MODULE B

Professional Ethics

LEARNING OBJECTIVES

| | | |
| |Review |Exercise, Problems, |
| |Checkpoints |and Simulations |
| | | |
|Understand general ethics and a series of steps for making ethical |1, 2, 3, 4 |54 |
|decisions. | | |
| | | |
|Reason through an ethical decision problem using the imperative, | |55, 56, 57 |
|utilitarian and generalization principles of moral philosophy. | | |
| | | |
|Identify the different entities that make ethics rules for CPAs and |5, 6 | |
|public accounting firms. | | |
| | | |
|With reference to American Institute of Certified Public Accounting |7, 8, 9, 10, 11 |45, 46, 47, 48, 53, 59, |
|(AICPA), Public Company Accounting Oversight Board (PCAOB), Securities | |62, 63, 65, 66, 67, 68 |
|and Exchange Commission (SEC), and Independence Standards Board (ISB) | | |
|rules, analyze factual situations and decide whether an accountant’s | | |
|conduct does or does not impair independence. | | |
| | | |
|With reference to AICPA rules on topics other than independence, analyze |12, 13, 14, 15 |49, 50, 51, 52, 58, 64 |
|factual situations and decide whether an accountant's conduct does or | | |
|does not conform to the AICPA Rules of Conduct. | | |
| | | |
|Explain the types of penalties that can be imposed on accountants. |16, 17 |60, 61 |

A Note on Module B, relating to the "Generalization Argument":

In the interest of fairness, it should be noted that the generalization argument does not work in all cases, particularly in two circumstances: (1) When the argument is invertible, that is (a) when both doing something and not doing something would be undesirable and (b) when both everyone and not everyone doing something would be undesirable. For example: "What if everyone was a full-time farmer?" The results would be undesirable in our society because all other social functions would disappear, but this cannot mean that no one should be a farmer because then we would all starve. (2) When the argument is reiterable, that is, when arbitrary times, places or measures can be inserted in such a way as to make a decision appear to be nonsense. For example, "What if every auditor were permitted to own 1/10 of a share of each client's common stock? Presumably, the consequences of such minor holdings would not be generally undesirable, and so ownership of 1/10 of a share could be permitted. Now change the amount to 2/10, 3/10, 10, 100, 99%, and the problem becomes one of "where to draw the line."

SOLUTIONS FOR REVIEW CHECKPOINTS

B.1 A professional accountant must be prepared to be agent, spectator, advisor, instructor, monitor, judge, critic.

B.2 Conscience might not be a sufficient guide for personal ethics decisions because the individual's indefinable mental processes may be based on caprice, immaturity, ignorance, stubbornness, or misunderstanding. Conscience may fail to show the consistency, clarity, practicability, impartiality, and adequacy preferred in ethical standards and behavior. Exactly the same can be said about professional ethics decisions because a non-hypocritical individual can no more split his behavior between personal life and professional life than he can voluntarily split his or her own personality.

B.3 The rule "Failure to tell the truth is wrong" would (a) require that the staff accountant refuse to "enhance" the financial statements, and (b) not worry about the consequence that seem to be predicted. (They might not turn out bad anyway if the company can get the loan honestly or can find another lender or can develop other means of survival.) This rule may be called imperative because it requires the truth regardless of what you might personally feel about the consequences. Strict imperative theory (e.g., Kant) excuses the individual from responsibility for undesirable consequences as long as the decisions do not cause other people to be used as means.

B.4 Utilitarian ethics theory requires that a decision maker recognizes value attributes of the consequences of ethical choice alternatives (good v. evil), somehow measure or weigh these, and then decide on the basis of the greater good (or the lesser evil). Imperative ethics does not require that consequences be considered.

B.5 Rules of conduct for practicing public accounting come from: • State boards of accountancy • American Institute of CPAs • State Societies of CPAs • Public Company Accounting Oversight Board • General Accounting Office

For practicing internal auditing: • The Institute of Internal Auditors (IIA) 1. Standards for the Professional Practice of Internal Auditing 2. The Institute of Internal Auditors Code of Ethics

For practicing management accounting: • Institute of Management Accountants (IMA) • Standards of Ethical Conduct for Management Accountants

For Fraud Examiners: • The National Association of Certified Fraud Examiners
B.6 a. The AICPA PEEC makes independence rules applicable to (1) CPAs who are members of AICPA (not all CPAs are members) who (2) perform audits (of both public companies and private entities)

b., c. The SEC and PCAOB make independence rules applicable to (1) all accountants (most are CPAs but the law doesn’t specify CPAs), who (2) perform audits of public companies (only of public companies who file financial statements with SEC, not all other audits).

d. The ISB’s jurisdiction was the same as the SEC and PCAOB.

B.7 The intent of this question is to require students to study the SEC definitions. Yolanda is in the chain of command (item 3–person who evaluates performance or recommends compensation of Javier, the audit engagement partner of Besame), and Yolanda is a covered person in the firm. Independence is impaired when Yolanda owns Besame stock, but independence is not impaired when her close relative (brother) owns a small amount.

Javier is a member of the audit engagement team.

B.8 No. Audit independence is impaired when the audit firm’s employees render legal services of this type.

B.9 The SEC believes that people who use financial statements and auditors’ reports can be enlightened with information about auditors’ fee arrangements with clients. (The “enlightenment” involves users’ perceptions of auditor independence in light of the relation of non-audit and audit revenues from an audit client.)

What must be disclosed: (1) total audit fees, (2) total fees to the audit firm for consulting services on financial information systems design and implementation, plus (3) total fees to the audit firm for all other consulting and advisory work (over and above the audit fees and the information systems fees above). In addition, the disclosure rules also require: (1) tell whether the those charged with governance (including the audit committee or the board of directors) considered the audit firm’s information systems work and other consulting work to be compatible with maintaining auditors’ independence, and (2) if greater than 50 percent, the percentage of the audit hours performed by persons other than the principal accountant's full-time, permanent employees (“leased employees” in an “alternative practice structure” arrangement).

B.10 They both want to ensure that those charged with governance (including the public company audit clients’ audit committees and boards of directors) consider their auditors’ independence in general and in connection with non-audit services.

B.11 The threat to independence is that the auditor considering a job offer from a client might not perform audit work properly while on the audit team (out of some newfound loyalty and interest in the audit client’s success via financial reporting).

B.12 Ethical responsibility for acts of nonmembers under a member's supervision. A member shall not permit others to carry out on his behalf, either with or without compensation, acts which, if carried out by the member, would place a member in violation of the Rules of Conduct.

B.13 Rules specifically applicable to members in government and industry:

Rule 102 (Integrity and Objectivity): Members in government and industry cannot subordinate their judgment to superiors and produce misleading financial statements. Members in government and industry must be candid and not omit information when dealing with external auditors. Members in government and industry cannot have undisclosed conflicts of interest in their jobs.

Rule 203 (Accounting Principles): When members in government and industry represent their companies' financial statements as being "in conformity with GAAP," they are expressing an "opinion" and subject to Rule 203 that requires disclosure of any material departure from accounting principles promulgated by a body designated by Council (FASB and GASB).

Rule 501 (Acts Discreditable): Participation in the production of false and misleading financial statements is a discreditable act.

