-5 Code of Conduct and Auditor independence

SEC Chair Art Levit statements

"Auditors, increasingly captives of their clients, would give them the clean audits they wanted, despite lots of chicanery. Consulting contracts were turning accounting firms into extensions of management -- even cheerleaders at times. Some firms even paid their auditors on how many non-audit services they sold to their clients."

AICPA Code

-members must adhere to rules of conduct or risk losing membership -2 sections: 1. principles and 2. rules -The Principles provide the framework for the Rules that govern the performance of professional services by members. -Interpretations of Rules of Conduct are provided in the Statements on Auditing Standards (SAS).

Rules of conduct

101 Independence 102 Integrity and Objectivity 201 General Standards 202 Compliance with Standards 203 Accounting Principles 301 Confidential Client Information 302 Contingent Fees 501 Acts Discreditable 502 Advertising and other forms of solicitation 503 Commissions and Referral Fees 505 Form of Practice and Name

auditor independence

AICPA defines in two components: 1) independence of mind, also known as independence of fact. The state of mind that permits the performance of an attest service without being affected by influences that compromise professional judgment, thereby allowing an individual to act with integrity and exercise objectivity and professional skepticism. 2) Independence in appearance. The avoidance of circumstances that would cause a reasonable and informed third party, having knowledge of all relevant information, including safeguards applied, to reasonably conclude that the integrity, objectivity, or professional skepticism of a firm or a member of the attest engagement team had been compromised.

auditor independence

Where an auditor is to be free from connection with parties having a financial interest in the company he or she is auditing through possessing integrity and objectivity.

AICPA Code: Principles cont.

• A member should maintain objectivity and be free of conflicts of interest in discharging professional responsibilities. • A member in public practice should be independent in fact and appearance when providing auditing and other attestation services. • A member should observe the profession's technical and ethical standards, strive continually to improve competence and the quality of services, and discharge professional responsibility to the best of the member's ability.

Independence safeguards

• Accounting industry or regulators • CPE, SOX, etc. • Client • Audit committee, board of directors, etc. • Audit firm • Independence rules, disclosure forms, etc.

Two views of auditor independence

• Deliberate collusion with client • Unconscious Biases

Unconscious biases

• In this model, biases affect the auditor unconsciously when they are making judgments concerning evidence. • As a result, decisions could be biased in a manner that is consistent with the auditor's self-interest. • Self-serving bias - Judgments are unconsciously and unintentionally biased towards one's self-interest on the basis of fairness. • Confirmation bias - Overlook disconfirming evidence that does not support client position.

Independence in Fact v. Appearance

• Independence in Fact is concerned with maintaining objectivity throughout the audit process. • Independence in Appearance is concerned with eliminating economic incentives or emotional ties that make it difficult to maintain objectivity. • Virtually all regulation is focused on factors related to the appearance of independence.

Deliberate collusion with client example

• Jeff the auditor reviews the accounts receivable balance of Spartan Inc. and determines that approximately $500K is uncollectible. • Upon discussing the adjustment with Spartan management, Jeff believes that they will fire him if he insists that they record an adjustment to write-off the receivables. As a result, no adjustment is recorded.

AICPA Code: Principles

• Members should exercise sensitive professional and moral judgments in all their activities -Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism -To maintain and broaden public confidence, members should perform all professional responsibilities with the highest sense of integrity.

Issue #7: What if the client offers me a job during the audit?

• Must withdraw from engagement if offer open—wait until after • "Cooling off" periods from SOX - CPAs are prohibited from performing audits if the Client's CEO, Controller, CFO, Chief Accounting Officer or person in an equivalent position was previously employed by the audit firm during the preceding year. • Audit Firms must make disclosures

Issue #3: Can I borrow money from a client (i.e., bank)?

• No, with the exception of: • Collateralized Auto Loans • Credit Card Balances < $10,000

Issue #6: Can bookkeeping be performed for a client?

• Only if privately-held client and • Client is responsible for financial statements • CPA does not assume role of an employee • CPA does not make any manager decisions • CPA properly complies with GAAP

What type of stock investments are allowed?

• Partners (Regardless of Office) 1. No Direct Ownership of Clients • Close relatives - Spouses, Parents, Children - Cannot own even 1 share 2. No material indirect ownership in clients • CPA plus "close"relatives (e.g., mutual funds) • Staff and managers (covered by these rules if they work on the engagement)

Issue #2: What about close relatives who work for a client?

• Relatives cannot serve in key roles: • Key Accounting, Financial Reporting, or Executive Position • Partners - Serving on Engagement - Client is in the same office • Managers and Staff - Serving on Engagement

Threats to independence

• Self-interest • Economically benefiting from the outcome of the audit • Self-review • Reviewing your own work • Advocacy • Engaged to support a specific position •Familiarity • Closeness to client may undermine objectivity • Intimidation • Engagement member is threatened by client

State codes

• State Rules are patterned closely after the AICPA's model Code. • Each state has a Board that licenses CPAs. • Members who violate the State Rules risk losing their license to practice.

Deliberate collusion with client

• This model assumes that auditors form unbiased judgments when evaluating evidence. • If the bias is deliberate, then it can be fixed by the threat of sanctions. i.e., auditors will evaluate the costs/benefits of collusion. • Some high profile audit failures have been the result of deliberate collusion with the client (e.g., Enron).

Why is independence valued by the market?

• Users can expect that an independent assurer will be in a better position to critically evaluate management assertions. • Put another way, lack of independence may impair the assurer's ability to perform. • The amount of credibility added to the assertions will be reduced if users are skeptical about the assurer's performance (via independence)

Unconscious biases ex

Example: • Molly the auditor believes that management of Redhawk Co. is upset with her service and is considering changing auditors. They have indicated to her that they do not want to record any audit adjustments in this year's audit. As a result, when she evaluates the collectability of the company's accounts receivable, she is more likely to unconsciously evaluate the receivables as being collectible.

In 2-3 sentences describe why several prominent psychologists claim that it is impossible for auditors to be independent.

It is impossible for auditors to be independent because people cannot process information impartially. Auditors also seek out information that confirms the conclusion they hope or are trying to reach through confirmation bias. Therefore, auditors also ignore information they don't think is as important or won't confirm their bias.

Issue #4: What about joint ownership with a client in a business?

No

Issue #5: Can a CPA serve on a BOD of a Client?

Only if directorship is strictly honorary (i.e., CPA does not make any decisions)

Psychological view of independence: Why do psychologists say independence is a much bigger problem (i.e., it's impossible) than auditors deliberately colluding with management?

The larger problem, however, is not with auditors' morality, but with limitations in the way they way that they process information. Thus independence remains a problem for even the most moral, honest auditor.

What are the implications? Of unconscious bias

Different methods are needed to improve independence. • The threat of legal sanctions will not affect the auditor if independence violations are the result of unconscious biases.

Issue #8: Can consulting services be performed for audit Client?

Sarbanes-Oxley: Audit committee must pre-approve all consulting arrangements (prohibited—internal audit, systems design, valuation, bookkeeping, HR, broker dealer, and actuarial)