Spidell s 4-Hour CPA Ethics Spidell Publishing, Inc. This is not a free publication.

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2 This publication is distributed with the understanding that the authors and publisher are not engaged in rendering legal, accounting or other professional advice and assume no liability in connection with its use. Tax laws are constantly changing and are subject to differing interpretation. In addition, the facts and circumstances in your particular situation may not be the same as those presented here. Therefore, we urge you to do additional research and ensure that you are fully informed before using the information contained in this publication. Federal law prohibits unauthorized reproduction of the material in Spidell s 4-Hour CPA Ethics self-study manual. All reproduction must be approved in writing by Spidell Publishing, Inc. This is not a free publication. Purchase of this electronic publication entitles the buyer to keep one copy on his/her computer and to print out one copy only. Printing out more than one copy and any electronic distribution of this publication is prohibited by international and United States copyright laws and treaties. Illegal distribution of this publication will subject the purchaser to penalties of up to $100,000 per copy distributed.

3 LEARNING ABOUT THE AICPA'S CODE OF PROFESSIONAL CONDUCT THROUGH WAR STORIES & CASE STUDIES Course Objectives: This course addresses the AICPA s Code of Professional Conduct in an insightful manner using case studies, investigative results, and real world applications. Information concerning the authoritative nature and application of the Code s standards are discussed with an emphasis on its application to California licensed CPAs. Students will learn about the basic structure of the Code itself and be introduced to the AICPA s Principles of Professional Conduct. Topics include independence, integrity, professional competency, due professional care, planning and supervision, gifts, commission and contingent fees, financial interests, employment, and more. With this four-hour general ethics course you will gain an understanding of the: Independence standards that govern investments including those through mutual funds, retirement accounts, and blind trusts; Responsibilities you have with clients, employers, and colleagues; Requirements for CPAs working in the public or private sectors; Standards that govern retention and distribution of client records and collection of outstanding delinquent fees; Non-attest service standards applicable to tax preparation, internal audit outsourcing, bookkeeping, expert witness, and litigation support services; and Implications for failing to file personal and business tax returns or remit payroll and other taxes collected on behalf of others. Category: General Ethics Recommended CPE Hours: 4 Level: Basic Prerequisite: None Advance Preparation: None Expiration Date: July 2013 i

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5 Table of contents CHAPTER ONE INTRODUCTION. 1 Authoritative Standards... 1 Application to California Licensed CPAs... 1 Other Authoritative Standards. 2 War Stories, Case Studies, & Author s Background... 2 Code Sections... 2 Principles of Professional Conduct 3 Glossary CHAPTER TWO INDEPENDENCE, INTEGRITY, & OBJECTIVITY... 9 Covered Member.. 9 Use of the Term Covered Member 10 Ownership Interest Gifts. 11 Trade Associations Management / Supervisory Services. 13 Board of Directors. 13 Financial Interest Immediate & Close Family Members Investments. 14 Mutual Funds. 15 Retirement, Compensation, or Similar Plans Retirement Plans & Accounts of Family Members.. 17 Checking, Savings, Certificates of Deposit, & Money Market... Accounts 18 Estates & Trusts 18 Blind Trust.. 19 Partnerships Investments Obtained Through Gifts. 20 Custody of Client Assets.. 20 Executor & Trustee Services.. 21 Stock Transfer or Escrow Agent, Registrar, or General Counsel. 21 Loans / Debt.. 22 Non-Attest Services Tax Services.. 24 Bookkeeping.. 24 Payroll Services Litigation Support / Expert Witness Services Internal Audit Outsourcing Valuation, Appraisal, & Actuarial Services iii

6 TABLE OF CONTENTS (cont.) System Design.. 26 External Non-Attest Standards Integrity & Objectivity Litigation Services Divorce Proceedings Client Referrals Other Conflicts of Interest Employment Relationships Former Employees Covered Members Formerly Employed by Clients Simultaneous Employment.. 32 Employment of Immediate & Close Family Members. 34 Employment Opportunities With Clients Operating & Capital Leases Outstanding Professional Fees.. 35 Review Questions Review Question Answers CHAPTER THREE GENERAL STANDARDS, RESPONSIBILITIES & PRACTICES.. 45 Discontinued Use of the Term Covered Member 45 General Standards Professional Competency Due Professional Care Planning & Supervision Sufficient Relevant Data.. 47 Compliance With Standards Accounting Principles Confidential Information Confidential Information Obtained From Clients. 48 Confidential Information Obtained From Employers & Accounting Firms.. 49 Commissions. 50 Contingent Fees 51 Outsourcing Retaining Client Records. 53 Client Provided Records Client Records Supporting Records Working Papers Copies, Fees, & Frequency iv

