Kirsten Hill
ACCT 5557
April 11, 2015 (original)
May 5, 2015 (revised)

Independence

Certified Public Accountants (CPA) perform many important services for individuals and companies, public or private. One essential assurance engagement a CPA performs is an audit of financial statements. Audits of financial statements play a vital role in the business industry. An auditor can reasonably assure investors, lenders, management, and stakeholders that the financial statements are free from material misstatement and accurately reflect the accounting of the entity for that period of time. However, an auditor cannot provide an absolute assurance due to the inherent limitations of an audit.
Generally, an audit includes the following steps: overall audit planning, assess control risk, perform tests of controls, perform substantive tests of account balances, and finally complete the audit (Kerr, Elder and Arens). In the overall audit planning stage, the CPA has to obtain an understanding of the potential client’s business and establish if the CPA Firm and its associates are independent. These two steps must be done before the CPA Firm can decide to accept the audit engagement. There are many important factors, steps, issues, knowledge, just to name a few that go into an audit but this paper will focus on the issue of independence.
One of the principles listed in the AICPA Professional Code of Conduct states that an auditor in public practice must be independent in appearance and fact (AICPA Standards). As stated previously, the initial step in the audit process is to perform overall audit planning. Within this first step the Firm and its associates have to decide if they are independent in regards to the potential client. The term associate will include all of the following entities and/or individuals; CPA Firm, the CPA employed by the CPA Firm, a partner or equivalent or manager that provides more than ten hours of non-attest services to the client, a partner or equivalent that works at this Firm’s location where the audit engagement team is located, any individual that is in a position to potentially influence the audit engagement, and professional employees of the CPA Firm (Firm).
An associate or Firm cannot accept an audit engagement with a client unless the associate and Firm are independent from the audit client (client). This may seem like an impossible task to ensure that some associates of a firm and all associates assigned to the audit engagement are independent in fact and appearance but this paper will analyze all possible threats to independence and mitigate these threats.
Most importantly, what is independence? And what governing board defines independence for this particular client’s audit?
First, let’s answer the latter question. Since this client is a private entity, even though in the future the client plans on going public, the governing board that the associates will follow is the AICPA independence rules and applicable standards. Although, the client does want to become a public company in a few years. Once the client goes public the governing board that the associates will follow will be the PCAOB. When PCAOB has different standards compared to the AICPA, these differences will be discussed when mitigating the possible threats. In most cases, PCAOB will have stricter requirements than AICPA will have.
Now the former question, how independence is defined in the AICPA auditing standards. The definition of independence can be broken out into two parts under the AICPA guidelines. Associates have to be independent in fact and in appearance. “In appearance” means an associate needs to appear independent to a third party. This third party isn’t just someone off the street looking into an unknown situation. This third party does not make assumptions about the situation because (s)he knows the situation, has been given any needed knowledge, and knows the safeguards that have been implemented to mitigate possible independence threats. Given all the information, this third party needs to “reasonably conclude that the integrity, objectivity, and professional skepticism” of the associate is not compromised (AICPA).
Independence in fact is a state of mind that the associate needs to maintain throughout the audit process. The associate needs to be able to act with professional judgement and integrity. Plus the associate should exercise professional skepticism and objectivity without being influenced by the client or outside forces (AICPA).
AICPA has set guidelines for an associate to assess independence and if independence is a problem then there are ways to eliminate or mitigate possible threats to independence to an acceptable level. Thankfully, a CPA Firm doesn’t just have to turn away potential audit clients due to independence issues because the AICPA allows these threats to independence to be mitigated. Firms would potentially lose a lot of revenue if this was not the case.
What is considered an “acceptable level” under the AICPA guidelines? Specifically, it is a “level at which a reasonable and informed third party who is aware of the relevant information would be expected to conclude that a member’s independence is not impaired” (AICPA Standards). An associate and the Firm must mitigate possible threats to independence to an acceptable level. During this paper there will be many examples of possible threats to independence. These threats will be downgraded to an acceptable level by implementing safeguards to mitigate the threat. Analysis of threats to independence and implemented safeguards will be documented as per the AICPA guidelines.
Based on the AICPA standards there are 7 categories that possible threats can fall into. In fact a threat could be placed into several categories. These categories are “adverse interest, advocacy, familiarity, management participation, self-interest, self-review, and undue influence” (AICPA Standards). During the analysis of each issue, each possible threat category will be explored.
Once possible threats are analyzed, then potential safeguards that can mitigate the threat will be reviewed. There are three broad categories that safeguards can fall into and they are policies and/or procedures implemented by the Firm, policies and/or procedures implemented by the client (although you can’t solely rely on these safeguards) and standards and/or laws created by profession, legislation, or regulation (AICPA Standards). Each possible safeguard described above will be analyzed for the effectiveness of mitigating the threat to an acceptable level.
