Chapter

Expected Learning Outcomes

After studying this chapter, you should be able to:
1. Describe the nature of ethics and ethical dilemmas.
2. Explain the profession's reasons for establishing
professional ethics.
3. Explain the fundamental principles in the Revised Code of
Ethics for Professional Accountants in the Philippines.
4. Describe the five (5) kinds of threats to compliance with
the rules in the Code of Ethics.
5. Explain briefly the safeguards to mitigate or eliminate the
threats to compliance with the rules in the Code of Ethics.
6. Describe the salient Code of Ethics Rules that can prevent
violations to the fundamental principles.
7. Explain the concept of independence and identify
circumstances in which independence is impaired and how
to mitigate or eliminate the threat.
CHAPTER 5
PROFESSIONAL ETHICS
 115
INTRODUCTION

Historically, a distinguishing characteristic of any profession is the existence of

code of ethics for its members. This signifies the profession's acceptance of its

responsibility to those it serves. A code of conduct is particularly important for CPAs

because of the reliance that investors, the public, government and business management
place on the accounting profession. The public's knowledge that members of the
accounting profession must adhere to such a code provides a set of expectations about the
quality of service CPAs provide. Furthermore, a code benefits individual members and the
profession as a whole by providing minimum standards all members are expected to
follow.

Ethics consist of moral principles and standards of conduct. It is a branch of philosophy

that deals with the study of the rightness or wrongness of human actions. Ethics can
focus either on society as a whole or on a particular group within a society.

Professional groups, such as physicians and accountants, have codes of behavior

known as professional ethics. Such codes attempt:
l) to ensure high standards of competence among a group's members,
2) to regulate and strengthen their relationships, and
3) to promote and protect the imag2 of the profession and the welfare of the
community.

Professional ethics extend beyond moral principles. They include standards of

behavior for a professional person that are designed for both practical and
idealistic purposes. While ethics may be designed in part to encourage ideal
behavior, they must be both practical and enforceable. To be meaningful,
ethics should be above the law but below the ideal. In summary, professional
ethics may be regarded as
"a mixture of moral and practical concepts, with a sprinkling of exhortation to ideal
conduct designed to invoke "right action" on the part of the members of the profession
concerned all reduced to rules which are intended to be enforceable, to some extent at
least, by disciplinary action."
(Carey, Doherty, "Ethical Standards of the Accounting Profession % A 1 CPA. 1966)
Chapters

Professional ethics arc imposed by a profession on its members, who

voluntarily accept standards of professional behavior more rigorous than those required
by law. A code of ethics significantly affects the reputation of a profession and the
confidence in which it is held. Professional ethics have evolved over time and
continue to be in the process of change as the practice of public accounting changes.
 WHY PEOPLE ACT UNETHICALLY

Most people define unethical behavior as conduct that differs from what they
believe would have been appropriate given the circumstances. Each Of us decides
for ourselves what we consider unethical behavior, both for ourselves and
Others. It is important to understand what causes people to act in a manner that
we decide is unethical.

There are two primary reasons why people act unethically:

I. the person's ethical standards are different from those of society as a whole, or
2. the person chooses to act selfishly.

In many instances, both reasons exist.

Person 's Ethical Standards Differ from General Society

Extreme examples of people whose behavior violates almost everyone's ethical
standards are drug. dealers, bank robbers, and larcenists. Most people who commit
such acts feel no remorse when they are apprehended, because their ethical standards
differ from those of society as a whole.

There are also many far less extreme examples when others violate our ethical
values. When people cheat on their tax returns, treat other people with hostility,
lie on employment applications, or perform below their competence level as
employees, most of us regard that as unethical behavior. If the other person has
decided that this behavior is ethical and acceptable, there is a conflict of ethical
values that is unlikely to be resolved.

The Person Chooses to Act Selfishly

The following example illustrates the difference between ethical standards that
differ from general society's and acting selfishly. Person A finds a briefcase in an
airport containing important papers and P 10,000. He tosses the briefcase and
 Professional Ethics

Il 7
keeps the money. He brags to his family and friends about his good fortune.
Person A's values probably differ from most of society's. Person B faces the
same situation but responds differently. He keeps the money but leaves the
briefcase in a conspicuous place. He tells nobody and spends the money on a
new wardrobe. It is likely that Person B has violated his own ethical standards,
but he decided that the money was too important to pass up. He has chosen to act
selfishly.

A considerable portion of unethical behavior results from selfish behavior.

Watergate and other political scandals resulted from the desire for political
power; cheating on tax returns and expense reports is motivated by financial
greed; performing below one's competence and cheating on tests are typically
due to laziness. In each case, the person knows that the behavior is
inappropriate, but chooses to do it anyway because of the personal sacrifice
needed to act ethically.

Rationalizing Unethical Behavior

There are alternative ways to resolve ethical dilemmas, but care must be taken
to avoid methods that are rationalizations of unethical behavior. The following
are rationalization methods commonly employed that can easily result in
unethical conduct:

Everybody Does It
The argument that it is acceptable behavior to falsify tax returns, cheat on
exams, or sell defective products is commonly based on the rationalization that
everyone else is doing it and therefore it is acceptable.

If it’s Legal, It's Ethical

Using the argument that all legal behavior is ethical relies heavily on the
perfection of laws. Under this philosophy, one would have no
obligation to return a lost object unless the other person could prove that it
was his or hers.

Likelihood of Discovery and Consequences

 5 Professional Ethics 118

This philosophy relies on evaluating the likelihood that someone else will
discover the behavior. Typically, the person also assesses the severity of the

penalty (consequences) if there is a discovery. An example is deciding

whether to correct an unintentional overbilling to a customer when the
customer has already paid the full billing. If the seller believes that the
customer will detect
the error and respond by not buying in the future, the seller will inform the
customer now; otherwise, he will wait to see if the customer complains.

THE NEED FOR PROFESSIONAL ETHICS

To have an appreciation of the importance of a code of ethics to public accountants

and other professionals, one must understand the nature of a profession as opposed
to other vocations. There is no universally accepted definition of what constitutes a
profession; yet, for generations, certain types of activities have been recognized as
professions while others have not. Medicine, law, engineering, architecture, and
theology are examples of disciplines long accorded professional status. Public
accounting is a relative newcomer to the ranks of the professions, but it has
achieved widespread recognition in recent decades.

All of the recognized professions have several common characteristics. The most
important of these characteristics are (a) a responsibility to serve the public, (b) a
complex body of knowledge, (c) standards of admission to the profession, and (d)

a need for public confidence. Let us briefly discuss these characteristics as they apply
to public accounting.