7 TABLE OF CONTENTS (cont.) Discreditable Acts. 56 Discrimination CPA Examination Questions & Answers Tax Returns & Remittances Advertisement & Solicitations. 58 False or Misleading Financial Statements & Records 59 CPAs Working in Public & Private Sectors.. 59 Use of CPA Designation When Working in the Public & Private Sectors 60 Firm Names.. 60 Other Miscellaneous Standards Selling Products to Clients Collection of Delinquent Fees Distribution of Third Party Publications to Clients Review Questions Review Question Answers BIBLIOGRAPHY INDEX v

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9 Chapter One Introduction AUTHORITATIVE STANDARDS The AICPA is the largest nationally recognized organization representing CPAs in the United States. Its Code of Professional Conduct (Code) is authoritative and must be followed when a CPA is a member of the AICPA or its affiliated state society. Additionally, the California Board of Accountancy (Board) recognizes the Code s authority in particular in the areas of independence, integrity, and conflict of interest. For example, while the Board s rules and regulations require that CPAs be independent and free of conflicts of interest when performing attestation engagements, the Board does not define independence or identify situations that specifically create a conflict of interest. The Board allows the AICPA through its Code to define independence and conflicts of interest on its behalf. The Code differs from other authoritative standards because it provides hundreds of authoritative examples in question and answer format in the body of the Code itself. Few, if any, trade organizations provide authoritative examples in their codes of conduct. For example, trade organizations including the Society of California Accountants (SCA), Association of Certified Fraud Examiners (ACFE), Institute of Internal Auditors (IIA), Information Systems Audit & Control Association (ISACA), etc., all have codes of conduct that require their members to be independent and free of conflicts of interest, but none of them define independence or conflicts of interest using authoritative examples. APPLICATION TO CALIFORNIA LICENSED CPAs The Code establishes a national standard that generally applies to CPAs in every state and territory of the United States. However, this student guide will emphasize the application of the Code specifically from the perspective of California licensed CPAs. Unless stated otherwise, the reader should assume that the California Board of Accountancy accepts the various ethical standards as promulgated through the Code. Whenever the Board has more restrictive standards than those promulgated through the Code, the more restrictive standards will be identified, presented, and discussed Arturo Ramudo, CPA, CISA

10 OTHER AUTHORITATIVE STANDARDS While the Code is authoritative, CPAs must be cognizant that other organizations may have ethical standards that are more restrictive than those of the AICPA. The application of other external standards will vary depending on many factors such as industry and the type of service provided. For example, CPAs must follow the ethical standards issued by the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board when performing SEC engagements. Further, CPAs are required to follow the ethical standards issued by the Government Accountability Office (GAO) when performing engagements in accordance with the Government Auditing Standards. Both the SEC and GAO recognize the authoritative nature of the Code and require that CPAs follow those standards; however, these organizations in certain areas have more restrictive standards than those promulgated through the Code. In those instances, CPAs must follow the more restrictive standards. WAR STORIES, CASE STUDIES, & AUTHOR S BACKGROUND Throughout this study guide, war stories and case studies are provided to help the reader apply the ethical standards to real world situations. These war stories and case studies are based on the author s investigative, advocacy, and litigation support experiences. The author performed over 200 investigations during his investigative career with the Board, and upon leaving the Board, represented dozens of CPAs subject to enforcement action by the Board s enforcement program. The war stories and case studies are also based on the author s experience as a Board appointed monitor. Monitors are frequently required for CPAs placed on probation for gross negligence in the practice of public accountancy. Monitors are required to review probationers working papers, financial statements, and reports and provide feedback to the probationers before the accountant s reports may be issued. Lastly, the war stories and case studies are based on the author s litigation support experiences and other investigative results recently published by the Board. CODE SECTIONS The AICPA organizes the Code s ethical standards using the following five major sections: 1. Principles of Professional Conduct; 2. Independence, Integrity, and Objectivity; Arturo Ramudo, CPA, CISA

11 3. General Standards Accounting Principles; 4. Responsibilities to Clients; and 5. Other Responsibilities and Practices. This self-study guide will present the Code s various ethical standards using the same order presented above. PRINCIPLES OF PROFESSIONAL CONDUCT The Principles of Professional Conduct provides the framework or over-arching principles for the Code. In general, if the AICPA provides specific guidance in any other section of the Code, CPAs should follow the specific guidance provided. However, if the Code does not provide specific guidance, the following over-arching principles apply. CPAs should: 1. Exercise sensitive, professional, and moral judgment in all engagements. 2. Serve the public interest, honor the public trust, and demonstrate a commitment to professionalism. CASE STUDY A CPA published an advertisement in a widely circulated newspaper that consisted of only one line. The ad stated, Only Fools and Idiots Pay Taxes, Which One Are You. While the Board could see the humor in the ad, they were obviously concerned because individuals are neither fools nor idiots for paying their tax liability, and because the CPA was not demonstrating a commitment to professionalism. As a result, the CPA was required to appear before the Board at an investigative hearing to explain his actions. 3. Perform all professional responsibilities with the highest sense of integrity. 4. Be independent in fact and appearance when providing auditing and other attestation services. Although the AICPA provides significant independence and conflict of interest guidance in other sections of the Code, it is not possible to provide Arturo Ramudo, CPA, CISA

