Rittenberg/Schwieger/Johnstone
Auditing: A Business Risk Approach
Sixth Edition
Chapter 3
Understanding and
Meeting Ethical
Expectations
Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo,
and South-Western are trademarks used herein under license.
1
Strong Governance and High
Ethical Standards
History shows companies with strong corporate
governance and high ethical standards generally
perform better then those with weak governance
and low ethical expectations
The key is the tone set by top management. A
well-managed organization will have and
enforce a code of ethics and/or a conflict of
interest policy to guide its members.
2
Accepting a Public Trust
To maintain the public's trust, public accountants
must act with professional integrity
To help accountants with ethical dilemmas,
professional associations including the AICPA,
Institute of Management Accountants, and
Information Systems Audit and Control
Association, have codes of professional conduct
The individual state boards of accountancy and
state societies of CPAs have generally adopted
the AICPA's Rules of Conduct
3
The Unique Licensure for CPAs
Audits and other attestation reports on financial
statements can only be signed by those licensed
to practice as CPAs by their state board of
accountancy
Each state board of accountancy sets its own
requirements to become a licensed CPA
To become a licensed CPA, a person must pass
the CPA exam, meet specific education and
experience requirements, and agree to uphold
the profession and its code of professional
conduct
4
Independence: A Foundation
Requirement
Auditors express an opinion about whether
financial statements are fairly presented
To be perceived as creditable, auditors must be
independent in fact and appearance
In fact, means the member must be unbiased
and objective
In appearance means that knowledgeable
users of financial statements must believe the
auditor is independent
5
Major Threats to Independence
Independence is a state of mind that can be
impaired by a number of potential threats
Compensation Schemes
Partners' compensation in many CPA firms is
based in large part on attracting and keeping
clients. Partners may feel pressure to accede to
client wishes in order to keep them happy
Although the client has the authority to hire and
the auditor, CPA firms must reinforce to its
auditors that maintaining the public trust is more
important than retaining a client where it might
appear that its objectivity could be compromised
6
Major Threats to Independence
(continued)
 Familiarity with the Client
 Auditors serving a client for several years may develop
relationships that cause the auditor to be less skeptical than
necessary
 Time Pressure
 Those in charge of audits are evaluated not only on the quality of
their work, but also on their ability to complete audits within time
budgets. This may create situations where auditors do not
investigate potential problems thoroughly in order to save time
 Ability to Rationalize
 It takes time to investigate potential misstatements. To save time,
an auditor may rationalize that the misstatement is not likely to
be material
 Auditing Your Own Work
 CPAs may provide certain services to non-public companies that
put auditors in the position of auditing their own work
7
Ways of Managing Threats to
Independence
Establishing and Monitoring Codes of Conduct
Balanced Compensation Schemes
Independent Reviews of Client
Acceptance/Retention Decisions
Separation of Consulting Activities from Audit
Activities
Independent Reviews of Audit Work and Audit
Documentation
Peer Reviews within the Profession
Improved Hiring Practices
8
The SEC's Principles for Judging
Independence & Prohibited Service
 In rules on auditor independence issued in 2001, the SEC summed up
its objectives:
 The independence requirement serves two public policy goals:
 Foster high quality audits by minimizing the possibility that any
 external factors will influence an auditor's judgment
 Promote investor confidence in the financial statements of public
companies
 In judging independence, the SEC determines whether a relationship or
the provision of service:
 Creates a mutual or conflicting interest between accountant and client
 Places the accountant in the position of auditing his/her own work
 Results in the accountant acting as management or an employee of an
audit client
 Places the accountant in the position of being an advocate for the client
 The SEC requires the audit committees to assess auditor independence
and make a written statement on that assessment to the stockholders
9
Prohibited Services, SarbanesOxley Act of 2002
Prohibits a public accounting firm that audits a
public company from providing the following
non-audit services to the company:
Bookkeeping or other services related to the
accounting records or financial statements of the
audit client
Financial information systems design and
implementation
Appraisal or valuation services, fairness
opinions, or contribution-in-kind reports
Actuarial services
10
Prohibited Services, SarbanesOxley Act of 2002 (continued)
Internal audit outsourcing services
Management functions or human resources
- Broker or dealer, investment advisor, or
investment banking services
Legal services and expert services unrelated to
the audit
Any other service that the Board determines, by
regulation, is impermissible
The Act requires that the client's audit committee
pre-approve any non-audit services, including
tax services, not specifically prohibited
11
The AICPA Code of
Professional Conduct
 The AICPA Code of Professional Conduct consists of
principles and rules; the Division of Professional Ethics
issues interpretations and rulings to the rules.
