Chapter Two

The auditing profession

2.1. GENERALLY ACCEPTED AUDITING STANDARDS (GAAS)

As Generally Accepted Accounting Principles are for Accounting (GAAP), Generally Accepted
Auditing Standards are for auditing. Generally Accepted Auditing Standards are road maps
which govern the work of the auditors. Assume that there is no GAAS, you can image the
diverse opinions that can come out of auditing the same set of financial statements by different
auditors. These standards serve as a benchmark against which the work of independent auditors
is judged. Ethiopia does not have its own Generally Accepted Accounting Principles as well as
Generally Accepted Auditing Standards. It seems that accountants and certified auditors are
using international standards for accounting as well as auditing. On the other hand, almost all
business schools in Ethiopia teach their students based on Western text and reference books
particularly USA. To this effect, this section deals with the Generally Accepted Auditing
Standards predominantly followed by US companies, and the general overview of International
Standards on Auditing.

2.1.1. Nature of Generally Accepted Auditing Standards

Auditing standards are general guidelines to aid auditors in fulfilling their professional
responsibilities in the audit of historical financial statements. They include consideration of
professional qualities such as competence and independence, reporting requirements, and
evidence. They refer to sets of standards against which the quality of audits are measured and
may be judged. Several organizations have developed such sets of principles, which vary by
territory. For Example, American Institute of Certified Public Accountants (AICPA) is mainly
responsible for the development of accounting standards for USA. As mentioned earlier,
Ethiopia does not have its own auditing standards although efforts are underway to adopt
international standards.

2.1.2. Categories of Generally Accepted Auditing Standards

There are three categories of auditing standards in US-based GAAS. These are general standards,
standards of field work, and reporting standards. There are three sub standards under general
standards, another three under standards of fieldwork, and four under reporting standards.
Altogether, there are 10 standards under General Accepted Auditing Standards (GAAS).Each of
these standards are discussed below:
A. General Standards
The general standards stress the important personal qualities that the auditor should possess.
There are three standards under general standards.
a. Adequate Technical Training and Proficiency. The first general standard is normally
interpreted as requiring the auditor to have formal education in auditing and accounting,

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 adequate practical experience for the work being performed, and continuing professional
education. Recent court cases demonstrate that auditors must be technically qualified and
experienced in those industries in which their audit clients are engaged. In any case in which
the independent or his/her assistants are not qualified to perform the work, a professional
obligation exists to acquire the requisite knowledge and skills, suggest someone else who is
qualified to perform the work, or decline the engagement. For example, ACCA has three
requirements to practice as an independent auditor. These are passing ACCA 14 examinations,
practical experience of three years, and continuous professional development.
b. Independence in Mental Attitude. The importance of independence was emphasized in
Chapter 1 under the definition of auditing. The Code of Professional Conduct stresses the
need for independence. Audit firms are required to follow several practices to increase the
likelihood of independence of all personnel. For example, there are established procedures on
larger audits when there is a dispute between management and the auditors. Specific methods
to ensure that auditors maintain their independence are discussed in chapter 2.

c. Due Professional Care. The third general standard involves due care in the performance of
all aspects of auditing. Simply stated, this means that auditors are professionals responsible
for fulfilling their duties diligently and carefully. Due care includes consideration of the
completeness of the audit documentation, the sufficiency of the audit evidence, and the
appropriateness of the audit report. As professionals, auditors must not act negligently or in
bad faith, but they are not expected to be perfect.

B. Standards of Field Work

The standards of field work concern evidence accumulation and other activities during the actual
conduct of the audit. Three standards are contained under standards of field work which are
discussed hereunder.
a. Adequate Planning and Supervision. The first standard requires that the audit be
sufficiently planned to ensure an adequate audit and proper supervision of assistants.
Supervision is essential in auditing because a considerable portion of the field work is done
by less experienced staff members.
b. Understand the Entity and its Environment, Including Internal Control. To adequately
perform an audit, the auditor must have an understanding of the client’s business and
industry. This understanding helps the auditor identify significant client business risks and
the risk of significant misstatements in the financial statements. For example, to audit a bank,
an auditor must understand the nature of the bank’s operations, federal and state (National
Bank of Ethiopia) regulations applicable to banks, and risks affecting significant accounts
such as loan loss reserves.

