Accounting Ethics

Chapter 6
Legal, Regulatory, and Professional
Obligations of Auditor
 After studying Chapter 6, you should be able to:
 LO6-1 Distinguish between common-law rulings and auditors’ legal
liability.
 LO6-2 Explain the basis for auditors’ statutory legal liability.
 LO 6-3 Discuss auditors’ legal liabilities under SOX.
 LO 6-4 Explain the provisions of the FCPA.
 LO6-5 Describe the cultural and professional constraints on adopting
IFRS.
 LO6-6 Distinguish between legal compliance and management by
values.
 LO 6-7 Discuss the factors that promote global ethics, and prevent
global fraud and bribery.
 Legal, Regulatory, and Professional Obligations of
Auditor

 Zoe-Vonna Palmrose identifies the 4 general stages in audit-related

dispute:
• Events that result in losses for users of the financial statements
• Investigation by plaintiff attorneys to link the user losses with
allegations of material omissions or misstatements of financial
statements
• The legal process, which commences with the filing of the lawsuit,
• Final resolution of the dispute
 Auditors can be sued by clients, investors, creditors, and the
government
 Auditors can be held liable under common and statutory law
 Types of Liability and Auditors’ Actions
Resulting in Liability
 Common law—Clients
 Breach of contract (privity relationship)
• Negligence
• Gross negligence/constructive fraud
• Fraud
 Common law—third parties
• Negligence
• Gross negligence/constructive fraud
• Fraud
Summary of Types of Liability and
Auditors’ Actions Resulting in Liability
 Federal statutory law—
• Civil liability Negligence
• Gross negligence/constructive fraud
• Fraud
 Federal statutory law—
• Criminal liability
• Willful violation of federal statutes
Common and Statutory Law
 Common law: Evolves from legal opinions issued by
judges in deciding a case
 Breach of contract is a claim that accounting or auditing
services were not performed in a manner proscribed in
the contract (brought by clients)
 Tort actions cover other civil complaints (brought by
clients and users of financial statements)
 Fraud
 Deceit
 Injury
Common and Statutory Law
 Statutory law: Legislation passed at state or federal
level that establishes certain courses of conduct that
must be adhered to by parties
Common Law Liability
 Auditor must perform professional services with
due care Evidenced by having exercised same
degree of skill and judgment possessed by others in
the profession
 Adherence to generally accepted auditing standards
can provide evidence of having exercised due care
in the audit
Common Law Liability
 Due care includes exercising the degree of
professional skepticism expected in the audit of
financial statements
 Audit failures – all possible causes – breach of
contract, tort, deceit, and fraud
Liability to Clients - Privity
 A contractual obligation to the client that creates a
privity relationship
 A client can bring a lawsuit against an accountant for
failing to live up to terms of the contract; plaintiff
must demonstrate:
• Economic loss
• Auditors breached contract
• Auditors failed to exercise appropriate level of professional
care
• Auditors breach or failure of care caused the loss
Liability to Clients - Privity
 Link of ethical responsibilities of auditors through
the due care ethics rule and the universality
perspective (Kantian Rights)
 Fraud includes gross negligence or constructive
fraud that represents an extreme or reckless
departure from professional standards of care
Liability to Third Parties Near-Privity Relationship

 Near privity relationship established in Credit

Alliance v. Arthur Andersen & Co
 Case establishes tests for holding auditors liable for
negligence to third parties
• Knowledge that financial statements to be used for
a particular purpose
• Intention of third party to rely on financial
statements
• Action linking the accountant and the third party
Liability to Third Parties Near-Privity Relationship

 Security Pacific Business Credit, Inc. v. Peat

Marwick Main & Co. Sharpened last criteria
of near privity test:
 The auditor must directly express the audited report to
the third party, OR
 The auditor acts to induce reliance on the audit report
Liability for Fraud
 Gross negligence may be interpreted as fraud
 Gross negligence, or constructive fraud, occurs
when the auditor acts so carelessly in the
application of professional standards that it implies
a reckless disregard for the standards of due care
 Fraudulent intent.
 Scienter is the intent to deceive, manipulate, or
defraud.
Plaintiff Claims for Action
 Common-law liability for fraud is available to third
parties in any jurisdiction. The plaintiff must prove:
• A false representation by the accountant
• Knowledge or belief by the accountant that the
representation was false
• The accountant had fraudulent intent or scienter
(established by proof that accountant acted with
knowledge of the false representation)
• The third party relied on the false representation
• The third party suffered damages
Auditor Defenses for Fraud Claims
 Auditor must prove:
• Auditor didn’t have duty to the third party
• The third party was negligent
• Auditor’s work was performed in accordance with
professional standards
• The third party did not suffer loss
• Any loss to the third party was caused by other
events
• The claim
Regulatory and Professional Issues: An International
Perspective

