Course Materials (163 Pages)

Table of Contents
Chapters
Preface
1 Overview: Accountancy Laws and Ethics
2 Accountancy Laws and Ethics Rules: Objectivity, Integrity
and Due Care
3 Accountancy Laws: Licensing and Enforcement
4 Fairness in Tax Returns and Financial Statements
5 Materiality
6 Pro Forma Financial Results
7 Off Balance Sheet Financing
8 Related Parties
9 Contingencies and Estimates
10 Accounting Changes and Errors
Appendices
Ethics, Taxes and Financial Reporting

A Bibliography
B Suggested Solutions - Test Your Knowledge
C Suggested Solutions - Case Problems
Laws
California Accountancy Act
California Accountancy Regulations

Preface
Preface
What You Can Expect to Get from This Course
This course candidly addresses the ethical realities of financial reporting and tax practice
in a competitive world. In addition, it provides a comprehensive review of public
accountancy laws and ethics rules and has been approved by the California Board of
Accountancy to fulfill the 8-hour ethics CPE requirement.
This course is ideal for accountants in industry as well as public accounting. It is

designed to help you keep your ethics, your license and your job or clients. It serves as a
review of GAAP as well as a course on ethics. The accounting principles, ethics rules
and laws are presented clearly and are illustrated by practical examples and case
problems. The straightforward presentation will appeal to tax professionals and other
accountants who do not necessarily work with these rules every day.
Goals and Objectives
The educational goals of this course are:
· To ensure that you have a current knowledge and understanding of ethical and
professional conduct standards, as well as statutory and regulatory requirements
in California.
· To help you resist the constant pressure to make unethical choices in your jobs in
industry or public accounting, especially related to the preparation of financial
statements.
· To ensure that you understand the primary ethical issues related to major areas of
generally accepted accounting principles.
On completion of this course, you will be able to:

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Preface
· Demonstrate a general knowledge and understanding of the current California

Accountancy Act and Accountancy Regulations
· Demonstrate a general knowledge and understanding of the current AICPA

Principles of Professional Conduct and Ethics Rules.
· Recognize potential problem areas concerning compliance with accountancy laws

and ethics rules
· Feel secure in your ability to reference the legal codes and ethics rules to find
information pertinent to specific topics or items of concern
· Recognize the common ethical issues associated with major areas of generally
accepted accounting principles.
· Demonstrate an understanding of what it means to present financial statements

fairly in accordance with generally accepted accounting principles
· Demonstrate an understanding of a realistic possibility standard for positions

taken in tax returns
Who Should Take This Course
CFO's, controllers, and other management accountants; partners and sole practitioners in
public accounting; accountants with a tax or accounting background.
Contents
Most chapters contain questions that you can use to assess the state of your knowledge
concerning the most important rules and disclosure requirements. The Appendix contains
a suggested solution for each question. Each chapter also contains copies of
transparencies and a list of key points.
This course guide contains numerous references to laws and professional standards and is
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Preface
designed to help you use the laws and standards and remember major provisions in them.
It is not designed for use as a substitute for the laws and standards themselves. Keep in
mind that no training manual is recognized as a source of GAAP, or as a source of
auditing or accounting standards, or as a source of laws. Only the laws and professional
standards themselves contain the official rules and interpretations.

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Preface

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Overview: Accountancy Laws and Ethics
Chapter 1
Objectives
Upon completion of this chapter, you should be able to:
• Identify the statutory and regulatory requirements that apply to CPAs in California.
• Identify the professional ethics standards that apply to CPAs.
• Summarize the typical ethical problems faced by CPAs in industry and public
accounting who are responsible for financial statements.
Readings/References
• California Accountancy Act and Regulations
These laws are published by the California Board of Accountancy and are
located in section D of this book. They are also available at the Board’s web
site, http://www.dca.ca.gov/cba/.
• AICPA Code of Professional Conduct, Introduction
The AICPA code of professional conduct and ethics rules are published by the
AICPA and they are also available at the AICPA’s web site,
http://www.aicpa.org.

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Key Points
Accountancy Laws and Ethics Standards
• The practice of public accountancy is governed by a large number of laws,

regulations and professional standards. Here is a partial list:
- California Accountancy Act
- Accountancy Regulations
- AICPA Code of Professional Conduct
- AICPA Ethics Rules
- Statements on Responsibilities in Tax Practice
- Generally Accepted Accounting Principles
- Generally Accepted Auditing Standards
• Those are the focus of this course. In addition, other laws apply to accountants and
the practice of accountancy, for example,
- Business and Professions Code
- Corporations Code
- Government Code
- Welfare and Institutions Code

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• The California Accountancy Act and Regulations define what it means to practice
public accountancy, delineate the legal responsibilities of CPAs and prescribe
penalties for noncompliance.
• The AICPA code of professional conduct and ethics rules require honesty,
objectivity, independence, competence, carefulness, and acceptance of responsibility.
• Although AICPA standards for ethics, accounting and auditing are not themselves
laws, Section 5062 of the California Accountancy Act states, “a licensee shall issue a
report which conforms to professional standards upon completion of a compilation,
review or audit of financial statements.”
• A particular focus of this course is dishonesty. Along with incompetence, dishonesty

is the most common charge made against CPAs.
Pressures on Accountants that Impair Ethics
• Client companies want their financial statements to present the company’s prospects
in a positive light, while ethics standards prescribe objectivity.
• Accounting standards are increasingly complex. Accountants have difficulties

finding the rules that apply and understanding their complexities. In addition,
required financial statement disclosures have become so complicated and numerous
that fewer readers understand them. Complexity has been added to standards to
increase the fairness of financial reporting, but many now complain that the
complexity itself diminishes fairness because it diminishes understandability.
• Materiality is left to each accountant’s and client’s judgment, which is the only
practical approach, but which also opens the door to bias.
• Clients demand creativity to minimize their taxes and press their CPAs to the limits of
legality.
• Accountants and their clients are human.

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Summary of the AICPA Code of Professional Conduct
Article Title
I Responsibilities
II The Public Interest
III Integrity
IV Objectivity and Independence
V Due Care
VI Scope and Nature of Services
Article I — Responsibilities
• To society, clients and employers and each other
• Improve art of accounting
• Maintain public confidence in the profession
• Self-governance
• Make sensitive professional and moral judgments
Article II — The Public Interest
• Accept responsibility to public, including—
- Clients and employers
- Credit grantors and investors
- Governments
• Do not place client or employer interests ahead of other interests
Article III — Integrity
• Honest and candid
• Personal gain or advantage must be subordinate to service and public trust

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• Observe form and spirit of technical and ethical standards
Article IV — Objectivity and Independence
• Impartial and intellectually honest
• Free of conflicts of interest
• If in public practice, be independent in fact and appearance,
• If employed (e.g., in industry),
- be objective
- be scrupulous in application of GAAP
- be candid with those in public practice
Article V — Due Care
• Competence
• Consult with others when needs exceed competence
• Diligence — prompt, careful, thorough
Article VI — Scope and Nature of Services
• Work in firms (and other organizations) that have quality-control procedures and are
concerned with integrity, objectivity and due care
• Consider potential conflicts of interest before performing other services for audit
clients.
• Do not perform other services that are not compatible with public accounting

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Test Your Knowledge
Choose the best answer from the alternatives.
1. Which of the following items is not covered in the California Accountancy Act or
Regulations?
A) what it means to practice public accountancy
B) the legal responsibilities of CPAs
C) penalties for noncompliance
D) rules that delineate independence
2. When making judgments about the fairness of financial statements, what weight
should a CPA give to the interests of a client relative to the interests of investors
and creditors?
A) Client interests should be treated as subordinate to the interests of investors and
creditors.
B) Client interests should be treated as superior to the interests of investors and
creditors.
C) Client interests should not be placed ahead of the interests of investors and
creditors.
D) Client interests should not be given any weight.
3. Accountants employed in industry must be—

A) free of conflicts of interest
B) objective
C) independent
D) all of the above

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Case Problem
An accounting supervisor who is a CPA discovers a material error in the company’s

financial statements caused by a mistake made within the supervisor’s area of
responsibility. Although the supervisor was worried that the mistake might cost him his
job, the supervisor brought the mistake to the attention of his boss, the controller. It was
not a pleasant meeting. The controller was visibly upset and after a lengthy discussion
told the supervisor to say nothing about the mistake and that they would fix it next year
quietly. Although the independent audit was not complete for the year, the controller
believed that it was unlikely that the auditors would detect the error because the auditors
had already completed their work related to that area of the financial statements. The
controller also remarked that changing the financial statements at such a late date would
be embarrassing not only to the controller, but also to the CFO and president. They
would all lose credibility with the company’s bank and prospective investors who already
had copies of the unaudited financial statements. The controller said that this error was
not so great as to justify such awful consequences. In addition, the controller said that
had we known about this mistake earlier, we may not have been as conservative on
certain reserves and thus, overall, the financial statements are not materially misstated if
we don’t correct this error.
The auditor did detect the misstatement and brought it to the attention of the controller,
the CFO and the president. They persuaded the auditor that the financial statements were
not materially misstated overall and that it was proper to issue an unqualified opinion.
What are the ethical issues in this case and what are the ethical responsibilities of the
corporate officers, the supervisor and the independent auditor? Summarize the issues in
this case and your conclusions. Identify the relevant AICPA ethics rules and articles.

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TR 1-1
Accountancy Laws, Regulations

and Rules
California Accountancy Act
California Accountancy Regulations
AICPA Code of Professional Conduct
AICPA Ethics Rules
Statements on Responsibilities in Tax Practice
Generally Accepted Accounting Principles
Generally Accepted Auditing Standards

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TR 1-2
Accountancy Act and

Regulations
Laws and regulations cover:
· What "Public Accountancy" means
· Who has permission to practice
· Discipline for noncompliance

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TR 1-3
AICPA Code of Professional

Conduct and Ethics Rules
Covers:
· Honesty
· Objectivity
· Independence
· Competence
· Carefulness
· Acceptance of responsibility

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TR 1-4
AICPA Code of Professional

Conduct
Article Title
I Responsibilities
II The Public Interest
III Integrity
IV Objectivity and Independence
V Due Care
VI Scope and Nature of Services

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TR 1-5
Article I - Responsibilities
· To society, clients and employers and each

other
· Improve art of accounting
· Maintain public confidence in the profession
· Self-governance
· Make sensitive professional and moral

judgments

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TR 1-6
Article II - The Public Interest
· Accept responsibility to public, including:

·· Clients and employers
·· Credit grantors and investors
·· Governments
· Do not place client or employer interests

ahead of other interests

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TR 1-7
Article III - Integrity
· Honest and candid
· Personal gain or advantage must be

subordinate to service and public trust
· Observe form and spirit of technical and

ethical standards

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TR 1-8
Article IV - Objectivity and

Independence
· Impartial and intellectually honest
· Free of conflicts of interest
· If in public practice, be independent in fact

and appearance
· If employed (e.g., in industry):

·· be objective
·· be scrupulous in application of GAAP
·· be candid with those in public practice

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TR 1-9
Article V - Due Care
· Competence
· Consult with others when needs exceed

competence
· Diligence - prompt, careful, thorough

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TR 1-10
Article VI - Scope and Nature of

Services
· Work in firms (and other organizations) that

have quality-control procedures and are
concerned with integrity, objectivity and due
care
· Consider potential conflicts of interest before

performing other services for audit clients
· Do not perform other services that are not

compatible with public accounting

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Accountancy Laws and Ethics Rules: Objectivity, Integrity and Due Care
Chapter 2
Accountancy Laws and Ethics Rules:

Objectivity, Integrity and Due Care
Objectives
• Recognize potential problem areas concerning compliance with the AICPA Code of
Professional Conduct and Ethics Rules.
• Make informed professional judgments concerning ethics rules.
• Conform to California accountancy laws pertaining to commissions, contingent fees

and continuing education.
Readings
California Accountancy Act and Board of Accountancy Regulations (recent versions are
included in section D to this book, but completely up-to-date versions are available at the
Board of Accountancy web site,
http://www.dca.ca.gov/cba/.)
AICPA Code of Professional Conduct and Ethics Rules (contained in Volume 2 of

AICPA Professional Standards, Section ET, and at the AICPA web site,
http://www.aicpa.org.)