Responsibility to Serve the Public. The certified public accountant is a

representative of the public — creditors, stockholders, consumers, employees, and
others in the financial reporting process. The role of the independent attester is to
ensure that information is fair to all parties and not biased to benefit one group at the
expense of another. This responsibility to serve the public interest must be a basic
motivation for the professional. Public accountants must maintain a high degree of
independence from their clients if they are to be of service to the larger community.
Independence is perhaps the most important concept embodied in public accounting's
Code of Ethics for Professional Accountants.

Complex Body of Knowledge. Any practitioner or student of accounting has

only to look at the abundance of authoritative pronouncements governing
119 Chapter
financial reports to realize that accounting is a complex body of knowledge. One
reason why such pronouncements continue to proliferate is that' accounting must
reflect what is taking place in an increasingly complex environment.

Standards of Admission to the Profession. Attaining a license to practice as a

certified public accountant requires an individual to meet minimum standards for
education and experience. The individual must also pass the CPA Licensure

Examination showing mastery of the body of knowledge described above. Once

licensed, certified public accountants must adhere to the ethics of the profession or
risk disciplinary action.

Need for Public Confidence. Physicians, lawyers, certified public accountants,

and all other professionals must have the confidence of the public to be
successful.' To the CPA, however, public confidence is of special significance.
The CPA's product is credibility. Without public confidence in the attestor, the
attest function serves no useful purpose.

CHARACTERISTICS AND VALUES ASSOCIATED WITH ETHICAL

BEHAVIOR

The following list of ethical principles incorporates the characteristics and values
that most people associate with ethical behavior.

Integrity
Be principled, honorable, upright, courageous and act on convictions; do not be
two-faced, or unscrupulous, or adopt an end-justifies-the-means philosophy
that ignores principle.

Honesty
Be truthful, sincere, forthright, straightforward, frank, candid; do not cheat, steal,
lie, deceive, or act deviously.

Promise Keeping
Be worthy of trust, keep promises, full commitments, abide by the spirit as well
as the letter of an agreement; do not interpret agreements in an unreasonably
•technical or legalistic manner in order to rationalize noncompliance or create
excuses and justifications for breaking commitments.
 Professional Ethics 120
Loyalty (Fidelity)
Be faithful and loyal to family, friends, employers, clients and country; do not use or
disclose information learned in confidence; in a professional context, safeguard the
influences and conflicts of interest.

Fairness
Be fair and open-minded, be willing to admit error and, where appropriate, change
positions and beliefs, demonstrate a commitment to justice, the equal treatment of
individuals, and tolerance for and acceptance of diversity; do not overreach or take
undue advantage of another's mistakes or adversities.

Caring for Others

Be caring, kind, and compassionate; share, be giving, be of service to others; help
those in need and avoid harming others.

Respect for Others

Demonstrate respect for human dignity, privacy, and the right to self
determination of all people; be courteous, prompt, and decent; provide others with the
information they need to make informed decisions about their own lives; do not
patronize, embarrass, or demean.

Responsible Citizenship
Obey just laws; if all law is unjust, openly protest it; exercise all democratic rights
and privileges responsibly by participation (voting and expressing informed views),
social consciousness, and public service; when in a position of leadership or
authority, openly respect and honor democratic processes of decision making, avoid
unnecessary secrecy or concealment of information, and assure that others have all
the information they need to make intelligent choices and exercise their rights.

Pursuit of Excellence
Pursue excellence in all matters; in meeting your personal and professional
responsibilities- be diligent, reliable, industrious, and committed; perform all
tasks to the best of your ability, develop and maintain a high degree of
competence, be well informed and well prepared; do not be content with
mediocrity; do not "win at any cost."

Accountability
Be accountable, accept responsibility for decisions, for the foreseeable
consequences of actions and inactions, and for setting an example of others.
Parents, teachers, employers, many professionals, and public officials have a
 121 Chapter
special obligation to lead by example, to safeguard and advance the integrity and
reputation of their families, companies, professions, and the government itself;
an ethically sensitive individual avoids even the appearance of impropriety, and
takes whatever actions are necessary to correct or prevent inappropriate conduct
of others.
The reputation of the accounting profession continues to be tarnished by the
scandals over the last two decades and continuing into the new millennium. TO
regain our status as one of the most highly respected professions, we must take the
extra step to show both the public and ourselves that we are indeed ethical — and
that our ethics are based upon a strict set of moral principles rather than just a long
list ofrules to which we only adhere in certain situations.

THE CODE OF ETHICS FOR PROFESSIONAL ACCOUNTANTS IN THE

PHILIPPINES

The Professional Regulation Commission and the Board of Accountancy

approved on February 20, 2018 Resolution No. 18, Series of 2018. This
resolution provided for the Adoption of the 2016 Code of Ethics. Code of
Ethics for Professional Accountants of the IESBA as "The Code of Ethics for
professional Accountants in the Philippines" and Prescribing Amendments
Therefore".

The 2018 Code of Ethics for Professional Accountants in the Philippines consists
of three parts, namely:

Part A — General Application of the Code

Part B — Professional Accountants in Public Practice

Part C — Professional Accountants in Business
This book will present salient provisions in Part A and Part B that have direct
applicability to a CPA in Public Practice.

The entire Code can be accessed in the Board of Accountancy website

(www.prc.gov.ph) and IFAC website (www.ifac.org)

Fundamental Principles
 Professional Ethics 122

The Code of Ethics requires auditors to adhere to the following fundamental

principles.

(a) Integrity

(b) Objectivity
(c) Professional Competence and Due Care
(d) Confidentiality
(e) Professional Behavior

(a) Integrity. TO be straight forward and honest in all professional and

business relationships.
Example: A professional accountant should not be associated with
reports, returns, communications or other information where the
professional accountant believes that the information:
i. Contains a materially false or misleading statement; ii. Contains
statements or information furnished recklessly; or iii. Omits obscures
information required to be included where such omission or obscurity
would be misleading.

(b) Objectivity. Not to allow bias, conflict of interest or undue influence Of

others to override professional or business judgments.
(c) Professional Competence and Due Care. To maintain professional
knowledge and skill at the level required to ensure that a client or employer
receives competent professional service based on current developments in
practice, legislation and techniques and act diligently and in accordance
with applicable technical and professional standards.