 Major financial statement frauds in the early 2000s

that led to legal liabilities for the auditors; the
blame for these frauds is due to a lack of internal
controls, ineffective internal audits, inattentive
boards of directors, and external audit failures
Regulatory and Professional Issues: An International
Perspective

 IFAC’s research report identifies several key

weaknesses in corporate governance with
recommendation for more effective corporate ethics
codes as well as the provision of training and support
for individuals in the organizations to better prepare
them to deal with ethical dilemmas
 IFAC considers the “public interest” to represent the
common benefits derived by stakeholders (i.e.,
investors and creditors) of the accounting profession
through sound financial reporting
The Influence of Culture on International Financial
Reporting

 Research reveals that two accounting values

directly influenced by national culture are
conservatism and secrecy, which affect the
measurement and disclosure of financial
information in financial reports and have the
greatest potential to affect cross-border financial
statement comparability
The Influence of Culture on International Financial
Reporting

 The widely recognized accounting values that can

be used to define a company’s cultural foundation
with respect to financial reporting:
 Professionalism versus statutory control
 Uniformity versus flexibility
 Conservatism versus optimism
 Secrecy versus transparency
International Financial Reporting Standards (IFRS)

 More than 120 countries currently use IFRS in one

form or another
 In 2005 the European Union adopted IFRS for all
companies doing business the European Zone
 The U.S. has been reluctant to adopt IRFS; current
approach is “condorsement,” which would address
differences between IFRS and U.S. GAAP to
determine acceptability of IFRS as part of GAAP
International Financial Reporting Standards (IFRS)

 The principles-based approach of IFRS has

increasingly influenced standards in the U.S.,
although the rules-based system is still the basic
framework for financial reporting
 The effectiveness of IFRS adoption may be hampered
by differences, across countries, which highlights the
need for a common set of ethical standards to deal
with differences
 International enforcement remain problematic given
legal differences and cultural considerations
Principles versus Rules-Based Standards

 Principles-only standards may present enforcement

difficulties because they provide little guidance or
structure for exercising professional judgment by
preparers and auditors
 SEC study recommends that those involved in the
standard-setting process more consistently develop
standards on a principles-based or objectives-based
basis
Principles versus Rules-Based Standards

 Rules-based standards can provide a basis for

avoidance of the accounting objectives inherent in
the standards Internal inconsistencies, exceptions,
and bright-line tests reward those willing to
engineer their way around the intent of standards
 This can result in financial reporting that is not
representational faithful to the underlying
economic substance of transactions and events
Global Ethics
 International Ethics Standards Board for Accountants
(IESBA) develops and issues high-quality ethical
standards for professional accountants around the world
 Issued a global code of ethics (IFAC Code) A member
body or firm from a member country may not apply less
severe standards than those stated in the IFAC Code
 If national law or regulation prohibits or is in conflict
with the IFAC Code, them member body or firm should
be governed by their country’s requirements but comply
with all other parts of the IFAC Code
Global Ethics
 IFAC Code contains provisions virtually identical to those
embodied in the AICPA Code of Professional Conduct
 Act in accordance with the public interest
 Identify threats to independence and develop safeguards
to mitigate such threats
 Be independent in fact
 Maintain the appearance of independence
 Adhere to standards related to integrity, objectivity,
professional competence and due care, confidentiality,
and professional behavior
Global Fraud and Bribery
 Seventh annual Global Fraud Survey
prepared by Kroll found Fraud is on the rise
(after a decrease in 2012) and so are costs involved
in managing fraud
 Awareness of fraud is up
 Cybercrime
 Information theft
 Outsourcing or expansion into new or riskier markets
Global Fraud and Bribery
 A Bribe is money or a gift given to someone to
change their behavior and perform an act or service
that is not part of their legal or authorized activities
 Serious Frauds Office (SFO) in the UK provides
guidance on corruption indicators, red flags, and
questionable business practices:
Global Fraud and Bribery
 Abnormal cash payments
 Pressure exerted for payments made urgently or
ahead of schedule
 Payments being made through a third party country
 Private meetings with public contractors
 Lavish gifts
 Agreeing to contracts not favorable to the
organization
 Unexplained preference for certain contractors
 Global Fraud and Bribery Prevention
Strategies
 Preventing corruption is fundamentally a matter of
corporate culture
 Assess the way things really happen in the
company
 Update anti-bribery & anti-corruption policies
 Ensure gifts & hospitality meet key criteria
 Conduct due diligence on all third parties
 Watch out for bribery & corruption red flags
 Global Fraud and Bribery Prevention
Strategies
 Add precautions for foreign public officials
 Avoid facilitation payments
 Report bribery & corruption concerns promptly
 Make anti-bribery training meaningful
 Get the tone right from the top
END