 PRINCIPLES are ideals of ethical conduct and provide a
broad conceptual framework for professional conduct
 RULES provide more detailed guidance to help CPAs in
carrying out their public responsibilities, and are
enforceable under AICPA bylaws
 INTERPRETATIONS provide specific guidance to help
CPAs interpret the rules
 RULINGS are issued in response to member questions
about specific situations
12
The AICPA Principles of
Professional Conduct (continued)
 Responsibilities - members should exercise sensitive professional and
moral judgment in all their activities
 Public interest - members should act in a way that serves the public
interest, maintains public trust, and shows commitment to
professionalism
 Integrity - members should perform all professional responsibilities with
the highest sense of integrity
 Objectivity and independence - members should be objective and free
of conflicts when performing professional responsibilities. Members in
public practice must be independent in fact and appearance when
providing attestation services.
 Due care - members shall observe the profession's ethical and
technical standards, strive to improve competence and quality of
services provided, and discharge professional responsibilities to the
best of their ability.
 Scope and nature of services - members in public practice shall
observe the principles of the Code of Professional Conduct in
determining the scope and nature of services to be provided.
13
The AICPA Rules of Conduct
Rule 101: Independence
Rule 102: Integrity and Objectivity
Rule 201: General Standards
Rule 202: Compliance with Standards
Rule 203: Accounting Principles
Rule 301: Confidential Client Information
Rule 302: Contingent Fees
Rule 501: Acts Discreditable
Rule 502: Advertising and Other Forms of Solicitation
Rule 503: Commissions and Referral Fees
Rule 505: Form of Organization and Name
14
The AICPA's Approach to
Independence
Rule 101: "A member in public practice shall be
independent in the performance of professional
services as required by standards promulgated
by bodies designated by the Council."
The auditor is required to be independent when
providing attestation services. The standards for
providing consulting, tax, or bookkeeping
services do not require independence.
There are several interpretations and over 100
rulings that provide more detailed guidance on
the application of Rule 101.
15
Interpretations of Rule 101 Financial Interest
 Independence would be considered impaired if during
the period of engagement, a covered member had, or
was committed to acquire, a direct or material indirect
financial interest in an attestation client.
 Covered member is defined as
 An individual on the attest engagement team
 An individual in a position to influence the attest engagement, or
 A partner in the office in which the lead attest engagement
partner primarily practices in connection with the attest
engagement
 A covered member's immediate family is also subject to
Rule 101 with some exceptions
16
Interpretations of Rule 101 Employment
Independence would be considered impaired if a
member holds management, employee, or
director positions with attest clients during the
period covered by the financial statements or the
period of engagement.
A covered member's independence would be
considered impaired if a close relative is
employed by an audit client where the relative is
allowed to exercise significant control over
operating, financial, or accounting policies, or
significant internal accounting controls
17
Independence Safeguard: A
Proactive Approach
Actions that firms can take to safeguard independence:
 The firm's leadership sets the proper "tone at the top"
 Communications with client's audit committee on matters that
may affect the firm's independence
 Participating in peer review programs
 Implement quality control standards
 Set up internal monitoring and compliance procedures
 Require professional staff to communicate to firm
management any independence or objectivity issues of
concern
 Encourage partner peer review by someone outside of the
audit engagement
 Periodically rotate partner in charge of the audit engagement
 Monitor threats to independence
18
Rule 102 - Integrity and
Objectivity
Requires members to act with integrity
and objectivity, be free of conflicts of
interest, and not knowingly misrepresent
facts or subordinate their judgment to
others.
