Auditing Course Assignment

2-1

Professionalism and Professional Responsibilities

CHAPTER 2

Au di

t D at

a An

al yt

ic s

(C ha

pt er

7 )

Au di

t E vi

de nc

e (C

ha pt

er 5

)

Client Acceptance/Continuance and Risk Assessment (Chapters 3 & 4)

Develop Responses to Risk and an Audit Strategy

Gaining an Understanding of

the Client

Identify Significant Accounts and Transactions

Set Planning Materiality

Make Preliminary Risk Assessments

Gaining an Understanding of Internal Controls

(Chapter 6)

Overview of Audit and Assurance

Audit Assurance (Chapter 1)

Concluding the Audit and Reporting (Chapters 14 & 15)

ReportingDrawing AuditConclusions Procedures Performed Near

the End of the Audit

Auditing the Balance Sheet and Related Income Accounts

(Chapter 13)

Auditing Purchases, Payables, and Payroll

(Chapter 12)

Auditing Sales and Receivables

(Chapter 11)

Reliance on Internal Controls (Chapter 8)

Substantive Strategy (Chapter 9)

Audit Sampling for Substantive Tests (Chapter 10)

Professionalism and Professional Responsibilities (Chapter 2)

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2-2 CHAPTER 2 Professionalism and Professional Responsibilities

Auditing and Assurance Standards

PCAOB ETHICS AND INDEPENDENCE RULES 3501 Definitions of Terms Employed in Section 3, Part 5 of the Rules

3502 Responsibility to Not Knowingly or Recklessly Contribute to Violations

3520 Auditor Independence

3521 Contingent Fees

3522 Tax Transactions

3523 Tax Services for Persons in Financial Reporting Oversight Roles

3524 Audit Committee Pre-approval of Certain Tax Services

3525 Audit Committee Pre-approval of Non-audit Services Related to Internal Control over Financial Reporting

3526 Communication With Audit Committees Concerning Independence

AICPA ETHICAL STANDARDS AICPA Code of Professional Conduct

Learning Objectives

LO1 Explain what it means to be a professional and how these traits apply to auditors.

LO2 Explain the structure of the AICPA Code of Professional Conduct.

LO3 Apply the conceptual framework approach to ethical decision making for members in public practice.

LO4 Evaluate the ethical behavior needed to comply with rules of conduct on integrity and objectivity.

LO5 Evaluate the ethical behavior needed to comply with rules of conduct on independence.

LO6 Evaluate the ethical behavior needed to comply with rules of conduct on general standards.

LO7 Evaluate the ethical behavior needed to comply with other rules of conduct for members in public practice.

LO8 Evaluate an auditor’s legal liability under common law.

LO9 Evaluate an auditor’s legal liability under statutory law.

Cloud 9 - Continuing Case Ron McLellan came to an arrangement with Chip Masters and sold McLellan’s Shoes to Cloud 9 Inc. (Cloud 9) in 2021. As part of the sale agreement, Ron McLellan was appointed to the Cloud 9 board of directors.

The accounting fi rm W&S Partners is bidding for the December 31, 2022 audit of Cloud 9. The partner responsible for writing the proposal, Jo Wadley, asks Sharon Gallagher and Josh Thomas to assist. Sharon will be the audit manager if the proposal

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Professionalism and Accounting 2-3

Chapter Preview: Audit Process in Focus The purpose of this chapter is to provide an overview of professionalism and the professional responsibilities of a certifi ed public accountant and auditor.

The chapter opens with a discussion of what it means to be a professional. The term pro- fessional is often used in a number of contexts. This introductory section discusses the various uses of the term and focuses on the relevance of the term for certifi ed public accountants (CPAs) and auditors.

A code of professional ethics is a critical part of any profession’s commitment to serve the public interest. A signifi cant portion of this chapter focuses on the Code of Professional Con- duct of the American Institute of Certifi ed Public Accountants (AICPA). This section begins with a discussion of the organization of the AICPA Code of Professional Conduct, followed by a discussion of how to use the Code’s conceptual framework for ethical decision making. It then explores the Code’s rules related to (1) integrity and objectivity, (2) independence, (3) general standards, and (4) other rules of conduct for members in public practice. Since you are studying to be an accountant or a CPA, you should develop the ability to evaluate various situations, and to appropriately apply the rules of conduct as circumstances dictate.

An overview of the auditor’s legal responsibilities and liability is discussed next. An auditor’s legal responsibilities fall into two broad categories. The fi rst is an auditor’s responsibilities under common law. Common law is a general law, such as law related to contracts, and it is derived from principles based on justice, reason, and common sense rather than absolute, fi xed, or infl exible rules. The principles of common law are determined by the social needs of the community or the state. Second, the chapter discusses the auditor’s responsibilities under securities law. Securities laws have been written to address the auditor’s responsibilities related to the new issue of a secu- rity, or related to the trading of securities on various exchanges. All auditors should understand their legal obligations to clients and the third-party investors who rely on their reports.

is successful. Her task is to help write the proposal documents and win the job for the fi rm. However, even more importantly, she must make sure that there are no surprises for the audit team once they win the audit. Sharon knows how crucial this is. She still has night- mares about an audit she worked on when she was a new graduate at another audit fi rm. The client in that case threatened to dismiss the auditor when the auditor wanted him to recognize an impair- ment loss on some assets. The client was the fi rm’s largest account and the partner was under a lot of pressure to keep the client.

Josh is an audit senior. He has not been involved in the pro- posal process before, and needs the experience so he can be pro- moted to audit manager. Sharon and Josh do not know anything about Cloud 9 except that it manufactures and retails customized basketball and other sports shoes, and it is a publicly listed U.S. company. Sharon stresses to Josh that they want to know that the client is not going to be diffi cult to deal with, and that W&S Part- ners can do a good job on the audit. Josh asks how they can know that now, before they start the audit.

Professionalism and Accounting

LEARNING OBJECTIVE 1 Explain what it means to be a professional and how these traits apply to auditors.

Is public accounting a recognized profession? If so, what does it mean to be part of a recognized profession? What rights come with being part of a recognized profession? Further, what respon- sibilities come with being part of a recognized profession? Is being a professional about expertise and about quality of work in a chosen occupation, or is it something more? These are important questions, and the answers are often misunderstood by many. These issues were covered well by Robert K. Mautz in a 1988 editorial in Accounting Horizons,1 and his views are summarized below.

1Robert K. Mautz. “Public Accounting: What Kind of Professionalism?” Accounting Horizons 2, no. 3/4 (1998): 121–125.

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2-4 CHAPTER 2 Professionalism and Professional Responsibilities

One way that professionals are commonly defi ned is by level of expertise. Professional athletes are often referred to as “pros” because of their skill and level of expertise. The same term may be used related to virtually any occupation as a way of recognizing an individual’s high level of skill. In the competitive world, the high level of skill is usually well rewarded, and the public often measures success of competitors in monetary terms. Robert Mautz refers to this defi nition of a professional as an expert competitor (EC professional). In the context of an EC professional, the profession is usually defi ned by the line or work or occupation (e.g., football, basketball, coaching, or consulting).

Another way to defi ne a professional, or a profession, relates to a profession’s respon- sibility and concern for the public interest. Such professions include medicine, architec- ture, and public accounting. Robert Mautz refers to this defi nition of a professional by its concern for the public interest (CPI professional). CPI professions are often recognized by a specialized body of knowledge, a formal education process, standards governing admis- sion to the profession, a code of ethics, recognized status indicated by a license, a public interest in the work that practitioners perform, and the recognition by practitioners of an obligation to society.

The cornerstone of the public accounting profession is recognized in the public interest in the work done by CPAs. State governments (through state boards of accountancy) grant a CPA license to individuals who complete the required education, pass a professional examination (the CPA exam), and complete an experience requirement. Upon obtaining a CPA license, a CPA has the unique right to sign an audit or attest report, and to sign tax returns as a tax preparer (a right that is also granted to licensed tax preparers). Upon becoming licensed as a CPA, individuals also agree to accept the responsibility to follow professional standards (e.g., accounting and auditing standards), and a code of professional conduct (usually written into state rules or law). This chapter will cover the AICPA Code of Professional Conduct that is recognized by many state boards of accountancy.

Chapter 1 summarized the demand for auditing, and the need for auditors to be inde- pendent of management when serving the public interest. The accounting profession has also seen fi rsthand the consequences of not fully meeting the demand from the public of provid- ing reasonable assurance that fi nancial statements are free of material misstatement. During the late 1990s and the fi rst few years of the twenty-fi rst century, auditors failed to fi nd many material misstatements on a timely basis, and many times management had to restate earn- ings due to material misstatements. The public was not satisfi ed with the quality of audits of public companies. The result was the Sarbanes-Oxley Act of 2002 (SOX), and the creation of the PCAOB to provide oversight of the auditors of public companies.

However, the events that led to additional regulation of the accounting profession need some perspective. When there were signifi cant restatements of earnings, about 8% of all public companies had to restate their earnings. Eight percent was suffi cient to shake the confi dence of the securities markets in reported fi nancial statements. For all that the accounting profes- sion did right, the view was that the profession needed to do better. That said, it is important to understand that many CPAs who work as chief fi nancial offi cers put fair presentation of the fi nancial statements, and their obligation to society, ahead of their obligation to their employ- ers. Further, many CPAs in public practice think about their responsibility to the public fi rst, their responsibility to their clients second, and their own well-being will work out if they take these other responsibilities seriously.

Professional Environment The Ethics of WorldCom: Misplaced Motives, Weaknesses, and Heroism

In July of 2002, WorldCom announced that it had understated ex- penses by over $3.8 billion (the number eventually was adjusted to over $11 billion) and the company fi led for bankruptcy. This was one of the largest accounting frauds in U.S. history and the size of the accounting fraud and bankruptcy at WorldCom shook investor confi dence already weakened by the prior restatement of fi nancial statements by companies like Enron, Waste Management, and

Sunbeam. The misstatement at WorldCom propelled Congress to pass SOX.

WorldCom was led by CEO Bernie Ebbers, who was fo- cused on delivering growth through acquisitions. The ac- quisition strategy reached new heights when WorldCom acquired MCI Communications in 1998. Continued growth through merger demanded increasing stock prices. In 2000,

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The Structure of the AICPA Code of Professional Conduct 2-5

Before You Go On 1.1 Do EC professionals exist in public accounting fi rms? Explain. 1.2 Explain the concept of the CPI professional and how it applies to auditors. 1.3 Would you call a plumber an EC professional or a CPI professional? Explain your reasoning.

the company’s stock experienced a decline and, in an effort to bolster stock prices, Scott Sullivan, WorldCom CFO, asked ac- countants in the corporate headquarters to begin a scheme of booking quarter-end journal entries that resulted in capitaliz- ing costs that should have been expensed. After being fired in 2002, Scott Sullivan was indicted by the Justice Department. He subsequently pleaded guilty to fraud and acknowledged that he willingly deceived investors. He also testified against CEO Bernie Ebbers and stated that Ebbers was fully aware of the accounting fraud. Scott Sullivan was sentenced to 5 years in prison and Bernie Ebbers was sentenced to, and is serving, 25 years in prison.

Some of the accountants at WorldCom who participated in the fraud included Buford Yates, Jr., Betty Vinson, and Troy Normand. Mr. Normand was a CPA who worked at WorldCom from 1997 to 2002. While he questioned CFO Scott Sullivan about the journal entries that he was asked to write, during testimony Mr. Normand was asked if he ever conducted any analysis to determine whether the accounting was accurate. He answered that he did not perform any such analysis and that he never obtained any accounting justification for the entries he was asked to make. In short, Troy Norman, Betty Vinson, and Buford Yates, Jr., did not find a way to stand up to Scott Sullivan and investigate the proper accounting treatment. Rather, they subordinated their judgment to the judgment of others (mainly Scott Sullivan).

However, there were those at WorldCom who did not sub- ordinate their professional judgment. The public learned about WorldCom’s fi nancial fraud through the hard work of several “au- diting heroes” led by Cynthia Cooper, then aged 38 and World- Com’s vice president for internal auditing, who took her public interest responsibilities seriously. What did Cynthia Cooper and her staff of internal auditors do to uncover the fi nancial fraud? The internal audit team:

• followed up on an email from a local newspaper article about a former employee in WorldCom’s Texas offi ce who had been fi red after he raised questions about a minor accounting mat- ter involving capital expenditures

• recognized that $2 billion in capital expenditures had not been authorized as part of the capital budget process

• did not settle for glib answers from the director of fi nancial planning who described the $2 billion in capital expendi- tures as “prepaid capacity” but could not explain the nature of “prepaid capacity”

• uncovered over $500 million in capitalized computer costs that were not supported by vendor’s invoices

• demonstrated their independence by continuing to investi- gate the capitalization of line costs (fees paid to lease por- tions of other companies’ telephone networks) even when instructed by CFO Scott Sullivan to delay this particular in- ternal audit until the third quarter

The issue came to a head when Cynthia Cooper and her audit team brought evidence of the improper capitalization of expense to the chairman of WorldCom’s audit committee. The audit com- mittee instructed the internal auditors to work with WorldCom’s new external auditor, KPMG. Within a week the internal and ex- ternal auditors compiled evidence of fi nancial fraud for the audit committee and the external auditors concluded that the account- ing treatment was not in accordance with generally accepted ac- counting principles. CFO Scott Sullivan was given the opportunity to make his case to the audit committee, but the committee mem- bers were not persuaded. The next day the audit committee and the board of directors made public the $3.8 billion restatement of earnings due to the fact that costs had been capitalized that should have been expensed. The audit committee and board of directors also fi red Scott Sullivan.

The Structure of the AICPA Code of Professional Conduct

LEARNING OBJECTIVE 2 Explain the structure of the AICPA Code of Professional Conduct.

Professional ethics represent a commitment by a profession to abide by ethical principles and rules of conduct. A commitment to ethical behavior is a key element that separates recognized professions from other occupations. A code of ethics usually represents standards of behavior that are both idealistic and practical in purposes. Although codes of ethics may be designed

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2-6 CHAPTER 2 Professionalism and Professional Responsibilities

in part to encourage ideal behavior, they must also be both practical and enforceable. To be meaningful they must strike a balance of being above the law but below the ideal. The adher- ence of professionals to a code of ethics signifi cantly aff ects the reputation of the profession and the confi dence in which it is held.

The AICPA’s Code of Professional Conduct (the Code) provides guidance to all members of the AICPA with respect to performance of their professional responsibilities. The AICPA is an organization (discussed in Chapter 1) that represents the accounting profession, and membership is voluntary. However, CPAs must be licensed by state boards of accountancy. The state boards of accountancy and the AICPA work together on many professional issues. Further, many state boards of accountancy have incorporated the AICPA Code of Professional Conduct in state rules so that it applies to all CPAs in the state. The Code consists of principles, rules, interpretations, and other guidance for AICPA members. Each of these components is described below.

• Principles express the basic tenets of ethical conduct and provide the framework for the rules that govern the performance of a member’s professional responsibilities. The principles are not enforceable.

• Rules of conduct establish minimum standards of acceptable conduct in the perfor- mance of professional services. The AICPA bylaws require that members adhere to the rules of the code. The rules of conduct are enforceable and members must be prepared to justify departures from the rules of conduct.

• Interpretations provide additional guidance regarding the scope and applicability of the rules of conduct. A member who departs from the interpretations shall have the bur- den of justifying such departure in any disciplinary hearing.

The AICPA Code of Professional Conduct can be found online at http://pub.aicpa.org/ codeofconduct/Ethics.aspx. The Code is searchable using key words. There are also a series of hyperlinks within the Code that make it easy to fi nd related topics. The Code can also be downloaded in PDF format.

The Code is organized in four major sections as presented in Illustration 2.1: (1) a pref- ace applicable to all AICPA members, (2) Part I, which includes ethical rules for members

principles express the basic tenets of ethical conduct and provide the framework for the rules that govern the performance of the member’s professional responsibilities rules of conduct establish minimum standards of acceptable conduct in the performance of professional services interpretations provide additional guidance regarding the scope and applicability of the rules of conduct

ILLUSTRATION 2.1 Structure of the AICPA Code of Professional Conduct

Preface: Applicable to all members

.100 Overview of the Code of Professional Conduct .200 Structure an Application of the Code of Professional Conduct .300 Principles of the Code of Professional Conduct .400 Defi nitions .500 Nonauthoritative Guidance .600 New, Revised and Pending Interpretations and Other Guidance .700 Deleted Interpretations and Other Guidance

Part 1: Members in Public Practice

1.000 Introduction and Conceptual Framework for Members in Public Practice 1.100 Integrity and Objectivity 1.200 Independence 1.300 General Standards 1.310 Compliance with Standards 1.320 Accounting Principles 1.400 Act Discreditable 1.500 Fee and Other Types of Remuneration 1.600 Advertising and Other Forms of Solicitation 1.700 Confi dential Information 1.800 Form of Organization and Name

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Conceptual Framework for Members in Public Practice 2-7

Part 2: Members in Business

2.000 Introduction and Conceptual Framework for Members in Business 2.100 Integrity and Objectivity 2.310 Compliance with Standards 2.320 Accounting Principles 2.400 Act Discreditable

Part 3: Other Members

3.000 Introduction 3.400 Act Discreditable

ILLUSTRATION 2.1 (continued)

Before You Go On 2.1 What is the purpose of the AICPA ethical principles? Explain their enforceability. 2.2 What is the purpose of the AICPA ethical rules? Explain their enforceability. 2.3 What is the purpose of the AICPA ethical interpretations? Explain their enforceability.

Conceptual Framework for Members in Public Practice

LEARNING OBJECTIVE 3 Apply the conceptual framework approach to ethical decision making for members in public practice.

The rules in the AICPA Code of Professional Conduct and related interpretations seek to address many situations for members in public practice. However, the rules and interpre- tations cannot address every possible relationship or circumstance that might arise. Thus, in the absence of a rule or an interpretation, a CPA should use the Conceptual Framework to evaluate what to do. The Code of Professional Ethics and the Conceptual Framework relate to all work performed by CPAs in public practice, audit engagements, tax engage- ments, accounting services performed for clients, or consulting engagements. Ultimately, a CPA should evaluate whether a relationship or circumstance would lead a reasonable and informed third party, who is aware of the relevant information, to conclude there is a threat to the CPA’s compliance with the rules and the threat is not capable of being reduced to an acceptable level.

in public practice (usually CPAs in CPA fi rms), (3) Part II, which includes ethical rules for members in business (such as a CFO, a controller, or an accountant working in industry or government), and (4) Part III, which includes ethical rules for other members (e.g., non-CPA members of the AICPA). If an individual has a good understanding of this structure, it is eas- ier to search and determine appropriate solutions to ethical dilemmas.

The remainder of the discussion of the Code will focus on explaining the Conceptual Framework for Members in Public Practice, and explain some key rules that are relevant to members in public practice.

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2-8 CHAPTER 2 Professionalism and Professional Responsibilities

Step 1: Identify threats. CPAs interact with clients in a number of circumstances. CPAs need to be alert to a possible relationship or situation that might cause a threat to their compliance with ethical rules. Following is a discussion of seven common threats that CPAs in public practice should be alert to, irrespective of the services the CPA is engaged to perform:

• Adverse interest threat. An adverse interest threat is the threat that a CPA will not act with objectivity because the CPA’s interests are opposed to the client’s interests. For example, an adverse interest threat exists if a client has expressed an intention to begin litigation against the CPA regarding the quality of tax work previously performed.

• Advocacy threat. An advocacy threat is the threat that a CPA will promote a client’s interests or position to the point that his or her objectivity or independence is compro- mised. For example, an advocacy threat exists if the CPA provides expert witness services to a client in litigation or dispute with a customer regarding a licensing arrangement. Once the CPA is advocating for a client, the CPA is no long objective. An advocacy threat would also exist if a fi rm acts as an investment adviser to an offi cer or director of a client.

• Familiarity threat. A familiarity threat is the threat that, due to a long or close rela- tionship with a client, a CPA will become too sympathetic to the client’s interests or too accepting of the client’s work or product. For example, a familiarity threat would exist if a CPA’s immediate family member were employed by the client in a key position (such as the CFO). A familiarity threat would also exist if a former partner or professional employee of an audit fi rm joined the client as its CFO and had knowledge of the fi rms’ policies and practices for the audit engagement.