(d) Confidentiality. To respect the confidentiality of information

acquired as a result of professional and business relationships and should not
disclose any such information to third parties without proper and specific
authority unless there is a legal or professional right or duty to disclose, nor
use the information for the personal advantage of the professional accountant
or third parties.
123 Chapter
Example: The following are circumstances where professional
accountants are or may be required to disclose confidential information
or when such disclosure may be appropriate:

i. Disclosure is permitted by law and is authorized by the client •or the

employer;

ii. Disclosure is required by law, for example:

• Production of documents or other provision of evidence in the course
of legal proceedings; or
• Disclosure to the appropri4te public authorities of infringements Of
the law that come to light; and

iii. There is a professional duty or right to disclose, when not prohibited by

law:
• To comply with the quality review of a member body or professional
body;

• To respond to an inquiry or investigation by a member body or

regulatory body;

• To protect the professional interests of a professional account in legal

proceedings; or
• To comply with technical standards and ethics requirements
(e) Professional behavior. To comply with relevant laws and regulations and avoid
any action that discredits the profession.

THREATS TO COMPLIANCE WITH RULES

When a professional accountant identifies threats to compliance with the

fundamental principles and based on an evaluation of those threats, determines
that they are not at an acceptable level, the professional accountant shall
determine whether appropriate safeguards are available and can be applied to
eliminate the threats to reduce them to acceptable level. In making that
determination, the professional accountant shall exercise professional judgment
and take into account whether a reasonable and informed third party, weighing
all the specific facts and circumstances available to the professional accountant
at the time, would be likely to conclude that threats would be eliminated or
 Professional Ethics 124
reduced to an acceptable level by application of the safeguards, such as that
compliance with the fundamental principles is not compromised.
Threat Summarized Definition Public Practice Examples
1. Self-interest A potential benefit to the 1. Having a direct financial
accountant, financially or interest or a material indirect
otherwise, from a financial financial interest in the client.
interest in I or some other 2. Having a loan from a client.
financial relationship with an 3. Excessive reliance on revenue
attest client. from a single client.
4. Having a material joint venture
with a client.
125

2. Self-review Accountant will ' not 1. Accountant performs

appropriately evaluate results bookkeeping services for a
of a previous judgment made client.
or service performed or 2. •A partner in the member's
supervised by the accountant office was associated with
or the accountant's firm. the client as an employee,
officer, director, or
contractor.
3. CPA firm providing non-
audit services relating to the
information system and the
accountant is now
considering results obtained
from that information s in
the audit.
3. Advocacy Accountant will promote a 1. Promoting clients securities
clients interests or position as part of an 'initial public
and compromise objectivity offering.
or independence. 2. Endorsing a clients services
or products.
3. Representing an audit client
in the court of tax als.
 Professional Ethics 126
4. Familiarity Accountant will become too 1. Accountant's immediate
sympathetic to the client's family, close relative or
work or product due to a long friend is employed by client
or director I officer of the
or close relationship or
client.
accountant has a close or
long-standing relationship 2. A former partner or
with client personnel. professional employee
joins the client in a key
position and has
knowledge of CPA firm's
policies and practices.
3. A partner or has provided
attest sewices for
a
prolonged

5. Intimidation /
Adverse I I. with
Accountant will
objectivity
not act
because
1. Threatened
litigation
or actual
between
Undue of interests opposed to the accountant and a client. CPA
influence clients interests. 2. firm is threatened with
dismissal.
2. Accountant will
An individual associated
subordinate judgment to 3. with a client threatens to
that of an individual withdraw or terminate a
associated with a client
due to client's reputation,
professional service unless
expertise, dominant
the accountant reaches
personality, or attempts to
certain judgments or
coerce or excessively
conclusions.
influence the acc0untant.
4. Accountant assumes a
Accountant will take on
3. the role of client client's role while
management or otherwise performing non-audit
assume management services.
5. A gift from the client that is
responsibilities.
other than clearly
insignificant.

Safeguards to Mitigate or Eliminate Threats

 127 Chapter
Safeguards are actions or other measures that may eliminate. threats or reduce them
to an acceptable level. They fall into two broad categories:
a) Safeguards created by the profession, legislation or regulation; and
b) Safeguards in the work environment.

a) Safeguards created by the profession, legislation or regulation include:

Educational, training and experience requirements for entry into the

profession.
Continuing professional development requirements.

Corporate governance regulations.

Professional standards.
Professional or regulatory monitoring and disciplinary procedures.
External review by a legally empowered third party of the reports, returns
communications or information produced by a professional accountant.

Effective, well publicized complaints system operated by the employing

organization, the profession or a regulator, which enable •colleagues,
employers and member of the public to draw attention to
unprofessional or unethical behavior..
An explicitly stated duty to report breaches of ethical requirements.
b) Safeguards in the work environment:
1. Firm-wide safeguards include, but not limited, to the following:
• Leadership of the firm that stresses the importance of compliance with the
fundamental principles.

• Policies and procedures to implement quality control of engagements.

• Documented internal policies and procedures requiring compliance with the

fundamental principles.
 Professional Ethics 128
• Policies and procedures to monitor, and, if necessary, manage the reliance on
revenue received from a single client.

2. Engagement-specific safeguards include, but not limited, to the following:

• Rotating senior assurance team personnel.
• Having a professional accountant who was not a member of the
assurance team review the assurance work perform or otherwise advise
as necessary.

• Discussing ethical issues with those charged with governance of the

client.

CODE OF ETHICS: APPLICABILITY TO CPAS IN PUBLIC PRACTICE

In the following sections, we discuss the various Code of Ethics Rules as they apply to
accountants in public practice.

Conflicts of Interests (Section 220)

A conflict of interest creates a threat to objectivity and may create threats to

the other fundamental principles.

Examples of situations in which conflicts of interest may arise include:

Providing a transaction advisory service to a client seeking to acquire an audit

client of the firm, where the firm has obtained confidential information during
the course of the audit that may be relevant to the transaction. Providing
services to both a vendor and a purchaser in relation to the same transaction.
 129 Chapter
Preparing valuations of assets for two parties who are in adversarial position with
respect to the assets.
Advising a client to invest in a business in which, for example, the spouse of the
professional accountant in public practice has a financial interest.
Advising a client on the acquisition of a business which the firm is also interested in
acquiring.

If a conflict of interest is identified, the professional accountant in public practice

shall evaluate
The significance of relevant interests or relationships;
The significance if the threats created by performing •the professional service(s),

and shall apply safeguards, when necessary, to eliminate or reduce the threats to
an acceptable level.

