as arising from privity of contract.
Clients are most likely to believe that the auditor was negligent if a material fraud or other illegal acts come to light after the
audit has been completed.
For example, a public accountant was sued by a client for failing to detect a fraud; the client asserted that the public
accountant had been negligent and the courts agreed, even though no audit had been performed.
This case illustrates the importance of spelling out the terms of the engagement in an engagement letter. Negligence
arising from a contractual relationship is often demonstrated with compelling facts showing that specific terms of the
contracts were breached.
It is worth noting, however, that even if you do have an engagement letter, it may not suffice to protect you.
CAS 210, Terms of audit engagements (CICA Handbook section 5110) (not required reading),
provides guidelines on establishing an understanding of, and agreement on, the terms of the engagement for the audit of
financial statements. Audit engagement is covered in Module 3.
Liability to third parties
Third-party liability is the most frequent basis for lawsuits against public accountants — acting as auditors or otherwise. The
concept of privity of contract is not strong enough to be used as a defence; potentially, anyone can claim that a duty of care
was owed to them by an auditor. Third parties cannot sue auditors based on a breach of contract claim. However, based on
precedent-setting decisions in past court cases, it has been established that auditors could potentially owe a duty of care to
certain third parties who rely on the financial statements, even though there is no contractual obligation owed to such third
parties. The case of Haig v. Bamford on page 141 describes circumstances under which a
duty of care is deemed to exist.
The three categories of third parties are listed on page 145. The courts have established that, for ordinary negligence,
auditors owe a duty of care to all known third parties and to all reasonably foreseeable third parties.
Fraud
An auditor who commits a fraud is liable to any person (including third-party users) who can prove that money was lost
because of the fraud. The auditor may also be subject to criminal prosecution (see page 147).

2.8 Responding to legal liability
Learning objective
● Describe how an auditor’s negligence is established, and explain how an auditor can respond to legal liability. (Level 2)
Required reading
● Chapter 5, page 140, Four Elements of Negligence; page 152, Defences of the Accountant; and pages 158–159
LEVEL 2
The auditor’s liability may arise under contract law or tort law. Regardless of the legal principles from which an auditor’s
liability may arise (contract or tort), the issue is almost always negligence.
The auditor’s legal liability may be divided into liability to clients and liability to third parties. The four elements that
determine negligence are outlined on page 140. Pay particular attention to why these elements are important for a public
accountant.
Activity 2.8-1: Negligence
What is the auditor’s primary defence in a negligence case?
Solution
Pages 158–159 describe other issues that may precipitate a litigation crisis. Read this section carefully; the suggestions may
seem self-evident, but they can protect you and your firm. You will see that knowledge of the client’s business is a recurring
theme in this course, because the more you know and understand your client, the better you can contain the risks of being
sued.

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Module 2 summary
State the generally accepted auditing standards (GAAS) and describe their implications
for auditors.
● The generally accepted auditing standards consist of

❍ one general standard
❍ three examination standards, and
❍ four reporting standards
General standard
● The audit should be performed objectively and with due care by a person or persons having adequate technical
training.
Examination standards
● The auditor should plan and perform the audit to reduce audit risk to an acceptably low level that is consistent with
the objective of an audit. The auditor should plan the nature, timing, and extent of the direction and supervision of
the engagement team members and review their work.
● The auditor should obtain an understanding of the entity and its environment, including internal control, sufficient to
identify and assess the risks of material misstatement of the financial statements whether due to fraud or error, and
sufficient to design and perform further audit procedures.
● The auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable conclusions on which to
base the audit opinion.
Reporting standards
● The report should identify the financial statements, the responsibilities of management, and the responsibilities of the
auditor.
● The report should describe the scope of the auditor’s examination.
● The report should contain either an expression of opinion on the financial statements or an assertion that an opinion
cannot be expressed. In the latter case, reasons should be stated.
● Where an opinion is expressed, it should indicate whether the financial statements present fairly, in all material
respects, the financial position, results of operations and cash flows, in accordance with Canadian GAAP, except when
the financial statements are prepared using a basis of accounting other than Canadian GAAP. The report should
adequately explain any reservations of opinion.
Implications for auditors
● These standards cover all audit engagements. Compliance with these standards is an essential part of auditing. The
standards cover the minimum requirements to be met before the auditor can state that the audit was carried out in
accordance with generally accepted auditing standards.
Differentiate between assurance standards, generally accepted auditing standards, and

