Rittenberg Schwieger Johnstone Auditing A Business Risk Approach Sixth Edition

Rittenberg/Schwieger/Johnstone Auditing: A Business Risk Approach Sixth Edition Chapter 3 Understanding and Meeting Ethical Expectations Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. 1

Strong Governance and High Ethical Standards q History shows companies with strong corporate governance and high ethical standards generally perform better then those with weak governance and low ethical expectations q The key is the tone set by top management. A well-managed organization will have and enforce a code of ethics and/or a conflict of interest policy to guide its members. 2

Accepting a Public Trust q To maintain the public's trust, public accountants must act with professional integrity q To help accountants with ethical dilemmas, professional associations including the AICPA, Institute of Management Accountants, and Information Systems Audit and Control Association, have codes of professional conduct q The individual state boards of accountancy and state societies of CPAs have generally adopted the AICPA's Rules of Conduct 3

The Unique Licensure for CPAs q Audits and other attestation reports on financial statements can only be signed by those licensed to practice as CPAs by their state board of accountancy q Each state board of accountancy sets its own requirements to become a licensed CPA q To become a licensed CPA, a person must pass the CPA exam, meet specific education and experience requirements, and agree to uphold the profession and its code of professional conduct 4

Independence: A Foundation Requirement q Auditors express an opinion about whether financial statements are fairly presented q To be perceived as creditable, auditors must be independent in fact and appearance q. In fact, means the member must be unbiased and objective q. In appearance means that knowledgeable users of financial statements must believe the auditor is independent 5

Major Threats to Independence q Independence is a state of mind that can be impaired by a number of potential threats q Compensation Schemes q Partners' compensation in many CPA firms is based in large part on attracting and keeping clients. Partners may feel pressure to accede to client wishes in order to keep them happy q Although the client has the authority to hire and the auditor, CPA firms must reinforce to its auditors that maintaining the public trust is more important than retaining a client where it might appear that its objectivity could be compromised 6

Major Threats to Independence (continued) q Familiarity with the Client q Auditors serving a client for several years may develop relationships that cause the auditor to be less skeptical than necessary q Time Pressure q Those in charge of audits are evaluated not only on the quality of their work, but also on their ability to complete audits within time budgets. This may create situations where auditors do not investigate potential problems thoroughly in order to save time q Ability to Rationalize q It takes time to investigate potential misstatements. To save time, an auditor may rationalize that the misstatement is not likely to be material q Auditing Your Own Work q CPAs may provide certain services to non-public companies that put auditors in the position of auditing their own work 7

Ways of Managing Threats to Independence q Establishing and Monitoring Codes of Conduct q Balanced Compensation Schemes q Independent Reviews of Client Acceptance/Retention Decisions q Separation of Consulting Activities from Audit Activities q Independent Reviews of Audit Work and Audit Documentation q Peer Reviews within the Profession q Improved Hiring Practices 8

The SEC's Principles for Judging Independence & Prohibited Service q In rules on auditor independence issued in 2001, the SEC summed up its objectives: q The independence requirement serves two public policy goals: q Foster high quality audits by minimizing the possibility that any q external factors will influence an auditor's judgment q Promote investor confidence in the financial statements of public companies q In judging independence, the SEC determines whether a relationship or the provision of service: q Creates a mutual or conflicting interest between accountant and client q Places the accountant in the position of auditing his/her own work q Results in the accountant acting as management or an employee of an audit client q Places the accountant in the position of being an advocate for the client q The SEC requires the audit committees to assess auditor independence and make a written statement on that assessment to the stockholders 9

Prohibited Services, Sarbanes. Oxley Act of 2002 Prohibits a public accounting firm that audits a public company from providing the following nonaudit services to the company: q Bookkeeping or other services related to the accounting records or financial statements of the audit client q Financial information systems design and implementation q Appraisal or valuation services, fairness opinions, or contribution-in-kind reports q Actuarial services 10

