Case #2.6 – The Fund of Funds: Independence.

Technical Audit Guidance To maximize the knowledge acquired by students, this book has been designed
to be read in conjunction with the post-Sarbanes-Oxley technical audit guidance. All of the PCAOB
Auditing Standards that are referenced in this book are available for free at: . In addition, the AU Sections
that are referenced in this book are available for free at: . Finally, a summary of the provisions of the
Sarbanes-Oxley Act of 2002 is available for free at: es-Oxley+Act+of+2002.htm.
II. Recommended Technical Knowledge the Sarbanes-Oxley Act of 2002Section 201Section 203Section
206
III.Classroom Hints this case provides students with the opportunity to understand what is meant by auditor
independence and why it is important to the audit profession. In addition, the case provides students with
an opportunity to understand how a lack of independence may impact the objectivity of auditors and
potentially lead to biased professional judgments. To meet these objectives, this case illuminates a number
of relevant issues about the relationship that existed between Arthur Andersen, the Fund of Funds (FOF),
and King Resources Corporation (KRC). In particular, the case focuses on the issues that can arise when
the same audit firm conducts the audit of two different organizations that share an important business
relationship. We believe it is essential for students to carefully read over the recommended technical
knowledge, along with this case reading. The educational psychology literature suggests that the
acquisition of technical/factual type knowledge increases dramatically when such knowledge can be
applied in a realistic context. Thus, we urge instructors to use this case as a mechanism to impart
the relevant post-Sarbanes technical audit knowledge, outlined above. This case assignment will
work best if is scheduled to coincide with the auditors ‘professional responsibilities/conduct
topic or the independence topic in the auditing course. We do believe that it is helpful to introduce
the notion of an auditor's responsibility to financial statement users before discussing how a lack
of independence can potentially bias an auditor’s professional judgments. Specifically, we suggest
that instructors do everything possible to illustrate the tension that auditors face when attempting to
maintain an attitude of independence during the financial statement audit. Students need to realize
that the nature of the auditing process sometimes makes it difficult to remember that your
primary responsibility when completing an audit is to financial statement users, not to the audit client.
The difficulty starts with the nature of the business relationship, particularly prior to the Sarbanes-
Oxley Act of 2002. The audit firm is hired and is paid by the audit client. Thus, the audit client can
also fire the audit firm. This is a nontrivial dynamic that can make it difficult to maintain your
independence and an attitude of professional skepticism throughout the audit. Another aspect that
adds to this tension is the reality that auditors need the client’s cooperation in order to complete their
work at the audit client. This reality forces the auditor to build a strong rapport with client personnel.
Such a rapport also just makes life more enjoyable for the auditor, who is forced to work with client
personnel on a daily basis. Each of these examples can add to the tension that auditors face on a daily
basis but they must always remember that their primary responsibility is to the financial
statement users. Thus, they must always maintain their independence and their professional
skepticism throughout the audit.
Overall, the case questions are designed to demonstrate how important it is for auditors to maintain an
independent and objective attitude at all times. By making sure that the firm is independent and
objective, this helps to unsure that auditors will always make audit judgments without any bias
whatsoever. Indeed, we believe that it is helpful to remind students that they have a professional
responsibility to maintain an attitude of skepticism throughout the audit process. One of the
primary goals of the Sarbanes-Oxley Act of 2002 was to take steps to improve the independence
and objectivity of the audit process (e.g., Section 201).
IV.Assignment Questions & Suggested Answers
1.What is auditor independence, and what is its significance to the audit profession? What is the difference
between independence in appearance and independence in fact? Based on the case information, do you
believe that Arthur Andersen violated any principles of auditor independence? Why or why not? The
second general standard of generally accepted auditing standards (GAAS) provides that, “In all matters
relating to the assignment, independence in mental attitude is to be maintained by the auditor or
auditors.” If the auditor is not independent, the financial statements are considered unaudited
for all practical purposes. In cases where the SEC has found that a CPA firm was not independent,
in the meaning provided by the second general standard, it has r e q u i r e d t h a t t h e f i n a n c i a l
s t a t e m e n t s b e r e - a u d i t e d b y a n o t h e r CP A f i r m . A l a c k o f independence can result in
disciplinary action by regulators and/or professional organizations and litigation by those who
relied on the financial statements (e.g., clients and investors). The profession, as a whole, depends on
the value of independence in that the auditor’s opinion on the financial statements loses its value if the
auditor is not considered to be substantially independent from the management of the firm. Article IV of
the AICPA’s Professional Code of Conduct requires that “a member in public practice should be
independent in fact and appearance when providing auditing and other attestation services.”
