Auditing

A Practical Approach
Third Canadian Edition
Moroney, Campbell, Hamilton, Warren

Chapter 2

ETHICS, LEGAL LIABILITY, AND CLIENT

ACCEPTANCE
 LEARNING OBJECTIVES (1 of 2)
1. Describe the fundamental principles of
professional ethics
2. Define and asses auditor independence
3. Explain the relationship between an auditor
and key groups they have a professional link
with during the audit engagement

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 LEARNING OBJECTIVES (2 of 2)
4. Explain the auditor’s legal liability to their
client, contributory negligence, and the extent
to which an auditor is liable to third parties
5. Identify the factors to consider in the client
acceptance or continuance decision.

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 Fundamental Principles of Professional
Ethics (1 of 6)
• All professional accountants in Canada must
abide by a code of professional conduct
• These principles are to act with:
─ Professional behaviour
─ Integrity and Due Care
─ Professional competence
─ Confidentiality
─ Objectivity

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 Fundamental Principles of Professional
Ethics (2 of 6)
Professional behaviour
• Comply with rules and regulations and do not harm
reputation of the profession
• Be honest in representations to current and
prospective clients
• Do not claim to provide services they cannot provide,
or qualifications they do not possess, or experience
they do not have
• Do not undermine reputation of, or quality of work
produced by, others
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 Fundamental Principles of Professional
Ethics (3 of 6)
Integrity and Due Care
• To be straightforward and honest
• Act diligently, taking care to complete each task
thoroughly, document all work, finish on a timely
basis

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 Fundamental Principles of Professional
Ethics (4 of 6)
Professional competence
• Maintain knowledge and skill at a level required by
the professional body
• Keep up-to-date with changes in regulations and
standards
• Continue education and work experience

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 Fundamental Principles of Professional
Ethics (5 of 6)
Confidentiality
• Refrain from disclosing information to people
outside the workplace that is learned as a result of
employment
• Exception: if legal requirement to disclose
• Not allowed to use confidential information to
their advantage or advantage of another person

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 Fundamental Principles of Professional
Ethics (6 of 6)
Objectivity
• Not allow personal feelings or prejudices to
influence professional judgement
• Be unbiased
• Not allow conflict of interest or influence of others
to impair decision process

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 Independence
• Independence is the ability to act with integrity,
objectivity, and with professional scepticism
(questioning mind)
• Lack of auditor independence impacts on
credibility and reliability of the financial
statements
• The auditor must be, and be seen to be,
independent

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 Auditor Independence (1 of 13)
Independence in fact
• ability to act independently with integrity,
objectivity and professional scepticism
• ability to make a decision free from bias, personal
belief, and client pressures

Independence in appearance
• belief that independence of mind has been
achieved
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 Auditor Independence (2 of 13)
Threats to independence
• Self-interest
• Self-review
• Advocacy
• Familiarity
• Intimidation

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 Auditor Independence (3 of 13)
Self-interest threat
• Can occur if the audit firm or its staff have financial
interest in audit client
• Examples:
─ Bank account held with the client
─ Shares owned in the client
─ A loan to or from the client
─ Fee dependence, where the fees from a client form a
significant proportion of all fees of the firm
─ Close business relationship with the client

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 Auditor Independence (4 of 13)
Self-review threat
• Can occur when the assurance team need to form
an opinion on their own work or work done by
others in their firm
• Examples:
─ Assurance team member has recently been an
employee or director of the client
─ Preparing information for the client that is then
assured
─ Performing services for the client that are then
assured
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 Auditor Independence (5 of 13)
Advocacy threat
• Can occur when an audit firm or assurance staff
act, or is believed to act, on behalf of assurance
client
• Can lead to questioning of auditor’s objectivity.