Marketing and Professional Services (250)

Sections 250.1 and 250.2 of the Revised Code of Ethics for Professional
Accountants in the Philippines, provide the guidelines in marketing professional
services as follows:
1. When a professional accountant in public practice solicits new work
through advertising or other forms of marketing, there may be potential
threats to compliance with the fundamental principles. For example, a self
interest threat to compliance with the principle of professional behavior is
created if services, achievements or products are marketed in a way that is
inconsistent with that principle.
2. A professional accountant in public practice should not bring the
profession into disrepute when marketing professional services. The
professional accountant in public practice should be honest and truthful
and should not:
• Make exaggerated Claims for services offered, qualifications possessed
or experience gained, or
• Make disparaging references to unsubstantiated comparisons to the
work of another,
 Professional Ethics 130
The practitioner should be guided by the provisions in the PRCBOA
Resolution No. 126, series of 2008 on Rules on Advertising and
Promotion for the Practice of Accountancy in the Philippines.

If the professional accountant in public practice is in doubt whether a

proposed form of advertising or marketing is appropriate, the
professional accountant in public practice should consult
with the relevant professional body.

Gifts and Hospitality (260)

A professional accountant in public practice, or an immediate or close family

member, may be offered gifts and hospitality from a client which might give rise
to threats to compliance with the fundamental principles. For example, self interest
threats to objectivity may be created if a gift from a client is accepted' intimidation
threats to objectivity may result from the possibility of such offers being made

public.

Where the gifts or hospitality offered is made in the normal course of business
without the specific intent to influence decision making or to obtain information,
it may be concluded that any threat to compliance with the fundamental
principles is at an acceptable level. When the threats cannot be eliminated or
reduced to an acceptable level through the application of safeguards, the
professional accountant in public practice should not accept such an offer.

Custody of Client Assets (270)

A professional accountant in public practice should not assume custody of client

monies or other assets unless permitted to do so by law and, if so, in compliance
with any additional legal duties imposed on professional accountant in public
practice holding such assets. He / she accountant shall make appropriate
inquiries about the source of such assets and consider legal and regulatory
obligations. For example, if the assets were derived from illegal activities such
as money laundering, a threat to compliance with the fundamental principles
would be created. In such situations, the professional accountant may consider
seeking legal advice.

A professional accountant in public practice entrusted with money or other assets

shall
131 Chapter
a) Keep such assets separately from personal or firm assets;
b) Use such assets only for the purpose for which they are intended;
c) At all times, be ready to account for those assets, and •any income, dividends or
gains generated, to any persons entitled to such accounting;
d) Comply with all relevant laws and regulations relevant to the holding of and
accounting for such assets.

Independence (290)

CPA firm independence from a client is required when providing audit and other
attestation and assurance services.

The public accounting profession acknowledges the critical importance of

independence of accountants who perform attestation services, independence of
both mind and appearance. Independence of mind is a state of mind that permits
the CPA to perform an attest service without being affected by influences that
might compromise professional judgment, thereby allowing that individual to act
with integrity and to exercise objectivity and professional skepticism.
Independence in appearance requires the avoidance of circumstances that might
cause a reasonable and informed third party, aware of all relevant information,
 Professional Ethics 132
including safeguards applied, to reasonably conclude that the integrity, objectivity,
or professional skepticism of an audit firm or member of the attest engagement
team has been compromised.

Issues on Independence Requirement for CPAs in Public Practice

Family and Personal Relationships (290.126)

Relative Effect on Accountant and Firm's Independence Immediate Family (spouse,
Genera/ Rule: CPAs must, in general, comply with the spousal equivalent, or
Independence rule. Accordingly, when an immediate dependent) family member
violates the Independence rule or one of its interpretations, independence of the
external auditor and the firm is impaired.

Exemptions to the General Rule: The accountant

and firm are independent
1. When a family member is employed by a client in
other than a key position.
2. In certain circumstances in which the immediate
family member participates in a benefit plan
related to a client.
Close relatives (parent, Accountant and firm independence are impaired if a sibling,
or nondependent individual on the audit team, an individual in a child) position to
influence the attest engagement, or any partner in the engagement office has a close
relative who has
1. A key position with the client or
2. A material financial interest of which the accountant has
knowledge.
Other Relatives and Independence is only impaired when a reasonable Friends
person, aware of all relevant facts relating to a situation, would conclude that
there is an unacceptable threat to independence. This evaluation (at both the
accountant and the firm levels) is made based on the Conceptual Framework ' on
Independence.

Financial Relationships
The Code restricts the financial interests that an auditing may have either in
the client itself or with client personnel. A financial interest is an ownership
interest in an equity or a debt security issued by an entity; such an
interest may be either direct or indirect. A direct financial interest includes
an investment in the client, such as owning capital stock or providing loans
to the client. An indirect financial interest generally involves an intermediary
of some sort; for example, assume that a CPA invest in a mutual fund, which
in turn owns stock in a client of that CPA. The CPA's portion of that
investment in the attest client is the indirect financial interest. Concerning
direct and indirect financial relationships of external auditors:
 133 Chapter 5
l) All direct financial interests are prohibited, regardless of amount.
2) Material indirect financial interests are prohibited.

The above restrictions begin with the period of the professional

engagement. Accordingly, when a public accounting firm acquires a new
attest client, those who will become external auditors must dispose of any
prohibited financial or other interest on a timely basis. By disposing of such
interests, the CPAs avoid a challenge to their independence in dealing with
the new client.

Loans and guarantees (290.117)

A loan, or a guarantee of a loan, from an audit client that is a

bank or a similar institution to a member of the audit team, or a
member of that individual's immediate family, does not create a
threat to independence if the loan or guarantee is made under
normal lending procedures, terms and conditions. Examples of
such loans include home mortgages, bank overdrafts, car loans
and credit card balances.

If a loan to a firm from an audit client that is a bank or similar

institution is made under normal lending procedures, terms and
conditions and it is material to the audit client or firm receiving
the loan, it may be possible to apply safeguards to reduce the self-
interest threat to an acceptable level. An example of such a
safeguard is having the work reviewed by a professional
accountant from a network firm that is neither involved with the
audit nor received the loan.

Business Relationship (290.123)

A close business relationship between a firm, or a member of the audit team,

or a member of that individual's immediate family, and the audit
client or its management, arises from a commercial relationship of
common financial interest and may create self-interest or intimidation threats
(e.g., Distribution or marketing arrangements under which the firm distributes
or markets the client's products or services).
 Professional Ethics 134
Unless the financial interest is immaterial and the business relationship is
significant, the business relationship shall not be entered into, or it shall be
reduced to an insignificant level or terminated.

In the case of a member of the audit team, unless any such financial interest
is immaterial and 'the relationship is insignificant to that member, the
individual shall be removed from the audit team.

A business relationship between the external auditor and the client or a

member of the auditor's immediate family, in a closely-held entity when the
audit client or a director or officer of the client, or any group thereof,
also holds an interest in that entity does not create threats to
independence if:

• The business relationship is insignificant to the firm, the member of the

audit team and the immediate family member, and the client;
• The financial interest is immaterial to the investor or groups of investors;
and
• The financial interest does not give the investor, or group of investors, the
ability to control the closely-held entity.

