Chapter 4

AICPA Code of Professional Conduct

Questions for Consideration1. What are the ethical obligations of CPAs

under the AICPA code?2. What is the role of independence in an audit

and how can CPAs manage the threats that exist to audit independence?

3. What are the professional and ethical obligations of CPAs in performing nonattest services including tax services?

Independent Audit

• Foundation for accounting profession• Trust by the public in audit opinion• Public obligation supersedes that to a client• Total independence from client• Members should act with integrity• Clients’ and employers’ interest served by

fulfilling responsibility to public

Public Interest in Accounting

• Major fraudulent financial statement frauds in early 2000s; effected virtually every continent– Public trust in accountants compromised – Lack of internal controls, ineffective internal audits,

and inattentive BOD all share blame for these frauds – How to rebuild public trust and confidence in

financial reporting– Profession must rebuild its reputation on its

historical foundation of ethics and integrity

The International Federation of Accountants (IFAC)

• Examined ways to restore credibility of financial reporting and recommended: – More effective corporate ethics codes – Provision of training and support for individuals within

organizations• International Ethics Standards Board of Accountants

(IESBA) & International Accounting Education Standards Board (IAESB)– Establish guidelines for about 2.5 million accountants– AICPA agrees to have ethics standards that are at least as

stringent as the IESBA standards

Professional Ethics Identified by IESBA

• Fundamental principles: integrity, objectivity, professional competence and due care, confidentiality, and professional behavior

• Ethics education needed to:– Develop a sense of ethical responsibility in accountants – Improve the moral standards and attitudes of accountants – Develop the problem-solving skills that have ethical

implications – Develop a sense of professional responsibility or obligation

• State boards of accountancy realize need for ethics education to incorporate behaviors and attitudes with ethics and ethical reasoning

Investigations of the Profession

• High profile frauds in the 1970s, 1980s, 2000s• Congressional concern of auditors’ ethical and

professional responsibilities• Themes of investigations

1. Nonaudit services impairing auditor independence2. Management to report on internal controls3. Prevention and detection of fraud4. Role of audit committee and communication

between them and auditors

Metcalf (Moss) Committee

• First investigation of profession since 1930s• Conducted between 1975-1977• Some recommendations– Establish self-regulatory organization of firms – Led to AICPA two-tier voluntary peer review program

• Public company clients (assumed by PCAOB in 2004)• Private companies

– Limitation of management service to those directly related to accounting

• Report didn’t lead to any new legislation at the time

Cohen CommissionExamined issues:• Auditor’s responsibility for detecting fraud• Expectation gap between public expectations and profession’s goals for the auditRecommendations:• Management should report on its internal controls• Auditors should evaluate management’s report• Both enacted as part of Sarbanes-Oxley Act of 2002Importance of Cohen Commission:• Demonstrated conflicts of providing nonauditing services for an audit client• Lowballing fees

– Deliberately underbidding for an audit; Less prevalent after SOX• Opinion shopping

– Client seeks auditor who will go along with accounting treatment• Later Major scandals

– 1980s – Savings and Loan Crisis– 1990s – 2000s – Earnings Management Crisis

Early 1980s• Fraud failure with ESM Government Securities,

Continental Illinois National Bank and Trust, and Penn Square Bank

• Rep. Wyden authored 1986 bill to hold auditors responsible for fraud detection

• Rep. Shad modified bill– Internal control reports– Detection of Material illegalities or irregularities– Bill did not pass

• ZZZZ Best Co.– Created fictitious revenue that amounted to 80% of total

revenue; Rep. Dingell chaired investigation; auditors did not disclose fraud to authorities

Savings and Loan Failures: Late 1980’s & Early 1990’s

• $300 million failure - Beverly Hills Savings and Loan • $250 million failure - Sunrise Savings– Deloitte & Touche audit

• $400 million overstatement at Western Savings Association– Arthur Young audit

• Lincoln Savings and Loan– Arthur Young Role gave unqualified opinion

• Accounting issues in failed S&Ls centered on three issues: – Inadequate allowances for loan losses – Non-disclosure of related party transactions – Inadequate internal controls

Treadway Commission Report• The National Commission on Fraudulent Financial Reporting• 1985 study and report on factors leading to fraudulent financial

reporting; formed in response to S&L debacle• Sponsored by Committee of Sponsoring Organizations (COSO)• COSO 1992 Internal Control Project most significant contribution to

date– Need to change the corporate culture– Establish systems to prevent fraud– Tone at the Top – sets ethical tone of organization– Extended review to role and responsibilities

• Internal Auditors• External Auditors• Board of Directors

– Importance of strong control environment– Internal auditors must have direct and unrestricted access to Audit

