ACC 492 Week 5 Assurance Services, Ethics and Legal Liability Example

Five Requests on a Partner's Desk: Choosing the Right Assurance Service, Testing Each Against the Code of Conduct and Weighing Legal Exposure at a Composite 40-Person CPA Firm

[Student Name]

University of Phoenix

ACC/492: Contemporary Auditing II

Week 5 Assignment

[Instructor Name]

[Date]

The firm, its clients and their requests are composites written for a model paper; standards, cases and research findings come from the sources listed.

A composite CPA firm with 40 people in two offices performs audits, reviews, tax work and advisory services for private companies and nonprofits. On a Monday in March, its audit partner reviewed five requests. Each could be handled several ways, and each carried ethical and legal questions. In a small firm, choosing the right service is not only a question of standards; it decides what the firm promises, what it may charge and whom it may one day answer to in court. This paper takes the requests in turn.

Request One: A Contractor's Bank Wants Assurance

A drywall contractor with $6 million of revenue needs financial statements for its bank, which will accept a review. A review provides limited assurance, obtained mainly through inquiry and analytical procedures, that the statements need no material modification, and it is performed under the accounting and review standards rather than the auditing standards (American Institute of Certified Public Accountants, 2014b). The firm prepares the contractor's tax returns, which does not impair independence for a review if management accepts responsibility. The partner accepts the engagement as a review, not an audit, because a review meets the bank's need at about a third of the cost.

Request Two: A Franchisor Wants Sales Checked

A franchisor of tutoring centers wants the firm to verify that twelve franchisees reported their gross sales accurately, since royalties are based on them. This fits an agreed-upon procedures engagement: the franchisor and the firm agree on specific procedures, such as comparing reported sales with point-of-sale records and bank deposits for sampled months, and the firm reports its findings without an opinion. The franchisor takes responsibility for the sufficiency of the procedures. The firm must be independent of the franchisor, and it confirms it has no financial interest in any franchisee.

Request Three: A Payroll Processor's Customers Want Comfort

A payroll processing company serving 900 employers is asked by its customers' auditors about its controls. The appropriate service is a service organization controls examination, reporting on the design and operating effectiveness of controls relevant to customers' financial reporting over a period. It is an examination with reasonable assurance and requires independence. The firm has the expertise but also performs consulting for the processor on a system upgrade; the partner evaluates whether that work creates a self-review threat. Because the consulting involves designing controls the firm would later test, the partner declines the consulting work so the firm can perform the examination.

Request Four: A Contingent Fee Offer

A long-time audit client asks the firm to seek a property tax reduction on its warehouses in exchange for a third of any savings. The AICPA Code of Professional Conduct prohibits contingent fees for clients for whom the firm performs attest services, because a fee tied to the result could impair objectivity (American Institute of Certified Public Accountants, 2014a). The partner declines the contingent arrangement and offers the work at an hourly fee instead.

Request Five: A Lender Wants to Rely on an Audit

A company the firm audits is seeking a new $12 million loan from a bank that has not previously lent to it. The bank asks the firm to confirm that it may rely on last year's audit report. This raises the question of the firm's liability to third parties.

Liability Under Common Law

Under common law, auditors are liable to clients for breach of contract and negligence. Liability to third parties depends on the state. In Ultramares Corp. v. Touche, decided in 1931, New York's highest court ruled that accountants are not liable to third parties for ordinary negligence absent privity of contract, while leaving room for liability for fraud or gross negligence. In Credit Alliance Corp. v. Arthur Andersen & Co., decided in 1985, the same court allowed liability to a third party when the accountant knew its work would be used by that party for a particular purpose, relied on that use and engaged in conduct linking it to the party, a near privity test. Other states follow the broader Restatement approach, covering a limited class of foreseen users, and a few extend liability to reasonably foreseeable users.

The partner's response to the bank is careful: the firm will not issue a letter inviting reliance, since doing so could create near privity, and it notes that the audit report speaks as of its date.

Liability Under Securities Law

For audits of public companies, federal securities laws add exposure. Under the Securities Act of 1933, auditors of a registration statement may be liable to purchasers for material misstatements unless they prove due diligence, a demanding standard. Under the Securities Exchange Act of 1934, plaintiffs generally must prove the auditor acted with scienter, intent or recklessness. The firm audits no public companies, but two clients are considering initial public offerings, which would bring these standards into play.

Engagement Letters as Protection

For each accepted engagement, the firm issues an engagement letter that states the service, the standard, the level of assurance or the absence of it, management's responsibilities and the intended users of the report. For the agreed-upon procedures, the letter restricts use of the findings to the franchisor, which limits the number of parties who could claim to have relied on them. For the review, it states plainly that a review is not an audit. Clear letters do not eliminate liability, but they define what the firm promised, which is the starting point in any dispute.

Quality Management and Litigation Risk

Palmrose (1988) found that audit firms associated with more litigation tended to be those with lower-quality work, suggesting that the best defense is quality itself. The firm's response to the five requests reflects that view: each engagement is matched to the right standard, independence threats are resolved before acceptance, prohibited fees are declined and communications with third parties are controlled.

Conclusion

The partner matched the requests to a review, an agreed-upon procedures engagement and a service organization examination, declined a contingent fee from an audit client and responded to a lender without inviting reliance. Each decision applied a standard, a rule of the code or a legal doctrine, which is how assurance, ethics and liability meet in practice.

References

American Institute of Certified Public Accountants. (2014a). Code of professional conduct.

American Institute of Certified Public Accountants. (2014b). Statements on standards for accounting and review services: Clarification and recodification (SSARS No. 21).

Credit Alliance Corp. v. Arthur Andersen & Co., 65 N.Y.2d 536 (1985).

Palmrose, Z.-V. (1988). An analysis of auditor litigation and audit service quality. The Accounting Review, 63(1), 55-73.

Ultramares Corp. v. Touche, 255 N.Y. 170 (1931).