Question 1
The following are situations that may violate the Code of Professional Conduct. Assume, in each case, that the CPA is a partner. Discuss whether the facts in any of the situations indicate violations of the Code of Professional Conduct. If so, identify the nature of the violation(s).
A. Contel, CPA, advertises in the local paper that his firm does the audit of 14 of the 36
largest community banks in the state. The advertisement also states that the average
audit fee, as a percentage of total assets for the banks he audits, is lower than any
other CPA firms in the state.
B. Davis, CPA, sets up a small loan company specializing in loans to business executives
and small companies. Davis does not spend much time in the business because he
spends full time with his CPA practice. No employees of Davis’s CPA firm are
involved in the small loan company.
C. Elbert, CPA, owns a material amount of stock in a mutual fund investment company,
which in turn owns stock in Elbert’s largest audit client. Reading the investment
company’s most recent financial report, Elbert is surprised to learn that the
company’s ownership in his client has increased dramatically.
D. Able, CPA, owns a substantial limited partnership interest in an apartment building.
Frederick Marshall is a 100% owner in Marshall Marine Co. Marshall also owns a
substantial interest in the same limited partnership as Able. Able does the audit of
Marshall Marine Co.
E. Baker, CPA, approaches a new audit client and tells the president that he has an idea
that could result in a substantial tax refund in the prior year’s tax return by application of a technical provision in the tax law that the client had overlooked. Baker
adds that the fee will be 50% of the tax refund after it has been resolved by the
Internal Revenue Service. The client agrees to the proposal. (15 marks)
Sample Answer
The discussion below analyzes whether the given situations indicate violations of the AICPA Code of Professional Conduct (the Code), assuming the CPA is a partner.
A. Contel, CPA: Advertising
The facts in situation A do not necessarily indicate a violation of the Code, provided the advertisement is not false, misleading, or deceptive.
Rule: The Code allows advertising that is not false, misleading, or deceptive. CPA firms can advertise their services, expertise, and accomplishments.
Analysis:
Stating that the firm audits "14 of the 36 largest community banks in the state" is a statement of fact or an enforceable claim, which is generally permissible if truthful and verifiable.
Stating that the "average audit fee, as a percentage of total assets... is lower than any other CPA firms in the state" is also a claim that must be factual and verifiable.
Potential Violation: The only way this would be a violation of the Acts Discreditable Rule (or the Advertising and Other Forms of Solicitation Rule under the old Code framework, now falling under the Integrity and Objectivity Rule and Acts Discreditable Rule) is if the claims made regarding the number of banks or the lower average audit fee are false, misleading, or deceptive. Assuming the statements are truthful, there is no violation.
B. Davis, CPA: Other Business
The facts in situation B do not necessarily indicate a violation of the Code.
Rule: The Code generally allows CPAs to engage in other occupations concurrently with their CPA practice, provided the CPA remains in compliance with all relevant rules of conduct.
Analysis:
Davis owning and operating a small loan company is permissible as long as the CPA maintains Integrity and Objectivity and avoids conflicts of interest that would impair professional judgment.
Since Davis is full-time in his CPA practice and no CPA firm employees are involved in the loan company, the risk of confusion or misuse of CPA firm resources is mitigated.
Potential Violation: The small loan company could pose a violation if it engages in transactions with his CPA clients that would impair Independence (e.g., if the loan company loans money to an audit client of the CPA firm, it could create a direct or material indirect financial interest, or a debtor-creditor relationship, impairing independence). Given the limited facts, no violation is confirmed, but the potential exists.
C. Elbert, CPA: Independence (Indirect Financial Interest)
The facts in situation C indicate a violation of the Code concerning Independence.
Rule: A CPA must be independent in fact and appearance when performing attest services (like an audit). A covered member's (which includes a partner) direct or material indirect financial interest in an audit client impairs independence.
Analysis:
Elbert owns a material amount of stock in a mutual fund (an investment company).
The mutual fund, in turn, owns stock in Elbert’s largest audit client.
The interest in the audit client is indirect because it is held through the mutual fund.
An interest in an audit client held through a mutual fund is considered a material indirect financial interest and impairs independence if:
The covered member (Elbert) owns a material amount of the mutual fund shares, AND
The mutual fund has the ability to exercise significant influence over the client. (This is generally the primary test, but sometimes the AICPA's interpretation also focuses on the size of the holding in the mutual fund).
However, the most common interpretation regarding mutual funds is: A covered member's interest in a diversified mutual fund is generally considered an immaterial indirect financial interest as long as the covered member does not have the ability to supervise or participate in the investment company's investment decisions.
Since Elbert owns a material amount of stock in the mutual fund, and the fund's ownership in the client has increased dramatically (suggesting a non-trivial investment), this situation creates a significant risk that the interest is considered a material indirect financial interest, thus impairing independence. The fact that Elbert is "surprised" suggests he is not involved in the investment decisions, which may save independence, but the materiality of his interest in the fund makes the risk of violation high. Based on the material ownership and the indirect link to the largest client, a violation of the Independence Rule is the most likely conclusion.