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 1 Introduction – the need for professional ethics The purpose of assurance engagements is to increase the confidence of end users of information by reducing their level of risk. It therefore follows that the user needs to trust the professional who is providing the assurance. In order to be trusted the auditor needs to be independent of their client. Independence can be defined as having 'freedom from situations and relationships where objectivity would be perceived to be impaired by a reasonable and informed third party.’ Despite this need for trust the last thirty years has witnessed a number of high profile corporate scandals that have had far reaching implications for companies, economies and accountancy firms. Enron and Worldcom are perhaps two of the most high profile examples from recent times. To improve the image of the profession and to restore trust between users of accountancy services and the practitioners, it is vital that accountants operate (and are perceived to operate) according to an accepted code of ethics. 2 The IFAC and ACCA codes and the conceptual framework IFAC, through the International Ethics Standards Board for Accountants, has issued a code of ethics, as has the ACCA. The ACCA Code of Ethics is covered in this chapter however, both the IFAC and ACCA codes have the same roots and are, to all intents and purposes identical. Both follow a conceptual framework which identifies:
A conceptual framework relies on a principles rather than a rules based approach. This provides guidance so that the principles may be applied to wide ranging and - potentially - unique circumstances. Giving the framework some teeth Whilst it is expected that practitioners apply the spirit of the code to every day practice the framework and principles would be of little use if they could not be enforced. Professional bodies like the ACCA therefore reserve the right to discipline members who infringe the rules through a process of:
3 The fundamental principles The formal definitions of the fundamental principles are as follows:
Members should act diligently and in accordance with applicable technical and professional standards when providing professional services.
4 Threats and safeguards The following are all examples of behaviour that could threaten the practitioner's independence from their clients: Self interest threat This occurs when an auditor has a beneficial interest in a client's performance. Examples include:
Self review threat This occurs when an auditor has to review work that they previously performed. For example: if the external auditor prepared the financial statements and then audited them. There is a risk that the auditor would not identify any shortcomings in their own work for fear of penalty (either financial or reputational). Advocacy threat This can occur when the auditor is asked to promote or represent their client in some way. In this situation the auditor would have to be biased in favour of the client and therefore cannot be objective. This could happen if the client asked the auditor to promote their shares for a stock exchange listing or if the client asked the auditor to represent them in court. Familiarity threat This occurs when the auditor is too sympathetic or trusting of the client because of a close relationship with them. This may be because a close friend or relative of the auditor works in a key role for the client. The auditor may trust their friend or relative to not make mistakes and therefore not review their work as thoroughly as they should and as a result allow material errors to go undetected in the financial statements. This can also arise after a long association with a client. Intimidation threat Clients may try to harass or bully auditors into giving preferential audit reports. They may use the fee as leverage. The auditor should not give in to such pressure and, in the circumstances, may choose to resign from such a client. Identifying the threats In order to guard against these threats, real or perceived, firms should establish procedures to enable them to:
Usually this will be done through the use of checklists. Whilst ethics should always be of paramount consideration it must be considered at these vital junctures:
Possible safeguards General safeguards, as recommended by ACCA
Specific safeguards It is important to note that the safeguards listed below are generally well regarded principles that can be applied across a range of engagements and national boundaries. However, national regulatory authorities may have their own ethical standards (such as the UK's Auditing Practices Board's Ethical Standards) which are enforceable nationally. In certain circumstances the limits and thresholds may be different Common safeguards that should be employed by auditors include:
5 Confidentiality External auditors are in a unique position of having a legal right of access to all information about their clients. The client must be able to trust the auditor not to disclose anything about their business to anyone as it could be detrimental to their operations. As a basic rule, members of an audit team should not disclose any information to those outside of the audit team, whether or not they work for the same firm. There is little point using different teams for different work assignments if staff from different teams are disclosing information to each other! Information should only be disclosed under certain circumstances. In some circumstances the auditor must disclose the information and in others the auditor may chose to disclose the information, as follows:
