Pick a case and become familiar with the case requirements. Use what you learned on chapter 19.

For formatting, use times new roman 12 pt font and double space your answers. You must include references to any sources used in the paper. For the case, you must answer the following questions:

1. What are the relevant facts?
2. What are the ethical issues?
3. Who are the primary stakeholders?
4. What are the possible alternatives?
5. What are the ethics of the alternatives?
6. What are the practical constraints?
7. Whatactionshouldbetaken?

This is the case I picked

MINICASE: ACCT ? 09 BUSINESS ETHICS PROGRAM 1992 Arthur Andersen & Co, SC. All rights reserved. Page 1 of 1

Damage Expense

Topic: Violations of Internal Control

Characters: Chris, New Distribution Supervisor at a large candy manufacturer Bob, Inventory Control Manager, Chris?s immediate boss

Chris has been recently hired as the Distribution Supervisor for an international candy company. The plant is in a rural area and is about to begin a major expansion that will triple its capacity. The company has generous benefits and has paid all moving expenses for Chris and his family. During the move, however, the movers damaged a large piece of oak furniture. Chris has contacted the moving company. The insurance is by the pound and would cover only a small part of the worth of the item. Chris has explained this to the moving company, but it refuses to reimburse him for the item?s value. Chris approaches his supervisor, Bob, about the problem. Chris has been on the job about a month and enjoys the partnership they have developed to date. Chris had originally interviewed with Bob, and Bob?s recommendation had been a major factor in Chris?s getting the job. Chris has found the types of challenges he was looking for in a new position and is already becoming a major player in planning for the new expansion. Bob tells Chris that he does not think he can do anything to persuade the moving company to reimburse Chris and suggests that Chris pad his next few expense reports to cover the cost. Chris is surprised at Bob?s suggestion, because thus far Bob has dealt with him in a very evenhanded manner and has appeared to have strong business ethical standards. Author: Originally developed by Michael Forget, graduate student at Washington University, as a class project in ?Ethical Decision Making.? Edited and submitted by Dr. Raymond L. Hilgert, Professor of Management and Industrial Relations, Washington University.

I n August 2008, the SEC required Deloitte, LLP, to provide the names and titles of all personnel who had served Walgreen, Inc., an entity audited by Deloitte that in July 2007 had announced its acquisition of Option Care, another public company. Thomas P. Flanagan, who had risen to serve as Deloitte's vice chairman, had served as an advisory partner for Walgreen and purchased stock in Option Care approximately one week before the acquisition was publicly announced. This trade represented a serious violation not only of Deloitte's policies but also professional ethics rules and insider trading laws. Flanagan resigned from Deloitte in September of 2008. Between January 2005 and June 2008, Flanagan traded more than 300 times in securities of companies audited by Deloitte, for several of which Flanagan served as advisory partner. During that time, Flanagan reportedly misrepresented his investment activities when filing annual independence representations required by Deloitte. Deloitte successfully sued Flanagan for compensation paid after breaching company policy, and for losses suffered by Deloitte relating to the investigation of the case. 1 In a public statement, Deloitte unequivocally condemned \"the actions of this individual, which are unprecedented in our experience. His personal trading activities were in blatant violation of Deloitte's strict and clearly stated policies for investments by partners and other professional personnel.\"2 In the end, Flanagan lost his job, paid over $14 million in civil penalties, and in October of 2012 was sentenced to 21 months in prison and one year of probation for insider trading. The judge in Deloitte's suit against Flanagan wrote: \"Because an auditor sells, at base, its independence and integrity, the firm relies heavily on the purported honesty and independence of its professionals.\" Similarly, a federal court judge presiding over a 2004 case involving independence violations by Ernst & Young reiterated the importance of auditor independence: Auditors have been characterized as \"gatekeepers\" to the public securities markets that are crucial for capital formation. The independent public accountant performing this special function owes ultimate allegiance to the corporation's creditors and stockholders, as well as to the investing public. This \"public watchdog\" function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust. 3 Page 644 In this chapter, we discuss the importance of ethical and professional conduct by auditors. We begin by defining ethics and professionalism and offering a general framework within which ethical issues can be evaluated. We then provide an overview of the nature of the principles, rules, and regulations governing public accountants' conduct, followed by a discussion of the specific rules and regulations that accountants, and auditors in particular, must follow. We highlight independence rules, which arguably constitute the most complicated and controversial aspect of auditor professionalism. Finally, we discuss how public accounting firms are monitored and inspected to help ensure quality audits and compliance with professional standards, regulations, and codes of conduct. Ethics and Professional Conduct Ethics and Professionalism Defined LO 191 Ethical conduct is the bedrock of modern civilizationit underpins the successful functioning of nearly every aspect of society, from daily family life to law, medicine, business, and government. Ethics refers to a system or code of conduct based on moral duties and obligations that indicate how an individual should interact with others in society. A sense for ethics guides individuals to value more than their own self interest and to recognize and respect the interests of others. Our society would fall into chaos if people were devoid of ethics and moral sentiments. Imagine what it would be like if everyone ignored rules of the road, moral standards, obligations, and the rights and interests of others! Life in such a society would be, as the philosopher Hobbes might say, \"solitary, poor, nasty, brutish, and short.\" Ethical conduct is also the bedrock of modern professionalism.Professionalism, broadly defined, refers to the conduct, aims, or qualities that characterize or mark a profession or professional person. 4 All professions establish rules or codes of conduct that define ethical behavior for members of the profession. These rules are established so that (1) users of the professional services know what to expect when they purchase such services, (2) members of the profession know what behavior is acceptable, and (3) the profession can use the rules to monitor the actions of its members and apply discipline where appropriate. Consider the medical profession. When you see a doctor for a potentially serious medical condition, you as a user of this professional service have a valid and vital interest in expecting competent and honest behavior that is free from conflicts of interest. You expect, for example, that the doctor will prescribe the best medication for your condition, rather than one for which the doctor receives a kickback. To better meet these expectations, the medical profession requires particular training and certifications, and it has a code of professional conduct, one of the earliest forms of which is the Hippocratic oath, written in about 400 BC. An essential distinguishing mark of a profession is that it recognizes the responsibility of its members to place the interests of the public above their own when the two are in conflict. Recall that in Chapter 1 we discussed the desired