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Key Points: AICPA Ethics Rules
• The AICPA Code of Professional Conduct contains two sections: principles and
rules. The principles are summarized in the tables included in the Overview chapter
of this guide.
• The ethics rules are listed by major categories in a table at the end of this section.
Note that the rules are divided into four sections and are assigned rule numbers in the
100’s, 200’s, 300’s and 500’s. Each section of the rules is followed by “ethics
rulings” which are presented in a question and answer format in the AICPA
Professional Standards.
Ethics Rules
Rule Title
101 Independence
102 Integrity and objectivity
201 Competence, due care, planning and supervision, and sufficient

relevant data
202 Compliance with professional standards (e.g.. auditing standards)
203 Compliance with GAAP
301 Confidentiality
302 Contingent fees restricted
501 Discreditable actions

502 Advertising and other solicitations
503 Commissions and referral fees
505 Form of organization and name

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Independence:
• Independence may be impaired by any direct or indirect financial interest in a client,

by joint investments with a client, by litigation involving the client or CPA, and by
many other circumstances.
• Under AICPA ethics rules, independence is required for:
1. A person on the attest engagement team for a client.

2. A person who can influence the attest engagement.
3. A person who provides ten hours of nonattest services to the client.
4. A partner in the office in which the lead attest engagement partner practices.
5. The firm providing attest services.
6. Any entity controlled by the firm or any of the above persons.
Integrity and objectivity:
• CPAs must be free of conflicts of interest when they provide professional services
and are not allowed to misrepresent facts to clients or others and when in dispute with
clients or others, a CPA is not allowed to subordinate his or her judgment to anyone
else.
Competence, due care, planning and supervision, and sufficient relevant

data:
• CPAs are not allowed to perform services for which they are not competent.
• CPAs are not permitted to make conclusions or recommendations unless they have
sufficient relevant data as support.
Compliance with professional standards:
• CPAs are required to perform all professional services in accordance with the
appropriate standards (e.g. auditing, management consulting, and tax.)

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Compliance with GAAP:
• Whenever CPAs are associated with financial statements as an auditor, reviewer,

compiler or preparer, the financial statements must conform to GAAP or to an other
comprehensive basis of accounting.
• This rule applies to employees in industry as well as to those in public practice.
Confidentiality:
• Disclosure of confidential client information requires client permission.
Contingent fees:
• The AICPA rule on contingent fees is less restrictive than California law. California
law should be followed.
Discreditable actions:
• Examples of discreditable actions include retaining client records after a client has
demanded their return, discriminatory employment practices, and negligence.
Advertising and other solicitations:
• Advertising is permitted as long as it is not false, misleading or deceptive.
Commissions and referral fees:
• The AICPA rule appears to be somewhat less restrictive than California law. In
circumstances in which commissions are permitted, however, the AICPA requires
disclosure of the commissions.
Form of organization and name:
• This ethics rule appear to be consistent with California law.

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Providing Nonattest Services to Attest Clients:
SEC rules and the Sarbanes-Oxley Act prohibit performing bookkeeping services as well
as certain other consulting and nonattest services for public companies. Otherwise, as
long as other laws and government regulations do not prohibit performing bookkeeping,
consulting or other nonattest services for audit or other attest clients, AICPA ethics rules
allow such services if the conditions of AIPCA rule 101-3 are met. Under that rule such
services are generally permitted if they do not place the CPA in a management role and if
the following requirements are met:
1. Related to the bookkeeping, consulting or other nonattest services, the client agrees to
perform the management role and oversee, evaluate, accept responsibility for, and
maintain internal controls over the services provided and the CPA is satisfied that the
client can do those things.
2. Before performing such nonattest services the CPA establishes in writing his or her
understanding with the client of the engagement objectives, the services the CPA will
perform, the client’s acceptance of the responsibilities described above, the CPA’s
responsibilities, and any engagement limitations.
Under the AICPA rule, preparing tax returns and transmitting the return and taxes due to
the IRS or other taxing authority does not impair a CPA’s independence as long as the
client reviews and approves the return and related payment and signs the return, if
applicable, before transmitting the return to the government. The rule also allows a CPA
to sign and file returns in special circumstances elaborate in the rule.

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California: Employment with an Audit Client
Under Accountancy Act Section 5062.2 a CPA cannot accept employment with a
publicly traded audit client or its affiliate within twelve months of the date a financial
report is issued if two criteria are met:
(a) The CPA participated in an audit engagement for the corporation and held
responsibility, with respect to the audit engagement, requiring the CPA to
exercise significant judgment in the audit process.
(b) The employment would permit the CPA to exercise significant authority over
accounting or financial reporting, including authority over the controls related to
those functions.
This restriction is in addition to the AICPA rule that says that independence is impaired
as long as a CPA is seeking employment with a client or as long as an employment offer
from a client is outstanding.
California: Confidentiality
Under Accountancy Act, Section 5063, a CPA cannot disclose confidential information
about a client or prospective client without written permission of the client or prospective
client, except:
• To comply with a subpoena or summons enforceable by order of a court.
• To maintain or defend himself or herself in a legal proceeding initiated by the client
or prospective client.
• To respond to an official inquiry from a federal or state government regulatory
agency.
• To communicate with another licensee in connection with a proposed sale or merger
of the CPA’s professional practice.
• To communicate with another CPA to the extent necessary for purposes of
• professional consultation.
• To communicate with organizations that provide professional standards review and
ethics or quality control peer review.
• To make disclosures when specifically required by law.

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• To make disclosures specified by the board in regulation.
If confidential client information needs to be disclosed to persons or entities outside the

United States of America in connection with the services provided, the CPA must inform
the client in writing and obtain the client's written permission for the disclosure.
Regulation 54 defines confidential information as all information obtained in a

professional capacity about a client or prospective client, except that it does not include
information obtained from a prospective client who does not subsequently become a
client if certain conditions are met.
California: Commissions
• The Accountancy Act prohibits the payment of a commission to obtain a client.

However, the Accountancy Act does not prohibit payments to purchase an accounting
practice, retirement payments, or payments to heirs or estates of deceased CPAs.
• The Accountancy Act permits accepting a commission for recommending the

products or services of a third party to a client if the following conditions are met:
a. The third party provides the products or services in conjunction with

professional services the CPA is providing to the client.
b. The CPA does not also perform an audit, review, compilation (as an
independent accountant) or examination of prospective information.
c. The CPA discloses the commission in a written statement signed by the client
containing the information required by Section 5061 (e).
• The law prohibits accepting a commission in the following circumstances:
a. The CPA’s referral of a client to a third party is not made in conjunction with
performing professional services for the client.
b. The CPA performs an audit, review, compilation (as an independent

accountant) or examination of prospective information for the client.

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c. The CPA does not disclose the commission to the client.
• Accountancy reform laws enacted in 2002 prohibit licensees from providing services
for a commission to the officers and directors of publicly traded companies and other
large for-profit audit clients and to the officers and directors of client-sponsored
retirement plans.
California: Contingent Fees
• Regulation 62 prohibits contingent fees for any services that require independence,
preparation of tax returns, or provision of expert testimony. In addition, the
regulation prohibits contingent fees for any professional services to a client for which
the CPA performs services that require independence. For example, a CPA that
performs an audit for a client may not perform any services under a contingent fee
arrangement for that client.
• Fees that are fixed by courts or governmental entities acting in a judicial regulatory
capacity are not regarded as contingent fees by regulation 62.
California: Continuing Education
• CPAs engaged in the practice of public accountancy are required to complete at least
80 hours of continuing education during the two years preceding their license
renewals. No carryover of continuing education is permitted from one two-year
period to another. If the Board approves regulations proposed in January 2009, for
license renewals after December 31, 2011, licensees must complete at least 20 hours
in each of the two-year license renewal periods with a minimum of 12 of those 20
hours in technical subjects as described in Reg. 88(a)(1).
• CPAs who perform government audits are required to complete 24 hours of

continuing education related to governmental accounting and auditing as part of the
80-hour requirement described above. (Reg. 87 (b))

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• A CPA who provides audit, review, other attestation services, or performs

compilations must complete at least 24 hours of continuing education related to
accounting and auditing as part of the 80 hour requirement described above.
(Accountancy Act, Section 5027(c))
1. This rule applies to all licensees who plan, direct or perform substantial portions
of the work or report on an audit, review, compilation or attestation service in
the 24-month period preceding the license expiration.
2. Courses that pertain to GAAP, other comprehensive bases of accounting,
auditing, review, compilation, industry accounting, attestation services, or
assurance services qualify.
• A CPA who performs audits, reviews, other attestation services, or compilations (for
commercial or government entities) must complete 8 hours of continuing education
related to detecting fraud in financial statements or reporting on financial statements.
That 8 hours is in addition to the basic 24 hour requirement for government or
accounting and auditing, but can be counted in meeting the basic 80-hour
requirement. This means that anyone doing attest work or compilations needs 32
hours of accounting and auditing courses including 8 hours related to detecting fraud
in financial statements or reporting on financial statements. (Regulation 87(d))
• All CPAs must complete an 8-hour continuing education course concerning the
provisions of the Accountancy Act and Regulations and other rules of professional
ethical conduct every six years. See Reg. 87.7 for more information. Under
regulations proposed in January 2009, for licenses renewed after December 31, 2009
the rules will change. The new rules, if adopted by the Board, will require four hours
of credit related to ethics every two years (Reg. 87(b) and two hours of credit from a
Board-approved regulatory review course every six years covering the California
Accountancy Act and Regulations and including a review of disciplinary actions.

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• The Board of Accountancy requires all CPAs to provide a list of the continuing
education courses taken in the last two years in connection with renewal of their
licenses.
• Continuing education records must be kept for four years after license renewal. See
Reg. 89.
• A wide variety of programs qualify for continuing education. Certain restrictions and
documentation requirements apply. See Regs. 88, 88.1, 88.2 and 89.
• At least 40 hours of the total 80 hours must be earned in accounting, auditing,

taxation, consulting, financial planning, professional conduct, computer and
information technology (except word processing) or specialized industry or
government practices focusing on maintenance and/or enhancement of public
accounting skills and knowledge for competently practicing public accounting. See
Reg 88(a)(1). If the Board approves regulations proposed in January 2009, for
license renewals after December 31, 2011, at least 12 hours of the 20-hour annual
minimum must be earned in these subjects.
• Interactive self-study programs earn eight hours credit for eight hours of interactive
study. See Reg. 88.2(c)
• Board of Accountancy Regulation 90 provides limited exceptions to continuing

education requirements. Possible exceptions, with Board approval include health,
military service, death of spouse or child, extreme financial hardship, and natural
disaster. Inactive status is another exception as explained below.
• CPA licenses may be active or inactive. A CPA must have an active license in order
to practice public accountancy.
• To maintain an active license, a CPA must renew and complete continuing education
requirements by the expiration date.

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• Although continuing education is not required for inactive licenses, renewal is still
required. (Reg. 80)
• Returning to active status from inactive status requires Board notification and
completion of the continuing education requirements.
• In its Spring 2007 Update newsletter the Board published a list of questions a CPA
can ask to determine which programs qualify for CPE credit:
Live Presentations:
• Does the provider retain attendance records?
• Does the provider have written educational goals and specific learning objectives,
as well as a syllabus?
• Does the provider issue certificates of completion?
Self-Study:
• Does the provider have written educational goals and specific learning objectives,
as well as a syllabus?
• Does the provider require a passing score on a test given at the conclusion of the
course or program?
• Does the provider issue certificates of completion?
• Is the course or program interactive?
For a course or program to be considered interactive, it must meet the following

criteria:
• Require frequent participant response to questions that test for understanding of
the material presented.
• Provide evaluated feedback to incorrectly answered questions by specifying why
the answer is wrong.
• Provide reinforcement feedback to correctly answered questions by restating why
the answer is correct.
Webcast:
• The Board accepts Webcast courses and programs provided they mirror the
requirements for a live presentation course or program.

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Test Your Knowledge: AICPA Ethics Rules
Chose the best answer from the alternatives.
Independence
1. Performing any bookkeeping services always impairs the independence of:

A) A CPA who audits the financial statements of a publicly held company.
B) A CPA who audits the financial statements of a company that is not publicly
held.
C) Neither A nor B.
D) Both A and B.
2. Performing which of the following bookkeeping services impairs the independence

of a CPA who audits, reviews or compiles the financial statements of a company
that is not publicly held?
A) Recording journal entries approved by management.
B) Proposing journal entries.
C) Preparing source documents.
D) None of the above.
3. Performing which of the following payroll services impairs the independence of a

CPA who audits, reviews or compiles the financial statements of a company that is
not publicly held?
A) Preparing payroll checks based on time reports and other information provided
and approved by management.
B) Submitting employees’ wage rates, time worked, and other information needed
to create payroll disbursements to a financial institution and authorizing the
financial institution to make direct deposits to the employees’ accountants.