• Employment with an Audit Client (290.133)

If a former member of the audit team or partner of the firm has joined the audit
client in such a position and significant connection remains between the firm and
the individual, the threat would be so significant that no safeguards could reduce the
threat to an acceptable level. Therefore, independence would be deemed to be
compromised if a former member of the audit team or partners joins the
audit client as a director or officer, or an employee in a position to exert
significant influence over the preparation of the client's accounting records or
the financial statements on which the firm will express an opinion,
unless:
 135 Chapter 5
a) The individual is not entitled to any benefits or payments from the firm,
unless made in accordance with fixed pre-determined arrangements, and
any amount owed to the individual is not material to the firm; and

b) The individual does not continue to participate or appear to participate in

the firm' business or professional activities.

If a former partner of the firm has previously joined an entity in such a position
and the entity subsequently becomes an audit client of the firm, the significance
of any threat to independence shall be evaluated and safeguards applied when
necessary to eliminate the threat or reduce it to an acceptable level. Examples
of such safeguards include:

• Removing individual from the audit team; or

• A review of any significant judgments made by that individual while on the
team

Temporary Staff Assignments (290.140)

Generally, the lending of staff by a firm to an audit client may create a self
review threat. However, such assistance may be given for only a short period
of time and the firm's personnel shall not be involved in:
(a) Providing non-assurance services that would not be permitted under this
code, or
(b) Assuming management responsibilities.

The significance of any threat shall be evaluated and safeguards applied when necessary
to eliminate or reduce the threat to an acceptable level. Examples of such safeguards
include:
l) Conducting additional review of the work performed by the loaned staff;
2) Not including the loaned staff as the member of auditing;
3) Not giving the loaned staff audit responsibility for any function that the staff
performed during the temporary staff assignment;
 Professional Ethics 136

Providing Non-attest Services (290.154)

While the CPAs should not perform management functions or make management
decisions for the attest client, they may provide advice, research materials, and
recommendations to assist the client. In such circumstances, the client must agree
to
I) Assume all management responsibilities
2) Oversee the services, by designing an individual, preferably within senior
management, who possesses suitable skill, knowledge, and/or experience.
3) Evaluate the adequacy and results of the services performed.
4) Accept responsibility for the results of the services.
5) Establish and maintain internal control, including monitoring ongoing
activities.

Given the rules, there are certain activities that CPA firm personnel cannot
perform for the firm to retain independence with respect to the client.
Examples of these prohibited activities include

I) Setting policy or strategic direction for the client.

2) Directing or accepting responsibility for the actions of the client's
employees, expect as allowable for using internal auditors to *ovide assistance.
3) Authorizing, executing, or consummating a transaction.
4) Preparing source documents (e.g., purchase orders, payroll time records, and
customer orders).
5) Having custody of client assets.
6) Supervising client employees in their normal recurring activities.
7) Performing ongoing evaluations of the client's internal control as monitoring
activities.

Preparing Accounting Records and Financial Statements (290.164)

Providing an audit client with accounting and bookkeeping services such as

preparing accounting records and financial statements creates a self-review
threat when the firm subsequently audits the financial statements.

The firm may provide services related to the preparation pf accounting records
and financial statements to an audit client that is not a public interest entity
 137 Chapter 5
where the services are of a routine or mechanical creature, so long as any
selfreview threat created is reduced to an acceptable level. Examples of such
services - include:
l) Payroll services based on client-originated data;
2) Recording transactions for which the client has determined or approved
the appropriate account classification;
3) Posting transactions coded by the client to the general ledger;
4) Posting client-approved entries to the trial balance; and
5) Preparing financial statements based on information in the trial balance.

Except in emergency situations, a firm shall provide to an audit client that is a

public interest entity accounting and bookkeeping services, including payroll
services, or prepare financial statements on which the firm will express an
opinion or financial information which forms the basis of the financial
statements. This may be the case when

a) Only the firm has the resources and necessary knowledge of the client's
systems and procedures to assist the client in the timely preparation of its
accounting records and financial statements, and
b) A restriction on the firm's ability to provide the services would result in
significant difficulties for the client (for example, as might result from a'
failure to meet regulatory reporting requirements).

In such situations, the following conditions shall be met:

I) Those who provide the services are not members of the audit
team;

2) The services are provides for only a short period of time and are not
expected to recur; and
3) The situation is discussed with those charged with governance.

Valuation Services (290.171)

Performing valuation services for an audit client may create a self-review

threat. The significance of any threat created shall be evaluated a safeguards
applied when necessary to eliminate or reduce the threat to an acceptable level.
Safeguards may include:
 Professional Ethics 138
a) Review of the audit or valuation work performed by another professional
not involved in providing the service. b) Making arrangements that the
personnel providing the service does not participate in the audit
 Chapter 5

Tax Return Preparation (290.177)

Providing tax return preparation service does not generally create a threat to
independence if client takes responsibility for the returns including any significant
judgment' made. Tax return preparation services are generally based on historical
information and principally involved analysis and presentation of such historical
information under existing law, including precedents and established practice.
Furthermore, the tax returns are subject to review or approval process that the tax
authority deems appropriate.

Internal Audit Services (290.190)

The provision of the internal audit services to an audit client creates a self-review
threat to independence if the firm uses the internal audit work in the course Of a
subsequent external audit. The significance of the threat shall be evaluated and
safeguards applied when necessary to eliminate or reduce the threat to an
acceptable level. An example of such a safeguard is using professionals who are
not member of the audit team to perform the internal audit service.

If the external auditor's personnel assumed a management responsibility when

providing internal audit services to an audit client, the threat created would be so
significant that no safeguards could reduce the threat to an acceptable level.

IT System Services (290.196)

Providing system services may create a self-review threat or threat to
independence depending on the nature of services and the IT systems. The
significance of any threat shall be evaluated and safeguards applied when
necessary to eliminate or reduce the threat to an acceptable level. An example
of such a safeguard is having a professional accountant review the audit or
non assurance work.

Litigation Support Services (290.202)

Litigation support services may include activities such as acting as an expert

witness, calculating estimated damages that might become receivable or payable as the
result of the litigation or other legal dispute and assistance with document
management and retrieval. These services may create a self-review or advocacy threat.
 Professional Ethics 140
The significance of any threat created shall be evaluated and safeguards applied when
necessary to eliminate or reduce the threat to an acceptable level.