First, let’s start out with some information about the CPA Firm that I work for. This Firm has seven partners and three offices located throughout Idaho. The particular location that I work at is located in Pocatello, Idaho. The managing partner, Ken Smith, has announced an exciting potential opportunity for our firm. Our Firm has been approached by local company and this company wants us to perform its audit of financial statements. The managing partner wants me to decide if there are any issues regarding independence with this potential client and if there are issues can the issues be mitigated to an acceptable level. The managing partner stresses how important this client could be to our firm but understands the Firm cannot take the client if there are threats to independence that can’t be mitigated.
Throughout the meeting, there were several issues brought up that might or might not effect independence. The general manager wants each possible issue that threatens independence to be mitigated, if possible. The analysis for each issue should be thoroughly researched and the analysis should be documented for the work papers to give supporting evidence of how each issue was mitigated or did not affect independence. Furthermore, the general manager wants the Firm to have a more stringent policy than the AICPA guidelines to ensure the Firm is always in compliance with independence. With these guidelines set, the final analysis will be able to answer the managing partner’s question of whether to take the engagement or not.
There are 11 possible threats to independence in regards to the potential audit client. These 11 threats are listed in outline form below. Once listed, the threat will be analyzed and then safeguards that need to be implemented to mitigate such threats will be documented. The goal is to mitigate each threat to an acceptable level so that the Firm can accept this audit engagement. The information is documented as follows: 1. Possible threat to independence: The audit fee is estimated to be $100,000, which is significant for the Firm. a. Possible category of threat: Self-interest b. The managing partner has stated that the audit fee for this client would be significant to the Firm. Significant indicates the Firm or an associate may heavily rely on the revenue from this single audit client. This can diminish the Firm’s or associate’s independence, as well as diminish integrity and objectivity as defined in the AICPA Professional Standards. The Firm must implement the following procedures to continually address this issue and mitigate any possible threats to independence: i. Always discuss and assess the audit client’s significance to the Firm in the planning stage of the audit engagement. 1. An audit client will be assessed as significant if the following are true: a. The estimated audit fee to be received from an audit client is 15% or more of Firm’s yearly fee revenues. 15% is a figure suggested by IESBA for a public entity (Hansend). This Firm will use this as a guideline. ii. If the audit client is considered significant to the Firm then the Firm will implement the following procedures: 2. Assign a second review partner who is not currently practicing at the same office the audit engagement will be performed and who has not previously been associated with the audit engagement. b. Second review partner will also re-review the personnel assigned to the audit engagement. 3. The overall review partner will not be the same each year the audit engagement is performed. 4. The Firm expects all associate’s engaged in this audit to perform their job by the standards listed in the AICPA Code of Conduct. 5. The audit engagement will have an external peer review every 2nd year. c. This is not a contingent fee or commission so under PCAOB this fee is allowed. The Firm will continue to follow all guidelines listed above. 2. Possible threat to independence: The new client wants to become a public entity in three years’ time. d. Possible categories of threats: SEC independent threats in regards to a public entity e. The Firm or any associates will not be able to audit this client once the client becomes a public entity. There is not a way to mitigate this independence threat based on SEC regulations and the governing PCAOB board. f. At this point in time there is no possible threat to independence under the AICPA standards. 3. Possible threat to independence: The new client wants our Firm to help them develop their internal controls. g. Possible categories of threats: Management participation and undue influence h. The Firm can help develop the new audit client’s internal controls and not have an issue with independence as long as the following guidelines are adhered to: iii. The Firm or associate will not assume or appear to assume management responsibility of the audit client. iv. The Firm or associate can only recommend internal controls that should be implemented but the actual implementation decision must be made by audit client. v. The associate cannot be an employee or member of management of the audit client. vi. The Firm or associate cannot perform functions of internal control on an ongoing basis. vii. The Firm or associate cannot report to the governing board or audit committee because that is the responsibility of the audit client. viii. The Firm or associate that helped design the internal controls for the audit client cannot be responsible for or work on the overall audit plan of the audit client. To increase this safeguard, the Firm has decided that any associate that works on the internal controls of an audit client will not be allowed to work on the audit engagement as well. ix. The Firm or associate must detail all non-attest services to be performed, list any limitations of the engagement due to impairment of independence, outline audit client’s responsibilities, and finally audit client must accept terms previously listed. i. The audit client must also do the following so that independence is not impaired: x. The audit client must select an employee that can oversee the design, implementation, and monitor the internal control function. This employee should be knowledgeable and have experience with internal control functions. xi. The audit client must be able to provide the Firm with important details pertaining to the needed internal controls (i.e. scope of work expected and/or objectives of internal control the audit client expects accomplished). xii. The audit client must be able to evaluate adequacy and results of the information obtained by the associate in regards to internal control and be able to make decisions based on the information obtained. j. The Firm could not design internal controls and audit the firm if the client was a public company. This would follow PCAOB guidelines. 