CHAPTER TWO

The Auditing Profession

Introduction

Except for certain governmental organizations, the audits of all general use financial statements in the
United States are done by CPA firms. The legal right to perform audits is granted to CPA firms by
regulation of each state. CPA firms also provide many other services to their clients, such as tax and
advisory services.
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, independence,

reporting requirements, and evidence.

 Activities of CPA Firms

Additional services commonly provided by CPA firms include accounting and bookkeeping services,
tax services, and management consulting services. CPA firms continue to develop new products and
services, such as financial planning, business valuation, forensic accounting, and information
technology advisory services.

• Accounting and bookkeeping services. Many small clients with limited accounting staff rely on
CPA firms to prepare their financial statements. Some small clients lack the personnel or expertise to
use accounting software to maintain their own accounting records. Thus, CPA firms perform a variety
of accounting and book -keeping services to meet the needs of these clients. In many cases in which
the financial statements are to be given to a third party, a review or even an audit is also performed.

• Tax services. CPA firms prepare corporate and individual tax returns for both audit and non audit
clients. Almost every CPA firm performs tax services, which may include estate tax, gift tax, tax
planning, and other aspects of tax services. For many small firms, such services are far more important
to their practice than auditing, as most of their revenue may be generated from tax services.

• Management consulting services. Most CPA firms provide certain services that enable their clients to
operate their businesses more effectively. These services are called management consulting or
management advisory services. These services range from simple suggestions for improving the
client’s accounting system to advice in risk management, information technology and e-commerce
1
system design, mergers and acquisitions due diligence, business valuations, and actuarial benefit
consulting. Many large CPA firms have departments involved exclusively in management consulting
services with little interaction with the audit or tax staff.
2.1 ORGANAIZATIONAL STRUCTURE

Six organizational structures are available to CPA firms.

Except for the proprietorship, each structure results in an entity separate from the CPA personally,
which helps promote auditor independence.

The last four organizational structures provide some protection from litigation loss.

 Proprietorship:

 Only firms with one owner can operate in this form.

 Traditionally, all one-owner firms were organized as proprietorships, but most have
changed to organizational forms with more limited liability because of litigation risks.

 General Partnership:

 This form of organization is the same as a proprietorship, except that it applies to multiple
owners. This organizational structure has also become less popular as other forms of
ownership that offer some legal liability protection became authorized under state laws.

 Limited Liability Partnership:

 A limited liability partnership (LLP) is owned by one or more partners.

 It is structured and taxed like a general partnership, but the personal liability protection of
an LLP is less than that of a general corporation or an LLC.

 Partners of an LLP are personally liable for the partnership’s debts and obligations, their
own acts, and acts of others under their supervision.

 Partners are not personally liable for liabilities arising from negligent acts of other partners
and employees not under their supervision.

 It is not surprising that all of the Big Four firms and many smaller firms now operate as
LLPs.

2
  General Corporation:

 The advantage of a corporation is that shareholders are liable only to the extent of their
investment in the corporation.

 Most CPA firms do not organize as general corporations because they are prohibited by
law from doing so in most states.

 Professional Corporation:

 A professional corporation (PC) provides professional services and is owned by one or

more shareholders.

 PC laws in some states offer personal liability protection similar to that of general
corporations, whereas the protection in other states is minimal.

 This variation makes it difficult for a CPA firm with clients in different states to operate as
a PC.

 Limited Liability Company:

 A limited liability company (LLC) combines the most favourable attributes of a general
corporation and a general partnership.

 An LLC is typically structured and taxed like a general partnership, but its owners have
limited personal liability similar to that of a general corporation.

 All of the states have LLC laws, and most also allow accounting firms to operate as LLCs.

International Standards on Auditing

3
4
 2.2.Generally Accepted Auditing Standards/GAAS

Generally Accepted
Auditing Standards
General
qualifications Field Work
and conduct performance of
Reporting
the audit results
1. Adequate
1. Proper planning and
training and 1. Whether statements
supervision
proficiency were prepared in
2. Sufficient
2. Independence accordance with GAAP
understanding of the
in mental 2. Circumstances when
entity, its environment,
attitude IFRS not consistently
and its internal control
3. Due followed
3. Sufficient appropriate
professional 3. Adequacy of informative
evidence
care disclosures
4. Expression of opinion on
financial statements

 The broadest guidelines available to auditors in the U.S. are the 10 generally accepted
auditing standards (GAAS), which were developed by the AICPA.

The individual standards in each category are included in Table 2-2. These standards are not
sufficiently specific to provide any meaningful guide to practitioners, but they do represent a
framework upon which the AICPA can provide interpretations.

