Chapter 15
Duties of Fiduciaries: Financial Planners, Trustees, and Executors
Sports agent Leigh Steinberg was once on top of the world. His financial savvy and smooth-as-silk demeanor charmed hundreds of the world's top professional athletes into choosing him as their agent. He negotiated multi-million-dollar deals by day and socialized with the rich and famous by night. In due course, he too became rich and famous.
Steinberg is credited with being the real-life inspiration for Tom Cruise's iconic character in the film Jerry Maguire. This movie popularized the often-repeated phrase, “Show me the money!” Steinberg's clients indeed did just that.
Unlike many Hollywood stories, Steinberg's real-life story does not end with everyone living happily ever after. After a nasty divorce and admitted bouts with alcoholism, Steinberg became so desperate that he started paying his personal bills with client money entrusted to him. When clients “showed him the money,” he gladly took it—and squandered it. Ultimately, Steinberg's moral bankruptcy forced him into a court of bankruptcy.
This chapter will examine the duties of financial professionals when they serve in fiduciary roles as money managers, trustees, and executors.
FIDUCIARY RELATIONSHIPS
The Nature of Fiduciary Relationships
When professionals are entrusted with other people's money or items of value, we expect them to perform their responsibilities with the highest degree of honesty and trustworthiness. This elevated level of care is called a fiduciary duty. Fiduciary duties commonly are imposed by law when one person could exploit his special position of knowledge or influence to take advantage of a vulnerable second person.
For accountants, a fiduciary relationship typically arises when clients entrust money to their accountants and give them broad discretion to make or influence important client decisions. For example, a fiduciary relationship is created when an accountant oversees client investments as a business manager, serves as the trustee of a trust fund, serves as a retirement plan asset manager, or serves as the executor of a deceased client's estate. In these situations, clients are especially vulnerable to an abuse of power because it is impractical, and maybe even impossible, for them to meaningfully oversee their accountant's conduct. For similar reasons, business partners, as well as corporate directors and officers, also are considered to be fiduciaries because they have great discretion in making decisions concerning others' financial well-being.
Courts sometimes even have imposed fiduciary duties on professionals outside the purely financial realm. For instance, doctors sometimes have been determined to owe a fiduciary duty to their patients because doctors have specialized knowledge and often are entrusted with patients' most valuable resource, their health.
Although accountants often serve in fiduciary capacities, auditing and tax engagements generally do not create a fiduciary relationship because these professional services do not involve the customary elements of a fiduciary relationship—heightened client vulnerability coupled with a dominant position of financial control or knowledge.
The Legal Consequences of Being a Fiduciary
When an accountant or other financial professional is classified as a fiduciary, a client gains certain rights.
First, a fiduciary is held to a very strict standard of honesty and loyalty. As Supreme Court Justice Cardozo once wrote, a fiduciary “is held to something stricter than the morals of the market place. Not honesty alone, but the level of conduct…higher than that trodden by the crowd.”1
In addition, because of their dominant influence over a client, fiduciaries in some situations have the burden of proving that their conduct was proper. Thus, unlike a customary lawsuit, plaintiffs suing a fiduciary may not affirmatively have to prove their accusations. Instead, a fiduciary may have to disprove these accusations. This makes it easier for a client to prevail in court against a fiduciary.
Last, if a client is harmed by a fiduciary's actions, the client may either recover damages or recover any ill-gotten gains earned by the fiduciary. This latter right is called profit disgorgement.
PERSONAL FINANCIAL PLANNERS AND ASSET MANAGERS
When accountants provide a broad array of investment and advisory services, they unknowingly can become entangled in a web of rules and regulations.
Applicable Professional Standards
CPAs who provide personal financial planning services are subject to the AICPA's Statement on Standards in Personal Financial Planning Services, issued in 2014. This statement governs the conduct of CPAs who design or implement strategies in areas such as estate planning, risk management, and retirement planning. It also applies when CPAs sell insurance, securities, or other financial products to their clients. When CPAs are engaged in any of these endeavors, they also must abide by the Code of Conduct, especially its provisions relating to conflicts of interest, commissions, and referral fees.2
General Legal Standards
When CPAs or other financial professional have managerial discretion over client funds, they customarily owe their clients fiduciary duties. These duties include the responsibility to be loyal to their clients' goals, prudent in managing client funds, candid about their compensation, and forthright in disclosing actual and apparent conflicts of interest.
