BPP ACCA P7 Advance Audit and Assurance 2017

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International regulatory

environments for audit

and assurance services

Introduction

This chapter covers a wide range of regulations that affect the work of audit

and assurance professionals. You need to be aware of the international nature

of the audit and assurance market and the main issues driving the development

of regulatory frameworks.

The detailed requirements relating to money laundering are then discussed.

You should be prepared to explain the responsibilities of professional

accountants in this area and to outline the procedures that audit firms should

implement.

The final section looks at the auditor's responsibilities in respect of laws and

regulations that apply to an audit client. This is a topic that could be built in to a

practical case study question.

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4 1: International regulatory environments for audit and assurance services  Part A Regulatory environment

Study guide

Intellectual level

A Regulatory environment

A1 International regulatory frameworks for audit and assurance services

(a) Explain the need for laws, regulations, standards and other guidance relating

to audit, assurance and related services.

2

(b) Outline and explain the legal and professional framework including:

(i) Public oversight to an audit and assurance practice

(ii) The role of audit committees and impact on audit and assurance

practice

2

A2 Money laundering

(a) Define 'money laundering'. 1

(b) Explain how international efforts seek to combat money laundering. 2

(c) Explain the scope of criminal offences of money laundering and how

professional accountants may be protected from criminal and civil liability.

2

(d) Explain the need for ethical guidance in this area. 2

(e) Describe how accountants meet their obligations to help prevent and detect

money laundering including record keeping and reporting of suspicion to

the appropriate regulatory body.

2

(f) Explain the importance of customer due diligence (CDD). 2

(g) Recognise potentially suspicious transactions and assess their impact on

reporting duties.

2

(h) Describe, with reasons, the basic elements of an anti money laundering

programme.

2

A3 Laws and regulations

(a) Compare and contrast the respective responsibilities of management and

auditors concerning compliance with laws and regulations in an audit of

financial statements.

2

(b) Describe the auditor's considerations of compliance with laws and

regulations and plan audit procedures when possible non-compliance is

discovered.

2

(c) Discuss how and to whom non-compliance should be reported. 2

(d) Recognise when withdrawal from an engagement is necessary. 2

Exam guide

The technical content of this part of the syllabus is mainly drawn from your earlier studies. Questions in

this paper are unlikely to ask for simple repetition of this knowledge, but are more likely to require

explanation or discussion of the reasons behind the regulations.

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Part A Regulatory environment  1: International regulatory environments for audit and assurance services 5

1 International regulatory frameworks for audit and

assurance services

Major developments in international regulation of audit and assurance have recently concluded, with farreaching

effects on ISAs.

1.1 The need for laws, regulations, standards and other guidance

Corporate scandals, such as Enron and Worldcom in the US, Olympus in Japan and Autonomy in the UK,

have brought the audit profession under close scrutiny from investors, businesses, regulators and others.

There is a trend towards businesses becoming more complex and global, and firms of accountants have

expanded their range of services well beyond traditional assurance and tax advice. This has led to a great

deal of re-examination of regulatory and standard-setting structures both nationally and internationally in

recent years.

Laws are in many respects a last resort in the task of ensuring that audits are conducted properly and are

of a high quality. As a generalisation, laws tend to be prescriptive and dissuasive. They are external to the

auditor, requiring them to act within the letter (although not necessarily the spirit) of the law in order to

avoid punishment. Law is a relatively blunt instrument for regulation.

At the other extreme would be a moral code that is purely internal to the auditor's self, which the individual

would adhere to irrespective of external consequences. The audit profession does not attempt to set out

such a code, this being the more proper area for broader social, moral or religious authority.

Audit regulations do take the presence of external laws and internal morality as their starting points, but sit

somewhere in between these two extremes. International standards are principles-based, representing a

common set of principles and practices which are more flexible than statutory laws, allowing for an

element of ambiguity and judgement on the part of the auditor. At the same time, however, auditing

standards are not simply general statements of morality: they contain specific suggestions for the auditor

to consider in specific circumstances, which are not legally binding but which provide a starting point for

the auditor in a given situation.

1.2 The legal and professional framework

One of the competencies you require to fulfil Performance Objective 18 of the PER is the ability to apply up

to date auditing standards and applicable frameworks. You can apply the knowledge you obtain from this

section of the Study Text to help you demonstrate this competency.

You have studied the regulatory framework in earlier papers. The following summaries will provide a quick

reminder. Note that the UK regulatory framework is given in this International-stream Study Text as an

example only.

1.2.1 Overview of the UK regulatory framework

The EU Eighth Directive on company law requires that persons carrying out statutory audits must be

approved by the authorities of EU member states. The authority to give this approval in the UK is delegated

to Recognised Supervisory Bodies (RSBs). An auditor must be a member of an RSB and be eligible under

its own rules. The ACCA is an RSB.

The RSBs are required by the Companies Act to have rules to ensure that persons eligible for appointment

as a company auditor are either:

 Individuals holding an appropriate qualification

 Firms controlled by qualified persons

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6 1: International regulatory environments for audit and assurance services  Part A Regulatory environment

The Financial Reporting Council

The Financial Reporting Council (FRC) is the UK's independent regulator for corporate reporting and

governance. It has the following core structure and responsibilities under the overarching FRC Board.

 Codes and Standards Committee – responsible for actuarial policy, audit and assurance, corporate

governance, and accounting and reporting policy

 Conduct Committee – responsible for audit quality review, corporate reporting review, professional

discipline, professional oversight, and supervisory inquiries

 Executive Committee – providing day to day oversight of the work of the FRC

The main changes that concern P7 students are:

 Auditing standards (ISAs) are the direct responsibility of the FRC Board – but the Board is advised

by the new 'Codes and Standards Committee', which is in turn advised by the new 'Audit and

Assurance Council'. Auditing standards were formerly the responsibility of the APB.

 Accounting standards are the responsibility of the FRC Board, which is advised by the 'Codes and

Standards Committee' and the 'Accounting Council' in turn. Accounting standards were formerly

the responsibility of the ASB.

The revised role of the FRC Board is:

 To set high standards of corporate governance through the UK Corporate Governance Code

 To set standards for corporate reporting and actuarial practice

 To monitor and enforce accounting and auditing standards

 To oversee regulatory activities of the actuarial profession and professional accountancy bodies

 To operate independent disciplinary arrangements for public interest cases

The revised structure is shown by the following diagram.

FRC Board

Conduct

Committee

Conduct

Committee

Actuarial

Council

Accounting

Council

Audit & Assurance

Council

Financial

Reporting Review

Panel

Case

Mangement

Committee

Monitoring

Committee

Tribunal

Codes & Standards

Committee

Although this restructure took place some time ago, the FRC is still in the process of 'rebranding'

documents and other publications issued by the former APB and other bodies under the old structure. You

will therefore see references in the Text to APB pronouncements where these still exist and are in force.

Point to note

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Part A Regulatory environment  1: International regulatory environments for audit and assurance services 7

1.2.2 International standard setting

International Standards on Auditing (ISAs) are produced by the International Auditing and Assurance

Standards Board (IAASB), a technical standing committee of the International Federation of Accountants

(IFAC). You should also be familiar with the International Ethics Standards Board for Accountants (IESBA),

another body of IFAC and the producer of the Code of Ethics (see Chapter 2).

The IAASB's Preface to International Standards on Quality Control, Auditing, Assurance and Related

Services Pronouncements states that all the IAASB's 'engagement standards' above are 'authoritative

material', which means that they must be followed in an audit that is conducted in accordance with ISAs.

The IAASB also publishes four kinds of 'non-authoritative material'.

 International Auditing Practice Notes (IAPNs). These do not impose additional requirements on

auditors, but provide them with practical assistance.

 Practice Notes Relating to Other International Standards, eg in relation to ISREs, ISAEs or ISRSs

 Staff Publications, which are used to help raise awareness of new or emerging issues, and to direct

attention to the relevant parts of IAASB pronouncements

 Consultation Papers, which seek to generate discussion with stakeholders

Within each country, local regulations govern, to a greater or lesser degree, the practices followed in the

auditing of financial or other information. Such regulations may be either of a statutory nature, or in the

form of statements issued by the regulatory or professional bodies in the countries concerned.

National standards on auditing and related services published in many countries differ in form and

content. The IAASB takes account of such documents and differences and, in the light of such knowledge,

issues ISAs which are intended for international acceptance.

The European Union, for example, has since 2014 required ISAs (as issued by the IAASB) to be adopted at

EU level. Member states may impose additional requirements on auditors (such as the FRC, whose ISAs

(UK and Ireland) are in some places more stringent than the IAASB's ISAs) but these must not contradict

EU ISAs.

IFAC

(International Federation of

Accountants)

IAASB

(International Auditing and

Assurance Standards Board)

 ISAs (International

Standards on Auditing)

 ISQCs (International

Standards on Quality

Control)

 ISREs (International

Standards on Review

Engagements)

 ISAEs (International

Standards on Assurance

Engagements)

 ISRSs (International

Standards on Related

Services)

IESBA

(International Ethics Standards

Board for Accountants) Board

for countants)

 Code of Ethics for

Professional Accountants

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8 1: International regulatory environments for audit and assurance services  Part A Regulatory environment

The IAASB issued A Framework for Audit Quality in this area, which is covered in Chapter 18.

1.2.3 Current ISAs and other examinable documents

Title F8 P7

International Standards on Auditing (ISAs)

Glossary of Terms  

International Framework for Assurance Assignments  

Preface to the International Standards on Quality Control, Auditing,

Review, Other Assurance and Related Services

 

ISA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit

in Accordance with ISAs

 

ISA 210 Agreeing the Terms of Audit Engagements  

ISA 220 Quality Control for an Audit of Financial Statements 

ISA 230 Audit Documentation  

ISA 240 The Auditor's Responsibilities Relating to Fraud in an Audit of Financial

Statements

 

ISA 250 Consideration of Laws and Regulations in an Audit of Financial

Statements

 

ISA 260 Communication with Those Charged with Governance  

ISA 265 Communicating Deficiencies in Internal Control to Those Charged with

Governance and Management

 

ISA 300 Planning an Audit of Financial Statements  

ISA 315 Identifying and Assessing the Risks of Material Misstatement through

Understanding the Entity and Its Environment

 

ISA 320 Materiality in Planning and Performing an Audit  

ISA 330 The Auditor's Responses to Assessed Risks  

ISA 402 Audit Considerations Relating to an Entity Using a Service Organisation  

ISA 450 Evaluation of Misstatements Identified During the Audit  

ISA 500 Audit Evidence  

ISA 501 Audit Evidence – Specific Considerations for Selected Items  

ISA 505 External Confirmations  

ISA 510 Initial Audit Engagements – Opening Balances  

ISA 520 Analytical Procedures  

ISA 530 Audit Sampling  

ISA 540 Auditing Accounting Estimates, Including Fair Value Accounting Estimates

and Related Disclosures

 

ISA 550 Related Parties 

ISA 560 Subsequent Events  

International Standards on Auditing (ISAs)

ISA 570 Going Concern  

ISA 580 Written Representations  

Point to note

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Part A Regulatory environment  1: International regulatory environments for audit and assurance services 9

Title F8 P7

ISA 600 Special Considerations - Audits of Group Financial Statements (Including

the Work of Component Auditors)



ISA 610 Using the Work of Internal Auditors  

ISA 620 Using the Work of an Auditor's Expert  

ISA 700 Forming an Opinion and Reporting on Financial Statements  

ISA 701 Communicating Key Audit Matters in the Independent Auditor's Report  

ISA 705 Modifications to the Opinion in the Independent Auditor's Report  

ISA 706 Emphasis of Matter Paragraphs and Other Matter Paragraphs in the

Independent Auditor's Report

 

ISA 710 Comparative Information – Corresponding Figures and Comparative

Financial Statements

 

ISA 720 The Auditor's Responsibilities Relating to Other Information in

Documents Containing Audited Financial Statements

 

Amendments Conforming amendments to other ISAs  

Amendments Addressing Disclosures in the Audit of Financial Statements – Revised

ISAs and Related Conforming Amendments

 

International Standards on Assurance Engagements (ISAEs)

ISAE 3000 Assurance Engagements other than Audits or Reviews of Historical

Financial Information

 

ISAE 3400 The Examination of Prospective Financial Information 

ISAE 3402 Assurance Reports on Controls at a Service Organisation 

ISAE 3420 Assurance Engagements to Report on the Compilation of Pro Forma

Financial Information Included in a Prospectus



International Auditing Practice Notes (IAPNs)

IAPN 1000 Special considerations in auditing financial instruments 

International Standards on Quality Control (ISQCs)

ISQC 1 Quality Controls for Firms that Perform Audits and Reviews of Financial

Statements, and Other Assurance and Related Services Engagements



International Standards on Related Services (ISRSs)

ISRS 4400 Engagements to Perform Agreed-Upon Procedures Regarding Financial

Information



ISRS 4410 Compilation Engagements 

International Standards on Review Engagements (ISREs)

ISRE 2400 Engagements to Review Financial Statements  

ISRE 2410 Review of Interim Financial Information Performed by the Independent

Auditor of the Entity



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10 1: International regulatory environments for audit and assurance services  Part A Regulatory environment

Title F8 P7

Exposure Drafts (EDs)

IAASB Responding to Non-Compliance or Suspected Non-Compliance

with Laws and Regulations



IESBA Responding to Non-Compliance with Laws and Regulations 

IESBA Responding to a Suspected Illegal Act 

Other Documents

ACCA Code of Ethics and Conduct  

IESBA Code of Ethics for Professional Accountants (Revised May 2015) 

ACCA Technical Factsheet 145 – Anti Money-Laundering Guidance for the

Accountancy Sector



The UK Corporate Governance Code as an example of a code of best

practice (Revised September 2014)

 

FRC Guidance on Audit Committees (Revised September 2012) as an

example of guidance on best practice in relation to audit committees



IAASB Practice Alert Challenges in Auditing Fair Value Accounting

Estimates in the Current Market Environment (October 2008)



IAASB Practice Alert Audit Considerations in Respect of Going Concern in

the Current Economic Environment (January 2009)



IAASB Applying ISAs Proportionately with the Size and Complexity of an

Entity (August 2009)



IAASB XBRL : The Emerging Landscape (January 2010) 

IAASB Auditor Considerations Regarding Significant Unusual or Highly

Complex Transactions (September 2010)



IAASB Questions and Answers Professional Scepticism in an Audit of

Financial Statements (February 2012)



IESBA Staff Questions and Answers on Implementing the Code of Ethics 

IAASB Staff Questions & Answers - Applying ISQC1 Proportionately with

the Nature and Size of a Firm (October 2012)



IAASB A Framework for Audit Quality: Key Elements that Create an

Environment for Audit Quality (February 2014)



Note. Topics of exposure drafts are examinable to the extent that relevant articles about them are

published in Student Accountant.

International standards are quoted throughout this Text and you must understand how they are applied in

practice. Make sure you refer to auditing standards when answering questions.

1.3 Public oversight

Public oversight of the audit profession and of standard setting has been a trend in recent regulatory

developments internationally.

1.3.1 Public oversight internationally

The Public Interest Oversight Board (PIOB) exists to exercise oversight for all of IFAC's 'public interest

activities' including its standard-setting bodies such as the IAASB. Its work involves:

 Monitoring the standard-setting boards

Exam focus

point

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Part A Regulatory environment  1: International regulatory environments for audit and assurance services 11

 Overseeing the nomination process for membership of these boards

 Co-operation with national oversight authorities

The objective of the international PIOB is to increase the confidence of investors and others that the public

interest activities of IFAC are properly responsive to the public interest. The PIOB is based in Madrid,

Spain, where it operates as a non-profit Spanish foundation.

1.3.2 Other examples of public oversight

An example of public oversight is the Professional Oversight team of the UK's FRC (formerly the

Professional Oversight Board, or POB), which has a number of statutory responsibilities. These include:

 Independent oversight of the regulation of statutory auditors by the RSBs (eg ACCA)

 Independent supervision of Auditors General in respect of the exercise of their function as

statutory auditors

 The receipt of statutory change of auditor notifications from companies and statutory auditors in

respect of 'major audits'

Case Study

Among other significant scandals in America in recent history was the Enron scandal, when one of the

country's biggest companies filed for bankruptcy. The scandal also resulted in the disappearance of Arthur

Andersen, one of the then-Big Five accountancy firms who had audited Enron's financial statements. The

main reasons why Enron collapsed were over-expansion in energy markets, too much reliance on

derivatives trading which eventually went wrong, breaches of federal law, and misleading and dishonest

behaviour. However, enquiries into the scandal exposed a number of deficiencies in the company's

governance:

(a) A lack of transparency in the financial statements, especially in relation to certain investment

vehicles that were kept off balance sheet.

