Chapter Two

Auditing Profession

2.1. Profession
A profession is a vocation of the highest standing. It calls on its members to serve the public by
offering to them highly technical and always confidential advise and services, which require a
different standard of conduct from the tradesman. Its members stand in a different relationship
altogether from the man doing ordinary business. A profession can satisfy be characterized by
the following elements:
 Specialized body of knowledge,
 Standard of qualification for admission,
 Standard of conduct of behavior,
 Level of status recognition, and
 Acceptance of social responsibility and legal liability

Specialized Body of Knowledge

A highly developed profession has a very highly specialized written body of knowledge. The
more the profession is highly developed the more specialized the body of knowledge and,
requiring longer period of time to absorb. The body of knowledge is dynamic and is in constant
development and growth and not static. The body of knowledge here goes far beyond general
educational knowledge.
Standard of qualification of admission

A profession to be a profession must have well- recognized and accepted predetermined criterion
of qualification for admission in to the profession. The standards include educational
requirements as well as other normal and legal criteria fulfillment. The educational requirements
are, composed of theoretical knowledge and practical experience. Usually, the fulfillment of
these requirements is measured through tests of qualifying examinations to prove the
consumption of the accumulated body of knowledge that exists in the profession, and
competence in it.
Standard of Conduct of behavior

A profession has standard of conduct of behavior to be observed by the professional through

prescribed code of ethics that attempt to enforce general rule conduct, and maximum and mini
mum rules on competency and responsibility to client and colleagues. Good example of such
code of conduct is the "Oath of Hippocrates" which is sworn by medical doctors at their
graduation.
Level of status recognition

The quality and level of professional services demanded y society determines the level of status
and recognition to the profession. The level of status and recognition earned in a society is a

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function of the quality f professional service rendered which in turn are a function of standard of
professional qualification and the degree of the social, moral and legal responsibility assumed.
The more rigorous are standard of qualification and cod of ethics needed for rendering the
professional services, the higher will be the level of status and recognition given to the
profession.
Acceptance of social responsibility and legal liability

A profession to be a Profession must accept responsibility for the consequences of its action. Not
only legal responsibility which arises out of the contractual obligation, but also moral
responsibility to the profession itself and the profession to the society at large. The profession
itself has responsibility to assure the society of the quality of services demanded and accept
sanction for failure to do so.
One can find these characteristics in different stages of growth and development in various
professions. Some profession more than others seem to have attempted to fulfill some elements
better. The roll of professional associations in this regard is crucial. An association is a body of
professional and it is this body that place important role in prescribing the professional standards
and policing their implement ability.

2.2. International Standards on Auditing (ISA)

International Standards on Auditing (ISA) refer to professional standards dealing with the
responsibilities of the independent auditor while conducting the financial audit of financial
information’s. These standards are issued by International Federation of Accountants (IFAC)
through the International Auditing and Assurance Standards Board (IAASB). The ISAs include
requirements and objectives along with application and other explanatory material. The auditor is
obligatory to have knowledge about the whole text of an ISA, counting its application and other
explanatory material, to be aware of the objectives and to apply the requirements.

2.3. Professional Ethics

Broadly defined, the term ethics represents the moral principles or values of conduct recognized
by an individual or group of individuals. Ethics apply when individual has to make decision from
various alternatives regarding moral principles. All societies and individuals possess a sense of
ethics in that they can identify what is "good" or "bad". As C.S. Lewis Observed, "Human beings
all over the earth have some sort of agreement as to what right and wrong are."
Ethical conduct is determined by each individual. Each person uses moral reasoning to decide
whether something is ethical or not. Ethics are a moral code of conduct that requires an
obligation by us to consider not only ourselves but others. There are a number of ways that
individuals can receive ethical guidance in making moral decisions. Sources for ethical guidance
include our family, friends, religion, and role models.
The purpose of professional ethics in the auditing profession as well as in any other profession is
to build the public confidence, to judge the quality of audit work and means of grounding
guidance of conduct for practitioners.
The advantage of prescribing professional ethics is to emphasize positive activity and encourage
high level of performance while preventing mal-practices. However, there is difficulty in

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concretizing them. First, they can only be prescribed in general terms to avoid prescribing
unacceptable behavior, and it's difficult to enforce general ideas of behavior. Second it is
difficult to interpret behavior without reference to specific situation at which point it requires
interpretation of rulings according to circumstances. However, important parts of ethics in
auditing are in relation to:
 Maintenance of mental and physical independence
 General competence and technical standards
 Responsibility to client and colleagues and
 Other responsibilities and Practices that have bearing on ethical conduct include acts
discreditable to the profession, i.e. commission, incompatible occupation, soliciting etc.
These are best maintained by following some guidance called code of professional conduct
2.4. Rules of professional conduct (code of conduct)