characteristics of a house inspector and concluded that competence, objectivity, and integrity are critical. We also discussed the role that auditors, as information inspectors, play in reducing information risk through independent verification of management assertions. To be a credible source of objective, independent assurance, the professional must have a solid reputation for competence and for unquestioned character and integrity. The concepts of ethical behavior and professional conduct are clearly central to the success of the accounting profession. In fact, those who enter the accounting profession and engage in unethical conduct will inevitably harm themselves, others, and the profession. The most important concept you will read in this chapter is that of personal responsibility and integrity. As an accountant, auditor, manager, or businessperson, you will face numerous difficult ethical issues, and you will experience temptations and pressures. Never forget that your most valuable assets as a professional are unquestioned integrity and a solid reputation. We encourage you to continually evaluate your choices and behavior and commit to a high level of integrity and ethical behavior as a student, professional, and member of society. Page 645 Given the importance of reputation, ethical behavior, and professionalism, the accounting profession has developed a Code of Professional Conduct that guides the behavior of accounting professionals. The profession's Code of Professional Conduct, together with related rules and regulations, is discussed later in this chapter, after we discuss a framework for considering ethical issues. Theories of Ethical Behavior LO 192 When individuals are confronted with situations that have moral and ethical implications, they do not always agree on the issues at hand, which individuals or groups will be affected, or what solutions or courses of action are available or appropriate for dealing with the situation. Such differences may be caused by differences in the individuals' concepts of fairness and different opinions about the right action to take in a particular situation. Some ethical choices are difficult simply due to the temptation or pressure to pursue one's selfinterest, which can cloud judgment regarding what is right or wrong. Other choices are complicated by the sheer difficulty of sorting out the issues and deciphering what might be appropriate or inappropriate actions to take. S. M. Mintz has suggested that there are three overlapping methods or theories of ethical behavior that can guide the analysis of ethical issues in accounting. 5 These theories are (1) utilitarianism, (2) a rights based approach, and (3) a justicebased approach. No single approach is necessarily better than another. In fact, elements of each theory may be appropriate for resolving ethical dilemmas in different circumstances. Utilitarian theory recognizes that decision making involves tradeoffs between the benefits and burdens of alternative actions, and it focuses on the consequences of a particular action on the individuals affected. The theory proposes that the interests of all parties affected, not just one's selfinterest, should be considered. From this perspective, an action conforms to the principle of utility only if that action will produce more pleasure or happiness (or prevent more pain or unhappiness) than any other possible action. The value of an action is determined solely by the consequences of the action on the welfare of individuals. This is why utilitarianism is sometimes also described as a \"consequentialist\" theory. One form of utilitarianism holds that rules have a central position in moral judgment due to the adverse consequences that would likely arise if everyone chose to break them. This approach has significance for auditors, who are expected to follow the Code of Professional Conduct in carrying out their responsibilities. One disadvantage in applying the utilitarian theory to ethical dilemmas is that it is often difficult to measure the potential costs and benefits of the actions to be taken. It may also be difficult to balance the interests of all parties involved when those interests conflict with one another. The rightsbased approach assumes that individuals have certain rights and other individuals have a duty to respect those rights. Thus, a decision maker who follows a theory of rights should undertake an action only if it does not violate the rights of any individual. An obvious disadvantage of the theory of rights is that it may be difficult or impossible to satisfy all rights of all affected parties, especially when those rights conflict. The theory of rights is important to auditors because of their publicinterest responsibility. As the judge's ruling in this chapter's preface indicates, in conflicting situations, the right of the public to have objective and clear information from the auditor takes precedence over any right the auditor might have to enter into relationships with the audited entity that might cloud the auditor's judgment. According to the concept known as the \"moral point of view,\" auditors must be willing to see issues through others' eyes and put the interests of other stakeholders, such as investors and creditors, ahead of their own self interests and those of the CPA firm. For example, if a difference of opinion with top management exists over an accounting or reporting issue, the auditor should emphasize the interests of the investors and creditors in deciding what action to take, even if it means losing the audit engagement. Page 646 The justicebased approach is concerned with issues such as equity, fairness, and impartiality. The theory of justice involves two basic principles.6 The first principle posits that each person has a right to have the maximum degree of personal freedom that is still compatible with the liberty of others. The second principle asserts that social and economic actions should be to everyone's advantage and the benefits available to all. For example, someone in a position to accumulate wealth has a moral obligation to make sure that others are not treated unfairly as a result of his or her gains. Mintz argues that decisions made within this theory should fairly and equitably distribute resources among those individuals or groups affected. There may be difficulty in trying to apply this theory in practice because the rights of one or more individuals or groups may be affected when a better distribution of benefits is provided to others. Under this approach, the auditor considers what would be the most just decision in terms of allocation of resources among interested parties. While none of these theories by itself can provide a perfect ethical framework, note that each emphasizes the need to consider more than one's selfinterest, and each can be useful in helping an auditor to solve dilemmas by providing an ethical perspective. Examplean Ethical Challenge Sun City Savings and Loan Company Pina, Johnson & Associates has recently been awarded the audit of Sun City Savings and Loan Company for the year just ended. Sun City Savings and Loan is now the largest client of the firm, and the fees from this engagement represent a significant portion of the firm's revenues. Upon accepting the Sun City engagement, the firm incurred additional costs by hiring several new employees and a new manager from a larger firm. In bidding on the engagement, Sam Johnson knew that the firstyear fees would be just enough to cover the actual cost of the first year's audit, but he hoped that future audit fee increases might lead to a longterm, profitable engagement. Based on his discussions with the predecessor auditors, Johnson knew that there were possible problems with Sun City's loans because of the collateral used for security. Johnson was also concerned that there might be problems with loanloss reserves due to the effects of the economic slowdown on the tourist industry in Sun City over the last two years. However, Johnson felt that these problems were manageable. During the current