Chapter 10

Independence and Moral Seduction

Imagine that you are about to have a relaxing meal at a restaurant in the fictional town of Toxic, Texas. It is a quaint, yet simple, community where restaurants select their own Health Code inspector, set the inspector's compensation, and may fire any inspector who cites them for food safety violations. Would you be delighted to dine at these eateries, or would you fear that the house specials are tainted tacos and roasted roaches?

Ridiculous as this lax regulatory regimen may sound, our auditing system works in this very manner. A company selects its auditor, pays its auditor, and may fire an overly tenacious auditor without governmental approval.

To counterbalance the potential risks of such a system, society imposes stringent ethical responsibilities on the auditing profession. As U.S. Supreme Court Justice Warren Burger once wrote, by “certifying the public reports that depict a corporation's financial status, the accountant performs a public responsibility transcending any employment relationship with the client, and owes allegiance to the corporation's creditors and stockholders, as well as to the investing public…. This ‘public watchdog’ function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust.”1

As a public protector, an auditor is bound by a professional standard known as the Independence Rule. According to this mandate, auditors must critically evaluate client financial statements and avoid circumstances that might lead an observer to doubt an auditor's objectivity.2 To paraphrase a prominent European regulator, the goal of the Independence Rule is to ensure that the “watchdog will always bark.”3

This chapter will examine the ethical responsibilities imposed by the Independence Rule and the numerous threats that jeopardize adherence to this standard.4

WHEN INDEPENDENCE IS REQUIRED

Independence is required whenever a CPA expresses an auditing or other attest opinion.5 In an audit opinion, a CPA expresses positive assurance that financial statements do fairly present a company's financial results and position. In contrast, in a review opinion, a CPA expresses negative assurance that it is not aware of any facts that compromise the trustworthiness of financial statements. Only licensed CPAs may issue attest opinions.6

Accountants are not formally required to satisfy the Independence Rule if they work in industry or provide nonattestation services such as tax return preparation or consulting services. Nonetheless, accountants always must conduct their activities with candor and objectivity.

How the Independence Rule is Satisfied

What Conduct Achieves Independence?

The global accounting profession has long recognized that it is impossible for “a person exercising professional judgment…to be free from all economic, financial, and other relationships.”7 As a result, the Code of Conduct has adopted a risk-based conceptual framework in which threats to an auditor's objectivity must be weighed against counterbalancing safeguards that diminish this risk. If an informed observer reasonably would consider the risks to independence to be acceptable on balance, a CPA may express an audit opinion.8 Conversely, a CPA must refrain from issuing an opinion when the risks to independence are unacceptable.

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Figure 10-1 The Twin Requirements to Maintain Independence.

To achieve independence, an accountant must satisfy a two-pronged test.

First, an auditor must be independent in state of mind. This element requires an unwavering mental commitment to integrity, objectivity, and professional skepticism.

Second, auditors must be independent in appearance. This means that surrounding circumstances should not give an informed observer any reason to doubt an auditor's integrity, objectivity, and professional skepticism.

Thus, in sum, independence in fact and in appearance are both required.9

Determinations concerning independence are made by accountants themselves, using their own professional judgment. Approval from regulators or others is not required.

Who Must Be Independent?

The Basic Rules

Many accountants marvel at how CPA firms have grown in recent decades. Currently, over 25 CPA firms generate annual revenues of more than $100 million.10 Even more strikingly, the Big 4 CPA firms generate more in combined revenues than entire countries such as Argentina or Portugal collect annually in taxes.11

As the size and scope of CPA firms have expanded, it has become increasingly impractical to expect every member of a CPA firm to be free of all social, professional, and familial connections to the firm's clients. As a result, the Code of Conduct classifies accounting professionals into two categories, called covered members and noncovered members.

Covered Members

A covered member is subject to the full range of independence requirements. The following five groups are considered to be covered members:

  • Accounting professionals who serve on an attest engagement team

    This grouping includes all direct participants in an attest engagement, including a partner who provides a concurring second opinion. Nonaccounting personnel who provide routine administrative or clerical assistance are excluded.

  • Accounting professionals who are in a position to influence an attest engagement

    This category includes senior firm members, and their superiors, who oversee quality control and certain performance evaluations. It also includes firm members who provide technical advice as internal advisors.

  • Partners and senior accounting staff members who provides at least 10 hours annually of nonattest services, such as tax or consulting services, to the attest client

  • All partners who work in the same office as the lead attest engagement partner

    This category includes all partners who are likely to interact on a regular basis with the lead audit partner. Under the Code of Conduct, the word office does not mean a

WHICH CPA FIRM PROFESSIONALS
MUST SATISFY INDEPENDENCE RULE?		 OBSERVATION
Covered Members Includes:
  • Members of audit team
  • Others who influence audit team
  • Partners and senior personnel who provide more than 10 hours of nonaudit services to client
  • Partners who share the same office as the lead audit partner
Others who have 5% or greater ownership interest in client Stock and other ownership interests held by immediate family members are counted as yours in applying the 5% test
Others who concurrently serve in a managerial capacity for client A CPA firm professional may not serve as a director, officer, or other decision maker for a firm's audit client, even if they are uninvolved in the audit

Figure 10-2 Accountants Who Are Subject to Independence Rules.

specific geographic workplace. Rather, it means a subgroup whose personnel regularly interact with one another on the same clients or types of matters, regardless of physical location. For example, all audit partners who work in a firm's Nonprofit Hospital Audit group would be an office, even if they live in different cities.

