Module B - Professional Ethics

MODULE B Professional Ethics LEARNING OBJECTIVES

Review Checkpoints ! "nderstand #eneral ethics and a series of steps for makin# ethical decisions! $! Reason throu#h an ethical decision problem usin# the imperative, utilitarian and #enerali(ation principles of moral philosoph)! %! ,dentif) the different entities that make ethics rules for CP-s and public accountin# firms! &! .ith reference to -merican ,nstitute of Certified Public -ccountin# /-,CP-0, Public Compan) -ccountin# 1versi#ht Board /PC-1B0, Securities and Exchan#e Commission /SEC0, and ,ndependence Standards Board /,SB0 rules, anal)(e factual situations and decide whether an accountant2s conduct does or does not impair independence! '! .ith reference to -,CP- rules on topics other than independence, anal)(e factual situations and decide whether an accountant6s conduct does or does not conform to the -,CP- Rules of Conduct! *! Explain the t)pes of penalties that can be imposed on accountants! ', * , $, %, & '&

Exercise, Problems, and Simulations

'', '*, '+

+, 3, 4, 5,

&', &*, &+, &3, '%, '4, *$, *%, *', **, *+, *3

$, %, &, '

&4, '5, ' , '$, '3, *&

*, +

*5, *

M17B-

Module B - Professional Ethics

A Note on Module B, relating to the "Generalization Argument": ,n the interest of fairness, it should be noted that the #enerali(ation ar#ument does not work in all cases, particularl) in two circumstances8 / 0 .hen the ar#ument is invertible, that is /a0 when both doin# somethin# and not doin# somethin# would be undesirable and /b0 when both ever)one and not ever)one doin# somethin# would be undesirable! 9or example8 :.hat if ever)one was a full-time farmer;: <he results would be undesirable in our societ) because all other social functions would disappear, but this cannot mean that no one should be a farmer because then we would all starve! /$0 .hen the ar#ument is reiterable, that is, when arbitrar) times, places or measures can be inserted in such a wa) as to make a decision appear to be nonsense! 9or example, :.hat if ever) auditor were permitted to own = 5 of a share of each client6s common stock; Presumabl), the conse>uences of such minor holdin#s would not be #enerall) undesirable, and so ownership of = 5 of a share could be permitted! ?ow chan#e the amount to $= 5, %= 5, 5, 55, 44@, and the problem becomes one of :where to draw the line!:

SOLUTIONS OR REVIE! C"EC#POINTS

B! B!$ - professional accountant must be prepared to be a#ent, spectator, advisor, instructor, monitor, Aud#e, critic! Conscience mi#ht not be a sufficient #uide for personal ethics decisions because the individual6s indefinable mental processes ma) be based on caprice, immaturit), i#norance, stubbornness, or misunderstandin#! Conscience ma) fail to show the consistenc), clarit), practicabilit), impartialit), and ade>uac) preferred in ethical standards and behavior! Exactl) the same can be said about professional ethics decisions because a non-h)pocritical individual can no more split his behavior between personal life and professional life than he can voluntaril) split his or her own personalit)! <he rule :9ailure to tell the truth is wron#: would /a0 re>uire that the staff accountant refuse to :enhance: the financial statements, and /b0 not worr) about the conse>uence that seem to be predicted! /<he) mi#ht not turn out bad an)wa) if the compan) can #et the loan honestl) or can find another lender or can develop other means of survival!0 <his rule ma) be called imperative because it re>uires the truth re#ardless of what )ou mi#ht personall) feel about the conse>uences! Strict imperative theor) /e!#!, Bant0 excuses the individual from responsibilit) for undesirable conse>uences as lon# as the decisions do not cause other people to be used as means! "tilitarian ethics theor) re>uires that a decision maker reco#ni(es value attributes of the conse>uences of ethical choice alternatives /#ood v! evil0, somehow measure or wei#h these, and then decide on the basis of the #reater #ood /or the lesser evil0! ,mperative ethics does not re>uire that conse>uences be considered! Rules of conduct for practicin# public accountin# come from8 State boards of accountanc) -merican ,nstitute of CP-s State Societies of CP-s Public Compan) -ccountin# 1versi#ht Board Ceneral -ccountin# 1ffice 9or practicin# internal auditin#8 <he ,nstitute of ,nternal -uditors /,,-0 ! Standards for the Professional Practice of ,nternal -uditin# $! <he ,nstitute of ,nternal -uditors Code of Ethics

B!%

B!&

B!'

M17B-$

Module B - Professional Ethics

9or practicin# mana#ement accountin#8 ,nstitute of Mana#ement -ccountants /,M-0 Standards of Ethical Conduct for Management Accountants 9or 9raud Examiners8 <he ?ational -ssociation of Certified 9raud Examiners a! <he -,CP- PEEC makes independence rules applicable to / 0 CP-s who are members of -,CP- /not all CP-s are members0 who /$0 perform audits /of both public companies and private entities0 b!, c! <he SEC and PC-1B make independence rules applicable to / 0 all accountants /most are CP-s but the law doesn2t specif) CP-s0, who /$0 perform audits of public companies /onl) of public companies who file financial statements with SEC, not all other audits0! <he ,SB2s Aurisdiction was the same as the SEC and PC-1B!

B!*

d! B!+

<he intent of this >uestion is to re>uire students to stud) the SEC definitions! Dolanda is in the chain of command /item %Eperson who evaluates performance or recommends compensation of Favier, the audit en#a#ement partner of Besame0, and Dolanda is a covered person in the firm! ,ndependence is impaired when Dolanda owns Besame stock, but independence is not impaired when her close relative /brother0 owns a small amount! Favier is a member of the audit engagement team!

B!3 B!4

?o! -udit independence is impaired when the audit firm2s emplo)ees render le#al services of this t)pe! <he SEC believes that people who use financial statements and auditors2 reports can be enli#htened with information about auditors2 fee arran#ements with clients! /<he Genli#htenmentH involves users2 perceptions of auditor independence in li#ht of the relation of non-audit and audit revenues from an audit client!0 .hat must be disclosed8 / 0 total audit fees, /$0 total fees to the audit firm for consultin# services on financial information s)stems desi#n and implementation, plus /%0 total fees to the audit firm for all other consultin# and advisor) work /over and above the audit fees and the information s)stems fees above0! ,n addition, the disclosure rules also re>uire8 / 0 tell whether the those char#ed with #overnance /includin# the audit committee or the board of directors0 considered the audit firm2s information s)stems work and other consultin# work to be compatible with maintainin# auditors2 independence, and /$0 if #reater than '5 percent, the percenta#e of the audit hours performed b) persons other than the principal accountant6s full-time, permanent emplo)ees /Gleased emplo)eesH in an Galternative practice structureH arran#ement0!

B! 5

<he) both want to ensure that those char#ed with #overnance /includin# the public compan) audit clients2 audit committees and boards of directors0 consider their auditors2 independence in #eneral and in connection with non-audit services! <he threat to independence is that the auditor considerin# a Aob offer from a client mi#ht not perform audit work properl) while on the audit team /out of some newfound lo)alt) and interest in the audit client2s success via financial reportin#0! Ethical responsibilit) for acts of nonmembers under a member6s supervision! - member shall not permit others to carr) out on his behalf, either with or without compensation, acts which, if carried out b) the member, would place a member in violation of the Rules of Conduct!

B!

B! $

M17B-%

Module B - Professional Ethics

B! %

Rules specificall) applicable to members in #overnment and industr)8 Rule 5$ /,nte#rit) and 1bAectivit)08 Members in #overnment and industr) cannot subordinate their Aud#ment to superiors and produce misleadin# financial statements! Members in #overnment and industr) must be candid and not omit information when dealin# with external auditors! Members in #overnment and industr) cannot have undisclosed conflicts of interest in their Aobs! Rule $5% /-ccountin# Principles08 .hen members in #overnment and industr) represent their companies6 financial statements as bein# :in conformit) with C--P,: the) are expressin# an :opinion: and subAect to Rule $5% that re>uires disclosure of an) material departure from accountin# principles promul#ated b) a bod) desi#nated b) Council /9-SB and C-SB0! Rule '5 /-cts 7iscreditable08 Participation in the production of false and misleadin# financial statements is a discreditable act!

B! &

Control of accountin# services8 ! $! %! CP-s shall have maAorit) /'5@ or more0 ownership and votin# ri#hts! CP-s must have ultimate responsibilit) for attest services! ?on-CP-s cannot be passive investors--must be active in the practice! ?on-CP-s cannot hold themselves out as CP-s! ?on-CP-s must abide b) the -,CP- Code of Professional Conduct! ?on-CP-s must have the same educational levels and meet the same continuin# education re>uirements as CP-s!

