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A I C P A Code of Professional Conduct

Chapter 04

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Learning Objectives

L O 4-1: Explain professional judgement and the C P A’s obligations under the A I C P A Code of Conduct.

L O 4-2: Explain how to apply the threats and safeguards approach to independence.

L O 4-3: Discuss S E C actions taken against auditors because of a lack of independence.

L O 4-4: Describe the process to resolve ethical conflicts that may cause violations of the rules.

L O 4-5: Explain how the conceptual framework works to keep in check possible violations of integrity and objectivity for C P As in business.

L O 4-6: Explain how to apply the rules of conduct in the A I C P A Code to the performance of professional services.

L O 4-7: Analyze the ethics rules for tax practice and how they are influenced by the realistic possibility standard.

L O 4-8: Describe the P C A O B independence and ethics rules.

Questions for Consideration

How can professional judgment deal with cognitive biases that can influence ethical behavior?

What is the risk-based approach to deal with situations where independence, integrity and objectivity, and adherence to other professional standards, is threatened by external relationships?

What are effective measures to deal with ethical conflicts that pose challenges to ethics and professionalism?

Professional Judgment in Accounting

Professional judgment is influenced by personal behavioral traits.

Attitudes.

Ethical values.

Personal values link to ethical sensitivity and judgment.

Ethical awareness of an ethical dilemma is a mediator of the personal factors and ethical judgment relationship.

Objectivity and due care are attitudes and behaviors that enable professional judgment.

Professional skepticism is essential in making professional judgments; helps frame auditors’ mindset of independent thought.

K P M G Professional Judgment Framework

Judgment is the process of reaching a decision or drawing a conclusion where there are a number of possible alternative solutions.

Judgment occurs in a setting of uncertainty, risk, and often conflicts of interest.

The K P M G Framework components revolve around one’s mindset.

Clarify issues and objectives.

Consider alternatives.

Gather and evaluate information.

Reach conclusion.

Articulate and document rationale.

Prescriptive framework is used but pressures, time constraints, and limited capacity may cause deviations.

Auditor should approach matters with objectivity and independence, with inquiring mind and critical assessment of audit evidence.

Link between K P M G Framework and Cognitive Processes

Auditors need to use System 2 thought process.

Ethical awareness.

Application of ethical reasoning, ethical analysis of harms and benefits and stakeholder rights; and professional obligations.

Judgments can fall prey to cognitive traps and biases that negatively influence judgments.

Group-think.

Rush to solve problems.

Judgment triggers.

Judgment triggers – can lead to accepting a solution before it is properly identified and evaluated.

Availability tendency.

Confirmation tendency.

Overconfidence tendency.

Anchoring tendency.

Role of Professional Skepticism

Professional skepticism links to professional judgment through the ethical standards of independent thought, objectivity and due care, which are incorporated in A I C P A Code of Professional Conduct.

C P A firm management should set an appropriate tone that emphasizes a questioning mind throughout the audit and the exercise of professional skepticism in gathering and evaluating evidence.

A I C P A Revised Code: Independence for Members in Public Practice

Conceptual framework incorporates a “threats and safeguards” approach.

New section on “Ethical Conflicts.”

Violation of the rules for a C P A to permit others acting on his behalf to engage in behavior that would have been a violation for the C P A.

When differences exist between A I C P A and those of the licensing state board of accountancy, the C P A should follow the state board’s rules.

Conceptual Framework for Independence Standards

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

A I C P A uses risk based approach for analyzing threats using the following steps:

Identifying and evaluating threats to independence.

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

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

Threats to Independence

EXHIBIT 4.1 Examples of Threats to Independence

Threat	Example
Self-Review Threat	Preparing source documents used to generate the client’s financial statements.
Advocacy Threat	Promoting Me client's securities as part of an initial public offering or representing a client in U.S. tax court.
Adverse Interest Threat	Commencing, or the expressed intention to commence, litigation by either the client or the C P A against the other.
Familiarity Threat	A C P A on the attest engagement team whose spouse is the client’s C E O.
Undue Influence Threat	A threat to replace the C P A or C P A firm because of a disagreement with the client over the application of an accounting principle.
Financial Self-Interest Threat	Having a loan from Me client, from an officer or director of the client, or from an Individual who owns 10% or more of the client’s outstanding equity securities.
Management Participation Threat	Establishing and maintaining internal controls for the client.