auditing procedures.
Auditing standards and procedures
● Auditing standards are recommendations that remain the same through time and for all audits.
● Auditing procedures are the particular and specialized actions auditors take to obtain sufficient appropriate evidence
in a specific audit engagement.
Assurance and GAAS
● Assurance standards provide an umbrella framework for all assurance engagements. They cover a much wider range
of audit and related activities and do not cover the audit of financial statements.
● CAS apply only to the audit of financial statements.
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● The major differences between the two sets of standards are in the areas of practitioner competence, internal
control, and reporting.
Define ethics, describe the accounting profession’s ethical concerns, and explain the
fundamental principles in accounting codes of conduct in relation to the CGA Code of
Ethical Principles and Rules of Conduct.
● Ethics has been defined as “that branch of philosophy which is the systematic study of reflective choice, of the
standards of right and wrong by which it is to be guided, and of the good toward which it may ultimately be directed.”
● The three elements of ethics are
❍ decision problems
❍ moral principles
❍ the consequences of decisions
● The Code of Ethical Principles sets out the ethical principles governing the behaviour of CGAs and students. The Rules
of Conduct show how the general ethical principles should be applied to specific situations.
● These standards apply to all members, although some are specific to those in public practice. They apply whenever a
member is acting as an accountant or holding himself or herself out to be a member of the Association.
● The fundamental principles are
1. Responsibility to society
2. Trust and duties
3. Due care and professional judgment
4. Deceptive information
5. Professional practice
6. Responsibilities to the profession
●
You should be able to explain the meaning of each of these fundamental principles.
Explain the importance of independence for a CGA, and evaluate situations that may
threaten independence.
● Independence is a major attribute of the CGA in public practice. It is a special condition of objectivity that applies to
audit engagements as specified in the codes or their interpretations (or as interpreted by the courts, because it is also
a legal term in Canada).
● Independence requires
❍ independence in mind, and
❍ independence in appearance.
● Independence is potentially affected by self-interest, self-review, advocacy, familiarity, and intimidation threats.
● Safeguards to eliminate threats to independence (or reduce them to an acceptable level) fall into three broad
categories:
❍ those created by the profession, legislation, or regulation
❍ those within the assurance client
❍ those within the public accounting firm’s own systems and procedures
Resolve ethical dilemmas using a case analysis approach.
The nine steps to analyzing a case are
1. Skim the case.

2. Read the case closely.
3. Identify problems and issues.
4. Analyze the data.
5. Generate alternatives.
6. Select the decision criteria.
7. Analyze and evaluate the alternatives.
8. Make a recommendation or decision.

9. Write a report or action plan.
Describe the relationship between legal liability and ethical responsibility.
● Under common law, an auditor will only be found liable if the plaintiff can prove all of the following:
1. The plaintiff suffered damages or loss.
2. The necessary privity of beneficiary relationship existed.
3. The financial statements were misleading or the auditor’s advice was faulty.
4. The plaintiff relied on the statements or advice.
5. Such reliance was the direct cause of the loss.
6. The auditor was negligent, grossly negligent, deceitful, or otherwise responsible for damages.
● The auditor’s moral responsibilities to third parties include a responsibility to act in the interest of his or her clients,
employers, and interested third parties.
● This includes acting with independence, and exercising due care and professional judgment.
● It also includes acting in accordance with appropriate assurance and auditing standards.
Identify the parties to which an auditor owes a duty of care, and describe the
circumstances under which liability to third parties arises.
● The auditor owes a duty of care to the client.

