M1S1 Intro

To address an ethical matter and make good judgments, you must first be able to recognize issues when they
arise. This means being familiar with the profession's body of rules and regulations from the AICPA and your
local state accountancy board, which issues your license to practice, among others. This also means staying
attuned to potential ethical “warning signs.”

You should understand the relevant rules, which may change over time. You can accomplish this by paying
attention to rule-making initiatives and making ethics part of your continuing education plans. Many state
accountancy boards require you to earn a certain number of educational hours in ethics each year or renewal
period. Even if your state has no such requirement, you'll want to stay up to date on ethics and keep ethics as
a part of your professional education.

To be effective, you also need to know how to analyze a matter. You will practice working through a few
matters in this course. Sometimes, especially when a matter is complex or sensitive, you may wish to allow
others to help you evaluate it from different perspectives, keeping mindful of your obligations to maintain
confidentiality.

It is a good practice to consider possible people with whom you can consult before you encounter a situation.
This should be someone whose judgment you trust and respect — a colleague, friend, or relative who is fair
and open-minded. You can contact the AICPA Ethics Hotline at 1.888.777.7077, Option 6, and then Option 1;
or your state CPA society or board of accountancy for assistance. When there are potential legal issues
involved, consider consulting with an attorney before making a decision.

And always, you must consider the sensitivity of the information to ensure that you do not
inappropriately divulge confidential details.

M1S2 Ethical decision-making model

Step 1: Recognize the ethical issue
First, we need to recognize the ethical issue in this situation. As controller, you are torn between helping your
employer and ensuring that the company seeking to acquire your employer, FCA, has complete, and accurate
information. This is an ethical dilemma because you are experiencing a conflict in your values, that is, loyalty
to your employer and fellow employees versus full and fair disclosure to FCA.
Step 2: Gather the critical facts
Next, you should gather the critical facts of the matter. Keep in mind that not having all of the facts can be
very dangerous. Although you may at times have to make decisions without the benefit of all the facts, you
should not be making decisions without key pieces of information.

In this case, whether the information is material to Apex's financial projection is a critical piece of data. You
should determine this before proceeding. It is critical because if the financial projections are overstated by a
minuscule amount, this will likely have little or no bearing on FCA's decision to buy Apex. In such a case, the
ethical issue would probably vanish.
Step 3: Identify the stakeholders

Let's assume you take further action and determine that the projection is overstated by
a material amount.

Next, you need to identify the stakeholders. These are the people or organizations that will benefit
from or be harmed by your decision and actions. For example, this would include Apex and its
owners and employees as well as FCA and its owners and employees. Owners include shareholders
of both companies.

You may also consider companies that have significant loans to Apex and FCA and both companies'
primary customers and vendors. Another stakeholder is the consulting firm hired by FCA to prepare
the financial projection. Generally, you should consider as many stakeholders as possible to get a
comprehensive picture of who would be affected by your decision.

Step 4: Consider the alternatives

Once you have identified the stakeholders, you should consider the alternatives — the various approaches you
could take to address this matter and resolve the ethical conflict. The following are just a few options:
Arrange a meeting with FCA to discuss your concerns.

Arrange a meeting with the Apex CFO to discuss your concerns.

Send an anonymous letter to FCA's consulting firm describing your concerns.

Take no action.
Step 5: Consider the effect on stakeholders
Now that you have identified the stakeholders and considered your alternatives, you need to consider how
each of these approaches is likely to affect each stakeholder. Obviously, you must use your judgment to
predict likely outcomes and this is far from an exact science. However, performing this analysis and applying
your best judgment allows you to assess the potential ramifications of each option.

For example, option 1 involves bypassing your superior at Apex, which will be very likely to jeopardize or
damage your employment situation. By avoiding discussion with the CFO of Apex, you do not allow her the
chance to respond to your concerns.

Because you were not directly involved in providing data to FCA, it is possible that she has additional
information that will eliminate your concerns. In addition, your actions will likely cast a negative light on Apex.

On the other hand, if the information is incorrect, as you suspect, you may help FCA to avoid a costly error —
their shareholders, creditors, and other stakeholders will likely benefit from your disclosure. It may also
prevent future litigation against Apex principals for providing misleading information to FCA.

However, without the acquisition, Apex will likely file for bankruptcy protection and you and your colleagues
will be out of work.

Option 2 allows you to air your concerns within Apex before deciding whether to go to anyone else. This gives
your boss a chance to respond to your concerns. It is also possible that she can provide you additional
information that will reduce or even eliminate your concerns. Assuming this outcome, no further action by
you will be necessary. On the other hand, if your meeting with the CFO is unsatisfactory and you still believe
FCA will be relying on inaccurate financial information, you will have delayed your disclosure to FCA and will
need to consider further actions.

Option 3 is similar to Option 1 because it involves reporting your concerns to a party outside of your
organization. However, the information is provided anonymously, so the consultants will not know who is
providing the information. Most likely, they will approach Apex management to obtain more information. This
approach can also affect the transaction because it will raise concerns about a lack of integrity and
cohesiveness at Apex.

Finally, we have option 4, which will maintain the status quo — FCA may purchase Apex based on what they
believe to be true and reliable information. If the information is in fact misleading, it is possible that FCA's
purchase of Apex will cause its owners and employees to suffer financial loss, which will include the newly
acquired Apex Corporation. This option can also result in litigation between the parties and between FCA and
its consultants. Another possibility is that FCA or its consulting firm may bring ethics charges against you
and the CFO of Apex Corporation with the AICPA, the state accountancy board, the state CPA society, or all
three.
Step 6: Consider your comfort level

So far, we have identified the issues and stakeholders, gathered information, and evaluated possible
approaches and how they would likely affect each stakeholder. Before making a decision, you
should ask yourself some questions:

• How comfortable are you with each option?

• If you had to discuss your decision in public, would you be concerned about how it reflects on
your ethics?

• Regarding options 1 and 3, would you feel embarrassed that you failed to raise these
concerns within Apex before going outside the organization?

• Are you uncomfortable with option 4 — doing nothing?

• Do you feel you could explain taking option 2? Does this feel like a correct decision (at least at
this time)?

Remember: option 2 may be only a partial solution to the problem. Depending on your meeting with
the CFO, you may need to take additional action.
Step 7: Consider rules, regulations, and laws
Are these options consistent with applicable professional ethics rules, regulations, and laws?

Obviously, this is an important question which you must be prepared to address. You may
determine that the greatest benefit and least amount of harm would likely result if you take a
particular course of action; but if that course of action is inconsistent with the profession's rules of
conduct, you may not ignore those rules.

You must weigh your ethical requirements against all your proposed alternative actions. For
example, would the professional ethics rules allow you to divulge information to outside parties in
these circumstances?

If you are uncertain of the professional, regulatory, or legal implications of your actions, you should
seek appropriate counsel. You must weigh the applicable rules, regulations, and laws against all
your proposed alternative actions.

Step 8: Make a decision

Once you have considered all these things, you may be ready to make your decision. Perhaps you have
discussed the matter with a trusted colleague and considered the matter from various perspectives.
However, if you still feel that you cannot make your decision, you should seek further counsel from a
colleague or from an attorney if warranted. Just remember, the final decision is yours to make. Although you
will not always have the luxury of time, whenever feasible, you should take the time you need to fully consider
all the issues. Hasty decisions may be regretted later.

You choose option 2 and will meet with the CFO to explain your concerns and see where that conversation
leads. This decision was rather an obvious one. In these situations, you should exhaust all your options and
gain as much information as possible before you consider disclosing information to parties outside of your
organization.

Of course, if that meeting does not resolve the issue, you have some more thinking to do!
Step 9: Document your efforts
Once you have made a decision, and while it is fresh in your mind, you should consider documenting your
understanding of the facts, the names of any people with whom you consulted, their professional affiliations
(if relevant), and your decision.
Step 10: Evaluate the outcome
Once time has passed, it may be constructive to reevaluate the decision you made and consider whether,
given the outcome of events, you would have done anything differently.

M1S3
The accounting profession
In this section you will learn about the numerous bodies that set ethics standards and rules for members of
the accounting profession, who work in various sectors of the profession.

Many professionals are “in public practice,” working for public accounting firms, from one-person firms to the
Big Four international accounting firms. These professionals provide a variety of services to clients and
ultimately the public, from audits of financial statements to tax compliance to an array of consulting services.

Many professionals are members “in business,” working or volunteering for commercial or not-for-profit
organizations; or they may be employed in the governmental sector, working for federal, state, or local
agencies (such as counties or municipalities). These members are responsible for accounting, finance, and
other areas of business, such as internal audit. Other members in business serve in teaching roles in
vocational programs, high schools, colleges, and universities.
Professional and regulatory bodies
Here are the main professional and regulatory bodies that set rules and regulations for the
accounting profession.
American Institute of Certified Public Accountants (AICPA)
The AICPA is the world's largest member association representing the accounting profession. Its
mission is to power the success of global business, CPAs, CGMAs, and specialty credentials by
providing the most relevant knowledge, resources, and advocacy, and protecting the evolving public
interest.

In fulfilling its mission, the AICPA works with state CPA societies and boards, giving priority to those
areas where public reliance on CPA skills is most significant.

The AICPA Professional Ethics Executive Committee (PEEC) promulgates and enforces ethics and
independence rules that apply to all members. We will discuss these rules extensively in this course.
U.S. SEC
The SEC is a federal agency that establishes and enforces accounting and auditing policy, including
auditor independence. Its mission is to improve the professional performance of public company
auditors to ensure that financial statements are presented fairly and have credibility. We will discuss
the SEC independence rules in this course.
PCAOB
The Sarbanes-Oxley Act of 2002 created and authorized the PCAOB to establish auditing and related
attestation, quality control, ethics, and independence standards for public company auditors. The
SEC oversees the PCAOB's activities. We will address the independence rules that apply to these
auditors, which include the PCAOB rules.
U.S. Government Accountability Office (GAO)
The GAO issues ethics and independence rules that apply to engagements performed under
generally accepted government auditing standards (GAGAS). These governmental standards are
published as Government Auditing Standards, commonly referred to as the “Yellow Book.” We will
discuss these rules in this course.
U.S. Department of Labor (DOL)
Auditors of employee benefit plans that file reports with the DOL should be aware of the DOL
interpretive bulletin on independence. These rules will be addressed in this course.
U.S. Department of the Treasury/Internal Revenue Service (IRS)
The IRS is a government agency under the U.S. Department of the Treasury. The Internal Revenue
Code (IRC) authorizes the Secretary of the Treasury to set rules and regulations necessary to
enforce the U.S. tax laws. Treasury Department Circular No. 230 governs federal tax practice before
the IRS by CPAs, enrolled agents, attorneys, and actuaries and the IRS Office of Professional
Responsibility (OPR) that enforces these regulations. Preparer penalty and confidentiality provisions
appear in the IRC. We will discuss the ethics requirements for CPAs in tax practice in this course.
State boards of accountancy
State boards of accountancy are charged with issuing CPA licenses and overseeing the ethical
conduct of CPAs in 55 jurisdictions in the United States. It is critically important for CPAs to know
their state board's requirements. If you are licensed by more than one state board or practice in
other states under their mobility laws, you should familiarize yourself with each state's
requirements.

