A CPA firm is approached by a prospective audit client, a rapidly growing tech startup. During the engagement acceptance process, the firm identifies that a significant portion of the startup's revenue is derived from complex licensing agreements with an entity in which one of the CPA firm's partners holds a material indirect financial interest. This partner is not part of the audit engagement team but is a partner in the same office. Which of the following is the most appropriate action for the CPA firm to take?
- AAccept the engagement, disclosing the financial interest to the audit committee and obtaining their approval.
- BAccept the engagement, but ensure the partner with the financial interest has no involvement in the audit.
- CDecline the engagement, as the identified financial interest impairs the firm's independence.
- DAccept the engagement, provided the partner divests the indirect financial interest before the audit commences.
Show answer & explanationAnswer & explanation
Correct answer: C. Decline the engagement, as the identified financial interest impairs the firm's independence.
A material indirect financial interest held by a partner in the same office as the engagement partner, in an entity that is a significant source of revenue for the audit client, generally impairs the firm's independence. Divestiture would only resolve the issue if the interest was direct or immaterial indirect, which is not the case here. Disclosure and committee approval do not mitigate an actual impairment.
Why the other options are wrong
- A. Disclosure and audit committee approval do not overcome a fundamental impairment of independence under AICPA rules.
- B. Simply excluding the partner does not resolve the firm's independence impairment due to the partner's material indirect financial interest.
- D. Divestiture might be an option for certain types of interests, but a material indirect interest in a significant revenue source for the client typically represents an unmitigable impairment.
Independence Impairment: Financial Interests
Independence is impaired if a covered member (which includes partners in the same office as the engagement partner) has a material indirect financial interest in an audit client.
- Materiality is key for indirect interests.
- Indirect interests are often held through intermediaries (e.g., mutual funds).
- A partner in the same office as the engagement partner is considered a covered member for independence purposes.
Memory trick: Always be independent, or your audit is incomplete.