Specific Duties Associated with Custody of Assets
If an accountant takes custody of client funds, additional professional and legal duties arise. According to the IFAC Code, when professional accountants in public practice are entrusted with client funds or other assets, they have five core duties:
- They must not commingle client assets with their own assets
- They must use assets only for their intended purpose
- They must maintain an up-to-date accounting for these assets and the related income generated
- They must comply with all relevant laws and regulations
- If client funds appear to have been derived from illegal activities, they must follow all applicable laws and avoid associating with others who might discredit them or the accounting profession3
CPAs also should never overlook the fact that the insurance, banking, and securities fields are highly regulated. For example, CPAs who provide financial planning advice or manage investors' portfolios may have to become Registered Investor Advisors under SEC rules or state securities laws.
How to Avoid Creating a Fiduciary Relationship
As we have seen, courts have to weigh various factors in deciding whether client dealings impose fiduciary duties on a financial adviser. To minimize the likelihood of a business arrangement being characterized as a fiduciary relationship, an accountant should do the following:
- Ensure that clients have the ability to understand and evaluate the advice given to them
- Ensure that clients understand that they have the ultimately responsibility for a decision
- Keep clients fully informed about relevant facts, so they are able to make their own decisions
- Encourage clients to consult with others, such as attorneys and insurance professionals, about the advice given to them
- Expressly enter into agreements with clients that specify that a fiduciary relationship is not created
TRUSTS AND TRUSTEES
Because accountants often serve as trustees or as their advisers, accountants need to understand how trusts operate and how different types of trusts affect their professional responsibilities.
The Structure of a Trust
A trust is comprised of three parties:
- The grantor is the person who places assets, such as stock and real estate, into a trust.4 Like a corporation, a trust is a distinct legal and accounting entity.
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The trustee oversees management of the trust. Grantors commonly appoint their lawyer, accountant, or close relatives to serve as the trustee. In some cases, the grantor names two or more cotrustees. For example, a widow might appoint her three children as cotrustees to manage a trust that benefits her grandchildren.
- The beneficiaries receive trust earnings and assets over time. The grantor selects the beneficiaries, who typically include the grantor's spouse, children, or grandchildren. In some situations, however, the beneficiary is a charity, a kind neighbor, or even a very pampered pet cat.
Figure 15-1 The Elements of a Trust.
Trusts that take effect while a grantor is alive are called inter vivos trusts.
Alternatively, if a trust does not take effect until a grantor dies, a trust is called a testamentary trust. Grantors commonly establish testamentary trusts in a written will if they do not want their heirs to receive lump-sum inheritances outright at the time of a grantor's death.
Advantages of Trusts
Trusts, like corporations, have a separate existence apart from the individuals who form and benefit from them. As a result, a trust must maintain its own set of accounting records and pay income taxes on its earnings. Maintaining accurate records and filing a trust's fiduciary tax return are among a trustee's most important responsibilities.
People establish trusts for many different reasons.
A primary reason for establishing a trust is to ensure that wealth is managed and disbursed wisely after a grantor's death. Many grantors, for instance, do not want their grandchildren to receive large lump-sum inheritances that might quickly be squandered on frivolous purchases. By appointing a responsible trustee, a grantor can ensure that trust funds are invested carefully and disbursed in modest, periodic amounts.
Trusts also can be helpful in minimizing estate taxes. By transferring assets into a trust, an elderly grantor removes assets from her balance sheet for tax purposes. Therefore, when the grantor dies, her family tax burden shrinks because the estate tax is imposed on a person's net assets at death. For this strategy to succeed, a grantor must permanently relinquish control over assets by creating an irrevocable trust.5
Another purpose for creating a trust is to shield assets from creditors and litigation claims. Because assets placed into trust are removed from the grantor's balance sheet, people in high-risk occupations, such as surgeons, often use trusts to protect their assets from potential lawsuit claims.
