Solutions for Chapter 3

Judgmental and Ethical Decision Making Frameworks and Associated Professional Standards

Review Questions:

3-1. History shows that companies with strong corporate governance and high ethical standards generally perform better than those with weak corporate governance and a low level of ethical expectations. Further, these companies typically have higher quality financial disclosures.

3-2. Auditors add value to the financial markets by providing an independent assessment of the reliability of the client’s financial statements. That independent assessment is only valued by public to the extent that the auditors providing it have acted, and are perceived to have acted, with the highest level of integrity and ethics.

3-3. Without independence, the work product of CPAs would be worthless. CPAs are expected to judge the fairness of the information to which they are attesting. If CPAs were not independent, the users of financial statements would have no reason to believe the fairness of the financial statements any more than if the statements had not been audited.

3-4. The major threats to auditor independence are: Partner compensation plans that emphasis attracting and keeping clients. This

creates an incentive to bend over backward to do what the client wants rather than doing what is right. Many compensation plans have now been changed to reflect quality of work rather than marketing ability.

Treating the client’s management as the client rather than the stockholders, as represented by the board of directors and its audit committee. This also creates an environment in which the auditor wants to keep management happy so they will continue to use the auditor’s service. For this reason, the Sarbanes-Oxley Act has placed additional responsibilities on the audit committee for oversight of the financial statement audit, including responsibilities related to hiring and firing the auditors.

Becoming too familiar with the client because of a long-term relationship. It is often difficult to remain objective when dealing with management personnel with whom the auditor has developed too close of a relationship. Partners on public company audits are now required to be rotated every five years.

Time pressure created by providing the lowest bid in order to get the client and the possibility of additional services. In order to get the audit completed “on

time,” shortcuts are often taken rather than pursuing questionable items. Failure to meet the time budget reflects unfavorably on the audit team. This threat is reduced by prohibiting auditors of public companies from providing many of those additional services, such as consulting. The threat of shortcuts being taken is also reduced through a variety of reviews of the audit work including reviews by second partners not associated with the client, internal quality reviews of the firm, peer reviews, and inspections by the PCAOB. Finally, the corporate culture of the audit firm, including the tone at the top, can serve to mitigate the threats caused by time pressure.

Rationalizing that detected misstatements are not material because it takes time to investigate them further.

Auditing a client for whom the firm has also performed other services such as information system consulting, bookkeeping, and/or human resource services. These services place the auditor in the position of auditing their own work and may increase the economic dependence of the auditor on the client. Auditors in those situations may have a tendency to “go easy” on the audit client and make the client happy so as not to risk losing the fees (both audit and non-audit) obtained from the client..

3-5. Public accounting firms can manage the threats to independence in several ways: Establishing a strong code of conduct that is reinforced by the firm’s senior

personnel and with appropriate actions when the code is violated. Providing compensation packages that do not place attracting and keeping clients

ahead of performing quality audits. Having a high-level committee evaluate the acceptance and retention of audit

clients based on risk models rather than just on increasing revenue. Separation of audit services from other services that could impair independence.

Separation can take place in two ways; (1) separating the audit function from the consulting function within the firm or, as required by the Sarbanes-Oxley Act, (2) not providing those services to audit clients. This eliminates the possibility of auditing your own work.

Requiring a quality review of each audit during the audit and before issuing the audit opinion. Knowing your work will be reviewed for quality during and at the end of the audit provides motivation to perform a quality audit. Individual performance evaluations will suffer if the reviewer challenges the quality of the work.

3-6. This question is designed to encourage the instructor and students to expand their horizon by looking at the SEC’s thinking regarding independence. Part of the rationale is based on the Supreme Court’s ruling on the importance of auditor independence. The court said:

“The SEC requires the filing of audited financial statements in order to obviate the fear of loss from reliance on inaccurate information, thereby encouraging public investment in the Nation's industries. It is therefore not enough that financial statements be accurate; the public must also perceive them as being accurate. Public faith in the reliability of a corporation's

financial statements depends upon the public perception of the outside auditor as an independent professional. . . . If investors were to view the auditor as an advocate for the corporate client, the value of the audit function itself might well be lost.”

The Commission focused on the following four principles in developing its rules on auditor independence. Essentially they ask whether or not the auditor’s relationship with the client:

(a) creates a mutual or conflicting interest between the accountant and the audit client;

(b) places the accountant in the position of auditing his or her own work;

(c) results in the accountant acting as management or an employee of the audit client; or

(d) places the accountant in a position of being an advocate for the audit client.

These factors are general guidance and their application may depend on particular facts and circumstances

3-7. The nine services that public accounting firms cannot provide to audit clients are:

Bookkeeping or other services related to the accounting records or financial statements of the audit client,

Financial information systems design and implementation, Appraisal or valuation services, fairness opinions, or contribution-in-kind reports, Actuarial services, Internal audit outsourcing services, Management functions or human resources, Broker or dealer, investment adviser, or investment banking services, Legal services and expert services unrelated to the audit, Tax services other than preparing the client’s tax return, and Any other service that the Board determines, by regulation, is impermissible.

Although not indicated in the text, the instructor may want to note that Rule 2-01 of the SEC identifies some prohibited services for which there is an exception if the services are not expected to be subject to audit.

3-8 There are four sections to the AICPA’s Code of Professional Conduct – Principles, Rules of Conduct, Interpretations, and Rulings. The Principles provide the ethical concepts on which the Rules of Conduct are based. The six Principles relate to exercising sensitive professional and moral judgments, serving the public interest, performing professional responsibilities with the highest sense of integrity, maintaining objectivity and avoiding conflicts of interest with the client, continually striving to improve competence and quality of services, and

observing these Principles in determining the scope and nature of services to be provided.

3-9. There are services that can be provided for non-public audit clients that cannot be performed for public audit clients. For example, bookkeeping services, financial information system consulting, tax services, and internal audit services can be performed for non-public audit clients. Many of these clients need help from a professional and their choices may be limited, particularly when located in small communities. The AICPA believes providing some of these services is acceptable as long as the auditor believes that providing such services does not affect independence in fact and appearance. When these services are provided to non-public clients the auditor is suppose to not assume the role of management and not make management decisions. The client also has to accept responsibility for the decision. The AICPA’s mantra is that the auditor can advise without affecting independence but cannot make management’s decisions for them.

3-10. Providing the services stated in the solution to question 3-9 to non-public audit clients may be the only cost-effective way the clients can obtain the services. Their auditor may be the only firm in a small community that can provide such services. In addition, it is probably true that the users of the financial statements of non-public companies place less reliance on those statements for making invest/credit decisions than do users of the financial statements of public companies, the owners and major creditors of which are often far removed from the day-to-day activities of the company.

