Auditor Independence and Non-Audit Services

Under SEC and AICPA independence rules for public companies:

1. Design and implementation of patient billing system: This is a management function and a system that generates financial information. Under SEC rules (Rule 2-01(c)(4)(i)), an auditor cannot design or implement a financial information system that is significant to the audit. The billing system directly affects revenue, a significant account. Providing this service would create a self-review threat (auditor reviewing its own work) and a management participation threat. No safeguards can reduce these threats to an acceptable level. Therefore, the firm should not provide this service.
2. Internal audit staffing: The SEC rules (Rule 2-01(c)(4)(v)) prohibit auditors from providing internal audit services if the client relies on the internal audit function for its financial reporting. However, if the client does not rely on internal audit, the auditor may provide internal audit services, but the client must retain responsibility for the function, and the auditor cannot act as management. Temporary staffing for six months may be considered management participation if the individual makes decisions. The firm must ensure that HCP's management directs the work and evaluates results. Given the significance of internal audit to financial reporting, this service may also impair independence if it involves testing controls or financial information that the auditor will rely on. Safeguards such as separate teams and quality reviews may help, but the threat may be too high.
3. Fee dependence: The $500,000 fee is 25% of the firm's total revenues from HCP? Actually, the problem says 25% of the firm's total annual revenues from HCP. Wait, it says: "$500,000, which is 25% of your firm's total annual revenues from HCP." That phrasing is ambiguous: it could mean 25% of total revenues of the firm? The text: "The fees for the non-audit services would be $500,000, which is 25% of your firm's total annual revenues from HCP." Actually it says "total annual revenues from HCP" – so it's 25% of the firm's total revenues from HCP? That would be a huge percentage of the client's fees? Usually, the concern is if fees from one client exceed 15% of the firm's total revenues. Here it says 25% of the firm's total annual revenues from HCP, meaning the non-audit fees are 25% of the total fees from HCP. That might not be the correct interpretation. Let's read carefully: "The fees for the non-audit services would be $500,000, which is 25% of your firm's total annual revenues from HCP." This likely means that the non-audit fees are 25% of the total revenues the firm receives from HCP (i.e., audit plus non-audit). So total fees from HCP would be $2 million, of which $500k is non-audit. That's not a fee dependence issue (the 15% rule applies to total fees from one client as a percentage of the firm's total revenues). But it could be if the firm's total revenues are small. The problem doesn't give the firm's total revenues, so we can't assess the 15% rule. However, the SEC also considers whether non-audit fees exceed audit fees? Actually, the SEC does not have a strict ratio, but high non-audit fees can create threats. The AICPA Conceptual Framework requires evaluating threats.
4. Partner's husband: Sarah's husband is a senior manager in finance at HCP. Under SEC rules, an audit partner's immediate family member in a "financial reporting oversight role" at the client impairs independence. A senior manager in finance may be in a financial reporting oversight role if they have influence over financial statements. Even if not directly involved, the appearance of a conflict exists. This is a threat that cannot be safeguarded. Sarah should be removed from the engagement.

Conclusion: The firm cannot provide the billing system design due to self-review and management participation threats. The internal audit staffing may also impair independence if it involves management functions or if the client relies on internal audit. The partner's husband situation requires Sarah's removal. The firm should decline both non-audit services to maintain independence.

Under SEC independence rules (Rule 2-01(c)(2)), an auditor's independence is impaired if an audit partner's immediate family member is employed by the client in a financial reporting oversight role. A senior manager in the finance department likely has influence over financial reporting, especially if involved in preparing or reviewing financial statements. Even if not directly involved in the billing system, the husband's position creates a familiarity threat and an appearance of conflict. The firm must remove Sarah from the audit engagement to maintain independence. Alternatively, if the husband's role is clearly not a financial reporting oversight role (e.g., he is a senior manager in a non-accounting finance function like treasury without influence over financial statements), the firm might document that determination. However, given the senior manager title in finance, it is safer to remove Sarah. The firm should also consider whether Sarah's removal is sufficient or if the entire engagement team needs to be independent of the husband. The firm should document the evaluation and the safeguards applied.