• Management participation threat. A management participation threat is the threat that a CPA will take on the role of client management or otherwise assume man- agement responsibilities. For example, a CPA may have a small business client, and the owner asks the CPA’s fi rm to do various bookkeeping services for the client. Providing bookkeeping services may cause the CPA to make various management decisions, which is a threat to the fi rm’s objectivity and independence.

adverse interest threat the threat that a CPA will not act with objectivity because the CPA’s interests are opposed to the client’s interests advocacy threat the threat that a CPA will promote a client’s interests or position to the point that his or her objectivity or independence is compromised

familiarity threat the threat that, due to a long or close relationship with a client, a CPA will become too sympathetic to the client’s interests or too accepting of the client’s work or product

management participation threat the threat that a CPA will take on the role of client management or otherwise assume management responsibilities

Step 1 Identify Threats

Step 5 Document

Threats and Safeguards

Applied

STOP Decline or terminate

engagement

Threats Identified

Step 2 Evaluate

Significance of Threats

Step 3 Identify

and Apply Safeguards

Threats Significant

Step 4 Evaluate the Effectiveness of Safeguards

Are Threats at an Acceptable

Level?

No

Yes

Proceed With

Engagement

Threats Not Significant

No Threats Identified

ILLUSTRATION 2.2 Conceptual framework fl owchart

In situations where there is not a specifi c rule or interpretation that relates to a rela- tionship or circumstance, the CPA should follow the steps outlined in Illustration 2.2. The following discussion explains each of these steps.

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Conceptual Framework for Members in Public Practice 2-9

• Self-interest threat. A self-interest threat is the threat that a CPA could benefi t, fi - nancially or otherwise, from an interest in, or relationship with, a client or persons asso- ciated with the client. For example, a self-interest threat exists when a CPA has a fi nancial interest in the client, or a CPA’s spouse enters into employment negotiations for a key position with a client. A self-interest threat also exists if a fi rm has an excessive reliance on the revenues from a single client.

• Self-review threat. A self-review threat is the threat that a CPA will not appropriately evaluate the results of a previous judgment made by, or service performed by, an individ- ual in the CPA’s fi rm, and that the CPA will rely on that work in forming a judgment as part of an engagement. For example, a self-review threat exists if a CPA performs book- keeping services for a private company client and that work needs to be evaluated by the same fi rm in the course of an attest engagement. (Attest engagements are explained in Chapter 1.)

• Undue infl uence threat. An undue infl uence threat is the threat that a CPA will subordinate his or her judgment to an individual associated with a client or any relevant third party due to that individual’s reputation or expertise, aggressive or dominant per- sonality, or attempts to coerce or exercise excessive infl uence over the CPA. For example, an undue infl uence threat exists if a client threatens to dismiss a fi rm from the current engagement, or if the client indicates that it will not award additional engagements, if the fi rm continues to disagree with the client on an accounting or tax matter.

Step 2: Evaluate the signifi cance of threats. If a CPA has identifi ed a threat result- ing from a relationship or circumstance, he or she should evaluate the signifi cance of the threat. CPAs should evaluate identifi ed threats both individually and in aggregate. The standard a CPA should use to determine if the threat is at an acceptable level is whether a reasonable and informed third party, who is aware of the relationship or circumstance, would conclude that a CPA is in compliance with the rules of the Code. If a CPA concludes the threat is not at an acceptable level, the CPA should proceed to step 3, identify and apply safeguards.

Step 3: Identify and apply safeguards. There are three basic types of safeguards. The fi rst is safeguards created by the profession (e.g., the safeguards suggested in the rules of the Code of Conduct), legislation, or regulation. A CPA should be familiar with both the Code of Conduct and regulatory rules that might apply. Safeguards are often suggested in these rules to guide a CPA. Second are safeguards implemented by a client. For example, a board of directors might take steps to remove a familiarity threat by reassigning a key person. How- ever, it is not possible for an accounting fi rm to rely solely on safeguards implemented by the client to eliminate or reduce signifi cant threats to an acceptable level. Finally, an accounting fi rm can implement safeguards within the fi rm. In a large accounting fi rm, safeguards might involve rotating someone off the engagement, or conducting an independent review of the work by another CPA. In a small accounting fi rm, appropriate safeguards might include the involvement of another fi rm. Step 4: Evaluate the eff ectiveness of safeguards. If a CPA concludes that threats are at an acceptable level after applying the identifi ed safeguards, then the CPA may proceed with the professional service. However, if there are no safeguards that would eliminate the threat or reduce it to an acceptable level, or the CPA is unable to implement eff ective safeguards, the CPA should decline or terminate the engagement.

self-interest threat the threat that a CPA could benefi t, fi nancially or otherwise, from an interest in, or a relationship with, a client or persons associated with the client

self-review threat the threat that a CPA will not appropriately evaluate the results of a previous judgment made by, or service performed by, an individual in the member’s fi rm, and that the CPA will rely on that work in forming a judgment as part of an engagement undue infl uence threat the threat that a CPA will subordinate his or her judgment to an individual associated with a client or any relevant third party due to that individual’s reputation or expertise, aggressive or dominant personality, or attempts to coerce or exercise excessive infl uence over the CPA

Cloud 9 - Continuing Case Familiarity is usually a greater issue for existing clients than for new clients, such as Cloud 9 for W&S Partners. However, there could be personal familiarity issues in any audit engagement. Josh is worried about asking the partners and management of the fi rm to declare their relationships with the management of Cloud 9.

He thinks they might regard that question as impertinent. Sharon tells Josh that she knows that the partners and managers at W&S Partners are very committed to ethical behavior. If they were not to ask this question as part of the process of accepting the new client, Sharon and Josh would be disciplined for poor performance.

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2-10 CHAPTER 2 Professionalism and Professional Responsibilities

Step 5: Document threats and safeguards. When safeguards are applied to reduce a threat to an acceptable level, best practice calls for the CPA to document the identifi ed threats, the safeguards applied, and the CPA’s evaluation of the eff ectiveness of the safeguards.

Consider the following example. An accounting fi rm is attempting to grow its audit prac- tice and make inroads in several industries where it wants to increase its concentration of practice. In the process, it obtains a new audit client by submitting a bid for the audit below the expected cost to the fi rm to perform the audit. In the long run, fi rm hopes to gain other clients at increased fees, and over time increase the fee for work with the new audit client.

In step 1, the CPA understands there is a self-interest threat to exercising due professional care when performing the audit. The fi rm understands there may be an incentive to cut cor- ners when doing audit work in order to make a profi t in performing the engagement.

In step 2, the CPA determines the threat is signifi cant and the fi rm should put a safeguard in place to ensure the fi rm uses due professional care and follows audit standards when per- forming the engagement.

In step 3, the CPA discusses the low bid with the audit team during audit planning and sets an expectation of following professional standards. In addition, the fi rm decides to have the work reviewed by a second audit partner to ensure compliance with fi rm policy and pro- fessional standards. (Note: a sole practitioner might engage another auditor to review the sole practitioner’s work.)

In step 4, the CPA determines that setting an appropriate tone at the top regarding com- pliance with professional standards, and the second partner review, is suffi cient to mitigate the self-interest threat, and the CPA accepts the engagement.

Finally, in step 5, the CPA writes a memo to the audit engagement fi le explaining the threat identifi ed, safeguards applied, and the CPA’s reasoning that the safeguards are suffi - cient to counter balance the self-interest threat.

Ethics Reasoning Example A Familiarity Threat

Maria is a partner in a medium-sized CPA practice, and she and her fi rm are bidding on a con- sulting engagement with Western Construction Company. Before Maria and her fi rm are able to make the proposal to Western Construction, Maria’s husband, Robert, comes home to share good news. Robert has just been off ered his dream job as CFO of Western Construction. Maria is happy for her husband, but now she must consider the ethics of bidding on the consulting engagement. Upon searching the code of conduct Maria does not fi nd a specifi c rule or ethics interpretation that addresses this circumstance so she applies the conceptual framework.

Maria approaches her partners with the problem and the following proposed solution. Maria identifi es that if her husband accepts the job, a familiarity threat is present as Maria could be viewed as too sympathetic to Western Construction’s interests. She suggests the CPA fi rm should disclose the confl ict of interest to Western Construction and the fi rm replace Maria on the con- sulting engagement during the interview process. She would remain off the consulting engage- ment if her husband accepts the job. In addition, the fi rm should be clear that it will have no role in the process of Western Construction hiring its next CFO. This allows the CPA fi rm to maintain an appropriate level of integrity and objectivity.

Source: Based on the AICPA Conceptual Framework Toolkit for Members in Public Practice, 2015.

Before You Go On 3.1 Explain each of the seven threats to compliance with the Code of Conduct. 3.2 What is the basis for determining that a threat is at an acceptable level after the application

of safeguards? 3.3 Assume that you have been the tax manager on the tax engagement of XYZ Company. Your

spouse has just been off ered the job of chief fi nancial offi cer for XYZ Company. What is the threat to ethical behavior? What would be an appropriate safeguard, if any, that might be applied if your spouse accepts the position with XYZ Company?

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Integrity and Objectivity 2-11

The next four learning objectives address the ethical rules for members in public practice. Illustration 2.3 provides a graphic outline of learning objectives 4 to 7.

Rules for Members in Public Practice

Integrity and

Objectivity Independence

General Standards

Other Rules for Members in

Public Practice

ILLUSTRATION 2.3 Ethical rules for members in public practice

Integrity and Objectivity

LEARNING OBJECTIVE 4 Evaluate the ethical behavior needed to comply with rules of conduct on integrity and objectivity.

The integrity and objectivity rule, AICPA codifi cation section 1.100.001, reads as follows:

In the performance of any professional service, a member shall maintain objectivity and integrity, shall be free of confl icts of interest, and shall not knowingly misrepresent facts or subordinate his or her judgment to others.

The rule on integrity and objectivity applies to all services performed by CPAs (e.g., tax, au- dit, bookkeeping, or consulting services). The following discussion addresses two common issues that arise related to integrity and objectivity: confl icts of interest and subordination of judgment.

A confl ict of interest occurs when a CPA or accounting fi rm provides a professional ser- vice related to a particular matter involving two or more clients whose interests, with respect to that matter, are in confl ict. In a tax matter this may occur when a CPA represents two clients (e.g., husband and wife) at the same time, who are in a legal dispute (e.g., a divorce) with each other. A larger fi rm may still provide tax services to the husband and to the wife, and safeguard this confl ict of interest by using separate engagement teams who are provided clear policies and procedures on maintaining confi dentiality. In a small fi rm, it is normal practice for a fi rm to resign providing tax services to one of the two parties in a divorce to remain free of any con- fl ict of interest. Additional details about confl icts of interest are discussed in the AICPA Code of Professional Conduct, section 1.110.

The integrity and objectivity rule also prohibits a CPA from subordinating his or her judg- ment when performing professional services for a client. Self-interest, familiarity, and undue infl uence threats to a CPA’s compliance with the integrity and objectivity rule may exist when a CPA and his or her supervisor, or another person within the accounting fi rm, have a dif- ference of opinion related to the application of accounting principles, auditing standards, or other relevant professional standards. The subordination of judgment threat is at an accept- able level if the CPA concludes the position taken by the fi rm does not result in a material misrepresentation of fact or a violation of applicable standards, laws, or regulations. If the CPA concludes the diff erence of opinion may result in a material misrepresentation of fact or a violation of professional standards, then the CPA should discuss his or her concerns with the supervisor. If the diff erence of opinion is not resolved after discussing the concerns with the supervisor, the CPA should discuss his or her concerns with the appropriate higher level(s) of management within the CPA’s fi rm. Most accounting fi rms have specifi c policies for resolving these diff erences to ensure the fi rm does not violate professional standards and to protect a CPA from subordination of judgment to a supervisor.

integrity and objectivity in the performance of any professional service, a member shall maintain objectivity and integrity, shall be free of confl icts of interest, and shall not knowingly misrepresent facts or subordinate his or her judgment to others

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2-12 CHAPTER 2 Professionalism and Professional Responsibilities

Ethics Reasoning Example Potential Subordination of Judgment

James, a senior on the audit of Woodland Industries (a private company), has been discussing the adequacy of the allowance for doubtful accounts with the CFO. The CFO thought the allow- ance was adequate, and James thought there was evidence to support raising the allowance by $300,000. Eventually, the audit partner and the owner of Woodland Industries discussed each questionable account, and the partner and owner agreed to an adjustment of $175,000. After the meeting, the audit partner talked to James, and told James he did not want James to change any of his documentation. The audit partner told James, “I don’t want you to subordinate your judgment to mine. You document your reasoning, and I will document why I reached a diff erent conclusion on a matter of professional judgment. That is the way we do things in our audit fi rm.”

Before You Go On 4.1 Defi ne integrity and objectivity. Illustrate with an example. 4.2 Develop an example of a confl ict of interest and explain a safeguard that would provide rea-

sonable assurance that the confl ict of interest does not result in a violation of the integrity and objectivity rule.

Independence

LEARNING OBJECTIVE 5 Evaluate the ethical behavior needed to comply with rules of conduct on independence.

Independence is the cornerstone of the auditing profession. It is so important that every audi- tor’s report is entitled “Independent Auditor’s Report.” Financial statement users need to know that auditors are unbiased and independent of the entities they audit. The independence rule, AICPA codifi cation section 1.200.001, reads as follows:

A member in public practice shall be independent in the performance of professional services as required by standards promulgated by bodies designated by Council.

A CPA must be independent of the client when performing attest services. Attest services include:

• performing audits • performing reviews under Statements on Standards for Accounting and Review Services

(SSARS) • performing examinations, reviews, and agreed-upon procedures under Statements

on Standards for Attestation Engagements (SSAE)

CPAs performing tax services or consulting services do not need to be independent of their client. Also, CPAs who compile fi nancial statements for a client with no assurance provided do not need to be independent. However, they need to disclose that they are not independent in the compilation report.

CPAs frequently think about independence in two ways, independence in fact and inde- pendence in appearance. These facets of independence are depicted in Illustration 2.4. Being independent in fact can be defi ned as acting with integrity and objectivity. Independence in fact is about being honest, about not subordinating the public trust to personal gain and

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

independent in fact acting with integrity and objectivity, being honest, and not subordinating the public trust to personal gain and advantages

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Independence 2-13

Being independent in appearance addresses a number of potential confl icts of interest that can be observed or factually determined by others. For example, an auditor (or immediate family member) having an ownership interest in an attest client, participating in a joint venture with an attest client, having litigation threatened by an attest client, or having a loan from an at- test client are examples of the types of activities that impair the appearance of independence for an accounting fi rm. The appearance of independence is observable and subject to enforcement under the rules of conduct. Section 1.200 of the AICPA Code of Professional Conduct specifi es a number of circumstances that can impair the appearance of independence to guide CPAs in ob- servable aspects of ethical conduct. The common factor of the issues raised in Code section 1.200 is that they are targeted to situations where CPAs appear to have a confl ict of interest, such as having loans from clients or providing certain consulting services to clients. In some situations, the Code identifi es safeguards that can preserve auditor independence. In other situations, the threat to independence is so signifi cant that no safeguards are appropriate, and the relationship or circumstance is prohibited. Numerous examples are included in the following discussion. CPAs must then use common sense and be aware of apparent threats to a CPA’s independence, such as an adverse interest threat, an advocacy threat, a familiarity threat, a management par- ticipation threat, a self-interest threat, a self-review threat, or an undue infl uence threat. A CPA should evaluate these threats from the point of view of an independent third party, and take steps to preserve the CPA’s independence. In some cases, no safeguard may preserve indepen- dence, and the existence of the threat may require resigning from the attest engagement.

independent in appearance avoiding potential confl icts of interest that can be observed by others

The following discussion explains the AICPA rule on independence and addresses some common threats to independence, such as investments in attest clients, loans to or from an attest client, taking on management responsibilities, family relationships, and performing nonattest services for an attest client.

Key Individuals and Independence Requirements Today, accounting fi rms have many professionals all over the globe, along with their fam- ily members, who have no infl uence over attest engagements of the fi rm. Accounting fi rms have also seen an increase in the number of dual-career families who potentially have inde- pendence problems when an accounting professional’s spouse works for an attest client, or

ILLUSTRATION 2.4 Independent in fact vs independent in appearance

Independent in Fact Independent In Appearance

State of Mind Apparent Conflict

of Interest Avoid Threats to

Independence

Unbiased and Impartial Not Subordinating the Public Trust

Follow the Rules (Minimum)

Follow Conceptual Framework

Cloud 9 - Continuing Case Sharon tells Josh about her experience at another accounting fi rm in which the client tried to pressure the audit partner into dropping a request to write down the asset values. It was an example of an undue infl uence threat to the auditor’s independence. Although it is diffi cult to stop a client from asking for a favor, the accounting

fi rm needs to have safeguards to prevent a simple request turning into unreasonable pressure on the audit team to meet that request. Sharon and Josh agree they need to consider the specifi c indepen- dence threats and safeguards for the audit of Cloud 9. The account- ing fi rm must be independent, as well as be seen to be independent.

advantages, and about being unbiased and impartial when performing attest services. Inde- pendence in fact is diffi cult for others to observe, but it is nevertheless the cornerstone upon which attest services provide value.

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2-14 CHAPTER 2 Professionalism and Professional Responsibilities

receives compensation through stock options or other stock ownership arrangements from an employer who is also an attest client. As a result, a CPA must think both about how his or her own activities could cause a threat to independence, as well as how the activities of his or her spouse or other family members threaten independence. The growth of non-audit ser- vices also raises questions about the ability of accounting fi rms to remain independent while providing services that may result in professional fees that are larger than those provided by performing an independent audit.

The independence rules follow an engagement-based approach and defi ne a level of ac- counting professional, a covered member, who is a person in a position to potentially infl u- ence attest decisions or the outcome of an attest engagement. While every professional in an accounting fi rm does not need to be independent of every attest client, the independence rules are particularly strict for accounting professionals who are defi ned as covered members.

Illustration 2.5 summarizes the defi nition of a covered member and activities that impair the independence of a covered member (and his or her accounting fi rm) and would be prohib- ited under the independence rules (as they cannot be safeguarded). With respect to investments in an attest client, a covered member cannot have a direct investment in the attest client, irre- spective of the materiality (or immateriality) of the investment. Therefore, a covered member cannot own one share of an attest client. A question often comes up about owning shares in a mutual fund (where the covered member does not control the investment decisions), and the mutual fund owns shares of the attest client. This is considered an indirect investment in the attest client. A covered member can own a mutual fund where the mutual fund owns shares in the attest client, as long as the investment in the mutual fund is not material to the covered member. If the investment in the mutual fund is material to the covered member, and the mutual fund owns any shares in an attest client, independence is impaired. Covered members must also take care not to engage in joint investments with attest clients. For example, an at- test partner and an attest client should not jointly own a business, or real property, together. In addition, a covered member cannot have a loan to or from an attest client. While there are some very limited exceptions (e.g., having a home mortgage from a bank who is an attest cli- ent), covered members must be very careful about making loans to, or accepting loans from, an attest client. A covered member also cannot be a trustee of a trust, or executor of an estate, that invests in an attest client. Being a trustee of a trust, or an executor of an estate, involves

covered member a person in a position to potentially infl uence attest decisions or the outcome of an attest engagement

ILLUSTRATION 2.5 Defi nition of a covered member and activities that impair independence

Covered Members Prohibited Activities

• Any member of the engagement team • Partners and managers with consultation,

oversight, or review responsibilities related to the engagement

• Direct supervisors of the engagement partner, including all successive senior levels

• Accounting firm professionals who perform (or expect to perform) more than 10 hours of non-attest services for the client

• Partners who are in the same office as the lead partner on the engagement

• The firm, its benefit plans, and entities controlled by covered members

• Those who evaluate partners’ performance and compensations, including members of compensation committees

• Cannot have a direct, or a material indirect, investment in the attest client

• Cannot have a joint, closely held investment with an attest client that is material to the covered member

• Cannot have loans to or from the attest client (There are some very limited exceptions.)

• Cannot be a trustee of a trust or executor of an estate who invests directly in an attest client (The AICPA and SEC permit an exception for a trustee who lacks authority to make investment decisions.)