3-11. The AICPA permits auditors to audit a client for which it also provides data processing and consulting services if, after assessing all of the relationships with the client, they believe they are independent in fact and appearance. The AICPA believes that auditors have the competence to do the data processing and consulting but it requires the auditors to do as thorough an audit as if they had not provided those services. The SEC prohibits auditors from doing audit of clients for which it provided data processing services believing auditors cannot independently audit their own work. The SEC is also very concerned about audit firms that provide both audit and consulting services for a client and now, because of the Sarbanes-Oxley Act, prohibits firms from providing such services to public-company audit clients.

3-12. Independence in fact means the auditor is unbiased and objective. Independence in appearance means that a third party with knowledge of the auditor’s relationship with the client would consider the auditor to be independent. An auditor could be independent in fact if he or she owned a few shares of common stock in an audit client (although the auditor would be in violation of the independence requirements of the SEC and the AICPA), but might not appear independent to a third party.

Further, as suggested by some of the examples provided in the chapter, an auditor may have violated an SEC independence rule, but because of the small amounts involved, a third party might perceive the auditor to be independent, and in fact, the auditor may have acted independently. Although not explicitly discussed in the chapter, for many of the relationships and requirements specified in the SEC’s Rule 2-01, materiality is not

considered when determining whether an independence violation has occurred. The sections of Rule 2-01 related to employment relationships, contingent fees, and non-audit services do not allow for any such relationships, regardless of the materiality of the relationship. For example, if an audit firm were to provide a prohibited non-audit service (e.g., bookkeeping services) to an audit client, then an independence violation would occur whether the audit firm obtained revenues from the bookkeeping services of $1,000 or $1,000,000. Further, direct financial interests in an audit client and direct business relationships with an audit client would be violations of Rule 2-01, without consideration of the amounts involved.

Rule 2-01 does imply a materiality consideration in limited situations. Specifically, Rule 2-01 (c) notes that material indirect financial interests in an audit client and material indirect business relationships with an audit client would be violations of Rule 2-01. Rule 2-01 (c) thus implies that immaterial indirect financial interests in an audit client and immaterial indirect business relationships with an audit client may not impair an auditor’s independence.

3-13. A direct financial interest is one in which a covered member makes the investment decisions. An indirect financial interest is one in which the covered member does not make the investment decisions, such as owning shares in a mutual fund. The investment in the mutual fund is a direct financial interest. However, the investments of the mutual fund are considered indirect financial interests.

3-14. Section 201 prohibits the auditor from providing various non-audit services to audit clients. Congress and the SEC likely viewed the auditor’s provision of non-audit services as creating the motivation for ethical lapses. Provision of these services could result in auditors auditing their own work and could increase the economic dependence of the audit firm on the client. Auditors who find themselves in the position of auditing their own (or the work performed by someone else in the same firm) may find it difficult to negatively evaluate that work. Further, auditors who have an increased economic dependence on the client may not have an appropriate level of skepticism when auditing the client and may take actions to make the client happy rather than to ensure that the financial reports are reliable.

This prohibition minimizes some incentives that auditors may have had to not perform a quality audit and thus should give the public increased trust in the quality of the work performed by the auditor.

3-15. a. Independence would not be impaired. Such mortgages are grandfathered in as long as the terms are not changed and the payments are up-to-date.

b. This is a violation of interpretation 101-1 that states that a covered member may not have served as management or an employee of the audit client during the period covered by the financial statements.

c. This is a violation of interpretation 101-5 that prohibits any loan to a covered member, with some exceptions.

3-16. The recent events, including the Enron debacle, have reiterated the basic concept that the audit committee is to represent the interests of the investor community, who is actually the auditor’s client. The audit committee has a responsibility to hire and fire the auditor, as well as monitor the audit process. The audit committee also has a responsibility to monitor all activities, other than audit, that is performed by the auditing firm and make a judgment on whether such activities might impair the auditor’s independence. Bottom line, the audit committee is designed to make the audit function independent of management influence and is the major evaluator of the auditor’s independence.

In 2007, the SEC developed a brochure to help audit committees understand their responsibilities related to auditor independence. That brochure is available at the SEC’s website (http://www.sec.gov/info/accountants/audit042707.htm).

3-17. The auditor may disclose confidential information with the client’s permission or to: Ensure the adequacy of accounting disclosures required by GAAP or GAAS, Comply with a validly issued and enforceable subpoena or summons, Provide relevant information for an outside review of the firm’s practice under

PCAOB, AICPA, or state Board of Accountancy authorization, or Initiate a complaint with, or respond to an inquiry made by, the AICPA’s

professional ethics division or trial board or investigative or disciplinary body of a state CPA society or Board of Accountancy.

3-18. Yes. Such a relationship creates a conflict of interest (Rule 102). The auditor is a judge of the fairness of financial statements. Legal counsel is an advocate for the client. A CPA cannot be both a judge and advocate for the same client.

3-19. a. A CPA may provide services on a contingent fee basis only if the related service is for a client for which the CPA does not also provide any attestation services.

b. A CPA may accept a commission only if the client is notified about the commission and only if the CPA does not also provide any attestation services for that client.

c. A CPA may pay or receive a referral fee if the client is notified of the referral fee.

3-20. The code is enforced by voluntary cooperation, public opinion and associated legal action, reinforcement by peers, and disciplinary proceedings of the Joint Ethics Enforcement Program sponsored by the AICPA, state boards of accountancy, and state CPA societies. Members in violation of the code may, for example, lose their membership in the AICPA, be required to take additional hours of containing professional education, and/or lose their CPA license.

3-21. Utilitarian theory holds that what is ethical is the action that brings the most good to the most people. Actions are ethical if they are useful for providing results that bring the greatest overall benefit to the greatest number of people. Rights theory focuses on evaluating actions in terms of the fundamental rights of the parties involved. But not all rights are equal. In the hierarchy of rights, higher-order rights take precedence over lower-order rights.

3-22. Auditors endeavor to make high quality decisions, i.e. decisions that are unbiased, meet the expectations of users, are in compliance with professional standards, and are based on sufficient factual information to justify the decision that is rendered. The decision process requires the auditor to appropriately structure the audit problem, understand potential outcomes and the consequences of those outcomes, consider the uncertainties and risks associated with evidence and the evidence-gathering process, evaluate alternative methods to gather evidence, determine if enough evidence has been gathered, and then make a decision about the audit problem (for example, should the auditor conclude that the financial statements are fairly stated). The decision-model is consistent across most professions. An understanding of the decision process will assist auditors in developing audit plans for most audit clients.

3-23. The IEBAS emphasizes the concepts of integrity and objectivity while the AICPA and SEC emphasizes auditor independence. Both the IEBAS and the SEC emphasize fundamental principles related to either objectivity or independence. The IEBAS states that a professional accountant should not allow bias, conflict of interest or undue influence of others to override professional or business judgments. The AICPA focuses on the auditor’s independence from the client and has developed a number of rules to help professionals deal with specific instances that might arise.