B.14 Control of accounting services:

1. CPAs shall have majority (50% or more) ownership and voting rights.

2. CPAs must have ultimate responsibility for attest services.

3. Non-CPAs cannot be passive investors--must be active in the practice. Non-CPAs cannot hold themselves out as CPAs. Non-CPAs must abide by the AICPA Code of Professional Conduct. Non-CPAs must have the same educational levels and meet the same continuing education requirements as CPAs.

B.15 This checkpoint is just a reminder that rules cannot cover all ethical decisions that an accountant may encounter.

B.16 This question is about self-regulation penalties. AICPA and the state societies can: • Admonish a violator (slap on the wrist) • Suspend the violator's membership • Expel the violator from membership in AICPA and a state society of CPAs • Require CPE hours to be undertaken by the violator • Publish the violator's name in a report of proceedings (e.g., in CPA Letter and a state society newsletter or magazine

B.17 This question is about public regulation by government agencies. State boards of accountancy can:

1. Admonish a license holder (slap on the wrist) 2. Suspend the violator's license to practice in the state 3. Revoke the violator's license to practice

The U.S. Securities and Exchange Commission can deny (temporarily or permanently) the privilege of practice before the SEC with a "Rule 102(e)" proceeding. (The SEC can also "censure" a CPA, which amounts to a slap on the wrist and settle for an injunction in which the CPA promises not to violate the rules of conduct in the suture.) In addition, where laws are broken (e.g. rule 501) the SEC can initiate legal proceedings resulting in fines and/or imprisonment.

The Internal Revenue Service can:

1. Suspend a CPA from practice before IRS 2. Disbar a CPA from practice before IRS (revoke the right to represent clients before IRS)
SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS

B.18 a. Incorrect Independence in fact is a mental quality. b. Correct Appearances influence the public. c. Incorrect Standards of field work do not mention independence. d. Incorrect This is the first of the GAAS standards of field work.

B.19 c. Correct Sarbanes-Oxley and PCAOB have placed the responsibility for ensuring that the external auditors are independent on those charged with governance (including the audit committee).

B.20 a. Correct Imperative means that a rule is always followed. b. Incorrect Utilitarian means that some exceptions based on a calculation of good and bad outcomes is sometimes used. c. Incorrect This is the second best answer because generalization can resemble imperative thought. d. Incorrect The firm is following a rule, not listening for "inner voices."

B.21 a. Incorrect FASB makes accounting principles (not independence rules) b. Incorrect GAO makes auditing standards for government audits c. Correct The PCAOB (in cooperation with SEC) makes independence rules for auditors of public companies d. Incorrect ARSC makes practice standards for accountants’ work on unaudited financial statements

B.22 a. Incorrect Merely auditing competitors does not impair independence. b. Correct This item is written to imply that the auditor subordinated judgment to the client’s officer, c. Incorrect Lack of competence itself is not an impairment of independence. While facts may be misrepresented, the auditors didn’t know it. d. Incorrect Another example of lack of competence. In this case the auditors misrepresented facts (giving the unqualified report when the audit was not entirely in conformity with GAAS), but they did not knowingly do so.

B.23 b. Correct Sarbanes-Oxley and the PCAOB have placed the responsibility for auditors’ independence on the audit committee. Primary in this responsibility is the monitoring of all engagements contracted with the external auditors to ensure that the auditors are not performing any assignments that are prohibited by PCAOB standards or otherwise impair the auditors’ independence.

B.24 a. Incorrect Rule 101 begins “A member in public practice...” b. Correct Integrity and objectivity are required of all members. c. Incorrect Rule 301 begins “A member in public practice...” d. Correct Prohibition of discreditable acts applies to all members.

B.25 a. Incorrect: Independence is impaired by this type of bookkeeping service. b. Correct: Independence is not impaired for nonfinancial-statement related internal audit services when the client has its own Director of Internal Auditing in charge. c. Incorrect Independence is impaired when the audit firm performs more than 40% of financial-related internal audit work (for clients with more than $200 million assets) d. Incorrect: Independence is impaired when auditors perform important actuarial work, then audit their own work product (the client’s actuarial calculations based on the audit team-prepared assumptions).
B.26 a. Incorrect The answer is both (a) and (b). Independence is not impaired in (a). Managers not on the engagement can own shares in nonclient sister funds. b. Incorrect The answer is both (a) and (b). Independence is not impaired in (b). Independence is not impaired Close family members of audit partners can own shares in audit client sister funds not audited by the close family member’s kin, so long as the shares are held through the family member’s employee benefit plan. c. Correct: Independence is not impaired in both (a) and (b). d. Incorrect Independence is not impaired in both (a) and (b).

B.27 a. Incorrect A spouse is defined as an immediate family member. b. Incorrect A spousal equivalent is defined as an immediate family member. c. Correct A parent is defined as a close relative, but is not an immediate family member d. Incorrect An uncle is neither an immediate family member nor a close relative

B.28 a. Incorrect The audit organization may not reduce the scope of its audit. b. Incorrect There are restrictions concerning where in the organization the nonaudit work can be performed. c. Incorrect The audit organization must document why the nonaudit service does not affect independence; not the government organization. d. Correct The scope of the audit work cannot be reduced because of the nonaudit services.

B.29 a. Incorrect Auditors freedom to talk with clients about employment is not denied. The audit firm simply must compensate for the threat to quality audit work. b. Incorrect Maybe a second-best answer, but the “efficiencies” are offset by the extra review the audit firm is obligated to perform. c. Incorrect Former audit partners can retain material retirement accounts only if they are fixed as to amount and timing. (The “variable” word in the question is supposed to negate the “fixed” requirement.) d. Correct Discussion of former firm employees now employed in accounting and reporting roles in the client is a matter for the independence reporting to the board.

B.30 d. Correct Along with the ASB and MCS Executive Committee.

B.31 b. Correct Along with the FASB and GASB.

B.32 a. Correct He is "holding out" as a CPA and performing services other CPAs perform. b. Incorrect Mere partnership with another CPA is not enough if the other CPA does not "hold out." c. Incorrect same idea as b. d. Incorrect If he does not "hold out" as a CPA, he is not in public accounting, according to the AICPA.

B.33 a. Incorrect CPAs generally prefer to compete on the basis of quality of service rather than price. b. Incorrect The conventional wisdom is the opposite. c. Correct The FTC dragged the AICPA kicking and screaming into the agreement. d. Incorrect The AICPA "principles" statements assert that objectivity is always necessary.

B.34 a. Incorrect Independence is impaired by a direct financial interest in the client. b. Incorrect Independence is impaired by the attribution of the financial interest of the spouse. c. Incorrect Independence is impaired by having a nondependent close relative in an audit-sensitive position with the client. d. Correct This is a situation of having an immaterial financial interest in a nonclient investee that is immaterial to the client's financial statements.
B.35 a. Incorrect "Must" is wrong. The public accounting firm can explain why the departure is necessary and then give an unqualified opinion paragraph in the auditors’ report.. b. Correct Rule 203 permits the explanation and the unqualified opinion. c. Incorrect "Must" is wrong. The public accounting firm can explain why the departure is necessary and then give an unqualified opinion paragraph in the auditors’ report.. d. Incorrect The opinion paragraph can be unqualified, but with the explanation, the report is not "standard."

