Chapter 4
AICPA Code of Professional Conduct
Questions for Consideration
1. What are the ethical obligations of CPAs
under the AICPA code?
2. What is the role of independence in an audit
and how can CPAs manage the threats that
exist to audit independence?
3. What are the professional and ethical
obligations of CPAs in performing nonattest
services including tax services?
Independent Audit
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Foundation for accounting profession
Trust by the public in audit opinion
Public obligation supersedes that to a client
Total independence from client
Members should act with integrity
Clients’ and employers’ interest served by
fulfilling responsibility to public
Public Interest in Accounting
• Major fraudulent financial statement frauds in
early 2000s; effected virtually every continent
– Public trust in accountants compromised
– Lack of internal controls, ineffective internal
audits, and inattentive BOD all share blame for
these frauds
– How to rebuild public trust and confidence in
financial reporting
– Profession must rebuild its reputation on its
historical foundation of ethics and integrity
The International Federation of
Accountants (IFAC)
• Examined ways to restore credibility of financial
reporting and recommended:
– More effective corporate ethics codes
– Provision of training and support for individuals within
organizations
• International Ethics Standards Board of
Accountants (IESBA) & International Accounting
Education Standards Board (IAESB)
– Establish guidelines for about 2.5 million accountants
– AICPA agrees to have ethics standards that are at least
as stringent as the IESBA standards
Professional Ethics Identified by IESBA
• Fundamental principles: integrity, objectivity,
professional competence and due care, confidentiality,
and professional behavior
• Ethics education needed to:
– Develop a sense of ethical responsibility in accountants
– Improve the moral standards and attitudes of accountants
– Develop the problem-solving skills that have ethical
implications
– Develop a sense of professional responsibility or obligation
• State boards of accountancy realize need for ethics
education to incorporate behaviors and attitudes with
ethics and ethical reasoning
Investigations of the Profession
• High profile frauds in the 1970s, 1980s, 2000s
• Congressional concern of auditors’ ethical and
professional responsibilities
• Themes of investigations
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Nonaudit services impairing auditor independence
Management to report on internal controls
Prevention and detection of fraud
Role of audit committee and communication
between them and auditors
Metcalf (Moss) Committee
• First investigation of profession since 1930s
• Conducted between 1975-1977
• Some recommendations
– Establish self-regulatory organization of firms
– Led to AICPA two-tier voluntary peer review program
• Public company clients (assumed by PCAOB in 2004)
• Private companies
– Limitation of management service to those directly
related to accounting
• Report didn’t lead to any new legislation at the
time
Cohen Commission
Examined issues:
• Auditor’s responsibility for detecting fraud
• Expectation gap between public expectations and profession’s goals for the
audit
Recommendations:
• Management should report on its internal controls
• Auditors should evaluate management’s report
• Both enacted as part of Sarbanes-Oxley Act of 2002
Importance of Cohen Commission:
• Demonstrated conflicts of providing nonauditing services for an audit client
• Lowballing fees
– Deliberately underbidding for an audit; Less prevalent after SOX
• Opinion shopping
– Client seeks auditor who will go along with accounting treatment
• Later Major scandals
– 1980s – Savings and Loan Crisis
– 1990s – 2000s – Earnings Management Crisis
Early 1980s
• Fraud failure with ESM Government Securities,
Continental Illinois National Bank and Trust, and
Penn Square Bank
• Rep. Wyden authored 1986 bill to hold auditors
responsible for fraud detection
• Rep. Shad modified bill
– Internal control reports
– Detection of Material illegalities or irregularities
– Bill did not pass
• ZZZZ Best Co.