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C) Preparing payroll tax returns that are signed by management.
4. Performing which of the following consulting services impairs the independence

of a CPA who audits, reviews or compiles the financial statements of a company
that is not publicly held?
A) Helping a client assess the client’s business and control risks.
B) Designing and recommending improvements to control procedures.
C) Presenting business risk information on behalf of management to investors.
D) Helping management develop business strategies.
5. T/F: An auditor’s independence is impaired when a client threatens to sue an

auditor alleging deficiency in audit work.
6. T/F: Independence will be impaired when a client employs the CPA’s

nondependent brother as controller.
7. When do unpaid audit fees from the prior year impair a CPA’s independence with
respect to the audit for the current year?
A) The fees remain unpaid at the beginning of fieldwork
for the current year.
B) The fees remain unpaid when the engagement letter is signed for
the current year.
C) The fees remain unpaid upon completion of fieldwork.
E) The fees remain unpaid when the current year financial statements are issued if
the prior year fees are for services performed more than one year before the
date of the current year report.
8. T/F: Seeking employment with a client impairs a CPA’s independence.

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9. T/F: Acceptance of free lodging, meals and entertainment at a client-owned resort

may impair a CPA’s independence.
Confidentiality
10. T/F: AICPA confidentiality rules prohibit disclosing the name of a client without
the client’s permission.
Test Your Knowledge: California Accountancy Act

and Regulations
Employment with an Audit Client
1. In what circumstances does the Accountancy Act restrict a CPA from accepting
employment with a company that is an audit client?
A) The restriction applies to publicly traded companies.
B) The restriction applies to publicly traded and private companies.
C) The restriction applies to all job positions with the company.
D) The restriction applies only to partners.

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Confidentiality
1. Which of the following actions is not permitted under the California Accountancy
Act?
A) Disclosure of confidential information about a client with the client’s oral

permission.
B) Disclosure of confidential information about a client with the client’s written
permission.
C) Disclosure of confidential information about a client to another CPA firm
without the client’s permission in connection with communications pertaining
to the sale or merger of the CPA’s practice.
D) Disclosure of confidential information in connection with a peer review
without the client’s permission.
Commissions
1. T/F: The Accountancy Act prohibits the payment of commissions to obtain

clients.
2. Which of the following transactions does the law pertaining to commissions

prohibit?
A) Purchase of an accounting practice in which the purchase price is based on the
first year’s actual fees for services.
B) Payment of a commission to a real estate broker for the sale of your home if
the broker is an audit client.
C) Giving a tax client a discount for referring a new client to you.
3. T/F: The Accountancy Act permits acceptance of a commission for

recommending a product or service to a client if certain conditions are met.
4. Which of the following transactions does the law pertaining to commissions

permit?

2-15
A) Accepting a commission from a software vendor for the sale of accounting

software package to an audit client as part of a consulting engagement
pertaining to the client’s accounting system.
B) Accepting a commission from a software vendor for the sale of accounting
software package as part of a consulting engagement as long as the
commission is properly disclosed to the client and as long as the CPA does not
perform an audit, review, or compilation of historical financial statements or an
examination of prospective financial information for the client.
C) Accepting a commission from an insurance company for referring a client for
whom the CPA performs only tax services.
D) Accepting a free week at a tropical resort from a lawyer to whom a CPA has
referred numerous clients.
Contingent Fees
1. T/F: Regulations prohibit contingent fees for any services that require
independence, preparation of tax returns, or provision of expert testimony.
2. For which of the following services can a CPA charge a contingent fee?
A) attest services for an audit client that are not related to the financial statements
B) attest services for which the CPA does not perform any other services that
require independence
C) nonattest services for an audit client
D) nonattest consulting services for a company for which the CPA does not
perform any other services that require independence
Continuing Education
1. T/F: CPAs engaged in the practice of public accountancy are required to complete
at least 80 hours of continuing education during the two years preceding their
license renewals.

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2. T/F: At least 40 hours of the total 80 hours must be earned in courses that focus on
maintenance and/or enhancement of public accounting skills and knowledge for
competently practicing public accounting (e.g., accounting, auditing, taxation,
financial planning, etc.)
3. T/F: Continuing education hours in excess of the minimum requirement may be

carried over to the next two-year period.
4. T/F: A CPA who performs one compilation per year must complete at least 24
hours of continuing education related to accounting and auditing during the two
years preceding license renewal.
5. T/F: Continuing education courses that satisfy the 24-hour governmental education
requirement usually also satisfy the 24-hour accounting and auditing requirement.
6. T/F: Under regulations effective for renewing active licenses in 2009, CPAs must
have completed an ethics course such as this one within the last six years.
7. During the last year a CPA performed compilations of businesses and audits of
government entities. It has been six years since the CPA last completed an ethics
course. So far the CPA has completed 60 hours of continuing education related to
income taxes. At a minimum, what does the CPA need to complete the continuing
education requirements for renewing an active license in 2009.
A) 24 hours of government, 24 hours of other accounting and auditing, and 8
hours of fraud detection or reporting on financial statements
B) 8 hours of ethics, 24 hours of governmental, and 8 hours of fraud detection or
reporting on financial statements
C) 8 hours of ethics, 24 hours of accounting and auditing area, and 8 hours of
fraud detection or reporting on financial statements

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D) 8 hours of ethics, and 24 hours of governmental including 8 hours pertaining to

fraud detection or reporting on financial statements
8. T/F: Continuing education records must be kept for three years after a continuing
education seminar.
9. Which of the following actions is legal if a CPA has not completed continuing
education requirements by the expiration date of the CPA’s license?
A. Stopping the practice of public accountancy.
B. Continuing to practice and renewing the license selecting inactive status.
C. Continuing the practice of public accountancy and completing the education
within the 30 day grace period.
D. Continuing the practice of public accountancy only in areas that do not require
independence.
10. T/F: A CPA who has completed the continuing education requirements may
continue to practice public accountancy past the expiration date of the CPA’s
license as long as license renewal fees are paid within 30 days.
11. T/F: Although continuing education is not required for inactive licenses, renewal is
still required.
12. T/F: To return to active status from inactive status, a CPA must notify the Board of
Accountancy and complete 80 hours of continuing education prior to practicing
public accountancy.

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TR 2-1
AICPA Ethics Rules
Rule Title
101 Independence
102 Integrity and objectivity
201 Competence, due care, planning and
supervision, and sufficient relevant data
202 Compliance with professional standards
(e.g., auditing standards)
203 Compliance with GAAP
301 Confidentiality
302 Contingent fees restricted
501 Discreditable actions
502 Advertising and other solicitations
503 Commissions and referral fees
505 Form of organization and name

2-19
TR2-2
Providing Nonnattest Services to Attest Clients
• Bookkeeping and consulting are permitted, if

otherwise legal
• CPA must not assume management role
• Written understanding with client required

2-20
TR 2-3
Commissions
and Contingent Fees
• Commissions are permitted if conditions are

met (5061)
• Contingent fees are prohibited for most services

(Reg. 62)

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TR 2-4
CE Requirements in 2009
• 80 hours total, every two years
• 40 hours of professional topics
• 24 hours governmental, if applicable
• 24 hours accounting and auditing, if
applicable
• 8 hours detecting fraud or reporting on
financial statements, if applicable
• 8 hours ethics, every six years
• Provide list with renewal
• Keep records for 4 years after license
renewal
• Effective in 2012 (if regs are approved,) 20-hour
minimum annually
• Effective in 2010 (if regs are approved), 4-hour
biannual ethics minimum and 2-hour regulatory
review every six years.
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TR 2-5
Possible CE Exceptions
• Health
• Military service
• Death of spouse or child
• Extreme financial hardship
• Natural disaster
• Inactive status

2-23
TR 2-6
License Status (5051)
· Active
·· legal to practice under your name
·· must renew by expiration date
· Inactive
·· not legal to practice
·· renewal still required
·· CE not required

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TR 2-7
Return to Active Status
• Meet CE requirement
• Notify Board

2-25

2-26
Accountancy Laws: Licensing and Enforcement
Chapter 3
Accountancy Laws: Licensing and
Enforcement
Objectives
• Maintain a license under the California Accountancy Act and Regulations.
• Recognize the most common violations of California accountancy laws.
• Be aware of the disciplinary actions to which CPAs are subject in California.
Readings/References
• California Accountancy Act and Regulations.
Key Points
Use of CPA designation
• No person or partnership may use a CPA designation unless they hold an active
license. (Accountancy Act 5055 and Reg. 87a)
Exceptions: The holder of a CPA license in inactive status who is not practicing
public accountancy and is employed in private industry, government, or education
may use the CPA designation in connection with that employment. The holder of a
CPA license in inactive status may perform the activities in Section 5051 (f)-(i) if
he or she does so without using the CPA designation or the designation “inactive
CPA.” (Source: Update, Issue No. 37, Jan/March 1998)

3-1
• To practice as a partnership, CPAs must register with the Board of Accountancy in

accordance with Accountancy Act Sections 5072 and 5073. Each CPA partner must
be a CPA in good standing in some state and at least one partner must be registered in
California. In addition, each partner engaged in public accounting within California
must hold an active license in California.
Retired Status
• Retired CPAs may keep their CPA certificate without continuing to renew their
licenses as long as they apply for permission to the Board and do not practice public
accountancy. (See UPDATE Issue No. 40, on page 7.) The law permits retired CPAs
to display their certificates and use the CPA designation for non-business purposes.
License Cancellation
• A license that is not renewed within five years after its expiration is cancelled. It may
not be renewed, restored or reinstated.
• After a certificate is cancelled, obtaining a certificate requires retaking a CPA exam

or otherwise establishing to the Board’s satisfaction that the CPA is qualified to
engage in public practice. (See Accountancy Act Section 5070.7)
Reportable Events
• Crime convictions and license cancellations by other states and several other events
must be reported to the Board of Accountancy in writing within 30 days. See
Accountancy Act Section 5063. Reportable events include:
• conviction of any felony

• any conviction related to practice as CPA
• any conviction involving stealing or fraud
• license cancellation by other state or foreign country

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• cancellation of rights to practice as CPA before any government
• In addition, any of the following events must be reported in writing to the Board
within 30 days of the date the licensee has knowledge of the events:
1. Any restatement of a financial statement and related disclosures by an audit client.
2. Any civil action settlement or arbitration award against the licensee relating to the
practice of public accountancy where the amount or value of the settlement or
arbitration award is thirty thousand dollars ($30,000) or greater and where the
licensee is not insured for the full amount of the award.
3. Any notice of the opening or initiation of a formal investigation by the Securities

and Exchange Commission or its designee.
4. Any notice from the Securities and Exchange Commission requesting a Wells
Submission.
5. Any notice of the opening or initiation of an investigation by the Public Company

Accounting Oversight Board or its designee.
• In addition, a licensee must report to the board in writing any judgment against the
licensee in any civil action alleging any of the following items within 30 days of the
entry of the judgment.
1. Dishonesty, fraud, gross negligence, or negligence.
2. Breach of fiduciary responsibility.
3. Preparation, publication, or dissemination of false, fraudulent, or materially

misleading financial statements, reports, or information.
4. Embezzlement, theft, misappropriation of funds or property, or obtaining money,

property, or other valuable consideration by fraudulent means or false pretenses,
or other errors or omissions.

3-3
5. Any actionable conduct by the licensee in the practice of public accountancy, the
performance of bookkeeping operations, or other professional practice.
• The Board has adopted regulations to provide additional guidance related to the self-
reporting process. (See sections 59, 60 and 61 in Appendix D):
Change of Address
• The Board of Accountancy allows individual CPAs and firms 30 days to notify the
Board in writing of changes to their address of record. A notification form is
published regularly in the Board’s newsletter, Update. It may be mailed or faxed to
the Board. (Reg. 3)
• Failure to notify the Board of such changes may result in a citation and fine.
Name Style
• A CPA must practice the name as set forth on his or her permit to practice unless
another name has been registered and approved by the Board of Accountancy.
(Accountancy Act Section 5060 and Reg. 67)
Retention of Client Records
• CPAs are not permitted to retain client records under any circumstances when a client
has demanded their return.
• A CPA may not retain client records to pressure clients to pay fees. The working
papers prepared by a CPA are considered property of the CPA. However, if the CPA
prepares journal entries, reconciliation or other calculations and analyses, those
working papers are treated the same as client records. Accordingly, clients are
entitled to have copies of those working papers. (Reg.68)

3-4
• The AICPA ethics rules allow a CPA more leverage when fees are not paid. Under
those rules, client-provided records must be returned on demand, but records prepared
by the CPA may be withheld until the fees are paid for the engagement in which those
records were prepared.
Nonlicensee Ownership
• CPA firms may have nonlicensed owners under certain conditions which require,
among other things, majority ownership by CPAs, participation in the business of the
firm by all owners, and CPA responsibility for attest and compilation engagements.
See Section 5079 of the Accountancy Act. The law is intended to enable CPAs to
offer a wide range of professional services and to retain and appropriately compensate
highly skilled non-accounting professionals.
• Firms with nonlicensee owners are required to disclose to their clients the actual or
potential involvement of nonlicensee owners in the services provided.
• The Board has adopted regulations to provide additional guidance. (Reg. 57.5)
Display of CPA License
• Board of Accountancy Regulation No. 50 requires a CPA to notify his or her clients
that the CPA is licensed by the Board of Accountancy. This rule is satisfied merely
by displaying the license in the office of the CPA, but may also be satisfied by several
other ways listed in the regulation.