B.36 a. Incorrect You cannot even tell a credit agency about the client's payment record. b. Incorrect The actuarial assumptions are not required to be disclosed by GAAP or GAAS in tax engagements. c. Incorrect Plans of this nature are not required by GAAP or GAAS. d. Correct Client permission is not needed for information required by GAAP in audited financial statements.

B.37 a. Correct These are generally considered outside the reach of professional conduct rules. b. Incorrect Failing to file one's own tax return is discreditable. c. Incorrect Filing a fraudulent tax return, even for a client in financial difficulty, is discreditable under AICPA interpretation. d. Incorrect Employment discrimination is discreditable.

B.38 a. Incorrect Selling products for profit is not forbidden by any rule. b. Incorrect Authorship itself is not forbidden. c. Correct Rule 503 prohibits commission compensation for referring products or services to clients for whom the CPA performs attest services. d. Incorrect Rule 503 permits CPAs to pay fees to obtain clients. (This answer is "close" to correct--forbidden--because the CPA must also disclose the fee payment to the new client.)

B.39 a. Incorrect The AICPA does not grant licenses to practice. b. Incorrect The state CPA societies do not grant licenses. c. Incorrect The ASB does not grant licenses. d. Correct The state board is the regulatory agency that grants a license to practice and can revoke one.

B.40 a. Incorrect Withholding client records is an “acts discreditable”. b. Incorrect Failing to file or remit tax payments is a felony and as such is an “acts discreditable”.. c. Incorrect Failure to follow standards during an SEC audit is “acts discreditable”. d. Correct Violating the advertising standards is a violation of rule 502 not rule 501 “acts discreditable”.

B.41 a. Correct A direct financial interest disposed before the auditor-client relationship arises does not impair independence. b. Incorrect A short sale creates the commitment to acquire the client's stock which impairs independence. c. Incorrect Service in the capacity of management during the period covered by the financial statements impairs independence. d. Incorrect Performing accounting services and preparing financial statements when the client cannot take responsibility for them impairs independence.
B.42 a. Incorrect Rule 301--Confidential Client Information is not relevant because the CPA did not tell anyone else about the omission. b. Correct Rule 102--Integrity and Objectivity. The CPA knowingly misrepresented facts. c. Incorrect Rule 101--Independence. Independence is not required in tax practice. d. Incorrect Rule 203--Accounting Principles is not relevant because the CPA is not giving an opinion on financial statements' conformity with GAAP.

B.43 a. Correct This is a commission – a percentage paid in connection with a business activity.

B.44 a. Correct A Non-CPA can be a partner if he or she does not have a majority interest and is not have ultimate responsibility for the firm’s services. b. Incorrect A CPA must have ultimate responsibility for the firm services. A non-CPA cannot be the managing partner. c. Incorrect A majority owner and partner in the firm cannot own stock in an audit client. d. Incorrect Non-CPA owners of the firm must hold a bachelor’s degree.

SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS

B.45 SEC Independence Rules

In these solutions, the responses below do not try to contemplate all the “maybe” exception conditions cited in the text related to the SEC independence rule exceptions.

a. Yes. A member of the engagement team cannot hold a direct financial interest.

b. Yes. No other partner in the Santa Fe office (covered persons) can own direct financial interest in CCC.

c. Yes. Immediate family members of covered persons in the firm cannot hold direct financial interest in CCC.

d. Yes. The son (presumed a dependent) is also an immediate family member.

e. No. Now according strictly to the definition, the father is a close family member (not an immediate family member) and the financial interest in CCC does not impair SIDA & Co.’s independence.

f. Yes. Controlling interests in audit clients when held by close family members of covered persons in the firm impair independence.

g. Yes. Independence is impaired when close family members of a covered person in the firm (Javier) holds a job with a client in a accounting or financial reporting role.

B.46 SEC Independence and Nonaudit Services

In these solutions, the responses below do not try to contemplate all the “maybe” exception conditions cited in the text related to the SEC-prohibited non-audit services.

a. Independence appears to be impaired because the SEC does not allow bookkeeping or other services by the audit team to prepare financial statements.

b. Independence appears to be impaired because the SEC does not allow “covered persons’” involvement in financial information systems design and implementation work to include designing or implementing a software system or supervising the client’s system.

c. Independence appears to be impaired because the audit firm audited its own work.

d. Independence is not impaired. Auditors can audit actuarial calculations when they have been originally prepared by clients’ actuaries (just like auditing a client-prepared depreciation schedule).

e. Independence is not impaired. According to the literal rule, the out-sourced internal audit work does not cover financial controls and financial statements, and Section has in place its own internal audit director with complete authority for all aspects of the work.

f. Independence is impaired. Churyk is a covered person (having authority in the chain of command), and she performs a management function by signing stock option documents on behalf of Section.

g. Independence is impaired because the SEC rule seems to be very strict to prohibit all aspects of executive search activity for audit clients.

h. This item is written to induce thought without keying directly to SEC-prohibitions on broker-dealer services. However, a conservative conclusion is that independence is impaired because the audit firm (albeit indirectly) performed broker-dealer services for the audit client.

i. Independence appears not to be impaired. While these export-import tax services have feathers like legal services, waddle like legal services, and quack like legal services, they do not involve strict legal work that requires admission to a lawyer’s bar association (admission to practice before a U.S. court).

B.47 Audit Simulation: Independence, Integrity, and Objectivity Cases

a. Interpretation--Honorary Directorships and Trusteeships. The CPA will not be considered independent unless:

1. the position is in fact purely honorary, and 2. listings of directors show she is an honorary director and 3. she restricts participation strictly to the use of her name, and 4. she does not vote or participate in management functions.

b. No violation, but students should note that Wolfe is "practicing public accounting" by virtue of "holding out as a CPA" and performing the types of services offered by other public accountants.

c. Interpretation--Accounting Services. The CPA must be careful to know whether outsiders would perceive relationships that would indicate status as an employee, hence impairing the appearance of independence. In particular, the CPA must:

1. Not have any business connection with Harper Corp. or with Marvin Harper that would in fact impair independence, objectivity and integrity, and

2. Impress Marvin Harper (and the board of directors) that they must be able and willing to accept primary responsibility for the financial statements as their own, and

3. Not take managerial responsibility for conducting operations of the Harper Corp. (although the CPA's supervision of the bookkeeper seems to have this characteristic), and

4. Conduct the audit in conformity with GAAS and not fail to audit records simply because they were processed under the CPA's supervision.

This case assumes Harper Corp. is not reporting to the SEC, in which case the CPA's audit independence would certainly be impaired as a result of participating in the bookkeeping work.

d. Interpretation of Rule 101.A.4 Independence is not impaired. Poirot's loan is "grandfathered," since it was acquired before 1992 and because it was obtained from a financial institution for which independence was not required (Farraway was not a client before merger with Nearby) but which later became part of an audit client's portfolio.

e. Interpretation of Rule 101.A.4 Independence is impaired. Not even home loans made under normal lending conditions are exempt from the prohibition. Paying off the old grandfathered loan does not matter.

f. Interpretation of Rule 101.A.4 Independence is impaired. Since the accounting firm and its partners own more than 50% of the partnership, the loan is considered to be a prohibited loan from a client.

g. Interpretation of Rule 101.A.4 Independence is not impaired. The CPAs own less than 50% of the partnership.

h. Independence is impaired. Interpretation 101-1. Since Schultz can order the investment under the insurance contract, the financial interest is a prohibited “direct” financial interest.

