You are on page 1of 26

C HAPTER 3

P ROFESSIONAL E THICS
Learning Check
3.1.

General ethics attempts to deal with two questions that can serve as guides to behavior:
(1) "What good do I seek?" and (2) "What is my obligation in this circumstance?"
General ethics attempts to deal with these questions by defining what is good for the
individual and society, and by trying to establish the nature of obligations or duties that
individuals owe themselves and each other.

3-2.

The ethical absolutist school of thought says there are universal standards that do not
change over time that apply to everyone. The ethical relativist school of thought says that
people's ethical judgments are determined by the changing customs and traditions of
society in which they live.

3-3.

a. The six steps in one general framework for ethical decision making are:
1. Obtain the facts relevant to the decision.
2. Identify the ethical issues from the facts.
3. Determine who will be affected by the decision and how.
4. Identify the decision maker's alternatives.
5. Identify the consequences of each alternative.
6. Make the ethical choice
b. Examples may vary. One example may be underreporting of time by a staff
accountant. A staff member may feel that he or she should not report the full time
that it takes to complete an audit task. The ethical issue is that audit management
does not know the full time required to complete a task. The person may also not get
paid for overtime worked. In some cases staff may feel pressure to meet unrealistic
budgets.

3-4.

a. Professional ethics provide members of a profession with guidelines for behavior that
enhance the stature of the profession. They include standards of behavior for a
professional person that are designed for both practical and idealistic purposes. They
must be both realistic and enforceable; they should be above the law but below the
ideal.

.b Professional ethics are imposed by a profession on its members who voluntarily
accept standards of professional behavior more rigorous than those required by law.
They are generally promulgated through a code of ethics.
3-5.

a. The core values identified in the CPA Vision Project are (1) integrity, (2) objectivity,
(3) competence, (4) continuing education and lifelong learning, and (5) attunement to
business issues.
b. Integrity, which means practicing with honesty and acting with professional ethics, is
critical earning the public trust. A CPAs opinion on the financial statements would
be worthless without confidence that CPAs are honest and act with integrity.
Objectivity and the freedom of bias or conflicts of interest allows CPAs to earn both
a client’s and the public’s trust. CPAs must demonstrate competence in GAAP,
GAAS, and in their ability to understand the connection between business
performance and reported financial performance in order to earn the confidence of
those who rely on the CPAs work. Continuing education and lifelong learning is
important to ensuring the public confidence in a CPAs ability to maintain cutting
edge skills in a rapidly changing environment. Attunement to broad business issues
is what separates CPAs from other professionals and allows CPAs to exercise the
professional judgment that is so important in accounting and auditing. In
combination, these core values have helps CPAs earn a reputation for being a trusted
in their role as independent auditors.

3-6.

The Professional Ethics Division of the AICPA functions through an executive committee
that is responsible for:
o Standard setting: The Professional Ethics Executive Committee interprets the
AICPA Code of Professional Conduct and proposes amendments to the code of
conduct.
o Ethics enforcement: The Professional Ethics Team investigates complaints of
potential disciplinary matters involving members of the AICPA and state CPA
societies through the Joint Ethics Enforcement Program (JEEP).
o Technical inquiry services (“ethics hotline”): The professional Ethics Team
educates members and promotes the understanding of ethical standards contained in
the AICPA Code of Professional Conduct by responding to member inquiries on the
application of the AICPA Code of Professional Conduct to specific areas of practice.

3-7.

a. The two sections of the AICPA's Code of Professional Conduct are (a) the Principles
and (b) the Rules of Conduct. The two types of pronouncements related to them are
Interpretations of the Rules of Conduct and Ethics Rulings.
b. Only the Rules of Conduct are meant to be enforceable. However, the CPA must
justify any departures from the Interpretations and Ethics Rulings.

3-8.

a. The principles express the basic tenets of ethical conduct and provide the framework
for the rules.

b.

The principles and their essence are:
 Responsibilities - members should exercise sensitive professional and moral
judgments in all their activities.

3-9.

Public interest - members should act in a way to serve the public interest, honor
the public trust, and demonstrate commitment to professionalism.
Integrity - members should have the highest sense of integrity.

Objectivity and independence - a member should maintain objectivity and be
free of conflicts in all engagements and be independent in fact and in
appearance in rendering auditing and attest services.

Due care - a member should observe the profession’s technical and ethical
standards, strive continually to improve competence and the quality of service,
and discharge professional responsibilities to the best of the member's ability.

Scope and nature of services - the Principles of the Code should be observed in
determining the scope and nature of services to be provided.

a. The authority of the rules is provided in the bylaws of the AICPA.
b. The rules differ in their applicability. Six rules apply only to members in public
practice whereas the remainder apply to all members, which includes members in
industry, and members in public practice who perform no attest services.

3-10.

The following trends influenced the adoption of an engagement based approach to
independence by both the SEC and the AICPA.

CPA firms have many professionals all over the globe, along with their family
members, who have no influence over an audit.

CPA firms have seen an increase in the number of dual-career families who
potentially have independence problems when an accounting professional’s
spouse receives compensation through stock options or other stock ownership
schemes from an employer who is also an audit client. More employees in
various business are also receiving compensation through the award of ownership
shares in a company.

3-11. a. The following table defines a covered person and explains the activities that are
prohibited for a covered person under the AICPA independence rules.
Covered Person

Any member of the engagement team

Partners and managers with consultation, oversight, or review
responsibilities related to the engagement.

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

Professionals who perform (or expect to perform) more than
10 hours of nonattest services for the client.

Prohibited Activities

Cannot have a direct, or a material indirect,
investment in the audit client.

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

Cannot have a joint, closely held investment that is




Partners who are in the same office as the lead partner on the
engagement.
The firm, its benefit plans, and entities controlled by covered
members
Those who evaluate partners’ performance and
compensations, including members of compensation
committees
Individuals who consult with the audit team regarding
technical or industry-related issues specific to the
engagement. This is intended to include individuals who are
authorized to give advice to the audit team, and there is no
hours test.
Individuals who participate in quality control activities for the
firm.

material to the covered member.
Cannot have loans to or from the audit client. (There
are some very limited exceptions.)

b. The following table defines immediate family members and explains the activities
that are prohibited for immediate family members of a covered person.