3-5
Practice Privilege for Out-of-State CPA’s
Until the end of 2005, an individual CPA licensed in another state could practice in
California without a California license and without paying any fee, provided that the
practice is “temporary and incidental” to the CPA’s practice in another state. Beginning
January 1, 2006, such CPA’s are required to meet certain qualifications, notify the Board
of Accountancy and pay a fee to obtain the privilege to practice in California. CPA’s
who practice in California under this law do not have all of the rights of a California
CPA, but the Board has more control over their practice of accountancy in the state.
(Accountancy Act, Section 5096-5096.10, and related regulations)
Section 5054 provides an exception that allows individuals who moved to California
from another state to continue using a CPA from another state that had been preparing
their tax returns before they moved. An out-of-state CPA can prepare tax returns for
these individuals and their estates without a California license or practice privilege as
long as the CPA does not physically enter California, does not solicit any California
clients, and does not assert or imply that the CPA has a license or registration to practice
public accountancy in California.
Audit Documentation
• The Accountancy Act (Section 5097) requires CPAs to prepare and retain audit
documentation for at least seven years showing:
1. the nature, timing, extent, and results of the procedures performed,

2. evidence obtained,
3. conclusions reached,
4. persons who performed and reviewed the work.
• If no documentation exists, the law assumes that no work was done.
• The Board has adopted regulations to provide additional guidance. (See sections 68.2
- 68.5 in Appendix D)

3-6
• Regulation 68.3 clarifies that the “report date” is the issuance date or release date
of the report.
• Regulation 68.4:
• Clarifies that the document assembly period is the 60-day time period
subsequent to report issuance.
• Specifies that audit documentation not completed before report issuance must
be completed during the document assembly period.
• Prohibits deletions, substitutions, or editing of audit documents after the
document assembly timeframe ends.
• Requires that additions to audit documents made after the document assembly
timeframe ends comply with existing professional standards as well as
include the following information: date of the addition, reason for the
addition, and the identity of both the person making the addition and the
person approving the addition.

3-7
Disciplinary Actions under the California Accountancy Act
• Relatively minor violations of the California Accountancy Act and Regulations result
in citations and fines.
Common Citations
Law Problem
5050 Practicing without an active license
5055 Using CPA title without active license
Reg. 67 Using an unregistered fictitious name
Reg. 87 Not meeting CE requirements
Reg. 89 Incorrectly reporting CE
Reg. 3 Failure to report address changes
• More serious violations result in prosecution and stiff penalties.
Examples of Cases Brought to Accusation
• Theft
• Embezzlement
• Extreme departures from GAAP & GAAS
• Fraudulent financial information
• Insider trading
• A particular focus of this course is dishonesty. Along with incompetence, dishonesty

is the most common serious charge made against CPAs.
Examples
• Fraudulent financial statements
• Fraudulent tax returns
• Breach of fiduciary responsibility

3-8
• Gross negligence in financial statements and tax returns

• Embezzlement
• Preparing false documents
• Working paper ownership disputes and illegal retention of client records also result in
complaints.
• The Board has an active Enforcement Program that receives about 500 to 600
licensee-related complaints each year. The Board’s Enforcement Program takes an
aggressive approach towards those licensees who violate provisions of the
Accountancy Act.
• Historically, about half of the complaints are generated by consumers, one-fourth by

CPA’s complaining about other CPAs and one-fourth by the Board itself. The Board,
through its staff and Administrative Committee, may initiate investigations of
licensees with or without the filing of a complaint by an outside party. For example,
the Board initiates complaints based on results of random audits of CPE and on
financial statements submitted by practitioners to the Board for evaluation.
• The primary options available to the Board for imposing discipline include
specifically mandated continuing professional education, citations and fines, or
formal accusations. Formal accusations are used for more substantive violations and
typically lead to license revocation or a term of probation, which may include a
period of license suspension. Complaint information is not disclosed to the public
unless an accusation is filed or a citation is issued.
• Complaints involving competency issues are generally investigated by staff CPAs

who are trained in both investigative techniques and the technical issues of the
profession of public accounting. Case investigations typically involve the receipt of
information from both the complainant and the licensee.
• Specific laws and regulations governing the authority and operation of the Citation
Program are contained in Business and Professions Code (B&P) and California Code

3-9
of Regulations (Reg.). A citation may be viewed as a legal means by which the

Board can impose enforcement action upon a licensed or unlicensed individual or
entity found to be in violation of a law or regulation governing a licensed profession.
Unless contested, a citation does not typically involve the courts, the Attorney
General, the District Attorney, or the Office of Administrative Hearings. Citations
may contain administrative fines as well as an order of abatement or correction. The
Executive Officer’s decision to issue a citation is determined by the evidence at hand
and related mitigating or aggravating factors; for example, a history of previous
violations. Supporting information and/or documentation for issuing citations must
include sufficient evidence to support each violation and justify any penalty
assessments.
• When the Board receives a complaint, it conducts a thorough investigation.

Information is gathered by staff investigative CPAs and in some cases by the
Department of Consumer Affairs’ Division of Investigation. The Administrative
Committee makes a recommendation to either close the case for lack of evidence, or
to refer the matter to the Attorney General for preparation of an Accusation against
the licensee which may lead to suspension or revocation of the license. Section 5100
of the Accountancy Act defines the general grounds for such action. In addition,
violation of certain sections of the Business and Professions Code or Board of
Accountancy Regulations can also lead to disciplinary action. If charges are filed, a
hearing is held before an independent administrative law judge who submits a
proposed decision to be considered by the Board. The Board may either adopt the
proposed decision or decide the matter itself by requesting a transcript of the hearing.
In some instances, licensees enter into a stipulated settlement agreement in lieu of
going to hearing.
• The Board’s publication, Update, reports causes for disciplinary actions taken against
licensees. Examples of disciplinary actions follow.

3-10
Examples of Disciplinary Actions
• The Board of Accountancy has provided the following examples of actions that
resulted in license revocation. For other examples, see Update published by the
Board of Accountancy and mailed to all California CPAs.
• Failing to comply with probation terms including requirements to appear at
probation interviews, provide information, and make payments for fines and
restitution.
• Committing felony grand theft by embezzling money from several clients.
• Issuing an audit report that departed materially from GAAS by using
outdated report language, omitting a statement of cash flows and not
including a summary of significant accounting policies.
• Writing excess payroll checks to himself. After discovery, promising to
repay and then defaulting.
• Providing false information in a Form 10-Q and insider trading.

3-11
Test Your Knowledge
Select the best answer from the alternatives.
Use of CPA Designation
1. Which of the following actions is permitted for a CPA whose license is inactive?
A) Using the CPA designation as an employee rather than as a partner in a CPA
firm.
B) Engaging in occasional practice of public accountancy that does not involve
attestation.
C) Using the CPA designation in connection with employment in industry,
government or education.
D) None of the above.
2. T/F: CPAs who hold active licenses may practice as a partnership without
registering the partnership with the Board of Accountancy.
Name Style
3. T/F: CPAs must practice under the name set forth on his or her permit to practice
unless another name has been registered with the Board of Accountancy.
Nonlicensee Ownership
4. T/F: A person or partnership or corporation may own a minority interest in a CPA

firm and not participate in the business of the firm.
5. If a CPA firm has one owner who is licensed as a CPA, how many nonlicensed
owners can the firm have?
A) one nonlicensed owner as long as the CPA owner has more than half of the
equity capital and majority voting rights.

3-12
B) an unlimited number of nonlicensed owners as long as the CPA owner has

more than half of the equity capital and majority voting rights.
C) no nonlicensed owners because licenses must comprise a majority of owners.
D) an unlimited number of nonlicensed owners as long as the CPA owner has
ultimate responsibility for professional services.
6. T/F: In a firm that has nonlicensee owners, a CPA must have ultimate
responsibility for each financial statement audit engagement.
7. T/F: Firms with nonlicensee owners are required to disclose to their clients the
actual or potential involvement of nonlicensee owners in the services provided.
Retired Status
8. T/F: Retired CPAs may practice public accountancy occasionally (such as

preparing a few tax returns) without continuing to renew their licenses as long as
they apply for permission from the Board.
License Cancellation
9. T/F: If a CPA does not renew a license within five years after its expiration, the
CPA must obtain a new license before practicing public accountancy again.
Reportable Events
10. Which of the following items is not an event that must be reported to the Board of
Accountancy in writing within 30 days?
A) conviction for a felony
B) a misdemeanor conviction for stealing or fraud
C) a misdemeanor conviction for assault
D) license cancellation by another state

3-13
11. Which of the following items is not an event that must be reported to the Board of
Accountancy within 30 days?
A) A restatement of a financial statement for an audit client
B) A restatement of a financial statement for a compilation or review client.
C) A civil action settlement award against the licensee for $30,000 that is not fully
covered by insurance.
D) Any notice of the opening or initiation of an investigation by the SEC.
Change of Address
12. T/F: When a CPA has a change of address of record the CPA must notify the
Board of Accountancy within 30 days.
13. T/F: Failure to notify the Board of such changes may result in citations and fines.
14. How long is a CPA permitted to retain client records?

A) seven years
B) until the engagement is completed
C) until fees are collected
D) until the client demands that they be returned
15. Which of the following items in a CPA’s working papers would be considered a
client record of which the client is entitled to have a copy?
A) journal entries proposed by the CPA and approved by the client
B) confirmation letters received from client customers
C) memoranda prepared by the CPA documenting management’s responses to
inquiries made in connection with a review of the financial statements
D) all of the above

3-14
Display of CPA License
16. T/F: A CPA must provide notice to his or her clients that the CPA is licensed by
the Board of Accountancy.
Practice Privilege for Out-of-State CPA’s
17. T/F: Out-of-state CPA’s are generally required to meet certain qualifications,
notify the Board of Accountancy and pay a fee to obtain the privilege to practice in
California.
Audit Documenation
18. Under the Accountancy Act, what automatically happens if audit documentation
omits information about evidence obtained in an audit?
A) the omission raises a presumption that the evidence was not obtained.
B) the omission raises a presumption that the financial statements are misstated
C) the auditor’s report must be recalled
D) the auditor’s license is revoked
19. How long must audit documentation be retained?

A) Three years
B) Seven years
C) Seven years, unless a longer period is required to satisfy professional standards
and to comply with applicable laws and regulations.
D) As long as is required to satisfy professional standards and to comply with
applicable laws and regulations, but not more than seven years.

3-15
TR 3-1
Use of CPA Designation

(5055)
· Requires active license
· Partnerships must be registered with Board

3-16
TR 3-2
Name of Firm
(5060 & Reg. 67)
· Name shown on permit to practice
· Fictitious names require approval

3-17
TR 3-3
Retirement
• Notify board
• Use CPA designation for non-business purposes
only

3-18
TR 3-4
License Cancellation (5070.7)
· Automatic after 5-year nonrenewal
· May apply for new certificate

3-19
TR 3-5
Reportable Events
(5063)
Original List
· Felony conviction
· Any conviction related to practice as CPA
· Any conviction involving stealing or fraud
· License cancellation by other state
· Cancellation of rights to practice as CPA

before any government

3-20
TR 3-6
Reportable Events (5063)

Items added by 2002 reforms:
• Certain financial statement restatements
• Uninsured litigation settlements more than $30,000
• SEC investigations
• Public Company Accounting Oversight Board

investigations
• Judgments against a CPA involving:
Dishonesty, fraud, gross negligence, or negligence.
Breach of fiduciary responsibility.