B! ' B! *

<his checkpoint is Aust a reminder that rules cannot cover all ethical decisions that an accountant ma) encounter! <his >uestion is about self-re#ulation penalties! -,CP- and the state societies can8 -dmonish a violator /slap on the wrist0 Suspend the violator6s membership Expel the violator from membership in -,CP- and a state societ) of CP-s Re>uire CPE hours to be undertaken b) the violator Publish the violator6s name in a report of proceedin#s /e!#!, in CP- Ietter and a state societ) newsletter or ma#a(ine <his >uestion is about public re#ulation b) #overnment a#encies! State boards of accountanc) can8 ! $! %! -dmonish a license holder /slap on the wrist0 Suspend the violator6s license to practice in the state Revoke the violator6s license to practice

B! +

<he "!S! Securities and Exchan#e Commission can den) /temporaril) or permanentl)0 the privile#e of practice before the SEC with a :Rule 5$/e0: proceedin#! /<he SEC can also :censure: a CP-, which amounts to a slap on the wrist and settle for an inAunction in which the CP- promises not to violate the rules of conduct in the suture!0 ,n addition, where laws are broken /e!#! rule '5 0 the SEC can initiate le#al proceedin#s resultin# in fines and=or imprisonment! <he ,nternal Revenue Service can8

M17B-&

Module B - Professional Ethics

! $!

Suspend a CP- from practice before ,RS 7isbar a CP- from practice before ,RS /revoke the ri#ht to represent clients before ,RS0

SOLUTIONS OR MULTIPLE$C"OICE %UESTIONS

B! 3 a! b! c! d! c! ,ncorrect Correct ,ncorrect ,ncorrect Correct ,ndependence in fact is a mental >ualit)! -ppearances influence the public! Standards of field work do not mention independence! <his is the first of the C--S standards of field work! Sarbanes-1xle) and PC-1B have placed the responsibilit) for ensurin# that the external auditors are independent on those char#ed with #overnance /includin# the audit committee0! ,mperative means that a rule is alwa)s followed! "tilitarian means that some exceptions based on a calculation of #ood and bad outcomes is sometimes used! <his is the second best answer because #enerali(ation can resemble imperative thou#ht! <he firm is followin# a rule, not listenin# for :inner voices!: 9-SB makes accountin# principles /not independence rules0 C-1 makes auditin# standards for #overnment audits <he PC-1B /in cooperation with SEC0 makes independence rules for auditors of public companies -RSC makes practice standards for accountants2 work on unaudited financial statements Merel) auditin# competitors does not impair independence! <his item is written to impl) that the auditor subordinated Aud#ment to the client2s officer, Iack of competence itself is not an impairment of independence! .hile facts ma) be misrepresented, the auditors didn2t know it! -nother example of lack of competence! ,n this case the auditors misrepresented facts /#ivin# the un>ualified report when the audit was not entirel) in conformit) with C--S0, but the) did not knowin#l) do so! Sarbanes-1xle) and the PC-1B have placed the responsibilit) for auditors2 independence on the audit committee! Primar) in this responsibilit) is the monitorin# of all en#a#ements contracted with the external auditors to ensure that the auditors are not performin# an) assi#nments that are prohibited b) PC-1B standards or otherwise impair the auditors2 independence! Rule 5 be#ins G- member in public practice!!!H ,nte#rit) and obAectivit) are re>uired of all members! Rule %5 be#ins G- member in public practice!!!H Prohibition of discreditable acts applies to all members!

B! 4

B!$5

a! b! c! d!

Correct ,ncorrect ,ncorrect ,ncorrect ,ncorrect ,ncorrect Correct ,ncorrect ,ncorrect Correct ,ncorrect ,ncorrect

B!$

a! b! c! d!

B!$$

a! b! c! d!

B!$%

b!

Correct

B!$&

a! b! c! d!

,ncorrect Correct ,ncorrect Correct

M17B-'

Module B - Professional Ethics

B!$'

a! b! c! d!

,ncorrect8 Correct8 ,ncorrect ,ncorrect8 ,ncorrect ,ncorrect

B!$*

a! b!

c! d! B!$+ a! b! c! d! B!$3 a! b! c! d! B!$4 a! b! c! d!

Correct8 ,ncorrect ,ncorrect ,ncorrect Correct member ,ncorrect ,ncorrect ,ncorrect ,ncorrect Correct services! ,ncorrect ,ncorrect ,ncorrect Correct

,ndependence is impaired b) this t)pe of bookkeepin# service! ,ndependence is not impaired for nonfinancial-statement related internal audit services when the client has its own 7irector of ,nternal -uditin# in char#e! ,ndependence is impaired when the audit firm performs more than &5@ of financial-related internal audit work /for clients with more than J$55 million assets0 ,ndependence is impaired when auditors perform important actuarial work, then audit their own work product /the client2s actuarial calculations based on the audit team-prepared assumptions0! <he answer is both /a0 and /b0! ,ndependence is not impaired in /a0! Mana#ers not on the en#a#ement can own shares in nonclient sister funds! <he answer is both /a0 and /b0! ,ndependence is not impaired in /b0! ,ndependence is not impaired Close famil) members of audit partners can own shares in audit client sister funds not audited b) the close famil) member2s kin, so lon# as the shares are held throu#h the famil) member2s emplo)ee benefit plan! ,ndependence is not impaired in both /a0 and /b0! ,ndependence is not impaired in both /a0 and /b0! - spouse is defined as an immediate famil) member! - spousal e>uivalent is defined as an immediate famil) member! - parent is defined as a close relative, but is not an immediate famil) -n uncle is neither an immediate famil) member nor a close relative <he audit or#ani(ation ma) not reduce the scope of its audit! <here are restrictions concernin# where in the or#ani(ation the nonaudit work can be performed! <he audit or#ani(ation must document wh) the nonaudit service does not affect independenceK not the #overnment or#ani(ation! <he scope of the audit work cannot be reduced because of the nonaudit -uditors freedom to talk with clients about emplo)ment is not denied! <he audit firm simpl) must compensate for the threat to >ualit) audit work! Ma)be a second-best answer, but the GefficienciesH are offset b) the extra review the audit firm is obli#ated to perform! 9ormer audit partners can retain material retirement accounts onl) if the) are fixed as to amount and timin#! /<he GvariableH word in the >uestion is supposed to ne#ate the GfixedH re>uirement!0 7iscussion of former firm emplo)ees now emplo)ed in accountin# and reportin# roles in the client is a matter for the independence reportin# to the board! -lon# with the -SB and MCS Executive Committee!

B!%5

d!

Correct

M17B-*

Module B - Professional Ethics

B!% B!%$

b! a! b! c! d!

Correct Correct ,ncorrect ,ncorrect ,ncorrect ,ncorrect ,ncorrect Correct ,ncorrect ,ncorrect ,ncorrect ,ncorrect Correct ,ncorrect Correct ,ncorrect ,ncorrect ,ncorrect ,ncorrect ,ncorrect Correct Correct ,ncorrect ,ncorrect ,ncorrect

-lon# with the 9-SB and C-SB! Le is :holdin# out: as a CP- and performin# services other CP-s perform! Mere partnership with another CP- is not enou#h if the other CPdoes not :hold out!: same idea as b! ,f he does not :hold out: as a CP-, he is not in public accountin#, accordin# to the -,CP-! CP-s #enerall) prefer to compete on the basis of >ualit) of service rather than price! <he conventional wisdom is the opposite! <he 9<C dra##ed the -,CP- kickin# and screamin# into the a#reement! <he -,CP- :principles: statements assert that obAectivit) is alwa)s necessar)! ,ndependence is impaired b) a direct financial interest in the client! ,ndependence is impaired b) the attribution of the financial interest of the spouse! ,ndependence is impaired b) havin# a nondependent close relative in an audit-sensitive position with the client! <his is a situation of havin# an immaterial financial interest in a nonclient investee that is immaterial to the client6s financial statements! :Must: is wron#! <he public accountin# firm can explain wh) the departure is necessar) and then #ive an un>ualified opinion para#raph in the auditors2 report!! Rule $5% permits the explanation and the un>ualified opinion! :Must: is wron#! <he public accountin# firm can explain wh) the departure is necessar) and then #ive an un>ualified opinion para#raph in the auditors2 report!! <he opinion para#raph can be un>ualified, but with the explanation, the report is not :standard!: Dou cannot even tell a credit a#enc) about the client6s pa)ment record! <he actuarial assumptions are not re>uired to be disclosed b) C--P or C--S in tax en#a#ements! Plans of this nature are not re>uired b) C--P or C--S! Client permission is not needed for information re>uired b) C--P in audited financial statements! <hese are #enerall) considered outside the reach of professional conduct rules! 9ailin# to file one6s own tax return is discreditable! 9ilin# a fraudulent tax return, even for a client in financial difficult), is discreditable under -,CP- interpretation! Emplo)ment discrimination is discreditable!