year, the amount included in the loanloss reserves account was $675,000, approximately the same as the figure for the prior year. The state's banking regulations require that an amount equal to 1.5 percent of the loans outstanding be included as a reserve against losses. The $675,000 was slightly above the statutory requirement. However, the audit staff identified two large loans, aggregating to $15 million, that appeared not to be collectible in full. The working papers disclosed that each loan had originated during the current year and that both had been in default for four months. Additionally, the collateral used to secure the loans was worth considerably less than the amount of the loans and was not in accordance with Sun City's loan policy procedures. Based on this information, the staff estimates that about 40 percent of the $15 million, or $6 million, will not be collected. The staff has also determined that these loans are to entities owned by Patricia Cabot, Sun City's CEO, and some of her business associates. Page 647 When Johnson met with Cabot to discuss the two delinquent loans, Cabot assured Johnson that the loans would be paid in full. She told Johnson that the loans had been properly made and that as soon as the economy picked up, payments would be made on the loans. She indicated that no additional reserves were needed and that if Johnson requires such adjustments, his firm might be replaced. Johnson is concerned that if the loanloss reserves are increased, Sun City Savings & Loan's owners and investors might be hurt financially. Further, if Johnson requires the adjustment, Pina, Johnson & Associates may lose Sun City as a client, his own career goals may be damaged, and the firm may have to lay off professional and staff employees. Johnson believes there could be serious consequences to several different parties whatever decision he makes. Stop and Think: What ethical and professional concerns should Johnson consider in deciding on a course of action? How would Johnson's views differ if the dilemma were viewed with a utilitarian perspective? How about a rightsbased or a justicebased approach? In situations such as this one, an auditor is well advised to think about the ethical issues carefully and from several different perspectives. According to the utilitarian perspective, Johnson should consider the consequences of his actions on all affected parties and whether any rules exist that might require a particular action. He should think not only about the consequences of breaking any applicable rule in the current situation but also what the consequences would be if everyone else also broke the rule. Costs and benefits need to be assessed in terms of the public, Sun City's stockholders, Cabot's reputation, and the situation of the public accounting firm. Using a rightsbased approach, Johnson should consider the rights of the involved parties. If he does so, he will realize that the stockholders' right to fair and accurate information for decisionmaking purposes would clearly be violated if he did not require an increase in the loanloss reserves. If Cabot has entered into inappropriate loans at the expense of the stockholders, they will not have received accurate information about Sun City's profitability, liquidity, and so on. Cabot, of course, has no defensible right to misappropriate funds or to report account balances incorrectly. Finally, from a justicebased perspective, Johnson should think about whether his decision might yield advantages for some at the expense of others, focusing on the protection of those who may otherwise be at a disadvantage. Johnson should avoid favoring the interests of any individual or group and should not select an action that will confer unfair advantages on some (e.g., the management of the S&L) at the expense of others (e.g., the public). Integrity and objectivity require that Johnson not place his self interest or that of the entity ahead of the public interest. Instead, he must focus on Sun City's shareholders as members of the investing public. If he does not allow his selfinterest to cloud his judgment, Johnson will require the entity to book the $6 million adjustment for the delinquent loans, regardless of the consequences to himself or to his firm. But, realistically, Johnson's professionalism is likely to be tested in this situation. While he realizes that the loanloss reserves probably should be increased, he is also likely to be concerned about the possibility of losing this valuable engagement and the significant investment in new personnel that the firm has made. After all, he could easily rationalize that there is a good chance the economy will turn around and the loans will be repaid, as promised by Cabot. While it seems fairly clear what action should be taken, the question becomesas it so often doesdoes the auditor have the courage to do the right thing? Page 648 Auditors frequently face ethical pressures, and the issues are often not quite as clearcut as in the above example. It is important that auditors develop sound moral character so that they can respond appropriately in such situations. Mintz points out that auditors who possess certain \"virtues\" or traits of character are more capable of adhering to a moral point of view. 7Examples of such virtues include honesty, integrity, impartiality, faithfulness, and trustworthiness. These characteristics are embodied in the profession's Principles of Professional Conduct, discussed later in the chapter, and are vital to the continued health of the profession.8 PracticeINSIGHT In the final analysis, individual morality is the basis for effectively dealing with ethical challenges. Moral virtues, such as honesty and fairness, are essential characteristics for members of the accounting profession. Accountants who do not possess these foundational characteristics are likely to do great harm to themselves, the profession, and others. An Overview of Ethics and Professionalism in Public Accounting A Tale of Two Companies A couple of true stories about two business organizations will help illustrate the importance of ethics and professionalism in accounting and auditing. The first Kmart store opened in Garden City, Michigan, in March 1962. Kmart Corp. filed for Chapter 11 bankruptcy protection in January 2002, representing the largest retail bankruptcy ever in the United States up to that time. In May 2002, Kmart announced that it was restating its earnings for the first three quarters of the preceding fiscal year to reflect an additional $554 million in losses for a 2001 loss of $2.4 billion. In January 2003, Kmart fired the last of 25 executives who pocketed a total of $28 million in loans that were forgiven before the company filed for bankruptcy. A month later, two former Kmart vice presidents, Enio Montini, Jr., and Joseph Hofmeister, were indicted for alleged crimes involving Kmart's accounting. In May 2003, Kmart emerged from bankruptcy and continued to operate independently for several years. The company now operates more than 1,300 stores as a wholly owned subsidiary of Sears Holding Company. Arthur Andersen, originally founded in 1913 as Andersen, Delaney & Co., grew to become one of the five largest and most respected accounting firms in the world by the late 1990s, with about 85,000 employees. In fall 2001, it became clear that issues were arising in connection with the firm's audits of Enron Corp., and Andersen's Houston office undertook a massive shredding operation to destroy Enronrelated documents in October and November 2001. The U.S. Justice Department indicted the firm in March 2002 on obstruction of justice charges relating to the shredding. Despite the fact that the Enron scandal was primarily centered in Texas, Andersen began to unravel quickly, losing over 400 of its publicly traded entities from all over the country by June 2002. The firm was convicted on a single count of obstruction of justice in June 2002, and the firm ceased to audit publicly held companies shortly thereafter. Ironically, the obstruction of justice charge was overturned