● The auditor also owes a duty of care to third parties.
● Usually this duty is limited to fraud or gross negligence unless the auditor has actual knowledge that the third party
will rely on the statements, in which case the auditor is liable for ordinary negligence as well.
Describe how an auditor’s negligence is established, and explain how an auditor can
respond to legal liability.
● There are four requirements for negligence to be established:

1. There must be a legal duty of care to the plaintiff.
2. There must be a breach of that duty (such as failure to follow generally accepted auditing standards).
3. There must be proof that damage resulted.
4. There must be a reasonably proximate connection between the breach of duty and the resulting damage.
● The auditor can deny that the plaintiff has established the necessary conditions to recover damages by asserting the
following:
❍ There was no legal duty of care to the plaintiff.
❍ There was no breach of that duty (such as failure to follow generally accepted auditing standards).
❍ No damage resulted.
❍ There was no reasonably proximate connection between the breach of duty and the resulting damage.

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Activity 2.3-1 solution 1
Ethical concerns important to the accounting profession covered in the CGA-Canada Code include the following:
● Serving the public interest

● Integrity
● Objectivity and independence
● Professional competence
● Due care
● Confidentiality
The Code also forbids CGAs from associating with false or misleading information and requires them to reveal material
omissions from the financial statements.
As a professional and a member of a self-governing body, a CGA must deal with issues that other business people do not
face. The public looks to CGA-Canada and the provincial associations to maintain a high ethical standard for their members.
Central to the function of auditors is the provision of reliable information about the organizations they audit.
But this raises the question about how much should be disclosed in an audit and to whom. Is the auditor supposed to serve
the interests of the organization being audited, or the interest of third parties including creditors, investors, and stockholders?
These issues are discussed in the reading “Accountants, full disclosure, and conflicts of interest” (ERH Unit C4).
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In conducting an audit, an auditor is supposed to assess information provided by the organization being audited.
Management of the organization is responsible for the presentation and fair presentation of the financial statements. If the
information provided to the auditor is incomplete, misleading, or even deceptive, who is responsible — the organization’s
management, the auditor, the financial reader, or some combination of these three? In the reading “Auditors and deceptive
financial statements: Assigning responsibility and blame” (ERH Unit C4), the authors discuss the ethics of honesty and
deception in communication. They provide a framework for assessing the responsibility and potential blameworthiness or non-
blameworthiness of accountants for deceptive financial statements.
The code of ethics of a profession should be viewed as the minimum level of behaviour expected of its
members. In fact, many public accounting firms have more rigorous standards of behaviour than their professional code of
ethics requires.
CGA students and members are bound by the Code promulgated by CGA-Canada and administered by the provincial
association of which you are a member.

Advantages and implications of a professional code of ethics
A professional code of ethics provides
● the public with a statement of the minimum standards to which the profession adheres
● members of the profession with guidelines to govern their behaviour so they know what is expected of them, and
● members of the profession with a benchmark against which they will be judged by their peers and by the public,
thereby facilitating disciplinary action.

Activity 2.4-1 solution
Independence is a special condition of objectivity that applies to audit engagements as specified in the codes or their
interpretations (or as interpreted by the courts, because it is also a legal term in Canada). Auditors are held to high standards
of independence since much of what is disclosed in the assurance reports is held to be true by those who rely on certified
company financial statements.

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The auditing environment after Enron
The Enron collapse focused on the firm’s relationship with Arthur Andersen, which served both as Enron’s auditor and
consultant.
The reaction in the United States was swift and, unfortunately, political. Though empirical evidence supporting the contention
that the non-audit work performed by Andersen was a factor in Enron’s demise was sketchy, it did not prevent U.S.
lawmakers from concluding that the audit firm had been at fault and that the collapse of Enron was a direct result of
Andersen’s dual function. The reaction to the perceived conflict of interest was a move to proscribe such relationships and to
preclude the auditor from providing advisory services to the same client.
Too many hats
The basis for creating the Sarbanes-Oxley Act of 2002 (SOX)

stemmed from the many “hats” worn by accountants, especially in the United States. In Enron’s case, it was an accounting
environment where the following took place:
● A body of accountants, the FASB, set the accounting standards.

