Auditing Theories Professional Liability.pptx

Auditing

1. PROFESSIONAL LEGAL LIABILITY Presented By : Group 2 Alunday Buyucan Maggay Cadiz Saludares Domingo Mandac

2. LEARNING OBJECTIVES 01 02 03 Discuss the liability environment in which auditors operate and explore the effects of lawsuits on audit firms. List laws from which auditor liability is derived and describe the causes of legal action against auditor. Describe auditor liability under contract law, common law, and statutory law 04 Articulate a framework for making quality professional decisions and apply this framework in selected audit settings 05 Articulate a framework for making quality ethical decisions and apply this framework in selected settings 06 Identify guidance on auditors’ professional responsibilities and make audit decisions informed by the appropriate professional guidance.

3. THE LEGAL LIABILITY OF AUDITORS TO THIRD PARTIES Who exactly are auditors responsible to? Can any third party sue an auditor, or only certain classes of parties? It is generally known that auditors are responsible to two groups of third parties: 1) known users of the financial statements , and 2) a limited class of foreseeable users who will rely on the audited financial statements.

4. LEARNING OBJECTIVE I DISCUSS THE LIABILITY ENVIRONMENT IN WHICH AUDITORS OPERATE AND EXPLORE THE EFFECTS OF LAWSUITS ON AUDIT FIRMS

5. EFFECTS OF LAWSUITS ON AUDIT FIRMS Litigation cases are expensive for audit firms: Practice protection costs are second-highest costs for audit firms after employee compensation costs. RESULT IN MONETARY LOSSES CONSUME TIME OF AUDIT FIRM MEMBERS HURT THEIR REPUTATION

6. REASONS FOR LITIGATION AGAINST AUDIT FIRMS Liability doctrines permit a recovery of full amount of settlement from an external audit firm even though that firm is found to be only partially responsible for the loss Deep-pocket theory: Suing another party based on perceived ability of that party to pay damages Class action suits and associated user awareness of possibilities and rewards of litigation Contingent-fee-based compensation for law firms Misunderstanding by some users of financial statements that an unqualified audit opinion represents an insurance policy against investment losses

7. LIABILITY DOCTRINES Joint and several liability: Apportions losses among all defendants who have an ability to pay for damages, regardless of level of fault Designed to protect users suffering losses because of misplaced reliance on materially misstated financial statements. Private Securities Litigation Reform Act (PSLRA) of 1995 Designed to curb frivolous securities class action lawsuits brought under federal securities laws against low performing stock of companies. Liability is proportional unless auditor knowingly participated in a fraud. Proportionate liability: Payment by an individual defendant based on degree of fault.

8. CLASS ACTION LAWSUITS Brought on behalf of a large group of plaintiffs to: ENCOURAGE CONSISTENT JUDGMENTS MINIMIZE LITIGATION COSTS Plaintiff shareholders may bring suit for themselves and all others in a similar situation Allows underprivileged individuals to seek compensation for damages CONSOLIDATE LAWSUITS

9. CONTINGENT-FEE COMPENSATION FOR LAWYERS Lawyers work on contingent fee basis Contingent fee: Depends on finding or results of servicesork on contingent fee basis Contingent-fee cases: Lawsuits brought by plaintiffs with compensation for their attorneys being contingent on the outcome of the litigation

10. AUDITS VIEWED AS AN INSURANCE POLICY Expectations gap: Shareholders mistakenly believe that they are entitled to recover losses on investments for which auditor provided unqualified opinion on financial statements Encourages large lawsuits against auditors even for cases when auditor is partially or not at fault

11. AUDITS VIEWED AS AN INSURANCE POLICY Expectations gap: Shareholders mistakenly believe that they are entitled to recover losses on investments for which auditor provided unqualified opinion on financial statements Encourages large lawsuits against auditors even for cases when auditor is partially or not at fault

12. LEARNING OBJECTIVE II LIST LAWS FROM WHICH AUDITOR LIABILITY IS DERIVED AND DESCRIBE THE CAUSES OF LEGAL ACTION AGAINST AUDITORS

