Certified Public Accountants (CPA) perform many important services for individuals and companies, public or private. One essential assurance engagement a CPA performs is an audit of financial statements. Audits of financial statements play a vital role in the business industry. An auditor can reasonably assure investors, lenders, management, and stakeholders that the financial statements are free from material misstatement and accurately reflect the accounting of the entity for that period of time. However, an auditor cannot provide an absolute assurance due to the inherent limitations of an audit.
Generally, an audit includes the following steps: overall audit planning, assess control risk, perform tests of controls, perform substantive tests of account balances, and finally complete the audit (Kerr, Elder and Arens). In the overall audit planning stage, the CPA has to obtain an understanding of the potential client’s business and establish if the CPA Firm and its associates are independent. These two steps must be done before the CPA Firm can decide to accept the audit engagement. There are many important factors, steps, issues, knowledge, just to name a few that go into an audit but this paper will focus on the issue of independence.
One of the principles listed in the AICPA Professional Code of Conduct states that an auditor in public practice must be independent in appearance and fact (AICPA Standards). As stated previously, the initial step in the audit process is to perform overall audit planning. Within this first step the Firm and its associates have to decide if they are independent in regards to the potential client. The term associate will include all of the following entities and/or individuals; CPA Firm, the CPA employed by the CPA Firm, a partner or equivalent or manager that provides more than ten hours of non-attest services to the client, a partner or equivalent that works at this Firm’s location where the audit engagement team is located, any individual that is in a position to potentially influence the audit engagement, and professional employees of the CPA Firm (Firm).
An associate or Firm cannot accept an audit engagement with a client unless the associate and Firm are independent from the audit client (client). This may seem like an impossible task to ensure that some associates of a firm and all associates assigned to the audit engagement are independent in fact and appearance but this paper will analyze all possible threats to independence and mitigate these threats.
Most importantly, what is independence? And what governing board defines independence for this particular client’s audit?
First, let’s answer the latter question. Since this client is a private entity, even though in the future the client plans on going public, the governing board that the associates will follow is the AICPA independence rules and applicable standards. Although, the client does want to become a public company in a few years. Once the client goes public the governing board that the associates will follow will be the PCAOB. When PCAOB has different standards compared to the AICPA, these differences will be discussed when mitigating the possible threats. In most cases, PCAOB will have stricter requirements than AICPA will have.
Now the former question, how independence is defined in the AICPA auditing standards. The definition of independence can be broken out into two parts under the AICPA guidelines. Associates have to be independent in fact and in appearance. “In appearance” means an associate needs to appear independent to a third party. This third party isn’t just someone off the street looking into an unknown situation. This third party does not make assumptions about the situation because (s)he knows the situation, has been given any needed knowledge, and knows the safeguards that have been implemented to mitigate possible independence threats. Given all the information,