Auditor Independence, Ethics and

Liability

Relates to Chapter 4 of Text

Independence
The most important ethical responsibility
of an auditor is to maintain
independence from the company being
audited. Independence is the
cornerstone of auditing.

The auditor must be both “independent in

fact” and “independent in appearance.”
What’s the difference and why are both
necessary?
Independence: Non-audit services
• Section 201 of SOX prohibits most non-
audit services for public audit clients:
– Bookkeeping / accounting processing
– Information systems design or implementation
– Valuation services
– Actuarial services
– Internal audit outsourcing
– Management outsourcing
– Investment banking
– Legal services
– Any other services that would impair auditor
independence
Independence: Non-audit services, cont.

• Tax services for public companies (per

PCAOB):
– A firm is not independent with respect to an
audit client if tax advice:
• Is (1) proposed by the firm with (2) a primary goal
to avoid taxes and (3) does not meet the “more
likely than not to be upheld” standard, OR
• Relates to certain types of tax shelters.
• Why does this create an independence issue?
Independence: Non-audit services, cont.

• More on tax services for public

companies (per PCAOB):
– A firm is also not independent with respect to a
public audit client if it provides personal tax
advice to any person who is in a financial
reporting oversight role (FROR) at the company
– i.e., who prepares the financial statements or
influences (or is in a position to influence) the
financial statements. Again, why?
Independence: Non-audit services,
cont.
• The PCAOB has also adopted rules
requiring audit firms to give written
notice to the audit committee of all
relationships between (1) the firm and
its affiliates and (2) the company and
persons with a FROR at the company
that may reasonably bear on the firm’s
independence.
• See also AS 16 re audit committee
communications (Ch. 2 slides).
Independence: Non-audit services, cont.

• The AICPA rules on non-audit

services are more lenient for audits
of privately held companies and
other entities that are not publicly
traded.

– Why?
Independence rules that apply to public and private
companies (see Exhibit 4.6 and pp. 153-60):
• No direct or material indirect financial interest in
an audited company by a CPA connected with
the audit (“covered members”).
• No interest > 5% of total equity of an audited
company for any employee(s) of the audit firm.
– Firms may have stricter requirements, though.
• No unusual / nonroutine/investment loans
between audit client and covered members.
– Normal loans on standard terms permitted.
• Covered members cannot have immediate family
members who hold key positions in the audited
company.
• You may laugh, but a real question: can you
date an employee of an audit client?
Independence: Contingent fees

• What is a contingent fee?

• Contingent fee arrangements with an audit
client (public or private) are not permitted.
• PCAOB affirmed this rule, clarifying that:
– Any contingent fee arrangement is prohibited
for an audit client.
– This includes any contingent fees for tax
services provided to an audit client.
Other rules in the AICPA Code of Professional Conduct

• Confidentiality: Other than as prescribed under AICPA /

PCAOB standards, an auditor may not communicate
confidential business information concerning audited
companies to outside parties.
– However, auditors must provide audit-related information
if it is subpoenaed in legal proceedings (or in certain other
situations noted on p. 159 of the text). Contrast this to the
attorney-client and attorney work product privileges.
– This area is difficult - consult counsel if in doubt!
• No coercive or misleading solicitation of new audit
business.
• No commissions or referral fees for directing business
to an audit client or third parties, except for referral fees
where disclosed to the client.
Above all else --
• “In the performance of any
professional service, a CPA shall
maintain objectivity and integrity”
(AICPA Code of Professional
Conduct, Rule 102, as adopted by
the PCAOB).
– Translation: Independence does not
only mean compliance with existing
rules.
• This rule applies to all CPAs,
whether or not the CPA is
conducting audits.
– E.g., the actions of a CFO.
– Exhibit 4.5 summarizes the AICPA
Principles of Professional Conduct.
The bigger picture …
• Knowing codifications of ethical principles
is very important, but exclusive reliance
on written rules is imprudent and
dangerous.
– Remember our discussion of rules-based
accounting?
• The mere fact that an action didn’t violate
a rule will be of little comfort if felt wrong
to you.
Ethics and auditing
• Sports referees lose everything when
they lose perceived integrity.
– E.g., NBA referee scandal
• The same is true of auditors.
• Proof: Arthur Andersen went out of
business in a matter of weeks.
– Firms can survive litigation, but they
can’t survive …
Ethical challenges in auditing
1. Additional audit effort usually does
not change the outcome.
• Auditing a company is not like studying
for an exam.
 If you study harder, you will most likely
earn a better grade.
 But if you audit more diligently, you will
most likely come to the same conclusion
as if you cut corners.
 And the more diligently you audit, the
greater the cost of the audit and/or the
lower the profit.
 Ethical challenges in auditing, continued
2. Human nature is to be friendly, flexible and
helpful. We like to be liked!
• However, effective auditing requires maintaining
consistent standards, skepticism (pp. 145-6) and
sometimes confrontation.
 Particularly difficult for junior auditors.

• Analogies:
 My relative’s experience with an employer.
 The stock option backdating scandal.
Ethical challenges in auditing, continued
3. It is difficult to take a stand against the
party that is paying your fee.
• This is why the enhanced role of the
independent audit committee (which must
assess your firm’s independence prior to
engagement) as the auditor’s “client” under
SOX and PCAOB guidance is critical.
• As an auditor, you should not feel pressured
to satisfy company management – you answer
to a “higher power” – but this is easier said
than done.
 Ethical challenges in auditing, continued

4. Motivated reasoning can lead auditors

to rationalize problems away.
• Audit example: Evaluating going concern
issues.
• Estimates and accounting choices are
also difficult areas.
Ask yourself (per the SEC) -
• Does your relationship create a mutual
(or conflicting) interest with the client?
• Are you auditing your own work?
• Are you acting as management or an
employee of the client?
• Are you in the position of being an
advocate for your client?
Audit-related litigation is costly!
• Driven, frequently, by joint and several
liability (deep-pocket theory), class
action suits, contingent fees for lawyers,
and a fundamental misunderstanding of
what an audit opinion represents
(“expectations gap”).
• Lawsuits may be brought by clients or
third parties, under contract law,
common law, and/or statutory law (see
Exhibit 4.1).