Question

Case Study

Thomas Gilbert and Susan Bradley formed a professional corporation called “Financial Services

Inc.---A Professional Corporation,” each taking 50 percent of the authorized common stock.

Gilbert is a CPA and a member of the AICPA. Bradley is a CPCU (Chartered Property Casualty

Underwriter). The corporation performs auditing and tax services under Gilbert’s direction and

provides insurance services under Bradley’s supervision. The plan has been to allow each

shareholder to refer services to the other, in return for referral fees.

One of the corporation’s first audit clients is Grandtime Company. Grandtime had total assets of

$600,000 and total liabilities of $270,000. In the course of his audit examination, Gilbert found

that Grandtime’s building, with a carrying value of $240,000 was pledged as collateral for a 10-

year term note in the amount of $200,000. The client’s financial statements did not mention that

the building was pledged as collateral. However, as the failure to disclose the lien did not affect

either the value of the assets or the amount of the liabilities, and his examination was satisfactory

in all other respects, Gilbert rendered an unmodified opinion on Grandtime’s financial

statements.

Two months after the date of his opinion, Gilbert learned that an insurance company was

planning to loan Grandtime $150,000 in the form of a first-mortgage note on the building.

Realizing that the insurance company was unaware of the existing lien on the building, Gilbert

had Bradley notify the insurance company of the fact.

Shortly after the events described above, Gilbert was charged with several violations of

professional ethics.

Identify and discuss at least four ethical implications of those acts by Gilbert that were in

violation of the AICPA Code of Professional Conduct

Answer 1

Thomas Gilbert and Susan Bradley formed a professional corporation called “Financial Services Inc.

Acts by Gilbert that were in violation of the AICPA Code of Professional Conduct, and their ethical implications are as follows (only four required):

(1) Gilbert may be in violation of Rule 102 that requires that a member be free of conflicts of interest in rendering professional services. The insurance aspects of the business might be considered incompatible if Gilbert was making recommendations concerning insurance coverage and selling insurance to the same firms. Also, the firm may be in violation of Rule 503 regarding commissions.

(2) Gilbert's expression of an unqualified opinion on Grand-time's financial statements that did not disclose a material lien on the building asset is a violation of both Rule 202 (Compliance with Standards) and Rule 203 (Accounting Principles).

Rule 202 provides that a member shall comply with appropriate standards when performing professional services. The third standard of reporting for audits states that "informative disclosures are to be regarded as reasonably adequate unless otherwise stated in the report." Since there was no disclosure of the business lien in the financial statements, Gilbert should have qualified his opinion.

Rule 203 requires that a member shall not express an opinion that financial statements are presented in conformity with generally accepted accounting principles if such statements contain any departure from an accounting principle promulgated by a body designed by Council to establish such principles. Statement of Financial Accounting Standards No. 5, which was published by a body designated by Council, requires disclosure of assets pledged as collateral for loans.

(3) Having Bradley inform the insurance company of the prior lien on Grand-time's building is a violation by Gilbert of Rule 301 of the Code, which enjoins a member from violating the confidential relationship between himself and his client without consent of the client. The lien should have been disclosed in Gilbert's report on Grand-time's statements, but he may not disclose it independently to a third party unless the client agrees to such disclosure. However, Rule 301 should not be interpreted to preclude a CPA from correcting a previous error—in this case expressing an opinion that the financial statements were prepared in accordance with generally accepted accounting principles when, in fact, they were not. Gilbert should have first exhausted all means to persuade Grand-time to correct the error by recalling the original financial statements and reissuing them in corrected form with a new auditor's report.

(4) Another point, not directly addressed by the text, and related to the first point above, concerns a CPA having a financial interest in a commercial corporation that performs such insurance services. Under certain circumstances this is allowed, provided such interest is not material to the corporation's stockholders' equity, and the member's interest in and relation to the corporation is solely that of an investor. Certainly Gilbert's 50-percent interest is material to Financial Services, Inc., and Gilbert's status is not that of an investor. In this respect Gilbert is in violation of Rule 505.