12 guidance for every conceivable situation. In those instances, the AICPA recommends that CPAs use the conceptual framework to assess potential threats to their independence. The conceptual framework is a risk-based approach where CPAs and accounting firms identify threats to their independence and potential safeguards that could eliminate or mitigate the identified threats to an acceptable level. The conceptual framework is an extremely subjective standard. As a result, many CPAs prefer to follow the more restrictive non-authoritative standard, i.e., if it appears you are impaired, you should assume you are impaired. Lastly, the AICPA prohibits CPAs from using the conceptual framework to override any existing standards identified in other sections of the Code. 5. Observe the profession s technical and ethical standards. CASE STUDY A CPA performed a financial audit in accordance with the Government Auditing Standards. During an investigation, the Board s investigator noted that the CPA did not document his understanding of the client s internal controls and did not perform any type of transaction testing. In lieu of those procedures, the CPA placed a single page in the working papers with the following comment printed in big bold letters: GOOD ENOUGH FOR GOVERNMENT WORK. Obviously, the Board concluded that the CPA did not observe the profession s technical standards and charged the CPA with gross negligence in the practice of public accountancy. The Board revoked the CPA s license; however, the revocation was stayed. The Board placed the CPA on three years of probation with standard probationary terms. Further, the CPA was required to complete 24 hours of additional continuing education over and above the standard 80 hours and reimburse the Board for its enforcement costs. 6. Consider their technical proficiency when determining the scope and nature of services to be provided. Both the AICPA and the Board do not require that CPAs have the technical expertise at the time they accept an engagement; however, they do require that CPAs have the appropriate expertise by the time they complete the engagement. This exclusion is in place to allow CPAs and their firms the opportunity to expand their practice into areas they historically have not provided services Arturo Ramudo, CPA, CISA

13 CASE STUDY A CPA with a tax practice had not performed an audit in over 15 years and had never performed an audit in accordance with the Government Auditing Standards (GAS). After the completion of the audit engagement, the governmental entity discovered an embezzlement and filed a complaint against the CPA. The CPA would have discovered the embezzlement had he simply reconciled the checking account. After a full Board investigation, it was determined that the CPA was not technically proficient to perform governmental audits. For example, the CPA had not documented his understanding of the internal controls, did not performed any type of transaction testing, and failed to perform substantive testing for various material accounts, including cash. Further, the CPA did not issue all the required reports as mandated by GAS. The Board found the CPA guilty of gross negligence in the practice of public accountancy and revoked his CPA license. The revocation was stayed and the CPA was placed on three years of probation, with a 90-day suspension. The CPA was required to reimbursement the Board for approximately $12,000 in enforcement costs and complete 48 hours of additional continuing education. Lastly, the CPA agreed to standard probationary terms that required he submit quarterly reports to the Board, allow the Board to perform on-site investigations at any time, and periodically appear before the Board s Enforcement Advisory Committee. GLOSSARY Accusation: Legal document used by the Board to press charges against a CPA s, partnership s, or accountancy corporation s license. Accusations are reserved for the most egregious violations such as fraud, embezzlement, and gross negligence in the practice of public accountancy. AICPA: American Institute of Certified Public Accountants Attestation engagements: Professional engagements that require CPAs and their firms to be free of conflicts of interest and impairments of independence. Attestation engagements include, but are not limited to, financial, performance, and compliance audits. Attestation engagements also include audits of accounts, forms, and programs as well as review engagements. However, compilation engagements are specifically excluded because they do not require independence Arturo Ramudo, CPA, CISA