Special Kinds of Trusts
Like a race car or a hand-sewn pair of embroidered jeans, trusts can be customized to fit a person's particular desires or needs. Some of the most common variations are spendthrift trusts, blind trusts, split-interest trusts, and living trusts.
Spendthrift Trusts
A spendthrift trust is designed to prevent beneficiaries who are minor children from accessing their trust wealth prior to reaching adulthood. A spendthrift trust accomplishes this by invalidating attempted sales or transfers of a trust interest by a minor beneficiary.
Blind Trusts
As its name suggests, a blind trust figuratively keeps beneficiaries in the dark by preventing them from knowing about the trust's assets or earnings performance.
In a typical blind trust, grantors appoint an independent trustee to oversee their investment portfolios but name themselves as both the trust grantor and beneficiary. Although this arrangement may sound rather unusual, judges and politicians often create blind trusts to shield themselves from knowing the composition of their investment holdings or intervening in trust decisions. By blinding themselves, decision makers in sensitive positions therefore prevent conscious or unconscious biases from influencing their choices. Furthermore, when a public official selects a particular government contractor or a judge decides in favor of a particular corporation, these decision makers can more readily refute critics who might accuse them of unethically favoring entities in which they have a self-interest.
Split-Interest Trusts
Figure 15-2 The Elements of a Split-Interest Trust.
When grantors want to split trust benefits between two or more beneficiaries, they often create a split-interest trust. A split-interest trust shares, or splits, the aggregate earnings and assets of a trust between multiple beneficiaries. Customarily, a split-interest trust designates that trust earnings belongs to one beneficiary, but trust net assets belongs to a different beneficiary. The first party is known as the income beneficiary, and the second is called the principal beneficiary or, alternatively, the remainderman.6
As an illustration, a married man might create a trust that states, “Income to my wife for her life, with the principal going to our three children after her death.” This type of trust allows the wife to maintain her current lifestyle out of trust earnings, but it also ensures that she will not deplete the children's intended inheritance, leaving them with nothing.
From a simplistic accounting perspective, a split-interest trust essentially gives benefits reported on a trust's income statement to the income beneficiary, but gives a trust's balance sheet net worth to the principal beneficiary.
Living Trusts
A living trust is a trust that a grantor creates for his own benefit. Upon creating a living trust, grantors transfer most, or all, of their assets into a trust and name themselves as the beneficiary. Because the grantor continues to participate as the beneficiary, the grantor remains in essentially the same economic position, both before and after the trust's creation.
The key advantage of a living trust is that, at the time of the grantor's death, trust assets controlled by the trustee technically are no longer the property of the grantor. Therefore, after a grantor's death, assets held in the trust are not subjected to a lengthy court proceeding, called probate. Instead, the trustee can manage and distribute these assets following the grantor's death without delays or interference from the court system.
At the outset, grantors usually serve as the trustee of their own living trusts. Living trusts, however, usually designate another person, such as an accountant or lawyer, to replace the grantor as the successor trustee if the grantor dies or becomes disabled.
Accountants in Trust Practice
Because of their financial acumen and reputations for trustworthiness, accountants often are asked to serve as trustees. Trustees have two principal duties.
A trustee's primary duty is to manage trust assets in a manner that carries out the grantor's intent. If the grantor's intent is unknown, the trustee should manage trust assets in the same manner that a prudent investor would conduct his own financial affairs. Customarily, trustees are entitled to fair compensation for their managerial efforts, unless they are voluntarily serving at the request of a friend or relative.
Also, a trustee is expected to prepare, or have someone else prepare, a trust's financial statements and tax returns. If trustees perform these tasks themselves, they are entitled to fair compensation for their accounting work in addition to their regular trustee fees.