Safeguards

EXHIBIT 4.2 Examples of Safeguards in Applying the Conceptual Framework

Source of Um Safeguard	Examples of Safeguards
Created by the profession, legislation, or regulation	Professional resources, such as hotlines, for consultation on ethical issues.
Implemented by the client	The client has personnel with suitable skill, knowledge, or experience who make managerial decisions about the delivery of professional services and makes use of third-party resources for consultation as needed. The tone at the top emphasizes the client's commitment to fair financial reporting and compliance With the applicable laws, rules, regulations, and corporate governance policies. Policies and procedures are in place to achieve fair financial reporting and compliance WM the applicable laws, rules, regulations, and corporate governance policies. Policies and procedures are In place to address ethical conduct. Policies are in place that bar the entity from hiring a firm to provide services that do not serve the public interest or that would cause the firm's Independence or objectivity to be considered Impaired.
Implemented by the firm	Policies and procedures addressing ethical conduct and compliance with laws and regulations.

S O X: Nonaudit Services

Financial 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 services, investment adviser, or investment banking services.

Legal services and expert services unrelated to the audit.

Any other service prohibited by B O D.

Tax services must be preapproved by the audit committee.

Relationships that May Impair Independence

Financial relationships.

Business relationships.

Employment or association with attest clients.

Providing non-attest services to an attest client.

Nontraditional forms of ownership.

Employment or Association with Attest Clients

Independence may be impaired when a partner or professional employee leaves the firm and is subsequently employed by the client in a key position unless the following is met:

Amounts due to the former professional are not material to the firm.

The former professional is not in a position to influence the accounting firm’s operations or financial policies.

The former professional employee does not participate in or appear to participate in or is not associated with the firm once the relationship with the client begins.

Participating in the firm may be continuing to consult for it or have one’s name included in firm literature.

Providing Nonattest Services to an Attest Client

Certain lucrative nonattest services create a conflict of interests.

A C P A should not perform management functions or make management decisions for an attest client.

Client must agree to perform the following functions:

Assume all management responsibilities.

Designate competent overseer of these services.

Evaluate adequacy and results of services performed.

Accept responsibility for the results of the services.

S E C Position on Independence

Emphasizes independence in fact and appearance in 3 ways:

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

Restricting certain nonauditing services to audit clients.

Subjecting all auditor conduct to a general standard of independence.

Three principles that underlie auditor independence:

An auditor cannot function in the role of management.

An auditor cannot audit her own work.

An auditor cannot serve in an advocacy role for her client.

General Standard of Independence

Judged by a reasonable investor with knowledge of all relevant facts and circumstances.

Auditor must be capable of exercising objective and impartial judgment on all issues within the engagement.

Principles.

Situations which impair independence.

Creates a mutual or conflicting interest between an accountant and his audit client.

Places an accountant in the position of auditing his own work.

Results in an accountant acting as management or employee of the audit client.

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

S E C Actions Against Big Four Audit Firms

P w C.

Violated independence rules when it performed restricted nonaudit services to audit clients.

E Y.

Audited partners engaged in personal relationships with client’s C F O.

K P M G.

Former partner engaged in insider trading of non-public information.

Deloitte.

Deloitte managers maintained bank accounts with audit client.

S E C Actions Because of Personal Conduct of Audit Partners

P w C.

Age Discrimination.

K P M G.

Hired former P C A O B staffers to obtain audit inspection information.

E Y.

Partner sexually harassed another partner.

Deloitte.

Partner traded in the securities of multiple clients.

Materiality Issues in Judging Whether Independence Has Been Impaired

Some firms are now using a materiality criterion to determine whether nonaudit services provided to an affiliate entity, that would be prohibited if the parent had provided them, violate the independence requirement in audit engagements.

Applying such a materiality standard can have the effect of dismissing otherwise improper relationships.