B!%%

a! b! c! d!

B!%&

a! b! c! d!

B!%'

a! b! c! d!

B!%*

a! b! c! d!

B!%+

a! b! c! d!

M17B-+

Module B - Professional Ethics

B!%3

a! b! c! d!

,ncorrect ,ncorrect Correct ,ncorrect

Sellin# products for profit is not forbidden b) an) rule! -uthorship itself is not forbidden! Rule '5% prohibits commission compensation for referrin# products or services to clients for whom the CP- performs attest services! Rule '5% permits CP-s to pa) fees to obtain clients! /<his answer is :close: to correct--forbidden--because the CP- must also disclose the fee pa)ment to the new client!0 <he -,CP- does not #rant licenses to practice! <he state CP- societies do not #rant licenses! <he -SB does not #rant licenses! <he state board is the re#ulator) a#enc) that #rants a license to practice and can revoke one! .ithholdin# client records is an Gacts discreditableH! 9ailin# to file or remit tax pa)ments is a felon) and as such is an Gacts discreditableH!! 9ailure to follow standards durin# an SEC audit is Gacts discreditableH! Miolatin# the advertisin# standards is a violation of rule '5$ not rule '5 Gacts discreditableH! - direct financial interest disposed before the auditor-client relationship arises does not impair independence! - short sale creates the commitment to ac>uire the client6s stock which impairs independence! Service in the capacit) of mana#ement durin# the period covered b) the financial statements impairs independence! Performin# accountin# services and preparin# financial statements when the client cannot take responsibilit) for them impairs independence! Rule %5 --Confidential Client ,nformation is not relevant because the CP- did not tell an)one else about the omission! Rule 5$--,nte#rit) and 1bAectivit)! <he CP- knowin#l) misrepresented facts! Rule 5 --,ndependence! ,ndependence is not re>uired in tax practice! Rule $5%---ccountin# Principles is not relevant because the CP- is not #ivin# an opinion on financial statements6 conformit) with C--P! <his is a commission E a percenta#e paid in connection with a business activit)! - ?on-CP- can be a partner if he or she does not have a maAorit) interest and is not have ultimate responsibilit) for the firm2s services! - CP- must have ultimate responsibilit) for the firm services! - nonCP- cannot be the mana#in# partner! - maAorit) owner and partner in the firm cannot own stock in an audit client! ?on-CP- owners of the firm must hold a bachelor2s de#ree!

B!%4

a! b! c! d! a! b! c! d!

,ncorrect ,ncorrect ,ncorrect Correct ,ncorrect ,ncorrect ,ncorrect Correct

B!&5

B!&

a! b! c! d!

Correct ,ncorrect ,ncorrect ,ncorrect ,ncorrect Correct ,ncorrect ,ncorrect Correct Correct ,ncorrect ,ncorrect ,ncorrect

B!&$

a! b! c! d!

B!&% B!&&

a! a! b! c! d!

M17B-3

Module B - Professional Ethics

SOLUTIONS OR E&ERCISES' PROBLEMS' AND SIMULATIONS

B!&' SEC Independence Rules ,n these solutions, the responses below do not tr) to contemplate all the Gma)beH exception conditions cited in the text related to the SEC independence rule exceptions! a! b! c! d! e! Des! - member of the en#a#ement team cannot hold a direct financial interest! Des! ?o other partner in the Santa 9e office /covered persons0 can own direct financial interest in CCC! Des! ,mmediate famil) members of covered persons in the firm cannot hold direct financial interest in CCC! Des! <he son /presumed a dependent0 is also an immediate famil) member! ?o! ?ow accordin# strictl) to the definition, the father is a close famil) member /not an immediate famil) member0 and the financial interest in CCC does not impair S,7- N Co!2s independence! Des! Controllin# interests in audit clients when held b) close famil) members of covered persons in the firm impair independence! Des! ,ndependence is impaired when close famil) members of a covered person in the firm /Favier0 holds a Aob with a client in a accountin# or financial reportin# role!

f! #! B!&*

SEC Independence and Nonaudit Ser ices ,n these solutions, the responses below do not tr) to contemplate all the Gma)beH exception conditions cited in the text related to the SEC-prohibited non-audit services! a! b! ,ndependence appears to be impaired because the SEC does not allow bookkeepin# or other services b) the audit team to prepare financial statements! ,ndependence appears to be impaired because the SEC does not allow Gcovered persons2H involvement in financial information s)stems desi#n and implementation work to include desi#nin# or implementin# a software s)stem or supervisin# the client2s s)stem! ,ndependence appears to be impaired because the audit firm audited its own work! ,ndependence is not impaired! -uditors can audit actuarial calculations when the) have been ori#inall) prepared b) clients2 actuaries /Aust like auditin# a client-prepared depreciation schedule0! ,ndependence is not impaired! -ccordin# to the literal rule, the out-sourced internal audit work does not cover financial controls and financial statements, and Section has in place its own internal audit director with complete authorit) for all aspects of the work! ,ndependence is impaired! Chur)k is a covered person /havin# authorit) in the chain of command0, and she performs a mana#ement function b) si#nin# stock option documents on behalf of Section!

c! d!

e!

f!

M17B-4

Module B - Professional Ethics

#! h!

,ndependence is impaired because the SEC rule seems to be ver) strict to prohibit all aspects of executive search activit) for audit clients! <his item is written to induce thou#ht without ke)in# directl) to SEC-prohibitions on broker-dealer services! Lowever, a conservative conclusion is that independence is impaired because the audit firm /albeit indirectl)0 performed broker-dealer services for the audit client! ,ndependence appears not to be impaired! .hile these export-import tax services have feathers like le#al services, waddle like le#al services, and >uack like le#al services, the) do not involve strict le#al work that re>uires admission to a law)er2s bar association /admission to practice before a "!S! court0!

i!

B!&+

Audit Simulation: Independence, Integrit!, and "#$ecti it! Cases a! ,nterpretation--Lonorar) 7irectorships and <rusteeships! <he CP- will not be considered independent unless8 ! $! %! &! b! the position is in fact purel) honorar), and listin#s of directors show she is an honorar) director and she restricts participation strictl) to the use of her name, and she does not vote or participate in mana#ement functions!

?o violation, but students should note that .olfe is :practicin# public accountin#: b) virtue of :holdin# out as a CP-: and performin# the t)pes of services offered b) other public accountants! ,nterpretation---ccountin# Services! <he CP- must be careful to know whether outsiders would perceive relationships that would indicate status as an emplo)ee, hence impairin# the appearance of independence! ,n particular, the CP- must8 ! $! ?ot have an) business connection with Larper Corp! or with Marvin Larper that would in fact impair independence, obAectivit) and inte#rit), and ,mpress Marvin Larper /and the board of directors0 that the) must be able and willin# to accept primar) responsibilit) for the financial statements as their own, and ?ot take mana#erial responsibilit) for conductin# operations of the Larper Corp! /althou#h the CP-6s supervision of the bookkeeper seems to have this characteristic0, and Conduct the audit in conformit) with C--S and not fail to audit records simpl) because the) were processed under the CP-6s supervision!

c!

%!

&!

<his case assumes Larper Corp! is not reportin# to the SEC, in which case the CP-6s audit independence would certainl) be impaired as a result of participatin# in the bookkeepin# work!

M17B- 5

Module B - Professional Ethics

d!

,nterpretation of Rule 5 !-!& ,ndependence is not impaired! Poirot6s loan is :#randfathered,: since it was ac>uired before 44$ and because it was obtained from a financial institution for which independence was not re>uired /9arrawa) was not a client before mer#er with ?earb)0 but which later became part of an audit client6s portfolio! ,nterpretation of Rule 5 !-!& ,ndependence is impaired! ?ot even home loans made under normal lendin# conditions are exempt from the prohibition! Pa)in# off the old #randfathered loan does not matter! ,nterpretation of Rule 5 !-!& ,ndependence is impaired! Since the accountin# firm and its partners own more than '5@ of the partnership, the loan is considered to be a prohibited loan from a client! ,nterpretation of Rule 5 !-!& ,ndependence is not impaired! <he CP-s own less than '5@ of the partnership! ,ndependence is impaired! ,nterpretation 5 - ! Since Schult( can order the investment under the insurance contract, the financial interest is a prohibited GdirectH financial interest!

e!

f!