(b) The non-executive directors were weak, and there were conflicts of interest.

(c) Inadequate scrutiny by the external auditors. Arthur Andersen failed to spot or failed to question

dubious accounting treatments. Since Andersen's consultancy arm did a lot of work for Enron,

there were allegations of conflicts of interest.

(d) Information asymmetry where the directors and managers knew more than the investors.

(e) Executive compensation methods were meant to align the interests of shareholders and directors,

but seemed to encourage the overstatement of short-term profits. Particularly in the USA, where

the tenure of Chief Executive Officers is fairly short, the temptation is strong to inflate profits in the

hope that share options will have been cashed in by the time the problems are discovered.

In the US, the response to the breakdown of stock market trust caused by perceived inadequacies in

corporate governance arrangements and the Enron scandal was the Sarbanes-Oxley Act 2002. The Act

applies to all companies that are required to file periodic reports with the Securities and Exchange

Commission (SEC).

The Public Company Accounting Oversight Board (PCAOB) is a private sector body in the USA created by

Sarbanes-Oxley. Its aim is to oversee the auditors of public companies. Its stated purpose is to 'protect

the interests of investors and further the public interest in the preparation of informative, fair and

independent audit reports'. Its powers include setting auditing, quality control, ethics, independence and

other standards relating to the preparation of audit reports by issuers. It also has the authority to regulate

the non-audit services that audit firms can offer.

Sarbanes-Oxley has been criticised in some quarters for not being strong enough on certain issues, for

example the selection of external auditors by the audit committee, and at the same time being over-rigid

on others. Directors may be less likely to consult lawyers in the first place if they believe that legislation

could override lawyer-client privilege.

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12 1: International regulatory environments for audit and assurance services  Part A Regulatory environment

In addition, it has been alleged that a Sarbanes-Oxley compliance industry has sprung up focusing

companies' attention on complying with all aspects of the legislation, irrespective of how significant they

may be. This has distracted companies from improving information flows to the market and then allowing

the market to make well-informed decisions. The Act has also done little to address the temptation

provided by generous stock options to inflate profits, other than requiring possible forfeiture if financial

statements are subsequently restated.

Most significantly, perhaps, there is recent evidence of companies turning away from the US stock

markets and towards other markets, such as London. An article in the Financial Times suggested that this

was partly due to companies tiring of the increased compliance costs associated with Sarbanes-Oxley

implementation. In addition, the nature of the regulatory regime may be an increasingly significant factor

in listing decisions.

2 Corporate governance and audit committees

Audit committees are made up of non-executive directors and are perceived to increase confidence in

financial reports.

The detail on corporate governance issues in this chapter is based on UK law and regulations. It is

included as an example of how law and regulations affect the auditor in this area.

2.1 General requirements of codes of corporate governance

Corporate governance was a part of Paper F8, and your knowledge of it continues to be relevant to Paper

P7. What follows in this section (2.1) is a summary of that material, but if you are unsure of your

knowledge then you should go back to your F8 notes to refresh your memory.

Knowledge brought forward from Paper F8

Corporate governance is the system by which companies are directed and controlled. Good corporate

governance is important because the owners of a company and the people who manage the company are not

always the same.

The OECD Principles of Corporate Governance set out the rights of shareholders, the importance of disclosure

and transparency and the responsibilities of the board of directors.

2.1.1 UK Corporate Governance Code

The FRC's UK Corporate Governance Code sets out standards of good practice regarding board leadership

and effectiveness, accountability (including audit), remuneration and relations with shareholders.

All companies with a Premium Listing of equity shares in the UK are required under the Listing Rules to

report on how they have applied the Code in their annual report and accounts (regardless of whether the

company is incorporated in the UK or elsewhere).

The Code contains broad principles and more specific provisions. Listed companies have to report how

they have applied the principles, and either confirm that they have applied the provisions or provide an

explanation if they have not. There is a separate section of the Code devoted to the application of this

'comply or explain' concept. It sets out that choosing not to follow a provision may be justified by the

board if good governance is achieved by other means. However, the reasons for not complying should be

clearly and fully explained to the shareholders. Any explanation must include details as to how actual

practices are consistent with the overall principle to which a provision relates.

The broad principles of the Code are as follows.

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Part A Regulatory environment  1: International regulatory environments for audit and assurance services 13

Principles of the UK Corporate Governance Code (for listed UK companies)

Leadership

 Every company should be headed by an effective board, which is collectively responsible for the longterm

success of the company.

 There should be a clear division of responsibilities at the head of the company between the running of

the board and the executive responsibility for the running of the company's business. No one

individual should have unfettered powers of decision.

 The chairman is responsible for leadership of the board and ensuring its effectiveness on all aspects of

its role.

 As part of their role as members of a unitary board, non-executive directors should constructively

challenge and help develop proposals on strategy.

Effectiveness

 The board and its committees should have the appropriate balance of skills, experience, independence

and knowledge of the company to enable them to discharge their respective duties and responsibilities

effectively.

 There should be a formal, rigorous and transparent procedure for the appointment of new directors to

the board.

 All directors should be able to allocate sufficient time to the company to discharge their responsibilities

effectively.

 All directors should receive induction on joining the board and should regularly update and refresh

their skills and knowledge.

 The board should be supplied in a timely manner with information in a form and of a quality

appropriate to enable it to discharge its duties.

 The board should undertake a formal and rigorous annual evaluation of its own performance and that

of its committees and individual directors.

 All directors should be submitted for re-election at regular intervals, subject to continued satisfactory

performance.

Accountability

 The board should present a balanced and understandable assessment of the company's position and

prospects.

 The board is responsible for determining the nature and extent of the principal risks it is willing to take

in achieving its strategic objectives. The board should maintain sound risk management and internal

control systems.

 The board should establish formal and transparent arrangements for considering how it should apply

the corporate reporting and risk management and internal control principles and for maintaining an

appropriate relationship with the company's auditor.

Remuneration

 Executive directors' remuneration should be designed to promote the long-term success of the

company. Performance-related elements should be transparent, stretching and rigorously applied.

 There should be a formal and transparent procedure for developing policy on executive remuneration

and for fixing the remuneration packages of individual directors. No director should be involved in

deciding their own remuneration.

Relations with shareholders

 There should be a dialogue with shareholders based on the mutual understanding of objectives. The

board as a whole has responsibility for ensuring that a satisfactory dialogue with shareholders takes

place.

 The board should use the AGM to communicate with investors and to encourage their participation.

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14 1: International regulatory environments for audit and assurance services  Part A Regulatory environment

The UK Corporate Governance Code was revised in September 2012. The revisions stated that FTSE 350

companies must put the external audit out to tender at least every ten years. The change was designed to

improve both competition in the audit market and the public perception of auditors' independence. In a market

where, as a committee of the UK Parliament has pointed out, there is a 'dearth of competition', this was an

important shift.

In September 2012, the FRC revised the UK Corporate Governance Code, Stewardship Code and Guidance

on Audit Committees to introduce further guidance aimed at ensuring management, audit committees and

auditors report material issues to investors completely and fairly.

Following a consultation in late 2013, the FRC published a revised UK Corporate Governance Code again in

September 2014, this time targeting the going concern, executive remuneration, and risk management

reporting. The changes, made in response to the Sharman Inquiry in 2012, are controversial with

companies and investors. The changes around the assessment of going concern by companies, in

particular, have been criticised for failing to address the investors' concerns, and placing a heavy risk

management and reporting burden on the boards.

2.2 UK Corporate Governance Code provisions

The key requirement of the UK Corporate Governance Code is that the board must establish an audit committee

of at least three or, in the case of smaller companies, two independent non-executive directors. The main

role and responsibilities of the audit committee are listed below.

 To monitor the integrity of the financial statements of a company, and any formal announcements

relating to the company's performance, reviewing significant financial reporting judgements

contained in them

 To review the company's internal financial controls and, unless expressly addressed by a separate

board risk committee composed of independent directors or by the board itself, to review the

company's internal control and risk management systems

 To monitor and review the effectiveness of the company's internal audit function

 To make recommendations to the board, for it to put to shareholders for their approval in general

meeting, in relation to the appointment, re-appointment and removal of the external auditor and to

approve the remuneration and terms of engagement of the external auditor

 To review and monitor the external auditor's independence and objectivity and the effectiveness of

the audit process, taking into consideration relevant UK professional and regulatory requirements

 To develop and implement policy on the engagement of the external auditor to supply non-audit

services, taking into account relevant ethical guidance regarding the provision of non-audit services

by the external audit firm, and to report to the board, identifying any matters in respect of which it

considers that action and improvement is needed and making recommendations as to the steps to

be taken

 To report to the Board how it has discharged its responsibilities, including:

– How it has addressed significant issues arising in the financial statements

– How it has assessed the effectiveness of the audit process

– How auditor objectivity and independence is safeguarded, where the auditor provides nonaudit

services.

The Code also requires the Annual Report to contain a separate section describing the work of the committee.

This deliberately puts the spotlight on the audit committee and gives it an authority that it might otherwise lack.

2.3 FRC Guidance on Audit Committees

The FRC issued its Guidance on Audit Committees in September 2012, which aims to help companies to

implement the requirements of the UK Corporate Governance Code.

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Part A Regulatory environment  1: International regulatory environments for audit and assurance services 15

The particular arrangements for an audit committee should be tailored to the circumstances of the

company. Audit committees need to be proportionate to the size, complexity and risk profile of the

company.

The Guidance should not be taken as a simple list of rules. Rather, it notes that, in respect of the

relationship between the audit committee and the board, 'the most important features of this relationship

cannot be drafted as guidance or put into a code of practice'. The relationship should be frank and open,

and it should be possible for disagreement between the audit committee and the board to be robust and

based on information made freely available to the audit committee.

2.3.1 Establishment of the audit committee

As noted above, there should be three independent non-executive directors on the committee, two in the case of

smaller companies. At least one member should have recent and relevant financial experience (and a

professional accountancy qualification).

Appointments are recommended by the nomination committee, and are for a maximum of three years, but

this may be extended by a further two three-year periods (nine years in total).

There should be a minimum of three meetings per year, but the precise number depends on the

circumstances. No one who is not on the committee has a right to attend meetings (but they may be there if

invited). The committee should meet external auditors at least annually.

The committee should have sufficient resources to undertake its duties, including remuneration for its

members.

2.3.2 Relationship with the Board

The Board decides the role of the audit committee, and it is to the board that the audit committee reports. The

audit committee should report to the board on how it has discharged its responsibilities.

The committee's terms of reference should be tailored to the circumstances, and should be reviewed at least

annually.

If the committee disagrees with the Board then it should be able to report its point of view to shareholders.

2.3.3 Role and responsibilities

Financial reporting. The audit committee reviews significant issues and judgements. Management is

responsible for preparing the financial statements – the audit committee then reviews them, taking into account

the external auditor's point of view.

Narrative reporting. If the board requests it to, the audit committee will review the annual report and advise on

whether it is fair, balanced and understandable.

Whistleblowing. The committee reviews arrangements by which staff can raise concerns about improper

financial reporting.

Internal controls and risk management systems. These systems are management's responsibility, but the

audit committee reviews them and approves statements made about them in the annual report.

Internal audit. The audit committee reviews the effectiveness of the internal audit function, including

assessing whether one is needed (if it is not already present).

In its review of the work of the internal audit function, the audit committee should:

 Ensure that the internal auditor has direct access to the board chairman and to the audit

committee, and is accountable to the audit committee

 Review and assess the annual internal audit work plan

 Receive a report on the results of the internal auditors' work on a periodic basis

 Review and monitor management's responsiveness to the internal auditor's findings and

recommendations

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 Meet with the head of internal audit at least once a year without the presence of management

 Monitor and assess the role and effectiveness of the internal audit function in the overall context of

the company's risk management system

2.3.4 Role and responsibilities in relation to external auditor

The audit committee is the body responsible for overseeing the company's relations with the external auditor.

Role and responsibilities of audit committee towards external auditor

The audit committee makes a recommendation on the appointment,

reappointment and removal of the external auditors.

If this is not accepted then the annual report must contain a statement

explaining the differing opinions of the audit committee and the board.

The committee assesses the auditor's qualifications, expertise, resources,

and independence annually.

Appointment and tendering

FTSE 350 companies put the audit out to tender at least every ten years.

The audit committee approves the terms of engagement and the

remuneration of the external auditor.

Terms and remuneration

The audit committee reviews:

 The engagement letter (each year)

 The scope of the audit

At the start of each annual audit cycle, the audit committee ensures

appropriate plans exist for the audit.

Considers whether the auditor's overall work plan, including planned

levels of materiality, and proposed resources are appropriate.

Discuss with auditor:

 Major issues found

 Key judgements

 Levels of errors, including uncorrected misstatements

Review:

 Written representations from management

 Auditor's management letter

Annual audit cycle

Review the effectiveness of the audit process annually, and report to the

board on its findings.

Independence Annually assess auditor's independence

Recommend and develop company's policy on the provision of non-audit

services by the auditor.

2.3.5 Communication with shareholders

The audit committee section of annual report should include the following.

 A summary of the role of the audit committee

 The names and qualifications of all members of the audit committee during the period

 The number of audit committee meetings

 The significant issues considered in relation to the financial statements and how these issues

were addressed

 An explanation of how it has assessed the effectiveness of the external audit process and the

approach taken to the appointment or reappointment of the external auditor, and information on the

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length of tenure of the current audit firm, when a tender was last conducted, and any contractual

obligations that acted to restrict the audit committee's choice of external auditors

 If the external auditor provides non-audit services, how auditor objectivity and independence is

safeguarded

2.4 Advantages and disadvantages of audit committees

The key advantage to an external auditor of having an audit committee is that such a committee of

independent non-executive directors provides the auditor with an independent point of reference other

than the executive directors of the company, in the event of disagreement arising.

Other advantages that are claimed to arise from the existence of an audit committee include:

(a) It will lead to increased confidence in the credibility and objectivity of financial reports.

(b) By specialising in the problems of financial reporting and thus, to some extent, fulfilling the

directors' responsibility in this area, it will allow the executive directors to devote their attention

to management.

(c) In cases where the interests of the company, the executive directors and the employees conflict,

the audit committee might provide an impartial body for the auditors to consult.

(d) The internal auditors will be able to report to the audit committee.

Opponents of audit committees argue that the disadvantages are:

(a) There may be difficulty selecting sufficient non-executive directors with the necessary competence

in auditing matters for the committee to be really effective.

(b) The establishment of such a formalised reporting procedure may dissuade the auditors from

raising matters of judgement and limit them to reporting only on matters of fact.

(c) Costs may be increased.

Question Audit committees

Since 1978 all public companies in the US have been required to have an audit committee as a condition

of listing on the New York Stock Exchange.

(a) Explain what you understand by the term audit committee.

(b) List and briefly describe the duties and responsibilities of audit committees.

(c) Discuss the advantages and disadvantages of audit committees.

Answer

(a) An audit committee reviews financial information and liaises between the auditors and the

company. It normally consists of the non-executive directors of the company.

(b) (i) To monitor the integrity of the financial statements of the company, reviewing significant

financial reporting issues and judgements contained in them

(ii) To review the company's internal financial control system and, unless expressly addressed

by a separate risk committee or by the board itself, risk management systems

(iii) To monitor and review the effectiveness of the company's internal audit function

(iv) To make recommendations to the board in relation to the appointment of the external

auditor and to approve the remuneration and terms of engagement of the external auditors

(v) To monitor and review the external auditor's independence, objectivity and effectiveness,

taking into consideration relevant professional and regulatory requirements

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(vi) To develop and implement policy on the engagement of the external auditor to supply nonaudit

services, taking into account relevant ethical guidance regarding the provisions of

non-audit services by the external audit firm

In addition to these responsibilities, any responsible audit committee is likely to want:

(i) To ensure that the review procedures for interim statements, rights documents and similar

information are adequate

(ii) To review both the management accounts used internally and the statutory financial

statements issued to shareholders for reasonableness

(iii) To make appropriate recommendations for improvements in management control

(c) There are a number of advantages and disadvantages.

Disadvantages

(i) It is possible that the audit committee's approach may prove somewhat pedestrian,

resolving little of consequence but acting as a drag on the drive and entrepreneurial flair of

the company's senior executives.

(ii) Unless the requirement for such a body were made compulsory, as in the US, it is likely that

those firms most in need of an audit committee would nevertheless choose not to have

one. (Note. The UK Corporate Governance Code requires listed companies to have an audit

committee.)

Advantages

(i) By its very existence, the audit committee should make the executive directors more aware

of their duties and responsibilities.