  • The firm itself12
Noncovered Members

CPA firm partners and professionals who are not covered members generally are exempt from satisfying independence requirements, except in two limited circumstances:

  • They own, individually or combined with immediate family members, over 5% of an audit client's stock.13
  • They simultaneously also are employed by an audit client in a position that involves, or may influence, the financial reporting process.14
FAMILY MEMBER DEFINED IMPACT ON INDEPENDENCE OF ACCOUNTING FIRM PROFESSIONAL
Immediate family members Spouse, spousal equivalent, dependent child, and other dependents Client stock owned by them is considered as if it is owned by you
Close relatives Parents, siblings, and self-supporting children Client stock owned by them is considered as if it is owned by you if, generally speaking, the client stock is material to your relative's net worth or the client stock gives your relative significant influence over the client company
Other relatives All others, including in-laws No specific detailed rule applies. However, client stock owned by them still may pose a risk to independence on a case-by-case basis

Figure 10-3 How Family Ownership of Client Stock Affects Independence.

The Impact of Family Members' Interests

If accounting professionals were predisposed to evade independence requirements, they might contemplate transferring formal ownership of client stock into relatives' names. To prevent potential abuse, the Code of Conduct has established special rules for determining when family members' interests should be treated as if they are an auditor's own interests. In applying these rules, loved ones are classified either as immediate family members or as close relatives.

Immediate Family

A covered member's spouse, spousal equivalent, and dependents are referred to as immediate family. Client stock belonging to an immediate family member is treated as being owned by the covered member.15

Close Relatives

An accountant's parents, brothers, sisters, and self-supporting children are referred to as close relatives. Unlike stock held by immediate family, client stock belonging to a close relative is not automatically deemed to be an accountant's own property. Instead, client stock owned by a close relative generally is attributed to a covered member only if it is material to the relative's net worth or it allows the relative to exert significant influence over client governance.16

Shares held by more distant relatives, such as uncles, aunts, nieces, nephews, cousins, and in-laws, normally do not jeopardize an auditor's independence.17

FAMILY MEMBER WORKS IN A KEY POSITION AT AUDIT CLIENT? DOES COVERED MEMBER RETAIN INDEPENDENCE?
Immediate Family Yes No
No Yes
Close Relative Yes No*
No Yes

*Per AICPA Code Section 1.270, close relatives of certain covered members may hold key positions without impairing independence.

Figure 10-4 How Family Members' Employment at a Client Affects Independence.

During What Time Period Is Independence Required?

An auditor customarily must maintain independence during the accounting periods covered by a client's financial statements and during the contractual period of a “professional engagement.”18 Frequently, these two time periods overlap significantly.

THE SEVEN THREATS TO INDEPENDENCE

The Code of Conduct recognizes that “it is impossible to identify every relationship or circumstance that creates a threat” to an accountant's impartiality. Nevertheless, the Code has identified seven broad categories that commonly compromise an accountant's independence. These seven categories are known as the familiarity threat, the adverse interest threat, the advocacy threat, the undue influence threat, the self-review threat, the management participation threat, and the self-interest threat.19

The Familiarity Threat

The Basic Rules

Harry Potter character Dumbledore once said, “It takes a great deal of bravery to stand up to our enemies, but just as much to stand up to our friends.”20

The accounting profession recognizes how challenging it can be to stand up to friends and others with whom we have a close bond. Preferential treatment, or at least the appearance of it, easily may result when an auditor has a kinship or allegiance to those who work for an audit client.

Under the Code of Conduct, the familiarity threat to independence generally arises when a covered member's close friends, family, or colleagues hold a key position with an audit client. A key position is a managerial role in which a person has primary responsibility for accounting functions underlying financial statements, primary responsibility for preparing financial statements, or significant influence on the content of financial statements. Thus, in addition to key accounting personnel, company directors and high-ranking financial officers, including a company's CEO, CFO, Controller, and General Counsel, likewise hold key positions because they have the authority to influence financial statement content.21 The SEC uses the term financial reporting oversight role in referring to a key position.

THREATS TO INDEPENDENCE NATURE OF THREAT
Familiarity A close relationship between an accountant and client personnel makes the accountant too sympathetic to the client's viewpoint or too reluctant to objectively challenge the client's views
Adverse Interest A client's interests are opposite to the accountant's interests, such as when they threaten, or are in, a lawsuit against each other
Advocacy An accountant promotes a client's interest, such as by representing it in an administrative hearing or marketing proposal
Undue Influence A client's aggressiveness, dominant personality, or sphere of influence may intimidate an accountant into subordinating its judgment to the client's views
Self-Review An accountant cannot objectively evaluate or audit services, such as accounts receivable or payroll source document preparation, that he or she previously performed in a role essentially equivalent to being a client employee
Management Participation An accountant cannot objectively evaluate or audit judgments or decisions that he or she made while serving in a role as a client director, officer, or equivalent managerial decision maker
Self-Interest An accountant has an economic or other interest in the success of a client or a person associated with a client. An accountant may not have any direct interest or a material indirect interest in a client

Figure 10-5 Major Threats to Independence.

The familiarity threat also may result when accountants have a long-standing professional relationship with client personnel.22

Special Familiarity Rules Governing Personnel Transitions

After changing jobs, long-standing friendships with former colleagues often endure. As Elton John lyrically reminds us, “I'll be on your side forever more, that's what friends are for.”23

Maintaining long-term friendships is wonderful, but the revolving door of accountants transitioning from a CPA firm to work for a client, or vice versa, creates unique familiarity threats.