3-21
False, fraudulent, or materially misleading financial

statements, reports, or information.
Embezzlement, theft, misappropriation

3-22
TR 3-7
Change of Address (Reg. 3)
· Notify Board within 30 days
· Use form in UPDATE

3-23
TR 3-8

(Reg. 68)
· Return to client upon demand
· No exception for unpaid fees
· Certain working papers are considered client

records

3-24
TR 3-9
Audit Documentation (5097)
Presumption: Not documented, not done
Minimum retention period: 7 years or longer

3-25
TR 3-10
Most Common Complaints
DISHONESTY & INCOMPETENCE
Includes:
· Fraudulent financial statements
· Fraudulent tax returns
· Breach of fiduciary responsibility
· Gross negligence in financial statements
and tax returns
· Embezzlement
· Preparing false documents

3-26
TR 3-11
Other Common Complaints
· Working paper ownership disputes & illegal

retention of client records
· Practicing without an active license
· Unregistered partnerships & firm

names

3-27
TR 3-12
Common Citations
Law Problem
5050 Practicing without an active license
5055 Using CPA title without active license
5071 Practicing in an unregistered partnership
Reg. 67 Using an unregistered fictitious name
Reg. 87 Not meeting CE requirements
Reg. 89 Incorrectly reporting CE
Reg. 3 Failure to report address changes

3-28
TR 3-13
Cases Brought to Accusation
· Theft
· Embezzlement
· Extreme departures from GAAP & GAAS
· Fraudulent financial information
· Insider trading

3-29

3-30
Fairness in Tax Returns and Financial Statements
Chapter 4
Fairness in Tax Returns and Financial
Statements
Objectives

• Identify the ethical threshold for positions taken in tax returns.
• Identify the criteria for evaluating the fairness of financial statements.
• Contrast the ethical thresholds for positions taken in tax returns and financial
statements.
Readings/References
• AICPA Statements on Standards for Tax Services located at

http://www.aicpa.org/download/tax/SSTSfinal.pdf
• AICPA Statement on Auditing Standards No. 69, AU 411
Key Points
Positions Taken in Tax Returns
Positions Taken in Tax Returns - Old Rules

• For many decades, the realistic possibility standard was the rule recognized by the
AICPA, the American Bar Association and the Internal Revenue Code concerning the
ethics of tax positions that CPAs recommend to their clients. Generally, it prohibited
recommending a position unless the CPA had a good faith belief that if the position is
challenged by the IRS it has a realistic possibility of being sustained on its merits.
• There was only one exception to the realistic possibility standard: If a position did not
satisfy the realistic possibility standard, it may still be ethical if it is not frivolous and if it
is properly disclosed in the tax return.

4-1
Positions Taken in Tax Returns - 2007 Revisions
The Small Business and Work Opportunity Tax Act of 2007 amended section 6694(a) by
raising the standards of conduct for tax return preparers. The IRS has summarized the
law as follows:
• For undisclosed positions, the Act replaced the realistic possibility standard with a
requirement that there be a reasonable belief that the tax treatment of the position
would more likely than not be sustained on its merits.
• For disclosed positions, the Act replaced the nonfrivolous standard with the
requirement that there be a reasonable basis for the tax treatment of the position.
• The amendments made by the Act did not modify the exception to liability under
section 6694 that is applicable when it is shown, considering all the facts and
circumstances, that the tax return preparer has acted in good faith and there is
reasonable cause for the understatement.
Positions Taken in Tax Returns – Current Rules
The Emergency Economic Stabiliation Act of 2008 superseded the 2007 requirement.
The current rule is:
• Undisclosed positions must have substantial authority.
• Disclosed positions must have a reasonable basis.
• Exception: If the position involves a tax shelter or reportable transaction, there must
be a reasonable belief that the position would more likely than not be sustained on its
merits if challenged.
Note about FIN 48: The FASB’s Interpretation No. 48, which applies to its standard for
accounting for income taxes, requires separately classifying and disclosing the effects of
aggressive tax positions. (See FASB ASC 740-10-50-15.) It does not make aggressive
positions unethical or less ethical. It does not change or in any way affect the ethical

4-2
standards for tax return preparation. Nevertheless FIN 48 may increase the chance that
the IRS will identify aggressive positions and that increased risk may discourage
management from taking aggressive positions even though it is legal and ethical to take
them. FIN 48 normally only affects C-Corporations because S- Corporations and other
pass-through entities normally do not report significant amounts of income taxes in their
financial statements.
Fair Financial Statements
• Fairness is defined by SAS 69.
• GAAP is defined as those standards included in the FASB Accounting Standards

Codification.
• Disclosure of a GAAP departure generally does not make the departure proper in the
way that disclosure of a tax position makes it proper to take an aggressive tax
position.
• Fairness requires complying with GAAP (or OCBOA), choosing appropriate

accounting methods where options exist, presenting financial statements and notes
informatively, classifying and summarizing information in a reasonable manner, and
presenting amounts, descriptions and other information that is materially correct.
• Information is material if its omission or misstatement would change or influence the

judgment of a reasonable person relying on it.
• Quantitative considerations (usually dollar amount), qualitative considerations

(usually the nature of the item) and surrounding circumstances (e.g., potential effects
of the information) affect judgments about materiality.
• Whether or not window dressing techniques are ethical depends on the action
involved and on the surrounding circumstances. Actions that may be ethical include:
1) Changing operations
2) Changing contracts

4-3
3) Reassessing the facts and circumstances

4) Reconsidering an interpretation of accounting principles
5) Revising an estimate
6) Changing an accounting method
7) Correcting an error
• Arbitrary adjustments, intentional misstatements or omissions and sham transactions

are not ethical.
Test Your Knowledge
1. What is the current rule for positions taken in tax returns?

A) A position must have a realistic possibility of being sustained on its merits if
challenged.
B) If undisclosed, the position must have substantial authority.
C) If undisclosed, it must be more likely than not that the position will be sustained
on its merits if challenged.
D) The position must be unlikely to be detected in an audit.
2. T/F: A tax preparer can recommend a position to a taxpayer that is less than likely to
be sustained on its merits if challenged as long as the position has a reasonable basis and
is properly disclosed.
3. T/F: Disclosure of a GAAP departure in a note to financial statements generally does

not make the departure proper in the way that disclosure of a tax position makes it proper
to take an aggressive tax position.
4. Which of the following actions would always be considered unethical?

A) Revising the financial statements for a change in an estimate after the books
have been closed.
B) Not disclosing an immaterial change in an accounting method.

4-4
C) Intentionally misstating the financial statements by an immaterial amount.

D) All of the above would always be considered unethical.

4-5
Case Problem 1
A CPA is a controller for a privately owned company, an S-Corporation. For ten years
the company has engaged a small CPA firm to review the company’s financial
statements. That CPA firm has also prepared the corporate tax returns and the individual
tax returns for the company’s owner. The company has been expanding its operations
and its needs for external financing have grown over the years to the point that now the
company needs an audit rather than a review. The company’s owner asked the controller
to obtain bids for the audit of the company from several firms and then arrange a meeting
with the owner and the partner from the two firms with the lowest bids. During the
meeting with one of the firms, a tax partner who accompanied the audit partner said,
“Our firm works with a lot of high net-worth individuals and I would like give you a
proposal to do the corporation’s and your personal tax work as well.” The owner said,
“Fine, the controller can give you my prior tax returns and explain my situation to you,
and I will consider your proposal.”
Later when the firm made the proposal the tax partner said that his firm would be able to
substantially reduce the owner’s taxes. When the owner asked what would be involved,
the tax partner said, “Your tax returns have been prepared conservatively and we know
how to be more aggressive. If you hire us I can explain in detail what we would do
differently.” The owner said she would like to think about it.
After the meeting and at the owner’s request, the controller phoned the CPA who had
been doing the tax return for the owner. The controller explained what was said during
the meeting and asked the CPA if he had any idea what the other firm was thinking about
doing. The CPA said that he did not know specifically what the other firm had in mind,
but that he has heard that the other CPA is very aggressive, so aggressive that the IRS
probably does not approve of many of the techniques. The CPA said that he believes that
the company is now paying taxes as low as can be supported under the law and that
becoming more aggressive would expose the company and the owner to expensive,
stressful IRS audits and penalties.

4-6
When the controller relayed the information back to the owner, she said, “What do you
think I ought to do?” Later the owner asked the independent CPA who had been
preparing her tax returns the same question.
What would you say?

4-7
Case Problem 2
A company is not having a good year. Two months before year-end, management
expects profits to be down 10 percent from the prior year because bad weather reduced
sales and a series of unfortunate events increased various expenses. This year’s lower
profits will break a five-year upward trend. Management hopes to sell an interest in the
company to an investor in the near future and is afraid the income slump will reduce
stock prices and that the Board will award smaller bonuses.
The president asked the CFO to think of ways to increase profits and the CFO proposed
the following actions:
a. Use a sales promotion that will involve giving rebates to customers who make
purchases before year-end. The marketing director estimated that such a program
would boost profits by 2% primarily by encouraging customers to buy goods that they
would otherwise not buy until next year. As a result, sales will be lower during the
next year potentially reducing profits that year by 4%. (Essentially, the rebate lowers
profitability over the two-year period by 2%.)
b. Accelerate product shipments. Normally it takes 10 days to fill a customer order.

That could be reduced to 6 days near year-end. This would increase profits by 2
percent. The shipping supervisor said the acceleration is feasible, but will require
several people to work overtime and cancel vacations during the year-end holiday
period and will adversely affect morale.
c. Postpone scheduled plant maintenance until next year increasing profits by 2 percent.
The plant manager opposes this action because she is concerned that delaying
maintenance will increase safety risks and may cause higher maintenance costs
during the next year, but is not able to quantify these effects. She says it is not right
to quantify safety risks.
d. Reduce the allowance for uncollectible accounts. This will increase net income 2
percent. The accounting supervisor does not believe it is right to reduce the

4-8
allowance. He said he calculated the allowance the same way he has always
calculated it. The controller said the allowance is just an estimate and it is possible to
support a smaller allowance. Although accounts receivable aging statistics are
comparable to prior years, recent write-offs have been somewhat lower than average.
e. Record certain costs as prepaids that have been charged to expense in prior years.
This would increase net income by 2 percent. The controller said that the costs have
been expensed in prior years because he considered them immaterial, but that the
costs do benefit future periods. He said that it would not be necessary to disclose this
change in accounting method because the effect is immaterial.
f. Reduce depreciation expense by lengthening the estimated useful lives of certain

equipment. This would increase net income by 2 percent in the current year. The
controller said the useful lives are not precise estimates and immaterial changes like
this do not require disclosure. The plant manager said it is possible to use the
equipment longer only by incurring additional maintenance expenses in future years.
The plant manager is not able to quantify this effect.
In your opinion, what issues bear on the ethics of management’s decision? Explain how
each of the strategies might be justified ethically and how each might be considered
unethical. Weigh the issues and choose which, if any, of the strategies you find
acceptable. Explain your conclusions.

4-9
Case Problem 3
Four days after year-end the controller and the assistant controller of a company met with
the CFO to review the financial results for the year. Profits were down 3 percent from a
forecast that had been presented to the Board and that the CFO had relayed to investors
and lenders in December. The CFO asked the controller to fix this problem. The
controller told the CFO that she did not think there was anything that could be done, but
that she would double check and let the CFO know. The CFO said, “I don’t want to hear
that. Just say you’ll fix it. You have my authorization and I will take responsibility for
this decision.” The controller then said nothing, left the meeting, made adjustments to
loss contingency accruals sufficient to make income approximately equal to the forecast,
and prepared a memorandum to support the lower accruals. The assistant controller said
nothing during the meeting with the CFO, but after leaving the meeting he told the
controller that she was on her own, and that he would not sign the journal entries because
he believed the entries to be dishonest.
In your opinion, what are the ethical issues in this case? What are the responsibilities of
the CFO, controller and assistant controller? Discuss the behavior of the CFO, the
controller and the assistant controller from an ethical perspective. Also describe how
each person might have handled this situation more ethically.

4-10
TR 4-1
Standard of Conduct for Tax

Preparers
Generally, to be ethical, a position taken in a tax

return must have substantial authority.

4-11
TR 4-2
Exception to the Substantial

Authority Standard
· Disclosure
· Permitted only if position has reasonable basis

4-12
TR 4-3
Taxes:
Where is the ethical line?
Frivolous
Reasonable basis, undisclosed
Reasonable basis, disclosed

Substantial authority, undisclosed
More likely than not

4-13
TR 4-4
Fairness Standard for Financial

Statements
Fairness requires:
· Compliance with GAAP (or OCBOA)
· Use of appropriate accounting methods where
options exist
· Presenting financial statements and notes
informatively
· Classifying and summarizing information
reasonably
· Presenting amounts, descriptions and other
information that is materially correct.

