ch 19 audit: Professional Conduct, Independence, and Quality Control
Professional Conduct, Independence, and Quality Control
Ethics and Professionalism
Ethics: Refers to a system or code of conduct based on moral duties and obligations that indicate how an individual should interact with others in society.
Professionalism: Refers to the conduct, aims, or qualities that characterize or mark a profession or professional person.
Standards for Auditors
Relevant Professional Standards for Audits of Private versus Public Companies
CPA (Auditor) Standards for Private Company Audits:
Auditing Standards: ASB (AICPA) GAAS (Generally Accepted Auditing Standards).
Standards of Professional Conduct: AICPA Code of Professional Conduct; ISB (Independence Standards Board) standards apply unless AICPA expressly disagrees.
CPA (Auditor) Standards for Public Company Audits:
Auditing Standards: PCAOB (Public Company Accounting Oversight Board) standards, currently similar to ASB standards with notable exceptions.
Standards of Professional Conduct: PCAOB Code of Professional Conduct (adopted from AICPA); SEC (Securities and Exchange Commission) has more stringent independence rules for public company audits.
ISB: A cooperative effort between the AICPA and SEC; now defunct but its standards still apply.
The AICPA Code of Professional Conduct: A Comprehensive Framework for Auditors
Structure of the Code of Professional Conduct
Principles of Professional Conduct (General): Not specifically enforceable but departures must be justified.
Represent ideal attitudes and behaviors.
Rules of Conduct (Specifically Enforceable): Minimally acceptable standards.
Interpretations of Rules of Conduct: Provide detailed interpretations and answers to questions regarding rules of conduct.
Principles of Professional Conduct
Responsibilities: Members should exercise sensitive professional and moral judgments in all their activities as professionals.
The Public Interest: Members should accept the obligation to act in a way that serves the public interest, honors the public trust, and demonstrates commitment to professionalism.
Integrity: Members should perform all professional responsibilities with the highest sense of integrity to maintain and broaden public confidence.
Objectivity and Independence: Members should maintain objectivity and be free of conflicts of interest. A member in public practice must be independent in fact and appearance when providing auditing and other attestation services.
Due Care: Members should observe the profession's technical and ethical standards, strive to continually improve competence and service quality, and discharge professional responsibility to the best of their ability.
Scope and Nature of Services: Members in public practice should observe the Principles of the Code of Professional Conduct when determining the scope and nature of services provided.
Definition of "Member"
A member refers to a member, associate member, affiliate member, or international associate of the AICPA. This includes:
Member in public practice.
Member in business.
All other members.
Ethical Framework for Members
Members should:
Identify Threats to compliance with the rules.
Evaluate the Significance of Those Threats:
Determine if the threat is at an acceptable level (i.e., a reasonably informed third party would conclude that the threat would not compromise compliance with the rules).
Identify and Apply Safeguards to eliminate the threats or reduce them to an acceptable level.
Overview of Part 1 AICPA Rules of Conduct
Rule 1.100.001 - Integrity and Objectivity:
Maintain objectivity and integrity in performing any professional service.
Be free of conflicts of interest.
Not knowingly misrepresent facts or subordinate judgment to others.
Rule 1.200.001 - Independence:
A member in public practice must be independent in performing professional services as required by standards promulgated by bodies designated by Council.
Rule 1.300.001 - General Standards:
Comply with four fundamental standards and their interpretations:
A. Professional competence.
B. Due professional care.
C. Planning and supervision.
D. Sufficient relevant data.
Rule 1.310.001 - Compliance with Standards:
Members performing auditing, review, compilation, management consulting, tax, or other professional services must comply with standards promulgated by designated bodies.
Rule 1.320.001 - Accounting Principles:
A member shall not express an opinion that financial statements conform to GAAP (Generally Accepted Accounting Principles) or state unawareness of material modifications needed for GAAP conformity, if the statements contain any material departure from an accounting principle.
Rule 1.400.001 - Acts Discreditable:
A member shall not commit an act discreditable to the profession.
Rule 1.510.001 - Contingent Fees:
A member in public practice shall not perform certain professional services for a contingent fee for a client for whom the member or firm also performs an audit, review, or compilation, or prepares an original or amended tax return or claim for a tax refund for a contingent fee.