Accounting Professionals Who Formerly Worked for a Client

When an accountant joins a CPA firm after previously working for one of its clients, an obvious familiarity threat arises. To preserve the CPA firm's independence, the newly hired CPA firm member must terminate all client financial ties and not participate in audits covering prior periods during which she earlier worked for the client.24

Accounting Professionals Who Subsequently Work for a Client

When a person leaves an audit firm to work for a client in a key position, the audit firm loses its independence unless the departed firm member ends all participation, and appearances of participation, in the audit firm. To satisfy this requirement, the former CPA firm member must sever essentially all financial ties to his former firm's operations, financial activities, and benefits. Moreover, all appearances of continued participation must terminate as well.25 CPA firms customarily accomplish this by removing all references to the former member from their offices and websites.26

Accounting Professionals Who Contemplate Leaving a CPA Firm to Join a Client

To protect their current employment, workers understandably might want to conceal searches for a new job from their present employer. In an auditing context, however, a serious ethical problem arises when an external audit team member conceals that he is negotiating employment opportunities with the very client he is in the midst of auditing. In such a situation, the audit team member's instinctive desire to please the prospective employer creates severe doubts about the auditor's ability to remain vigilant and objective.

Because of this divided loyalty, accountants pursuing employment with an audit client generally must cease participation on the audit engagement immediately and disclose their intentions to their current employer. This disclosure duty arises at the moment that an auditor “intends to seek or discuss” potential employment with an audit client. The type of job sought is irrelevant.

Upon learning of an employee's intent to obtain employment with an audit client, an audit firm assumes additional duties as well. It must carefully evaluate work previously performed by the employee and, if necessary, reperform all such tasks.27

The Adverse Interest Threat

According to a classic soul ballad, “We make up to break up…first you love me then you hate me; that's a game for fools.”28 When contentious issues arise during the course of an audit, clients and auditors sometimes threaten to break up, but then they invariably make up out of mutual interest. Terminating an audit relationship is indeed a game for fools because no client wants to jeopardize its reputation for trustworthy financial reporting by firing its auditor.

Even though most auditor–client disputes are resolved amicably, overt antagonisms make it difficult for an auditor to remain impartial. Thus, because of this adverse interest threat, an auditor's independence is extinguished when an auditor and client have commenced, or threatened to commence, litigation against one another.29

The Advocacy Threat

Consider this dilemma: An auditor testified under oath in a regulatory hearing that government accusations about her client engaging in illegal money laundering are “speculative and without merit.” Did this auditor's statement in support of her client result in a loss of her independence?

According to the Code of Conduct, the advocacy threat arises when an accountant's service as a client representative makes others reasonably doubt her ability to remain an impartial arbiter of facts. In this case, the auditor's announcement that claims against her client are without merit makes it unlikely that she subsequently could objectively evaluate audit evidence that tends to show that her client did in fact engage in money laundering. This tendency to consciously or unconsciously reinforce a previously held belief by seeking out corroborating evidence and disregarding contradictory evidence is known in the psychological literature as confirmation bias. Thus, by serving as a client spokesperson, this CPA lost her independence to continue as the client's auditor.

The Undue Influence Threat

Discussions between a client and its auditor need not be as polite as, say, a palace tea party with the queen, but they should not resemble the pushing and shoving of a rugby scrum either. The undue influence threat arises when a client overreaches in its attempts to entice an auditor to subordinate its best judgment to conform to the client's wishes. This threat can arise in several different ways.

Pressures from a Client

In our client-pays audit system, a client inherently has the monetary leverage to affect its auditor's livelihood. Fortunately, although clients and auditors alike understand this economic reality, most auditor–client interactions proceed in a cordial and professional manner, free of overt threats.

On some occasions, however, clients try to exploit their advantageous economic position by intimidating their auditors, such as by threatening to replace them. When a client's honorable expression of a legitimate viewpoint crosses an ethical line to become a dishonorable act of intimidation, the resulting undue influence threat extinguishes auditor independence. This situation also can be called the intimidation threat.

Gifts and Entertainment

Receiving Items of Value from a Client

As Disney character Mary Poppins reminds us, a “spoonful of sugar” can accomplish great things. Mindful of this adage, some clients try to influence their auditors using kindness rather than contentiousness.

When a client gives its auditor an item of value, its intentions may be completely honorable, but a cynical observer might perceive the gift to be a subtle bribe. Therefore, to prevent the appearance of impropriety, an auditor may accept client gifts only if they are “clearly insignificant” in value. Entertainment and other acts of hospitality, such as tickets to concerts and sporting events, are permitted only if they are “reasonable under the circumstances.”30 Relevant circumstances include the nature and value of the entertainment, the presence of client personnel at a hospitality activity, and the connection of the event to business activities.

Offering Items of Value to a Client

The counterpart issue of an accountant giving gifts and entertainment to clients is not particularly controversial. A CPA firm, at its core, is a business that has every right to promote its services. Hence, gifts and entertainment from accountants to their clients do not impair auditor independence as long as the accountants' actions are “reasonable under the circumstances.”31

The Self-Review Threat

The Basic Issue

In a standard audit report, a CPA firm recites that “management is responsible for the preparation and fair presentation” of financial statements, and “our responsibility is to express an opinion” on these statements. That is, to use a sports analogy, the company plays the game and the auditor is the referee.

This separation of responsibilities would become blurred, though, if CPAs were allowed to prepare financial statements and then review their accuracy. To eliminate this self-review threat, auditors generally may not originate client bookkeeping entries, invoices, purchase orders, or other source documents. Auditors may, however, give clients guidance in implementing accounting policies and complying with disclosure requirements because, as the IFAC Code states, the audit process “necessitates dialogue between the firm and management of the audit client.”32

The Management Participation Threat

The Basic Issue

In guiding South Africa from apartheid to democracy, Nelson Mandela famously said: “Lead from the back and let others believe they are in front.” This proved to be sage advice for his homeland's political transformation, but it would be devastating advice for an auditor. According to the management participation threat, an auditor impairs its independence when it assumes a client leadership role, whether in the background or in the forefront. Managerial decision making by an auditor is inappropriate because an auditor cannot make important business decisions for a client and then objectively review the consequences of its own actions. Thus, although the management participation threat primarily is concerned with executive-level decisions rather than more routine tasks, both the management participation threat and the self-review threat are based on the foundational principle that auditors cannot impartially evaluate their own work.