5
  The existence of GAAS is evidence that auditors are very concerned with the maintenance of a
uniformly high quality of audit work by all independent auditors.

 There are 10 standards, which fall into three categories:

1. General standards

2. Standards of fieldwork

3. standards of reporting

GAAS (i): General Standards

 The general standards stress the important personal qualities that the auditor should possess.
 the examination should be performed and the report prepared by a person having adequate
technical training and proficiency in auditing, with due care and with an objective state of
mind”.

 stress the important personal qualities that the auditor should possess.

 General Standard therefore emphasizes:

1. Adequate Technical training and proficiency as an auditor. ===Competence

2. Independence in mental attitude is to be maintained by the auditor. ===Objectivity

3. Due professional care is to be exercised===Due Professional Care

 GAAS (ii): Standards of Fieldwork

 The standards of field work concern evidence accumulation and other activities during the
actual conduct of the audit.

1. Work is to be adequately Planned and properly supervised

2. Sufficient understanding of Internal control is to be obtained

3. Sufficient competent Evidential matter is to be obtained to afford a reasonable basis for the
opinion/decision,

 GAAS (iii): Standards of Reporting

 The reporting standards require the auditor to prepare a report on the financial statements taken
as a whole, including informative disclosures. The reporting standards also require that the
report state whether the statements are presented in accordance with IFRS and also identify any
6
 circumstances in which IFRS have not been consistently applied in the current year compared
with the previous one.

 The following are the standards:

1. State whether the financial statements are presented in accordance with IFRS.

2. Identify circumstances in which such standards have not been Consistently applied

3. Informative Disclosures are adequate unless otherwise stated in the report

4. Report should clearly state the degree of responsibility being assumed by the auditors by
expressing an Opinion or stating that one cannot be expressed, and the reason therefor.

Audit Practice and Quality Centers

The AICPA has established audit practice and quality centers as resource centers to improve audit
practice quality. The Center for Audit Quality (CAQ) is an autonomous public policy organization
affiliated with the AICPA serving investors, public company auditors and the capital markets. The
Center’s mission is to foster confidence in the audit process and to make public company audits even
more reliable and relevant for investors.

The Private Companies Practice Section (PCPS) provides practice management information to firms of
all sizes. In addition to these firm resources, the AICPA has established audit quality centers for
governmental audits and employee benefit plan audits.

2.2. International Standards on Auditing/ISAs

IFAC(international federation of accountants)

• is the worldwide organization for the accountancy profession.

• works to improve the uniformity of auditing practices and related services throughout the
world.

 The ISA are issued by the International Auditing and Assurance Standards Board (IAASB) of
the International Federation of Accountants (IFAC).

2.3. Auditing Professional Ethics

 All recognized professions have developed codes of professional ethics. Professional ethics
refer to the basic principles of right action for the member of a profession.

7
What is ethics? It is a set of moral principles and standard of conduct. It includes such characteristics
as honesty, integrity, reliability, accountability, as well as other aspects of rights versus wrong
behaviors.

All recognized professions have developed codes of professional ethics. Professionals are expected to
conduct themselves at a high level than most of other members of the society.

“Professional ethics” refers to the behavior of a professional man towards other members of his
profession and also towards the members of the public. Professional ethics refer to the basic principles
of right action for the member of a profession. Professional ethics may be regarded as a mixture of
moral and practical concepts.

The term professional means a responsibility for conduct that extends beyond satisfying individual
responsibilities and beyond the requirement of our society’s law and regulations.\

The underlying reason for 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.

The fundamental purpose of such codes is to provide members with guidelines for maintaining a
professional attitude and conducting themselves in a manner that will enhance the professional stature
of their discipline.

The AICPA code of professional conduct considers the following to be followed by auditors and
accountants in the conduct of professional relations with others.

- Integrity: - An accountant should be straightforward, honest and sincere in his approach to his

professional work.

- Objectivity: - An accountant should be fair and should not allow bias to override his objectivity.

When reporting on financial statements, which come his review, he should maintain an impartial

attitude.

- Independence: - When in public practice, an accountant should both be and appear to be free of

any interest which might be regarded, whatever its actual effect, as being incompatible with

integrity and objectivity.

8
- Confidentiality: - A professional accountant should respect the confidentiality of information

acquired in the course of his work and should not disclose any such information to a third party

without specific authority or unless there is a legal or professional duty to disclose.

- Technical standards: - An accountant should carry out his professional work in accordance with

the technical and professional standards relevant to that work.

- Professional competence: - An accountant has a duty to maintain his level of competence

throughout his professional career. He should only undertake works, which he or his firm can

expect to complete with professional competence.