• Accounting firm professionals who consult with the attest team regarding technical or industry-related issues specific to the engagement. This is intended to include individuals who are authorized to give advice to the attest team, and there is no hours test.

• Individuals who participate in quality-control activities for the firm

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Independence 2-15

holding a key management position over the trust or estate. A covered member should not be in a management position to exercise authority over a direct investment in an attest client. Finally, the accounting fi rm as an entity is prohibited from the same activities as a covered member of the fi rm.

Covered members must also be aware of potential confl icts of interest that may be raised by the activities of immediate family members and close relatives. Illustration 2.6 sum- marizes the defi nition of both immediate family members and close relatives, and activities of an immediate family member or close relative that impair the independence of the covered member (and his or her accounting fi rm) and would be prohibited under the independence rules. An immediate family member is one where the relationship is considered to be so close that any relationship between an immediate family member and an attest client is equivalent to the relationship between a covered member and the attest client. An immediate family member would be prohibited from making any investment, making or having a loan, or serv- ing as a trustee of a trust or an executor of an estate that invests in an attest client. Further, as noted above, an immediate family member cannot work for an attest client in a key position. A key position would include a position where an immediate family member could exercise infl uence over the fi nancial statements, such as CEO, CFO, member of the board of directors, or treasurer. In addition, a key person would be someone who prepares, or supervises others who prepare, (1) the fi nancial statements or (2) material accounting records, or is involved in accounting decision making. Also, if a close relative held a key position with an attest client it would impair the independence of the covered member. Finally, if a close relative had a direct investment in an attest client that is material to the close relative, or had signifi cant infl uence over an attest client, the covered member’s independence would be impaired.

immediate family member a covered member’s spouse, spouse equivalent, or dependent close relative a covered member’s parents, nondependent children, brothers and sisters, or stepbrothers or stepsisters

key position a position with an attest client where an individual can exercise infl uence over the fi nancial statement

ILLUSTRATION 2.6 Defi nitions of an immediate family member and close relatives and activities that impair independence

Covered Members’ Immediate Family Prohibited Activities

• Spouse • Spousal equivalent • Dependents

• Exactly the same as for a covered member. • Cannot be employed in a “key position” with

an attest client. A key position would be a position where the individual would: • Exercise influence over the financial

statements, such as CEO, CFO, member of the board of directors, or treasurer.

• Prepare, or supervise others who prepare, (1) the financial statements or (2) material accounting records.

• Be involved in accounting decision making.

Covered Members’ Close Relatives Prohibited Activities

• Parents • Nondependent children or step children • Brothers and sisters or step brothers and sisters

• May not hold a key position with an attest client.

• May not hold a material financial interest in an audit client, or have significant influence over an attest client (ASC 323–10)

An important issue for many spouses is their ability to participate in stock compensation plans. Today, it is common for many employees to be compensated with equity securities in addition to cash. If an accounting fi rm professional is not a covered member (e.g., a tax pro- fessional who does no work for the attest client), the spouse can work for the attest client and can participate in an employee benefi t plan that includes employee stock ownership plans or employee stock option plans as long as the benefi ts are off ered equitably to all similar employ- ees. The same benefi ts are also extended to a limited group of covered members, nonattest partners and managers, and other partners in the offi ce of the lead engagement partner that may have an immediate family member who works for an attest client as long as the immedi- ate family member is not in a key position.

Finally, an accounting fi rm does need to consider when the activities of professional employees, who are not covered members for a particular audit client, might impair the

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2-16 CHAPTER 2 Professionalism and Professional Responsibilities

independence of the fi rm. As a general rule, professional employees in an accounting fi rm who are not covered members, and their immediate family members, cannot:

• have a direct investment of more than 5% in an attest client • hold a key position with an attest client • be a trustee, director or offi cer of an attest client, or of the client’s pension or profi t-sharing

trust

Ethics Reasoning Example Investments of an Immediate Family Member

Janice is an audit manager in a large public accounting fi rm with 35 offi ces on the East Coast. Janice has been dating Keith, a CFO of a company who is not a client of Janice’s fi rm. Keith has a signifi cant investment portfolio of his own. After dating for about 4 months, Janice and Keith decide to get married. However, Janice tells Keith it is important for him to take a careful review of his investment portfolio. The fi rm policy in Janice’s fi rm is that she cannot have a direct in- vestment, of any size, in any audit client of the fi rm. Further, she cannot have a material indirect investment in the audit client. This is so the fi rm is independent of its clients, and the fi rm can assign any staff member to any audit client. Given their relationship, Keith cannot have any in- vestment that would be prohibited for Janice. As a result, Keith has to sell several investments and invest them in other ways.

Cloud 9 - Continuing Case Josh and Sharon know that they will have to put together an au- dit team where each member of the audit team is independent with respect to Cloud 9. Jo Wadley, the partner, will discuss this matter with other partners in the offi ce, and with other offi ces, to ensure that there will be no independence problems. Sharon and Josh both discuss their own independence with Jo Wadley, to confi rm that there are no independence problems associated with either their investments or relationship with Cloud 9, or the

investments or relationships associated with immediate family members or close relatives.

Jo Wadley advises them to discuss independence with all potential members of the audit team. Jo wants Sharon and Josh to make sure that every member of the audit team knows his or her responsibility to be independent, and to advise the fi rm of any investments in Cloud 9, or of immediate family members or close relatives who may work for Cloud 9.

Since independence is critical to the performance of attest services, the AICPA has pub- lished a number of interpretations of the independence rule. Illustration 2.7 summarizes these interpretations. Two key issues are discussed further below, employment or association with an attest client and nonattest services.

Before You Go On 5.1 Explain what is meant by “independence in fact.” Explain what is meant by “independence

in appearance.” Give an example of each. 5.2 An audit manager in another offi ce from the audit client has quality control responsibili-

ties in the same region as the audit engagement. Is the audit manager a covered member? Explain.

5.3 An audit staff person has been with the fi rm for only 6 months. Her spouse works for an audit client in an accounting position and makes material accounting decisions in the corporate accounting offi ce. Are there safeguards that can be implemented to preserve the audit fi rm’s independence?

5.4 A partner works on the audit engagement of XYZ Company. After her husband died from a heart attack, she has had dinner a couple of times with a major shareholder in XYZ Com- pany. The shareholder is not part of management. What are the implications if the personal relationship becomes serious between the partner and the shareholder?

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Independence 2-17

AICPA Code of Conduct Section Interpretation

1.210 Conceptual Framework Approach

1.220 Accounting Firms

1.224 Affi liates, Including Governmental Units

1.228 Engagement Contractual Terms

1.230 Fees and Other Types of Remuneration

1.240 Financial Interests

1.250 Participation in Employee Benefi t Plants

1.255 Depository, Brokerage, and Other Accounts

1.257 Insurance Products

1.260 Loans

1.265 Business Relationships

1.270 Family Relationship with Attest Clients

1.275 Honorary Director or Trustee of a Not-for-Profi t Organization

1.277 Former Employment or Association with an Attest Client

1.279 Considering or Subsequent Employment or Association with an Attest Client

1.280 Memberships

1.285 Gifts and Entertainment

1.290 Actual or Threatened Litigation

1.295 Nonattest Services

1.297 Independence Standards for Engagements Performed in Accordance with Statements on Standards for Attestation Engagements

ILLUSTRATION 2.7 Interpretations of the independence rule

Employment or Association with an Attest Client When a partner or professional employee of an accounting fi rm leaves the fi rm and is subse- quently employed by the fi rm’s attest client, independence can be impaired inasmuch as the partner or professional employee may have continuing relationships, such as the payout of a pension plan, with the accounting fi rm. Furthermore, if a professional employee goes to work for an attest client, that employee may be familiar with the audit plan and/or staff working on the engagement, and there is a familiarity and undue infl uence risk that the former employee could infl uence the engagement. These are important risks that may impair an accounting fi rm’s independence.

The rules are diff erent for public company audit clients than for private company audit cli- ents. With respect to public company clients, Section 206 of SOX states that the CEO, controller, CFO, chief accounting offi cer, or person in an equivalent position cannot have been employed by the company’s audit fi rm during the one-year period preceding the period under audit.

With respect to private company clients, a fi rm’s independence will be considered im- paired with respect to a client if a partner or professional employee leaves the accounting fi rm and is subsequently employed by the client in a key position, unless a series of safeguards dis- cussed in Code section 1.279.02 are met. The general purpose of these safeguards is to ensure that the amounts due to the former partner or professional employee (e.g., retirement bene- fi ts) are not material to the fi rm, and the partner or professional employee is not in a position to infl uence the fi rm’s operations or does not participate or appear to participate in the fi rm’s business. The fi rm should also consider whether the former partner or professional employee has suffi cient knowledge of the fi rm’s attest engagement such that the fi rm should consider whether to modify engagement procedures. If the former partner or professional employee

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2-18 CHAPTER 2 Professionalism and Professional Responsibilities

joins the attest client in a key position within one year of disassociating from the fi rm, and has signifi cant interaction with the engagement team, an appropriate professional in the fi rm should review the subsequent attest engagement to determine whether the engagement team members maintained the appropriate level of skepticism when evaluating the former part- ner’s or professional employee’s representations and work.

A partner or professional employee merely seeking employment with an attest client may also impair independence. When a member of the attest engagement team or an individual in a position to infl uence the attest engagement intends to seek or discuss potential employment or association with an attest client, or is in receipt of a specifi c off er of employment from an attest client, independence will be impaired with respect to the client unless the person:

a. promptly reports such consideration or off er to an appropriate person in the fi rm, and b. removes himself or herself from the engagement until the employment off er is rejected or

employment is no longer being sought.

The purpose of this rule is to avoid situations where a CPA’s integrity or objectivity might be compromised. If a professional is seeking a job from an attest client, it is important to avoid a situation where the person might be tempted to take an aggressive stance in favor of the client on a matter of professional judgment while seeking the favor of a client by way of a job off er.

Further, when any covered member becomes aware that a member of the attest engagement team or an individual in a position to infl uence the attest engagement is considering employ- ment or association with a client, the covered member should notify an appropriate person in the accounting fi rm. Finally, the appropriate person in the accounting fi rm should consider what additional safeguards, such as additional review of any work performed by the individual consid- ering employment with the attest client, may be necessary to provide reasonable assurance that any work performed for the client by that person was performed with objectivity and integrity.

Nonattest Services A major issue that continues to face the auditing profession is whether the performance of non- attest services (such as accounting services or internal control design and implementation) im- pairs an auditor’s integrity and objectivity. Critics wonder whether an auditor can be objective with respect to audit issues when fees from nonattest services exceed fees from attest services.

When an auditor considers the rules related to nonattest services and independence, the auditor needs to understand that a diff erent set of rules apply to auditors of public companies than auditors of private companies. Both the SEC and SOX set out the independence guidelines for public company audits that will be discussed in SEC and PCAOB Independence Rules. The AICPA and state boards of accountancy have rules appropriate to audits of private companies. The AICPA and many state boards of accountancy allow activities for private companies that are not allowed for public companies because many private companies (e.g., owner-managed business and small not-for-profi t organizations that require audits) do not have the resources to internalize services that are often performed within public companies, such as bookkeeping, preparing fi nancial statements, or payroll services. The demand for these services from smaller entities often causes a management participation threat. The following discussion outlines the appropriate rules for nonattest services as they relate to private company audits.

AICPA independence rules (1.295) allow a member of a fi rm to perform nonattest ser- vices for private company attest clients under certain conditions. In each case, the CPA must evaluate the eff ect of nonattest services on independence. In general, a CPA should not per- form management functions or make management decisions for the attest client. However, the CPA may provide advice, research materials, and make recommendations to assist the cli- ent’s management in performing its functions and making its decisions. In addition, the client must agree to perform the following functions in connection with the CPA’s engagement to perform nonattest services (safeguards implemented by the client):

• Make all management decisions and perform all management functions. • Designate a competent employee, preferably within senior management, to oversee the

services.

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Independence 2-19

• Evaluate the adequacy and results of the services performed. • Accept responsibility for the results of the services. • Establish and maintain internal controls, including monitoring ongoing activities.

If management cannot perform these functions (establish these safeguards), the fi rm’s independence is impaired.

Interpretation 1.295 also indicates that before performing nonattest services, the CPA should establish, and document in writing, an understanding with the client regarding (1) the objectives of the engagement, (2) the services to be performed, (3) the client’s acceptance of its responsibilities, (4) the CPA’s responsibilities, and (5) any limitations of the engagement. It is preferable that this understanding be documented in an engagement letter (explained further in Chapter 3). In addition, the CPA should be satisfi ed that the client is in a position to have an informed judgment on the results of the nonattest services and the client’s management understands its responsibilities.

The purpose of the AICPA rule is to allow CPAs to assist many small business clients who may not have a CPA within the entity. These entities often need outside professional expertise that the accounting fi rm can provide. Nevertheless, a number of general activities would be considered to impair a CPA fi rm’s independence when auditing nonpublic companies. These are summarized in Illustration 2.8, which also provides examples of how the performance of these general activities would impair an accounting fi rm’s independence, or how the client could take appropriate responsibilities to allow the accounting fi rm to assist the client without impairing the accounting fi rm’s independence with regard to the audit.

Interpretation 1.295 provides additional specifi c examples of activities that would or would not impair independence. For example, CPAs can perform various accounting and bookkeeping services for an attest client. However, independence would be impaired if an accounting fi rm determined or changed journal entries, account codings or classifi cation for transactions, or other accounting records without obtaining client approval; and authorized or approved transactions, prepared source documents, or made changes to source documents without client approval. Independence would not be impaired if the CPA recorded transac- tions for which management had determined or approved the appropriate account classifi ca- tion, or posted coded transactions to a client’s general ledger; prepared fi nancial statements based on information in the trial balance; posted client-approved entries to a client’s trial balance; or proposed standard, adjusting, or correcting journal entries or other changes af- fecting the fi nancial statements to the client, provided the client reviewed the entries and the CPA was satisfi ed management understood the nature of the proposed entries and the impact of the entries on the fi nancial statements. You can read the actual Interpretation 1.295 for additional discussions related to payroll and other disbursements; appraisal, valuation and actuarial services; benefi t plan administration; business risk consulting; corporate fi nance consulting; executive or employee recruiting; forensic accounting; information system de- sign, implementation, or integration; internal audit; investment advisory or management services; and tax services.

Ethics Reasoning Example Nonattest Services

Fred Holland is a CPA in rural Wisconsin. Fred has a tax practice, he does payroll work for sev- eral businesses in the area, and he performs compilation and review services for some of his business clients. Fred has been careful with respect to performing payroll services as he wants to be independent of his clients. While independence is not required for compilations, Fred knows it is required for reviews and at times Fred has been requested to increase the level of assurance from a compilation to a review. As a result, whenever Fred performs payroll services for a client he implements the following safeguards: (1) he requires the client to maintain all original time records for employees, (2) he does not sign checks on any client accounts, and (3) while Fred’s payroll system prepares checks and payroll tax returns, all of these documents are reviewed and signed by the client. Fred does not undertake a payroll engagement unless he believes the client has suffi cient competence to review Fred’s work.

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2-20 CHAPTER 2 Professionalism and Professional Responsibilities

SEC and PCAOB Independence Rules Illustration 2.9 provides the full listing of the PCAOB’s Ethics and Independence Rules. In a number of ways, the SEC and PCAOB rules related to auditor independence for public companies are stricter than the AICPA rules that apply to non-public entity audits. First, SOX mandates that a committee of the board of directors, called the audit committee, be directly responsible for oversight of the company’s independent auditors. (Chapter 4 provides further discussion on the role of an audit committee.) The SEC’s general standard of auditor independence is that an audit fi rm’s independence is impaired if a reasonable investor with knowledge of all the facts and circumstances would conclude that the fi rm

audit committee a committee of the board of directors responsible for oversight of: internal controls, fi nancial reporting and disclosure in the fi nancial statements, regulatory compliance, and the company’s independent auditors

ILLUSTRATION 2.8 Independence and nonattest services for non-public clients

Examples Where Independence Is Impaired

General Activities That Will Impair Independence

Examples Where Independence Is Not Impaired

A CPA may not accept responsibility to authorize payment of client funds, or accept responsibility to sign or cosign client checks, even if only in emergency situations. In a consulting engagement, a CPA may not act as a promoter, underwriter, broker-dealer, or guarantor of client securities, or distributor of private placement memoranda or off ering documents.

Authorizing, executing, or consummating a transaction, or

otherwise exercising authority on behalf of a client or having the

authority to do so

When assisting a small business client with payroll using payroll time records provided and approved by the client, the CPA can generate unsigned checks or process the client’s payroll. In a consulting engagement, a CPA may assist in identifying or introducing the client to possible sources of capital that meet the client’s specifications or criteria.

In an accounting service engagement for a nonpublic client, a CPA may not determine or change journal entries, account codings or classification for transactions, or other accounting records without obtaining client approval. A CPA may not prepare source documents or originate data or make changes to source documents without client approval.

Preparing source documents or originating data, in electronic or other form, evidencing the

occurrence or a transaction (for example, purchase orders, payroll

time records, and customer orders)

In an accounting service engagement for a nonpublic client, a CPA may record transactions for which management has determined or approved the appropriate account classification, or post coded transactions to a client’s general ledger and prepare financial statements based on information in the trial balance.

When performing payroll services, benefit plan administration, or other financial advisory services, a CPA may not have custody of client assets or maintain custody of client securities.

Having custody of client assets Another accounting firm has custody or assets and performs payroll services, benefit plan administration, or other financial advisory services.

In an IT engagement, a CPA may not supervise client personnel in the daily operation of a client’s information system.

Supervising client employees in the performance of their normal

recurring activities

In an IT engagement a CPA may design, install, or integrate a client’s information system, provided the client makes all management decisions.

In an investment advisory engagement with an attest and tax client, a CPA cannot make investment decisions on behalf of client management or otherwise have discretionary authority over a client’s investments.

Determining which recommendations of the CPA should be implemented

In an investment advisory engagement with an attest and tax client, a CPA can recommend the allocation of funds that a client should invest in various asset classes, depending upon the client’s desired rate of return, risk tolerance, and so on.

In a attest engagement, a CPA may not present business proposals to the board on the behalf of management.

Reporting to the board of directors on behalf of management

In an attest engagement, provide recommendations for improving the system for monitoring business risks.

In an investment advisory engagement a CPA may not execute a transaction to buy or sell a client’s investment or have custody of client assets, such as taking temporary possession of securities purchased by a client.

Serving as a client’s stock transfer or escrow agent, registrar, general

counsel, or its equivalent

In an investment advisory engagement, a CPA may review the manner in which a client’s portfolio is being managed by investment account managers, including determining whether the managers are (1) following the guidelines of the client’s investment policy statement; (2) meeting the client’s investment objectives; and (3) conforming to the client’s stated investment styles.

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Independence 2-21

is not capable of exercising objective and impartial judgment on all issues encompassed within the audit engagement. The SEC developed some general rules for an audit committee to consider when evaluating an audit fi rm’s independence. A public company’s audit com- mittee should consider whether a relationship with the accounting fi rm or service provided by the accounting fi rm:

• creates a mutual or confl icting interest between the company and the audit fi rm • places the accounting fi rm in a position of auditing its own work • places the accounting fi rm in a position of acting as management or an employee of the

company, or • places the accounting fi rm in a position of being an advocate for the company

To encourage the independence of audit partners, Section 203 of SOX mandates rotation of the lead audit partner and the audit partner having responsibility for reviewing the audit every fi ve years. Additionally, SEC rules prohibit the audit fi rm from providing the following nonat- test services to an audit client:

• bookkeeping • fi nancial information system design and implementation • appraisal or valuation series, fairness opinions, or contribution-in-kind reports • actuarial services • internal audit outsourcing services • management functions or human resources functions • broker-dealers, investment advisor, or investment banking services • legal services and expert services unrelated to the audit

SEC rules also prohibit certain relationships between audit fi rms and the public companies they audit. The prohibited relationships include:

• Employment relationships. A one-year “cooling-off period” is required before a com- pany can hire certain individuals formerly employed by its auditor in a fi nancial report- ing oversight role for the company. For example, an audit manager on a public company audit cannot go to work directly for a public company as its CFO or controller unless there has been at least a one-year period from the time the audit manager last worked on the audit to the time he or she is hired by that client. SEC rules ask the public company’s audit committee to consider whether the hiring of personnel who are or were formerly employed by the audit fi rm might aff ect the audit fi rm’s independence.