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c. Sufficient Appropriate Evidence. Decisions about how much and what types of evidence to
accumulate for a given set of circumstances require professional judgment. The term
sufficient indicates the quantity of audit evidence whereas appropriateness refers to the
quality of audit evidence.
C. Reporting Standards
The four reporting standards require the auditor to prepare a report on the financial statements
taken as a whole, including informative disclosures.
a. The auditor must state in the auditor’s report whether the financial statements are presented
in accordance with generally accepted accounting principles (GAAP).
b. The auditor must identify in the auditor’s report those circumstances in which such principles
have not been consistently observed in the current period in relation to the preceding period.
c. When the auditor determines that informative disclosures are not reasonably adequate, the
auditor must so state in the auditor’s report.
d. The auditor must either express an opinion regarding the financial statements, taken as a
whole, or state that an opinion cannot be expressed, in the auditor’s report. When the auditor
cannot express an overall opinion, the auditor should state the reasons thereof in the auditor’s
report.

2.1.3. International Standards on Auditing

International Standards on Auditing (ISAs) are issued by the International Auditing and
Assurance Standards Board (IAASB) of the International Federation of Accountants (IFAC). The
IAASB works to improve the uniformity of auditing practices and related services throughout the
world by issuing pronouncements on a variety of audit and attest functions and by promoting
their acceptance worldwide.
ISAs do not override a country’s regulations governing the audit of financial or other
information, as each country’s own regulations generally govern audit practices. These
regulations may be either government statutes or statements issued by regulatory or professional
bodies. Most countries base their auditing standards on ISAs, modified as appropriate for each
country’s regulatory environment and statutory requirements.

2.2. PROFESSIONAL ETHICS AND LEGAL LIABILITY OF AUDITORS

2.2.1. THE NATURE OF A PROFESSION

According to Wikipedia, a profession is a vocation founded upon specialized educational

training, the purpose of which is to supply objective counsel and service to others, for a direct
and definite compensation, wholly apart from expectation of other business gain. As indicated in
this definition, profession requires its members to acquire certain specialized training.
2.2.2. CHARACTERISTICS OF A PROFESSION

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A profession arises when any trade or occupation transforms itself through "the development of
formal qualifications based upon education, apprenticeship, and examinations, the emergence of
regulatory bodies with powers to admit and discipline members, and some degree of monopoly
rights.
Professions are typically regulated by statute, with the responsibilities of enforcement delegated
to respective professional bodies, whose function is to define, promote, oversee, support and
regulate the affairs of its members. These bodies are responsible for the licensure of
professionals, and may additionally set examinations of competence and enforce adherence to an
ethical code of practice. However, they all require that the individual hold at least a first
professional degree before licensure. There may be several such bodies for one profession in a
single country, an example being the accountancy bodies of ACCA of the United Kingdom and
CPA in USA.

Professions enjoy a high social status, regard and esteem, conferred upon them by society. This
high esteem arises primarily from the higher social function of their work, which is regarded as
vital to society as a whole and thus of having a special and valuable nature. All professions
involve technical, specialized and highly skilled work often referred to as "professional
expertise."

A profession is a vocation founded upon specialized educational training , having own code of
conduct, status of recognition, maintaining social responsibility and assuming legal liability, and
having standards for admission.

Auditing is a profession because it fulfills all the characteristics of a typical profession. It has a
specialized body of knowledge which can be learnt and transferred to others through training.

In general, a profession has the following characteristics:

1) Has a specialized body of knowledge

2) Has a status recognition
3) Has a standard or Code of conduct
4) Maintains social responsibility and assume legal liability
5) Has standard for admission

2.2.3. AUDITOR’S PROFESSIONAL ETHICS

Professional Ethics plays an important role in the field of auditing. Users of audit services trust
the opinions of the auditors only if they believe that there exists a professional ethics for the
practitioners and the practitioners respect these ethics. The auditing profession has a well-
documented professional code of conduct.
Ethics can be defined broadly as a set of moral principles or values. Each of us has such set of
values, although we may or may not have considered them explicitly. Philosophers, religious
organizations, and other groups have defined (in various ways) the ideal sets of moral principles
or values. Examples of prescribed sets of moral principles or values at the implementation level