B.48 Audit Simulation: Independence, Integrity and Objectivity Cases

(a, b, c, d, e, f) Interpretation--Effect of Actual or Threatened Litigation on Independence.

In general, when the present management of a client commences or expresses an intention to commence legal actions against its public accounting firm, the public accounting firm and the client management may be placed in adversary positions in which the management's willingness to make complete disclosures and the auditors’ objectivity may be affected by self-interest. Independence may be impaired whenever the auditors and the client or its management are in positions of material adverse interest by reason of actual or threatened litigation. Various situations are hard to generalize, and the responses offered below are guidelines expressed in AICPA Ethics Interpretations (Effect of Litigation).

a. An expressed intention by the client to begin litigation alleging deficiencies in audit work is considered to impair independence if the public accounting firm concluded that there is a strong possibility that such a claim will actually be filed.

b. The commencement of litigation alleging deficiencies in audit work impairs independence.

c. The commencement of litigation by the public accounting firm alleging management fraud or deceit impairs independence.

d. The claim under subrogation by the insurance company would not "normally" affect auditors’ independence. In this case, the client and members of management are not the nominal plaintiffs. However, the idea of "normally" needs to be evaluated. If members of Contrary management are going to testify on behalf of the insurance company's interest and thus act in an adversary relation to the public accounting firm, independence would seem to be impaired. The substance of the situation is essentially the same as if Contrary Corporation was the named plaintiff.

e. Litigation not related to the audit work, whether threatened or actual, for an amount that is not material to the audit form or to the financial statements of the client would not usually be considered to affect the CPA-client relationship in such a way as to impair independence. However, according to the SEC, this situation might impair independence.)

f. The class action lawsuit against both public accounting firm and company in itself would not alter fundamental relationships between the management and directors and the public accounting firm and therefore would not be considered to have an adverse impact on the auditors’ independence. These situations, however, should be examined carefully.

Actions to be taken. When independence is considered impaired, the public accounting firm should (a) withdraw from the audit engagement in order to avoid the appearance that self-interest would affect his objectivity or (b) disclaim an opinion because of lack of independence, as prescribed by GAAS.

g. Interpretation--Investor or Investee Relationships with Nonclients

The CPA's financial interest in Dove Corp. (investor) is sufficiently large to allow him to influence the actions of Dove, and the CPA's (and the public accounting firm's) independence would be considered impaired. The CPA's ability to influence Dove Corp. could permit him to exercise a degree of control over Tale Company (the investee, a client) that would place the CPA in a capacity equivalent to that of a member of management.

B.48 Audit Simulation: Independence, Integrity and Objectivity Cases (Continued)

h. Interpretation--Investor or Investee Relationships with Nonclients.

Independence is impaired. The exception does not apply: The nonclient investee (Hydra) is material to the investor (Sabrina); no matter whether the investment is or is not material to the CPAs' wealth. The reasoning is that the client investor (Sabrina) has the ability to influence the nonclient investee (Hydra, in which the Queens have ownership), and Sabrina can therefore increase or decrease the CPAs' wealth. Since the CPAs are associated with Sabrina, the firm may appear to lack independence in relation to being able to interact with the management that can influence the CPAs wealth (via Hydra).

h. Rule 101--Interpretation 101

1. Assuming that the First National Bank is a profit-seeking enterprise, the independence of the auditors is not impaired by the association of the two individuals who served both as members of the auditing firm and as directors for the client during the period examined as long as they have ended all ties with the bank and are not involved in the audit.

2. The auditors’ services may consist of advice and technical services, but he must not make management decisions or take positions which might impair his objectivity. The independence of the auditing firm would be compromised by any partner making a decision on loan approvals and the minimum balance checking account policy, but normally not by his performing a computer feasibility study. If the former controller's participation in the feasibility study was objective and advisory, and his advice was subject to effective client review and decision, the firm's independence has not been compromised. It is desirable, however, that the former controller not participate in the audit of the First National Bank's financial statements. (AICPA Adapted)

j. Rule 101. The acceptance by the CPA of the unsecured interest-bearing notes in payment of unpaid fees would not be construed as discrediting the CPA's independence in his relations with his 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 fee. Under SEC rules, however, a definite arrangement for paying the notes must be stated by the client. However, the acceptance of two shares of common stock (or prior commitment to accept stock) would be a violation of Rule 101. Any direct financial interest such as common stock holdings are construed as discrediting the CPA's independence. (AICPA adapted)

k. Ruling -- Acceptance of a Gift. (Not in text. Use common sense.) The Code of Ethics does not apply to Debra. She's neither a CPA nor a member of AICPA. The ruling applies to independence of a firm if an employee accepts a gift that is more than token. Independence is impaired because a member cannot permit his employees to break rules he himself is obligated to observe.

l. Rule 101.4.A: Ruling 52 (ET 191.104)--Past Due Fees. Independence is considered impaired. At the time a member issues a report on financial statements, the client should not be indebted for more than one year's fees. In the Groaner case, the debt would be for last year and the current year audit fees. Groaner will have to pay the fees for last year when the current year report is ready (or else get a non-independent disclaimer). The past due fees take on characteristics of a loan within the meaning of Rule 101, and collection may depend on the nature of the auditors’ report on the financial statements.

B.48 Audit Simulation: Independence, Integrity and Objectivity Cases (Continued)

m. Rule 102--Integrity and Objectivity The CPA has violated the rule. The CPA (1) lacked integrity, (2) knowingly misrepresented facts by omitting the gain in the current-year tax return, and (3) subordinated CPA judgment to another (the client). The proper action is to file an amended return for last year and request a refund, then file a correct return for this year.

n. Rule 102--Integrity and Objectivity Both CPAs probably violated Rule 102. Lestrade has a conflict of interest in owning another business that provides services to her employer and (apparently) not disclosing the business to Baker's board of directors. The "prepaid expenses" classification is wrong. Lestrade has falsified an entry in the accounts and in the financial statements (a violation of Rule 501). Both CPAs have fooled the external auditors by lying about the related party loan and the repayment terms.

B.49 Integrity and Objectivity

This is a true case. It is clear that Deloitte subordinated its judgment to the judgment of the other firms. This is clearly against the standards interpretation of integrity and objectivity. Students’ opinions may vary as to the need for other auditors’ opinion. However, it should be emphasized that while you may be persuaded by others that based on the facts of the case a change in your position is warranted, you should not change your judgment solely because someone else makes a different judgment based on the facts.

The transaction in question was one of the focal points during an investigation of Liven and regulatory bodies and experts in accounting and auditing took exception with regards to recording any of this as revenue.