Rule applies to performance of all
professional services by all members
19
Rule 201 - General Standards
Members shall provide only those services that
they are able to perform with professional
competence
Members shall exercise due professional care in
performance of services
Professional services shall be adequately
planned and supervised
Members must gather sufficient relevant data to
provide a reasonable basis for any conclusions
or recommendations rendered in connection
with professional services
Applies to all services provided by all members
20
Rule 301 - Confidential Client
Information
In order for an auditor to develop a complete
understanding of the client, there must be a free
flow and sharing of information between client
and auditor. To ensure this happens, the client
must be assured that the auditor will not
communicate confidential information to outside
parties.
Rule 301 prohibits members from disclosing
confidential client information obtained during an
engagement except with client consent.
21
Rule 301 - Confidential Client
Information - Exceptions
Disclosures required by GAAP or GAAS
Comply with subpoenas or summons or to
comply with applicable laws and government
regulations
Provide information for outside review of firm's
practice under PCAOB, AICPA, or State Board
of Accountancy authorization
Initiate a compliant with, or respond to inquiries
made by, recognized investigative and
disciplinary agencies (including the AICPA, state
CPA societies, State Board of Accountancy)
22
Rule 302 - Contingent Fees
Contingent fee - fee for the performance of
a service where the collection or amount
depends on whether a specified finding or
result is attained
Contingent fees are prohibited for any
service provided to an attestation client.
Why? Such contingent fees would give the
auditor a financial interest in client results
23
Rule 502 - Advertising and Other
Forms of Solicitation
Members in public practice shall not advertise or
solicit in any way that is false, misleading,
deceptive, harassing, or coercive. This would
include advertising that
Creates a false or unjustified expectation of
favorable results
Implies ability to influence any court, regulatory
agency, or similar body
Understates fees for current or future fees
Contains any other representations that would
likely cause a reasonable person to understand
or be deceived
24
Rule 503 - Commissions and
Referral Fees
Members in public practice are prohibited from
receiving commissions for recommending
products and services to attest clients. Why?
The commission gives the auditor a financial
interest in his/her client's decisions.
Commissions are allowed for recommending
products or services to non-attest clients, but
must be disclosed to the client
Members may pay or receive fees for referral of
any professional services (including attest
services) as long as the client is notified of the
fee
25
Enforcement of the Code
Members who violate the AICPA code may have
their membership terminated
Members who violate a State Board of
Accountancy's code are subject to disciplinary
action including suspension or revocation of the
member's certificate and license to practice.
If the State Board suspends the member's
certificate, it can mandate conditions, such as
additional continuing education, that must be
satisfied before the member's certificate is
reinstated.
26
Ethical Theories:
Resolving Issues
Ethical problem occurs when an individual is
morally or ethically required to take an action
that conflicts with his or her immediate selfinterest
Ethical dilemma occurs when there are
conflicting moral duties or obligations
Ethical theories present frameworks to assist
individuals in dealing with both ethical problems
and dilemmas. Two such frameworks - utilitarian
theory and rights theory - have influenced the
development of codes of conduct and can be
used by professionals dealing with ethical issues27
Utilitarian Theory
Utilitarian theory - an action is ethical if it achieves
the greatest good for the greatest number of
people. Utilitarianism requires:
Identify potential problem and courses of action
Identify potential impact of actions on each affected
party
Assess the desirability of each action
Perform overall assessment of the greatest good for
the greatest number
Problems with utilitarianism include:
Disagreement about the likely impact of actions
Problems measuring the "greatest good"
Assumption that the ends achieved justify the means
28
Rights Theory
Rights theory - evaluates actions based on the
fundamental rights of the parties involved. Uses
a hierarchy of rights where higher-order rights
take precedence over lower-order rights.
Rights theory requires the rights of affected
parties be examined as a constraint on ethical
decision making.
It is most effective in identifying outcomes that
should be eliminated or identifying situations in
which the utilitarian answer would be at odds
with most societal values.
29
An Ethical Framework (Using the
Utilitarian & Rights Theories)
 Identify the ethical issue(s)
 Determine the affected parties and identify their rights
 Determine the most important rights
 Develop alternative courses of action
 Determine the likely consequences of each proposed
course of action
 Assess possible consequences including estimation of
the greatest good for the greatest number
 Determine whether rights framework would cause any
action to be eliminated
 Decide on appropriate course of action
30