Managing and performing the accounting for a split-interest trust poses special challenges because a trustee must carefully distinguish between income and principal. If a trustee classifies too much trust cash flow as income, the remaindermen might sue the trustee for giving away their money. Conversely, if the trustee allocates too much cash flow to principal, the income beneficiary will be exceedingly displeased. To avoid accusations of favoritism, trustees who are not accountants often hire an independent accountant to perform these calculations.
In distinguishing between trust income and trust principal, an accountant must first determine whether trust documents specify that a special accounting framework that differs from GAAP should be applied. For instance, a trust document might adopt a cash basis methodology rather than accrual accounting. If so, the parties must abide by the grantor's wishes, as expressed in the trust document.
If a trust does not specifically define income, an accountant must apply state law interpretations for measuring trust income. With one major exception, most states interpret the word income roughly according to GAAP. The one major exception is that the proceeds from the sale of an asset, which includes the related capital appreciation or decline, are assigned to principal, not income. To illustrate, assume that a grantor contributes land worth $10 to a trust and this land later is sold for $17. Although GAAP would consider the $7 gain on sale to be income, trust accounting rules commonly consider the full $17 sum, including the capital appreciation element, to be principal. Accordingly, the income beneficiary would not participate in this gain because the full $17 of the sales proceeds belongs to the remainderman.8
The Specific Duties of a Trustee
A trustee has certain legal and ethical duties, including the duties of loyalty, care, and impartiality.
The Duty of Loyalty
Like all fiduciaries, a trustee owes a duty of loyalty. The key question is: To whom is this duty owed?
A trustee manages a trust for the benefit of the beneficiaries. However, it would be difficult to consistently remain loyal to the beneficiaries because beneficiaries often have different, and sometimes conflicting, goals. In a trust with two beneficiaries, for instance, one beneficiary might desire capital gains because she is in a high tax bracket, and the other beneficiary might desire stable, but highly taxed, interest income.
To avoid these problems, a trustee is expected to be loyal to the wishes of the grantor. The intent of the grantor often is expressed in the trust document itself, but it also can be inferred from the surrounding circumstances.
The Duty of Care
A trustee's core duty is to carefully adhere to a grantor's wishes. In the absence of clear guidance, though, trustees historically have fulfilled their duty of care by investing in low-risk investments, such as government bonds.
Over time, the Uniform Prudent Investor Act and similar laws have liberalized a trustee's authority to create a financially sound, overall trust portfolio. Under this modern approach, a trustee who lacks information about a grantor's wishes satisfies the duty of care by crafting a diversified investment portfolio, even if any single investment in the mixture is prone to wild fluctuations in value.
The Duty of Impartiality
Because a split-interest trust assigns trust income and trust principal to different beneficiaries, it is important for a trustee to select investments that further the interests of all trust beneficiaries. This duty to treat all beneficiaries fairly is known as the duty of impartiality.
To illustrate this issue, assume that a trust states the following: “Income shall be paid to my niece, and upon her death, trust assets shall be distributed to my nephew as the remainderman.” If the trustee invests all of the trust's funds in raw land and holds it solely for appreciation, the niece would not receive any income distributions because raw land does not generate current income.
Alternatively, if the trustee invests all of a trust's funds in a coal mine, the trust would likely earn substantial profits from coal sales, but the value of the coal mine would decline over time as coal is extracted and sold. As a result, the niece would be thrilled, but the nephew would be upset because trust assets would be nearly worthless by the time he receives the depleted coal mine.
As this illustration shows, by selecting certain types of investments, an unethical trustee could skew financial rewards to unfairly favor certain beneficiaries over others. To prevent such an outcome, trustees of split-interest trusts have a strict fiduciary duty to act objectively and impartially.
EXECUTORS AND ADMINISTRATORS
Accountants often are involved in developing wealth and succession plans for clients, as well as performing estate accounting tasks. As a result, accountants have to become familiar with the tax, financial, and ethical issues that arise in connection with estate planning and administration.
The Structure of an Estate
Figure 15-4 The Elements of an Estate.
When a person dies, property technically transfers to an estate. If the deceased had a will, the will customarily designates the person who will serve as the executor of the estate. If a valid will does not exist or the named executor cannot serve in this position, a court will appoint an administrator. Usually, the administrator is a close family member.