Prohibited Services, Sarbanes. Oxley Act of 2002 (continued) q Internal audit outsourcing services q Management functions or human resources q - Broker or dealer, investment advisor, or investment banking services q Legal services and expert services unrelated to the audit q Any other service that the Board determines, by regulation, is impermissible The Act requires that the client's audit committee pre-approve any non-audit services, including tax services, not specifically prohibited 11

The AICPA Code of Professional Conduct q The AICPA Code of Professional Conduct consists of principles and rules; the Division of Professional Ethics issues interpretations and rulings to the rules. q PRINCIPLES are ideals of ethical conduct and provide a broad conceptual framework for professional conduct q RULES provide more detailed guidance to help CPAs in carrying out their public responsibilities, and are enforceable under AICPA bylaws q INTERPRETATIONS provide specific guidance to help CPAs interpret the rules q RULINGS are issued in response to member questions about specific situations 12

The AICPA Principles of Professional Conduct (continued) q Responsibilities - members should exercise sensitive professional and moral judgment in all their activities q Public interest - members should act in a way that serves the public interest, maintains public trust, and shows commitment to professionalism q Integrity - members should perform all professional responsibilities with the highest sense of integrity q Objectivity and independence - members should be objective and free of conflicts when performing professional responsibilities. Members in public practice must be independent in fact and appearance when providing attestation services. q Due care - members shall observe the profession's ethical and technical standards, strive to improve competence and quality of services provided, and discharge professional responsibilities to the best of their ability. q Scope and nature of services - members in public practice shall observe the principles of the Code of Professional Conduct in determining the scope and nature of services to be provided. 13

The AICPA Rules of Conduct Rule 101: Independence Rule 102: Integrity and Objectivity Rule 201: General Standards Rule 202: Compliance with Standards Rule 203: Accounting Principles Rule 301: Confidential Client Information Rule 302: Contingent Fees Rule 501: Acts Discreditable Rule 502: Advertising and Other Forms of Solicitation Rule 503: Commissions and Referral Fees Rule 505: Form of Organization and Name 14

The AICPA's Approach to Independence Rule 101: "A member in public practice shall be independent in the performance of professional services as required by standards promulgated by bodies designated by the Council. " The auditor is required to be independent when providing attestation services. The standards for providing consulting, tax, or bookkeeping services do not require independence. There are several interpretations and over 100 rulings that provide more detailed guidance on the application of Rule 101. 15

Interpretations of Rule 101 Financial Interest q Independence would be considered impaired if during the period of engagement, a covered member had, or was committed to acquire, a direct or material indirect financial interest in an attestation client. q Covered member is defined as q An individual on the attest engagement team q An individual in a position to influence the attest engagement, or q A partner in the office in which the lead attest engagement partner primarily practices in connection with the attest engagement q A covered member's immediate family is also subject to Rule 101 with some exceptions 16

Interpretations of Rule 101 Employment q Independence would be considered impaired if a member holds management, employee, or director positions with attest clients during the period covered by the financial statements or the period of engagement. q A covered member's independence would be considered impaired if a close relative is employed by an audit client where the relative is allowed to exercise significant control over operating, financial, or accounting policies, or significant internal accounting controls 17

Independence Safeguard: A Proactive Approach Actions that firms can take to safeguard independence: q The firm's leadership sets the proper "tone at the top" q Communications with client's audit committee on matters that may affect the firm's independence q Participating in peer review programs q Implement quality control standards q Set up internal monitoring and compliance procedures q Require professional staff to communicate to firm management any independence or objectivity issues of concern q Encourage partner peer review by someone outside of the audit engagement q Periodically rotate partner in charge of the audit engagement q Monitor threats to independence 18

Rule 102 - Integrity and Objectivity q. Requires members to act with integrity and objectivity, be free of conflicts of interest, and not knowingly misrepresent facts or subordinate their judgment to others. q. Rule applies to performance of all professional services by all members 19