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 Auditor Independence (6 of 13)
Familiarity threat
• Examples:
─ Encouraging others to buy client’s shares or bonds
─ Representing client in negotiations with third party
─ Representing the client in a legal dispute
• Can occur when close relationship exists or
develops between assurance firm and client, or
firm and client personnel

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 Auditor Independence (7 of 13)
Familiarity threat (cont.)
• Assurance staff can become too sensitive to needs
of client and lose objectivity
• Examples:
─ Long association between assurance firm and client
─ Long association between assurance firm and client
personnel
• Assurance team member with a close relative holding
a position of influence at the client

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 Auditor Independence (8 of 13)
Familiarity threat (cont.)
• Former partner of assurance firm holding senior
position at the client
• Acceptance of gifts by members of assurance team
from their client (other than minor tokens)
• Acceptance of hospitality by members of
assurance team from client (other than minor
gestures)

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 Auditor Independence (9 of 13)
Intimidation threat
• Can occur when member of assurance team feels
threatened by the client’s staff or directors
• Assurance team member unable to act objectively,
fearing negative consequences
• Examples:
─ Threat that client will use different assurance firm
next year
─ Undue pressure to reduce audit hours to reduce
fees paid

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 Auditor Independence (10 of 13)
Additional requirements for public companies
with market capitalization and a book value of
total assets great than $10 million include:

• Mandatory partner rotated

• Audit committee must pre-approve all services
provided to the client
• Audit partners not to be directly compensated for
selling non- assurance services to client

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 Auditor Independence (11 of 13)
Additional requirements (cont.):
• Auditor cannot perform certain prohibited
services– examples include: bookkeeping services,
management functions, internal audit
• If engagement team member accepts employment
in financial reporting role with client, firm refrains
from being the auditor of client for one year from
last filing

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 Auditor Independence (12 of 13)
Safeguards to independence
• Created by profession, legislation, or regulation
─ Quality control standards
─ Education and Code of ethics
─ Legislative requirement to be independent

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 Auditor Independence (13 of 13)
Safeguards to independence (cont.)
• Created by profession, legislation, or regulation
(cont.)
─ Created by clients
• Corporate governance
• Policies and procedures
─ Created by accounting firms
• Quality control procedures and education
• Client acceptance and continuance

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Auditor’s Relationships with Others (1 of 6)
Shareholders
• Audit report addressed to them
• Attendance at AGM
• Formal responsibility for auditor appointment

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Auditor’s Relationships with Others (2 of 6)
Board of directors
• Represents shareholders
• Executive and non-executive directors
• Large companies have committees made up of
several directors to deal with specific issues

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Auditor’s Relationships with Others (3 of 6)
Audit committee
• A special committee of the board of directors
• Acts on behalf of board in financial reporting and
audit matters
• Canadian Securities Administrators require all
listed companies must have an audit committee

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Auditor’s Relationships with Others (4 of 6)
Audit committee (cont.)
• Aid to auditor independence
─ Non-executive directors, majority independent
─ At least three independent directors must be
financially literate
─ Meets with external and internal auditors

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Auditor’s Relationships with Others (5 of 6)
• Internal auditors
─ Viewed by external auditor as part of client
─ External auditor can modify the nature and
timing of their procedures and reduce the
extent of their testing if there is an effective
internal audit function (CAS 610).

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Auditor’s Relationships with Others (6 of 6)
• Internal auditors (cont.)
─ Modifications by external auditor depends on
internal auditor’s:
• Objectivity
• Technical competence
• Due professional care
• Communication with external auditors

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 Legal Liability (1 of 12)
• External auditor must exercise due care, be
diligent in applying standards and documenting
work
• Auditor can be found negligent and liable for
damages under tort law if it is established that:
─ A duty of care was owed by the auditor
─ There was a breach of the duty of care
─ A loss was suffered as a consequence of that
breach
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 Legal Liability (2 of 12)
• Legal liability to clients:
─ Liability under either contract or tort law
─ Negligence: failed in performance of audit by
being careless and breaching duty of care
─ Contract: failed to live up to their
responsibilities agreeing to act as the auditor
and explicit in engagement letter

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 Legal Liability (3 of 12)
• Contributory Negligence
─ Where a plaintiff (party suing) and the
defendant (the auditor) can be proven to have
been negligent, each party must be held
responsible in proportion to their guilt