The SEC has been very clear that some areas create a mutual or conflicting interest and the auditor should avoid auditing his or her own work. However, the AICPA does not prohibit an auditor from performing bookkeeping work and still perform an audit. The rationale is that in smaller businesses, the client may need the bookkeeping expertise of the auditor and that knowledge is extremely important to high quality reporting. The AICPA thus believes that adherence to objectivity is sufficient to overcome the potential impact on auditor independence.

Multiple Choice Questions:

3-24. c.3-25 e.3-26. a.3-27. d.3-28. d.3-29. c.3-30. d.3-31. e

Discussion and Research Questions:

3-32. a. Personal Financial Services. The SEC principle states that the auditor should consider whether performance of the service would create either a mutual or conflicting interest with the client. The SEC would likely conclude that performance of such services for high income individuals would create a mutuality of interest if those high wealth individuals were members of top management, e.g. a CEO or CFO of an audit client, and those individuals had an influence on the selection of the audit firm. The SEC would view the situation in a similar fashion for members of an audit committee that would be selecting an audit firm.

b. Audit Committee. As long as the audit committee was independent of management, the SEC would not view this as a conflict of interest.

c. The SEC is very explicit that an audit firm cannot audit its own work. Thus, the service described here would be considered a violation of one of their independence principles.

d. Improvement of Controls. This is potentially a ‘grey area.’ Auditors, as a matter of due course, will pass on ideas to improve controls to their clients. However, a contract for training would likely imply that the controls will be implemented according to the audit firm’s own methodology. If so, this would be akin to the firm then auditing their own work and would be considered a violation of the SEC independence principle.

3-33.a. Establishing ethical standards and enforcing them is a hallmark of a profession.

Professionals need guidance on ethical issues - what is and what is not ethical in this profession. The public expects a profession to police its members to ensure that its ethical standards are followed and violators are properly dealt with. Standards present specific guidelines to assist members of the profession in dealing with both ethical problems and ethical dilemmas.

b. There are a number of sanctions for violating the Professional Code of Conduct depending on the severity of the violation. Sanctions range from requiring specific continuing education or documenting procedures to prevent such a violation in the future, to more extreme sanctions such as suspension of membership in the AICPA. Reporting violations to the state board of accountancy may result in a suspension or revocation of the practitioner's license to practice as a CPA.

3-34.Scene 1 a. You should request additional staffing or get the audit partner to get the CFO

to ease up on the time pressure so a quality audit can be completed.b. Improve/increase the advanced training and preparation of the new staff so

the training on the job can be minimized or, knowing the potential time problem because of new staff, request additional staffing or more experienced staff.

Scene 2 a. This is a threat to independence because of the motivation for partners to make concessions to attract prospective clients and keep existing clients happy rather than insist on doing what is “right.”

b. Change the compensation arrangements to emphasize the conduct of quality audits rather than on obtaining and retaining clients and selling new services to them that could impair independence. Further, under the current SEC and PCAOB independence rules the ability to provide additional non-audit services to audit clients is greatly limited.

3-35. a. Shareholders would normally not know what qualifications are important for their

external auditors. If the CEO or CFO had these responsibilities, the auditor would be more likely to bend to their wishes rather than take the hard stances that may be required for fair financial reporting. Part of the purpose of designating the audit committee to oversee the audit is to have an advocate for the stockholders of the company.

b. Factors to consider in evaluating the external auditor’s independence include: The nature and extent of non-audit services provided to the client. The policies and procedures the external auditor’s firm has to assure

independence. The lengths of time individuals have been in charge of the audit. Any pending or completed investigations by the SEC or PCAOB of the firm. Results of the quality inspection of the firm by PCAOB.

3-36.

a. The Commission focused on the following four principles in developing its rules on auditor independence. Essentially they ask whether or not the auditor’s relationship with the client:

1. creates a mutual or conflicting interest between the accountant and the audit client; 2. places the accountant in the position of auditing his or her own work; 3. results in the accountant acting as management or an employee of the audit client;

or4. places the accountant in a position of being an advocate for the audit client.

b. These principles apply specifically to auditors of public companies. However, they are essentially imbedded in the AICPA’s Code of Professional Conduct and, therefore, apply to auditors of all clients, including smaller, privately-held companies.

c. 1. This creates a mutual interest between the auditor and the audit client and, therefore, violates that principle.

2. This places the auditor in the position of auditing her own work and, thus, violates that principle.

3. This results in the auditor acting as management or an employee of the audit client and, therefore, violates that principle.

4. This violates the SEC requirements and was prohibited since it gives the appearance of tying the auditor too closely with the interests of the CEO and CFO.

5. This is a difficult question because it raises the issue of whether the CPA’s objectivity might be compromised when dealing with either of those clients. On the other hand, the auditor should not be precluded from having normal social interactions. Ms. Keuhn will have to be very careful to demonstrate that all audit decisions demonstrate complete objectivity if she is to continue the social relationship described herein.

3-37. a. i. Barnes is a “covered member” and his direct financial interest in the client violates the independence rule.

ii. Barnes is a “covered member” and the direct financial interest of his wife is attributed to him and, therefore, violates the independence rule.

b. Putts is a “covered member” and the direct financial interest violates the independence rule.

c. Independence is impaired because Nels has knowledge of his mother’s financial interest in the audit client that is material to her net worth (Interpretation 101-1)

d. Independence is impaired because Kard owns more than 5% of the audit client’s stock (Interpretation 101-1 B)

3-38. The following SEC principles should be used in considering independence:

Does the auditor’s relationship with the client: create a mutual or conflicting interest between the accountant and the audit client; place the accountant in the position of auditing his or her own work; result in the accountant acting as management or an employee of the audit client;

or place the accountant in a position of being an advocate for the audit client.

1. The auditor needs to determine the proper application of tax rules and regulations as they relate to tax expense and accruals/deferrals. Therefore, it seems appropriate for the auditor to prepare the client’s tax returns as long as they do not take aggressive or questionable positions on tax issues. However, because preparation of the tax return could involve a mutual interest, the auditor cannot prepare any tax returns on a contingent fee basis.

Also note that the PCAOB adopted rules in 2005 that prohibit registered public accounting firms from performing the following tax-related services for audit clients:

• Providing tax services to certain members of management serving in financial reporting oversight roles or to their immediate family members

• Providing services related to marketing, planning, or opining in favor of the tax treatment of certain confidential transactions or based on an aggressive interpretation of applicable tax laws and regulations

2. Such analysis is an important part of a risk based audit because many economic and business risks of clients have accounting implications. Provision of this service would not appear to violate any of the four principles. However, the

auditor should refrain from making decisions based on the analysis that would result in the accountant acting as client management.