4-14
TR 4-5
Window Dressing Techniques
Actions that may be ethical:

1) Changing operations
2) Changing contracts
3) Reassessing the facts and circumstances
4) Reconsidering an interpretation of
accounting principles
5) Revising an estimate
6) Changing an accounting method
7) Correcting an error
Actions that are not ethical:

· Arbitrary adjustments
· Intentional misstatements or omissions
· Sham transactions

4-15

4-16
Materiality
Chapter 5
Materiality
Objectives
• Define and assess materiality.
• Apply professional standards concerning materiality to judgments about materiality in

• Contrast ethical and unethical applications of materiality standards.
Readings/References
• SAS No. 107, Audit Risk and Materiality in Conducting an Audit
Key Points
• Information is material if its omission or misstatement would change or influence the

• Quantitative considerations (usually dollar amount), qualitative considerations

(usually the nature of the item) and surrounding circumstances (e.g., potential effects
of the information) affect judgments about materiality.
• Assessing materiality ultimately involves making judgments about how investors and
lenders would perceive the importance of information in financial statements.
• Management is responsible for fair presentation of financial statements, which

involves making judgments about materiality.
Ethics, Taxes, and Financial Reporting

5-1
Materiality
• Auditors are required to make judgments about materiality along with risk in planning
and conducting audits.
• CPAs performing compilations and reviews are also required to make judgments
about materiality.
• Although CPA firms commonly establish quantitative guidelines for assessing

materiality, professional standards themselves do not contain such guidelines.
• Misstatements can result from errors or fraud, and include GAAP departures and
incomplete or misleading disclosures. Fraud is intentional misstatement; error is
unintentional misstatement.
• Materiality is inherently an ethical idea. The definition of materiality could be

restated:
- It is not ethical or fair to omit information from financial statements or to

misstate items in financial statements that would change or influence the
- Material misstatements and omissions are not ethical because they cause harm
to people who make decisions based on the financial statements.
• Unethical material misstatements or omissions can result from insufficient diligence

or from fraud.
• Arbitrary adjustments, intentional misstatements or omissions and sham transactions

are not ethical.

5-2
Materiality
Test Your Knowledge
1. T/F: Information is material if its omission or misstatement would change or

influence the judgment of a reasonable person relying on it.
2. T/F: Dollar amount is generally the only consideration that affects materiality.
3. T/F: Arbitrary adjustments and intentional misstatements are ethical if they are
immaterial.
4. T/F: A CPA’s assessment of materiality is properly influenced by the CPA’s own

perception of the needs of a reasonable person who will rely on the financial
statements.
5. If an independent CPA believes the financial statements of a client are materially

misstated, the independent CPA has the right and responsibility to:
A) change the financial statements.
B) modify the accountant’s report on the financial statements.
C) either change the financial statements or modify the accountant’s report on the
6. If management of a company believes an item is material to the financial

statements, but the company’s independent CPA believes it is not,
A) management may defer to the judgment of the independent CPA.
B) the CPA may defer to the judgment of management.
C) neither management nor the CPA should defer to the other’s judgment.

5-3
Materiality
TR 5-1
What is material?
Information is material if its omission or

misstatement would change or influence the
(References: FASB Concept No. 2)

5-4
Materiality
TR 5-2
Factors Affecting Materiality
· Dollar amount (quantitative)
· Nature of the item (qualitative)
· Surrounding circumstances

5-5
Materiality

5-6
Proforma Financial Results
Chapter 6
Pro Forma Financial Results
Objectives
• Properly classify and disclose unusual, infrequent and extraordinary items.
• Assess the propriety of management statements about pro forma financial results and
the incorporation of pro forma information into an income statement.
• Identify the ethical issues associated with reporting these items.
Readings/References
• FASB Accounting Standards Codification, 225-20, Income Statement Presentation:

Extraordinary Items and Unusual Items
Key Points
Pro Forma Financial Disclosures
• Pro forma financial information has gained in popularity among companies and their
investors while GAAP financial statements have declined in popularity (even though
GAAP financial statements are still expected and required by laws and contracts.)
• Many investors believe pro forma information helps them assess the future prospects
of a business.

6-1
• Critics believe pro forma information is less reliable than the information in GAAP
financial statements because pro forma information is not regulated by GAAP and
because it tends to be less conservative. They believe it is frequently used unethically
to mislead investors.
• The pro forma financial information that investors most often seek is net income or
earnings per share before items such as:
- Restructuring charges
- Unusual expenses
- Infrequent expenses
- Extraordinary items
- Discontinued operations
- Asset impairments
- Other one-time charges
- Goodwill amortization
- Research and development costs
- Stock compensation
- Interest expense
• In addition, for privately owned companies pro forma income might exclude
depreciation and officer’s compensation.
• Pro forma income disclosures seek to differentiate recurring and non-recurring items
and cash and non-cash items.
• Pro forma income disclosures often amount to cash profits before non-recurring
items.
• Pro forma income disclosures are usually made outside of GAAP financial
statements, but GAAP financial statements sometimes include subtotals or line items
that facilitate the pro forma disclosures.

6-2
• Pro forma income disclosures often emphasize favorable results and obscure
unfavorable results.
• Existing accounting standards generally do not provide guidance for the fair
presentation of pro forma financial results, except in connection with disclosures of
particular events and transactions such as discontinued operations, extraordinary
items and accounting changes and in connection with formal financial forecasts and
projections.
• It is not unethical to report pro forma information, but it is unethical to distort

financial results or to mislead investors in either GAAP financial statements or pro
forma information.
Extraordinary, Infrequent and Unusual Items
• Extraordinary items should be reported separately from income from continuing

operations.
• To be classified extraordinary, an event or transaction must be both unusual and

infrequent.
• Unusual means not related to the ordinary and typical activities of the business.
• Infrequent means not reasonably expected to happen again in the foreseeable future.
• Items that are either unusual or infrequent, but not both, should be reported as part of
continuing operations. They should be reported as a separate line within continuing
operations item if they are material.
• Taxes should be allocated to extraordinary items, but not to items that are merely
unusual or infrequent.
• Unethical actions include deliberate misclassification or deliberate improper

presentation and disclosure.

6-3
Illustrations and Tables
Definitions
Term Meaning
Unusual Not ordinary or typical
Infrequent Nonrecurring
Extraordinary Both unusual and infrequent
Presentation
Type Presentation
Unusual Continuing operations
Infrequent Continuing operations
Extraordinary Below continuing operations
Classification Rule
The only items reportable below income from continuing operations are:
• Discontinued operations
• Extraordinary items
• Cumulative effect of a change in accounting principle

6-4
Example - Extraordinary Items
Revenues $5,000,000
Selling expenses 2,000,000
Administrative expenses 1,700,000
Income before extraordinary loss 1,300,000
Extraordinary loss 1,000,000
Net income $ 300,000
Example - Unusal or Infrequent Items (in this case, a litigation settlement)
Revenues $5,000,000
Litigation settlement 1,000,000
Test Your Knowledge
1. Why has reporting pro forma income become popular with companies and their
investors?
A) Many investors believe it helps them assess the future prospects of a business.
B) Management can use it to mislead investors.
C) It is required by the FASB.
2. Which of the following items are often added to net income when reporting pro
forma income for a privately held business?

6-5
A) Depreciation
B) Nonrecurring expenses
C) Interest
D) All of the above
3. Extraordinary items are events or transactions that:

A) occur infrequently.
B) are not related to ordinary operating activities of a business.
C) have either characteristic A or B
D) have both characteristics A and B
4. T/F: Extraordinary items should be reported net of taxes after income from
continuing operations in an income statement.
5. T/F: Catastrophic hurricane damage would be an extraordinary item.

6-6
Case Problem 1
During the current year, a company (S-Corporation) settled litigation for $1,000,000,
which is material to its financial statements. Although the company is seldom the
defendant in litigation, the litigation pertained to the ordinary operating activities of the
business and was not extraordinary. Management wants to present the loss separately
from other results of operations so that the users of its financial statements can easily see
that the company had an especially profitable year except for the litigation loss. In
addition, management wants to report depreciation separately from other expenses
because it is not a cash expense.
Consider the examples on the next page as well as other options for reporting these items.
What is your opinion about the ethical propriety of the examples shown on the next page?
Explain your conclusions concerning those examples and the presentation you believe is
most ethical.
Example - Acceptable?
Revenues $5,000,000
Income before litigation
settlement and depreciation 1,700,000
Depreciation 400,000
Revenues $5,000,000

Total operating expenses 3,300,000

6-7

Total other expenses 1,400,000
Case Problem 2
During the current year, a company (S-Corporation) terminated a group of employees,

relocated to less expensive facilities and wrote-off unproductive assets. The company did
not discontinue a segment of its business, it simply restructured its organization and
cleaned-up the balance sheet. The cost of this restructuring and other one-time charges
was $1,000,000, which is material to its financial statements. The company’s
accountants do not consider these costs extraordinary. Management wants to show these
expenses as a separate line item and show a subtotal before that item so that it can
emphasize to creditors and investors that the company would have had much higher
income without them and that the subtotal rather than the net income is indicative of the
company’s future financial performance. What is your opinion about the ethical
propriety of this treatment?
Proposed Presentation
Revenues $5,000,000
Income before restructuring and other one-time charges 1,300,000
Restructuring and other one-time charges 1,000,000

6-8
Case Problem 3
At the beginning of the current year, a company began to outsource much of its
accounting activities. This enabled the company to reduce the number of employees, to
lower its office lease costs and to eliminate certain data processing costs. It now pays a
monthly fee for accounting services that is about twenty percent lower than the cost it
incurred in the prior year for these accounting activities (including salaries, benefits,
office rent, data processing and other related costs). In addition, the company
recognized a gain on the sale of the computer equipment and furniture to the accounting
services firm. (The firm agreed to buy these items to facilitate obtaining the contract for
accounting services.) That gain has been recorded as an offset to the expense for the
monthly fees.
The company’s income statement includes a line item titled “moving expenses” which
represents the cost of moving the whole company to smaller offices at the beginning of
the year. The rent per square foot is lower than the rent in the previous space, and rent
expense decreased about 30% from the prior year. About one-third of that decrease
resulted from outsourcing accounting and the other two-thirds from the lower rental rate
per square foot.
Overall income increased 11% over the prior year for the following reasons:
Higher revenues 3%
Lower accounting expenses 10%
Lower rent per square foot 1%
Gain on sale of equipment and furniture 2%
Moving expenses (5%)
Net increase 11%
In a letter to a potential investor, the president stated that net income from the company’s
core business had increased 17% over the prior year after adjusting for non-recurring
moving expenses. He attributed the increase to higher sales and lower costs, but did not
provide the detailed analysis shown above.

6-9
Is the president’s letter ethical? If the controller, who is a CPA, attends a meeting with
the prospective investor at which the letter is presented to the investor, what obligation, if
any, does the controller have to provide additional information about the increase in
income? If the company’s independent CPA is at that meeting, what obligation does he
or she have to provide additional information about the increase in income?