#! h!

B!&3

Audit Simulation: Independence, Integrit! and "#$ecti it! Cases /a, b, c, d, e, f0 ,nterpretation--Effect of -ctual or <hreatened Iiti#ation on ,ndependence! ,n #eneral, when the present mana#ement of a client commences or expresses an intention to commence le#al actions a#ainst its public accountin# firm, the public accountin# firm and the client mana#ement ma) be placed in adversar) positions in which the mana#ement6s willin#ness to make complete disclosures and the auditors2 obAectivit) ma) be affected b) self-interest! ,ndependence ma) be impaired whenever the auditors and the client or its mana#ement are in positions of material adverse interest b) reason of actual or threatened liti#ation! Marious situations are hard to #enerali(e, and the responses offered below are #uidelines expressed in -,CP- Ethics ,nterpretations /Effect of Iiti#ation0! a! -n expressed intention b) the client to be#in liti#ation alle#in# deficiencies in audit work is considered to impair independence if the public accountin# firm concluded that there is a stron# possibilit) that such a claim will actuall) be filed! <he commencement of liti#ation alle#in# deficiencies in audit work impairs independence! <he commencement of liti#ation b) the public accountin# firm alle#in# mana#ement fraud or deceit impairs independence! <he claim under subro#ation b) the insurance compan) would not :normall): affect auditors2 independence! ,n this case, the client and members of mana#ement are not the nominal plaintiffs! Lowever, the idea of :normall): needs to be evaluated! ,f members of Contrar) mana#ement are #oin# to testif) on behalf of the insurance compan)6s interest and thus act in an adversar) relation to the public accountin# firm, independence would seem to be impaired! <he substance of the situation is essentiall) the same as if Contrar) Corporation was the named plaintiff!

b! c! d!

M17B-

Module B - Professional Ethics

e!

Iiti#ation not related to the audit work, whether threatened or actual, for an amount that is not material to the audit form or to the financial statements of the client would not usuall) be considered to affect the CP--client relationship in such a wa) as to impair independence! Lowever, accordin# to the SEC, this situation mi#ht impair independence!0 <he class action lawsuit a#ainst both public accountin# firm and compan) in itself would not alter fundamental relationships between the mana#ement and directors and the public accountin# firm and therefore would not be considered to have an adverse impact on the auditors2 independence! <hese situations, however, should be examined carefull)! -ctions to be taken! .hen independence is considered impaired, the public accountin# firm should /a0 withdraw from the audit en#a#ement in order to avoid the appearance that self-interest would affect his obAectivit) or /b0 disclaim an opinion because of lack of independence, as prescribed b) C--S!

f!

#!

,nterpretation--,nvestor or ,nvestee Relationships with ?onclients <he CP-6s financial interest in 7ove Corp! /investor0 is sufficientl) lar#e to allow him to influence the actions of 7ove, and the CP-6s /and the public accountin# firm6s0 independence would be considered impaired! <he CP-6s abilit) to influence 7ove Corp! could permit him to exercise a de#ree of control over <ale Compan) /the investee, a client0 that would place the CP- in a capacity equivalent to that of a member of management!

B!&3

Audit Simulation: Independence, Integrit! and "#$ecti it! Cases %Continued& h! ,nterpretation--,nvestor or ,nvestee Relationships with ?onclients! ,ndependence is impaired! <he exception does not appl)8 <he nonclient investee /L)dra0 is material to the investor /Sabrina0K no matter whether the investment is or is not material to the CP-s6 wealth! <he reasonin# is that the client investor /Sabrina0 has the abilit) to influence the nonclient investee /L)dra, in which the Oueens have ownership0, and Sabrina can therefore increase or decrease the CP-s6 wealth! Since the CP-s are associated with Sabrina, the firm ma) appear to lack independence in relation to bein# able to interact with the mana#ement that can influence the CP-s wealth /via L)dra0! i! Rule 5 --,nterpretation 5 ! -ssumin# that the 9irst ?ational Bank is a profit-seekin# enterprise, the independence of the auditors is not impaired b) the association of the two individuals who served both as members of the auditin# firm and as directors for the client durin# the period examined as lon# as the) have ended all ties with the bank and are not involved in the audit!

M17B- $

Module B - Professional Ethics

$!

<he auditors2 services ma) consist of advice and technical services, but he must not make mana#ement decisions or take positions which mi#ht impair his obAectivit)! <he independence of the auditin# firm would be compromised b) an) partner makin# a decision on loan approvals and the minimum balance checkin# account polic), but normall) not b) his performin# a computer feasibilit) stud)! ,f the former controller6s participation in the feasibilit) stud) was obAective and advisor), and his advice was subAect to effective client review and decision, the firm6s independence has not been compromised! ,t is desirable, however, that the former controller not participate in the audit of the 9irst ?ational Bank6s financial statements! /-,CP- -dapted0

A!

Rule 5 ! <he acceptance b) the CP- of the unsecured interest-bearin# notes in pa)ment of unpaid fees would not be construed as discreditin# the CP-6s independence in his relations with his client because the notes are merel) a substitution for an open account pa)able! <he rule of professional conduct that prohibits a CP- from havin# an) financial interest in a client does not extend to the liabilit) for the CP-6s fee! "nder SEC rules, however, a definite arran#ement for pa)in# the notes must be stated b) the client! Lowever, the acceptance of two shares of common stock /or prior commitment to accept stock0 would be a violation of Rule 5 ! -n) direct financial interest such as common stock holdin#s are construed as discreditin# the CP-6s independence! /-,CP- adapted0 Rulin# -- -cceptance of a Cift! /?ot in text! "se common sense!0 <he Code of Ethics does not appl) to 7ebra! She6s neither a CP- nor a member of -,CP-! <he rulin# applies to independence of a firm if an emplo)ee accepts a #ift that is more than token! ,ndependence is impaired because a member cannot permit his emplo)ees to break rules he himself is obli#ated to observe! Rule 5 !&!-8 Rulin# '$ /E< 4 ! 5&0--Past 7ue 9ees! ,ndependence is considered impaired! -t the time a member issues a report on financial statements, the client should not be indebted for more than one )ear6s fees! ,n the Croaner case, the debt would be for last )ear and the current )ear audit fees! Croaner will have to pa) the fees for last )ear when the current )ear report is read) /or else #et a non-independent disclaimer0! <he past due fees take on characteristics of a loan within the meanin# of Rule 5 , and collection ma) depend on the nature of the auditors2 report on the financial statements!

k!

l!

B!&3

Audit Simulation: Independence, Integrit! and "#$ecti it! Cases %Continued& m! Rule 5$--,nte#rit) and 1bAectivit) <he CP- has violated the rule! <he CP- / 0 lacked inte#rit), /$0 knowin#l) misrepresented facts b) omittin# the #ain in the current-)ear tax return, and /%0 subordinated CP- Aud#ment to another /the client0! <he proper action is to file an amended return for last )ear and re>uest a refund, then file a correct return for this )ear! Rule 5$--,nte#rit) and 1bAectivit) Both CP-s probabl) violated Rule 5$! Iestrade has a conflict of interest in ownin# another business that provides services to her emplo)er and /apparentl)0 not disclosin# the business to Baker6s board of directors! <he :prepaid expenses: classification is wron#! Iestrade has falsified an entr) in the accounts and in the financial statements /a violation of Rule '5 0! Both CP-s have fooled the external auditors b) l)in# about the related part) loan and the repa)ment terms!

n!

M17B- %

Module B - Professional Ethics

B!&4

Integrit! and "#$ecti it! <his is a true case! ,t is clear that 7eloitte subordinated its Aud#ment to the Aud#ment of the other firms! <his is clearl) a#ainst the standards interpretation of inte#rit) and obAectivit)! Students2 opinions ma) var) as to the need for other auditors2 opinion! Lowever, it should be emphasi(ed that while )ou ma) be persuaded b) others that based on the facts of the case a chan#e in )our position is warranted, )ou should not chan#e )our Aud#ment solel) because someone else makes a different Aud#ment based on the facts! <he transaction in >uestion was one of the focal points durin# an investi#ation of Iiven and re#ulator) bodies and experts in accountin# and auditin# took exception with re#ards to recordin# an) of this as revenue!

