Study Notes on Professional Conduct, Independence, and Quality Control

Chapter 19: Professional Conduct, Independence, and Quality Control

COLLEGE OF BUSINESS
COLORADO STATE UNIVERSITY

Page 2: Introduction to Professional Skepticism and Independence

  • Article Citation:

    • Title: If You Need Love, Get a Puppy: A Case Study on Professional Skepticism and Auditor Independence

    • Authors: Robert L. Braun and H. Lynn Stallworth

    • Source: Issues in Accounting Education, Vol. 24, No. 2 (May 2009), pp. 237-252

  • Abstract Overview:

    • Objective: Expand understanding of professional skepticism and independence concepts.

    • Case Based On: Actual incident involving a staff auditor accusing a friend of fraud.

    • Key Elements:

      • Exercise of professional skepticism

      • Auditor independence rules

      • Analysis of audit evidence and internal controls

      • Appropriate audit responses in adverse situations

Page 3: Definition of Professional Skepticism

  • Definition:

    • Professional skepticism is an attitude characterized by:

      • Questioning mind

      • Critical assessment of audit evidence

  • Approach:

    • The auditor does not assume management is either dishonest or inherently honest.

    • Auditors must seek persuasive evidence rather than being content with less due to beliefs about honesty.

  • Regulation Reference:

    • AS 1015.07-9 superseded AU 230 as of 12/31/2016

Page 4: Auditor Independence

  • Forms of Independence:

    • Independence in Mind:

      • Definition: Auditor’s true mental attitude regarding the client.

    • Independence in Appearance:

      • Definition: How an investor perceives the auditor’s independence based on external interpretations.

    • Independence in Fact:

      • Definition: Actual state of independence free from conflicts.

Page 6: Learning Objectives

  • Objectives Covered in Chapter 19:

    • LO 19-1: Ethics and Professionalism

    • LO 19-2: Theories of Ethical Behavior

    • LO 19-3: Standards of Auditor Professionalism

    • LO 19-4: AICPA Code of Professional Conduct

    • LO 19-5: Integrity, Objectivity & Independence

    • LO 19-6: SEC and PCAOB Independence

    • LO 19-7: General Standards and Accounting Principles

    • LO 19-8: Quality Management Standards

    • LO 19-9: PCAOB Inspections

Page 7: Role of Auditors

  • Gatekeepers Description:

    • Auditors serve as "gatekeepers" in public securities markets, crucial for capital formation.

    • Responsibilities:

      • Owe allegiance to creditors, stockholders, and the investing public.

      • The role demands complete independence from clients to maintain public trust.

Page 8: Overview of Ethics and Professionalism

  • Definitions:

    • Ethics:

      • A code of conduct based on moral duties and obligations for interpersonal interactions.

    • Professionalism:

      • Conduct, aims, or qualities characteristic of a profession or professional person.

    • Key Characteristics:

      • Unquestionable integrity

      • Solid reputation

Page 9: Standards of Professionalism by Type of Audit

  • Standards Overview:

    • Private Company Audit:

      • Follow AICPA auditing standards (GAAS).

    • Public Company Audit:

      • Governed by PCAOB standards, which are similar to ASB but with notable exceptions.

      • More stringent independence rules compared to private audits.

      • Cooley article mentions the now-defunct ISB, but applicable standards remain.

Page 10: Principles of Professional Conduct

  • Key Principles:

    1. Responsibilities:

      • Exercise sensitive moral and professional judgments in all activities.

    2. Public Interest:

      • Obligation to serve public interest and honor trust.

    3. Integrity:

      • Perform responsibilities with the highest sense of integrity.

    4. Objectivity and Independence:

      • Maintain independence in fact and appearance.

    5. Due Care:

      • Adhere to technical and ethical standards and improve competency.

    6. Scope and Nature of Services:

      • Observe the Code of Professional Conduct in determining service scope.

Page 11: Importance of Auditor Independence

  • Key Questions:

    • Why is auditor independence essential?

    • When is independence necessary?

Page 12: Services Requiring Independence

  • Requirement of Independence:

    • Independence must be maintained when performing any attest services, including:

      • Financial statement audits

      • Financial statement reviews

      • Other attest services such as agreed-upon procedures and reporting on internal control

  • Non-Attest Services:

    • Independence is not required for strictly non-attest services such as tax or consulting if these are the only services provided.