Covered Members’ Immediate Family

Spouse

Spousal equivalent

Dependents

Prohibited Activities

Cannot have a direct, or a material indirect,
investment in the audit client.

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

Cannot have a joint, closely held investment that is
material to the covered member.

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

Cannot be employed in a “key position” with an audit
client.
o In a position to exercise influence over the
financial statement, such as CEO, CFO,
member of the board of directors, or
treasurer.
o Prepares, or supervises others who prepare,
(1) the financial statements or (2) material
accounting records.
o Involved in accounting decision-making.

c. The following table defines close relative and explains the activities that are
prohibited for a close relative of a covered person.
Covered Persons’ Close Relatives

Parents

Nondependent children

Brothers and sisters

Prohibited Activities

May not hold a key position with an audit client.

May not hold a material financial interest in an audit
client, or have significant influence over an audit
client (APB 18).

d. The following table defines other professional employees and explains the activities
that are prohibited for other professional employees.
Other Professional Employees

Any other professional employee in the accounting firm.

The immediate family members of other professional
employees.

3-12. a.

Prohibited Activities

Cannot have a direct investment of 5% or more in an
audit client.

Cannot have a business or key position employment
relationship with an audit client.

Cannot be a trustee, director or officer of an audit
client, or a client’s pension or profit-sharing trust.

Section 206 of the Sarbanes-Oxley Act of 2002 states that the CEO, Controller, CFO,
Chief Accounting Officer, or person in an equivalent position cannot have been
employed by the company’s audit firm during the one-year period preceding the
audit.

b. A private company can employ a partner or other professional employee of its audit
firm if all the following conditions are met.
1. Amounts due to the former partner or professional employee for his or her
previous interest in the firm and for unfunded, vested retirement benefits are not
material to the audit firm, and the underlying formula used to calculate the
payments remains fixed during the payout period. Retirement benefits may also
be adjusted for inflation, and interest may be paid on amounts due.
2. The former partner or professional employee is not in a position to influence the
accounting firm's operations or financial policies.
3. The former partner or professional employee does not participate or appear to
participate in, and is not associated with the firm, whether or not compensated for
such participation or association, once employment or association with the client
begins. An appearance of participation or association results from such actions as:
 The individual provides consultation to the firm.
 The firm provides the individual with an office and related amenities (for
example, secretarial and telephone services).
 The individual's name is included in the firm's office directory.
 The individual's name is included as a member of the firm in other
membership lists of business, professional, or civic organizations, unless
the individual is clearly designated as retired.
4. The ongoing attest engagement team must consider the appropriateness or
necessity of modifying the engagement procedures to adjust for the risk that, by
virtue of the former partner or professional employee's prior knowledge of the
audit plan, audit effectiveness could be reduced.
5. The firm must assesses whether existing attest engagement team members have
the appropriate experience and stature to effectively deal with the former partner
or professional employee and his or her work, when that person will have
significant interaction with the attest engagement team.
6. The subsequent attest engagement should be reviewed to determine whether the
engagement team members maintained the appropriate level of skepticism when
evaluating the representations and work of the former partner or professional

employee, when the person joins the client in a key position within one year of
disassociating from the firm and has significant interaction with the attest
engagement team. The review should be performed by a professional with
appropriate stature, expertise, and objectivity and should be tailored based on the
position assumed at the client, the position he or she held at the firm, the nature of
the services he or she provided to the client, and other relevant facts and
circumstances. Appropriate actions, as deemed necessary, should be taken based
on the results of the review.
In addition, a partner or a professional employee merely seeking employment with an
audit client may also impair independence. Rule 101-2 states that when a member of the
attest engagement team or an individual in a position to influence the attest engagement
intends to seek or discuss potential employment or association with an attest client, or is
in receipt of a specific offer of employment from an attest client, independence will be
impaired with respect to the client unless the person promptly reports such consideration
or offer to an appropriate person in the firm, and removes himself or herself from the
engagement until the employment offer is rejected or employment is no longer being
sought.
3-13. a. The following nonattest services impair independence when they are performed for
an audit client.
 Bookkeeping or other services related to the accounting records or financial
statements of the audit client.
 Financial information systems design and implementation.
 Appraisal or valuation services, fairness opinions, or contribution-in-kind reports.
 Actuarial services.
 Internal audit outsourcing services.
 Management functions or human resources.
 Broker or dealer, investment advisor, or investment banking services.
 Legal services and expert services unrelated to the audit.
 Any other service that the PCAOB determines, by regulation, is impermissible.
b. The following general activities impair independence when they are performed for a
private company.
 Authorizing, executing, or consummating a transaction, or otherwise exercising
authority on behalf of a client or having the authority to do so.
 Preparing source documents or originating data, in electronic or other form,
evidencing the occurrence of a transaction (for example, purchase orders, payroll
time records, and customer orders).
 Having custody of client assets.
 Supervising client employees in the performance of their normal recurring
activities.
 Determining which recommendations of the member should be implemented.
 Reporting to the board of directors on behalf of management.

Serving as a client's stock transfer or escrow agent, registrar, general counsel, or
its equivalent.

3-14. The ethical standards that apply to a CPA who is a CFO for a company include:

3-15.

Rule 102: Integrity and Objectivity

Rule 201: General Standards

Rule 202: Compliance with Standards

Rule 203: Accounting Principles

Rule 501: Discreditable Acts

a. Rule 201focus on the technical qualifications of a member and the ability of a
member to review and supervise the work of others.
b. The four subcategorizes are (1) professional competence, (2) due professional care,
(3) planning and supervision, and (4) sufficient relevant data.

3-16.

a.

The essence of Rule 301 is that a member in public practice shall not disclose any
confidential client information without the consent of the client. The following five
situations explain when a member can ethical disclose confidential client
information.
 When complying with rule 202 on compliance with professional standards.
 When complying with rule 203 on accounting principles.
 When responding to a validly issued subpoena
 When responding to a review or inspection of a member’s professional practice.
 When initiating a complaint with or responding to an inquiry made by the
professional ethics division or a disciplinary body of a state society of CPAs or
to a state board of accountancy.
b. Rule 302 prohibits contingent fees for any professional service whenever a
member in public practice also performs (1) an audit or review of a financial
statement; or (2) a compilation of a financial statement when the member expects,
or reasonably might expect, that a third party will use the financial statement and
the member's compilation report does not disclose a lack of independence; or (3)
an examination of prospective financial information. The rule also prohibits
preparing an original or amended tax return or claim for a tax refund for a
contingent fee for any client.