- Ethical behavior: - the Accountant (auditor) should conduct himself with a good reputation of the

profession and refrain from any conduct, which might bring discredit to the profession.

- Contingent (uncertain) fees: - The AICPA code of professional conduct prohibits a CPA firm

from rendering any professional services on a contingent fee basis.

- Responsibilities to colleagues: - The auditor should promote cooperation and good relations with

other members of the profession.

- Advertising: -The advertising should not be false or misleading,” should not contravene

“professional good taste,” should not make “unfavorable reflection on the competence or integrity

of the profession,” and should not” involve a statement the contents of which” cannot be

substantiated.

2.4 Legal liability and responsibility of auditors

 The auditor is responsible for his report. The auditor then has certain duties to fulfill to the
users of the financial statements that he reports on.

 Responsibilities impose liabilities if things go wrong.

 The auditor can be sued under the following legal concepts.

1. Prudent man concept (betinkakie yemisera)- The auditor is responsible for exercising due
professional care, and he is subject to lawsuit if he fails to do so.

2. Liable for acts of others - The partners are jointly liable for civil actions against a partner.

3. Lack of privileged communication - CPAS do not have the right under common law to
withhold information from the courts on the grounds that the information is privileged.
9
 2.4.1 Auditor’s liabilities

A. Auditors’ liability to their clients

 Auditor’s are liable to their clients for any losses proximately caused by the auditor’s failure to
exercise due professional care.

 That is to recover its losses, an injured client need only prove that the auditors were guilty of
negligence and that the auditors’ negligence was the proximate cause of the client’s losses.

B. Auditors’ liability to third parties

 Bankers and other creditors or investors who utilize financial statements covered by an audit
report can recover damages from the auditors if it can be shown that the auditors were guilty of
fraud/gross negligence and special relation ship in the performance of their professional duties.

2.4.2 Auditors’ responsibility for the detection of fraud and error

 The auditor is not responsible for the prevention and detection of error and fraud since it’s the
managements responsibility.

 The auditor is responsible to design audit procedures to reduce the risk of not detecting a
material error or fraud, to an appropriate level to provide reasonable assurance.

 Accordingly, the auditor must exercise due care in planning, performing, and evaluating the
results of audit procedures.

2.4.3 Auditor’s defenses for legal liabilities

1. Auditor’s Defenses Against Client Suits

 Lack of duty to perform

 Non negligent performance

 Contributory negligence

 Absence of causal connection

2. Auditor Defenses Against Third-Party Suits

The preferred defense is Non negligent performance.

2.4.4 The Profession’s Response to Legal Liability

 Research in auditing

 Standard and rule setting

 Set requirements to protect auditors

10
  Establish peer review requirements Oppose lawsuits

 Education of users

 Sanction members for improper conduct and performance

 Lobby for changes in laws

 Deal only with clients possessing integrity

 Hire qualified personnel

 Follow the standards of the profession

 Maintain independence

Protecting individual auditors from legal liability

 Understand the client’s business

 Perform quality audits

 Document the work properly

 Obtain an engagement and a representation letter

 Maintain confidential relations

 Carry adequate insurance

 Seek legal counsel

 Choose a form of organization with limited liability

 Exercise professional skepticism/uncertainty

Management Responsibility
The auditor should also understand the responsibilities of management and auditors.

The management is responsible for:

 Adopting sound accounting policies

 Maintaining adequate internal control
 Making fair representation (assertion) in the financial statement
Determining which disclosures to consider.

11
2.4.4 Possible causes of misstated financial statements
To misstate means to state wrongly or falsely. Financial statements could be misstated by reason of
errors, irregularities, illegal acts or inappropriate assumptions about the entity's viability status.

Errors-are unintentional misstatements or omissions of amounts or disclosures in financial statements.

Irregularities: - are intentional misstatements or omissions of amounts or disclosures in financial

statements. There are two types of irregularities:

 Fraudulent financial reporting or management fraud –are irregularities undertaken to render

financial statements misleading. This is often perpetrated by top management and entails an
override of the control structure. Good control structures have little chance to prevent fraudulent
financial reporting.

 Defalcations or employee fraud- are irregularities that involve the misappropriation of assets by
employees. Often to conceal this irregularity, employees must perform incompatible functions.
Such irregularities thrive in weak control structures and can be prevented by proper controls.

Illegal acts refer to violations of laws or governmental: -regulations by the client (whose financial
statements are being audited) or by management and employees acting on behalf of the client. It does
not include personal misconduct by the entity's personnel unrelated to their business activities.

12