Matthew Wolfe Weng Seong Siu

Rui MaoLili Kong ACC 418

Professor Zhou11/12/2014

Regulation of the Audit Profession

Introduction

The auditing profession has experienced considerable changes over the last decade due to

several scandals. Many components involve the auditors examining the financial statements and

internal controls of various clients only when there were significant material misstatements that

did not meet the audit objectives. During some occasions, the auditors do not consistently assess

the given situational circumstances because they either do not have reasonable audit evidence or

the audit risks measured did not change significantly. Thesis statement: The regulations found

within the auditing profession help determine the past, present and future behaviors by ensuring

all audit risk factors and materiality judgments are reasonable and in the client’s best interests.

History of Auditing Profession Regulation

Regulation of the Auditing profession possesses an important history that began many

years ago. The development of auditing profession regulation can be roughly divided into three

stages: (1) Prior to 1920s – prior auditing standards and authorities; (2) 1920s to 1930s – the

exploring stage; (3) 1930s to present – the development stage. In this paper, we will focus on the

latest period.

Prior to 1920s – Prior Auditing Standards and Authorities

During the Industrial Revolution from 1840s to 1920s, there was no standard procedure

for an audit. The American Institute of Certified Public Accountants (AICPA) started issuing

series of pamphlets to provide guidance to accountants and auditors for the preparation of

financial statements and auditing since 1917. However, during that period of time, an audit was

performed simply for verification purposes.

1920s to 1930s – The Exploring Stage

In 1920s, U.S. became the world’s economic center because of the growing strength of

economy after the World War I. The stock market boomed and people invested lots of money

with a belief that they could make a fortune from it, forgetting how risky the stock market could

be. Stock prices eventually went up as more and more people and companies investing in the

stock market and making risky investing decisions.

Later in 1929, the Wall Street (Stock Market) Crash and Great Depression took place.

Since then, investors realized the importance of financial accountability of the investing

companies and started to rely on companies’ financial reports when making any investment

decisions. At the time, most U.S. companies raised funds through banks and investors, and

therefore, a true and fair company financial statement became a necessary and essential process

in the U.S. in order for banks and investors to evaluate a company’s financial position accurately.

As a result, in 1929, the first pamphlet providing guidance specific to auditing called

“Verification of Financial Statements” was issued by the AICPA to offer more directions to

auditors. In this period of time during 1920s to 1930s, the primary audit objective was to provide

credibility to the financial statements rather than to detect frauds.

1930s to Present – The Development Stage

Since the 1930s, U.S. stock market had been growing rapidly for near 30 years. To

protect the interests of investors, the Congress enacted two of the most important laws for the

U.S. capital markets during that period. The first is the Securities Act of 1933, which requires

companies that offer securities to the public to register with the Securities and Exchange

Commission (SEC) by submitting various periodic reports on a timely basis in order to provide

investors sufficient information to make investing decisions. The second is the Securities Act of

1934. The Securities Act of 1934 established the SEC which has powers to govern the secondary

trading of securities such as stocks and bonds in the U.S in order to maintain a fair, orderly, and

efficient stock market. In addition, the 1934 law contains several provisions including the insider

trading provision to protect the public’s interest. This antifraud provision prohibits fraudulent

activities related to private trading of securities based on nonpublic information. Under this

provision, an individual with access to information that is confidential to the public is in

violation of the insider trading laws if he/she trades a security illegally with another person by

disclosing material nonpublic information to that person.

Since the 1930s, audit reports underwent frequent revisions during the development

stage. In 1936, AICPA issued “Examination of Financial Statements by Independent Public

Accountants” to provide more detailed guidance on audit procedures for small- and medium-

sized companies. In 1938, the McKesson & Robbins Scandal, the greatest fraud in the 20th

century, was disclosed to the public. It turned out that more than 20% of the company’s total

assets was made up with fake inventories and accounts receivables. This fraud was remained

undetected until 1938 because Price Waterhouse, the auditor of McKesson & Robbins at that

time, simply relied upon information from the company’s management rather than performing a

physical inspection of inventories and confirmation of receivables. Price Waterhouse argued that

they followed the “Examination of Financial Statements by Independent Public Accountants”

and therefore was not responsible for the fraud. As a result, in 1939, AICPA formed the

Committee on Auditing Procedure (CAP), the antecessor of the Auditing Standards Board

(ASB), and issued Statement on Auditing Procedure (SAP) No.1 to refine the audit standards by

requiring auditors to perform physical inspection of inventories and confirm receivables during

audits. The CAP continued issuing Statements on auditing standards and principles to the public.

