Chapter 3

The Auditor’s Role in Society

Learning Objectives1. Describe the contributions audit services make to

society and relationships among auditors, audit clients and the public.

2. Describe the different inputs to and influences on personal ethics and morals.

3. Understand the role and contributions of professionals in society.

4. Recognize the potential for ethical considerations and outcomes in decisions and the decision-making models applicable to ethical decisions.

5. Become familiar with external regulation and professional standards governing the accounting profession’s conduct and quality control.

Auditors as Professionals

Professionals Make a living by providing services to others Recipients of professional services have to

trust the professional because they do not have the knowledge that would be needed to monitor the quality of work

Auditors Are different from most professionals

because their services benefit the public but their compensation for the services does not come from the public

Constituents of Auditors’ Services

The public and capital markets are the ultimate beneficiaries

As owners of the company being audited, the shareholder group is actually the client

The shareholders elect the Board of Directors to oversee the company for them

As a committee of the Board of Directors, the Audit Committee is a subset of the board of directors

The Audit Committee selects and hires the auditors, oversees the auditor’s compensation, and interacts with the auditors

Examples of Different PhilosophiesWhat is right? It depends on the philosophical

underpinning… Whatever creates the greatest good Whatever is fundamentally “right,” regardless

of consequences Whatever preserves the life of even one person The decision made by a single ruler with

ultimate authority The decision made by the group of people

affected Whatever the law requires

Theory of Moral Development

Pre-conventional level: completely self-centered decisions

Conventional level: considers impacts beyond personal consequences; considers others

Post-conventional level: abstract analysis of right and wrong

Food for thought

Accountants and auditors must behave at a conventional level when performing their work. If they were to behave in a post-conventional manner they would apply abstract analysis and decide that their preferences were “right.” If accountants and auditors used personal preferences instead of following the standards set according to due process, financial statements would lose comparability.

Ethical Orientation

Ethic of Rights Business Laws Courts United States culture

Ethic of Care Family Sports teams Military Pacific Rim and other cultures

Sociology of Professions

Entry and membership in the group Regulation

Self regulation Coordination with authorities

Individual characteristics Taxonomic description

Technical expertise Integrity Believe their work is of value, important Believe they make a contribution through

their work Social contract

Auditing is a Profession

A profession is an occupational group of individuals with a collective identity

Body of knowledge: accounting and auditing Community of peers: AICPA and other groups Entry and Membership: CPA exam, continuing

education Regulation of the group: AICPA is internal; SEC,

PCAOB, states and courts are external Individual Characteristics: competence, integrity Social Contract: oversight of the quality of

financial reporting provided to the public in exchange for professional status

Decision Process for Moral Issues Environment produces issues with moral components Decision maker recognizes the moral issue or moral

components. Moral intensity affects whether the decision maker recognizes the moral components. Magnitude of the consequences Social consensus Probability of effect Temporal immediacy Proximity Concentration of effect

Decision maker goes through a decision process to make a judgment regarding the issue, and selects and carries out a behavior. This is done using a decision model that considers ethical consequences.

Model for Making Ethics-Related Decisions

Determine the facts of the situation. Identify the ethical issues and people involved. Who

are the stakeholders? Identify the values related to the situation: honesty,

loyalty, compassion, integrity, etc. Identify any that conflict.

Identify alternative courses of action that are available.

Evaluate courses of action and match each with relevant values.

Consider the consequences of viable courses of action remaining.

Make the decision; take indicated action.

Value of Using an Ethics Decision Model

Supports considering ethics during the decision making process

Does not guarantee a particular decision result

Moral dilemmas will still exist; this type of decision model just helps provide a process for addressing them A moral dilemma is an ethics-

related situation for which there is no clear right or wrong answer

AICPA Code of Conduct Principles of Professional Conduct

Conceptual, ideal standards; not enforceable Rules of Conduct

Threshold for minimum acceptable behavior Stated in behavior-related language Enforceable

Interpretations of the Rules of Conduct Response when there are frequent questions about a rule Departures must be justified in any disciplinary hearing

Rulings by the Professional Ethics Executive Committee Rulings on individual cases; responses to specific factual

circumstances Justification for departures may be requested in any

disciplinary hearing

Principles

Responsibilities Professional and moral judgment

Public interest Integrity Objectivity and Independence

Conflict of interest Public practice; attest functions, independent in

fact and appearance Due Care Scope and Nature of Services

Observe the other principles in making these decisions

How AICPA Rules Use the Term “Public Practice”

What does it mean to be in public practice? …covered in the definitions Performance for a client by a member or a

member’s firm, while holding out as a CPA, of the professional services of accounting, tax, personal financial planning, litigation support and professional services for which standards are promulgated by bodies designated by Council.