3. Performing such services for audit clients would not appear to violate any of the SEC’s principles as long as the CPA does not make management decisions based on the research results.

4. As long as the CPA is unaware of the consulting services performed by the board member, it is hard to argue that it would impair the CPA’s independence. However, in a case in 2005, such an activity took place when a board member for Best Buy, Inc. also performed consulting work for Ernst & Young (Best Buy’s auditor). This led to the dismissal of Ernst & Young as the auditor of Best Buy because some parties believed it created a mutuality of interests. Further, such a situation might be viewed as a business relationship that would be prohibited the SEC’s rules.

3-39.a. Five ways in which a firm might take positive actions regarding independence:

1. emphasize the importance of independence in all training regarding audits,2. review the work of staff auditors,3. concurring partner review of the audit before the engagement is completed,4. compensation plans emphasize importance of independent, quality audits,5. perform internal quality reviews of audit engagements that have been

completed.

b. The intent of this question is to encourage students to look at the websites of local or regional audit firms. In doing so, they will likely see a much different approach to audit value, i.e. many of these firms see themselves as their client’s “most trusted business advisor”. Further, some of these firms may not perform financial statement audits for public companies. Some examples of smaller firms’ websites might include:

http://www.larsonallen.com/www.wipfli.comwww.virchowkrause.com

The discussion needs to focus on whether there are different independence issues when these audit firms audit smaller, closely-held companies. In other words, does the provision of consulting advice to the clients impair the auditor’s ability to perform an independent audit? Why would the concept be different for these types of firms? The instructor can challenge various assumptions and statements made by the students. The question is aimed at getting the students to think about the fundamental issues rather than memorizing rules.

c. Challenges that might be faced by smaller public accounting firms include the following:

1. Client familiarity – both from an audit viewpoint, but also it is more likely that the audit partner and client know each other socially, e.g. belonging to the same country club, working on charities, and so forth.

2. Performance of Advisory Services. Auditors of smaller businesses are often the ‘most trusted business advisors’ and will often provide advice on business plans, financing alternatives, etc.

3. Alumni Relationship. Many auditors with smaller firms accept positions with former audit clients.

4. Technical competence to make accounting and audit judgments. Many smaller businesses are complex. It may be difficult to keep all staff auditors up to date on technical pronouncements.

5. Economic dependence on one or two very large clients.

6. Difficulty in adhering to partner rotation rules due to fewer partners in the firm.

d. In providing consulting services for the client the auditor cannot act in the position or capacity of management. They can offer advice but cannot make management decisions. Management must make and accept responsibility for decisions made. Providing the advice is ok, e.g., indicating the strengths and weakness of different computer applications, but selecting the particular computer application should be management’s decision.

3-40.a. Independence, as it applies to a CPA, means that the auditor is free of potential

conflict or influence from the client, is objective, and has the independent mental competence to make informed judgments about the fairness of the client's financial presentations. Independence, as applied in public accounting, has two facets, factual and appearance. Independence in fact means that the auditor performs the audit with an objective and unbiased perspective. Issues are resolved based on facts and professional opinion, not because the client or others are pressuring the auditor to take a certain position. Independence in appearance means that third parties who have knowledge of the auditor's relationships with the client and others interested in the audited financial statements believe the auditor is independent.

b. Independence of auditors is similar to that of judges. Auditors judge the fairness of financial statements and do not take the role of advocate for their clients. Lawyers, on the other hand, are advocates for their clients and are not independent as a result.

c. External auditors are perceived as being more independent of a company than that company's internal auditors in the eyes of people outside that company. The external auditors receive their income from several companies and, as a result, do not depend totally on any one company for their financial well-being (although, they do derive their fees directly from audit clients).

Internal auditors, on the other hand, are financially dependent, on an individual basis, on the company that employs them. As a result, people outside the company do not perceive them as being independent. However, they can still maintain a high degree of independence in the eyes of top management by being organizationally independent of the areas they audit. Therefore, it is important that the internal audit department be responsible to and report to top management and the board of directors or its audit committee.

d. Potential violations of the AICPA's code

1. (a). The auditor is not in violation of Rule 101. A custodial engineer does not usually have significant influence over operating, financial, or accounting policies, nor is he likely to be involved in significant internal accounting controls.

(b). The auditor is in violation of Rule 101. A treasurer does have significant influence over operating, financial, and/or accounting policies and is likely involved in significant internal accounting controls because of his responsibility for cash management and handling.

2. The auditor is probably not in violation of Rule 101 unless the third cousin lives in the auditor's household. Otherwise, such a distant relative is not likely to have any more influence on the auditor than someone who is not a relative.

3. The auditor is in violation of Rule 101. A treasurer enters into transactions and has significant influence over operating, financial, and/or accounting policies and is likely involved in significant internal accounting controls for the organization. The auditor/treasurer would be in a position of auditing his or her own work and would not be independent in fact or appearance.

3-41.a. Hart is not violating the rules of the AICPA's code as long as he is not performing

any attestation services for Sanders. Attestation services include audits or reviews of its financial statements, examinations of its prospective financial information, or compilations of its financial statements if it is likely the compiled statements will be used by a third party and the compilation report does not describe a lack of independence. Hart must disclose the commission arrangement to Sanders. [Rule 503]

b. If both Stone and Rock inform the client of the referral fee, the payment and receipt of the referral fee are ethical. [Rule 503]

c. This contingent fee arrangement is not in violation of the AICPA code unless she is performing some attest function for Ettes, Inc. [Rule 302]

d. Gage should be sure he has the competence to perform the computer study. If he lacks the competence, he needs to determine whether he can obtain the competence by training or hire someone who has the competence and whom he can adequately supervise.