During 1939 to 1970s, the CAP issued 54 SAPs, the predecessors of Statements on Auditing

Standards (SAS), to discuss the auditors’ professional judgment and its application in audits.

During this period, the SEC required auditors to perform audits in compliance with

Generally Accepted Auditing Standards (GAAS). The CAP published “Generally Accepted

Auditing Standards – Their Significance and Scope” in 1954 in response to the SEC’s

requirement. In 1963, the CAP issued SAP No. 33 to codify previous pronouncements and

statements. SAP No. 33 was superseded later by the Codification of Auditing Standards and

Procedures. In 1972, the AICPA renamed the CAP Auditing Standards Executive Committee

(AudSEC). It consolidated all SAPs and summarized them under SAS No. 1. From 1972 through

1978, AudSEC issued a total of 23 SASs to provide the authoritative guidance on auditing. These

standards were codified by section AU numbers on the AICPA Professional Standards database

beginning in 1976. In 1978, the ASB was formed with missions of guiding auditors’ behavior

and enabling them to provide professional and objective services to the auditees effectively by

developing GAAS that are easy to understand and apply.

The Growth of IT Auditing:

Since the late 1970s, as the use in computer technology increased, IT auditing developed

rapidly as a result of the increased need for auditors to audit the computerized accounting

systems and tools, which are used by companies especially those with a more complex financial

structure and a growing size. Some significant negative events such as the Equity Funding

Corporation scandal and Enron scandal, which will be briefly discussed in the next two

paragraphs, raised the public awareness that a more reliable and secure system was needed and

how critical and important the roles of the accounting profession are. Therefore, in order to give

confidence to the public in regards to the audit process, increased regulation on IT auditing was

adopted to improve internal controls and audit procedures for information systems.

Equity Funding Corporation Scandal

In 1973, Equity Funding Corporation, an American insurance company, collapsed after

the reveal of a massive accounting fraud. Managers of the company created fictitious insurance

policies and concealed the activities via the use of a specific computer system with the help of as

many as 100 employees. This fraud addressed the importance of internal controls and

information systems professionals. Consequently, knowledgeable IT specialists are closely

involved in assisting in auditing companies’ information systems.

Enron Scandal

Enron Corporation used to be one of the largest energy companies in the world. In 2001,

Enron Corporation filed the largest bankruptcy in the U.S. history at that time after the reveal

that the company had overstated profits on the financial statements for years. On the other hand,

Arthur Andersen, the auditor of Enron Corporation, was found guilty for destroying accounting

records related to the company’s audit. The significant impact of the Enron scandal led to the

passage of the Sarbanes-Oxley Act (SOX) in 2002. The SOX established the Public Company

Accounting Oversight Board (PCAOB) to oversee the audits of public companies and to develop

standards for audit reports in order to protect the interests of the public. The act also increased

the accountability of both management and auditors regarding the reasonable assurances about

internal control, operations, and financial reporting.

Current Issues within Auditing Profession

In “Inappropriate relationship sinks Ernst & Young Audit” by David M. Katz, the

authors discussed that Ventas has been forced to re-audited financial reports by a new auditor

which was a clean financial reporting because its auditor violated the Securities and Exchange

Commission’s auditor-independence rules and had inappropriate relationship with clients.

There was an inappropriate personal relationship between an anonymous Ernst & Young

partner and his client, Robert Brehl, who was Ventas’s chief accounting officer and controller.