When a person dies without a will, all jurisdictions provide a default rule that governs estate distributions. The customary allocation pattern distributes all wealth to the deceased's spouse if one is alive, or to the deceased's children if there is no living spouse, and so on. This wealth distribution pattern is triggered when a person dies intestate, which means without a will.
Executors and administrators have a fiduciary duty to carefully manage an estate with loyalty to the deceased's wishes. These duties include gathering all of the deceased's assets, investing these assets prudently, winding up the deceased's affairs, repaying the deceased's outstanding debts, and distributing estate property in accordance with the deceased's desires. Because of the substantial work involved, executors and administrators are entitled to withdraw cash from the estate as reasonable compensation for their efforts. State laws typically regulate the amount of this compensation.
Also, when accountants serve as an executor or administrator, they are entitled to additional compensation for any bookkeeping or tax return preparation work they perform.
Accountants in Estate Practice
It is sometimes said that “only two things in life are certain—death and taxes.” In the case of estate accounting, both occur at the same time.
When a person dies, a final balance sheet must be prepared. This is necessary to ensure that all the deceased's assets are gathered and all the related debts are paid. To satisfy their fiduciary duties, executors and administrators often hire skilled estate accountants to handle these tasks.
In addition, an estate tax return must be filed if the deceased's net worth exceeds a specified exemption amount. This exemption amount has several nuances, and Congress changes it from time to time. At present, a person can die with over $5 million of net wealth without incurring the estate tax. Thus, only the richest Americans have to worry about the estate tax.
An estate tax return essentially is a modified balance sheet that reports a deceased individual's net worth. For policy reasons, amounts bequeathed in a will to a spouse or to charity then are subtracted in determining the net wealth that is subjected to an estate tax burden. Contrary to a popular misconception, the estate tax technically is imposed on the deceased's right to transfer away wealth at death. It is not imposed on the heirs who receive inheritances. Thus, the estate tax is a transfer tax imposed on the giver of wealth, not on the receiver.
Because estate taxes are based on the value of a deceased individual's net assets, accountants often are asked to perform asset valuation services for an estate. This can become quite complicated when the deceased owned illiquid interests in a closely held family business, raw land, or certain intangible assets.
Apart from submitting an estate tax return, an estate also might have to file an income tax return. Although it seems implausible that a deceased individual would keep earning postdeath income, estates frequently continue to collect dividend, interest, rents, and other passive sources of income between the date of death and the time when all estate assets have been distributed to heirs. An estate is a taxpayer, and the estate executor or administrator has a duty to file and pay taxes on its earnings.
FIDUCIARY ISSUES IN TAX PRACTICE
Negotiating Tax Refunds
Accountants who handle the financial affairs of trusts or estates often find it convenient to have all related correspondences, including tax refund checks, sent directly to them. This practice is acceptable, but the IRS unequivocally mandates that tax practitioners “may not endorse or otherwise negotiate any check…into an account owned or controlled by the practitioner.”9 Thus, accountants who manage trusts and estates should always maintain separate bank accounts for each such entity and ensure that all tax refund payments, including wire and electronic transfers, are deposited directly into these accounts.
Resolving Conflicts of Interest
As we illustrated in a previous chapter, when an accountant performs professional services for multiple co-owners of a business, Dual-Client Conflicts often arise. Similarly, when an accountant performs services for multiple beneficiaries of a trust or estate, conflicts of interest inevitably tend to emerge.10
As an illustration, assume that an accountant prepares income tax returns for two sisters, Farah and Tera, and for a trust created to benefit these sisters. Under a new tax law, the trust can make a special tax election that will benefit Farah but harm Tera. It is impossible for you to ethically give objective advice to the trustee managing the trust because your professional duty to advocate on behalf of Farah's economic interests clashes with your duty to Tera.
AUDITOR INDEPENDENCE REQUIREMENTS FOR TRUSTEES AND EXECUTORS
A previous chapter emphasized the importance of independence in audit and other attest engagements. Let's now build upon this foundation by examining the independence issues that arise in the context of trusts and estates.