Litigation involving the public accounting firm and the client also may affect
the independence of CPAs. The relationship between the CPAs and client
management must be characterized by complete candor and full disclosure. A
relationship with these characteristics may not exist when litigation places the
CPAs and client management in an adversarial position. CPAs in litigation, or
potential litigation, with a client must evaluate the situation to determine
whether the significance of the litigation affect the client's confidence in the
CPAs or the CPAs objectivity.

Legal Servicß (290.204)

Legal services that support an audit client in executing legal action (e.g., •legal
advice, legal due diligence and restructuring) may create self-review threats.
The significance of any threat created shall be evaluated and safeguards
applied when necessary to eliminate or reduce the threat to an acceptable level.

Recruiting Services (290.209)

Providing recruiting services to an audit client may create self-interest,

familiarity or intimidation threats. The existence and significance of any threat
will depend on factors such as:

• the nature of the requested assistance; and

• the role of the person to be recruited

The significance of any threat created shall be evaluated and safeguards applied
when necessary to eliminate or reduce the threat to an acceptable level.

The firm may generally provide such services as reviewing the professional
qualification of a number of applicants and providing the advice on their
suitability for the post. The firm may also interview and advise on candidate's
competence for financial accounting, administrative or control positions.

Fees and Other Types of Remuneration

Fees - Relative Size (290.215)

 141 Chapter 5
A professional accountant in public practice may quote whatever fee deemed to be
appropriate. However, a self-interest threat to professional competence and due
care is created if the fee quoted is so low that it may be difficult to perform the
engagement in accordance with applicable technical and professional
standards for that price.

In certain circumstances, a professional accountant in public practice may receive

a referral fee or commission relating to a client. Accepting suclia referral fee or
commission for sale of goods or services to a client may give rise to self-interest
rates to objectivity and professional competence and due care. The significance of
the threat shall be evaluated and safeguards applied to eliminate the threat or
reduce it to an acceptable level. Examples of such safeguards are:

• Disclosing to the client any arrangements to pay a referral fee to another

professional accountant for the work preferred.

• Disclosing to the client any arrangements to receive a referral fee for referring the
client to another professional accountant in public practice.

• Obtaining advance agreement from the client for commission arrangements in

connection with sale by a third party of goods or services to the client.

Fees - Overdue (290.218)

If fees owed by a client to a public accounting firm are long overdue, it may appear
that the firm's prospects for collection depend upon the nature of the CPA's report
on the current financial statements. Thus, the public accounting firm's independence
is considered impaired if fees for professional services rendered more than one year
prior to the audit report date for the current year's audit have not been collected
before issuance of the CPA's report for the current

Contingent Fees (290.219)

Contingent fees are fees calculated on a predetermined basis relating to ther outcome
of a transaction or the result of the services performed by the firm. A fee is not
regarded as being contingent if established by a court or other public

authority.
 Professional Ethics 142
Compensation and Evaluation Services (290.223)

A self-interest threat is created when a member of an audit team is evaluated

on or compensated for selling non-assurance services to that audit client. The
significance of the threat shall be evaluated and if the threat is not at an
acceptable level, the firm shall either revise the compensation plan or
evaluation process for that individual or apply safeguards to eliminate or
reduce the threat to an acceptable level. Examples of safeguards are:
-I. Removing such members from the audit
2. Having a professional accountant review the work of the member of the audit
team
 Professional 143

RESOLVING ETHICAL CONFLICT

The professional accountant may be required to resolve a conflict in complying

with the fundamental principles.

When initiating either a formal or informal conflict resolution process, the

following factors, either individually or together with other factors, may be
relevant to the resolution process:
a) Relevant facts;
b) Ethical issues involved;
c) Fundamental principles related to the matter in question;

d) Established internal procedures; and

e) Alternative courses of action.

Having considered the relevant factors, a professional accountant shall

determine the appropriate course of action, weighing the consequences of each
possible course of action. If the matter remains unresolved, the professional
accountant may wish to consult with other appropriate persons within the firm
or employing organization for help in obtaining resolution.
 Professional Ethics 144

REVIEW QUESTIONS
Questions

I. Why is there a special need for ethical behavior by professional? Why

do the ethical requirements of the CPA profession differ from other
professions?

2. Distinguish between independence in fact and independence in appearance.

State three activities that may not affect independence in fact but are likely to
affect independence in. appearance.

3. What do the principles of the Code •imply about a CPA's

obligation toward the public interest?

4. Describe an ethical dilemma, "How does a person resolve an ethical

dilemma?"

5. Why might the rule "Let conscience be your guide" not be suffcient
basis for your personal ethics decisions? For your
professional ethics decisions?
 145 Chapter 5
6. What roles must a professional accountant be prepared to occupy in
regard to ethical decision problems?

7. What ethical responsibilities do CPAs have for acts of non-CPAs who

are under their supervision (e.g., recent college graduates who are not
yet CPAs)?

8. What benefit does an independent auditor gain when a client

corporation has an audit committee of the board of directors?

9. Ben Santos works as a manager in the Manila office of an international

CPA firm. His father has just taken a position as a purchasing agent for
one of the CPA firm's Manila clients. Has Ben's independence been
impaired with respect to this audit client? Has the CPA
firm's independence been impaired if Ben does not
work on the audit?
to
10. Three months ago, a national CPA firm hired Gary
Angeles staff auditor in its Cebu office. Yesterday clients.
Angele's father was hired the chief financial officer impaired?
of one of the CPA firm's Cebu independence of the CPA firm with
respect to this client been
I l . Alex Ybaöez is a CPA who often serves as an expert witness in court
cases. It is proper for Ybafiez to receive compensation in a damage suit
based on the amount awarded t o the plaintiff? Discuss.

12. Lea Sanchez, wife of Juan Sanchez, CPA, is a life insurance agent. May
Juan Sanchez refer audit clients needing officer life insurance to Lea
Sanchez or to another life insurance agent who will share a commission
with Lea Sanchez? Explain.

Multiple Choice Questions

l. Auditors are periodically punished for holding an investment in a client.

This violates which ethical rule?
a. Integrity.
b. Independence.
c. Non compliance with PFRS.
d. Confidentiality.
 Professional Ethics 146
2. Which of the following is not a broad category of threauo auditor
independence?
a. Familiarity.
b. Positive work relationship.
c. Financial self interest.
d. Undue Influence.