He should also assess the effect of this engagement on his independence. He should consider all of his relationships with Hi-Dee to be sure his appearance of independence will not be adversely affected and that he can remain unbiased and objective during the next year's audit. He should avoid making management decisions and he should serve only as an adviser, not as a decision maker. If he becomes too closely involved with the client and the new system, he may not be able to remain unbiased and objective when performing an audit of information that is processed by that new system.

e. Interpretation 101-1 prohibits the auditor from serving as a member of management or employee during the period covered by the financial statements. Therefore, the auditor would not be independent for purposes of performing the audit.

f. The unpaid fees for the prior year's audit places Holt in the position of being a creditor of Tree, thus having a direct financial interest in Tree. Holt thus lacks independence. (ET §191.104)

3-42.a. The auditor cannot do the audit work unless the client is willing to share sensitive

information, which the client would not be willing to do if they knew it was going to be made public. As a result the client can sue the auditor and impose fines and penalties upon them for the disclosure to unauthorized parties of confidential information provided to them in the audit process.

b. Because of this stringent confidentiality requirement imposed upon the auditor, the profession has specifically designated certain instances when it is allowable for the auditor to disclose confidential information to outside parties, relieving the auditor of legal liability to the client in these specific situations. The four allowed situations are 1) to comply with GASB or GAAP professional standards, 2) to comply with subpoenas, laws, and regulations, 3) to provide relevant information for an outside quality review of the firm’s practice under PCAOB, AICPA, or State Board of Accountancy authorization, or 4) to initiate a complaint with or respond to a inquiry made by AICPA’s professional ethics division or trial board or investigative or disciplinary body of a state CPA society or state Board of Accountancy.

c. When the client is auditing Client A and learns information that would be useful for Client B, then the auditor would be well advised to consult with their lawyer before they communicate such information to Client B. The courts have gone both ways in evaluating

such a communication of information, penalizing the auditor for communicating such information as well as penalizing them for not communicating such information. In the text the authors have developed an ethical framework to use in evaluating the particular facts of the situation.

d. The audit report is a public document and is not considered confidential information. If the client is in violation of GAAS or disclosure requirements, the auditor is under obligation to require adjustment or disclosure of such information in the financial statements or must modify the audit report for violation of GAAS or disclosure requirements. Further, if the auditor believes that the client does not have the ability to operate as a going concern in the near future (usually one year or one operating cycle) the auditor would provide that information in the audit report.

3-43.

a. The following rules and interpretations would likely be referred to:Rule 201A - professional competence.Rule 201B - due professional care.Rule 202 - compliance with appropriate standards.Rule 501 (Interpretation 501-3) - compliance with governmental audit standards, guides, procedures, statutes, rules and regulations in addition to GAAS.

b. Robert could have avoided violating these rules and interpretations by taking steps to ensure his firm was technically competent to conduct the community college audit. Courses, training materials and official pronouncements are available to firms wishing to enter new practice areas or service clients in new industries. In addition, adequate firm wide supervision and review procedures helps ensure that the work has been performed with due care and all applicable standards have been met.

3-44.

a. GAAP is silent on the nature of the particular transaction described. Management has made a decision to effectively forgo a sale to build good relations with a major client. It could be argued that this is no different than reducing price to keep a client. The bottom line is not affected by the decision (i.e., net income is not affected by the accounting). The decision has been made, but it is only a question of disclosure. A counter argument is that the sales and cost of goods sold have been misstated. Appealing only to specific accounting pronouncements does not, by itself, solve the problem.

b. The ethical framework developed in the chapter may assist an auditor in addressing the problem, using the following steps:

1. The ethical issue. The ethical issue involves the disclosure of the transaction and how either disclosure or nondisclosure may affect the rights of various parties and which approach might result in the greatest good. Part of the resolution depends on whether the auditor assesses that management has a stewardship obligation

that requires the reporting to shareholders of how well management has managed the resources of the organization. It also depends on whether the auditor believes that the essence of stewardship can fully be captured in reported net income.

2. The parties affected and their rights. To keep the discussion manageable, we limit discussion of parties to current and existing shareholders, lenders, and company management. Shareholders have a right to know how well management has safeguarded and managed the resources entrusted to it. Lenders and shareholders have a right to fairly presented financial statements as governed by GAAP. Management has a right to prepare the financial statements and to make decisions it believes are in the best interest of the organization.

3. The most important rights. It is the author's assessment that a stewardship function does exist and that the owners of the organization (shareholders) have a right to know how well that stewardship function is being carried out. The inability of the company to collect on the transaction (even though made by management decision) is a reflection on management's stewardship in designing systems to safeguard and efficiently use the organization's assets. Thus, the transaction is directly related to a right of the owners.

4. Alternative courses of action.

(a). Do not describe the transaction as requested by management.

(b). Account for the transaction as a separate line item in the financial statements, showing the sale and cost of goods sold but a loss on collection due to the management decision.

(c). Do not adjust the financial statements but disclose the effect of not attempting to collect the amounts related to the sale and ascribe the problem to a deficiency in the company's control system.

5. Likely consequences of each action.(a). There will likely be a consequence only if the client subsequently fails and a

lawsuit asserts that the auditor covered up mismanagement.

(b). Management will be upset and will claim that GAAP do not require such reporting and may threaten to fire the auditor. Owners, on the other hand, receive more information on the stewardship of management in maximizing the return and safeguarding their assets.

(c). Likely outcome is similar to (b).

6. Assess the possible consequences and estimate the greatest good for the greatest number. The two potential consequences from requiring disclosure or specific accounting are that (a) owners receive a more informative report on the operations of the company

and the stewardship of management and (b) management becomes disillusioned and chooses to replace the auditor. However, if all members of the profession adhere to the same standard of reporting, changing auditors will not assist management.

The potential consequences of not requiring disclosure include (a) potential lawsuit against the auditor for not disclosing material information (although the auditor may be able to defend the lawsuit by arguing that such disclosure was not specifically required by GAAP. In addition, the lawsuit may arise only if the audit client fails) and (b) the auditor retains the client. However, the acquiescence to management's wishes may set a precedent the auditor does not want to face in the future.

7. Decide on the appropriate course of action. The intent is to generate discussion of the topic by the students. The case was taken from the files of a Big 5 firm that chose not to disclose the transaction. The authors of the text believe that the stewardship function is an important concept in financial reporting and therefore believe that it, and the second standard of conduct dealing with the public interest would require the reporting of the transaction: "Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism." - The authors favor alternative (b) but believe that the process of dealing with the problem should be emphasized in class.

3-45.a. An ethical dilemma is one in which more than one course of action is apparently

required, but the individual cannot do both. In other words, there are conflicting moral duties or obligations. In this case, GAAP are not defined, and the client has the right to know the opinions of other auditors. By definition, GAAP embody the concept of general acceptance. Thus, in the absence of rules, the client is making the case that the approach advocated has general acceptance.

The problem is accentuated for the auditor because AU Sec. 411 requires the auditor, in the absence of authoritative pronouncements, to (1) reason by analogy to existing accounting principles and (2) emphasize the substance of the transaction over its form. Following AU Sec. 411 would lead the auditor to reject the approach and potentially lose the client because other auditors may find the approach to be acceptable.

b. The answer that competition leads to the acquiescence of auditors to lower ethical standards is not clear-cut. However, a number of leading accountants, such as Art Wyatt, a former member of the FASB, perceive that competition has led to an approach by which the auditors are essentially acting as client advocates and are not necessarily always acting in the public interest. Academic research (e.g., Farmer, Rittenberg, and Trompeter) also suggests that competition can significantly affect the judgments made by auditors in an experimental setting.

c. The profession has attempted to build a number of safeguards into the profession to guard against losing the public trust. The 10 generally accepted auditing standards are designed to ensure independence and due professional care in conducting audit engagements. The Code of Professional Conduct discussed in this chapter is designed to ensure attention to the public trust. Violations of the standards can lead to a suspension of the auditor's license to practice. However, it is argued that codes of conduct do not necessarily ensure the attainment of the profession's objectives unless individual practitioners accept them. The profession attempts to monitor adherence to the code through the peer review process described in the chapter.