3.17.

3-18.

a. Under Rule 501, a member is prohibited from (1) retaining client records, (2)
discrimination in employment, (3) failure to follow standards in government audits,
and (4) negligence in the preparation of financial statements, (5) failure to follow
requirements of governmental bodies, commissions, or other regulatory agencies in
performing attest or other similar services; (6) solicitation or disclosure of CPA
examination questions and answers; and (7) failure to file a tax return or pay a tax
liability.
b.

Under Rule 502, a member cannot engage in advertising or other forms of
solicitation in a manner that is false, misleading, or deceptive. Solicitation by the
use of coercion, overreaching, or harassing conduct is also prohibited.

c.

Rule 503 states that a member in public practice shall not for a commission
recommend or refer to a client any product or service or any product or service to
be supplied by a client, or receive a commission when the member or the
member's firm also performs for that client (1) an audit or review of a financial
statement; (2) a compilation of a financial statement when the member expects, or
reasonably might expect, that a third party will use the financial statement and the
member's compilation report does not disclose a lack of independence; or (3) an
examination of prospective financial information.

a.

b.

Rule 505 permits a CPA to practice public accounting only in a form of organization
permitted by state law or regulation whose characteristics conform to resolutions of
Council. Depending on the state, this may include a sole proprietorship, a
partnership, a professional corporation, and a limited liability partnership or
corporation (LLP or LLC).
Under Rule 505, characteristics conforming to resolutions of Council include:
 One important resolution of Council includes a requirement that CPAs own
the majority (greater than 50 percent) of the financial interests in an attest
firm.
 A CPA must have ultimate responsibility for all services provided by the firm
that are governed by Statements on Auditing Standards or Statements on
Standards for Accounting and Review Services.
 Non-CPA owners must abide by the AICPA Code of Professional Conduct,
must meet certain education requirements, and complete the same workrelated continuing professional education requirements as CPAs.

3-19. The state board of accountancy has the authority to issue CPA licenses. The ethical rules
of followed by the state boards of accountancy are usually written into the state’s
accountancy law. The maximum sanction of a state board of accountancy is the
revocation of a CPA license.
3-20. The PCAOB has authority over the ethical behavior of CPAs who audit public companies.
The PCAOB has the authority to set its own ethical standards so the standards of the

PCAOB apply. The PCAOB has the authority to levy fines, or prohibit an individual or a
firm from auditing a public company.
3-21. The two groups that are responsible for enforcement of the AICPA code of conduct are
AICPA and the state societies of CPAs. The maximum sanction that the AICPA and state
societies can impose is expulsion of the member.
3-22. The purpose of JEEP is to make enforcement of the Rules of Conduct more effective and
disciplinary action more uniform. Under JEEP, complaints against a member may be filed
with either the AICPA or the state society. Each group may act independently or jointly.
3-23. The Joint Trial Board consists of at least 36 AICPA members. The trial board becomes
involved only when earlier enforcement procedures have found the complaint to be
serious or the member involved has refused to cooperate. The trial board may (1)
admonish the member, (2) suspend the member for a period of no more than two years, or
(3) expel the member.
3-24. Under the automatic disciplinary provisions of the AICPA, suspension or termination of
membership can result without a hearing for certain acts. Suspension results when a
judgment or conviction has been imposed on a member for:

A crime punishable by imprisonment for more than one year.

Willful failure to file any income tax return that the member, as an individual
taxpayer, is required by law to file.

The filing of a false or fraudulent income tax return on the member's or a client's
behalf.

Willful aiding in the preparation and presentation of a false and fraudulent income
tax return of a client.

Termination results when a member’s CPA certificate has been revoked, withdrawn, or
cancelled as a disciplinary measure by any governmental agency.

Comprehensive Questions
3-25.

(Estimated time - 20 minutes)
a. Professional ethics evolve over time and continue to be in the process of change as
the practice of public accounting changes. A code of ethics provides standards of
behavior for a professional person that are designed for both practical and
idealistic purposes. A code of ethics significantly affects the reputation of a
profession and the confidence in which it is held.
b. In some respects, the Principles section of the Code that expresses the basic tenets
of ethical conduct, and that is more enduring, draws from the ethical absolutists

school of thought. In contrast, the Rules of Conduct section, which is revised more
frequently to reflect changing customs and traditions of society, draws from the
ethical relativists school of thought.
c. Example 1: In auditing Client A, the auditor discovers that Client A has been
underbilled by another client, Client B. Should the auditor inform Client B when
doing the audit of B?
Example 2: While performing a tax engagement, the engagement team discovers a
misstatement that was missed by the separate audit engagement team that
performed the last annual audit. Does the CPA firm have a responsibility to bring
the matter discovered by the tax engagement team to anyone's attention?
d. According to the Preamble to the AICPA's Code, the CPA has responsibilities to
the following three groups: (1) the public, (2) clients, and (3) colleagues.
3-26.

