Professional Ethics & Independence

Why this topic matters

Area I of Auditing and Attestation (AUD) — Ethics, Professional Responsibilities and General Principles — is 15–25% of the section. Most of it tests the American Institute of Certified Public Accountants (AICPA) Code of Professional Conduct, with independence rules from the Securities and Exchange Commission (SEC), the Public Company Accounting Oversight Board (PCAOB), and the Government Accountability Office (GAO) layered on top for public companies and government audits.

Structure of the AICPA Code

• Part 1: members in public practice. Part 2: members in business. Part 3: other members (retired, unemployed).
• Principles: responsibilities, the public interest, integrity, objectivity and independence, due care, and scope and nature of services.
• Rules (enforceable): independence, integrity and objectivity, general standards, compliance with standards, accounting principles, confidential client information, contingent fees, acts discreditable, advertising, commissions and referral fees, and form of organization and name.
• Interpretations explain how the rules apply to specific situations.

The conceptual framework approach

When no specific rule or interpretation addresses a situation, members apply the conceptual framework:

1. Identify threats to compliance.
2. Evaluate whether each threat is at an acceptable level.
3. Apply safeguards to eliminate threats or reduce them to an acceptable level. If safeguards cannot, decline or withdraw from the engagement.

Threat	Example
Self-review	Auditing records or systems the firm prepared or designed
Advocacy	Promoting a client's shares or representing the client in a dispute
Adverse interest	Threatened or actual litigation between the firm and the client
Familiarity	Long association with the client; a close relative in a key position at the client
Management participation	Taking on management responsibilities such as authorizing transactions
Self-interest	A financial interest in the client, or fee dependence on one client
Undue influence	Pressure from the client to accept an accounting position, or threats to replace the firm

Safeguards may be created by the profession or regulation, implemented by the client, or implemented by the firm (for example, an engagement quality review or rotating personnel).

Independence — who must be independent?

Independence is required for attest engagements: audits, reviews, and examinations and reviews under the attestation standards, and agreed-upon procedures engagements. It is not required for compilations (the report must disclose the lack of independence), preparation engagements, tax work, or consulting.

Covered members include:

• Individuals on the attest engagement team, and those who can influence it (including the chain of command).
• Partners and managers who provide 10 or more hours of nonattest services to the client.
• Partners in the office where the lead attest partner primarily practices.
• The firm itself, including its benefit plans, and entities the firm controls.

Immediate family members (spouse, spousal equivalent, dependents) are treated the same as the covered member. Close relatives (parents, siblings, nondependent children) impair independence only in specific cases — for example, a key position at the client or a material financial interest the member knows about.

Financial interests and relationships

Relationship	Effect
Any direct financial interest by a covered member or immediate family (even one share)	Impaired — materiality is irrelevant
Material indirect financial interest (for example, through a mutual fund with a large holding)	Impaired; immaterial indirect interests are allowed
A partner or professional employee (not a covered member) owning more than 5% of the client	Impaired
Loans from the client to a covered member	Impaired, except permitted loans below
Joint closely held investment material to the member	Impaired
Serving as a director, officer, promoter, or trustee of the client's pension plan	Impaired
Former client employee joining the firm	Must not participate in the attest engagement covering the period they were employed by the client

Permitted loans from a financial institution client (normal terms)

• Automobile loans and leases collateralized by the vehicle.
• Loans fully collateralized by cash deposits at the institution, including cash surrender value of life insurance.
• Credit cards and overdraft reserves with aggregate outstanding balances of $10,000 or less (paid by the due date).
• Grandfathered loans: home mortgages and other secured loans obtained before the lender became a client (or before the person became a covered member), kept current.

Nonattest services

A firm can provide bookkeeping, tax, and advisory services to a nonissuer attest client if all the general requirements are met:

• The member does not assume management responsibilities (authorizing transactions, having custody of assets, deciding which recommendations to implement, designing internal control for the client).
• The client designates an individual with suitable skill, knowledge, or experience (not necessarily expertise) to oversee the service, evaluate its adequacy, accept responsibility, and make management decisions.
• The understanding (objectives, services, client acceptance of responsibilities) is documented in writing before the service is performed.

When several nonattest services are provided, the firm must also consider the cumulative effect of threats. For issuers, the Sarbanes-Oxley Act (SOX) prohibits most nonaudit services outright — bookkeeping, financial information systems design, appraisal and valuation, actuarial services, internal audit outsourcing, management functions, human resources, broker-dealer and investment services, legal and expert services — and requires audit committee pre-approval of permitted services such as tax.

Other key rules

• Contingent fees: prohibited for any client for which the firm performs an audit, review, examination, or compilation (when a third party will rely on it and the report doesn't disclose lack of independence), and for preparing an original or amended tax return. Permitted for representation in a tax examination and when fees are set by courts or public authorities.
• Commissions and referral fees: commissions prohibited for attest clients; otherwise disclose. Referral fees must be disclosed.
• Confidential client information: may not be disclosed without consent, except for a subpoena or summons, peer review, an AICPA or state ethics investigation, or compliance with laws.
• Acts discreditable: retaining client records after a request (client-provided records must be returned even if fees are unpaid), discrimination, negligence in preparing statements, and failing to follow government audit requirements.
• Integrity and objectivity: apply to all services — members may not knowingly misrepresent facts or subordinate their judgment.

Issuer audits — additional rules

• Partner rotation: the lead and concurring partners rotate after 5 years, with a 5-year cooling-off period.
• Cooling-off for client employment: a one-year period before a member of the audit team can become the client's chief executive officer (CEO), chief financial officer (CFO), controller, or equivalent.
• Audit committees must pre-approve all audit and permitted nonaudit services.
• Government audits under Government Auditing Standards (the Yellow Book) apply their own conceptual framework and prohibit certain nonaudit services.

How it is tested

• Decide whether a relationship or service impairs independence.
• Identify the threat in a scenario and an appropriate safeguard.
• Apply the contingent fee, commission, and confidentiality rules.
• Contrast AICPA rules with SEC and PCAOB rules for issuers.