CHAPTER 19: PROFESSIONAL CONDUCT, INDPENDENCE, AND QUALITY CONTROL

1. Ethics and Professional Conduct

- Ethics: code of conduct based on moral duties and obligations that indicate how an individual should interact with others in
society.

- Professionalism: conduct, aims, or qualities that characterize a profession or professional person.

o These rules are established so that (1) users of the professional services know what to expect when they purchase
such services, (2) members of the profession know what behavior is acceptable, and (3) the profession can use
the rules to monitor the actions of its members and apply discipline where appropriate.

- To be a credible source of objective, independent assurance, the professional must have a solid reputation for competence
and for unquestioned character and integrity.

a) Theories of Ethical Behavior

- Three overlapping methods or theories of ethical behavior that can guide the analysis of ethical issues in accounting.

o Utilitarian: Interest of all parties affected, not just one’s self-interest should be considered

 An action conforms only if that action will produce more pleasure or happiness for the greatest number of
people

 Value of an action: consequences of the action of welfare of individuals

 Disadvantage: difficult to measure the cost and benefits of actions + Difficult to balance interests of all
parties when they are conflict.

o Rights-based: individuals have certain rights and other individuals have to respect them.

 Should take action only if it does not violate the rights of any individual

 Disadvantage: difficult to satisfy all rights of all parties that conflict.

 The right of the public to have objectivity and clear information from auditor takes precedent over any
right.

 Auditors must see issues through others’ eyes and pur interests of stakeholders ahead their own self-
intersts.

o Justice-based: two principles:

 1st: person has a rigt to have the maximum degree of personal freedom that is still compatible with the
liberty of others.

 2nd: social and economic actions should be to everyone’s advantage and the benefits available to all.

 Disadvantage: difficult to apply in practice because the rights of one or more individuals or groups may
be affected when a better distribution of benefits is provided to others

2. An Overview of Ethics and Professionalism in Public Accouting

a. Standards for Auditor Professionalism

- AICPA established Auditing Standards and a Code of Professional Conduct, mapping out the primary areas in which ethical
conduct is expected.

- SEC allowed ASB to set accounting and auditing standards. SEC influences in the standard-setting process and has
established standards of its own.

- PCAOB adopted the Professional Standards of AICPA

 Privately held: auditing standards of ASB, Code of Professional Conduct, ISB

 Publicly held: auditing standards of PCAOB, Code of Professional Conduct, more strigent independence requirements by
SEC, ISB, and PCAO

3. The Newly Revised AICPA Code of Professional Conduct: A Comprehensive Framework for Auditors

- Code of Professional Conducts is organized into 3 parts:

 o Part 1: CPA in public pratice (public wil rely)  require CPA to be independent of the entities receiving assurance

o Part 2: CPA who is working in business but not working as auditor that issue assurance report on which public will
rely  not require independence but require integrity and objectivity

o Part 3: CPA who are neither audtior nor in business

- Principles of Professional Conduct: provide framework for Rules of Conduct for each part  not enforceable

- Rules of Conduct: minimum level of conduct a CPA must maintain  specifically enforceable

- Interpretations of Rules of Conduct: detailed interpretations and answers to questions regarding rules of conduct  not
specifically enforceable but departures must be justified

a. Principles of Professional Conduct

b. Rules of Conduct
 4. Integrity, Objectivity, and Independence

a. Integrity and Objectivity – Framework, Rule, and Intepretations

- Threats to CPA’s integrity:

o Adverse self-interest: CPA’s interest runs contrary to those of clients

o Self-interest threats: CPA is forced to choose between actions that futher his/her self-interests and actions that
serve the investing public’s interests.

o Advocacy threats: CPA might feel inclined to advocate for client’s preferred outcomes

o Familiarity threats: CPA have close, long-standing relationship with client that it becomes difficult to maintain
objectivity

o Management participation threats: CPA involved in management decisions can’t be ojective

o Self-review threat: CPA in a position that involves evaluating his/her own judgements.

o Undue influence threat: CPA’s integrity is pressured due to another involved party’s aggressiveness or domnant
personality

 Safeguards: depend on specific circumstance (additional training, uninvolved third parties, availability of hotlines and direct
consultation on ethical matters)

- Interpretations:
 o Interpretations 1.110: CPA performs professional service for an entity and the CPA has a relationship with
another entitiy that could be viewed as imparing CPA’s objectivity.

o Interpretations 1.130: Member who knowingly makes, permits, or directs another to make materially false and
misleading entries in FS violates to Intergirty and Objectivity Rule

o Interpretations 2.130.010: In dealing with his or her employer’s external accountants, a member must be
candid and not knowingly misrepresent facts or knowingly fail to disclose material facts

o Interpretations 2.130.020: if a CPA working in industry (e.g., as an accountant in a company) has a

disagreement with supervisor relating to the preparation of FS/transactions, the member must ensure that the
situation does not result in a subordination of judgment. If the member concludes that the FS could be materially
misstated, he or she should communicate those concerns to a higher level of management within the organization.
If appropriate action is not taken, the member should consider whether to continue the relationship with the
employer. The member should also consider communicating the problem to third parties, such as regulatory
agencies or the employer’s external accountants

b. Independence

- Independence is required in attest service (FS audit, FS reviews,…)

- Independence is not required in nonattest service (compile FS, tax preparation, financial planinng, consulting services) if
those services are the only services provided.

