ACCT 340 Week 6 Group Discussion Board Forum 4 Example

Group Discussion Board Forum 4: Legal, Regulatory and Professional Obligations of Auditors

ACCT 340 Accounting Ethics, Group Discussion Board Forum 4

Thread by [Student Name]

The CPA firm, the medical device client and the classmate are composites; the textbook, Scripture and the peer-reviewed sources cited are real.

A composite 40-person CPA firm has served a medical device maker for nine years. Each month its staff record the company's transactions, run payroll and reconcile the bank accounts; each spring it prepares the tax returns; and each year a separate team audits the financial statements. The client's management reviews and approves the firm's work, and the firm has documented safeguards under the AICPA Code, so the arrangement has been permitted while the company is private. This spring the company hired an investment bank and announced plans for an initial public offering. The firm's partners want to keep both the audit, which brings prestige, and the bookkeeping, which brings steady fees.

Mintz and Morris (2019) explain that independence is the cornerstone of the audit, because the audit's value lies in an outside party's objective opinion. They distinguish independence in fact, the auditor's actual freedom from bias, from independence in appearance, whether a reasonable observer who knows the relevant facts would conclude the auditor is objective. For private clients, the AICPA Code allows certain non-attest services, including bookkeeping, if the client's management accepts responsibility for the work and the firm applies safeguards. For public companies, the rules are stricter. The Sarbanes-Oxley Act of 2002 prohibits the auditor of an issuer from providing several services, including bookkeeping and other services related to the accounting records or financial statements, and requires the audit committee to preapprove the non-audit services that remain permitted. Once the device maker becomes an issuer, the firm cannot both keep its books and audit them.

The logic is the self-review threat. An auditor who audits records its own staff prepared is asked to find errors in its own work. Even if the audit team is separate and honest, investors who have never met the partners must take that on trust. Independence in appearance is not a lesser standard; it is the only form of independence an investor reading the report can actually see.

Does providing non-audit services really compromise auditors? The research is divided, and the disagreement is instructive. Frankel et al. (2002) found that companies paying their auditors higher non-audit fees were more likely to just meet or beat earnings targets and showed larger discretionary accruals, evidence they interpreted as consistent with impaired independence. DeFond et al. (2002) examined a different outcome, the willingness of auditors to issue going-concern opinions to financially distressed clients, and found no association between non-audit fees and those opinions, which suggests that auditors' concern for their reputation and legal exposure may outweigh the pull of fees. Both studies were published around the time Congress passed Sarbanes-Oxley, and both have been debated since.

I think the mixed evidence actually supports a firm line for public companies. If researchers with large data sets cannot agree on whether fees compromise auditors, an individual investor certainly cannot tell from reading one company's report. The prohibition settles the question of appearance even where the question of fact is uncertain, and it removes a temptation that some auditors, under some circumstances, may fail to resist.

Proverbs contrasts the dishonest scales the Lord hates with the accurate weights that please him (English Standard Version Bible, 2001/2016, Proverbs 11:1). An auditor is meant to be the just weight against which a company's claims are measured. A scale that belongs to the seller is not trusted, however accurate it may be, which is why the profession insists that the auditor stand apart from the work being audited.

The firm has two honest options. It can keep the audit and transfer the bookkeeping to another firm or to the client's own accounting staff before the period covered by the registration statement, or it can keep the bookkeeping and resign the audit. Given the firm's size and the scrutiny of an IPO, I would recommend helping the client hire a controller and an accounting team now, transferring the bookkeeping over the coming months and keeping the audit. The firm loses steady fees but keeps the work its license exists to protect. The transition also has to be timed carefully. Independence rules for an IPO apply to the periods included in the registration statement, so the partners should consult the SEC independence rules and their own quality control partner early, rather than discovering in the middle of the offering that bookkeeping performed last year has already disqualified them. A firm that plans the handoff well can present the change to the client as preparation for public-company life, which is exactly what it is: a company about to answer to public investors needs its own capable accounting staff, not an outside firm doing the work that management is supposed to own.

Reply to Rebecca

Rebecca, your thread described the PCAOB's creation as the end of self-regulation for auditors of public companies, and you questioned whether inspections actually improve audits or only add paperwork. Research offers a fairly encouraging answer. DeFond and Lennox (2017) studied PCAOB inspection reports on internal control audits and found that when inspectors reported higher rates of deficiencies at a firm, its auditors responded by issuing more adverse internal control opinions, and those opinions were more often given to clients that really did have misstatements. Audit fees also rose, consistent with firms doing more costly work to fix what inspectors found.

That suggests inspections change what auditors do, not merely what they document. It also connects to my thread. If the medical device maker goes public, its new auditor will face PCAOB inspection, and inspectors look closely at independence and at engagements where the firm has a long history with the client. A firm that kept a prohibited service would not only violate the rule but also expose itself to findings that could follow it across all its public clients.

I would add one caution to your point about paperwork. Mintz and Morris (2019) note that rules work only as well as the culture behind them. Inspections can catch deficiencies after the fact, but the decision our CPA firm faces, whether to give up the bookkeeping fees, is made long before any inspector arrives. Oversight raises the cost of the wrong choice; character still has to make the right one, often in a partners' meeting where the fees are discussed openly and the principle has to be defended out loud.

References

DeFond, M. L., & Lennox, C. S. (2017). Do PCAOB inspections improve the quality of internal control audits? Journal of Accounting Research, 55(3), 591-627. https://doi.org/10.1111/1475-679X.12151

DeFond, M. L., Raghunandan, K., & Subramanyam, K. R. (2002). Do non-audit service fees impair auditor independence? Evidence from going concern audit opinions. Journal of Accounting Research, 40(4), 1247-1274. https://doi.org/10.1111/1475-679X.00088

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Frankel, R. M., Johnson, M. F., & Nelson, K. K. (2002). The relation between auditors' fees for nonaudit services and earnings management. The Accounting Review, 77(Suppl.), 71-105. https://doi.org/10.2308/accr.2002.77.s-1.71

Mintz, S. M., & Morris, R. E. (2019). Ethical obligations and decision making in accounting: Text and cases (5th ed.). McGraw-Hill Education.