13. LIST OF LAWS FROM WHICH AUDITOR LIABILITY IS DERIVED Common law: Liability concepts developed through court decisions based on negligence, gross negligence, or fraud. Contract is between external auditor and client for performance of financial statement audit Contract law: Liability occurred where there is a breach of contract. Statutory law: Developed through legislation. Sarbanes-Oxley Act of 2002 Securities Exchange Act of 1934 Securities Act of 1933

14. SPECIFIC CAUSES OF LEGAL ACTION COMMON LAW - Failure to exercise reasonable care, thereby causing harm to another or to property Gross negligence -Failure to use minimal care or evidence of activities that show a recklessness or careless disregard for truth Ordinary negligence -Evidence may not be present, but inferred by jury because of carelessness of defendant’s conduct

15. SPECIFIC CAUSES OF LEGAL ACTION Fraud: Intentional concealment or misrepresentation of a material fact Causing damage to deceived person Intending to deceive another person Scienter: Knowledge on part of person making representations, at the time they are made, that they are false

16. C SPECIFIC CAUSES OF LEGAL ACTION Breach of contract Failure to perform a contractual duty that has not been excused. For audit firms, parties to a contract include clients and designated third-party beneficiaries. CONTRACT LAW

17. PARTIES THAT MAY BRING SUIT AGAINST AUDITORS Client and third-party users - Anyone who can support a claim that damages were incurred based on misleading audited financial statements can bring a claim against an auditor Can accuse auditor of: Breach of contract Tort: A civil wrong, other than breach of contract, based on negligence, constructive fraud, or fraud

18. OVERVIEW OF AUDITOR LIABILITY

19. LEARNING OBJECTIVE III DESCRIBE AUDITOR LIABILITY UNDER CONTRACT LAW, COMMON LAW, AND STATUTORY LAW

20. COMMON-LAW LIABILITY TO CLIENTS - BREACH OF CONTRACT Auditors are expected to fulfill contractual responsibilities to clients: Can be held liable to clients under contract law and/or under common law for breach of contract Can be sued under concepts of negligence, gross negligence, and fraud

21. COMMON-LAW LIABILITY TO CLIENTS - BREACH OF CONTRACT Causes for action against auditor for breach of contract: Violating client confidentiality Failing to provide audit report on time Failing to discover a material error or employee fraud Withdrawing from an audit engagement without justification

22. COMMON-LAW LIABILITY TO CLIENTS - BREACH OF CONTRACT Remedies for breach of contract: Requires specific performance of contract agreement Grant of an injunction to prohibit auditor from doing certain acts Provide for the recovery of amounts lost as a result of breach When an injunction is not appropriate the client is entitled to recover compensatory damages.

23. COMMON-LAW LIABILITY TO CLIENTS - BREACH OF CONTRACT Auditor’s arguments as defenses against a breach of contract suit: Auditor exercised due professional care in accordance with contract Client was contributory negligent Client’s losses not caused by breach These defenses can help auditors reduce or eliminate their liability if they can prove that they were not solely responsible for the breach

24. COMMON-LAW LIABILITY TO THIRD PARTIES To win a claim against the auditor, third parties suing under common law must prove that: They suffered a loss The loss was due to reliance on misleading financial statements The auditor knew, or should have known, that financial statements were misleading

25. DIFFERING REQUIREMENTS FOR AUDITOR LIABILITY TO THIRD PARTIES FORESEEABILITY AND NEGLIGENCE: EXPANSION OF ULTRAMARES: FORESEEN USER TEST FORESEEABLE USER TEST Identified user test THE ULTRAMARES CASE: Third-party beneficiary test Common Law The auditor’s liability depends on the jurisdiction of the case.

26. FORESEEABILITY AND NEGLIGENCE Critical point in determining the type of claim is the likelihood that an auditor could foresee the user relying upon audited financial statements Less foreseeable plaintiffs need to establish a gross negligence claim Foreseeable users, in some jurisdictions, have to establish only a negligence claim

27. THE THIRD-PARTY BENEFICIARY TEST New York Court of Appeals in 1931, Ultramares Corporation v. Touche case Court held auditors liable to third parties for fraud and gross negligence, but not for negligence Third-party beneficiary: A person who was not a party to a contract, but is named in contract as one to whom contracting parties intended that benefits be given For liability to be established, a third-party beneficiary must be specifically identified as a user