Ventas is a real estate investment trust (REIT) in the health-care industry. The public also

disclosed the scandal by a press release. The release reported that Ventas has previously let Ernst

& Young know about the relationship. After the disclosure, REIT hired KPMG instead of Ernst

& Young as its auditor and fired Robert Brehl. At the same time, KPMG, as Ventas’s new

auditor, has been engaged to finish a re-audit report of Ventas. From Ernst & Young side, it

admitted that its partner’s behavior violated of firm’s Code of Conduct and unprofessional.

Besides that, the partner was also suspended immediately.

Since that Ernst & Young wasn’t independent of Ventas during the fiscal year from the

end of 2012 to the end of 2013, the clients were told that Ventas’ audit reports for those two

years would be withdrawn. From 8-K filed recently, the senior Ernst & Young partner signed the

2012 and 2013 audit report was not the one related to the inappropriate personal relationship.

Ernst & Young admitted the firm’s quarterly review of Ventas’ financial statement until 2014 the

first quarter should not be reliable. Ventas said the main reason Ernst & Young withdrew the

audit reports was only due to the inappropriate relationship, not the financial statements’ issues.

Ventas CFO Richard A. Schweinhart has taken Robert Brehl’s position and will be the

company’s new chief accounting officer. Schweinhart agreed to delay his retirement plans and

would ensure the completeness of re-audit and a smooth transition to the next successor.

Ernst & Young’s global code of conduct contains five aspects of employees’ behavior.

They are working with one another, working with clients and others, acting with professional

integrity, maintaining objectivity and independence and respecting intellectual capital. It is

obvious that partner’s behavior violated one rules under maintaining independence “We avoid

relationships that impair – or appear to impair – our objectivity and independence.”

Auditing Profession Ethics

Independence definition and regulatory agencies

The American Institute of Certified Public Accountants (AICPA) and the International

Ethics Standards Board for Accountants (IESBA) each have ethical codes that openly define

independence as consisting of two components: independence of both mind and appearance.

Independence of mind requires the auditor to consistently maintain a neutral and impartial

mental attitude in all matters relating to the audit. That means an individual has to act with

integrity and exercise open objectivity and professional skepticism. The other component is

independence in appearance, in which the auditor and the attest engagement team should have

suitable knowledge of all relevant information relating to a reasonable and informed third party

that provide services in integrity, objectivity, or professional skepticism manner. These common

definitions of independence clearly reflect the auditing professional requirement that is the

members should keep independent both in mind and in appearance.

In addition to AICPA and IESBA codes of ethics, many other federal regulatory agencies

set independence rules. For example, the Government Accountability Office (GAO) establishes

and regulates independence rules that apply to entities audited under Government Auditing

Standards (Yellow Book). Also, the Securities and Exchange Commission (SEC) establishes the

overall qualifications of independent auditors. This guide refers to these independence rules as

SEC rules. The Public Companies Accounting Oversight Board (PCAOB), which was created by

the Sarbanes-Oxley Act of 2002 and supervised by the SEC, is authorized to set independence

standards for accounting firms that audit issuers and adopted interim ethics standards based on

AICPA Code: Rule 101 and 102, and relating interpretations and rulings.

The Importance of Independence Rules

The independence requirement provided by the AICPA and SEC serve two goals: to

increase the high quality of audits since regulations can minimizes any risks that  may influence

auditors’ judgments during the auditing process. The other goal is related to outside investors.

With these introductions of principles, the investors, who are rely on issuers’ financial

statements, will feel more confident in the financial information and auditors’ opinion.

Therefore, the public can be helped to make right financial decisions. If auditor lost the trust

from the investors, it is almost impossible for investors to invest in the public company’s

securities. Principles about auditors’ independence can protect the reliability of the financial

statements issued by public companies and investors’ confidence will be increased. Therefore,

the public can be encouraged to invest in the nations’ major businesses/industries and to promote

long-term market development.

