One area of concern for the accounting profession for the past 20 years has been the proliferation of alternative practice structures. Potential problems exist because the audit side of the business may be influenced by the public entity that controls it. One such situation involves K&B, CPA Associates, and Cryden Business and Tax Services.
Billy Kamen, CPA, has been a partner of K&B for more than 30 years. He thought he had seen it all in the accounting profession. The rules of conduct slowly have been eaten away because of growing commercial interests. First it was competitive bidding, which used to be against the rules but has become the standard way to gain new clients. Next, it was advertising and soliciting new clients. He reflected on the good old days when all CPAs could do was use their professional designation on business cards or in yellow pages advertisements. That was it! No media advertising and certainly no cold calls to potential clients. Then, the commissions and contingent fees rules were amended to allow such practices for nonaudit clients. The final rule to be changed was the 100 percent CPA-ownership requirement for a firm to “hold out” as a CPA firm. It now requires only majority licensed CPA ownership. Billy had thought about early retirement after Cryden bought out K&B, but decided to stay on.
This is the way the arrangement works. K&B provides all of the audit and other attest-related services and is 100 percent owned by CPAs. Cryden, on the other hand, provides accounting (i.e., bookkeeping), tax compliance, and consulting services (i.e., financial planning) often to the same audit clients of K&B. The owners of K&B are also employees of Cryden and, from time to time, do tax planning work and some consulting services for clients of Cryden who may also be audit clients of K&B. The rest of the employees of Cryden are employees of the company only, and some of them hold the CPA designation.
There is an administrative services agreement between the two entities, stipulating that support and personnel staff are made available to the CPA firm by Cryden. Cryden also provides office space, equipment, and recordkeeping for K&B.
On his first audit under the new structure, an issue arose where Billy faced an ethical dilemma. He wasn’t sure what to do. He has been involved in the audit of Hall Technologies, a large company that researched and developed new software products and had been serviced by K&B CPAs for 15 years. Billy has been the lead engagement partner on the audit during that time. One day Billy was sitting in his office reflecting on a meeting he just had with Chad Cryden where Chad told Billy he had to accept Hall’s accounting for a new R&D program whereby the company had spent $1 million to date on pre-development costs basically testing out the product to ensure technological feasibility. Billy had already decided those costs should be expensed immediately, but Chad had told him the costs would benefit future periods so they should be amortized over 5 years.
It turns out that Hall Industries was a tax client of Cryden as well as an audit client of K&B, and Frederick Hall had pressured Chad to exert influence over Billy to accept the company’s accounting for the software development expenses. That is why Chad had come to see Billy.
Billy wasn’t sure how to proceed. He knew the accounting was wrong, but he also knew the CPA firm was trying to do everything possible to make the new arrangement work. K&B had been a middle-market firm before Cryden acquired it, and may have been forced to go out of business because it no longer could meet the demands for capital to meet technology requirements and because of the difficulty the firm was having attracting and retaining talented young professionals.
The professional accountant does not have to follow the Code rigidly, blindly or merely because the rules are there. However, the professional accountant has a responsibility to identify, evaluate and address the threats to compliance with the fundamental principles of the Code. If the threats identified are considered to be significant, a professional accountant shall, where appropriate, apply measures and safeguards to eliminate or reduce them to an acceptable level that will not compromise the compliance with the fundamental principles of the Code.
The threats to compliance with the fundamental principles of the Code can be broadly categorised into the following types:
(a) Self-interest threats, which may occur as a result of the financial or other interests of a professional accountant or of an immediate or close family member. This threat arises as the professional accountant may have a conflict of interest resulting from his/her equity or debt interest in a client, or the dependency on the fees received from the client (fees represent a large proportion of the professional accountant’s total income), or the close business relationship that exists between the professional accountant and the client and/or senior management (related party transactions). Self-interest may therefore threaten to obscure the professional accountant’s judgement and objectivity.
(b) Self-review threats, which may occur when a previous judgement needs to be re-evaluated by the professional accountant responsible for that judgement. This threat arises as the professional accountant may be biased and prejudiced in his/her review, and review decisions may be slanted to protect his/her professional status and/or competence. The situations which give rise to these threats are those in which the professional accountant finds him/herself in a compromising position through reviewing work which he/she has performed. Highlighting errors or raising different opinions on work previously performed may reflect badly on the professional competence and integrity of the professional accountant – “what objective conclusion can be obtained if one reviews one’s own work…”.
(c) Advocacy threats, which may occur when a professional accountant promotes a position or opinion to the point that it subsequently compromises the objectivity of the professional accountant. This threat arises when the professional accountant promotes or defends the business of the client to such an extent where he/she is seen as part of the client’s business, which compromises the independence of the professional accountant.