14 Board: California Board of Accountancy CEO: Chief executive officer CFO: Chief financial officer Close family member: Includes parents, siblings, and non-dependent children. Code: AICPA Code of Professional Conduct Conceptual Framework: A risk based approach to help identify potential threats to independence and possible safeguards that could eliminate or mitigate the identified threats to an acceptable level. Covered member: Includes anyone assigned to an attestation engagement; any partner that resides in the same office as the lead engagement partner; anyone in the position to influence an attestation engagement; any partner or manager that provides 10 or more hours of non-attest services; and the firm. CPA: Certified Public Accountant. For purposes of this self-study guide, it also includes Public Accountants (PA). CPE: Continuing professional education Direct financial interest: An investment that a covered member both owns and controls. Engagement partner: Partner responsible for professional services including audits, reviews, and compilations. Exchange facilitator: An independent third party who facilitates 1031 like-kind exchanges. These individuals hold the proceeds from the sales of business or investment properties in escrow until they are needed to purchase the replacement property. A 1031 exchange is an IRS-authorized process where like-kind properties may be exchanged without immediate tax liability. Exchange facilitators are also referred to as deferred accommodators, exchange accommodators, or qualified intermediaries. Firm: The Board defines a firm as a sole practitioner, partnership, limited liability partnership, or accountancy corporation. FTB: California Franchise Tax Board GAAP: Generally Accepted Accounting Principles Arturo Ramudo, CPA, CISA

15 GAO: U.S. Government Accountability Office GAS: Government Auditing Standards Government Auditing Standards: Standards promulgated by the U.S. Comptroller General. Government Auditing Standards are followed when require by law, regulations, agreement, policy, or contract. Immediate family member: Includes spouses or equivalent and dependents. Indirect financial interest: Investments that covered members own, or financially benefit from, but do not control. IRS: Internal Revenue Service Key position: Includes upper level executive officers, directors, promoters, underwriters, and trustees. Non-attest services: Any service that does not require independence. Examples of non-attestation services include tax, consulting, training, financial planning, and compilations. Partner: Individual with ownership interest in an accountancy firm. For purposes of this study guide, the term partner will include partners, limited partners, and shareholders in accountancy corporations, including junior and non-cpa partners and shareholders. Practice of Public Accountancy: The Board defines the practice of public accountancy as any individual that holds out to the public as a CPA; maintains a business office as a CPA; offers attestation services; and prepares an audit or review report. Also CPAs that provide bookkeeping services; prepare or sign tax returns; prepare financial or investment plans; and/or provide management consulting services are considered to be practicing public accountancy. Qualified intermediary: See exchange facilitator Sarbanes Oxley: The most comprehensive change to securities regulations since the SEC Act of This Act established significant ethical, accounting, and auditing regulations and standards for firms performing SEC engagements. SEC: U.S. Securities and Exchange Commission SSARS: Statements on Standards for Accounting and Review Services Arturo Ramudo, CPA, CISA

16 Standard probationary terms: Terms required of CPAs and firms placed on probation for violations of the California Accountancy Act or the Board s regulations. Standard probationary terms require that CPAs and / or firms submit quarterly reports to the Board, periodically appear before the Board s Enforcement Advisory Committee, allow on-site investigations at any time, and comply with all laws, rules, and regulations. Unsolicited financial interest: An investment a covered member obtains through gift or inheritance Arturo Ramudo, CPA, CISA

17 Chapter Two Independence, integrity, & objectivity COVERED MEMBER Generally, the Code s independence, integrity, and objectivity standards only apply to covered members. A covered member includes: 1. Any member of the attestation team. This includes staff auditors, supervisors, managers, and partners. 2. All partners that reside in the same office as the lead engagement partner. These partners have nothing to do with the engagement. They simply reside in the same office as the lead engagement partner. 3. Any individual in a position to influence an engagement. For example, the partner that makes the decisions on hiring, firing, promotions, bonuses, and salary increases would be in the position to influence an engagement. 4. A partner or manager who provides 10 or more hours of non-attest services. Nonattest services include, but are not limited to, tax preparation, bookkeeping, financial planning, consulting, litigation support, and training. 5. The firm. The Board defines a firm as a sole proprietor, general partnership, limited liability partnership, or accountancy corporation. While rare, there are instances in which the independence, integrity, and objectivity standards apply to all professionals in a firm. For example, if any professional in the firm sits on the board of directors of a client, the entire firm is impaired. The reader should assume that the independence, integrity, and objectivity standards apply only to covered members unless the wider application of a specific standard is discussed and presented in the material Arturo Ramudo, CPA, CISA

18 USE OF THE TERM COVERED MEMBER Covered members include staff auditors, supervisors, managers, and partners who may or may not be CPAs. As a result, during our discussion in this chapter of the Code s independence, integrity, and objectivity standards, we will replace the terms CPA and firm with the more inclusive term covered member. However, the war stories and case studies presented throughout the course material are based on factual cases; therefore, we will continue to use the term CPA in those limited situations, when applicable. OWNERSHIP INTEREST Independence requires that a covered member be free from the authority, control, or influence of others. As a result, the Code prohibits covered members from purchasing or committing to purchase any direct or materially indirect interest in attestation clients. Further, covered members are prohibited from having any joint business investments with the enterprise or its officers, directors, or principal stockholders. CASE STUDY A CPA performed two audits and two reviews of two different corporations over a fouryear period. No issues were identified during the Board s review of the working papers and financial statements. However, during the investigation the Board determined that the CPA had a one-third ownership interest in both corporations. Clearly, the CPA was impaired. The Board revoked the CPA s license. The revocation was stayed with the condition that the CPA be placed on three years of probation, serve a 180-day suspension, and reimburse the Board for its enforcement cost. Further, the CPA had to complete 24-hours of additional continuing education over and above the standard 80-hour requirement and re-enroll and successfully complete a Board approved eight-hour professional conduct and ethics course. Standard probationary terms applied Arturo Ramudo, CPA, CISA