3. A small CPA firm provides audit services to a large local company.

Almost eighty percent of the CPA firm's revenues come from this client.
Which statement is most likely to be true?
a. Appearance of independence may be lacking.
b. The small CPA firm does not have the proficiency to perform a
larger audit.
c. The situation is satisfactory if the auditor exercises due skeptical
negative assurance care in the audit.
d. The auditor should provide an "emphasis of a matter paragraph" to
his/her audit report adequately disclosing this information and then it
may issue an unqualified opinion.
147

4. Contingency fee based pricing of accounting services is:

a. Always strictly prohibited in public accounting practice.
b. Never restricted in public accounting practice.
c. Prohibited for clients for whom attestation services are provided.
d. Considered an act discreditable to the profession.

5. Which of the following family relationships is •most likely to impair a

CPAs independence with respect to a particular audit client on which the

CPA works?
a. A close relative has a material investment in that client of which the
CPA is notaware.
b. A cousin has an immaterial investment in the client of which the
CPA is aware.
c. The CPA's sister is controller of the audit client.

d. The CPA's spouse participates in a savings plan sponsored by the

client.

6. Independence requirements suggest that a CPA should evaluate whether a

particular threat to independence would lead a reasonable person, aware of
all the relevant facts, to conclude that:
a. A questioning mind reveals doubt as to independence.
b. An unacceptable risk of non-independence exists.
c. The accountant is definitely not independent.

d. There is substantial cause for a legal finding of non-independence.

7. If the Code of Ethics does not specifically address a
threat to auditor independence, the
auditor should:
a. Conclude that the threat is not significant unless proven so.
b. Conclude that the threat results in a lack of independence unless it can be
shown that no impairment of independence occurs.
 Professional Ethics 148
c. Consider the threat from the perspective of a reasonable and
informed third party who has knowledge of all the relevant
information.
d. Consult the Statements on Auditing Standards for guidance.

8. Which of the following is not a broad •category of safeguards that mitigate

or eliminate threats to independence?
a. Safeguards created by the profession, legislation, or regulation.
b. Safeguards created to assure proper training within both the client and
attest environment.
c. Safeguards implemented by the attest client.
d. Safeguards implemented by the firm, including policies and

procedures to implement professional and regulatory requirements.

9. Which of the following statements is correct?

a. Client prepared records (e.g., the general ledger) may be retained by
the CPA until fees due to the CPA are received.
b. CPA working papers are the joint property of the CPA and the client.
c. Working papers prepared by the auditor solely for the engagement
need not be returned to the client.
d. CPA working papers that include copies of client's records are not available
to third parties under any circumstances.

10. When a threat to independence arises, an auditor should consider:

a. Alternative threats to a lack of independence.
b. Available safeguards to independence.
c. Global independence rules.
d. Required lack of independence approaches.

11. Which of the following •attributes is more closely associated with attestation
services performed by a CPA firm than with other lines of
professional work?
a. Integrity.
b. Competence.
c. Independence.
d. Keeping informed on current professional developments.
 149 Chapter 5
12. Which of the following types of employees must be independent of an audit
client?
a. A partner in the office that performs the engagement.
b. Senior auditors assigned to the office that performs the audit.
c. Managers assigned to an office that does not participate in the engagement.
d. All firm professionals, regardless of their position.

13. Cruz & Santos CPAs has one office. Which of the following is lemt likely to
impair independence with respect to an audit client? a. The client owes the
firm for two prior years' audit fees.
b. A partner in the CPA firm is the son of the president of the client.
c. The husband of a partner in the firm has a small direct
financial interest in the client.
d. A partner in the firm has an investment in a mutual fund that has a
direct interest in the client.

14. Which of the following forms of advertising would most likely be

considered a violation of the Code of Ethics?
a. Advertising including the types of services offered and the standard
fees for the services.
b. Advertising including the experience of the firm's professional staff.
c. Advertising including an indication that the firm has a close
relationship with several tax court judges.
d. Advertising including the percentage of the firm's staff that have
CPA certificates.

15. Independence is required Of a CPA performing:

a. Audits, but not any other professional services.
b. Attestation services, but not other professional services.
c. Attestation and tax services, but not other professional services.
d. All professional services,
16. A CPA should maintain objectivity and be free of conflicts of interest
when performing:
a. Audits, but not any other professional services.
b. All attestation services, but not other professional services.
c. All attestation and tax services, but not other professional services.
 Professional Ethics 150
d. All professional services.
17. -In determining the scope and nature of services to be
performed in public practice, a CPA firm should:
a. Require independence for all services performed.
b. Determine that the performance of all services is consistent with the
firm's members' role as professionals.
c. Have in place internal control procedures.
d. Only perform accounting related services.
18. Which of the following is considered a type of threat to compliance with the
Rules of the Code of Ethics?
a. Self interest.
b. Illegitimate skepticism.
c. Lack of management participation.
d. Irrevocability.

19. A CPA's retention of client records as a means of enforcing payment of an

overdue audit fee is an action that is:
a. Considered acceptable by the Code of Ethics.
b. Ill advised since it would impair the CPA's independence with respect to
the client.
c. Considered discreditable to the profession.
d. A violation of generally accepted auditing standards.

20. An audit independence issue might be raised by the auditor's participation in

consulting services engagements. Which of the following statements is most
consistent with the profession's attitude toward this issue?
a. Information obtained as a result of a consulting services engagement is
confidential to that specific engagement and should not influence
performance of the attest function.
b. The decision as to loss of independence must be made by the client
based on the facts of the particular case.
c. The auditor should not make management decisions for an audit
client.
d. The auditor who is asked to review management decisions, is also
competent to make these decisions and can do so without loss of
independence.

21. When an accountant is not independent, the accountant is precluded from

issuing a:
 151 Chapter 5
a. Compilation report.
b. Review report.
c. Management advisory report.
d. Tax planning report.

Acc
22. Competence as a certified public accountant includes all of the
following
except:
a. Having the technical qualifications to perform an engagement.
b. Possessing the ability to supervise and to evaluate the quality Of staff
work.
c. Guaranteeing the accuracy of the work performed.
d. Consulting others if additional technical information is needed.
23. A client company has not paid its 20X6 audit fees.

According to the. Code Of Ethics, in order for the auditor to be considered

independent with respect to the 20X7 audit, the 20X6 audit fees must be
paid before the:
a. 20X6 report is issued.
b. fieldwork is started.
c. 20X7 report is issued.
d. 20X8 fieldwork is started.

24. A primary purpose for establishing a code of conduct within a professional

organization is to:
a. Reduce the likelihood that members of the profession will be sued
for substandard work.
b. Ensure that all members of the profession perform at approximately
the same level of competence.

c. Demonstrate acceptance of responsibility to the interests of those

served by the profession.
 Professional Ethics 152
d. Require members of the profession to exhibit
loyalty in all matters pertaining to the affairs of their organization.