State board rules can vary significantly from one state to another. Some states incorporate the rules
of other bodies, such as the AICPA and the GAO, the SEC, and the PCAOB, “by reference.” This
means that the board adopts the rules of these other bodies into their state's statute and/or
regulations. Other boards have adopted portions of the AICPA code or versions of the code as of a
certain date, and still others (for example, New York) have their own rules. Boards post their rules
and statutes to their websites.
International Federation of Accountants (IFAC)
The IFAC supports four independence standard-setting bodies that develop standards for auditing,
education, ethics, and public sector financial reporting in the accounting profession globally. IFAC
also promotes good ethical practices by encouraging professional accounting organizations
throughout the world to adopt high ethical standards and helps foster meaningful debate on ethical
issues that accountants face. The IFAC's International Ethics Standards Board for Accountants
(IESBA) develops ethical standards and guidance for use by professional accountants. The IESBA
ethical standards appear in the International Code of Ethics for Professional Accountants (including
International Independence Standards), which serves as a global benchmark for codes of ethics. It is,
developed and enforced by IESBA member bodies, such as the AICPA in the United States.
Others
In addition, banking, and insurance regulators, such as the U.S. Federal Deposit Insurance
Corporation (FDIC) and state insurance regulators, adopt (not explicitly) the AICPA, SEC, and PCAOB
rules into their regulatory requirements. Finally, state CPA societies also have ethics codes (often
adopting the AICPA code) that state society members agree to abide by.

In some cases, you may be subject to rules of different bodies. For example, auditors of public
companies need to comply with the independence rules of the AICPA, the SEC, and the PCAOB. If
more than one rule applies to a situation, you should apply the most restrictive requirement.
Although we will address all these rules, this course focuses primarily on a CPA's obligations under
the AICPA code.

M1S4
Codes of conduct
In this next section, we will explore the basic tenets of ethical conduct in a profession.

In general, a code of professional conduct describes the basic tenets of ethical conduct in a profession,
whether accounting, medicine, or engineering. A code of professional conduct requires you to assume
responsibilities above and beyond those required by law. For example, no laws exist that limit the fee a lawyer
may charge his or her client, but a member of the Association of Personal Injury Lawyers should not make
“excessive or unnecessary monetary charges to the client.” Professions that serve the public interest adopt a
code of conduct to help maintain public confidence in the profession.

For example, we do not usually think of chemists as serving the public interest, but the Royal Society of
Chemistry highlights service to the public as a primary duty of the professional chemist. Members of a
profession are commonly called upon to act honorably, even at the sacrifice of personal advantage. For
example, hockey coaches who are members of the American Hockey Coaches Association are admonished
never to place the value of a win over instilling higher ideals and character traits in their players.
As a member of the accounting profession, you should be aware of all the ethical requirements that apply to
you. The specific rules that you need to follow will depend on which area in the profession you serve, for
example, public practice or business (and in some cases, both).

In 2014, the AICPA's PEEC adopted a completely restructured AICPA Code of Professional Conduct so that
one part of the code provides the rules for members in public practice, another for members in business, and
a third for members falling into neither category (for example, retired or between jobs). The AICPA's code
also reflects many of the same concepts of the professional codes mentioned previously. Exhibit 1-1
contains the preamble to the code. This course will describe the code's structure, approach, and content as
well as its underlying requirements.

Exhibit 1-1: Preamble to principles of professional conduct

1. Membership in the AICPA voluntary. By accepting membership, a member assumes an

obligation of self-discipline above and beyond the requirements of laws and regulations.

2. The principles of the Code of Professional Conduct of the AICPA express the profession's
recognition of its responsibilities to the public, to clients, and to colleagues. They guide
members in the performance of their professional responsibilities and express the basic
tenets of ethical and professional conduct. The principles call for an unswerving
commitment to honorable behavior, even at the sacrifice of personal advantage.

3. Professional responsibilities and the public

interest
4.
5. Professional responsibilities and the public interest

The preamble of the code's “Principles of Professional Conduct” (ET sec. 0.300.010)
clearly states that membership in the AICPA is voluntary, and a member assumes an
obligation of self-discipline in addition to the requirements of laws and regulations. These
principles express the profession's recognition of its responsibilities to the public, to
clients, and to colleagues. They “guide members in the performance of their professional
responsibilities and express the basic tenets of ethical and professional conduct. The
principles call for an unswerving commitment to honorable behavior, even at the sacrifice
of personal advantage.”

Ethics may be defined as a set of principles of conduct and, more generally, as a theory or
system of moral values. When something is “ethical,” it is in accordance with the accepted
principles of right and wrong governing the conduct of a person or the members of a
profession.

The first two principles in the code, “Responsibilities” (ET sec. 0.300.020) and “The Public
Interest,” (ET sec. 0.300.030) say, in part, that “[m]embers of the AICPA have
responsibilities to all those who use their professional services.” The code also notes that
“a distinguishing mark of a profession is acceptance of its responsibility to the public.” The
public interest is defined as “the collective well-being of the community of people and
institutions the profession serves.”

These AICPA principles also indicate, in part, that “members should exercise sensitive
professional and moral judgments in all their activities.” They should also act in a manner
that serves the public interest and honors the public trust that is bestowed upon them as a
member of the accounting profession.
 The code includes a glossary of terms, refers to relevant nonauthoritative guidance when
applicable, and provides a mapping document for those who want to link between the old
(pre-2014) code and the 2014 code.

Click here to view the code online.

6. https://pub.aicpa.org/codeofconduct/Ethics.aspx
7.
8. 1 All ET sections can be found in AICPA Professional Standards.
2 The American Heritage Dictionary, fifth edition.

9. Structure of the code

10.
11. The code fully embodies the conceptual framework approach, which provides a
methodology for assessing facts and circumstances not contemplated under the rules.
Members of the AICPA agree to comply with the code as a condition of membership. The
code applies to many non-AICPA members, too. Many state accountancy boards adopt
the code or parts of the code into their laws or regulations, making them applicable to the
CPAs who practice public accounting in those states and territories. In addition,
professionals — whether they are AICPA members or not — must comply with AICPA
independence rules when they perform audit or other attestation services for clients.

The basic structure of the code is as follows:

Preface

Applies to all members of the AICPA (provides an overview, the principles, structure and application of the
code, and definitions)

Part 1

Rules and interpretations applicable to members in public practice, including a conceptual framework
applicable to rules other than independence, an independence conceptual framework, and guidance on
ethical conflict resolution

Part 2

Rules and interpretations applicable to members in business, including a conceptual framework applicable to
all rules and guidance on ethical conflict resolution

Part 3

Rules and interpretation applicable to all other members (for example, retired or between jobs)

The code includes a glossary of terms, refers to relevant nonauthoritative guidance when applicable, and
provides a mapping document for those who want to link between the old (pre-2014) code and the 2014
code.
M1S5 Principles

The principles

In this section, we will focus on the detailed rules interpretations of the rules of conduct.

Imagine a classic building such as the Parthenon. Anchored to the foundation are several large
pillars. In turn, these pillars support the roof of the structure.

The AICPA's code is structured in a similar manner. The “Principles of Professional Conduct” (ET
sec. 0.300) are the pillars of the code. The principles set forth the broad ethical standards and
guidance for the profession. Upon these pillars rest the rules, detailed interpretations, and rulings.

In this course, we will focus on the detailed rules interpretations of the rules of conduct. However, it
is important for you to understand the principles from which these rules are derived.
Responsibilities
In carrying out your professional responsibilities, you should exercise sensitive professional and
moral judgment.
The public interest
You should act in a way that will serve the public interest, honor the public trust, and demonstrate
your commitment to professionalism.
Integrity
To maintain and broaden public confidence, you should perform all professional responsibilities
with the highest sense of integrity.
Objectivity and independence
You should maintain objectivity and be free of conflicts of interest in discharging your professional
duties. If you work for a public accounting firm that provides audit and other attestation services,
you should be independent in fact and appearance.
Due care
You should observe the profession's technical and ethical standards, strive continually to improve
competence and the quality of services, and discharge professional responsibility to the best of your
ability. When performing audits or other attest services, due care requires CPAs to exercise
professional skepticism.
Scope and nature of services
As a member in public practice, you should observe the principles of the Code of Professional
Conduct in determining the scope and nature of services to be performed.

Rules of conduct
Click or tap the panels to learn more.

The rules in the code, grouped by the professionals (i.e. members) to whom they apply, are as
follows:

Part 1: Members in public practice (those providing professional services to clients) panel
text:
1.100 — Integrity and Objectivity
1.200 — Independence
1.300 — General Standards
1.310 — Compliance with Standards
1.320 — Accounting Principles
1.400 — Acts Discreditable
1.500 — Fees and Other Types of Remuneration
1.600 — Advertising and Other Forms of Solicitation
1.700 — Confidential Information
1.800 — Form of Organization and Name
Part 2: Members in business (those providing professional services to employers
or other organizations)* panel text
2.100 — Integrity and Objectivity
2.300 — General Standards
2.310 — Compliance With Standards
2.320 — Accounting Principles
2.400 — Acts Discreditable
*A member who is employed or engaged on a contractual or volunteer basis in a(n) executive, staff,
governance, advisory, or administrative capacity in such areas as industry, the public sector,
education,
the not-for-profit sector, and regulatory or professional bodies.
Part 3: Other members (neither in public practice nor business) panel text:
3.400 — Acts Discreditable

Interpretations

The bulk of the text in the code provides interpretations of each of the rules of conduct. These
interpretations provide guidelines to the member on the scope and application of each rule;
however, they are more than informational. Members are required to apply these interpretations
unless they can justify noncompliance. See the following excerpt:
Exhibit 1-2: “Interpretations and Other Guidance” (ET sec. 0.100.020)
Interpretations of the rules of conduct are adopted after exposure to the membership, state
societies, state boards, and other interested parties. The interpretations of the rules of conduct,
“Definitions” (0.400), “Application of the AICPA Code” (0.200.020), and “Citations” (0.200.030),
provide guidelines about the scope and application of the rules but are not intended to limit such
scope or application. A member who departs from the interpretations shall have the burden of
justifying such departure in any disciplinary hearing. Interpretations that existed before the adoption
of the code on January 12, 1988, will remain in effect until further action is deemed necessary by the
appropriate senior committee.

M1S6 Conceptual framework

In this section, we will look at how the conceptual framework is an integral part of the code.