(Estimated time - 25 minutes)
Obtain the facts relative to the decision: This would include determining the specifics
of the string of operating losses and the client's current financial position, data on the
probability and effects of additional operating losses, including an assessment of
materiality from the perspective of potential users of the financial statements, and the
specifics of the financial statement and footnote disclosures management proposes to
make.
Identify ethical issues from the facts: The ethical issue relates to the need to make a
decision on whether to require the client to make the disclosure based on a judgment
call when there may be evidence that different auditors might reach different
judgments based on the same facts. The auditor may have difficulty reaching a
judgment, but the auditor must not subordinate his or her judgment to others.
Determine who will be affected by the decision and how: Among the stakeholders are
management, employees, customers, creditors, and stockholders whose welfare could
be adversely affected by the disputed disclosure if it were to become a self-fulfilling
prophecy as feared by management. On the other hand, some of these stakeholders
might benefit from the disclosure now if in fact the entity ultimately has to close
down. The auditor is also a stakeholder. Compelling the client to make the disclosure
might result in loss of the client. But failure to require the disclosure followed by the
entity's having to discontinue operations could leave the auditor vulnerable to charges
of failing to comply with professional standards, possibly resulting in monetary losses
and damage to the auditor's reputation as well as the reputation of the profession.
Identify the decision maker's alternatives: Two alternatives are: (1) defer to the client's
reasoning and judgment and do not require the disclosure, and (2) insist on the
disclosure. In case of the latter, if the client refuses to go along, the auditor may have

to issue a qualified or adverse opinion, rather than an unqualified opinion with
explanatory language, or withdraw from the engagement.
Identify the consequences of each alternative: The consequences are dynamic and will
likely depend on whether the entity does in fact have to close down. If the auditor does
not require the disclosure and the entity does have to close down due to continued
losses, many parties, including the auditor, may suffer adverse consequences. But
mandating the disclosure might induce negative consequences that could otherwise
have been avoided, or it might reduce the negative consequences that might ensue
from not making the disclosure. Regardless of whether the entity eventually has to
shut down, the auditor's giving in to the client's position could establish a precedent
that would be difficult to overcome in future dealings with the client, and if it were to
become known, in dealings with other clients. Further, if the auditor subordinates his
or her judgment to the client, he or she has violated the AICPA's Code (Rule 102) and
is subject to sanctions.
Make the ethical choice: This is each individual's call. The key here is whether there
is evidence that causes the auditor to conclude that there is or is not substantial doubt
about the entity’s ability to continue as a going concern.

3-27.

(Estimated time - 25 minutes)
a.a There are two integral sections of the Code:

Principles that express the basic tenets of ethical conduct and provide the
framework of the Rules.

Rules which govern the performance of professional services by members.

b. The principles are not enforceable in their own right. All of the rules are
enforceable in their own terms.
c.a The six principles (articles) are

Responsibilities. In carrying out their responsibilities as professionals,
members should exercise sensitive professional and moral judgments in all
their activities.

The public interest. Members should accept the obligation to act in a way that
will serve the public interest, honor the public trust, and demonstrate
commitment to professionalism.

Integrity. To maintain and broaden public confidence, members should
perform all professional responsibilities with the highest sense of integrity.

d.

e.

3-28.

Objectivity and independence. A member should maintain objectivity and be
free of conflicts of interest in discharging professional responsibilities. A
member in public practice should be independent in fact and appearance
when providing auditing and other attestation services.

Due care. A member should observe the profession's technical and ethical
standards, strive continually to improve competence and the quality of
services, and discharge professional responsibility to the best of the member's
ability.

Scope and nature of services. A member in public practice should observe the
Principles of the Code of Professional Conduct in determining the scope and
nature of services to be provided.

Possible courses of action are:
 Responsibilities - a member should cooperate with other members to (1)
improve the art of accounting, (2) maintain the public's confidence in the
profession, and (3) carry out the profession's self-governance responsibilities.

The public interest - members should act with integrity and strive earnestly to
continually demonstrate their dedication to professional excellence. A CPA is
expected to meet both quality and professional standards in all engagements.

Integrity - members must be honest and candid; members act with integrity
when they observe both the form and the spirit of technical and ethical
standards.

Objectivity and independence - members should avoid circumstances that
involve conflicts of interest; a CPA should not have a financial interest or a
key business relationship with the client.

Due care - a member should discharge his or her professional responsibilities
with competence and diligence and engagements should be planned and
supervised.

Scope and nature of services - a member should decline any engagement if
any principle cannot be met and should assess whether the requested service
is consistent with his or her role as a professional.

The rules are applicable to all members of the AICPA whenever they perform
professional services except that Rules 101, 301, 302, 502, 503, and 505, pertain
only to members in public practice.

(Estimated time - 30 minutes)
a.

Auditor's independence as it relates to third party reliance upon financial
statements suggests that the auditor's professional judgment must be self-reliant

and not subordinate to the views of clients in fact or in appearance. Investors,
credit grantors, prospective purchasers of businesses, regulatory agencies of
government, and others may rely on an auditor's opinion that financial statements
fairly reflect the financial position and results of operations of the enterprise that
has been audited. To be independent, the auditor must not only consciously
refuse to subordinate judgment to that of others, but must also avoid relationships
which would appear likely to warp the auditor's judgment even subconsciously in
reporting whether or not the financial statements are fairly presented.
Independence means avoidance of situations which would tend to impair
objectivity or create personal bias which would influence delicate judgments or
lead a reasonable observer to believe that such objectivity might have been
impaired. In its essence, independence is an expression of the professional
integrity of the auditor and is primarily a condition of mind, character, and
appearance.
b.

c.

1.

An auditor's independence "in fact" refers to objectivity, to the quality of not
being influenced by regard to personal advantage. The auditor is in fact
independent if his or her judgments are uncolored by personal interests, the
interest of client, or other special parties. Thus, independence in fact exists
if the auditor exercises an objective state of mind.

2.

The auditor is independent in appearance when no potential conflict of
interest exists which might tend to jeopardize public confidence in the
auditor's independence in fact. For there to be independence in appearance,
there should be no reason to suspect that any factors exist which may
influence the uninhibited exercise of the auditor's professional judgment.

An auditor may be independent in fact, i.e., have an objective state of mind, but
appear to third parties not be independent. This situation arises where potential
conflicts of interest exist which might tend to jeopardize public confidence in the
auditor's independence in fact. For example, an auditor might not appear to be
independent through the eyes of third parties, even though he or she might be
independent in fact, if the auditor or a partner (a) during the period of the
professional engagement or at the time of expressing an opinion, had, or was
committed to acquire, any direct financial interest or material indirect financial
interest in the enterprise, (b) during the period of the professional engagement, at
the time of expressing an opinion or during the period covered by the financial
statements, was connected with the enterprise as a promoter, underwriter, voting
trustee, director, officer, or key employee, or (c) renders professional services for
a fee which would be contingent upon the findings or results of such services,
except in certain tax matters when the contingent fee is determined by a court.
The auditor may not be independent in appearance if there exists the
opportunity for personal advantage as a result of his or her opinions, even though
he or she in fact ignores such considerations in rendering an objective, unbiased
professional judgment.

d.

