Professional Ethics Chapter 4

Key Topics in Chapter 4 AICPA Code of Professional Conduct Rule 101, Independence Rules 301, 302, 501, 503 Sarbanes-Oxley Act and SEC Provisions Addressing Auditor Independence

Special Need for Ethical Conduct in Professions Our society has attached a special meaning to the term professional. A professional is expected to conduct himself or herself at a higher level than most other members of society. Trustworthiness and a strong sense of ethics are assets of the CPA.

AICPA Code of Professional Conduct Principles Ideal standards of ethical conduct stated in philosophical terms. They are not enforceable. Rules of conduct Minimum standards of ethical conduct stated as specific rules. They are enforceable. Interpretations of the rules of conduct Interpretation of the rules of conduct by the AICPA Division of Professional Ethics. They are not enforceable, but a practitioner must justify departure.

AICPA Code of Professional Conduct Ethical rulings Published explanations and answers to questions about the rules of conduct submitted to the AICPA by practitioners and others interested in ethical requirements. They are not enforceable, but a practitioner must justify departure.

Who Falls Under the AICPA Rules of Conduct (Code)? Technically, members of the AICPA. However, state and federal courts have held that all practicing CPAs must follow ethical standards, as set forth in the Code of Professional Conduct.

Standards of Conduct Substandard Ideal conduct by practitioners Principles Rules of conduct Substandard Ideal conduct by practitioners Minimum level of conduct by practitioners

Independence The value of auditing depends heavily on the public’s perception of the independence of auditors. Independence in fact, means the member must be unbiased and objective mentally – it is a state of mind. Independence in in appearance means that knowledgeable users of financial statements must believe the auditor is independent – avoiding observable conflicts of interest

AICPA Rules of Conduct Rule 101 – Independence A member in public practice shall be independent in the performance of professional services as required by standards promulgated by bodies designated by Council.

Financial Interests Interpretations of Rule 101 prohibit covered members from owning any direct investments in audit clients. Covered members Direct versus indirect financial interest Material or immaterial

Engagement Based Approach Covered members are persons in a position with the potential to influence audit decisions, including: Individuals on engagement team. Individuals who supervise or evaluate the engagement partner. Partners who provide non-attest services to the client. Refer to p. 86 of chapter for others.

Prohibited Activities by Covered Members Members cannot: Have a direct or material indirect investment in the audit client. Be a director, officer, manager, or employee of the client. Participate in joint business ventures with the client. Have loans to or from the client. Automobile loans and leases Collateralized loans Credit cards and cash advances #2 Trustee who lacks authority to make investment decisions is allowable. #4 Unpaid fees by the client assume the characteristics of a loan. Exceptions to the loan rule include automobile loans and leases (collateralized by the auto) loans fully collateralized by cash deposits of the cash surrender of life insurance policies Credit cards and cash advances with the aggregate outstanding balance is $5,000 or less

Related Financial Interests Issues Former practitioners Normal lending procedures Financial interests and employment of immediate and close family Joint investor or investee relationship with client Director, officer, management, or employee of a company

Litigation Between CPA Firm and Client A lawsuit or intent to start a lawsuit between a CPA firm and its client is a violation of Rule 101 for the current audit.

Bookkeeping The AICPA Code permits a CPA firm to do both bookkeeping and auditing for the same client. See p. 89. Note that SOX takes a different position with publicly traded (SEC) clients, p. 83.

Other Services and Unpaid Fees Consulting and other nonaudit services Must avoid performing management functions Note that SOX takes a different position with publicly traded (SEC) clients, p. 83 Unpaid fees Can cause a conflict of interest if they relate to professional services provided more than one year prior to the date of the report

Rule 301 – Confidential client information Generally, a member may not disclose any confidential client information without the specific consent of the client. Exceptions: Obligations related to technical standards Subpoena or summons Peer review Response to ethics division

Rule 302 – Contingent fees Contingent fees for any professional services are generally prohibited when (1) a member (or firm) performs: (a) an audit or review of financial statements; or (b) a compilation of a financial statement (see text) (c) an examination of prospective financial information; or (2) Prepare an original or amended tax return or claim for a tax refund for a contingent fee for any client.

Rule 501 – Acts discreditable A member shall not commit an act discreditable to the profession, including: Retention of client records. Discrimination and harassment in employment practices. Failure to follow standards and/or procedures or other requirements in governmental audits. Negligence in the preparation of financial statements or records. Failure to follow requirements of governmental bodies, commissions, or other regulatory agencies in performing attest or similar services. Solicitation or disclosure of CPA examination questions and answers. Failure to file tax return or pay tax liability.

Rule 503 – Commissions and referral fees Commissions are not allowed when a member or the member's firm also performs for that client: An audit or review of financial statements; or A compilation of a financial statement (see text) ; or An examination of prospective financial information. Disclosure of permitted commissions or referral fees.

Other AICPA Rules of Conduct 102 – Integrity and objectivity 201 – General standards 202 – Compliance with standards 203 – Accounting principles 502 – Advertising and other forms of solicitation 505 – Form of organization and name

Enforcement mechanisms for the rules of conduct Action by AICPA: Remedial or corrective action Expulsion and notification to that effect in the CPA Newsletter Action by a state Board of Accountancy: Varies by state, but license may be revoked.

Sarbanes-Oxley Act and SEC Provisions Addressing Auditor Independence The SEC adopted rules strengthening auditor independence in January 2003 Consistent with the requirements of the Sarbanes-Oxley Act. The Sarbanes-Oxley Act and the revised SEC rules further restrict, but do not completely eliminate the type of nonaudit services that can be provided to the public.

Who Falls Under the SEC Provisions for Auditor Independence? Auditors of publicly traded companies.

Sarbanes-Oxley Act and SEC Provisions Addressing Auditor Independence Prohibited Services 1. Bookkeeping and other accounting services 2. Financial information systems design and implementation 3. Appraisal or valuation services 4. Actuarial services 5. Internal audit outsourcing 6. Management of human resource functions 7. Broker or dealer or investment adviser or investment banker services 8. Legal and expert services unrelated to the audit 9. Any other service that the PCAOB determines by regulation is impermissible

Audit Committees An audit committee is a selected number of members of a company’s board of directors whose responsibilities include helping auditors remain independent of management. Duties include: Pre-approval of all audit and nonaudit services Oversight of auditors work Resolution of disagreements between management and auditors

Audit Committees The Sarbanes-Oxley Act requires that all members of the audit committee be independent. Companies must disclose whether or not the audit committee includes at least one financial expert.

Conflicts Arising from Employment Relationships The SEC has added a one year “cooling off ” period before a member of the audit engagement team can work for the client in certain key management positions. Chief Executive Officer Chief Financial Officer Chief Accounting Officer Equivalent positions to the above

Partner Rotation The Sarbanes-Oxley Act requires that the lead and concurring audit partner rotate off the audit engagement after a period of five years.

Ownership Interests SEC rules adopted in 2000 on financial relationships narrow the restrictions on ownership in clients to those persons who can influence the audit. Members of the engagement team Those in a position to influence audit engagement Partners and managers providing >10 hrs of non-audit svcs. to client Partners in the office of the partner primarily responsible for engagement