The Ethical Dilemma
Consider this ethical quandary: A CPA who has audited Casey Company for many years recently agreed to serve as the trustee of a trust that owns stock in Casey Company. Does this CPA satisfy the Independence Rule to continue as Casey's auditor?
The succinct answer is no. Upon accepting this trustee role, this CPA has a duty to promote the trust's best interests. On the other hand, this CPA, acting in the role of auditor, might have to issue an audit opinion that would diminish the value of Casey Company stock, causing the trust to suffer a loss. Accordingly, this accountant's objectivity has been compromised because she might one day, to use an old English phrase, be “impaled on the twin horns of a dilemma.”
The Independence Rules
In balancing potentially conflicting duties, the Code of Conduct mandates that if a CPA acts as a trustee for a trust that owns an audit client's stock, the CPA loses the independence to audit this client in any of three situations:
- The CPA is authorized to make investment decisions for the trust;
- The trust is a significant stockholder in the client company; or
- The company's stock is a significant asset of the trust.11
Stock ownership is considered to be significant for this purpose if it is more than 10% of a company's outstanding shares or a trust's investment portfolio.
Identical rules apply when a CPA is an executor of an estate that owns an audit client's stock.
EXERCISES
General Fiduciary Duties
- Why would a pension fund manager be considered to owe fiduciary duties?
- While acting as a fiduciary, you recommended that your client buy a particular brand of refueling station to charge her new, electricity-powered car. You told your client that she would be able to save 70% of the purchase price of the home refueling station through a combination of tax credits and utility rebates. You were correct, and the client achieved these savings. However, you did not tell the client that you were receiving a $200 commission from the manufacturer of that particular refueling station brand. Your client now is furious that you received this commission and never told her about it. Do you owe your client $200?
- You recently introduced your wealthy client Grace to a broccoli importer named Gonzalo. You told your client that she would likely “get along well” with the broccoli importer because they both were entrepreneurial and they both were raised in Guatemala. You also told your client to strongly consider investing with the broccoli importer because he was a “stand-up guy.”
After several business discussions between Grace and Gonzalo, Grace invested $5 million in Gonzalo's business. Several months later, a fierce hurricane destroyed the broccoli importer's crop, causing the company to cease its operations. Grace now has sued you for breach of fiduciary duty. Are you liable?
Trusts and Trustee Duties
- A trustee of a split-interest trust has to allocate income to the income beneficiary and principal to the remaindermen. The trustee recently used $20 million of the trust's assets to purchase a zero-coupon bond in a very safe company. The effective annual yield on this bond is 8%. Zero-coupon bonds are purchased at a deep discount and provide the full face value to an investor in cash on the maturity date of the bond.
- As the accountant for this split-interest trust, would it be important for you to read the trust document? Why?
- Do you have to do any research to perform your task properly?
- How should the annual appreciation in the maturity value of this bond be accounted for?
- How much cash income will this bond generate for the income beneficiary in the first year of ownership?
- Has the trustee breached a fiduciary duty?
Wills and Executor Duties
- “An accountant has agreed to be named as the executor of a client's will. The will provides that the accountant will receive a fee equal to 1% of the assets under management and will receive a fee equal to 5% of estate net income during the existence of the estate.” Do you see any ethical conflicts of interest potentially arising out of this arrangement?
Executors and the Estate Tax
- “A person pays income taxes on his earnings, then pays sales taxes when he spends those earnings. If anything is left when he dies, then we tax that away with the estate tax. That is triple tax, and it just ain't right.” Do you agree with this statement?
- The unified estate and gift tax credit exempts people with taxable estates under $5 million from paying any estate taxes at all. Should the exemption be set higher? Or lower?
- “If you've gotta have taxes, the best kind are death taxes. Estate taxes do not distort the economy, they do not distort incentives to work, and they do not distort incentives to save.” Do you agree?