19 GIFTS The AICPA changed their gift standard in January of Prior to 2006, the AICPA used the token gift standard. After 2006, the AICPA modified their gift standard incorporating both the old token gift standard with a new reasonable under the circumstance standard. The new standard has four different components: gifts to covered members, gifts to non-covered members, gifts to clients or perspective clients, and lastly a standard for food, beverage, or entertainment either to or from a client or perspective client. Gifts to covered members follow the previously established token gift standard. The Code does not define a dollar amount for token gift purpose. Therefore, while a $100 limit would appear reasonable, covered members are free to establish their own token gift limitations so long as the maximum amount allowed is clearly inconsequential. For example, an attestation client gives a covered member a small fruit basket for the holidays or a tee shirt or hat with their company logo. The AICPA views these gifts as token in nature and no impairment would exist. However, if the client offers the covered member an all-expense paid trip to Las Vegas, that would be more than a token gift and the member would be impaired if they accepted the client s offer. Gifts to non-covered members must comply with the new reasonable under the circumstance gift standard. Non-covered members should consider the following criteria to determine whether gifts offered by attestation clients are reasonable under the circumstances. 1. The nature of the gift or entertainment; 2. The occasion that resulted in the gift or entertainment; 3. The cost of the gift or entertainment; 4. The nature, frequency, and value of other gifts and entertainment offered; 5. Whether the entertainment was associated with the conduct of business; and 6. Whether other clients, customers, or vendors participated. Gifts from covered members to clients or perspective clients also follow the reasonable under the circumstance gift standard. This standard ensures that covered members do not give the impression that they are improperly inducing clients or perspective clients to keep or obtain their business. Food, beverage, and entertainment either to or from a client also follow the reasonable under the circumstance gift standard. For food, beverage, or entertainment, reasonable Arturo Ramudo, CPA, CISA

20 under the circumstance will vary based on many factors such as the position of the impacted member, types of services offered, and the industry in which the client operates. CASE STUDY The CEO of a fortune 500 company invites the financial audit engagement partner to dinner. Generally, the CEO would treat the partner to dinner at a high-end restaurant, potentially spending $200 or more on the meal. Would this be reasonable under the circumstances? Yes, because at the CEO and partner levels, that is how business is conducted. The CFO of a fortune 500 company invites the financial audit engagement partner to a $500 round of golf at an exclusive country club. Would this be reasonable under the circumstances? Once again, the answer would be yes because at the CFO and partner levels that is how business is conducted. Would it be reasonable for the CEO or the CFO of a fortune 500 company to invite a lower-level staff auditor to a $200 meal or a $500 round of golf? No, because at the lower staff auditor level it would not be reasonable under the circumstances. Lastly, the Code prohibits covered members to knowingly offer or accept any gift or entertainment that violates the client s, customer s, or vendor s gift and entertainment policies. TRADE ASSOCIATIONS Joining a trade association does not impair a covered member s independence as long as they do not serve in the capacity as a director, officer, manager, or employee. Examples of trade associations include the State Accounting Society, the National Society of Accountants, the Institute of Internal Auditors, and the Association of Fraud Examiners. Frequently, trade associations require that their financial information be audited or reviewed. These associations typically prefer using one of their members to provide such services. The Code permits covered members to perform these audits and reviews so long as they are merely members of the association and do not serve in the capacity as a director, officer, manager, or employee Arturo Ramudo, CPA, CISA

