Ch03_PrinciplesOfAuditing_Ed3

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Chapter 3
ETHICS FOR PROFESSIONAL ACCOUNTANTS
3.1 Learning Objectives
After studying this chapter, you should be able to:
1.
Explain the three general subject areas of ethics.
2.
Explain what ethics means to an accountant.
3.
State the purpose for a professional code of ethics.
4.
Give the three parts of the IESBA Code and what each part covers.
5.
Explain purpose and content of the IESBA Code of Ethics for Professional Accountants.
6.
Identify and discuss the fundamental principles of ethics as described by the IESBA Code of
Ethics.
7.
Discuss what threats to the fundamental principles are.
8.
List and define the four categories of threats to the fundamental principles.
9.
Define safeguards and give some examples.
10. Recite the different areas of ethical concern listed as headings in the IESBA Code.
11. Explain the concept of independence and identify the principles-based approach for resolving
the attendant issues.
12. Differentiate between “independence of mind” and “independence in appearance”.
13. Describe non-audit services prohibited by the Code of Ethics.
14. Discuss the responsibilities of an accountant in public practice in dealing with ethical conflicts
that apply to his clients and colleagues.
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15. State the topics of guidance that are particularly relevant to professional accountants working
in industry, commerce, the public sector or education.
16. Summarize the possible disciplinary actions for violation of ethics codes.
3.2 What Are Ethics
Ethics represent a set of moral principles, rules of conduct, or values. Ethics are a discipline
dealing with values relating to human conduct, with respect to the rightness and wrongness of
certain actions and to the goodness and badness of the motives and ends of such actions. 1 Ethics
apply when an individual has to make a decision from various alternatives regarding moral
principles. All individuals and societies possess a sense of ethics in that they have some sort of
agreement as to what right and wrong are, although this can be influenced by cultural differences.
Ethical questions you can think of are: “Do I always have to keep my promise?” and “Do I need to
put my own interest aside in favor of others?” Illustration 3.1 incorporates the characteristics most
people associate with ethical behavior.2
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[UNFig near here]
Ethical behavior is necessary for society to function in an orderly manner. The need for ethics
in society is sufficiently important that many commonly held ethical values are incorporated into
laws. However, a considerable portion of the ethical values of a society such as integrity, loyalty,
and pursuit of excellence cannot be incorporated into law. By establishing a code of ethics, a
profession assumes self-discipline beyond the requirements of the law.
History of Ethics
“Philosophers today usually divide ethical theories into three general subject areas: metaethics,
normative ethics, and applied ethics.
Metaethics investigates where our ethical principles come from, and what they mean. Are they
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merely social inventions? Do they involve more than expressions of our individual emotions?
Metaethical answers to these questions focus on the issues of universal truths, the will of God, the
role of reason in ethical judgments, and the meaning of ethical terms themselves.
Normative ethics takes on a more practical task, which is to arrive at moral standards that regulate
right and wrong conduct. This may involve articulating the good habits that we should acquire, the
duties that we should follow, or the consequences of our behavior on others.
Finally, applied ethics involves examining specific controversial issues, such as abortion,
infanticide, animal rights, environmental concerns, homosexuality, capital punishment, or nuclear
war.
By using the conceptual tools of metaethics and normative ethics, discussions in applied ethics try
to resolve these controversial issues. The lines of distinction between metaethics, normative ethics,
and applied ethics are often blurry. For example, the issue of abortion is an applied ethical topic
since it involves a specific type of controversial behavior. But it also depends on more general
normative principles, such as the right of self-rule and the right to life, which are litmus tests for
determining the morality of that procedure. The issue also rests on metaethical issues such as,
“where do rights come from?” and “what kinds of beings have rights?”3
“Normative ethics involves arriving at moral standards that regulate right and wrong conduct. In a
sense, it is a search for an ideal litmus test of proper behavior. The Golden Rule is a classic
example of a normative principle: We should do to others what we would want others to do to us.
Since I do not want my neighbor to steal my car, then it is wrong for me to steal her car. Since I
would want people to feed me if I was starving, then I should help feed starving people. Using this
same reasoning, I can theoretically determine whether any possible action is right or wrong. So,
based on the Golden Rule, it would also be wrong for me to lie to, harass, victimize, assault, or kill
others. The Golden Rule is an example of a normative theory that establishes a single principle
against which we judge all actions. Other normative theories focus on a set of foundational
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principles, or a set of good character traits.”4
Ethics in the Accounting Profession
The attitude and behavior of professional accountants in providing auditing and assurance
services5 have an impact on the economic well-being of their community and country. Accountants
can remain in this advantageous position only by continuing to provide the public with these unique
services at a level that demonstrates that the public confidence is well founded.
The distinguishing mark of the profession is acceptance of its responsibility to the public.
Therefore the standards of the accountancy profession are heavily determined by the public
interest. One could say in accountancy “the public and the auditees are our clients and our main
product is credibility.”
Objectives of Accountancy
It is in this context that the International Ethics Standards Board of Accountants (IESBA)
Code of Ethics for Professional Accountants6 states: A distinguishing mark of the accountancy
profession is its acceptance of the responsibility to act in the public interest. Therefore, a
professional accountant’s responsibility is not exclusively to satisfy the needs of an individual
client or employer.7 To achieve these objectives, the Code of Ethics suggests several fundamental
principles for professional accountants and for those who are undertaking reporting assignments,
which is discussed in the balance of this chapter. Due to the importance of the Code, it will be
quoted extensively in this chapter. When a direct quote is taken from the Code, that quote will be
given in bold.
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3.3 The International Ethics Standards Board of Accountants
(IESBA) Code of Ethics for Professional Accountants
The ethical guidance set out by International Ethics Standards Board for Accountants (IESBA)
who report their recommendations to the IFAC Board after a research and appropriate exposure of
draft guidance. The guidance is incorporated into the Handbook of the Code of Ethics for
Professional Accountants (the Code). The Code is intended to serve as a model on which to base
national ethical guidance. It sets standards of conduct for professional accountants and states the
fundamental principles that should be observed by professional accountants in order to achieve
common objectives.
The Code is divided into three parts:

Part A establishes the fundamental principles of professional ethics for professional
accountants and provides a conceptual framework that is applied to:
o
Identify threats to compliance with the fundamental principles;
o
Evaluate the significance of the threats identified; and
o
Apply safeguards, when necessary, to eliminate the threats or reduce them to an
acceptable level.

Parts B and C describe how the conceptual framework applies in certain situations 8. They
provide examples of safeguards that may be appropriate to address threats to compliance
with the fundamental principles. They also describe situations where safeguards are not
available to address the threats. Part B applies to professional accountants in public
practice.

Part C applies to professional accountants in business. Professional accountants in public
practice may also find Part C relevant to their particular circumstances. We will not discuss
Part C in detail in this chapter.
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The process of establishing ethical principles is complicated. In France and Japan, the ethical
code is a matter of law. In the USA, Singapore, Mexico, and the UK, the standards are developed
and regulated by professional bodies. The IESBA Handbook of the Code of Ethics for Professional
Accountants offers fundamental principles that are of a general nature which may be threatened and
safeguards that may be applied.
Conceptual Framework Approach
Rather than a list of rules that must be obeyed to be an ethical accountant, the so-called “rule
based” approach which holds sway in many countries, the IESBA and IFAC have chosen to use a
“conceptual framework” approach. A conceptual framework requires a professional accountant to
identify, evaluate and address threats to compliance with the fundamental principles, rather than
merely comply with a set of specific rules which may be arbitrary.
When an accountant identifies threats to compliance with the fundamental principles and
determines that they are not at an acceptable level, he/she shall determine whether appropriate
safeguards are available and can be applied to eliminate the threats or reduce them to an acceptable
level.9 What is a threat may depend on the auditor’s perspective. The auditor should always
consider the situation conservatively. If you put a safeguard in place that you believe will reduce
the impact of a threat on a fundamental principle to an acceptable level, then the fundamental is not
impaired. If you believe that a threat impairs the fundamental principle, then you should consider
that no safeguard will repair that impairment.
There are five fundamental principles of ethics applicable to ALL accountants, as they are
stated in part A of the Code. They are:

Integrity – to be straightforward and honest in all professional and business relationships.
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Objectivity - to not allow bias, conflict of interest or undue influence of others to override
professional or business judgments.

Professional Competence and Due Care – to maintain professional knowledge and skill at
the level required to ensure that a client or employer receives competent professional
services based on current developments in practice, legislation and techniques and act
diligently and in accordance with applicable technical and professional standards.

Confidentiality – to respect the confidentiality of information acquired as a result of
professional and business relationships and, therefore, not disclose any such information to
third parties without proper and specific authority, unless there is a legal or professional
right or duty to disclose, nor use the information for the personal advantage of the
professional accountant or third parties.

Professional Behavior – to comply with relevant laws and regulations and avoid any action
that discredits the profession.
3.4 PART A General Application of the IESBA Code of Ethics for
Professional Accountants
The IESBA guideline offers further discussion on these five fundamental principles. Each
concept is the topic of subsequent Sections (110–150) in the Code.
Integrity (Sec. 110)
The principle of integrity imposes an obligation on all professional accountants to be
straightforward and honest in all professional and business relationships. Integrity also
implies fair dealing and truthfulness.
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A professional accountant shall not knowingly be associated with reports, returns,
communications or other information where the professional accountant believes that the
information:

Contains a materially false or misleading statement;

Contains statements or information furnished recklessly; or

Omits or obscures information required to be included where such omission or
obscurity would be misleading.
Objectivity (Sec. 120)
The principle of objectivity imposes an obligation on all professional accountants not to
compromise their professional or business judgment because of bias, conflict of interest or the
undue influence of others.
An accountant or auditor may be exposed to situations that may impair their objectivity. They
should not perform a professional service if a circumstance or relationship biases or unduly
influences the accountant’s professional judgment.
But how does the auditor know if she is biased? A wealth of evidence suggests that judgments
are often clouded by a number of cognitive and motivational biases. Individuals consistently rate
themselves above average across a variety of domains, take credit for their successes but explain
away their failures, assume they are more likely than their peers to experience the good things in
life and avoid the bad, and tend to detect more support for their favored beliefs than is objectively
warranted.10 Although the Code of Ethics does not address this, in the auditing sense bias is
associated with money and personal association, e.g., if possible gains of wealth, prospects of a
better income, or personal relationships as with family or friends are involved, this may bias the
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auditor’s work. There exist religious and cultural biases that may also affect an auditor’s work and
these biases have been well studied. Psychologists at Harvard, the University of Virginia and the
University of Washington created "Project Implicit" to develop Hidden Bias Tests —to measure
unconscious bias primarily of this sort. 11
Professional Competence and Due Care (Sec. 130)
The principle of professional competence and due care imposes the following obligations
on all professional accountants:

To maintain professional knowledge and skill at the level required to ensure that
clients or employers receive competent professional service; and

To act diligently in accordance with applicable technical and professional standards
when providing professional services.
Professional competence may be divided into two separate phases: (a) Attainment of
professional competence; and (b) Maintenance of professional competence. Professional
competence requires a high standard of general education followed by specific education, training,
examination in relevant subjects, and work experience. The maintenance of professional
competence requires a continuing awareness and an understanding of relevant technical,
professional and business developments through continuing professional education. Diligence is
the responsibility to act in accordance with the requirements of an assignment, carefully,
thoroughly and on a timely basis.
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Confidentiality (Sec. 140)
Professional accountants have an obligation to respect the confidentiality of information about
a client’s (or employer’s) affairs acquired in the course of professional services. The principle of
confidentiality imposes an obligation on all professional accountants to refrain from:

Disclosing outside the firm or employing organization confidential information
acquired as a result of professional and business relationships without proper and
specific authority or unless there is a legal or professional right or duty to disclose;
and

