Ethics Case Study of the Week: We Do More Than Just Auditing!

By Gary Sarkissian posted 17 days ago

CFA Institute’s Code of Ethics and Standards of Professional Conduct outline the ethical guidelines for the investment profession that are critical to maintaining the integrity of capital markets and investor trust.  Members, candidates, and even firms make a commitment to uphold these standards as they help elevate ethical decision-making universally around the globe.  

As investment professionals, we face important ethical decisions in our day-to-day activities.  Some scenarios we encounter will be straightforward, while others may be more complex.  No matter the circumstances, continuous learning remains imperative in an evolving investment industry and an adapting regulatory environment.

For that reason, each week we feature a sample case from CFA Institute’s Ethics in Practice Casebook.  Many cases are built upon real-life examples that may involve a regulatory matter or even a CFA Institute Professional Conduct investigation.  At the end of each case is a multiple-choice question that addresses the ethical nature of the actions taken in that case.  

This week’s case involves Standard I(B) Independence and Objectivity..

We Do More than just Auditing!
Smithson, the CEO of Bolton Investment Management, uses JOLF LLP to audit its financial records, including checking the accuracy of client account records and verifying historical performance information. The annual cost of the audit is typically $10 million. Over time, Smithson hires JOLF to also provide consulting services to Bolton in a number of areas, including consulting on information technology security, regulatory compliance, compliance with the CFA Institute Global Investment Performance Standards (GIPS®), and other “ad hoc accounting advice.” Eventually, Bolton pays JOLF close to $50 million per year for these other services. Smithson’s actions are

 A. acceptable because JOLF’s consulting work for Bolton improves the audit by enhancing JOLF’s knowledge of Bolton’s business. 
 B. acceptable only if Bolton makes a determination that JOLF’s historical knowledge of the firm will uniquely inform its consultant work.
 C. acceptable only if Bolton discloses its use of JOLF as both its auditor and as a consultant for other financial services.
 D. not acceptable.
 E. none of the above.

Click the “Analysis” button below to see the analysis for this case, and feel free to discuss in the comments below.  The completion of this case qualifies for 0.25 hour of Standards, Ethics, and Regulation (SER) credit

This case relates to independence and objectivity and conflicts of interest. An independent financial audit of a firm’s financial records can provide confidence to clients, investors, and counterparties that the firm is in good financial health and is not engaged in financial fraud. When an auditor has a thorough knowledge of a firm’s business, this knowledge can help the auditor to perform a compressive, in-depth, and accurate audit, which will benefit both the firm and its stakeholders by enhancing the effectiveness of the audit. But there may be the appearance of a conflict of interest and a concern that the auditor’s objectivity may be impeded if it also earns large consulting fees from the same client. If accounting firms sell extra services based on their knowledge of the company they are auditing, will independence related to the audit be compromised?

There may be a perception that an auditor is more likely to provide a favorable assessment of a company’s finances to protect a lucrative consulting relationship with the firm. In this case, JOFL collects five times more fees from Bolton for consulting services than for auditing their financial records. Smithson can avoid this conflict by hiring a third-party consultant, rather than JOFL, for these additional consulting services, or at least could restrict the consulting services (and therefore fees) given to JOFL. If Smithson did not want to lose the benefits of having JOFL, a firm intimately familiar with Bolton’s business through the audit relationship, provide advice on a number of other issues, Smithson could try to mitigate the conflict by being fully transparent about Bolton’s relationship with JOFL, including the nature of the consulting JOFL provides and the fees paid to JOFL by Bolton. In some situations, accounting firms should be able to offer additional services to their auditing clients. But with respect to verification of performance history, CFA Institute guidance on the GIPS standards would prevent JOFL from providing a third-party verification of Bolton’s claim of compliance while also providing assistance in the firm’s ongoing compliance with the GIPS standards. In regards to the GIPS verification and consulting, choice D is the best response.

For the other consulting services, it does not appear that regulatory rules would prevent JOFL from performing both audit and consulting services. In addition, it does not appear that JOFL’s performance of the audit on Bolton is influenced by its consulting work or that mitigation of the conflict through disclosure would not be effective. In these cases, choice C is an acceptable answer. But many accounting firms may determine to refrain from engaging firms for both audit and consulting work to maintain their independence.

Image by mohamed Hassan from Pixabay

© 2019 CFA Institute. All rights reserved. You may copy and distribute this content, without modification and for non-commercial purposes, provided you attribute the content to CFA Institute and retain this copyright notice.  This case was written as a basis for discussion and is not prescriptive of how a business situation or professional conduct matter should or should not be handled or addressed. Certain characters mentioned are fictional to facilitate discussion, and any resemblance to actual persons is coincidental.