(ii) It could act as a deterrent to the committing of illegal acts by the executive directors and

may discourage them from behaving in ways which could be prejudicial to the interests of

the shareholders.

(iii) Where illegal or prejudicial acts have been carried out by the executive directors, the audit

committee provides an independent body to which the auditor can turn. In this way, the

problem may be resolved without the auditor having to reveal the matter to the

shareholders, either in their report or at a general meeting of shareholders.

3 Internal control effectiveness

Internal control is a key part of good corporate governance. Directors are responsible for maintaining a

system of control that will safeguard the company's assets.

3.1 Importance of internal control and risk management

The UK Corporate Governance Code states that directors 'should maintain sound risk management and

internal control systems' (Section C2). Internal control systems help a company to manage the risks that it

takes in trying to achieve its strategic objectives. Internal control also helps to prevent and detect fraud,

and to safeguard the company's assets for the shareholders.

3.2 Directors' responsibilities

The ultimate responsibility for a company's system of internal controls lies with the board of directors.

The UK Corporate Governance Code requires directors to review the effectiveness of internal controls

at least annually.

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Part A Regulatory environment  1: International regulatory environments for audit and assurance services 19

Part of setting up an internal control system will involve assessing the risks facing the business, so that

the system can be designed to ensure those risks are avoided. As you know from your earlier studies in

auditing the system of internal control in a company will reflect the control environment, which includes

the attitude of the directors towards risk, and their awareness of it.

Internal control systems will always have inherent limitations, the most important being that a system of

internal control cannot eliminate the possibility of human error, or the chance that staff will collude in fraud.

Once the directors have set up a system of internal control, they are responsible for reviewing it regularly,

to ensure that it still meets its objectives.

The board may decide that in order to carry out their review function properly they have to employ an

internal audit function to undertake this task. The role of internal audit is discussed in more detail in

Chapter 16, but this is potentially part of its function.

If the board does not see the need for an internal audit function, the UK Corporate Governance Code

suggests that it revisits this decision on an annual basis, so that the need for internal audit is regularly

reviewed.

The UK Corporate Governance Code requires the board of directors of listed companies to report on its

review of internal controls as part of the annual report. The statement should be based on an annual

assessment of internal control which should confirm that the board has considered all significant aspects

of internal control. In particular the assessment should cover:

(a) The changes since the last assessment in risks faced, and the company's ability to respond to

changes in its business environment

(b) The scope and quality of management's monitoring of risk and internal control, and of the work of

internal audit, or consideration of the need for an internal audit function if the company does not

have one

(c) The extent and frequency of reports to the board

(d) Significant controls, failings and deficiencies which have or might have material effects on the

financial statements

(e) The effectiveness of the public reporting processes

In addition, in September 2012, the Code was revised to require directors to include a statement in the

annual report that they consider the annual report and accounts as a whole to be fair, balanced and

understandable and provides the information necessary for shareholders to assess the entity's

performance, business model and strategy.

The 2014 revision of the Code adds another specific requirement, this time about going concern. The

directors are required to state in annual and half-yearly financial statements whether they considered it

appropriate to adopt the going concern basis of accounting, and identify any material uncertainties in going

concern over a period of at least twelve months from the date of approval of the financial statements.

3.3 Auditors' responsibilities

In the UK, the FRC's Bulletin 2006/5 The combined code on corporate governance: requirements of

auditors under the listing rules of the financial services authority and the Irish stock exchange considers

what auditors should do in response to a statement on internal controls by directors.

Auditors should concentrate on the review carried out by the board. The objective of the auditors' work

is to assess whether the company's summary of the process that the board has adopted in reviewing the

effectiveness of the system of internal control is supported by the documentation prepared by the

directors and reflects that process.

The auditors should make appropriate enquiries and review the statement made by the board in the

financial statements and the supporting documentation.

Auditors will have gained an understanding of controls as part of their audit (ISA 315). However, the

requirements of ISAs are much narrower than the review performed by the directors. To avoid

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misunderstanding of the scope of the auditors' role, the auditors are recommended to use the following

wording in the auditor's report.

'We are not required to consider whether the board's statements on internal control cover all risks

and controls, or form an opinion on the effectiveness of the company's corporate governance

procedures or its risk and control procedures.'

This could be included as part of the 'Scope of the audit of financial statements' section of the report.

It is particularly important for auditors to communicate quickly to the directors any significant deficiencies

they find, because of the requirements for the directors to make a statement on internal control.

The directors are required to consider the material internal control aspects of any significant problems

disclosed in the financial statements. Auditors' work on this is the same as on other aspects of the

statement; the auditors are not required to consider whether the internal control processes will remedy the

problem.

The auditors may report by exception if problems arise, such as:

(a) The board's summary of the process of review of internal control effectiveness does not reflect the

auditors' understanding of that process.

(b) The processes that deal with material internal control aspects of significant problems do not

reflect the auditors' understanding of those processes.

(c) The board has not made an appropriate disclosure if it has failed to conduct an annual review, or the

disclosure made is not consistent with the auditors' understanding.

The report should be included in a separate paragraph below the opinion paragraph. For example:

Other matter

We have reviewed the board's description of its process for reviewing the effectiveness of internal control

set out on page x of the annual report. In our opinion the board's comments concerning ... do not

appropriately reflect our understanding of the process undertaken by the board because ...

3.4 Assurance services

Accountants may also provide assurance services relating to internal control systems. This is discussed in

Chapter 12.

4 Money laundering Pilot paper, 12/07, 12/09, 6/12, 6/14

Money laundering law is an increasingly important issue for auditors to be aware of.

This section is based on UK law and regulation. It is included as an example of how law and regulation

affects the auditor in this area.

'Money laundering is the process by which criminals attempt to conceal the true origin and ownership of

the proceeds of their criminal activity, allowing them to maintain control over the proceeds and, ultimately,

providing a legitimate cover for their sources of income.' (ACCA Code of Ethics and Conduct)

Money laundering is a particularly hot topic internationally. Clearly, auditors should consider it when

assessing compliance risks at a client.

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Key term

Point to note

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Part A Regulatory environment  1: International regulatory environments for audit and assurance services 21

4.1 What is money laundering?

4.1.1 Background

Once they have gotten hold of money through crime, criminals face a difficulty when it comes to actually

using it. For example, a group of organised criminals might generate huge amounts of money from

dealing illegal drugs, but as soon as they try to spend it they end up drawing attention to the fact that they

obtained the money from drug dealing. Usually the money to be laundered is in the form of cash.

Money laundering is the attempt to conceal the origin of this money by making it look legitimate or 'clean'.

This is a big problem for the world economy: the International Monetary Fund (IMF) has stated that

something like 2-5% of world GDP is likely to be related to money laundering.

4.1.2 How money is laundered

There are essentially three stages in laundering money.

1. Placement. This is the introduction or placement of the illegal funds into the financial system.

Examples include (amongst many possibilities):

 Making lots of small cash deposits into numerous bank accounts

 Using a cash-intensive business, such as a betting shop or a used car dealership, to

disguise 'dirty' money as legitimate revenue

2. Layering. This is passing the money through a large number of transactions or 'layers', so that it

becomes very difficult to trace back it to its original source. Examples include:

 Transferring the money through multiple bank accounts, perhaps across several different

national jurisdictions

 Making numerous purchases and sales of investments

 Making fake sales between controlled companies (this can often be extremely subtle, eg

through the use of invoices that do involve a transfer of goods, but which exaggerate the

price)

3. Integration. This is the final integration of funds back into the legitimate economy. The criminal

now has 'clean' money which can be spent or invested.

Question Money laundering

Required

(a) Explain the reasons why a criminal may want to launder money, even if this means that they may

have to pay tax on it.

(b) Explain the reasons why it would be difficult for an external auditor to detect money laundering

activity.

Answer

(a) Although money laundering does usually diminish the amount of money possessed by the criminal

in absolute terms, it actually increases the amount of money they can actually use. There is little

point in owning lots of cash if none of it can be spent without arousing suspicion – for instance, a

criminal buying a new Porsche with $100,000 in cash would be at risk of being detected by the

authorities. Money laundering enables criminals to enjoy at least some benefit from their activities.

The aim of money laundering is to 'clean' the 'dirty' money by passing it through an apparently

legitimate business, so that it can then be accessed without fear of the authorities becoming aware

of it.

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It may therefore be preferable to have 'clean' money on which tax is paid, since, although the tax

paid would be an expense, the alternative would be to have money that cannot be spent at all.

(b) In common with fraud generally, money laundering is difficult to detect because those perpetrating

it have an obvious incentive to cover their tracks very carefully. The nature of money laundering

means that the owners or senior management of the business would likely be implicated. These

people are likely to be able to manipulate a company's records, so that the auditor will struggle to

detect any problems.

Money laundering would be more difficult to detect than a typical fraud because it involves cash

flowing into the business, whereas fraud more typically involves attempts to conceal an outflow of

assets. It would be difficult to design audit procedures to detect the recording of fictitious revenue

that was backed up by cash in the bank.

As money laundering is associated with criminal activity, it is possible that those involved may be

subject to intimidation to co-operate with the scheme, or to deny knowledge of it. This could even

extend to members of the audit team. This makes it very difficult for auditors to detect money

laundering.

4.2 International recommendations and UK law

An intergovernmental body, the Financial Action Task Force on Money Laundering (FATF) was established

to set standards and develop policies to combat money laundering and terrorist financing. In 1990, FATF

issued 49 recommendations for governments on how to combat these offences and these

recommendations have now been endorsed by more than 130 countries.

Relevant legislation in the UK includes:

 The Terrorism Act 2000

 The Proceeds of Crime Act 2002

 Money Laundering Regulations 2007

This UK legislation applies to any professional work carried out in the UK, even if the accountant is based

outside the UK.

Ireland has legislation which is broadly equivalent to that in the UK.

In Singapore, there are various pieces of legislation:

 Corruption, Drug Trafficking and Other Serious Crimes (Confiscation of Benefits) Act 1992

 United Nations Act 2001

 United Nations (Anti-Terrorism Measures) Regulations 2001

 Terrorism (Suppression of Financing) Act 2002

In Australia, the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 is relevant.

In the United States there is a raft of relevant legislation, including:

 The Bank Secrecy Act

 The Money Laundering Control Act 1986

 The PATRIOT Act of 2001, which requires all financial institutions to establish anti-money

laundering programmes.

US legislation affects entities based outside the US if they use US Dollars ($) or use US banks.

4.3 Ethical guidance

4.3.1 Need for ethical guidance

Ethical guidance on money laundering is needed because applying the law involves making difficult

judgements, particularly if there are confidentiality issues.

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Part A Regulatory environment  1: International regulatory environments for audit and assurance services 23

The ACCA has issued Technical Factsheet 145 on Anti-money laundering for the accounting sector as

guidance for its members on their responsibilities under this legislation. The ACCA's Code of Ethics and

Conduct also includes detailed guidance for members on money laundering. Its requirements are very

similar to those in the Technical Factsheet, but less detailed. The Technical Factsheet gives guidance in the

context of current UK law, whereas the ethical guidance emphasises the international nature of money

laundering and the need for ACCA members to be aware of local legal frameworks and the basic

procedures to be applied, irrespective of where in the world their work is taking place.

4.3.2 Confidentiality and ethical conflict

'Ethical conflict' means conflict between the auditor's duty to be ethical and the auditor's relationship with

the client. This conflict may be particularly sharp where an auditor suspects the client of money

laundering. In the UK, there is a legal requirement to report even a suspicion of money laundering (see

Section 4.6 below), which would be likely to conflict with the auditor's duty of confidentiality to their

client.

The situation is further complicated by the need to avoid 'tipping off' the client that the auditor suspects

money laundering (see Section 4.6.3 below), which could make it very difficult for an auditor to decide

whether they have a duty to report their suspicions, as it would be hard to gather evidence of money

laundering without tipping the client off.

If such an ethical conflict cannot be resolved then the auditor may consider obtaining professional advice

from the ACCA or from legal advisers. This can generally be done without breaching the fundamental

principle of confidentiality if the matter is discussed anonymously with the ACCA, or under legal privilege

with a legal adviser.

4.4 Accountants' obligations

Many countries have now made money laundering a criminal offence. In some countries, such as the UK,

Australia, Singapore and the USA, the criminal offences include those directed at accountants. It is useful

to look in detail at the obligations of UK accountants in relation to the law regarding money laundering as

an example.

In the UK, the basic requirements are for accountants to keep records of clients' identity and to report

suspicions of money laundering to the National Crime Agency (NCA, formerly SOCA). These obligations

apply both to firms and to individuals. A firm must establish an anti-money laundering programme such

as that set out below, which includes appointing a Money Laundering Reporting Officer (MLRO) who is

responsible for reporting to the NCA. Individuals within the firm are then legally required to report any

offences to the MLRO.

Elements of a money laundering programme:

Procedures Explanations

 Appoint a Money Laundering

Reporting Officer (MLRO)

and implement internal

reporting procedures

 The MLRO should have a suitable level of seniority and experience.

 Individuals should make internal reports of money laundering to

the MLRO.

 The MLRO must consider whether to report to the NCA, and

document the process.

 Train individuals to ensure

that they are aware of the

relevant legislation, know

how to recognise and deal

with potential money

laundering, how to report

suspicions to the MLRO, and

how to identify clients

 Individuals should be trained in the firm's obligations under law,

and their personal obligations.

 They must be made aware of the firm's identification, record

keeping and reporting procedures.

 They must be aware that 'tipping off' is an offence, to reduce the

risk of this happening inadvertently.

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24 1: International regulatory environments for audit and assurance services  Part A Regulatory environment

Procedures Explanations

 Establish internal procedures

appropriate to forestall and

prevent money laundering,

and make relevant

individuals aware of the

procedures

 Procedures should cover:

– Client acceptance

– Gathering 'know your client' (KYC) / 'Customer Due Diligence'

(CDD) information (see Section 4.4.1 below)

– Controls over client money and transactions through the client

account

– Advice and services to clients that could be of use to a money

launderer

– Internal reporting lines

– The role of the MLRO

 Verify the identity of new and

existing clients and maintain

evidence of identification (ie

customer due diligence

measures)

 The firm must be able to establish that new clients are who they

claim to be.

 Typically, this will include taking copies of evidence, such as

passports, driving licences and utility bills.

 For a company this will include identities of directors and

certificates of incorporation.

 Maintain records of client

identification, and any

transactions undertaken for

or with the client

 Special care needs to be taken when handling clients' money to

avoid participation in a transaction involving money laundering.

 Report suspicions of money

laundering to the NCA

 The NCA has designed standard disclosure forms.

4.4.1 'Customer due diligence' information

The firm must gather 'know your client' information. This includes:

 Who the client is

 Who controls it

 The purpose and intended nature of the business relationship

 The nature of the client

 The client's source of funds

 The client's business and economic purpose

KYC enables the audit firm to understand its client's business well enough to spot any unusual business

activity. This assists the firm in identifying suspicions of money laundering.

In the UK the Money Laundering Regulations 2007 extended the circumstances under which Customer

due diligence (CDD) must be carried out from new to existing clients.

CDD is the term used in the Money Laundering Regulations for the steps that businesses must take to:

(a) Identify the customer and verify their identity using documents, data or information obtained from

a reliable and independent source.

(b) Identify any beneficial owner who is not the customer. This is the individual (or individuals) behind

the customer who ultimately owns or controls the customer or on whose behalf a transaction or

activity is being conducted.

(c) Where a business relationship is established, you will need to understand the purpose and intended

nature of the relationship, for example details of the customer's business or the source of the

funds.

Businesses must also conduct ongoing monitoring to identify large, unusual or suspicious transactions as

part of CDD.

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Part A Regulatory environment  1: International regulatory environments for audit and assurance services 25

The requirement to confirm the identity of customers and other individuals clearly links to the concept of

KYC described above.

4.5 Risk-based approach

On any assignment, the auditor should assess the risk of money laundering activities. Clearly, every

circumstance is different, but the following diagram illustrates some key risk factors.

Secrecy over

transactions

Excessive use of

wire transfers

Transactions routed

through several

jurisdictions

A pattern that after a deposit,

the same (or nearly the same)

amount is wired to another

financial institution

MONEY LAUNDERING

RISK INDICATIONS

High value deposits or

withdrawals not characteristic

of the type of account

Large currency or bearer

instrument transactions

Repeated deposits or withdrawals

just below the monitoring threshold

on the same day

Question Money laundering II

You are the audit manager of Loft Co, a chain of nightclubs across the North-West of England. During the

course of the audit Mr Roy, an employee of the company, informed you that a substantial cash deposit

was paid into the company's bank account and a month later, the same amount was paid by direct transfer

into a bank account in the name of Evissa, a company based overseas. The employee also informed you

that Mr Fox, the managing director of Loft Co, had instructed him not to record the transaction in the

accounting records as it had nothing to do with Loft Co's business.