Rule 201 - General Standards q Members shall provide only those services that they are able to perform with professional competence q Members shall exercise due professional care in performance of services q Professional services shall be adequately planned and supervised q Members must gather sufficient relevant data to provide a reasonable basis for any conclusions or recommendations rendered in connection with professional services q Applies to all services provided by all members 20

Rule 301 - Confidential Client Information q In order for an auditor to develop a complete understanding of the client, there must be a free flow and sharing of information between client and auditor. To ensure this happens, the client must be assured that the auditor will not communicate confidential information to outside parties. q Rule 301 prohibits members from disclosing confidential client information obtained during an engagement except with client consent. 21

Rule 301 - Confidential Client Information - Exceptions q Disclosures required by GAAP or GAAS q Comply with subpoenas or summons or to comply with applicable laws and government regulations q Provide information for outside review of firm's practice under PCAOB, AICPA, or State Board of Accountancy authorization q Initiate a compliant with, or respond to inquiries made by, recognized investigative and disciplinary agencies (including the AICPA, state CPA societies, State Board of Accountancy) 22

Rule 302 - Contingent Fees q. Contingent fee - fee for the performance of a service where the collection or amount depends on whether a specified finding or result is attained q. Contingent fees are prohibited for any service provided to an attestation client. Why? Such contingent fees would give the auditor a financial interest in client results 23

Rule 502 - Advertising and Other Forms of Solicitation Members in public practice shall not advertise or solicit in any way that is false, misleading, deceptive, harassing, or coercive. This would include advertising that q Creates a false or unjustified expectation of favorable results q Implies ability to influence any court, regulatory agency, or similar body q Understates fees for current or future fees q Contains any other representations that would likely cause a reasonable person to understand or be deceived 24

Rule 503 - Commissions and Referral Fees q Members in public practice are prohibited from receiving commissions for recommending products and services to attest clients. Why? The commission gives the auditor a financial interest in his/her client's decisions. q Commissions are allowed for recommending products or services to non-attest clients, but must be disclosed to the client q Members may pay or receive fees for referral of any professional services (including attest services) as long as the client is notified of the fee 25

Enforcement of the Code q Members who violate the AICPA code may have their membership terminated q Members who violate a State Board of Accountancy's code are subject to disciplinary action including suspension or revocation of the member's certificate and license to practice. q If the State Board suspends the member's certificate, it can mandate conditions, such as additional continuing education, that must be satisfied before the member's certificate is reinstated. 26

Ethical Theories: Resolving Issues q Ethical problem occurs when an individual is morally or ethically required to take an action that conflicts with his or her immediate selfinterest q Ethical dilemma occurs when there are conflicting moral duties or obligations q Ethical theories present frameworks to assist individuals in dealing with both ethical problems and dilemmas. Two such frameworks - utilitarian theory and rights theory - have influenced the development of codes of conduct and can be used by professionals dealing with ethical issues 27

Utilitarian Theory Utilitarian theory - an action is ethical if it achieves the greatest good for the greatest number of people. Utilitarianism requires: q. Identify potential problem and courses of action q. Identify potential impact of actions on each affected party q. Assess the desirability of each action q. Perform overall assessment of the greatest good for the greatest number Problems with utilitarianism include: q. Disagreement about the likely impact of actions q. Problems measuring the "greatest good" q. Assumption that the ends achieved justify the means 28

Rights Theory q Rights theory - evaluates actions based on the fundamental rights of the parties involved. Uses a hierarchy of rights where higher-order rights take precedence over lower-order rights. q Rights theory requires the rights of affected parties be examined as a constraint on ethical decision making. q It is most effective in identifying outcomes that should be eliminated or identifying situations in which the utilitarian answer would be at odds with most societal values. 29

An Ethical Framework (Using the Utilitarian & Rights Theories) q Identify the ethical issue(s) q Determine the affected parties and identify their rights q Determine the most important rights q Develop alternative courses of action q Determine the likely consequences of each proposed course of action q Assess possible consequences including estimation of the greatest good for the greatest number q Determine whether rights framework would cause any action to be eliminated q Decide on appropriate course of action 30