by the U.S. Supreme Court in 2005, but this was a hollow victory for Andersen, as all of the firm's entities and audit staff had fled by that time to other firms and in all practical respects ceased to exist. Page 649 Stop and Think: Why was financially feeble Kmart able to continue its operations despite questionable accounting practices and federal indictments, while Arthur Andersen was not able to survive even though it was financially strong? The answer is that Kmart had physical assets and traded in physical goods, while Andersen's primary asset was its reputation for competence, professionalism, and integrity. That reputation was damaged prior to the Enron scandal by a string of questionable practices and audit failures (involving Sunbeam, Waste Management, the Baptist Foundation of Arizona, and others) and was finished off by the Enron scandal and the firm's subsequent indictment. The sudden death of one of the largest and formerly most respected public accounting firms was a serious wakeup call for the profession, and the collapse underscored the vital importance of ethical conduct and professionalism on the part of auditors. Standards for Auditor Professionalism LO 193 This section provides an overview of the principles, rules, and regulations governing ethics and professionalism in public accounting. The topic is complicated by the fact that these rules and regulations were established over time by different professional and regulatory bodies and in some cases by legislation. Early in the history of the public accounting profession in the United States, nongovernmental associations took charge of setting standards and establishing codes of conduct for practicing accountants. In particular, the AICPA (and its predecessor, the American Association of Public Accountants) established auditing standards and a Code of Professional Conduct, mapping out the primary areas in which ethical conduct is expected of public accountants. The AICPA, being a private, nongovernmental association, only has the authority to require its members to comply with the Code. However, state and federal courts have consistently held that all practicing CPAs, whether in public or private practice and whether or not a member of the AICPA, must follow professional ethical standards as laid out in the Code of Professional Conduct. Further, most state boards of accountancy have adopted the Code, thus integrating it into statelevel regulation of the practice of accountancy. PracticeINSIGHT It is important to understand that the U.S. capital markets system is based on public confidence. Public accountants play a central role in the public's ability to place confidence in companies' financial reports, and thus greatly influence how efficiently and effectively our capital markets work. Integrity and independence in fact and in appearance are cornerstones of the auditor's social responsibility and are critical to public confidence and to the proper functioning of our economic system. The SEC has legal authority to oversee the public accounting profession. Through much of its history, the SEC has allowed privatesector entities such as the Financial Accounting Standards Board and the Auditing Standards Board (or ASB, a standing senior technical committee within the AICPA) to set accounting and auditing standards, respectively. However, the SEC exercises considerable influence in the standardsetting process and has established standards of its own from time to time, some of which differ from those established by privatesector bodies. The PCAOB adopted the professional standards established by the AICPA on an interim basis in 2003, including the Code of Professional Conduct. However, the PCAOB and the SEC have additional, more stringent standards of professional conduct, mostly in the key area of auditor independence, which must be followed by auditors of public companies. Because the AICPA Code of Professional Conduct provides the broadest map of the areas in which professionalism is expected from auditors, the Code serves as the organizing framework for the following discussion. However, we also highlight the more stringent independence requirements the SEC and PCAOB impose on public company auditors. Page 650 Figure 19-1 summarizes the auditor's responsibilities with respect to auditing standards and standards of professional conduct for the audits of private and public companies. As the figure illustrates, in auditing a privately held entity a CPA must follow the auditing standards established by the ASB, as well as the independence and other standards of professional conduct established by the Code of Professional Conduct. In addition, the three standards and the three interpretations issued by the Independence Standards Board (ISB) during its short existence from 1997 to 2001 generally must be followed. 9 FIGURE 19-1 Relevant Professional Standards for Audits of Private versus Public Companies In auditing a publicly held company, a CPA must follow the auditing standards of the PCAOB (currently similar to those of the AICPA with some notable exceptions), the Code of Professional Conduct, and also the more stringent independence requirements established by the SEC, ISB, and PCAOB. The AICPA Code of Professional Conduct: A Comprehensive Framework for Auditors LO 194 The AICPA Code of Professional Conduct defines both ideal principles and a set of specific, mandatory rules describing minimum levels of conduct a CPA must maintain. The AICPA Code of Professional Conduct consists of two sections: Principles of Professional Conduct (setting forth ideal attitudes and behaviors). Rules of Conduct (defining minimum standards). The Principles of Professional Conduct provide the framework for the Rules of Conduct. Additional guidance for applying the Rules of Conduct is provided by Interpretations of Rules of Conduct. Rulings by the Professional Ethics Executive Committee (PEEC). The Interpretations of Rules of Conduct and Rulings are promulgated by the AICPA's PEEC to provide guidelines as to the scope and application of the Rules of Conduct. Unlike the Rules of Conduct, interpretations and ethics rulings are not specifically enforceable, but an auditor who departs from them has the burden of justifying such departures. The guidance provided by the Code of Professional Conduct starts at a conceptual level with the principles and progressively moves to general rulesand detailed interpretations and then to specific rulings on individual cases.Figure 19-2 illustrates the four parts of the Code of Professional Conduct. FIGURE 19-2 Code of Professional Conduct Principles of Professional Conduct LO 194 The framework for the Code of Professional Conduct is provided by six fundamental ethical principles. The preamble to the Principles of Professional Conduct states the following: They [the principles] 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. (ET 51.02) Table 19-1 presents the definition of each of the six principles. Please take a moment to read these vital precepts. Stop and Think: Why do you think the profession has adopted these high ideals for accountants and auditors? The first two principles address a CPA's responsibilities to exercise professional and moral judgment in a manner that serves the public interest. These principles reinforce the conviction that a CPA's role in society is to serve the public. As indicated by the third and fourth principles, the public relies on a CPA's integrity, objectivity, and independence in providing highquality services. Integrity requires that a CPA be honest and candid and honor both the form and the spirit of ethical standards. Thus, a CPA should make judgments that are consistent with the theories of rights and justice. When faced with an ethical challenge, the CPA should ask, \"What actions would an individual with integrity take, given these facts and circumstances?