According to the SEC’s final rule on the Revision of the Commission's Auditor

Independence Requirements, auditors have an important public trust: they must their offer

opinions in an objective, impartial, and skilled professional manner. One reason is the investors

are able to rely on issuers' financial statements and make important decisions if they would like

to invest in that public company's securities. Therefore, auditor independence is essential to help

protect the reliability and integrity of the financial statements of public companies and promote

long-term investor confidence (www.sec.gov).

AICPA, DOL and SEC Independence Rules

According to AICPA’s website (http://www.aicpa.org), there are three different kinds of

auditor’s independence rules in the auditor independence resource center: AICPA, DOL and

SEC independence rules. Also, based on the ethics case, this part will introduce Ernst & Young’s

internal independence code.

AICPA Independence Rules

According to AICPA Rule 101, during the period of the engagement, independence shall

be considered to be impaired in following situations:

1. A covered member has any direct or material indirect financial interest in the client,

and if the covered member was a trustee or executor or administrator of any estate

who acquire any direct or material indirect financial interest in the client and had the

investment decisions authority or owned more than 10 percent of the client's

outstanding equity securities or other ownership interests, including total assets of the

trust or estate.

2. A partner or professional employee of the firm and his or her immediate family together

owned more than 5 percent of a client's outstanding equity securities or other ownership

interests.

3. A firm, or partner or professional employee of the firm was simultaneously associated with

the client as a director, officer, or employee, or in any capacity equivalent to that of a

member of management; or promoter, underwriter, or voting trustee; or trustee for any

pension or profit-sharing trust of the client. (www.aicpa.org)

DOL (Department of Labor) Independence Rules

Under the U.S. Department of Labor, Code of Federal Regulation section 2509.75-9

interpretive bulletins relates to guidelines on independence of accountant retained by Employee

Benefit Plan. This rule determined when a qualified public accountant is independent for

purposes of auditing and rendering an opinion on the financial information filed with the

Department of Labor. According to the code, Section 103(a)(3)(A) requires that the accountant

retained by an employee benefit plan be “independent”.

DOL independence guidance defines the term “member” to include all partners or

shareholder employees in the firm and all professional employees participating in the audit or

located in an office of the firm participating in a significant portion of the audit. Different from

the AICPA’s definition of member, it excludes the immediate family members of those covered

members to subject certain financial relationship restrictions, such as independences rules.

Specially, the DOL considers evidence relating all relationships between an accountant or

accounting firm and that of the plan sponsor or any affiliate should be without existing

relationship connecting with the filing of annual reports, and then determines whether or not the

accountant or accounting firm is independent in fact (www.dol.gov).

SEC Independence Rules

The SEC adopted rules strengthening auditor independence in January 2003 consistent

with the requirements of the Sarbanes-Oxley Act. The Sarbanes-Oxley Act and the revised SEC

rules further restrict, but do not completely eliminate the type of non-audit services that can be

provided to the public.

Under the general standard of auditor independence rule, an audit committee needs to

consider not only the relationships related to reports filed with the Commission, but also all

related relationships between the auditor and the company, the company's management and

directors to determine whether an auditor is independent. In addition, the audit committee should

consider whether a relationship with or service provided by an auditor, including creates a

conflicting interest with client and the auditor in the position of auditing their own work or be an

advocate for the audit client.The SEC’s independence standards are generally focus on a mental

state of objectivity and lack of bias. Similar to the AICPA and IESBA codes, the independence

standards also required that the auditor should be independent “in fact” (www.sec.gov).

EY Code of Conduct and Professional Standards

In our case, Ernst & Young said their partner’s actions were a flagrant violation of their

firm’s Code of Conduct and professional standards. On EY’s website, the global code of conduct

provides five divisions of guiding principles, including “working with one another, working with

clients and others, acting with professional integrity, maintaining our objectivity and

independence and respecting intellectual capital.” EY’s fourth rule on maintaining on objectivity

and independence state emphasizes the auditor must comply with the firm’s independence rules,

which are more rigorous than applicable professional and legal requirements, including the

restrictions applicable to their families. Moreover, Ernst & Young’s employees avoid

relationships that impair or may appear to impair their objectivity and independence and also

monitor their independence (www.ey.com). The main purpose of the code of conduct is to ensure

the auditors present a professional attitude and maintain an impartial personality when

interacting with their clients. In other words, all firm employees must trust the client and verify

their responses to ensure no fraudulent or suspicious activities occur during the audit

engagement.