Required

Comment on the situation outlined above.

Answer

The transaction described in the scenario raises suspicion of money laundering for several reasons.

(a) It has been alleged by Mr Roy that the purpose of the transaction has nothing to do with the

nightclub business. This could be a sign that Mr Fox is attempting to legitimise the proceeds of a

crime through Loft Co by concealing the illegal source of the cash.

(b) The amount of the transaction is substantial for Loft Co. An unusually large transaction should alert

the auditor to the possibility of money laundering, especially as it does not seem to relate to the

business of Loft Co.

(c) The cash amount paid into Loft Co's bank account is the same as the amount paid to Evissa. This

could be an attempt by Mr Fox to make the cash appear legitimate by moving it through several

companies and jurisdictions.

(d) Mr Roy was instructed not to record the transaction in the accounting records of Loft Co. Increased

secrecy over transactions is another indicator of money laundering.

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26 1: International regulatory environments for audit and assurance services  Part A Regulatory environment

Loft Co's bank statement should be checked to confirm Mr Roy's assertion. The suspicious transaction

should be reported to the firm's MLRO or the NCA as soon as possible and any 'tipping off' (see Section

4.5.3) must be avoided. It is a criminal offence to not report suspicions of money laundering.

4.6 The scope of criminal offences

The firm requires these procedures to avoid committing any of the wide range of offences under the UK's

Money Laundering Regulations.

4.6.1 Money laundering offences

These include:

 Concealing criminal property

 'Arranging' – becoming involved in an arrangement which is known or is suspected of facilitating

the acquisition of criminal property

 Acquiring, using or possessing criminal property

 Tipping off (see below)

Defences against these offences include:

 Reporting to the NCA or the MLRO before the act took place

 Reporting to the NCA or the MLRO after the act took place if there was good reason for the failure

to report earlier

4.6.2 Failure to report offences under the legislation

Knowledge

 Actual knowledge

 Shutting one's mind to the obvious

 Deliberately deterring a person from making disclosures, the content of which one might not care

to have knowledge of

 Knowledge of circumstances which would indicate the facts to an honest and reasonable person

 Knowledge of circumstances which would put an honest and reasonable person on inquiry and

failing to make the reasonable inquiries which such a person would have made

Suspicion is not defined in existing legislation. Case law and other sources indicate that suspicion is more

than speculation but it falls short of proof or knowledge. Suspicion is personal and subjective but will

generally be built on some objective foundation and so there should be some degree of consistency in

how a business's MLRO treats possible causes of suspicion.

 Failure by an individual in the regulated sector to inform the NCA or the MLRO as soon as

practicable of knowledge or suspicion of money laundering

 Failure by the MLRO to pass on a report to the NCA as soon as possible

The defences here for an individual would include that there was a reasonable excuse for not

having made a report, or that the person did not know or suspect money laundering and their

employer has not provided them with appropriate training.

The defence for the MLRO is that there is a reasonable excuse for not having made a report. The

Court would consider whether relevant guidance, such as the ACCA Technical Factsheet, had been

followed.

Key term s

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Part A Regulatory environment  1: International regulatory environments for audit and assurance services 27

4.6.3 Tipping off and other offences

Tipping off is when the MLRO or any individual discloses something that might prejudice any

investigation. If the auditor tells a client that they suspect money laundering has taken place, then this is

an offence. It is a defence if the person did not know or suspect that it was likely to prejudice the

investigation.

Other offences include:

 Falsifying, concealing, destroying or disposing of documents relevant to the investigation

 Consenting to a transaction which they know or suspect is money laundering, where consent has

not been received from the NCA

This is an extremely difficult area for auditors and accountants, as it can be very easy to tip off a client

inadvertently. For example, a client might ask an accountant to perform a transaction which the accountant

suspects might involve criminal property. In this case, even just delay in carrying out the instruction might

alert the criminal client to the fact that the accountant is suspicious: this would be tipping off. The way the

legislation gets around this is by requiring the accountant to report suspicions as quickly as possible

before undertaking such a transaction. Legal advice should also be obtained.

The June 2012 exam featured nine marks on money laundering. In order to get them, however, you first

had to spot that money laundering was happening in the scenario. The question itself did not mention

'money laundering' anywhere, which is like real life: money laundering is something that you need to be

alert for, because criminals who launder money do not tell you that this is what they are doing!

The requirement itself was to discuss the implications of the circumstances in the scenario (six marks),

and to explain the auditor's reporting responsibilities for money laundering.

The June 2014 paper had 11 marks on money laundering, with a requirement first to explain the stages of

money laundering and to comment on why a client in a scenario might be high-risk, and then to

recommend elements of an anti-money laundering programme.

4.6.4 Interaction of reporting duties

Auditors have several reporting duties which can interact with the duty to report under anti-money

laundering legislation. The main problem is how to avoid tipping off. Other reporting duties include:

 Auditors' reports under ISAs

 Communications to those charged with governance (ISA 260)

 Reports to regulators

 The 'statement of circumstances' upon resignation as an auditor

In general, one cannot obtain consent to tip off. Instead, the firm which suspects money laundering should

agree the wording of its reports with the relevant authority. If this cannot be done, then legal advice should

be obtained.

If an auditor who suspects a client resigns and receives a professional clearance letter from a prospective

auditor, then they should not respond to questions concerning the identity of the individual, or any

suspicions regarding money laundering.

5 Laws and regulations 6/12, 12/13, 6/15

Auditors must be aware of laws and regulations as part of their planning and must be aware of any

statutory duty to report non-compliance by the company.

In addition to the laws and regulations which bind the audit firm, the audit client is itself subject to laws

and regulations.

FAST FORWARD

Exam focus

point

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28 1: International regulatory environments for audit and assurance services  Part A Regulatory environment

5.1 Legal requirements relating to the company

Companies are increasingly subject to laws and regulations with which they must comply. Some examples

are given in the following diagram.

Company law

Civil law

Tort

Contract

Employment law

Health and Safety Regulation

Environmental

law and regulation

LAWS AND REGULATIONS

An auditor must be aware of the effect that non-compliance with the laws and regulations would have on

the financial statements.

ISA 250 Consideration of laws and regulations in an audit of financial statements provides guidance on the

auditor's responsibility to consider laws and regulations in an audit of financial statements.

5.2 Responsibility of management for compliance

It is the responsibility of management (with oversight from those charged with governance) to ensure that

a client's operations are conducted in accordance with laws and regulations.

The following policies and procedures, among others, may be implemented to assist management in the

prevention and detection of non-compliance with laws and regulations.

 Monitor legal requirements and ensure that operating procedures are designed to meet these

requirements.

 Institute and operate appropriate systems of internal control including internal audit and an audit

committee.

 Develop, publicise and follow a code of conduct.

 Ensure that employees are properly trained and understand the code of conduct.

 Monitor compliance with the code of conduct and act appropriately to discipline employees who

fail to comply with it.

 Engage legal advisers to assist in monitoring legal requirements.

 Maintain a register of significant laws with which the entity has to comply within its particular

industry, and a record of complaints.

'Non-compliance' refers to acts of omission or commission by the entity, either intentional or

unintentional, which are contrary to the prevailing laws or regulations. Such acts include transactions

entered into by the entity, or on its behalf by its management or employees. It does not include personal

misconduct.

5.3 Responsibility of the auditor

As with fraud and error, the auditor is not, and cannot be held responsible for preventing non-compliance.

There is an unavoidable risk that some material misstatements in the financial statements go undetected,

even though the audit is properly planned and performed.

Certain factors will increase the risk of material misstatements due to non-compliance with laws and

regulations not being detected by the auditor.

(a) There are many laws and regulations, relating principally to the operating aspects of an entity, that

typically do not affect the financial statements and are not captured by the entity's information

systems relevant to financial reporting.

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Part A Regulatory environment  1: International regulatory environments for audit and assurance services 29

(b) Non-compliance may involve conduct designed to conceal it, such as collusion, forgery, deliberate

failure to record transactions, management override of controls or intentional misrepresentations

being made to the auditor.

(c) Whether an act constitutes non-compliance is ultimately a matter for legal determination by a court

of law.

Laws and regulations governing a business entity can vary enormously (financial disclosure rules, health

and safety, pollution, employment, etc). Whether an act constitutes non-compliance is a legal matter that

may be beyond the auditor's professional competence, although the auditor may have a fair idea in many

cases through his knowledge and training. Ultimately such matters can only be decided by a court of law.

The further removed non-compliance is from the events and transactions normally reflected in the

financial statements, the less likely the auditor is to become aware of it or recognise non-compliance.

ISA 250.10

The objectives of the auditor are:

(a) To obtain sufficient appropriate audit evidence regarding compliance with the provisions of those

laws and regulations generally recognised to have a direct effect on the determination of material

amounts and disclosures in the financial statements;

(b) To perform specified audit procedures to help identify instances of non-compliance with other

laws and regulations that may have a material effect on the financial statements; and

(c) To respond appropriately to non-compliance or suspected non-compliance with laws and

regulations identified during the audit.

5.4 The auditor's consideration of compliance

ISA 250.12

As part of obtaining an understanding of the entity and its environment in accordance with ISA 315, the

auditor shall obtain a general understanding of:

(a) The legal and regulatory framework applicable to the entity and the industry or sector in which the

entity operates

(b) How the entity is complying with that framework.

The auditor may obtain a general understanding of laws and regulations affecting the entity in the

following ways.

 Use the auditor's existing understanding of the entity's industry, regulatory and other external

factors

 Update the understanding of those laws and regulations that directly determine the reported

amounts and disclosures in the financial statements

 Enquire of management as to other laws or regulations that may be expected to have a

fundamental effect on the operations of the entity

 Enquire of management concerning the entity's policies and procedures regarding compliance

with laws and regulations

 Discuss with management the policies or procedures adopted for identifying, evaluating and

accounting for litigation claims

The auditor should obtain sufficient appropriate audit evidence of compliance with those laws and

regulations which have a direct effect on the determination of material amounts and disclosures in the

financial statements. These laws and regulations will be well-established, will be known both to the entity

and within the entity's industry, and will be relevant to the entity's financial statements. They could relate

to:

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30 1: International regulatory environments for audit and assurance services  Part A Regulatory environment

 The form and content of financial statements

 Industry-specific financial reporting issues

 Accounting for transactions under government contracts

 The accrual or recognition of expenses for income tax or pension costs

In obtaining this general understanding the auditor should obtain an understanding of the procedures

followed by the entity to ensure compliance. The auditor should recognise that some laws and regulations

may have a fundamental effect on the operations of the entity, ie they may cause the entity to cease

operations or call into question the entity's continuance as a going concern. For example, non-compliance

with the requirements of the entity's licence or other title to perform its operations could have such an

impact (for example, for a bank, non-compliance with capital or investment requirements).

ISA 250.14

The auditor shall perform the following audit procedures to help identify instances of non-compliance with

other laws and regulations that may have a material effect on the financial statements:

(a) Inquiring of management and, where appropriate, those charged with governance, as to whether

the entity is in compliance with such laws and regulations; and

(b) Inspecting correspondence, if any, with the relevant licensing or regulatory authorities.

ISA 250.15

During the audit, the auditor shall remain alert to the possibility that other audit procedures applied may

bring instances of non-compliance or suspected non-compliance with laws and regulations to the

auditor's attention.

Examples include:

 Reading minutes

 Enquiring of the entity's management and in-house legal counsel or external legal counsel

concerning litigation, claims and assessments

 Performing substantive tests of details of classes of transactions, account balances or disclosures

ISA 250.16

The auditor shall request management and, where appropriate, those charged with governance to provide

written representations that all known instances of non-compliance or suspected non-compliance with

laws and regulations whose effects should be considered when preparing financial statements have been

disclosed to the auditor.

In the absence of identified or suspected non-compliance, the auditor is not required to perform audit

procedures other than those detailed above.

5.4.1 Audit procedures when non-compliance is identified or suspected

ISA 250.18

If the auditor becomes aware of information concerning an instance of non-compliance or suspected noncompliance

with laws and regulations, the auditor shall obtain:

(a) An understanding of the nature of the act and the circumstances in which it has occurred; and

(b) Further information to evaluate the possible effect on the financial statements.

The ISA sets out examples of the type of information that might come to the auditor's attention that may

indicate non-compliance.

 Investigation by a regulatory organisation or government department or payment of fines or

penalties

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Part A Regulatory environment  1: International regulatory environments for audit and assurance services 31

 Payments for unspecified services or loans to consultants, related parties, employees or

government employees

 Sales commissions or agents' fees that appear excessive in relation to those normally paid by the

entity or in its industry or to the services actually received

 Purchasing at prices significantly above or below market price

 Unusual payments in cash, purchases in the form of cashiers' cheques payable to bearer or

transfers to numbered bank accounts

 Unusual transactions with companies registered in tax havens

 Payments for goods or services made other than to the country from which the goods or services

originated

 Payments without proper exchange control documentation

 Existence of an information system that fails, whether by design or by accident, to provide an

adequate audit trail or sufficient evidence

 Unauthorised transactions or improperly recorded transactions

 Adverse media comment

When evaluating the possible effect on the financial statements, the auditor should consider:

 The potential financial consequences, such as fines, penalties, damages, threat of expropriation

of assets, enforced discontinuation of operations and litigation

 Whether the potential financial consequences require disclosure

 Whether the potential financial consequences are so serious as to call into question the fair

presentation given by the financial statements, or otherwise make the financial statements

misleading

ISA 250.19

If the auditor suspects there may be non-compliance, the auditor shall discuss the matter with

management and, where appropriate, those charged with governance.

Such discussions are subject to the laws concerning 'tipping off' (see Section 4.5.3). If information

provided by management is not sufficient, the auditor may find it appropriate to consult the entity's lawyer

and, if necessary, their own lawyer on the application of the laws and regulations to the particular

circumstances.

ISA 250.20/21

If sufficient information about suspected non-compliance cannot be obtained, the auditor shall evaluate

the effect of the lack of sufficient appropriate audit evidence on the auditor's opinion.

The auditor shall evaluate the implications of non-compliance in relation to other aspects of the audit,

including the auditor's risk assessment and the reliability of written representations, and take appropriate

action.

On this last point, as with fraud and error, the auditor must reassess the risk assessment and the validity

of written representations. In exceptional cases, the auditor may consider whether withdrawal from the

engagement is necessary. If withdrawal from the engagement is not possible under applicable law or

regulation, the auditor may consider alternative actions including describing the non-compliance in an

Other Matters paragraph in the auditor's report.

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32 1: International regulatory environments for audit and assurance services  Part A Regulatory environment

5.5 Reporting of identified or suspected non-compliance

5.5.1 To those charged with governance

ISA 250.22/23/24

[…] the auditor shall communicate with those charged with governance matters involving non-compliance

with laws and regulations that come to the auditor's attention during the course of the audit, other than

when the matters are clearly inconsequential.

If, in the auditor's judgment, the non-compliance… is believed to be intentional and material, the auditor

shall communicate the matter to those charged with governance as soon as practicable.

If the auditor suspects that management or those charged with governance are involved in noncompliance,

the auditor shall communicate the matter to the next higher level of authority at the entity, if it

exists, such as an audit committee or supervisory board.

In relation to the last point, where no higher authority exists, or if the auditor believes that the

communication may not be acted on or is unsure as to the person to whom to report, the auditor shall

consider seeking legal advice.

5.5.2 To the users of the auditor's report

ISA 250.25/26/27

If the auditor concludes that the non-compliance has a material effect on the financial statements, and it

has not been adequately reflected in the financial statements, the auditor shall … express a qualified

opinion or an adverse opinion on the financial statements.

If the auditor is precluded by management or those charged with governance from obtaining sufficient

appropriate audit evidence to evaluate whether non-compliance that may be material to the financial

statements has, or is likely to have, occurred, the auditor shall express a qualified opinion or disclaim an

opinion on the financial statements on the basis of a limitation on the scope of the audit […].

If the auditor is unable to determine whether non-compliance has occurred because of limitations imposed

by the circumstances rather than by management or those charged with governance, the auditor shall

evaluate the effect on the auditor's opinion […].

5.5.3 To regulatory and enforcement authorities

Confidentiality is an issue again here, but it may be overridden by the law, statute or the courts of law. The

auditor should obtain legal advice. If the auditor has a statutory duty to report, a report should be made

without delay.

Alternatively, it may be necessary to make disclosures in the public interest. In practice it will often be

extremely difficult for an auditor to decide whether making a disclosure in the public interest is warranted.