To eliminate the management participation threat, auditors are forbidden from serving as a client officer or director, overseeing a client's internal controls, supervising client operations, signing client checks, disbursing client funds, and making client personnel decisions, among other acts. Despite the breadth of this prohibition, independence is not impaired, however, if an accountant provides consulting advice or analyses, as long as the client is the ultimate decision maker.

Providing Tax and Other Nonattest Services to an Audit Client

When a CPA firm provides tax services to an audit client, the CPA firm's Audit Department, in effect, critiques work performed by its Tax Department. Because Tax Expense is such a significant income statement, some investor groups have complained that an untenable threat to independence arises when a CPA firm performs tax services and then audits the reliability of its own tax work. If an auditor detects a Tax Department colleague's error, they ask, isn't it fair to wonder whether the audit firm might try to cover up the mistake to spare itself embarrassment?

Others dismiss this concern, claiming that important knowledge spillover benefits result when a CPA firm performs both tax and audit services for a client. According to one prominent CPA, auditors conduct “a more efficient audit with respect to the tax matters” if CPA firm personnel participate in developing client tax strategies and have firsthand knowledge about a client's tax return assertions.33

In addition to expressing concerns about tax services, investor groups have raised similar concerns about audit firms that provide consulting and other types of nonattest services. An audit firm simply cannot give advice and then objectively critique its own advice, they contend.

After much debate, the Code of Conduct has resolved this issue by generally allowing CPA firms to provide nonattest services to audit clients as long as four elements all are present:

  • The CPA firm does not make client managerial decisions.
  • The client has the skill to supervise and evaluate the provided nonattest services.
  • The client accepts full responsibility for all services rendered.
  • Both parties documented in writing the nature and scope of the nonattest services to be provided.34

The Self-Interest Threat

Basketball fans around the world cried foul when National Basketball Association referee Tim Donaghy pleaded guilty in 2007 to betting on games that he had refereed. Sports fans were aghast at the thought that Donaghy had a financial stake in the very games that he was officiating.

According to the self-interest threat to independence, auditors, like referees, are prohibited from having financial stakes that make others question their impartiality. The four principal situations in which the self-interest threat arises are when an auditor has an ownership interest in a client, a creditor interest in a client, a shared business arrangement with a client, or excessive dependence on fees earned from a client.

Ownership Interests that Impair Independence

Independence is impaired when a covered member has any direct financial interest or a material indirect financial interest in a client.

A direct interest exists when a covered member owns even one share of stock in a client. Materiality is irrelevant.35

An indirect interest exists when a covered member owns a stake in another entity but does not control or influence the entity's investment decisions. Indirect interests commonly include passive ownership stakes in mutual funds and retirement plans that hold client stock in their investment portfolios. Indirect interests impair independence only if a covered member owns a material indirect interest. Materiality is determined in relation to the covered member's net worth.36

Creditor Interests That Impair Independence

According to an old Dutch proverb, “Your friend lends you money; your enemy demands repayment.”

Many cordial relationships quickly sour when a borrower fails to repay a debt. In recognition of this, loans between an auditor and a client often imperil an auditor's independence.

Credit Advanced by a Client to a Covered Member

After borrowing money from a client, an auditor might be tempted to treat the client with leniency in the hope of obtaining more favorable loan repayment terms. To guard against this, as a general rule, covered members lose their independence if a client extends them credit.37

Independence, however, is not impaired if an auditor obtains a car loan or the use of a credit card on customary terms and conditions. Other collateralized loans, such as home mortgage loans, and small unsecured loans also are permissible in specialized situations.38

Credit Advanced from an Auditor to a Client

When a client owes its auditor money, the auditor has an obvious interest in the client's continuing prosperity. Although few auditors expressly grant loans, most do give their clients a customary period of time in which to pay outstanding invoices. According to the Code of Conduct, credit extended for a typical commercial period has no impact on independence. However, if an auditor's fees for previously rendered professional services remain unpaid for over one year, the unpaid fees resemble a loan, which extinguishes auditor independence.

Business Arrangements with Clients

Accountants and their clients usually respect one another's business acumen. As a result, accountants occasionally team up with their clients to become co-owners or comarketers in joint endeavors.

When an auditor enters into a joint business endeavor with a client, however, outsiders justifiably are entitled to wonder whether the auditor will remain candid and objective in auditing the client's core business. Thus, under most circumstances, an auditor loses its independence to audit a client when it enters into a material cooperative business arrangement or joint closely held investment with that client.39 Lease arrangements between an auditor and client, however, usually do not impair independence as long as the rent paid reflects prevailing market rates.

Excessive Reliance on a Particular Client

When auditors become too financially dependent on one client or client group, they may tend to become unduly deferential. In recognition of this concern, the Code of Conduct states that “excessive reliance on revenue from a single attest client” may impair independence.40

PROHIBITED PERMITTED
Any direct financial interest or material indirect interest in a client An immaterial indirect interest. An indirect interest is a passive interest in an entity, such as a mutual fund or retirement plan, that in turn makes active decisions about client stock investments
Loans to or from a client (or a person associated with a client) Standardized grants of credit, such as on car loans and credit cards, made on the customary terms offered to the general public
Also, an accountant's extension of customary credit terms to a client as long as invoices do not remain outstanding for more than one year
Material interests in joint business arrangements or ventures with a client Immaterial joint business activities
Excessive reliance on a single client An accounting firm usually may generate up to 15% of its revenues from a single client group, according to SEC guidance

Figure 10-6 The Self-Interest Threat.