Rule 1.520.001 - Commissions and Referral Fees:
A member in public practice shall not recommend or refer a product/service for a commission to a client, or receive a commission when the member or firm also performs an audit or review for that client.
Any member accepting or paying a referral fee for CPA services must disclose such acceptance or payment to the client.
Rule 1.600.001 - Advertising and Other Forms of Solicitation:
A member in public practice shall not seek clients by advertising or solicitation that is false, misleading, or deceptive. Coercion, overreaching, or harassing conduct is prohibited.
Rule 1.700.001 - Confidential Client Information:
A member in public practice shall not disclose any confidential client information without the specific consent of the client.
Members shall not use to their own advantage or disclose confidential client information obtained through their professional activities.
Rule 1.800.001 - Form of Organization and Name:
A member may practice public accounting only in a form of organization permitted by law/regulation that conforms to Council resolutions.
A firm name must not be misleading; names of past owners may be included.
A firm cannot designate itself as "Members of the American Institute of Certified Public Accountants" unless all its CPA owners are members of the Institute.
Assurance, Attestation, and Audit Services
Assurance Services: Any information (broad scope).
Attestation Services: Primarily financial information.
Auditing Financial Statements: A specific type of attestation service.
Independence Rule
General Principle: A member in public practice must be independent in performing professional services required by standards designated by Council.
Covered Members: Must be independent for Financial Statement Audits, Financial Statement Reviews, and Other Attest Services (as defined by SSAEs - Statements on Standards for Attestation Engagements).
Partner Equivalent
An individual who:
Has the ultimate responsibility for the conduct of the attest engagement, including the authority to sign the firm's name to an attest report; OR
Has the authority to bind the firm to conduct an attest engagement without partner approval (e.g., signing the engagement letter).
Attest Engagement: An engagement that requires independence.
Covered Members (Definition)
An individual or entity that, if they have a financial interest or relationship with an attest client, impairs the firm's independence. Specifically:
An individual on the attest (audit) engagement team.
A partner, partner equivalent, or manager who provides non-attest services to the attest client, beginning after providing 10 hours of non-attest services in a fiscal year.
A partner or partner equivalent in the office where the lead attest/audit engagement partner primarily practices.
The firm, including the firm's benefit plan.
An entity whose operating, financial, or accounting policies can be controlled by any of the above individuals/entities, or by two or more acting together.
Prohibited Financial Relationships
Direct Financial Interest: Occurs when a covered member has a direct financial interest in a client (e.g., ownership of stock or debt securities).
Indirect Financial Interest: Occurs when a covered member beneficially owns a financial interest through an investment vehicle (e.g., estate, trust, intermediary) where the covered member does not control the intermediary or influence its investment decisions.
An indirect financial interest in a non-client may impair independence if the non-client has a financial interest in the client.
Example: If an auditor owns stock in a non-client, and that non-client owns stock in the audit client, this could impair independence if the auditor's interest in the non-client is material to the auditor, and the non-client's interest in the client is material to the non-client.
Prohibited Business Relationships
The independence of a CPA is impaired if the CPA performs a managerial or other significant role for a client's organization during the period covered by an attest engagement.
A firm's independence is impaired if a partner or professional employee leaves the public accounting firm and is subsequently employed by a client in a key position, unless specific conditions are met (e.g., disassociation from the firm, client reassessment, and a "cooling off" period).
Effect of Family Relationships
Immediate Family: A covered member's immediate family (spouse, spousal equivalent, dependent) is subject to the Independence Rule and its interpretations and are treated as covered members.
Close Relatives: Independence can be impaired in two major situations involving close relatives (nondependent children, brothers, sisters, parents, grandparents, parents-in-law, and their respective spouses):
A close relative has a financial interest in the client that is material to the close relative, and the CPA participating in the engagement is aware of the interest.
An individual participating in the engagement has a close relative who could exercise significant influence over the financial or accounting policies of the client.
Loans and Independence
A loan to or from an audited entity generally impairs independence.
Exceptions:
Automobile loans and leases collateralized by the automobile.