Council is the AICPA’s Council For example, standards referred to are: SFAS,

SAS, SSARS, SSCS, SSAE – and now also IFRS and ISA

AICPA Code, Rules Rule 101 - Independence Rule 102 – Integrity and Objectivity

Be objective Behave with integrity Don’t misrepresent facts Don’t subordinate judgment

Rule 201 – General Standards Professional competence Due professional care Planning and supervision Sufficient relevant data

Rule 202 – Follow the rules Rule 203 - Financial statements have to be GAAP to issue a

clean opinion unless the exception applies

AICAP Code, Rules continued

Rule 301 - Confidential client information Exceptions: subpoenas, practice monitoring, complaints

regarding professional performance Rule 302 - Contingent Fees Rule 501 – Acts Discreditable Rule 502 – Advertising & Other Forms of Solicitation

False, misleading, deceptive, coercion, overreaching, harassing Rule 503 –

Can’t recommend anything to (attest) client if you get a fee for it

Can’t recommend anything an attest client does or sells to anyone if you get a fee from the attest client

If you are allowed to, and receive a commission, have to disclose it to the person to whom you make the recommendation

Referral fees; if you pay or receive a referral fee have to disclose it to the client

Rule 505 – Form of Practice and Name Only an allowed organizational form Name that is not misleading All owners have to be AICPA members to say the firm is:

“Member of AICPA”.

Definitions

The following terms have specific definitions for the AICPA Code of Professional Conduct:

Attest engagement Interpretation Professional services

Attest engagement team Key position Significant influence

Client Loan

Close relative Key position

Council Loan

Covered member Manager

Financial institution Member

Firm Normal lending procedures

Holding out Office

Immediate family Partner

Individual…position to influence Period of the…engagement

Institute Practice of public accounting

Conceptual Framework, AICPA Independence

ET 100.01…a member’s relationship with a client is evaluated to determine whether it poses an unacceptable risk to the member’s independence. Risk is unacceptable if the relationship would compromise (or would be perceived as compromising by an informed third party having knowledge of all relevant information) the member’s professional judgment when rendering an attest service to the client.

Independence

In fact and in appearance General SEC guidelines communicate the essence

of independence SEC General Standard of Auditor Independence

No mutual or conflicting interest with the audit client

Audit firm cannot audit its own work Audit firm cannot act as management Audit firm cannot be an advocate for the client

In 2001 SEC relaxed the group of people to whom independence rules apply

AICPA Interpretation 101 of Rule 101

Independence shall be considered to be impaired if: A. During the period of the professional

engagement a covered member…

Definitions, Important for Covered Member

Individual: the person or the person’s immediate family Immediate family: spouse, spousal

equivalent, dependent (whether or not related)

Attest engagement team: Individuals participating in the attest engagement, including those who perform concurring and second partner reviews, regardless of functional classification (audit, tax, consulting). Excludes specialists and those performing clerical tasks.

Definitions, Important for Covered Member

An individual in a position to influence the audit engagement; Someone who Evaluates the performance or recommends the

compensation of the attest engagement partner Directly supervises or manages the attest

engagement partner (all the way up to firm’s chief executive)

Consults with the attest engagement team on technical or industry-related issues specific to the attest engagement

Participates in or oversees quality control activities with respect to this attest engagement (all the way up to the top of the firm)

A Covered Member Is…. An individual on the engagement team An individual in a position to influence the

engagement A partner or manager who provides 10 or

more hours of nonattest services to the client Another partner in the office of the lead

attest engagement partner The firm, including the firm’s employee

benefit plans Any entities whose policies are controlled by

any of the people described above

AICPA Interpretation 101

Important terms: Financial interest: direct financial interest, material indirect

financial interest Management role Family: immediate, close Period covered by the audit, period of the professional

engagement Financial interests that are problems:

Have direct or material indirect interest Be a trustee or executor of an entity with a direct or material

indirect interest Have joint investment Have a loan through other than normal lending procedures Cannot own more than 5% of the client either together or in a

group (even if it is not material and indirect) Applies to CPAs doing the audit and people who previously worked

for the client; Someone who worked for client and moves to audit firm can sever financial ties

Control positions/functions that are problems Director Officer Management or equivalent Promoter Underwriter Voting trustee Pension or profit sharing trustee

Works in both directions CPA performing those services for the client Person in a client control position coming to work for the

CPA firm and auditing the period they perform the control function.

AICPA Interpretation 101 continued

Close Relatives

Close relative – only independence problems When close relative is in a key position, or Has a financial interest that is material to the

close relative that the auditor knows about that can result in significant influence over the client

in a key position means… Significant accounting function Preparation of financial statements Ability to exercise influence over the contents

of the financial statements Can influence an attest engagement that is not

about the financial statements

Immediate Family, Close Relatives

Differences exist for independence issues when immediate family and close relatives are involved Covered member is expected to know everything

about immediate family Financial interests and employment of immediate

family can cause independence problems Employment of close relative in key position is

visible, so covered member knows about it Finances of close relative can only be a problem

if the covered member has knowledge

Public Company Issues Sarbanes Oxley 1 year cooling off period (Section 206, Conflicts of

Interest) Services that impair independence: SEC, SOX

Bookkeeping Systems design and implementation Appraisal or valuation services Actuarial services Internal audit outsourcing services Management functions Human resources Broker-dealer, investment adviser, investment banking services Legal services Expert services unrelated to the auditNote: Not all of these would be prohibited by AICPA rules

Fees paid to the audit firm for non-audit services must be disclosed in the proxy statement

Audit Committee Approvals

Under SOX Audit committee hires the auditor, and

as a result, approves the audit service Audit committee approves any other

services If a non-audit service is not prohibited it must be approved in advance by the client’s audit committee

Peer Review

AICPA Peer Review Program (AICPA PRP) National Peer Review Committee

Reviews the portion of a firm’s practice not inspected by the PCAOB

PCAOB Firm Registration Inspections

International Code of Ethics

International Federation of Accountants

International Ethics Standards Board for Accountants (IESBA)

Code of Ethics for Professional Accountants

Applicability of IESBA Code

CPAs must comply with the standards of the applicable jurisdiction, or most restrictive code

IESBA Code revised in July 2009, effective January 1, 2011

CPA Exam coverage of IESBA Code could begin effect January 2011

Structure of IESBA Code

Set up in 3 sections Part A, General Application of the IESBA Code

Part B, Professional Accountants in Public Practice

Part C, Professional Accountants in Business

Conceptual Framework, IESBA

Uses a Conceptual Framework approach Identify threats to compliance with

the fundamental principles Evaluate the significance of the

threats identified Apply safeguards, when necessary

to eliminate threats or reduce them to an acceptable level

Fundamental Principles, IESBA

IntegrityObjectivityProfessional Competence and Due Care

ConfidentialityProfessional Behavior

Threat Categories, IESBA

Self-interest threat Self-review threat Advocacy threat Familiarity threat Intimidation threat

Some of these look familiar – AICPA, SEC

Safeguards, IESBA

Safeguards created by the profession, legislation or regulation

Safeguards in the work environment

Safeguards: Professional, Legislation, Regulation

Educational, training and experience requirements for entry into the profession

Continuing professional development requirements

Corporate governance regulations Professional standards Professional or regulatory monitoring and

disciplinary procedures External review by a legally empowered

third party

Other Safeguards

Safeguards to identify or deter Effective, well-publicized compaint systems Explicitly stated duty to report breaches of

ethical requirements From the work environment

Presented in Parts B and C These are the details of Parts B and C –

what CPAs should and shouldn’t do

AICPA, IESBA

An example of differences between the Codes:

Addressing familiarity threats, these examples are not addressed directly in AICPA Code: Long Association of Senior Personnel

(Including Partner Rotation) with a Client Fees-Relative Size

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