MORAL SEDUCTION AND OTHER BEHAVIORAL BIASES

Scandals involving corrupt auditors leave an indelible stain on the accounting profession and have a corrosive impact on investor confidence. However, notwithstanding their deserved notoriety, cases in which auditors are discovered to have intentionally violated their professional duties are relatively rare. This is not to suggest that deficiencies in the audit process are infrequent, inconsequential, or institutionally tolerable. Rather, it highlights that auditor shortcomings predominantly are attributable to carelessness and unconscious favoritism toward clients, not deliberate deception.

According to social psychologists, several factors cause auditors to unconsciously succumb to client influences.41

Self-Serving Bias

Because auditors' livelihoods depend on maintaining client relationships, some auditors unwittingly skew interpretations of ambiguous information to give their clients the benefit of the doubt. As a prominent Congressman once said, “You've gotta go along to get along.”42 This selective perception of data in support of a client's viewpoint is often called the self-serving bias.

Confirmation Bias

People often seek out information that confirms their preconceived beliefs and disregard information that undercuts these views. For instance, after a great first date with a romantic partner, we often look for confirmatory evidence that they are honest, kind, and responsible, and we disregard a cornucopia of clues that they are a lying, abusive loser. This form of wishful thinking, called confirmation bias or motivated blindness, can be devastating in auditing relationships as well as romantic relationships.

The Cooperation Preference

Like most people, accountants prefer cooperation over conflict. Accordingly, audit team members instinctively strive for harmonious client relationships rather than stressful, discordant client interactions. Auditors are watchdogs, not rabid pit bulls, but the duty of professional skepticism nonetheless requires auditors to ask probing, and occasionally prickly, questions.

The Desire to Please

We all prefer to put smiles of contentment on others' faces rather than expressions of shock or disappointment. As a classic blues-gospel tune reminds us, “Bring me something that I can use, but don't nobody bring me no bad news.”43 Sometimes, however, when client positions violate accounting standards, accountants must resist the temptation to please clients and must tactfully deliver messages that contravene client goals.

Discounting

Researchers have observed that people essentially make decisions using a psychological present value calculation known as discounting. In resolving ethical matters, decision makers often lightly weight the effects of an uncertain event that potentially may arise several years into the future, but heavily weight the definite impact of an immediate occurrence. In an accounting context, this may lead auditors to expend great effort to avoid the immediate discomfort and income loss often associated with a bitter client confrontation. Correspondingly, it leads auditors to largely ignore the litigation and reputational harms that potentially may result from leaving dubious client positions unchallenged because these harms are distant in time and uncertain to even occur.

Moral Seduction

Moral seduction is the gradual process by which people unconsciously adopt the perspectives of others with whom they regularly interact. Moral seduction can arise in both tax and financial reporting contexts when an accountant initially indulges a client's minor ethical infraction and then, over time, fails to contest escalating client improprieties. For example, an auditor might accept a new client's decision to capitalize rather than expense a minor outlay when the correct treatment is unclear, but then continue to acquiesce in later periods to larger, more dubious client determinations.

Various experimental studies have observed the effects of moral seduction on auditor behavior. In one study, for instance, two identical groups of experienced accountants were asked to estimate the fair value of inventory destroyed in a warehouse fire. Both groups received the same information, except that one set of participants was told that they had been hired by the warehouse owner to submit an insurance claim and the other group was told that it worked for the insurance company liable on the claim. As you may have guessed, the first group slanted its results to support a high insurance recovery for its client, the warehouse owner, and the second group biased its loss determination downward to favor its insurance company client.44

As this example illustrates, people often focus selectively on facts that favor their peer group or employer and filter out conflicting information. Accordingly, accounting firms need to provide countervailing incentives to offset auditors' natural tendencies to please their clients. Moreover, auditors regularly must examine whether unconscious biases prevent them from being honest with some really important folks—themselves.

SAFEGUARDS THAT COUNTERBALANCE THREATS TO INDEPENDENCE

As mentioned earlier, independence is evaluated on a continuum in which slight gradations separate acceptable levels of risk from unacceptable levels. Although auditors should strive to avoid such threats, independence sometimes can be preserved by implementing safeguards to counteract the impact of threats. These safeguards may be created by an external regulatory or legislative body, the client, or the auditor itself.

Safeguards Created by Regulatory and Legislative Bodies

Some commentators have criticized the accounting profession for failing to adequately encourage robust auditor vigilance. In response to these criticisms, organizations such as the AICPA, state boards of accountancy, the SEC, and state legislatures have mandated the following safeguards for auditors:

  • Mandatory education on independence and ethics for new professionals
  • Mandatory continuing education for experienced professionals
  • Vigorous monitoring processes and disciplinary proceedings
  • External quality control reviews of CPA firms

Safeguards Created by Attest Clients

Clients sometimes implement the following safeguards to help preserve their auditors' independence:

  • Employment of skilled personnel who can properly supervise and evaluate nonattest services provided by audit firms
  • Establishment of a tone at the top that emphasizes a commitment to candid financial reporting
  • Establishment of a governance structure, such as a proactive Audit Committee, that promotes forthright communications concerning financial reporting issues

Safeguards Created by Auditors

CPA firms also implement numerous safeguards to diminish threats that could extinguish their own independence. Major safeguards include

  • Policies that identify financial interests or relationships that jeopardize independence
  • Policies that segregate audit professionals from firm personnel who perform nonattest services
  • Policies that identify excessive reliance by the firm or a specific partner on a single client
  • Schedules that regularly rotate senior personnel to different clients
  • Use of internal subject matter experts to help diffuse undue client pressures
  • Use of a senior firm member or an outside, unaffiliated CPA to oversee firm quality control

REQUIRED ACTIONS WHEN INDEPENDENCE IS IMPAIRED

If a CPA firm lacks independence, it should not accept an audit engagement or other attest engagement. If it discovers independence issues after commencing an audit engagement, it should disclose its lack of independence by issuing a disclaimer of opinion.