B!'5

Audit Simulation: General and 'echnical Rule Cases a! Rule $5 Professional Competence <he competence provision of Rule $5 is probabl) not violated! - CP- can learn about a technical area while work is in pro#ress! -n)wa), Cheese ac>uired si#nificant technical expertise /competence0 b) placin# Cilliam on the audit team! Rule $5$8 C--S--9ourth Standard of Reportin# <he CP- violated Rule $5$ b) not followin# the fourth C--S Standard of Reportin#! <he CP- prepared financial statements and /apparentl)0 did not render a report of the work and the de#ree of responsibilit) as re>uired b) C--S! <he CP- should have attached a compilation report to the unaudited financial statements, declarin# lack of independence! <he CP- is :associated with: the financial statements, practices public accountin#, and should render a report!

b!

c!

B!'5

Rule $5%---ccountin# Principles ?o violation of Rule $5%! Students ma) not know enou#h accountin# to answer this >uestion well! Rule $5% refers to official pronouncements made b) bodies desi#nated b) Council /i!e!, 9-SB0, not to C--P in #eneral! C--P is :all the accountin# that has authoritative support!: SEC re>uirements hold the place of hi#hest level of authoritative support for public companies, but Mont) is not a public compan)! <he SEC-re>uired tax reconciliation disclosure is not in 9-SB pronouncements! <he financial statements contain no departure from an 9-SB financial accountin# standard! ,f Mont) were a public compan), the financial statements would be :in accordance with 9-SB pronouncements,: but not :in accordance with C--P!: Audit Simulation: General and 'echnical Rule Cases %Continued& d! Rule $5% -ccountin# Principles ?o violation! Chapman is followin# the exception clause of Rule $5%--believin# a departure from 9-SB pronouncements is necessar) to prevent financial statements from bein# misleadin#, explainin# the departure, then #ivin# the un>ualified opinion! /<his topic is also covered in Chapter $!0

M17B- &

Module B - Professional Ethics

B!'

Responsi#ilities to Clients( Cases a! Rule %5 /and Rules $5 and $5$0! Retainin# an outside mail service to handle confirmation of accounts receivable for the CP- is not acceptable practice! <he confirmation of receivables is an important part of the audit, and therefore cannot be dele#ated to a nonaccountant, unsupervised b) the CP-! Such an arran#ement would violate Rule $5$ concernin# the observance of Cenerall) -ccepted -uditin# Standards, especiall) the Ceneral Standards and the Standards of 9ield .ork! ,n addition, the use of an outside mailin# service for this work would be a violation of Rule %5 concernin# the confidentialit) of information obtained from the client6s records! <he public accountin# firm would be makin# available to outsiders /the mailin# service6s personnel0 a list of the client6s customers and their outstandin# balances! <he auditors would probabl) also be in violation of Rule $5 , /Ceneral Standards0 parts /b0 and /c0! Rule %5 ! <he CP- has apparentl) violated the rule! /,n the author6s opinion, however, the violation has some Austification! .hile Austification does not necessaril) excuse rule-breakin# completel), an) penalt) for doin# so should be li#ht in a case like this one!0 <he CP- should seek client permission to disclose information to an)one /includin# a successor auditor0! <he banker should ask Candentoe to permit the CP- to speak to him, and refusal should itself raise >uestions and cautions for the banker! Rule %5 ! ,nterpretation! - prospective purchaser ma) review the client files before purchasin# the practice, but client permission must be obtained to turn them over to a new owner!0 <urnin# over work papers and business correspondence to a purchaser of a public accountin# practice would be proper onl) if consent of the clients to whom such papers relate has been obtained! 1therwise, the action would be a violation of Rule %5 re#ardin# the confidentialit) of information obtained from clients! Rule %5 , Rulin# /E< %4 !55*0 ,nformation to Successor -ccountant about <ax Return 9rauds! Rule %5 is not intended to help an unscrupulous client cover up ille#al acts or otherwise hide information b) chan#in# CP-s! <he former CP- should at a minimum su##est that her CP- friend /successor0 ask Larvard Co! to permit the former CP- to discuss all matters freel)! ,f Larvard refuses, the successor CP- can consider himself warned! "pon withdrawin#, the fired CP- should have stated all her reasons and her knowled#e of frauds in a letter to Larvard Co! ?ow in answer to the successor CP-6s in>uir) she could su##est that he ask Larvard to show him the letter! /-uthor6s note8 ?otwithstandin# the rule of confidentialit), the fired CP- could do her collea#ue a #reat disservice if she did not make sufficient effort to put him on #uard!0 .allace violates -,CP- Rule of Conduct %5 ! ,nformation #ained in the course of work for a client /B! .ard, individual tax client0 is confidential and cannot be disclosed to an) other client or an) other person without B! .ard2s express permission! Rule %5$ still prohibits contin#ent fees on uncontested tax matters - ori#inal and amended returns!

b!

c!

d!

e!

f!

M17B- '

Module B - Professional Ethics

#! B!'

Since the rules impl) that auditors are not independent if the) have received a contin#ent fee :durin# the period covered b) the financial statements,: then the CP- cannot be 9addle6s independent auditor! Responsi#ilities to Clients Cases %Continued& h! Rule %5$ ,nterpretation! <he CP- violated Rule %5$ b) takin# a contin#ent fee from a client for whom attest /audit0 services were performed! Bur#ess, Maclean, and Cairncross are all considered clients of the CP-! <he CP- performed the audit of Maclean for Cairncross /the holdin# compan)0 at the direction and re>uest of Bur#ess! <he fee as described--paid onl) if the ,P1 is successful--is a contin#ent fee!

B!'$

Audit Simulation: "ther Responsi#ilities and )ractices Cases a! ,nterpretation '5 - /E< '5 !5$0 -cts 7iscreditable! <he lien under state law does not matter for Rule '5 ! <he CP- violates Rule '5 if he does not return the cash disbursement Aournal! b! ,nterpretation Rule '5 <he CP- committed a discreditable act! <he CP- Examination is :nondisclosed,: and inducin# exam-takers to recite the >uestions for disclosure purposes in violation of their a#reement not to disclose is discreditable! c! ,nterpretation '5$- /E< '5$!5$0 and E< '5$-$ /E< '5$!5%0 and Rulin# %% /E< '4 !5**0! ,nformation about the CP-2s firm, his educational back#round, and his professional affiliations is permitted under Rule '5$! <estimonials are permitted, but the comparisons with other CP-s are inadvisable since the) are probabl) not based on verifiable facts! d! Rulin# +3 /E< '4 ! '*0 Ietterhead8 Iaw)erPCP-! <he -,CP- rules of conduct do not prohibit dual practice, and the dual letterhead description is permitted! <he CP- should also determine whether such practice and letterhead description is permitted b) the State Bar! e! f! Rule '5%8 Referral fees are permitted, as lon# as the) are disclosed! Rule '5'! Rulin# %& /E< '4 !$*30 -ssociation of -ccountants ?ot Partners! 1thers could assume a partnership existed! -n) reports issued under the Aoint headin# would violate Rule '5'! - letterhead should not be used showin# the names of two accountants when a partnership does not exist! <he first name is misleadin#! #! Rule '5' and Rulin# &' /E< '4 !$450 permit retention of the retired partner6s name in the name of the successor partnership! AIC)A Independence and "ther Ser ices -,CP- ,nterpretation 5 -% /Performance of 1ther Services8 www!aicpa!or#0 cites several Gother servicesH that do and do not impair audit independence! Co to the -,CP- website, and find whether the items below impair independence /G)esH0 or do not impair independence /GnoH0 when performed for audit clients!

B!'%

M17B- *

Module B - Professional Ethics

,mpair ,ndependenc e; ---------------a! b! c! d! e! f! #! h! Post client-approved entries to a client2s trail balance! -uthori(e client2s customer credit applications! "se CP-2s information processin# facilities to prepare client2s pa)roll and #enerate checks for the client treasurer2s si#nature! Si#n the client2s >uarterl) federal pa)roll tax return! -dvise client mana#ement about the application or financial effect of provisions in a emplo)ee benefit plan contract! Lave emer#enc) si#nature authorit) to co-si#n cash disbursement checks in connection with a client2s hospital benefit plan! -s an investment advisor) service, provide anal)ses of a client2s investments in comparison to benchmarks produced b) unrelated third parties! <ake temporar) custod) of a client2s investment assets each time a purchase is made as a device to reduce cash float expense! ?1 DES ?1 DES ?1 DES ?1 DES

B!'&

General Ethics <his is a thou#ht-t)pe >uestion that deals with the :whatever )ou can #et awa) with: issue! 1f course, an act has the same ethical character whether it is known to others or not! /Remember that an act that affects no one but the a#ent--rare as such acts ma) be--is one that has no substantive ethical implications!0 <he latter part of the >uestion asks the student to proAect himself into his or her future business role!