Auditing Profession Legal Liability and Consequences

Common Legal Terms Affecting CPAs Liability

The legal liability that is associated with the accounting/auditing profession originates

from several traditional legal concepts in negligence & fraud, contract law, and other areas. Most

of the legal ramifications are based on the prudent person concept, which states auditors accept

the full responsibility to “exercise reasonable care and due diligence” when doing audits for their

clients (Arens et al. 2014:116). Auditors make a commitment to maintain their relationships with

their customers while complying with professional and governmental regulations that attempt to

expose them to legal liability. One component of negligence & fraud is ordinary negligence,

which refers to the “absence of reasonable care” that is usually expected of a person in certain

circumstances “defined by the auditor’s incompetent actions in performing the audit without due

diligence” (Arens et al. 2014:117). Similarly, gross negligence indicates “the lack of slight care

equivalent to reckless behavior expected by a person” (Arens et al. 2014:117). One example is

when an auditor tries to follow the given instructions but is not able to understand the language

in the proper manner. Constructive fraud is “extreme or unusual negligence that does not show

the intent to deceive and harm.” For example in the auditing case, the auditor knew an adequate

audit was not being performed but still issued an unqualified opinion, even though there was no

intention to deceive financial statement users (Arens et al. 2014:117). Fraud refers to a “material

misstatement that occurs in an intentionally deceptive and false manner” (Arens et al. 2014:117).

This involves unethical, illegal behavior that is deliberately carried out such as the embezzlement

of company funds and misappropriation of organizational assets.

Besides negligence & fraud, contract law is affected when a breach of contract occurs

due to multiple “parties unsuccessfully fulfilling contract requirements” (Arens et al. 2014:117).

An example is when a CPA firm fails to deliver the income statement or balance sheet on the

agreed-upon date. This established relationship is considered to have privity of contract. But a

third-party beneficiary “does not have privity of contract but possesses certain rights and

benefits under the contact.” One example is when a bank with a large loan outstanding at the

balance sheet date needs an audit as part of its loan agreement. Even though the stated audit

contract “is between the client and the audit firm, both parties understand the bank will be

relying on the audited financial statements” (Arens et al. 2014:117). The ability to cooperate

under tight economic conditions is an important skill that auditors must follow consistently.

The auditing profession is regulated by four different legal systems. One is common

law, which is “implied or expressed contracts between auditors and their clients.” This means

auditors have a responsibility to perform their required fiduciary duties or they are liable to their

clients and other crucial stakeholders (Arens et al, 2014: 118). Another factor is statutory law,

which has been passed by the U.S. Congress and other key government units such as the

Securities and Exchange Commission (SEC). The third factor affecting legal liability is joint and

several liability, which refers to an “assessment against a defendant of the full loss suffered by

the plaintiff, regardless of the extent to which the other parties shared wrongdoing.” One typical

example is when a client’s management purposefully misstated financial statements and the

auditor assessed the loss to the shareholders because the client goes bankrupt and is unable to

pay (Arens et al. 2014:118). The fourth factor of legal liability is separate and proportional

liability, which is “the assessed portion of the damage caused by the defendant gross negligence”

(Arens et al. 2014:118). One example is the courts penalizing CPA firms a certain percentage of

the aggregate damage caused by an auditor’s negligence of a client’s audit reports. Separate and

proportional liability is a less severe penalty than joint and several liability because it involves a

smaller loss for CPA firms, which have other clients to see.