The interpretations of the rules in the code (ethics interpretations) provide guidelines and
requirements for complying with the rules in many — but not all — situations a member may
encounter. The code employs a “threats and safeguards” approach to analyzing threats to
compliance with the ethics rules that is referred to as the conceptual framework. The conceptual
framework is an integral part of the code. The code's interpretations are based on this framework
and members must employ the framework when evaluating a matter that the interpretations
do not address. The following describes the process you should use when applying the framework.
(Key terms are in italics and defined after the list.)

• Identify threat(s) to compliance with one or more rules.

• Evaluate whether the threat (or threats in the aggregate, if applicable) is significant.

• If threat is not significant — Stop, no further consideration is needed.

• If threat is significant — Proceed to next step.

• Identify and apply safeguards.

• If safeguard(s) would eliminate the threat or reduce the threat to an acceptable level,
proceed with professional services and or engagement.

• If safeguard(s) is not available or is insufficient (that is, it does not reduce threat(s) to
an acceptable level), decline or discontinue professional service or resign from the
engagement.

Three conceptual frameworks appear in the code. They will be discussed throughout the modules
that discuss the AICPA ethics and independence rules.

Note: The AICPA provides three conceptual framework toolkits — two for members in public
practice (an independence framework and a framework addressing all other rules), and one for
members in business. The toolkits were created to assist members in applying the conceptual
frameworks and are available at https://competency.aicpa.org/media_resources/208442-
conceptual-framework-toolkit-for-independence.
M2

Integrity and objectivity

Learning objectives

We will now review some of the rules and interpretations found in the AICPA Code of Professional
Conduct (the code).

• Recall the application of key interpretations under the “Integrity and Objectivity Rule” in the
AICPA Code of Professional Conduct.

•
Introduction
•
• The “Integrity and Objectivity Rule” (ET sec. 1.100.001) requires a member to maintain
objectivity and integrity, be free of conflicts of interest, and to not knowingly misrepresent
facts or subordinate his or her judgment to others. All ET sections can be found in
AICPA Professional Standards.

M2S2 Integrity ad objectivity rule

The code, in the Principles of Professional Conduct, states under the “Integrity” principle that
“Integrity is an element of character fundamental to professional recognition.” (ET sec. 0.300.040)

As controller for Apex (the company discussed in module 1), would you feel that you maintained
your integrity by doing nothing about the misleading financial projection?

The code adds that “(i)ntegrity requires a member to be, among other things, honest and candid.”

Integrity is measured in terms of what is right and just. To maintain and broaden public confidence,
members should perform all professional responsibilities with the highest sense of integrity.

As stated earlier, when a person becomes a member of the AICPA, that person agrees to abide by
the AICPA code. AICPA members are subject to disciplinary proceedings if they are found to have
engaged in acts that violate the AICPA rules of conduct or the bylaws.

Exhibit 2-1 shows one interpretation that relates to a member's obligation to maintain integrity in
performing professional services.

There are also specific obligations that members in business have to their employers' external
auditors.

The code defines members in business as “members employed or engaged on a contractual or

volunteer basis in an executive, staff, governance, advisory, or administrative capacity in such areas
as industry, the public sector, education, the not-for-profit sector, or regulatory or professional
bodies.” This would include the following:

• Accounting professor

• Corporate board or audit committee member (including volunteer positions)

• CFO of a not-for-profit organization

• Corporate controller or CEO

• Internal auditor

Click or tap on the button below to learn more about Exhibit 2-1 “Integrity and Objectivity Rule”
Exhibit 2-1

Exhibit 2-1 “Integrity and Objectivity Rule” interpretation

“In the performance of any professional service, a member shall maintain objectivity and integrity,
shall be free of conflicts of interest, and shall not knowingly misrepresent facts or subordinate his or
her judgment to others.”

One interpretation of this rule for members in business, “Knowing Misrepresentations in the
Preparation and Presentation of Information” [2.130.010] states:

.05 Threats to compliance with the “Integrity and Objectivity Rule” [2.100.001] would not be at an
acceptable level and could not be reduced to an acceptable level by the application of safeguards,
and the member would be considered to have knowingly misrepresented facts in violation of the
“Integrity and Objectivity Rule,” if the member

1. makes, or permits or directs another to make, materially false and misleading entries in an
entity's financial statements or records;

2. fails to correct an entity's financial statements or records that are materially false and
misleading when the member has the authority to record the entries; or

3. signs, or permits or directs another to sign, a document containing materially false and
misleading information. [Prior reference: paragraph .02 of ET section 102].

.06 Preparing or presenting information may require the exercise of discretion in making
professional judgments. Preparing or presenting such information in compliance with the “Integrity
and Objectivity Rule” [2.100.001] requires the member not to exercise such discretion with the
intention of misleading.

Case study 2-1: Helping Hands

When a company is in crisis mode, the temptation to manipulate accounting information and justify
actions it would otherwise never consider may become overwhelming. Here is the background for
this case study:

Sara Cabibi is the controller for Helping Hands, a charity that helps disabled people find employment
with training for résumé preparation, interview techniques, wardrobe, transportation, and job skills
improvement.

However, the charity is struggling financially. The extended recession has taken a toll on fundraising,
and Sara has serious concerns. The payroll is due, she has delayed paying the utilities, and the
charity's largest donor, Gerald Alles, hasn't been provided with quarterly financial statements for
eight months — since the charity's prior year-end.

Helping Hands is required to provide Alles with those statements to continue receiving donations.
Gerald: “I don't mean to be rude, Sara. I've known you a long time, but my accountant needs the
financial information I was promised. After all, it's been months. If I could just show him that the
organization is doing well, I can give you this quarter's check.”

Sara: “I'm sorry, Gerald. In fact, I'm working on the statements now. It has just been so hectic.”

Gerald: “I apologize if I seem harsh, but is there a problem? I've been quite frustrated by not being
able to get an answer about Helping Hands' finances. Furthermore, my accountant says I can't
donate any more money to your organization until I get those financials.”

Sara: “I understand. You'll have the statements next week.”

Gerald: “Be sure to. There are lots of other places that could use my donations.”
Later that day, Sara meets with Don McElroy, Helping Hands' executive director.
Don: “At least we have enough cash to get through another week, until Gerald makes his next
contribution.”

Sara: “Just barely.”

Don: “I understand. We'll give Gerald the financial statements for the past two quarters, and then we
will be caught up with our obligations. I know we're facing a cash crunch. Our fundraising efforts
have slowed down these past few years.”

Sara: “In fact, if Gerald hadn't made his second quarter contribution despite not having our financial
statements, we would have already run out of money.”

Don: “I know. The financials don't look good. It's just a vicious cycle right now. We need Gerald's
contribution to stay in operation, but we need solid financials to get his contribution. So, all we have
to do is make the financial statements look good for the short term.

“I've thought this through, and I think I have a quick fix to our problem. One of our biggest payables
(besides payroll) is to C.A. Transport. Charles, the president, is a golfing buddy of mine. Even though
we haven't paid him in months, he told me he would be willing to give us an official letter
immediately waiving our debt to his company — not permanently, but just until we get through this
cash crunch.”
Sara frowns.
Don: “It will keep us afloat. We wouldn't be doing anything illegal. Charles is fully authorized to do
this, you know, as a goodwill gesture to a worthy cause. Who knows? Maybe in the end, he will
cancel our debt. What do you think?”
Sara: “This is not a satisfactory solution, for several reasons. In the first place, I don't perform magic
accounting tricks. To manipulate financial statements is a clear violation of my professional
obligations. Second, this is no small thing. This would be material to the financial statements. We'd
be tricking Gerald into making his donation. If Gerald knew the true state of our finances, not to
mention the fact that we are lying about the numbers, it would undoubtedly affect his decision to
continue donating to Helping Hands.”
Sara is well aware that if Gerald stops donating to Helping Hands, the charity might not be
viable. Considering all the people who depended on Helping Hands, she feels a sense of guilt
and helplessness in risking the loss of those donations.
Given all the facts, what should she do?

The issue of whistleblowing — that is, alerting parties outside your organization of unethical conduct by your
client or employer — has gained a lot of attention over the years. You should proceed cautiously whenever
you are contemplating making such disclosures and consider all the relevant professional and legal
requirements.

The AICPA code provides guidance in terms of the steps you should consider when faced with challenging
ethical matters, such as pressure to subordinate your judgment to another or breach the rules. Before
alerting an outside party to wrongdoing, you should first exhaust all appropriate channels and obtain legal
and other advice prior to making your decision.

Members should consider provisions in the code on client and employer confidentiality. For example, a
member should maintain the confidentiality of his or her employer or firm's confidential information and
should not use or disclose any confidential employer information obtained through an employment
relationship (such as a discussion of confidential firm information with employer's vendors, customers, or
lenders).

Case study 2-2: Revenue recognition

A young accountant believes his employer may be booking income prematurely. Here is the
background for this case study:

Jeff Cavanaugh, newly hired by the accounting department of internet retailer Amazing Online Buys
(AOB), has heard good things about his new employer. The family-owned business grew rapidly and
is now a public company. Still, the way the company is booking revenue does not make sense. In
fact, it seems as if revenue is being recognized prematurely.

Being new to the company, Jeff doesn't want to rock the boat. Nevertheless, as the company's
senior accountant, he would be directly responsible for recording these transactions. He cannot risk
being involved in fraudulent financial reporting. He visits Carl Adams, the CFO and controller, to ask
him about it.
Carl

Jeff
Carl: “Always glad to answer questions, Jeff. You've picked a difficult topic to start with. Revenue
recognition can be very tricky.”

Jeff: “I appreciate that. My question is quite simple. When do we recognize sales? Looking at some
recently booked sales, it appears as though this occurs when the product is shipped, not when the
customer receives the goods. But that doesn't seem right to me because title does not change until
the consumer receives it. Based on my research, that's not how it should be booked. Am I missing
something?”

Carl: “No, you aren't, but let me explain. At the beginning of our company's history, we looked at that
whole issue — the difference between booking the sale on the ship date or when the customer
received the merchandise. It was small enough that we decided it was just simpler to book it on the
ship date.”

Jeff: “Maybe that was the case way back then, but aren't the numbers pretty significant now?”

Carl: “Let's face it. We don't know exactly when people receive their products. Plus, as far as I can
tell in the industry, everybody records at ship date, bigger companies than ours. So, we've continued
to record at the ship date.”

Jeff: “This makes me uncomfortable. I know you've been with the company since the beginning, and
you have a lot more experience than I do. But the company just went public, and if the SEC
determines you're wrong, there's a lot at stake here. It makes me a bit nervous.”

Carl: “You're exactly right. None of us needs any problems. Listen, Jeff, after 28 years in this
profession, I will tell you, accounting is not an exact science. Not by a long shot. A lot of judgment is
involved.”

Given all these facts, what should Jeff do?