B.50 Audit Simulation: General and Technical Rule Cases

a. Rule 201 Professional Competence The competence provision of Rule 201 is probably not violated. A CPA can learn about a technical area while work is in progress. Anyway, Cheese acquired significant technical expertise (competence) by placing Gilliam on the audit team.

b. Rule 202: GAAS--Fourth Standard of Reporting The CPA violated Rule 202 by not following the fourth GAAS Standard of Reporting. The CPA prepared financial statements and (apparently) did not render a report of the work and the degree of responsibility as required by GAAS. The CPA should have attached a compilation report to the unaudited financial statements, declaring lack of independence. The CPA is "associated with" the financial statements, practices public accounting, and should render a report.

c. Rule 203--Accounting Principles No violation of Rule 203. Students may not know enough accounting to answer this question well. Rule 203 refers to official pronouncements made by bodies designated by Council (i.e., FASB), not to GAAP in general. GAAP is "all the accounting that has authoritative support." SEC requirements hold the place of highest level of authoritative support for public companies, but Monty is not a public company. The SEC-required tax reconciliation disclosure is not in FASB pronouncements. The financial statements contain no departure from an FASB financial accounting standard. If Monty were a public company, the financial statements would be "in accordance with FASB pronouncements," but not "in accordance with GAAP."
B.50 Audit Simulation: General and Technical Rule Cases (Continued)

d. Rule 203 Accounting Principles No violation. Chapman is following the exception clause of Rule 203--believing a departure from FASB pronouncements is necessary to prevent financial statements from being misleading, explaining the departure, then giving the unqualified opinion. (This topic is also covered in Chapter 12.)

B.51 Responsibilities to Clients’ Cases

a. Rule 301 (and Rules 201 and 202). Retaining an outside mail service to handle confirmation of accounts receivable for the CPA is not acceptable practice. The confirmation of receivables is an important part of the audit, and therefore cannot be delegated to a nonaccountant, unsupervised by the CPA. Such an arrangement would violate Rule 202 concerning the observance of Generally Accepted Auditing Standards, especially the General Standards and the Standards of Field Work. In addition, the use of an outside mailing service for this work would be a violation of Rule 301 concerning the confidentiality of information obtained from the client's records. The public accounting firm would be making available to outsiders (the mailing service's personnel) a list of the client's customers and their outstanding balances. The auditors would probably also be in violation of Rule 201, (General Standards) parts (b) and (c).

b. Rule 301. The CPA has apparently violated the rule. (In the author's opinion, however, the violation has some justification. While justification does not necessarily excuse rule-breaking completely, any penalty for doing so should be light in a case like this one.) The CPA should seek client permission to disclose information to anyone (including a successor auditor). The banker should ask Candentoe to permit the CPA to speak to him, and refusal should itself raise questions and cautions for the banker.

c. Rule 301. Interpretation. A prospective purchaser may review the client files before purchasing the practice, but client permission must be obtained to turn them over to a new owner.) Turning over work papers and business correspondence to a purchaser of a public accounting practice would be proper only if consent of the clients to whom such papers relate has been obtained. Otherwise, the action would be a violation of Rule 301 regarding the confidentiality of information obtained from clients.

d. Rule 301, Ruling (ET 391.006) Information to Successor Accountant about Tax Return Frauds. Rule 301 is not intended to help an unscrupulous client cover up illegal acts or otherwise hide information by changing CPAs. The former CPA should at a minimum suggest that her CPA friend (successor) ask Harvard Co. to permit the former CPA to discuss all matters freely. If Harvard refuses, the successor CPA can consider himself warned. Upon withdrawing, the fired CPA should have stated all her reasons and her knowledge of frauds in a letter to Harvard Co. Now in answer to the successor CPA's inquiry she could suggest that he ask Harvard to show him the letter. (Author's note: Notwithstanding the rule of confidentiality, the fired CPA could do her colleague a great disservice if she did not make sufficient effort to put him on guard.)

e. Wallace violates AICPA Rule of Conduct 301. Information gained in the course of work for a client (B. Ward, individual tax client) is confidential and cannot be disclosed to any other client or any other person without B. Ward’s express permission.

f. Rule 302 still prohibits contingent fees on uncontested tax matters - original and amended returns.

g. Since the rules imply that auditors are not independent if they have received a contingent fee "during the period covered by the financial statements," then the CPA cannot be Faddle's independent auditor.
B.51 Responsibilities to Clients Cases (Continued)

h. Rule 302 Interpretation. The CPA violated Rule 302 by taking a contingent fee from a client for whom attest (audit) services were performed. Burgess, Maclean, and Cairncross are all considered clients of the CPA. The CPA performed the audit of Maclean for Cairncross (the holding company) at the direction and request of Burgess. The fee as described--paid only if the IPO is successful--is a contingent fee.

B.52 Audit Simulation: Other Responsibilities and Practices Cases

a. Interpretation 501-1 (ET 501.02) Acts Discreditable.

The lien under state law does not matter for Rule 501. The CPA violates Rule 501 if he does not return the cash disbursement journal.

b. Interpretation Rule 501

The CPA committed a discreditable act. The CPA Examination is "nondisclosed," and inducing exam-takers to recite the questions for disclosure purposes in violation of their agreement not to disclose is discreditable.

c. Interpretation 502-1 (ET 502.02) and ET 502-2 (ET 502.03) and Ruling 33 (ET 591.066).

Information about the CPA’s firm, his educational background, and his professional affiliations is permitted under Rule 502. Testimonials are permitted, but the comparisons with other CPAs are inadvisable since they are probably not based on verifiable facts.

d. Ruling 78 (ET 591.156) Letterhead: Lawyer—CPA.

The AICPA rules of conduct do not prohibit dual practice, and the dual letterhead description is permitted. The CPA should also determine whether such practice and letterhead description is permitted by the State Bar.

e. Rule 503: Referral fees are permitted, as long as they are disclosed.

f. Rule 505. Ruling 134 (ET 591.268) Association of Accountants Not Partners.

Others could assume a partnership existed. Any reports issued under the joint heading would violate Rule 505. A letterhead should not be used showing the names of two accountants when a partnership does not exist. The first name is misleading.

g. Rule 505 and Ruling 145 (ET 591.290) permit retention of the retired partner's name in the name of the successor partnership.
B.53 AICPA Independence and Other Services

AICPA Interpretation 101-3 (Performance of Other Services: www.aicpa.org) cites several “other services” that do and do not impair audit independence. Go to the AICPA website, and find whether the items below impair independence (“yes”) or do not impair independence (“no”) when performed for audit clients.

Impair Independence? -----------------

a. Post client-approved entries to a client’s trail balance. NO b. Authorize client’s customer credit applications. YES c. Use CPA’s information processing facilities to prepare client’s payroll and generate checks for the client treasurer’s signature. NO d. Sign the client’s quarterly federal payroll tax return. YES e. Advise client management about the application or financial effect of provisions in a employee benefit plan contract. NO f. Have emergency signature authority to co-sign cash disbursement checks in connection with a client’s hospital benefit plan. YES g. As an investment advisory service, provide analyses of a client’s investments in comparison to benchmarks produced by unrelated third parties. NO h. Take temporary custody of a client’s investment assets each time a purchase is made as a device to reduce cash float expense. YES

B.54 General Ethics

This is a thought-type question that deals with the "whatever you can get away with" issue. Of course, an act has the same ethical character whether it is known to others or not. (Remember that an act that affects no one but the agent--rare as such acts may be--is one that has no substantive ethical implications.) The latter part of the question asks the student to project himself into his or her future business role.

B.55 Competition and Audit Proposals

The audit proposal scenario was adapted from a Wall Street Journal article entitled "Ethics on the Job: Companies Alert Employees to Potential Dilemmas" (July 14, 1986). It was reported to have been used in a company ethics training/awareness session. Cases like this do not pretend to have "solutions" 100 percent acceptable to everyone. The Wall Street Journal reported the following:

Some participants said: Dena should do as she's told. She's not on a level where she's supposed to think. She doesn't know all the facts. It may not be what she thinks.