As elsewhere, the auditor should obtain professional advice, either anonymously from the ACCA, or under

legal privilege from a legal adviser.

5.6 Withdrawal from the engagement

As is the case for fraud or error, withdrawal may be the only option if the entity does not take the remedial

action the auditor thinks is necessary, even for non-material matters.

5.7 Documentation

The auditor must document identified or suspected non-compliance with laws and regulations and the

results of discussions with management and, where applicable, those charged with governance and other

parties outside the entity.

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Part A Regulatory environment  1: International regulatory environments for audit and assurance services 33

5.8 Practical problems with ISA 250

5.8.1 Distinction between types of law

The most difficult distinction in practice is between:

 Laws which have a direct effect on the determination of material amounts in the financial

statements; and

 Other laws and regulations.

In practice:

(a) For some businesses, certain laws and regulations have a direct effect on material amounts in the

financial statements; for other businesses, the same laws and regulations will not.

(b) For some businesses, laws and regulations which did not have a direct or material effect last year

may have this year (for example, where the maximum penalty for a first offence is a warning, but

subsequent infringements may lead to closure of the business).

5.8.2 Procedures that should be performed

There is a distinction between checking systems of compliance and checking actual compliance. An

example would be emissions from a chemical factory; auditors would review the company's systems for

keeping these under control, and would also review correspondence with the environmental authority.

However, the auditors would not be expected to check the actual emissions.

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34 1: International regulatory environments for audit and assurance services  Part A Regulatory environment

Chapter Roundup

 Major developments in international regulation of audit and assurance have recently concluded, with farreaching

effects on ISAs.

 Public oversight of the audit profession and of standard setting has been a trend in recent regulatory

developments internationally.

 Audit committees are made up of non-executive directors and are perceived to increase confidence in

financial reports.

 Internal control is a key part of good corporate governance. Directors are responsible for maintaining a

system of control that will safeguard the company's assets.

 Money laundering law is an increasingly important issue for auditors to be aware of.

 Auditors must be aware of laws and regulations as part of their planning and must be aware of any

statutory duty to report non-compliance by the company.

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Part A Regulatory environment  1: International regulatory environments for audit and assurance services 35

Quick Quiz

1 Fill in the blanks:

ISAs are set by the ........................................ ........................................ ........................................

........................................ ........................................ ........................................ . This is a technical

standing committee of the ........................................ ........................................ ...................................

........................................ . Oversight for all of IFAC's public interest activities is undertaken by the

........................................ ........................................ ........................................ ........................................

2 List four potential duties of the audit committee.

(1) ……………………….

(2) ……………………….

(3) ……………………….

(4) ……………………….

3 Auditors are responsible for a company's system of internal controls.

True

False

4 List the main elements of an anti money laundering programme that should be followed by a firm of

professional accountants.

(1) ……………………….

(2) ……………………….

(3) ……………………….

(4) ……………………….

(5) ……………………….

(6) ……………………….

5 Name four areas of law which might affect a company.

(1) ……………………….

(2) ……………………….

(3) ……………………….

(4) ……………………….

6 It is the responsibility of the auditor to ensure that a client's operations are conducted in accordance with

laws and regulations.

True

False

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36 1: International regulatory environments for audit and assurance services  Part A Regulatory environment

Answers to Quick Quiz

1 International Auditing and Assurance Standards Board, International Federation of Accountants, Public

Interest Oversight Board

2 (1) Review of financial statements

(2) Liaison with external auditors

(3) Review of internal audit

(4) Review of internal controls

3 False – this is the directors' duty.

4 (1) Appoint a Money Laundering Reporting Officer (MLRO) and set up internal reporting procedures

(2) Train individuals on the legal requirements and the firm's procedures

(3) Establish appropriate internal procedures

(4) Verify the identity of new clients / existing clients

(5) Maintain records of client identification

(6) Report suspicions of money laundering to the NCA (in the UK)

5 From:

(1) Company law

(2) Contract law

(3) Tort law

(4) Employment law

(5) Environmental law

6 False – it is the responsibility of management (with oversight from those charged with governance).

Now try the question below from the Practice Question Bank.

Number Level Marks Time

Q1 Introductory 7 14 mins

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37

Professional and ethical

considerations

P

A

R

T

B

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38

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39

Topic list Syllabus reference

1 Fundamental principles and the conceptual framework

approach

B1, G1

2 Specific guidance: independence B1

3 Specific guidance: confidentiality B1

4 Specific guidance: conflicts of interest B1

5 Conflicts in application of the fundamental principles B1

Code of ethics

and conduct

Introduction

You have already learnt about ethical rules for auditors in your earlier studies.

We will examine the issues in more detail and consider some of the complex

ethical issues that auditors may face.

We also refer to the ethical guidance of the International Federation of

Accountants. This is similar to the ACCA's guidance. Both approach issues of

ethics in a conceptual manner.

ISQC 1 Quality control for firms that perform audits and reviews of financial

statements and other assurance and related services engagements is also

relevant in providing the ethical aspects of quality control and review.

Some of this chapter is likely to be revision, but that does not mean you should

ignore it. Ethics is a key syllabus area. Complex ethical issues are introduced in

this chapter. You particularly need to work through the questions given so that

you practise applying ethical guidelines in given scenarios, as this is how this

topic will be tested in the exam.

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40 2: Code of ethics and conduct  Part B Professional and ethical considerations

Study guide

Intellectual level

B1 Code of ethics for professional accountants

(a) Explain the fundamental principles and the conceptual framework approach. 1

(b) Identify, evaluate and respond to threats to compliance with the

fundamental principles.

3

(c) Discuss and evaluate the effectiveness of available safeguards. 3

(d) Recognise and advise on conflicts in the application of fundamental

principles.

3

(e) Discuss the importance of professional scepticism in planning and

performing an audit.

2

(f) Assess whether an engagement has been planned and performed with an

attitude of professional scepticism, and evaluate the implications.

3

G1 Professional and ethical developments

(a) Discuss the relative advantages of an ethical framework and a rulebook. 2

(b) Identify and assess relevant emerging ethical issues and evaluate the

safeguards available.

3

(c) Discuss IFAC developments. 2

Exam guide

Professional ethics are of vital importance to the audit and assurance profession and a major area of the

syllabus, so this is likely to be a regular feature of the exam.

Questions are likely to be practical, giving scenarios where you are required to assess whether the

situations are acceptable. Some of these can be answered by reference to specific guidance in the ACCA

Code of Ethics and Conduct but others may require you to apply your understanding of the fundamental

principles underlying the Code. Ethics may be examined alongside other areas within scenarios;

commonly, practice management.

You may also have to suggest appropriate safeguards that the audit firm should implement.

1 Fundamental principles and the conceptual framework

approach Pilot paper, 12/07, 6/09

Accountants require an ethical code because they hold positions of trust, and people rely on them.

1.1 The importance of ethics

The IESBA's Code of Ethics for Professional Accountants gives the key reason why accountancy bodies

produce ethical guidance: the public interest.

'A distinguishing mark of the accountancy profession is its acceptance of the responsibility to act in the

public interest. Therefore, a professional accountant's responsibility is not exclusively to satisfy the needs

of an individual client or employer.'

The public interest is considered to be the collective wellbeing of the community of people and institutions

the professional accountant serves, including clients, lenders, governments, employers, employees,

investors, the business and financial community, and others who rely on the work of professional

accountants.

FAST FORWARD

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Part B Professional and ethical considerations  2: Code of ethics and conduct 41

The key reason why accountants need to have an ethical code is that people rely on them and their

expertise.

Accountants deal with a range of issues on behalf of clients. They often have access to confidential and

sensitive information. Auditors claim to give an independent view. It is therefore critical that accountants

and particularly auditors are, and are seen to be, independent.

1.2 Sources of ethical guidance

As the auditor is required to be, and seen to be, ethical in their dealings with clients, ACCA publishes

guidance for its members in its Code of Ethics and Conduct. This guidance is given in the form of

fundamental principles, guidance and explanatory notes. (This guidance is contained within the ACCA

Rulebook, which you can find on the ACCA website and which is of crucial importance for ACCA members.)

The IESBA (International Ethics Standards Board for Accountants), a body of IFAC, also lays down

fundamental principles in its Code of Ethics for Professional Accountants. The fundamental principles of

the two associations are extremely similar (much of the ACCA Code is drawn directly from the IESBA).

IFAC also issues quality control standards and auditing standards (ISAs), which work together to promote

auditor independence and audit quality.

One of the competences you require to fulfil Performance Objective 1 of the PER is the ability to act

diligently and honestly, following codes of conduct, giving due regard to, and keeping up to date with,

relevant legislation. You can apply the knowledge you have obtained from this chapter of the Text to help

demonstrate this competence.

1.3 The fundamental principles

The IESBA and ACCA Codes of ethics are principles-based. These fundamental principles underpin the

detailed guidance, which we expound in this chapter, and should be used by members to help interpret

that guidance.

ACCA/IESBA Codes of ethics

Integrity. To be straightforward and honest in all professional and business relationships.

Objectivity. To not allow bias, conflict of interest or undue influence of others to override professional

or business judgements.

Professional competence and due care. To maintain professional knowledge and skill at a level required

to ensure that a client or employer receives competent professional services based on current

developments in practice, legislation and techniques and act diligently and in accordance with applicable

technical and professional standards when providing professional services.

Confidentiality. To respect the confidentiality of information acquired as a result of professional and

business relationships and, therefore, not disclose any such information to third parties without proper

and specific authority, unless there is a legal or professional right or duty to disclose, nor use the

information for the personal advantage of the professional accountant or third parties.

Professional behaviour. To comply with relevant laws and regulations and to avoid any action that

discredits the profession.

1.4 The conceptual framework

The ethical guidance discussed above is in the form of a conceptual framework. It contains some rules, for

example, prohibiting making loans to clients, but in the main it is flexible guidance. It can be seen as a

framework rather than a set of rules. There are a number of advantages of a framework over a system of

ethical rules. These are outlined in the table below.

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42 2: Code of ethics and conduct  Part B Professional and ethical considerations

Advantages of an ethical framework over a rules-based system

A framework of guidance places the onus on the auditor to actively consider independence for every given

situation, rather than just agreeing a checklist of forbidden items. It also requires them to demonstrate

that a responsible conclusion has been reached about ethical issues.

The framework prevents auditors interpreting rules-based requirements narrowly to get around them.

There is a sense in which lists of prohibitive rules engender deception, whereas principles encourage the

formation of the positive practices which result in compliance.

A framework allows for the variations that are found in every individual situation. Each situation is likely

to be different.

A framework can accommodate a rapidly changing environment, such as the one that auditors are

constantly in.

However, a framework can contain prohibitions (as noted above) where these are necessary as

safeguards are not feasible.

1.5 Threats to compliance with the fundamental principles

There are five general sources of threat.

 Self-interest threat (for example, having a financial interest in a client)

 Self-review threat (for example, auditing financial statements prepared by the firm)

 Advocacy threat (for example, promoting shares in a listed entity when that entity is a financial

statement audit client)

 Familiarity threat (for example, an audit team member having family at the client)

 Intimidation threat (for example, threats of replacement due to disagreement)

1.6 Available safeguards

In order to counteract these threats to compliance, audits are subject to safeguards. There are two general

categories of safeguard.

 Safeguards created by the profession, legislation or regulation, eg training requirements for entry

into the profession, continuing professional development (CPD) requirements, professional

standards, corporate governance regulations

 Safeguards in the work environment, which can be either firm-wide or engagement-specific

Examples of firm-wide safeguards in the work environment include:

Examples of firm-wide safeguards

Leadership of the firm that stresses the importance of compliance with the fundamental principles

Policies and procedures that will enable the identification of interests or relationships between the firm

or staff and clients

Policies and procedures to monitor and, if necessary, manage the reliance on revenue received from a

single client (this could create a self-interest and an intimidation threat)

Policies and procedures to encourage and empower staff to communicate any issue relating to

compliance with the fundamental principles that concerns them

Specific threats and safeguards within these general areas will be considered in the next section. However,

you may be able to use the following general list to help generate ideas in the exam.

Examples of engagement-specific safeguards

Having a professional accountant who was not involved with audit review the work performed, or provide

advice

Consulting an independent third party, such as a committee of independent directors, a professional

regulatory body or another professional accountant

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Part B Professional and ethical considerations  2: Code of ethics and conduct 43

Examples of engagement-specific safeguards

Discussing ethical issues with those charged with governance of the client

Disclosing to those charged with governance of the client the nature of services provided and extent of

fees charged

Involving another firm to perform or reperform part of the engagement

Rotating senior assurance team personnel

1.7 Breach of a provision of the Code of Ethics

The IESBA Code states:

IESBA Code of Ethics, 290.40

When the firm concludes that a breach has occurred, the firm shall terminate, suspend or eliminate the

interest or relationship that caused the breach and address the consequences of the breach.

When a breach occurs, the firm should consider whether any legal or regulatory requirements apply, and

if necessary report the breach to a member body or regulator.

The breach should be communicated to the engagement partner (and other relevant personnel).

Evaluate the significance of the breach, based on:

 The nature and duration of the breach

 Any previous breaches re. the current audit engagement

 Whether a member of the audit team had knowledge of the interest or relationship that caused the

breach

 Whether the individual who caused the breach is a member of the audit team

 If they were on the audit team, their role

 The impact of any relevant services on the accounting records or the amounts recorded in the

financial statements

 The extent of any threats created by the breach

Examples of actions that the firm may consider include:

 Removing the individual from the audit team

 Conducting an additional review of the affected audit work (or reperforming it), using different

personnel

 Recommending that the audit client engage another firm to review/reperform the affected audit

work to the extent necessary

 Where the breach relates to a non-assurance service that affects the accounting records or an

amount that is recorded in the financial statements, engaging another firm to evaluate the results

of (or reperform) the non-assurance service

If necessary, terminate the audit engagement. If this is not necessary, discuss with those charged with

governance and communicate the matter in writing.

1.8 ACCA Disciplinary procedures

If a member breaches regulations or fails to conduct themselves professionally, then they may be liable to

disciplinary action. Breaches include the following.

 Being guilty of misconduct in the course of carrying out professional duties or otherwise

 Performing work erroneously, inadequately, inefficiently or incompetently to such an extent, or on

such a number of occasions, as to amount to misconduct

 Breaching any ACCA Bye-law or Regulation

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44 2: Code of ethics and conduct  Part B Professional and ethical considerations

 BeIng disciplined by another professional body

 Becoming insolvent or entering into a voluntary arrangement or similar

 Failing to satisfy a judgment debt without reasonable excuse for two months

Anyone may bring a complaint. Complaints are considered first by an assessor, who decides whether to

pass it onto the Disciplinary Committee. The Committee can impose the following penalties on members

and students.

Members and Firms Registered Students

Member excluded from membership Student removed from student register

Member severely reprimanded, reprimanded or

admonished

A specified period of the student's experience is not

recognised as approved accountancy experience

Member's certificate(s), and/or ability to conduct

specific activities, suspended or made subject to

conditions

Student is declared ineligible to be admitted to

membership for a specified period of time.

Member pays a fine of up to £50,000 Student is ineligible to sit ACCA exams for a period

of time

Member pays compensation of up to £5,000 Student is disqualified from exams

Member waives/reduces fees charged to

complainant

Student is severely reprimanded or admonished

2 Specific guidance: Independence 6/08, 12/08, 6/09, 6/10,

6/12, 12/12, 6/13, 12/13, 6/14, 12/14, 6/15

The ACCA's guidance complies with the requirements of the IESBA Code.

2.1 Objective of the guidance

You should be familiar with the concept of independence from your earlier studies. The IESBA Code

discusses independence requirements for audit and review engagements in Section 290. The guidance

states its purpose in a series of steps, which you should learn and understand. It aims to help firms and

members:

Step 1 Identify threats to independence

Step 2 Evaluate the significance of the threats identified

Step 3 Apply safeguards when necessary to eliminate the threats or reduce them to an acceptable level.

It also recognises that there may be occasions where no safeguard is available. In such a situation, it is

only appropriate to:

 Eliminate the interest or activities causing the threat; or

 Decline the engagement, or discontinue it.

Where the Code contains a prohibition (eg on providing a non-audit service in a particular situation), then

this means that no safeguards could ever reduce the threat to an acceptable level.

Applying safeguards should not be a mechanical process. Where the Code contains a list of safeguards,

these lists are generally not exhaustive – if you can think of further relevant safeguards, then these may

also be applied. Further, applying the safeguards given by the Code does not automatically mean that the

threat has been reduced to an acceptable level – this depends on your judgement in the situation.