• Contingent fee. Accounting fi rms are prohibited from performing work for public com- panies where the accounting fi rm is paid on either a contingent fee or a commission basis. The AICPA rules for auditors of non-public entities are also clear that when a fi rm is compensated on a commission or contingent fee basis, independence is violated. If the

ILLUSTRATION 2.9 PCAOB ethics and independence rules

Source: https://pcaobus.org/Standards/EI/Pages/default.aspx

3501 Defi nitions of Terms Employed in Section 3, Part 5 of the Rules

3502 Responsibility Not to Knowingly or Recklessly Contribute to Violations

3520 Auditor Independence

3521 Contingent Fees

3522 Tax Transactions

3523 Tax Services for Persons in Financial Reporting Oversight Roles

3524 Audit Committee Pre-approval of Certain Tax Services

3525 Audit Committee Pre-approval of Non-audit Services Related to Internal Control Over Financial Reporting

3526 Communication with Audit Committees Concerning Independence

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2-22 CHAPTER 2 Professionalism and Professional Responsibilities

compensation for an accounting fi rm is tied to the outcome of the engagement, the fi rm becomes an advocate for the client with these compensation arrangements, violating a general principle of independence.

• Direct or material indirect business relationships. Accounting fi rms may not have any direct or material indirect business relationships with the company, its offi cers, di- rectors, or signifi cant shareholders. For example, an accounting fi rm may not enter into a joint venture with a public company audit client. It would be inappropriate for an auditor of a software company to enter into a business relationship with the same software com- pany to develop accounting software to market to the public.

• Certain fi nancial relationships. Certain fi nancial relationships between the company and the independent auditor are prohibited. These include creditor–debtor relationships, banking relationships, broker–dealer relationships, futures commission merchant account relationships, insurance product relationships, and joint interests in investment companies.

As a matter of strengthening corporate governance, the SEC rules require accounting fi rms to disclose to their client’s audit committee, in writing, all relationships between the accounting fi rm and the company that may reasonably be thought to bear on the account- ing fi rm’s independence. SEC rules also require the auditor to confi rm and discuss its inde- pendence with the client’s audit committee. As part of its responsibilities, the client’s audit committee should consider discussing the following issues with the auditor in regards to the fi rm’s independence disclosure:

• the processes the accounting fi rm uses to ensure complete disclosure of all relationships with the company and its affi liates

• the relationships the accounting fi rm may have with offi cers, board members and signif- icant shareholders

• the relationships not included in the communication because they were deemed immaterial

Prior to the passage of SOX, many accounting fi rms received sig- nifi cant fees from off ering consulting services to audit clients. In some cases the size of the consulting fee was larger than the au- dit fee, creating a potential confl ict of interest for the audit fi rm. This was true for both Waste Management and Enron. The fact was also not lost on chief fi nancial offi cers, who would use the size of the consulting engagement as leverage to get the auditor to go along with accounting decisions that were not black and white. Ultimately, the delivery of non-audit services to audit clients led to

a public concern about audit independence. As noted above, the SEC stepped in and now prohibits the delivery of many non-audit services to audit clients.

As a result, it is common for large audit clients to use more than one accounting firm for various services. It is likely that a global audit client might use one firm for audit services, another firm for tax services, another firm for internal control consulting, and yet another firm to assist in merger and acqui- sition services.

Professional Environment Non-Audit Fees

Cloud 9 - Continuing Case Josh and Sharon do not know of any current work being done for Cloud 9 by W&S Partners, or any other relationships between members of the audit team and the client’s staff . However, they will check with all other departments, particularly the consulting department, and other offi ces of W&S Partners. They will also ask any new members of the audit team to disclose their interests and relationships with the client before they join the team.

Subsequently, the partner, Jo Wadley, advises Sharon and Josh that she has reached out to other offi ces, and discussed the proposal with the other partners in his offi ce, and that the fi rm is not working for Cloud 9 on any other matter. Jo Wadley, Sharon, and Josh want to make sure that there are no potential independ- ence issues when their proposal is discussed with Cloud 9’s audit committee.

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General Standards 2-23

General Standards

Before You Go On 5.5 The audit manager on an audit engagement of a large private company has been asked by the

company to consider becoming the company’s CFO. What are the independence implications of this situation? What are the appropriate safeguards to preserve the fi rm’s independence?

5.6 An audit fi rm serves only private companies. It also provides tax services and investment ad- visory services to its clients. Can a partner in the fi rm advise an audit client on the allocation of funds in the client’s investment portfolio, based on the client’s desired rate of return and risk tolerances? Explain your reasoning.

5.7 Explain the general rules that an audit committee of a public company should consider when evaluating the potential services that it might request of its audit fi rm.

LEARNING OBJECTIVE 6 Evaluate the ethical behavior needed to comply with rules of conduct on general standards.

The general standards of the AICPA Code of Professional Conduct apply to all CPAs in pub- lic practice. For example, the independence standards apply only to accounting fi rms that perform attest engagements, and the professionals in those fi rms who are in a position to in- fl uence the outcome of an attest engagement (e.g., covered members, their immediate family members, and close relatives). The general standards apply to any CPA performing any profes- sional service for a client (e.g., tax services, consulting services, or nonattest services). Further, the same standards are found in the section of the Code related to members in business. The general standards (1.300.001) read as follows:

A member shall comply with the following standards and with any interpretations thereof by bodies designated by Council:

a. Professional Competence. Undertake only those professional services that the member or the member’s fi rm can reasonably expect to be completed with professional competence.

b. Due Professional Care. Exercise due professional care in the performance of professional services.

c. Planning and Supervision. Adequately plan and supervise the performance of professional services.

d. Suffi cient Relevant Data. Obtain suffi cient relevant data to aff ord a reasonable basis for conclusions or recommendations in relation to any professional services performed.

The standard on professional competence is clear that a CPA, or an accounting fi rm, should only undertake professional services that he or she reasonably expects to complete with professional competence. While a CPA does not assume infallibility of knowledge or judgment, a normal part of providing professional services involves performing additional research or consulting with others to gain suffi cient competence. If a CPA is unable to gain suffi cient competence, a CPA should suggest, in fairness to the client and the public, the en- gagement of a competent person to perform the needed professional service. For example, a tax practitioner might be approached by a tax client that needs an audit or a review of the company’s fi nancial statements for the bank. If the tax practitioner does not have experience

professional competence undertaking on those professional services that a CPA or a CPA’s fi rm can reasonably expect to complete with professional competence due professional care exercising professional care expected of other CPAs in the performance of professional services planning and supervision adequately plan and supervise the performance of professional services suffi cient relevant data obtain suffi cient relevant data to aff ord a reasonable basis for conclusion or recommendation in relation to any professional services performed

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2-24 CHAPTER 2 Professionalism and Professional Responsibilities

performing audits or reviews, the practitioner should refer the engagement to another CPA with the appropriate qualifi cations. Alternatively, if the tax practitioner chooses to accept the engagement, he or she should take appropriate continuing professional education (CPE) courses, and consider consulting the experienced colleagues to ensure that the engagement is performed in accordance with professional standards.

The due care standard expects CPAs to exercise the professional care that would be ex- pected of other CPAs performing the same work. In particular, CPAs should follow all pro- fessional standards that relate to providing services. For example, in a tax engagement, this would include following tax practice standards.

All engagements should be adequately planned and supervised. Further, in the performance of nonattest services, CPAs should obtain suffi cient, relevant data to aff ord a reasonable basis for a conclusion or recommendation. Note that this is diff erent than the expectation in an audit. In performing an audit, a CPA should obtain suffi cient, appropriate evidence, which is a higher standard. The standard of suffi cient and appropriate evidence is discussed further in Chapter 5.

Adherence to these requirements contributes to the quality of performance of professional engagements for the benefi t of clients, the public, and the overall reputation of the profession.

Ethics Reasoning Example Professional Competence

Dana Moore is a CPA in Georgia. Dana has a modestly sized tax practice and she performs a num- ber of audits of local school districts, as well as of a few cities and counties. Dana is also on the board of directors of several charities where she interacts with some of the business people in the area. One day a local technology entrepreneur in the area walks into her offi ce and says, “I have worked with you on the board of directors of a local charity, and I like the perspectives you bring to the board. My company is growing and needs an audit. I know you do audits, and I am wonder- ing if you would give me a bid on doing my company’s audit.” Dana was not expecting this, but she knows what her response should be. “I appreciate your interest in my work and my services. However, not all audits are the same. I understand the accounting and auditing issues with local governments and school districts, but I am not well-versed in the accounting, internal control, and auditing issues for technology companies. This is beyond the scope of my expertise, and I only want to consider an engagement that I can expect to complete with professional competence and due care. However, through the State Society of CPAs I know some other auditors who might have the skills you need. Let me give you their names.”

Before You Go On 6.1 Identify two types of engagements that would be covered by the general standards in the

AICPA Code of Professional Conduct. 6.2 If a CPA does not have the professional competence to complete an investment advisory en-

gagement, what steps should the fi rm take to ensure that the engagement is completed with professional competence?

6.3 When evaluating whether an engagement was completed with due professional care, how might a state board of accountancy judge the due care that was used in completing an engagement?

Other Rules of Conduct for Members in Public Practice

LEARNING OBJECTIVE 7 Evaluate the ethical behavior needed to comply with other rules of conduct for members in public practice.

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Other Rules of Conduct for Members in Public Practice 2-25

It is not possible in the scope of this chapter to discuss all of the rules of conduct for CPAs in public practice. The following discussion addresses three additional rules of conduct that you should understand: Rule 1.320 on Accounting Principles, Rule 1.500 on Fees and other Types of Remuneration, and Rule 1.700 on Confi dential Information.

Accounting Principles Rule It is imperative that CPAs, who are experts in accounting principles, follow accounting prin- ciples in the performance of their duties. This is made clear in Rule 1.320. Further, a similar rule exists for members in business, Rule 2.320. Rule 1.320 on accounting principles reads as follows:

A member shall not (1) express an opinion or state affi rmatively that the fi nancial statements or other fi nancial data of any entity are presented in conformity with generally accepted accounting principles or (2) state that he or she is not aware of any material modifi cations that should be made to such statements or data in order for them to be in conformity with generally accepted accounting principles, if such statements or data contain any departure from an accounting principle promulgated by bodies designated by Council to establish such principles that has a material eff ect on the statements or data taken as a whole. If, however, the statements or data contain such a departure and the member can demonstrate that due to unusual circumstances the fi nancial statements or data would otherwise have been misleading, the member can comply with the rule by describing the departure, its approximate eff ects, if practicable, and the reasons why compliance with the principle would result in a misleading statement.

The bodies that are designated by the AICPA Council to promulgate accounting prin- ciples are (1) the Financial Accounting Standards Board (FASB), (2) the Federal Account- ing Standards Advisory Board (FASAB), (3) the Governmental Accounting Standards Board (GASB), and (4) the International Accounting Standards Board (IASB). Financial statements prepared using other accounting principles would be considered fi nancial reporting frame- works other than generally accepted accounting principles (GAAP). For example, CPAs often prepare fi nancial statements for small businesses on a cash basis of accounting or a federal income tax basis of accounting. In these situations, the client’s fi nancial statements, and the CPA’s report thereon, should not purport that the fi nancial statements are in accordance with GAAP, and the fi nancial statements and the CPA’s report should clarify the fi nancial reporting framework used.

Finally, there is a strong presumption that adherence to GAAP would, in nearly all cir- cumstances, result in fi nancial statements that are not misleading. The question of what constitutes unusual circumstances, referred to in the rule above, is a matter of professional judgment. In considering that judgment, a CPA must consider whether a reasonable person reading the fi nancial statements would consider the adherence to the promulgated accounting principle to be misleading. In practice these circumstances are extremely rare.

Fees and Other Types of Remuneration The rule on fees and other types of remuneration address two circumstances that are particu- larly important: Rule 1.510 on Contingent Fees and Rule 1.520 on Commissions and Referral Fees. In general, entering into a contingent fee arrangement or accepting a commission or a referral fee associated with an attest client impairs independence due to the advocacy threat associated with these types of fees. For example, if a CPA accepted a contingent fee associ- ated with helping an attest client sell the business, the CPA would become an advocate for the client, and independence would be impaired. Further, it is particularly important that commission arrangements be disclosed to the client. For example, a CPA might be paid a commission by a software company for recommending its accounting software to a nonattest client. It is important for the client considering the accounting software to know that the

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2-26 CHAPTER 2 Professionalism and Professional Responsibilities

CPA is being paid a commission if the business purchases the software, so that the client fully evaluates the product and incentives involved. It is appropriate for CPAs to perform en- gagements on a contingent fee basis, or to accept a commission or a referral fee, with respect to nonattest clients. However, these fee arrangements are prohibited for attest clients as they impair independence.

Confidential Information In general, a CPA in public practice shall not disclose confi dential client information without the specifi c consent of the client.

However, there are some well-known exceptions to this rule. First, the rule on confi den- tial client information should not be construed as relieving a CPA of his or her professional obligation to comply with accounting principles. Therefore, a client cannot claim that infor- mation should not be disclosed in fi nancial statements due to client confi dentiality if the in- formation is required by GAAP. Second, the rule on confi dential client information allows a CPA to comply with a validly issued and enforceable subpoena or summons, or allows a CPA to comply with applicable laws and government regulations. For example, in certain circum- stances an auditor might have to report confi dential information to regulators such as the SEC if the information is not reported by management or those charged with governance of the entity. Third, the confi dential client information rule does not prohibit a review of a CPA’s professional practice under the AICPA, state society, or state board of accountancy authori- zation. This exception allows for peer review of a CPA’s practice and allows the peer reviewer to become knowledgeable of confi dential client information. However, there is an obligation on the part of the peer reviewer to respect the confi dential client information rule. Finally, the confi dential client information rule does not preclude a CPA from initiating a complaint with, or responding to any inquiry made by, the professional ethics division of the AICPA, a duly constituted investigative or disciplinary body of a state CPA society, or a state board of accountancy.

Before You Go On 7.1 Do the rules of conduct on accounting principles prevent a CPA from preparing fi nancial

statements for a client on a cash basis of accounting, which is not GAAP? Explain your reasoning.

7.2 Can a CPA represent a private company attest client, in connection with obtaining a private letter ruling from the IRS, on a contingent fee basis where the CPA is entitled to a percentage of tax savings the client obtains, if any? Explain your reasoning.

7.3 After work, can a member of an audit team discuss confi dential information about a client’s business with his or her spouse, who works for the client’s competitor? Explain your reasoning.

Legal Liability The previous sections have focused on an auditor’s ethical responsibilities to society (respon- sibilities to the client and to the public that relies on fi nancial statements). The legal system plays an important role in supporting the quality of work performed by auditors. It provides an important framework for accountability regarding the behavior of CPAs in society.

Auditors need to understand the legal impacts aff ecting the environment in which they work. Specifi cally, they need to know who can sue them, the allegations typically made in lawsuits against auditors, and defenses the auditor can use in court.

The following discussion is broken into two learning objectives. First it addresses the au- ditor’s liability under common law, which may vary from state to state. Second, the discussion addresses federal statutes regarding an auditor’s responsibility to fi nancial statement users.

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Auditor Liability Under Common Law 2-27

Auditor Liability Under Common Law

LEARNING OBJECTIVE 8 Evaluate the auditor’s legal liability under common law.

Common law is frequently referred to as unwritten law. It is based on judicial precedent rather than legislative rule. Common law is derived from principles based on justice, reason, and common sense rather than absolute, fi xed, or infl exible rules. The principles of common law are determined by the social needs of the community. Therefore, common law changes in re- sponse to society’s needs. In a specifi c case, the accountant’s liability is determined by a state or federal court that attempts to apply case law precedents that it feels are controlling. Because there are 51 such independent jurisdictions in the United States (50 states and the District of Columbia), diff erent decisions may result with respect to relatively similar factual circum- stances. In a common law case, the judge has the fl exibility to consider social, economic, and political factors as well as prior case law doctrines (precedents). Under common law, a CPA’s legal liability extends principally to two classes of parties: clients and third parties.

Illustration 2.10 outlines the discussion of an auditor’s liability under common law. An au- dit fi rm may be liable to clients either under contract law or under tort law, as discussed below. An audit fi rm is also concerned about its exposure to liability to clients. This liability will vary from state to state depending on state laws and legal precedent. The discussion of third-party liability will address whether an audit fi rm is liable to primary benefi ciaries of the audit, to a foreseen class of third-party users of fi nancial statements, or to foreseeable users of fi nancial statements.

common law law based on justice, reason, and common sense, rather than on absolute rules

ILLUSTRATION 2.10 Auditor liability under common law

Common Law

Liability to Clients Liability to Third Parties

Contract Law Tort Law Primary

Beneficiaries Foreseen Class of Third Parties

Foreseeable Third Parties

Liability to Clients A CPA is in a direct contractual relationship with clients. In agreeing to perform services for clients, the CPA assumes the role of an independent contractor. The specifi c service(s) to be rendered should preferably be set forth in an engagement letter, as described in Chapter 3. The term privity of contract refers to the contractual relationship that exists between two or more contracting parties. In the typical auditing engagement, it is assumed that the audit is to be made in accordance with professional standards (i.e., generally accepted auditing stan- dards) unless the contract contains specifi c wording to the contrary. A CPA may be held liable to a client under either contract law or tort law. Each of these is explained below.

Contract Law An auditor may be liable to a client for breach of contract when the audit fi rm:

• issues a standard audit report when he or she has not made an audit in accordance with generally accepted auditing standards (GAAS)

• does not deliver the audit report by the agreed-upon date • violates the client’s confi dential relationship

privity of contract a contractual relationship that exists between two or more contracting parties

breach of contract a binding agreement is not honored by one or more parties to a contract

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2-28 CHAPTER 2 Professionalism and Professional Responsibilities

A CPA’s liability for breach of contract extends to subrogees. A subrogee is a party who has acquired the rights of another by substitution. For example, the bonding of the client’s em- ployees is considered an important part of a company’s system of internal control. When an embezzlement occurs, the bonding company reimburses the insured (the client) for its losses. Then, under the right of subrogation to the insured’s contractual claim, the bonding company can bring suit against the CPA for failing to discover the fraud.

When a breach of contract occurs, the client usually seeks one or more of the follow- ing remedies: (1) specifi c performance of the contract by the defendant (the CPA), (2) direct monetary damages for losses incurred due to the breach, or (3) incidental and consequential damages that are an indirect result of nonperformance.

Tort Law A CPA may also be liable to a client under tort law. A tort is a wrongful act that injures an- other person’s property, body, or reputation. A tort action may be based on any one of the following causes:

• Ordinary negligence. Failure to exercise the degree of care a person of ordinary pru- dence (a reasonable person) would exercise under the same circumstances

• Gross negligence. Failure to use even slight care in the circumstances • Fraud. Intentional deception, such as misrepresentation, concealment, or nondisclosure

of a material fact, that results in injury to another. In some cases a distinction has been made between fraud and constructive fraud. Constructive fraud may be inferred from gross negligence or reckless disregard for the truth.

Under tort law, the injured party normally seeks monetary damages. The auditor’s documentation is vital in refuting charges for breach of contract and breach of duty in a tort action.

Cases Illustrating Liability to Clients Two cases pertaining to liability to clients are considered below. The fi rst case involves negli- gence, and the second relates to breach of contract.

1136 Tenants’ Corp. v. Max Rothenberg & Co. (1971) In this case the plaintiff was a corporation owning a cooperative apartment house that sued Max Rothenberg, an accounting fi rm, for damages resulting from the failure of the CPA to dis- cover the embezzlement of over $110,000 by the plaintiff ’s managing agent, Riker. Riker had orally engaged Rothenberg at an annual fee of $600. The plaintiff maintained that Rothenberg had been engaged to perform all necessary accounting and auditing services. The CPA claimed he was only engaged to prepare fi nancial statements without assurance and prepare related tax returns. As evidence of their respective contentions, the plaintiff booked the accountant’s fee as auditing expenses, and the CPA defendant marked each page of the fi nancial statements as “unaudited.” In addition, the CPA’s letter of transmittal to the fi nancial statements stated that (1) the statements were prepared from the books and records of the corporation and (2) no independent verifi cations were undertaken thereon.