21 MANAGEMENT / SUPERVISORY SERVICES Independence is impaired if a covered member provides management or supervisory services. For example, supervising or managing a client s internal audit function; managing a client s information systems; maintaining a client s local area network; reporting to the board of directors on behalf of management; establishing or maintaining internal controls; and providing ongoing monitoring services are all management or supervisory related activities that will impair a covered member s independence. Lastly, signing or co-signing checks is a management function. As a result, even signing one check on behalf of management will impair a covered member s independence. BOARD OF DIRECTORS Board members make policy and management decisions and are ultimately responsible for the actions of their organizations. Therefore, serving on the board of directors will impair independence. This impairment limitation extends to all professionals in a firm and is not limited to covered members. Even an entry-level staff auditor will impair the entire firm if they sit on the board of directors of an attestation client. While serving on the board of directors impairs independence, the Code provides an exception for serving as an honorary director. Only honorary directors that are not involved with forming policy or making management decisions are exempted. Although not required, firms should strongly consider whether their independence is impaired if any professional in the firm serves in the capacity as an honorary director. Generally, to become an honorary director, individuals make significant financial contributions or contribute a significant amount of their time and effort. Through such contributions, it may appear that the individual and / or firm are impaired. FINANCIAL INTEREST The Code contains two different standards for financial interests. There is one standard for direct financial interests and another standard for indirect financial interests. Direct financial interests are investments that covered members both own and control. These investments can be held in brokerage accounts, retirement accounts, blind trusts, general partnerships, etc. Indirect financial interests are investments that covered members either own or benefit from but do not control. The Code uses the example of a cover member who is a beneficiary of an estate or trust, but is not the executor or trustee. As a result, the Arturo Ramudo, CPA, CISA

22 member would own or draw benefit from the underlying estate or trust assets, but does not control the investments. Direct financial interests impair a covered member s independence. The materiality of these investments is not considered. If the covered member owns one share in a client through an investment account, they are impaired. If they own one share in a client through an investment club, they are impaired. However, indirect financial interests only impair a covered member s independence if the investments are material to the member s personal wealth. The Code does not define materiality for purposes of indirect financial interests. Therefore, it is recommended that covered members use five percent to define materiality. If the indirect financial interest is less than five percent of the member s personal wealth, then no impairment exists. If the indirect financial interest is five percent or greater of the member s personal wealth, then an impairment exists. Only direct or indirect financial interests of covered members may affect a firm s independence. Generally, the investments of non-covered members do not impair a firm s independence and may be ignored. For example, a firm performs an SEC audit engagement out of their Los Angeles office. A partner out of the firm s San Francisco office owns common stock in the audit client. The San Francisco partner is not assigned to the audit engagement and does not provide non-attest services for the client. While the San Francisco partner is personally impaired, that impairment does not affect the firm because the partner is not a covered member. The Code provides specific guidance for various investments including those made by family members and through mutual funds, retirement accounts, trusts and estates, blind trusts, and partnerships. The following is a summary of that guidance: Immediate & Close Family Members Investments For investment purposes, the Code defines an immediate family member as a spouse or equivalent and any dependent. While the Code does not define a dependent, it is recommended that covered members use the same criteria used for tax purposes. Based on this definition, a dependent may include a child, mother, father, in-law, nephew, niece, etc. The Code defines a close family member as a parent, sibling, or non-dependent child. Investments of immediate family members are treated as if they belong to the covered members themselves. If a covered member s dependent son or daughter owns one share in an attestation client, the covered member is impaired. If their spouse owns one share in the client through a retirement account, the covered member is impaired Arturo Ramudo, CPA, CISA

23 Investments of close family members will impair a covered member s independence only if the member knows, or should have known, about the investments. Additionally, the investments must be material to the close family member and enabled the relative to exercise significant influence over the client. For materiality purposes, the covered member must consider the materiality of the investment based on the close family member s personal wealth, not their own. The Code does not define materiality for close family member investments; therefore, it is recommended that the five percent criteria previously discussed be applied. Generally, investments of other family members will not impair independence. According to the Code, the investments of grandparents, aunts, uncles, nephews, nieces, cousins, and in-laws do not impair a covered member s independence, so long as those family members are not dependents. For example, a covered member s non-dependent grandparents own 100 percent of a closely held corporation. According to the standards, the covered member is not impaired and they could ethically perform the financial audit of their grandparent s closely held corporation. While the Code establishes the minimum standards for family investments, it is strongly recommended that covered members and their firms establish more restrictive internal policies and procedures. Those policies and procedures should be more inclusive of family members and restrict services when investments by grandparents, aunts, uncles, nephews, nieces, an all in-laws are involved. Mutual Funds Mutual fund investments have historically been safe harbor investments. A covered member did not have to consider the underlying investments in the mutual fund because those investments could not impair their independence. However, in 2006 the AICPA modified the Code s standard for mutual fund investments. Currently there are two separate standards for mutual fund investments. One standard applies for investments in diversified mutual funds where the covered member owns less than five percent of the outstanding shares, and another standard applies to investments in non-diversified mutual funds or in diversified mutual funds where the covered member owns five percent or more of the outstanding shares. For investments in diversified mutual funds where the covered member does not own more than five percent of the outstanding shares, the previous safe harbor standard applies. As long as the investment does not represent more than five Arturo Ramudo, CPA, CISA