● Another body of accountants, the AICPA, set the standards for attestation.
● Accountants, as either employees and/or consultants, prepared the financial statements based on the standards
created by other accountants.
● Accountants, in their capacity as auditors, examined the financial statements and reported on their conformance with
the standards set by accountants and followed by other accountants.
● Finally, accountants acted as management consultants and advised company accountants on how to apply the rules
devised by other accountants.
Ideally, the audit function should be separated from any and all other functions performed. This view is rooted in agency
theory. Given the separation of management and ownership, agency theory suggests that management will attempt to take
advantage of the asymmetric information it possesses. Auditors are seen as fulfilling the monitoring function necessary to
ensure that management does not take (too much) advantage of its “insider knowledge.”
New standard bearers
As a result of the Enron failure, the institutional environment in which U.S. auditors functioned changed. Prior to the changes
mandated by the Sarbanes-Oxley Act of 2002 , the U.S. peer review
program was administered under the authority of state accountancy laws in cooperation with state Certified Public
Accountants (CPA) societies and other organizations that elect to participate as administering entities. Effective July 2002, the
CPA profession lost both the right to self-assessment for public company auditors and the right to set auditing standards for
those auditors. Peer review was replaced by practice reviews. Further, the performance of these reviews became the
responsibility of an organization called the Public Company Accounting Oversight Board (PCAOB).
The Sarbanes-Oxley Act of 2002 represented a quantum shift in the

environment faced by auditors. Inherent to the Act were the following key notions:1
1. Investors should have access to information about financial performance, condition, and risk.
2. Investors should have prompt access to critical information.
3. CEOs should personally vouch for veracity and fairness of their financial disclosures.
4. Investors should have complete confidence in the independence and integrity of auditors.
5. Officers should not profit from erroneous financial information.

6. Officers should be required to promptly tell the public when they sell company stock for gain.
An analysis of these points is revealing:
● Points 1 and 2 are at the heart of corporate disclosures.
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● Point 4 is essential if there is to be confidence in the external audit.

● Points 5 and 6 are intended to ensure that insiders do not profit at the expense of outsiders.
Quality control
So how do these points affect the auditor? The creation of the PCAOB in the United States and the Canadian Public
Accountability Board (CPAB) in Canada was intended to restore investor confidence in the quality of public audits. The CPAB
sets requirements that apply to all firms that audit public companies; it also establishes quality control policies and
procedures for such audits. Other CPAB requirements that apply to firms auditing public companies include the following:
● Firms that audit Canada’s publicly listed companies undergo more frequent and rigorous inspections, which are
conducted by the independent National Inspection Unit (NIU). Firms that do not audit public companies have a
practice inspection, which focuses on individual practicing units of a firm.
● Major firms conducting public company audits are reviewed annually and subject to a more comprehensive
examination of their quality control policies and procedures.
● If the inspection process identifies concerns, the matter will be referred directly to the disciplinary process of the
appropriate body for action. The NIU will be able to recommend immediate suspension of a firm or partner if the
public trust is deemed to be at risk.
● Canadian auditor independence standards have moved to match the world standards recently established by the
International Federation of Accountants (IFAC) and incorporate the U.S. Securities and Exchange Commission (SEC)
requirements for public company audits. The standards place limits on the types of non-audit services that firms may
provide to their public company audit clients.
Improved governance — improved conduct
There is little doubt that much of the blame for the U.S. business failures can be attributed to poor governance practices.
There is also general agreement that something needed to be done to motivate enterprises to adhere
to appropriate corporate codes of conduct. Further, there is agreement that there may have been incidents where
professionals exhibited a lack of independence in their relationships. Nonetheless, it is not obvious that the measures adopted
to resolve issues in the United States are appropriate for Canada.
Is conformance with Sarbanes-Oxley a necessary action in Canada? The U.S. capital markets are an order of magnitude
bigger than Canada’s. To adopt the rules of the SEC regarding non-assurance services because “the United States did it” is
not a valid reason. The argument that “… the provision of certain non-assurance services is incompatible with the
independence in mind or appearance required when providing an assurance service” may be true, but it may not. It is wrong
to simply accept that this perspective is correct. One adopts a set of proscriptions because there has been demonstrated
evidence that failure to do so results in harm. However, no empirical proof is provided to justify the assertion. A few years on
from the implementation of SOX, it has still not been established that the collapse of Enron was an
audit failure as much as it was a failure of the audit firm .
What is certain is that public company auditors in both the United States and Canada face a much different environment than
they did in the late 1990s. What has yet to be ascertained is whether this change is a change for the better.
1 There are four more: Officers abusing power should lose the right to serve in any corporate leadership position; an
independent regulatory board should ensure that accountants (and auditors) are held to the highest ethical standards; the
FASB must be responsive to the needs of investors; and company accounting systems should be compared to best practices,
not minimum standards.
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The first alternative is that Johnny accepts the discount. The second is that he refuses the 70% discount and takes only the
normal cash discount.