\" Objectivity and independence are hallmarks of the public accounting profession. The principle of objectivity requires the CPA to be impartial and free of conflicts of interest. Independence requires that the CPA avoid relationships that would impair his or her objectivity. When a CPA provides auditing or attestationrelated services, independence in both fact and appearance must be maintained. Page 652 The fifth principle, due care, requires that the CPA perform his or her professional responsibilities with competence and diligence. While the performance of professional services must take into account the interests of the entity, the public's interest must be considered more important when the two interests conflict. The last principle requires that the CPA determine that the services to be rendered are consistent with acceptable professional behavior for CPAs. This principle also requires that the CPA's firm maintain internal quality control activities to ensure that services are delivered competently and that no conflict of interest exists. Rules of Conduct The bylaws of the AICPA specifically require that members adhere to the Rules of Conduct of the Code of Professional Conduct. The PCAOB also requires auditors of public companies to adhere to the Rules of Conduct.Table 19-2 provides an overview of the existing Rules of Conduct. Take a few minutes to read through these rules. As you can see, the Rules of Conduct cover much of the same ground as the Principles of Professional Conduct but are somewhat more specific. The rules are grouped and numbered in five categories: Page 653 Independence, Integrity, and Objectivity (Section 100). General Standards and Accounting Principles (Section 200). Responsibilities to Clients (Section 300). Responsibilities to Colleagues (Section 400).10 Other Responsibilities and Practices (Section 500). Much of the original text of the rules is included in Table 19-2. The \"nittygritty\" details in implementing the rules are found in the interpretations of each rule. For example, while Rule 101 relating to independence is comprised of only one brief sentence, the 15 inforce interpretations of Rule 101 comprise over 30 pages of detail relating to financial or business interests that are, or are not, considered to compromise independence. In addition, there are dozens of ethics rulings related to independence. Interpretations of the other rules tend to be significantly shorter and less involved. This is because independence has become the most complex and controversial area of auditor ethics and professionalism not only has the AICPA established multiple pages of interpretations and rulings regarding independence, but the SEC and the now defunct ISB also weighed in heavily on the independence issue.11 Differences between AICPA independence standards and the SEC independence regulations, which apply only to the audits of public companies, are discussed in the context of the AICPA Code of Professional Conduct, which we'll now explore in more depth. Independence, Integrity, and Objectivity LO 195 Section 100 of the AICPA Rules of Conduct currently contains two rules related to independence, integrity, and objectivity. SEC and PCAOB rules and standards relating to auditor independence are also discussed in this section to the extent that they add to the AICPA's requirements. While we cover minimum guidelines required by the profession, it is important to note that firms often require their employees to comply with rules and guidelines that are even stricter than those imposed on them by outside bodies. Independence If an auditor is not perceived to be independent of the audited entity, it is unlikely that a user of financial statements will place much reliance on the CPA's work. Rule 101 is a very general statement concerning auditor independence and relates only to attestationrelated services, including audits. Rule 101: A member in public practice shall be independent in the performance of professional services as required by standards promulgated by bodies designated by Council. AICPA professional standards require a public accounting firm, including the firm's partners and professional employees, to be independent in accordance with AICPA Rule 101 whenever the firm performs an attest service for an entity. Attest services include Financial statement audits. Financial statement reviews (see Chapter 21). Other attest services as defined in the Statements on Standards for Attestation Engagements (SSAEs). Performing a compilation of an entity's financial statements (see Chapter 21) does not require independence, but an accountant or a firm that lacks independence must explicitly indicate this fact in the compilation report. Likewise, independence is not required to perform other nonattest services (e.g., tax preparation, financial planning, or consulting services) if those services are the only services provided to a particular entity. Because of the difficulties that sometimes arise in defining independent relationships, numerous interpretations of Rule 101 have been issued. Page 655 Table 19-3 presents Interpretation 1011, a major interpretation related to independence. In reading Interpretation 1011 it is important to consider the definition of a \"covered member.\" The AICPA uses an engagement team approach to determine independence. Under this approach, a covered member includes An individual on the attest engagement team. An individual in a position to influence the attest engagement. A partner or manager who provides nonattest services to the attest entity beginning once he or she provides 10 hours of nonattest services to the entity within any fiscal year and ending on the later of the date (1) the firm signs the report on the financial statements for the fiscal year during which those services were provided, or (2) he or she no longer expects to provide 10 or more hours of nonattest services to the attest entity on a recurring basis. A partner in the office in which the lead attest engagement partner primarily practices in connection with the attest engagement. The firm, including the firm's employee benefits plans. An entity whose operating, financial, or accounting policies can be controlled (as defined by generally accepted accounting principles for consolidation purposes) by any of the individuals or entities described above or by two or more such individuals or entities if they act together. Note that the independence rules apply to more than just the partner on the attest engagement. Every individual on the engagement team and others who may be in a position to influence the engagement must be independent with respect to the attest entity. Other partners or managers of the CPA firm who are not on the attest engagement team must also generally be independent of the entity if they provide nonattest services to that entity (such as tax or consulting services), or even if a partner simply works in the same office as the attest engagement's lead partner. Under the engagement team approach, a staff member of the CPA firm does not need to be independent of the attest entity unless he or she performs work directly for the entity or becomes a partner in the same office where the attest engagement's lead partner works. The CPA firm itself must also be independent with respect to the entity; for example, the CPA firm's benefit plan cannot invest in the firm's attest entities. Note that with few exceptions, the independence requirements under Rule 101 extend to the CPA's immediate family members (spouse, spousal equivalent, or dependents) and, in a few cases, to the CPA's close relatives (nondependent children, siblings, parents, etc.). The applicability of the independence requirements to family members and relatives is discussed later in this section. Note the \"Other Considerations\" section at the end of Interpretation 1011 (Table 19-3), which recognizes the impossibility of addressing all circumstances in which the appearance of independence might be questioned. In the absence of specific guidance, CPAs should evaluate whether a reasonable person would conclude that the member's and the firm's independence are unacceptably threatened. The AICPA has prepared a Conceptual Framework for AICPA Independence Standards for use in making