Using confidential information acquired as a result of professional and business
relationships to their personal advantage or the advantage of third parties.
Accountants should respect the confidentiality of information acquired during the course of
performing professional services, including in a social environment. The auditor should be alert to
the possibility of inadvertent disclosure, particularly to a close business associate or a close or
immediate family member. There exists a responsibility to keep the information discovered in the
course of an assurance service confidential and thus continues even after the accountant–client or
the accountant–employer relationship ends. Accountants must also ensure that, in addition to
themselves, staff and outside advisers under their control understand and follow the principle of
confidentiality.
Permitted Disclosure of Confidential Information
Confidential information may be disclosed when disclosure is authorized by the client,
required by law, or where there is a professional duty or right to disclose (such as in a peer review
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quality control program). When disclosure is authorized by the employer or client, the accountants
should consider the interests of all the parties, including third parties, who might be affected.
Concept and a Company 3.1
Confidentiality – Deloitte, Reliance, and KKR
Concept
Professional accountants have an obligation to respect the confidentiality of information
about a client’s (or employer’s) affairs acquired in the course of professional services.
Story
According to a court filing by the US State of Pennsylvania Insurance Department, within days of
Deloitte signing off on an audit of Reliance Insurance Co. indicating sufficient cash reserves in
February 2000, the firm told another client, the Kohlberg Kravis & Roberts (KKR) investment
partnership, that Reliance was suffering a “seriously deficient” $350 million shortfall in its
reserves. (WSJ 2003)
Deloitte told the investment company about the shortfall “in exchange for millions of dollars” in
accounting fees, according to the state. Deloitte “exploited the competing interests of [the
investment company] and Reliance and benefited financially by receiving payments from clients
on opposite sides” of the proposed deal, according to the state. KKR also got another opinion
from Am-Re Consultants, of Princeton, an affiliate of American Reinsurance Co. Am-Re
estimated Reliance’s reserve shortfall at $500 million, the state reported. (DiStefano 2003)
In 2001 Reliance Insurance Company, an auto and workman’s compensation insurer, defaulted
on its stock, bonds and loans, and left policyholders and industry bailout funds with more than $2
billion in unpaid losses. The Pennsylvania Insurance Department was charged with liquidating
the assets of the company.
Deloitte issued a short written statement accusing the state of “serious distortion of the facts.”
According to Deloitte, Pennsylvania Insurance Commissioner E. Diane Koken was trying to
“improperly” fault Reliance’s ex-auditors “for a business and regulatory failure that largely rests
with [Koken] herself.” (DiStefano 2003)
Discussion Questions
Does an auditor violate the confidentially of their client by revealing the client’s
financial condition to another client?
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Why would an auditor report sufficient cash reserves in their audit report and then tell another
client that the audited company had a shortfall cash position?
References DiStefano, J.N. 2003, “Insurance regulators say the accounting firm called the company healthy
shortly before its $2 billion collapse, while revealing a bleak picture to a potential investor,”
Philadelphia Inquirer, October 12.
WSJ, 2003, “Pennsylvania Charges Deloitte Contributed to Insurer’s Failure,” Wall Street
Journal, October 20.
Examples of Disclosure
One example of when disclosure to client information is required by law is when the
accountant produces documents or gives evidence in legal proceedings. Another example is
disclosure of infringements of the law to appropriate public authorities. In the USA, accountants
may be required to give evidence in court and in the Netherlands and UK auditors may be required
to disclose fraud to government-appointed authorities.
There is also a professional duty to disclose information, when not prohibited by law, in the
following circumstances:

To comply with the quality review of a [peer auditing firm] or professional body;

To respond to an inquiry or investigation by a member body or regulatory body;

To protect the professional interests of a professional accountant in legal proceedings;
or

To comply with technical standards and ethics requirements.
Confidentiality of information is part of statute or common law and therefore requirements of
confidentiality will depend on the law of the home country of each accountant.
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Professional Behavior (Sec. 150)
The principle of professional behavior imposes an obligation on all professional
accountants to comply with relevant laws and regulations and avoid any action that the
professional accountant knows or should know may discredit the profession. This includes
actions that a reasonable and informed third party, weighing all the specific facts and
circumstances available to the professional accountant at that time, would be likely to
conclude adversely affects the good reputation of the profession.
For example, in marketing and promoting themselves and their work, professionals should be
honest and truthful and not: (a) Make exaggerated claims for the services they are able to offer, the
qualifications they possess, or experience they have gained; or (b) Make disparaging references or
unsubstantiated comparisons to the work of others.
Threats to the Fundamental Principles and Safeguards
Compliance with the fundamental principles may potentially be threatened by a broad range of
circumstances and relationships. The nature and significance of the threats may differ depending on
whether the audit client is a public interest entity, to an assurance client that is not an audit client,
or to a non-assurance client. The conceptual framework of the IESBA Code discusses ways to
identify threats to fundamental principles, determine the significance of those threats, and, if they
are significant, identify and apply safeguards to reduce or eliminate the threats.
Threats fall into one or more of the following categories:

Self-interest;

Self-review;

Advocacy;

Familiarity; and
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Intimidation.
Self Interest Threat
A “Self-Interest Threat” occurs when an auditor could benefit from a financial interest in, or
other self-interest conflict with, an assurance client. Examples of circumstances that create selfinterest threats for a professional accountant in public practice include:

A member of the assurance team having a direct financial interest in the assurance client.

A firm having undue dependence on total fees from a client.

A member of the assurance team having a significant close business relationship with an
assurance client.

A firm being concerned about the possibility of losing a significant client.

A member of the audit team entering into employment negotiations with the audit client.

A firm entering into a contingent fee arrangement relating to an assurance engagement.

A professional accountant discovering a significant error when evaluating the results of a
previous professional service performed by a member of the professional accountant’s
firm.
Self-Review Threat
A “Self-Review Threat” occurs when (1) results of a previous engagement needs to be reevaluated in reaching conclusions on the present assurance engagement or (2) when a member of
the assurance team previously was an employee of the client (especially a director or officer) in a
position to exert significant influence over the subject matter12 of the assurance engagement.
Examples of circumstances that create self-review threats for a professional accountant in public
practice include:
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A firm issuing an assurance report on the effectiveness of the operation of financial
systems after designing or implementing the systems.

A firm having prepared the original data used to generate records that are the subject matter
of the assurance engagement.

A member of the assurance team being, or having recently been, a director or officer of the
client.

A member of the assurance team being, or having recently been, employed by the client in
a position to exert significant influence over the subject matter of the engagement.

The firm performing a service for an assurance client that directly affects the subject matter
information of the assurance engagement.
Advocacy Threat
An “Advocacy Threat” occurs when a member of the assurance team promotes, or seems to
promote, an assurance client’s position or opinion. That is, the auditor subordinates his judgment to
that of the client. Examples of circumstances that may create this threat include:

selling, underwriting or otherwise promoting financial securities or shares of an assurance
client;

acting as the client’s advocate in a legal proceeding.
Familiarity Threat
A “Familiarity Threat” occurs when an auditor becomes too sympathetic to the client’s
interests because he has a close relationship with an assurance client, its directors, officers or
employees. Examples of circumstances that may create this threat include:
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a member of the engagement team having an immediate family member or close family
member who is a director or officer of the assurance client.

a member of the engagement team having a close family member who is an employee of
the assurance client and in a position to significantly influence the subject matter of the
assurance engagement.

A director or officer of the client or an employee in a position to exert significant influence
over the subject matter of the engagement having recently served as the engagement
partner

A professional accountant accepting gifts or preferential treatment from a client, unless the
value is trivial or inconsequential.

Senior personnel having a long association with the assurance client.
In some countries, “immediate family member” may mean the engagement member’s spouse
and dependent. In other countries immediate family member may be the engagement member’s
child, or her spouse, her parent or grandparent, parent-in-law, brother, sister, or brother-in-law or
sister-in-law of the client. For example, a CPA firm that prepares a tax return for a client who is an
immediate family member, for example, a spouse or a sister, and gives a tax deduction in which
adequate evidence for the deduction is not provided, could be in violation of independency law.
Intimidation Threat
An “Intimidation Threat” occurs when a member of the assurance team may be deterred
from acting objectively and exercising professional skepticism by threats, actual or perceived, from
the directors, officers or employees of an assurance client. Examples of circumstances that create
intimidation threats for a professional accountant in public practice include:

A firm being threatened with dismissal from a client engagement.
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An audit client indicating that it will not award a planned non-assurance contract to the
firm if the firm continues to disagree with the client’s accounting treatment for a particular
transaction.

A firm being threatened with litigation by the client.

A firm being pressured to reduce inappropriately the extent of work performed in order to
reduce fees.

A professional accountant feeling pressured to agree with the judgment of a client
employee because the employee has more expertise on the matter in question.

A professional accountant being informed by a partner of the firm that a planned promotion
will not occur unless the accountant agrees with an audit client’s inappropriate accounting
treatment.
Safeguards
When threats are identified, other than those that are clearly insignificant, appropriate
safeguards should be identified and applied to eliminate the threats or reduce them to an acceptable
level. If elimination or reduction is not possible the auditor should decline or terminate the
engagement. When deciding what safeguards should be applied one must consider what would be
unacceptable to an informed third party having knowledge of all relevant information.
Safeguards fall into two broad categories:
(1) safeguards created by the profession, legislation or regulation; and
(2) safeguards in the work environment
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Safeguards Created by the Profession, Legislation or Regulation: Examples
Safeguards created by the profession, legislation or regulation, may include: educational,
training and experience requirements to become a certified member of the profession; continuing
education requirements; professional accounting, auditing and ethics standards and monitoring and
disciplinary processes; peer review of quality control; and professional rules or legislation
governing the independence requirements of the firm.
Safeguards within the Work Environment: Examples
In the work environment, the relevant safeguards will vary depending on the circumstances.
Work environment safeguards comprise firm-wide safeguards and engagement-specific
safeguards. Examples of firm-wide safeguards in the work environment include:

Leadership of the firm that stresses the importance of compliance with the fundamental
principles and requires that members of an assurance team act in the public interest.

Policies and procedures to implement and monitor quality control of engagements.

Documented policies regarding the need to identify threats to compliance with the
fundamental principles, evaluate the significance of those threats, and apply safeguards to
eliminate or reduce the threats to an acceptable level or when to terminate or decline the
relevant engagement.

Policies and procedures that will enable the identification of interests or relationships
between the firm or members of engagement teams and clients.

Policies and procedures to monitor and, if necessary, manage the reliance on revenue
received from a single client.

Using different partners and engagement teams with separate reporting lines for the
provision of non-assurance services to an assurance client.
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Policies and procedures to prohibit individuals who are not members of an engagement
team from inappropriately influencing the outcome of the engagement.

Timely communication of, appropriate training, and education on a firm’s policies and
procedures, including any changes to them, to all staff.

Designating a member of senior management to be responsible for overseeing the adequate
functioning of the firm’s quality control system.

Advising all staff of assurance clients from which independence is required.

A disciplinary mechanism to promote compliance with policies and procedures.

Published policies and procedures to encourage and empower staff to communicate to
senior levels within the firm any issue relating to compliance with the fundamental.
Safeguards within the firm’s own systems and procedures may also include engagement
specific safeguards such as:

Using an additional professional accountant not on the assurance team to review the work
done.

Consulting an outside third party (e.g. a committee of independent directors or a
professional regulatory body).

Rotation of senior assurance team personnel.

Communicating to the audit committee the nature of services provided and fees charged.