- A member of Congress expressed outrage that “some rich folks are foregoing leaving their wealth to their children. Instead, they give their wealth straight to their grandchildren. They do this to avoid the estate tax that would eventually be imposed at the time of their children's deaths when these assets transfer from the child generation to the grandchildren generation.” This Congressman has proposed a generation-skipping tax. Under this proposal, if a rich person's will leaves his wealth directly to his grandchildren, two estate taxes will be imposed: One on the deceased's estate and then a second one as if these asset hypothetically had been left to his kids and then they hypothetically died. For example, if the estate tax rate is 60% and a person's will leaves $10 million to his grandchildren, the deceased will lose $6 million in estate taxes and the remaining $4 million will be taxed at 60% upon the “hypothetical death” of his children, leaving only $1.6 million for the grandchildren. Do you think that this crazy-sounding generation-skipping tax could ever be enacted in America?
Independence and Conflicts of Interest
- An accountant audits Quickiron, LLC. This accountant also serves as a trustee of a trust that has an ownership interest in Quickiron, LLC. As the trustee, she is expressly empowered to make all investments for the trust. Ownership interests in Quickiron, LLC, are traded infrequently and are illiquid.
- Should this accountant be concerned about violating the Independence Rule?
- If the accountant–trustee sells the Quicksilver, LLC ownership interests on behalf of the trust, will that fix the accountant's independence problem?
- If the accountant–trustee sells the Quicksilver, LLC ownership interests, could this constitute a breach of fiduciary duty?
- A CPA serves as the trustee of a trust that owns many different stocks, including stock in a client company that the CPA audits. The client company sold a complex set of products and services for one combined price. The client would like to record the entire price as revenue of the current year, in the hope that this large revenue boost will increase its stock price. The GAAP rules that govern how revenue should be allocated among the various products and services sold are not clear-cut. Does the auditor have a conflict of interest?
- You are the auditor for Q Company, and you also serve as the trustee of a trust that owns some shares of Q Company stock. According to trust documents, you are prohibited from making investment decisions for the trust. Furthermore, the trust owns a diversified portfolio of 100 stocks in large, publicly traded companies. No stock accounts for more than 2% of the trust's net worth. Does your position as trustee impair your independence to audit Q Company?
- For many years, you have audited the financial statements of Youster Company, an auto parts retail chain. Throughout the years, the founder of Youster Company, Yojan Youster, admired your advice and “good ol' business sense.”
When Yojan Youster recently died, you learned that his will designates you as the executor of his estate. You have agreed to serve as the executor.
According to the will, you must continue to maintain his investment portfolio exactly as it existed at the time he died. His estate's investment portfolio, in part, consists of 70,000 of the 100,000 common shares outstanding in Youster Company. These shares accounted for 5% of Yujan's net worth as of the date of death. Do you retain the independence to audit Youster Company?
- During the past two years, you audited the financial statements of many clients, including Zohank Company. After one of your individual clients had a stroke, she created a living trust and appointed you as the trustee. According to the trust documents, you may disburse “funds on behalf of the grantor to adequately satisfy her medical needs.” You may not, however, alter the trust's investment portfolio. The trust's total investment portfolio is worth $1 million and is comprised of five different stocks, each of which represents 20% of the value of the trust's assets. Zohank Company common stock is one of the five stocks held in the trust's portfolio. Do you retain the independence to audit Zohank Company?
- You are a CPA who was appointed to serve as the trustee of a trust that owns stock issued by a publicly traded company. This company is one of your major audit clients. The trust owns $4 million of stock in your audit client, the trust's net worth is $50 million, and the total market value of the client company is over $1 billion. You have numerous duties as trustee, but the trust agreement clearly prohibits you from making investment decisions. Do you retain the independence to serve as the company's auditor?
Conflicts of Interest
- Your aunt knows that you specialize in wealth and retirement planning, so she brought various documents to your office and asked you to assist her with the accounting aspects of her estate plan. She has told you that she wants all her children, nieces, and nephews to “share fairly and equally” in her wealth upon her death. She has asked you to develop a plan that will minimize her estate taxes and divide up her various assets fairly.