Four Major Sources of Auditor’s Legal Liability

Four major sources of auditor’s legal liability exists: liability to clients, liability to third

parties under common law, civil liability under federal securities laws, and criminal liability. The

liability to clients originates from lawsuits that occur due to not fully “completing an audit

engagement, withdrawing inappropriately from an audit, failing to discover a theft of assets, and

breaching the CPAs’ confidentiality requirements” (Arens et al. 2014:118). Auditor liability to

third parties under common law ranges from a narrow interpretation (primary beneficiary or

identified user), where the auditor “knows and intends the user will use the audit report,” to a

broad interpretation (foreseeable user), where the auditor could have reasonably foresee the

likely users of the financial statements having “the same rights as those with privity of contract.

The range between the narrow and broad interpretation is covered by a “limited and identifiable

group of users who have relied on the auditor’s work” for making important financial decisions

such as actual and potential stockholders, vendors, bankers, creditors, employees, and customers

(Arens et al. 2014:122). Each stage of the courts’ interpretation of the third-party liability focuses

on the different judicial language that is used to convey the major laws. The key to keeping the

given activities independent is ensuring financial statements and internal controls are properly

delegated to the correct personnel and handled in a careful manner.

The next component involves civil liability under the federal securities laws, which are

handled by various federal courts and government agencies such as the Securities and Exchange

Commission (SEC), which enforces the Securities Act of 1933, the Securities Exchange Act of

1934, the Foreign Corrupt Practices Act of 1977, the Sarbanes-Oxley Act of 2002, and the recent

Dodd-Frank Wall Street Reform and Consumer Protect Act of 2010. The SEC also uses their

Rules of Practices sanctions to “deny a CPA from being associated with financial statements of

public companies” either due to “a lack of appropriate qualifications or being engaged in

unethical or improper professional conduct” (Arens et al. 2014:122). Similarly, the U.S. Public

Company Accounting Oversight Board (PCAOB) is a private organization established under the

Sarbanes-Oxley Act that deals with public companies’ auditing processes while “protecting the

interests of investors by promoting accurate, informative, and independent audit reports”

(Marchand 2014: 70). The most important aspect is the SEC keeping a close watch on the

auditing profession through quasi-public organizations that monitor and enforce standards on

ethics/independence, quality control, attestation and guidance.

The fourth source of auditor’s liability is criminal liability where an auditor can be tried

under both federal and state laws that supplement the civil penalties. For example, auditors can

be charged with all applicable SEC offenses plus the Federal Mail Fraud Statute, the Federal

False Statement Statute, and any state laws such as the Uniform Securities Act (Arens et al.,

2014: 129). These criminal cases can result in the defendant paying substantial fines or facing

jail time for the defendant if convicted. Also, there are international rule-making bodies such as

the IESBA and foreign governments that observe the auditing firms’ activities and impose strict

penalties for organizations that repeatedly violate their national laws. General consensus about

increasing auditors’ oversight has featured a mixture of praise and doubt that governments are

successfully monitoring the auditing industry.

Benefits and Drawbacks of Regulating Auditing Profession

Over the last decade, tremendous changes have occurred in the environment where public

companies select external auditors. Regulatory changes from the Sarbanes-Oxley Act of 2002,

the consolidation of firms within the public accounting profession, the mandated escalation of

audit firms' quality control procedures regarding consultation with national firm experts, and

increasing financial pressures within audit firms all have contributed to transforming the auditing

profession (Almer, Philbrick & Rupley 2014). The benefits and drawbacks of more regulations

of the auditing profession depend on the auditor’s compliance with the current laws. One main

positive feature of the Sarbanes-Oxley Act (SOX) was that it extended regulation of internal

controls beyond the financial sector to all large public and private companies. This was done

through inspection reports and enforcement actions that “conveyed a “strong message” about

improving audit quality and addressing concerns such as “egregious and reckless behavior”

(Murphy 2014:16).

Also, SOX Section 301 requires audit committees be “directly responsible for the

appointment, compensation and oversight of the work of any registered public accounting firm”

(Almer, Philbrick, & Rupley 2014). These provisions address concerns about the full influence

of company management on auditor selection by incorporating transparent systems of

professional networking relationships. Another benefit of regulating the auditing profession is to

provide a solid foundation for improved operations. One approach is to apply internal control

frameworks such as COSO (Committee of Sponsoring Organizations of the Treadway

Commission), which was updated in 2013 to reflect transformation in the business environment.