Involving another audit firm to perform or re-perform part of the assurance engagement.
Depending on the nature of the engagement, the engagement team may be able to rely on
safeguards that the client has implemented. However it is not possible to rely solely on such
safeguards to reduce threats. The audit client (auditee) may be biased or restrictive in what
safeguards they implement or the safeguards may not be followed in the ordinary course of events.
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3.5 PART B Ethics Applicable to Professional Accountants in
Public Practice
Whereas the ethics guidance discussed above (Part A of the Code) is applicable to all
professional accountants. Part B of IESBA’s Code of Ethics is only applicable to accountants in
public practice. Part B describes how the conceptual framework contained in Part A applies in
certain situations to professional accountants in public practice. A professional accountant in
public practice is a professional accountant, irrespective of functional classification (for example,
audit, tax or consulting) in a firm that provides professional services. This term is also used to refer
to a firm of professional accountants in public practice.
Ethical guidance for accountants in public practice is offered in the areas of: professional
appointment, conflicts of interest, second opinions, fees and other remuneration, marketing
professional services, gifts and hospitality, custody of client assets, objectivity and independence
Concept and a Company 3.2
Lincoln Savings and Loan – Employment of a Former Auditor
Concept
Independence in Fact and Appearance
Story
Upon completion of the 1987 Arthur Young (later Ernst & Young) audit of Lincoln Savings & Loan
Association (Lincoln) which resulted in an unqualified opinion, the engagement audit partner,
Jack Atchison, resigned from Arthur Young and was hired by Lincoln’s parent American
Continental Corporation (ACC) for approximately $930,000 annual salary. His prior annual
earnings as a partner at Arthur Young was approximately $225,000 (Knapp 2001)
Charles Keating, Jr. siphoned money out of Lincoln Savings and Loan for his own benefit from
the day he acquired Lincoln in 1984 until the Federal Home Loan Bank Board (FHLBB) seized
control on April 14, 1989. At the time of the seizure nearly two-thirds of Lincoln’s asset portfolio
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was invested in high-risk land ventures and Keating had used fraudulent accounting methods to
create net income. In the end, Lincoln’s demise involved investors’ losses of $200 million and its
closure cost US taxpayers $3.4 billion in guaranteed deposit insurance and legal, making it the
most costly savings and loan failure in US history. For their part in the Lincoln failure, Ernst &
Young paid the California State Board of Accountancy (the state agency which registers
California CPAs) $1.5 million in 1991 to settle negligence complaints and in 1992 paid the US
Government $400 million to settle four lawsuits. (Knapp 2001)
In the court case of Lincoln S&L v Wall, it was suggested that Atchison might have known about
the financial statement problems during his audit of Lincoln. ACC was in dire need of obtaining
$10 million because of an agreement with the Bank Board to infuse an additional $10 million into
Lincoln. Thus, Lincoln was actually the source of its own $10 million cash infusion. Ernst &
Young LLC learned of these facts from Jack Atchison after Atchison had become a top official at
Lincoln. (USDC – DC 1990)
At the time Atchison made his move, the practice of “changing sides” was not against the
AICPA’s ethics standards; however, the Securities and Exchange Commission (SEC) stated that
Atchison’s should certainly be examined by the accounting profession’s standard setting
authorities as to the impact such a practice has on an accountant’s independence. Furthermore,
they stated that it would seem that a “cooling-off period” of one to two years would not be
unreasonable before the client can employ a senior official on an audit. (SEC 1990)
Ultimately, the Sarbanes-Oxley Act of 2002 required a cooling-off period of one year after a
company’s last audit before clients can hire as an officer any member of the audit team.
Discussion Questions
What impact does employment of former independent auditors by an audit client
have on that auditor’s independence during the audit?
Were Atchison’s actions ethical?
References Knapp, M., 2001, “Lincoln Savings and Loan Association,” Contemporary Auditing Real Issues &
Cases, South Western College Publishing, Cincinnati, Ohio, pp.57–70.
SEC, 1990, Final rule release 33-7919, Final Rule: Revision of the Commission’s Auditor
Independence Requirements, Securities and Exchange Commission, February, 5.
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USDC – DC, 1990, Lincoln Savings & Loan Association v Wall, “Consolidated Civil Action
Nos.89-1318, 89-1323,” 743 F. Supp. 901; 1990 US Dist. LEXIS 11178, United States District
Court for the District of Columbia, August 22, 1990; Decided, August 22, 1990, Filed.
Professional Appointment (Sec. 210)
Before accepting a new client relationship, a professional accountant in public practice
shall determine whether acceptance would create any threats to compliance with the
fundamental principles.13
The fundamental principle of professional competence and due care imposes an obligation on
a professional accountant in public practice to provide only those services that they are competent
to perform. Competence is important in engagement acceptance and the acceptance of the client
themselves. Before accepting a specific client engagement, the auditor must determine whether
acceptance would create any threats to compliance with the fundamental principles. A self-interest
threat to professional competence and due care is created if the engagement team does not possess,
or cannot acquire, the competencies necessary to properly carry out the engagement. When
evaluating whether to accept the client, the auditor should consider that potential threats to integrity
or professional behavior may be created from questionable issues associated with that client (its
owners, management or activities), client involvement in illegal activities (such as money
laundering), or dishonesty or questionable financial reporting practices.
Basic safeguards against client acceptance and engagement acceptance threats include
obtaining knowledge of the client and its governance and business activities or securing the client’s
commitment to improve corporate governance practices or internal controls. Examples of such
safeguards include: (Some safeguards are also discussed in ISA 22014 on quality control.
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Acquiring an appropriate understanding of the nature of the client’s business, the
complexity of its operations, the specific requirements of the engagement and the purpose,
nature and scope of the work to be performed.

Acquiring knowledge of relevant industries, subject matters and relevant regulatory or
reporting requirements.

Assigning sufficient staff with the necessary competencies.

Using experts where necessary. (When an auditor in public practice intends to rely on the
advice or work of an expert they should consider reputation, expertise, resources available
and applicable ethical standards.) See ISA 62015.

Accept specific engagements only when they can be performed competently.
Replacing an Existing Auditor
An auditor who is asked to replace another auditor, or who is considering a new engagement
for a company currently audited by another auditor must consider whether there are any reasons,
professional or otherwise, for not accepting the engagement. There may be a threat to professional
competence and due care if an auditor accepts the engagement before knowing all the pertinent
facts. Determining possible reasons for not accepting a new client may require direct
communication with the existing auditor to establish the facts and circumstances regarding the
proposed change in auditors.
Safeguards to deal with threat to a due professional care include:

When requested by a prospective client to submit proposal to perform the audit, stating in
the tender that, before accepting the engagement, contact with the existing accountant16
will be made;
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Asking the existing auditor to provide known information on any facts or circumstances
that, in the existing accountant’s opinion, the proposed auditor needs to be aware of before
deciding whether to accept the engagement; or

Obtaining necessary information from other sources.
A professional accountant in public practice will generally need to obtain the client’s
permission, preferably in writing, to initiate discussion with an existing accountant. The existing
accountant should provide information to the proposed auditor honestly and unambiguously. If the
proposed accountant for whatever reason is unable to communicate with the existing accountant,
the proposed accountant should take reasonable steps to obtain information such as through
inquiries of third parties or background investigations of senior management or those charged with
governance of the client.
Conflicts of Interest (Sec. 220)
A professional accountant in public practice shall take reasonable steps to identify
circumstances that could pose a conflict of interest17 and apply safeguards when necessary to
eliminate the threats. For example, a threat to objectivity may be created when a professional
accountant in public practice competes directly with a client or has a joint venture or similar
arrangement with a major competitor of a client. If a conflict of interest may exist, application of
one of the following safeguards is appropriate:

Notifying the client of the audit firm’s activities that may represent a conflict of interest; or

Notifying all known relevant parties that the professional accountant in public practice is
acting for two or more parties in respect of a matter where their respective interests are in
conflict and obtaining their consent to so act; or
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Notifying the client that the professional accountant in public practice does not act
exclusively for any one client in the provision of proposed services (for example, in a
particular market sector or with respect to a specific service).
The professional accountant shall also determine whether to apply one or more of the following
additional safeguards:

The use of separate engagement teams;

Procedures to prevent access to information (for example, strict physical separation of such
teams, confidential and secure data filing);

The use of confidentiality agreements signed by employees and partner of the firm; and

Regular review of the application of safeguards by a senior individual not involved with
relevant client engagements.
Where a conflict of interest creates a threat to one or more of the fundamental principles,
including objectivity, confidentiality, or professional behavior, that cannot be eliminated or
reduced to an acceptable level through the application of safeguards, the professional
accountant in public practice shall not accept a specific engagement or shall resign from one
or more conflicting engagements.18
Second Opinions (Sec. 230)
Sometimes a professional accountant in public practice is asked to provide a second opinion
on the application of accounting, auditing, reporting or other standards or principles to specific
circumstances on behalf of a company that is not an existing client. This may create threats to
compliance with the fundamental principles. For example, there may be a threat to professional
competence and due care in circumstances where the second opinion is not based on the same set of
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facts that were made available to the existing accountant or is based on inadequate evidence. When
asked to provide such an opinion, the auditor should consider any threats that may arise and apply
safeguards. Examples of possible safeguards include seeking client permission to contact the
existing accountant, describing the limitations surrounding any opinion in communications with the
client and providing the existing accountant with a copy of the opinion.
Fees and Other Types of Remuneration (Sec. 240)
When negotiating to provide services to an assurance client, a professional accountant in
public practice may quote whatever fee is deemed appropriate. The fact that one professional
accountant in public practice may quote a fee lower than another is not in itself unethical.
Nevertheless, there may be threats to compliance with the fundamental principles arising from the
level of fees quoted. For example, a self-interest threat to professional competence and due care is
created if the fee quoted is so low that it may be difficult to perform the engagement in accordance
with applicable technical and professional standards for that price. Examples of safeguards against
possible threats would include making the client aware of the terms of the engagement and the
basis of the fees.
Contingent fees are widely used for certain types of non-assurance engagements. However,
they may create threats to compliance with the fundamental principles in certain circumstances.
They may create a self-interest threat to objectivity. The existence and significance of such threats
will depend on a number of factors including nature of the engagement, fee range, and the basis for
determining the fee.
Accepting a referral fee or commission relating to a client creates a self-interest threat to
objectivity and professional competence and due care. For example, safeguards must be set up for a
fee received for referring a continuing client to another accountant or other expert or receiving a
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commission from a third party (for example, a software vendor) in connection with the sale of
goods or services to a client. Similarly, safeguards must be made for payments by a professional
accountant in public practice such as a referral fee to obtain a client.
Examples of safeguards for receiving and paying fees include: disclosing to the client any
arrangements either to pay a referral fee to another professional accountant for the work referred or
to receive a referral fee for referring the client to another. Another safeguard would be to obtain
advance agreement from the client for commission arrangements.
A professional accountant in public practice may purchase all or part of another accounting
firm on the basis that payments will be made to individuals formerly owning the firm or to their
heirs or estates. Such payments are not regarded as commissions or referral.
Marketing Professional Services (Sec. 250)
When a professional accountant in public practice solicits new work through advertising or
other forms of marketing, there may be a threat to compliance with the fundamental principles. For
example, a self-interest threat to compliance with the principle of professional behaviour is created
if services, achievements, or products are marketed in a way that is inconsistent with that principle.
The accountant shall be honest and truthful, and not make exaggerated claims for services offered,
qualifications possessed, or experience gained; or make disparaging references or unsubstantiated
comparisons to the work of another.
Gifts and Hospitality (Sec. 260)
An offer of gifts and hospitality from a client to a professional accountant in public practice,
or an immediate or close family member may create threats to compliance with the fundamental
principles. For example, a self-interest or familiarity threat to objectivity may be created if a gift
from a client is accepted; an intimidation threat to objectivity may result from the possibility of
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such offers being made public. However, if a reasonable and informed third party, weighing all the
specific facts and circumstances would consider specific gifts or hospitality trivial and
inconsequential, the offers would be considered part of the normal course of business which was
not intended to influence the auditor’s decision making.
Custody of Client Assets (Sec. 270)
A professional accountant in public practice shall not assume custody of client monies or
other assets unless permitted to do so by law and, if so, in compliance with any additional
legal duties imposed on a professional accountant in public practice holding such assets19. The
holding of client assets creates threats to compliance with the fundamental principles; for example,
there is a self-interest threat to professional behavior and may be a self-interest threat to objectivity
arising from holding client assets. An accountant entrusted with money (or other assets) belonging
to others must:

Keep other’s assets separately from personal or accounting firm assets;

Use such assets only for the purpose for which they are intended;

At all times be ready to account for those assets and any income, dividends, or gains
generated, to any persons entitled to such accounting; and

Comply with all relevant laws and regulations relevant to the holding of and accounting for
such assets.

