Ethics Releases Mergers and acquisitions raise ethical questions.

By Laura Ellis

In Brief

The New Extended Family The trend of large financial services corporations acquiring CPA firms hasn't stopped. Consumers benefit from being able to access an immense range of related products and services from one source. Acquired firms benefit from joining a broad network that can include economies of scale--in addition, of course, to the financial advantages of the transaction itself.

But these mergers and acquisitions create ethical problems and questions that make the newly created extended family complicated, even potentially hazardous.

Last year, the AICPA issued new releases that address the independence and conflict-of-interest rules for alternative practice structures, as well as new interpretations of standing rules that speak to these areas. Awareness of these rules and their implications is essential.

Last June, H&R Block Inc. announced that it had signed an agreement under which Block would acquire substantially all of the nonattest assets of McGladrey & Pullen, the nation's seventh largest accounting and consulting firm. At that time, H&R Block had already acquired seven other accounting firms in its drive to develop a national network of accounting, tax, and consulting services.

Acquiring accounting firms has become the latest strategy to support the wide range of services provided by diversified financial companies. For instance, Century Business Services Inc.'s accounting, consulting, and tax division promises much more than bookkeeping and tax return preparation. Services include cash flow management, merger and acquisition analysis, and investment counseling. Century has bought dozens of accounting firms to support these services. American Express, in its 1998 annual report, noted that its Tax & Business Services subsidiary had acquired an additional 14 accounting firms during the year in its efforts to become a leader in providing financial and tax advice to small businesses.

In these transactions, partners and other personnel of the original accounting firm become employees of the purchasing company. Property and equipment become the property of the acquiring firm. The nonattest client base is usually served by the original CPAs, who now work for the acquiring firm. The attestation portion of the accounting firm's business, however, remains the property of the original firm's partners.

For example, H&R Block's announcement specifically notes that "McGladrey & Pullen's attest business--including audits, reviews, and other engagements in which the firm issues written opinions evaluating client financial statements--will remain in a partnership owned by McGladrey & Pullen partners."

This arrangement forces an individual CPA to wear two hats: one as an employee of the acquiring company, the other as a partner in the original accounting firm, which is now limited to attest work. The potential for independence violations becomes, to say the least, vastly more complex.

AICPA Addresses Independence

New releases from the AICPA Professional Ethics Executive Committee speak directly to these problems, as well as to various other issues resulting from the changing structure of the accounting industry and how it does business.

Alternative Practice Structures. The discussion of alternative practice structures (APSs) has probably given more practitioners pause than any other part of the new Code of Professional Conduct. Particularly, questions abound regarding how various relationships held by acquiring firm personnel, vis-à-vis a member's attest clients, affect a member's independence. To give guidance for an APS in which the nonattest portion of a member's practice is conducted under public or private ownership and the attest portion of the practice is conducted through a separate firm owned and controlled by that member, the Professional Ethics Executive Committee developed Interpretation 101-14.

Figure 1 presents a hypothetical organization that fits this category. Parent Corporation has three divisions, each of which provides a different financial service to the public: banking, insurance, and consulting and tax. Donna Doe and Richard Roe are partners in the firm Doe & Roe, CPAs. They sell the nonattest portion of their business to Parent Corporation, and that part of the business becomes part of Division 3. Donna Doe, CPA, and Richard Roe, CPA, become employees in Division 3 and provide management and tax consulting services for the clients of Parent Corporation. However, Doe and Roe retain ownership of Doe & Roe, CPAs, and continue to perform attest services. Doe & Roe, CPAs, has negotiated terms whereby it pays Parent Corporation for the use of office space, equipment, employees, billing, and advertising services. Smith & Jones, CPAs, has a similar arrangement with Parent Corporation. The figure shows that both CPA firms' partners double as employees of Division 3.

Problematic Relationships

A quick review of Rule 101, Independence, highlights the problematic relationships inherent in Doe & Roe's relationship with Parent Corporation.