3-46. A primary purpose of having the students complete this assignment is to have them recognize that professionals face ethical dilemmas on an on-going basis. You may choose to have the students limit their articles to those focusing on accountants and auditors or you may choose to allow for a broader approach. Examples of two articles that you could provide to your students as guidance for their selection include:

Floyd Norris, August 10, 2007, Is Fraud O.K., if You Help Just a Little? The New York Times, nytimes.com, available at http://select.nytimes.com/2007/08/10/business/10norris.html?_r=1&oref=slogin

Jonathan Weil, August 15, 2007, At Mortgage Banks, `Going Concerns,' Going, Gone, available at http://www.bloomberg.com/apps/news?pid=20601039&sid=aOmLOmdkq73k&refer=columnist_weil

3-47. a. The difference between an ‘ethical dilemma” and ‘just doing her job’ is that an ethical dilemma is a situation in which moral duties or obligations conflict; one action is not necessarily the correct action. Ms. Cooper did not view her situation as an ethical dilemma. Rather, she knew her responsibilities as an internal auditor was to investigate potential breakdowns in internal control, as well as potential fraud, and to report her findings to the audit committee and other affected parties. In a similar fashion, if an external auditor were applying the decision framework introduced in this chapter and there was uncertainty, but potential evidence of a fraud, the external auditor is obligated by both professional standards and the decision framework to further gather information until a sound judgment can be made.

b. External auditors are not considered “whistleblowers” because there are formal channels in which to report fraud or other problems with a client’s financial statements. If the external auditor concludes that a company has violated GAAP, there are three approaches to reporting that finding:

Report the findings to the audit committee with a recommendation that the financial statements be corrected.

Failing proper action by the audit committee, the auditor should issue an adverse audit opinion on the financial statements and state all the reasons for the adverse audit opinion.

If the auditor is fired by the client and the audit committee, and the client is a public company, the auditor should report all disagreements with the client to the SEC and make the GAAP violation a matter of public record.

If the audit client is a private company, the auditor should be willing to communicate the GAAP departure to the succeeding auditor (providing that the succeeding auditor asks).

c. This does represent an ethical dilemma because the amounts are not material to the financial statements, but the action is a fraud against the company (and therefore a breakdown in internal controls). The auditor has an obligation to report on significant breakdowns in internal control to management and the audit committee. Then, it is up to the company to handle the matter. The auditor is not obligated to report the finding beyond notifying the appropriate people in the company.

3-48. a. High quality decisions are unbiased, meet the expectations of users, are in compliance with professional standards, and are based on sufficient factual information to justify the decision that is rendered. For example, auditors have to make decisions about the types of evidence to gather, how to evaluate that evidence, when to gather additional evidence, and what conclusions are appropriate given the knowledge that they have gained via the evidence.

b. The risk of making an incorrect decision is incorporated into the decision-model because the auditor is required to assess the consequences of the decision. Thus, the auditor should consider the potential impact of certifying that the financial statements are fairly presented when they are not. The risk that errors exist in the accounting records is covered in the requirement that the auditor must consider the risk associated with the evidence gathering process to make support high quality decisions.

c. The decision-making model (applicable to most professions) requires that the decision-maker (auditor) has to gather a sufficient amount of persuasive information to justifiably support a high quality decision. Sensitivity analysis is an approach to examining whether additional information would affect the nature of the decision to be made. For example, if the auditor has information based on a well-formulated statistical sample, the auditor might decide that the additional cost of information to go from a 95% confidence level to a 99% confidence level might not be justified. However, if the decision is very important, such as a diagnosis of a patient’s medical condition, and it might be a life or death matter, the decision-maker might determine that a 99% confidence level is more appropriate.

` d. The auditor’s major decision is whether the financial statements are fairly presented, in all material aspects, in conformity with GAAP. If the statements contain misstatements that are not material, the auditor can so state without any serious consequences to the auditor (assuming the auditor’s assessment of what might be material to users is correctly made). But, if the financial statements contain material misstatements, the auditor would potentially be subject to lawsuits for any damages incurred by a user who reasonably relied on the financial statements in making decisions regarding investing or divesting in a company.

Cases:

3-49.a. Seeking loopholes describes an approach to accounting that assumes that if something

is not specifically prohibited (or required) it is okay (or not required). It is an approach that views accounting as a tool to be utilized by management. The intent is to manipulate to develop the most favorable picture of management that can be portrayed by the financial statements and still fall within the broad framework of GAAP. It is an approach that emphasizes the form of pronouncements rather than the substance of transactions.

The ability of an accountant to find loopholes would be valued by some clients who wish to utilize accounting as a tool, and the accountant is one with the expertise to utilize the tool to the company's benefit. However, if auditors are viewed as typically allowing their clients (or even helping their clients) work around the rules, the public will cease t place trust in the auditor’s work.

b. This is a fundamental question. Many believe that the two are inconsistent and that the auditors compromise independence whenever they aggressively seek loopholes. Others argue that there is no compromise with independence because auditors are still guided by the overall professional standards. Again, the public will place less trust on the auditor’s work if that work is viewed as helping clients aggressively seek loopholes. In the area of tax work, the PCAOB has issued a rule that prohibits registered public accounting firms from providing services related to marketing, planning, or opining in favor of the tax treatment of certain confidential transactions or based on an aggressive interpretation of applicable tax laws and regulations

c. Art Wyatt, in the article cited, makes a strong case that professionalism and fairness are intertwined. The professional is seeking the fair (accurate or in conformity with economic reality to the extent to which GAAP are capable) presentation of financial results. Professionals recognize the ultimate responsibility to the user public, not necessarily to the management that is paying them.

d. There is some anecdotal evidence that the “loophole seeking” mindset has changed since SOX. For example, the number of restatements has declined since that time. However, these situations are not made public until a serious problem is uncovered, so the extent to which the actual behavior of auditors has changed is relatively unknown. Still, SOX put into place a variety of safeguards to help prevent “loophole seeking” behavior. For example, Section 104 provides for quality inspections by the PCAOB, which should encourage high quality decision making on the part of auditors. Section 201 enhances auditor independence, which should make incentives for finding loopholes less enticing. Section 204 requires auditors to discuss sensitive issues with the audit committee, which should enhance transparency of “loophole seeking” scenarios and therefore make them less likely to occur in the first place. Finally, penalties upon both auditors and management have increased with SOX, so the downside risk of inappropriate behavior has increased.