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Part B Professional and ethical considerations  2: Code of ethics and conduct 45

Applying safeguards should not be a mechanical process. Where the Code contains a list of safeguards,

these lists are generally not exhaustive – if you can think of further relevant safeguards, then these may

also be applied. Further, applying the safeguards given by the Code does not automatically mean that the

threat has been reduced to an acceptable level – this depends on your judgement in the situation. You

should apply the three steps set out above when approaching questions of independence, and show the

marker that you have done so in your answer. It is important for this exam that you do not simply learn

the rules for each situation, but that you can apply the spirit of the guidance to a given situation. Finally,

remember that if there appears to be no safeguard, then you must consider the fallback option of not

continuing with the professional relationship.

2.1.1 Current issues in ethical guidance

This is currently a very topical area within the profession. Auditor independence has been under intense

outside scrutiny since the financial crisis of 2007-8. Recent debate has focused on the provision of nonaudit

services alongside the external audit.

April 2015 saw some revisions to the IESBA Code of Ethics in relation to these non-assurance services.

These are covered at the appropriate points in this chapter, and in Chapter 18.

In June 2014, the European Union brought into force legislation aimed at improving audit quality, which

EU member states have until June 2016 to implement. The legislation introduces mandatory auditor

rotation, prohibits some non-audit services, and introduces a cap on the level of fees received from nonaudit

services at 70% of the audit fee. These are not part of the core material examinable for P7, but you

should be aware of this as an important current issue in the profession.

In March 2013, the Code was revised to address conflicts of interest, breaches of a requirement of the

Code, and to amend the definition of the term 'engagement team' to include any internal auditors who

provide direct assistance on an audit engagement.

In September 2012, the UK Corporate Governance Code was revised to require FTSE 350 companies in the

UK to put the external audit out to tender at least every ten years.

The December 2011 paper contained a topical requirement offering six marks for evaluating the

arguments for and against the outright prohibition on auditors providing any non-audit services at all. This

was a very topical issue at the time, and you should be prepared for something comparably topical in your

exam.

Professional skepticism (see Sections 2.2 and 2.4 below) is another topical area, with several bodies

having issued publications recently. The IAASB itself issued a useful Q&A Paper in this area (see Chapter

18), and the FRC in the UK and the AASB in Canada have also issued their own publications. Professional

skepticism is a crucial component of professional judgement, and therefore of the skillset of an auditor.

2.1.2 Public interest entities

The IESBA Code distinguishes between 'public interest entities' and other entities. The ethical

requirements applicable to public interest entities are frequently stricter than for other entities.

Public interest entity is defined as follows.

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46 2: Code of ethics and conduct  Part B Professional and ethical considerations

Public interest entity

(a) Any listed entity; and

(b) Any entity defined by regulation or legislation as a public interest entity; or

(c) Any entity that is required by legislation or regulation to have an audit that is as independent as an

audit of a listed entity would be; and

(d) Any other entity the firm determines to be a public interest entity, because it has a large number

and wide range of stakeholders. Factors to be considered include:

(i) The nature of the business, such as the holding of assets in a fiduciary capacity for a large

number of stakeholders. Examples may include financial institutions, such as banks and

insurance companies, and pension funds

(ii) Size

(iii) Number of employees

At P7 level you must be able to do more than just recite this definition in your exam. You should be able to

recognise a public interest entity in a question, and adapt your answer accordingly.

2.2 What is independence? 6/15

A provider of assurance services must be, and be seen to be, independent. What is required for this to be

the case?

Independence of mind. The state of mind that permits the provision of an opinion without being affected

by influences that compromise professional judgement, allowing an individual to act with integrity, and

exercise objectivity and professional scepticism.

Independence in appearance. The avoidance of facts and circumstances that are so significant that a

reasonable and informed third party, having knowledge of all relevant information, including safeguards

applied, would reasonably conclude that a firm's, or a member of the assurance team's, integrity,

objectivity or professional scepticism had been compromised.

Professional scepticism. An attitude that includes a questioning mind, being alert to conditions which

may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence.

The degree of independence required is less stringent for a firm providing a low-level assurance

engagement to a non-audit client than for audit. This is summarised in the following table.

Audit Non-audit, general use Non-audit, restricted use

Audit client The assurance team, the

firm and the network

firm* must all be

independent of the client.

The assurance team, the

firm and the network firm

must all be independent of

the client.

The assurance team, the firm

and the network firm must all

be independent of the client.

Non-audit

assurance

client

N/A

The assurance team and the

firm must be independent of

the client.

The assurance team and the

firm must have no material

financial interest in the client.

*For an explanation of the term 'network firm', see Chapter 3.

2.2.1 When must the assurance provider be independent?

The team and the firm should be independent 'during the period of the engagement'.

The period of the engagement is from the commencement of work until the signing of the final report

being produced. For a recurring audit, independence may only cease on termination of the contract

between the parties.

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Part B Professional and ethical considerations  2: Code of ethics and conduct 47

The ACCA and IESBA Codes give examples of a number of situations where independence might be

threatened and suggest safeguards to independence.

2.3 Management responsibilities

The Code's guidance on non-assurance services is given in the relation to each individual type of service

below, but the Code does also include some general considerations. The main issue is management

responsibilities, with the point being that:

IESBA Code of Ethics, 290.161 (extract)

A firm shall not assume a management responsibility for an audit client. The threats created would be so

significant that no safeguards could reduce the threats to an acceptable level.

Management responsibilities are defined as follows.

Management responsibilities involve controlling, leading and directing an entity, including making

decisions regarding the acquisition, deployment and control of human, financial, technological, physical

and intangible resources. IESBA Code of Ethics, 290.159

Avoiding taking on management responsibilities is one of the key problems for the auditor when providing

many types of non-assurance service. But in general, an important prerequisite is that the firm is 'satisfied'

that the client's management is actually taking on its responsibilities, ie so that none of these are left to the

auditor.

2.4 A dilemma: independence vs effectiveness

Auditor independence is rarely a matter of clear questions with black and white answers. It is not just an

issue of whether the 'rules' say that an audit engagement should be accepted or declined ('yes or no'), but

rather of the auditor exercising proper judgement in the complex circumstances of an actual audit.

The basic dilemma is this. The auditor must be independent of the client in order to express their own

opinion on whether the client's financial statements give a true and fair view. However, the auditor must

also place some trust in the client if the audit is to be conducted effectively, as they will need to rely on

anything from the accounting systems and controls to explanations provided by management.

It is between the two extremes of this dilemma that the concept of 'professional skepticism' attempts to

place itself:

– overly trusting

If the auditor is too skeptical about everything the client does or says, then it will be impossible for them

to conduct the audit effectively. At the extreme, this would mean checking every transaction in the

financial statements, without accepting any internal records or documents at all as genuine. More

practically, a breakdown in trust would mean that the audit would be conducted less efficiently: if the

auditor must assume that management is not at all competent to prepare the financial statements, then

much more audit work will need to be done than if management could be trusted. This would take more

time and would make the audit more costly. Some degree of trust is therefore essential to the effective and

professional running of the audit process.

On the other hand, if the auditor is not skeptical enough then the quality of the audit is likely to suffer. The

auditor may easily be deceived in the case of fraud, or may mistakenly place too much trust in the validity

of evidence and explanations provided by the client. ISA 200 Overall objectives of the independent auditor

and the conduct of an audit in accordance with international standards on auditing lists the following

examples of risks that may arise from a lack of professional scepticism.

FAST FORWARD

Unprofessional skepticism Professional scepticism

– overly suspicious

Professional relationship

– overly trusting

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48 2: Code of ethics and conduct  Part B Professional and ethical considerations

ISA 200.A19

Maintaining professional scepticism is necessary to reduce the risks of:

 Overlooking unusual circumstances.

 Overgeneralising when drawing conclusions from audit observations.

 Using inappropriate assumptions in determining the nature, timing and extent of the audit

procedures and evaluating the results thereof.

In the UK, the FRC's Audit Quality Review team (formerly the Audit Inspection Unit) has found a lack of

professional scepticism to be a significant problem in every year since at least 2010-11. The 2014-15

report stated that a common issue was:

'Insufficient scepticism in challenging the appropriateness of assumptions in key areas of

audit judgment such as impairment testing and property valuations..'

(FRC Audit Quality Inspections, Annual Report 2014-15, p6 s2.3)

This links with the question of independence generally, and the risk that the audit is not conducted with

professional competence and due care as a result of a lack of scepticism. In the end, the auditor must balance

being sceptical with being trusting, and the concept of 'professional scepticism' is an attempt to convey this. It

has also been said elsewhere that the auditor should 'trust, but verify' what the client tells them.

2.5 Revision of threats to independence

The area of threats to independence should not be new to you. You should be aware of many of the threats

to independence from your earlier studies in auditing. To refresh your memory about independence

issues, try the following question.

Question Revision of audit independence

From your knowledge brought forward from your previous studies, and any practical experience of

auditing you may have, write down as many potential ethical risk areas as you can in the areas below.

(Some issues may be relevant in more than one column.)

Personal interests Review of your own work Disputes Intimidation

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Part B Professional and ethical considerations  2: Code of ethics and conduct 49

Answer

Personal interests Review of your own work Disputes Intimidation

Undue dependence on an audit

client due to fee levels

Overdue fees becoming similar

to a loan

An actual loan being made to a

client

Contingency fees being offered

Accepting commissions from

clients

Provision of lucrative other

services to clients

Relationships with persons in

associated practices

Relationships with the client

Long association with clients

Beneficial interest in shares or

other investments

Hospitality

Auditor prepares the

accounts

Auditor participates in

management decisions

Provision of any other

services to the client

Actual litigation

with a client

Threatened

litigation with a

client

Client refuses to

pay fees and they

become long

overdue

Any threat of litigation

by the client

Personal relationships

with the client

Hospitality

Threat of other services

provided to the client

being put out to tender

Threat of any services

being put out to tender

The ACCA and IESBA Codes give extensive lists of examples of threats to independence and applicable

safeguards. In the rest of this section, these threats and some relevant factors and potential safeguards

will be outlined. Definite rules are shown in bold. You should learn these.

2.6 Self-interest threat

The ACCA Code of Ethics and Conduct highlights a great number of areas in which a self-interest threat

might arise.

Financial

interest

Recruitment

Lowballing

High %

of fees

% or contingent

fees

Overdue fees

Loans and guarantees

Gifts and hospitality

Compensation and evaluation policies

Partner on client board

Temporary staff assignments

Close business

relationships

SELF-INTEREST THREAT

2.6.1 Financial interests

A financial interest exists where an audit firm has a financial interest in a client's affairs, for example, the

audit firm owns shares in the client, or is a trustee of a trust that holds shares in the client.

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50 2: Code of ethics and conduct  Part B Professional and ethical considerations

A financial interest in a client constitutes a substantial self-interest threat. According to both the ACCA and

the IESBA, the parties listed below are not allowed to own a direct financial interest or an indirect

material financial interest in a client.

 The assurance firm

 A member of the assurance team

 An immediate family member of a member of the assurance team

The following safeguards may therefore be relevant.

 Disposing of the interest

 Removing the individual from the team if required

 Keeping the client's audit committee informed of the situation

 Using an independent partner to review work carried out if necessary

Such matters will involve judgement on the part of the partners making decisions about such matters. For

example, what constitutes a material interest? A small percentage stake in a company might be material to

its owner. How does the firm judge the closeness of a relationship between staff and their families, in

other words, what does immediate mean in this context?

Audit firms should have quality control procedures requiring staff to disclose relevant financial interests

for themselves and close family members. They should also foster a culture of voluntary disclosure on an

ongoing basis so that any potential problems are identified on a timely basis.

Question Financial interests

You are the Ethics Partner at Stewart Brice & Co, a firm of Chartered Certified Accountants. The following

situations exist.

Teresa is the audit manager assigned to the audit of Recreate, a large quoted company. The audit has been

ongoing for one week. Yesterday, Teresa's husband inherited 1,000 shares in Recreate. Teresa's husband

wants to hold on to the shares as an investment.

The Stewart Brice & Co pension scheme, which is administered by Friends Benevolent, an unconnected

company, owns shares in Tadpole Group, a listed company with a number of subsidiaries. Stewart Brice &

Co has recently been invited to tender for the audit of one of the subsidiary companies, Kermit Co.

Stewart Brice has been the auditor of Kripps Bros, a limited liability company, for a number of years. It is a

requirement of Kripps Bros' constitution that the auditor owns a token $1 share in the company.

Required

Comment on the ethical and other professional issues raised by the above matters.

Answer

(a) Teresa is at present a member of the assurance team and a member of her immediate family owns

a direct financial interest in the audit client. This is unacceptable.

In order to mitigate the risk to independence that this poses on the audit, Stewart Brice & Co needs

to apply one of two safeguards.

 Ensure that the connected person divests the shares

 Remove Teresa from the engagement team

Teresa should be appraised that these are the options and removed from the team while a decision

is taken regarding whether to divest the shares. Teresa's husband appears to want to keep the

shares, in which case Teresa should be removed from the team immediately.

The firm should appraise the audit committee of Recreate of what has happened and the actions

they have taken. The partners should consider whether it is necessary to bring in an independent

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Part B Professional and ethical considerations  2: Code of ethics and conduct 51

partner to review audit work. However, given that Teresa's involvement is subject to the review of

the existing engagement partner and she was not connected with the shares while she was carrying

out the work, a second partner review is likely to be unnecessary in this case.

(b) The audit firm has an indirect interest in the parent company of a company it has been invited to

tender for by virtue of its pension scheme having invested in Tadpole Group.

This is no barrier to the audit firm tendering for the audit of Kermit Co.

Should the audit firm win the tender and become the auditors of Kermit Co it should consider

whether it is necessary to apply safeguards to mitigate against the risk to independence on the

audit as a result of the indirect financial interest.

The factors that the partners will need to consider are the materiality of the interest to either party

and the degree of control that the firm actually has over the financial interest.

In this case, the audit firm has no control over the financial interest. An independent pension

scheme administrator is in control of the financial interest. In addition, the interest is unlikely to be

substantial and is therefore immaterial to both parties. Only if the threat is significant should the

interest be divested.

It is likely that this risk is already sufficiently minimal so as not to require safeguards. However, if

the audit firm felt that it was necessary to apply safeguards, it could consider the following.

 Notifying the audit committee of the interest

 Requiring Friends Benevolent to dispose of the shares in Tadpole Group.

(c) In this case, Stewart Brice & Co has a direct financial interest in the audit client, which is

technically forbidden by ACCA guidance. However, it is a requirement of any firm auditing the

company that the share be owned by the auditors.

The interest is not material. The audit firm should safeguard against the risk by not voting on its own

re-election as auditor. The firm should also strongly recommend to the company that it removes this

requirement from its constitution, as it is at odds with ethical requirements for auditors.

2.6.2 Close business relationships

Examples of when an audit firm and an audit client have an inappropriately close business relationship

include:

 Having a material financial interest in a joint venture with the assurance client

 Arrangements to combine one or more services or products of the firm with one or more services

or products of the assurance client and to market the package with reference to both parties

 Distribution or marketing arrangements under which the firm acts as distributor or marketer of the

assurance client's products or services or vice versa

Again, it will be necessary for the partners to judge the materiality of the interest and therefore its

significance. However, unless the interest is clearly insignificant, an assurance provider should not

participate in such a venture with an assurance client. Appropriate safeguards are therefore to end the

assurance provision or to terminate the (other) business relationship.

If an individual member of an audit team had such an interest, they should be removed from the audit

team.

However, if the firm or a member (and immediate family of the member) of the audit team has an interest

in an entity when the client or its officers also has an interest in that entity, the threat might not be so

great.

Generally speaking, purchasing goods and services from an assurance client on an arm's length basis

does not constitute a threat to independence. If there are a substantial number of such transactions,

there may be a threat to independence and safeguards may be necessary.

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52 2: Code of ethics and conduct  Part B Professional and ethical considerations

2.6.3 Temporary staff assignments

Staff may be loaned to an audit client, but only for a short period of time. Staff must not assume

management responsibilities, or undertake any assurance work that is prohibited elsewhere in the Code.

The audit client must be responsible for directing and supervising the activities of the loaned staff.

Possible safeguards include:

 Conducting an additional review of the work performed by the loaned staff;

 Not giving the loaned staff audit responsibility for any function or activity on the audit, that they

performed during the temporary staff assignment; or

 Not including the loaned staff in the audit team.

2.6.4 Partner on client board

A partner or employee of an assurance firm should not serve on the board of an assurance client.

It may be acceptable for a partner or an employee of an assurance firm to perform the role of company

secretary for an assurance client, if the role is essentially administrative and if this practice is specifically

permitted under local law and professional rules.

Although a partner or employee cannot serve on a client's board, it is possible for them to attend board

meetings. This is common practice, and moreover may be necessary if there are issues that need to be

raised with management.