Many U.S. public companies have worked to implement the new framework to satisfy their

internal control over financial reporting conditions under the Sarbanes-Oxley Act (Tysiac 2014).

Regulating the auditing profession can help many users anticipate what financial events that

might occur in the future because it will determine what information auditors need to examine

and disclose on their audit reports. This component focuses on ensuring the audit report is being

performed in accordance with the applicable industry accounting requirements.

Increasing oversight of the auditing profession also allows people who graduate with an

accounting degree to be prepared better than those who do not go for a degree at all. Control of

the auditing profession “ensures that the audit requirement for public companies by a registered

independent auditor will continue” (Tysiac 2014). High demand exists for skilled auditors

because material misstatements and fraud occurs frequently. Two laws that help the auditing

profession are the False Claims and Dodd-Frank Acts, which “enhance a whistleblower’s rights”

by “detecting a fraudulent scheme” and recovering money improperly obtained for false claims

and tax evasions towards the federal government” (Henning 2014). These laws have improved

the audit quality because the fraud is discovered by auditors early in the engagement and the

problem addressed in a timely manner.

However, many drawbacks exist with the regulation of the auditing profession. One key

component is auditors will have to consume more time and effort trying to comply with the new

laws that affect the entire audit. Concerns persist about auditor independence, which is “driven

by management’s influence on the auditors or audit committee at different stages of the audit

process.” For example, the PCAOB spent three years strongly advocating the mandatory audit

firm rotation because of the auditor keeps a close relationship with the client by constantly

interacting with each other on various financial statement and internal control matters. Another

disadvantage of more auditing regulations is the increased audit and operational costs associated

with “intensified PCAOB inspections and increased concerns over potential litigation and client

loss.” According to subjective evidence provided by several audit partners, client service partners

currently have less autonomy over important audit decisions and are exposed to firm-wide

controls when compared with the pre-SOX period before 2002 (Almer, Philbrick, & Rupley

2014). The audit firms' quality control procedures require technical issues to transfer to a firm's

national technical experts for consultation and the process has become more lengthy and

bureaucratic. Besides the Sarbanes-Oxley Act, the Dodd-Frank Act and various international

laws present challenges to PwC, Deloitte, KPMG and EY because the strict requirements would

increase audit costs and decrease audit quality and shareholder choice. The Dodd-Frank law

would penalize employers whose employees report violations of federal securities laws that

would change their reputation (Henning 2014). Likewise, new laws passed by the European

Parliament will require companies to put their audit contracts out to tender every ten years and

“the same (accounting) firm cannot audit a company for more than 20 years,” which will “restrict

the degree to which professional services firms can act concurrently as auditor and consultant”

(James 2014). This situation would impact auditors negatively because it increases competition

for firms who have performed the audit for a long time. Besides, there are many organizations

such as the NYSE and Nasdaq stock exchanges, the Federal Reserve and the Federal Accounting

Standards Board that provide audit guidance differing from each other, which may deter many

auditors from following them (Marchand 2014: 71). Each organization has their own standards

that agree only with specific accounting situations such as the accounting methods for inventory

in FASB and the auditing standards established by the AICPA.

Regulators’ Proposals to Address Auditing Profession Regulations

The gray area existing in auditing profession regulations is being addressed by entities

who investigate different situations relating to the practicing accounting firms. One group is the

Standing Advisory Group, which is led by the PCAOB’s Chief Auditor and provides the PCAOB

and SEC with recommendations about various crucial audit issues such as “expanding the audit

report’s scope” and “developing Audit Quality Indicators to measure each firm’s performance

and disclose their most important audit components” (Feinberg 2014). Another group engaged

with auditing regulations is the Center for Economic Analysis, which is described by PCAOB

chairman James Doty as an organization that “analyzes many aspects of auditing, including the

audit’s role in financial markets, the auditing profession’s structure and the audit’s effectiveness

in facilitating capital formation and protecting investors” (“Expert Perspective: Authority on

Accounting Regulation Discusses Past, Future of Auditing” 2014). Both organizations contribute

many provisions that provide guidance for the auditing profession such as making the audit more

relevant to the long-term investors’ needs and re-establishing the audit for investing shareholder

confidence. These steps in improving corporate conduct has created a solid auditing foundation

fostered by rules on auditor independence and fairness.