B!''

Competition and Audit )roposals <he audit proposal scenario was adapted from a .all Street Fournal article entitled :Ethics on the Fob8 Companies -lert Emplo)ees to Potential 7ilemmas: /Ful) &, 43*0! ,t was reported to have been used in a compan) ethics trainin#=awareness session! Cases like this do not pretend to have :solutions: 55 percent acceptable to ever)one! <he .all Street Fournal reported the followin#8 Some participants said8 7ena should do as she6s told! She6s not on a level where she6s supposed to think! She doesn6t know all the facts! ,t ma) not be what she thinks! 1thers said8 7ena should refuse! <he situation has a :bad smell!: She should keep her own hands clean! /Caution! -lwa)s worr) about someone who thinks throu#h his or her noseQ0

B!'*

Engagement 'ime*eeping Records -s in all cases of this t)pe, a :solution: is difficult! Some discussion thou#hts8

M17B- +

Module B - Professional Ethics

! $!

Ed is indeed l)in# b) makin# false timekeepin# records! <he bud#et appears to be unrealistic! -pparentl), Sara did not know /or did not care0 that seven cash accounts had been added, and the work should take lon#er /probabl) in comparison to last )ear6s time bud#et0! Ed does not seem to #ive credit to Sara for the possibilit) of explainin# wh) the work took lon#er! <he case seems to set Sara up as a t)rant about the bud#et! Ed compounds the lie b) puttin# the extra time in a bud#et area where someone else will seem to have fewer hours to do another se#ment of the work /internal control evaluation0! Ed is also improvin# his chances of #ettin# cau#ht, because surel) Sara can see that his work had little or nothin# to do with internal control evaluation! Fu##lin# the time records, if successful, will have an effect on next )ear6s audit staff! -uditors t)picall) use the prior )ear actual time records to help plan the current time bud#et! ,f the) are misstated, the next time bud#et ma) also be unrealistic! Sooner or later, some poor assistant will have to pa)Q

%! &!

'!

B!'+

Audit " ertime ! Man) aspects of this case are similar to B!%', except that Eli(abeth did not put the extra time an)where else! She Aust donated four hours of her own time /ma)be seven hours if she was not paid for the time worked at home0! 1f course, her action makes it look like the work can be done in six hours next )ear! Receivin# help from her husband overni#ht should not raise an) new issues! <his event Aust increases the number of unreported hours! /-ctuall), some students ma) see a new issue related to Rule %5 --revealin# client information to someone outside the firm!0 Ieavin# the work with the husband raises the new issue of havin# audit work done, unsupervised, b) someone not emplo)ed b) the firm who ma) be un>ualified to do it correctl)! Students should ask whether Eli(abeth reviewed all her husband6s work before puttin# in the workin# paper file! /<he confidentialit) issue can be raised a#ain!0

$!

%!

B!'3

Con+lict o+ Clients, Interests ,f Fack and Fill #an# up on Bill, Fon ma) lose the work that #oes to Phil! 7espite the bad poetr), this situation raises a t)pical :.ho6s the client;: >uestion! "nfortunatel), the relevant relationships are Fon6s individual en#a#ements with Fack and Bill--because Fon would have essentiall) the same problem if 1newa) Corporation were not a client! <he situation is :unfortunate: because Fon is in a no-win situation! ,f he keeps Bill informed, he mi#ht save the 1newa) en#a#ement and Bill6s friendship /not to mention the well-bein# of little 1tto, his #odchild0, but he will suffer the #uilt of havin# en#a#ed in industrial espiona#e and mi#ht face an ethics complaint for havin# thumbed his nose at the rule of accountants6 confidentialit)! ,f Fon keeps >uiet, he mi#ht lose the en#a#ement and a si#nificant portion of his personal income at least temporaril), Bill will probabl) suffer and life Aust won6t be the same!

M17B- 3

Module B - Professional Ethics

,f Fon believes rules are the most important element of ethical behavior and the conse>uences of action or inaction must fall where the) ma), he will refuse Bill6s re>uest with an elo>uent and s)mpathetic explanation of the professional reasons for not discussin# other clients6 business affairs! - happ) outcome for this approach depends upon Bill6s understandin# the difficult situation he has created for Fon! /-fter all, Bill created the situation b) askin# Fon to #ive him the information! 9riendship runs both wa)s, and in this case Bill has unintentionall) been :unfriendl)!:0 ,f Fon believes in wei#hin# the :#ood and evil conse>uences: of ethics-related choices, he will need to decide which ultimate outcome is most desirable8 Bill6s well-bein# /and his own income0 or Fack6s and Fill6s well-bein#, whatever it ma) be! Choosin# to tell Bill about Fack6s plans could be construed as a selfish act on Fon6s part! Professional :selfishness: ma) not be a#ainst the rules, but in this case, different avenues of anal)sis seem to su##est the rule is a #ood one, even in this difficult personal situation! B!'4 Managerial In ol ement and Audit Independence <his scenario was adapted from the facts of an actual case! ,n the real case, the compan) /Lobart0 experienced financial difficult), defaulted on the loan, and the CP- firms were investi#ated! <he criticism was focused on the .ilde N -ssociates, IIP firm, because it was the firm of record and si#ned the auditors2 report! <he >uestion was :independence!: <he .ilde partner and mana#er had none of the independence problems of financial interests or mana#erial involvement! <he issue concerned the :loaned: staff members /Iacosta and Martine(0 who were emplo)ees of Marlowe N Chandler, the firm that certainl) was not independent /because Marlowe was a member of the Lobart board of directors0! <he CP- firms6 position was that no problem existed because Marlowe and the Marlowe N Chandler firm had nothin# to do with the audit! <he) did not supervise an) personnel and did not make audit evidence or reportin# decisions! <he facts of the case seemed to speak otherwise! Marlowe was in char#e of the firm6s audit practice! Le was interested in the professional development and performance of Iacosta and Martine(! <he), in turn, were ver) aware that Marlowe6s evaluations affected their pa) and promotion, indeed their continuance with the firm! -s it turned out, Marlowe occasionall) visited their work cubicle and asked :how6s the Lobart audit #oin#;: Marlowe also submitted the Marlowe N Chandler bills to Lobart for the work these assistants performed! Le also responded briefl) to some >uestions other board members posed about the audit while it was in pro#ress! Le knew about the audit! ,n his dual positions /director and partner in char#e of the firm6s audit department0, he could not avoid some tan#ential knowled#e of the audit! Certainl), Iacosta and Martine( were well aware of Marlowe6s interest in seein# the loan application and the ac>uisition succeed! <he .ilde N -ssociates, IIP firm was Aud#ed to lack independence because of the association of Iacosta and Martine( to Marlowe and hence to the mana#ement of Lobart! B!*5 -isciplinar! Action <he solution will be different dependin# on the state and the time!

M17B- 4

Module B - Professional Ethics

B!*

Audit Simulation: Ethics Case <here is a Rule '5 /acts discreditable0 violations since failin# to pa) the taxes is a felon)! Sall) could receive an) of the penalties available to the -,CP- and the state board includin# admonishment, suspension, or expulsion! - discussion of the penalties should ensue! 1pinions ma) ran#e from the least penalt) since sall) has resolved her le#al difficultiesK to the most severe penalties since the publicit) re#ardin# a member of the professions portra)s a ne#ative ima#e of the profession and a severe penalt) will send a messa#e to the public re#ardin# professional conduct!