Under Rule 101, independence is considered impaired if, during the engagement, a CPA or her firm--

* had acquired or was committed to acquire any direct, or any material indirect, financial interest (e.g., ownership of stock) in the client;
* was a trustee, executor, or administrator of a fiduciary that had any direct or material indirect financial interest in the client;
* had a close business investment with the client or the client's officers, directors, or principal stockholders that was material to the CPA or her firm;
* had a loan to or from the client or the client's officers, directors, or principal stockholders;
* was a trustee for any pension or profit-sharing trust of the client;
* was connected with the client as a promoter, underwriter, director, officer, employee, or CPA of management at any time during the period of the financial statements, as well as during the engagement.

Under certain possible interpretations of the meaning of "a member's firm," a client that avails itself of any of the services provided by Parent Corporation would be in one of these forbidden categories. Because of independence impairment, Doe & Roe, CPAs, would be unlikely to have as attest clients any of the customers of Parent Corporation.

Interpretation 101-14 softens this potentially harsh result by defining "member's firm" as the attestation firm (Doe & Roe, CPAs, in this case). Thus, if Doe, Roe, or any employees participating in an engagement, even if leased from Parent Corporation, had a direct financial interest in (or any of the other forbidden relationships with) a client, independence would be lost. However, independence would not be impaired if the client had a loan from a banking division of Parent Corporation or pension assets in trust with yet another division.

Ordinarily, however, the surviving attestation partnerships from each purchased accounting firm are considered separate firms. In our example, the relationships of partners and personnel of Smith & Jones, CPAs (another acquired firm), do not affect Doe & Roe's client independence.

In two situations, however, the entity separation implied by the basic rule does not apply:

* The attestation firm is considered too closely related to Parent Corporation for independence to exist. Doe & Roe, for example, could not perform an audit on Parent Corporation or any of its divisions.

* The potential audit client holds a material investment in Parent Corporation, or is otherwise in a position to exercise significant influence over Parent Corporation. In this case also, the independence of Doe & Roe, CPAs, is impaired with respect to the client.

The Ethics Committee paid considerable attention to the effects of various levels of Parent Corporation supervision on a member's independence with respect to the client. For example, a CPA may have superiors at several levels of the Parent Corporation organization. The committee distinguished between two classifications of superiors: direct and indirect.

* A direct superior is one who is in a position to recommend promotions and compensation levels. The direct superior has day-to-day responsibility for the activities of the CPA. The assumption is made that the direct superior can directly control the activities of the CPA. Normally, a CPA's direct superior will be a manager in the local office of the appropriate division. Because relationships between client firms and direct superiors are imputed to the CPA, if a CPA's direct superior owned one share of stock, extended a loan, or had any of the other forbidden relationships with a client firm, the CPA's independence would be impaired with respect to that client.

* An indirect superior is a manager in Parent Corporation who is one or more levels above a CPA's direct superior. The imputation rules apply here as well. For example, relationships held by spouses and dependents are imputed to the indirect superior.

Relationships held by indirect superiors are subject to materiality and significant influence tests. If an indirect superior's relationship with a client is neither material nor allows significant influence to be exercised over the client, then the CPA's independence is not impaired.

The rules treat other divisions of Parent Corporation in the same manner as indirect superiors. Materiality is measured against the indirect superior's net worth or the Parent Corporation's consolidated financial statements.

Additionally, certain activities will always impair independence, even when undertaken by indirect superiors or other segments of Parent Corporation. These include acting as a promoter, underwriter, voting trustee, director, or officer of the client firm.

The rules allow segments of Parent Corporation to undertake services with a client which would be forbidden if attempted by the CPA alone. For example, the committee pointed out that trustee and asset custodial services by a bank subsidiary would be acceptable, assuming that the bank segment is not included in the definition of the CPA or her firm.

Other Independence Issues

The most extensively rewritten sections of the interpretation refer to the requirements of independence, which affect CPAs that perform attest services for a client. The definition of "client" has been expanded, and the scope of nonattest services allowable for an attest client has been examined.

Nonattest Services for an Attest Client. Interpretation 101-3 addresses how performing nonattest services for a client impacts the independence of the CPA performing attest services for the same client.