– Created fictitious revenue that amounted to 80% of
total revenue; Rep. Dingell chaired investigation;
auditors did not disclose fraud to authorities
Savings and Loan Failures: Late 1980’s
& Early 1990’s
• $300 million failure - Beverly Hills Savings and Loan
• $250 million failure - Sunrise Savings
– Deloitte & Touche audit
• $400 million overstatement at Western Savings Association
– Arthur Young audit
• Lincoln Savings and Loan
– Arthur Young Role gave unqualified opinion
• Accounting issues in failed S&Ls centered on three issues:
– Inadequate allowances for loan losses
– Non-disclosure of related party transactions
– Inadequate internal controls
Treadway Commission Report
• The National Commission on Fraudulent Financial Reporting
• 1985 study and report on factors leading to fraudulent
financial reporting; formed in response to S&L debacle
• Sponsored by Committee of Sponsoring Organizations (COSO)
• COSO 1992 Internal Control Project most significant
contribution to date
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Need to change the corporate culture
Establish systems to prevent fraud
Tone at the Top – sets ethical tone of organization
Extended review to role and responsibilities
• Internal Auditors
• External Auditors
• Board of Directors
– Importance of strong control environment
– Internal auditors must have direct and unrestricted access to Audit
Committee of BOD
• COSO Enterprise Risk Management – Integrated Framework
2007 – 2008 Financial Crisis
• Excessive risk taking
• Mortgage meltdown
• Moral Hazard – One person responsible for the
interests of another, but has incentive to put own
interests first
• Concern over independence, objectivity, and audit
quality
• Growing personal and business relationships between
auditing firms, the client, and client management
• Emphasis on marketing of professional services
• Lehman’s Brothers
Lehman’s Financial Transactions and
Accounting Disclosures
• Insufficient liquidity to meet its current obligations
• CEO, CFOs, and external auditors all failed to meet
professional responsibilities
• Lehman used “Repo 105”, did not disclose its use
• Share dropped 94% over 8 months, from $62.19 to $3.65 a
share
• U.S. refused to fund a solution for Lehman
• SEC unit knew about problems and did nothing
• SEC requires mandatory rotation of key audit personnel
within a firm every five years
• Controversial proposal is to institute a mandatory auditor
rotation policy whereby every few years (i.e., 5 or 10 years)
there would be a required change in the audit firm
AICPA, State Boards, NASBA
• AICPA
– Code of Conduct model for state societies codes
– Applies to members of these voluntary organizations
• State boards of accountancy
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License accountants in a given state
Establishes standards of professional conduct
Most important rules to follow
Rules take precedent over AICPA
• National Association of State Boards of Accountancy
(NASBA)
– 55 state boards of accountancy
– Uniform accountancy act
• Either/or approach for ethics education
• Substantial equivalency provision
Professional Services of CPAs
• Cornerstone ethical obligation to society is to
render an opinion on the financial statements
– Review - assurance that no material modifications
needed
– Audit - reasonable assurance that financial statements
are free of material misstatements
• Compilation - based on data provided
– No assurance
– Independence not required
• SOX prohibits performance of certain services for
audit clients
– Create conflict of interest
– Impairs independence
– Cannot act as member of client’s management
AICPA and IFAC Code of Professional
Conduct
• Apply to CPAs
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Public accounting
Private industry
Government agencies
Educational institutions
• Covered professional services
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Accounting
Auditing and assurance services
Taxation
Financial advisory services
Consulting services
Practice of Public Accounting
• Performance of specific services for a client
• Holding out as a CPA
• Professional services
– Accounting
– Auditing
– Tax
– Personal financial planning
– Litigation support
– Advisory services
– Consulting
AICPA and IFAC Principles of
Professional Conduct
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Integrity principle should be used when:
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Accounting rules are unclear
Difference of opinion with an employer or client on an
accounting issue
Conflicts between the interests of stakeholder groups
IFAC fundamental principles
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Integrity; Objectivity; Professional Competence and Due
Care; Confidentiality; and Professional Behavior
IFAC explicitly recognizes compliance with relevant laws
and regulations and avoiding actions that bring discredit