The trial court found that the defendant was engaged to perform an audit because Rothenberg admitted that he had performed some limited auditing procedures such as ex- amining bank statements, invoices, and bills. In fact, the CPA’s own worksheets included one entitled “Missing Invoices,” which showed over $40,000 of disbursements that did not have supporting documentation. The CPA did not inform the plaintiff of these invoices, and no eff ort was made to fi nd them. The trial court also found that the CPA was negligent in the performance of the service and awarded damages totaling $237,000. The appellate court affi rmed, saying:

tort a wrongful act that injures another person’s property, body, or reputation

ordinary negligence failure to exercise the degree of care a reasonable person would exercise under the same circumstances gross negligence failure to use even slight care in the circumstances fraud intentional deception, such as misrepresentation, concealment, or nondisclosure of a material fact, that results in injury to another

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Auditor Liability Under Common Law 2-29

• Regardless of whether the CPA was conducting an audit or drafting fi nancial statements, there was a duty to inform the client of known wrongdoing or other suspicious actions by the client’s employees.

• The defendant’s worksheets indicate that the defendant did perform some audit procedures.

The 1136 Tenants’ case has frequently been used to demonstrate the importance of having a written contract (engagement letter) for each professional engagement. A written contract is important, but it was not the only issue in this case. The critical issue was the CPA’s failure to inform the client of employee wrongdoing, regardless of the type of service rendered.

F und of Funds, Ltd. v. Arthur Andersen & Co. (1982) In this case, the plaintiff sued the auditors for breach of contract because the auditors failed to dis- close fraud to the client when the auditors’ engagement letter contained a specifi c representation that any fraud would be revealed. The fraud, totalling over $120 million, resulted from overcharges on a contract between the plaintiff and King Resources, both audited by Andersen. Andersen ad- mitted discovery of the violation of the contract in auditing King, but declined to disclose the fraud to Fund of Funds because the AICPA’s Rule on Confi dential Client Information prohibits disclo- sure of confi dential information. The court ruled for the plaintiff on the grounds that the defen- dants failed to comply with the terms of their engagement letter, a breach of contract.

Liability to Third Parties The common law liability of the auditor to third parties is important in any discussion of the auditor’s legal liability. A third party may be defi ned as an individual who is not in privity with the parties to a contract. From a legal standpoint, there are two classes of third parties: (1) a primary benefi ciary and (2) other benefi ciaries. A primary benefi ciary is anyone identifi ed to the auditor by name prior to the audit who is to be the primary recipient of the auditor’s report. For example, if at the time the engagement letter is signed, the client informs the auditor that the report is to be used to obtain a loan at the Second National Bank, the bank becomes a primary benefi ciary. In contrast, other benefi ciaries are unnamed third parties, such as creditors, stockholders, and potential investors.

An auditor is liable to all third parties for gross negligence and fraud under tort law. In contrast, the auditor’s liability for ordinary negligence has traditionally been diff erent be- tween the two classes of third parties. The following discussion explains the importance of how the case law has defi ned an auditor’s liability to third parties for the auditor’s negligence.

Ultramares Corp. v. Touche (1931) This decision extended the concept of privity of contract to the primary benefi ciary of the auditor’s work. In this landmark case, the defendant auditors, Touche, failed to discover fi cti- tious transactions that overstated assets and stockholders’ equity by $700,000 in the audit of Fred Stern & Co. Subsequent to the audit, Ultramares loaned Stern large sums of money that Stern was unable to repay because the company was actually insolvent. Ultramares sued the accounting fi rm for negligence and fraud. The court found the auditors guilty of negligence but ruled that accountants should not be liable to any third party for negligence except to a primary benefi ciary. Judge Cardozo said:

If liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft or forgery beneath the cover of deceptive entries may expose accountants to a liability in indeterminate amounts, for an indeterminate time, to an indeterminate class. The hazards of a business conducted on these terms are so extreme as to enkindle doubt whether a fl aw may not exist in the implication of a duty that exposes to these consequences.

The court also ruled that the fi nding on negligence does not emancipate accountants from the consequences of fraud. It concluded that gross negligence may constitute fraud. Ultramares Corp. v. Touche upheld the privity of contract doctrine under which third parties cannot sue

third party an individual or collective group who is not in privity with the parties to a contract primary benefi ciary anyone identifi ed to the auditor by name prior to the audit who is a recipient of the auditor’s report other benefi ciaries unnamed third parties, such as creditors, stockholders, and potential investors who use the auditor’s report

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2-30 CHAPTER 2 Professionalism and Professional Responsibilities

auditors for ordinary negligence. However, Judge Cardozo’s decision extended to primary ben- efi ciaries the rights of one in privity of contract. Therefore, Ultramares as a primary benefi ciary could sue and recover for losses suff ered because of the auditor’s ordinary negligence.

Rusch Factors v. Levin (1968) The Ultramares decision remained virtually unchallenged for 37 years, and it still is followed today in many jurisdictions. However, since 1968, several court decisions have served to ex- tend the auditor’s liability for ordinary negligence beyond the privity of contract doctrine. The following environmental factors contributed to this development:

• The concept of liability evolved signifi cantly to include consumer protection from the wrongdoing of both manufacturers (product liability) and professionals (service liability).

• Businesses and accounting fi rms grew in size, making them better able to shoulder the new threshold of responsibility.

• The number of individuals and groups relying on audited fi nancial statements grew steadily.

In Rusch Factors v. Levin, the plaintiff had asked the defendant accountant to audit the fi - nancial statements of a corporation seeking a loan. The certifi ed statements indicated that the potential borrower was solvent when, in fact, it was insolvent. Rusch Factors sued the auditor for damages resulting from its reliance on negligent and fraudulent misrepresentations in the fi nancial statements. The defendant accountant asked for dismissal on the basis of lack of privity of contract. The court ruled in favor of the plaintiff . While the decision could have been decided on the basis of the primary benefi ciary rule set forth in Ultramares, the court instead said:

The accountant should be liable in negligence for careless fi nancial misrepresentation relied upon by actually foreseen and limited classes of persons. In this case, the defendant knew that his certifi cation was to be used for potential fi nanciers of the … corporation (emphasis added).

This decision extended the auditor’s liability from known specifi c primary benefi cia- ries, to an actually foreseen limited class of third parties known to be relying on the fi nancial statements.

Restatement (Second) of Torts § 552 (1977) The shift away from Ultramares occurred in the form of judicial acceptance of the specifi cally foreseen class concept. Subsection (2) of the Restatement (second) of Torts § 552 extends the auditor’s liability to “a limited group of persons for whose benefi t the CPA intends to supply the information.” Thus, if the client informs the CPA that the audit report is to be used to obtain a bank loan, all banks are foreseen parties, but trade creditors and potential stockhold- ers would not be part of the foreseen class. However, a CPA would not be liable if the audit report were used by a bank to invest capital in the client’s business in exchange for common stock instead of granting a loan.

The foreseen class concept does not extend to all present and future investors, stockhold- ers, or creditors. Court decisions have not required that the injured party be specifi cally iden- tifi ed, but the class of persons to which the party belonged had to be limited and known at the time the auditor provided the information.

Rosenblum v. Alder (1983) The Rosenblum case extended an auditor’s liability to foreseeable parties, individuals, or entities whom the auditor either knew or should have known would rely on the audit report in making business and investment decisions, and it extended the auditor’s duty of due care to any fore- seeable party who suff ers a pecuniary loss from relying on the auditor’s representation. Fore- seeable parties include all creditors, stockholders, and present and future investors. The courts use foreseeability extensively in cases involving physical injury. For example, foreseeability is almost universally used in product liability cases when the manufacturer’s negligence causes the physical injury. This concept was fi rst applied in an audit negligence case in the early 1980s.

foreseen class a limited class of third parties known to be relying on the fi nancial statements

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Auditor Liability Under Common Law 2-31

In reaching its decision in Rosenblum, the New Jersey Supreme Court cited the following public policy factors that appear, in part, aimed at countering Judge Cardozo’s arguments in upholding the privity doctrine in Ultramares: (1) insurance is available to accountants to cover these risks, (2) the CPA has a moral responsibility to anyone relying on his or her opinion, and (3) more rigid standards will cause accountants to do better work. The foreseeability standard was subsequently embraced by similar rulings in Wisconsin, California, and Mississippi.

Credit Alliance Corp v. Arthur Andersen & Co. (1985) In 1985, the New York Court of Appeals expressly rejected the foreseeability standard in Credit Alliance Corp. v. Arthur Andersen & Co. Instead, the court reverted to a “near privity rule,” establishing three criteria for determining whether a plaintiff can bring a claim against an audi- tor for ordinary negligence: (1) the plaintiff did in fact rely on the auditor’s report, (2) the audi- tor knew that the plaintiff intended to rely on the report, and (3) the auditor, through some actions on his or her own part, evidenced understanding of the plaintiff ’s intended reliance.

Bily v. Arthur Young & Co. (1992) In 1992, in yet another landmark case known as Bily v. Arthur Young & Co., the California Supreme Court ended the foreseeability standard in that state. After perhaps the most thor- ough analysis by any court of the purpose and eff ects of audits and audit reports, and follow- ing a thorough review of approaches taken by other courts as well as the basic principles of tort liability announced in the California court’s own prior cases, it stated:

We conclude that an auditor owes no general duty of care regarding the conduct of an audit to persons other than the client. An auditor may, however, be held liable for negligent misrepresentations in an audit report to those persons who act in reliance upon those misrepresentations in a transaction which the auditor intended to infl uence, in accordance with the rule of section 552 of the Restatement Second of Torts. . . . Finally, an auditor may also be held liable to reasonably foreseeable third persons for intentional fraud in the preparation and dissemination of an audit report.

A summary of the auditor’s liability under common law is presented in Illustration 2.11. Although the extent of the auditor’s exposure to liability to third parties for ordinary negligence

ILLUSTRATION 2.11 Liability to third parties under common law

1931

Ultramares decision

extends

liability to

primary

beneficiaries

Pre-1931

Liability

excluded

by privity of contract

doctrine

1968

Rusch Factors

decision

extends

liability to

foreseen

class

of third

parties

1977

Forseen

class

concept

adopted in

Restatement (Second) of Torts

1983

Rusenblum decision extends liability to

foreseeable third parties

1985 1992 1993

Credit

Alliance decision

restricts

liability

to users

acknowledged

by the

auditor

Bily

decision

returns

California to

Restatement (Second) of Torts

for negligent

misrepresentation

Some states

adopt privity legislation restricting

liability to

users

acknowledged

by the

auditor

R e

la ti

v e

e x

p o

su re

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2-32 CHAPTER 2 Professionalism and Professional Responsibilities

has been subject to the court decisions in various jurisdictions, it now appears that in all but three states (Mississippi, New Jersey, and Wisconsin) either the rule embraced in the Restatement (Second) of Torts, or the stricter Credit Alliance or privity legislation rules, prevail.

Burden of Proof and Common Law Defenses In general, the plaintiff must prove the following when suing an auditor:

• The auditor owed a duty of care to the plaintiff . • The auditor breached the duty by failing to act with due care (negligence). • The auditor’s negligence was the proximate cause of the plaintiff ’s damage. • The plaintiff had actual damages.

A key issue is whether the auditor owed a duty of care to the plaintiff . As noted in the previous discussion, most states extend the auditor’s duty of care to foreseen third parties under the Restatement (Second) of Torts standard.

The auditor’s defenses generally include:

• The auditor was not negligent and performed an audit in accordance with professional standards.

• No duty of care was owed to the plaintiff . • The plaintiff had no loss. • The loss was caused by other events. • The plaintiff ’s negligence (contributory negligence) contributed to the auditor’s failure

to perform. • The claim was invalid because the statute of limitations had expired.

The auditor must generally use the due care defense in breach of contract suits involving negligence. Under a due care defense, the auditor’s documentation should provide evidence that the audit was performed in accordance with auditing standards generally accepted in the United States. The due care defense is also a primary defense against tort actions, along with contributory negligence.

In a contributory negligence defense, the plaintiff must have contributed to his or her own injury (loss) by his or her own negligence. Therefore, the law considers the plaintiff to be as responsible as the defendant for the injury. In such a case, there is no basis for recovery because the negligence of one party nullifi es the negligence of the other party. For example, the plaintiff may have withheld vital information from the CPA during the audit, contributing to the audit fi rm’s failure to follow professional standards.

If a plaintiff wants to prove the auditor was guilty of gross negligence or fraud, it is a much higher burden of proof. In this instance, the plaintiff must prove:

• A false representation was made by the auditor. • The auditor knew the representation was false. • The auditor intended to induce the plaintiff to rely on the false representation. • The plaintiff relied on the misrepresentation. • The plaintiff suff ered damages.

This is a high burden of proof and an audit fi rm with good quality controls would not let this sit- uation happen. If the plaintiff can make the case that an audit fi rm was guilty of gross negligence or fraud, the plaintiff may be entitled to both compensatory damages and punitive damages.

due care defense the auditor’s documentation should provide evidence that the audit was performed in accordance with auditing standards generally accepted in the United States

Legal Reasoning Example Duty of Care

Grace Chermak is the audit partner on the audit of Price Construction LLC, a private com- pany that manufacturers small tools. Both Grace and Price are located in a state that follows

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Auditor Liability Under Statutory Law 2-33

Before You Go On 8.1 Explain each of the two primary situations in which a CPA may be liable to his or her client. 8.2 Distinguish between foreseen and foreseeable third parties. Give an example of each. 8.3 Explain the signifi cance of the Ultramares, Rusch Factors, Rosenblum, Credit Alliance, and

Bily cases on the auditor’s liability to third parties for negligence. 8.4 What is the plaintiff ’s burden of proof under common law? 8.5 Explain the due care defense as it applies to an audit. Explain the contributory negligence

defense as it applies to an audit.

Auditor Liability Under Statutory Law

LEARNING OBJECTIVE 9 Evaluate the auditor’s legal liability under statutory law.

Statutory law is established by state and federal legislative bodies and specifi cally addresses auditor’s liability under certain circumstances. The following discussion addresses a num- ber of statutory laws that address an auditor’s responsibility and liability to third-party users of fi nancial statements. Some of these statutes also address management’s responsibility for preparing fi nancial statements that are free of material misstatement. The discussion also ad- dresses key cases that have set precedence under these statutes. Finally, the section concludes with a discussion of the auditor’s exposure to criminal liability under these statutes.

Illustration 2.12 outlines the auditor’s liability under statutory law. The key elements of statutory law that are discussed in this section include the SEC Act of 1933, the SEC Act of 1934, the Foreign Corrupt Practices Act of 1977, the Private Securities Litigation Reform

statutory law law established by state and federal legislative bodies that specifi cally addresses the auditor’s liability under certain circumstances

ILLUSTRATION 2.12 Auditor liability under statutory law

Statutory Law

Foreign Corrupt

Practices Act of 1977

SEC Act of 1934

SEC Act of 1933

Private Securities Litigation

Reform Acts of 1995 and

1998

Sarbanes Oxley Act

of 2002

Criminal Liability

the restatement of torts laws. When planning the audit Grace knew the financial statements were primarily intended to be used by Last National Bank in evaluating debt covenants. After completing the audit and unbeknown to Grace, the financial statements are given to two other users: (1) another bank, and (2) a purchaser of 50% of Price Construction that was unforeseen at the time of the audit. To whom does Grace owe a duty of care under the restate- ment of torts law?

Under restatement of torts Grace owes a duty of care to a specifi c class of foreseen third par- ties, which would include the two banks that used the fi nancial statements. Grace does not owe the same duty of care to the purchaser of the 50% ownership interest in Price Construction. Had Grace known the fi nancial statements would have been used in buying and selling the business, Grace might have planned the audit diff erently.

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2-34 CHAPTER 2 Professionalism and Professional Responsibilities

Acts of 1995 and 1998, the Sarbanes Oxley Act of 2002, and the auditor’s exposure to criminal liability under statutory law.

The Securities Act of 1933 The 1933 Act is known as the Truth in Securities Act. It is designed to regulate the off ering of a new security to the public through the mails or in interstate commerce. Suits against auditors under this Act are usually based on Section 11, Civil Liabilities on Account of False Registra- tion Statement, which allows “any person” purchasing or otherwise acquiring the securities to sue when the fi nancial statements are materially misstated. The Act makes the auditor liable for losses to third parties resulting from ordinary negligence, as well as from fraud and gross negligence, to the eff ective date of the registration statement.

The principal eff ects of this Act on the parties involved in a suit may be summarized as follows:

The plaintiff (e.g., investors):

• may be any person acquiring securities described in the registration statement, whether or not he or she is a client of the auditor

• must base the claim on an alleged material false or misleading fi nancial statement con- tained in the registration statement

• does not have to prove reliance on the false or misleading statement or that the loss suf- fered was the proximate result of the statement if purchase was made before the issuance of an income statement covering a period of at least 12 months following the eff ective date of the registration statement

• does not have to prove that the auditors were negligent or fraudulent in certifying the fi nancial statements involved

The defendant (e.g., the auditor):

• has the burden of establishing freedom from negligence by proving that the audit fi rm made a reasonable investigation, that the fi rm followed auditing standards, and accord- ingly, had reasonable grounds to believe, and did believe, that the statements certifi ed were true at the date of the statements and as of the time the registration statement be- came eff ective (a due diligence defense), or

• must establish, by way of defense, that the plaintiff ’s loss resulted in whole or in part from causes other than the false or misleading statements

Therefore, there is a signifi cant burden of proof that rests upon the auditor to show that the audit fi rm used due diligence in conducting the audit.

Escott v. BarChris Construction Corp (1968) B arChris was a company that was in constant need of cash. Purchasers of bonds fi led suit un- der Section 11 when the company fi led for bankruptcy, alleging that the registration statement pertaining to the sale of the bonds contained material false statements and material omissions. One of the defendants was Peat, Marwick, Mitchell & Co. (now KPMG), which pleaded the due diligence defense. The case revolved around the eff ectiveness of the audit fi rm’s subsequent events review (discussed in Chapter 14), called an S-1 review by the SEC. The purpose of the re- view was to determine whether, subsequent to the certifi ed balance sheet, any material changes had occurred that needed to be disclosed to prevent the balance sheet from being misleading.

The court concluded that Peat Marwick’s written audit program for the subsequent events review was in conformity with generally accepted auditing standards. However, it also found that the work done by the auditor who was performing his fi rst S-1 review was unsatisfactory. The court concluded that the auditor did not meet the standards of the profession because he did not take some of the steps prescribed in the audit fi rm’s written program, the auditor did not spend an adequate amount of time on a task of this magnitude, and, most important of all, the auditor was too easily satisfi ed with glib answers given by the client.

due diligence defense an audit fi rm must show that it made a reasonable investigation, that the fi rm followed auditing standards, and accordingly had reasonable grounds to believe, and did believe, that the statements certifi ed were true at the date of the statements and as of the time the registration statement became eff ective

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Auditor Liability Under Statutory Law 2-35

This case is important in that the court determined that following auditing standards generally accepted in the United States would meet the due diligence defense. The courts also determined that the subsequent events review by Peat Marwick did not meet professional standards, or the fi rm’s own standards.

The Securities Act of 1934 Congress passed this Act to regulate the public trading of securities in the secondary market (in contrast to the new issue of securities in the primary market covered by the 1933 Act). The 1934 Act requires companies included under the Act to (1) fi le a registration statement when the securities are publicly traded on a national exchange or over the counter for the fi rst time and (2) keep the registration statement current through the fi ling of annual reports, quarterly reports, and other information with the SEC. Certain fi nancial information, including the fi nancial statements, must be audited by independent public accountants. The principal lia- bility provisions of the 1934 Act are set forth in Sections 18 and 10.