The Impact of the Independence Rule on Other Endeavors

Independence in Tax Practice

The Independence Rule only applies to attest engagements, not to tax preparation or tax advisory engagements. Thus, for instance, accountants are not precluded from preparing tax returns for business enterprises in which they are a partner, stockholder, director, officer, or employee.

Nonetheless, a tax advisor's suggested strategies and recommendations can strongly influence how an audit client reflects an uncertain tax position in its IRS filings and as tax expense on its financial statements.45 Accordingly, before advocating tax-related positions to an audit client, accountants must be mindful to not create an unacceptable advocacy threat, self-review threat, or management participation threat to their firm's continuing independence.

Independence in Consulting and Outsourced Internal Audit Services

When a client retains its audit firm to provide outside advice or internal audit services, risks to auditor independence can arise, particularly advocacy, self-review, and management participation threats. Advisory services that involve an audit client's internal accounting controls, asset valuation, or actuarial obligations pose especially delicate issues because these services directly impact the preparation and content of a company's financial statements. As a result, audit firms providing consulting and internal audit services to audit clients must meticulously ensure that they merely give advice and do not dictate managerial decisions that affect the preparation, presentation, or content of financial statements.

Independence in Trust and Estate Administration

Independence issues relating to auditors who concurrently manage ownership interests held in trusts or estates are examined in Chapter 15.

OTHER SOURCES OF INDEPENDENCE RULES

The Government Accountability Office, or GAO, mandates independence standards for government auditors as well as private-sector auditors. Its rules apply to a wide range of attest services, including audits of various government entities, nonprofit organizations, and for-profit organizations that receive federal grants, subsidies, and contracts. Thus, many colleges, hospitals, local governmental units, and defense contractors are required by law, regulation, or contractual agreement to follow GAO rules. According to one estimate, over $300 billion of annual government expenditures are subject to the GAO's standards.

The SEC and the Public Company Accounting Oversight Board impose additional independence restrictions regarding public-company audits, the Department of Labor regulates audits of employee retirement plans, and the various agencies that comprise the Federal Financial Institutions Examination Council have established standards that modify and strengthen independence requirements for audits of banks and credit unions. A CPA must abide by these requirements if they are stricter than the Code of Conduct's standards.

EXERCISES

When Independence Is Required and Satisfied

  1. Indicate if independence is required for an accountant to perform the following tasks:
    1. Render tax advice to a nonaudit client
    2. Issue an audit opinion concerning a government-run airport
    3. Issue a review opinion concerning quarterly reports of a privately held company
    4. Make recommendations as an internal auditor to your employer
    5. Determine proper account classifications prior to recording journal entries that will appear on your employer's books and affect the content of its year-end audited financial statements
    6. Issue an audit opinion concerning the financial statements of an employer-funded pension plan
    7. Provide litigation-related advice to a nonaudit client
  2. Consider the following prose:

    I am ferocious, hear me roar

    My professional skepticism is tough to the core

    I may look like a pussycat, but I'm a lion on the inside, dude

    Who cares about appearances when you've got my attitude?

    Can an auditor satisfy the Independence Rule by having a tough attitude, or do appearances also matter?

  3. Is an auditor allowed to own a direct interest in an audit client? Is ownership of an indirect interest permitted? What is the difference between direct and indirect interests?

    Covered Members

  4. Ryan and Darla are married. Darla is partner at Ernst and Notold, CPAs, where she serves as the lead engagement partner on the audit of Mortis Company. Darla does not own any stock in Mortis Company, but Ryan owns 1% of Mortis Company's preferred stock. Ryan's ownership of Mortis stock is not material to his net worth.
    1. Does Ernst and Notold, CPAs satisfy the independence standard to audit Mortis?
    2. Would your answer be the same if Ryan was Darla's brother instead of her husband?
    3. Would your answer be the same if Ryan was Darla's grown son who is married to a highly successful investment banker?
  5. A CPA firm has numerous partners, all of whom work out of the firm's sole office in New York City. Jeanne is the lead attest partner on the audit of Bell Bank, a small financial institution located in midtown Manhattan. The audit team is comprised of five professional staff members and two administrative staff members. Tony is the managing partner of the firm, who also serves on the firm's Compensation Committee.

    Casey is the partner in charge of quality control monitoring for the firm, and Carina is the CPA firm's technical expert on derivatives valuation and auditing. Carina was consulted by the audit engagement team to help resolve a difference of opinion between the client and the firm on how a securitization transaction should be reported. Liam is a tax manager who spent four hours addressing a client matter with the state sales tax authorities.

    Which of these individuals is a covered member regarding the audit of Bell Bank?

  6. Sterling, CPAs has offices in major cities throughout the United States. Julieanne, a partner at Sterling, has a brother named Hudson who recently accepted a position as CFO of Tivoli Gardens, Inc. The lead partner on the Tivoli Gardens engagement is located in the firm's Minneapolis, Minnesota office, the client is located in Iowa, and partner Julieanne is located in Denver, Colorado. Julieanne spends all of her professional time auditing Owen Cornery, Inc., an unrelated glass manufacturer.

    Does Sterling, CPAs have the independence to audit Tivoli Gardens, Inc.?