Legal advice should be sought beforehand to avoid the risk of being sued. Matters to consider before disclosing information in the public interest are whether that matter is likely to be repeated and how serious the effects of the client’s actions are. Conflicts of interest Any advice given should be in the best interests of the client. However, where clients' interests conflict (for example, clients in the same line of business), the firm’s work should be arranged to avoid the interests of one being adversely affected by those of another. The steps to be taken by the auditor are:
6 Accepting new audit engagements Preconditions Auditors should only accept a new audit engagement, or continue an existing audit engagement if the 'preconditions for an audit' required by ISA 210 Agreeing the terms of audit engagements are present. ISA 210 requires the auditor to:
If the preconditions for an audit are not present, the auditor should discuss the matter with management, and should not accept the engagement unless required to do so by law or regulation. If offered an audit role, the auditor should:
7 Engagement letters Engagement letters – main considerations The engagement letter will be sent before the audit. It specifies the nature of the contract between the audit firm and the client and minimises the risk of any misunderstanding of the auditor’s role. It should be reviewed every year to ensure that it is up to date but does not need to be reissued every year unless there are changes to the terms of the engagement. The auditor must issue a new engagement letter if the scope or context of the assignment changes after initial appointment. ISA 210 requires the auditor to consider whether there is a need to remind the entity of the existing terms of the audit engagement for recurring audits and many firms choose to send a new letter every year, to emphasise its importance to clients. Reasons for changes include:
The contents of the engagement letter The contents of a letter of engagement for audit services are listed in ISA 210 Agreeing the Terms of Audit Engagements. They should include the following:
Whites & Harper Inc. 25 November 20X0 To the Board of Directors of Blake Co. This letter and the attached terms of business dated 25 November 20X0 set out the basis on which we are to provide services as auditors and your and our respective responsibilities. The objective and scope of the audit: You have requested that we audit the financial statements of Blake Company, which comprise the statement of financial position as at December 31, and the income statement, statement of changes in equity and cash flow statement for the year then ended, and a summary of significant accounting policies and other explanatory information. We are pleased to confirm our acceptance and our understanding of this audit engagement by means of this letter. Our audit will be conducted with the objective of our expressing an opinion on the financial statements. The responsibilities of the auditor: We will conduct our audit in accordance with International Standards on Auditing (ISAs). Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the financial statements. The procedures selected depend on the auditor's judgment, including the assessment of the risks of material misstatement of the financial statements, whether due to fraud or error. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the financial statements. Because of the inherent limitations of an audit, together with the inherent limitations of internal control, there is an unavoidable risk that some material misstatements may not be detected, even though the audit is properly planned and performed in accordance with ISAs. In making our risk assessments, we consider internal control relevant to the entity's preparation of the financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity's internal control. However, we will communicate to you in writing concerning any significant deficiencies in internal control relevant to the audit of the financial statements that we have identified during the audit. The responsibilities of management: Our audit will be conducted on the basis that management acknowledge and understand that they have responsibility: (a)For the preparation and fair presentation of the financial statements in accordance with International Financial Reporting Standards; (b)For such internal control as management determines is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error; and (c)To provide us with: (i)Access to all information of which management is aware that is relevant to the preparation of the financial statements such as records, documentation and other matters; (ii) Additional information that we may request from management for the purpose of the audit; and (iii)Unrestricted access to persons within the entity from whom we determine it necessary to obtain audit evidence. As part of our audit process, we will request from management written confirmation concerning representations made to us in connection with the audit. We look forward to full cooperation from your staff during our audit. Report: We will report to the members of Blake Company as a body, whether in our opinion the financial statements present fairly in all material respects, the financial position of Blake Company as at December 31, and its financial performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards. The form and content of our report may need to be amended in the light of our audit findings. Fees: Our fees, which will be billed as