Make appropriate inquiries about the source of such assets and consider legal and
regulatory obligations.
Objectivity—All Services (Sec. 280)
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Are there threats to compliance with the fundamental principle of objectivity resulting from
having interests in, or relationships with, a client or its directors, officers or employee? For
example, a familiarity threat to objectivity may be created from a family or close personal or
business relationship. A professional accountant in public practice must determine when providing
any professional service whether there are such threats and act accordingly with safeguards.
Examples of such safeguards include:

Withdrawing from the engagement team.

Supervisory procedures.

Terminating the financial or business relationship giving rise to the threat.

Discussing the issue with higher levels of management within the firm.

Discussing the issue with those charged with governance of the client.
A professional accountant in public practice who provides an assurance service shall be
independent of the assurance client. Independence of mind and in appearance is necessary to
enable the professional accountant in public practice to express a conclusion, and be seen to
express a conclusion, without bias, conflict of interest, or undue influence of others 20.
Independence will be discussed in the next section.
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3.6 Independence―Audit and Review Engagements (Section 290)
The independence of the auditor from the firm that he is auditing is one of the basic
requirements to keep public confidence in the reliability of the audit report. Independence adds
credibility to the audit report on which investors, creditors, employees, government and other
stakeholders depend to make decisions about a company. The benefits of safeguarding an auditor’s
independence extend so far as to the overall efficiency of the capital markets.
Across the world, national rules on auditors’ independence differ in several respects such as:
the scope of persons to whom independence rules should apply; the kind of financial, business or
other relationships that an auditor may have with an audit client; the type of non-audit services that
can and cannot be provided to an audit client; and the safeguards which should be used. The
European Commission has issued independence standards to be applied throughout the European
Union (EU). The USA enacted the Sarbanes-Oxley Act of 2002, which describes independence
requirements of US auditors.
The European Commission Council Directive 84/253/EEC (EU Eighth Company Law
Directive), gives discretionary power to Member States to determine the conditions of
independence for a statutory auditor. Article 24 states21 that Member States shall prescribe that
auditors shall not carry out statutory audits22 if they are not independent in accordance with the
law of the Member State which requires the audit.
To provide each EU country with a common understanding of this independence requirement,
the European Union Committee on Auditing developed a set of fundamental principles set out in a
Commission Recommendation called Statutory Auditors’ Independence in the EU: A Set of
Fundamental Principles.23 The principles based approach was considered “preferable to one based
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on detailed rules because it creates a robust structure within which statutory auditors have to justify
their actions.”24
The EU framework, which parallels the threat and safeguard approach of IFAC, is based on
the requirement that an auditor must be independent from his audit client both in mind and
appearance. The auditor should not audit a client if there are any financial, businesses, employment
or other relationships between them that a “reasonable and informed third party” would conclude
compromised independence.
US based firms and firms that audit US publicly traded firms must adhere to the regulations of
the Sarbanes-Oxley Act,25 Title II, Auditor Independence, as interpreted by the Public Company
Accounting Oversight Board (PCAOB).26 The Independence sections and the prohibited services
are listed in Illustration 3.2.
ILLUSTRATION 3.2
INDEPENDENCE IN THE SARBANES-OXLEY ACT OF 2002
TITLE II – AUDITOR INDEPENDENCE
Sec. 201. Services outside the scope of practice of auditors.
Sec. 202. Pre-approval requirements.
Sec. 203. Audit partner rotation.
Sec. 204. Auditor reports to audit committees.
Sec. 205. Conforming amendments.
Sec. 206. Conflicts of interest.
Sec. 207. Study of mandatory rotation of registered public accounting firms.
Sec. 208. Commission authority.
Sec. 209. Considerations by appropriate State regulatory authorities.
Prohibited non-audit service contemporaneously with the audit include:
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(1) bookkeeping or other services related to the accounting records or financial statements of the
audit client;
(2) financial information systems design and implementation;
(3) appraisal or valuation services, fairness opinions, or contribution-in-kind reports;
(4) actuarial services;
(5) internal audit outsourcing services;
(6) management functions or human resources;
(7) broker or dealer, investment adviser, or investment banking services;
(8) legal services and expert services unrelated to the audit; and
(9) any other service that the Board determines, by regulation, is impermissible.
Under PCAOB rules all non-audit services to clients, which are not specifically prohibited,
must be pre-approved by the Audit Committee and disclosed to the shareholders. Audit partners
must be rotated every five years. Clients cannot hire as an officer any member of the audit team
within one year after their last audit. Determination of independence of auditors who audit nonpublicly traded firms is left up to the regulatory authorities of the 50 states of the USA.
Europe is currently taking the lead in this global discussion of auditor independence strongly
expressed by Michel Barnier, the European internal market and services commissioner. Mr.
Barnier has said, “Just like beauty, quality and independence are in the eye of the beholder,
therefore perception of audit quality and of auditor independence is paramount.”27 He is proposing
the questions: Why do companies with serious shortcomings receive a clean audit report? How
great is the pressure on an auditor to not lose a company that has been a client for decades? How
independent is an audit when there are other commercial interests and the auditor could be auditing
work performed by other departments of his firm? He suggests that mandatory rotation of audit
firms, restrictions on the provision of non-audit services and the prohibition to provide any non-
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audit services for audit firms of a very substantial size address these questions linked to
independence. He has proposed several audit reforms in his European Commission Green Paper28.
Independence as Discussed in the IESBA Code (Section 290)
The IESBA Code of Ethics for Professional Accountants, Section 290 addresses the independence
requirements for audit engagements and review engagements. Independence requirements for
assurance engagements that are not audit or review engagements are addressed in Section 291, not
covered in this chapter. The Code discusses independence in assurance services in terms of a
principles-based, conceptual approach that takes into account threats to independence, accepted
safeguards and the public interest.
Concepts Based Approach
IFAC strongly believes that a high-quality principles based approach to independence will best
serve the public interest by eliciting thoughtful auditor assessment of the particular circumstances
of each engagement.29 However, the Code gives related guidance and explanatory material as well.
The section on independence (Section 290) discusses the application of the conceptual approach to
specific situations such as financial interest, loans, fees and others listed in Illustration 3.3.
Illustration 3.3 Code of Ethics section 290 on independence
SECTION 290 INDEPENDENCE―AUDIT AND REVIEW ENGAGEMENTS
CONTENTS
Paragraph
Structure of Section ..................................................................................... 290.1
A Conceptual Framework Approach to Independence ................................ 290.4
Networks and Network Firms ...................................................................... 290.13
Public Interest Entities ................................................................................. 290.25
Related Entities ............................................................................................ 290.27
Those Charged with Governance ................................................................. 290.28
Documentation ............................................................................................. 290.29
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Engagement Period ...................................................................................... 290.30
Mergers and Acquisitions ............................................................................ 290.33
Other Considerations ................................................................................... 2 90.39
Application of the Conceptual Framework Approach to
Independence ............................................................................................ 290.100
Financial Interests ........................................................................................ 290.102
Loans and Guarantees .................................................................................. 290.118
Business Relationships ................................................................................. 290.124
Family and Personal Relationships .............................................................. 290.127
Employment with an Audit Client ............................................................... 290.134
Temporary Staff Assignments ..................................................................... 290.142
Recent Service with an Audit Client ............................................................ 290.143
Serving as a Director or Officer of an Audit Client ..................................... 290.146
Long Association of Senior Personnel (Including Partner Rotation)
with an Audit Client .................................................................................... 290.150
Provision of Non-assurance Services to Audit Clients ................................ 290.156
Management Responsibilities .....................................................
209.162
Preparing Accounting Records and Financial Statements ............ 290.167
Valuation Services ............................................................
290.175
Taxation Services .......................................................................... 290.181
Internal Audit Services .................................................................. 290.195
IT Systems Services ...................................................................... 290.201
Litigation Support Services ........................................................... 290.207
Legal Services ................................................................................ 290.209
Recruiting Services ........................................................................ 290.214
Corporate Finance Services ............................................................. 290.216
Fees ............................................................................................................... 290.220
Fees—Relative Size ........................................................................ 290.220
Fees—Overdue ............................................................................... 290.223
Contingent Fees .............................................................................. 290.224
Compensation and Evaluation Policies ......................................................... 290.228
Gifts and Hospitality ..................................................................................... 290.230
Actual or Threatened Litigation .................................................................... 290.231
Reports that Include a Restriction on Use and Distribution . ............ 290.500
Accountants must not only maintain an independent attitude in fulfilling their responsibilities,
but the users of financial statements must have confidence in that independence. These two
objectives are frequently identified as “independence of mind” and “independence in appearance.”
Independence of mind (historically referred to as independence in fact) exists when the accountant
is able to maintain an unbiased attitude throughout the audit, so being objective and impartial,
whereas independence in appearance is the result of others’ interpretations of this independence.
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The conceptual framework involves two views of independence to which the auditor must
comply: (1) Independence of Mind and (2) Independence in Appearance. Independence of Mind is
the state of mind that permits the expression of a conclusion without being affected by
influences that compromise professional judgment, thereby allowing an individual to act with
integrity and exercise objectivity and professional skepticism30. Independence in Appearance is
the avoidance of facts and circumstances that are so significant that a reasonable and
informed third party would be likely to conclude, weighing all the specific facts and
circumstances, that a firm’s, or a member of the audit team’s, integrity, objectivity or
professional skepticism has been compromised.31
The Ethics Code discusses independence in assurance services in terms of a principles-based
approach that takes into account threats to independence, accepted safeguards and the public
interest. The Section states principles that members of assurance teams should use to identify
threats to independence (self-interest, self-review, advocacy, familiarity and intimidation threats),
evaluate the significance of those threats, and, if the threats are other than clearly insignificant,
identify and apply safeguards created by the profession, legislation or regulation, safeguards within
the assurance client, and safeguards within the firm’s own systems and procedures to eliminate the
threats or reduce them to an acceptable level.
A professional accountant shall use professional judgment in applying this conceptual
framework to:

Identify threats to independence;

Evaluate the significance of the threats identified; and

Apply safeguards, when necessary, to eliminate the threats or reduce them to an acceptable
level.
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Independence for audit and review services and possible threats and safeguards are given in
detail in Section 290, the largest section of the Code. See Illustration 3.3. Review and audit
independence is discussed on the topics of conceptual framework, network firms, public interest
entities, documentation, engagement period, financial interests, loans and guarantees, business
relationships, family and personal relationships, employment with an audit client, temporary staff
assignments, recent service with an audit client, serving as director or officer of an audit client,
long association of senior personnel with audit clients, and other topics not covered in this chapter,
including mergers and acquisitions and related entities. The sub-section on non-assurance services
discuss safeguards and threats of non-assurance services to the audit client including the following
topics: management responsibilities, preparing accounting records and financial statements,
taxation services, internal audit services, IT systems services, litigation support services, legal
services, recruiting services, and valuation and corporate finance services. The independence
section ends with a discussion of general topics including fees, compensation and evaluation
policies, gifts and hospitality, actual or threatened litigation, and restricted reports (not discussed in
this chapter).
The Code states: “In the case of audit engagements, it is in the public interest and,
therefore, required by this Code, that members of audit teams, firms and network firms shall
be independent of audit clients32.
If a firm is a network firm33, the firm must be independent of the audit clients of the other
firms within the network. The independence requirements that apply to a network firm apply to any
entity, such as a consulting practice or professional law practice, which meets the definition of a
network firm irrespective of whether the entity itself meets the definition of a firm.
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Documentation of Independence (290.29)
The professional accountant must document conclusions regarding compliance with
independence requirements, and the substance of any relevant discussions that support those
conclusions.34 Accordingly:

When safeguards are required, the auditor shall document the nature of the threat and the
safeguards in place or applied that reduce the threat to an acceptable level; and

When a threat required significant analysis to determine whether safeguards were
necessary and the conclusion was that they were not because the threat was already at an
acceptable level, the professional accountant shall document the nature of the threat and the
rationale for the conclusion.
Engagement Period (290.30)
Independence from the audit client is required both during the engagement period and
the period covered by the financial statements35. The engagement period starts when the audit
team begins to perform audit services. The engagement period ends when the audit report is issued.
When the engagement is of a recurring nature, it ends at the later of the notification by either party
that the professional relationship has terminated or the issuance of the final audit report. During or
after the period covered by the financial statements the audit firm must consider threats to
independence created by financial or business relationships with the audit client or previous
services provided to the audit client.
Auditors should consider threats if a non-assurance service that would not be permitted during
the period of the audit engagement was provided to the audit client before the audit. Safeguards
include:
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Not including personnel who provided the non-assurance service as members of the audit
team;

Having a professional accountant review the audit and non-assurance work as appropriate;
or

Engaging another accounting firm to evaluate the results of the non-assurance service or
having another firm re-perform the non-assurance service to the extent necessary to enable
it to take responsibility for the service.
Application of the Conceptual Framework Approach to Independence
(290.100)
The final paragraphs of Part B (paragraphs 290.102 to 290.231) of the ESBA Code describe
specific circumstances and relationships that create or may create threats to independence. The
paragraphs describe the potential threats and the types of safeguards that may be appropriate to
eliminate the threats or reduce them to an acceptable level and identify certain situations where no
safeguards could reduce the threats to an acceptable level. Here we will not cover all the examples
discussed in these paragraphs, but cover the most common safeguards concerning financial
interests, loans, guarantees, and business relationship. To determine whether a material interest
exists the combined net worth of the individual and the individual’s immediate family members
may be taken into account.
Financial Interests (290.102)
If a member of the audit team, a member of that individual’s immediate family, or a
firm has a direct financial interest or a material indirect financial interest in the audit client,
the self-interest threat created would be so significant that no safeguards could reduce the
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threat to an acceptable level36. None of the following shall have a direct financial interest or a
material indirect financial interest in the client: a member of the audit team; a member of that
individual’s immediate family; or the firm. If other partners and managerial employees who provide
non-audit services to the audit client or their immediate family members, hold a direct financial
interest or a material indirect financial interest in the audit client, the self-interest threat created
would be so significant that no safeguards could reduce the threat to an acceptable level.
A loan, or a guarantee of a loan, to a member of the audit team, or a member of that
individual’s immediate family, or the firm from an audit client that is a bank, a similar institution,
or non-bank entity (except if the non-bank loan is immaterial) may create a threat to independence.
The loan or guarantee must not be made except under normal lending procedures, terms and
conditions, otherwise a self-interest threat would be created that would be so significant that no
safeguards could be sufficient. If the loan or guarantee is made under normal lending procedures,
terms and conditions safeguards such as having the work reviewed by a professional accountant
from a network firm that is neither involved with the audit nor received the loan.
Business, Family and Personal Relationships (290.124 – 290.150)
A close business relationship between a firm, or a member of the audit team, or a member of
that individual’s immediate family, and the audit client or its management, arises from a
commercial relationship or common financial interest and may create self-interest or intimidation
threats. Unless the financial interest is immaterial and the business relationship is insignificant, the
business relationship must not be entered into because NO safeguards would be sufficient and the
individual with the relationship must be removed from the audit team. Examples of close business
relationships include:
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Having a financial interest in a joint venture with either the client or a controlling owner,
director, officer or other individual who performs senior managerial activities for that
client.

Arrangements to combine one or more services or products of the firm with one or more
services or products of the client and to market the package with reference to both parties.

Distribution or marketing arrangements under which the firm distributes or markets the
client’s products or services, or the client distributes or markets the firm’s products or
services.
Family and personal relationships between a member of the audit team and a director or
officer or certain employees (depending on their role) of the audit client may create self-interest,
familiarity or intimidation threats. If an immediate family member of a member of the audit team is
a director or officer of the audit client; or an employee in a position to exert significant influence
over the preparation of the client’s accounting records or the financial statements or was in such a
position during any period covered by the engagement the threats can only be reduced to an
acceptable level by removing that individual from the audit team.
If a director or officer of the audit client, or a significant employee has been a member of the
audit team or partner of the firm, familiarity or intimidation threats may be created. The threat
would be so significant that no safeguards could reduce the threat to an acceptable level unless: the
individual is not entitled to any benefits or payments from the audit firm and any amount owed to
the individual is not material to the firm; and that individual does not continue to participate in the
audit firm’s business activities. Furthermore, a self-interest threat is created when a member of the
audit team participates in the audit engagement while knowing that the member of the audit team
will, or may, join the client some time in the future.
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The lending of staff by a firm to an audit client may create a self-review threat. Such
assistance may be given, but only for a short period of time and the firm’s personnel shall not be
involved in: providing non-assurance services not be permitted under Section B of the IESBA Code
or assuming management responsibilities.
Familiarity and self-interest threats are created by using the same senior personnel on an audit
engagement over a long period of time. Examples of such safeguards include:

Rotating the senior personnel off the audit team;

Having a professional accountant who was not a member of the audit team review the work
of the senior personnel; or

Regular independent internal or external quality reviews of the engagement.
In respect of an audit of a public interest entity, an individual shall not be a key audit partner
for more than seven years. After such time, the individual shall not be a member of the engagement
team or be a key audit partner for the client for two years.
Provision of Non-assurance Services to Audit Clients (290.156 – 290.216)
Firms have traditionally provided to their audit clients a range of non-assurance services that
are consistent with their skills and expertise. Providing non-assurance services may, however,
create threats to the independence of the firm or members of the audit team. The threats created are
most often self-review, self-interest and advocacy threats. Providing certain non-assurance services
to an audit client may create a threat to independence so significant that no safeguards could reduce
the threat to an acceptable level.
If a firm were to assume a management responsibility37 for an audit client, the threats created
would be so significant that no safeguards could reduce the threats to an acceptable level. For
example, deciding which recommendations of the firm to implement will create self-review and
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self-interest threats. Further, assuming a management responsibility creates a familiarity threat
because the firm becomes too closely aligned with the views and interests of management.
Therefore, the firm shall not assume a management responsibility for an audit client.
Providing an audit client with accounting and bookkeeping services, such as preparing
accounting records or financial statements, creates a self-review threat when the audit firm
subsequently audits the financial statements. Except in emergency situations38, an audit firm shall
not provide to an audit client that is a public interest entity accounting and bookkeeping services,
including payroll services, or prepare financial statements or financial information which forms the
basis of the financial statements. However, the firm may provide services related to the preparation
of accounting records and financial statements to an audit client that is not a public interest entity
where the services. Examples of such services include:

Providing payroll services based on client-originated data;

Recording transactions for which the client has determined or approved the appropriate
account classification;

Posting transactions coded by the client to the general ledger;

Posting client-approved entries to the trial balance; and

Preparing financial statements based on information in the trial balance.
Tax return preparation services involve assisting clients with their tax reporting obligations
by drafting and completing information, including the amount of tax due (usually on standardized
forms) required to be submitted to the applicable tax authorities. The tax returns are subject to
whatever review or approval process the tax authority deems appropriate. Accordingly, providing
such service does not generally create a threat to independence if management takes responsibility
for the returns including any significant judgments made.
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Tax planning or other tax advisory services such as advising the client how to structure its
affairs in a tax efficient manner or advising on the application of a new tax law or regulation may
create a self-review threat where the advice will affect matters to be reflected in the financial
statements. For example, where the effectiveness of the tax advice depends on a particular
accounting treatment or presentation in the financial statements and the audit team has reasonable
doubt as to the appropriateness of the related accounting treatment and the outcome or
consequences of the tax advice will have a material effect on the financial statements, the selfreview threat would be so significant that no safeguards could reduce the threat to an acceptable
level.
The existence and significance of any threat will depend on a number of factors. For example,
providing tax advisory services where the advice is clearly supported by tax authority or other
precedent does not generally create a threat to independence. If safeguards are required, they may
include:

Using professionals who are not members of the audit team to perform the service;

Having a tax professional, who was not involved in providing the tax service, advise the
audit team on the service and review the financial statement treatment;

Obtaining advice on the service from an external tax professional; or

Obtaining pre-clearance or advice from the tax authorities.
An advocacy or self-review threat may be created when the firm represents an audit client in
the resolution of a tax dispute. Where the taxation services involve acting as an advocate for an
audit client before a public tribunal or court in the resolution of a tax matter and the amounts
involved are material to the financial statements the advocacy threat created would be so significant
that no safeguards could eliminate or reduce the threat to an acceptable level. Therefore, the firm
shall not perform this type of service for an audit client.
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The provision of internal audit services to an audit client creates a self-review threat to
independence if the firm uses the internal audit work in the course of a subsequent external audit.
Performing a significant part of the client’s internal audit activities increases the possibility that
firm personnel providing internal audit services will assume a management responsibility.
Assuming management responsibility when providing internal audit services to an audit client
creates a threat that would be so significant that no safeguards could reduce the threat to an
acceptable level.
To avoid assuming a management responsibility, the firm shall only provide internal audit
services to an audit client if it is satisfied that:

Client senior management takes responsibility at all times for internal audit activities and
acknowledges responsibility for designing, implementing, and maintaining internal control

Client management reviews, assesses and approves the scope, risk and frequency of the
internal audit services;

The client’s management evaluates and determines which recommendations resulting from
internal audit services to implement and manages the implementation process; and

The client’s management reports to those charged with governance the significant findings
and recommendations resulting from the internal audit services.
In the case of an audit client that is a public interest entity, a firm shall not provide
internal audit services that relate to:

A significant part of the internal controls over financial reporting;

Financial accounting systems that generate information that is significant to the client’s
accounting records or financial statements; or