1. No. A CPA would be considered not independent for an audit of the financial
statements of a church for which he or she is serving as treasurer without
compensation. The CPA's independence would be impaired in the eyes of
someone who had knowledge of all the facts, since the CPA would be
reporting on his or her stewardship of the church's funds as its treasurer, even
though without compensation.
2.

3-29.

No. A CPA would be considered not independent for an audit of the financial
statements of a club for which his or her spouse is serving as treasurerbookkeeper, even though the CPA is not to receive a fee. The CPA's
independence would be impaired in the eyes of someone who had
knowledge of all the facts because the CPA might not be considered
objective and unbiased in evaluating the spouse's stewardship as treasurer
and record keeping as bookkeeper. The fact that the CPA would not receive a
fee would usually not affect independence.

(Estimated time - 30 minutes)
a.

In auditing and expressing opinions on financial statements, the CPA is required
at all times to maintain independence of thought and action. Independence is a
major part of the CPA's professional integrity-the quality that makes his or her
opinion valuable to third parties who will be relying on the financial statements
on which he or she gives an opinion.
Independence is an attitude of mind that goes much deeper than surface
compliance with visible standards. It results in unbiased judgment and objective
consideration of all the factors involved in planning and conducting an audit and
in arriving at and expressing an opinion. It results in the CPA's rising above the
interests of the client in deference to the interests of readers and users of the
statements.
The requirement for independence of action places upon the CPA the
responsibility for assessing his or her relationships with the enterprise. These
relationships must be evaluated by the same criteria that a third party in
possession of all the facts would apply, that is, whether the CPA is in a position
where there would be pressures to subordinate decisions or judgments to personal
financial interests or the reasons of others.

b

Six of the Rules of Conduct relate either directly or indirectly to independence.
The rules are:
Rule 101 - Independence, which states that a member in public practice shall be
independent in the performance of professional services. Interpretation 101-1
precludes any direct or material indirect financial interest and certain business
relationships with the client enterprise.

Rule 102 - Integrity and Objectivity, which states that the member shall not
knowingly misrepresent facts nor subordinate his or her judgment to others in the
practice of public accounting.
Rule 202 - Compliance with Standards, which includes the GAAS that requires
the auditor to maintain an independent mental attitude in all matters relating to
the assignment.
Rule 302 - Contingent Fees, which requires the CPA to avoid certain situations
where he or she might receive an exceptional financial return that is conditioned
by the outcome of his or her findings.
Rule 502 - Advertising and Other Forms of Solicitation, which prohibits a CPA
from soliciting business in a manner that may lessen his or her independence.
Rule 503 - Commissions and Referral Fees, which prevents the member from
paying or receiving commissions in certain situations because such dealings may
impair his or her independence.
c.

The acceptance by the CPA of the unsecured interest bearing notes in payment of
unpaid fees would not be construed as impairing the CPA's independence in
relations with the client because the notes are merely a substitution for an open
account payable. The rule of professional conduct that prohibits a CPA from
having any financial interest in a client does not extend to the liability for the
CPA's unpaid fee as long as any prior year's fees are paid prior to issuing a report
on the current year's statements. If liability for the CPA's current fee was
considered to be financial interest in a client, the present form of the CPA client
relationship would not be permitted to continue because often (frequently in
engagements for continuing audits) the client statements being audited include a
liability for the CPA's services.

d.a

1. Under the conditions cited, the CPA cannot render an independent opinion on
the financial statements of the Rocky Hill Corporation. The basic premise
underlying the rules of professional conduct pertaining to independence is
that the CPA should make a conscious effort to refrain from any relationships
with a client that might leave professional independence open to question
where he or she intends to express an opinion on the financial statements.
In this case the CPA has twice violated the profession's Rules of
Professional Conduct. By being the client's secretary, the CPA has been an
officer in the company during the period of the professional engagement.
Secondly, by temporarily resigning and then resuming the position upon
expressing an opinion (which does not cure the first violation), the CPA has
violated the spirit of the Rules of Professional Conduct pertaining to
independence because he or she is not in fact independent with respect to the
client.

2. Though the CPA merely assumed an officership with a client as a temporary
measure, the Rules of Professional Conduct pertaining to independence
provide for no exceptions. The CPA is not in a position to render an opinion
on the financial statements of the Rocky Hill Corporation covering the period
during which he or she was an officer. After the CPA has resigned and has
become in fact independent, he or she may express an opinion on statements
covering subsequent periods.
3-30.

(Estimated time - 30 minutes)
a. Rule of Conduct

b. Additional Circumstance

1.

Rule 203 - Accounting
Principles

A member shall not express an opinion......unless
the pronouncements of the Governmental
Accounting Standards Board (GASB) have been
followed.

2.

Rule 501 - Acts
Discreditable

A member is negligent in the preparation of
financial statements.

3.

Rule 502 - Advertising and
Other Forms of Solicitation

Solicitation of clients by the use of coercion,
overreaching, or harassing conduct is prohibited.

4.

Rule 503 - Commissions
and Referral Fees

A member shall not pay a commission to obtain
a client when the member also performs an
examination of prospective financial statements.

5.

Rule 302 - Contingent Fees

A member's fees may not be contingent on the
results of the service.

6.

Rule 301 - Confidential
Client Information

A member is permitted to disclose information in
an AICPA quality control review.

7.

Rule 101 - Independence

A member shall not be connected with the
enterprise as a promoter, director, or officer.

8.

Rule 201 - General
Standards

A member shall exercise due professional care in
the performance of an engagement.

9.

Rule 101 - Independence

A member shall not have any joint, closely held
business investment with the enterprise.

10.

Rule 505 - Form of Practice
and Name

The firm cannot designate itself as "Members of
the AICPA" unless all its owners are members of
the Institute.

11.

Rule 102 - Integrity and

A member shall not knowingly misrepresent

a. Rule of Conduct

b. Additional Circumstance

Objectivity

facts.

12.

Rule 202 - Compliance with
Standards

A member shall comply with the standards of the
Accounting and Review Services Committee in a
review engagement.