work progresses, are based on the time required by the individuals assigned to the engagement plus out-of-pocket expenses. Individual hourly rates vary according to the degree of responsibility involved and the experience and skill required. Period of engagement: This engagement will start on 01 January 20X1 with the company's accounting period ending on 31 December. We will not be responsible for earlier years. The company’s previous advisers, Jones & Mackay Inc. will deal with outstanding returns, assessments and other matters relating to earlier periods. This letter supersedes any previous engagement letter for the period covered. Once agreed, this letter will remain effective for future years from the date of signature unless it is terminated, amended or superseded. You or we may agree to vary or terminate our authority to act on your behalf at any time without penalty. Notice of variation or termination must be given in writing. Limitation of liability: To the fullest extent permitted by law, we will not be responsible for any losses, where you or others supply incorrect or incomplete information, or fail to supply any appropriate information or where you fail to act on our advice or respond promptly to communications from us. Our work is not, unless there is a legal or regulatory requirement, to be made available to third parties without our written permission and we will accept no responsibility to third parties for any aspect of our professional services or work that is made available to them. Confirmation of your agreement: Please confirm your agreement to the terms of this letter and the attached terms of business by signing and returning the enclosed copies. Please sign and return the attached copy of this letter to indicate your acknowledgement of, and agreement with, the arrangements for our audit of the financial statements including our respective responsibilities. If this letter and the attached terms of business are not in accordance with your understanding of our terms of appointment, please let us know. Whites & Harper Inc. Acknowledged and agreed on behalf of Blake Company by .......................... In addition to the above the engagement letter may also make reference to:
The APB has issued a set of UK specific ethical standards designed to ensure practitioners comply with the IFAC Code of Ethics. These can be summarised as follows: Ethical Standard 1 - integrity, objectivity and independence
(i)when considering whether to accept or retain an audit or non-audit service; (ii) when planning the audit (iii)when forming an opinion on the financial statements; and (iv)when potential threats are reported
(i)consider the audit firm's compliance with APB Ethical Standards; and (ii) form an independent opinion as to the appropriateness and adequacy of the safeguards applied. Ethical Standard 2 - financial, business, employment and personal relationships
ES 3 - Long association with the audit engagement
ES 4 - Fees, remuneration and evaluation policies, litigation, gifts and hospitality
ES 5 - non-audit services provided to audited entities
ES - Provisions Available for Small Entities (PASE)
You are a manager in the audit firm of JT & Co; and this is your first time you have worked on one of the firm's established clients, Pink Co. The main activity of Pink Co is providing investment advice to individuals regarding saving for retirement, purchase of shares and securities and investing in tax efficient savings schemes. Pink is regulated by the relevant financial services authority. You have been asked to start the audit planning for Pink Co, by Mrs Goodall, a partner in JT & Co. Mrs Goodall has been the engagement partner for Pink Co, for the previous six years and so has a sound knowledge of the client. Mrs Goodall has informed you that she would like her son Simon to be part of the audit team this year; Simon is currently studying for his first set of fundamentals papers for her ACCA qualification. Mrs Goodall also informs you that Mr Supper, the audit senior, received investment advice from Pink Co during the year and intends to do the same next year. In an initial meeting with the finance director of Pink Co, you learn that the audit team will not be entertained on Pink Co's yacht this year as this could appear to be an attempt to influence the opinion of the audit. Instead, he has arranged a day at the horse races costing less than two fifth's of the expense of using the yacht and hopes this will be acceptable. JT & Co have done some consultive work previously and the invoice is still outstanding. Required: (a) (i) Explain the ethical threats which may affect the auditor of Pink Co. (6 marks) (ii) For each ethical threat, discuss how the effect of the threat can be mitigated. (6 marks) (Total: 12 marks) You are a manager in the audit firm of JT & Co; and this is your first time you have worked on one of the firm's established clients, Pink Co. The main activity of Pink Co is providing investment advice to individuals regarding saving for retirement, purchase of shares and securities and investing in tax efficient savings schemes. Pink is regulated by the relevant financial services authority. You have been asked to start the audit planning for Pink Co, by Mrs Goodall, a partner in JT & Co. Mrs Goodall has been the engagement partner for Pink Co, for the previous six years and so has a sound knowledge of the client. Mrs Goodall has informed you that she would like her son Simon to be part of the audit team this year; Simon is currently studying for his first set of fundamentals papers for her