24 percent of the outstanding shares of a diversified mutual fund, the materiality of the investment does not matter. Because of this safe harbor provision, diversified mutual fund investments are ideal for audit partners in firms with a large number of SEC engagements. For investments in non-diversified mutual funds, or where a covered member owns more than five percent of the outstanding shares of a diversified mutual fund, the underlying assets of the funds are treated as indirect financial interests. As a result, a covered member would be required to determine whether the funds have any ownership interest in an attestation client. If the funds have investments in attestation clients, then the covered member is required to determine whether their proportionate share of those underlying investments are material to their personal wealth. Once again, the Code does not define materiality for mutual fund investments; therefore, it is recommended that covered members apply the previously discussed five percent standard. If the underlying investment in an attestation client represents five percent or more of a covered member s personal wealth, they should assume that an impairment exists. If less than five percent, no impairment. Retirement, Compensation, or Similar Plans Investments through retirement, compensation, or similar plans may result in either a direct or an indirect financial interest. Retirement, compensation, or similar plans include defined contribution pension plans, defined benefit pension plans, traditional IRAs, Roth IRAs, SEPs, SIMPLES, 401Ks, 403s, 457s, etc. Investments through retirement, compensation, or similar plans are subject to the following limitations: 1. If a covered member has the ability to self-direct investments in retirement, compensation, or similar plans, the investments are treated as direct financial interests. If the investments are not self-directed, they are treated as indirect financial interests. Retirement investment standards for immediate and close family members are less restrictive than those for covered members and are addressed separately in the subsequent section. 2. Investments held by a retirement, compensation, or similar plan sponsored by a covered member s firm are direct financial interests of the firm. 3. Investments held in defined benefit plans are neither a direct nor an indirect financial interest of the covered member unless the member, or any member of his or her immediate family, has the ability to make investment decisions for the plan Arturo Ramudo, CPA, CISA

25 4. Shares held in an employee stock ownership plan (ESOP) are treated as indirect financial interests until the covered member, or any member of his or her immediate family, has the right to dispose of the shares. Once the participant has the right to dispose of the shares, the investments are treated as direct financial interests. 5. The right to acquire equity, restricted stock, or any other share-based compensation is treated as a direct financial interest, regardless of whether the financial interest is vested or exercisable. Retirement Plans & Accounts of Family Members The Code permits immediate and close family of covered members to obtain a direct or materially indirect financial interest in an attest client through their retirement plans and accounts. Immediate family members may hold a direct or materially indirect financial interest in an attest client through a retirement plan or account subject to the following limitations: 1. The covered member cannot be assigned to the attestation team or be in a position to influence the engagement; 2. The immediate family member may not hold a key position with the attest client. Key positions include upper level executive officers (such as the CEO or CFO), directors, promoters, underwriters, and trustees; 3. The retirement plan or account must be offered to others in similar positions as the immediate family member; 4. The immediate family member may not participate in the plan s management; 5. The immediate family member may not supervise or participate in the plan s investment decisions; 6. The financial interest in the attest client must be due to the unavoidable consequence of participating in the retirement plan or account; and 7. If the plan offers self-directed investment options, the immediate family member must select an option that does not include an investment in the attest client Arturo Ramudo, CPA, CISA

26 The retirement investment standards for close family members are less restrictive than those standards for immediate family members. Close family members may hold a direct or materially indirect financial interest in an attest client through a retirement plan or account so long as the investment is immaterial to the family member. If necessary, covered members should review Interpretation (ET ) of the Code for further guidance regarding potential impairments caused by family member investments though nonqualified deferred compensation plans and sharebased arrangements such as stock options and ESOPs. Checking, Savings, Certificates of Deposit, & Money Market Accounts Any fully insured deposit within a financial institution does not impair a covered member s independence. This standard applies equally to checking, savings, certificates of deposit, or money market accounts. Any amount deposited over the insured limit is treated as an indirect financial interest and only impairs a covered member s independence if the excess amount is material to their personal wealth. The Code does not define materiality for financial deposits; therefore, it is recommended that covered members use the five percent standard previously discussed. Currently, interest-bearing accounts in financial institutions are insured up to a combined total of $250,000. Financial institutions may insure some non-interest bearing accounts for higher limits, but the higher limits are generally negotiated between the financial institutions and their clients. Estates & Trusts Investments through estates or trusts are either a direct or an indirect financial interest. If a covered member is the beneficiary of an estate or trust, and they are also the executor or trustee, then the underlying investments of the estate or trust are a direct financial interest because the member both owns and controls the investments. Any investment in attestation clients through the estate or trust would impair the independence of the covered member, and because these are a direct financial interest, the materiality of the investment is not considered. However, if the covered member is the beneficiary of an estate or trust, but is not the executor or trustee, then the underlying investments of the estate or trust are an indirect financial interest. Under these circumstances, only investments in attestation clients that are material to the covered member s personal wealth would impair Arturo Ramudo, CPA, CISA