28. THE IDENTIFIED USER TEST Credit Alliance Corp. v. Arthur Andersen & Co., New York Court of Appeals extended auditor liability for ordinary negligence to identified users Identified user: The auditor has specific knowledge that known users will be utilizing financial statements in making specific economic decisions

29. FORESEEN USER TEST Restatement (Second) of Torts expanded auditor liability for negligence to: Identified users Foreseen users: Individually unknown third parties who are members of a known or intended class of third-party users who the auditor can foresee will use the statements Client must inform auditor that third parties intend to use financial statements Auditor does not have to know identity of third party

30. FORESEEN USER TEST Some courts have extended auditor liability to foreseeable users of audited financial statements Foreseeable users: Not known by auditors to be using financial statements Recognized by general knowledge as current and potential creditors and investors who will use them

31. FORESEEABILITY CONCEPTS FOR AUDITOR’S COMMON-LAW LIABILITY TO THIRD PARTIES

32. AUDITOR LIABILITY UNDER STATUTORY LAW Primary federal statutes affecting auditor liability for public clients: Securities Act of 1933 Securities Exchange Act of 1934 Sarbanes-Oxley Act of 2002 Enacted to assure that investors in public companies have access to full and adequate disclosure of relevant information.

33. SECURITIES ACT OF 1933 Requires companies to file registration statements with the SEC before issuing new securities to public Registration statement contains: Information about company itself Lists of its officers and major stockholders Plans for using proceeds from new securities issue

34. SECURITIES ACT OF 1933 PROSPECTUS Registration statement contains: First part of a registration statement filed with SEC Issued as part of a public offering of debt or equity Used to solicit prospective investors in a new security issue containing, among other items, audited financial statements Securities Act of 1933 imposes liability for misstatements in a prospectus

35. SECURITIES ACT OF 1933 SECTION 11 Most important liability section from the perspective of external auditors It imposes penalties for misstatements contained in registration statements Accuracy of registration statement is determined at its effective date

36. SECURITIES ACT OF 1933 SECTION 11 SEC intends to assure full and fair disclosure of public f inancial information An auditor may be held liable to purchasers of securities for negligence, or gross negligence and fraud Purchasers need to prove that: They incurred a loss Financial statements were materially misleading or not fairly stated

37. SECURITIES ACT OF 1933 In their defense, auditors must prove that: Due professional care was used Statements were not materially misstated The purchaser did not incur a loss caused by the misleading financial statements

38. SECURITIES EXCHANGE ACT OF 1934 Regulated companies are required to file periodic reports with the SEC and stockholders

39. SECURITIES EXCHANGE ACT OF 1934 Prohibits material misrepresentations or omissions and fraudulent conduct Provides a general antifraud remedy for purchasers and sellers of securities Auditor may be held liable for fraud when a plaintiff alleges being misled by misstatements in financial statements

40. SECURITIES EXCHANGE ACT OF 1934 Act makes it unlawful to: Make any untrue statement of a material fact Omit to state a material fact necessary for understanding financial statements Basic elements for a successful case for securities fraud: Material misrepresentation or omission Fraudulent conduct in connection with purchase or sale of a security

41. SECURITIES EXCHANGE ACT OF 1934 Scienter, when making the misrepresentation or omission Reliance upon fraudulent conduct Measurable monetary damages A causal connection between misrepresentation or omission and economic lossdamages Showing compliance with generally accepted accounting principles (GAAP) is an acceptable defense by an auditor

42. AUDITOR LIABILITY UNDER STATUTORY LAW Auditors found unqualified, unethical, or in willful violation of any provision of federal securities laws can be sanctioned by SEC Temporarily or permanently revoking the firm’s registration with the PCAOB, meaning that the SEC will not accept its audit reportsrovisions of either Act and related rules or regulations Imposing civil monetary penalties Requiring special continuing education of firm personnel Suspending individuals from serving as officers or directors of securities issuers or participating in the securities industry

43. LEARNING OBJECTIVE IV ARTICULATE A FRAMEWORK FOR MAKING QUALITY PROFESSIONAL DECISIONS AND APPLY THIS FRAMEWORK IN SELECTED AUDIT SETTINGS