Due to national differences of culture, language, legal and social systems, the task of preparing
detailed ethical requirements is primarily that of the member bodies in each country concerned
and that, they also have the responsibility to implement and enforce such requirements.
However, the identity of the auditing profession is characterized worldwide by its endeavor to
achieve a number of common objectives and by its observance of certain fundamental principles
for that purpose. Therefore, recognizing the responsibilities of the auditing profession as such,
and considering its own role to be that of providing guidance, encouraging continuity of efforts,
and promoting harmonization, has deemed it essential to establish an international Code of
Ethics for Professional auditors to be the basis on which the ethical requirements (code of ethics,
detailed rules, guidelines, standards of conduct, etc.) for professional auditors in each country
should be founded.
This international Code is intended to serve as a model on which to base national ethical
guidance. It sets standards of conduct for professional auditors and states the fundamental
principles that should be observed by them in order to achieve common objectives. Auditing
profession throughout the world operates in an environment with different cultures and
regulatory requirements. The basic intent of the Code, however, should always be respected. It is
also acknowledged that, in those instances where a national requirement is in conflict with a
provision in the Code, the national requirement would prevail.
Further, the Code is established on the basis that unless a limitation is specifically stated, the
objectives and fundamental principles are equally valid for all professional auditors, whether
they are in public practice, industry, commerce, the public sector or education.
Members’ duty to their profession and to society may at times seem to conflict with their
immediate self-interest or their duty of loyalty to their employer. Against this background, it is
beholden on member bodies to lay down ethical requirements for their members to ensure the
highest quality of performance and to maintain public confidence in the profession.
These include:
1. The Public Interest

A distinguishing mark of a profession is acceptance of its responsibility to the public. The

auditing profession’s public consists of clients, credit grantors, governments, employers,

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employees, investors, the business and financial community, and others who rely on the
objectivity and integrity of professional auditors to maintain the orderly functioning of
commerce. This reliance imposes a public interest responsibility on the auditing profession.
Auditor’s responsibility is not exclusively to satisfy the needs of an individual client or
employer. The standards of the auditing profession are heavily determined by the public interest.
Auditors have an important role in society. Investors, creditors, employers and other sectors of the
business community, as well as the government and the public at large rely on auditors' sound
financial reporting, effective financial management and competent advice on a variety of
business and taxation matters. The attitude and behavior of auditors in providing such services
have an impact on the economic well-being of their community and country.
Auditors can remain in this advantageous position only by continuing to provide the public with
these unique services at a level which demonstrates that the public confidence is firmly founded.
It is in the best interest of the worldwide auditing profession to make known to users of the
services provided by them that they are executed at the highest level of performance and in
accordance with ethical requirements that strive to ensure such performance.
In formulating their national code of ethics, member bodies should therefore consider the public
service and user expectations of the ethical standards of auditing profession and take their views
into account. By doing so, any existing “expectation gap” between the standards expected and
those prescribed can be addressed or explained.
2. Fundamental Principles

In order to achieve the objectives of auditing profession, auditors have to observe a number of
prerequisites or fundamental principles.
The fundamental principles are:
• Integrity: Auditors should be straightforward and honest in performing professional services.
• Objectivity: Auditors should be fair and should not allow prejudice or bias, conflict of interest
or influence of others to override objectivity.
• Professional Competence and Due Care: Auditors should perform professional services with
due care, competence and diligence and has a continuing duty to maintain professional
knowledge and skill at a level required to ensure that a client or employer receives the advantage
of competent professional service based on up-to-date developments in practice, legislation and
techniques.
• Confidentiality: Auditors should respect the confidentiality of information acquired during the
course of performing professional services and should not use or disclose any such information
without proper and specific authority or unless there is a legal or professional right or duty to
disclose it.
• Professional Behavior: Auditors must act in a manner consistent with the good reputation of
the profession and refrain from any conduct which might bring discredit to the profession.
• Technical Standards: Auditors should carry out professional services in accordance with the
relevant technical and professional standards.
Auditors have a duty to carry out with care and skill, the instructions of the client or employer
insofar as they are compatible with the requirements of integrity, objectivity and, in the case of
professional accountants in public practice. In addition, they should conform to the technical and
professional standards promulgated by:
 IFAC (e.g., International Standards on Auditing);
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  International Accounting Standards Board;
 The member’s professional body or other regulatory body; and
 Relevant legislation.
Integrity and Objectivity

Integrity implies not merely honesty but fair dealing and truthfulness. The principle of
objectivity imposes the obligation on all professional accountants to be fair, intellectually honest
and free of conflicts of interest.

Auditors serve in many different capacities and should demonstrate their objectivity in varying
circumstances. They undertake assurance engagements, and render tax and other management
advisory services. As professional accountants, they prepare financial statements as a
subordinate of others, perform internal auditing services, and serve in financial management
capacities in industry, commerce, the public sector and education. They also educate and train
those who aspire to admission into the profession. Regardless of service or capacity, auditors
should protect the integrity of their professional services, and maintain objectivity in their
judgment.