Credit cards/cash advances where the total outstanding balance is 10,000 or less by the payment date.
Loans must be made with normal lending procedures.
Effect of Actual or Threatened Litigation
Independence is impaired if:
The auditor sues management and alleges fraud or deceit.
Management sues the auditor alleging deficiencies in audit work.
Management expresses an intention to commence litigation against the CPA alleging deficiencies in audit work, if it is probable that a claim will be filed.
SEC and PCAOB Independence Requirements for Audits of Public Companies
The SEC's rules are based on four basic principles of auditor objectivity and independence:
An auditor should not audit his or her own work.
An auditor should not function in the role of management.
An auditor should not serve in an advocacy role for the entity.
An auditor should not have a mutual or conflicting interest with an audit client.
One-Year "Cooling Off" Period: Required for employees in a "financial reporting oversight role" who previously worked with the CPA firm performing the audit.
Compensation Restriction: A firm is not independent if an audit partner's compensation is based on selling engagements to that client for services other than audit, review, and attest services.
Independence Case Studies
Scenario 1: Lucy (Audit Partner) and Randy (Spouse)
Details: Lucy is an audit partner in the Boston office (where the lead audit partner for Bond Financial Services practices). Her spouse, Randy, holds 120 shares of Bond common stock, which is currently not material to their net worth. Randy makes his own investment decisions.
Analysis:
Lucy is a covered member (partner in the lead office).
Her spouse, Randy, is immediate family and thus subject to independence rules.
Randy's stock ownership in Bond is a direct financial interest of immediate family, making Lucy non-independent.
Conclusion: Lucy cannot work on the audit due to impaired independence.
Scenario 2: Denise (Consulting Senior Manager)
Details: Denise is a consulting senior manager in the Boston office, being considered for partnership, and provides no services to Bond. She contributes to a "529" educational savings plan.
Analysis:
Denise is not currently a covered member as she doesn't work on the audit and hasn't provided 10 hours of non-attest services.
Therefore, she does not currently need to determine if her 529 Plan holds Bond funds.
Note: If she were to provide services for 10+ hours, she would become a covered member and need to check.
Scenario 3: Sanjay (Tax Partner) and Dennis (Bond's COO)
Details: Sanjay (tax partner in a different office, no services to Bond) co-owns a vacation home with Dennis (Bond's COO). The investment is not material to either.
Analysis:
Sanjay is not a covered member as he is not on the attest team, not in the lead attest partner's office, and does not provide 10+ hours of non-attest services.
While not a covered member by rule, the firm might have stricter policies regarding business relationships with client executives.
Conclusion: Based purely on covered member definitions, Sanjay is not a covered member for Bond, so this relationship itself doesn't automatically impair firm independence through Sanjay. However, a significant business relationship could be an issue for firms with stricter internal policies or other specific rules.
Scenario 4: David (Staff Member) with Trust Account
Details: David (staff in Boston office, potentially on engagement team) has a trust account (sole beneficiary, 87,000 value) created by his grandparents (trustees, David has no control). Half of trust funds are in Bond stock/mutual fund, material to David's net worth.
Analysis:
David, as a staff member on the engagement team, is a covered member.
He has an indirect financial interest in Bond (through the trust).
The interest is material to his net worth.
Conclusion: Independence is impaired due to a material indirect financial interest.
Scenario 5: Adam (Staff Member) with Girlfriend
Details: Adam (staff in Boston office, potentially on engagement team) lives with his girlfriend, a former Bond employee, who has investments in Bond's 401(k) plan (holds Bond stock). They keep separate finances and have no marriage plans.
Analysis:
Adam is a covered member if on the engagement team.
The key is whether the girlfriend is considered a "spousal equivalent" or "dependent."
If she is considered a spousal equivalent, her investments would be treated as Adam's immediate family's direct financial interest, impairing independence.
If not, and they keep separate finances, it might not be a direct impairment for Adam, but the firm's policies on close relationships with client employees would be crucial.
Conclusion: Dependent on how "spousal equivalent" is interpreted by the firm and the independence standards. If she is explicitly a spousal equivalent per firm policy, then independence is impaired.