To be independent in fact, an auditor must have integrity, character of intellectual honesty and
candor; and objectivity, a state of mind of judicial impartiality that recognizes an obligation of
fairness to current and prospective management and owners of a client, creditors and other
stakeholders. To be independent in appearance, the auditor must not have any obligations or interests
in the client, its management, or its owners, that could cause others to believe the auditor is biased
with respect to the client, its management, or its owners. It is important that even if an auditor
maintains independence in fact, that independence in appearance is also maintained. Without
being independent in appearance, the value that the audit function has to the public is weakened or lost.
Given the facts and circumstances of the case, there are some concerns.
2. Consider that both KRC and FOF, including its NRFA, were audited by Arthur Andersen. In addition,
Arthur Andersen audited King’s personal accounts. Do you believe these relationships impaired the
independence of Arthur Andersen? Why or why not?
While it may be possible for the Arthur Andersen auditors to remain objective and unbiased (unless the
auditor was auditing his/her own work), the interrelationships among the entities would make it
very difficult to do so. Indeed, while the AICPA Code of Professional Conduct does not
specifically preclude auditors from performing audit services for clients that are
interrelated, it is absolutely essential that auditors perform all of their duties in an objective,
unbiased manner. In this case, the public may perceive the interdependency of KRC and FOF (since
essentially NRFA’s financial statements rely upon information generated from KRC) as a
violation of independence in appearance. This is particularly true since the partner and manager
assigned to the KRC audit also had the same responsibilities on the NRFA audit. The bottom line
is that students need to consider whether the interrelationship would possibly impair the professional
judgments of the partner and/or manager.
3. Would your answer change if different partners were assigned to both the KRC audit and the NRFA
audit? Assume that both audit teams were completely different. Why or why not would your answer be
different? The answer might be different. As stated previously, the relationships do not
explicitly violate independence in fact (unless the auditor was auditing his/her own work). However,
there is still a question as to whether independence in appearance has been violated. The fact that
there would now be completely different audit teams does help to mitigate the poss ible
independence in appearance concern. However, the dependency of NRFA’s financial statements on the
information presented by KRC still poses a potential issue of concern. It is certainly possible
that the investing public would still believe that this interdependency might impair Arthur
Andersen’s ability to be objective and unbiased in performing its duties. The bottom line, again, is that
students must consider whether the interdependency would impair the professional judgments of the
auditors.4.Refer to Sections 201, 203, and 206 of SARBOX. Based on your understanding of the FOF
audit, do you believe these sections were needed? Why or why not? Be specific. Section 201 says that “it
shall be unlawful for a registered public accounting firm to provide any non-audit service to an issuer
contemporaneously with the audit, including:
 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 adviser, or investment banking services;
 legal services and expert services unrelated to the audit;
 Any other service that the Board determines, by regulation, is impermissible.”
Importantly, the bill allows an accounting firm to “engage in any non-audit service,
including tax services,” that is not listed above, only if the activity is pre-approved by the audit
committee of the issuer. The audit committee is required to disclose to investors in its periodic
filings its decision to pre-approve non-audit services. Section 203 says that “the lead audit or
coordinating partner and the reviewing partner must rotate off of the audit every
5years.”Based on the case information provided, Section 201 would not have had much of an
impact on the Fund of Funds audit. However, Section 203 of the Sarbanes-Oxley Act
would clearly apply to the FOF audit as the lead audit partner and the concurring review
audit partner would have to rotate off of the audit after five years of serving in this
capacity. It is likely that this provision would have indirectly reduced the likelihood that
the same partner would have been auditing both FOF and KRC, depending on the rotation
schedule.Given the importance for auditors to remain objective and unbiased in
completing their professional duties, most would agree that these sections of the law were
needed. For example, Section 201 prevents accounting firms from offering audit services in
conjunction with certain on-audit services, such as human resources. The intent is to make
sure that the audit firm is only focused on the audit and does not have to worry about whether
judgments made on the audit may impact the ability of the firm to “win” other professional
service contracts from the audit client. In addition, by requiring audit partners to rotate,
Section 203 helps to mitigate the possibility of audit partners becoming too “close” with
management at their clients. The law is therefore designed to ensure that auditors are always
unbiased and independent in completing their audit duties.