Conflicts of interest

Although most of us are familiar with the phrase conflict of interest, what does it mean to the
accounting professional? An interpretation of the code's “Integrity and Objectivity Rule” provides
guidance.
Exhibit 2-2
Exhibit 2-2: “Conflicts of Interest” interpretation (ET sec. 1.110) — The code states in part: “A
member or his or her firm may be faced with a conflict of interest when performing a professional
service. In determining whether a professional service, relationship or matter would result in a
conflict of interest, a member should use professional judgment, taking into account whether a
reasonable and informed third party who is aware of the relevant information would conclude that a
conflict of interest exists. A conflict of interest creates adverse interest and self-interest threats to
the member's compliance with the 'Integrity and Objectivity Rule' [1.100.001].”
Applying this interpretation requires judgment. To illustrate the application of this rule, let's consider
an example. Assume you perform tax services for a married couple who decide to divorce.

Does this situation create a potential conflict of interest?

Some would say yes because your professional relationship may be stronger with one spouse than
the other. Even if the spouses agree they each want you to remain in their employ, and their
relationship appears amicable, the spouses' relationship can quickly sour as the divorce proceeds,
leaving you in the middle of an unfortunate situation.

According to the interpretation, several scenarios, including this one, may create adverse interest or
self-interest threats to your compliance with the “Integrity and Objectivity Rule,” as follows:

• The member or the member's firm provides a professional service related to a particular
matter involving two or more clients whose interests with respect to that matter are in
conflict.

• The interests of the member or the member's firm with respect to a particular matter and the
interests of the client for whom the member or the member's firm provides a professional
service related to that matter are in conflict.

Gifts and entertainment

Another interpretation of the “Integrity and Objectivity Rule” describes how the exchange of gifts or
entertainment with clients or other parties can affect your compliance with that rule.

Assume you are a senior financial analyst working for a large brokerage firm. Because you also have an
information technology (IT) background, you are responsible for making recommendations regarding any
new software your department needs to do its research.

One of the firm's vendors invites you to lunch to discuss some new software programs it would like your firm
to consider purchasing for your department. The vendor takes you to a nice, upscale restaurant in town and
you discuss business over your meal. Does this situation threaten your ability to be objective?

The “Gifts and Entertainment” interpretation (ET sec. 2.120) considers three possible threats:

Self-interest
Threat that member could benefit, financially or otherwise, from an interest in, or relationship with the client,
or people associated with the client.

Familiarity

Threat that due to a long or close relationship with the client, a member will become too sympathetic to the
client's interests or too accepting of the client's work product.

Undue influence

Threat that member will subordinate his or her judgment to an individual associated with the client or any
relevant third party due to that individual's reputation or expertise, aggressive or dominant personality, or
attempts to coerce or exercise excessive influence over the member.

Generally, having a meal with a vendor to discuss business would not create a significant threat to your
objectivity and integrity, although you would want to consider other relevant factors — such as how
frequently you are treated to meals by this vendor, whether the same vendor also provides you other gifts or
entertainment, and so on. If your only activity with this vendor is an occasional outing to discuss business,
you would likely conclude that threats are at an acceptable level.

But what if this vendor also sends you an expensive watch as a gift? Does that threaten your objectivity? In
this case, you would likely conclude differently; the expensive gift creates a significant self-interest or undue
influence threat. It is not reasonable in the circumstances and it may tempt you to do business with the
vendor as a result of the gift by engaging in a quid pro quo (“something for something” in Latin).

You should also consider your employer's internal policies for accepting gifts from suppliers. There may be
regulatory restrictions involved in accepting gifts and entertainment from your company's suppliers or other
business associates. For example, government employees have strict guidelines to follow in this area.

Case study 2-3: Conflicts of interest

Bob

Bob Durak, CPA, is a senior accountant at Maritime Financial Services, a diversified financial services
company with many subsidiaries. Bob is well-regarded at Maritime. He's seeking to become part of the
company's leadership and has modeled behavior meeting the highest ethical standards. He's also mentored
incoming accountants.

Bob works for a division of Maritime that makes business loans.

His aunt has been offered a seat on the board of directors of a Maritime subsidiary that is an investment
adviser.
To determine whether a conflict exists, Bob should consider a few more things. First, would this situation
cause third parties to question his ethics given his relative's position on the board? Bob should also ask
himself whether he feels he can be completely unbiased providing services to Maritime under these
circumstances. Let's observe what he is thinking.

Bob knows that his company and the subsidiary company are in separate and distinct businesses. Each
company has its own independent board and management structure.

His aunt's service on the subsidiary's board would have no bearing on his work, position, status, or
compensation. However, he is being considered for a leadership position in the company. That requires more
scrutiny on in evaluating the appearance of objectivity.

He is currently comfortable with the situation, but if he is promoted to a management position, he is

concerned that the familiarity threats to the appearance of his objectivity would not be at an acceptable level.

Bob decided he should discuss this situation with his aunt to see if they can discover a solution they had not
previously considered.

He discusses the matter with his aunt, and she suggests the following possibilities:
Perhaps she could serve as an adviser to the board (as opposed to a member).

Perhaps Bob could share oversight responsibilities with another executive who would address any issues
arising with the subsidiary's board.

Bob and his aunt should have conversations with both boards, each company's management, and any other
appropriate parties to ensure full transparency and compliance with the code, which requires that all potential
conflicts be discussed with the appropriate parties. (Generally, these are the people who are affected by the
work Bob does and, therefore, have an interest in his continued objectivity. If such persons raise concerns, he
should address them.)

If concerns cannot be resolved, Bob must take other actions to sufficiently reduce these threats. If these
persons believe that the situation is acceptable and provide their consent to move forward with the
suggested safeguards, the rule's requirements would be satisfied.

Mergers and acquisitions

A conflict of interest may arise when a CPA firm provides services to clients involved in a merger or
acquisition. What happens when two of your clients agree to merge or one of your clients acquires another?
For example, Company A wants to acquire Company B. Both are your clients, and both want your firm to
perform services related to the transaction.

The code does not explicitly prohibit a CPA firm from representing both companies in this situation, provided
the CPA considers the “Conflicts of Interest” interpretation, addresses any threats, and discloses the
relationship to both companies. To move forward representing both sides, each party must agree to let the
CPA represent the other party.

However, as a matter of policy, many CPA firms do not permit themselves to represent both sides in a
merger or acquisition. If you find yourself in this position, you should determine whether your firm has an
established policy covering the situation.

If your firm does not have a policy, you should carefully consider the threats to your compliance with the
code — specifically, the “Conflicts of Interest” interpretation — if you were to provide services to both
companies involved in the merger or acquisition.

Responding to conflicts of interest

Question 1: Are threats at an acceptable level?

First, consider whether the situation creates threats to your compliance with the rule. Be realistic and honest
with yourself. For example, can you truly be objective in performing services for a plaintiff when the
defendant is a former client? Do not underestimate the influence a relationship may have on your thinking
and your services.

If threats are insignificant (for example, perhaps the defendant is a client you haven't provided services to in
10 years), your evaluation is complete. Due to the passage of time, you conclude that threats are at an
acceptable level.

However, if threats are significant, you will need to apply safeguards to eliminate or sufficiently reduce the
threats to an acceptable level. In some cases, safeguards will be insufficient, or the threats will be so
significant that you should not perform the service.

Question 2: Have you disclosed the matter to the appropriate people?

If the answer to question 1 is no, then you may not perform the services. If the answer to question 1 is yes,
then you should disclose the matter to all of the relevant parties. (You are required to maintain the
confidentiality of your client's information when making disclosure under this rule.)

Question 3: Do the relevant parties agree with your assessment?

If the relevant parties agree to let you perform the engagement, you may do so. If they do not agree, you must
decline the engagement.

Note: This rule applies to all professional services you provide; however, if your engagement requires
independence, you must comply with the independence requirements. That is, independence impairments
under the code cannot be eliminated by disclosure and consent.

Module summary

In this module, we gained in-depth knowledge of key interpretations under the “Integrity and Objectivity Rule”
(ET sec. 1.100.001) in the AICPA Code of Professional Conduct and applied these rules to illustrative case
studies.

Have you ever had to face similar challenges in your workplace?

M3

Introduction

An AICPA member should observe the profession's technical and ethical standards, strive continually to
improve competence and the quality of his or her services, and discharge professional responsibilities to the
best of his or her ability. Evaluating your own skills, knowledge, and efforts can be subjective because there is
no precise definition of competence or due care in the AICPA Code of Professional Conduct (the code).

Competence

The following is a summary of the code's guidelines on the subject of competence:

Each CPA should assess professional competence by evaluating whether his or her education, experience,
and judgment are adequate for the professional services he or she will perform. CPA practice has become
more and more specialized and it behooves CPAs to be honest in their self-assessments to avoid situations
that put themselves and their clients or employers at risk.

Diligence imposes the responsibility to render services promptly and carefully, to be thorough, and to observe
applicable technical and ethical standards.

Due care requires a CPA to adequately plan and supervise professional activities.

The principles of competence and due care are intertwined. Exhibit 3-1 “Competence” interpretation (ET sec.
1.300.010)1 offers an interpretation on competence that may provide context for self-evaluation.

Click or tap on the button below to learn more about Exhibit 3-1: “Competence” interpretation (ET sec.
1.300.010).

Exhibit 3-1 “Competence” interpretation

.01 Competence, in this context, means that the member or member's staff possess the appropriate
technical qualifications to perform professional services and that the member, as required,
supervises and evaluates the quality of work performed. Competence encompasses knowledge of
the profession's standards, the techniques and technical subject matter involved, and the ability to
exercise sound judgment in applying such knowledge in the performance of professional services.

.02 A member's agreement to perform professional services implies that the member has the
necessary competence to complete those services according to professional standards and to
apply the member's knowledge and skill with reasonable care and diligence. However, the member
does not assume a responsibility for infallibility of knowledge or judgment.

.03 The member may have the knowledge required to complete the services in accordance with
professional standards prior to performance. A normal part of providing professional services
involves performing additional research or consulting with others to gain sufficient competence.
.04 If a member is unable to gain sufficient competence, the member should suggest, in fairness to
the client and public, the engagement of a competent person to perform the needed professional
service, either independently or as an associate. [Prior reference: paragraph .02 of ET section 201]

Due care

As described in the AICPA code's Principles of Professional Conduct, the quest for excellence is the essence
of due care (paragraph .02 of ET sec. 0.300.060). The standard of due care requires members to

• discharge professional responsibilities with competence and diligence;

• perform professional services to the best of one's abilities; and

• serve the best interests of those for whom services are performed, consistent with the profession's
responsibility to the public.

Professional ethical standards also refer to due professional care. What does this mean? By exercising due
care, you take whatever steps are necessary to provide the client with a level of service that is consistent with
the level of care that a “prudent professional” would exercise under the profession's standards.

The code requires its members to exercise due care when performing professional services. Due care
requires a member to be diligent in performing professional services; diligence requires service delivery that
is prompt, thorough, and consistent with the applicable technical and ethical standards.