- Threats to CPA’s independece as above

- If such a threat does exist, the CPA considers whether the threat might reasonably be considered to compromise the
member’s professional judgment. If so, the CPA evaluates whether the threat can be effectively mitigated or eliminated
using various safeguards. Depending on the evaluation, the CPA implements safeguards to eliminate or reduce the threats
to an acceptable level or concludes that independence is impaired.
- Applied not only to engagement team or those influencing the engagement but also partners or managers of the CPA firm
who are not on the attest engagement team must also generally be independent of the entity if they provide nonattest
services to that entity (such as tax or consulting services), or even if a partner simply works in the same office as the attest
engagement’s lead partner.

- Interpretations of Independe Rule classified into 3 dimensions:

o Financial Relationships: Direct/Material indirect Financial interest.

 Financial interest: ownership interest in equity/debt security, including obligations to acquire the
interest

 Direct Financial interest:

 Interest owned directly, or is under the control of an individual/entity.

 Financial interest owned through an intermediary (trust) when beneficiary controls/supervises the
intermediary’s investment decision.

 Financial interest owned when individual is not the recorded owner but has a right to benefits of
ownership.

 Indirect Financial interest:

 An auditor or other covered member has a financial interest in an entity that is associated with
an attest entity

 The financial interest is beneficially owned through an investment vehicle, estate, trust, or other
intermediary
  The auditor does not control the intermediary or have authority to supervise or participate in the
intermediary’s investment decisions.

 Interpretation 1.240.030: if the mutual fund is diversified, and if the covered member owns 5 percent
or less of the outstanding shares of the mutual fund, the investment would not be considered to constitute
a material indirect financial interest

 Interpretaion 1.245.03: Because the investments generally ultimately revert to the owner and the
owner usually retains the right to amend or revoke the trust, both the blind trust and the underlying
investments are considered to be direct financial interests of the covered member.

 Interpretation 1.260.020: permits the following types of personal loans from an audited entity that
operates as a financial institution: (1) Automobile loans and leases collateralized by the automobile, (2)
Loans fully collateralized by the cash surrender value of an insurance policy, (3) Loans fully collateralized
by cash deposits at the same lending institution, (4) Credit cards and cash advances where the aggregate
outstanding balance is reduced to $10,000 or less by the payment due date.

 Interpretation in Code section 1.230: fees pertaining to services provided more than one year prior to
the date of the audit report remain unpaid, the auditor’s independence is impaired (except for bankruptcy
entity).

o Business Relationships:

 Interepretation in Code section 1.275: the independence of a CPA is impaired if the CPA performs a
managerial or other significant role for an entity’s organization during the time period covered by an attest
engagement. (former employee of entity becomes employed by CPA firm or CPA takes a job with former
audit entity).

 Interpretation 1.279.020: firm’s independence is considered to be impaired if a partner or professional

employee leaves the firm and is subsequently employed by that entity in a key position unless a number
of conditions are met. These conditions require that the CPA be completely disassociated from the CPA
firm, and that the firm take steps to ensure that the engagement team exercises sufficient professional
skepticism and is not unduly influenced by the former employee of the firm

 Interpretation 1.279.010: if a member of the attest engagement team or an individual in a position to

influence the attest engagement has a job offer from or even develops the intention to seek or discuss
potential employment with an attest entity, independence is impaired with respect to the entity unless the
person promptly reports the situation to an appropriate person in the firm and removes himself or herself
from the engagement until the offer is rejected or employment is no longer being sought. If another
employee of the CPA firm becomes aware that a member of the attest engagement team (or an individual
in a position to influence the attest engagement) is considering employment with an attest entity, the
employee should notify an appropriate person in the firm so the firm can take steps to prevent the
impairment of its independence

 Interpretation 1.275.010: allows a member to serve as a director or trustee for an audited not-for-
profit entity “so long as his or her position is clearly honorary, and he or she cannot vote or otherwise
participate in board or management functions.”

 Interpretation 1.275.005: permits a CPA to seek employment as an adjunct faculty member of an

educational institution that is an audited entity of the CPA’s firm. Such a relationship does not impair
independence provided that the CPA does not hold a key position at the educational institution, does not
participate on the attest engagement team, is not an individual in a position to influence the attest
engagement, is employed by the educational institution on a part-time and nontenure basis, and does not
assume any management responsibilities or set policies for the educational institution.

o Family Relationships:

 Immediate Family: subject to the Independence Rule. Exceptions: spouse employed by an audited
entity would not impair independence if he or she were not in key position.

 Close relatives: not normally impair independence. The two major situations that can impair
independence are as follows:

 A close relative has a financial interest in the entity that is material to the close relative and the
CPA participating in the engagement is aware of the interest

 An individual participating in the engagement has a close relative who could exercise significant
influence over the financial or accounting policies of the entity (i.e., a key position)

5. Quality Control Standards

- To provide the firm with reasonable assurance that the firm and its personnel comply with professional, legal. And
regulatory requirements and that the partners issue appropriate reports
- Elements of quality control:

- Types of policies or procedures a firm might implement to comply with a sound system of quality control.
- The standards require that the firms continually monitor the appropriateness of the design and the effectiveness of the
operation of their quality control system. Procedures for monitoring include the following:

o Review of records pertaining to the quality control elements

o Review of engagement documentation, reports, and entity financial statements

o Discussions with the firm’s personnel

o Review of summarized reports, at least annually, on the findings of the monitoring procedures and the
investigation of their causes so that improvements can be made

o Determination of any corrective actions to be taken or improvements to be made in the system, including providing
feedback into the firm’s policies and procedures relating to education and training

o Communication of findings to appropriate firm management

o Follow-up on a timely basis by appropriate firm management and determination of what actions are necessary,
including modifications to the quality control system