Chapter 3: Professional ethics, regulation and liability

Review questions

3.11 How does ethics apply to auditors?

Ethics are concerned with the evaluation of choices where the options are not clear or
where there is no absolute right or wrong answer. The study and practice of ethics are
important to enable accountants to examine critically a situation in which there is a
conflict of loyalties and interests, involving issues that relate to roles and
responsibilities, both as an individual and a professional. The practice of ethical
behaviour requires an understanding of ethical issues, a framework within which a
responsible decision can be made, and awareness of the consequences of such
decisions. Ethics therefore not only encompasses professionalism and the code of
professional conduct which accountants should adhere to, it relates to the numerous
decisions accountants make, as a professionally responsible accountant, safeguarding
the public interest, and the underpinning system which helps the accountant to manage
difficult situations. Ethics consists of moral principles and standards of conduct,
which includes professional and organisational ethics. They include standards of
behaviour for professional accountants and are incorporated into the Code of Ethics
for Professional Accountants (APES110) issued by the Accounting Professional
Ethics Standards Board established by the CPA Australia and The Institute of
Chartered Accountants in Australia.
In regard to auditors, there is an additional requirement that they must also comply
with the Auditing Standards in relation to audit independence, quality control
procedures and ensuring that the audit engagements are carried out objectively.
Auditors are also expected to comply with various requirements of common law
where the duty of care and diligence is applied to their professional services.
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3.12 Identify the five types of ethical threats to professional

independence and give a specific example of each.

Threats Examples
Self-interest threats  Financial interests, loans or guarantees such as a
bank account held with the client or a loan to or
from the client
 Incentive schemes entitlements
 Concern over the security of the employment
 Inappropriate personal use of corporate assets
 Commercial pressure from outside the employing
organisation

Self-review threats  Business decisions or data subject to review or

justification by the same person responsible for the
decision such as performing services for the client
that are then assured

Advocacy threats  Commenting publicly on future events where

outcomes are doubtful or information is incomplete
 Acting publicly as an advocate for a position where
bias may arise such as representing the client in a
legal dispute
 Encouraging others to buy shares or bonds being
sold by the client
.
Familiarity threats  A person who can influence financial or non-
financial reporting decisions having a relationship
with someone who may benefit from the influence
 Long association with business contacts influencing
decisions
 Acceptance of gifts or preferential treatment unless
the value is clearly insignificant

Intimidation threats  Threats of dismissal or replacement due to

disagreement about an accounting treatment
 A dominant personality attempting to influence
business decisions
 Undue pressure to reduce audit hours to reduce fees
paid

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3.14 Describe what is meant by independence in mind and independence

in appearance.

Independence of mind relates to the state of mind that permits the expression of a
conclusion without being affected by influences that compromise professional
judgement. It requires the professional accountant to exercise scepticism and act with
integrity and objectivity.

Independence in appearance means avoiding situations and facts that are so significant
that a reasonable person, knowing all relevant facts and having considered the
safeguards in place, would reasonably conclude that a firm’s or a professional
accountant’s integrity and objectivity had been impaired.

3.17 How did the key principles of ‘due care’ develop through the
Kingston Cotton Mill Co. case, the London and General Bank case
and the Pacific Acceptance case?

In the Kingston Cotton Mill Co. case the auditors were judged to have exercised their
reasonable care under the circumstances, where management representation was
acceptable and that an auditor is not bound to be a detective to seek out fraudulent
activities. The auditor was said to be a watchdog and not a bloodhound. What is
reasonable skill, care and caution must depend on the particular circumstances of the
case.

In London and General Bank, it was no part of the auditors’ duty to give advice either
to the directors or shareholders as to what they ought to do. He is not an insurer and
he does not guarantee that the books do correctly show the true and fair position of the
company. The auditor must be honest, and must not certify what he does not believe
to be true, and he must take reasonable care and skill before he believes that what he
certifies is true.

In summary
· The auditor does not guarantee the financial report is fairly presented.
· The auditor is only expected to exercise the skill and care of a reasonably
competent and well-informed member of the profession.
· The auditor is not liable for the detection of fraud where his or her suspicion
has not been aroused.

It has been suggested that there has been a too literal interpretation of these cases,
which has retarded the development of the profession of auditing. Such a narrow
view was laid to rest by the Pacific Acceptance case in 1970, which
comprehensively evaluated auditing practices at the time and led to the development
of a number of auditing standards.

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 Chapter 3: Professional ethics, regulation and liability

The Pacific Acceptance case (1970) is probably the most significant, as it was the first
major case to review auditing under modern concepts with respect to what is
reasonable due care and diligence. The auditor was found to be liable to exercise care
to competently carry out his audit. The judgement has been wide ranging and requires
several matters to be attended to by the auditor.

These include:
 Paying due regard to the possibility of material fraud or error in framing the
audit procedures;
 Promptly report fraud or warn of possibility of fraud;
 Closely supervise and review the work of inexperienced staff;
 Carry out proper objective auditing procedures; and
 Recommendations regarding the standards of auditing to be performed.

The Pacific Acceptance case calls for a changed standard to be met where the
conditions or understanding of dangers is changed. The audit profession has accepted
a change in emphasis in procedures and acknowledged a different approach to the
exercise of due skill and care.

3.18 The Esanda case established the elements that would be necessary
for a third party to succeed in an action of negligence against the
auditor due to reliance on the audited accounts. Identify what these
elements are.