The decision between the two alternatives should be based on the Principles of Ethics and Rules of Conduct. The CGA-
Canada Code of Ethical Principles and
Rules of Conduct applies to Johnny even though he has not yet finished his studies.
Rule R202 requires that Johnny remain free of conflicts of interest as an auditor.

On the first alternative - accepting the 70% discount - the following points should be mentioned:
● Allowing auditors to accept gifts from clients may so compromise the appearance of auditor independence that no
one would believe auditors’ statements.
● The discount being offered to Johnny is significant, especially since he would otherwise not be able to afford the
lumber.
● If he accepts the discount, Johnny will save over $300.
● It is possible that no one at Johnny’s firm or in his provincial association will find out about the discount.
● Johnny’s firm may discover the gift and decide to discipline or fire Johnny for conflict of interest.
● The provincial association may discover the gift and discipline Johnny under R202 of the Code.
● The controller may have made the offer simply because he likes Johnny, but it could also be an attempt to buy
Johnny’s cooperation. During the audit, if Johnny discovers some questionable items in the lumber firm’s books, the
controller may remind Johnny of the 70% discount. He may also mention that if the discount became public, other
people, including Johnny’s bosses, “might not be too happy.”
● Johnny may feel a debt of gratitude to the controller and may therefore be willing to compromise auditing standards
to repay the benefit conferred.
● Even if Johnny does not compromise auditing standards, he may feel that he did not behave with enough
independence.

On the second alternative - refusing the 70% discount - the following points should be mentioned:
● Johnny will pay more for the lumber.
● The controller may be upset that Johnny did not accept the gift and may even threaten to seek another auditor,
which may upset Johnny’s boss.
● His boss may take the refusal to accept the lumber as a good sign of Johnny’s integrity and commitment to
professional ethics.
● The controller may feel much more respect for Johnny.

● Johnny would feel good about himself because he did not compromise professional standards.

The ethically correct solution to this situation is the second alternative. It would not be professional for Johnny to accept the
70% discount. He should politely tell the controller that as an accounting student engaged in audit work, he is not permitted
to accept any gifts or discounts from those he audits. He should also tell his supervisor at the accounting firm that this offer
of a discount was made and that he refused it.

