Chapter 3: Audit Reports

AICPA sets standards for nonpublic entities and PCAOB sets auditing standards for public companies

Describe the parts of the standard unmodified opinion audit report for nonpublic entities under AICPA
auditing standards

Standard unmodified opinion audit report contains 8 parts:

1. Report title – “independent auditor’s report” the word independent must be included in the title
to convey it was unbiased
2. Audit report address – address to those for whom the report is prepared (company,
stockholders, board of directors, etc.) customary to indicate that auditor is independent of
company
3. Introductory paragraph – indicate CPA firm has performed an audit. Distinguish from a
compilation or review report. Lists the financial statements that were audited, include notes to
the financial statements as well as balance sheet dates and the accounting periods covered in
the income statement and statement of cash flows.
4. Manager’s responsibility – “Management’s responsibility for the financial statements” and a
paragraph that describes management’s responsibility for the financial statements.
Responsibility include selecting appropriate accounting principles and maintain internal control
over financial reporting
5. Auditor’s responsibility – “Auditor’s responsibility” and three paragraphs that describe the
auditor’s responsibility
a. State auditor’s responsibility to express an opinion on the financial statement and that
the audit was in accordance to auditing standards generally accepted in the US. Should
also state to obtain reasonable assurance whether financial statements are free of
material misstatement
b. Describes the scope of the audit and the evidence accumulated about the amounts and
disclosures in the financial statements
c. Indicate auditor believes that sufficient appropriate evidence has been obtained
6. Opinion paragraph – “opinion” is auditor’s conclusion based on results of the audit
7. Signature and address of CPA firm
8. Audit report date – should be when auditor last finished obtaining transactions from the
company
Specify the conditions required to issue the standard unmodified opinion report

The standard unmodified opinion audit report is issued once the following conditions have been met

1. All statements are included in the financial statements

2. Sufficient appropriate evidence has been accumulated and the auditors was able to conclude
that the audit was performed in accordance with auditing standards
3. Financial statements are fairly presented in all material respects in accordance with US GAAP or
appropriate accounting framework. Also means, adequate disclosures have been included in the
footnotes and other parts of the financial statements
4. No circumstance requiring addition of an emphasis-of-matter paragraph or modification of the
wording or auditor’s opinion in the report

If any requirements are not met, the standard unmodified opinion audit report cannot be issued.
Financial statements are more concerned about a disclaimer or adverse opinion than unmodified
opinion audit report that contains an additional emphasis-of-matter or other matters paragraph

Understand reporting on financial statements and internal control under PCAOB auditing standards

Two significant audit reporting differences for public companies:

1. standard unmodified opinion audit report is different for audits of financial statements of public
companies
2. Auditors of larger public companies must also issue an opinion on internal control over financial
reporting

PCAOB refer to the standard unmodified opinion audit report as an “unqualified opinion” audit report

 AKA unmodified opinion

Describe the five circumstances when an emphasis of matter explanatory paragraph or non-standard
wording is appropriate to include in an unmodified opinion audit report

Chapter 4: Professional Ethics

Distinguish ethical from unethical behavior in personal and professional contexts

Ethics can be broadly defined as a set of moral principles or values

 We need ethics because it is necessary for a society to function orderly and is often argued to be
the glue that holds a society together
 Unethical behavior can be defined as conduct that differs from what they believe is appropriate
given the circumstances

Primary reason why people act unethically

o The person’s ethical standards are different from society as a whole

o The person chooses to act selfishly

Resolve ethical dilemmas using an ethical framework

An ethical dilemma is a situation a person faces in which a decision must be made about the appropriate
behavior

Common rationalization methods that can result in unethical conduct:

 Everybody does it
 If it’s legal, it’s ethical
 Likelihood of discovery and consequences

A formal framework to help people to resolve ethical dilemma to identify ethical issues and decide
appropriate course of action is developed called the six-step approach:

1. Obtain the relevant facts

2. Identify the ethical issues from the facts
3. Determine who is affected by the outcome of the dilemma and how each person or group is
affected
4. Identify the alternatives available to the person who must resolve the dilemma
5. Identify the likely consequence of each alternative
6. Determine the appropriate action

Explain the importance of ethical conduct for the accounting profession

Professionals are expected to conduct themselves at a higher level than most other members of society.
Reason higher level is for the need of public confidence in the quality of service by the profession

 Also have a responsibility for conduct that extends beyond satisfying individual responsibilities
and beyond the requirements of our society’s law and regulations. Honorable behavior and
personal sacrifice

Two most influential factors to why CPA’s are encouraging to conduct themselves professional:

 AICPA Code of professional conduct, to provide a standard of conduct for all members of the
AICPA
 PCAOB, authorized to establish ethics and independence standards for auditors of public
companies
 SEC, plays significant role in establish independence standards for auditors of public companies
Describe the purpose and content of the AICPA Code of Professional Conduct

Client: any person or entity other than the member’s employer, that engages a member or a member’s
firm to perform professional services

Firm: a form of organization permitted by law or regulation whose characteristics conform to resolutions
of the Council of the American Institute of Certified Public Accounts that is engaged in public practice.
Also includes the individual partners thereof, except for purposes of applying the rule in independence

Institute: The American Institute of Certified Public Accountants

Member: a member, associate member, or international associate of the American Institute of Certified
Public Accountants

Public Practice: consists of the performance of professional services for a client by a member or a
member’s firm
Principle section of AICPA code includes 2 main parts:

1. A list of six ethical principles

o Designed to guide members in performance of professional responsibilities and in
meeting the basic requirements of ethical and professional conduct
2. Discussion of those principles

Conceptual framework approach for members to evaluate threats to compliance with the Code:

Threats to compliance: 7 broad categories: adverse interest, advocacy, familiarity, management

participation, self-interest, self-review, and undue influence.
The firm should evaluate the significance of this threat and whether safeguards can reduce thus threat
to an acceptable level

Safeguards: after evaluating the significance of a threat if the member concludes that the threat is not at
an acceptable level, the member should identify safeguards that eliminate the threat or reduce it to an
acceptable level.