such an evaluation. The conceptual framework, which became effective as of early 2006, describes the riskbased approach used by the PEEC when it develops independence standards. Under this approach, a CPA is required to identify and assess the extent to which a threat to independence exists. If such a threat does exist, the CPA considers whether the threat might reasonably be considered to compromise the member's professional judgment. If so, the CPA evaluates whether the threat can be effectively mitigated or eliminated. Depending on the evaluation, the CPA implements safeguards to eliminate or reduce the threats to an acceptable level or concludes that independence is impaired. However, the riskbased conceptual framework cannot be used to justify departures from specific independence standards. Page 657 While CPA firms are required to comply with Rule 101, most major CPA firms have their own firmspecific independence rules that are typically more stringent than the AICPA's standards. In addition, firms are required by AICPA and PCAOB standards to establish and maintain a system of quality control, a significant aspect of which is to ensure the firms' compliance with independence standards. Quality control requirements, the AICPA's peer review program, and the PCAOB's auditor inspection program are discussed later in this chapter. Note that Interpretation 1011 examines independence along two dimensionsfinancial relationships and business relationshipsand explicitly considers the effects of family relationships on independence. A number of other interpretations of Rule 101 provide further explanations on such relationships. PracticeINSIGHT During the audit of a public company, a senior auditor at one of the Big 4 accounting firms purchased $5,000 of the company's stock. The auditor was sanctioned by the PCAOB, fired by the firm, and banned from association with a registered public accounting firm for one year (PCAOB Release 1052007003). Financial Relationships Interpretation 1011 prohibits members from any financial relationship with an audited entity that may impair or give the appearance of impairing independence. This includes any direct or material indirect financial interest in the entity. Note that the materiality of the interest is only considered if the interest is indirect. A direct interest impairs independence even if it is so small as to be considered immaterial. Interpretation 10115 defines financial interest, direct financial interest, and indirect financial interest as used in Interpretation 1011 and provides guidance to members in determining whether financial interests should be considered direct or indirect financial interests. A financial interest is an ownership interest in an equity or a debt security issued by an entity, including rights and obligations to acquire such an interest. A direct financial interest is a financial interest that is owned directly by an individual or entity, or is under the control of an individual or entity. A financial interest that is beneficially owned through an intermediary (e.g., an estate or trust) is also considered a direct financial interest when the beneficiary either controls the intermediary or has the authority to supervise or participate in the intermediary's investment decisions. A financial interest is beneficially owned when an individual or entity is not the recorded owner of the interest but has a right to some or all of the underlying benefits of ownership. With few exceptions (see below), direct financial interests by CPAs in attest entities impair independence. An indirect financial interest arises when (a) an auditor or other covered member has a financial interest in an entity that is associated with an attest entity; (b) the financial interest is beneficially owned through an investment vehicle, estate, trust, or other intermediary; and (c) the auditor does not control the intermediary or have authority to supervise or participate in the intermediary's investment decisions. Indirect financial interests are generally permissible only if the amount involved is immaterial with respect to the covered member's income and wealth. For example, the ownership of shares in a mutual fund is considered to be a direct financial interest in the mutual fund. The securities that the mutual fund invests in are considered indirect financial interests to the covered member. Interpretation 10115 indicates that if the mutual fund is diversified, and if the covered member owns 5 percent or less of the outstanding shares of the mutual fund, the investment would not be considered to constitute a material indirect financial interest in the underlying investments. However, if a covered member owns more than 5 percent of the outstanding shares of a diversified mutual fund, or if the mutual fund is not diversified, the covered member needs to evaluate the underlying investments of the mutual fund to determine whether the investment in the mutual fund constitutes a material indirect financial interest in any of the mutual fund's underlying investments. Page 658 Interpretation 10115 offers the following example relating to investments in mutual funds. Assume that a nondiversified mutual fund owns shares in attest entity, Company A. Further assume that the mutual fund's net assets are $10,000,000; the covered member owns 1 percent of the outstanding shares of the mutual fund, having a value of $100,000; and the mutual fund has 10 percent of its assets invested in Company A. The indirect financial interest of the covered member in Company A is $10,000. This amount should be measured against the covered member's net worth (including the net worth of his or her immediate family) to determine if it is material. You may have heard that in some circumstances, individuals can place their assets into a \"blind trust\" to avoid possible conflicts of interest. A blind trust is a trust in which the owner of the trust assets does not supervise or participate in the trust's investment decisions during the term of the trust. Interpretation 101 1 addresses the question of whether CPAs can avoid impairing their independence by placing financial interests in an audited entity in a blind trust. Because the investments will ultimately revert to the owner and the owner usually retains the right to amend or revoke the trust, both the blind trust and the underlying investments are considered to be direct financial interests of the covered member. Interpretation 10115 clarifies other circumstances, such as ownership in retirement plans, partnerships, LLCs, and insurance policies of various types. For example, if a CPA owns an insurance policy issued by an attest entity, independence is not considered to be impaired so long as the policy was purchased under the insurance company's normal terms and procedures and does not offer an investment option. Some insurance policies allow the policy owner to invest part of the cash value in a variety of underlying investments (stocks, bond, etc.). These underlying investments are considered to be a financial interest. Thus, in such circumstances the CPA must determine whether the underlying investments are direct or indirect financial interests. Generally a loan to or from an audited entity is considered to impair the member's independence (Exhibit 19-1). However, there are situations in which a CPA is permitted to obtain loans from a financial institution for which he or she provides audits. Interpretation 1015 permits the following types of personal loans from an audited entity that operates as a financial institution: Automobile loans and leases collateralized by the automobile. Loans fully collateralized by the surrender value of an insurance policy. Loans fully collateralized by cash deposits at the same financial institution. Credit cards and cash advances where the aggregate outstanding balance is reduced to $10,000 or less by the payment due date. EXHIBIT 191ESM Government Securities, Inc., Audit Partner Had \"Loan\" from Client ESM Government Securities, Inc., was a Fort Lauderdale brokerage firm that specialized