Chapter 4 - Ethics and Independence

What is the code of behavior required of all CPAs

AICPA Code of Professional Conduct

What are the different categories/levels within the AICPA Code of Professional Conduct

Principles → Rules → Interpretations

What are the principles of the AICPA Code of Professional Conduct

Responsibilities, Public Interest, Integrity, Objectivity and Independence, Due Care, and Scope and Nature of Services

What is the purpose of the principle of public interest within the AICPA Code of Professional Conduct designed for?

To maintain that the work of the auditors is for the public interest, not the client.

What is the most prominent rule of the AICPA Code of Professional Conduct?

The independence rule

What CPA firm services require independence?

• All attestation services

  • Financial statement audits

  • Financial statement reviews

What are the principles of independence?

1. Has a mutual or conflicting interest with the audit client

2. Audits their own work

3. Functions as management or as an employee of the audit client

4. Acts as an advocate for the audit client (many independence rules do not apply to other services provided by CPAs)

What are the primary threats to independence?

1. Self-interest

2. Adverse interest

3. Self-review

4. Management Participation—When the auditor takes on duties that should ultimately be performed by a member of the client’s management

5. Advocacy

6. Familiarity—When the auditor has a new or existing relationship with the client or an associate of that client

7. Undue Influence—Management attempts to exercise influence over the auditor.

If a rule or interpretation exists for an independence question, how should a CPA decide on their independence?

Independence Framework (Must pass both of the following)

• Independence of mind (i.e., independence in fact)

• Independence in appearance

  • Reasonable investor rule

What is the reasonable investor rule?

In the absence on rules or interpretation, would a reasonable investor with all relevant information conclude that there is a threat to the member’s or firm’s independence that is not at an acceptable level

• Even when specific rules or interpretations exist, you must still pass

When is independence a concern for the individual vs the whole firm?

When a covered member’s independence is impaired, the firm is also impaired.

Who is a covered member?

• Individual on the attest engagement team, even those performing concurring and 2nd partner review

• Individuals with influence over the engagement team

• Partner or manager who provides more than 10 hrs of nonattest services with a fiscal year

• Partner in the office of the lead engagement partner

• The firm, including the firm’s employee benefit plans

• An entity that can be controlled by any covered members or combination of covered members

Who are individuals in a position to influence attest engagement?

• Evaluates performance or recommends compensation of engagement partner

• Directly supervises/manages engagement partner (all the successively senior people in the firm)

• Consults with the engagement team on technical or industry-related matters

• Participates in quality control activities

Define immediate family vs close family in terms of independence

Immediate family: Spouse or equivalent and dependents

Close relative: Immediate family, plus a parent, sibling, or nondependent child

Define a key position in an audit engagement

An individual at a client (works for the client) who has primary responsibilities for

• Significant accounting functions

• Preparation of F/S

• Ability to exercise influence over contents of F/S: Director, CEO, CAO, COO, President, General Counsel, Controller, Director of Internal Audit or Financial Reporting, Treasurer, or equivalent

What are the key rules/interpretations of independence?

• Financial interest

• Employment Relationships

• Non-audit services

• Contingent fees—paying extra for a clean opinion (not allowed)

What are the independence rules around direct financial interest?

A direct financial interest exists when the auditor owns equity or debt instruments of a client directly

• Covered persons and their immediate families are prohibited from ANY direct investment in clients

• Direct investments of >5% of the equity of an audit client/affiliate are prohibited for ALL audit firm professionals (if you work in the same office), their immediate family, and close relatives

What are the independence rules around indirect financial interest?

An indirect financial interest exists when an individual has an economic stake in a business or investment, but the connection is not direct; it’s through a third party or an intermediary.

• Ex. Ownership in a mutual fund that contains the client’s stock or direct financial interest in a subsidiary

Rule: Firm, covered persons, and immediate family are prohibited from having a material indirect investment, including:

• Owning >5% of an entity that owns an interest in an audit client

• Owning >5% of an entity of which the audit client owns an interest

What is the rule for diversified mutual funds?

If the individual owns 5% or less of the outstanding shares of a diversified mutual fund by a covered member, it is immaterial

Ownership of more than 5% of outstanding shares of a diversified mutual fund by a covered member should be evaluated to decide if the mutual fund’s underlying investments determine whether the covered member holds a material indirect interest (if a fund is not diversified, this paragraph still applies).

Does it matter if a covered person is indirectly invested in a client through a mutual fund, but it is not material to their net worth?

If the ownership is less than 5% and it is not material to the auditor’s net worth, then it is immaterial. If the ownership of the fund is >5% then it is an independence violation no matter what.

What is the independence rule around loans/debt

Loans to/from audit clients are generally prohibited

• Exception: Consumer loans (car loans) and unpaid credit card balances >10,000 at all times during the engagement

  • Must follow the bank’s normal lending process

What is the independence rule around bank or brokerage accounts held with the client (if your client is a bank)

Balance with bank cannot exceed FDIC limit = 250k

What is the rule around insurance companies as clients?

A client cannot hold insurance policies for covered members or the firm’s professional liability policy.

What is the independence rule on employment relationships

• Covered members and their immediate and close family members are prohibited from key positions in the audit client

• Former partner or professional employee prohibited from key positions—one year cooling-off period required by SOX

• Former audit client employees prohibited from becoming partners in the audit firm and being involved in the audit