In order for a third party to succeed they would have to establish:

 The report was prepared on the basis that it would be conveyed to a third
party
 The report would be conveyed for a purpose that was likely to be relied on
by that party
 The third party would be likely to act in reliance on that report, thus running
the risk of suffering the loss if the statement was negligently prepared.

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 Chapter 3: Professional ethics, regulation and liability

Professional application questions

 BASIC |  MODERATE |  CHALLENGING

3.21 Professionalism 

Brenda Jones is a newly qualified accountant who is carrying out her first audit
as the in-charge auditor for a construction company client that is engaged in a
range of long-term contracts. Brenda has little experience of these types of clients
and the accounting requirements in relation to long-term contracts. John Bull is
the CFO of the client, he is a busy man and has a notorious reputation for being
unfriendly to auditors. You are Brenda’s supervisor and it has become apparent
that she has not got to grips with the accounting issues involved and has avoided
asking the necessary questions of John Bull to gain an understanding of the
company’s transactions and the necessary audit work required to obtain
evidence on the long-term contract transactions.

Required
Explain to Brenda the importance of professionalism, using the Code
of Ethics for Professional Accountants and particularly referring to its
guidance on competence and give advice as to how she should
proceed.

The importance of a profession is evident in its attributes, which include, (1) a

systematic body of theory, (2) authority, (3) community sanction, (4) ethical codes
and (5) culture. It is acknowledged that non-professionals to a lesser degree also
possess these attributes. Professional organisations differentiate themselves by
emphasising the community sanction that they strive so hard to achieve. Professionals
would also claim that they benefit society by their superior performance in fulfilling a
highly competent and sophisticated role.

The accounting professional bodies have implemented a built-in regulatory code to

compel ethical behaviour on the part of its members. The profession would see this
regulatory code as a key way of differentiating itself from other organisations.
Through its ethical code, the profession’s commitment to social welfare becomes a
matter of public interest, thereby helping to ensure the continued confidence of
society. Self-regulatory codes are characteristic of all occupations. However, a
professional code is more explicit, systematic, and binding: it possesses altruistic
overtones and is more public service orientated. The code also provides the principles
of competence and due care, and guidelines where accountants and auditors should
avoid performing tasks, which they are not competent in.

Brenda should be advised that the exercise of due care and diligence is part of the duty
of auditors. Where there are doubts relating to the tasks, she should raise it with her
seniors and seek independent advice if necessary. She should be advised that it is not
uncommon for auditors to consult others. Section 130 of the Code of Ethics for
Professional Accountants (APES110) refers to the requirement to maintain adequate
professional knowledge and technical skills regarding professional competence.

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Brenda should take responsibility for making sure that she has the skills necessary to
carry out her work and consult with others and request the necessary training where
there are gaps. I would discuss with her the steps to complete the current audit,
assisting her in establishing steps to complete the necessary audit work and I would
also supervise her closely to ensure that her work is monitored and she has the support
she needs in order to not be afraid to ask questions, seek advice from others and ask
for training to fill her knowledge and skills gaps.

Case studies

3.31 Liability to shareholders and the company 

Maxref Ltd is a new dotcom company specialising in online trading in
multimedia items such as DVDs, music, online reports and celebrity
commodities. It has been listed on the Australian Securities Exchange since last
year. As auditor for Maxref’s first year’s financial statements for the year ended
30 June 2020, you note that the accounts show a turnover of about $10 million,
shareholders’ funds of $3 million, and a profit before tax of $ 250 000. During the
course of your audit you discover that the balance of the sales ledger control
account is $500 000 and that about 80 per cent of the accounts receivable are
from new customers who bought items online without full details of the banking
particulars. You further discover that all online transactions were reported and
executed without proper security checks. Moreover, half of the items listed as
stock for sale cannot be located. The share price of the company stands at $1.50.
You raise the issue with the director of Maxref and he tells you that this is not
uncommon with this type of e-business and that he is concerned only that the
Australian Securities Exchange allows it to go on trading. He assures you that
nothing major will happen; an unqualified auditor’s report is all that is
necessary. However, you are worried about your own liability.

Required
Discuss the potential liability of the auditor to:
(a) the shareholders
(b) the company.

You may refer to any relevant case law in your answer.

The auditor is equally liable to the general body of shareholders and the company.
In relation to the annual accounts, the auditor may be guilty of negligence for not
seeking further evidence to substantiate the accounts receivable and inventory. The
auditor is aware of the discrepancies in internal accounting systems in that they are
unreliable in terms of the sales ledge control accounts and the recording of the
inventory for sale. These are major items, which render the financial statements
misleading. As a listed company, the auditor should realise that misleading financial
statements may affect both the company and the shareholders concerned. When the
problem is brought to light, the explanations of management do not provide enough
support for the auditor to express an unqualified report.

In WA Chip & Pulp (1987), it was stated that irrespective of the materiality of the
irregularity, the auditors should report irregularities to management. ASA240 states

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 Chapter 3: Professional ethics, regulation and liability

that if the auditor suspects irregularities he/she should report it to management

regardless of the materiality of the item. Furthermore, in the Caparo case, the auditor
may find himself liable to the general class of shareholders for a set of negligently
prepared financial reports and for a misleading audit report. The auditor is potentially
liable to both the shareholders and the company for not exercising due care and
diligence in support of his audit opinion, if he remains silent about the discrepancies.

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