Materiality Issues

Using a materiality criterion to determine whether certain nonaudit services should be allowed opens a can of worms. Logical questions are: (1) Is independence a standard left to the individual judgment of the auditors or is it based on S E C regulations and P C A O B standards? and (2) Where do you draw the line in making materiality determinations?

Integrity and Objectivity

Conflicts of interest for public practice occur when a professional service, relationship, or specific matter creates a situation that might impair objective judgment.

A conflict of interest creates adverse and self-adverse threats to integrity and objectivity.

Safeguards include:

Implementing mechanisms to prevent disclosure or violation of confidentiality.

Senior individual not involved in the engagement regularly reviewing safeguards.

Member of the firm not involved in the conflict reviews the work performed to assess whether key judgments and conclusions are appropriate.

Consulting with third parties, such as professional body, legal counsel, or another C P A.

The C P A should disclose the nature of the conflict to clients and obtain their consent to perform professional services.

If consent is not received, then the C P A should either cease performing the services or take action to eliminate or reduce the threat to an acceptable level.

A I C P A Code: Ethical Conflicts

Assess whether an ethical conflict exists.

Ethical conflicts create challenges to ethical decision making because they present barriers to meeting the requirements of the rules of conduct.

Consider whether any departures exist to the rules, laws, or regulations and how they will be justified in order to ensure that conflicts are resolved in a way that permits compliance with these requirement.

Any unresolved conflicts can lead to a violation of the rules of conduct which should focus the C P A’s attention on any continuing relationship with the engagement team, specific assignment, client, firm, or employer.

Subordination of Judgment

Integrity rule prohibits a C P A from knowingly misrepresenting facts or subordinating one’s judgments when performing professional services for a client or employer.

Addresses differences of opinion between a C P A accountant/auditor and that person’s supervisor or others in the organization including top management on material accounting issues.

C P A should consider any threats to integrity and objectivity, and assess their significance whenever there is a material misrepresentation of fact.

C P A should assess if threats are at an acceptable level; if not, evaluate significance of safeguards to prevent impairment to independence/objectivity.

Follow prescribed process to protect against subordination of judgment (see Exhibit 3.11).

A I C P A Code: Conceptual Framework for Members in Business

The conceptual framework for members in business applies to integrity and objectivity, as well as other rules of conduct, but not independence.

Threats.

Adverse interest threat.

Advocacy threat.

Familiarity threat.

Self-interest threat.

Self-review threat.

Undue influence threat.

Safeguards to Mitigate Risk

Safeguards include:

Tone at the top.

Policies, procedures, implementation, and monitoring addressing ethical conduct and compliance with laws and regulations.

Internal policies and procedures for disclosure of interests and relationships.

Whistle-blower hotlines and reporting structure.

Internal auditors not allowed to audit areas where they have operational responsibilities.

Policies for promotion, rewards and enforcement of a culture of high ethics and integrity.

Use of third-party resources for consultation as needed.

Rules of Professional Practice

The General Standards rule establishes requirements for competence, compliance with professional standards, and adherence to accounting principles.

Acts Discreditable covers a broad number of actions that may bring discredit to the profession including:

Discrimination and harassment.

Solicitation or disclosure of C P A examination questions and answers.

Failure of a C P A / C P A firm to file and pay taxes.

Negligence in preparation of financial statements or records.

Standards relating to governmental accounting and auditing.

Confidentiality of information gained through employment, except in specified situations.

Records Request governing what is client-provided records, member-prepared records, member’s work products, and member’s working papers.

Contingent Fees, Commissions, and Referral Fees

Contingent fees and commissions are permitted when performing advisory-type services for a nonattest client.

Contingent fees are prohibited from an attest (audit) client.

Prohibits acceptance of contingent fees if C P A or firm performs any of the following:

An audit or review of a financial statement.

Compilation of financial statement that third party may use.

Examination of prospective financial information.

Prepares original/amended tax return.

Permits acceptance of contingent fee based upon initiation by and findings of governmental agencies (that is, I R S-initiated investigation of income taxes paid).