on the profession; also explicitly recognizes a
Confidentiality principle
Conceptual Framework for AICPA
Independence Standards
• Independence required for audit and other
attestation services; in fact and in appearance
• AICPA uses risk based approach for analyzing
threats using the following steps:
– Identifying and evaluating threats to independence
– Determining whether safeguards already eliminate or
sufficiently mitigate identified threats and whether
threats that have not yet been mitigated can be
eliminated or sufficiently mitigated by safeguards
– If no safeguards are available to eliminate an
unacceptable threat or reduce it to an acceptable
level, independence would be considered impaired
Threats to Independence
Independence must be in fact and appearance
Threats include:
• Self review threat
• Advocacy threat
• Adverse interest threat
• Familiarity threat
• Undue influence threat
• Financial self-interest threat
• Management participation threat
• Safeguards to counteract threats:
– Safeguards created by the profession, legislation, or regulation
– Safeguards implemented by the attest client
– Safeguards implemented by the firm
Financial Relationships that Impair
Independence
• Direct or material indirect financial interest in
a client
• Loans to or from a client
– Example: Alexander Grant and ESM
– Permitted Loans
• Automobiles loans collateralized by the car
• Loans fully collateralized by cash deposits at the same
financial institution (passbook loans)
• Credit cards and overdraft accounts of $10,000 or less
Other Relationships
• Family Relationships
– Immediate family members
• Spouse or spouse equivalent, or dependents
– Close relatives in financial sensitive position with the
client or material financial interest
• Parent, sibling, or nondependent child
– Subject to independence rule if CPA knows member
has material financial interest
• Business Relationships
– Partner or manager who provides more than 10 hours
of nonattest services to the attest client
– Partnerships or joint ventures with attest client
Providing Nonattest Services to an
Attest Client
• Certain lucrative nonattest services creates a
conflict of interests
• Gives the client leverage over the CPA firm and its
audit opinion
• Client must agree to perform the following
functions:
1. Make management decisions and perform all
management functions
2. Designate competent overseer of these services
3. Evaluate adequacy and results of services performed
4. Accept responsibility for the results of the services
5. Establish and maintain internal controls
SEC Positions
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Emphasizes independence in fact and appearance in 3
ways:
1. Proscribing certain financial interests and business
relationships with the audit client
2. Restricting certain nonauditing services to audit clients
3. Subjecting all auditor conduct to a general standard of
independence
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3 principles that underlie auditor independence:
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An auditor cannot function in the role of management
An auditor cannot audit her own work
An auditor cannot serve in an advocacy role for her client
General Standard of Independence
• Judged by a reasonable investor with knowledge of all
relevant facts and circumstances
• Auditor must be capable of exercising objective and
impartial judgment on all issues within the engagement
• Principles
– Situations which impair independence
1. Creates a mutual or conflicting interest between an
accountant and his audit client
2. Places an accountant in the position of auditing his own work
3. Results in an accountant acting as management or employee
of the audit client
4. Places an accountant in position of being an advocate for the
audit client
SEC Actions Against Auditing Firms
PeopleSoft Case
• EY and PeopleSoft developed a software program
• Joint sales and marketing; license fees and royalty
• Mutuality of interests/financial self-interest
threat
KPMG Audit Partner, Scott London
• Insider Trading on Skechers and Herbalife
• Leaking confidential information to jeweler friend
Deloitte Management Advisory Partner, Thomas
Flannigan
• Insider trading by Flannigan and son
Sarbanes-Oxley Provisions: Prohibited
Nonattest Service for Public Clients
1. Financial information systems design and implementation
2. Appraisal or valuation services, fairness opinions, or
contribution-in-kind reports
3. Actuarial services
4. Internal audit outsourcing services
5. Management functions or human resources
6. Broker or dealer services, investment adviser, or
investment banking services
7. Legal services and expert services unrelated to the audit
8. Any other service prohibited by BOD
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Tax services must be preapproved by the audit committee
Corporate Responsibility for
Financial Reports
• CEO and CFO certify financial reports