In selecting the situations and practices to be specifically dealt within ethics requirements
relating to objectivity, adequate consideration should be given to the following factors:
 Auditors are exposed to situations which involve the possibility of pressures being exerted
on them. These pressures may impair their objectivity.
 It is impracticable to define and prescribe all such situations where these possible pressures
exist. Reasonableness should prevail in establishing standards for identifying relationships
that are likely to, or appear to, impair auditor’s objectivity.
 Relationships should be avoided which allow prejudice, bias or influences of others to
override objectivity.
 Auditors have an obligation to ensure that personnel engaged on professional services
adhere to the principle of objectivity.
 Auditors should neither accept nor offer gifts or entertainment which might reasonably be
believed to have a significant and improper influence on their professional judgment or
those with whom they deal.

Professional Competence

Auditors should not portray themselves as having expertise or experience they do not possess.
Professional competence may be divided into two separate phases:

Phase I Attainment of professional competence

The attainment of professional competence requires initially a high standard of general education
followed by specific education, training and examination in professionally relevant subjects, and
whether prescribed or not, a period of work experience. This should be the normal pattern of
development for auditors.
Phase II Maintenance of professional competence

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The maintenance of professional competence requires a continuing awareness of developments
in the auditing profession including relevant national and international pronouncements on
accounting, auditing and other relevant regulations and statutory requirements.
Auditors should adopt a program designed to ensure quality control in the performance of
professional services consistent with appropriate national and international pronouncements.

Confidentiality

 Auditors have an obligation to respect the confidentiality of information about a client’s or

employer’s affairs acquired in the course of professional services. The duty of confidentiality
continues even after the end of the relationship between the auditors and the client or
employer.
 Confidentiality should always be observed by auditors unless specific authority has been
given to disclose information or there is a legal or professional duty to disclose.
 Professional accountants have an obligation to ensure that staff under their control and
persons from whom advice and assistance is obtained respect the principle of confidentiality.
 Confidentiality is not only a matter of disclosure of information. It also requires that Auditors
acquiring information in the course of performing professional services does neither use nor
appear to use that information for personal advantage or for the advantage of a third party.
 Auditors have access to much confidential information about a client’s or employer’s affairs
not otherwise disclosed to the public. Therefore, the professional auditor should be relied
upon not to make unauthorized disclosures to other persons. This does not apply to disclosure
of such information in order properly to discharge the professional accountant’s
responsibility according to the profession’s standards.
 It is in the interest of the public and the profession that the profession’s standards relating to
confidentiality be defined and guidance given on the nature and extent of the duty of
confidentiality and the circumstances in which disclosure of information acquired during the
course of providing professional services shall be permitted or required.
 It should be recognized, however, that confidentiality of information is part of statute or
common law and therefore detailed ethical requirements in respect thereof will depend on the
law of the country of each member body.

When to disclose confidential information?

The following are points which should be considered in determining whether confidential
information may be disclosed:
 When disclosure is authorized. When authorization to disclose is given by the client or the
employer the interests of all the parties including those third parties whose interests might
be affected should be considered.
 When disclosure is required by law. Examples of when the auditor is required by law to
disclose confidential information

The law requires the auditor to disclose information to:

 Produce documents or to give evidence in the course of legal proceedings; and
 Disclose to the appropriate public authorities infringements of the law which come to light.
 When there is a professional duty or right to disclose:

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Independence

It is in the public interest and, therefore, required by this Code of Ethics, that members of
assurance teams, firms and, when applicable, network firms be independent of assurance clients.
Assurance engagements are intended to enhance the credibility of information about a subject
matter by evaluating whether the subject matter conforms in all material respects with suitable
criteria. The International Standard on Assurance Engagements issued by the International
Auditing and Assurance Standards Board describes the objectives and elements of assurance
engagements to provide either a high or a moderate level of assurance. The International
Auditing and Assurance Standards Board have also issued specific standards for certain
assurance engagements. For example, International Standards on Auditing (ISA) provide specific
standards for audit (high level assurance) and review (moderate level assurance) of financial
statements.
A Conceptual Approach to Independence

Independence requires:
A. Independence of Mind
The state of mind that permits the provision of an opinion without being affected by influences
that compromise professional judgment, allowing an individual to act with integrity, and exercise
objectivity and professional skepticism.
B. Independence in Appearance
The avoidance of facts and circumstances that are so significant that a reasonable and informed
third party, having knowledge of all relevant information, including safeguards applied, would
reasonably conclude a firm’s, or a member of the assurance team’s, integrity, objectivity or
professional skepticism had been compromised. The use of the word “independence” on its own
may create misunderstandings. Standing alone, the word may lead observers to suppose that a
person exercising professional judgment ought to be free from all economic, financial and other
relationships. This is impossible, as every member of society has relationships with others.
Therefore, the significance of economic, financial and other relationships should also be
evaluated in the light of what a reasonable and informed third party having knowledge of all
relevant information would reasonably conclude to be unacceptable.