in buying and selling debt securities issued by the federal government and its various agencies. Its main customers were small to moderatesize banks and municipalities. The major type of transaction engaged in by ESM was known as a \"repo,\" in which a securities dealer sells a customer a large block of federal securities and simultaneously agrees to repurchase the securities at a later date at an agreedupon price. A massive fraud was conducted at ESM by Ronnie Ewton and Alan Novick, who hid trading losses and other misappropriations from ESM's auditor, Alexander Grant. The trading losses incurred by ESM were transferred to an affiliated company. When the thefts and trading losses were finally tallied, there was a net deficit of $300 million for ESM. Sadly, the audit partner, Jose Gomez, was aware of the fraud. Gomez was admitted as a partner to Alexander Grant in 1979. His major client was ESM Securities. Shortly after making partner, Gomez was informed by Novick that the company's 1977 and 1978 financial statements had been misstated. Novick was able to convince Gomez not to withdraw Alexander Grant's audit report on the assumption that ESM would recoup its losses. Novick was aware that Gomez was experiencing financial problems in spite of his salary as a partner. Over the course of the fraud (1977-1984), Gomez received approximately $200,000 in payments from Novick to relieve his financial woes. Such loans must be made in accordance with the financial institution'snormal lending procedures, terms, and requirements and must, at all times, be kept current as to all terms. Normal lending procedures, terms, and requirements are defined as lending procedures, terms, and requirements that are reasonably comparable to those relating to loans of a similar character given to other borrowers during the period in which the loan to the member is given. Stop and Think: Could unpaid fees be considered an outstanding debt by the entity to the auditora direct financial interest on the part of the auditor? Page 659 The rulings and interpretations of Rule 101 specify that if fees pertaining to services provided more than one year prior to the date of the audit report remain unpaid, the auditor's independence is impaired with respect to that entity. However, unpaid fees from an audited entity that is in bankruptcy do not impair the auditor's independence. Let's test your intuition. Think about the following situations to determine if the financial interest represented is a direct financial interest, an indirect financial interest, or neither. Also decide whether the financial interest would impair the auditor's independence. (1) The auditor owns a $1,000 investment in a mutual fund that spreads its holdings evenly across companies listed in the S&P 500. One of the auditor's audit entities is an S&P 500 company. (2) The managing audit partner of the office owns stock in one of the office's audited entities, but the amount is immaterial and the managing partner is not involved in the audit. The first situation represents an indirect financial interest in the audited entity. The relationship would not impair independence because the auditor owns very little of the fund and the fund is diversified over a large number of companies. The second scenario represents a direct financial interest by a covered member. Independence is considered impaired despite the fact that the amount of stock owned is immaterial. Business Relationships Rule 101 (including relevant interpretations) essentially indicates that the independence of a CPA is impaired if the CPA performs a managerial or other significant role for an entity's organization during the time period covered by an attest engagement. Such situations often arise when a former employee of the entity becomes employed by the CPA firm or, more commonly, when a CPA takes a job with a former audit entity. Interpretations of this rule, however, provide for certain exceptions. For example, a former employee of an attest entity cannot become a member of the attest engagement team or be placed in a position to influence the engagement for that entity unless the subject of the attest engagement does not include any period of his or her former employment or association with the entity. In addition, if an entity employee joins the CPA firm and becomes a covered member with respect to the entity, the CPA firm is not independent unless the former entity employee first dissociates from the entity essentially by terminating noncomplying managerial and financial relationships with the entity (see Table 19-4 for details). Next, consider the situation that arises when a CPA goes to work for an entity audited by his or her former CPA firm. This has been a controversial area, because unfortunately several of the highprofile frauds of the past decade were facilitated by former auditors. Interpretation 1012 indicates that a firm's independence is considered to be impaired with respect to an entity if a partner or professional employee leaves the firm and is subsequently employed by or associated with that entity in a key position unless a number of conditions are met (see the list of terms at the end of the chapter for the definition of a key position). These conditions require that the CPA be completely disassociated from the CPA firm, and that the firm take steps to ensure that the engagement team exercises sufficient professional skepticism and is not unduly influenced by the former employee of the firm (see Table 19-4 for details). In fact, Interpretation 1012 indicates that if a member of the attest engagement team or an individual in a position to influence the attest engagement has a job offer from or even develops the intention to seek or discuss potential employment with an attest entity, independence is impaired with respect to the entity unless the person promptly reports the situation to an appropriate person in the firm and removes himself or herself from the engagement until the offer is rejected or employment is no longer being sought. If another employee of the CPA firm becomes aware that a member of the attest engagement team (or an individual in a position to influence the attest engagement) is considering employment with an attest entity, the employee should notify an appropriate person in the firm so the firm can take steps to prevent the impairment of its independence. Page 661 PracticeINSIGHT Despite the SEC's restrictions on auditors accepting key positions for former audit clients, auditors continue to be highly sought to fill highlevel financial management positions. The breadth and depth of the business knowledge and expertise auditors develop by working with various clients over time makes them highly valuable to companies as prospective employees, especially once the auditor has reached the manager or partner level. Thus, companies continue to find various ways to hire former auditors while allowing the auditors and their former firms to comply with professional standards. Another type of business relationship can arise when a CPA is asked to serve as an honorary director or trustee for a notforprofit entity. It is not unusual for members of a CPA firm to be asked to lend the prestige of their names to a charitable, religious, civic, or similar organization and for their firm to provide accounting and auditing services to the notforprofit organization. Interpretation 1014 allows a member to serve as a director or trustee for an audited notforprofit entity \"so long as his or her position is clearly honorary, and he or she cannot vote or otherwise participate in board or management functions.