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Activity 2.8-1 solution
An auditor’s primary defence in a negligence case is to prove the audit has been executed in accordance with GAAS and
other relevant professional standards. This defence means showing that the duty of care has not been breached. The
evidence to demonstrate this comes mainly from the audit working paper file, which you learn to develop throughout this
course.
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Module 2 self-test
Question 1
Problem EP 2 LO.2, page 61.
Note: The “three generally accepted standards of field work” refer to the three examination standards of GAAS.
Solution
Question 2
Why does the CGA-Canada Code of Ethical Principles

and Rules of Conduct include a section on confidentiality?
Solution
Question 3
Many laypersons believe that the auditor’s role is the detection of fraud; as a consequence, they tend to believe that the
auditor is at fault when fraud is discovered after the financial statements have been issued with a clean opinion from the
auditor. What is the auditor’s liability with respect to the discovery of fraud?
Solution
Question 4
A layperson comments that, based on a reading of the financial press, being a public accountant is a risky occupation
because public accountants seem to be sued quite often. How would you respond? How can auditors reduce the likelihood of
being sued?
Solution
Question 5
An important moral test is putting yourself in the other person’s shoes. If you were a bank officer, what moral characteristics
would you want in the auditor of the financial statements of a company requesting a loan from your bank?
Solution
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Self-test 2
Solution 1
The three examination standards and their relation to the illustration are as follows:
● The first standard is that the work should be adequately planned and properly executed using knowledge of the
entity’s business as a basis, and that assistants, if any, should be properly supervised. Fulfilling this standard would
include the preparation of an audit program for the accounts receivable based on an updated knowledge of the
client’s business with respect to the accounts receivable, and reviewing it with the assistant prior to the assistant
beginning the examination. These things were not done. Also, the completed working papers should have been
reviewed to determine whether the assistant performed an adequate examination. The illustration states that this
procedure was followed. Also, there should have been a level of supervision during the collection of audit evidence.
● The second standard requires the auditor to obtain an understanding of the entity and its environment, including
internal control, sufficient to identify and assess the risks of material misstatement and to design and perform further
audit procedures. The case presented makes no mention of any work performed in updating the auditor’s
understanding of the client’s environment or reviewing internal control. Reliance entirely on prior-year working papers
in lieu of an evaluation of the existing internal control is improper because changes may have been made in the
system.
● The third standard is that the auditor should obtain sufficient appropriate audit evidence to be able to draw
reasonable conclusions on which to base the audit opinion. This may be obtained through inspection, confirmation,
inquiry, observation, computation, and analysis to support the content of the audit report. The assistant’s preparation
of working papers, confirmation requests, and other procedures seem to fulfil the requirements of this standard if the
audit work is properly performed and provided that all other necessary evidence will be obtained later on during the
field work.
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Self-test 2
Solution 2
The auditee provides the auditor with a lot of confidential information during the course of the audit so the auditor may fully
carry out his or her responsibilities. The auditee trusts that the auditor will not disclose any of the confidential information to
which he or she is privy.
If the auditor discloses the confidential information, the auditee could cease to trust the auditor and cease to provide all the
information the auditor needs for fear it would be made public; or the auditee could change auditors.
The CGA’s reputation for maintaining the confidentiality of client data leads clients to trust a CGA and to provide any
information needed for the audit.
If there were no confidentiality rules, the auditor could profit through insider trading or by providing a client’s private
information to competitors. Notwithstanding the confidentiality requirements, a CGA is required to disclose confidential
information when disclosure is compelled by either a court of law or the CGA Association and may disclose information when
aware of an apparent or suspected criminal activity (but in the last case, only after obtaining legal advice).

Self-test 2
Solution 3
The auditor should conduct the audit with due care in accordance with generally accepted auditing standards. Due care
entails planning the audit, which includes obtaining knowledge of the entity and assessing the likelihood of material
misstatements for error or fraud and other irregularities in the financial statements. If fraud existed and the auditor
conducted the audit with due care in accordance with GAAS but did not discover the fraud, then the auditor would probably
have no liability. If the fraud would have been revealed had the auditor conducted the audit with due care in accordance with
GAAS but did not do so, then the auditor is likely to be found liable.
Management is responsible for producing the financial statements and for implementing controls that will prevent and detect
errors or fraud. The auditor is responsible for assessing the risk of material misstatements from errors or fraud in order to
issue an opinion on whether the financial statements are free of material misstatement. [This subject is covered in detail in
Topic 3.1 and CAS 240 (formerly CICA Handbook section 5135).]