B!*$

.aplan C)A E/am Simulation: Independence

.hich of the followin# should the CP- firm of -bernath) and Chapman desi#nate as a covered member for this en#a#ement; - member of the audit team who recentl) #raduated from colle#e and has onl) limited auditin# experience! - tax accountant emplo)ed b) the firm of -bernath) and Chapman who is classified as a GseniorH in the firm but who is not involved with the audit of ?orman, ,nc! - staff auditor emplo)ed b) the firm of -bernath) and Chapman who is classified as a GseniorH in the firm but who is not involved with the audit of ?orman, ,nc! - non-auditin# administrator emplo)ed b) the firm of -bernath) and Chapman who assi#ns personnel to each of the audit en#a#ements but does not work directl) on an) audit en#a#ements! <he CP- firm of -bernath) and Chapman itself! - non-auditin# administrator emplo)ed b) the firm of -bernath) and Chapman who sets salar) levels for the auditin# personnel but does not work directl) on an) audit en#a#ements! R R

R R

M17B-$5

Module B - Professional Ethics

.hich of the followin# situations would cause the CP- firm of -bernath) and Chapman to not be considered independent in respect to ?orman, ,nc! - non-dependent brother of a covered member holds common stock of ?orman, ,nc!, an amount that is considered to be less than a material amount! - dependent brother of a covered member has a financial interest in ?orman, ,nc!, an amount that is considered to be less than a material amount! -n emplo)ee of -bernath) and Chapman who is not a covered member holds &!$ percent of the outstandin# shares of ?orman, ,nc! <he spouse of a covered member is emplo)ed b) ?orman, ,nc! in the compan)2s marketin# department but is not in a position to influence the financial statements! <he non-dependent father of a covered member is an emplo)ee of ?orman, ,nc! <he father2s emplo)ment position does have a si#nificant relationship to the compan)2s accountin# function! B!*% .aplan C)A E/am Simulation: Independence 0alse <o emphasi(e independence from mana#ement, auditors are appointed b) the shareholders of the compan)! /-uditors are appointed b) the audit committee of the board of directors and voted on b) the shareholders!0 <o ensure independence, the public accountin# firm cannot render an opinion on statements in a current )ear until all fees /includin# the current )ear0 have been paid! /1nl) the fees from the prior )ear/s20 audit/s0 need to have been paidK the fees for the current )ear audit could be paid after the auditors2 report release date!0 -n) professional emplo)ee who is not a covered emplo)ee for a particular en#a#ement can hold up to 5@ of the outstandin# stock of the client2s e>uit) shares! /<he statement is true for no more than '@ of the outstandin# stock!0 - covered member2s close relatives could include his mother, his nephew, and his brother! /<he covered member2s close relatives are defined as a parent, siblin#, or nondependent child! ?ephews do not fit an) of those criteria!0 R R

0alse

0alse

0alse

M17B-$

Module B - Professional Ethics

'rue

- covered member2s immediate famil) could include his common-law partner or his adopted son! /<he covered member2s immediate famil) is defined to include a spousal e>uivalent and an) dependent! - common-law partner >ualifies as a spousal e>uivalent! - dependent could include an adopted childK an adopted child is treated the same as a blood relative!0 <he CP- firm would be a covered member on an) of its client en#a#ements! /<he firm itself, as a separate le#al entit), is a covered member!0

'rue

B!*&

Mini1Case: Ethics NOTE TO INSTRUCTOR: For this assignment, question *! from this Mini!Case is applicable"

1pinions will var)! 7avid 7uncan directed the actual shreddin# of documents and probabl) knew an investi#ation was imminent! Even if he received direction from ?anc) <emple concernin# the document retention polic), he had the opportunit) to determine the applicabilit) of the polic) to the situation and the ramifications of followin# the polic) in this instance! Remember, man) people have #one to Aail or suffered even #reater conse>uences utili(in# the defense that the) were only following orders E or, in this case, polic)!

B!*'

Mini1Case: Non1Audit Ser ices and Independence NOTE TO INSTRUCTOR: For this assignment, questions # through $ from this Mini!Case are applicable" ! <he -merican ,nstitute of Certified Public -ccountin#2s /-,CP-2s0 position on performin# tax services for clients is consistent with the #eneral prohibition a#ainst performin# Gmana#ementH duties for the client! ,n this particular scenario, the public accountin# firm could provide tax plannin# advice and prepare the client2s tax returnsK however, the public accountin# firm should not be makin# operatin# decisions /includin# tax plannin# decisions0 that affect the client! <he -,CP- also provides #uidelines for tax services for CP-s in public practice /for both audit clients and non-audit clients0! <hose #uidelines can be found in the Statements on Standards for %a& Services and, amon# others, re>uires that /see <S 5508 - CP- should not recommend that a tax return position be taken with respect to an) item unless the position has a realistic possibilit) of bein# sustained administrativel) or Audiciall) on its merits if challen#ed! - CP- should not prepare or si#n a return that the member is aware takes a position that does not meet the above standard! - CP- ma) recommend a tax return position that the member concludes is not frivolous as lon# as the member advises the taxpa)er to appropriatel) disclose!

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Module B - Professional Ethics

.hen recommendin# tax return positions and when preparin# or si#nin# a return on which a tax return position is taken, a member should, when relevant, advise the taxpa)er re#ardin# potential penalt) conse>uences of such tax return position and the opportunit), if an), to avoid such penalties throu#h disclosure!

Lowever, the standards do reco#ni(e that, when recommendin# a tax return position, a member has both the ri#ht and responsibilit) to be an advocate for the taxpa)er with respect to an) position satisf)in# the aforementioned standards! <his Gadvocac)H position has resulted in man) believin# that it is difficult for a CP- to provide tax services to audit clients, with the thou#ht that the advocac) mi#ht Gspill overH into the audit work! -s a direct result of the BPMC case, the Public Compan) -ccountin# 1versi#ht Board /PC-1B0 has recentl) adopted rules related to tax-shelter advice provided to an accountin# firm2s audit clients! <hese rules, which are currentl) bein# reviewed b) the Securities and Exchan#e Commission for final approval, prohibit the followin# t)pes of services related to tax shelters8 <ax services involvin# contin#ent fees for tax services! <ax services related to marketin#, plannin#, or opinin# in favor of the tax treatment of a confidential transaction, or if the services are related to transactions that are based on a##ressive interpretations of tax laws and re#ulations! <ax services to members of mana#ement /or their families0 who serve in financial reportin# roles at an audit client!

-n exception to the prohibition would exist if the firm Greasonabl)H believes the strate#ies have a #reater than '5@ chance of bein# upheld if challen#ed b) the ,nternal Revenue Service /see G-ccountin# 9irms Cet ?ew Curbs on <ax Shelters,H 'all Street (ournal, Ful) $+, $55', p! C , C&!0! B!*' Mini1Case: Non1Audit Ser ices and Independence %Continued& $! Sarbanes-1xle) has placed some restrictions on the extent and t)pe of nonaudit services that can be provided b) a compan)2s audit firm! 9or example, under Sarbanes-1xle), an audit firm can no lon#er provide information services consultin# and internal auditin# services to its attestation clients! -s a result, companies desirin# such services are contractin# them with other providers /in man) cases, lar#e audit firms0! <he .abtec Corp! and ,ntel Corp! examples discussed in this case illustrate how the nonaudit services provided b) lar#e accountin# firms ma) actuall) limit companies2 choices of auditors! <he most fre>uentl)-cited example of permittin# nonaudit services to be provided b) audit firms to their attestation clients is the Gknowled#e spilloverH effectsK that is, information learned b) the audit firm as the) are providin# these services will enable them to better identif) areas of risk and conduct a more effective and efficient audit! <he primar) disadvanta#ed cited for permittin# nonaudit services to be provided b) audit firms is related to independence! Simpl) stated, as the audit firm is providin# a hi#her level of services to its attestation clients, the financial dependence upon those clients increases, makin# auditors less likel) to challen#e client mana#ement on important issues arisin# durin# the attestation en#a#ement!

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Module B - Professional Ethics

B!**

Mini1Case: Non1Audit Ser ices and Independence NOTE TO INSTRUCTOR: For this assignment, questions # and ) from this Mini!Case are applicable" ! <he re>uirements of Sarbanes-1xle) appear to enhance perceptions of auditors2 independence because of the) prohibit certain t)pes of nonaudit services that have been controversial in terms of their impact on auditors2 independence /financial information s)stems desi#n and implementation and internal audit outsourcin#0! ,n addition, while Sarbanes-1xle) allows other t)pes of nonaudit services, these services must be explicitl) approved b) the entit)2s audit committee! <his latter re>uirement would seem to provide users with #reater assurance that potential conflicts of interest were carefull) considered b) the audit committee prior to approvin# nonaudit services! ,n $555, fees paid b) Ceneral Electric /CE0 to BPMC for nonaudit services were J*&!$ million /J'5!& for financial information s)stems desi#n and implementation and J %!3 million for tax services0! <his is substantiall) #reater than the fees paid for audit and audit-related services /a total of J%4!& million0! 1ne potential downside of auditors insistin# upon adAustments to CE2s financial statements is the fear of losin# future revenues from nonaudit services, should CE decide to en#a#e another firm to provide these services!

$!