Others said: Dena should refuse. The situation has a "bad smell." She should keep her own hands clean. (Caution. Always worry about someone who thinks through his or her nose!)

B.56 Engagement Timekeeping Records

As in all cases of this type, a "solution" is difficult. Some discussion thoughts:

1. Ed is indeed lying by making false timekeeping records.

2. The budget appears to be unrealistic. Apparently, Sara did not know (or did not care) that seven cash accounts had been added, and the work should take longer (probably in comparison to last year's time budget).

3. Ed does not seem to give credit to Sara for the possibility of explaining why the work took longer. The case seems to set Sara up as a tyrant about the budget.

4. Ed compounds the lie by putting the extra time in a budget area where someone else will seem to have fewer hours to do another segment of the work (internal control evaluation). Ed is also improving his chances of getting caught, because surely Sara can see that his work had little or nothing to do with internal control evaluation.

5. Juggling the time records, if successful, will have an effect on next year's audit staff. Auditors typically use the prior year actual time records to help plan the current time budget. If they are misstated, the next time budget may also be unrealistic. Sooner or later, some poor assistant will have to pay!

B.57 Audit Overtime

1. Many aspects of this case are similar to B.35, except that Elizabeth did not put the extra time anywhere else. She just donated four hours of her own time (maybe seven hours if she was not paid for the time worked at home). Of course, her action makes it look like the work can be done in six hours next year.

2. Receiving help from her husband overnight should not raise any new issues. This event just increases the number of unreported hours. (Actually, some students may see a new issue related to Rule 301--revealing client information to someone outside the firm.)

3. Leaving the work with the husband raises the new issue of having audit work done, unsupervised, by someone not employed by the firm who may be unqualified to do it correctly. Students should ask whether Elizabeth reviewed all her husband's work before putting in the working paper file. (The confidentiality issue can be raised again.)

B.58 Conflict of Clients' Interests

If Jack and Jill gang up on Bill, Jon may lose the work that goes to Phil. Despite the bad poetry, this situation raises a typical "Who's the client?" question. Unfortunately, the relevant relationships are Jon's individual engagements with Jack and Bill--because Jon would have essentially the same problem if Oneway Corporation were not a client. The situation is "unfortunate" because Jon is in a no-win situation. If he keeps Bill informed, he might save the Oneway engagement and Bill's friendship (not to mention the well-being of little Otto, his godchild), but he will suffer the guilt of having engaged in industrial espionage and might face an ethics complaint for having thumbed his nose at the rule of accountants' confidentiality. If Jon keeps quiet, he might lose the engagement and a significant portion of his personal income at least temporarily, Bill will probably suffer and life just won't be the same.

If Jon believes rules are the most important element of ethical behavior and the consequences of action or inaction must fall where they may, he will refuse Bill's request with an eloquent and sympathetic explanation of the professional reasons for not discussing other clients' business affairs. A happy outcome for this approach depends upon Bill's understanding the difficult situation he has created for Jon. (After all, Bill created the situation by asking Jon to give him the information. Friendship runs both ways, and in this case Bill has unintentionally been "unfriendly.") If Jon believes in weighing the "good and evil consequences" of ethics-related choices, he will need to decide which ultimate outcome is most desirable: Bill's well-being (and his own income) or Jack's and Jill's well-being, whatever it may be. Choosing to tell Bill about Jack's plans could be construed as a selfish act on Jon's part. Professional "selfishness" may not be against the rules, but in this case, different avenues of analysis seem to suggest the rule is a good one, even in this difficult personal situation.

B.59 Managerial Involvement and Audit Independence

This scenario was adapted from the facts of an actual case. In the real case, the company (Hobart) experienced financial difficulty, defaulted on the loan, and the CPA firms were investigated. The criticism was focused on the Wilde & Associates, LLP firm, because it was the firm of record and signed the auditors’ report. The question was "independence." The Wilde partner and manager had none of the independence problems of financial interests or managerial involvement. The issue concerned the "loaned" staff members (Lacosta and Martinez) who were employees of Marlowe & Chandler, the firm that certainly was not independent (because Marlowe was a member of the Hobart board of directors).

The CPA firms' position was that no problem existed because Marlowe and the Marlowe & Chandler firm had nothing to do with the audit. They did not supervise any personnel and did not make audit evidence or reporting decisions.

The facts of the case seemed to speak otherwise. Marlowe was in charge of the firm's audit practice. He was interested in the professional development and performance of Lacosta and Martinez. They, in turn, were very aware that Marlowe's evaluations affected their pay and promotion, indeed their continuance with the firm. As it turned out, Marlowe occasionally visited their work cubicle and asked "how's the Hobart audit going?" Marlowe also submitted the Marlowe & Chandler bills to Hobart for the work these assistants performed. He also responded briefly to some questions other board members posed about the audit while it was in progress. He knew about the audit. In his dual positions (director and partner in charge of the firm's audit department), he could not avoid some tangential knowledge of the audit. Certainly, Lacosta and Martinez were well aware of Marlowe's interest in seeing the loan application and the acquisition succeed.

The Wilde & Associates, LLP firm was judged to lack independence because of the association of Lacosta and Martinez to Marlowe and hence to the management of Hobart.

B.60 Disciplinary Action The solution will be different depending on the state and the time.

B.61 Audit Simulation: Ethics Case

There is a Rule 501 (acts discreditable) violations since failing to pay the taxes is a felony. Sally could receive any of the penalties available to the AICPA and the state board including admonishment, suspension, or expulsion.

A discussion of the penalties should ensue. Opinions may range from the least penalty since sally has resolved her legal difficulties; to the most severe penalties since the publicity regarding a member of the professions portrays a negative image of the profession and a severe penalty will send a message to the public regarding professional conduct.

B.62 Kaplan CPA Exam Simulation: Independence

|Which of the following should the CPA firm of Abernathy and Chapman designate as a covered member for this |
|engagement? |
|A member of the audit team who recently graduated from college and has only limited auditing |X |
|experience. | |
|A tax accountant employed by the firm of Abernathy and Chapman who is classified as a “senior” in | |
|the firm but who is not involved with the audit of Norman, Inc. | |
|A staff auditor employed by the firm of Abernathy and Chapman who is classified as a “senior” in | |
|the firm but who is not involved with the audit of Norman, Inc. | |
|A non-auditing administrator employed by the firm of Abernathy and Chapman who assigns personnel |X |
|to each of the audit engagements but does not work directly on any audit engagements. | |
|The CPA firm of Abernathy and Chapman itself. |X |
|A non-auditing administrator employed by the firm of Abernathy and Chapman who sets salary levels |X |
|for the auditing personnel but does not work directly on any audit engagements. | |

|Which of the following situations would cause the CPA firm of Abernathy and Chapman to not be considered independent |
|in respect to Norman, Inc. |
|A non-dependent brother of a covered member holds common stock of Norman, Inc., an amount that is | |
|considered to be less than a material amount. | |
|A dependent brother of a covered member has a financial interest in Norman, Inc., an amount that |X |
|is considered to be less than a material amount. | |
|An employee of Abernathy and Chapman who is not a covered member holds 4.2 percent of the | |
|outstanding shares of Norman, Inc. | |
|The spouse of a covered member is employed by Norman, Inc. in the company’s marketing department | |
|but is not in a position to influence the financial statements. | |
|The non-dependent father of a covered member is an employee of Norman, Inc. The father’s |X |
|employment position does have a significant relationship to the company’s accounting function. | |