1. Safeguards created by the profession, legislation, or regulation

2. Safeguards implemented by the client
3. Safeguards implemented by the firm, including policies and procedures to implement
professional and regulatory requirement
Apply the AICPA Code rules and interpretations on independence and explain their importance

Independence of mind and independence in appearance

 Independence of mind: reflects the auditor’s state of mind is often referred to as being
independent in fact
 Independence in appearance: is the result of others’ interpretation of this independence

Independence Rule: A member in pubic practice shall be independent in the performance of

professional services as required by standards promulgated by bodies designed by Council

The ownership of stock or other equity shares and debt securities by members or their immediate family
is called a direct financial interest

When there is a close, but not direct, ownership relationship between the auditor and the client, it is
called an indirect relationship

Materiality affects whether ownership is a violation of independence only for indirect ownership

 Materiality must be considered in relation to the member person’s wealth and income
Understand Sarbanes – Oxley Act and other SEC and PCAOB independence requirements and additional
factors that influence auditor independence

Audit committees – conflicts arising from employment relationships – partner rotation (require lead
partner to rotate after 5 years – ownership interests

Understand the requirements of other rules under the AICPA Code

Integrity and Objectivity Rule: in the performance of any professional service, a member shall maintain
objectivity and integrity, shall be free of conflicts of interest, and shall not knowingly misrepresent facts
or subordinate his or her judgement to others
Describe the enforcement mechanisms for CPA conduct
Chapter 5: Legal Liability

Understand the litigious environment in which CPAs practice

Auditors generally owes a duty of care to third parties who are part of a limited group of persons whose
reliance is “foreseen” by the auditor.

 Auditors may be held liable to third parties under statutory law along with common law liability
o The Securities Act of 1933 – The Securities Exchange Act of 1934 – The Sarbanes – Oxley
Act
All those provide provisions that serve as a basis for legal actions against auditors

Explain why the failure of financial statement users to differentiate among business failure, audit failure,
and audit risk has resulted in lawsuits

The major cause of lawsuit against CPA firms is financial statement users’ lack of understanding two
concepts:

1. The difference between a business failure and an audit failure

2. The difference an audit failure and an audit risk

Business failure: when a business is unable to repay its lenders, or meet the expectations of its investors
because of economic or business conditions, such as a recession, poor management decisions, or
unexpected competition in the industry

Audit failure: occurs when the auditor issues an incorrect audit opinion because it failed to comply with
the requirements of auditing standards

Audit risk: represents the possibility that the auditor concludes after conducting adequate audit that the
financial statements were fairly stated when, in fact, they were materially misstated
Use the primary legal concepts and terms concerning accountants’ liability as a basis for studying legal
liability of auditors
Liability for the acts of others

Lack of privileged communication

The four sources of auditors’ legal liability

1. Liability to clients
2. Liability to third parties under common law
3. Civil liabilities under the federal securities laws
4. Criminal liability

Describe the accountants’ liability to clients and related defenses

The most common source of lawsuits against CPAs is from clients. A typical lawsuit brought by a client
involves a claim that the auditor did not discover an employee theft as a result of negligence in the
conduct of the audit

The CPA firm normally uses one or a combination of four defenses when there are legal claims by
clients:

 Lack of duty to perform the service, nonnegligent performance, contributory negligence, and
absence of casual connection

Lack of duty to perform: the CPA firm claims that there was no implied or expressed contract

Nonnegligent performance: the CPA firm claims that the audit was performed in accordance with
auditing standards. Even if there were undiscovered misstatements, the auditor is not responsible if the
audit was conducted properly.

 Audit is subject to limitations and cannot be relied on for complete assurance that all
misstatements will be found

Contributory negligence: exists when the auditor claims the client’s own actions either resulted in the
loss that is the basis for damages or interfered with the conduct of the audit in such a way that
prevented the auditor from discovering cause of the loss
Absence of casual connection: to succeed in an action against the auditor, the client must be able to
show that there is a close casual connection between the auditor’s failure to follow auditing standards
and the damages suffered by the client

Describe accountants’ liability to third parties under common law and related defenses

CPAs may be liable to third parties under common law. May be liable if a loss was incurred by the
claimant due to reliance on misleading financial statements

Courts have broadened the Ultramares doctrine to allow recovery by third parties in more
circumstances by introducing the concept of foreseen users, who are members of a limited class of users
that the auditor knows will rely on the financial statements

Describe the accountants’ civil liability under the federal securities laws and related defenses
Under the 1933 act when performing its review of events occurring subsequence to the balance sheet
date. This case (Escott et al. v. BarChris Construction Corporation [1968]) brought about two noteworthy
consequences:
Specify what constitutes criminal liability for accountants

Describe how the profession and individual CPAs can reduce the threat of litigation

The AICPA and the profession as a whole can do a number of things to reduce practitioners’ exposure to
lawsuits:

1. Seek protection from nonmeritorious litigation

2. Improve auditing to better meet users’ needs
3. Educate users about the limits of auditing

To minimize liability common actions are:

 Deal only with clients possessing integrity

 Maintain independence
 Understand the client’s business
 Perform quality audits
 Document the work properly
 Exercise professional skepticism