Auditing Profession’s Response to Legal Liability

The consequences of introducing regulations to monitor the auditing profession focus on

several indicators. One component is the auditor-client relationship which has undergone many

transformations over the years. The auditors need to understand the standards and rules that

are being set and revise them in a timely manner to meet the changing needs of auditing.

Next, CPA firms must continue to oppose and prevent unnecessary lawsuits from

occurring because it will save them the time and money focusing on their audit process instead

of fighting with their clients over small errors. CPA leaders need to educate investors and

others who read financial statements about the meaning of an auditor’s opinion and the extent

and nature of the auditor’s work.

Moreover, financial statement users need to understand that auditors do not guarantee

the accuracy of the financial records or the future prosperity of an audited company. The

auditing profession needs to sanction members for improper conduct by performing consistent

reviews of the most important issues and openly implementing rules for all practicing auditors.

Additionally, the profession should lobby for changes in state and federal laws that allow

accounting firms to practice in diverse organizational forms such as limited liability partnerships.

Constant changes to the auditor-client relationship will continue to define the auditing profession

in the future (Arens et al. 2014: 130).

One approach to improve the auditing profession is to perform joint brainstorming

sessions that identifies all strengths and weaknesses found within the company and proposes

strategies to help solve the major issues. Another way is to discuss the most important issues

about the auditor’s relationship with the client and focus on solving the most manageable

weaknesses within the audit.

Protecting Individual CPAs from Legal Liability

Besides the rigorous steps that professional auditing associations are collectively taking

to preserve their organizational integrity, practicing auditors must monitor their individual issues.

One important recommendation is to “deal only with clients possessing integrity” because “there

is an increased likelihood” of getting into legal problems “when a client lacks honesty in dealing

with customers, employees,” governmental units, and other important stakeholders. The second

suggestion is to “maintain independence in a financial and behavioral manner” that “requires

an attitude of responsibility separate from the client’s interest” (Arens et al. 2014: 131). There

is litigation over a conflict of interest because of the auditor’s inclination to accept the client

under pressure instead of using their professional skepticism.

Moreover, all CPAs need to “fully understand the client’s business” because “the lack

of knowledge of industry practices and client operations” has been “an important indicator of

auditors failing to detect misstatements and potential lawsuits” (Arens et al. 2014: 131). Poor

audit quality can be corrected by openly “performing quality audits” to “obtain appropriate

evidence and make appropriate judgments about evidence provided” (Arens et al. 2014: 131).

This situation can be accomplished when all auditors fully understand the client’s internal

controls and modify the evidence to reflect the findings, reducing the potential lawsuits from

poor judgment.

Moreover, auditors should “document their work properly” by preparing for many

different situations that may appear unexpectedly such as “defending an audit in court,” which

includes “an engagement letter and a representation letter that define the respective obligations

of the client and the auditor” (Arens et al. 2014: 131).

Finally, auditors need to “consistently exercise (their) professional skepticism” because

they are liable when presented with information indicating a problem that they fail to recognize.”

The auditor’s best approach is to maintain a “healthy level of skepticism” that “keeps them alert

to potential misstatements” so they can respond to the errors in a timely and effective manner

(Arens et al. 2014: 131). Auditor neutrality is a key component that drives audits.

Conclusion

In closing, the accounting/auditing profession needs to follow many rules that govern the

overall operations of the clients they serve and provide social and economic stability. Each CPA

entity involved in the auditing process has to carefully manage the circumstances of the client’s

financial statements and internal controls to prevent scandals that ruins the public’s confidence

with the profession. Therefore, accountability, responsibility and transparency are very important

principles to practice when dealing with all types of businesses and industries.

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201410116

Appendixes:

Table 1

Table 2