Under Section 18(a) the plaintiff :

• may be any person buying or selling the securities • must prove the existence of a material false or misleading statement • must prove reliance on such statement and damage resulting from such reliance

The defendant (the auditor) in a Section 18 suit must prove that he or she:

• acted in good faith • had no knowledge of the false or misleading statement

This means that the minimum basis for liability is gross negligence, not ordinary negligence. Ac- cordingly, the auditor’s position under Section 18 is the same as under the common law doctrine of Ultramares, in which the auditor may also be held liable to third parties for gross negligence.

Under section 10(b) and the SEC promulgated Rule 10b-5, it is unlawful for any person, directly or indirectly, to

• employ any device, scheme, or artifi ce to defraud • make any untrue statement of a material fact or omit to state a material fact necessary

to make the statements made, in the light of the circumstances under which they were made, not misleading

• engage in any act, practice, or course of business that operates, or would operate, as a fraud or deceit on any person in connection with the purchase or sale of any security

Section 10(b) and Rule 10b-5 are often referred to as the antifraud provisions of the 1934 Act. These antifraud provisions were made clear by the Ernst and Ernst v. Hochfelder decision, as discussed below.

The securities acts apply to diff erent situations. The 1933 Act applies to the initial distribu- tion of securities (capital stock and bonds) to the public by the issuing corporation (primary mar- ket), whereas the 1934 Act applies to trading of securities in national security markets (secondary market). Diff erences between Section 11 of the 1933 Act and Sections 10 and 18 of the 1934 Act exist as to (1) the plaintiff , (2) proof of reliance on the false or misleading fi nancial statements, and (3) the auditor’s liability for ordinary negligence, as summarized in Illustration 2.13.

Item 1933 Act 1934 Act

Plaintiff Any person acquiring the security

Either the buyer or seller of the security

Plaintiff must prove reliance No Yes

Defendant liability for ordinary negligence

Yes No

ILLUSTRATION 2.13 Summary of diff erences in key sections of the 1933 and 1934 Acts

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2-36 CHAPTER 2 Professionalism and Professional Responsibilities

Ernst & Ernst v. Hochfelder (1976)

Lawsuits against auditors under the 1934 Act are usually based on Section 10(b) and Rule 10b-5. The plaintiff s (Hochfelder) were investors in an escrow account allegedly kept by the president (Lester K. Nay) of First Securities Co., a small brokerage fi rm, audited by Ernst & Ernst (now Ernst & Young). The escrow account, in which a high rate of return was promised, was a ruse perpetrated by Mr. Nay. To prevent detection, all investors were instructed to make their checks payable to Nay and to mail them directly to him at First Securities. Within the brokerage house, Nay imposed a “mail rule” that such mail was to be opened only by himself. The escrow account was not recorded on First Securities’ books.

Plaintiff s sued Ernst for damages under Rule 10b-5 for aiding and abetting the embezzle- ment. They based their claim entirely on the premise that the auditors were negligent in their audit because they had not challenged or investigated the “mail rule.” Following confl icting lower court decisions, the U.S. Supreme Court ruled in favor of Ernst & Ernst, saying:

When a statute speaks so specifi cally in terms of manipulation and deception, and of implementing devices and contrivances—the commonly understood terminology of intentional wrongdoing—and when its history refl ects no more expansive intent, we are quite unwilling to extend the scope of the statute to negligent conduct.

Based on this decision, an auditor is no longer liable to third parties under Section 10(b) and Rule 10b-5 of the 1934 Act for ordinary negligence. That is, the auditor has no liability in the absence of any intent to deceive or defraud (legally called scienter).

Therefore, a plaintiff fi ling a lawsuit against an auditor under Rule 10(b)-5 of the 1934 Act must prove:

• The fi nancial statements contain a material, factual misrepresentation or omission, • The plaintiff relied on the fi nancial statements, • Damages were suff ered as a result of the reliance on the fi nancial statements, and • Scienter, that the auditor either had actual knowledge of the falsity of the representa-

tion, or had a reckless disregard for the truth or falsity of the representation.

The Foreign Corrupt Practices Act of 1977 The Foreign Corrupt Practices Act (FCPA), passed by Congress in 1977, makes bribing for- eign offi cials illegal. The FCPA also addresses records retention required under the Securities Exchange Act of 1934. Through the FCPA, Congress increased the bookkeeping and account- ing records requirement of those corporations bound by the 1934 Act. The major change was that the FCPA requires companies to maintain reasonable records and to have an adequate system of internal control. For records to be reasonable, they must be both complete and ac- curate. The FCPA applies to the work of auditors when an integrated audit reports on internal control over fi nancial reporting. If the auditor concludes that internal control over fi nancial reporting is eff ective, and it is proved otherwise, the auditor may be liable under the FCPA.

The Private Securities Litigation Reform Acts of 1995 and 1998 As a result of the Hochfelder decision, many lawsuits against auditors moved to state court under common law actions, and audit fi rms experienced an increase in both frivolous and abusive lawsuits. In response to this environment, Congress passed the Private Securities Litigation Reform Act of 1995 (Reform Act) to reduce frivolous litigation risk for audi- tors, publicly traded companies, and those parties affi liated with security issuers, such as offi cers, directors, and other professional advisors (e.g., underwriters and lawyers). The Reform Act substantially revised the Securities Act of 1933 and the Securities Exchange Act of 1934.

scienter the auditor either had actual knowledge of the falsity of the representation, or had a reckless disregard for the truth or falsity of the representation

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Auditor Liability Under Statutory Law 2-37

The Reform Act instituted a system of proportionate liability whereby defendants who are not found to have “knowingly committed a violation” of securities laws are liable based on the defendant’s percentage of responsibility. This is intended to reduce the coercive pressure for innocent parties to settle meritless claims out of court rather than risk exposing themselves to liability for a grossly disproportionate share of the damages in a case. Defen- dants who “knowingly committed a violation” continue to be jointly and severally liable for all damages that may be assessed. For example, assume that a company has gone bankrupt, investors successfully claim the audited fi nancial statements were materially misstated, and a jury determines that the auditor was 35% responsible for damages incurred by investors and the company was 65% responsible for the damages. Under proportionate liability the auditor would be responsible for 35% of the damages. However, under joint and several liability inves- tors can recover damages from any of the defendants. If the company is bankrupt and unable to pay any damages, the auditor could potentially be responsible for 100% of the damages.

If a defendant does not knowingly commit a violation of the securities acts, the Reform Act also places a cap on the proportionate share of damages that can be collected from other defendants. If another defendant’s share cannot be collected from that defendant, or from jointly and severally liable defendants, each proportionately liable defendant is then liable for a proportionate share of the uncollectible amount, only up to an amount equal to an addi- tional 50% of such defendant’s initial share.

The Reform Act imposed new reporting requirements on auditors who detect or other- wise become aware of illegal acts by issuers of securities. If an auditor concludes that an illegal act has a direct and material eff ect on the fi nancial statements, and senior management has not taken appropriate action, and the failure warrants a departure from a standard report or a resignation from the engagement, the auditor should report these conclusions directly to the board of directors. The board should then notify the SEC within one day. If the board does not fi le a timely report with the SEC, the auditor should make a report to the SEC. The Reform Act explicitly states that the auditor will not be held liable in a private action for any fi nding, conclusions, or statements made in such reports.

Three years later Congress passed the Securities Litigation Uniform Standards Act of 1998. This was passed to prevent plaintiff s from evading federal courts by taking abusive law- suits to state courts. Large class action lawsuits alleging securities fraud against auditors must now be fi led in federal court. Only smaller class action lawsuits of fewer than 50 people can be fi led in state court.

The Sarbanes–Oxley Act of 2002 The Sarbanes-Oxley Act of 2002 (SOX) had a number of provisions that infl uenced the au- diting environment. SOX made it illegal for auditors to provide certain nonattest services to clients, and it changed the regulation of the auditing profession. It also signifi cantly changed the audit environment by imposing increased penalties for management of public companies who engage in fraudulent fi nancial reporting, as discussed below.

Changes for Auditors As discussed previously in SEC and PCAOB Independence Rules, SOX makes it “unlawful” to perform audit services for a public company and also perform the following nonattest services for audit clients:

• bookkeeping or other services related to the accounting records or fi nancial statements of the audit client

• fi nancial information systems design and implementation • appraisal or valuation services, fairness opinions, or contribution-in-kind reports • actuarial services • internal audit outsourcing services • management functions or human resources • broker or dealer, investment adviser, or investment banking services

proportionate liability defendants who are not found to have “knowingly committed a violation” of the securities law are liable based on the defendant’s percentage of responsibility

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2-38 CHAPTER 2 Professionalism and Professional Responsibilities

• legal services and expert services unrelated to the audit • any other service that the PCAOB determines, by regulation, is impermissible

Further, Section 203 of SOX mandates rotation of the lead audit partner and the audit partner having responsibility for reviewing the audit every fi ve years.

SOX also changed the regulatory environment. The Act gave the PCAOB authority to establish auditing standards, quality control standards, and independence standards for au- ditors of public companies. Prior to SOX, the auditing profession was responsible for these functions through the self-regulatory functions of the American Institute of CPAs.

Changes for Management of Public Companies SOX strengthened penalties imposed on management of public companies who were respon- sible for false and misleading fi nancial statements. Following is an overview of key provisions of the Act that aff ect management of public companies.

Section 302 requires a public company’s CEO and CFO to prepare a statement to accom- pany the audit report to certify the “appropriateness of the fi nancial statements and disclo- sures contained in the periodic report, and that those fi nancial statements and disclosures fairly present, in all material respects, the operations and fi nancial condition of the issuer.” It also creates a liability for the CEO and CFO who knowingly and intentionally make false certifi cations.

Section 303 makes it unlawful for any offi cer or director of an issuer to take any action to fraudulently infl uence, coerce, manipulate, or mislead any auditor engaged in the perfor- mance of an audit for the purpose of rendering the fi nancial statements materially misleading.

Section 305 requires the CEO and CFO of a company that restates fi nancial statements due to “material noncompliance” with fi nancial reporting requirements to “reimburse the company for any bonus or other incentive-based or equity-based compensation received” during the 12 months following the issuance or fi ling of the noncompliant document and “any profi ts realized from the sale of securities of the issuer” during that period. Furthermore, this section of the Act authorizes the federal courts to “grant any equitable relief that may be appropriate or necessary for the benefi t of investors” for any action brought by the SEC for violation of the securities laws.

A provision within SOX is the Corporate and Criminal Fraud Accountability Act of 2002. Illustration 2.14 summarizes the key provisions of this act.

ILLUSTRATION 2.14 Key provisions of the Corporate and Criminal Fraud Accountability Act of 2002

Title VIII of the Corporate and Criminal Fraud Accountability Act of 2002

Title IX of the Corporate and Criminal Fraud Accountability Act of 2002

• Makes it a felony to “knowingly” destroy or create documents to “impede, obstruct or influence” any existing or contemplated federal investigation.

• Requires auditors to maintain “all audit or review work papers” for five years.

• Extends the statute of limitations on securities fraud claims to the earlier of five years from the fraud or two years after the fraud was discovered.

• Extends “whistleblower protection” to employees of public companies and their auditors that would prohibit the employer from taking certain actions against employees who lawfully disclose private employer information to, among others, parties in a judicial proceeding involving a fraud claim. Whistleblowers are also granted a remedy of special damages and attorney’s fees.

• Creates a new crime for securities fraud that has penalties of fines and up to 10 years imprisonment.

• The maximum penalty for mail and wire fraud under the 1933 and 1934 Acts was increased from 5 to 10 years.

• Financial statements filed with the SEC must be certified by the CEO and CFO. The certification must state that the financial statements and disclosures fully comply with provisions of the Securities Exchange Acts and that they fairly present, in all material respects, the operations and financial condition of the issuer. Maximum penalties for willful and knowing violations of this section are a fine of not more than $500,000 and/or imprisonment of up to five years.

• The SEC was given authority to seek a court freeze of extraordinary payments to directors, offices, partners, controlling persons, and agents of employees and to prohibit anyone convicted of securities fraud from being an officer or director of any publicly traded company.

• Makes it a criminal offense to tamper with a record or otherwise impeding any official proceeding and asks the U.S. Sentencing Commission to review sentencing guidelines for securities and accounting fraud.

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Auditor Liability Under Statutory Law 2-39

Criminal Liability The only entities that can bring charges for criminal causes of action are governments (fed- eral and state). Auditors can be subject to criminal liability under both the 1933 and 1934 Securities Acts. Criminal liability subjects auditors to penalties of fi nes or imprisonment or both. Criminal penalties are provided under Sections 17 and 24 of the Securities Act of 1933. For example, Section 24 provides for penalties on conviction of no more than $10,000 in fi nes or imprisonment of not more than ten years, or both, for willfully making an un- true statement or omitting a material fact in a registration statement. Further, Section 32(a) of the Securities Act of 1934 establishes criminal liability for “willfully” and “knowingly” making false or misleading statements in reports fi led under the Act. This section also pro- vides for criminal penalties for violating the antifraud provisions of Section 10(b) consisting of fi nes of not more than $100,000 or imprisonment for not more than fi ve years, or both. Further, state boards of accountancy will usually revoke CPA licenses for fi ndings of crim- inal violations.

In addition, SOX prohibits the destruction of documents and increases the prison penalty for such actions to 20 years. SOX also increases penalties under criminal statutes of the 1933 and 1934 Securities Act from 5 years to 10 years. Following is a summary of several key cases related to criminal liability for auditors.

United States v. Simon (1969) This was a criminal case brought under Section 24 of the 1933 Securities Act. The case in- volved the adequacy of disclosure about loans made by Continental Vending to its affi liated company, Valley Commercial Corporation, which subsequently lent the money to the pres- ident of Continental (Roth). The loans to Roth were secured primarily by the pledging of Continental common stock owned by Roth. Valley, in turn, pledged this stock as collateral against the loans from Continental. The government charged that the disclosure was false and misleading. The defendants (two partners and an audit senior) argued that the disclosure was in conformity with GAAP and that such compliance was a conclusive defense against criminal charges of misrepresentation.

The trial judge rejected this argument and instructed the jury that the “critical test” was whether the balance sheet fairly presented fi nancial position without reference to generally accepted accounting principles. The jury concluded that the balance sheet did not present fairly, and the three defendants were convicted of the criminal charges. The U.S. Court of Appeals refused to reverse the decision and held that

We do not think the jury was . . . required to accept the accountants’ evaluation whether a given fact was material to overall fair presentation, at least not when the accountant’s testimony was not based on specifi c rules and prohibitions to which they could point, but only on the need for the auditor to make an honest judgment and their conclusion that nothing in the fi nancial statements themselves negated the conclusion that an honest judgment had been made. Such evidence may be highly persuasive, but it is not conclusive, and so the trial judge correctly charged.

The defendants were found guilty. They were fi ned $17,000 and their licenses to prac- tice as CPAs were revoked because of the criminal conviction. The defendants did not re- ceive jail time.

United States v. Natelli (1975) This was a landmark case because the auditors were convicted and sentenced to time in prison. Anthony Natelli, a Peat, Marwick, Mitchell & Company (now KPMG) partner, and audit supervisor Joseph Scansaroli were involved in the audit of National Student Marketing Corporation. The fi nancial statements for fi scal year ended August 31, 1968, were misstated because the company reported as actual sales amounts that were really only commitments. A material amount of the commitments were known to be uncollectible and were written off in the next fi scal year, but were still shown as income in the fi nancial statements used in the

criminal liability subjects auditors to penalties of fi nes or imprisonment or both. The only entities who can bring charges for criminal causes of action are federal or state governments

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2-40 CHAPTER 2 Professionalism and Professional Responsibilities

September 30, 1969, proxy statement. The two auditors were convicted of willingly and know- ingly making false and misleading statements in the proxy statements under the Securities Act of 1934. Both received fi nes in addition to prison sentences. Scansaroli’s conviction was later reversed.

United States v. Weiner (1978) This case was associated with the audit of Equity Funding Corporation of America. Equity Funding sold insurance. To maintain the value of the company’s stock, management directed that fraudulent sales of insurance policies, and related receivables, be recorded in the com- pany’s records. Eventually the fraud evolved to a reissuance scheme in which fraudulent insurance policies were resold to other insurers. The scheme required a massive amount of fi ctitious document creation and recordkeeping to maintain appearances. The auditors were found guilty because the fraud was so extensive that they should have known about it. One public accounting fi rm partner and two managers received criminal convictions and over $40 million of civil penalties were paid.

ESM Government Securities v. Alexander Grant & Co. (1987) The ESM case involved a fraud perpetrated by ESM management that was voluntarily revealed to the Alexander Grant (now Grant Thornton) audit partner responsible for the engagement. The audit partner, Joe Gomez, chose to remain silent about the fraud with the expectation that management would be able to reverse the problems if given time. In addition, the fraud had been going on for years, and Gomez did not want to admit and report to his fi rm that he had missed fi nding the fraud in prior audits. Because of his silence, which helped the fraud to continue, Gomez was charged with knowingly fi ling false and misleading audit reports. In addition, he was charged with having received secret payments from ESM offi cers totaling $125,000. Gomes was sentenced to 12 years in prison.

HealthSouth (2003) HealthSouth made its name as a provider of outpatient surgery, diagnostic, imaging, and rehabilitation health-care services. In 2003 the company and CEO Richard M. Scrushy were charged with accounting fraud and overstating earnings. The fraud dealt with intentional manipulation of corporate accounts to increase earnings so that the company would meet analyst’s expectations. Scrushy was accused of managing the company in such a way that it infl uenced employees to participate in the fraud. He placed extreme emphasis on meeting earnings expectations. The entire senior management team was relatively young and inexpe- rienced, enabling Scrushy to manage the team through fear. HealthSouth’s CFO, William T. Owens, admitted to accounting fraud and instructing subordinates to make phony account- ing entries. He turned himself in to authorities in 2003 and testifi ed against Scrushy. Scrushy was eventually acquitted of criminal wrongdoing in 2005. Nevertheless, he settled with the SEC in 2007 for $77.5 million plus $3.5 million in civil penalties. In 2009 Scrushy was sued for fraud by HealthSouth investors, and he was ordered to repay his company $2.8 billion.

Cloud 9 - Continuing Case Sharon, Josh, and Ian Harper (a fi rst-year audit staff ) are having lunch and talking about Cloud 9, a potential audit client. Ian asks, “Cloud 9 is a public company and has operations in a number of states, as well as internationally. I remember from my auditing class that an auditor’s legal liability may diff er from state to state, and that federal laws, which are diff erent, may take precedence over state laws. In this litigious environment, how does the fi rm plan to adequately protect itself with this apparent patchwork of

diff erent laws?” Sharon turns to Josh, asking him what he thinks about this question. Josh answers that one defense that is virtually universal is the due diligence defense. W&S Partners has invested signifi cant time and eff ort in developing a strong system of quality control. If the fi rm’s working papers show that the auditors have used due diligence in carrying out their audit, the fi rm should be able to fend off legal liability. Sharon agrees with Josh. “It is very important that we follow professional standards at all times.”

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Learning Objectives Review 2-41

Before You Go On 9.1 What transactions are covered by the 1933 Securities Act? Develop examples of transactions

that are, and are not, covered by this Act. 9.2 What is the burden of proof for the plaintiff and the defendant auditor under the 1933 Secu-

rities Act? Explain in the context of the BarChris case. 9.3 Explain the conditions of auditor liability under Rule 10(b)-5 of the 1934 Securities Exchange

Act. What were the fi ndings under this section as they related to the Hochfelder case? 9.4 What is proportionate liability under the Private Securities Reform Act of 1995? What fi nding

is important for a defendant to obtain the benefi ts of proportionate liability? 9.5 Explain how SOX signifi cantly changed the audit environment for auditors. 9.6 Explain how criminal liability is diff erent from civil liability. Illustrate your discussion with

the results of actual cases.

Learning Objectives Review

1 Explain what it means to be a professional and how these traits apply to auditors.

The term professional is often used loosely in various contexts. Robert Mautz talked articulately about the diff erence between the expert competitor (EC) professional and the concern for the public interest (CPI) professional. Auditors fall into the category of CPI profession- als. CPI professions are often recognized by a specialized body of knowledge, a formal education process, standards governing admis- sion to the profession, a code of ethics, recognized status indicated by a license, a public interest in the work that practitioners perform, and the recognition by practitioners of an obligation to society. Audi- tors are granted an exclusive license to perform audits in exchange for their responsibility to the public to provide reasonable assurance that fi nancial statements are free of material misstatements.