– No untrue statement of material facts
– No omission or misleading material facts
• Required by section 302 of SOX
• Penalties in section 906 of SOX
– Maximum fine of $1 million
– Maximum imprisonment is 10 years
– Or both fine and imprisonment
– Willful false certification - $5 million and 20 years,
or both
HealthSouth:
The Case of Richard Scrushy
• First major test of Section 302 in 2003
• Earnings restatement of $2.7 billion
• State acquitted Scrushy but SEC brought
successful federal suit against him
• Sanctions and penalties
– Permanently barred from public company officer
or director
– Permanently enjoined from future violations
– Requires payment of $81 million in disgorgement
and civil penalties
Principles of Professional Practice
• Integrity and objectivity
– Rule 102 of AICPA Code
– IESBA takes a broader view than the AICPA
– Quality of CPA
• Section 200 of Code outlines basic principles for
requirements to follow professional standards in
public accounting—i.e., GAAP, SAS, SSARS
• Rule 201: Due Care
– Perform services competently, accurately, and
completely
– Quality of services
Other Professional Standards
• Rule 203 of the AICPA Code
– Financial statements in conformity with GAAP
– Disclosures in conformity with GAAP
– Applies equally to internal and external
accountants
• 2 sources of GAAP:
– (1) authoritative standards
– (2) nonauthoritative
Responsibilities to Clients
• Rule 301: confidential client information
– CPA’s obligation not to divulge client information (unless client agrees)
– Internal whistle blowing allowed; external may violate confidentiality
– Permitted disclosure of confidential client information
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Response to validly issues subpoena or summons
Adherence to applicable laws and regulations
Compliance with peer review of CPA practice
Defense in an investigation of the CPA
• Rule 502: Advertising and solicitation permitted
– Requires that advertising not be false, deceptive or misleading or
imply ability to influence official bodies
– Prohibits solicitation by use of coercion, over-reaching, or harassing
conduct
– CPAs “pushing the envelope”
Confidentiality/Illegal Acts &
Whistleblowing
• When the auditor believes a client has
committed an illegal act that has a material
effect on the financial statements, the matter
must be reported to the audit committee.
• The board then has one business day to
inform the SEC. If the board decides not to
inform the SEC, the auditor must provide the
same report to the board within one business
day or resign from the engagement.
Auditor Obligation to Blow the Whistle on Illegal Acts
• If a client refuses to accept an auditors’ report
that has been modified in any of the following
situations, the public accounting firm should
withdraw from the engagement and give its
reasons in writing to the board of directors:
• (1) the inability to obtain sufficient appropriate
evidence about a suspected illegal act; (2) failure
to account for or disclose properly a material
amount connected with an illegal act; or (3) the
inability to estimate amounts involved in an
illegal act.
Responsibilities to Clients (Cont)
• Rule 302 Contingent fees from an attest (audit) client
– Prohibits acceptance of contingent fees if CPA or firm
performs any of the following:
(1) an audit or review of a financial statement
(2) compilation of financial statement that third party may use
(3) examination of prospective financial information
(4) prepares original/amended tax return
– Permits acceptance of contingent fee based upon initiation
by and findings of governmental agencies
• Rule 503 Commissions
– Cannot accept a commisson from audit client
– Commissions require a disclosure by a CPA to the client
when recommending that service or product to which the
commission relates
Ethical Standards in Operating
a CPA Practice
• State boards have regulatory authority over
practice units and alternative practice
structures (APS), as well as individual CPAs
• Rule 505 permits practice of public accounting
only in form of organization permitted by state
law or regulation
• Prohibits use of a firm name that is misleading
• Requires that a majority of the ownership of
the firm belongs to CPAs to be a CPA firm
Acts Discreditable
• Client Books and Records
– Client-provided records
– Member-prepared records, product or papers
– Reasonable time period, reasonable fee
• Negligence in the Preparation of Financial Statements
or Records
• Other
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Discrimination and harassment
Failure to follow standards
Solicitation or disclosure of CPA exam questions
Failure to file tax returns or pay taxes
False, misleading, or deceptive acts in promoting or
marketing professional services
Client Books/CPA Work Papers
• Client-provided records in the custody or control
of the CPA should be returned to the client at the
client’s request.