2.5. Threats to Independence and safe guards

Independence is potentially affected by self-interest, self-review, advocacy, familiarity and

intimidation threats.

Self-Interest Threat: Occurs when a firm or a member of the assurance team could benefit from
a financial interest in, or other self-interest conflict with, an assurance client.
Examples of circumstances that may create this threat include, but are not limited to:
 A direct financial interest or material indirect financial interest in an assurance client;
 A loan or guarantee to or from an assurance client or any of its directors or officers;
 Undue dependence on total fees from an assurance client;
 Concern about the possibility of losing the engagement;
 Having a close business relationship with an assurance client;
 Potential employment with an assurance client; and

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  Contingent fees relating to assurance engagements.

Self-Review Threat: Occurs when

 Any product or judgment of a previous assurance engagement or non-assurance engagement

needs to be re-evaluated in reaching conclusions on the assurance engagement or
 Member of the assurance team was previously a director or officer of the assurance client, or
was an employee in a position to exert direct and significant influence over the subject matter
of the assurance engagement.
Examples of circumstances that may create this threat include, but are not limited to:
 A member of the assurance team being, or having recently been, a director or officer of the
assurance client;
 A member of the assurance team being, or having recently been, an employee of the
assurance client in a position to exert direct and significant influence over the subject matter
of the assurance engagement;
 Performing services for an assurance client that directly affect the subject matter of the
assurance engagement; and
 Preparation of original data used to generate financial statements or preparation of other
records that are the subject matter of the assurance engagement.
Advocacy Threat: Occurs when a firm, or a member of the assurance team, promotes, or may be
perceived to promote, an assurance client’s position or opinion to the point that objectivity may,
or may be perceived to be, compromised. Such may be the case if a firm or a member of the
assurance team were to subordinate their judgment to that of the client.
Examples of circumstances that may create this threat include, but are not limited to:
 Dealing in, or being a promoter of, shares or other securities in an assurance client; and
 Acting as an advocate on behalf of an assurance client in litigation or in resolving disputes
with third parties.
Familiarity Threat: Occurs when, by virtue of a close relationship with an assurance client, its
directors, officers or employees, a firm or a member of the assurance team becomes too
sympathetic to the client’s interests.
Examples of circumstances that may create this threat include, but are not limited to:
 A member of the assurance team having an immediate family member or close family
member who is a director or officer of the assurance client;
 A member of the assurance team having an immediate family member or close family
member who, as an employee of the assurance client, is in a position to exert direct and
significant influence over the subject matter of the assurance engagement;
 A former partner of the firm being a director, officer of the assurance client or an employee
in a position to exert direct and significant influence over the subject matter of the
assurance engagement;
 Long association of a senior member of the assurance team with the assurance client; and
 Acceptance of gifts or hospitality, unless the value is clearly insignificant, from the
assurance client, its directors, officers or employees.
Intimidation Threat: Occurs when a member of the assurance team may be deterred from
acting objectively and exercising professional skepticism by threats, actual or perceived, from
the directors, officers or employees of an assurance client.
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Examples of circumstances that may create this threat include, but are not limited to:
 Threat of replacement over a disagreement with the application of an accounting principle;
and
 Pressure to reduce inappropriately the extent of work performed in order to reduce fees.

2.5.1. Safeguards

The firm and members of the assurance team have a responsibility to remain independent by
taking into account the context in which they practice, the threats to independence and the
safeguards available to eliminate the threats or reduce them to an acceptable level. When threats
are identified, other than those that are clearly insignificant, appropriate safeguards should be
identified and applied to eliminate the threats or reduce them to an acceptable level. This
decision should be documented.

The nature of the safeguards to be applied will vary depending upon the circumstances.
Consideration should always be given to what a reasonable and informed third party having
knowledge of all relevant information; including safeguards applied, and would reasonably
conclude to be unacceptable. The consideration will be affected by matters such as the
significance of the threat, the nature of the assurance engagement, the intended users of the
assurance report and the structure of the firm.
Safeguards fall into three broad categories. These are:
1. Safeguards created by the profession, legislation or regulation;
2. Safeguards within the assurance client; and
3. Safeguards within the firm’s own systems and procedures.
The firm and the members of the assurance team should select appropriate safeguards to
eliminate or reduce threats to independence, other than those that are clearly insignificant, to an
acceptable level.
1. Safeguards created by the profession, legislation or regulation, include:
 Educational, training and experience requirements for entry into the profession;
 Continuing education requirements;
 Professional standards and monitoring and disciplinary processes;
 External review of a firm’s quality control system; and
 Legislation governing the independence requirements of the firm.
2. Safeguards within the assurance client include:
 When the assurance client’s management appoints the firm, persons other than
management ratify or approve the appointment;
 The assurance client has competent employees to make managerial decisions;
 Policies and procedures that emphasize the assurance client’s commitment to fair
financial reporting;
 Internal procedures that ensure objective choices in commissioning non assurance
engagements; and
 A corporate governance structure, such as an audit committee, that provides appropriate
oversight and communications regarding a firm’s services.