3-50.

a. If the auditors ignore the fact that the property is significantly overvalued, they would be issuing an unqualified opinion knowing full well that the statements were not fairly stated. This could result in an expensive lawsuit by the users of the Fund of Funds financial statements and its management against the auditors.

They could tell the management of Fund of Funds what they knew about King Resources selling the property to them at inflated prices. This could result in a lawsuit by King against the auditors for disclosing confidential information without their permission.

The auditors could obtain or have the management of Fund of Funds obtain an independent appraisal of the property and use that as evidence for properly valuing the property. This is probably the best solution. It might have resulted in a lawsuit by Fund of Funds against King Resources.

b. This situation could have been avoided had the CPA firm not accepted one of the two clients that do business with each other.

c. The confidential information in the Consolidata case was obtained while doing tax work (not audit work) and was shared with other clients without the permission and to the detriment of Consolidata. That information only served the interests of the other clients but was not available to other users of Consolidata’s services.

3-51.

Following are discussion points following the ethical framework provided in the chapter. Students are not likely to identify all of the points or may come up with others, but these are the primary ones.

a. Identify the ethical issue(s).

There are two ethical issues:

1. Whether to issue an unqualified opinion based on the evidence already obtained, disclaim an opinion, or follow up on the information provided by the chairperson of the board, knowing that the client may not pay for the additional audit time spent.

2. What to tell the second client. Providing confidential information will violate the Code of professional conduct but if it is not provided, the second client may purchase Hi-Sail, which could be a bad investment, and the auditor might lose the second client.

The parties are affected and their rights are

1. Management, including the president and controller, have the right to have the audit completed on a timely and cost-effective basis and to a proper consideration of their claims.

2. The board of directors, including the chairperson, have the right to insist that the financial statements be fairly presented by management and on a timely and effective audit. The chairperson has a right to be heard and to have the auditor obtain evidence to support or contradict his claims.

3. Current and prospective creditors and investors, including the second client and any other prospective purchaser of Hi-Sail, have the right to receive fairly presented financial statements on a timely basis and to an unbiased opinion on those statements.

4. The individual auditor and audit firm have the right to be paid for services rendered and to have access to all evidence needed to form an opinion on the statements.

5. The public accounting profession has the right to expect you and your firm to uphold the Code of Professional Conduct and to take actions that enhance the general reputation and perception of the integrity of the profession.

The highest-order right is autonomy - the right to reliable information needed to make decisions. The president, controller, and chairperson of the board already know whether the chairperson's claims are valid - current and potential creditors and investors do not have this information. The fundamental purpose of the audit is to provide an independent opinion on the reliability of financial statements.

Alternative courses of action concerning the audit are the following:

1. Issue an unqualified opinion based on the evidence already obtained.

2. Disclaim an opinion or express a qualified opinion because of the uncertainties that have been raised by the chairman's claims.

3. Continue the audit and try to obtain the necessary evidence concerning the chairman's claims.

4. Hold a conference in which all three of the parties - the president, controller, and chairperson - are present and tell them you cannot continue the audit issue an opinion until they resolve the issues. Then you should obtain the necessary evidence to support the "facts" they agree to and issue an appropriate opinion. If they cannot resolve the issues among themselves, you will not be able to complete the audit.

5. Discuss the problem with appropriate members of your firm and then decide what course of action to take.

6. Withdraw from the engagement.

Concerning the second client's question, the following alternative courses of action are available:

1. Tell the second client that the chairperson had provided you with information that, if true, indicates that the financial statements as currently prepared are not fairly presented.

2. Tell the second client you need to obtain more evidence before completing the audit and to wait until the audit is completed before making any investment decision.

3. Tell the second client not to invest in this company because it is insolvent and is not a good investment.

Regarding the likely consequences of each proposed course of action concerning the audit, consider the following:

1. By issuing an unqualified opinion without further investigation, you may luck out and it may ultimately be determined that the chairperson's claims are not true. However, you may also issue an inappropriate opinion that may result in your being sued by the client and/or third parties, lose your reputation, and lose the client and other clients.

2. By disclaiming an opinion or expressing a qualified opinion, the creditors and investors will not know whether the financial statements are reliable, which will inhibit their ability to make rational decisions.

3. By continuing the audit, you may not be able to obtain the necessary evidence to form an opinion and end up issuing a disclaimer or qualified opinion. If the information is available, you will be in a good position to issue an appropriate opinion. In either case, you may not be paid for the extra time spent.

4. Holding the conference may reduce the amount of time you would otherwise need to spend trying to obtain the needed evidence to form a proper opinion, thus reducing the loss resulting from spending extra time on the audit for which you may not be paid. The president, controller and chairperson may not be able or willing, however, to resolve their differences, and you will then have to resort to one of the other alternative courses of action, which will delay the issuance of the opinion even more.

5. Discussing the problem with other members of your firm will also delay the issuance of your opinion but may result in making a better decision.

a. Withdrawing will mean that the financial statements will not be issued on as timely basis because another audit firm will likely be hired to perform the audit. The creditors and investors will then have to make decisions without the statements or delay their decisions. If another audit firm is not hired and the financial statements are issued unaudited, the creditors and investors will not know whether they are reliable, but if they were expecting an audit report and none is available, this should tell the users something about the reliability of the financial statements. If they rely on them and they are not fairly presented, bad credit and investment decisions may be made.

(Note: The actual result of this case was that the CPA firm told the client they were suspending their audit, to let them know if the management and chairperson can agree on the facts, and they would then return to complete the audit. The CPA firm never heard from that client again.)

Concerning the second client's question, (1) if you tell them the information provided by the chairperson you are giving them confidential information that other investors do not have, and you would be violating the Code of Professional Conduct. You could end up being sued by Hi-Sail or other investors. (2) If you tell the second client to wait for your opinion, you are not providing confidential information but are suggesting that it should not make a hasty decision. Because of the delay, the second client may decide not to invest and Hi-Sail may sue you. Or the second client may go ahead and buy Hi-Sail with the possibility of losing money on its investment. (3) If you tell the second client not to invest, Hi-Sail may sue you because it was not able to sell the company.

In assessing the possible consequences, including an estimation of the greatest good for the greatest number, students should determine whether the rights framework would cause any courses of action to be eliminated. In addition to the points listed above, the greatest good for the greatest number concerning the audit would indicate that the auditor should not issue an opinion until further attempts are made to determine whether the statements are fairly presented. Concluding the audit before then to cut the auditor's losses is a lower-order right than the right of creditors and investors to receive reliable information. Thus, the alternatives of issuing an unqualified opinion, a disclaimer, or qualified opinion without further investigation or withdrawing should be eliminated.