2.6.5 Compensation and evaluation policies

There is a self-interest threat when a member of the audit team is evaluated on selling non-assurance

services to the client. The significance of the threat depends on:

 The proportion of the individual's compensation or performance evaluation that is based on the

sale of such services

 The role of the individual on the audit team

 Whether promotion decisions are influenced by the sale of such services

The firm should either revise the compensation plan or evaluation process, or put in place appropriate

safeguards. Safeguards include:

 Removing the member from the audit team; or

 Having the team member's work reviewed by a professional accountant.

A key audit partner shall not be evaluated based on their success in selling non-assurance services to

their audit client.

In the UK, the Audit Quality Review Team's annual report for 2010-11 expressed concern over the selling

of non-audit services to audited entities. The report stated that partners and staff were too often

compromised by an inappropriate focus on this area, with the result that firms sometimes failed to identify

the nature and extent of threats, and therefore failed to apply appropriate safeguards.

2.6.6 Gifts and hospitality

Unless the value of the gift/hospitality is clearly trivial and inconsequential, a firm or a member of an

assurance team should not accept.

2.6.7 Loans and guarantees

The advice on loans and guarantees falls into two categories:

 The client is a bank or other similar institution

 Other situations

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Part B Professional and ethical considerations  2: Code of ethics and conduct 53

If a lending institution client lends an immaterial amount to an audit firm or member of the assurance

team on normal commercial terms, there is no threat to independence. If the loan were material, it would

be necessary to apply safeguards to bring the risk to an acceptable level. A suitable safeguard is likely to

be an independent review (by a partner from another office in the firm).

Loans to members of the assurance team from a bank or other lending institution client are likely to be

material to the individual but, provided that they are on normal commercial terms, these do not constitute

a threat to independence.

An audit firm or individual on the assurance engagement should not enter into any loan or guarantee

arrangement with a client that is not a bank or similar institution.

2.6.8 Overdue fees

In a situation where there are overdue fees, the auditor runs the risk of, in effect, making a loan to a client,

whereupon the guidance above becomes relevant.

Audit firms should guard against fees building up and being significant by discussing the issues with

those charged with governance, and, if necessary, the possibility of resigning if overdue fees are not paid.

2.6.9 Percentage or contingent fees

Contingent fee. A fee calculated on a predetermined basis relating to the outcome of a transaction or the

result of the services performed by the firm. A fee that is established by a court or other public authority is

not a contingent fee.

A firm shall not enter into a contingent fee arrangement in respect of an assurance engagement. For

both audit and assurance engagements, a contingent fee would carry a threat so great that no safeguards

could reduce it to an acceptable level.

For non-assurance engagements (eg tax services), where the client is not also an audit client, the

significance of the threat depends on:

 The range of possible fee amounts

 Whether an appropriate authority determines the outcome of the matter on which the contingent

fee will be determined

 The nature of the service

• The effect of the event or transaction on the subject matter information.

Possible safeguards include:

 Having a professional accountant review the relevant assurance work or otherwise advise as

necessary; or

 Using professionals who are not members of the assurance team to perform the non-assurance

service.

2.6.10 High percentage of fees

When a firm receives a high proportion of its fee income from just one audit client, there is a self-interest

or intimidation threat, as the firm will be concerned about losing the client. A high percentage fee income

does not by itself create an insurmountable threat. This depends on the following.

 The structure of the firm

 Whether the firm is established or new

 The significance of the client to the firm

These caveats are important for all of the threats to independence in this chapter. You should know most

of the rules from your previous studies, but at P7 level you will need to be able to apply them in detail.

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54 2: Code of ethics and conduct  Part B Professional and ethical considerations

Possible safeguards include:

 Reducing the dependence on the client;

 External quality control reviews; or

 Consulting a third party, such as a professional regulatory body or a professional accountant, on

key audit judgements.

It is not just a matter of the audit firm actually being independent in terms of fees, but also of it being

seen to be independent by the public. It is as much about public perception as reality.

The Code also states that a threat may be created where an individual partner or office's percentage fees

from one client is high. The safeguards are as above, except that internal quality control reviews are also

relevant.

For audit clients that are public interest entities, the Code states that where total fees from the client (for

the audit and any non-audit services) represent more than 15% of the firm's total fees for two

consecutive years, the firm shall:

 Disclose this to those charged with governance

 Conduct a review, either by an external professional accountant or by a regulatory body. This

review can be either before the audit opinion on the second year's financial statements is issued (a

'pre-issuance review'), or after it is issued (a 'post-issuance review').

If total fees significantly exceed 15%, then a post-issuance review may not be sufficient, and a preissuance

review will be required.

Be careful when making points about fee dependence in the exam – as a rule, it is best not to make the

point unless there is information in the question that specifically indicates that this is an issue. Your

examination team does not like it when candidates routinely mention fee dependence in ethics questions,

so marking schemes often do not include marks here.

2.6.11 Lowballing

When a firm quotes a significantly lower fee level for an assurance service than would have been charged

by the predecessor firm, there is a significant self-interest threat. If the firm's tender is successful, the firm

must apply safeguards such as:

 Maintaining records such that the firm is able to demonstrate that appropriate staff and time are

spent on the engagement

 Complying with all applicable assurance standards, guidelines and quality control procedures

2.6.12 Recruitment

Recruiting senior management for an assurance client, particularly those able to affect the subject matter

of an assurance engagement, creates a self-interest threat for the assurance firm.

Assurance providers must not make management decisions for the client. Their involvement could be

limited to reviewing a shortlist of candidates, providing that the client has drawn up the criteria by which

they are to be selected.

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Part B Professional and ethical considerations  2: Code of ethics and conduct 55

2.7 Self-review threat

General other

services

Preparing accounting records

and financial statements

Valuation services

Internal audit Tax services

services

Corporate

finance SELF-REVIEW THREAT

The key area in which there is likely to be a self-review threat is where an assurance firm provides services

other than assurance services to an assurance client (providing multiple services). There is a great deal of

guidance in the ACCA and IESBA Codes about various other services that accountancy firms might provide

to their clients, and these are dealt with below.

In exam questions, bear in mind the nature of the entity being audited. Is it a small owner-managed

business where the auditor is in effect an all-round business adviser and accountant, or is it a listed

company where the above rule is relevant?

In the US, rules concerning auditor independence for listed companies state that an accountant is not

independent if they provide certain non-audit services to an audit client. The relevant services are:

 Bookkeeping

 Financial information systems design and implementation

 Appraisal or valuation services or fairness opinions

 Actuarial services

 Internal audit services

 Management functions

 Human resources

 Broker-dealer services

 Legal services

The rules, found in the Sarbanes-Oxley Act, have an international impact because they apply not only to

any company listed on the US Stock Exchange, but also to all subsidiaries of US-listed companies no

matter where they are based. So, for example, a UK-based subsidiary of a multinational group that is

listed in the US must comply with the Sarbanes-Oxley requirements.

2.7.1 General other services

For assurance clients, accountants are not allowed to:

 Authorise, execute or consummate a transaction

 Determine which recommendation of the company should be implemented

 Report in a management capacity to those charged with governance

Having custody of an assurance client's assets, supervising client employees in the performance of their

normal duties, and preparing source documents on behalf of the client also pose significant self-review

threats which should be addressed by safeguards. These could be:

 Ensuring non-assurance team staff are used for these roles

 Involving an independent professional accountant to advise

 Quality control policies on what staff are and are not allowed to do for clients

 Making appropriate disclosures to those charged with governance

 Resigning from the assurance engagement

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56 2: Code of ethics and conduct  Part B Professional and ethical considerations

2.7.2 Preparing accounting records and financial statements

There is clearly a significant risk of a self-review threat if a firm prepares accounting records and financial

statements and then audits them.

On the other hand, auditors routinely assist management with the preparation of financial statements and

give advice about accounting treatments and journal entries.

Therefore, assurance firms must analyse the risks arising and put safeguards in place to ensure that the

risk is at an acceptable level. If this can be done, then these services may be provided.

Safeguards include:

 Using staff members other than assurance team members to carry out the work

 Obtaining client approval for work undertaken

The rules are more stringent when the client is listed or public interest. Firms should not prepare

accounts or financial statements for listed or public interest clients. Note that there used to be an

exception here for 'emergency situations', in which the auditor used to be allowed to prepare accounts,

but this was removed in 2015.

For any client, assurance firms are also not allowed to:

 Determine or change journal entries without client approval

 Authorise or approve transactions

2.7.3 Valuation services

A valuation comprises the making of assumptions with regard to future developments, the application of

certain methodologies and techniques, and the combination of both in order to compute a certain value, or

range of values, for an asset, a liability or a business as a whole.

If an audit firm performs a valuation which will be included in financial statements audited by the firm, a

self-review threat arises.

Audit firms should not carry out valuations on matters which will be material to the financial

statements. If the valuation is for an immaterial matter, the audit firm should apply safeguards to ensure

that the risk is reduced to an acceptable level. Matters to consider when applying safeguards are the extent

of the audit client's knowledge of the relevant matters in making the valuation and the degree of

judgement involved, how much use is made of established methodologies and the degree of uncertainty in

the valuation. Safeguards include:

 Second partner review

 Confirming that the client understands the valuation and the assumptions used

 Ensuring the client acknowledges responsibility for the valuation

 Using separate personnel for the valuation and the audit

2.7.4 Taxation services

The Code divides taxation services into four categories.

(a) Tax return preparation

(b) Tax calculations for the purpose of preparing the accounting entries

(c) Tax planning and other tax advisory services

(d) Assistance in the resolution of tax disputes

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Guidance in respect of each of these categories is:

(a) Tax return preparation does not generally threaten independence, as long as management takes

responsibility for the returns.

(b) Tax calculations for the purpose of preparing the accounting entries may not prepared for public

interest entities. There used to be an exception for 'emergency situations', but changes in 2015

meant that taxation services cannot provided in any circumstances at all.

For non-public interest entities, it is acceptable to do so provided that safeguards are applied.

(c) Tax planning may be acceptable in certain circumstances, eg where the advice is clearly

supported by tax authority or other precedent. However, if the effectiveness of the tax advice

depends on a particular accounting treatment or presentation in the financial statements, the audit

team has reasonable doubt about the accounting treatment, and the consequences of the tax advice

would be material, then the service should not be provided.

(d) Assistance in the resolution of tax disputes may be provided, depending on whether the firm

itself provided the service which is the subject of the dispute, and whether the effect is material to

the financial statements. Safeguards include using professionals who are not members of the audit

team to perform the service, and obtaining advice on the service from an external tax professional.

2.7.5 Internal audit services

A firm may provide internal audit services to an audit client. However, it should ensure that the client

acknowledges its responsibility for establishing, maintaining and monitoring the system of internal

controls. It may be appropriate to use safeguards, such as ensuring that an employee of the client is

designated as responsible for internal audit activities and that the client approves all the work that internal

audit does.

If the client is a public interest entity, then internal audit services must not be provided if they relate to:

(a) A significant part of the internal controls over financial reporting;

(b) Financial accounting systems generating information which is significant to the financial

statements; or

(c) Amounts or disclosures which are material to the financial statements.

2.7.6 Corporate finance

Certain aspects of corporate finance will create self-review threats that cannot be reduced to an acceptable

level by safeguards. Therefore, assurance firms are not allowed to promote, deal in or underwrite an

assurance client's shares. They are also not allowed to commit an assurance client to the terms of a

transaction or consummate a transaction on the client's behalf.

Other corporate finance services, such as assisting a client in defining corporate strategies, assisting in

identifying possible sources of capital and providing structuring advice, may be acceptable, providing that

safeguards are put in place, such as using different teams of staff and ensuring no management decisions

are taken on behalf of the client.

2.7.7 Other services

The audit firm might sell a variety of other services to audit clients, such as:

 IT services

 Litigation support

 Legal services

The assurance firm should consider whether there are any threats to independence, such as if the firm

were asked to design internal control IT systems, which it would then review as part of its audit. The firm

should consider whether the threat to independence could be reduced by appropriate safeguards.

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58 2: Code of ethics and conduct  Part B Professional and ethical considerations

2.8 Advocacy threat

ADVOCACY THREAT

Legal

services

Corporate

finance

Contingent fees

An advocacy threat arises in certain situations where the assurance firm is in a position of taking the

client's part in a dispute or somehow acting as their advocate. The most obvious instances of this would

be when a firm offered legal services to a client and, say, defended them in a legal case or provided

evidence on their behalf as an expert witness. Advocacy threat might also arise if the firm carried out

corporate finance work for the client, for example, if the audit firm was involved in advice on debt

reconstruction and negotiated with the bank on the client's behalf.

The December 2013 exam featured a scenario in which the auditor was asked to attend a meeting with the

client's bank in relation to a possible new loan. Although most students would have sensed that this was

wrong, many would not have gotten the marks for saying specifically that it was an advocacy threat.

As with the other threats above, the firm has to appraise the risk and apply safeguards as necessary.

Relevant safeguards might be using different departments in the firm to carry out the work and making

disclosures to the audit committee. Remember, the ultimate option is always to withdraw from an

engagement if the risk to independence is too high.

Question Advocacy threat

Explain why contingent fees represent an advocacy threat.

Answer

If an accountant is paid fees on a contingency basis, then their interest becomes too closely aligned to that

of the client. They will both want the same thing to occur (ie the thing the fee is contingent on) and the risk

is that the accountant will act in the interests of the client to ensure it happens.

2.9 Familiarity threat

A familiarity threat arises where independence is jeopardised by the audit firm and its staff becoming over

familiar with the client and its staff. There is a substantial risk of loss of professional scepticism in such

circumstances.

We have already discussed some examples of when this risk arises, because very often a familiarity threat

arises in conjunction with a self-interest threat.

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FAMILIARITY THREAT

Where there are family and personal

relationships between client/firm

Employment with

assurance client

Recent service with

assurance client

Long association

with assurance clients

2.9.1 Long association of senior personnel with audit clients

Having an audit client for a long period of time may create a familiarity threat to independence. The

severity of the threat depends on such factors as how long the individual has been on the audit team; how

senior the person is; whether the client's management has changed; and whether the client's accounting

issues have changed in nature or complexity.

Possible safeguards include:

 Rotating the senior personnel off the audit team;

 Having a professional accountant who was not a member of the audit team review the work of the

senior personnel; or

 Regular independent internal or external quality reviews of the engagement.

The rules for public interest entities are stricter. If an individual is a key audit partner for seven years,

they must be rotated off the audit for two years. During this time they cannot be on the audit team, and

cannot consult with the audit team or the client on any issues that may affect the engagement (including

giving just general industry advice).

The Codes do allow some flexibility here: if key partner continuity is particularly beneficial to audit quality,

and there is some unforeseen circumstance (such as the intended engagement partner becoming

seriously ill), then the key audit partner can remain on the audit for an additional year, making eight

years in total.

If a client that was not a public interest entity becomes one, then the seven year limit still applies, starting

from the date when the key audit partner originally became the key partner for that audit client.

Finally, it is possible for an independent regulator to give permission for an audit partner to remain a key

audit partner indefinitely, provided alternative safeguards are applied (eg external review).

The December 2010 exam contained four marks for evaluating the advantages and disadvantages of

compulsory firm rotation. The candidates who score well on questions of this sort are those who don't

just know the rules, but are also able to think through the issues underlying them. They are also those who

have done a bit of reading around the syllabus.

That being said, you don't need to be intimidated by questions like this: they are within reach of virtually

every P7 candidate, provided that you can come up with some sensible points both for and against, and

can then draw a reasonable conclusion from what you have written. These are skills that you have

demonstrated in the earlier P-level papers; they just need to be applied to the subject matter of P7.

2.9.2 Recent service with an audit client

Individuals who have been a director or officer of the client (or an employee in a position to exert direct

and significant influence over the subject matter information of the assurance engagement) in the period

under review should not be assigned to the assurance team.

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60 2: Code of ethics and conduct  Part B Professional and ethical considerations

If an individual had been closely involved with the client prior to the time limits set out above, the

assurance firm should consider the threat to independence arising and apply appropriate safeguards, such

as:

 Obtaining a quality control review of the individual's work on the assignment

 Discussing the issue with the audit committee

2.9.3 Employment with an audit client

It is possible that staff might transfer between an assurance firm and a client, or that negotiations or

interviews to facilitate such movement might take place. Both situations are a threat to independence:

 An audit staff member might be motivated by a desire to impress a future possible employer

(objectivity is therefore affected – self-interest threat).

 A former partner turned finance director has too much knowledge of the audit firm's systems and

procedures.