B.63 Kaplan CPA Exam Simulation: Independence

|False |To emphasize independence from management, auditors are appointed by the shareholders of the company. |
| | |
| |(Auditors are appointed by the audit committee of the board of directors and voted on by the |
| |shareholders.) |
|False |To ensure independence, the public accounting firm cannot render an opinion on statements in a current|
| |year until all fees (including the current year) have been paid. |
| |(Only the fees from the prior year(s’) audit(s) need to have been paid; the fees for the current year |
| |audit could be paid after the auditors’ report release date.) |
|False |Any professional employee who is not a covered employee for a particular engagement can hold up to 10%|
| |of the outstanding stock of the client’s equity shares. |
| |(The statement is true for no more than 5% of the outstanding stock.) |
|False |A covered member’s close relatives could include his mother, his nephew, and his brother. |
| |(The covered member’s close relatives are defined as a parent, sibling, or nondependent child. |
| |Nephews do not fit any of those criteria.) |

|True |A covered member’s immediate family could include his common-law partner or his adopted son. |
| |(The covered member’s immediate family is defined to include a spousal equivalent and any dependent. |
| |A common-law partner qualifies as a spousal equivalent. A dependent could include an adopted child; |
| |an adopted child is treated the same as a blood relative.) |
|True |The CPA firm would be a covered member on any of its client engagements. |
| |(The firm itself, as a separate legal entity, is a covered member.) |

B.64 Mini-Case: Ethics

NOTE TO INSTRUCTOR: For this assignment, question 6 from this Mini-Case is applicable.

6. Opinions will vary. David Duncan directed the actual shredding of documents and probably knew an investigation was imminent. Even if he received direction from Nancy Temple concerning the document retention policy, he had the opportunity to determine the applicability of the policy to the situation and the ramifications of following the policy in this instance. Remember, many people have gone to jail or suffered even greater consequences utilizing the defense that they were only following orders – or, in this case, policy.

B.65 Mini-Case: Non-Audit Services and Independence

NOTE TO INSTRUCTOR: For this assignment, questions 1 through 3 from this Mini-Case are applicable.

1. The American Institute of Certified Public Accounting’s (AICPA’s) position on performing tax services for clients is consistent with the general prohibition against performing “management” duties for the client. In this particular scenario, the public accounting firm could provide tax planning advice and prepare the client’s tax returns; however, the public accounting firm should not be making operating decisions (including tax planning decisions) that affect the client.

The AICPA also provides guidelines for tax services for CPAs in public practice (for both audit clients and non-audit clients). Those guidelines can be found in the Statements on Standards for Tax Services and, among others, requires that (see TS 100):

• A CPA should not recommend that a tax return position be taken with respect to any item unless the position has a realistic possibility of being sustained administratively or judicially on its merits if challenged.

• A CPA should not prepare or sign a return that the member is aware takes a position that does not meet the above standard.

• A CPA may recommend a tax return position that the member concludes is not frivolous as long as the member advises the taxpayer to appropriately disclose.

• When recommending tax return positions and when preparing or signing a return on which a tax return position is taken, a member should, when relevant, advise the taxpayer regarding potential penalty consequences of such tax return position and the opportunity, if any, to avoid such penalties through disclosure.

However, the standards do recognize that, when recommending a tax return position, a member has both the right and responsibility to be an advocate for the taxpayer with respect to any position satisfying the aforementioned standards. This “advocacy” position has resulted in many believing that it is difficult for a CPA to provide tax services to audit clients, with the thought that the advocacy might “spill over” into the audit work.

As a direct result of the KPMG case, the Public Company Accounting Oversight Board (PCAOB) has recently adopted rules related to tax-shelter advice provided to an accounting firm’s audit clients. These rules, which are currently being reviewed by the Securities and Exchange Commission for final approval, prohibit the following types of services related to tax shelters:

• Tax services involving contingent fees for tax services.

• Tax services related to marketing, planning, or opining in favor of the tax treatment of a confidential transaction, or if the services are related to transactions that are based on aggressive interpretations of tax laws and regulations.

• Tax services to members of management (or their families) who serve in financial reporting roles at an audit client.

An exception to the prohibition would exist if the firm “reasonably” believes the strategies have a greater than 50% chance of being upheld if challenged by the Internal Revenue Service (see “Accounting Firms Get New Curbs on Tax Shelters,” Wall Street Journal, July 27, 2005, p. C1, C4.).

B.65 Mini-Case: Non-Audit Services and Independence (Continued)

2. Sarbanes-Oxley has placed some restrictions on the extent and type of nonaudit services that can be provided by a company’s audit firm. For example, under Sarbanes-Oxley, an audit firm can no longer provide information services consulting and internal auditing services to its attestation clients. As a result, companies desiring such services are contracting them with other providers (in many cases, large audit firms). The Wabtec Corp. and Intel Corp. examples discussed in this case illustrate how the nonaudit services provided by large accounting firms may actually limit companies’ choices of auditors.

3. The most frequently-cited example of permitting nonaudit services to be provided by audit firms to their attestation clients is the “knowledge spillover” effects; that is, information learned by the audit firm as they are providing these services will enable them to better identify areas of risk and conduct a more effective and efficient audit. The primary disadvantaged cited for permitting nonaudit services to be provided by audit firms is related to independence. Simply stated, as the audit firm is providing a higher level of services to its attestation clients, the financial dependence upon those clients increases, making auditors less likely to challenge client management on important issues arising during the attestation engagement.

B.66 Mini-Case: Non-Audit Services and Independence

NOTE TO INSTRUCTOR: For this assignment, questions 1 and 2 from this Mini-Case are applicable.

1. The requirements of Sarbanes-Oxley appear to enhance perceptions of auditors’ independence because of they prohibit certain types of nonaudit services that have been controversial in terms of their impact on auditors’ independence (financial information systems design and implementation and internal audit outsourcing). In addition, while Sarbanes-Oxley allows other types of nonaudit services, these services must be explicitly approved by the entity’s audit committee. This latter requirement would seem to provide users with greater assurance that potential conflicts of interest were carefully considered by the audit committee prior to approving nonaudit services.

2. In 2000, fees paid by General Electric (GE) to KPMG for nonaudit services were $64.2 million ($50.4 for financial information systems design and implementation and $13.8 million for tax services). This is substantially greater than the fees paid for audit and audit-related services (a total of $39.4 million). One potential downside of auditors insisting upon adjustments to GE’s financial statements is the fear of losing future revenues from nonaudit services, should GE decide to engage another firm to provide these services.

In 2004 and 2006, the fees paid to KPMG for nonaudit services were substantially less than that in 2000 ($8.9 million in 2004 and $9.0 million in 2006 versus $64.2 million in 2000). Further, the fees paid for audit services were substantially higher in 2004 and 2006 than in 2000 (total audit and audit-related fees of $93.7 million and $106.4 million in 2004 and 2006, respectively versus $39.4 million in 2000). As a result, GE’s auditors do not have the same monetary incentives related to nonaudit service revenues in 2004 and 2006 that they had in 2000.
B.67 Mini-Case: Effect of Sarbanes-Oxley on Fees

NOTE TO INSTRUCTOR: For this assignment, questions 3 and 4 from this Mini-Case are applicable.