Committee of BOD• COSO Enterprise Risk Management – Integrated Framework

2007 – 2008 Financial Crisis

• Excessive risk taking• Mortgage meltdown• Moral Hazard – One person responsible for the

interests of another, but has incentive to put own interests first

• Concern over independence, objectivity, and audit quality

• Growing personal and business relationships between auditing firms, the client, and client management

• Emphasis on marketing of professional services• Lehman’s Brothers

Lehman’s Financial Transactions and Accounting Disclosures

• Insufficient liquidity to meet its current obligations • CEO, CFOs, and external auditors all failed to meet professional

responsibilities• Lehman used “Repo 105”, did not disclose its use • Share dropped 94% over 8 months, from $62.19 to $3.65 a share• U.S. refused to fund a solution for Lehman• SEC unit knew about problems and did nothing• SEC requires mandatory rotation of key audit personnel within a

firm every five years • Controversial proposal is to institute a mandatory auditor

rotation policy whereby every few years (i.e., 5 or 10 years) there would be a required change in the audit firm

AICPA, State Boards, NASBA• AICPA

– Code of Conduct model for state societies codes– Applies to members of these voluntary organizations

• State boards of accountancy– License accountants in a given state– Establishes standards of professional conduct– Most important rules to follow– Rules take precedent over AICPA

• National Association of State Boards of Accountancy (NASBA)– 55 state boards of accountancy– Uniform accountancy act

• Either/or approach for ethics education• Substantial equivalency provision

Professional Services of CPAs• Cornerstone ethical obligation to society is to render an

opinion on the financial statements – Review - assurance that no material modifications needed– Audit - reasonable assurance that financial statements are

free of material misstatements• Compilation - based on data provided – No assurance– Independence not required

• SOX prohibits performance of certain services for audit clients– Create conflict of interest– Impairs independence– Cannot act as member of client’s management

AICPA and IFAC Code of Professional Conduct

• Apply to CPAs– Public accounting– Private industry– Government agencies– Educational institutions

• Covered professional services– Accounting– Auditing and assurance services– Taxation– Financial advisory services– Consulting services

Practice of Public Accounting• Performance of specific services for a client• Holding out as a CPA• Professional services– Accounting– Auditing – Tax– Personal financial planning– Litigation support– Advisory services– Consulting

AICPA and IFAC Principles of Professional Conduct

• Integrity principle should be used when:– Accounting rules are unclear– Difference of opinion with an employer or client on an

accounting issue – Conflicts between the interests of stakeholder groups

• IFAC fundamental principles– Integrity; Objectivity; Professional Competence and Due Care;

Confidentiality; and Professional Behavior – IFAC explicitly recognizes compliance with relevant laws and

regulations and avoiding actions that bring discredit on the profession; also explicitly recognizes a Confidentiality principle

Conceptual Framework for AICPA Independence Standards

• Independence required for audit and other attestation services; in fact and in appearance

• AICPA uses risk based approach for analyzing threats using the following steps:– Identifying and evaluating threats to independence – Determining whether safeguards already eliminate or

sufficiently mitigate identified threats and whether threats that have not yet been mitigated can be eliminated or sufficiently mitigated by safeguards

– If no safeguards are available to eliminate an unacceptable threat or reduce it to an acceptable level, independence would be considered impaired

Threats to IndependenceIndependence must be in fact and appearance

Threats include:• Self review threat• Advocacy threat• Adverse interest threat• Familiarity threat• Undue influence threat• Financial self-interest threat• Management participation threat

• Safeguards to counteract threats:– Safeguards created by the profession, legislation, or regulation – Safeguards implemented by the attest client – Safeguards implemented by the firm

Financial Relationships that Impair Independence

• Direct or material indirect financial interest in a client

• Loans to or from a client– Example: Alexander Grant and ESM– Permitted Loans• Automobiles loans collateralized by the car• Loans fully collateralized by cash deposits at the same

financial institution (passbook loans)• Credit cards and overdraft accounts of $10,000 or less

Other Relationships

• Family Relationships– Immediate family members

• Spouse or spouse equivalent, or dependents

– Close relatives in financial sensitive position with the client or material financial interest• Parent, sibling, or nondependent child

– Subject to independence rule if CPA knows member has material financial interest

• Business Relationships– Partner or manager who provides more than 10 hours of

nonattest services to the attest client– Partnerships or joint ventures with attest client

Providing Nonattest Services to an Attest Client

• Certain lucrative nonattest services creates a conflict of interests

• Gives the client leverage over the CPA firm and its audit opinion

• Client must agree to perform the following functions:1. Make management decisions and perform all

management functions2. Designate competent overseer of these services3. Evaluate adequacy and results of services performed4. Accept responsibility for the results of the services5. Establish and maintain internal controls

SEC Positions

• Emphasizes independence in fact and appearance in 3 ways:

1. Proscribing certain financial interests and business relationships with the audit client

2. Restricting certain nonauditing services to audit clients3. Subjecting all auditor conduct to a general standard of

independence• 3 principles that underlie auditor independence: – An auditor cannot function in the role of management – An auditor cannot audit her own work – An auditor cannot serve in an advocacy role for her client

General Standard of Independence• Judged by a reasonable investor with knowledge of all relevant

facts and circumstances• Auditor must be capable of exercising objective and impartial

judgment on all issues within the engagement• Principles

– Situations which impair independence1. Creates a mutual or conflicting interest between an accountant and

his audit client2. Places an accountant in the position of auditing his own work3. Results in an accountant acting as management or employee of the

audit client4. Places an accountant in position of being an advocate for the audit

client

SEC Actions Against Auditing FirmsPeopleSoft Case• EY and PeopleSoft developed a software program • Joint sales and marketing; license fees and royalty• Mutuality of interests/financial self-interest threatKPMG Audit Partner, Scott London• Insider Trading on Skechers and Herbalife• Leaking confidential information to jeweler friendDeloitte Management Advisory Partner, Thomas

Flannigan• Insider trading by Flannigan and son

Sarbanes-Oxley Provisions: Prohibited Nonattest Service for Public Clients

1. Financial information systems design and implementation2. Appraisal or valuation services, fairness opinions, or

contribution-in-kind reports3. Actuarial services4. Internal audit outsourcing services5. Management functions or human resources6. Broker or dealer services, investment adviser, or investment

banking services7. Legal services and expert services unrelated to the audit8. Any other service prohibited by BOD

• Tax services must be preapproved by the audit committee

Corporate Responsibility for Financial Reports

• CEO and CFO certify financial reports– No untrue statement of material facts– No omission or misleading material facts

• Required by section 302 of SOX• Penalties in section 906 of SOX– Maximum fine of $1 million– Maximum imprisonment is 10 years– Or both fine and imprisonment– Willful false certification - $5 million and 20 years,

or both

HealthSouth: The Case of Richard Scrushy

• First major test of Section 302 in 2003• Earnings restatement of $2.7 billion• State acquitted Scrushy but SEC brought

successful federal suit against him• Sanctions and penalties– Permanently barred from public company officer

or director– Permanently enjoined from future violations– Requires payment of $81 million in disgorgement

and civil penalties

Principles of Professional Practice

• Integrity and objectivity– Rule 102 of AICPA Code– IESBA takes a broader view than the AICPA – Quality of CPA

• Section 200 of Code outlines basic principles for requirements to follow professional standards in public accounting—i.e., GAAP, SAS, SSARS

• Rule 201: Due Care– Perform services competently, accurately, and completely – Quality of services

Other Professional Standards

• Rule 203 of the AICPA Code– Financial statements in conformity with GAAP– Disclosures in conformity with GAAP– Applies equally to internal and external

accountants• 2 sources of GAAP: – (1) authoritative standards – (2) nonauthoritative

Responsibilities to Clients• Rule 301: confidential client information

– CPA’s obligation not to divulge client information (unless client agrees)– Internal whistle blowing allowed; external may violate confidentiality– Permitted disclosure of confidential client information

• Response to validly issues subpoena or summons• Adherence to applicable laws and regulations• Compliance with peer review of CPA practice• Defense in an investigation of the CPA

• Rule 502: Advertising and solicitation permitted– Requires that advertising not be false, deceptive or misleading or

imply ability to influence official bodies– Prohibits solicitation by use of coercion, over-reaching, or harassing

conduct– CPAs “pushing the envelope”

Confidentiality/Illegal Acts & Whistleblowing

• When the auditor believes a client has committed an illegal act that has a material effect on the financial statements, the matter must be reported to the audit committee.

• The board then has one business day to inform the SEC. If the board decides not to inform the SEC, the auditor must provide the same report to the board within one business day or resign from the engagement.

Auditor Obligation to Blow the Whistle on Illegal Acts

• If a client refuses to accept an auditors’ report that has been modified in any of the following situations, the public accounting firm should withdraw from the engagement and give its reasons in writing to the board of directors:

• (1) the inability to obtain sufficient appropriate evidence about a suspected illegal act; (2) failure to account for or disclose properly a material amount connected with an illegal act; or (3) the inability to estimate amounts involved in an illegal act.