Amounts or disclosures that are material to the financial statements on which the audit
firm will express an opinion.
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Providing IT systems services may create a self-review threat depending on the nature of the
services and the IT systems. Providing services to an audit client involving the design or
implementation of IT systems that form a significant part of the internal control over financial
reporting or generate accounting records or financial statements creates a self-review threat. For a
non-public interest entity other IT systems services may not create a threat to independence if the
audit firm’s personnel do not assume management responsibility, but safeguards must be put in
place.
Performing valuation services or litigation support services for an audit client may create a
self-review threat. The existence and significance of any threat will depend on several factors such
as whether the services will have a material effect on the financial statements, the active
participation of the client’s in determining and approving the methodology and other significant
matters of judgment, the degree of subjectivity inherent in the service, the extent and clarity of the
disclosures in the financial statements.
Legal services that support an audit client in executing a transaction (for example, contract
support, legal advice, legal due diligence and restructuring) may create self-review threats. Acting
in an advocacy role for an audit client in resolving a dispute or litigation when the amounts
involved are material to the financial statements on which the firm will express an opinion would
create advocacy and self-review threats so significant that no safeguards could reduce the threat to
an acceptable level. Therefore, the firm shall not perform this type of service for an audit client.
However, when the amounts involved are not material to the financial statements, the audit firm
may provide the service if safeguards are in place.
Providing recruiting services to an audit client may create self-interest, familiarity or
intimidation threats. The audit firm may generally provide such services as reviewing the
professional qualifications of a number of applicants and providing advice on their suitability for
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the post. In addition, the firm may interview candidates and advice on a candidate’s competence for
financial accounting, administrative or control positions. The audit firm cannot provide search
services or reference checks for a director, officer or senior management who has influence over
the accounting records or financial statements.
Advocacy and self-review threats may be created if the auditor provides the audit client corporate
finance services such as assisting in developing corporate strategies, identifying possible targets for the audit
client to acquire, advising on disposal transactions, assisting finance raising transactions, or providing
structuring advice, If the effectiveness of corporate finance advice depends on a particular accounting
treatment or presentation in the financial statements and the audit team has reasonable doubt as to
the appropriateness and the consequences of the corporate finance advice, and the treatment will
have a material effect on the financial statements, the self-review threat would be so significant
that no safeguards could reduce the threat to an acceptable level. Providing corporate finance
services involving promoting, dealing in, or underwriting an audit client’s shares would create an
advocacy or self-review threat that no safeguards could reduce to an acceptable level.
Fees (290.220 – 290.224)
Professional fees should be a fair reflection of the value of the professional service performed
for the client, taking into account the skill and knowledge required, the level of training and
experience of the persons performing the services, the time necessary for the services and the
degree of responsibility that performing those services entails. The IESBA Ethics Code discusses
threats to independence in pricing auditing services in terms of size, whether fees are overdue, and
contingent fees.
When the total fees from an audit client represent a large proportion of the total fees of the
firm expressing the audit opinion, the dependence on that client and concern about losing the client
creates a self-interest or intimidation threat. These threats are also created when the fees generated
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from one audit client represent a large proportion of the revenue from an individual partner’s
clients or a large proportion of the revenue of an individual office of the audit firm. Safeguards
should be applied to eliminate the threat or reduce it to an acceptable level. Examples of such
safeguards include: reducing the dependency on the client; internal or external quality control
reviews; or consulting a third party to review key audit judgments.
The ethics code lists a specific situation of a single client’s fees as a proportion of total fees. If
an audit client is a public interest entity and, for two consecutive years, the total fees from the
client represent more than 15% of the total fees received by the audit firm, the firm must disclose to
the audit client that fact and discuss which safeguards (such as those in Ethics Code paragraph
290.222) it will apply.
The Code warns that a self-interest threat may be created if fees due from an assurance client
for professional services remain unpaid for a long time, especially if a significant part is not paid
before the issue of the assurance report for the following year. Generally the payment of such fees
should be required before the report is issued. The firm should also consider whether the overdue
fees might be regarded as being equivalent to a loan to the client and whether, because of the
significance of the overdue fees, it is appropriate for the firm to be re-appointed.
Contingent fees are fees (except those established by courts) calculated on a predetermined
basis relating to the outcome of a transaction or the result of the services performed by the firm. A
contingent fee charged directly or indirectly by an audit firm for an audit or non-assurance
engagement creates a self-interest threat that is so significant that no safeguards could reduce the
threat to an acceptable level. Some non-assurance engagements may be acceptable under certain
safeguards.39
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Fees are distinct from reimbursement of expenses. Out-of-pocket expenses, in particular
traveling expenses, attributable directly to the professional services performed for a particular
client would normally be charged in addition to the professional fees.
Compensation and Evaluation Policies (290.228)
A self-interest threat is created when a member of the audit team or a key audit partner is
evaluated on or compensated for selling non-assurance services to that audit client. The
significance of the threat must be evaluated and, if the threat is not at an acceptable level, the firm
shall either revise the compensation plan or evaluation process for that individual or apply
safeguards to eliminate the threat or reduce it to an acceptable level. Examples of such safeguards
include: removing such members from the audit team; or having a professional accountant review
the work of the audit team member.
Concept and a Company 3.3
Independence of Audit and Consulting – PeopleSoft and E&Y
Concept
Auditor independence – auditors should be aware of significant threats to independence
that may arise and the appropriate safeguards to apply in an attempt to eliminate those
threats.
Story
In 2002, the Securities and Exchange Commission (SEC) announced proceedings against Big
Four audit firm Ernst & Young (E&Y). The case involved alleged independence violations due to
product sales and consulting fees related to PeopleSoft software, while PeopleSoft was an E&Y
audit client. SEC suggested a sanction be imposed against Ernst & Young, which would not
allow the firm to provide audit services to publicly traded companies for a period of six months.
(SEC 2002a)
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The SEC alleged that E&Y and PeopleSoft co-developed and co-marketed a software product
called “EY/GEMS for PeopleSoft.” These allegations focus on E&Y’s use of components of
PeopleSoft’s proprietary source code in software previously developed and marketed by the
accounting firm’s tax department. In return for the code, SEC says E&Y agreed to pay royalties
ranging from 15 per cent to 30 per cent from each sale of the resulting product.
Additionally, the SEC finds fault with hundreds of millions of dollars in consulting revenues from
implementing PeopleSoft software for clients. The SEC says the revenues were derived from
close coordination and co-marketing. As evidence, it cites reciprocal endorsements, links to
each other’s websites, holding themselves out as “business partners” of one another, and
sharing customer information, customer leads, and “target accounts.” (SEC 2002b)
In response to SEC’s announcement, Ernst & Young released this statement (Schlank 2002):
“Our conduct was entirely appropriate and permissible under the profession’s rules. It did not
affect our client, its shareholders, or the investing public, nor is the SEC claiming any error in our
audits or our client’s financial statements as a result of them. Moreover, the issues the SEC has
raised are purely technical and relate to judgments we made and actions we took in good faith
years ago.
“The SEC’s main focus is on the activities of our former consultants in implementing PeopleSoft
software for third parties. These occurred between 1994 and 1999 and have no bearing on our
current business. In fact, we sold our consulting business to Cap Gemini in May 2000. The
SEC’s other focus is on a software license agreement between Ernst & Young and PeopleSoft
entered into when the parties were making an EY software product compatible with PeopleSoft.
This issue is also purely historical. The license agreement terminated years ago and the
PeopleSoft-compatible version of the product is no longer sold.
“For the record, we did carefully consider the potential independence implications of our
consultants’ actions before they undertook them. We correctly concluded at the time that the
actions were permissible under the profession’s rules and that they were commonplace.”
Discussion Questions
Why would selling and servicing the product of an audit client for significant
revenue be considered a threat to independence?
What safeguards could E&Y have put in place to compensate for this threat?
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Would the relationship between E&Y and PeopleSoft be viewed differently if it happened after
the Sarbanes-Oxley Act was passed?
References Schlank, R., 2002, “SEC Reaches Way Back for EY Independence Case,” Accountingweb.com,
May 21.
SEC, 2002a, Litigation release 8146, “SEC Institutes Proceedings against Ernst & Young to
Resolve Auditor Independence Allegations,” US Securities and Exchange Commission,
November 13.
SEC, 2002b “SEC Institutes Proceedings Against Ernst & Young To Resolve Auditor
Independence Allegations Stemming From Joint Business Relationships With Audit Client,” SEC
News Digest, Issue 2002–97, May 20.
Gifts and Hospitality (290.230)
Accepting gifts or hospitality from an audit client may create self-interest and familiarity threats. If
a firm or a member of the audit team accepts gifts or hospitality, unless the value is trivial and
inconsequential, the threats created would be so significant that no safeguards could reduce the
threats to an acceptable level.
Actual or Threatened Litigation (290.231)
When litigation takes place, or appears likely, between the audit firm or a member of the audit team
and the audit client, self-interest and intimidation threats are created. The relationship between
client management and the members of the audit team must be characterized by complete candor
and full disclosure regarding all aspects of a client’s business operations. When the firm and the
client’s management are placed in adversarial positions by actual or threatened litigation, affecting
management’s willingness to make complete disclosures, self-interest and intimidation threats are
created. The significance of the threats shall be evaluated and safeguards applied when necessary to
eliminate the threats or reduce them to an acceptable level. Examples of such safeguards include:
removing the individual involved in litigation from the audit or having a professional review the
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work performed. If such safeguards do not reduce the threats to an acceptable level, the only
appropriate action is to withdraw from, or decline, the audit engagement.
Independence requirements for assurance engagements that are not audit or
review engagements (Section 291)
The IESBA Code of Ethics for Professional Accountants Section 291 (see Illustration 3.4 for
contents) addresses independence requirements for assurance engagements that are not audit or
review engagements. If the assurance client is also an audit or review client, the requirements in the
prior section of this chapter (and Ethics Code Section 290) also apply to the firm, network firms
and members of the audit or review team. We will not explore the non-financial statement audit or
review assurance ethics in this book.
Illustration 3.4
SECTION 291
INDEPENDENCE―OTHER ASSURANCE ENGAGEMENTS
CONTENTS
Paragraph
Structure of Section ..................................................................................... 291.1
A Conceptual Framework Approach to Independence ................................ 291.4
Assurance Engagements .............................................................................. 291.12
Assertion-Based Assurance Engagements ................................................... 291.17
Direct Reporting Assurance Engagements ................................................... 291.20
Reports that Include a Restriction on Use and Distribution ......................... 291.21
Multiple Responsible Parties ....................................................................... 291.28
Documentation ............................................................................................. 291.29
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Engagement Period ...................................................................................... 291.30
Other Considerations ................................................................................... 291.33
Application of the Conceptual Framework Approach to Independence ..... 291.100
Financial Interests ........................................................................................ 291.104
Loans and Guarantees .................................................................................. 291.113
Business Relationships ................................................................................. 291.119
Family and Personal Relationships .............................................................. 291.121
Employment with Assurance Clients ........................................................... 291.128
Recent Service with an Assurance Client .................................................... 291.132
Serving as a Director or Officer of an Assurance Client .............................. 291.135
Long Association of Senior Personnel with Assurance Clients ................... 291.139
Provision of Non-assurance Services to Assurance Clients .................. 291.140
Management Responsibilities ............................................................... 291.143
Other Considerations ............................................................................ 291.148
Fees .......................................................................................................291.151
Fees―Relative Size .............................................................................. 291.151
Fees―Overdue ..................................................................................... 291.153
Contingent Fees .................................................................................... 291.154
Gifts and Hospitality .............................................................................291.158
Actual or Threatened Litigation ............................................................291.159
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3.7 PART C—Professional Accountants In Business
Part C of the IESBA Code describes how the conceptual framework contained in Part A
applies in certain situations to professional accountants in business. Part C also addresses
circumstances in which compliance with the fundamental principles may be compromised under
the topics of potential conflicts, preparation and reporting information, acting with sufficient
expertise, financial interests, and inducements. Part C does not contain discussion of independence.
This is because accountants in business do not provide assurance in any form and do not play a role
in the society at large. Also, because accountants in business are employees it is difficult to require
independence from the organization that is the source of their income.
A professional accountant in business may be a salaried employee, a partner, director, an
owner manager, a volunteer or another working for one or more employing organization.
Professional accountants in business may be responsible for the preparation and reporting of
financial and other information or for providing effective financial management and competent
advice on a variety of business-related matters. The accountant has a responsibility to further the
legitimate aims of the accountant’s employing organization. A professional accountant in business
is expected to encourage an ethics-based culture in an employing organization that emphasizes the
importance that senior management places on ethical behavior. A professional accountant in
business shall not knowingly engage in any business, occupation, or activity that impairs or
might impair integrity, objectivity or the good reputation of the profession and as a result
would be incompatible with the fundamental principles.40
As we discussed in the Part A section of this chapter, compliance with the fundamental
principles may potentially be threatened by a broad range of circumstances and relationships.
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Threats fall into one or more of the following categories: Self-interest, Self-review, Advocacy,
Familiarity, and Intimidation.
Self-interest threats are perhaps the most frequent for a professional accountant in business:

Holding a financial interest in, or receiving a loan or guarantee from the employing
organization.

Participating in incentive compensation arrangements offered by the employing
organization.

Inappropriate personal use of corporate assets.

Concern over employment security.

Commercial pressure from outside the employing organization.
Some examples of circumstances leading to self-review and advocacy threats for a professional
accountant in business can be mentioned. Determining the appropriate accounting treatment for a
business combination after performing the feasibility study that supported the acquisition decision
creates a self-review threat. Any false or misleading statements made when furthering the goals
and objectives of their employing organizations creates an advocacy threat.
Examples of circumstances that may create familiarity threats for professional accountants in
business include:

Being responsible for the employing organization’s financial reporting when an immediate
or close family member employed by the entity makes decisions that affect the entity’s
financial reporting.

