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;
or
4. 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.com
www.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 AND
TOYOTA 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.