6-10
TR 6-1
Pro Forma Income
Practical definition: Income before one-time

charges and non-cash expenses
Pro forma income often excludes:

• Restructuring charges
• Unusual expenses
• Infrequent expenses
• Extraordinary items
• Discontinued operations
• Asset impairments
• Other one-time charges
• Goodwill amortization
• Research and development costs
• Stock compensation

6-11
TR 6-2
Definitions
Term Meaning
Unusual Not ordinary or typical
Infrequent Nonrecurring
Extraordinary Both unusual and infrequent

6-12
TR 6-3
Presentation
Type Presentation
Unusual Continuing operations
Infrequent Continuing operations
Extraordinary Below continuing operations

6-13
TR 6-4
Example - Extraordinary Item

Revenues $5,000,000
Expenses 4,000,000
Income before extraordinary
loss 1,000,000
Extraordinary loss 600,000

6-14
TR 6-5
Example - Unusual or Infrequent

Items
Revenues $5,000,000

6-15
TR 6-6
Desirability Ranking
If positive If negative
effect effect
Unusual or
infrequent 1 2
Extraordinary 2 1

6-16
TR 6-7
Unethical Actions
· Deliberate misclassification
· Improper presentation and disclosure

6-17
TR 6-8
Classification Rule
The only items reportable below income from

continuing operations are:
· Discontinued operations
· Extraordinary items
· Cumulative effect of a change in accounting

principle

6-18
TR 6-9
Revenues $5,000,000
Income before litigation
settlement and depreciation 1,700,000

6-19
TR 6-10
Revenues $5,000,000

Total operating expenses 3,300,000

Total other expenses 1,400,000

6-20
Off Balance Sheet Financing
Chapter 7
Objectives
• Distinguish between capital and operating equipment leases from a lessee’s

perspective.
• Describe the standards for purchase commitments.
• Describe the conditions that require consolidation.
• Identify the ethical issues associated with off balance sheet financing.
Readings/References
FASB Accounting Standards Codification, Sections
• 440 Commitments: Long-Term Obligations
• 810 Consolidations
• 840 Leases
Key Points
• Off balance sheet financing often involves leases, long-term purchase commitments,
and unconsolidated entities.
• The economic substances of leases, long-term purchase commitments and

unconsolidated entities do not always correspond to their legal forms. This ambiguity
requires accountants to make significant judgments in applying accounting principles

7-1
to the transactions. Making those judgments tests an accountant’s ability to prepare

fair financial statements. In making those judgments an accountant experiences how
difficult it can be to make objective decisions and to scrupulously apply accounting
principles as required by standards of ethics.
• In the view of critics, off balance sheet financing involves unethical applications of
accounting principles that ignore the substance of a transaction or complex
structuring of transactions to obscure their substance. The truth is more subtle than
these critics publicly acknowledge.
• For equipment leases, the criteria for distinguishing capital leases from operating
leases are set forth in the following table:
Capital Leases for Lessees (not involving real estate)

Capitalize equipment leases if any one of the following is met:
• Ownership transfers to lessee by end of lease term.
• Lease contains a bargain purchase option
• Lease term is 75% or more of estimated economic life
• Present value of minimum lease payments is 90% or more of fair value
Note that different rules apply to leases of real estate and those rules are not
summarized in this course. A bargain purchase option is a lease provision that
permits the lessee to buy the lease property at a price so much lower than the fair
value of the property that one can be reasonably assured that the lessee would
exercise the option. The lease term is the non-cancelable term of the lease plus any
period covered by a bargain renewal option and any period during which failure to
renew the lease results in a penalty and certain other periods enumerated at ASC
840-10-20, Glossary.
• Certain unconditional purchase obligations (such as take-or-pay contracts) require

disclosures that are similar to disclosures related to long-term debt but are not
necessarily recorded as liabilities. Disclosure is not considered a fair alternative to

7-2
recording the liability if the substance of the transaction indicates an asset has been
acquired and a liability incurred. ASC 440-10-50.
• Generally, when one company owns a controlling financial interest in another

company, consolidated financial statements are required. A controlling financial
interest generally involves owning more than half of the voting shares of another
entity, but it may also involve control by contract, lease, stockholder agreement or
court decree.
• Generally, when one company owns less than a controlling interest in another
company, but owns an interest large enough to enable it to exercise significant
influence over the operating and financial policies of the investee, then the equity
method should be applied to the investment.
• Generally, ownership of more than 50% of the voting stock of an entity requires
consolidation and an investment of 20% to 50% requires the equity method of
accounting.

7-3
Test Your Knowledge
1. Off balance sheet financing often involves:

A) leases
B) long-term purchase commitments
C) unconsolidated affiliates
D) All of the above
2. Why does off balance sheet financing test an accountant’s objectivity and ability to
scrupulously apply accounting principles?
A) Off balance sheet financing often involves transactions that are ambiguous in
that their economic substances do not always correspond to their legal forms.
B) Off balance sheet financing is illegal.
C) Off balance sheet financing requires unethical applications of accounting
principles that ignore the substance of a transaction or complex structuring of
transactions to obscure their substance.
3. T/F: An equipment lease is not a capital lease unless it contains a bargain purchase
option or transfers ownership of the equipment to the lessee by the end of the lease
term.
4. T/F: Certain unconditional purchase obligations (such as take-or-pay contracts)

require disclosures that are similar to disclosures related to long-term debt but are
not recorded as liabilities.
5. T/F: Consolidation is required when one company owns a majority voting interest
in another company.

7-4
Case Problem
To finance the purchase of telecommunications equipment, Company A’s management

(all of whom are stockholders) formed Company B that purchased and financed the
equipment and agreed to sell the machine’s output to Company A under a long-term
purchase agreement. Company A has agreed to pay a fee based on actual monthly
output. If Company A’s usage does not equal or exceed levels established in the contract,
Company A has agreed to reimburse Company B for its expenses plus a fee that
guarantees Company B a 12% return on investment. Company A does not own any stock
in Company B. Management of Company A does not want to consolidate Company B
because it does not want to show the debt of Company B on its balance sheet. Under
what circumstances is that ethical?

7-5
TR 7-1
Capital Leases
for Lessees
Capitalize equipment leases if any one of the

following is met:
· Ownership transfers to lessee by end of lease
term.
· Lease contains a bargain purchase option
· Lease term is 75% or more of estimated
economic life
· Present value of minimum lease payments is
90% or more of fair value
Different rules for leases involving real estate.

7-6
Related Parties
Chapter 8
Related Parties
Objectives
• Identify, classify and disclose related party transactions and balances.
• Identify the ethical issues associated with related party transactions and disclosures.
Readings/References
• FASB Accounting Standards Codification, 850, Related Party Disclosures
Key Points
• Generally, related party transactions should be recorded according to the same rules
that apply to other transactions. The problem is that related party transactions are
often not like other transactions either in their legal form or in their economic
substance.
• The economic substances of related party transactions do not always correspond to

their legal forms. In addition, the economic substance is often not readily discernable
and the legal form is often not established in writing nor itself readily discernable.
These ambiguities require accountants to make significant judgments in applying
accounting principles to the transactions because the ambiguities suggest that more
than one accounting method might be appropriate. Making those judgments tests an
accountant’s scrupulousness, objectivity and impartiality. The ambiguities make it
hard, even impossible, to prepare fair financial statements.
• Examples of related parties include:

8-1
Related Parties
- people who own and manage the company (and their immediate families and
other entities that they own or control)
- parent or subsidiary companies and their affiliates
- subsidiaries of a common parent
- employee benefit trusts
• All material related party transactions and balances should be disclosed (i.e., nature,
terms, amount, relationship, etc.)
• For material related party transactions, disclose:
- nature of the relationship with the related party

- transaction terms and amounts
- effects of changing transaction terms from prior years
- balances and settlement terms for receivable and payable balances
• Generally, related party balances should be classified separately from other amounts
in balance sheets.
• Even when there are no transactions with an affiliate, disclosure of common control is
required when that control could affect results of operations or financial position.
• Related party transactions are not presumed to be arms-length. However, if

disclosures represent or imply that a transaction is equivalent to arms-length,
management must have evidence to substantiate that representation.
• Unethical actions include:
- Ignoring the substance of a transaction

- Deliberately misclassifying or misstating a transaction or balance
- Deliberately omitting or misstating a required disclosure

8-2
Related Parties
• The AICPA has published a “toolkit” titled, “Accounting and Auditing for Related
Parties and Related Party Transactions.” It summarizes the relevant accounting
standards, professional standards and securities laws and provides practical guidance
for implementing them. At the AICPA website use the search feature to find:
Accounting and Auditing for Related Parties and Related Party Transactions Toolkit.

8-3
Related Parties
Test Your Knowledge
1. Why do related party transactions that have ambiguous legal terms and economic
substances pose ethical challenges for CPAs?
A) The accounting principles that apply to related party transactions are not the
same as the principles that apply to other transactions.
B) Such related party transactions are designed to deceive the users of financial
statements.
C) The ambiguities suggest that more than one accounting method might be
appropriate and that tests an accountant’s scrupulousness, objectivity and
impartiality.
2. Which related party transactions must be disclosed?

A) Related party transactions that are carried out on an arms-length basis.
B) Related party transactions that are not carried out on an arms-length basis.
C) Transactions with affiliates, but not loans to employees.
D) All related party transactions.
3. T/F: When the reporting entity is under common control with another entity,
disclosure of common control may be required even if there are no transactions
between the entities.
4. T/F: Notes or accounts due from officers, employees and affiliates may be
combined with other receivables in the balance sheet if the amounts are disclosed
in accompanying notes.

8-4
Related Parties
Case Problem
A stockholder/officer of a small company borrowed $200,000 from the company on

December 1, repaid the loan on December 31, then borrowed the money again on January
3 (immediately after the end of the fiscal year that ended on December 31) and repaid the
loan on January 20. The stockholder paid interest at the same rate at which the company
can borrow money under its bank credit line. The stockholder does not want the balance
sheet to show the stockholder loan as of the end of the year and has asked the controller
and independent CPA if it is acceptable to omit disclosure of this transaction based on
immateriality. The company’s net worth is $4 million. In your opinion, what
disclosures, if any, are ethically required? Explain your conclusion and draft an
appropriate disclosure.

8-5
Related Parties
TR 8-1
Related Parties - Examples
· people who own and manage the company

(and their immediate families and other
entities that they own or control)
· parent or subsidiary companies and their

affiliates
· subsidiaries of a common parent
· employee benefit trusts

8-6
Related Parties
TR 8-2
Related Party Disclosures
For material related party transactions, disclose:
· nature of the relationship with the related

party
· transaction terms and amounts
· effects of changing transaction terms from

prior years
· balances and settlement terms for receivable

and payable balances

8-7
Related Parties
TR 8-3
Unethical Actions
· Ignore the true substance of a transaction
· Deliberately misclassify or misstate a

transaction or balance
· Deliberately omit or misstate a required

disclosure

8-8
Contingencies and Estimates
Chapter 9
Objectives
• Properly account for and disclose gain and loss contingencies.
• Properly disclose the use of estimates
• Identify the ethical issues associated with contingencies and other estimates.
Readings/References
FASB Accounting Standards Codification, Sections:
• 450, Contingencies
• 275, Risks and Uncertainties
Key Points
• Accounting for contingencies and other events and transactions that involve estimates
involve predicting the future. The judgements an accountant must make concerning
the fairness of estimates require objectivity that is often elusive when trying to predict
the future. In addition, particularly when judging estimates related to loss
contingencies, an accountant’s faithfulness to ethical obligations to be impartial and
scrupulous is tested. An accountant’s obligation to remain impartial conflicts with
management’s hopes for a favorable outcome to contingencies. An accountant’s
obligation to scrupulously apply GAAP conflicts with management’s interest in using
reserves based on estimates to manage earnings.

9-1
Contingencies:
• Loss contingencies should be accrued when the chance of an unfavorable outcome is

probable and the amount of the loss is estimable.
• When the estimated loss is a range and no amount within the range is more probable
than any other, then the loss accrual should equal the low end of the range.
• When there is at least a reasonable possibility of an unfavorable outcome, a material

loss contingency should be disclosed.
• Disclosure is not required when the chance of an unfavorable outcome is remote.
• It may be necessary to disclose the amount of a loss accrual to prevent financial

statements from being misleading.
• Gain contingencies should not be accrued because that would result in recognition
before realization.
Note: In 2009 the FASB may issue a new standard that will enhance disclosures related
to loss contingencies.
Use of estimates:
• The use of estimates must be disclosed.
• Specific estimates must be disclosed when there is at least a reasonable possibility

that an estimate will change materially within one year.
Unethical Actions:
• Misstate estimated loss
• Misstate probability of unfavorable outcome
• Recognize gain contingencies before they are realized

9-2
• Delay recognition of a realized gain contingency
• Inadequately or improperly disclose significant estimates
Table Summarizing Treatment of Contingent Losses
Chance of Loss Treatment
Remote No disclosure*
Reasonable possibility Disclose
Probable, not estimable Disclose
Probable and estimable Accrue and

disclose
* Exception: Guarantees Disclose
Example of Use of Estimates Disclosure
In accordance with generally accepted accounting principles management has made

estimates and assumptions that affect the amounts reported in the financial statements and
disclosures. Actual results could differ from those estimates.
(Derived from FASB ASC 275-10-55-6.)
Summary of Significant Estimates Disclosure Requirements
Disclosure is required when:
• Near term change is reasonable possibility

9-3
(Near term generally means up to one year.)
• Potential change is material
Example of a Significant Estimate Disclosure
Inventories have been reduced by a valuation allowance to reflect management’s best

estimate of the amount of loss that the company will incur upon the complete liquidation
of Product X. The amount of cash that the company will ultimately realize from the sale
of this inventory could differ materially from the $2.5 million included in inventories for
Product X.

9-4
Test Your Knowledge
1. What is it about loss contingencies that can test an accountant’s faithfulness to

ethical standards?
A) An accountant’s obligation to scrupulously apply GAAP conflicts with
management’s interest in using reserves based on estimates to manage
earnings.
B) The judgements an accountant must make concerning the fairness of estimates
require objectivity that is often elusive when trying to predict the future.
C) An accountant’s obligation to remain impartial conflicts with management’s
hopes for a favorable outcome to contingencies that can cause bias when
estimating the likelihood or impact of an unfavorable outcome.
D) All of the above
2. For which loss contingencies is it proper to accrue a loss?