For example, performing an audit of a company's financial statements requires adherence to technical
auditing standards that specify the profession's standard of care for audit services. You will also apply your
professional judgment, an important element of competence.

Technical standards help to define due care for audit, attestation, accounting and review, consulting, tax, and
personal financial planning services performed for clients. It is important to remember that the standards of
due care and competence apply to all members who provide professional services, including members in
business who work in private industry, government, and academia.

Case study 3-1: Competence and due care — The promotion

Ben Archer could not believe his ears. After only one year as the controller of Cindy Dee's Restaurants, he was
being offered the position of chief financial officer. Ben was a CPA who spent four years in public accounting
before joining Cindy Dee's. His five-year plan was to be a CFO, either in this company or another one.
Suddenly, the current CFO announced that she would be moving within a month. That would not allow much
of a transition period, and Ben was a little concerned. Another issue was the company's decision to become a
public company. These plans were only recently put in motion, and there was a lot to do. He wondered if he
would be able to manage the whole process without having any real background in SEC rules and
regulations. He had attended a class when the company announced its plans, but was that enough?
As CFO, he would be the key player in preparing financial information for the filing and discussing matters
with the attorneys, auditors, and underwriters. He would be responsible for supervising other professionals,
including the person who would fill his position.

Despite his concerns, he kept coming back to how great this would be for his career. The promotion would
also provide a sizable increase in salary and status. Obviously, he had made a very favorable impression on
the management of Cindy Dee's, and they had told him that he was the only person in the company they
thought could handle the job. Ben attributed this to his excellent people and presentation skills and the solid
relationships he had with certain company executives. In fact, the company had not even interviewed anyone
outside the company and would only do so if Ben declined the offer.

Ben knew it would be nearly impossible to take the position and gain the competence he needed to be
effective; after all, he would be plunging straight into preparations for the offering. There would be no time.
He really wanted this position, though, and said to himself, “Management wouldn't offer me an executive
position if they didn't think I was capable, would they?”

M3S3 Accounting principles

Accounting principles

CPAs should not indicate that a company's financial data (for example, financial statements) are presented in
conformity with generally accepted accounting principles (GAAP) if such information contains any departure
from an accounting principle. An exception exists for data that justifiably departs from GAAP because not
doing so would make the information misleading. This rule applies to letters and other communications that
members in industry send to their employer's auditors or to others, such as regulators and creditors. It also
applies to members in public practice when they issue an opinion on a company's financial statements.

Members may prepare or report on financial statements under frameworks besides U.S. GAAP, such as the
GAAP of another country or other frameworks (for example, a framework prescribed by law or contract). The
member should ensure that the basis of accounting (such as income tax-based financial statements) is
clearly specified so that readers do not wrongly assume that the statements were prepared in accordance
with U.S. GAAP. Exhibit 3-2 lists the rule that relates to a member's obligations concerning accounting
principles.

Click or tap the button to learn more about Exhibit 3-2: “Accounting principles rule” (ET sec. 1.320.001).

Exhibit 3-2
.01 A member shall not (1) express an opinion or state affirmatively that the financial statements or
other financial data of any entity are presented in conformity with generally accepted accounting
principles or (2) state that he or she is not aware of any material modifications that should be made
to such statements or data in order for them to be in conformity with generally accepted accounting
principles, if such statements or data contain any departure from an accounting principle
promulgated by bodies designated by Council to establish such principles that has a material effect
on the statements or data taken as a whole. If, however, the statements or data contain such a
departure and the member can demonstrate that due to unusual circumstances the financial
statements or data would otherwise have been misleading, the member can comply with the rule by
describing the departure, its approximate effects, if practicable, and the reasons why compliance
with the principle would result in a misleading statement.
M3S4 Confidential client information

A CPA in public practice is privy to a great deal of confidential information about his or her clients.
For that reason, the code requires that you do not disclose any confidential information unless the
client specifically allows you to do so. Generally, it is best to treat all client information as
confidential.

Few clients would want to share with other persons or entities the type of information they regularly
provide you. Can you imagine your client willingly providing his coworkers with a copy of his W-2?

So, what is confidential client information? The code includes a definition (para. .09, ET sec. 0.400,
“Definitions”):

Confidential client information is any information obtained from the client not available to the public.
Information available to the public includes, but is not limited to, information

• in a book, periodical, newspaper, or similar publication;

• in a client document released by the client to the public or that has otherwise become a
matter of public knowledge;

• on publicly accessible websites, databases, online discussion forums, or other electronic

media by which members of the public can access the information;

• released or disclosed by the client or other third parties in media interviews, speeches,
testimony in a public forum, presentations made at seminars or trade association meetings,
panel discussions, earnings press release calls, investor calls, analyst sessions, investor
conference presentations, or a similar public forum;

• maintained by, or filed with, regulatory or governmental bodies available to the public; or

• obtained from other public sources.

Unless the client's information is available to the public, that information should be considered
confidential client information.

Note: Federal, state, or local statutes, rules, or regulations concerning confidentiality of client
information may be more restrictive than the requirements contained in the code.

There are a few exceptions to the “Confidentiality Client Information Rule” (ET sec. 1.700.001), as described
below.

You may disclose confidential client information without client permission only in certain circumstances, as
outlined by the code:

Comply with standards

To comply with the requirements of other professional standards; for example, audit, review, or tax
standards. (Your requirement to comply with these other standards always takes precedence over
your responsibilities to maintain client confidentiality.)
Comply with laws
In response to a validly issued and enforceable subpoena or summons or to comply with a law or
regulation.
Ethics investigation
To initiate a complaint with or respond to inquiries made in connection with an investigation or
disciplinary proceeding.
Firm sale or merger
In conjunction with a prospective sale, purchase, or merger of your practice, you must take
appropriate precautions; for example, establishing a formal agreement with the prospective
purchaser not to disclose any information obtained during the review. (Members who obtain client
files as the result of acquiring all or part of another member's professional practice should not
disclose any confidential client information contained in such files.)
Third-party service
Member has a contractual agreement with the third party to protect the client's data and is
reasonably assured that the third party has appropriate controls in place to prevent unauthorized
release of the data to others.

Tax practice quality

A member who meets certain criteria may disclose confidential client information to the quality
reviewer of his or her tax practice without obtaining each client's permission.

M3S4

Coach your staff

Maintaining client confidentiality is usually not intuitive, but instead is a learned behavior. Staff members who
are new to the profession may not be aware of this responsibility. They have probably never held a job before
in which customers trusted them with privileged information. Part of being a professional is being discreet
when discussing client matters, especially in public places.

Background: Doug sold computer equipment before getting his degree in accounting.

What he said: “One of my first assignments was the audit of an electronics retailer. A few days after
observing inventory, I was telling another staff person my experience. We were in the client's lobby, and I said
something like, 'You wouldn't believe all the old junk they have in their warehouse. Some of this stuff is two
years old. Who'd buy it?'”

Who found out: “Sitting in the lobby was the electronics company's banker, who was waiting to see the
company president. The banker told the president, who called the partner, who called me. She pulled me off
the job that afternoon and reassigned me. From there, my career had nowhere to go but up.”

Background: Theresa worked in a combination coffeehouse and bookstore to put herself through college.

What she said: “In my old job, we had a lot of regular customers who used to sit around the coffeehouse for
hours and talk. The rule at the table was that if you weren't there, we talked about you. Then I joined the
accounting firm. One night, on an out-of-town assignment, I went to dinner with an old friend from college
and told her stories about how awful and incompetent the client was. Coffeehouse gossip.”

Who found out: “In the booth right next to us was the client's treasurer and her family. I was talking about her
staff! She came over to my table and introduced herself, and I turned bright red. She asked if we could talk
privately. She was nice — but also very firm in telling me that I should never, ever discuss client matters in a
public place. I'm just glad she didn't tell my manager.”

Disclosure or use of confidential information

A regional manufacturing association asks a firm to provide certain financial information about the firm's
manufacturing clients. Once compiled and analyzed, the association will distribute the information to its
members. None of the supplied information will be specifically identified as belonging to any particular client.
Would this violate the code?

The member will violate code if the clients' information is confidential client information. (Note: If information
is already available to the public, it is not confidential information.) If it is confidential client information, the
member should first obtain the clients' specific consent, preferably in writing, about the nature of the
information that may be disclosed, the persons to whom it may be disclosed, and its intended use.

The member should consider whether federal, state, or local statutes, rules, or regulations concerning
confidentiality of client information are more restrictive than the code.

Another scenario

Imagine you are an auditor. A local auditing professor wants to perform academic research and asks you to
provide confidential client information that has been stripped of any identifying reference to your client.
Before providing any information, you should obtain your client's permission, preferably in writing, to disclose
and use the information. You should also consider entering into a formal agreement with the professor to
help ensure that he or she uses or discloses your client's information only in accordance with what the client
agreed to. The same standard applies to you if you want to use or disclose the client's confidential
information; for example, if you wanted to develop a benchmarking study to distribute to clients and
prospects.

Case study 3-2: Confidential client information — XYZ Company

Ms. Alphonso

You are auditing the financial statements of XYZ Company. During your audit, you determine that the client's
financial statements should disclose concentrations in revenue from Product AB and in the available sources
of raw materials (as required by accounting standards). You explain this to Ms. Alphonso, president of XYZ,
who responds as follows: “That's confidential information. I don't want our competitors to know that most of
our profits come from that one product. And I sure don't want our supplier to know he's our sole source. Can
you imagine what sort of leverage he'd have over me? You can't disclose that.”

Acts discreditable to the profession

The “Acts Discreditable Rule” (ET sec. 2.400.001) is broad and subject to some degree of interpretation.
Some of the more obvious discreditable acts might include, among other things, mis-appropriation of client
funds, insider trading, or other acts of lawlessness. The AICPA Professional Ethics Executive Committee
(PEEC) has issued several interpretations of this rule, as shown below.

Discrimination and harassment

Being found guilty of violating any antidiscrimination laws.

Government regulations

Failure to follow standards and procedures or other requirements in governmental or regulatory audits or
attest services.

Preparation of financial statements

• Through negligence, making or permitting others to make materially false or misleading entries in the
financial statements or accounting records

• Failure to correct an entity's financial statements that are materially false and misleading when the
member has the authority to record an entry

• Signing (or permitting or directing another to sign) a document containing materially false and
misleading information

• Removing client files

• Upon leaving a public accounting firm, an employee removes the firm's client files (or copies of files)
or proprietary information without the firm's permission except where permitted by contractual
arrangement.

• Timely filing of tax returns

• Failure to timely file personal tax returns or those of the firm, or failure to remit payroll or other taxes
in a timely manner.

• Indemnification and limitation of liability

• Entering into (or directing another to enter into) an indemnification or other liability-limiting agreement
 with an attest client which does not comply with applicable provisions of regulatory bodies (for
example, SEC, banking and insurance regulators).