44. A FRAMEWORK FOR PROFESSIONAL DECISION MAKING Quality decisions of auditors: Add value to financial markets Unbiased Comply with professional standards Based on sufficient factual information to justify the decision that is rendered

45. A FRAMEWORK FOR PROFESSIONAL DECISION MAKING

46. STEPS IN DECISION MAKING Step 1 - Auditor structures the problem Consider relevant parties to involve in the decision process Identify and consider evaluation of various feasible alternatives Identify uncertainties or risks Determining and weighing dimensions on which to evaluate the alternatives Step 2 - Auditor assesses consequences of alternatives

47. STEPS IN DECISION MAKING Step 3 - Auditor assesses the risks in the situation Risks the audit client faces Quality of evidence the auditor gathers Sufficiency of audit evidence gathered Decision rules are articulated in terms of generally accepted accounting principles or auditing standards Step 4 - Auditor evaluates the various information/audit evidence

48. STEPS IN DECISION MAKING Step 5 - Auditor considers the sensitivity of the conclusions reached in earlier steps Professional judgment: Application of professional knowledge to facts and circumstances to reach a conclusion or make a decision Client and auditor use their professional judgment to determine a value most reflective of economic reality

49. STEPS IN DECISION MAKING Step 6 - Auditor gathers information in an iterative process that affect considerations about consequences and uncertainties of potential alternatives Costs and benefits of information acquisition considered Step 7 - Auditor needs to decide whether: The problem has been sufficiently analyzed The risk of making an incorrect decision has been minimized

50. IMPORTANCE OF SKEPTICISM IN MAKING PROFESSIONAL JUDGMENTS A professionally skeptical auditor will: Critically question contradictory audit evidence Carefully evaluate reliability of audit evidence Reasonably question authenticity of documentation Reasonably question honesty and integrity of: Management Individuals charged with governance Third party providers of audit evidence

51. IMPORTANCE OF SKEPTICISM IN MAKING PROFESSIONAL JUDGMENTS Tips to encourage skeptical mindset: Be sure to collect sufficient evidence When evidence is contradictory, be diligent in evaluating reliability of individuals or processes Generate independent ideas about reasons for unexpected trends or financial ratios Question trends that appear too good Wait to make professional judgments until facts known Have confidence in your knowledge to understand complex situations

52. IMPORTANCE OF SKEPTICISM IN MAKING PROFESSIONAL JUDGMENTS Tips to encourage skeptical mindset: Be sure to collect sufficient evidence When evidence is contradictory, be diligent in evaluating reliability of individuals or processes Generate independent ideas about reasons for unexpected trends or financial ratios Question trends that appear too good Wait to make professional judgments until facts known Have confidence in your knowledge to understand complex situations

53. LEARNING OBJECTIVE V ARTICULATE A FRAMEWORK FOR MAKING QUALITY ETHICAL DECISIONS AND APPLY THIS FRAMEWORK IN SELECTED SETTINGS

54. RESOLVING ETHICAL DILEMMAS Ethical dilemma: A situation in which moral duties or obligations conflict An ethically correct action may conflict with an individual’s immediate self-interest Ethical theories help in dealing with ethical dilemmas Utilitarian theory Rights theory

55. UTILITARIAN THEORY Suggests that ethical is the action that achieves the greatest good for the greatest number of people Requirements An identification of the potential problem and possible courses of action An identification of the potential direct or indirect impact of actions on each affected party An assessment of the desirability of each action An overall assessment of the greatest good for the greatest number

56. PROBLEM WITH UTILITARIAN THEORY This approach can lead to disastrous courses of actions when those making decisions fail to adequately measure or assess potential costs and benefits.

57. RIGHTS THEORY Identifies a hierarchy of rights that should be considered in solving ethical dilemmas Based on fundamental rights of parties involved Higher order rights take precedence over lower order rights Most effective in identifying outcomes that ought to be automatically eliminated

58. HIERARCHY OF RIGHTS

59. EXHIBIT 4.4 - A FRAMEWORK FOR ETHICAL DECISION MAKING STEP 1 Identify the ethical issue (s). STEP 2 Determine the affected parties and identify their rights. STEP 3 Determine the most important rights. STEP 4 Develop alternative courses of action.