13.

Rule 302 - Contingent Fees

Fees are not regarded as contingent if fixed by
courts.

14.

Rule 301 - Confidential
Client Information

Information may be disclosed to comply with a
validly issued and enforceable subpoena.

15.

Rule 203 - Accounting
Principles

A member issues an unqualified opinion when
the statements depart from principles
promulgated by the GASB.

3-31. (Estimated time - 35 minutes)
a. Rule of Conduct
1. Rule 101 - Independence
2. Rule 203 - Accounting Principles
3. Rule 501 – Acts Discreditable
4. Rule 101 - Independence
5. Rule 101 – Independence

6. Rule 201 - General Standards
7. Rule 302 - Contingent Fees
8. Rule 502 - Advertising

b. Effect on Rule
Indeterminate. The information needed to assess the
applicability of Interpretations 101-1(A)(4) and 101-5 is not
stated.
No violation. GASB principles are recognized as
authoritative pronouncements for governmental entities.
Violation. This is considered to be an act discreditable
creditable to the profession.
No violation. Retirement payments to individuals formerly
engaged in the practice of public accounting are specifically
permitted absent certain conditions.
No violation. The prohibition against direct financial
interest in interpretation 101-1 applies only to the period of
the professional engagement or at the time of expressing an
opinion.
Violation. A member shall undertake only engagements that
member or member's firm can reasonably expect to
complete with professional competence.
No violation. A member's fee may vary depending on the
complexity of the engagement.
No violation. The rule can no longer be used to prevent

a. Rule of Conduct

b. Effect on Rule

and Other Forms of Solicitation

members from using advertising that includes self-laudatory
claims.

9. Rule 101 - Independence
10. Rule 301 - Confidential Client
Information

Violation. Interpretation 101-1 states that a member cannot
be an officer of the client during the time period covered by
the financial statements.
Indeterminate. No information is given as to whether the
client approved disclosure of the information.

11. Rule 102 - Integrity and
Objectivity

Violation. A member should not perform a professional
service when he or she has a conflict of interest.

12. Rule 502 - Advertising and Other
Forms of Solicitation

No violation. The rule can no longer be used to prevent
members from using advertising that includes testimonials.

13. Rule 202 - Compliance with
Standards

No violation. The Accounting and Review Services
Committee is the body designated to promulgate standards
for review services for nonpublic entities.
Violation. Interpretation 101-1 states that a member's
independence is impaired by serving in this capacity
(business relationship) for a bank client.
Indeterminate. A member is allowed to pay a commission to
obtain a client provided disclosure is made to the client.

14. Rule 101 - Independence
15. Rule 503 - Commissions and
Referral Fees

Cases
3-32. (Estimated time - 30 minutes)
a. The ethical dilemma is that two of the rules of conduct compete with each other and lead
to opposite choices about how to resolve this situation.
b. The two competing rules of ethics are rule 102 on integrity and objectivity and not
knowingly associating with a material misstatement is in conflict with rule 301 on
confidential client information.
c. A student might apply the six step ethical framework to this case as follows:
Obtain the facts relative to the decision: As you are completing EFW’s audit you
learn, through planning S&F’s audit that a significant customer may not be able to pay

a material receivable. You know this from information that is confidential and cannot
be disclosed to EFW.
Identify ethical issues from the facts: The ethical issue relates to the fact that you do
not want to knowingly be associated with misstated financial statements of EFW.
Further, you cannot ethically disclose the information obtained from S&F.
Determine who will be affected by the decision and how: The stakeholders in EFW
would possible be mislead by the material overstatement of assets (accounts
receivable) and earnings. On the other hand, S&F’s relationship with its supplier
(EFW) might be damaged by disclosing the confidential information.
Identify the decision maker's alternatives: Various alternatives exist:
1.

Ask for S&F’s permission to disclose the confidential information about is
financial condition.

2.

Use the information normally available in the EFW audit to evaluate the adequacy
of its allowance for doubtful accounts.

3.

Disclose S&F’s financial condition to EFW without S&F’s permission.

4.

Remain silent and do nothing.

Identify the consequences of each alternative:
1.

This is the best alternative, but it only woks if you can persuade S&F to disclose the
confidential information about is financial condition.

2.

This is a reasonable alternative, but it might not disclose information that you would
need to increase the allowance for EFW. You would have to look at the shipments to
and payments from S&F. This might not fully disclose key information need to
increase the allowance.

3.

Disclosing S&F’s financial condition to EFW without S&F’s permission, would serve
the stakeholders of EFW but would possibly damage S&F.

4.

Remaining silent will favor S&F but possible damage the EFW stakeholders.

Make the ethical choice: There is no right answer here. The auditor must make a choice
based on evaluating the consequences and benefits in the context of the auditor’s ethical
values. Professional practice does not always present situations with clear right and
wrong answers.

3-33 (Estimated Time: 30 minutes)
a.

Under AICPA rules (Interpretation 101-3) CPAs may perform bookkeeping and
accounting services and remain independent if the following four conditions are met.
 The CPA must not have any other relationships, such as a financial interest, that
would impair his or her independence.
 The client must accept full responsibility for the financial statements.
 The CPA must not assume the role either of an employee or management in the
client’s operations (e.g., the CPA should not initiate transactions or sign check).
 The CPA must conform to professional standards in performing the attest
engagement.
Even thought Jones and Jones drafts the financial statements, they can remain
independent as long as the above conditions are met.

b.

If WTI is a public company SEC rules have long prohibited CPAs from performing
bookkeeping and accounting services for SEC registrants.

c.

Under AICPA rules Jones and Jones can perform business valuation services and
consulting services for non-public companies. If Jones and Jones is to remain
independent, however, they must not assume management responsibility in the
process and the client must take full responsibility for key assumptions and any final
decisions based on a consulting engagement. Jones and Jones must act strictly in an
advisory capacity.

d. Under the SEC rules CPAs are prohibited from performing appraisal or valuation
services, fairness opinions, or contribution-in-kind reports for SEC audit clients.
3-34.