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include laws and regulations, church doctrine, codes of business ethics for professional groups
such as CPAs and ACCAs, and codes of conduct within individual organization.
It is common for people to differ in their moral principles and values and the relative importance
they attach to these principles. These differences reflect life experiences, successes and failures,
as well as the influences of parents, teachers, and friends.
2.2.4. NEED FOR ETHICS IN AUDITING

Ethical behavior is necessary for a society to function in an orderly manner. It can be argued that
ethics is the glue that holds a society together. Imagine, for example, what would happen if we
couldn't depend on the people we deal with to be honest. If parents, teachers, employers, siblings,
co-workers, and friends all consistently lied, it would be almost impossible for effective
communication to occur.
The term professional means a responsibility for conduct that extends beyond satisfying
individual responsibilities and beyond the requirements of society's laws and regulations. A
Certified Accountants (auditors), as a professional, recognizes a responsibility to the public, to
the client, and to fellow practitioners, including honorable behavior, even if that means personal
sacrifice.
The underlying reason for a 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. For the Certified Accountants (auditors), it is essential that the client and external
financial statement users have confidence in the quality of audits and other services. If users of
services do not have confidence in physicians, judges, or Certified Accountants, the ability of
those professionals to serve clients and the public effectively is diminished.
2.2.5. ETHICAL DILEMMA FOR AUDITORS
Ethics is a set of moral principles or values. It also refers to a field of study dealing with the
moral values. The four types of ethics are meta, normative, descriptive, and applied ethics. Ethics
is essential in auditing to enhance the confidence of the public in the services of the auditors. In
providing their professional services, auditors are confronted with several ethical dilemmas.

An Ethical dilemma is a complex situation that often involves an apparent mental conflict
between moral imperatives, in which to obey one would result in transgressing another.

Ethical dilemmas for auditors may originate from various sources. Some of them are:

a) Auditor providing non-audit services to the client such as accounting services, tax services, and
management consultancy services

For example, the auditor should not be involved in the audit of financial statements when he/she
is involved in one or all of the following accounting services:
 Initiate, authorize or approve transactions
 Prepare originating data/source documents
 Determine or change journal entries, or the classifications for accounts or transactions, or
other accounting records without client management approval
 Make changes to source documents without client approval
 Authorize or approve disbursements, including disbursements for payroll or payroll taxes.

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  Authorize or approve purchase invoices for payment
b) Audit fee level where by the auditor generates a significant amount of fee from a given client

This involves auditor’s dependence on a single client for his/her income. The dilemma comes in
to play when the auditor has found major irregularity in the financial statements of the client. If
he/she decided to report adversely, there is a possibility to clash with the client which may result
in loss of that client and loss of major revenue.
c) Dilemma in relation to Ethics Partner

The ethics partner is a partner or other person in the audit firm having the responsibility for the
adequacy of the firm’s policies and procedures relating to integrity, objectivity and
independence, their compliance with Ethical Standards and the effectiveness of their
communication to partners and staff within the firm. In a sole practitioner situation, there is no
person who can ensure that the firm is behaving ethically. In such situation, advice on matters
where a difficult and objective judgment needs to be made is obtained through contact with the
practitioner’s professional body or through discussion with a practitioner from another firm.
d) Long association with the audit client

This occurs when the auditor served a given audit client for several years (e.g. 10 years). Where
the auditor has held an audit appointment for a continuous period of time, careful consideration
should be given to impairment of objectivity and independence.

e) Financial interests in a client

This may refer to the situation in which the auditor and/or his/her immediate family member are
a shareholder or other similar financial stake in the audit client.

f) Business relationship with the audit client

Audit firms, persons in a position to influence the conduct and outcome of the audit and
immediate family members, should not enter into business relationships with an audit client
except where they involve the purchase of goods and services from the audit firm or the audit
client in the ordinary course of business and on an arm’s length basis and the value involved is
not material to either party.
g) Requirement to Develop and implement own Policies and Procedures
Government policies or professional associations usually require all audit firms to have written
and communicated policies and procedures in relation to the following matters;
 General matters such as in-house reporting structures and in- house monitoring and
evaluation of compliance
 Relationships (financial, business, employment and personal)
 Long association with the audit client
 Fees, remuneration and evaluation, gifts and hospitality
 Non-audit services

2.3. CODE OF PROFESSIONAL CONDUCT

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The professional bodies in each country have their own code of conduct for their members. For
example, American Institute of Certified Public Accountants (AICPA) has its own code of
conduct for CPAs. This code provides both general standards of ideal conduct and specific
enforceable rules of conduct.