B!*+

,n $55& and $55*, the fees paid to BPMC for nonaudit services were substantiall) less than that in $555 /J3!4 million in $55& and J4!5 million in $55* versus J*&!$ million in $5550! 9urther, the fees paid for audit services were substantiall) hi#her in $55& and $55* than in $555 /total audit and audit-related fees of J4%!+ million and J 5*!& million in $55& and $55*, respectivel) versus J%4!& million in $5550! -s a result, CE2s auditors do not have the same monetar) incentives related to nonaudit service revenues in $55& and $55* that the) had in $555! Mini1Case: E++ect o+ Sar#anes1"/le! on 0ees

NOTE TO INSTRUCTOR: For this assignment, questions $ and * from this Mini!Case are applicable" %! -n initial review reveals that total fees paid to BPMC increased followin# the issuance of Sarbanes-1xle), but not as si#nificantl) as mi#ht have been expected! 9or example, the total fees paid to BPMC in $55& /J 5$!* million0 actuall) decreased from fees paid in $555 /J 5%!* million0! Lowever, it is important to note that the fees paid in $55* /J '!& million0 were markedl) hi#her than those paid in an) of the other )ears! <o compare CE2s fees prior to and followin# the issuance of Sarbanes-1xle), the followin# table summari(es the percenta#e of total fees in each )ear that are related to each cate#or)K this information is summari(ed below /totals ma) not e>ual 55@ because of roundin#08

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Module B - Professional Ethics

$555 -udit fees -uditrelated fees <ax fees 9inancial information s)stems fees 1ther fees $%! @ '!5@ %!%@ &3!*@

$55$ &%!%@ $*! @ $%!+@ 5!5@

$55& +*!$@ '! @ 3!+@ 5!5@

$55* +&!&@ +!4@ +!3@ 5!5@

5!5@

*!3@

5!5@

5!5@

Sarbanes-1xle) had the followin# effect on CE2s fees8 <he internal control re>uirements of Sarbanes-1xle) si#nificantl) increased the percenta#e of total fees that were classified as audit fees in $55& and $55*! ,n addition, the SEC2s revised definition of Gaudit feesH ma) have resulted in some of this increase! <he prohibition of providin# financial information s)stems desi#n and implementation services eliminated this fee after $555K as shown above, this fee was a si#nificant portion of total fees paid b) CE to its auditors in $555! <he fees paid for tax services also decreased in $55& and $55* compared to the level of these fees in $555 and $55$! .hile tax services were not prohibited b) Sarbanes-1xle), it is possible that the re>uirement that audit committees specificall) approve all nonaudit services ma) have reduced the extent of tax services provided to CE b) BPMC!

B!*+

Mini1Case: E++ect o+ Sar#anes1"/le! on 0ees %Continued& &! <he total fees paid b) 9ortune 55='55 entities to their auditors were >uite stable over this period of timeK for both #roups of companies, the hi#hest total fees were paid in $555! ,n addition, both #roups of companies experienced sli#ht increases in their total fees paid to auditors from $55$ throu#h $55*! Similar to the anal)sis undertaken for CE, the followin# summari(es the percenta#e of fees paid b) 9ortune 55='55 companies to their auditors over this period of time /9ortune '55 results are in parenthesesK totals ma) not e>ual 55@ because of roundin#08

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Module B - Professional Ethics

$555 -udit fees $&!%@ /$*!%@0 -udit-related fees %! @ /&!'@0 <ax fees %!3@ /$!+@0 9inancial information s)stems fees 1ther fees %!&@ / $!+@0 ''!'@ /'%!*@0

$55$ %4!'@ /&$!$@0 %!+@ / %!$@0 $$!5@ / 4!%@0 &!4@ /%!*@0 $5!5@ /$ !+@0

$55& *4! @ /+ !3@0 !4@ / !+@0 *!4@ / &!*@0 5!5@ /5!5@0 $! @ / !4@0

$55* +&!'@ /++! @0 !3@ / !5@0 $!*@ / !5@0 5!5@ /5!5@0 !$@ / !5@0

<he effects of Sarbanes-1xle) on fees paid to auditors b) 9ortune 55='55 companies are similar to the effects on CE, namel)8 <he internal control re>uirements of Sarbanes-1xle) si#nificantl) increased the percenta#e of total fees that were classified as audit fees in $55& and $55*! ,n addition, the SEC2s revised definition of Gaudit feesH ma) have resulted in some of this increase! <he prohibition of providin# financial information s)stems desi#n and implementation services eliminated this fee in $55& and $55* /thou#h CE paid much hi#her fees to its auditors for financial information s)stems desi#n and implementation in $555 than 9ortune 55='55 companies0!

B!*+

<he fees paid for tax services also decreased in $55& and $55* compared to the levels of these fees in $55$! .hile tax services were not prohibited b) Sarbanes1xle), similar to CE, it is possible that the re>uirement that audit committees specificall) approve all nonaudit services ma) have reduced the extent of tax services provided to 9ortune 55='55 companies! Mini1Case: E++ect o+ Sar#anes1"/le! on 0ees %2uestion 3, Continued& 1ne maAor difference in the fees paid b) 9ortune 55='55 companies and CE is the lar#e GotherH fees paid b) 9ortune 55='55 companies! -s shown above, these fees were a much lar#er percenta#e of total fees for 9ortune 55='55 companies in $555 and $55$ than for CEK in addition, these fees dramaticall) decreased followin# the issuance of Sarbanes-1xle)! ,t is possible that the difference between the 9ortune 55='55 companies and CE is the result of classification differences!

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Module B - Professional Ethics

B.68

Mini-Case: Indemnity Clauses and Independence NOTE TO INSTRUCTOR: For this assignment, questions 1 through 5 from this Mini-Case are applicable. All quotations are from Auditing Liability Caps Face Fire, The Wall Street Journal (November 28, 2005). ! ,t is eas) to understand wh) accountin# firms favor alternative dispute resolution! Each of the maAor firms has been involved with clients who have suffered throu#h maAor accountin# scandals, and often the auditors are tar#ets of corporate and investor lawsuits! Provisions for alternative dispute resolution efforts are included in en#a#ement letters to tr) to limit auditor liabilit) should somethin# #o wron#! G,f San audit clientT runs into accountin# problems and thinks a botched audit b) Sits auditorsT is to blame, it is barred from takin# the accountin# firm to court! ,nstead, SitT has to #o throu#h mediation and arbitration! ,t also can6t seek an) dama#es be)ond the actual, compensator) dama#es related to Sthe auditors2T conduct!H -n Ernst N Doun# spokesman states that Gthese clauses have been part of our standard client a#reements for some time and are not newH and notes that the provisions don2t limit the abilit) of investors to seek redress from the firm! $! ,f maAor accountin# firms want liabilit) caps as part of the en#a#ement letter, there is little that a compan) can do to have them excluded! Lowever, it seems lo#ical that companies would prefer to have this lan#ua#e excluded, since it potentiall) exposes them to #reater losses! ,nvestors would probabl) prefer that these caps be excluded, since the) can been seen as relievin# auditors of their responsibilit) and encoura#in# less strin#ent audits! 9urther, some critics wonder whether the #ood will #enerated b) a compan)2s decision to limit auditors2 liabilit) mi#ht ultimatel) create a conflict of interest! C)nthia Richson, the corporate #overnance officer for the 1hio Public Emplo)ees Retirement S)stem, states8 GSome investors don6t like what the) see as the auditors6 attempt to avoid accountabilit)! ,t does a disservice to investorsU! ,t6s not in the compan)6s best interests and not in the investor6s best interests!H &! <he SEC has said that an) move b) a compan) to indemnif) its auditor a#ainst liabilit) would violate auditor independence! <hat bar doesn6t appl) specificall) to the sorts of liabilit) limitations the firms are usin#, but the SEC also sa)s that if a reasonable investor believes such a provision causes a conflict of interest, then it impairs independence! Mini-Case: Indemnity Clauses and Independence (Continued) '! .hether or not liabilit) caps impair independence is currentl) bein# debated b) the PEEC! 9rom its latest exposure draft /available at www!aicpa!or#08

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Module B - Professional Ethics

GSome limitations of liabilit) provisions do not impair independence! 9or example, certain provisions commonl) included in en#a#ement letters or other a#reements with clients that are used b) members to facilitate dispute resolution or mana#e risk, such as provisions providin# for alternative dispute resolution or waiver of Aur) trials and Gloser pa)sH provisions do not impair independence! ,n addition, indemnification and limitation of liabilit) provisions in nonattest en#a#ements for attest clients and in en#a#ements performed under the Statements on Standards for -ttestation En#a#ements /SS-Es0 that are re>uired to be restricted to identified parties, do not impair independence! -lso, a#reements that define the respective responsibilities of the member and the attest client in a manner consistent with applicable attest standards do not impair independence! 1n the other hand, certain t)pes of indemnification and limitation of liabilit) provisions in an attest en#a#ement are considered to pose an unacceptable threat to a member2s independence!H

M17B-$3