Accounting Chapter 4 Homework Will Kpmg Decide That More Lucrative Only

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Ethical Obligations and Decision Making in Accounting, 4/e 1

Chapter 4 Discussion Questions

Suggested Discussion and Solutions

1. In our discussion of the KPMG professional judgment framework, we pointed

out that biased judgments can be made because of judgment tendencies. One such

tendency that was not included in the framework is self-serving bias. Explain

what you think this means and how it might influence audit judgment.

A self-serving bias is any cognitive or perceptual process that is distorted by the need to

maintain and enhance self-esteem, or the tendency to perceive oneself in an overly

favorable manner. In social psychology, the self-serving bias is people’s tendency to

attribute positive events to their own character but attribute negative events to external

factors; it is considered a common type of cognitive bias.

2. Explain the threats to professional skepticism that might influence audit

judgment.

Skepticism is an important part of independence, due care, and objectivity. Thus, any

threats to one of those will also be a threat to skepticism. The threats listed in Exhibit 4.2

can be threats to skepticism as well as independence. The management participation

threat and self-review threat would tend to dampen skepticism as the CPA would be

preparing and reviewing her own work. The advocacy, familiarity, and financial self-

interest threats would have the CPA willing to take the first explanation from the client

Extended Discussion

Ethical Obligations and Decision Making in Accounting, 4/e 2

The Institute of Chartered Accountants in England and Wales (ICAEW) provides the

following guidance on threats to independence.1

The threats

The framework identifies the following general categories of

threats to independence:

Self–interest threat

This occurs when the audit firm or a member of the audit team could

benefit from a financial interest in, or other self-interest conflict with,

an audit client. Examples of circumstances that may create this threat

include, but are not limited to:

•

a direct financial interest or material indirect financial interest in

an audit client;

•

a loan or guarantee to or from an audit client or any of its

directors or officers;

•

undue dependence on total fees from an audit client;

Self–review threat

This occurs when the audit firm, or an individual audit team

member, is put in a position of reviewing subject matter for

which the firm or

individual was previously responsible, and

which is significant in the context of the audit engagement.

Examples of circumstances that may create this threat include:

Ethical Obligations and Decision Making in Accounting, 4/e 3

audit engagement.

Advocacy threat

This occurs when the audit firm, or a member of the audit team,

promotes, or may be perceived to promote, an audit client’s position

Familiarity threat

This occurs when, by virtue of a close relationship with an audit client, its directors,

officers or employees, an audit firm or a member of the audit team becomes too

sympathetic to the client’s interests. Examples of circumstances that may create this

threat include:

Intimidation threat

This occurs when a member of the audit team may be deterred from acting

objectively and exercising professional skepticism by threats, actual or perceived,

from the directors, officers or employees of an audit client.

Examples of circumstances that may create this threat include:

Ethical Obligations and Decision Making in Accounting, 4/e 4

magnitude will depend on the circumstances, and therefore a considered assessment will

require the application of judgement. It is therefore impractical and inappropriate to

suggest that any list of threats identified constitutes a complete list. The judgement of

3. Explain the safeguards that can be used to reduce or eliminate threats to audit

independence.

There are the three broad categories of safeguards that help eliminate or reduce threats to

audit independence. They are

1. Safeguards created by the profession, legislation, or regulation. In addition to the

2. Safeguards implemented by the attest client. The client’s tone at the top and

commitment to governance structure, including an active audit committee, is of

upmost importance.

Extended Discussion

The Institute of Chartered Accountants in England and Wales (ICAEW) provides the

following guidance on threats to independence.2

The safeguards

The purpose of safeguards is to reduce the impact of threats to independence

to a level that does not impair the auditor’s opinion-forming process in fact, or

in the perception of a reasonable and informed observer.

Ethical Obligations and Decision Making in Accounting, 4/e 5

Safeguards fall into three broad categories:

•

created by the profession, legislation or regulation;

Safeguards created by the profession, legislation or regulation

Include the following:

•

educational, training and experience requirements for entry into the profession;

•

continuing education requirements;

•

professional standards and monitoring and disciplinary processes;

•

external review of an audit firm’s quality control system; and

•

legislation governing the independence requirements of the audit firm.