There are four parts to the code of professional conduct; namely,

a) Principles,
b) Rules of conduct,
c) Interpretations of the rules of conduct, and
d) Ethical rulings
2.3.1. PRINCIPLES OF PROFESSIONAL CONDUCT
According to AICPA, the section of Code dealing with principles of professional conduct
contains a general discussion of certain characteristics required of a CPA. There are six ethical
principles. These ethical principles are given as follows:
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.

2.3.2. RULES OF PROFESSIONAL CONDUCT

Rules of the Code of Professional Conduct are:

A. INDEPENDENCE
Independence in auditing- means taking an unbiased viewpoint in the performance of audit tests,
the evaluation of the results, and the issuance of the audit report.
Independence states that "A member in public practice shall be independent in the
performance of professional services required by standards promulgated by bodies
designated by council."

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In dealing with this rule, auditors preserve independence by:
a) Avoiding financial connections that make it appear that the auditor's wealth depends upon the
outcome of the audit, and
b) Avoiding managerial connections that make it appear that the auditors are involved in
management decisions of the audit client (thus auditing their own work).
Auditors are required to be:
 Independent in fact and
 Independent in appearance
 Independent in fact exists when the auditor is actually able to maintain an unbiased attitude
throughout the audit,
 Independence in appearance is the result of others’ interpretations of this independence.
 If auditors are independent in fact, but users perceive them as favoring the client, most of the
value of the audit function will be lost.
According to the rule of independence the most common factors that affect auditors’
independence are:
Financial interest: both direct and indirect.
Loan to or from the audit client: if it is taken without fulfilling normal lending
procedures.
 More than one year’s professional fees due from the client that remained unpaid for an
extended period of time.
 Auditor obtains loan from an audit client at an interest rate lower than the usual lending rate.
 The auditor accepts more than a token gift from a client.
 The auditor has a part in the operations of the audit client like:
 Cosigning the checks of a client,
 Preparing the client’s payrolls,
 Providing other bookkeeping services,
 Recruiting and hiring the internal auditor, accountant and other employees who
assume an audit sensitive position.
 Direct financial interest exists:
 when the auditor has investment or owns a stock in an audit client,
 When there is investment in an audit client by the auditor’s spouse, dependent children,
or a relative living in a common household which is supported by the auditor.
 Indirect financial interest:
 Having a financial interest or investments by distant relatives in an audit client.

B. INTEGRITY AND OBJECTIVITY

 In the performance of any professional service, auditors shall be free of conflicts of

interest, and shall not knowingly misrepresent facts or subordinate his or her judgment to
others.
 This rule requires auditors to be free of any bias and base his/her conclusion on facts rather

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 than on any predetermined judgments. This helps auditors to maintain public confidence.
This rule emphasizes:
a) Being free from conflicts of interest between auditor and others,
b) Truthful representation of facts in reports and discussions, and
c) Not allowing other people to dictate or influence the auditor's judgment and
professional decisions.

What are the potential threats to integrity, objectivity and independence?