3. Safeguards within the firm’s own systems and procedures.

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Audit committees can have an important corporate governance role when they are independent
of client management and can assist the Board of Directors in satisfying themselves that a firm is
independent in carrying out its audit role. There should be regular communications between the
firm and the audit committee (or other governance body if there is no audit committee) of listed
entities regarding relationships and other matters that might, in the firm’s opinion, reasonably be
thought to bear on independence.

2.6. Legal Liability of Auditors

We are in the era of litigation in which person real or fenced grievances are likely to their
compliances to courts. In this environment, investors and creditors who suffer financial reversal
find auditor as well as attorney and corporate directors tempting target for law suit alleging
professional “mal practice”. Therefore, auditors must approach any engagement with the
prospect that they may be required to defend their work in court.
 In court of defending legal action which may be astronomical are not limited to monetary
measures. For instance
 Law suit can be extremely damaging professional reputation which, if once damaged is
difficult to return back.
 The auditor may even be detained criminally for “mal practice”.

Definition of Legal Terms

Discussion of auditor’s liability is best described by defining some of the common terms of the
business law. The following are few to mention
1. Ordinary or Simple Negligence: Absence of reasonable care that can be expected of a person
in a set of circumstances. When negligence of an auditor is being evaluated, it is in terms of
what other competent auditors would have done in the same situation.
`2 Gross Negligence (also called recklessness or constructive fraud): is a serious occurrence
of negligence tantamount to a flagrant or a reckless departure from the standard of due care.
These terms are frequently used interchangeably and are equivalent to sloppy auditing or lack
of a reasonable basis for a belief. Lack of even slight care in discharging responsibility.
3. Fraud: Knowledge (intentionally) misrepresenting facts to decide the other party and with
the result that the party is injured. It occurs when a CPA issue an opinion on the financial
statement knowing that the financial statements or the audit report thereon is false.
4. Privity of contract: is the relationship between two or more parties that creates contractual
duty. In auditing, context, the CPA and the client have a privity or a contractual relationship
that is usually established by a contract called an engagement letter.
5. Third Party: are those who do not have privity of contract but is known to the contracting
parties and is intended to have certain rights and benefits under the contract.
6. An engagement Letter: A written letter contract summarizing contractual relationship
between the auditor and client.
7. Breach of Contract: Failure of one or both parties in a contract to fulfill the requirements of
the contract.
8. Proximity Cause: Exist when damage to other is directly attributed wrong doing act.
9. The Plaintiff: Is party claiming damage and bringing suit against defendant.
10. Contributory Negligence: Is negligence in the part of the plaintiffs that has contributed to
his/her having incurred a loss.

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11. Common Laws: Laws that have been developed through court decisions rather than through
government statutes. An example is an auditor's liability to a bank related to the auditor's
failure to discover material misstatement in financial statements that was relied on in issuing
loan.
12. Statutory Law: is a law that has been adopted by government such as federal government.
13. Comparative Negligence: is a concept used by certain courts to allocate damages between
negligent parties based on the degree to which each party is at fault. It is also called as
proportionate liability.

2.6.1. Auditors Legal Liability to client

The most frequent source of lawsuit against CPAs is from clients. The suits vary widely
including such claims as failure to complete an unaudited engagement on the agreed upon date,
inappropriate withdrawal from an audit, failure to discover a defalcation, and breaching the
confidentiality requirements of CPAs.
A typical lawsuit involves a claim that the auditor did not discover an employee defalcation
(theft of assets) as a result of negligence in the conduct of the audit. The lawsuit can be for
breach of contract, a tort action for negligence, or both. Tort action (wrongful act or damage (not
involving breach of contract) for which an evil action can be brought) can be based on ordinary
negligence, gross negligence or fraud. Tort actions are common because the amounts recoverable
under them are normally larger than under breach of contract.
The principal issue in cases involving alleged negligence is usually the level of care required.
Although it is generally agreed that nobody is perfect, not even a professional, in most instances
any significant error or mistake in judgment will create at least a presumption of negligence that
the professionals will have to rebut. In the auditing environment, failure to meet generally
accepted auditing standard is often conclusive evidence of negligence.
Auditors Defense against Client Suit

The CPA firm normally one or a combination of four defense mechanisms when there are legal
claims by clients: Lack of duty to perform the service, non-negligent performance, contributory
negligence and absence of causal connection.
1. Lack of Duty: Lack of duty to perform the service means that the CPA firm claims there was
no implied or expressed contract. For example, the CPA firm might claim that errors were
not uncovered because the firm did a review service, not an audit. A common ways for CPA
firm to demonstrate a lack of duty to perform the service is by use of an engagement letter.
Many litigation experts believe well-written engagement letters are one of the most important
ways CPA firm can reduce the likelihood of adverse legal action.
2. Non-negligent Performance: For non-negligent performance in an audit, the CPA firm
claims that the audit was performed in accordance with International Audit Standard (IAS).
Even if there were undiscovered mistakes (errors) or intentional misstatements or
misrepresentations (irregularities), the auditor is not responsible if the audit was properly
conducted.
3. Contributory Negligence: A defense of contributory negligence by the client means that the
CPA firm claims that if the client had performed certain obligations, the loss would not have
occurred. For example, suppose the client claims that the CPA firm was negligent in not