(Estimated time - 30 minutes)
1. A member of the AICPA may practice public accounting in any form of
organization permitted by state law or regulation as long as the characteristics of
the organization conform to a resolution adopted by Council of the AICPA. CPAs
must own the majority (greater than 50 percent) of the financial interests in an
attest firm. Non-CPA owners must be actively engaged in providing services to the
firm's clients as their principal occupation. Ownership by others is considered
against the public interest and continues to be prohibited. Bradley's 50%
ownership, and provision of insurance services rather than professional accounting
services, violates this characteristic.
2. A member in the practice of public accounting may have a financial interest in a
commercial corporation which performs, for the public, services of a type
performed by public accountants and whose characteristics do not conform to
resolutions of Council, provided such interest is not material to the corporation's

net worth, and the member's interest in and relation to the corporation is solely that
of an investor. Certainly Gilbert's 50 percent interest is material to Financial
Services, Inc., and Gilbert's status is not that of an investor. In this respect, Gilbert
is in violation of Interpretation 505-1.
3. Expressing an unqualified opinion on Grandtime's financial statements, which did
not disclose a material lien on the building asset, is a violation of both Rule 202
(Compliance with Standards), and Rule 203 (Accounting Principles). Rule 202
includes auditing standards promulgated by the Auditing Standards Board. These
standards include the requirement that a member shall not permit his or her name
to be associated with financial statements unless the member has complied with
generally accepted auditing standards. The third standard of reporting says that
informative disclosures are to be regarded as reasonably adequate unless otherwise
stated in the report. Since there was no disclosure of the building lien in the
financial statements, Gilbert should have qualified his opinion.
Rule 203 requires that a member shall not express an opinion that financial
statements are presented in conformity with generally accepted accounting
principles if such statements contain any departure from an accounting principle
promulgated by the body designated by Council to establish such principles.
Accounting Research Bulletin No. 50, which was published by a body designated
by Council, requires disclosure of assets pledged as security for loans.
4. Having Bradley inform the insurance company of the prior lien on Grandtime's
building is a violation of Rule 301 of the Code, which enjoins a member from
violating the confidential relationship between himself and his client without
consent of the client. The lien should have been disclosed in Gilbert's report on
Grandtime's statements, but it may not be disclosed by him independently to a third
party unless the client agrees to such disclosure. However, Rule 301 should not be
interpreted to preclude a CPA from correcting a previous error - in this case
expressing an opinion that the financial statements were prepared in accordance
with generally accepted accounting principles when, in fact, they were not. Gilbert
should have first, exhausted all means to persuade Grandtime to correct the error
by recalling the original financial statements and reissuing them in corrected form
with a new auditor's report.

3-35.

(Estimated time - 35 minutes)
1. This situation relates to Rule 101-Independence. Basically, the situation would be
acceptable providing that Herb does not assume the role of employee and the client
is sufficiently knowledgeable of the company's activities and financial condition
and the applicable accounting principles so that the client can reasonable accept

responsibility for the work. For SEC purposes, responsibility for maintenance of
the accounting records must be performed by accounting personnel employed by
the client. Therefore, if Ethical was an SEC client, Herb could not do this work.
2. This situation relates to responsibilities to clients, Rule 301-Confidential Client
Information. Herb has violated professional ethics because Rule 301 states "A
member shall not disclose any confidential information obtained in the course of a
professional engagement except with the consent of the client." 'this does not apply
to a validly issued subpoena or summons enforceable by order of a court. A CPAs
confidential client relationship is similar to that of an attorney, with one major
exception - information obtained by an attorney is not subject to subpoena.
3. This situation relates to Rule 101-Independence. If an employee or partner accepts
more than a token gift from a client, even with the knowledge of the member's
firm, the appearance of independence may be lacking. Good advice would be to
never accept anything from a client at a price less than what other independent
buyers pay.
4. This situation relates to Rule 101-Independence. Interpretation 101-1 states that a
member, or a firm of which the member is a partner or shareholder, shall not
express an opinion on financial statements of an enterprise unless the member and
the member's firm are independent with respect to such enterprise. Independence
will be considered to be impaired if a member or a member's firm had any loan to
or from an enterprise except as permitted in Interpretation 101-5. The exceptions
pertain to certain collateralized loans, loans against insurance policies, and credit
card and cash advances on checking accounts which meet certain balance
requirements. The exceptions do not include unsecured loans.
5. This situation relates to Rule 101-Independence. Interpretation 101-1 states that
independence will be considered to be impaired if a member, or a firm of which he
or she is a partner, had or was committed to acquire any direct or material indirect
financial interest in the enterprise.
Cash & Green would not have a problem performing an independent audit because
Herb is not a managerial employee of the office doing the audit.
Rule 2-01(b) of Regulation S-X applies to SEC clients and states that "an
accountant will be considered not independent with respect to any person or any of
its parents, its subsidiaries, or other affiliates (1) in which, during the period of his
professional engagement or at the date of his report, he or his firm or a member
thereof, had, or was committed to acquire, any direct financial interest or any
material indirect financial interest....' "...the term 'member' means 'all partners in
the firm and all professional employees participating in the audit or located in an
office of the firm participating in a significant portion of the audit.' Because Herb
is not participating in the audit and is not working in an office of Cash & Green
that is performing the work, the action of the investment club does not violate the
AICPA or SEC independence rules. (Author's note: Reference to SEC rules is

beyond the scope of the chapter. This material is included for the instructor who
wishes to point out the SEC implications.)

Solution to Professional Simulations Chapter #3
(Estimated time - 30 to 45 minutes)
Independence
Situation

Research

In planning for the audit, Langdale instructed Robert Benson, an assistant on the engagement, to
draft a list of individuals who would need to be independent so that they could be assigned to the
engagement. Indicate whether the following individuals (or entities) would cause independence
problems if they owned stock in EquipCo.