A) all loss contingencies
B) those for which an unfavorable outcome is probable and estimable
C) those for which an unfavorable outcome is reasonable possible
D) none
3. When the estimated probable loss is a range rather than a single amount, and no
amount within that range is a better estimate than any other, how much should be
accrued for the loss?
A) the low end of the range
B) the high end of the range
C) the midpoint of the range
D) nothing

9-5
4. T/F: Probable and estimable gains should be recorded.
5. T/F: If litigation is settled between the balance sheet date and the date financial
statements are issued, the loss accrual should be adjusted to the settlement amount
as of the balance sheet date.
6. T/F: Financial statements are considered issued as of the date of the independent
auditor’s report.
7. T/F: Loss contingencies should be disclosed unless the chance of an unfavorable

outcome is remote.
8. T/F: Each material estimate must be disclosed.

9-6
Case Problem
The IRS has assessed a large tax penalty against a company. Management has appealed
the assessment in court and expects to pay a smaller penalty than assessed by the IRS.
Management expects a court decision about 45 days after year-end. Normally the
company issues its financial statements about 45 days after year-end. During the final
month of the year, the president, CFO and controller discussed the possible outcomes of
the tax case and noted that it may be necessary to adjust income if the court decision is
issued before the financial statements are issued. Management’s estimate of the loss is a
range and the low end of the range has been accrued. If the actual loss is higher, then
profits (and management bonuses) will be lower. In addition, waiting for the court
decision will delay the issuance of financial statements because it will take at least a
week to issue them after the court’s decision. Although lawyers do not expect the court
decision to be delayed past about 45 days, they say, “anything is possible.” Loan
covenants require issuance of financial statements within sixty days after year- end.
The controller suggested accelerating the issuance of the financial statements so that they
will be “set in concrete” before the court decision is issued. Any difference between the
loss accrual and final penalty would then be reported next year. In addition, this strategy
will avoid further delaying the issuance of financial statements if the court decision is
delayed. The president and CFO agreed with this suggestion. What is your opinion
concerning the propriety of this strategy? What are the ethical issues that must be
considered? Summarize and explain your opinion and the reasons for it.

9-7
TR 9-1
Contingent Losses
Chance of Loss Treatment
Remote No disclosure*
Reasonable possibility Disclose
Probable, not estimable Disclose
Probable and estimable Accrue and

disclose
* Exception: Guarantees Disclose

9-8
TR 9-2
Loss Contingencies
When estimate is a range
High End
Best Estimate?
Low End

9-9
TR 9-3
Unethical Actions
· Misstate estimated loss
· Misstate probability of unfavorable outcome
· Recognize gain contingencies before they are

realized
· Delay recognition of a realized gain

contingency

9-10
TR 9-4
Use of Estimates Disclosure

In accordance with generally accepted accounting
principles management has made estimates and
assumptions that affect the amounts reported in the
financial statements and disclosures. Actual results
could differ from those estimates.
(Derived from AICPA SOP 94-6,

paragraph A-9.)

9-11
TR 9-5
Significant Estimates
Disclosure is required when:
· Near term change is a reasonable possibility
(Near term generally means up to one year.)
· Potential change is material

9-12
TR 9-6
Example of a Significant Estimate

Disclosure
Inventories have been reduced by a valuation

allowance to reflect management's best estimate of
the amount of loss that the company will incur upon
the complete liquidation of Product X. The amount
of cash that the company will ultimately realize
from the sale of this inventory could differ
materially from the $2.5 million included in
inventories for Product X.

9-13

9-14
Accounting Changes and Error Corrections
Chapter 10
Objectives

• Account for changes in accounting principles, changes in estimates and corrections of
errors.
• Identify the ethical issues associated with changes in accounting principles, changes
in estimates and corrections of errors.
Readings/References
• FASB Accounting Standards Codification, 250, Accounting Changes and Error

Corrections
Key Points
• Changes in principle, changes in estimates and error corrections engage an

accountant’s ethics because they have different effects on the financial statements and
because they can be more difficult to distinguish from each other in practice than they
are in theory. In addition, given the opportunity, management will tend to favor
reporting a transaction as a change in estimate if it increases income and favor
reporting it as a change in accounting principle or error correction if it decreases
income. A scrupulous accountant, however, must try to objectively, impartially judge
which treatment is the most fair in the circumstances.
• Accounting standards permit changing an accounting method as long as the new

method is preferable to the old method because the new method represents a more

10-1
authoritative accounting principle or because it more fairly presents financial position

and results of operations.
• For many decades, GAAP generally required financial statements to show the
cumulative effect of a change in an accounting principle on the income statement, net
of taxes, after income from continuing operations. That rule changed beginning with
2006 financial statements. The new rule generally requires financial statements to
show the effect of a change in an accounting principle retrospectively by essentially
restating prior financial statements.
• Financial statements should show the effects of changes in estimates as part of current
(or future) operations in the income statement.
• Sometimes changes in estimates result in changes in accounting principles. For

example, a change in expected future benefits associated with certain costs may result
in capitalizing costs that were previously expensed. When that happens, the change
should be reported as a change in estimate.
• Financial statements should show the effects of material error corrections by restating
prior period financial statements or by showing the effect on beginning retained
earnings if prior period financial statements are not presented.
• Changing from an unacceptable accounting principle to an acceptable one is an error

correction.
• It is often possible to support a voluntary change in an accounting principle on the

basis of revised estimates. This allows disclosing most voluntary changes (rather than
those required by new FASB standards) as changes in estimates rather than as changes
in accounting principles. When the change increases net income, the change often
sounds like better news if it is called a change in estimate rather than a change in
accounting principle. That is why management tends to prefer reporting items that
increase income as changes in estimates.

10-2
Effects of Accounting Changes and Error Corrections
Prin- Esti-
ciple mate Error
Income from
operations Usually Yes No
Net income Usually Yes No
Prior year
financial Usually No Yes

10-3
Ranking of Desirability from Management’s Perspective
effect effect
Change in estimate 1 3
Change in principle 2 2
Error correction 3 1
Unethical Actions
• Deliberate misclassification
• Improper presentation and disclosure
• Changing to a less preferable accounting method
• Making arbitrary estimates

10-4
Test Your Knowledge
1. Why do changes in principle, changes in estimates and error corrections engage an

accountant’s ethics?
A) They have different effects on the financial statements.
B) They can be more difficult to distinguish from each other in practice than they
are in theory.
C) Given the opportunity, management will tend to favor reporting a transaction
as a change in estimate if it increases income and favor reporting it as a change
in accounting principle or error correction if it decreases income.
D) All of the above combined.
2. T/F: Changing from an unacceptable accounting method to an acceptable method

is an error correction.
3. A change from MACRS to straight-line depreciation over the estimated useful life
may be considered:
A) a change in estimate effected by a change in accounting principle
B) a change in accounting principle
C) an error correction.
D) A or C
4. T/F: If the settlement of litigation results in lower costs than has been accrued in
prior years, the difference should be reported by restating prior financial
statements.
5. T/F: A write-off of capitalized costs should be reported as a change in an

accounting principle.
10-5
Case Problem
To increase profits, the new president of a company asked the controller to change from
an accelerated to straight-line depreciation method and to depreciate assets over longer
lives. The president wants to make the changes, but does not want to report them as a
change in accounting principle nor to otherwise “make a big deal about the changes in the
footnotes.” The controller studied the estimated useful lives of the company’s plant and
equipment and concluded that using longer lives can be supported by past experience.
However, the shorter lives are also supportable. The useful lives appear to depend on the
level of maintenance applied to the plant and equipment and on subjective decisions
concerning when it is efficient to buy new equipment. The controller also evaluated
whether switching to the straight-line method can be justified and the controller
concluded that it can be argued that the straight-line method does result in a more rational
allocation of costs, but that the accelerated method also has merit. When management
originally started using the accelerated method, management believed that greater
benefits would be derived from using the equipment in early years than in later years.
Although that has been true to some extent, the decline in benefits over time is much
more gradual than the decline in depreciation expense that results from the use of the
accelerated method. The straight-line appears to be a better, but less than perfect, match
with the pattern of benefits.
In your opinion, do the changes appear appropriate? If the changes are made, how should
they be reported in financial statements and notes? What ethical issues should the
controller consider? Summarize and explain your conclusions.

10-6
TR 10-1
Accounting Changes and Errors
Changes in:
· Principle
· Estimate
· Reporting entity
Error Corrections

10-7
TR 10-2
Effects of Accounting Changes

and Error Corrections
Prin- Esti-
ciple mate Error
Income from
operations Usually Yes No
Net income Usually Yes No
Prior year
financial
statements Usually No Yes

10-8
TR 10-3
Ranking of Desirability from

Management's Perspective
effect effect
Change in estimate 1 3
Change in principle 2 2
Error corrections 3 1

10-9
TR 10-4
Unethical Actions
· Deliberate misclassification
· Improper presentation and disclosure
· Changing to a less preferable accounting

method
· Making arbitrary estimates

10-10
Bibliography
Bibliography
Update, published by the California Board of Accountancy.
This quarterly news letter contains information about changes to the laws and regulations
that govern public accountancy and describes recent disciplinary actions.
Web Site, California Board of Accountancy
The Board’s web site includes the latest laws that govern accountancy as well as copies
of Update, forms, and other valuable information. www.dca.ca.gov/cba/
AICPA Professional Standards.
The AICPA publishes the AICPA Code of Professional Conduct and Ethics Rulings along
with other professional standards. The Code of Professional Conduct and some
professional standards are available online at the AICPA web site, www.aicpa.org
The CPA Letter, published by the AICPA.
This news letter, published at the AICPA web site, www.aicpa.org, contains information
about changes to the AICPA Code of Professional Conduct and Ethics Rulings and also
reports recent disciplinary actions.
The Journal of Accountancy, published by the AICPA.
This monthly magazine often contains articles concerning ethics and information about
the common inquiries that CPAs make to the AICPA.

A-1
Bibliography

A-2

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Table of Contents

1 Overview: Accountancy Laws and Ethics

2 Accountancy Laws and Ethics Rules: Objectivity, Integrity

and Due Care

3 Accountancy Laws: Licensing and Enforcement

4 Fairness in Tax Returns and Financial Statements

6 Pro Forma Financial Results

7 Off Balance Sheet Financing

9 Contingencies and Estimates

10 Accounting Changes and Errors

Ethics, Taxes and Financial Reporting

B Suggested Solutions - Test Your Knowledge

C Suggested Solutions - Case Problems

California Accountancy Act

California Accountancy Regulations

Ethics, Taxes and Financial Reporting

This course is ideal for accountants in industry as well as public accounting. It is

Goals and Objectives

The educational goals of this course are:

On completion of this course, you will be able to:

Ethics, Taxes and Financial Reporting

· Demonstrate a general knowledge and understanding of the current California

· Demonstrate a general knowledge and understanding of the current AICPA

· Recognize potential problem areas concerning compliance with accountancy laws

· Demonstrate an understanding of what it means to present financial statements

· Demonstrate an understanding of a realistic possibility standard for positions

Who Should Take This Course

Ethics, Taxes and Financial Reporting

Ethics, Taxes and Financial Reporting

• Identify the professional ethics standards that apply to CPAs.

• California Accountancy Act and Regulations

• AICPA Code of Professional Conduct, Introduction

Ethics, Taxes and Financial Reporting

Accountancy Laws and Ethics Standards

• The practice of public accountancy is governed by a large number of laws,

- California Accountancy Act

- AICPA Code of Professional Conduct

- AICPA Ethics Rules

- Statements on Responsibilities in Tax Practice

- Generally Accepted Accounting Principles

- Generally Accepted Auditing Standards

- Business and Professions Code

- Welfare and Institutions Code

Ethics, Taxes and Financial Reporting

• A particular focus of this course is dishonesty. Along with incompetence, dishonesty

Pressures on Accountants that Impair Ethics

• Accounting standards are increasingly complex. Accountants have difficulties

• Accountants and their clients are human.

Ethics, Taxes and Financial Reporting

Summary of the AICPA Code of Professional Conduct

• To society, clients and employers and each other

• Improve art of accounting

• Maintain public confidence in the profession

• Make sensitive professional and moral judgments

Article II — The Public Interest

• Accept responsibility to public, including—

- Clients and employers

- Credit grantors and investors

• Do not place client or employer interests ahead of other interests

Article III — Integrity

• Honest and candid

• Personal gain or advantage must be subordinate to service and public trust