Responsibilities to Clients (Cont)• Rule 302 Contingent fees from an attest (audit) client

– Prohibits acceptance of contingent fees if CPA or firm performs any of the following:

(1) an audit or review of a financial statement(2) compilation of financial statement that third party may use (3) examination of prospective financial information(4) prepares original/amended tax return

– Permits acceptance of contingent fee based upon initiation by and findings of governmental agencies

• Rule 503 Commissions– Cannot accept a commisson from audit client– Commissions require a disclosure by a CPA to the client when

recommending that service or product to which the commission relates

Ethical Standards in Operating a CPA Practice

• State boards have regulatory authority over practice units and alternative practice structures (APS), as well as individual CPAs

• Rule 505 permits practice of public accounting only in form of organization permitted by state law or regulation

• Prohibits use of a firm name that is misleading• Requires that a majority of the ownership of

the firm belongs to CPAs to be a CPA firm

Acts Discreditable• Client Books and Records

– Client-provided records– Member-prepared records, product or papers– Reasonable time period, reasonable fee

• Negligence in the Preparation of Financial Statements or Records

• Other – Discrimination and harassment – Failure to follow standards – Solicitation or disclosure of CPA exam questions– Failure to file tax returns or pay taxes– False, misleading, or deceptive acts in promoting or marketing

professional services

Client Books/CPA Work Papers

• Client-provided records in the custody or control of the CPA should be returned to the client at the client’s request.

• Unless a CPA and the client have agreed to the contrary, when a client makes a request for member-prepared records, or a member’s work products that are in the custody or control of the CPA/CPA firm that have not previously been provided to the client, the member should respond to the client’s request as follows:

Client Books/CPA Work Papers• Member-prepared records relating to a completed and issued work

product should be provided to the client, except that such records may be withheld if there are fees due for the specific work product.

• Member’s work products should be provided to the client, except that such work products may be withheld in any of the following circumstances:

• If there are fees due to the member for the specific work product• If the work product is incomplete• For purposes of complying with professional standards (for example,

withholding an audit report due to outstanding audit issues)• If threatened or outstanding litigation exists concerning the

engagement or member’s work• For purposes of complying with professional standards (for example,

withholding an audit report due to outstanding audit issues)• If threatened or outstanding litigation exists concerning the

engagement or member’s work

Ethics and Tax Services

• Rule 101 – audit independence may be impaired by certain tax services

• Rule 102 – maintain integrity and objectivity in performing tax services

• Rule 201 – exercise of due care• Rule 202 – follow professional standards,

Statements on Standards for Tax Services• Rule 301 – confidentiality• Rule 302 – acceptance of contingent fees

Tax Compliance Services

• Preparation of a tax return• Transmittal of a tax return• Transmittal of any related tax payment to the

taxing authority• Signing and filing a tax return• Authorized representation of clients in

administrative proceedings before a taxing authority

• May not impair a CPA’s independence

Statements on Standards for Tax Services

• 7 statements explain CPAs’ responsibilities to their clients and the tax systems

• Tax different from audit:– Independence requirement for an auditor does not pertain to the tax practitioner – Objectivity relates to tax services differently

• SSTS No.1, Tax Return Positions– CPA should not recommend a tax position that minimizes tax burden unless it has

a “realistic possibility of success”• More likely than not (greater than 50%); substantial authority (40% likelihood); realistic

possibility of success(33%); reasonable basis (20%)

– CPA doesn’t need to satisfy realistic possibility in tax planning if all of the following are true: reasonable basis exists for position, CPA recommends appropriate disclosure, and higher standard is not required under laws

• Commitment to balance advocacy and planning with compliance• Tax return information is taxpayer’s representation of facts• CPA can recommend a non-frivolous position with appropriate disclosure

Tax Shelters• Sometimes called tax avoidance transactions• “Prohibited tax shelter transaction" means listed transactions,

transactions with contractual protection, or confidential transactions

• Investments to help wealthy clients avoid paying taxes• In KPMG case, the firm prepared false documents to deceive

regulators (fraud)– KPMG shelters broke the law since no economic risk and designed solely

to minimize taxes– KPMG shelters generated $11 billion in fraudulent losses and $2.5 billion

in tax evaded– KPMG settled criminal tax case for $456 million

• Most recent tax shelter scandal: BDO failed to register various tax shelters as required by law

PCAOB Rules on Tax ServicesVariety of standards that pertain to ethics and independence:

– Rule 3520: Auditor Independence– Rule 3521: Contingent Fees; mirrors rules 302 & 503 of AICPA code– Rule 3522: Tax Transactions; “aggressive tax position” transaction– Rule 3523: Tax Services for Persons in Financial Reporting Oversight Roles; not

independent if firm provides tax services to persons who serve in financial reporting oversight roles at an audit client unless:• Person only serves as member of BOD• If member serves in an affiliate of audit company and has non material financial

statements • Person was not in role when audit began

– Rule 3524: Audit Committee Pre-Approval of Certain Tax Services– Rule 3525: Audit Committee Pre-Approval of Nonaudit Services Related to

Internal Control Over Financial Reporting– Rule 3526: Communication With Audit Committees Concerning Independence