4. Possible threat to independence: The CEO and CFO of the new client are very good friends with the managing partner and they play golf on a weekly basis. k. Possible categories of threats: Familiarity and undue influence l. This may cause an issue of impaired independence for the Firm because the managing partner clearly has a close relationship with the CEO and CFO of the potential new audit client. The issue is that the managing partner can become too sensitive to the new audit client’s business interests or too compliant of client’s financial statements. m. The Firm will implement the following to mitigate these issues: xiii. The managing partner cannot be in a position to influence the audit in any way. Based on this the managing partner needs to change to a different work location than the location that the audit engagement will be performed. xiv. The managing partner cannot manage from afar the location that is performing the audit for the client. xv. No associate can accept a gift or offer a gift to the audit client. Even though, AICPA allows some acceptable forms of gift giving or gift accepting based on whether the gift is considered reasonable given the circumstances. xvi. No associate will accept any form of entertainment or offer any form of entertainment to the audit client. Even though, AICPA allows some acceptable forms of entertainment based on whether the entertainment is considered reasonable given the circumstances. n. Under PCAOB this could be construed as a gift if the client is paying for the golf games or they take turns paying for the golf games. This would impair independence under PCAOB even if the Firm was made aware of the situation. xvii. To mitigate this threat under PCAOB, no associate will accept any form of entertainment or offer any form of entertainment to the audit client. 5. Possible threat to independence: The CEO’s, CFO’s, and managing partner’s children go to school together and are good friends. o. Possible category of threat: Familiarity p. Under the AICPA rules, dependent children are included as a covered member of the associate. But the children do not meet any of the other guidelines that could cause an issue with the Firm’s independence. Reasons are listed below: xviii. None of the children hold a key position with either the Firm or the audit client. xix. None of the children are able to influence the financial statements or the audit process. xx. None of the children own a significant portion of the Firm or the audit client. q. Based on the above information there is no threat to independence due to the fact that the children are friends and go to school together. r. The above information holds true under PCAOB as well as under AICPA. 6. Possible threat to independence: The Firm has been performing bookkeeping services for the new audit client for several years. s. Possible categories of threats: Self-review, management participation, and undue influence t. The Firm can continue to perform bookkeeping services for the new client and not have an issue with independence as long as the following guidelines are adhered to: xxi. The audit client must take responsibility for the resulting information provided by the associate. xxii. The audit client must provide all accounting information to the associate so the associate can perform bookkeeping services. xxiii. The audit client must approve all classification of accounts. xxiv. The Firm or associate must detail all non-attest services to be performed, list any limitations of the engagement due to impairment of independence, outline audit client’s responsibilities, and finally audit client must accept terms previously listed. u. The Firm would still be able to perform bookkeeping services and not impair independence under PCAOB as long as if followed the above guidelines. 7. Possible threat to independence: The Firm prepares the entity’s tax return as well as personal tax returns for the entity’s top management. v. Possible categories of threats: Self-review, management participation, and undue influence w. The Firm can continue to prepare taxes for the new audit client and not have an issue with independence as long as the following guidelines are adhered to: xxv. The audit client must take responsibility for the final tax returns prepared by the associate. xxvi. The audit client must provide all accounting information to the associate so the associate can prepare the tax returns. xxvii. The Firm or associate must detail all non-attest services to be performed, list any limitations of the engagement due to impairment of independence, outline audit client’s responsibilities, and finally audit client must accept terms previously listed. x. Under PCAOB, the Firm will not provide tax services to financial managers of the client or provide confidential or aggressive tax transactions for the client. Any other tax services provided to client’s employees must be approved by the client’s audit committee. The Firm will be able to continue preparing tax returns as long as the services do not provide confidential or aggressive tax transactions. 8. Possible threat to independence: The managing partner’s son works for the new audit client on the client’s production line. His son also owns shares in the company as part of the employee stockholder plan. y. Possible categories of threats: Familiarity and undue influence z. In this particular issue, the associate that threatens the Firms independence is the managing partner. Otherwise, it would apply to any associate who has this same or similar issue. {. The independence of the Firm would be impaired if an associate has an immediate family member who works for an audit client in a key position and owns shares in the audit client’s company. Immediate family includes an associate’s spouse or equivalent and dependent(s). Dependents do not have to be genetically related. xxviii. Does the Firm need to implement policies and procedures based on the managing partner’s son? 6. First issue: does the managing partner’s son work in a key position? c. Not likely since he works on the production line. So key position is not an issue with the son. 7. Second issue: does the managing partner’s son owning shares of the company effect the Firm’s independence? d. Based AICPA guidelines, the son can contribute to an employee benefit plan as long as all employees in comparable positions are also offered the same benefit. The managing partner said that his son has not special benefits packages. So this is not a threat to independence. 