Previously, an AICPA member was considered independent of a client for whom the CPA performed bookkeeping or data processing services or rented "block time" on their computers, provided the following requirements were met:

* The client was required to accept responsibility for the financial statements, and the CPA was responsible for educating that client to the point necessary.
* The CPA did not assume the roles of management or employee.
* The CPA complied with attestation standards when examining books and records that she personally maintained.

The entire preceding interpretation has been removed. The new interpretation stresses avoidance of management activities by the CPA and requires the CPA to avoid any management decisions or management functions. Any exercise of authority on behalf of the client is considered to be a management function.

A necessary corollary to this requirement is that the client must be in a position to make an informed judgment on the results of the nonattest services. The client should designate a management-level individual to oversee the nonattest services being provided. In addition, the client should be able to evaluate the adequacy of the services and any findings that result in order to make management decisions and to accept responsibility for the results of these services. The client should also be able to establish and maintain internal controls, including the monitoring of ongoing activities.

This interpretation strongly suggests that the limits of each party's responsibilities, along with the customary objectives, description, and limitations of the services provided, be documented in an engagement letter.

The Exhibit, adapted from the AICPA official release, itemizes general activities that impair independence. In general, advising or recommending is permitted without impairing independence. However, authorizing, executing, or consummating a transaction impairs independence. For example--

* recommending job descriptions or candidates would not impair independence, but negotiating employee salary and benefits or hiring or terminating employees would, because these are management functions.
* recording the source documents in the accounting records would not impair independence, but preparing them or other originating data would.
* determining appropriate account classifications is considered a management function, but preparing financial statements from a client's trial balance is not. The preparation of payroll time records, purchase orders, or customer orders is thus not permitted.

Because having custody of a client's assets impairs independence, maintaining a client's bank account, signing payroll tax returns, taking possession of client securities, or making disbursements on behalf of a client's benefit plan are prohibited for an attest client.

Supervision of employees in their day-to-day activities is a management function. For example, a CPA may--

* provide the initial training to client employees on a newly instituted information and control system but not supervise client personnel in its daily operation.
* not serve as a client's stock transfer agent, registrar, general counsel, or their equivalents, without impairing independence.
* make recommendations to management but not decide which recommendation should be implemented. Likewise, representation of management to the board of directors would impair independence.

For example, within the payroll function, a CPA would be permitted to generate unsigned checks from time reports provided and approved by the client, transmit payroll information to the client's financial institution, and make electronic payroll tax payments (provided that the client has authorized the transmission, limited the amount, and named the payee).

Independence would be impaired if the CPA signed checks, authorized payment of funds, signed payroll tax returns, or used a bank account in the CPA's name to clear the payroll.

Redefining Terms

Clients. The definition of "client" has been expanded to include Federal, state, and local governments or their component units, under certain circumstances. If the AICPA member is 1) directly elected by voters of that governmental unit,
2) appointed by a legislative body and subject to removal by that body, or
3) appointed by someone else but subject to confirmation and oversight by the legislative body, then that governmental unit is not considered an employer. The government or governmental unit is then a client, and the CPA is engaged in public accounting. Because independence is not impaired, this CPA is allowed to issue audit reports under GAAS.

Indirect Loans. Ruling 110, under Rules 101 and 102, applies to situations in which an AICPA member is associated with an entity that loans money to the CPA's client. For example, assume that Brown, CPA, is a stockholder of ABC Financial. ABC has extended a loan to XYZ, Inc. Is Brown independent with respect to XYZ, Inc.?

As long as Brown does not control (as defined in FASB 94) ABC Financial, Brown's independence is not impaired. FASB 94 defines "control" as holding more than a 50% voting interest (unless control is actually held by others, such as with a firm in bankruptcy) in the entity. If Brown owns more than a 50% interest in ABC, independence is impaired and Brown may not perform attest services for XYZ, Inc.