3. An initial review reveals that total fees paid to KPMG increased following the issuance of Sarbanes-Oxley, but not as significantly as might have been expected. For example, the total fees paid to KPMG in 2004 ($102.6 million) actually decreased from fees paid in 2000 ($103.6 million). However, it is important to note that the fees paid in 2006 ($115.4 million) were markedly higher than those paid in any of the other years.

To compare GE’s fees prior to and following the issuance of Sarbanes-Oxley, the following table summarizes the percentage of total fees in each year that are related to each category; this information is summarized below (totals may not equal 100% because of rounding):

| | 2000 | 2002 | 2004 | 2006 |
|Audit fees |23.1% |43.3% |76.2% |74.4% |
|Audit-related fees |15.0% |26.1% |15.1% |17.9% |
|Tax fees |13.3% |23.7% |8.7% |7.8% |
|Financial information|48.6% |0.0% |0.0% |0.0% |
|systems fees | | | | |
|Other fees |0.0% |6.8% |0.0% |0.0% |

Sarbanes-Oxley had the following effect on GE’s fees:

• The internal control requirements of Sarbanes-Oxley significantly increased the percentage of total fees that were classified as audit fees in 2004 and 2006. In addition, the SEC’s revised definition of “audit fees” may have resulted in some of this increase.

• The prohibition of providing financial information systems design and implementation services eliminated this fee after 2000; as shown above, this fee was a significant portion of total fees paid by GE to its auditors in 2000.

• The fees paid for tax services also decreased in 2004 and 2006 compared to the level of these fees in 2000 and 2002. While tax services were not prohibited by Sarbanes-Oxley, it is possible that the requirement that audit committees specifically approve all nonaudit services may have reduced the extent of tax services provided to GE by KPMG.

B.67 Mini-Case: Effect of Sarbanes-Oxley on Fees (Continued)

4. The total fees paid by Fortune 100/500 entities to their auditors were quite stable over this period of time; for both groups of companies, the highest total fees were paid in 2000. In addition, both groups of companies experienced slight increases in their total fees paid to auditors from 2002 through 2006.

Similar to the analysis undertaken for GE, the following summarizes the percentage of fees paid by Fortune 100/500 companies to their auditors over this period of time (Fortune 500 results are in parentheses; totals may not equal 100% because of rounding):

| |2000 |2002 |2004 |2006 |
|Audit fees |24.3% |39.5% |69.1% |74.5% |
| |(26.3%) |(42.2%) |(71.8%) |(77.1%) |
|Audit-related fees |3.1% |13.7% |11.9% |11.8% |
| |(4.5%) |(13.2%) |(11.7%) |(11.0%) |
|Tax fees |3.8% |22.0% |16.9% |12.6% |
| |(2.7%) |(19.3%) |(14.6%) |(11.0%) |
|Financial information systems fees |13.4% |4.9% |0.0% |0.0% |
| |(12.7%) |(3.6%) |(0.0%) |(0.0%) |
|Other fees |55.5% |20.0% |2.1% |1.2% |
| |(53.6%) |(21.7%) |(1.9%) |(1.0%) |

The effects of Sarbanes-Oxley on fees paid to auditors by Fortune 100/500 companies are similar to the effects on GE, namely:

• The internal control requirements of Sarbanes-Oxley significantly increased the percentage of total fees that were classified as audit fees in 2004 and 2006. In addition, the SEC’s revised definition of “audit fees” may have resulted in some of this increase.

• The prohibition of providing financial information systems design and implementation services eliminated this fee in 2004 and 2006 (though GE paid much higher fees to its auditors for financial information systems design and implementation in 2000 than Fortune 100/500 companies).

• The fees paid for tax services also decreased in 2004 and 2006 compared to the levels of these fees in 2002. While tax services were not prohibited by Sarbanes-Oxley, similar to GE, it is possible that the requirement that audit committees specifically approve all nonaudit services may have reduced the extent of tax services provided to Fortune 100/500 companies.
B.67 Mini-Case: Effect of Sarbanes-Oxley on Fees (Question 4, Continued)

One major difference in the fees paid by Fortune 100/500 companies and GE is the large “other” fees paid by Fortune 100/500 companies. As shown above, these fees were a much larger percentage of total fees for Fortune 100/500 companies in 2000 and 2002 than for GE; in addition, these fees dramatically decreased following the issuance of Sarbanes-Oxley. It is possible that the difference between the Fortune 100/500 companies and GE is the result of classification differences.

B.68 Mini-Case: Indemnity Clauses and Independence

NOTE TO INSTRUCTOR: For this assignment, questions 1 through 5 from this Mini-Case are applicable. All quotations are from “Auditing ‘Liability Caps’ Face Fire,” The Wall Street Journal (November 28, 2005). 1. It is easy to understand why accounting firms favor alternative dispute resolution. Each of the major firms has been involved with clients who have suffered through major accounting scandals, and often the auditors are targets of corporate and investor lawsuits. Provisions for alternative dispute resolution efforts are included in engagement letters to try to limit auditor liability should something go wrong. “If [an audit client] runs into accounting problems and thinks a botched audit by [its auditors] is to blame, it is barred from taking the accounting firm to court. Instead, [it] has to go through mediation and arbitration. It also can't seek any damages beyond the actual, compensatory damages related to [the auditors’] conduct.” An Ernst & Young spokesman states that “these clauses have been part of our standard client agreements for some time and are not new” and notes that the provisions don’t limit the ability of investors to seek redress from the firm. 2. If major accounting firms want liability caps as part of the engagement letter, there is little that a company can do to have them excluded. However, it seems logical that companies would prefer to have this language excluded, since it potentially exposes them to greater losses. 3. Investors would probably prefer that these caps be excluded, since they can been seen as relieving auditors of their responsibility and encouraging less stringent audits. Further, some critics wonder whether the good will generated by a company’s decision to limit auditors’ liability might ultimately create a conflict of interest. Cynthia Richson, the corporate governance officer for the Ohio Public Employees Retirement System, states: “Some investors don't like what they see as the auditors' attempt to avoid accountability. It does a disservice to investors…. It's not in the company's best interests and not in the investor's best interests.” 4. The SEC has said that any move by a company to indemnify its auditor against liability would violate auditor independence. That bar doesn't apply specifically to the sorts of liability limitations the firms are using, but the SEC also says that if a reasonable investor believes such a provision causes a conflict of interest, then it impairs independence.
B.68 Mini-Case: Indemnity Clauses and Independence (Continued)

5. Whether or not liability caps impair independence is currently being debated by the PEEC. From its latest exposure draft (available at www.aicpa.org):

“Some limitations of liability provisions do not impair independence. For example, certain provisions commonly included in engagement letters or other agreements with clients that are used by members to facilitate dispute resolution or manage risk, such as provisions providing for alternative dispute resolution or waiver of jury trials and “loser pays” provisions do not impair independence. In addition, indemnification and limitation of liability provisions in nonattest engagements for attest clients and in engagements performed under the Statements on Standards for Attestation Engagements (SSAEs) that are required to be restricted to identified parties, do not impair independence. Also, agreements that define the respective responsibilities of the member and the attest client in a manner consistent with applicable attest standards do not impair independence. On the other hand, certain types of indemnification and limitation of liability provisions in an attest engagement are considered to pose an unacceptable threat to a member’s independence.”