8. Based on the above information the Firm does not have a threat based on the managing partner’s son. So no specific safeguard needs to be implemented to mitigate this issue. xxix. Safeguards to be implemented so that independence is not threatened in the future: 9. This Firm will not allow an associate’s immediate family to invest in a share based compensation plan or nonqualified deferred compensation plan. If the immediate family member is offered such investments then the immediate family must sell the investment immediately. 10. The Firm will not allow an associate’s immediate family to own more than 5% of the audit client’s outstanding equity shares or any other ownership interests. |. Under PCAOB, this is not an issue for independence. Although, the Firm will implement the safeguards stated above in item ii. 9. Possible threat to independence: The managing partner’s father-in-law is the director of the new client’s internal audit department. }. Possible categories of threats: Familiarity and undue influence ~. Under the AICPA Code of Professional Conduct the managing partner’s father-in-law is not considered immediate family because the father-in-law is not a spouse, equivalent to spouse, or dependent. But the father-in-law would be considered a close relative because the managing partner is married to the father-in-law’s daughter. . Furthermore the father-in-law, to cause an impairment on independence, needs to be an employee in a key position (key position is defined as a position that has a significant role in accounting and/or preparing financial statements) that has a direct effect on the financial statements. xxx. In this case the father-in-law does hold a key position at the audit client’s company but this position does not have a direct effect on the financial statement so this is not an issue that the Firm needs to mitigate. . Under PCAOB, this is not an issue because the father-in-law is not immediate family. 10. Possible threat to independence: The new client’s CFO will be retiring in two years and one our staff CPA might get the job. . Possible categories of threats: Self-interest, undue influence, familiarity, and management participation . When can this possible threat arise? When an associate of the Firm intends to seek employment with an audit client or has received an offer of employment from an audit client. . Safeguards to implement so that independence is not impaired due to an associate seeking employment with an audit client or an audit client seeking to hire an associate: xxxi. Firm implemented policies and procedures: 11. An associate must notify a partner in the Firm if the associate is considering going to work for an audit client or has received an offer of employment. 12. This associate will have to immediately stop working on an audit of financial statement for that particular client the associate is seeking work or has an offer from. If the associate rejects the offer of employment then the associate may then continue working on client’s audit again. 13. Any associate that discovers that another associate is seeking employment or has received an offer with an audit client should immediately tell a partner in the Firm. xxxii. Safeguards implemented by audit client: 14. An audit client should notify a partner in the Firm performing their audit to let the Firm know that the client is interested in hiring an associate of the Firm. . Safeguards to implement so that independence is not impaired due to an associate who does accept a key position with an audit client (key position is defined as a position that has a significant role in accounting and/or preparing financial statements): xxxiii. Safeguards implemented by the Firm 15. If the Firm owes the associate any money, then the amount owed cannot be material to the Firm. Examples of money’s owed are vacation payout or vested retirement benefits. 16. The associate will not remain or appear to remain in a position that could influence the Firm in any way once the associate begins working for the audit client. 17. The Firm will review and mitigate possible further threats to independence if the former associate becomes part of the audit engagement in the audit client’s company. This could even remain an issue for future audit engagements. . The above rules still hold true under the PCAOB guidelines. 11. Possible threat to independence: Some of the Firm’s employees at other offices own non-voting preferred stock in the potential new client. . Possible category of threat: Self-interest . Which associate at the Firm does it apply to? All associates who own a direct financial interest in this audit client with no regard to materiality or who own an indirect material financial interest in this audit client. . Safeguards to implement so that independence is not impaired due to an associate owning a material indirect or a nonmaterial direct financial interest in this audit client: xxxiv. No associate of this Firm located at any location can own material or nonmaterial indirect or direct financial interest in any audit client of the Firm’s. xxxv. If a new client is accepted and an associate has this issue, the associate will have to immediately sell his/her ownership in the client so that independence is not affected. . Under PCAOB these particular employees are not covered members thus they do not affect the Firms independence. Although, the Firm will follow the safeguards listed in item c above.

In conclusion, every issue that the managing partner brought up that could possibly cause a threat to our independence has been mitigated with safeguards. Once each threat is mitigated with the documented safeguards, the threat level will then be lowered to an acceptable level. Based on this assessment, the Firm can accept audit engagement of the client.
On the other hand, when this client becomes a public entity we will no longer be able to audit them. Our independence would be impaired under PCAOB and PCAOB does not allow a way to mitigate that issue. The Firm will still be able to provide valuable consulting services to them.

Bibliography

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