• Unless a CPA and the client have agreed to the
contrary, when a client makes a request for
member-prepared records, or a member’s work
products that are in the custody or control of the
CPA/CPA firm that have not previously been
provided to the client, the member should
respond to the client’s request as follows:
Client Books/CPA Work Papers
• Member-prepared records relating to a completed and issued work
product should be provided to the client, except that such records may be
withheld if there are fees due for the specific work product.
• Member’s work products should be provided to the client, except that
such work products may be withheld in any of the following
circumstances:
• If there are fees due to the member for the specific work product
• If the work product is incomplete
• For purposes of complying with professional standards (for
example, withholding an audit report due to outstanding audit issues)
• If threatened or outstanding litigation exists concerning the
engagement or member’s work
• For purposes of complying with professional standards (for
example, withholding an audit report due to outstanding audit issues)
• If threatened or outstanding litigation exists concerning the
engagement or member’s work
Ethics and Tax Services
• Rule 101 – audit independence may be impaired
by certain tax services
• Rule 102 – maintain integrity and objectivity in
performing tax services
• Rule 201 – exercise of due care
• Rule 202 – follow professional standards,
Statements on Standards for Tax Services
• Rule 301 – confidentiality
• Rule 302 – acceptance of contingent fees
Tax Compliance Services
• Preparation of a tax return
• Transmittal of a tax return
• Transmittal of any related tax payment to the
taxing authority
• Signing and filing a tax return
• Authorized representation of clients in
administrative proceedings before a taxing
authority
• May not impair a CPA’s independence
Statements on Standards for Tax
Services
• 7 statements explain CPAs’ responsibilities to their clients and the tax
systems
• Tax different from audit:
– Independence requirement for an auditor does not pertain to the tax
practitioner
– Objectivity relates to tax services differently
• SSTS No.1, Tax Return Positions
– CPA should not recommend a tax position that minimizes tax burden unless it
has a “realistic possibility of success”
• More likely than not (greater than 50%); substantial authority (40% likelihood); realistic
possibility of success(33%); reasonable basis (20%)
– CPA doesn’t need to satisfy realistic possibility in tax planning if all of the
following are true: reasonable basis exists for position, CPA recommends
appropriate disclosure, and higher standard is not required under laws
• Commitment to balance advocacy and planning with compliance
• Tax return information is taxpayer’s representation of facts
• CPA can recommend a non-frivolous position with appropriate disclosure
Tax Shelters
• Sometimes called tax avoidance transactions
• “Prohibited tax shelter transaction" means listed
transactions, transactions with contractual protection, or
confidential transactions
• Investments to help wealthy clients avoid paying taxes
• In KPMG case, the firm prepared false documents to
deceive regulators (fraud)
– KPMG shelters broke the law since no economic risk and
designed solely to minimize taxes
– KPMG shelters generated $11 billion in fraudulent losses and
$2.5 billion in tax evaded
– KPMG settled criminal tax case for $456 million
• Most recent tax shelter scandal: BDO failed to register
various tax shelters as required by law
PCAOB Rules on Tax Services
Variety of standards that pertain to ethics and independence:
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Rule 3520: Auditor Independence
Rule 3521: Contingent Fees; mirrors rules 302 & 503 of AICPA code
Rule 3522: Tax Transactions; “aggressive tax position” transaction
Rule 3523: Tax Services for Persons in Financial Reporting Oversight
Roles; not independent if firm provides tax services to persons who
serve in financial reporting oversight roles at an audit client unless:
• Person only serves as member of BOD
• If member serves in an affiliate of audit company and has non material
financial statements
• Person was not in role when audit began
– Rule 3524: Audit Committee Pre-Approval of Certain Tax Services
– Rule 3525: Audit Committee Pre-Approval of Nonaudit Services
Related to Internal Control Over Financial Reporting
– Rule 3526: Communication With Audit Committees Concerning
Independence