It seems that the proper course of action would be to discuss the problem with other members of your firm, which will likely lead to one of the remaining two courses of action: (1) to hold a conference followed by additional audit work or (2) to continue the audit to try to obtain the needed evidence and then to issue an appropriate opinion, even if you are not paid for the extra time.

b. Concerning the response to the second client's question, if you provide the second client with confidential information or investment advice and are sued by the client or other creditors and investors, you are more likely to be found liable because you violated the code and failed to use due professional care. You should simply tell the second client to wait for your opinion when the audit is completed before making an investment decision.

3.52.Note that this ethics project has been used in undergraduate auditing classes at the University of Wisconsin – Madison. This project was assigned approximately 5 percent of students’ grade. The project required students to complete the questions in a maximum of seven pages of double-spaced typed text. However, the project could also be completed in a group format where the questions are discussed in class, possibly as a “capstone” discussion of ethics. In that case, it may be helpful for the instructor to have students outline their answers to the questions prior to the class discussion to assure adequate preparation.

Instructors may download these articles from most on-line resources at your institution. Both of these articles are suitable for the educational level of undergraduate auditing students. The Waddock article can be found at: http://www.austincc.edu/njacobs/1370_Ethics/Ethics_Articles/Hollow_05_files/cs_client_data/17022699.pdf

The Warming-Rasmussen and Windsor article can be found at:http://www.springerlink.com/content/n63j5k7068827887/

a. Strengths of the analysis include the idea that talking about ethical issues is important, and that the analysis suggests avenues for improving ethics education. The weaknesses primarily cited by students included the “idealistic” nature of the discussion. One common theme emerged, which is that frauds and unethical behavior occurred long before formal business school education. Students often cited this fact as an unaddressed weakness in Professor Waddock’s analysis.

b. The average level of moral reasoning for the Danish auditors in the study was a p-score of 35.48, which corresponds to a conventional level of moral reasoning. However, about 37 percent of auditors in the study were in the pre-conventional moral reasoning group. Auditors in the pre-conventional group are at moral level are characterized by the phrases “doing what you are told” and “let’s make a deal”. Auditors in the conventional group are at a moral level characterized by the phrases “be considerate, nice, and kind; you’ll make friends”, and “everyone in society is obligated to and protected by the law”. Only about a third of the sample in the study achieved the post-conventional moral reasoning level, which is characterized by the phrases “you are obligated by the arrangements that are agreed to by due process procedures” and “morality is defined by how rational and impartial people would ideally organize cooperation.” Based on Kohlberg’s categories, this implies that many auditors in the

sample will be heavily swayed by client preferences, and that regulatory pressure/compliance threats will be important in affecting auditors’ judgments.

c. The arguments in Paper 1 assume that ethics can be taught, and yet the evidence in Paper 2 suggests that many auditors who have received a business school education are still operating at very low levels of moral reasoning. Therefore, students’ expressed concerns about whether ethics can really be taught in formal business school settings. Students’ discussion focused on issues including the quality and extent of exposure to ethics interventions as being important in determining whether they will be effective. Students also commented on overall ethical climates at different audit firms, and in different cultures (i.e., the Danish sample of auditors provided an avenue to discuss possible cross-cultural differences in ethical norms in a business setting).

d. Students completing this project provided many examples of possible dilemmas. Common examples included concerns about client pressure on difficult accounting issues, independence issues, the relationship between tax and audit services, and interpersonal dynamics (including age and gender issues, and concerns about how to handle the inappropriate judgments of colleagues). In terms of plans for handling the situation, any reasonable plan was deemed appropriate for purposes of assigning points. However, plans that incorporated the ethical decision-making frameworks described in the chapter were considered superior. Regarding anticipated outcomes, students expressed concerns about their own welfare (pay, performance, job satisfaction, and job retention), and they also discussed the effects on other stakeholders (clients, shareholders, bankers, and society in general).

FORD MOTOR COMPANY ANDTOYOTA MOTOR CORPORATION:FORD MOTOR COMPANY: ETHICS JUDGMENTS

1. This question asks students to make their own decision about whether the provision of other non-audit services might compromise the independence, or perception of independence, of PricewaterhouseCoopers from Ford management. The steps in the decision analysis framework in Exhibit 3.1 include:

Step 1: Structure the audit problem. Considerations that students may include are:o Who are the relevant parties to involve in the decision process? The relevant decision-

making parties are limited to the audit committee, but that committee should consider the actions of decisions of management and PricewaterhouseCoopers.

o What are the feasible alternatives? There are two alternatives: (1) the audit firm is independent of Ford, or (2) the audit firm is not independent of Ford. Given that the Sarbanes-Oxley Act requires that the audit committee approve non-audit services prior to their conduct, it seems logical to conclude that the audit committee’s belief is that such services do not compromise the audit firm’s independence.

o How should the audit committee evaluate the alternatives? The audit committee should evaluate the alternatives in terms of both independence in fact, e.g., whether Ford and the audit firm have complied with applicable restrictions on non-audit fees as detailed in the Sarbanes-Oxley Act, and independence in appearance, e.g., whether an informed user of the financial statements would conclude that the non-audit services provided are inconsequential enough to not warrant concern.

o What are uncertainties or risks? The primary risk that Ford’s audit committee faces is that it may decide that independence in fact and/or appearance are not impaired, when in fact there is an impairment. The most likely scenario would be that while there is no problem with independence in fact, there may be a problem with independence in appearance.

o How should the problem be structured? The audit committee will likely structure the problem through a direct conversation among its members, with insights gained by consulting industry comparisons.

Step 2: Assess consequences of decision. The consequences of deciding that independence in fact is not impaired, when it is actually impaired, is that the SEC may sanction the company for purchasing disallowed services. The consequence of deciding that independence in appearance is not impaired, when it is actually impaired, is a loss of confidence on the part of investors.

Step 3. Assess risks and uncertainties. The primary uncertainty arises from not knowing how investors and analysts will view the purchase of this magnitude of non-audit services from PricewaterhouseCoopers.

Step 4. Evaluate information/audit evidence-gathering strategies. Since the level of non-audit services and tax services purchased from PricewaterhouseCoopers has declined, the alternative of deciding that independence in either fact or appearance is not impaired seems the most logical. However, the auditor could gather evidence about industry norms in this regard.

Step 5. Conduct sensitivity analysis. If management were to inform the audit committee that a large increase in non-audit services is required for the upcoming year, the audit committee may compare that amount with industry norms to determine a threshold amount above which users may perceive an impairment of independence.

Step 6. Gather information/audit evidence. The audit committee will gather information on industry practices in the relative size of non-audit services to the total audit fee.

Step 7. Make decision. The audit committee will meet to decide between the two alternatives. Given the reduced magnitude of non-audit and tax fees, the decision actually reached in this case seems reasonable.