Long association with business contacts influencing business decisions.

Accepting a gift or preferential treatment, unless the value is trivial and inconsequential.
Examples of circumstances that may create intimidation threats for a professional accountant in
business include:
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Threat of dismissal or replacement of the accountant or a close or immediate family
member over a disagreement about the application of an accounting principle or the way in
which financial information is to be reported.

A dominant personality attempting to influence the decision making process, for example
with regard to the awarding of contracts or the application of an accounting principle.
As previously discussed in the Part A section of this chapter, safeguards that may eliminate or
reduce threats to an acceptable level fall into two broad categories: (1) Safeguards created by the
profession, legislation or regulation; and (2) Safeguards in the work environment. Safeguards in the
work environment for the professional accountant include:

The employing organization’s systems of corporate oversight or other oversight structures.

The employing organization’s ethics and conduct programs.

Recruitment procedures in the employing organization emphasizing the importance of
employing high caliber competent staff.

Strong internal controls.

Appropriate disciplinary processes.

Leadership that stresses the importance of ethical behavior and the expectation that
employees will act in an ethical manner.

Policies and procedures to implement and monitor the quality of employee performance.

Timely communication of the employing organization’s policies and procedures, including
any changes to them, to all employees and appropriate training and education on such
policies and procedures.

Policies and procedures to empower and encourage employees to communicate to senior
levels within the employing organization any ethical issues that concern them without fear
of retribution.
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Consultation with another appropriate professional accountant.
In those extreme situations where all available safeguards have been exhausted and it is not
possible to reduce the threat to an acceptable level, a professional accountant in business may
conclude that it is appropriate to resign from the employing organization.
Potential Conflicts (Sec. 310)
Although, this section is written for accountants in business it may also be particularly interesting for
accountants in public practice because understanding conflicts in the work place may give the public
accountant a perspective on the quality of the accounting numbers. There may be times when a
professional accountant’s responsibilities to an employing organization and professional
obligations to comply with the fundamental principles are in conflict. Pressure may come from the
employing organization to act contrary to law or regulation or to technical or professional
standards. Pressure may be exerted to facilitate unethical or illegal earnings management strategies,
to lie or otherwise intentionally mislead others, in particular auditors or regulators, to be associated
with an employer report (financial statements, tax compliance, securities reports, etc.) that
materially misrepresents the facts.
Safeguards applied should be applied to eliminate or reduce these threats to an acceptable
level, for example:

Obtaining advice, where appropriate, from within the employing organization, an
independent professional advisor or a relevant professional body.

Using a formal dispute resolution process within the employing organization.

Seeking legal advice.
Other Sections of Part C (Sections 320, 330, 340, and 350)
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There are other sections in Part C which address specific aspects of the work of
professional accountants in business. These sections include discussion of preparation and
reporting of information (Sec. 320,), acting with sufficient expertise (sec. 330), financial interests
(Sec. 340), inducements (Sec. 350). We will not discuss these sections in this chapter.
Concept and a Company 3.4
Accountant Falsifies Accounts for Bosses at WorldCom
Concept
Ethics and the employed accountant – caving in to pressure from your bosses
Story
On October 10, 2002 the US attorney’s office announced that Betty Vinson, former Director of
Management Reporting at WorldCom, had pleaded guilty to two criminal counts of conspiracy
and securities fraud, charges that carry a maximum sentence of 15 years in prison. One year
later, October 10, 2003, she was charged with breaking Oklahoma securities laws by entering
false information on company documents a charge that potentially carries a ten-year prison
sentence. (English 2003)
Over the course of six quarters Vinson made illegal entries to bolster WorldCom’s profits at the
request of her superiors. Each time she worried. Each time she hoped it was the last time. At the
end of 18 months she had helped falsify at least $3.7 billion in profits. (Lacter 2003)
In 1996, Ms. Vinson got a job in the international accounting division at WorldCom making
$50,000 a year. Ms. Vinson developed a reputation for being hardworking and diligent. Within
two years Ms. Vinson was promoted to be a senior manager in WorldCom’s corporate
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accounting division where she helped compile quarterly results and analysed the company’s
operating expenses and loss reserves. Ten employees reported to her. (Pulliam 2003)
Work began to change in mid-2000. WorldCom had a looming problem: its huge line costs –
fees paid to lease portions of other companies’ telephone networks – were rising as a
percentage of the company’s revenue. Chief Executive Bernard Ebers and Chief Financial
Officer Scott Sullivan informed Wall Street in July that the company’s results for the second half
of the year would fall below expectations.
A scramble ensued to try to reduce expenses on the company’s financial statements enough to
meet Wall Street’s expectations for the quarter. But the accounting department was able to
scrape together only $50 million, far from the hundreds of millions it would take to hit the
company’s profit target. In October, her boss told Vinson to dip into a reserve account set aside
to cover line costs and other items for WorldCom’s telecommunications unit and use $828
million to reduce expenses, thereby increasing profits. (Pulliam 2003)
Ms. Vinson was shocked by her bosses’ proposal and the huge sum involved. She worried that
the adjustment wasn’t proper. She agreed to go along. But afterward Ms. Vinson suffered pangs
of guilt. On October, 26, the same day the company publicly reported its third-quarter results,
she told her colleagues who were also involved that she was planning to resign. A few
suggested that they, too, would quit.
CFO Sullivan heard of the mutiny in accounting and called Vinson and other employees into his
office. He explained that he was trying to fix the company’s financial problems. Think of it as an
aircraft carrier, he said, we have planes in the air. Let’s get the planes landed. Once they are
landed, if you still want to leave, then leave. But not while the planes are in the air. Mr. Sullivan
assured them that nothing they had done was illegal and that he would assume all responsibility.
He noted that the accounting switch wouldn’t be repeated. (Pulliam 2003)
That night, she told her husband about the meeting and her worries over the accounting. Mr.
Vinson urged her to quit. But in the end, she decided not to quit. She was the family’s chief
support, earning more than her husband. She, her husband and daughter depended on her
health insurance. She was anxious about entering the job market as a middle-aged worker.
By the end of the first quarter of 2001, it was clear Ms. Vinson could find no large pools of
reserves to transfer to solve the profit shortfall. Sullivan suggested that rather than count line
costs as part of operating expenses in the quarterly report, they would shift $771 million in line
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costs to capital-expenditure accounts which would result in decreased expenses and increased
assets and retained earnings. Accounting rules make it clear that line costs are to be counted as
operating leases, not capital assets.
Ms. Vinson felt trapped. That night she reviewed her options with her husband and decided to
put together a resume and begin looking for a job. Nevertheless, she made the entries
transferring the $771 million, backdating the entries to February by changing the dates in the
computer for the quarter. She faced the same dilemma in the second, third and fourth quarters of
2001. Each subsequent quarter she made more fraudulent entries. (Pulliam 2003)
Ms. Vinson began waking up in the middle of the night, unable to go back to sleep because of
her anxiety. Her family and friends began to notice she was losing weight and her face took on a
slightly gaunt look. At work she withdrew from co-workers, afraid she might let something slip. In
early 2002, she received a promotion, from senior manager to director, along with a raise that
brought her annual salary to about $80,000. (Pulliam 2003)
In March 2002 the SEC made requests for information from WorldCom and Cynthia Cooper,
head of internal auditing (see Chapter1) started asking questions. Ms. Vinson and two other
accountants hired an attorney and told their story to federal officials from the FBI, SEC and US
attorney, hoping to get immunity from prosecution for their testimony.
On August 1, 2002, Ms. Vinson received a call from her attorney telling her that the prosecutors
in New York would probably indict her. In the end, they viewed the information Ms. Vinson had
supplied at the meeting with federal officials as more of a confession than a tip-off to
wrongdoing. Within hours, WorldCom fired her because of the expected indictment. The only
thing she was allowed to take with her was a plant from her desk. (Pulliam 2003)
Two of her colleagues pleaded guilty to securities fraud. Unable to afford the legal bill that would
result from a lengthy trial, Betty Vinson decided to negotiate a guilty plea as well.
Discussion Questions
Was Betty Vinson justified in her actions because there were at the request of her
superiors? Why?
If you were in Ms. Vinson’s situation, what would you have done?
References English, S., 2003, “City – WorldCom boss on fraud charges,” The Daily Telegraph, September 4.
Lacter, M., 2003, “Looking the other way (Comment) (Editorial),” Los Angeles Business Journal,
June 30.
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Pulliam, S., 2003, “Over the Line: A Staffer Ordered To Commit Fraud Balked, Then Caved –
Pushed by WorldCom Bosses, Accountant Betty Vinson Helped Cook the Books – A Confession
at the Marriott,” The Wall Street Journal, June 23, p.1.
3.8 Enforcement of Ethical Requirements
The effectiveness of enforcing ethical standards varies from country to country. In many
countries an auditor who violates the ethical standard may be disciplined by law or by the
professional organization. The penalties range from a reprimand to expulsion or fine. In the USA
expulsion from a state society or the American Institute of Certified Public Accountants (AICPA)
does not mean that the expelled member cannot practice public accounting because only the state
boards of public accountancy have the authority to revoke a license. As illustrated in the case of
Arthur Andersen41 if a company is convicted of a felony, the US Security and Exchange
Commission (SEC) prohibits them from auditing publicly traded companies. In other countries such
as Japan, France and Germany government often takes a formal role in the enforcement of the
standards.
International Ethics Standards Board of Accountants (IESBA) has no authority to require
disciplinary action for violation of the Code of Ethics. IESBA relies on legislation or the
constitution of professional bodies in each country.
Disciplinary action ordinarily arises from such issues as: failure to observe the required
standard of professional care, skills or competence; non-compliance with rules of ethics and
discreditable or dishonorable conduct. Sanctions commonly imposed by disciplinary bodies
include: reprimand, fine, payment of costs, withdrawal of practicing rights, suspension, and
expulsion from membership. Other sanctions can include a warning, the refund of the fee charged
to the client, additional education, and the work to be completed by another member at the
disciplined member’s expense.
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3.9 Summary
The attitude and behavior of professional accountants in providing auditing and assurance
services have an impact on the economic well-being of their community and country. Accountants
can remain in this advantageous position only by continuing to provide the public with these unique
services at a level that demonstrates that the public confidence is well-founded. The standards of
the accountancy profession are heavily determined by the public interest. Therefore, a professional
accountant’s responsibility is not exclusively to satisfy the needs of an individual client or
employer.
The International Ethics Standards Board of Accountants (IESBA) Ethics Code is divided into
three parts:

Part A establishes the fundamental principles of professional ethics for all professional
accountants and provides a conceptual framework that is applied to: Identify threats to
compliance with the fundamental principles; evaluate the significance of the threats
identified; and apply safeguards, when necessary, to eliminate the threats or reduce them to
an acceptable level.