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 uncovering an employee theft of cash. A likely contributory negligence defense is the
auditor's claim that the CPA firm informed management of a weakness in the system of
internal control that enhanced the likelihood of the fraud but management did not correct it.
Management often does not correct the internal control weakness because of cost
considerations, attitude about employee honesty, or procrastinations. In this event of lawsuit
of the nature described, the auditor is unlikely to loss the suit, assuming a strong contributory
negligence defense, if the client was informed in writing of the internal control weaknesses.
4. Absence of Causal connection: To succeed in an action against the auditor, the client must
be able to show that there is a close causal connection between the auditor's breach of the
standard of due care and the damages suffered by the client. For example, assume an auditor
failed to complete an audit the agreed- upon date. The client alleges that this caused a bank
not to renew an outstanding loan, which caused damages. A potential auditor defense is that
the bank refused to renew the loan for other reasons, such as the weakening financial
condition of the client.

2.6.2. Auditor Liability to Third Party

A CPA firm may be liable to third parties if a loss was incurred by the claimant due to reliance
on misleading financial statements. Third parties include actual and potential stockholders,
vendors, bankers, and other creditors, employees, and customers. A typical suit might occur
when a banker can claim that misleading audited financial statements were relied upon in making
the loan, and that the CPA firm should be held responsible because it failed to perform the audit
with due care.

Auditors Defense against Third Party Suit

Three of the four defenses available to auditor in suit by client are also available in third party
lawsuit. These are:
1. Non-negligence performance
2. Lack of duty to Perform the Services
3. Absence of Causal Connection
Contributory negligence is ordinary not available because the third party is not in apposition to
contribute to misstated financial statement. The preferred defense in third party suit is non-
negligent performance. If the auditor conducted the audit in accordance with IAS, the other
defenses are unnecessary. On the other hand, non-negligent performance is difficult to
demonstrate to the court, especially if it is jury trial and the jury is made up of lay people.
A lack of duty defense in third-party suits contends lack of privity of contract. The extent to
which privity of contract is an appropriate defense depends heavily on the judicial jurisdiction.
Absence of causal connection in third-party suits usually means non reliance on the financial
statements by the user. For example, assume the auditor can demonstrate that a lender relied
upon an ongoing banking relationship with a customer, rather than the financial statements, in
making a loan. The fact that the auditor was negligent in the conduct of the audit would not be
relevant in that case. Of course, it is difficult to prove non -reliance on the financial statements.

2.7. Materiality and the Auditor

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Materiality is an essential consideration in determining the appropriate type of report for a given
set of circumstances. So what is the concept of materiality?
The common definition of materiality as it applies to accounting and, therefore, to the audit is:
A misstatement in the financial statement can be considered material if knowledge of the
misstatement would affect a decision of a reasonable user of the statement.
In applying this definition, three gradation of materiality are used for determining the type of
opinion to issue.
Amounts are immaterial : When a misstatement in the financial statements exist, due to of the
two conditions (1) scope restricted by client or by circumstances or (2) statements are not in
accordance with IFRS, but is unlikely to affect the decisions of a reasonable user, it is considered
to be immaterial.
Amounts are material but do not overshadow the financial statement as a whole: The
second level of materiality exists when a misstatement in the financial statement would affect a
users' decision, but the overall statements are still fairly stated, and therefore, useful. For
example, knowledge of a large misstatement in permanent assets might affect a user's willingness
to loan money to a company if the assets were the collateral. A misstatement of inventory does
not mean that cash, accounts receivable, and other elements of the financial statements, or
financial statements as a whole, are materially incorrect.
Amounts are so material or so pervasive that overall fairness of statements is in question:
The highest level of materiality exists when users are likely to make incorrect decision if they
rely on the overall financial statements.
The auditor's responsibility therefore, is to determine whether financial statements are materially
misstated. If the auditor determines that there is a material misstatement, he/she will bring it to
the client's attention so a correction can be made. If the client refuses to correct the statements, a
qualified or adverse opinion must be issued, depending on how material the misstatement is.
Auditors must, therefore, have a thorough knowledge of the application of materiality.