Page 13: Covered Members Definition

  • Who is a Covered Member:

    • Individuals on the attest engagement team

    • Individuals who can influence the engagement team

    • Managers/partners providing nonattest services to the attest client

    • The accounting firm and its employees

    • Organizations whose policies can be controlled by covered members

  • Resource Reference:

    • The AICPA Plain English Guide to Independence is a helpful resource for understanding these principles.

Page 14: Threats to Independence

  • Independence Impairments:

    • Financial Relationships

    • Business Relationships

    • Family Relationships

    • Actual or Threatened Litigation

    • Provision of Nonattest Services

Page 15: Financial Relationships Impairments

  • Prohibited Relationships:

    • Direct Financial Interest:

      • Example: ownership of individual stocks in audit entity (independence impaired regardless of materiality).

    • Indirect Financial Interest:

      • Example: mutual fund ownership (materiality matters; immaterial=not impaired).

    • Permissible Example:

      • CPA loan from bank audit entity issued at standard terms.

    • Impermissible Example:

      • Direct financial interest in audit entity in a blind trust; contingent audit fees are also not acceptable.

  • Monitoring Procedures:

    • Annual surveys and restricted entity lists to ensure compliance.

Page 16: Business Relationships Impairments

  • Independence Impacts:

    • Performing managerial or significant roles for a client during an attest engagement impairs independence.

    • Independence is also impaired if a partner/employee leaves the firm for a key position in an audit client unless specific conditions are met.

Page 17: Family Relationships Impairments

  • AICPA Code Requirements:

    • Immediate family classified under independence rule.

    • Close relatives with material investment or control over the client impair auditor independence if knowledgeable.

    • Categories of Family Affected:

      • Spouses, dependents, parents, siblings, and nondependent children.

Page 18: Litigation Impacts on Independence

  • Independence Impairments Due to Litigation:

    • Independence is impaired if litigation is pending or threatened by the client due to deficient audit work.

    • Any litigation initiated by the auditor against the client also compromises independence.

Page 19: Nonattest Services Restrictions

  • Regulatory Framework:

    • AICPA, SEC, and SOX impose restrictions on specific nonaudit services provided to audit clients.

    • Most relevant examples of restrictions include:

      • Bookkeeping

      • Design/implementation of financial information systems

      • Fairness opinions

      • Internal audit outsourcing

      • Management functions

      • Legal services

      • Unrelated expert services

Page 20: AICPA Rules for Attest Clients

  • Engagement Conditions:

    • Firm must ensure clients handle certain functions when performing nonattest services, such as:

      • Management decisions made by clients

      • Client overview by skilled individual

      • Evaluation of service adequacy and responsibility acceptance

      • Maintenance of internal controls

    • Compliance Assurance:

      • Involvement of specific language in engagement letters to enforce these conditions.

Page 21: Job Offers Impact on Independence

  • Duty to Report:

    • Engagement team members must report any job offers or negotiations with attest clients and must remove themselves from engagements until concluded.

    • This is further emphasized in internal training sessions by firms like Moss Adams.

Page 22: SEC Independence Standards

  • Sarbanes-Oxley Act Provisions:

    • Identifies nine non-audit services that impair auditor independence when provided, including:

      • Bookkeeping and financial services

      • Valuation and actuarial services

      • Internal audit outsourcing

      • Investment services

      • Legal services

    • Core Idea: Auditors should not audit their own work or advocate for clients.

Page 23: SEC Accountability Measures

  • Approval Process:

    • Audit Committee must approve all non-audit services.

  • Partner Rotation Rules:

    • Audit partners must rotate after five years.

    • One-year “cool off” for partners assuming oversight roles in financial reporting post-audit.

  • Compensation Concerns:

    • Firms are not independent if audit partner remuneration depends on selling non-attest engagements to clients.

Page 24: General Standards and Ethical Principles

  • Overview of AICPA Code:

    • Sets a foundational ethics level for auditors to ensure independence and objectivity in judgments.

Page 25: Quality Control Standards

  • Quality Management Standards Overview (LO 19-8):

    • Establish CPA firm policies and procedures for compliance assurance.

    • Comprise six elements as per SQCS No. 8.

  • PCAOB Inspections Overview (LO 19-9):

    • PCAOB conducts inspections of audit practices and quality control.

    • Annual inspections for public company audits exceeding 100 and triennial for all other registered firms.