27 independence. The Code does not define materiality for investments through estates or trusts; therefore, the five percent standard is recommended. Any subsequent distribution of investments to a covered member from an estate or trust is treated as an unsolicited financial interest. Unsolicited financial interests must be disposed of within 30 days. If the unsolicited financial interest in an attestation client is disposed of within 30 days, independence is not impaired. If the covered member retains the unsolicited financial interest for more than 30 days, their independence is impaired. Blind Trusts The Code treats all investments through blind trusts as direct financial interests. Investments through blind trusts are managed by a fiduciary, trustee, or administrator. In many instances, the beneficiaries are unaware of the underlying investments held in the blind trusts and have no rights to manage the underlying investments. Some covered members place their investment assets into blind trusts under the false assumption that those investments will not impair their independence. However, the Code indicates that investments in blind trusts are a direct financial interest and any investment in an attestation client through such trusts will impair independence. The materiality of the investment is not considered. Investments in blind trusts are a direct financial interest because the covered member has limited control over the investments. The member generally has the ability to provide a list of clients and instruct the fiduciary to invest in any entity other than the listed clients. Because of this limited control, blind trusts are not appropriate vehicles to avoid potential conflicts of interest arising from investments in attestation clients. Partnerships Investments through partnerships may either be a direct or indirect financial interest. If a covered member is a general partner, any investment through the partnership is treated as a direct financial interest. Any investment in an attestation client through a general partnership would impair the member s independence. The materiality of the investment is not considered. If the covered member is a limited partner, any investment through the partnership in an attestation client would be treated as an indirect financial interest. Under these circumstances, only investments in attestation clients that are material to the covered Arturo Ramudo, CPA, CISA

28 member s personal wealth would impair independence. The Code does not define materiality for investments through limited partnerships; therefore, the five percent standard is recommended. Investments Obtained Through Gifts An investment obtained through gift or inheritance is an unsolicited financial interest. As previously discussed in the estates and trusts section, unsolicited financial interests must be disposed of within 30 days in order to avoid an impairment of independence. Investments gifted by clients must also follow the gift standards previously discussed in this chapter. CUSTODY OF CLIENT ASSETS Having custody of client assets impairs a covered member s independence. This includes, but is not limited to, personal, business, investment, estate, and trust assets. The impairment exists until the covered member relinquishes custody of the assets. CASE STUDY A CPA provides his clients with qualified intermediary services for 1031 like-kind exchanges. The IRS allows up to 180 days to complete a 1031 like-kind exchange so long as the seller of the investment property does not have constructive use of the proceeds from the sale. A qualified intermediary must hold the sales proceeds in escrow. While qualified intermediary services are generally provided by financial institutions or businesses specifically geared toward facilitating 1031 exchanges, this CPA provided such services. The CPA subsequently embezzled $4.4 million from his exchange clients and invested the money in a significant number of businesses, all of which failed. While the greater issue was the embezzlement of funds, this CPA was also impaired because he had custody of client assets. Initially the CPA fought the Board s charges. However, he ultimately surrendered his license because he found it difficult to fight the Board from prison Arturo Ramudo, CPA, CISA

29 EXECUTOR & TRUSTEE SERVICES Serving as the executor or trustee for an attestation client s estate or trust will impair a covered member s independence. However, if the covered member is merely designated, and is not yet serving in the capacity as the executor or trustee, no impairment exists. A designated covered member does not serve in any official capacity until the individual or grantor becomes incapacitated or deceased, at which time the designated member may accept or reject service. If the covered member rejects service as the executor or trustee, no impairment will exists. However, if the member is aware of the designation and ultimately intends to reject service, they have an ethical responsibility to inform the client to designate another individual. STOCK TRANSFER OR ESCROW AGENT, REGISTRAR, OR GENERAL COUNSEL While rarely provided by covered members, serving as a client s stock transfer or escrow agent, registrar, or general counsel will impair a covered member s independence. CASE STUDY The Board placed a CPA on three years probation for practicing public accountancy in a grossly negligent manner. As part of the CPA s negotiated settlement with the Board, he was required to hire a third party monitor to review and comment on his audit working papers, financial statements, and accountant s reports. The CPA was practicing through a registered partnership with his brother, an attorney. The partnership provided one-stop services for a number of non-profit entities. The one-stop services included bookkeeping, preparing the financial statements, preparing the notes to the financial statements, auditing the financial statements, and providing general counsel services. The monitor informed the CPA that his firm was impaired because he was auditing his own work. Specifically, he maintained the clients books, prepared the financial statements, and prepared the note disclosures without obtaining client approval of the account classifications and financial information. Additionally, the CPA s brother and Arturo Ramudo, CPA, CISA