2.7.1. Factors Affecting Materiality Judgment

Several factors affect setting a preliminary judgment about materiality for a given set of
financial statements. The most important of these are:
Materiality is a relative rather than absolute concept: A misstatement of a given magnitude
might be material for a small company, whereas, the same birr amount error could be immaterial
for a large one. Hence, it is not possible to establish any birr- value guidelines for a preliminary
judgment about materiality applicable to all audit clients.
Bases are needed for evaluating materiality: since materiality is relative, it is necessary to
have base for establishing whether misstatements are material. Net income before taxation is
normally the most important base for deciding what is material because it is regarded as a critical
item of information for users. It is also important to learn whether the misstatements could
materially affect the reasonableness of other possible base such as current assets, current
liabilities, and owners' equity.
Qualitative factors also affect materiality: certain types of misstatements are likely to be more
important to users than others, even if the birr amounts are the same. For example:
 Amounts involving irregularities are usually considered more important than unintentional
errors of equal dollar amounts because irregularities reflect on the honesty and reliability of
the management or other personnel involved.

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 Errors that are otherwise minor may be material if there are possible consequences arising
from contractual obligations.
 Errors that are otherwise immaterial may be material if they affect a trend in earnings. For
example, if reported income has increased 3 percent annually for the past five years, but
income for the current year has declined 1 percent, that change of trend may be material.
Similarly, an error that could cause a loss to be reported as a profit would be of concern.

2.8. Error and Fraud

Error – An error represents an unintentional misstatement of the financial statement. It may be
material or immaterial.
- Mistake in gathering and reporting data
- Mistake in application of IFRS
- Unintentional omission of amount
- Informative disclosure on financial statement.
Fraud: Fraud represents an intentional misstatement of the financial statement which can be
material or immaterial. The misstatement due to fraud may occur due to either of:
1. Misappropriation of assets defalcations or employee fraud. E.g. theft of cash or another
asset.
2. Fraudulent financial reporting often called management fraud. E.g. intentional misstatement
of sales near the balance sheet date to increase reported earnings.

2.9. Truth and Fairness

The term truth and fairness are essential elements of audit report. There is no statutory or
professional definition of truth and fairness. Truth and fair is a technical in the phrase to be
looked at as entirely. In general, the word "true" means, information is factual confirms to
reality, not false. The information confirms with standards.
Fairness means; clear distinct and plain
- Impartial, not biased or
- Just and equitable
To show true and fairness accounts must be prepared
- In accordance with IFRS
- On constant basis so as net to be misleading
- The accounts must be taken from books and records.

2.10. Rights and duties of Auditors

2.10.1. Rights of auditors

The following are the rights of auditors:

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 • Resignation notice – deposit a resignation notice in writing to that effect at the
company’s registered office and the notice shall be effective only when it is signed by
auditors.
• Make representation – have a statement of circumstances connected with the resignation
or the termination, prepared by the auditor who retires or is removed sent to all members;
or to have them read out at the general meeting, except that the auditor is using the notice
to secure needless publicity for defamatory matter.
• Resigning auditor may requisition meeting – require the director to convene a general
meeting for the purpose of receiving and considering such explanation of the
circumstances connected with his resignation as he may wish to place before the meeting.
• Attend general meeting – receive all notices and communication of, attend and be heard
at the general meetings at which his term of office would otherwise have expired and it is
proposed to appoint a new auditor.

2.10.2. Duties of Auditors

Auditors have the following duties:

1. Provide an Audit Report
2. Make Proper Enquiry: It is the duty of every auditor to seek access to books of accounts,
vouchers and other information and explanation from the company.
3. Assist in Branch Audit: The accounts of a branch office can be audited by:
 a company’s auditor
 any individual appointed as the branch auditor as per the act company’s auditor or
accountant or any competent person appointed as per the laws
4. Compliance With Auditing Standards
5. Reporting of Frauds
6. Provide Assistance in Investigation: Auditor checking of specific records of a business
systematically and critically.
7. Adhere Principles of Auditing
One of the basic principles that govern an audit is confidentiality. Thus, the auditor should
maintain confidentiality of information acquired while performing his duties as an auditor.
He should not disclose the client information without his prior permission. Furthermore, the
auditor must be honest, sincere, impartial and free from biasness. Thus, he should exercise a high
degree of integrity and objectivity while examining the company’s books of accounts.

8. Provide Negative Opinion

The auditor needs to give his opinion in the auditor’s report. Such an opinion can be qualified or
unqualified.
• An unqualified opinion is the one that concludes that the company’s financial statements
present its affairs fairly in almost all the important aspects.
• Furthermore, it states that the company complies with the necessary statutory
requirements and IFRS.
• A qualified opinion, on the other hand, concludes that the company has dealt with most
of the issues except for the few ones. Under this, it is the duty of the auditor to give even
an adverse opinion regarding the company’s financial statements.
• Such an opinion must be given when the auditor disagrees with the management
regarding application, acceptability or adequacy of accounting policies.
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2.11. Appointment, Dismissal and resignation of an auditor

2.11.1. Appointment of Auditor

The directors appoint the first auditor of the company. They then hold office until the end of the
first meeting of the shareholders at which the accounts are laid before the members. At that
meeting the members can re-appoint the auditor, or appoint a different one, to hold office from
that date until the end of the next shareholders' meeting at which accounts are laid. However,
private companies can pass an 'elective resolution' not to lay accounts before the members in a
general meeting. If this is done, then the auditor has to be re-appointed, or a new one appointed,
at another meeting of the company's members that must be held within 28 days of the accounts
being sent to the members.