2 Explain the structure of the AICPA Code of Profes- sional Conduct.

The AICPA Code of Conduct applies to all AICPA members as well as to all CPAs in many states. The Code consists of principles, rules, and interpretations. Rules of conduct are enforceable and a CPA must be prepared to justify departures from the rules. Further, members whose conduct departs from interpretations have the burden of jus- tifying the departure in a disciplinary hearing. The AICPA Code is also structured into four parts: a preface applicable to all members; Part I, which includes ethical rules for members in public practice; Part II, which includes ethical rules for members in business; and Part III, which includes ethical rules for other members (e.g., non-CPA members of the AICPA).

3 Explain the conceptual framework approach to ethi- cal decision making for members in public practice.

The conceptual framework is designed to assist CPAs in situations that are not addressed in the rules or interpretations of the AICPA

Code of Conduct. Illustration 2.2 depicts the fi ve steps a CPA should apply when considering evaluating an ethical situation: (1) identify threats to compliance with rules, (2) evaluate the signifi cance of the threat, (3) identify and apply safeguards, (4) evaluate the eff ectiveness of the safeguards, and (5) document the threats and safeguards. A CPA should judge his or her ethical conduct from the perspective of a reasonable and informed third party.

4 Evaluate the ethical behavior needed to comply with rules of conduct on integrity and objectivity.

The ethical rule on integrity and objectivity requires a CPA to (1) be free of confl icts of interest, (2) not knowingly misrepresent facts, and (3) not subordinate his or her judgment to others.

5 Evaluate the ethical behavior needed to comply with rules of conduct on independence.

A CPA should be both independent in fact (act with integrity and ob- jectivity) and independent in appearance the eyes of reasonable and informed third parties. It is important for CPAs to understand how independence rules apply to covered members, immediate family members, close relatives, and other professionals in an audit fi rm. CPAs also need to understand what is prohibited or allowed in terms of investments in an attest client, loans to or from an attest client, employment relationship with an attest client, or the performance of nonattest services for an attest client.

6 Evaluate the ethical behavior needed to comply with rules of conduct on general standards.

The general standards apply to any CPA performing any professional engagement for a client. At a minimum a CPA must have the appro- priate professional competence to complete the engagement, use due professional care, adequately plan and supervise the engage- ment, and obtain suffi cient relevant data to support conclusions or recommendations.

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2-42 CHAPTER 2 Professionalism and Professional Responsibilities

7 Evaluate the ethical behavior needed to comply with other rules of conduct for members in public practice.

It is not possible to cover all the remaining rules of conduct for mem- bers in public practice. Illustration 2.1 provides a general outline of the rules of conduct for members in public practice. In particular, you should understand a CPA’s responsibility for complying with ac- counting principles and the types of engagements and the situations in which it is appropriate for a CPA to accept a commission, a referral fee, or a contingent fee. A CPA must also take care not to disclose con- fi dential client information without the specifi c consent of the client, and a CPA must be cognizant of specifi c situations where confi dential client information may be disclosed.

8 Evaluate an auditor’s legal liability under common law

Auditors are liable to clients for their negligent actions that result in either breach of contract or tort actions. Auditor liability to third parties under common law varies from state to state. Three important doctrines that address common law to third parties are (1) the primary benefi cia- ries doctrine, (2) the restatement of torts doctrine, and (3) the foreseeable third parties doctrine. These doctrines explain when an auditor would be liable to third parties for ordinary negligence. Illustration 2.11 identi- fi es important cases discussed in the chapter that address liability to third parties under common law. The auditor’s primary defense under com- mon law is the due care defense, where the auditor’s working papers and documentation show that an audit was performed in accordance with auditing standards generally accepted in the United States.

9 Evaluate an auditor’s legal liability under statutory law.

The auditor’s liability to financial statement users under the Securities Acts of 1933 and 1934 are significantly different as

summarized in Illustration 2.13. Under the 1933 Securities Act, auditors are liable for their negligence to persons who purchased or otherwise acquired a new issue of securities covered by a reg- istration statement that included a material misstatement of fact in the financial statements. Under the 1934 Act, the auditor must be found to intend to deceive or defraud or be guilty of gross neg- ligence to be found liable. Today, investors who suffer damages due to material misstatements in financial statements often find it easier to sue auditors under common law than under the 1934 Securities Act.

The two most important reforms under the Private Securities Litigation Reform Act of 1995 include instituting a system of propor- tionate liability and a cap on damages into the federal securities laws. In addition, the law imposed new reporting requirements on auditors who detect or otherwise become aware of illegal acts that have a mate- rial eff ect on the fi nancial statements by issuers of securities. The law also instituted a number of other reforms, making it diffi cult to bring frivolous lawsuits against auditors.

SOX signifi cantly changed the audit environment for both audi- tors and management. This section of the chapter discusses both non- attest services that are now unlawful for auditors to perform for audit clients, and the PCAOB’s responsibility for setting auditing standards, quality control standards, and independence standards for auditors of public companies. In addition, the section describes the legal liability of management, particularly the CEO and CFO. Knowing and willful violation of SOX can result in fi nes and imprisonment. Finally, im- proved systems of internal control are designed to improve the audit environment.

The federal government can bring criminal charges against au- ditors under the 1933 and 1934 Securities Act for willfully and know- ingly making false or misleading statements in reports fi led under the Acts. Criminal penalties include fi nes and imprisonment. Also, state boards of accountancy have the ability and will usually revoke CPA licenses for criminal violations.

Key Terms Review Gross negligence Immediate family member Independence Independence in appearance Independence in fact Integrity and objectivity Interpretations Key position Management participation threat Ordinary negligence Other benefi ciaries Planning and supervision Primary benefi ciary Principles

Adverse interest threat Advocacy threat Audit committee Breach of contract Close relative Common law Covered member Criminal liability Due care defense Due diligence defense Due professional care Familiarity threat Foreseen class Fraud

Privity of contract Professional competence Proportionate liability Rules of conduct Scienter Self-interest threat Self-review threat Statutory law Suffi cient relevant data Third party Tort Undue infl uence threat

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Key Terms Review 2-43

CPAexcel CPAexcel questions and other resources are available in WileyPLUS.

Audit Decision-Making Example

Background Information Lisa Cole is a tax partner in the mid-sized CPA fi rm of Cole and Bayless LLP. Cole and Bayless LLP has been doing signifi cant tax work and advising the owners of Aiwa Hardware on business re- structuring over the last two years. Lisa’s husband, Perry, is one of six investors and owners of Aiwa Hardware. As a result, a con- fl ict of interest was identifi ed and disclosed to the owners of Aiwa Hardware. Lisa has not been allowed to have any connection to, or infl uence on, the tax or business restructuring engagements for Aiwa Hardware, and a second partner reviewed these engage- ments to ensure the fi rm acted with integrity and objectivity. Aiwa Hardware owes Cole and Bayless LLP $200,000 in fees for the tax and restructuring work.

On December 1, 20X1 after signifi cant discussions between Fifth State Bank and the owners of Aiwa Hardware, the bank will require audited fi nancial statements from Aiwa Hardware for the year ended December 31, 20X2. Aiwa Hardware has not been au- dited before and the only fi nancial information used by the bank have been tax returns.

After discussions on December 3, 20X1 involving Aiwa Hard- ware’s owners and the accounting fi rm’s managing partner Rick Bayless, the following conclusions are reached: (a) Perry Cole will sell his share to the other fi ve investors and owners of Aiwa Hard- ware for cash as of December 15, 20X1, and will discontinue any participation in the business as of that date and (b) Rick Bayless will accept an off er from the remaining owners of Aiwa Hardware to give Cole and Bayless, LLP a secured, interest-bearing note dated December 15, 20X1 in settlement of the outstanding account receivable to the CPA fi rm with repayment terms over 3 years.

On May 1, 20X2 Rick Bayless and Lee Aiwa sign an engage- ment letter for Cole and Bayless LLP to do the audit of Aiwa Hard- ware for the year ended December 31, 20X2.

Identify the Ethics Issue(s) Identify any threats to ethical behavior on the part of Cole and Bayless LLP. Also address the signifi cance of the threats and any safeguards that can be put in place to reduce the threat to an ac- ceptable level.

Gather Information and Evidence Ethical threats include:

• A familiarity threat presents a confl ict of interest and a threat to acting with integrity and objectivity (ET 1.110.010.04)— exists because Lisa Cole is a partner in the CPA fi rm and her husband is an owner in Aiwa Hardware through December 15, 20X1.

• A self-interest threat presents a confl ict of interest and a threat to acting with integrity and objectivity (ET 1.110.010.04)—

exists because Lisa Cole is a partner in the CPA fi rm and her husband is an owner in Aiwa Hardware through December 15, 20X1.

• A self-interest threat presents a confl ict of interest and a threat to acting with integrity and objectivity (ET 1.110.010.04)— exists because Cole and Bayless LLP has a direct investment in Aiwa Hardware in the form of a secured debt instrument as of December 15, 20X1.

• A self-interest threat presents a confl ict of interest and a threat to independence (ET 1.120.010.16)—exists because Cole and Bayless LLP has direct investment in Aiwa Hardware in the form of a secured debt instrument, as of December 15, 20X1.

Analysis and Evaluation of Alternatives • Cole and Bayless LLP does not need to be independent to do

tax work or consulting work (advising on business restructur- ing). It does need to be independent to do any attest work, in- cluding auditing the fi nancial statements of Aiwa Hardware.

• The fact that Lisa Cole’s confl ict of interest is disclosed to the client; she is not allowed to perform any work, or infl uence the work for Aiwa Hardware; and a second partner reviews the work for Aiwa Hardware is suffi cient to ensure the integ- rity and objectivity of the fi rm with respect to performing tax and consulting services for Aiwa Hardware (ET 1.110.010).

• Lisa’s husband sells his ownership interest in Aiwa Hardware and discontinues any participation in the Aiwa Hardware business prior to the period under audit beginning January 1, 20X2. This eliminates the familiarity and self-interest threats associated with his ownership interest for periods beginning after January 1, 20X2.

• A self-interest threat presents a confl ict of interest, and a threat to independence exists because Cole and Bayless LLP has a direct investment in Aiwa Hardware in the form of a secured debt instrument. No safeguard (ET 1.210.010.02) can be put in place to safeguard this threat and Cole and Bayless LLP is not independent with respect to performing any attest work for Aiwa Hardware, including an audit. The indepen- dence of Cole and Bayless LLP is impaired. The fact that the relationship is known by Aiwa Hardware does not eliminate the threat to independence.

Ethical Conclusions Cole and Bayless can continue to perform tax and consulting en- gagements for Aiwa Hardware. However, the fi rm cannot perform any attest engagements because the fi rm is not independent. There is no safeguard to the self-interest threat created by the direct in- vestment in Aiwa Hardware.

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2-44 CHAPTER 2 Professionalism and Professional Responsibilities

1. (LO 1) A key aspect of the “concern for the public interest” defi - nition of a professional is:

a. the level of professional expertise of the professional.

b. the fact that there are situations where professionals must put the interest of society ahead of the interest of their clients or their own well-being.

c. the incorporation of this defi nition into the Sarbanes–Oxley Act of 2002.

d. the unique ability of CPAs to sign attest reports.

2. (LO 2) Which of the following statements is true about Interpre- tations of the AICPA Code of Professional Conduct?

a. Interpretations are not enforceable by the AICPA in a disci- plinary matter.

b. Interpretations are strictly enforceable by the AICPA in a dis- ciplinary matter.

c. Interpretations are strictly enforceable by the AICPA and all state boards of accountancy in a disciplinary matter.

d. An AICPA member who departs from an interpretation has the burden of justifying a departure in any disciplinary hearing.

3. (LO 3) In the Conceptual Framework to the AICPA Code of Pro- fessional Conduct, a self-interest threat is:

a. the threat that a CPA could benefi t, fi nancially or otherwise, from an interest in, or a relationship with, a client or persons associated with the client.

b. the threat that a CPA will not act with objectivity because the CPA’s interests are opposed to the client’s interests

c. the threat that a CPA will take on the role of client manage- ment or otherwise assume management responsibilities.

d. the threat that a CPA will promote a client’s interests or po- sition to the point that the CPA’s objectivity or independence is compromised.

4. (LO 4) A CPA would violate the AICPA rule on integrity and ob- jectivity if:

a. a CPA in industry knowingly misrepresented the earnings of the company he worked for.

b. a CPA in public practice represented both the buyer and seller in helping the parties negotiate the sale (purchase) of a business.

c. a CPA who was an audit staff member subordinated his or her judgment to that of the audit partner.

d. All of the answers are violations of the AICPA rule on integrity and objectivity.

5. (LO 5) According to the profession’s ethical standards, an auditor would be considered independent in which of the following instances?

a. A professional employee, who does not work on the audit, has a spouse who is a marketing manager for an audit client.

b. The auditor is also an attorney who advises the client as its general counsel.

c. An employee of the auditor donates service as treasurer of a charitable organization that is a client.

d. The client owes the auditor fees for two consecutive annual audits.

6. (LO 5) A CPA who is a “covered person” purchased stock in a cli- ent corporation and placed it in a trust as an educational fund for the CPA’s minor child. The trust securities were not material to the CPA but were material to the child’s personal net worth. Would the inde- pendence of the CPA be considered impaired with respect to the client?

a. Yes, because the stock would be considered an indirect fi nan- cial interest that is material to the CPA’s child.

b. No, because the CPA would not be considered to have a direct fi nancial interest in the client.

c. Yes, because the stock would be considered a direct fi nancial interest and, consequently, materiality is not a factor.

d. No, because the CPA would not be considered to have a mate- rial indirect fi nancial interest in the client.

7. (LO 5) Under the AICPA ethics rules on independence, which of the following individuals would NOT be a covered member?

a. A consulting manager in another offi ce who provides 100 hours of nonaudit services to the audit client.

b. A partner in the same offi ce as the lead partner who provides no services to the audit client.

c. A partner in another offi ce who evaluates partner perfor- mance and compensation, but provides no services to the audit client.

d. A tax partner in another offi ce who provides 9 hours of tax services to the audit client.

8. (LO 5) Which of the following best describes the independence requirements for a close relative of a covered member?

a. A close relative cannot have an immaterial, direct investment in an audit client.

b. A close relative cannot have a loan from an audit client. c. A close relative cannot hold a key position with an audit client. d. A close relative cannot have an immaterial, indirect invest-

ment in an audit client.

9. (LO 6) The essence of the due care standard is that the auditor should not be guilty of:

a. bias. b. errors in judgment. c. fraud. d. negligence.

10. (LO 7) Without the consent of the client, a CPA should not disclose confi dential client information contained in working papers to a:

a. voluntary quality control review board. b. CPA fi rm that is a likely successor auditor. c. federal court that has issued a valid subpoena. d. disciplinary body created under state statute.

11. (LO 8) If a stockholder sues a CPA for common law fraud based on false statements contained in the fi nancial statements audited by the CPA, which of the following is the CPA’s best defense?

a. The CPA did not fi nancially benefi t from the alleged fraud. b. There was contributory negligence of the client. c. The stockholder lacks privity to sue. d. The auditor followed GAAS.

Multiple-Choice Questions

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Review Questions 2-45

12. (LO 8) Starr Corp. approved a plan of merger with Silo Corp. One of the determining factors in approving the merger was the strong fi nancial statements of Silo, which were audited by Cox & Co., CPAs. Starr had engaged Cox to audit Silo’s fi nancial statements. While performing the audit, Cox failed to discover material fraud, which subsequently caused Starr to suff er substantial losses. For Cox to be liable under common law under the Ultramares decision, Starr, at a minimum, must prove that Cox:

a. was a party to the fraud. b. acted recklessly or with a lack of reasonable grounds for belief. c. failed to exercise due care. d. was grossly negligent.

13. (LO 9) When a plaintiff is suing the auditor for damages under Rule 10(b)-5 of the 1934 Securities Act, which of the following is NOT part of the plaintiff ’s burden of proof?

a. The fi nancial statements contained a material, factual mis- representation or omission.

b. The auditor was negligent.

c. The plaintiff relied on the fi nancial statements. d. Damages were suff ered as a result of reliance on the fi nancial

statements.

14. (LO 9) One of the elements necessary to recover damages if there has been a material misstatement in a registration statement fi led pursuant to the Securities Act of 1933 is that:

a. there was a material false or misleading statement in the fi nancial statements.

b. the plaintiff knew the auditor. c. issuer and plaintiff were in privity of contract with each other. d. issuer failed to exercise due care in connection with the sale

of the securities.

R2.1 (LO 1) Explain the “public interest” in the work performed by auditors.

R2.2 (LO 1) There are a series of characteristics associated with CPI professionals. Explain how they apply to architecture and to public accounting.

R2.3 (LO 2) Explain the diff erences between Part 1, Part 2, and Part 3 of the AICPA Code of Professional Conduct.

R2.4 (LO 2, 3) Assume that a CPA has an opportunity to bid on a new audit client. The accounting fi rm is being considered because the CPA’s best friend from college is the CFO of the potential client. Apply the conceptual framework for members in public practice to this sit- uation. Explain any threats involved and whether any safeguards can be applied to reduce the threat to an acceptable level.

R2.5 (LO 2, 3) Assume that a CPA has just received a new audit client. The client will be the fi rm’s largest audit client, and the fi rm will have to hire one new staff member to staff the engagement. The fees will represent 25% of the fi rm revenues. Apply the conceptual framework for members in public practice to this situation.

R2.6 (LO 4) Explain the rule on integrity and objectivity. Give ex- amples of confl icts of interest, knowingly misrepresenting facts, or subordinating judgment.

R2.7 (LO 5) Is it appropriate for an audit fi rm to ask questions of an employee about his or her investments or the investments of his or her spouse? Why or why not?

R2.8 (LO 3, 5) What independence problems are created when an au- dit manager is approached by a private company audit client, which he or she audits, to become the company’s CFO? Are there appropriate safe- guards that can be put in place to protect the audit fi rm’s independence?

R2.9 (LO 5) List three situations in which the SEC and PCAOB in- dependence rules are stricter than the AICPA rules. Give an example of each.

R2.10 (LO 6) The AICPA rule on general standards identifi es four aspects of professional behavior. Identify each of the four aspects and develop an example illustrating the violation of each aspect.

R2.11 (LO 7) Henry Owens, CPA works in a local accounting fi rm. He is the tax manager on a major client in the offi ce. The fi rm pre- pares compiled fi nancial statements for the client on a quarterly basis. The client was impacted by the BP oil spill on the Gulf coast, and the client would like to engage Henry to help the business prepare a claim for damages from BP. The client would like to pay Henry on a contingent fee basis where Henry and his fi rm would receive 15% of any amounts recovered in a settlement with BP. Henry would receive no fee unless amounts are recovered. Can Henry accept this engage- ment? Why or why not?

R2.12 (LO 8) What does a third-party user of fi nancial statements have to prove under common law in a suit against an auditor for the auditor’s negligence? Illustrate with an example.

R2.13 (LO 8) John Rodrigeuz purchased newly issued bonds of Fly By Night Airlines in the primary market. Subsequently Fly By Night went bankrupt. What statutory law applies to this trans- action? What does John have to prove in a lawsuit against Fly By Night’s auditors?

R2.14 (LO 9) Mary Chen purchased shares of Fly By Night Airlines in the secondary market. Subsequently Fly By Night went bankrupt. What statutory law applies to this transaction? What does Mary have to prove in a lawsuit against Fly By Night’s auditors?

Review Questions

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2-46 CHAPTER 2 Professionalism and Professional Responsibilities

Analysis Problems AP2.1 (LO 2, 3) Basic Framework for ethical decision making Assume that you are the audit partner on an engagement for a client that has had a string of operating losses. You know the CFO, who is a former audit manager of your fi rm. The company still has a positive net worth, but you are worried that the company might have to close down within the next year or so. When you tell the CFO that the company should make full disclosure in the notes concerning substantial doubt about the company’s ability to continue as a going concern, your colleague says, “Hogwash! There’s no substantial doubt. The probability of our having to close down is remote. We’ll make no such disclosure. To do so would only make our customers and creditors nervous, possibly making such a disclosure a self-fulfi lling prophecy. Our competitors are as bad off as we are, and their auditors aren’t making them send out a distress signal.” You agree that the determination of “substantial doubt” is a judgment call.