Safeguards within the audit client

Include the following:

•

when the audit client’s management appoints the firm, persons other than

Safeguards within the audit firm

These may include firm-wide safeguards such as policies and procedures to

ensure:

•

quality control of audit engagements;

Ethical Obligations and Decision Making in Accounting, 4/e 6

•

designation of a member of senior management as responsible for overseeing the

adequate functioning of the safeguarding system;

•

arrangements to ensure physical and virtual separation of staff involved in

conflicting transactions;

•

operation of disciplinary mechanism to promote compliance with policies and

•

disclosing to the audit committee the nature of services provided and extent of

fees charged and discussing with it independence issues;

•

policies and procedures to ensure members of the audit team do not make, or

assume responsibility for, management decisions for the audit client;

•

involving another firm to perform or re–perform part of the audit engagement or to

4. It has been said that independence is the cornerstone of the accounting

profession. Explain what this means. What does it mean to say that auditors have

special and critical gatekeeping duties?

Independence is considered the cornerstone of the accounting profession as without

independence the other skills, competencies and values of an accountant are a distant

The role of the external auditor is to assess the reliability of the accounts of the

company, disclosing whether or not the financial statements present fairly financial

position, results of operations, and changes in cash flows in accordance with GAAP.

This role arises because there is an information asymmetry between the management of

the company, and those who rely on the company’s accounts. The reason for this

asymmetry arises because the different stakeholders do not run the company alongside

its management. Auditing involves performing procedures to identify material

misstatements arising from fraud or errors in the company’s financial statements,

An interesting article on the gatekeeper role of Andersen in the Enron audit can be found

at the following link.4

5. Is independence impaired when an auditor is hired, paid, and fired by the same

corporate managers whose activities are the subject of the audit? Does it matter

that in most companies the audit committee hires, evaluate, fires (if appropriate),

and determines the fees of the external auditor with minimal input from senior

management?

The problem with auditors being hired, paid and fired by the clients is that the paycheck

from the client tends to override the public interest obligation. On paper, publicly traded

companies have the audit committee hire, evaluate, fire, and determine the fees of the

external auditors. It is hard to know how independent or dependent the committee is on

6. How might financial incentives in the form of client services unconsciously

introduce auditor bias into the independent audit function? Are there any

solutions to the conflict?

($24) in the case of Enron and it colored the way Andersen auditors evaluated the

unusual special-purpose-entities transactions.

Recently, the Big 4 firms who have acquired consulting firms will have to work within

SOX requirements that no consulting services can be conducted for audit clients.

However, the audits tend to be fixed fees contracts with a low profit margin while

consulting services tend to be cost plus contracts with a large profit margin. When audit

firms do consulting for nonattest clients, one issue is whether, in the future, the firms

Another solution might be audits contracts should be cost plus and have higher profit

margins. How could that be accomplished? It would be hard to change audit contracts

7. Do you believe the internal audit activity should be independent? Explain.

Internal auditors cannot be totally independent as they are hired, fired, and paid

by the company. However, internal auditors should be independent of the operation side

of the company and of top management. The internal auditors should communicate with

Extended Discussion

Here is an excerpt from the Government Accountability Organization’s (GAO’s)

Government Auditing Standards that discusses internal auditor independence.5

Organizational Independence for Internal Audit Functions:

Certain federal, state, or local government entities employ auditors to work for

management of the audited entities. These auditors may be subject to administrative

direction from persons involved in the entity management process. Such audit

organizations are internal audit functions and are encouraged to use the Institute of

Internal Auditors (IIA) International Standards for the Professional Practice of Internal

Auditing in conjunction with Generally Accepted Government Auditing Standards

(GAGAS). Under GAGAS, a government internal audit function can be presumed to be

free from organizational impairments to independence for reporting internally if the head

of the audit organization meets all of the following criteria:

• is accountable to the head or deputy head of the government entity or to those

charged with governance;

Ethical Obligations and Decision Making in Accounting, 4/e 10

8. Do you believe that the SEC should prohibit auditors from providing all nonaudit

services for audit clients? Use ethical reasoning to support your answer.