(d) Familiarity threats, which may occur when a professional accountant becomes too sympathetic to the interests of others due to a close relationship. This threat, whether real or only perceived by the public, arises as a result of the personal, family or business relationship with the client. The relationship can exert significant influence over the manner in which the professional accountant conducts the professional service, and may result in the professional accountant making judgements which favour the client. This also includes accepting gifts or preferential treatment from a client, unless the value is clearly insignificant. It is perceived as being rewarded for doing a favour, which compromises the professional accountant’s integrity.
(e) Intimidation threats, which may occur when a professional accountant is deterred from acting objectively by threats, whether actual or perceived. These threats may arise as a result of the significant influence the client exerts over the professional accountant, especially in terms of dependency on the fee income, knowledge of unprofessional and/or unethical behaviour, or interference with the scope of work.
The safeguards a professional accountant may implement to eliminate or reduce such threats to an acceptable level fall into two broad categories:
(a) Safeguards created by the profession (legislation or regulation)
These safeguards place the responsibility on the profession to establish entities to develop, monitor and evaluate the professional competence of the professional accountant, and include amongst others the following;
(i) establishing minimum requirements for the development of professional competence through education, training and experience within the profession, including continuing professional development (CPD);
(ii) establishing good corporate governance regulations;
(iii) establishing professional or regulatory monitoring and disciplinary procedures to ensure compliance with professional standards; and
(iv) establishing external reviews of the reports, returns, communications or information produced by a professional accountant through a legally empowered third party.
(b) Safeguards in the work environment
In the work environment, the significance of the threats will be affected by the nature of the professional services rendered and the structure of the firm. When assessing the significance of the threats and the safeguards to be implemented, a professional accountant in public practice shall consider what a reasonable and informed third party (who has knowledge of all relevant information, including the significance of the threats and the safeguards applied) would reasonably conclude to be acceptable.
Firm-wide safeguards against the threats to compliance with the fundamental principles of the Code in the work environment may include:
(i) the importance the leadership of the firm places on compliance with the fundamental principles and on ensuring that its staff conduct their professional service in a manner that serves the public interest;
(ii) the policies and procedures the firm establishes regarding compliance with the fundamental principles of the Code (identifying and evaluating threats and implementing safeguards to eliminate and reduce the threats), including quality control assurance of engagements;
(iii) the policies the firm establishes regarding the identification and evaluation of threats to independence with respect to its professional and business relationships with its clients;
(iv) the separate reporting and functional division that the company establishes for services which may result in a conflict of interest or violation of the fundamental principles of the Code;
(v) the regular procedures the firm establishes for peer and independent reviews of professional services performed;
(vi) the employment of competent staff and implementation of appropriate training and education on policies and procedures;
(vii) the disciplinary mechanisms the firm establishes to promote compliance with policies and procedures;
(viii) the discussion of ethical issues with those charged with the governance of the client.
Depending on the nature of the engagement, a professional accountant in public practice may also be able to rely on safeguards that the client has implemented. However, it is not possible to rely solely on such safeguards to reduce threats to an acceptable level. The safeguards within the client’s systems and procedures that may eliminate or reduce the threats to compliance with the fundamental principles of the Code may include:
(i) the appointment of a firm in public practice to perform an engagement is approved by persons or a committee other than management, such as the audit committee;
(ii) the client has competent employees with experience and seniority to make managerial decisions;
(iii) the client has a corporate governance structure that provides appropriate oversight and communications regarding the firm’s services.
A professional accountant has the responsibility to identify and evaluate threats to compliance with the fundamental principles of the Code of Ethics for Professional Accountants, and implement safeguards to eliminate or reduce the threats identified to an acceptable level. A professional accountant shall not apply the provisions of the Code blindly, but is advised to assess each situation based on the facts and make a judgement that an independent prudent third party, having knowledge of all information and the significance of the threat, would make.
The major threats to compliance with the Code stem from the personal and/or professional business relationships that the professional accountant has with the client or members of management that exert influence over the manner in which the professional services are performed. These threats may arise from a conflict of interest, lack of independence or objectivity when the professional services are rendered.
A professional accountant of a firm in public practice may implement safeguards to eliminate and reduce the threats to compliance with the fundamental principles of the Code by ensuring that the staff are professional and competent to render the services and are aware of the fundamental principles that they should comply with when rendering professional services. A firm in public practice shall implement policies and procedures which will ensure compliance with the fundamental principles of the Code as well as procedures for identifying and evaluating threats to the fundamental principles.
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