(a) Undue dependence on an audit client
It is recognized that dependence on income from particular client or group of clients may impair
objectivity. A firm which derives most of its income from one client for instance might find it
difficult to make a stand on a particular issues as the loss of the client (either through the
auditor's removal or his resignation would have a disastrous effect on the firm's financial
positions.
(b) Family and other personal relations
Problems may arise where a practice or anyone closely connected with him has a mutual
business interest with a client, or with an officer or employee of a client, and where an officer or
employee is closely connected with a partner or member of staff.
(c) Beneficial interest in shares and other investment
A practice should ensure that it does not have as an audit client a company in which any partner
or anyone closely connected with a partner holds shares (or has a beneficial interest in shares).
The practice should not employ on the audit a member of staff if that member of staff or a person
closely connected with him holds shares ( or has a beneficial interest in shares) in the client.
(d) Loans
A practice or anyone closely connected with it should not, either directly or indirectly make a
loan or guarantee borrowings by an audit client, accept a loan from such a client: or have
borrowing or other obligations guaranteed by such a client.
This does not normally exclude an account in credit with client clearing bank or similar financial
institution and a loan, overdraft or home mortgage being accepted from a client provided it is in
the normal course of business and normal commercial terms.
(e) Goods and services: hospitality
Objectivity may be threatened or appear to be threatened by acceptance of goods, services or
hospitality from an audit client. Goods or services should not be accepted by a practice or by
anyone closely connected with it unless the value of any benefit is modest. Acceptance of undue
hospitality poses a similar threat.
(f) Provision of other services to audit clients
There is no objection in principle to this but care must be taken not to perform management
functions or to make management decisions. Accountancy work, however, should not be
performed for a public company except in relation to assistance of a routine clerical nature or in
emergency situations. Such assistance might include, for example, work on the finalization of

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statutory accounts, including consolidations and tax provisions. The scale and nature of such
work should be regularly reviewed.
(g) Overdue fees
The existence of significant overdue fees can be a threat to objectivity (or appear to be). Before
work is commenced on an audit the situation should be reviewed to ascertain whether the
overdue fees, taken together with the fees for the current assignment could be regarded as a
significant loan.
(h) Actual or threatened litigation
Objectivity may be threatened (or appear to be) where there is actual or threatened litigation
between an auditor and his client. The adversarial position would call into question the auditor's
ability to report fairly and impartially on the company's accounts. In an action, under the
circumstances, management may be unwilling disclose information to the auditor.
(i) Associated firms: influences outside the practice
Pressures may arise from outside the practice from associated practices or organizations, or from
other external sources such as bankers, solicitors, government or those introducing business. The
firm's review machinery should be designed to deal with this.
(j) Voting on audit appointment
Where a partner or member of staff holds shares in any capacity in an audit client company they
should not vote at any general meeting of the company in relation to the appointment, removal or
remuneration of auditors.
C. CONFIDENTIAL CLIENT INFORMATION
A member in public practice shall not disclose any confidential information without the specific
consent of the client. Auditors are not, in general, legally obligated to blow the whistle on clients.
However, circumstances may exist where auditors are legally justified in making disclosures to a
regulatory agency or a third party. Such circumstances include:
(1) When a client has intentionally and without authorization associated or involved a auditor in
its misleading conduct,
(2) When a client has distributed misleading draft financial statements prepared by a auditor for
internal use only, or
(3) When a client prepares and distributes in an annual report or prospectus misleading
information for which the auditor hasn't assumed any responsibility.
The auditor also disclose any information requested by
 Validly issued and enforceable subpoena or summons;
 A regulating body that evaluates the professional performance of auditors; and
 A recognized investigative or disciplinary body.

D. CONTINGENT FEES
Contingent fee is a fee established for the performance of any service pursuant to an
arrangement in which no fee will be charged unless a specified finding or result is attained,
or in which the amount of the fee is otherwise dependent upon the finding or result of such
service.
 Contingent fees - are fees based on findings or outcomes.
 An auditor shall not perform any professional services for a contingent fee, because such

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 thing tends to undermine the independence or objectivity.
 Contingent fees are prohibited in auditing.
 This rule prohibits an auditor from performing the following services for contingent fee:
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.
 The primary objective of this rule is to avoid the undesirable temptation from the auditor to
bill a higher fee.

E. ACTS DISCREDITABLE

An auditor shall not commit an act discreditable to the profession. Employment on the basis
of race, color, religion, sex, age, national origin, Retaining client’s records and negligence in
the preparation of reports are considered as acts discreditable to the profession.
Discreditable acts may include:
 Withholding a client's books and records and important documentation when the client
has requested their return.
 Being found guilty by a court or administrative agency to have violated employment
antidiscrimination laws, including ones related to sexual and other forms of harassment.
 Failing to follow government audit standards and guides in governmental audits when the
client or the government agency expects such standards to be followed.
 Soliciting or disclosing CPA Examination questions and answers from the closed CPA
Examination.
 Failing to file tax returns or remit payroll and other taxes collected for others (e.g.,
employee taxes withheld).
 Making, or permitting others to make, false and misleading entries in records and
financial statements.

