CHAPTER 4.

ETHICS

Ethics
Ethics can be defined broadly as a set of moral principles or values. Each of us has
such a set of values. We may or may not have considered them explicitly. Ethical
behavior is necessary for a society to function in an orderly manner. The need for
ethics in society is sufficiently important that many commonly held ethical values
are incorporated into laws.
Why People Act Un-ethically:

 The person’s ethical standards are different from those of society as a

whole.
 The person chooses to act selfishly.
 In many instances, both reasons exist.
Prescribed Ethical Principles Example:

 Trustworthiness
 Respect
 Fairness
 Responsibility
 Caring
 Citizenship

Ethics Dilemma
An ethical dilemma is a situation a person faces in which a decision must be made
about appropriate behavior.
Rationalizing Unethical Behavior :

 Everybody does it.

 If it’s legal, it’s ethical.
 Likelihood of discovery and consequences
Resolving Ethical Dilemmas :

 Obtain the relevant facts.

 Identify the ethical issues from the facts.
 Determine who is affected.
 Identify the alternatives available to theperson who must resolve the
dilemma.
 Identify the likely consequence of each alternative.
 Decide the appropriate action.
An ethical dilemma example :
A staff person has been informed that he will work hours without recording them
as hours worked. Firm policy prohibits this practice. Meanwhile, another staff
person has stated that this is common practice in the firm.

Special Need for Ethical Conduct in Professions

Our society has attached a special meaning to the term professional. A
professional is expected to conduct himself or herself at a higher level than most
other members of society.

Ways the Profession and Society encourage CPAs to conduct themselves at a

high level
Code of Professional Conduct
Principles: Ideal standards of ethical conduct in philosophical terms. They are not
enforceable.
Rules of conduct: Minimum standards of ethical conduct stated as specific rules.
They are enforceable.
Interpretation of the rules of conduct: Interpretation of the rules of conduct by
the AICPA Division of Professional Ethics. They are not enforceable, but a
practitioner must justify departure.
Ethical rulings: Published explanations and answers to questions about the rules
of conduct submitted to the AICPA by practitioners and others interested in
ethical requirements. They are not enforceable, but a practitioner must justify
departure.

Ethical Principles
 Responsibilities: Professionals should exercise sensitive and moral
judgments in all their activities.
 Public Interest: Members should accept the obligation to act in a way that
will serve and honor the public.
 Integrity: Members should perform all responsibilities with integrity to
maintain public confidence.
 Objectivity and Independence: Members should be objective, independent,
and free of conflicts of interest.
 Due Care: Members should observe the profession’s standards and strive to
improve competence.
 Scope and Nature of Services: A member in public practice should observe
the Code of Professional Conduct.
Standard of the conduct

Independence Rule
Independence means taking an unbiased viewpoint in performing audit tests. A
member in public practice shall be independent in the performance of
professional services as required by standards promulgated by bodies designated
by Council.

Revision of SEC Auditor Independence Requirements

 Ownership interests
 IT and other non-audit services
 ISB pronouncements and interpretations remain enforceable unless they
conflict with the independence rulings issued by the SEC.

Enforcement
 Action by AICPA Professional Ethics Division
 Action by a State Board of Accountancy
 It’s all a matter of trust.
 CHAPTER 5. LEGAL LIABILITY

Changed Legal Environment

Audit professionals have a responsibility under common law to fulfill
implied or expressed contracts with clients. They are liable to their clients
for negligence and/or breach of contract should they fail to provide the
services or not exercise due care in their performance. Despite efforts by
the profession to address the legal liability of CPAs, both the number of
lawsuits and sizes of awards to plaintiffs remain high.

Major contributors:
 Growing awareness of responsibilities of public accountants by users
of financial statements
 Increased consciousness of the Securities and Exchange Commission
(SEC) for its responsibility for protecting investors’ interests
 Complexity of auditing and accounting functions caused by increasing
size of businesses, globalization of business, and complexities of
business operations
 Tendency of society to accept lawsuits by injured parties against
anyone who might be able to provide compensation, regardless of
fault (“deep-pocket” concept of liability)
 Large civil court judgments against CPA firms awarded in a few cases
encourage attorneys to provide legal services on a contingent-fee
basis – offers the injured party a potential gain when the suit is
successful, but minimal losses when it is not
 Willingness of many CPA firms to settle legal problems out of court in
an attempt to avoid costly legal fees and adverse publicity, rather
than resolution through judicial process
 Judges and jurors difficulty in understanding and interpreting
technical accounting and auditing matters
Business Failure, Audit Failure, and Audit Risk

 Business failure: It occurs when a business is unable to repay its

lenders or meet the expectations of its investors because of
economic or business conditions.
 Audit failure: It occurs when the auditor issues an incorrect audit
opinion because it failed to comply with the requirements of auditing
standards.
 Audit risk: It represents the risk that the auditor will conclude that
the financial statements are fairly stated and an unqualified opinion
can be issued when, in fact, they are materially misstated.
Legal Concepts Affecting Liability

 Prudent person concept

 Liability for the acts of others
 Lack of privileged communication
Terms related to negligence and fraud:

 Ordinary negligence
 Gross negligence
 Constructive fraud
 Fraud
Terms related to contract law:

 Breach of contract
 Third-party beneficiary
Other terms:

 Common law
 Statutory law
 Joint and several liability
 Separate and proportional liability
Four major sources of Auditor legal liability

 Liability to clients: The most common source of lawsuits against

CPAs is from clients.
Auditor defenses against client suits:
- Lack of duty to perform
- Non-negligent performance
- Contributory negligence
- Absence of causal connection

 Liability to third-parties:
Auditor defenses against client suits: The preferred defense is non-
negligent performance.

 Federal securities laws: The Securities Act imposes an unusual

burden on the auditor. Section 11 of the 1933 act defines the rights
of third parties and auditors.
Securities Exchange Act of 1934: The liability of auditors under this
act often centers on the audited financial statements issued to the
public in annual reports or submitted to the SEC as a part of annual
Form 10-K reports.
Auditor defenses-1934 Act:
- Non-negliegent performance
- Lack of duty
- Absence of causal connection
 Criminal liability: CPAs can be held liable under criminal liability for
accountants. CPAs can be found guilty for criminal action under both
federal and state laws.
Sarbanes oxley act: This act makes it a felony to destroy or create
documents to impede or obstruct a federal investigation.
The Profession’s Response to Legal Liability

 Research in auditing
 Standard and rule setting
 Set requirements to protect auditors
 Establish peer review requirements
 Oppose law-suits
 Education of users
 Sanction members for improper conduct and performance
 Lobby for changes in law

Protecting Individual CPAs from Legal Liability

 Deal only with clients possessing integrity

 Hire qualified personnel

 Follow the standards of the profession

 Maintain independence

 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