Commissions and Referral Fees.

Rule is similar to that for contingent fees; cannot accept commissions or referral fees from audit client.

Commissions and referral fees require disclosures by C P As when recommending or referring a service or product to which the commission relates.

Advertising and Solicitation

Advertising and solicitation permitted.

Requires that advertising not be false, deceptive or misleading.

Imply ability to influence official bodies.

Contain a representation that specific services will be performed for a stated fee, when such fees would be substantially increased.

Prohibits solicitation by use of coercion, over-reaching, or harassing conduct.

Contain any representation that would be likely to cause a reasonable person to misunderstand or be deceived.

Confidentiality

Confidential information.

C P A should not disclose confidential client information without specific consent of the client.

Internal whistleblowing allowed; external may violate confidentiality; consult legal counsel.

Permitted disclosure of confidential client information.

Response to validly issued subpoena or summons.

Adherence to applicable laws and regulations (i.e., Dodd-Frank whistle-blowing provisions).

Compliance with peer review of C P A practice under P C A O B, A I C P A, state C P A society, or board of accountancy authorization.

Defense in an investigation of the C P A.

Ethics and Tax Services

Tax services include tax compliance, tax consulting, tax planning, and tax shelters.

A I C P A explicitly recognizes the tax professional’s dual obligations to the client to act as advocate and to foster integrity in the tax system by honesty and fairly administering the tax laws.

The tax accountant remains obligated to act objectively, with integrity, exercise due care, and follow the Statements on Standards for Tax Services (S S T S).

When auditing tax client’s financial statements: The tax C P A is expected to consider whether any threats to independence exist that cannot be reduced or eliminated by safeguards and how such matters will be handled to avoid a violation of audit independence.

S S T S No. 1, Tax Return Position

7 statements explain C P As’ responsibilities to their clients and the tax systems:

S S T S No.1, Tax Return Positions.

A tax return position is a position reflected on a tax return on which a C P A has specifically advised a taxpayer, or a position about which a C P A has knowledge of all material facts and, based on those facts, has concluded whether the position is appropriate.

A taxpayer is a client, a C P A’s employer, or any other third-party recipient of tax services.

C P A’s obligation to advise a taxpayer of relevant tax return disclosure responsibilities and potential penalties.

C P A should not recommend a tax return position or sign a tax return unless she has a good-faith belief that the position has at least a “realistic possibility of success”.

C P A cannot recommend a tax return position that he knows exploits the audit selection process of a taxing authority.

C P A may recommend a tax return position if there is a “reasonable basis” for the position and advises the taxpayer to disclose that position appropriately.

Tax Shelters

Sometimes called tax avoidance transactions.

“Prohibited tax shelter transaction" means listed transactions, transactions with contractual protection, or confidential transactions.

Investments to help wealthy clients avoid paying taxes.

In K P M G case, the firm prepared false documents to deceive regulators (fraud) and shelters generated $11B in fraudulent losses and $2.5B in tax evaded. K P M G settled criminal tax case for $456M.

Caterpillar shifted profits from the U S to a subsidiary in Switzerland to avoid $1B in taxes. I R S assessed $2B in back taxes and penalties.

Treasury Circular 230

Regulations governing the practice before the I R S.

Knowledge of error return.

Advise client of the error and potential consequences.

Taxpayer decides whether to correct the error.

Determine if the taxpayer correct the return.

If not, what does this mean for future behavior of taxpayer?

Concluding Thoughts

Whenever a C P A must render an opinion on an ethical dilemma, it must be grounded in specific, quoted, and explained rules of the profession.

However, rules are sterile without the application of principles in both their making and implementation.

The takeaway is to always apply rules in a principled way, and always apply your principles in harmony with the rules.

The thought process of dealing with an ethical dilemma is as simple (and as complicated) as aligning the profession's rules with ethical principles.

The principles to follow are those in the A I C P A Code and those called for in ethical reasoning methods.

After all the various concepts, philosophies and models are discussed, the bottom line is that C P As are bound by a deontological system requiring adherence to the A I C P A rules of professional conduct.

case 6

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