F. ADVERTISING AND OTHER FORMS OF SOLICITATION

According to this rule, seeking clients by in a manner that is false, misleading, or deceptive is
prohibited. Solicitation by the use of coercion, overreaching, or harassing conduct is
prohibited.
G. COMMISSIONS AND REFERRAL FEES
The payment or receipt of a commission by a professional accountant in public practice could
impair objectivity and independence. A professional accountant in public practice should not
therefore, pay a commission to obtain a client nor should a commission be accepted for referral

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of a client to third party. A professional accountant in public practice shall not accept a
commission for referral of the product/service of others.
H. FORM OF PRACTICE AND NAME

A member may practice public accounting only in the form of a proprietorship, a partnership, or
a professional corporation.
A member shall not practice public accounting under a firm name that is misleading. This rule
permits practitioners to organize as a proprietorship, a partnership, or a professional corporation.
A proprietorship and each partner in a partnership must be a CPA to be qualified to practice.
When a public accounting firm is established in the form of Professional Corporation all
shareholders should be CPAs and all shareholders in professional corporations are individually
liable in litigation against the CPA firm.
2.4 AUDITOR RESPONSIBILITIES
Many users of audit reports expect auditors to detect fraud, theft, and illegal acts and to report
them publicly. Auditors take responsibility for detecting material misstatements in financial
statements but they are very cautious about taking responsibility for detecting all manner of
fraud, and are especially cautious about accepting a public reporting responsibility. Fraud and
misleading financial statements appear large among the concerns of financial statement users.
They are afraid of information risk, and they want it to be reduced, even eliminated.
When auditors do not meet the expectations of financial statement users, they may be held liable
under common law or statutory law. Common law is composed of legal decisions regarding
actions taken that injure a person or a person's property. In a common law action, the judge will
evaluate prior decisions looking for legal precedent. Where no legal precedent can be found, the
judge will follow a sense of justice or morality taking into consideration prevailing customs and
moral standards. Statutory law is based on laws passed by legislative bodies and compiled in
federal, state, and local codes. In a statutory case, the primary basis for a decision is whether the
law, as written in the code, has been violated by the actions of the party. A lawsuit claiming that
the auditor did not perform the audit in an appropriate manner would be a common law action.
2.4.1. Sources of Material Misstatements
Before we start to discuss the various legal liabilities faced by auditors, it would be better to see
issues that are considered to be the sources of material misstatements in financial reports that
form the basis of professional responsibility of auditors.
Detect and Report Errors and Irregularities: Errors are basically defined as unintentional
mistakes, and irregularities refer to intentional distortions of financial statements.
Detection of illegal Client Acts: Two kinds of illegal acts can be identified. The first is the kind
that has a direct and material effect on the determination of numbers in the financial
statements; for example, income tax determination, product pricing regulations, and government
contract terms for revenue accrual.
The second type, which in the audit literature is called illegal acts, involves violations of laws
and regulations which do not enter directly into accounting numbers, at least not initially.
Examples include violations of employment discrimination laws, securities laws, occupational
health and safety laws, environmental protection regulations, and antitrust laws. These matters
are generally beyond auditors' detection capabilities.

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Communication with Audit Committees: Characteristic of general information intended to
inform the audit committee about (1) auditors' responsibilities, and (2) auditor-management
interactions. The audit committee should be informed, either orally or in writing, of the
following:
a) The nature of assurance provided in an independent audit as reasonable assurance, not
absolute assurance, that material misstatement in the financial statements will be detected.
b) The auditors' responsibility for information other than the audited financial statements in an
annual report (e. g., president's letter, financial reviews).
c) Discussions with management concerning major issues of accounting principles and auditing
standards related to the financial statements and the audit engagement.
d) The significant accounting policies selected by management and the handling of unusual
transactions in controversial accounting areas.
e) Management's judgments used in calculating estimated amounts in the financial statements
and the auditors' conclusions about the reasonableness of these estimates.
f) Adjusting entries recommended by the auditors.
g) Disagreements with management over applications of accounting principles, necessity for
disclosures, scope of the audit work, and wording of the audit report.
h) The facts and circumstances relating to management's consultation with other accountants
about accounting and auditing matter (i.e., opinion shopping).
i) The facts and circumstances relating to any serious difficulty encountered in performing the
audit, especially events related to management's lack of cooperation with the audit team.