Private companies can also pass an elective resolution dispensing with the need to appoint an
auditor every year. If that happens, the auditor already appointed remains in office without
further formality until a resolution is passed to re-introduce annual appointment or to remove
them as auditor.

1. Auditors are usually appointed by the directors

2. They hold office until the next Annual General Meeting
3. If the directors fail to do this, the general meeting may appoint the first auditors.
3. Auditors must be appointed annually
4. A private company may elect to dispense with annual re-appointment. In this case, there is
an automatically re-appointment until there is a resolution to end the appointment.
5. The subsequent appointment are usually at each Annual General Meeting until the next AGM
6. Where at the AGM no auditor has been appointed
7. The company has to inform the registrar
8. The Registrar will appoint the auditor
9. If the management does remain silent it will be held liable.

2.11.2. Dismissal of Auditor

How is a company auditor dismissed from office?

The members of a company may remove an auditor from office at any time during their term of
office or decide not to re-appoint them for a further term.

They must give the company 28 days' notice of their intention to put a resolution to remove the
auditor, or to appoint somebody else, to a general meeting. A copy of the notice of the intended
resolution must be sent to the auditor, who then has the right to make a written response and
require that it be sent to the company's shareholders. If an auditor ceases for any reason to hold
office, they must deposit a statement at the company's registered office. The statement should set
out any circumstances connected with their ceasing to hold office that they consider should be
brought to the attention of the members and creditors of the company.

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 If there are any such circumstances, the company must send a copy of the statement to all the
shareholders unless a successful application is made to the court to stop this. If the auditor does
not receive notification of an application to the court within 21 days of depositing the statement
with the company, they must within a further 7 days send a copy of the statement to Companies
House for the public record.

11.2.3. Resignation of auditors

1. Auditors may resign prior to the completion of their term of Office
2. The auditor may do so by depositing a written notice of resignation at the company’s office .
The notice must contain a statement explaining if there are no circumstances connected with
resignation that should be brought to the member’s attention or statement of any such
circumstances.
Action by Company
Within 14 days of the receipt of the notice, the company must send a copy to the registrar. If the
notice contain a statement of any circumstances which the Auditor consider should be brought to
member’s attention, the company must also send a copy to every person entitled to receive
copies of the accounts
The auditors right to an EGM
The Auditors may require the directors to convene an Extraordinary General Meeting for the purpose
of explaining the circumstances connected with the resignation which the Auditors considers
should be brought to the member’s attention.

2.12. Audit Risk

Audit risk represent the risk that the auditor will conclude that financial statement are fairly
stated and unqualified opinion can be issued when in fact they are misstated. Audit risk refers to
the possibility that the auditor may unknowingly fail to appropriately modify their opinion on
financial statement that is materially misstated.
Audit risks are divided in to four:
a) Inherent Risk
b) Control Risk
c) Detection Risk
d) Acceptable Audit Risk
a. Inherent Risks: is a measure of the sensitivity or susceptibility of the financial statement
account to material misstatement before considering the effectiveness of internal control,
accounting controls, policies or procedures. Internal control is ignored in setting inherent risk
because they are considered separately in audit risk assessment as control risk.
b. Control Risk: is the risk that a material misstatement will not be prevented or detected on
timely basis by the clients internal control structure. Control risk represent an assessment of
whether clients internal control structure is effective for prevention or detecting error and the
more effective the internal control, the lower the control risk
c. Detection Risk: is the audit risk that the auditor will fail to detect material misstatement with
their audit procedures. It is the possibility that audit procedures will lead them to conclude that a
material misstatement does not exist in an account, in fact such misstatement does exist.
Detection risk is a function of the procedures auditors perform for testing assertions.
d. Acceptable Audit Risk: is the measure of how willing the auditor is to accept that the
financial statement may be martially misstated after the audit is completed and unqualified
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opinion has been issued. When the auditor decides on lower acceptable risk, the auditor wants to
be more certain that the financial statement will not materially misstated. Zero acceptable risk
would be high certainty and 100% acceptable audit risk would be complete uncertainty. The
primary way that the auditors deal with risk in planning audit evidence is through the application
of the audit risk model. The audit risk model is used primarily for planning purposes in deciding
how much evidence to accumulate in each cycle.

PDR = __AAR_
IR X CR
Where:
PDR = planned Detection risk
AAR = acceptable audit risk
IR = inherent risk
CR = control risk
Example: Assume that the auditor have assessed inherent risk for a particular assertion at 50%
and control risk at 40%. In addition, they have performed audit procedures that they believe have
a 20% risk of failing to detect a material misstatement in the assertion. Compute the acceptable
audit risk.
Solution
PDR = __AAR_
IR X CR
0.20 = __AAR_
0.50 X 0.40

AAR = 0.04 = 4%

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