• Disclosure of employer's confidential information (including volunteer positions)

• Member should maintain the confidentiality of his or her employer's or firm's (employer) confidential
information and should not use or disclose any confidential employer information obtained as a result
of an employment relationship; for example, discussions with the employer's vendors, customers, or
lenders. (Confidential employer information is any proprietary information pertaining to the employer
or any organization for which the member may work in a volunteer capacity that is not known to be
available to the public and is obtained as a result of the relationships.).

Case study 3-3: A messy situation

Suppose that you are preparing a tax return for a new individual client. The return is much more complicated
than you originally thought because the client failed to inform you of several significant transactions. You tell
the client that the cost of finishing the return will be $2,000 greater than the original estimate. The client
refuses to pay this, and the engagement is terminated. The client owes you $5,000 for the work you have
already performed. He refuses to pay. He demands that you return his original accounting records.

The AICPA's rule on records requests provides detailed guidelines on how members should respond to
records requested by their clients. For example, a member must always return to the client documents the
client provided him or her to perform the service — even if the member's state law allows the member to
place a lien on those records because fees are due. However, the member may withhold certain work product
that is incomplete or for which the client has not yet paid, provided the member's state accountancy board
also permits this.

The AICPA interpretation follows:

Click or tap on the buttons below to learn more about Exhibit 3-3: “Records Requests” (ET sec. 1.400.200)

Exhibit 3-3 Terminology

.01 The following terms are defined here solely for use with this interpretation:

• A client includes current and former clients.

• A member means the member or the member's firm.

• Client-provided records are accounting or other records, including hardcopy and electronic
reproductions of such records, belonging to the client that were provided to the member
by, or on behalf of, the client.

• Member-prepared records are accounting or other records that the member was not
specifically engaged to prepare and that are not in the client's books and records or are
otherwise not available to the client, thus rendering the client's financial information
incomplete. Examples include adjusting, closing, combining, or consolidating journal
entries (including computations supporting such entries) and supporting schedules and
documents that the member proposed or prepared as part of an engagement (for
 example, an audit).

• Member's work products are deliverables set forth in the terms of the engagement, such
as tax returns.

• Working papers are all other items prepared solely for purposes of the engagement and
include items prepared by the
o member, such as audit programs, analytical review schedules, and statistical
sampling results and analyses.

o client at the request of the member and reflecting testing or other work done by the
member.

Exhibit 3-3 Interpretation

.05 Members must comply with the rules and regulations of authoritative regulatory bodies, such as
the member's state board(s) of accountancy, when the member performs services for a client and is
subject to the rules and regulations of such regulatory body.

For example, a member's state board(s) of accountancy may not permit a member to withhold
certain records, even though fees are due to the member for the work performed. Failure to comply
with the more restrictive provisions of the applicable regulatory body's rules and regulations
concerning the return of certain records would constitute a violation of this interpretation.

.06 The member should return client-provided records in the member's custody or control to the
client at the client's request.

.07 Unless a member and the client have agreed to the contrary, when a client makes a request for
member-prepared records or a member's work products that are in the member's custody or control
and that have not previously been provided to the client, the member should respond to the client's
request as follows:

• The member should provide member-prepared records relating to a completed and issued
work product to the client, except that such records may be withheld if fees are due to the
member for that specific work product.

• Member's work products should be provided to the client, except that such work products
may be withheld
o if fees are due to the member for the specific work product;

o if the work product is incomplete;

o if for purposes of complying with professional standards (for example, withholding

an audit report due to outstanding audit issues); or

o if threatened or outstanding litigation exists concerning the engagement or

member's work.
.08 Once a member has complied with these requirements, he or she is under no ethical obligation
to

• comply with any subsequent requests to again provide records or copies of records
described in paragraphs .03–.04. However, if subsequent to complying with a request, a
client experiences a loss of records due to a natural disaster or an act of war, the member
should comply with an additional request to provide such records.

• retain records for periods that exceed applicable professional standards, state and federal
statutes and regulations, and contractual agreements relating to the service performed.
[Prior reference: paragraph .02 of ET section 501]

.09 A member who has provided records to an individual designated or held out as the client's
representative, such as the general partner, majority shareholder, or spouse, is not obligated to
provide such records to other individuals associated with the client. [Prior reference:
paragraphs .377–.378 of ET section 591]

.10 Working papers are the member's property, and the member is not required to provide such
information to the client. However, state and federal statutes and regulations and contractual
agreements may impose additional requirements on the member.

.11 In fulfilling a request for client-provided records, member-prepared records, or a member's work
products, the member may

• charge the client a reasonable fee for the time and expense incurred to retrieve and copy
such records and require that the client pay the fee before the member provides the
records to the client.

• provide the requested records in any format usable by the client. However, the member is
not required to convert records that are not in electronic format to electronic format. If the
client requests records in a specific format and the records are available in such format
within the member's custody and control, the client's request should be honored. In
addition, the member is not required to provide the client with formulas, unless the
formulas support the client's underlying accounting or other records or the member was
engaged to provide such formulas as part of a completed work product.

• make and retain copies of any records that the member returned or provided to the client.

.12 A member who is required to return or provide records to the client should comply with the
client's request as soon as practicable but, absent extenuating circumstances, no later than 45 days
after the request is made.

.13 The fact that the statutes of the state in which the member practices grant the member a lien on
certain records in his or her custody or control does not relieve the member of his or her obligation
to comply with this interpretation. [Prior reference: paragraph .02 of ET section 501]

.14 A member would be considered in violation of the “Acts Discreditable Rule” [1.400.001] if the
member does not comply with the requirements of this interpretation.
M3S5: CPAs in public practice

Ethics rulings on outsourcing

Certain ethics rules relate only to CPAs in public practice. In this section, we will look at a few examples.

The code requires you to take certain actions when you outsource the performance of your services to “third-
party service providers.” The standards apply to all independent contractors that your firm uses.
Prior to sharing confidential client information with the contractor, you are required to inform the client,
preferably in writing, that you may be using a service provider when providing professional services to that
client.

When you use a service provider to render professional services to clients, you are responsible for overseeing
the service provider's work and ensuring that all applicable professional standards are met.

You are required to enter into a contractual agreement with the contractor to maintain the confidentiality of
the client's information, including those who provide only administrative support services. You should also
ensure that the service provider has appropriate procedures in place to prevent the unauthorized release of
confidential client information.

Advertising and solicitations

Members in public practice may not advertise their services in a manner that is false, misleading, or
deceptive. Solicitation using coercion, overreaching, or harassing conduct is prohibited.

Form of organization and firm name

You may practice public accounting only in a form of organization permitted by law or regulation that also
conforms to the resolutions of the AICPA Council. Your firm name cannot be misleading. Names of past
owners may be included in the firm name, even when the firm merges with another firm. You may designate
your firm as a member of the AICPA only if all CPA owners are members of the Institute.

Does the code apply to a separate business?

It is not unusual for a member to own all or part of a separate business that performs accounting, consulting,
or other professional services. Does the code apply to a separate business? This issue is addressed in the
code and is clear.
If the member, either individually or with members of his or her firm, controls the separate business, as
defined by GAAP, then the separate business (including all its owners and employees) is subject to the code.
If the member does not control the separate business, then only the member (as an individual) must comply
with the code.

Ethical conflicts

What if my compliance with one rule in the code causes me to violate another rule in the code?

The code includes an interpretation on ethical conflicts, as shown in exhibit 3-4

Click or tap on the button below to learn more about Exhibit 3-4: “Ethical conflicts” (ET sec. 1.000.020).

Exhibit 3-4: “Ethical conflicts” (ET sec. 1.000.020)

.01 An ethical conflict arises when a member encounters one or both of the following:

• Obstacles to following an appropriate course of action due to internal or external

pressures

• Conflicts in applying relevant professional standards or legal standards. For example, a

member suspects a fraud may have occurred, but reporting the suspected fraud would
violate the member's responsibility to maintain client confidentiality.

.02 Once an ethical conflict is encountered, a member may be required to take steps to best
achieve compliance with the rules and law. In weighing alternative courses of action, the member
should consider factors such as the following:

• Relevant facts and circumstances, including applicable rules, laws, or regulations

• Ethical issues involved

• Established internal procedures

.03 The member should also be prepared to justify any departures that the member believes were
appropriate in applying the relevant rules and law. If the member was unable to resolve the conflict
in a way that permitted compliance with the applicable rules and law, the member may have to
address the consequences of any violations.

.04 Before pursuing a course of action, the member should consider consulting with appropriate
persons within the firm or the organization that employs the member.

.05 If a member decides not to consult with appropriate persons within the firm or the organization
that employs the member and the conflict remains unresolved after pursuing the selected course of
action, the member should consider either consulting with other individuals for help in reaching a
resolution or obtaining advice from an appropriate professional body or legal counsel. The member
also should consider documenting the substance of the issue, the parties with whom the issue was
discussed, details of any discussions held, and any decisions made concerning the issue.

.06 If the ethical conflict remains unresolved, the member will in all likelihood be in violation of one
or more rules if he or she remains associated with the matter creating the conflict. Accordingly, the
member should consider his or her continuing relationship with the engagement team, specific
assignment, client, firm, or employer.

Consequences of ethical infractions

As auditors and accountants, CPAs play a key role in safeguarding the integrity of financial reporting. They
also provide tax compliance and other advisory services that are valuable to the public. They serve the
business community in many important ways.

For these reasons, CPAs are subject to numerous ethical requirements and must be able to

• identify ethical issues,

• critically assess them, and

• use professional judgment to arrive at a reasonable decision.

None of this is easy. There are many hard choices to make, but it is extremely important to develop these
skills. The stakes are very high. A single significant error in judgment could lead to investigation by the AICPA,
the state accountancy board, or the SEC, to name just a few of the bodies charged with overseeing the
profession.

The results can be significant. For example, you could

• lose your license to practice as a CPA,

• be expelled from membership in the AICPA or a state CPA society, and

• incur significant fines and steep legal liabilities.

The following is an example of a fictional matter that could appear in the CPA letter and that would result in
multiple violations of AICPA rules, termination of membership by the AICPA, and publication of the matter on
the AICPA website.

Fictional disclosure in the CPA letter, of ethics infractions by a CPA in business and industry, John A. Doe of
Anywhere, USA

Information came to the attention of the Ethics Charging Authority (ECA) — composed of the AICPA's
Professional Ethics Executive Committee — alleging a potential disciplinary matter with respect to John A.
Doe's performance of professional services as controller and, later, chief financial officer of a public company
(the company) for the fiscal years ended 2016 and 2017. After an investigation, John A. Doe was charged
with violating the AICPA Code of Professional Conduct, as follows:
Integrity and Objectivity Rule

- Knowing misrepresentations in the preparation of financial statements or records.