\" Any of the organization's documents that contain the member's name must identify the member's position as honorary. Interpretation 10119 permits a CPA to seek employment as an adjunct faculty member of an educational institution that is an audited entity of the CPA's firm. Such a relationship does not impair independence provided that the CPA does not hold a key position at the educational institution, does not participate on the attest engagement team, is not an individual in a position to influence the attest engagement, is employed by the educational institution on a parttime and nontenure basis, and does not assume any management responsibilities or set policies for the educational institution. Effect of Family Relationships The issues related to a CPA's financial or business interest in an entity may extend to members of the CPA's family. Certain relationships between members of a CPA's family and an audited entity are considered to affect the CPA's independence. This is an area where the AICPA's independence rules have been modified to recognize changing social factors such as dual career families. A distinction is made in Interpretation 1011 between a covered member's immediate family (spouse, spousal equivalent, or dependent) and close relatives (parent, sibling, or nondependent child). A covered member's immediate family is subject to Rule 101 and its interpretations and rulings. Table 19-3contains a few exceptions, the first of which is that a covered member's spouse employed by an audited entity would not impair independence if he or she were not employed in a key position. Financial or business interests by close relatives that are not members of the auditor's immediate family, such as nondependent children, brothers, sisters, parents, grandparents, parentsinlaw, and their respective spouses, do not normally impair independence. Interpretation 1011 (see Table 19-3) lists the situations where independence would be impaired by a close relative. The two major situations that can impair independence are A close relative has a financial interest in the entity that is material to the close relative, and the CPA participating in the engagement is aware of the interest. An individual participating in the engagement has a close relative who could exercise significant influence over the financial or accounting policies of the entity (i.e., a key position). For example, suppose a staff auditor's brother works as the controller for an entity audited by the CPA firm. Because the staff auditor's brother exercises influence over significant accounting functions for the entity, the staff auditor would not be allowed to participate in the audit of this entity. Page 662 PracticeINSIGHT The PCAOB sanctioned a regional accounting firm and its partners for, among other things, violating PCAOB independence standards. At the time of the firm's audit of a client, the mother of one of the partners owned stock in the client along with warrants to purchase additional stock. The partner knew of his mother's investments and their material nature to her. He also helped purchase the shares of stock before the audit commenced and then actually sold the shares for his mother after the issuance of the audit report. The partner and the firm also failed to conduct basic audit procedures during the course of this audit and other audits and, as a result, the firm was permanently revoked of its registration and the partner in question was permanently banned from association with a registered public accounting firm (PCAOB Release 1052007009). Effect of Actual or Threatened Litigation Sometimes threatened or actual litigation between the entity and the auditor can impair the auditor's independence. Such situations affect the CPA's independence when a possible adversarial relationship exists between the entity and the CPA. Interpretation 1016 cites three categories of litigation: (1) litigation between the entity and the CPA, (2) litigation by security holders, and (3) other thirdparty litigation where the CPA's independence may be impaired. In order for a CPA to provide an opinion on an entity's financial statements, the relationship between the entity's management and the CPA must be one of \"complete candor and full disclosure regarding all aspects of the entity's business operations.\" When actual or threatened litigation exists between management and the CPA, complete candor may not be possible. The following criteria are offered as guidelines for assessing independence when actual or threatened litigation exists between the audited entity and the CPA: The commencement of litigation by the present management alleging deficiencies in audit work for the entity would be considered to impair independence. An expressed intention by the present management to commence litigation against the CPA alleging deficiencies in audit work would also impair independence if the auditor concluded that it is probable that such a claim will be filed. The commencement of litigation by the CPA against the present management alleging management fraud or deceit would be considered to impair independence. Litigation by entity security holders or other third parties also may impair the auditor's independence under certain circumstances. For example, litigation may arise from a class action lawsuit by stockholders alleging that the entity's management, officers, directors, underwriters, and auditors were involved in the issuance of \"false or misleading financial statements.\" Generally, such lawsuits do not alter the fundamental relationship between the CPA and the entity. However, independence may be impaired if material entity-auditor crossclaims are filed. For example, suppose that a class action suit is filed and the current entity management intends to testify against the CPA, alleging that an improper audit was conducted. In such a situation, an adversarial relationship would exist and the CPA would no longer be independent. When this occurs, the CPA should either withdraw from the engagement or disclaim an opinion because of a lack of independence. Provision of Nonattest Services The AICPA Code of Professional Conduct restricts the types of nonaudit services that can be provided to attest entities. Interpretation 1013 outlines these requirements and binds member CPAs to follow the relevant requirements of other regulatory bodies where applicable. The Code permits CPAs to provide bookkeeping, systems implementation, internal audit outsourcing, and other services to nonpublic attest entities subject to certain conditions and limits. For example, a CPA may assist an audit entity in implementing a computer software package but may not \"design\" the financial information system by creating or changing the computer source code underlying the system. If the auditor makes any such modifications, the changes cannot be \"more than insignificant.\" In addition, the Code indicates that CPAs may not perform appraisal, valuation, or actuarial services if the results of those services will have a material effect on the entity's financial statements and the service involves considerable subjectivity. Page 663 Interpretation 1013 of the Code outlines general requirements for performing other professional services for attest entities. This interpretation basically indicates that in performing nonattest services for an attest entity, the CPA should ensure that the entity assumes all management responsibilities. The entity must appropriately oversee and evaluate the adequacy and results of the nonattest services performed and be responsible for making significant judgments and decisions that are the proper responsibility of management. If the entity is unable or unwilling to assume these responsibilities (for example, the entity cannot oversee the nonattest services due to lack of ability, time, or desire), providing these services would impair the CPA's independence with respect to any attest services to be provided to that entity. Interpretation 1013 indicates that prior to performing nonattest services the CPA should establish with the entity in writing the objectives of the engagement, the services to be performed, the entity's acceptance of its responsibilities, the CPA's responsibilities, and any anticipated limitations of the engagement. Some of the examples offered in Interpretation 1013 of management responsibilities that would be considered to impair a CPA's independence include Authorizing, executing, or consummating a transaction or otherwise exercising authority on b