25. Which of the following is a possible safeguard implemented by the client

that might mitigate an audit independence threat?
a. CPA firm leaderships stresses the importance of complying with professional
standards.
b. Management has suitable skills to make managerial decisions.

c. Management maintains substantial common stock investments in the

company.

d. Top management selects the auditing firm.

26. Which of the following is prohibited by the Code of Ethics?

a. Advertising in a general newspaper to attract clients.
b. Auditing a competitor of the current audit client.

c. Charging and accepting a contingent fee for a financial statement review

engagement.
d. Purchasing a product and reselling that product at a higher price.

Cases

Case 1
Tan and Caiada, a firm of certified public accountants, audited the accounts of
Sterling Skins, Inc., a corporation that imports and deals in skin wellness products.
Upon completion of the examination, the auditors supplied Sterling
 153 Chapter 5
Skins with twenty copies of the certified statement of financial statements. The firm
knew in a general way that Sterling wanted that number of copies of the
auditor's report to furnish to banks and other potential lenders.
The statement of financial position in question was in error by approximately P800,000.
Instead of having a P600,000 net worth, the corporation was

insolvent. The management of Sterling Skins had doctored the books to avoid
bankruptcy. The assets had been overstated by P500,000 of fictitious and nonexistent
accounts receivable and P300,000 of nonexistent skin products listed as inventory when in
fact Sterling Skins had only empty boxes. The audit failed to detect these fraudulent entries.
JC, relying on the certified statement of financial position, loaned Sterling Skins P200,000.
They seek to recover their loss from Tan and Caiada.

Required:

State whether each of the following is true or false and give your reasons:
a. If JC alleges and proves negligence on the part of Tan and Caiada, he will be
able to recover his loss.
b. If JC alleges and proves constructive fraud (that is, gross negligence on the
part of Tan and Caiada) he will be able to recover his loss.

not c. JC does have a contract with Tan

and Canada.
Unless the part of Tan and Canada
could be shown, JC

of the contract Tan and Canada made

(AICPA Adapted)

Case 2

The CPA firm of Angeles, Belen, and Cruz was expanding very rapidly.
Consequently, it hired several junior accountants, including a man named Dantes.
The. partners of the firm eventually became dissatisfied with Dantes' production
and warned him that they would be forced to discharge him unless his output
increased significantly.
 Professional Ethics 154
At that time, Dantes was engaged in audits of several Clients. He decided
that to avoid being fired, he would reduce or omit entirely some of the standard
auditing procedures listed in audit programs prepared by the partriers. One of the
CPA firm's clients, Best Corporation, was in serious. financial difficulty and had
adjusted several of the accounts being examined by Dantes to appear financially
sound. Dantes prepared fictitious working papers in his home at night to support
purported completion of auditing procedures assigned to him, although he in fact did
not examine ihe adjusting entries. The CPA firm rendered an unqualified opinion on
Best's financial statements, which were grossly misstated. Several creditors, relying
on the audited financial statements, subsequently extended large sums of money to
Best Corporation.

Required:

Would the CPA firm be liable to the creditors who extended the money
because of their reliance on the erroneous financial statements if Best Corpomtion
should fail to pay them? Explain.
(AICPA Adapted)

Case 3
Carlos, CPA, is the auditor for Jupiter Manufacturing Corporation, aa privately
owned company that has a June 30 fiscal year. Jupiter arranged for a substantial bank
loan that was dependent on the bank receiving, by September 30, audited financial
statements which showed a current ratio of at least 2 to I. On September 25, just
before the audit report was to be issued, Carlos received an anonymous letter on
Jupiter's stationery indicating that a lease by Jupiter, as lessee, of a factory
building accounted for in the financial statements as an operating lease was, in fact,
a capital lease. The letter stated that there was a secret written agreement with the
lessor modifying the lease and creating a capital lease.
Carlos confronted the president of Jupiter, who admitted that a secret agreement
existed but said it was necessary to treat the lease as an operating lease to meet
the current ratio requirement of the pending loan and that nobody would ever
discover the secret agreement with the lessor. The president said that if Carlos
did not issue his report by September 30, Jupiter would sue Carlos for substantial
damages that would result from not the loan. Under this pressure and because the
working papers contained a copy of the five—year lease agreement that
supported the operating lese treatment, Carlos issued his report with an
unqualified opinion on S«anber 29.

Required:

Answer the following questions, setting forth reasons for any conclusions stated:
 155 Chapter 5
a. Is Carlos liable to the bank?
b. Is Carlos liable to the lessor?
c. Is there potential for criminal action against Carlos?

Case 4
Rain Tan recently joined the CPA firm of Base, Umapas & Canada. She quickly
established a reputation for thoroughness and a steadfast dedication to following prescribed
auditing procedures to the letter. On her third audit for the firm, Tan examined the
underlying documentation of two hundred disbursements as a test of purchasing, receiving,
vouchers payable, and cash disbursement procedures. In the process, she found
twelve disbursements for the purchase of materials that had no receiving
reports documentation. She
noted the exceptions in her working papers and called them to the attention of the in-charge
acc•ountant. Relying on prior experience with the client, the in-charge accountant
disregarded Tan's comments. Nothing further was done about the exceptions.,

Subsequently, it was learned that one of the client's purchasing agents and a member of

its accounting department were engaged in a fraudulent scheme to divert the receipt
of materials to a public warehouse while sending the
invoices to the client. When the client discovered the fraud, the conspirators had
diyerted approximately P70,000 in materials, P50,000 of it after the completion of the
audit.

Required:
a. Discuss the legal implications and liabilities to Base, Umapas & Caiada as a
result of these facts,
b. Discuss the legal implications and liabilities to Base, Umapas & Canada if the
CPA firm is a limited liability partnership.

Case 5
Gonzales & Esteban, CPAs, audited Nicole, Inc. The audit was deficient in •
several respects:

• Gonzales & Esteban failed to verify properly certain receivables that later
proved to be fictitious.
 Professional Ethics 156

• With respect to other receivables, although they made a cursory check, they
failed to detect many accounts that were long overdue and obviously
uncollectible.
• No physical inventory was taken of the securities claimed to be in Nicole's
possession; which in fact had been sold. Both the securities and cash
received from the sales were listed on the statement of financial position as
assets.

There is no indication that Gonzales & Esteban actually believed that the
financial statements were false. Subsequent creditors, not known to Gonzales &
Esteban, are now suing based on the deficiencies in the audit as described above.
Gonzales & Esteban moved to dismiss the lawsuit against it on the basis that the
firm did not have actual knowledge of falsity and therefore did not commit fraud.

Required:

May the creditors recover without demonstrating that Gonzales & Esteban had
actual knowledge of falsity? Why or why not?