60. EXHIBIT 4.4 - A FRAMEWORK FOR ETHICAL DECISION MAKING STEP 5 Determine the likely consequences of each proposed course of action. STEP 6 Assess the possible consequences, including the estimation of the greatest good for the greatest number. Determine whether the rights framework would cause any course of action to be eliminated. STEP 7 Decide on the appropriate course of action.

61. LEARNING OBJECTIVE VI IDENTIFY GUIDANCE ON AUDITORS’ PROFESSIONAL RESPONSIBILITIES AND MAKE AUDIT DECISIONS INFORMED BY THE APPROPRIATE PROFESSIONAL GUIDANCE.

62. INTERNATIONAL ETHICS STANDARDS BOARD FOR ACCOUNTANTS (IESBA) CODE OF ETHICS FOR PROFESSIONAL ACCOUNTANTS The Code requires auditors to adhere to fundamental principles: • Integrity • Objectivity • Professional competence and due care • Confidentiality • Professional Behavior

63. AICPA RULES OF CONDUCT Detailed guidance to assist an auditor in applying broad principles contained in AICPA’s Code of Professional Conduct. Rules evolved over time as members of profession encountered specific ethical dilemmas in complying with principles of the Code

64. INDEPENDENCE - RULE 101 External auditors required to be independent when providing services to either public or private entities Specific rulings provide detailed guidance on such matters as: • Financial interests in the client • Family relationships • Loans with a client • Performance of nonaudit services

65. INTEGRITY AND OBJECTIVITY - RULE 102 AICPA members required to act with integrity and objectivity in all services that may be provided to a client . Applies to CPAs who are not in public practice CPA - Special certificate that holds its owner to a high standard of ethical conduct

66. GENERAL STANDARDS - RULE 201 • Members required to comply with following standards and with any interpretations thereof by bodies designated by Council • Professional competence • Due professional care • Planning and supervision • Sufficient relevant data

67. COMPLIANCE WITH STANDARDS - RULE 202 Members performing following tasks required to comply with standards promulgated by bodies designated by Council ( Auditing, Review, Compilation, Consulting, Tax, Other professional services) -FASB, PCAOB AND THE AICPA.

68. ACCOUNTING PRINCIPLES - RULE 320 • When financial statements are not in conformance with GAAP, members not allowed to: - Express an opinion that financial data are presented in conformity with generally accepted accounting principles or -State unawareness regarding any material modifications that should be made to financial data to be in conformity with generally accepted accounting principles

69. CONTINGENT FEES - RULE 302 • Contingent fee: Charged for performance of any service • Contingent fees are not allowed for audit engagements

70. ACTS DISCREDITABLE - RULE 400 • Members not allowed to commit an act discreditable to the profession (Violation of laws, failure to file tax return, presentation of false information, failure to follow the accountancy laws and standards)

71. ADVERTISING AND OTHER FORMS OF SOLICITATION - RULE 600 • Members in public practice not allowed to seek clients by advertising or other forms of solicitation in a false, misleading, or deceptive manner

72. COMMISSIONS AND REFERRAL FEES - RULE 503 • Commissions prohibited for: - Recommendation or referring to a client any product or service. -Recommendation or referring any product or service to be supplied by a client. -Members or the members’ firms performing attestation services for client

73. COMMISSIONS AND REFERRAL FEES - RULE 503 • Disclosure of permitted commissions: • Referral fees: • Any member who accepts a referral fee for recommending or referring any service of a CPA to any person or entity or who pays a referral fee to obtain a client shall disclose such acceptance or payment to the client.

74. FORM OF ORGANIZATION AND NAME - RULE 600 • Members allowed to practice public accounting only in a form of organization permitted by state law or regulation. • Members not allowed to practice public accounting under a firm name that is misleading

75. OTHER GUIDANCE • The Sarbanes-Oxley Act, the PCAOB, and the SEC also have requirements for professional responsibilities for audits of public companies.

76. THANK YOU

77. References: Johnstone, K. M., Gramling, A. A., & Rittenberg, L. E. (2019). Auditing: A Risk-Based Approach To Conducting A Quality Audit.