1. A tax partner in Sharon Langdale’s office.
2. A consulting partner in another office where work on the EquipCo audit is
performed. However, the partner performed no work for EquipCo. The
partner owns only a few shares of EquipCo.
3. The spouse of a staff accountant who works on the EquipCo audit works as a
financial analyst for EquipCo.
4. The audit firm’s benefit plan.
5. A manager in another office who regularly is involved in internal quality
control functions.
6. A parent of a staff accountant who works on the EquipCo audit, holds an
immaterial investment in EquipCo.
7. The spouse of an audit partner is a divisional controller for EquipCo. The audit
partner is not in the lead office, does not perform any work for on EquipCo and
is not in the chain of command for the audit.
8. A tax manager in an office that performs work for EquipCo performs five hours
of work on the audit of the tax accrual.
9. The Midwest regional audit partner who performs no work on the EquipCo
audit.
10. An audit manager in Asia who performs no work on the EquipCo audit owns
1% of EquipCo’s outstanding stock.
11. An audit partner in Sharon’s office finds that a mutual fund that he owns in his
investment portfolio has an immaterial investment in EquipCo.

Independenc
e Problem?










Following is an explanation of the solution outlined above.
1. Any partner in the same office of the lead partner on the audit is considered a covered
member. As a result the partner cannot have a loan to or from the audit client.
2. A consulting partner is not likely going to be in the chain of command for an audit partner
nor would the person be in a position to influence the audit engagement. The partner is in

another office and performs no work for EquipCo. Hence the partner is not a covered
member. This partner could own less than 5% of the outstanding stock of the audit client.
3. The staff accountant who works on the EquipCo audit is a covered member. The rules for the
spouse of a covered member are the same as those for a covered members. Independence is
impaired if the spouse owns EquipCo stock. The spouse may also be employed in a key
position as the financial analysts may be in a position to exercise influence over the financial
statements.
4. The firm’s benefit plan is treated as a covered member. Hence, ownership of EquipCo stock
violates independence rules.
5. A manager in another office who regularly is involved in internal quality control functions is
considered a covered member as they can influence audit work. Hence, they cannot own
EquipCo stock.
6. A parent of a staff accountant who works on the EquipCo audit is considered a close relative
of a covered member. The parent can hold an immaterial investment in EquipCo.
7. An audit partner that is not in the lead office, does not perform any work for on EquipCo and
is not in the chain of command for the audit is not a covered member. The spouse of another
professional, who is not a covered member, can hold a key position with the company.
8. A tax manager in an office that performs work for EquipCo performs five hours of work on
the audit of the tax accrual is a covered member by virtue of the fact that the manager work
on the audit. No hours tests is relevant for someone who works on the audit – auditing the
tax accrual. Hence, the tax manager cannot own EquipCo stock.
9. The Midwest regional audit partner may perform no work on the EquipCo audit, but this
individual is in the chain of command for the audit. Hence the partner is a covered member
and cannot own any EquipCo stock.
10. An audit manager in Asia who performs no work on the EquipCo is considered an other
profession, not a covered member. Hence the individual can own less than 5% of EquipCo’s
outstanding stock.
11. An audit partner in Sharon’s office is a covered member. However, a covered member can
invest in a mutual fund that might have an immaterial investment in EquipCo.
Research
Situation

Independence

This situation is addressed in ethics interpretation 101-2, which is presented below:
101-2—Employment or association with attest clients. A firm's independence will be considered to be impaired
with respect to a client if a partner or professional employee leaves the firm and is subsequently employed by or
associated with that client in a key position unless all the following conditions are met:
1. Amounts due to the former partner or professional employee for his or her previous interest in the firm and
for unfunded, vested retirement benefits are not material to the firm, and the underlying formula used to
calculate the payments remains fixed during the payout period. Retirement benefits may also be adjusted for
inflation and interest may be paid on amounts due.
2. The former partner or professional employee is not in a position to influence the accounting firm's
operations or financial policies.

3. The former partner or professional employee does not participate or appear to participate in, and is not
associated with the firm, whether or not compensated for such participation or association, once employment or
association with the client begins. An appearance of participation or association results from such actions as:
• The individual provides consultation to the firm.
• The firm provides the individual with an office and related amenities (for example, secretarial and
telephone services).
• The individual's name is included in the firm's office directory.
• The individual's name is included as a member of the firm in other membership lists of business,
professional, or civic organizations, unless the individual is clearly designated as retired.
4. The ongoing attest engagement team considers the appropriateness or necessity of modifying the
engagement procedures to adjust for the risk that, by virtue of the former partner or professional employee's
prior knowledge of the audit plan, audit effectiveness could be reduced.
5. The firm assesses whether existing attest engagement team members have the appropriate experience and
stature to effectively deal with the former partner or professional employee and his or her work, when that
person will have significant interaction with the attest engagement team.
6. The subsequent attest engagement is reviewed to determine whether the engagement team members
maintained the appropriate level of skepticism when evaluating the representations and work of the former
partner or professional employee, when the person joins the client in a key position within one year of
disassociating from the firm and has significant interaction with the attest engagement team. The review should
be performed by a professional with appropriate stature, expertise, and objectivity and should be tailored based
on the position that the person assumed at the client, the position he or she held at the firm, the nature of the
services he or she provided to the client, and other relevant facts and circumstances. Appropriate actions, as
deemed necessary, should be taken based on the results of the review.
Responsible members within the firm should implement procedures for compliance with the preceding
conditions when firm professionals are employed or associated with attest clients.
With respect to conditions 4, 5, and 6, the procedures adopted will depend on several factors, including whether
the former partner or professional employee served as a member of the engagement team, the positions he or
she held at the firm and has accepted at the client, the length of time that has elapsed since the professional left
the firm, and the circumstances of his or her departure. fn 3
Considering Employment or Association With the Client
When a member of the attest engagement team or an individual in a position to influence the attest engagement
intends to seek or discuss potential employment or association with an attest client, or is in receipt of a specific
offer of employment from an attest client, independence will be impaired with respect to the client unless the
person promptly reports such consideration or offer to an appropriate person in the firm, and removes himself or
herself from the engagement until the employment offer is rejected or employment is no longer being sought.
When a covered member becomes aware that a member of the attest engagement team or an individual in a
position to influence the attest engagement is considering employment or association with a client, the covered
member should notify an appropriate person in the firm.
The appropriate person should consider what additional procedures may be necessary to provide reasonable
assurance that any work performed for the client by that person was performed with objectivity and integrity as
required under rule 102 [ET section 102.01]. Additional procedures, such as reperformance of work already
done, will depend on the nature of the engagement and the individual involved.