As controller, Mr. Doe was responsible for the internal financial reporting of the company for
the fiscal years ended December 31, 2016, and 2017, knowing that those financial
statements and records were materially misstated.

- Obligation of a member to his or her employer’s ex-ternal accountant

Mr. Doe knowingly misrepresented facts to the company's external accountants in regards to the
company's financial statements for the fiscal years ended December 31, 2016 and 2017, by representing
that the financial statements were in accordance with generally accepted accounting principles (GAAP)
when he knew they were not.

Mr. Doe was not candid, knowingly misrepresented facts, and failed to disclose facts to the external
accountants.
- Subordination of judgment by a member

Mr. Doe subordinated his judgment to his superior by relying on his superior's
representations for recording revenue in the financial statements for the fiscal years ended
December 31, 2016, and 2017, instead of using appropriate judgment.
- Accounting principles rule

Mr. Doe stated affirmatively that the financial statements were in conformity with GAAP,
when they did not comply with the requirements of revenue recognition when the right of
return exists (FASB ASC 605-15-05).

- Acts discreditable rule

Mr. Doe was negligent in his role as controller of the company for not having performed
sufficient procedures to determine whether the financial statements were free from material
misstatements in the allowance for doubtful accounts area for the fiscal years ended
December 31, 2016, and 2017.

In consideration of the ECA forgoing further investigation of Mr. Doe's conduct as described
previously, and in consideration of the ECA forgoing any further proceedings in this matter, Mr. Doe
agrees as follows:

• To waive his rights to a hearing under AICPA bylaws (BL section 7.4, Disciplining of Member
by Trial Board)

• To neither admit nor deny the previously specified charges

• To his expulsion from membership in the AICPA, effective

• That the ECA shall publish his name, the charges, and terms of this settlement agreement in
an abbreviated format in the printed version of a membership periodical of the AICPA with a
more detailed description of the disciplinary action in the online version of this periodical on
the AICPA's website.
You may have noticed that the “Acts Discreditable Rule” was cited in the CPA letter. Although the
rule is interpreted to include several examples of behavior that would be considered an act that
discredits the profession, the PEEC also applies this rule in disciplinary matters on a case-by-case
basis. To discredit the profession means

• to harm the reputation of, as to make someone or something appear untrustworthy or wrong
or

• the loss of someone's or something's good name or reputation, or a person or thing that
causes its loss (for example, conduct that is considered to taint the profession as a whole).

M3S6 Recent updates

Recently adopted rules

This section will cover recently adopted rules and pending proposals.

In June 2019, PEEC issued two revised interpretations under the “Independence Rule” of the code:

Click or tap the arrow buttons to learn more.

“Information System Services” (ET sec. 1.295.145)

The revised interpretation, “Information System Services” (previously, “Information Systems Design,
Implementation, or Integration”), provides independence guidance when a firm performs the following
services for an attest client:

• Information system design or development

• System implementation, including installation, customization, integration, interfacing, configuration,

and data translation

• Post-implementation system and network maintenance, support, and monitoring

Overall, the revised interpretation provides more explicit guidance on performing information system services
while maintaining independence.
The revised interpretation is effective for years beginning on January 1, 2022.
This section will cover recently adopted rules and pending proposals.

In June 2019, PEEC issued two revised interpretations under the “Independence Rule” of the code:

Click or tap the arrow buttons to learn more.

“Information System Services” (ET sec. 1.295.145)

The revised interpretation, “Information System Services” (previously, “Information Systems Design,
Implementation, or Integration”), provides independence guidance when a firm performs the following
services for an attest client:
 • Information system design or development

• System implementation, including installation, customization, integration, interfacing, configuration,

and data translation

• Post-implementation system and network maintenance, support, and monitoring

Overall, the revised interpretation provides more explicit guidance on performing information system services
while maintaining independence.

The revised interpretation is effective for years beginning on January 1, 2022.

“State and Local Government Client Affiliates” (ET sec. 1.224.020)
The PEEC also adopted a revised independence interpretation entitled, “State and Local Government Client
Affiliates” (formerly “Entities Included in State and Local Government Financial Statements.”)

The interpretation helps members identify the entities related to a state or local government (SLG) (such as
component units or funds) that are "affiliates" of the SLG for independence purposes. With limited
exceptions, members must apply the independence rules to relationships and interests with affiliates of an
SLG financial statement attest client even if the member (or member's firm) provides no attest services to
the affiliate. Nonattest services the firm provides to an affiliate may be permissible if the nonattest services
do not create a self-review threat to the member's independence. Also, any other significant threats to
independence need to be eliminated or reduced to an acceptable level.

The revised interpretation is effective for years beginning after December 15, 2021.

In May 2020, the PEEC released proposed revisions to the interpretation, “Records Requests,” which seeks to
clarify PEEC's intent and enhance the rule.

In December 2018, the PEEC proposed a new interpretation under the “Independence Rule” that would
address a nonattest service called “Staff Augmentation Arrangements.”

Staff augmentation is a nonattest service in which the audit firm lends staff to the client to perform certain
activities. The proposed interpretation acknowledges that staff augmentation may create self-review or
management participation threats to independence but also suggests there are certain safeguards that may
mitigate the threats and allow the service.

PEEC received feedback from various stakeholders requesting additional clarity on the proposed change to
the code. PEEC is currently working on revisions to the proposal.

In 2016, the International Ethics Standards Board for Accountants (IESBA) issued a standard, Responding to
Non-Compliance with Laws and Regulations (NOCLAR), which provided a framework to guide professional
accountants on how best to act in the public interest when confronted with their client or employer's actual or
suspected noncompliance with laws or regulations. The standard became effective on July 15, 2017.

What is NOCLAR?
NOCLAR is committed by either a client or an employer, including the client or employer's
governance body, management, and employees.
NOCLAR is further narrowed as follows

• The law or regulation directly affects material amounts and disclosures in a client or
employer's financial statements.
 • Compliance with the law or regulation is fundamental to the client or employer's business
and operations, or to avoid material penalties.

NOCLAR does not include

• clearly inconsequential matters,

• personal misconduct unrelated to the company's business, or

• misconduct by persons not included in the scope of NOCLAR.

Examples of laws and regulations

The standard addresses those related to the following:

• Fraud, corruption, and bribery

• Money laundering, terrorist financing, and proceeds of crime

Securities markets and trading

• Banking and other financial products and services

• Data protection

• Tax and pension liabilities and payments

• Environmental protection

• Public health and safety

•
What is required under the NOCLAR standard?
• As adopted by IESBA, if a professional accountant concludes that a client or employer is
committing NOCLAR violations, the accountant should disclose the matter to the appropriate
members of his or her client's or employer's management. Once known, if subsequently
those parties (for example, management and/or the board of directors) do not address the
NOCLAR violations, and the accountant believes there's a significant threat of substantial
harm to the public, the accountant may conclude that it's in the public's interest to disclose
the matter to a governmental body (or other relevant public authority) for investigation. In
other words, the NOCLAR standard provides an additional exception to the confidentiality
rules that would normally preclude such disclosure without the client or employer's consent.

• AICPA proposed NOCLAR standard

• In March 2017, the AICPA proposed NOCLAR rules tailored to members in public practice and
members in business (parts 1 and 2 of the code, respectively) that, while based on the IESBA
standard, departed from it in significant ways. The AICPA and state accountancy board rules
and regulations generally prohibit disclosure of confidential information to an outside party
without client or employer consent unless required by rule or law. Therefore, the AICPA
proposal did not include a provision that would require the member to consider disclosing
the NOCLAR to an outside body.

The AICPA received comments on the proposal, some critical of the expansion of
responsibilities to nonauditors and members in business, and others questioning why the
 AICPA did not propose a rule that conforms more closely to the IESBA rule. Due to the
comments received, PEEC has been studying the issues further. The AICPA and NASBA are
exploring the confidentiality provision in the Uniform Accountancy Act, a model of rules and
laws the state accountancy boards may adopt through a standing joint committee.

In late 2019, the PEEC asked the AICPA's Auditing Standards Board (ASB) to consider
changes to the auditing standards that would allow a predecessor auditor to disclose
NOCLAR to a successor without client consent. The ASB agreed, and the PEEC is continuing
to work on this project.

Module summary

In this module, we explored the provisions for competence, due care, and professional behavior in the AICPA
Code of Professional Conduct. We also learned to distinguish between competence and due care, and
reviewed situations within which these sets of rules are applicable.
M4S1

Introduction

The AICPA Code of Professional Conduct (the code) contains the rules that guide AICPA members and
others subject to the AICPA rules in the performance of their professional responsibilities. In this chapter, we
will discuss the threats to independence caused by your — and your family's — financial interests, loans,
employment, and business relationships.

AICPA independence standards and the conceptual framework

AICPA professional standards require independence — both in fact and appearance — for all attest
engagements. Attest services often culminate in the accountant's expression of an opinion or some other
form of assurance that the information being reported on — for example, a financial statement — is free of
material misstatements. The investing public or other interested parties, such as creditors, financial analysts,
and vendors, typically rely on the accountant's report. Therefore, the accountant should be unbiased in
forming his or her judgments when performing attest services and forming the opinion.

Attest client
An attest client is an entity whose financial statements or other information is being audited,
reviewed, or attested to. Attest engagements include the following:

• Financial statement audits

• Financial statement reviews

• Audits of internal control over financial reporting (as required by Section 404 of the Sarbanes-
Oxley Act of 2002) performed under PCAOB Auditing Standard (AS) 2201, An Audit of
Internal Control Over Financial Reporting That Is Integrated With an Audit of Financial
Statements1

• Other engagements performed under the AICPA Statements on Auditing Standards (SASs) or
Statements on Standards for Attestation Engagements (SSAEs)

An audit of a company's financial statements is a common example of an attest service. In this

chapter, the terms attest client, audit client, and client are synonymous.

1 All PCAOB auditing standards can be found in AICPA PCAOB Standards and Related Rules.
Firm
A firm and its people are required to be “independent” during
 • the period of the professional engagement and

• the period covered by the financial statements or other information to which the attest
services relate.

Financial interests and relationships (such as stock interests, credit cards, or loans) may impair
independence when they exist during the period of professional engagement — essentially, the
period that follows the firm's engagement as auditor and continues until the relationship is
terminated.

Some relationships (such as a business or employment relationship with the client) may taint the
firm's independence if they occurred during the period covered by the financial statements or the
period of the professional engagement. Therefore, for a new attest client, the relationships you had
with the client before your firm was engaged to provide attest services can impair your
independence.

Independence, in fact, is sometimes referred to as independence “of mind” — meaning the auditor's
state of mind in performing professional services. Because this is impossible to gauge with
complete accuracy, the standards also incorporate the notion of the “appearance” of independence
to the “reasonable and informed third party.” (Would a rational person who is aware of the relevant
facts and circumstances conclude that threats to a member or firm's independence are at an
acceptable level?) This requires you to think critically and in the abstract (that is, from the
perspective of another person).