    The Familiarity Threat

  7. Bob is an accounting supervisor who works in Jimenco's tax department. Sharon is a partner at Delight, CPAs, and Delight, CPAs audits Jimenco. Recently, Bob asked Sharon if he could “make some extra cash” by preparing individual tax returns on weekends for Delight, CPA during tax busy season. Delight, CPA hired Bob to prepare tax returns on the condition that his employment will be temporary and he will not have any involvement in the preparation, presentation, or content of Jimenco's financial statements. Does Delight, CPAs satisfy the independence standard to audit Jimenco?
  8. Eldridge Elderly retired from the active practice of public accounting last year. As part of his retirement, he received a buyout package from his former CPA firm that pays him $300,000 per year for 10 years. The payout is not contingent on firm profits and is guaranteed by a well-established insurer. After retiring, Eldridge used some of his retirement money to buy stock in Wojo Warehouse Stores, a wholesaler that had been a firm client when he was active. Wojo has remained a firm audit client since Eldridge's departure. Eldridge never was a covered member with respect to Wojo, and he has severed all operational ties to his former CPA firm. His photo and biography, however, remain proudly displayed on his former firm's website.
    1. Does Eldridge's ownership of Wojo stock affect his former firm's independence to audit Wojo?
    2. In retirement, Eldridge was getting bored, so he has agreed with Wojo to provide quality control and oversight over Wojo's financial reporting staff as a paid consultant. His title is Chief Internal Control Officer. He only works one half-day per week. Could Eldridge's retirement activity affect his former firm's independence to audit Wojo?
    3. What should Eldridge's CPA firm do to ensure that it retains its independence to continue as Wojo's auditor?
  9. The lead attest partner, Lisha, on an audit engagement recently got married to Samid.
    1. If Lisha's husband is a sales representative for one of Lisha's attest clients, is her independence impaired?
    2. If Lisha's husband is promoted to become the client company's Chief Executive Officer, will Lisha's independence become impaired?
    3. Lisha's husband plans to apply for a new job. Can Lisha's husband work as a data entry assistant in the Accounting and Finance Department at her attest client without impairing her independence?
    4. After falling in love with Samid, Lisha discovered that her future father-in-law is the CFO of her largest attest client. What, if anything, should Lisha do to preserve her independence to remain this client's auditor?
    5. Lisha's new husband owns a few shares of stock issued and outstanding in Lisha's attest client. Lisha did not learn of his stock ownership until after they got married. Is Lisha's independence impaired? Do you have any recommendations that might preserve Lisha's independence?

    Adverse Interest and Advocacy Threat

  10. In a lawsuit between Bottomfisher Bank and Cellular Dynamico, a question has arisen concerning whether Cellular Dynamico's bookkeeping staff routinely recorded a journal entry in the ordinary course of business at approximately the same time that the accounting event reflected in the journal entry occurred. The bank claims that the company manipulated its books and records several months after year-end to gain a tactical advantage in this litigation.

    By coincidence, you happen to be the lead partner on the audit engagements for both Bottomfisher Bank and Cellular Dynamico. You have been subpoenaed into court to testify about whether you saw this journal entry on the client's book prior to year-end. Your testimony is going to be yes, which will help Cellular Dynamico's defense, but it will harm the bank's claim. Will your testimony affect your continuing ability to serve as the bank's auditor? Will it affect your independence to remain Cellular Dynamico's auditor?

    Adverse Interest Threat

  11. After a fee dispute arose between a CPA firm and its client, the parties agreed to discuss their dispute confidentially with a retired federal judge in mediation. As of now, the parties have not managed to resolve their dispute. No lawsuits have been threatened or filed. Does the CPA firm still retain the independence to audit this client?
  12. Your audit client is upset that you insisted that it apply lower of cost or market to its holdings of marketable trading securities. Your client correctly informed you that a portfolio of marketable trading securities may be written up to market value, as well as down. However, you incorrectly refused to allow upward adjustments to its holdings of marketable trading securities.

    Your client has filed a multimillion-dollar lawsuit against you for malpractice. Outside counsel has advised you that “you screwed up, but no one read these statements or relied on these statements. The client suing you will never be able to prove that it suffered damages, so don't sweat it.” You agree.

    Is your independence impaired with respect to this audit client?

    Undue Influence Threat

  13. Your audit client was thrilled with your audit team's efficiency and slightly wacky sense of humor. On the day that the client's audited statements were issued, the client's Controller invited all of you to “share some beer, catch some dinner, and watch a basketball game at a sport bar.” The Controller insisted on “picking up the tab” on the company credit card. What, if anything, should you do?
  14. Due to major medical bills in your family, an audit client's Chief Financial Officer personally agreed to lend you $10,000 interest-free for one year. The client had no knowledge of, or involvement in, this loan. What, if anything, should you do?

    Self-Review Threat

  15. When a member of your review client's accounting staff quit abruptly, you agreed to “help out” by preparing customer invoices and verifying shipping documents and warehouse receipts. Was your kindness a mistake?

    Management Participation Threat

  16. A CPA was elected to serve as his township's City Manager. The City Manager job is a paid, part-time position that requires 10 hours of work per month. The City Manager is not involved in the preparation or presentation of the city's financial statements. The CPA has been the township's auditor for the past decade. Does he continue to satisfy the independence standard to continue as the township's auditor?
  17. Your CPA firm performs tax services for an audit client. The client has asked you to prepare and sign its tax return. Do you satisfy the independence standard to audit this client?
  18. A client has asked you to cosign disbursement checks of over $500 when the CFO of the company is traveling abroad. The company's Assistant Controller is the other designated cosigner. You want to help out your client, but you are concerned that this might impair your independence. May you do so?