Public companies often have their auditors perform nonaudit services for audit clients

such as general consulting and financial planning. There appears to be no ethical

reasoning to prohibit these services for audit clients and from a Utilitarian perspective the

benefits of trusted auditors providing basic nonaudit services to an audit client would

seem to exceed any “costs” of the independence being impaired. Certain nonaudit

services create threats to independence because there is a blatant self-review threat during

the audit, such as when audit firms perform financial information systems design and

installation work. These are prohibited by SOX.

9. Assume that a CPA serves as an audit client’s business consultant and performs

each of the following services for the client. Identify the threats to independence.

Do you believe any safeguards can be employed to reduce the threat to an

acceptable level? Explain.

1. Advising on how to structure its business transactions to obtain specific

accounting treatment under GAAP.

2. Advising and directing the client in the accounting treatment that the client

employed for numerous complex accounting, apart from its audit of the

client’s financial statements.

3. Selecting the audit client’s most senior accounting personnel by directly

interviewing applicants for those positions.

1. A CPA’s independence would be impaired if he advised an audit client how to

structure transactions to obtain specific accounting treatment under GAAP. To do

2. This situation impairs the actual and appearance of independence because of the

self-review threat. The transactions or methods are part of the audit if the

transactions are material. Would the CPA be able to render an unbiased opinion

and point out deficiencies in the accounting when the CPA recommended the

accounting method? The appearance that the CPA might not be able to remain

3. The SEC and SOX would consider this an impairment of independence since the

CPA is making decisions on the client’s behalf and subsequently examining the

work of a key person that helped to hire. For non-public clients, there is not a

specific rule against helping the client interview and hire personnel. However,

Ethical Obligations and Decision Making in Accounting, 4/e 12

10. What are the dangers of creeping commercialism in the accounting profession?

What we see today in the accounting profession is troubling. Increased commercial

activities threatens the independence cornerstone of the profession that underlies its

public interest obligation. Audit firms are pushing the envelope in their involvement with

non-audit services that makes it appear as though they might compromise their

independence on the audit because of these relationships.

The dangers of creeping commercialism include professional self-interest versus the

public interest. As former SEC chief accountant Lynn Turner asked. “Are the auditors

Creeping commercialism can also be a danger as when professional services firm

acquires a consulting entity. For example, KPMG has acquired two consulting firms in

the last two years that specialize in healthcare consulting. Will KPMG decide that it is

more lucrative to do only healthcare consulting rather than audits in the healthcare

industry?

Steven Mintz has an informative blog on this issue at the following link:6

11. Can a CPA auditor be independent without being objective? Can a CPA auditor

be objective without being independent? Explain.

Yes, a CPA can be independent of a client and still not have objectivity. Independence is

having no financial interest or the appearance of a financial interest. Objectivity is having

12. What is the problem with an auditor overrelying on management’s

representations on the financial statements?

During an audit, management makes many representations to the auditor, both oral and

written, in response to specific inquiries or through the financial statements. Such

representations from management are part of the evidential matter the independent

13. Andy Simmons is a CPA with his own accounting and tax practice. He

occasionally does an audit for small business clients. One day an audit client

shows Andy a letter from the local Property Tax Assessor’s office. It seems the

client inquired about the process to be followed to appeal the 20 percent increase

in his property taxes. He already wrote an appeal letter and was denied. The

letter said that most folks who appeal those decisions hire a CPA to represent

them before the administrative board in property tax assessment hearings. If

your client asks you to represent him in the appeal process, can you do so under

the AICPA Code? Explain.

Ethical Obligations and Decision Making in Accounting, 4/e 14

14. You’re struggling in your new accounting practice to tap into a potential client

base. You have tried traditional advertising and marketing tools to no avail. Your

friend tells you to use social media as a tool to reach potential customers. You’re

not sure about it. Your concern is one of ethics. The last thing you want to do is

violate the ethical standards of the accounting profession. Identify the ethical

issues that should be of concern to you in deciding whether and how to use social

media for advertising and solicitation of new clients.

As with all advertising, it cannot be false, misleading or deceptive. The CPA should also

take care not to imply the ability to influence any court, agency, or similar body or

official. The communication cannot contain a representation that current future