You told your aunt that you need to read her will, prepare a schedule of her major assets, and evaluate the risk tolerances and liquidity of each intended beneficiary. Your aunt has insisted on paying for your efforts. Do you have a conflict of interest?
- A married couple came to your office to ask you to help them structure their estate plan. When the wife stepped out of your office to visit the restroom, the husband told you that he “hates with a passion his wife's son from a previous marriage” and wants you to “find a way to give him less than zero in the will!”
- Do you owe a duty of confidentiality to the husband, or may you share his comments with his wife?
- Do you have a conflict of interest in representing both spouses?
- Is it possible for these spouses to consent to your conflict of interest?
Comprehensive Problems
- Graywall, CPA, serves as a trustee of the CureCancerNow Foundation, a charitable foundation that is dedicated to cancer research activities. For years, he has been the loyal friend and advisor to Adolpho Rabin. In fact, Adolpho made a fortune as the founder of an apparel manufacturing corporation. After his mother died of cancer, Adolpho Rabin asked Graywall for advice about how he could meaningfully preserve the memory of his mother. Shortly after attending the funeral for Adolpho's mother, Graywall persuaded Adolpho to designate the CureCancerNow Foundation as one of several beneficiaries of his will, along with Adolpho's grown children and two grandchildren. Adolpho's will also provides that the executor may redirect more money to Adolpho's “offspring and their offspring if needed to facilitate their medical care, education, or critical life needs.” Adolpho also designated Graywall to be the executor of his estate.
- Does Graywall satisfy the Independence Rule to audit the charitable foundation?
- Did Graywall have a conflict of interest when he advised Adolpho to designate the CureCancerNow Foundation as one of his estate beneficiaries?
- Does Graywall have a conflict of interest in serving as the executor of Adolpho's estate?
- Your client is the founder of Epsilonia, a highly successful, closely held business. Your client never married or had children, but he did have three sisters, all of whom were active in the company's management and served on the company's Board of Directors. Epsilonia was started over 70 years ago. Prior to 1960, your client was the sole stockholder of Epsilonia. As the company's value grew rapidly, your client became concerned about income taxes and estate taxes. This concern was common in 1960 because the top income tax rate was 91%, and the top estate and gift tax was likewise extremely high. Long-term capital gains tax rates were 25%.
In 1960, your client retained 40% of Epsilonia stock for himself and placed the remaining 60% of the stock into trust for the benefit of his sisters and their children. The trust said, in relevant part: “The split-interest trust annually shall distribute trust income to each sister during her life. Upon each sister's death, the principal attributable to her share of the trust shall be distributed in kind to her then-living children.” Your client remained the sole trustee of the trust during his lifetime. Upon the recent death of your client, his sisters became cotrustees. Due to the generosity of your client to his sisters during his lifetime, each sister is independently wealthy and self-sufficient financially.
Epsilonia stock historically has paid a dividend distribution rate equal to only .007% on market value. Two of the three sisters do not mind that Epsilonia stock pays such a low dividend because the stock has generated substantial capital appreciation, making each sister's children “ridiculously rich.” In fact, the Epsilonia stock has appreciated at more than twice the rate of the overall stock market from 1960 to present. However, one of the sisters would like to receive more income for herself and has pleaded with her sisters, as cotrustees, to shift the trust's assets into a High-Income Stock Index Fund that will generate significant dividend income. The other sisters have refused, however. As a result, the aggrieved sister has filed a lawsuit, claiming that, as the income beneficiary of the trust, she is receiving an inadequate amount of money. She contends that:
- The cotrustees have breached their fiduciary duty of reasonable care by failing to adequately diversify the trust.
- The cotrustees have breached their fiduciary duty of impartiality. This duty requires trustees to establish investment policies that give “due regard” to the interests of both the income beneficiary and the principal beneficiary in a split interest trust.
- Did the three sisters, as cotrustees, unethically gamble with the trust's wealth by maintaining a concentrated investment ownership position only in Epsilonia stock?
- In this situation, was it unethical for the cotrustees to keep all the trust's assets invested in a stock that generated such a low dividend that the trust's income beneficiaries barely received any income?