Scenario 6: Catyln (Manager) and Tim (Husband)
Details: Catyln (manager in Boston office, potentially covered member) has a husband, Tim, who is a Bond employee (human resources) and participates in Bond's stock compensation plan (holds unvested stock options).
Analysis:
Catyln's husband, Tim, is immediate family.
Tim's unvested stock options in Bond represent a direct financial interest of immediate family.
Conclusion: Independence is impaired. Catyln cannot serve on the engagement team.
Integrity and Objectivity (Rule 1.100.001)
In performing any professional service, a member must maintain objectivity and integrity, be free of conflicts of interest, and not knowingly misrepresent facts or subordinate his or her judgment to others.
Confidential Client Information (Rule 1.700.001)
A member in public practice shall not disclose any confidential client information without the specific consent of the client.
Five Exceptions to disclosing confidential client information without consent:
To meet disclosure and performance requirements (e.g., GAAP/GAAS).
To comply with a valid subpoena or summons.
To allow a review of a member's (CPA's) professional practice under the authority of the AICPA, state CPA society, or state board of accountancy.
To comply with an investigative or disciplinary proceeding.
To allow a review of a CPA's professional practice related to a purchase, sale, or merger of the practice.
Confidentiality Case Studies
Scenario 1: John Field (Partner) and State Board Review
Details: John Field, partner on the 2022 Beach Incorporated audit, is undergoing a review by the Florida State Board of Public Accountancy, which selected the Beach audit for review. Can John discuss client information with reviewers without consent?
Analysis: This falls under exception #3 (review of a member's professional practice under authority of a state board of accountancy).
Conclusion: Yes, John can discuss the audit and client information with the reviewers without client consent.
Scenario 2: Samantha Brown (Senior) and AICPA Investigation
Details: Samantha Brown, senior on the 2022 Dolphin Company audit, discovers a material misstatement post-issuance. The AICPA investigates, believing the audit partner was deficient. Can Samantha discuss client information with the AICPA without consent?
Analysis: This falls under exception #4 (comply with an investigative or disciplinary proceeding).
Conclusion: Yes, Samantha can discuss the audit and client information with the AICPA without client consent.
Quality Control
PCAOB Inspections (for public company audits):
Firms auditing more than 100 public companies (issuers) are inspected annually.
Firms auditing 100 or fewer public companies are inspected every 3 years.
AICPA Peer Review Program (for non-PCAOB regulated work):
Inspects work not done under PCAOB jurisdiction (e.g., private company audits).
Acts Discreditable (Rule 1.400.001)
A member shall not commit an act discreditable to the profession.
Examples of Acts Discreditable:
Inappropriate response to requests by clients and former clients for certain records.
Discrimination and harassment in employment practices.
Failure to follow standards/procedures or other requirements in government audits.
Negligence in the preparation of financial statements or records.
Failure to follow requirements of government bodies, commissions, or other regulatory agencies in performing attest or similar services.
Solicitation or disclosure of CPA examination questions and answers.
Failure to file a tax return or pay tax liability.
Disclosing confidential information obtained from employment or volunteer activities.
False, misleading, or deceptive acts in promoting or marketing professional services.
Acts Discreditable Case Studies
Scenario 1: Paul (Tax Partner) - Misleading Solicitation
Details: Paul, a newly promoted tax partner, seeking new clients, meets with Jaguar Company. He states his firm is well-equipped for all their tax needs, including transfer pricing, despite knowing only one person with that experience who just left the firm.
Analysis: This is a false, misleading, or deceptive act in promoting professional services.
Conclusion: This is an act discreditable to the profession.
Scenario 2: Jack (Staff Member) - CPA Exam Disclosure Request
Details: Jack, a new staff member, is taking the financial accounting section of the CPA exam. His friend Robert, who repeatedly failed, asks Jack to call immediately after the exam to share as many questions as possible.
Analysis: This involves solicitation or disclosure of CPA examination questions and answers.
Conclusion: This is an act discreditable to the profession. Asking or attempting to disclose specific exam content violates ethical standards. No. If Jack does disclose it would be discreditable. If he solicits as well. If he does it, it's a no.