Required Apply the fi ve-step conceptual framework for members in public practice to this dilemma.

AP2.2 (LO 5) Moderate Independence The attribute of independence has been traditionally asso- ciated with the CPA’s function of auditing and expressing opinions on fi nancial statements.

Required a. What is meant by “independence” as applied to the CPA’s function of auditing and expressing opin-

ions on fi nancial statements? Discuss. b. The Wallydrug Company is indebted to a CPA for unpaid fees and has off ered to issue to the CPA

unsecured interest-bearing notes. Would acceptance of these notes have any bearing on the CPA’s independence with respect to Wallydrug Company? Discuss.

c. The Rocky Hill Corporation was formed on October 1, 2021, and its fi scal year will end on September 30, 2022. You audited the corporation’s opening balance sheet and rendered an unqualifi ed opinion on it. A month after rendering your report, you are off ered the position of secretary of the board of directors because of the need for a complete set of offi cers and for convenience in signing various documents. You will have no fi nancial interest in the company through stock ownership or other- wise, will receive no salary, will not keep the books, and will not have any infl uence on its fi nancial matters other than occasional advice on income tax matters and similar advice normally given a client by a CPA. 1. Assume that you accept the off er but plan to resign the position prior to conducting your annual

audit, with the intention of again assuming the offi ce after rendering an opinion on the state- ments. Can you render an independent opinion on the fi nancial statements? Discuss.

2. Assume that you accept the off er on a temporary basis until the corporation has gotten under way and can fi nd a replacement for secretary of the board of directors. In any event, you would perma- nently resign the position before conducting your annual audit. Can you render an independent opinion on the fi nancial statements? Discuss.

AP2.3 (LO 5) Challenging Research Public Company Independence Jones and Jones, CPA, has a manufacturing client, Widgit Technologies, Inc. (WTI), that is a small, owner-managed busi- ness with annual revenues of approximately $8 million. WTI employs a bookkeeper but is not large enough to employ a CPA in-house. WTI regularly asks Margaret Jones, the partner on the engagement, for advice on accounting issues, and Jones and Jones drafts the fi nancial statements for the company. The client reviews the fi nancial statements before they are printed by Jones and Jones with an audit opinion attached.

During the current year WTI asked Jones and Jones to assist the company by rendering a business valuation service. WTI is asking Jones and Jones to (1) estimate the value of WTI and (2) consult with WTI in the form of making recommendations on steps that WTI can take that will grow the value of the business.

Required a. Since Jones and Jones is preparing the fi nancial statements for WTI, is Jones and Jones independent

with respect to WTI? What conditions, if any, must Jones and Jones meet in order to be independent with respect to WTI?

b. Would Jones and Jones be independent if WTI were a public company subject to SEC rules and regulations? Explain your reasoning.

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Analysis Problems 2-47

c. Can Jones and Jones take on the business valuation services and consulting engagement and remain independent with respect to WTI? Explain your reasoning.

d. Can Jones and Jones take on the business valuation services and consulting engagement if WTI were a public company subject to SEC rules and regulations? Explain your reasoning.

AP2.4 (LO 4, 5, 6, 7) Moderate Research Rules of conduct In the practice of public account- ing, an auditor who is a member of the AICPA is expected to comply with the rules of the Code of Profes- sional Conduct. Listed below are circumstances that raise a question about an auditor’s ethical conduct.

1. The auditor has a bank loan with a bank that is an audit client.

2. An unqualifi ed opinion is expressed when the fi nancial statements of a county are prepared in con- formity with principles established by the Governmental Accounting Standards Board.

3. An auditor retains the client’s records as a means of enforcing payment of an overdue audit fee.

4. The auditor makes retirement payments to individuals who formerly were members of his fi rm.

5. An auditor sells her shares of stock in a client company in April prior to beginning work on the audit for the year ending December 31.

6. An auditor accepts an engagement knowing that he does not have the expertise to do the audit.

7. The auditor quotes a client an audit fee but also states that the actual fee will be contingent on the amount of work done.

8. The auditor’s fi rm states in a newspaper advertisement that it has had fewer lawsuits than its prin- cipal competitors.

9. The auditor resigns her position as treasurer of the client on May 1, prior to beginning the audit for the year ending December 31.

10. The auditor discloses confi dential information about a client to a successor auditor.

11. The auditor accepts an audit engagement when he has a confl ict of interest.

12. An auditor prepares a small brochure containing testimonials from existing clients that he mails to prospective clients.

13. An auditor complies with the technical standards of the Accounting and Review Services Commit- tee in reviewing the fi nancial statements of a nonpublic entity.

14. An auditor audits the fi nancial statements of a local bank and also serves on the bank’s committee that approves loans.

15. An auditor pays a commission to an attorney to obtain a client.

Required a. Identify the rule of the Code of Professional Conduct that applies to each circumstance. Following

is a link to the AICPA Code of Professional Conduct (http://www.aicpa.org/Research/Standards/ CodeofConduct/Pages/default.aspx).

b. Indicate for each circumstance whether the eff ect on the rule is (1) a violation, (2) not a violation, or (3) indeterminate. Give the reason(s) for your answer.

AP2.5 (LO 4, 5, 6, 7) Moderate Research Ethical issues Gilbert and Bradley formed a corpora- tion called Financial Services, Inc., each taking 50 percent of the authorized common stock. Gilbert is a CPA and a member of the American Institute of CPAs. Bradley is a CPCU (Chartered Property Casualty Underwriter). The corporation performs auditing and tax services under Gilbert’s direction and insur- ance services under Bradley’s supervision. The opening of the corporation’s offi ce was announced by a three-inch, two-column ad in the local newspaper.

One of the corporation’s fi rst audit clients was the Grandtime Company. Grandtime had total assets of $600,000 and total liabilities of $270,000. In the course of the audit, Gilbert found that Grandtime’s building with a book value of $240,000 was pledged as security for a 10-year term note in the amount of $200,000. The client’s statements did not mention that the building was pledged as a security for the note. However, as the failure to disclose the lien did not aff ect either the value of the assets or the amount of the liabilities and the audit was satisfactory in all other respects, Gilbert rendered an unqualifi ed opinion on Grandtime’s fi nancial statements. About two months after the date of the opinion, Gilbert learned that an insurance company was planning a loan to Grandtime of $150,000 in the form of a fi rst-mortgage note on the building. Realizing that the insurance company was unaware of the existing lien on the building, Gilbert had Bradley notify the insurance company of the fact that Grandtime’s building was pledged as security for the term note.

Shortly after the events described above, Gilbert was charged with a violation of professional ethics.

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2-48 CHAPTER 2 Professionalism and Professional Responsibilities

Required Identify and discuss the ethical implication of those acts by Gilbert that were in violation of the AICPA Code of Professional Conduct.

AP2.6 (LO 4, 5, 6, 7) Challenging Research Ethical issues The following situations involve Herb Standard, staff accountant with the regional accounting fi rm of Cash & Green:

1. The bookkeeper of Ethical Manufacturing Company resigned two months ago and has not yet been replaced. As a result, Ethical’s transactions have not been recorded and the books are not up to date. To comply with terms of a loan agreement, Ethical needs to prepare interim fi nancial statements but cannot do so until the books are posted. Ethical looks to Cash & Green, its independent auditors, for help and wants to borrow Herb Standard to perform the work. Ethical wants Herb because he did its audit last year.

2. Herb Standard discovered that his client, Ethical Manufacturing Company, materially understated net income on last year’s tax return. Herb informs his supervisor about this and the client is asked to prepare an amended return. The client is unwilling to take corrective measures. Herb informs the Internal Revenue Service.

3. While observing the year-end inventory of Ethical Manufacturing Company, the plant manager of- fers Herb Standard a fi shing rod, which Ethical manufactures, in appreciation for a job well done.

4. Herb Standard’s acquaintance, Joe Lender, is chief loan offi cer at Local Bank, an audit client of Cash & Green. Herb approaches Joe for an unsecured loan from Local Bank and Joe approves the loan.

5. Herb Standard is a member of a local investment club composed of college fraternity brothers. The club invests in listed stocks and is fairly active in trading. Last week the club purchased the stock of Lever- age Corp., a client of another Cash & Green offi ce. Herb has no contact with the members of this offi ce.

Required For each situation, (a) identify the ethical issues that are involved and (b) discuss whether there has or has not been any violation of ethical conduct. Support your answers by reference to the rules of the Code of Professional Conduct. Following is a link to the AiCPA Code of Professional Conduct (http://www. aicpa.org/Research/Standards/CodeofConduct/Pages/default.aspx).

AP2.7 (LO 8) Moderate Common law Tyler Corp. is insolvent. It has defaulted on the payment of its debts and does not have assets suffi cient to satisfy its unsecured creditors. Slade, a supplier of raw materials, is Tyler’s largest unsecured creditor and is suing Tyler’s auditors, Field & Co., CPAs. Slade had extended $2 million of credit to Tyler based on the strength of Tyler’s audited fi nancial statements. Slade’s complaint alleges that the auditors were either (1) negligent in failing to discover and disclose fi ctitious accounts receivable created by management or (2) committed fraud in connection with Tyler. Field believes that Tyler’s fi nancial statements were prepared in accordance with GAAP and, therefore, its opinion was proper. Slade has established that:

• The accounts receivable were overstated by $10 million. • Total assets were reported as $24 million, of which accounts receivable were $16 million. • The auditors did not follow their own audit program, which required that confi rmation requests

be sent to an audit sample representing 80% of the total dollar amount of outstanding receivables. Confi rmation requests were sent to only 45%.

• The responses that were received represented only 20% of the total dollar amount of outstanding receivables. This was the poorest response in the history of the fi rm, the next lowest being 60%. The manager in charge of the engagement concluded that further inquiry was necessary. This recom- mendation was rejected by the partner in charge.

• Field had determined that a $300,000 account receivable from Dion Corp. was nonexistent. Tyler’s explanation was that Dion had reneged on a purchase contract before any products had been shipped. At Field’s request, Tyler made a reversing entry to eliminate this overstatement. However, Field ac- cepted Tyler’s explanation as to this and several similar discrepancies without further inquiry.

Slade asserts that Field is liable:

• as a result of negligence in conducting the audit • as a result of fraud in conducting the audit

Required Discuss Slade’s assertions and the defenses that might be raised by Field, setting forth reasons for any conclusions stated.

AP2.8 (LO 8) Challenging Common law Astor Inc. purchased the assets of Bell Corp. A condition of the purchase agreement required Bell to retain a CPA to audit Bell’s fi nancial statements. The purpose

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of the audit was to determine whether the unaudited fi nancial statements furnished to Astor fairly pre- sented Bell’s fi nancial position. Bell retained Winston & Co., CPAs, to perform the audit.

While performing the audit, Winston discovered that Bell’s bookkeeper had embezzled $500. Winston had some evidence of other embezzlements by the bookkeeper. However, Winston decided that the $500 was immaterial and that the other suspected embezzlements did not require further investigation. Winston did not discuss the matter with Bell’s management. Unknown to Winston, the bookkeeper had, in fact, embez- zled large sums of cash from Bell. In addition, the accounts receivable were signifi cantly overstated. Winston did not detect the overstatement because of Winston’s inadvertent failure to follow its audit program.

Despite the foregoing, Winston issued an unqualifi ed opinion on Bell’s fi nancial statements and fur- nished a copy of the audited fi nancial statements to Astor. Unknown to Winston, Astor required fi nancing to purchase Bell’s assets and furnished a copy of Bell’s audited fi nancial statements to City Bank to obtain approval of the loan. Based on Bell’s audited fi nancial statements, City loaned Astor $600,000.

Astor paid Bell $750,000 to purchase Bell’s assets. Within six months, Astor began experiencing fi nancial diffi culties resulting from the undiscovered embezzlements and overstated accounts receivable. Astor later defaulted on the City loan.

City has commenced a lawsuit against Winston based on the following causes of action:

• constructive fraud • negligence

Required In separate paragraphs, discuss whether City is likely to prevail on the causes of action it has raised, set- ting forth reasons for each conclusion.

AP2.9 (LO 9) Moderate Public Company Statutory law - 1933 Act The Dandy Container Cor- poration engaged the accounting fi rm of Adams and Adams to audit fi nancial statements to be used in connection with a public off ering of securities. The audit was completed, and an unqualifi ed opinion was expressed on the fi nancial statements that were submitted to the Securities and Exchange Commission along with the registration statement. Two hundred thousand shares of Dandy Container common stock were off ered to the public at $11 a share. Eight months later, the stock fell to $2 a share when it was disclosed that several large loans to two “paper” corporations owned by one of the directors were worthless. The loans were secured by the stock of the borrowing corporation that was owned by the director. These facts were not disclosed in the fi nancial statements. The director involved and the two corporations are insolvent.

1. The Securities Act of 1933 applies to the above-described public off ering of securities in interstate commerce.

2. The accounting fi rm has potential liability to any person who acquired the stock in reliance on the registration statement.

3. The accountants could avoid liability if they could show they were neither negligent nor fraudulent. 4. The accountants could avoid or reduce the damages asserted against them if they could establish

that the drop in price was due in whole or in part to other causes. 5. The Dandy investors would have to institute suit within one year after discovery of the alleged un-

true statements or omissions. 6. The SEC would defend any action brought against the accountants in that the SEC examined and

approved the registration statement. 7. Although Adams and Adams knew of the loans, and related collateral, and concluded that they did

not need to be disclosed, they can still sustain the claim that they are only proportionally liable for any damages suff ered by shareholders because the fi nancial statements are management’s responsibility.

Required Indicate whether each of the above statements is true or false under statutory law. Give the reason(s) for your answer.

AP2.10 (LO 8, 9) Challenging Public Company Statutory law; common law PART I: The common stock of Wilson, Inc. is owned by 10,000 stockholders who live in several states. Wilson’s fi nan- cial statements as of December 31, 20X5, were audited by Doe & Co., CPAs, who rendered an unqualifi ed opinion on the fi nancial statements. In reliance on Wilson’s fi nancial statements, which showed net income for 20X5 of $1.5 million, Peters, on April 10, 20X6, purchased 10,000 shares of Wilson stock for $200,000. The purchase was from a shareholder who lived in another state. Wilson’s fi nancial statements contained material misstatements. Because Doe did not carefully follow GAAS, it did not discover that the statements failed to refl ect unrecorded expenses that reduced Wilson’s actual net income to $800,000. After disclosure of the corrected fi nancial statements, Peters sold his shares for $100,000, which was the highest price he could obtain.

Peters has brought an action against Doe under federal securities law and state common law.

Analysis Problems 2-49

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2-50 CHAPTER 2 Professionalism and Professional Responsibilities

Required Answer the following, setting forth reasons for any conclusions stated:

a. Will Peters prevail on his federal securities law claims? b. Will Peters prevail on his state common law claims?

PART II: Able Corporation decided to make a public off ering of bonds to raise needed capital. On June 30, 20X6, it publicly sold $2.5 million of 12% debentures in accordance with the registration requirements of the Securities Act of 1933.

The fi nancial statements fi led with the registration statement contained the unqualifi ed opinion of Baker & Co., CPAs. The statements overstated Able’s net income and net worth. Through negligence Baker did not detect the overstatements. As a result, the bonds, which originally sold for $1,000 per bond, have dropped in value to $700.

Ira is an investor who purchased $10,000 of the bonds. He promptly brought an action against Baker under the Securities Act of 1933.

Required Answer the following question, setting forth reasons for any conclusions stated: Will Ira prevail on his claim under the Securities Act of 1933?

AP2.11 (LO 8, 9) Challenging Public Company Statutory law; common law To expand its operations, Dark Corp. raised $4 million by making a private interstate off ering of $2 million in com- mon stock and negotiating a $2 million loan from Safe Bank. The common stock was properly off ered pursuant to the Securities Act of 1933.

In connection with this fi nancing, Dark engaged Crea & Co., CPAs, to audit Dark’s fi nancial state- ments. Crea knew that the sole purpose for the audit was so that Dark would have audited fi nancial state- ments to provide to Safe and the purchasers of the common stock. Although Crea conducted the audit in conformity with its audit program, Crea failed to detect material acts of embezzlement committed by Dark’s president. Crea did not detect the embezzlement because of its inadvertent failure to exercise due care in designing its audit program for this engagement.

After completing the audit, Crea rendered an unqualifi ed opinion on Dark’s fi nancial statements. The purchasers of the common stock relied on the fi nancial statements in deciding to purchase the shares. In addition, Safe Bank approved the loan to Dark based on the audited fi nancial statements.

Within 60 days after the sale of the common stock and the making of the loan by Safe, Dark was in- voluntarily petitioned into bankruptcy. Because of the president’s embezzlement, Dark became insolvent and defaulted on its loan to Safe. Its common stock became virtually worthless.

• Actions have been commenced against Crea by:the purchasers of the common stock who have as- serted that Crea is liable for damages under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934.

• Safe Bank fi led suit against Crea & Co. under common law based on Crea’s negligence.

Required In separate paragraphs, discuss the merits of the actions commenced against Crea, indicating the likely outcomes and the reasons therefore.

AP 2.12 (LO 2, 3, 4, 5) Challenging Research Independence Johnson and Wiley, CPAs ac- quires Fritz and Rufner, CPAs as of January 1, 2022. Johnson and Wiley have audited the fi nancial state- ments of Matthews Grocery for the last 5 years. Fritz and Rufner provided nonattest services to Matthews Grocery that would have been prohibited for Johnson and Wiley. Fritz and Rufner resigned performing the nonattest services for Matthews Grocery as of December 1, 2021. Matthews Grocery has a calendar year end of December 31. Do any independence problems exist for Johnson and Wiley for the audits of Matthews Grocery as of December 31, 2021 and 2022? If so, can safeguards be applied to preserve Johnson and Wiley’s independence? Explain your answer and cite any professional standards that apply.

Ethical Decision Case C2.1 (LO 3, 5) Challenging Research Ethics: Application of the Conceptual Framework. Ocean & Leisure Resorts (O&L) is a resort company based in Hawaii. Its operations include water sports and full service spas; a hotel; and a fi ve-star resort. Eric and Patricia King own the majority of the shares in the King Companies, Inc., which owns 100% of O&L. Eric is the chairman of the board of directors

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Ethical Decision Case 2-51

of both O&L and King Companies, Inc., and Patricia is a director of both companies as well as the CFO of O&L.

King Companies, Inc. is a private company. Shares not owned by Eric and Patricia are owned by friends and family who helped the Kings get started. Eric started the company with the hotel, and a signifi cant inheritance. Their accounting fi rm, Thomson & Danforth, LLP has done tax returns for the company for the last ten years. Thomson & Danforth is an accounting fi rm with 55 professionals, which performs audit and tax services for a number of clients. James Danforth, a tax partner in the CPA fi rm, is a long-time friend of Eric, and owns 5% of King Companies.

In October of 2021, Eric opens a conversation with James Danforth about upcoming expansion and the plan to develop another fi ve-star resort. Eric has learned this will mean taking on signifi cant debt to fund the project. Every lender that Eric has talked with will require an annual audit. Eric asks James if his fi rm can perform the annual audit. Eric knows that Thomson & Danforth is familiar with O&L’s busi- ness and they have been doing the annual tax returns for the King Companies, Inc. and the King family.

James explains concerns about the independence of Thomson & Danforth. Because the new fi ve star resort is still in the early planning stages, Eric agrees to purchase James 5% stake in King Companies, Inc. in November of 2021. Further, James expects that the fi rst audited fi nancial statements that King Companies will need will be for the year ended December 31, 2022.

Required Thomson & Danforth plans to continue to prepare tax returns for the King Companies, Inc and the King family. Danforth also plan on performing the audit for the year ended December 31, 2022. Apply the conceptual framework to this situation.

a. Identify any ethics issues that exist. b. Gather appropriate information for each ethical issue. c. Analyze the relevant information for each ethical issue and evaluate the alternatives. d. Draw a conclusion about each ethical issue and explain your reasoning. Cite appropriate references

from the AICPA Code of Professional Conduct.

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