    Self-Interest Threat

  19. A CPA firm audits a large international bank. The bank has agreed to give a home mortgage loan to a senior manager at the CPA firm. The senior manager has stated that she “does not have any affiliation” with the bank. What issues need to be resolved to determine if the CPA firm's independence is impaired?
  20. A CPA firm maintains its savings and checking accounts at Columbus Bank. The CPA firm also is negotiating to become this bank's auditor. Does the CPA firm meet the independence requirements to audit this bank?
  21. A CPA audits a well-known New York bank and also uses a credit card issued by that bank. The CPA makes purchases using the credit card near the start of a month, but always pays her outstanding balance on time by the end of the month. Does she satisfy the independence standard to audit this bank?
  22. A CPA recently purchased several bonds issued by its audit client. Does this CPA satisfy the independence standard to continue auditing this client?
  23. A CPA firm has idle space in the small office building it owns. One of its clients, while visiting the CPA firm, noticed this empty space and offered to sublease this space at prevailing market rates for a one-year term. Does the CPA firm retain its independence to still audit this client?
  24. You plan to issue an audit report next month. Your client still owes you $20,000 for performing last year's audit, and you do not expect to collect all of these fees by the expected issuance date of the current-year audit. You have offered to lower your fee for last year's services by 25%. Also, you have offered to cancel the remaining unpaid fee and rebill it as part of the fee for performing this year's audit. If your client agrees to this compromise, do you retain the independence to issue the current-year audit report?
  25. Ratha Gupta is a sole practitioner CPA. Ratha has a profitable audit client that operates a chain of hospitals in Arizona. This client also owns 65% of a hematology testing laboratory in Mexico. This client has offered to allow Ratha to purchase a 2% stake in that testing laboratory for $80,000. Will Ratha retain her independence to audit her current client, the hospital chain?
  26. An audit client designs and builds regional shopping centers for its customers. After the audit client introduced his CPA to one of these customers, the customer wanted the CPA to install and operate the supply chain software that would control inventory flow into its regional shopping centers. As a convenience, the audit client has offered to send one bill to the shopping center customer and then disburse the CPA's portion of the revenues billed within 10 days of collection. The audit client will also retain an 8% “solicitation and promotion fee” for its efforts. Does the CPA retain the independence to continue auditing this client?
  27. To be independent, an auditor may not have any direct interests in a client, but may have immaterial indirect interests. Would an auditor's objectivity really change if it owned, say, 3 shares of a client?
  28. In 19th-century Great Britain, auditors actually were required by law to “have at least one share in the [corporate] undertaking.” Would our auditing system be better if auditors did own shares in the companies they audit?

    Behavioral Aspects of Auditing

  29. What steps would you recommend that the auditing profession take to minimize the impact of moral seduction?

    Comprehensive Problems

  30. When Ramin was growing up in a small suburb of Boston, he was best friends with his cousin Saureb. Both boys played soccer on the same school team. Their parents even held joint birthday parties for them because their birthdays were two days apart.

    Saureb's family moved away from the Boston area when the boys were teenagers. Thereafter, they would email each other occasionally, but they grew apart from one another, as often happens in high school.

    After graduating from college, Ramin went to work for a CPA firm in Waltham, Massachusetts, and Saureb became the Assistant CFO at MassFin Bank in nearby Weyburn, Massachusetts. By coincidence, Ramin was assigned to work as a member of the team that was auditing MassFin Bank. (Ramin was excited to join this audit team because his mother had owned eight shares of this bank's stock for many years and had always admired the bank's financial success. Her holdings have tripled in value over her original $100 cost.)

    Due to their physical proximity, Ramin and Saureb renewed their friendship and, like the old days, even began playing soccer together on fall weekends. Ramin lamented that he “probably should be spending time studying to pass the CPA exam instead of playing soccer,” but he loved the sportsmanship of playing soccer.

    One weekend, Saureb told Ramin that an “awesome” job opening had become available in the bank's Public Interest Entity Financial Reporting Department. Saureb clearly told Ramin that company policy was to advertise all job openings to the general public and that Saureb had “absolutely no pull” to get Ramin the job. Ramin applied nonetheless and was granted a first-round interview.

    Because the interview was during the workday, Ramin “called in sick” that day and went to the job interview. He thought that the interview went well, and he was told that “callbacks” for the second round, if he were to make it to that level, would take place in about two weeks. The interviewer took Ramin to lunch at a rather expensive sushi restaurant. Ramin expected the interviewer to pay for lunch, but Ramin nonetheless gestured that he would split the bill by placing his credit card on the table. MassFin Bank was the largest credit card issuer in the area, so not surprisingly, Ramin happened to have a MassFin credit card. The interviewer politely told Ramin to put his credit card away. She also told Ramin that she “made the big bucks” and had the “company's blessing to pick up the lunch tab.” Ramin returned to his audit duties the following day, with renewed energy and excitement.

    1. Is Ramin a covered member on the bank audit?
    2. Is his cousin's employment at the bank relevant to issues of independence?
    3. Is his mother's stock ownership in the bank relevant to issues of independence?
    4. Is Ramin's credit card ownership relevant to issues of independence?
    5. Was Ramin's free meal relevant to issues of independence?
    6. What disclosures, if any, should Ramin have made to the CPA firm that employs him?
    7. Would Ramin's disclosure duties have been any different if he was interviewing for a position in New Business Development?
  31. Your college friend has always respected your financial acumen as a CPA. As a result, when your college friend formed his business in February, he asked you to serve on the company's Board of Directors. You gladly served on the Board of Directors for one month, without compensation, and then resigned in March when the company appointed an experienced venture capitalist to replace you. During the time you served on the Board, you successfully promoted the firm's business model to prospective investors. As compensation, the company awarded you 300 long-term stock options.

    Toward the end of the year, the company's Board of Directors selected you to audit the company's calendar-year financial statements for its first year of operation. Your college friend did not participate in that decision. Rather, the other Board members unanimously selected you based on your prior experience in their industry. Your friend did help you celebrate your selection by buying an extremely expensive bottle of aged wine. What threats exist to your ability to serve as the lead auditor on this client engagement?

Notes

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