The AICPA's “Conceptual Framework for Independence”

For many years, the AICPA code has employed a “threats and safeguards” approach to analyzing
independence threats that is similar to the framework approach described in the previous chapters. And, like
the frameworks already described, members must employ the “Conceptual Framework for Independence”
(ET sec. 1.210.110) (the framework) when evaluating matters that the code does not specifically address.

Here's a quick recap of the approach:

First, a member should identify threats to independence arising from particular circumstances; for example,
a self-interest threat exists when a member has a financial interest in a client. Then, the member should
consider whether there are “safeguards” that could reduce or eliminate the threat to an acceptable level.
Some examples of safeguards include

• removing an individual from an engagement team,

• disposing of a financial interest, or

• having an independent partner perform a second review of the work.

If safeguards do not adequately reduce or eliminate the threat, independence would be impaired. The
independence rules address many situations in which this is the case and state so. In other words, a member
of the audit team could never hold a financial interest in the team's client, and no safeguards (other than
disposal of the investment or the person's exit from the audit team) are sufficient to eliminate that threat.
What if an audit manager has a friend who is the assistant controller of his audit client? This set of
circumstances is not addressed in the code. However, the auditor could apply the framework to evaluate
whether threats to independence are of such magnitude that independence is impaired after applying any
appropriate safeguards.

Internally, the auditor should first feel able to perform services objectively despite the circumstances. Then,
the auditor should consider, for example, whether his relationship with the assistant controller causes a
familiarity threat that threatens his objectivity in performing the audit. An important part of the analysis is
considering the appearance of independence to outside parties who are aware of the relevant facts and
circumstances.

Click or tap the button below to learn more.

What should you consider?

Consider: Will your relationship with this person at the client, in a financial reporting role, cause
investors to question whether you would challenge your friend over a controversial accounting
issue? How close is the relationship? For example, has it been years since you last spoke, or do you
see each other regularly? These are the two ends of the spectrum that make the decision a lot
easier. You can imagine how the facts, should they land somewhere in the middle of the spectrum
of possibilities, could become quite “gray.” Usually, in those instances, the firm should make a
personnel change to eliminate any question about the relationship. If this is not an option, it's
possible that other safeguards could be applied that would sufficiently mitigate possible threats.

Another consideration is the type of client involved in the matter. The framework uses the term public interest
entity to describe the type of client that might require stronger safeguards than another type of client to
eliminate a threat or reduce it to an acceptable level. A public interest entity includes (a) listed entities (such
as an SEC registrant) and (b) entities subject to the same independence requirements as listed entities (for
example, banks subject to Federal Deposit Insurance Corporation Improvement Act rules).

Listed entities include any entities — including those outside the U.S. — whose shares, stock, or debt are
quoted or listed on a recognized stock exchange or are marketed under the regulations of a recognized stock
exchange or equivalent body.

If the auditor believes that a significant threat does exist, then he or she should consider, among other things,
not serving on the audit team and other possible safeguards to reduce or eliminate the threat.

Independence relationships

Independence rules focus on the relationship between certain individuals in a firm (which we will refer to
as the covered member) and the attest client, or in some cases, an “affiliate” of the client.

In applying the rules, it is vital to know who must be independent of the client or its affiliate. Certainly, the firm
and various individuals in the firm must be independent, but what about the covered member's spouse,
dependents, or other close relatives? We will explain the instances in which additional individuals related to
the individuals working in the firm will also be subject to the rules.

M4S3 Definition of a covered member

Covered member

In the first part of this section of the chapter, we will define covered member to determine who must be
independent with respect to a particular client.

Covered members must avoid certain financial, business, and other relationships with the attest client to
maintain their independence.

The following diagram illustrates who (or what) meets the definition of a covered member, and therefore,
must be independent of a particular client.

Individuals and entities that meet the definition of a covered member:

Click or tap on each level of the pyramid to learn more.

Click or tap the next arrow to continue.

2 All AU-C sections can be found in AICPA Professional Standards.

Case study 4-1: James & Jon, P.C.

The following is a case study to help you identify individuals who would be considered covered members.
You will be introduced to a client and meet several people who work in a CPA firm. You must decide whether
each person you meet does or does not meet the definition of a covered member. As you work on this case
study, you may want to refer to the pyramid of definition.

Scenario:

You are a manager in the quality control group of the firm James & Jon, P.C. The firm's primary office is
located in Santa Rosa, California, and there is a total of five offices in various cities along the West Coast.
Recently, the firm acquired a new client — RLR Design — a privately held advertising and graphic design
company. Your firm will perform an audit of RLR's financial statements. The Petaluma office personnel will
perform the audit work.

Your assignment is to review the firm's personnel roster and to send letters to each person advising them
whether they are a covered member that needs to be independent of RLR Design.

The following are several people who work at the firm, together with a description from the code of their titles
and some of their duties. For each of these individuals, consider whether the person is or is not a covered
member for purposes of applying the independence rules. Constance James, managing partner of the
Petaluma office, will have no client responsibilities of any kind relating to the RLR engagement.

Office: A reasonably distinct subgroup within a firm, whether constituted by formal organization or informal
practice, in which personnel who make up the subgroup generally serve the same group of clients or work on
the same categories of matters. Substance should govern the office classification. For example, the
expected regular personnel interactions and assigned reporting channels of an individual may well be more
important than an individual's physical location.

The following are several people who work at the firm, together with a description from the code of their titles
and some of their duties. For each of these individuals, consider whether the person is or is not a covered
member for purposes of applying the independence rules.

Robert H. Olsen, audit manager who works in the firm's San Diego office, has no client responsibilities of any
kind relating to the RLR engagement.

Manager: A professional employee of the firm who has continuing responsibility for the planning and
supervision of engagements for specified clients.

The following are several people who work at the firm, together with a description from the code of their titles
and some of their duties. For each of these individuals, consider whether the person is or is not a covered
member for purposes of applying the independence rules.

A tax accountant who is located in the Petaluma office, helps prepare the tax return and assists the client in
computing the tax provision for RLR Design.
The following are several people who work at the firm, together with a description from the code of their titles
and some of their duties. For each of these individuals, consider whether the person is or is not a covered
member for purposes of applying the independence rules.

Felipe Arturo, e-business consulting manager located in the Petaluma office, will provide approximately 25
hours of consulting services to the client this year.
M4S4 Relationship

Family relationships

Your family's interests, employment, and other relationships may create self-interest or familiarity threats to
your independence because their interests are closely aligned to yours. In fact, the independence rules
generally extend from a covered member to the covered member's immediate family (the covered member's
spouse or equivalent and the people he or she supports financially, including children, parents, or even non-
relatives).

For example, your spouse's investment would be treated as if it was yours — your interests are considered
inseparable — even if you keep your finances and investments in separate accounts and with separate
brokers.

Click or tap on the panels to learn more about spousal equivalent and dependent.

Spousal equivalent. In determining whether an individual is a spousal equivalent, one must look to the
closeness of the bond between the covered member and the individual. For example, persons in domestic
partnerships or common law marriages, cohabitants, and others in close committed relationships that are in
substance the equivalent of marriage generally meet this criterion.
Dependent. In general, a dependent is any individual for whom the covered member provides more than half
of his or her financial support.

Key positions

Your immediate family's employment may create threats to your independence. For example, if you provide
tax services throughout the year to your spouse's employer, and your spouse is the CEO of that company, the
threats will be considered so significant that safeguards would not sufficiently reduce them to an acceptable
level. Your independence would be considered impaired.

However, not all your immediate family's employment creates such significant threats under the rules. So the
question is, “Under what circumstances do threats become unacceptable?” If your immediate family holds a
“key” position, the rules indicate that threats are significant and impair your independence. The position is a
“key position” if he or she

• has primary responsibility for significant accounting functions that support material components of
the financial statements;
 • has primary responsibility for preparing the financial statements; or

• can exercise influence over the contents of the financial statements (for example, as a member of the
board of directors, CEO, president, CFO, chief operating officer, general counsel, chief accounting
officer, controller, director of internal audit, director of financial reporting, treasurer, or any equivalent
position).

In general, you should not rely solely on job titles to determine whether a position held by a covered
member's spouse or dependent impairs independence; rather, you should consider the nature of the
individual's responsibilities.

Case study 4-2: James & Jon, P.C. — Manager's spouse considers a position
with an attest client

Jack Garry receives a call from a recruiting agency offering him a new position with Vertex, a mid-sized
company in Toledo, Ohio. Vertex is an audit client of James & Jon, P.C. His spouse, Kathy, is a manager in the
consulting practice of James & Jon, P.C. The position is an entry-level position in the company's internal
audit group. Jack would report to the internal audit manager and help formulate, test, and monitor internal
control over the company's financial reporting. Does Jack's position create significant threats to Kathy's
independence? Kathy provides occasional consulting services to Vertex.

Close relatives

Some of the independence rules relating to employment of immediate family also apply to close relatives of
certain covered members. Close relatives include the following:

• Nondependent children

• Brothers and sisters

• Parents

In some cases, financial and employment relationships of a covered member's close relatives create
significant threats to independence. Covered members in this category are

• people on a client's attest engagement team,

• people able to influence a client's attest engagement, and

• partners in the office in which the lead attest engagement partner or partner equivalent primarily
practices in connection with the attest engagement.
When is independence required?

The requirement to comply with the independence rules begins when a firm accepts a new attest client.
Independence rules will continue to apply for the entire duration of the attest relationship, called
the professional engagement, which could span many years.

Compliance with the rules ends only when the firm or the client terminates the professional engagement.
This means either the firm or the client provides formal notice, or the firm issues the final attest report if the
report is issued after the notice of termination. In other words, the professional engagement is ongoing and
does not end with the issuance of a report and recommence when the following year's engagement letter is
signed.

The firm and its professionals must be independent during the period of the professional engagement and
the period covered by the financial statements. Some of the independence rules (for example, business
relationships and board directorships to borrow) apply to both periods, but others (for example, financial
interests) apply only to the period of the professional engagement.

Example 1
A partner was on a client's board of directors during 20X1, but resigned from the board before her
firm accepted an engagement to audit the 20X1 financial statements.

Even though the partner resigned before the professional engagement period began, her service as
a board member during the period covered by the financial statements would be considered to
impair the firm's independence.

This is because the firm would be auditing a period during which a firm professional served in a
decision-making capacity for the client (that is, management participation threat). Resignation
would not sufficiently mitigate the threat to the firm's independence.

Example 2
A covered member owned shares in the client but disposed of the shares before the professional
engagement period.

In this case, the threats would be eliminated because financial interest rules do not apply to the
period covered by the financial statements, only to the professional engagement period; thus, the
covered member could sell her shares before the professional engagement began and still be
independent. The self-interest threat would be eliminated.
M4S5 Financial Interests