ACCA qualification. Mrs Goodall also informs you that Mr Supper, the audit senior, received investment advice from Pink Co during the year and intends to do the same next year. In an initial meeting with the finance director of Pink Co, you learn that the audit team will not be entertained on Pink Co's yacht this year as this could appear to be an attempt to influence the opinion of the audit. Instead, he has arranged a day at the horse races costing less than two fifth's of the expense of using the yacht and hopes this will be acceptable. JT & Co have done some consultive work previously and the invoice is still outstanding. Required: (a) (i) Explain the ethical threats which may affect the auditor of Pink Co. (6 marks) (ii) For each ethical threat, discuss how the effect of the threat can be mitigated. (6 marks) (Total: 12 marks)
Explain each of the FIVE fundamental principles of ACCA’s Code of Ethics and Conduct. Real exam question: December 2007 (5 marks)
(a)There are legal and professional arrangements for the appointment and removal of auditors. (i)State the circumstances in which a person is not eligible to act as an auditor (2 marks) (ii) Describe the steps required to remove an auditor from an engagement. (3 marks) You are a manager in the audit department of Whilling and Abel. A potential new client, Truckers Ltd, a haulage company, has approached your firm to do the statutory audit in addition to some other non-audit services for the financial year ended 30 September 2011. Your audit firm was recommended to Truckers by an existing client, O&P, a shipping company who is also a major customer of Truckers Ltd. You have been chosen to lead the assignment as you have experience of auditing haulage companies and you also manage the audit of O&P. Whilst arranging the initial meeting with the directors of Truckers you discover that you studied accountancy with the finance director at university. During the meeting, you establish that Truckers has not made a profit for the last 2 years. The directors explain that this is largely due to escalating costs in the industry including fuel price rises. They are confident they have now controlled their costs for the current year to 30 September 2010. They have also been approached to tender for a large profitable contract which would improve their financial performance going forward. They would like you to assist them with the preparation of this tender and present with them on the day. The current year's financial statements and audit are being finalised with another audit firm. The finance director tells you that the current auditors have identified material misstatements but the board of directors are refusing to make these adjustments. If adjusted, it would turn the break even position into a loss. The finance director told you this information informally whilst catching up on old times at the local pub. The current auditors have replied to your professional clearance letter and have informed you that they are still owed fees relating to the year ended 30 September 2010. This is under dispute with the client. Once back from the meeting you calculate that the potential fees from Truckers would amount to about 14% of your firms total fee income. Required: (b)Identify and explain the threats to auditor independence if Whilling and Abel accept Truckers as a new client. For each threat, recommend how the threat can be managed. (15 marks) (Total: 20 marks) Client confidentiality underpins the relationship between Chartered Certified Accountants in practice and their clients. It is a core element of ACCA's Rules of Professional Conduct. Required: (a)Explain the circumstances in which ACCA's Rules of Professional Conduct permit or require external auditors to disclose information relating to their clients to third parties without the knowledge or consent of the client. (8 marks) (b)A waste disposal company has breached tax regulations, environmental regulations and health and safety regulations. The auditor has been approached by the tax authorities, the government body supervising the award of licences to such companies and a trade union representative. All of them have asked the auditor to provide them with information about the company. The auditor has also been approached by the police. They are investigating a suspected fraud perpetrated by the managing director of the company and they wish to ask the auditor certain questions about him. Describe how the auditor should respond to these types of request. (12 marks) (Total: 20 marks) 8 Chapter summary Test your understanding answers
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Fundamental principles Integrity. A professional accountant should be honest and straightforward in performing professional services. Objectivity. A professional accountant should be fair and not allow personal bias, conflict of interest or influence of others to override objectivity. Professional competence and due care. When performing professional services, a professional accountant should show competence and duty of care by keeping up-to-date with developments in practice, legislation and techniques. Confidentiality. A professional accountant should respect the confidentiality of information acquired during the course of providing professional services and should not use or disclose such information without obtaining client permission. Professional behaviour. A professional accountant should act in a manner consistent with the good reputation of the profession and refrain from any conduct which might bring discredit to the profession.