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 Legal Liability (4 of 12)
• Legal liability to third parties
─ Third party = anyone other than the client and
its shareholders who use the financial
information to make a decision
─ No contract between auditor and third parties
─ Need to establish that:
• a duty of care was owed to the third party and
• the auditor’s negligence was responsible for the
third party’s loss

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 Legal Liability (5 of 12)
• Legal liability to third parties (cont.)
─ Utramares Corp. vs. Touche (1931 US)
• auditors not liable for ordinary negligence to
parties that they do not have a contractual
relationship with

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 Legal Liability (6 of 12)
• Legal liability to third parties (cont.)
─ Hedley Byrne & Co. Ltd. vs. Heller and Partners
Ltd. (1963)
• expanded concept of liability beyond the
contractual one to those third parties provided
the auditors knew before-hand this party would
be relying on their opinion

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 Legal Liability (7 of 12)
• Legal liability to third parties (cont.)
─ Haig vs. Bamford et al. (1976)
• although the auditor did not know the actual
name of the investor, they knew the financial
statements were being passed on to
unidentified members of a limited class for
use in a transaction

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 Legal Liability (8 of 12)
• Legal liability to third parties (cont.)
─ Hercules Management vs. Ernst & Young (1997)
• ruled the audited financial statements were
prepared to evaluate management stewardship
and not for individuals making investment
decisions

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 Legal Liability (9 of 12)
• Overall:
─ To determine care owed to third parties
─ The third party must establish that:
• auditor was aware the third party was going to
use the financial statements and
• third party relied upon the financial statements
for the purpose they were prepared

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 Legal Liability (10 of 12)
• Auditor can take steps to avoid litigation:
─ Hire competent staff, regular training
─ Comply with ethical and auditor regulations

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 Legal Liability (11 of 12)
• Auditor can take steps to avoid litigation (cont.):
─ Implement policies and procedures:
• Client acceptance
• Staff allocation
• Ethical and independence issue identification dealt
with on a timely basis
• Adequate work documentation
• Gather adequate and appropriate evidence to
support opinion

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 Legal Liability (12 of 12)
• Auditor can take steps to avoid litigation (cont.)
─ Meet with client’s audit committee to discuss
significant issues arising in audit
─ Follow up any significant weaknesses in client’s
internal control procedures from previous
year’s audit

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Client Acceptance and Continuance (1 of 7)
• The first stage in any audit is client acceptance
or continuance decision
• Guidance provided in CSQC1
Step 1: Assess client integrity
Step 2: Assess audit firm’s ability to meet
ethical requirements, service client
Step 3: Prepare client engagement letter

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Client Acceptance and Continuance (2 of 7)
Client integrity - Auditor should consider:
• Reputation of client, management, directors, key
stakeholders
• Client’s reason for switching auditor
• Client’s attitude to risk exposure and management
• Client’s attitude to using internal controls to
mitigate risk

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Client Acceptance and Continuance (3 of 7)
Client integrity (cont.)
• Appropriateness of the client’s interpretation of
accounting rules
• Client’s willingness to allow auditor full access to
information required to form an opinion
• Client’s attitude and willingness to pay fair amount
for audit work

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Client Acceptance and Continuance (4 of 7)
Auditor can obtain information from:
• Communication with prior auditor, client
personnel, third parties, key competitors
• Review of press articles and internet or
background search
• Review of prior period financial statements

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Client Acceptance and Continuance (5 of 7)
Ethical requirements
• Consider if any threats to fundamental principles
arise from appointment
• Auditor must ensure it has sufficient staff available
with required knowledge to complete audit
(professional competence and due care)
• Consider potential safeguards and remedies
• Decline appointment if threat insurmountable

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Client Acceptance and Continuance (6 of 7)
Engagement letter (CAS 210)
• Prepared by auditor, acknowledged by client (need
to update each year)
• Explains scope of audit
• Summarizes the responsibilities of both
management and the auditor

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Client Acceptance and Continuance (7 of 7)
Engagement letter (CAS 210) (cont.)
• Identifies the applicable financial reporting
framework
• References the expected form/content of audit
report
• See Figure 2.5 in text for example

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