2.5. AUDITOR’S LEGAL LIABILITY AND RIGHTS

Auditors are liable to their clients for negligence and/or breach of contract should they fail to
provide the services or not exercises due care in their performance. Auditors may also be held
liable under common law in certain circumstances to parties other than their clients. In addition
to common law, auditors may be held liable to third parties under statutory law. In general,
auditor's liability can be categorized under the following headings; namely, liability to clients,
liability to third parties under common law & statutory law, and Criminal liability.

2.5.1. AUDITOR’S LIABILITY TO CLIENTS

Why are auditors liable to the client? The most common source of lawsuits against independent
auditors is from clients. The suits vary wide including such claims as failure to complete a
nonaudit engagement on the agreed-upon date, inappropriate withdrawal from an audit, failure to
discover a defalcation (theft of assets), and breaching the confidentiality requirements. Typically,
the amount of these lawsuits is relatively small, and they do not receive the publicity often given
to other types of suits.
Clients may bring a lawsuit for breach of contract. The relationship of direct involvement
between parties to a contract is known as privity. When privity exists, a plaintiff usually need
only show that the defendant auditor was negligent. Negligence is the opposite of diligence, or
being careful. There are two types of negligence. These are ordinary and gross negligence. Or-
dinary negligence refers to a lack of reasonable care in the performance of professional
accounting tasks. By analogy, if somebody has been grossly negligent, that means they have

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fallen so far below the ordinary standard of care that one can expect to warrant the label of being
"gross".
Gross negligence is a legal concept which means serious carelessness. If negligence is proved,
the accountant may be liable, provided the client has not been involved in some sort of
contributory negligence in the dispute.

2.5.2. LIABILITY TO THIRD PARTIES

Legal liabilities of professional accountants (auditors) may arise from lawsuits brought on the
basis of the law of contracts or as tort actions for negligence. Breach of contract is a claim that
accounting or auditing services were not performed in the manner agreed. As discussed above,
this basis is most characteristic of lawsuits involving a public accountant and his/her client. Tort
actions cover civil complaints other than breach of contract (e.g. fraud, deceit, and injury), and
such actions are normally initiated by users of financial statements.
Actions brought under common law place most of the burdens of affirmative proof on the
plaintiff (burden of proof), who must prove:
(1) He or she was damaged or suffered a loss,
(2) The necessary privity or beneficiary relationship,
(3) The financial statements were materially misleading or the accountant's advice was faulty,
(4) He or she relied on the statements or advice,
(5) Their reliance was the direct cause of the loss, and
(6)The accountant was negligent, grossly negligent, deceitful, or otherwise responsible for
damages.

2.5.3. CRIMINAL LIABILITY OF THE AUDITOR

Note that what may amount to a civil offence in one country may amount to a criminal offence in
another and vice versa. Criminal liability can arise in the following circumstances:
a) It is always an offence to accept appointment as auditor when ineligible to do so, or to
continue in office after becoming ineligible.
b) It may be a criminal offence to misappropriate another's property; obtain a financial
advantage by deception, falsify accounting records or documents, or publish a misleading
statement intended to deceive members or creditors.
c) In countries with established and mature stock markets, securities legislation usually
makes "insider dealing" an offence. This is the misuse of unpublished price sensitive
information'.
d) Financial services legislation, as noted above, provides criminal sanctions for auditors
and others (principally directors) who knowingly or recklessly make false statements in
connection with the issue of securities (principally via the prospectus).

2.5.4. AUDITOR’S RIGHTS

In order to carry out their responsibilities properly, auditors have very powerful rights. Some of
these rights include:
 Right of access to books of account and vouchers

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 Right to receive information and explanations.
 Right of access to books and papers of branch
 Right to receive notices of general meetings and to attend those meetings.
 Right to make representation where another person is being appointed as auditor.
 Right to defend him/herself in lawsuits

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