Self-test 2
Solution 4
It is true, especially in the United States, that a number of lawsuits have been launched against public accountants. Often the
suits are without merit; the auditor is perceived as having “deep pockets” (lots of money) in the form of professional liability
insurance.
The best way to avoid such a suit is to perform quality audits in accordance with GAAS. Quality audits are a product of hiring
competent, qualified people with integrity and providing them with proper training and supervision. Quality audits are not
possible if a client is not honest; an auditor will be well advised to deal only with honest clients. In short, an auditor can take
steps to reduce the likelihood of being sued, and if sued, to increase the likelihood of a successful defence.

Self-test 2
Solution 5
If you were a bank loan officer, you would want the auditor to act morally and follow the ethical guidelines of the auditor’s
profession as set out in the CGA-Canada Code of Ethical
Principles and Rules of Conduct . Specifically, you
would want the auditor to be independent (Rule 202), so that you could have confidence in the fairness of the information in
the financial statements. You would also want the auditor to act with integrity and due care (Ethical Principles
“Responsibilities to Society” and “Due Care and Professional Judgment”), so that you could be confident the audit was done
honestly and carefully. Finally, you would want the auditor to be technically competent and to follow the standards of the
profession (Ethical Principles “Due Care and Professional Judgment” and “Responsibilities to the Profession,” the Rules of
Conduct, and GAAS), so that you could be confident the statements were prepared according to generally accepted
accounting principles.

Module 2: Professional Standards, Ethics, and Legal Liabilities

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file:///F|/Courses/2010-11/CGA/AU1/06course/m02intro.

Module 2: Professional standards, ethics, and legal liabilities

Test your knowledge

2.1 Professional standards State the generally accepted auditing standards

2.3 Professional ethics Define ethics, describe the accounting profession’s

2.4 Independence Explain the importance of independence for a CGA,

2.8 Responding to legal liability Describe how an auditor’s negligence is established,

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Print this module

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2.1 Professional standards

● Chapter 2, pages 30–41 and 53–57

● Canadian Standards on Quality Control

Generally accepted auditing standards (GAAS)

Here are the various sources of GAAS available to practitioners:

● CICA Handbook — Assurance, Part I

Quality control standards

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There are several ways of regulating adherence to GAAS:

● Have a set of principles or code of conduct for guiding professional practice.

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2.2 Assurance standards, generally accepted audit standards, and audit

● Chapter 2, pages 48–53

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2.3 Professional ethics

● Chapter 4, pages 94–95, 101–103, and 110–118

Rules of professional and ethical conduct

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In an audit, who is to blame for deceptive financial statements?

Code of Ethical Principles and Rules of Conduct

The CGA-Canada Code of Ethical Principles and

● Code of Ethical Principles

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● Chapter 4, pages 104–110

Activity 2.4-1: Concept of independence

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2.5 An ethical case study

● Resolve ethical dilemmas using a case analysis approach. (Level 1)

● How to analyze a case (under the Resources tab)

Activity 2.5-1: Johnny Keems case

What should Johnny do?

Case analysis approach

The relevant steps are evaluated below.

Step 3. Identify problems and issues.

Step 5. Generate alternatives.

Step 7. Analyze and evaluate the alternatives.

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Hints: First alternative

a. Will it compromise the appearance of auditor independence? (independence of mind)

b. Is the discount of significant benefit to Johnny?

d. What would happen if the provincial association discovered the gift?

Hints: Second alternative

a. Will Johnny be able to take advantage of the discount?

c. How will Johnny himself feel?

Step 8. Make a recommendation or decision.

Hint: What is the ethically correct decision?

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2.6 Legal liability and ethical responsibility

● ERH , Unit A7, Responsibility

Auditors’ statutory responsibilities are defined by statutes such as the Canada

Relationship between legal liability and ethical responsibility