Parts B and C describe how the conceptual framework applies in certain situations. They
provide examples of safeguards that may be appropriate to address threats to compliance
with the fundamental principles. They also describe situations where safeguards are not
available to address the threats. Part B applies only to those professional accountants in
public practice; and Part C applies to employed professional accountants.
Rather than a list of rules that must be obeyed to be an ethical accountant, the so-called “rule
based” approach which holds sway in many countries, the IESBA and IFAC have chosen to use a
“conceptual framework” approach. A conceptual framework requires a professional accountant to
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identify, evaluate and address threats to compliance with the fundamental principles, rather than
merely comply with a set of specific rules which may be arbitrary.
The fundamental principles of ethics are described in Part A of the Code. They are: integrity,
objectivity, professional competence and due care, confidentiality and professional behavior. Part
A of the Code offers further discussion on these principles. Each concept is the topic of subsequent
Sections (110–150) in the Code.
Compliance with the fundamental principles may potentially be threatened by a broad range of
circumstances and relationships. The nature and significance of the threats may differ depending on
whether the audit client is a public interest entity, to an assurance client that is not an audit client,
or to a non-assurance client. The conceptual framework of the IESBA Code discusses ways to
identify threats to fundamental principles, determine the significance of those threats, and, if they
are significant, identify and apply safeguards to reduce or eliminate the threats. Threats fall into
one or more of the following categories: Self-interest; Self-review; Advocacy; Familiarity; and
Intimidation.
When threats are identified, other than those that are clearly insignificant, appropriate
safeguards should be identified and applied to eliminate the threats or reduce them to an acceptable
level. If elimination or reduction is not possible the auditor should decline or terminate the
engagement. When deciding what safeguards should be applied one must consider what would be
unacceptable to an informed third party having knowledge of all relevant information. Safeguards
fall into two broad categories: (1) safeguards created by the profession, legislation or regulation;
and (2) safeguards in the work environment
Whereas the ethics guidance discussed above is applicable to all professional accountants. Part
B of IESBA’s Code of Ethics is only applicable to accountants in public practice. A professional
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accountant in public practice is a professional accountant, irrespective of functional classification
(for example, audit, tax or consulting) in a firm that provides professional services. Part B describes
how the conceptual framework contained in Part A applies in certain situations to professional
accountants in public practice. Ethical guidance for accountants in public practice is offered in the
areas of: professional appointment, conflicts of interest, second opinions, fees and other
remuneration, marketing professional services, gifts and hospitality, custody of client assets,
objectivity, and independence for both audit and review engagements and other assurance
engagements.
An auditor who is asked to replace another auditor, or who is considering a new engagement
for a company currently audited by another auditor, must consider whether there are any reasons,
professional or otherwise, for not accepting the engagement. Determining possible reasons for not
accepting a new client may require direct communication with the existing auditor to establish the
facts and circumstances regarding the proposed change in auditors.
Across the world, national rules on auditors’ independence differ in several respects such as:
the scope of persons to whom independence rules should apply; the kind of financial, business or
other relationships that an auditor may have with an audit client; the type of non-audit services that
can and cannot be provided to an audit client; and the safeguards which should be used. The
European Commission has issued independence standards to be applied throughout the EU. The
USA enacted the Sarbanes-Oxley Act of 2002 that describes independence requirements of US
auditors.
The IESBA Code of Ethics for Professional Accountants, Part B Section 290, addresses the
independence requirements for audit engagements and review engagements. Independence
requirements for assurance engagements that are not audit or review engagements are addressed in
Section 291. The Code discusses independence in assurance services in terms of a principles-based,
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conceptual approach that takes into account threats to independence, accepted safeguards and the
public interest.
Accountants must not only maintain an independent attitude in fulfilling their responsibilities,
but the users of financial statements must have confidence in that independence. These two
objectives are frequently identified as “independence of mind” and “independence in appearance.”
Independence of mind (historically referred to as independence in fact) exists when the accountant
is able to maintain an unbiased attitude throughout the audit, so being objective and impartial,
whereas independence in appearance is the result of others’ interpretations of this independence.
The Ethics Code defines the two views. Independence of Mind is the state of mind that permits the
expression of a conclusion without being affected by influences that compromise professional
judgment, thereby allowing an individual to act with integrity and exercise objectivity and
professional skepticism. Independence in Appearance is the avoidance of facts and circumstances
that are so significant that a reasonable and informed third party would be likely to conclude,
weighing all the specific facts and circumstances, that a firm’s, or a member of the audit team’s,
integrity, objectivity or professional skepticism has been compromised.
The Ethics Code discusses independence in assurance services in terms of a principles-based
approach that takes into account threats to independence, accepted safeguards and the public
interest. The Section states principles that members of assurance teams should use to identify
threats to independence (self-interest, self-review, advocacy, familiarity and intimidation threats),
evaluate the significance of those threats, and, if the threats are other than clearly insignificant,
identify and apply safeguards created by the profession, legislation or regulation, safeguards within
the assurance client, and safeguards within the firm’s own systems and procedures to eliminate the
threats or reduce them to an acceptable level.
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Independence for audit and review services and possible threats and safeguards are given in
detail in Section 290, the largest section of the Code. Review and audit independence is discussed
in on the topics of conceptual framework, network firms, public interest entities, documentation,
engagement period, financial interests, loans and guarantees, business relationships, family and
personal relationships, employment with an audit client, temporary staff assignments, recent
service with an audit client, serving as director or officer of an audit client, long association of
senior personnel with audit clients, and other topics not covered in this chapter, including mergers
and acquisitions and related entities. Non-Assurance services discuss safeguards and threats of noassurance services to the audit client including the following topics: management responsibilities,
preparing accounting records and financial statements, taxation services, internal audit services, IT
systems services, valuation and litigation support services, legal services, recruiting services, and
corporate finance services. The independence section ends with a discussion of general topics
including fees, compensation and evaluation policies, gifts and hospitality, actual or threatened
litigation, and restricted reports (not discussed in this chapter).
Part C of the IESBA Code describes how the conceptual framework contained in Part A
applies in certain situations to professional accountants in business. A professional accountant in
business may be a salaried employee, a partner, director, an owner manager, a volunteer or another
working for one or more employing organization. Professional accountants in business may be
responsible for the preparation and reporting of financial and other information or for providing
effective financial management and competent advice on a variety of business-related matters. The
accountant has a responsibility to further the legitimate aims of the accountant’s employing
organization. A professional accountant in business is expected to encourage an ethics-based
culture in an employing organization that emphasizes the importance that senior management
places on ethical behavior.
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The effectiveness of enforcing ethical standards varies from country to country. In many
countries an auditor who violates the ethical standard may be disciplined by law or by the
professional organization. The penalties range from a reprimand to expulsion or fine. In the USA
expulsion from a state society or the American Institute of Certified Public Accountants (AICPA)
does not mean that the expelled member cannot practice public accounting because only the state
boards of public accountancy have the authority to revoke a license. As illustrated in the case of
Arthur Andersen if a company is convicted of a felony, the US Security and Exchange Commission
(SEC) prohibits them from auditing publicly traded companies. In other countries such as Japan,
France and Germany government often takes a formal role in the enforcement of the standards.
\
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3.10 Notes
1
Other definitions of ethics are (1) the discipline dealing with what is good and bad and with moral duty and
obligation – Merriam-Webster Dictionary, (2) The moral correctness of specified conduct – for instance, the
ethics of euthanasia. Or (3. )The branch of knowledge that deals with moral principles - Wikipedia
2
Developed by the Josephson Institute for the Advancement of Ethics, a US not-for-profit
foundation to encourage ethical conduct of professionals in the fields of government, law,
medicine, business, accounting and journalism.
3
Internet Encyclopedia of Philosophy: http://www.iep.utm.edu/ethics
4
Ibid.
5
An Assurance service or assurance engagement is an engagement in which a practitioner
expresses a conclusion designed to enhance the degree of confidence of the intended users other
than the responsible party about the outcome of the evaluation or measurement of a subject matter
against criteria
.
6 International Ethics Standards Board of Accountants (IESBA). 2010. Introduction – Objectives,
para.100.1, Handbook of the Code of Ethics for Professional Accountants 2010 Edition,
International Federation of Accountants, New York.
7
Please note, the Code of Ethics for Professional Accountants is so clear that this chapter will use
several direct quotes from the Code. To distinguish the direct quotes from the authors’ discussion,
the direct quotes will be in bold font.
8
The Dutch version (or translation) of the Code of Ethics distinguishes between Part B1 and Part B2, making
a distinction between accountants (auditors) in public practice and internal accountants (auditors) as opposed
to Part B and C. Other translations may have similar distinctions. The original code does not make this
distinction.
9
This book and the Code of Ethics (implicitly) assume a scalability of threats to the fundamental principles.
One can challenge whether this is possible regarding fundamental principles.
10
Ehrliner, J. Thomas Gilovich, & Lee Ross (2005). Peering Into the Bias Blind Spot:
People’s Assessments of Bias in Themselves and Others. Page 2. Personality and Social Psychology Bulletin,
31, 1-13.
11
Project Implicit web site https://implicit.harvard.edu/implicit/
12
A subject matter of an assurance is the topic about which the assurance is conducted.
13
IESBA Code of Ethics for Professional Accountants, paragraph 210.1.
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14
International Auditing and Assurance Standards Board (IAASB). 2012. International Standard on Auditing
220 (ISA 220). “Quality Control For An Audit Of Financial Statements.” Handbook of International Quality
Control, Auditing, Review, Other Assurance, and Related Services Pronouncements, 2012 Edition, Volume I.
International Federation of Accountants. New York
15
International Auditing and Assurance Standards Board (IAASB). 2012. International Standard on Auditing
620 (ISA 620). “Using the Work of an Auditor’s Expert.” Handbook of International Quality Control,
Auditing, Review, Other Assurance, and Related Services Pronouncements, 2012 Edition, Volume I.
International Federation of Accountants. New York
16
Existing auditor is the auditor who is currently holding an audit or assurance services
appointment with the prospective client.
17
IESBA Code Of Ethics For Professional Accountants paragraph 220.1
18
IESBA Code Of Ethics For Professional Accountants paragraph 220.5
19
IESBA Code Of Ethics For Professional Accountants paragraph 270.1
20
IESBA Code Of Ethics For Professional Accountants paragraph 280.2
21
Council of European Communities, Eighth Council Directive of 10 April 1994, Article24, Official Journal
of the European Communities, No.L126, 12.5.1984, pp.20–26.
22
Statutory audits are audits established by law.
European Union Committee on Auditing, 2002, Commission Recommendation, Statutory Auditors’
Independence in the EU: A Set of Fundamental Principles, 2002/590/EC, Official Journal of the European
Communities, 19.7.2002, pp.L191/22–L191/97.
23
24
Ibid. Commission Recommendation para.11.
25
The Senate and House of Representatives of the United States of America, Sarbanes-Oxley Act of 2002,
Public Law 107–204, July 30, 2002.
SEC, 2003, Final Rule: Strengthening the Commission’s Requirements Regarding Auditor Independence;
Rel. Nos. 33-8183, 34-47265; 35-27642; IC-25915; IA-2103; File No. S7-49-02, Securities and Exchange
Commission, January 28.
26
Barnier, Michel. 2012. “Audit Reform: Michel Barnier”. The Parliament.com.
http://www.theparliament.com/latest-news/article/newsarticle/audit-reform-michel-barnier/
27
28
European Commission. 2010. “Green Paper, Audit Policy: Lessons from the Crisis”. October. Brussels
Pendergast, Marilyn A., “Strengthening the Commission’s Requirements Regarding Auditor
Independence: file s7-49-02,” International Federation of Accountants, New York, January 10,
2003.
29
30
IESBA Code Of Ethics For Professional Accountants paragraph 290.6
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Ibid
32
IESBA Code Of Ethics For Professional Accountants paragraph 290.4
33
70
A Network firm is a firm or entity that belongs to a network. A Network is a larger structure that
is aimed at cooperation, and is clearly aimed at profit or cost-sharing or shares common ownership,
control or management, common quality control policies and procedures, common business
strategy, the use of a common brand name, or a significant part of professional resources.
34
IESBA Code Of Ethics For Professional Accountants paragraph 290.29
35
IESBA Code Of Ethics For Professional Accountants paragraph 290.30
36
IESBA Code Of Ethics For Professional Accountants paragraph 290.104
IESBA Code of Ethics for Professional Accountants paragraphs 290.162 – 164 describe what
management responsibilities might be.
37
38
IESBA Code Of Ethics For Professional Accountants paragraph 290.174 describes Emergency
Situations
39
40
See IESBA Code of Ethics for Professional Accountants paragraph 290.227.
IESBA Code Of Ethics For Professional Accountants paragraph 300.6
41
Arthur Andersen was one of the largest auditing firms in the world (one of the Big Five) when
they were convicted by the US Department of Justice of obstruction of justice (a felony) when in
2001, the Houston, Texas, branch shredded documents relating to their audit client, Enron
Corporation. See Concept and a Company 2.2 in Chapter 2.
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