If the CPA's association with ABC is as director, officer, or minority owner, independence is not impaired; however, a conflict of interest may exist. The CPA should determine whether services can be performed with objectivity; if not, the engagement should be declined. If objectivity is possible, then the engagement falls under the guidance of Interpretation 102-2, which requires full disclosure of the relationship to the client and the client's consent. Figure 2 presents the decision process.

Contingent Fees from Attest Clients. Assume that a CPA provides an attest client with advisory services for its investment portfolio. Can the CPA charge a fee based on the performance of this portfolio? In general, the answer is "no," because this arrangement would constitute a contingent fee. The CPA could, however, construct the fee arrangement in such a way that the fee would not be considered contingent upon the portfolio's performance and, thus, would not violate the rule. An acceptable arrangement would meet the following three criteria:

* The fee is determined as a specified percentage of the portfolio.
* The dollar amount of the portfolio that determines the fee is fixed at the beginning of each period and not adjusted for changes in market value (except that client additions or withdrawals may be taken into consideration). These periods may not be shorter than quarterly.
* The fee arrangement itself is not renewable more often than quarterly.

Additional Rules and Changes in Interpretations

In general, the Code of Professional Conduct applies to all AICPA members in their performance of all types of professional services, in both public and private accounting. As with most general rules, this one has exceptions, the most obvious resulting from the wording of the rules themselves, such as the one that limits the independence requirement to attestation services. The code's umbrella, however, generally covers all CPAs and their professional services.

A new interpretation addresses the applicability of the code: An AICPA member may not violate the code "by proxy." In other words, if an AICPA member knowingly permits a nonmember who is under the member's authority or control to violate the code, that member is considered to have violated the code. Furthermore, a member in the practice of public accounting may be held responsible for the acts of all associated persons, if the member has the authority to control their acts.

For example, assume a nonmember staff accountant in a public accounting firm violates the rule of confidentiality. Under this interpretation, the AICPA-member CPAs of that firm could be disciplined, even if they were unaware of the breach when it occurred. Good practice would indicate, then, that the orientation of newly hired personnel include careful attention to the Code of Professional Conduct.

A rewritten interpretation to Rule 505 deals with the application of the code to secondary businesses at least partially owned by the member.

For instance, assume a CPA associated with a public accounting firm owns an interest in a second business that performs various financial services for clients, such as tax planning and litigation support. Must the CPA adhere to the code with this second business? And, must all of the CPA's colleagues and employees in the second business also adhere to the code?

For the AICPA member, the answer is a simple "yes." The CPA must adhere to the code in all professional activities, wherever performed. For the co-owners and employees of this second business, the answer is a not-so-simple "it depends." The determining factor is whether or not the AICPA member controls this second business.

For the purposes of determining control, control that lies in the hands of other members of the public accounting firm is imputed to the CPA. Under these rules, if the CPA (either individually or collectively) controls the second business, then that firm, including all of its owners and employees, must comply with the Code of Professional Conduct. If the CPA does not control this second business, then the business, its other owners, and employees are not required to adhere to the code. Furthermore, if the CPA does not control this second business, the firm could, for example, enter into contingent fee arrangements or accept commissions for referrals of products from the CPA's attest client. However, for the CPA to be involved in such activities would violate the code.

Misrepresentation and Acts Discreditable

Two new interpretations expand the liability of AICPA members for knowingly misrepresenting facts and for being judged guilty of committing an act discreditable to the profession due to negligence.

Under the new interpretations, if a CPA permits another person to make materially false and misleading entries, then the member has violated the code. Furthermore, if the member has the authority to record an entry and fails to do so when statements are false, the member has violated the code.

Finally, if a CPA signs, or permits another person to sign, a document containing materially false and misleading information, that act violates the code. This rule applies to any document, not only to financial statements. Also, innocent people could be found in violation through their negligence in not detecting falsifications developed by others. With these interpretations in mind, CPAs in private accounting should take particular care if they are able to record journal entries or if they are asked to sign any document. *

Laura Ellis, PhD, CPA, is a professor of accounting at the Kania School of Management, University of Scranton, Scranton, Penn.

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