(a) (i)A person is not eligible to act as an auditor for the following reasons:
(ii) Steps required to remove an auditor from an engagement
(b)Threats to independence
(a)Disclosure of information relating to clients to third parties (i)Auditors are permitted or required to disclose information about their clients to third parties without their knowledge or consent in very limited circumstances. (ii) Generally, auditors can be required to, or are permitted to, disclose information to certain regulatory bodies, including certain specialist units within police forces under legislation. Such legislation in many countries includes financial services legislation, legislation concerning banks and insurance companies, legislation concerning money laundering and legislation concerning the investigation of serious fraud or tax evasion. (iii)Auditors are also permitted or required to disclose information where they are personally involved in litigation, including litigation that involves the recovery of fees from clients, or where they are subject to disciplinary proceedings brought by ACCA or other, similar professional bodies. (iv)Auditors are also permitted to disclose information where they consider it to be in the 'public interest' or in the interests of national security. Factors to take into account include the seriousness of the matter, the likelihood of repetition and the extent to which the public is involved. This right is rarely used in practice. (b) Response to requests (i)It is not unusual in practice for various bodies to request information from auditors 'informally' because it relieves them of the obligation to obtain the necessary statutory authorities which may be time consuming or difficult. (ii) Auditors must not disclose information without the consent of the client or unless the necessary statutory documentation is provided by the person(s) requesting the information. (iii)Unless the auditor has reason to believe that there is a statutory duty not to inform the client that an approach has been made, the client should first be approached to see if consent can be obtained, and to see if the client is aware of the investigations, as should normally be the case. The auditor should ensure that the client is aware of the fact the voluntary disclosure may work in the client's favour, in the long run, but if the client refuses, the auditor should inform the client if the auditor has a statutory duty of disclosure. (iv)Auditors should take legal advice in all of the cases described. (v) Where the auditor is made aware of potential actions against the client that may have an effect on the financial statements, the auditor must consider the effect on the audit report. If the client is aware of the investigation, the auditor will be able to seek audit evidence to support any necessary provisions or disclosures in the financial statements. (vi)The auditors should consider whether the suspected fraud relating to the managing director relates to the company and affects the financial statements. (vii)Auditors will be in a very difficult situation if they become aware of an action that may materially affect the financial statements, but where the client is not, and where auditors are under a statutory duty not to inform the client. This situation will not be improved by the resignation of auditors as they may be obliged to make a statement on resignation. This puts auditors in a very difficult position and legal advice is essential in such circumstances. (viii)Tax authorities normally have powers to ask clients to disclose information voluntarily. Such voluntary disclosure is often looked on favourably by the tax authorities and the courts. Tax authorities normally also have statutory powers to demand information from both clients and auditors. The same is generally true of environmental and health and safety inspectors. (ix)The power of the police to demand information is sometimes less clear and auditors and clients should take care to ensure that the appropriate authorities are in place. Those sections of the police investigating serious frauds usually have more powers than the general police. It is unlikely that trade union representatives have any statutory powers to demand information.
What are safeguards in auditing?Safeguards are actions or other measures that may eliminate threats or reduce them to an acceptable level.
Which of the following may be considered by a professional accountant to eliminate or reduce identified threats to an acceptable level?200.9 Safeguards that may eliminate or reduce threats to an acceptable level fall into two broad categories: (a) Safeguards created by the profession, legislation or regulation; and (b) Safeguards in the work environment.
What are the threats of an auditor?Five Threats to Auditor Independence. Self-Interest Threat. A self-interest threat exists if the auditor holds a direct or indirect financial interest in the company or depends on the client for a major fee that is outstanding. ... . Self-Review Threat. ... . Advocacy Threat. ... . Familiarity Threat. ... . Intimidation Threat.. How can auditors reduce selfSelf-review threat can be avoided by having separate teams for audit and other services. If that is not possible, consider relinquishing the engagement. It arises when an auditor also acts as an advocate for (or against) an audit client's position or opinion by representing them.
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