In general there may be familiarity and intimidation threats when a member of the audit team joins an

audit client. If a 'significant connection' still remains between the audit firm and the former

employee/partner, then no safeguards could reduce the threat to an acceptable level. This would be the

case where:

 The individual is entitled to benefits from the audit firm (unless fixed and predetermined, and not

material to the firm)

 The individual continues to participate in the audit firm's business or professional activities

If there is no significant connection, then the threat depends on:

 The position the individual has taken at the client

 Any involvement the individual will have with the audit team

 The length of time since the individual was a member of the audit team or partner of the firm

 The former position of the individual within the audit team or firm; for example, whether the

individual was responsible for maintaining regular contact with the client's management or those

charged with governance

Safeguards could include:

 Modifying the audit plan;

 Assigning individuals to the audit team who have sufficient experience in relation to the

individual who has joined the client; or

 Having an independent professional accountant review the work of the former member of the audit

team.

If the audit client is a public interest entity, 'cooling off' periods are required. Both the ACCA and IESBA

Codes state that when a key audit partner joins such a client, either as a director or as an employee with

significant influence on the financial statements, the client must have issued audited financial statements

covering at least 12 months before the employment can begin. The partner in question must also not have

been a member of the audit team in relation to those audited financial statements.

In the case of a senior or managing partner joining an audit client, 12 months must have passed (ie

there is no requirement for audited financial statements to have been issued).

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Part B Professional and ethical considerations  2: Code of ethics and conduct 61

The key audit partner is the:

 Engagement partner,

 Individual responsible for the engagement quality control review,

 Other audit partners on the engagement team,

who make key decisions or judgements on significant matters with respect to the audit of the financial

statements on which the firm will express an opinion. Depending upon the circumstances and the role of

the individuals on the audit, 'other audit partners' may include, for example, audit partners responsible for

significant subsidiaries or divisions.

2.9.4 Family and personal relationships

Family or close personal relationships between assurance firm staff and client staff could seriously

threaten independence. Each situation has to be evaluated individually. Factors to consider are:

 The individual's responsibilities on the assurance engagement

 The closeness of the relationship

 The role of the other party at the assurance client

When an immediate family member of a member of the assurance team is a director, an officer or an

employee of the assurance client in a position to exert direct and significant influence over the subject

matter information of the assurance engagement, the individual should be removed from the assurance

team.

The audit firm should also consider whether there is any threat to independence if an employee who is not

a member of the assurance team has a close family or personal relationship with a director, an officer or

an employee of an assurance client.

A firm should have quality control policies and procedures under which staff should disclose if a close

family member employed by the client is promoted within the client.

If a firm inadvertently violates the rules concerning family and personal relationships they should apply

additional safeguards, such as undertaking a quality control review of the audit and discussing the matter

with the audit committee of the client, if there is one.

2.10 Intimidation threat

An intimidation threat arises when members of the assurance team have reason to be intimidated by client

staff.

INTIMIDATION THREAT

Close business

relationships

Family and personal

relationships

Assurance staff members move to

employment with client

Litigation

These are also examples of self-interest threats, largely because intimidation may only arise significantly

when the assurance firm has something to lose.

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62 2: Code of ethics and conduct  Part B Professional and ethical considerations

The following examples of intimidation threats are taken from the IESBA Code.

Examples of intimidation threats

A threat of dismissal from a client engagement, if it continues to disagree with the client/plans to modify

the auditor's report

A threat of not giving a firm a contract for non-assurance work

A threat of litigation by the client (see below)

Pressure to reduce the amount of work done in order to reduce fees

Pressure to agree with the client because the client has more experience on the matter

A partner within the firm telling a member of the audit team that they will not be promoted if they

disagree with the client

2.10.1 Actual and threatened litigation

There may be an intimidation threat when the client threatens to sue, or indeed sues, the assurance firm

for work that has been done previously. The firm is then faced with the risk of losing the client, bad

publicity and the possibility that they will be found to have been negligent, which will lead to further

problems. This could lead to the firm being under pressure to produce an unmodified audit report when

they have been modified in the past, for example.

Generally, assurance firms should seek to avoid such situations arising. If they do arise, factors to

consider are:

 The materiality of the litigation

 The nature of the assurance engagement

 Whether the litigation relates to a prior assurance engagement

The following safeguards could be considered.

 Disclosing to the audit committee the nature and extent of the litigation

 Removing specific affected individuals from the engagement team

 Involving an additional professional accountant on the team to review work

However, if the litigation is at all serious, it may be necessary to resign from the engagement, as the threat

to independence is so great.

2.10.2 Second opinions

Another way that auditors can suffer an intimidation threat is when the audit client is unhappy with a

proposed audit opinion, and seeks a second opinion from a different firm of auditors.

In such a circumstance, the second audit firm will not be able to give a formal audit opinion on the financial

statements – only an appointed auditor can do that. However, the problem is that if a different firm of auditors

indicates to someone else's audit client that a different audit opinion might be acceptable, the appointed

auditor may feel under pressure to change the audit opinion. In effect, a self-interest threat arises, as the

existing auditor may feel that they will lose next year's audit if they does not change this year's opinion.

There is nothing to stop a company director talking to a second firm of auditors about treatments of

matters in the financial statements. However, the firm being asked for a second opinion should be very

careful, because it is possible that the opinion they form could be incorrect anyway if the director has not

given them all the relevant information. For that reason, firms giving a second opinion should ensure that

they seek permission to communicate with the existing auditor and they are appraised of all the facts. If

permission is not given, the second auditors should decline to comment on the audit opinion.

Given that second opinions can cause independence issues for the existing auditors, audit firms should

generally take great care if asked to provide one anyway.

Increasingly, new accounting standards do not give a choice of accounting treatments, meaning that

second opinions might be less called for.

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Part B Professional and ethical considerations  2: Code of ethics and conduct 63

Question Threats to independence

You are a partner in a firm of Chartered Certified Accountants. The following issues have emerged in

relation to three of your clients.

(a) Easter is a major client. It is listed on a major Stock Exchange. The audit team consists of eight

members, of whom Paul is the most junior. Paul has just invested in a personal pension plan that

invests in all the listed companies on the exchange.

(b) You are at the head of a team carrying out due diligence work at Electra, a limited company which

your client, Powerful, is considering taking over. Your second in command on the team, Peter, has

confided in you that in the course of his work he has met the daughter of the managing director of

Electra, and he is keen to invite her on a date.

(c) Your longest standing audit client is Teddies, which you have been involved in for ten years, four as

engagement partner. You recently went on an extended cruise with the managing director on their

yacht.

Required

Comment on the ethical and other professional issues raised by the above matters. Your answer should

outline the threat arising, the significance of the threat, any factors you have taken into account and, if

relevant, any safeguards you could apply to eliminate or mitigate the threat.

Answer

(a) In relation to Easter, there is a threat of self-interest arising, as a member of the audit team has an

indirect financial interest in the client.

The relevant factors are:

(i) The interest is unlikely to be material to the client or Paul, as the investment is recent and

Paul's interest is in a pool of general investments made by the pension scheme on his

behalf.

(ii) Paul is the audit junior and does not have a significant role on the audit in terms of

drawing audit conclusions or identifying audit risk areas.

The risk that arises to the independence of the audit here is not significant. It would be

inappropriate to require Paul to divest his interest in the audit client. If I wanted to eliminate all

elements of risk in this situation, I could simply change the junior assigned to my team, but such a

step is not vital in this situation.

(b) In relation to Powerful, two issues arise. The first is that the firm appears to be providing multiple

services to Powerful, which could raise a self-interest threat. The second is that the manager

assigned to the due diligence assignment wants to engage in a personal relationship with a person

connected to the subject of the assignment, which could create a familiarity or intimidation

threat.

With regard to the issue of multiple services, insufficient information is given to draw a conclusion

as to the significance of the threat. Relevant factors would be matters such as the nature of the

services, the fee income and the team members assigned to each. Safeguards could include using

different staff for the two assignments. The risk is likely to be significant only if one of the services

provided is audit, which is not indicated in the question.

In relation to the second issue, the relevant factors are as follows.

 The assurance team member has a significant role on the team as second in command

 The other party is closely connected to a key staff member at the company being reviewed

 Timing

In this situation, the firm is carrying out a one-off review of the company, and timing is a key

issue. Presently Peter does not have a personal relationship which would significantly threaten the

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64 2: Code of ethics and conduct  Part B Professional and ethical considerations

independence of the assignment. In this situation, the safeguard is to request that Peter does not

take any action in that direction until the assignment is completed. If he refuses, then I may have to

consider rotating my staff on this assignment, and removing him from the team.

(c) In relation to Teddies, there is a risk that my long association and personal relationship with the

client will result in a familiarity threat. This is compounded by my acceptance of significant

hospitality on a personal level.

The relevant factors are:

 I have been involved with the client for ten years and have a personal relationship with client

staff.

 The company is not a listed or public interest company.

 It is an audit assignment.

The risk arising here is significant but, as the client is not listed, it is not insurmountable. However,

it would be a good idea to implement some safeguards to mitigate against the risk. I could invite a

second partner to provide a hot review of the audit of Teddies, or even consider requesting that I

am rotated off the audit of Teddies for a period, so that the engagement partner is another partner

in my firm. In addition, I must cease accepting hospitality from the directors of Teddies unless it is

clearly insignificant.

When answering exam questions, do not just identify the ethical threats in a given scenario. You must also

be able to explain why the issue is an ethical threat. Ideally you should say what type of threat it is (selfinterest,

self-review, advocacy, familiarity or intimidation), as this will help to show the marker that you

are applying specific knowledge of ethical codes to the scenario.

2.11 Quality control: independence

The quality control standard for firms, ISQC 1 Quality control for firms that perform audits and reviews of

financial statements, and other assurance and related services engagements, which we shall look at in

detail in Chapter 4, contains a section looking at the firm's procedures with regard to ethics and, in

particular, independence.

ISQC 1.20

The firm shall establish policies and procedures designed to provide it with reasonable assurance that the

firm and its personnel comply with relevant ethical requirements.

The policies and procedures should be in line with the fundamental principles, which should be reinforced by:

 The leadership of the firm

 Education and training

 Monitoring

 A process for dealing with non-compliance

ISQC 1.22

Such policies and procedures shall require:

(a) Engagement partners to provide the firm with relevant information about client engagements,

including the scope of services, to enable the firm to evaluate the overall impact, if any, on

independence requirements

(b) Personnel to promptly notify the firm of circumstances and relationships that create a threat to

independence so that appropriate action can be taken

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Part B Professional and ethical considerations  2: Code of ethics and conduct 65

(c) The accumulation and communication of relevant information to appropriate personnel so that:

(i) The firm and its personnel can readily determine whether they satisfy independence

requirements

(ii) The firm can maintain and update its records relating to independence

(iii) The firm can take appropriate action regarding identified threats to independence that are

not at an acceptable level

ISQC 1.23

The firm shall establish policies and procedures designed to provide it with reasonable assurance that it is

notified of breaches of independence requirements, and to enable it to take appropriate actions to resolve

such situations. The policies and procedures shall include requirements for:

(a) Personnel to promptly notify the firm of independence breaches of which they become aware

(b) The firm to promptly communicate identified breaches of these policies and procedures to:

(i) The engagement partner who, with the firm, needs to address the breach

(ii) Other relevant personnel in the firm and, where appropriate, the network, and those subject

to the independence requirements who need to take appropriate action

(c) Prompt communication to the firm, if necessary, by the engagement partner and the other

individuals referred to in subparagraph (b)(ii) of the actions taken to resolve the matter, so that the

firm can determine whether it should take further action

ISQC 1.24

At least annually, the firm shall obtain written confirmation of compliance with its policies and procedures

on independence from all firm personnel required to be independent by relevant ethical requirements.

2.11.1 Familiarity threat

Lastly, the ISQC sets out some specific guidance in relation to the threat of overfamiliarity with clients.

ISQC 1.25

The firm shall establish policies and procedures:

(a) Setting out criteria for determining the need for safeguards to reduce the familiarity threat to an

acceptable level when using the same senior personnel on an assurance engagement over a long

period of time; and

(b) Requiring, for audits of financial statements of listed entities, the rotation of the engagement

partner and the individuals responsible for engagement quality control review and, where

applicable, others subject to rotation requirements, after a specified period in compliance with

relevant ethical requirements.

3 Specific guidance: confidentiality 12/13

The ACCA and the IESBA Codes recognise a duty of confidence and several exceptions to it.

3.1 Duty of confidence

Confidentiality is a fundamental principle, defined in Section 1.3 above. Here is the definition again:

Confidentiality. To respect the confidentiality of information acquired as a result of professional and

business relationships and, therefore, not disclose any such information to third parties without proper

and specific authority, unless there is a legal or professional right or duty to disclose, nor use the

information for the personal advantage of the professional accountant or third parties.

(IESBA and ACCA Codes of Ethics)

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66 2: Code of ethics and conduct  Part B Professional and ethical considerations

The key parts of this definition are:

 Do not disclose information without proper authority.

 Do not use information for personal advantage.

 Information may be disclosed if there is a right or duty to do so.

In exchange for this duty of confidence owed by the auditor to the client, the client must agree to disclose in

full all information relevant to the engagement. The professional accountant must make the client aware of

the duty of confidentiality, and of the fact that it can be overridden where there is a right or duty to disclose.

Maintaining confidentiality means avoiding inadvertent disclosure as much as intentional disclosure. For

instance, information must not be disclosed unintentionally when socialising. The Codes also note that the

duty of confidentiality continues even after the end of the relationship with the client.

3.2 Exceptions to the rule of confidentiality

Binding though the duty of confidence is, there are nevertheless exceptions to it. The Codes identify three

general circumstances where disclosure may be appropriate.

 Disclosure is permitted by law and authorised by the client.

 Disclosure is required by law (eg for legal proceedings).

 There is a professional duty or right to disclose (eg to comply with a quality review by a

professional body such as ACCA; to respond to an investigation by a regulatory body; to protect the

professional accountant's interests in legal proceedings; to comply with ethics requirements).

Disclosure may be obligatory or merely voluntary, depending on the situation.

ACCA and IESBA Codes of Ethics

Obligatory disclosure. A professional accountant who believes that a client has committed terrorist

offences, or has reasonable cause to believe that a client has committed treason, is bound to disclose that

knowledge to the proper authorities immediately. (Code, B 1.22)

Voluntary disclosure. In certain cases a professional accountant is free to disclose information, whatever

its nature:

 When it is in the public interest

 In order to protect a professional accountant's interests

 Where it is authorised by statute

 To non-governmental bodies

(Code, B 1.30)

In deciding whether to disclose, some general factors to consider include:

 Whether it would harm the interests of all parties (including third parties)

 Whether all relevant information is known and substantiated

 The type of communication that is expected

 Whether the parties to whom the communication is addressed are appropriate recipients

The following four subsections address the four kinds of voluntary disclosure.

3.2.1 Disclosure in the public interest

The courts have never given a definition of 'the public interest', which makes things difficult for the auditor

as it is not certain exactly when they must disclose. But the Codes state that disclosure is probably only

permitted to 'one who has a proper interest to receive that information', such as:

 The police;

 The government department for trade and industry; or

 A recognised stock exchange.

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Part B Professional and ethical considerations  2: Code of ethics and conduct 67

Whether disclosure is justified depends on the following factors (Code B1.32).

 The size of the amounts involved and the extent of likely financial damage

 Whether members of the public are likely to be affected

 The possibility or likelihood of repetition

 The reasons for the client's unwillingness to make disclosures to the proper authority

 The gravity of the matter

 Relevant legislation, accounting and auditing standards

 Any legal advice obtained

The Codes do state that this is a difficult area to decide on, and that it will often be appropriate to take

legal advice (Code B1.33).

Under ISA 250, if auditors become aware of a suspected or actual instance of non-compliance with law

and regulation which gives rise to a statutory right or duty to report, they should report it to the proper

authority immediately. They should also seek legal advice.

If you are required to make judgements about whether such a disclosure should be made in a given

scenario, you should apply a checklist like the one above to the scenario to ensure you have shown

evidence of your consideration of all the relevant factors.

3.2.2 Disclosure to protect a professional accountant's interests

Disclosure can be made to protect a professional accountant's interests to:

 Enable the professional accountant to defend themselves against a criminal charge or suspicion

 Resist proceedings in relation to a taxation offence

 Resist legal action by a client or a third party

 Enable the professional accountant to defend themselves against disciplinary proceedings by the

ACCA or another body

 Enable the professional accountant to sue for their fees

3.2.3 Disclosure authorised by statute

There are two areas where legislation may require the auditor to break their duty of confidentiality:

 Where required to disclose by anti money laundering legislation (see Chapter 1)

 Where required to disclose by any whistleblowing responsibilities, eg for an auditor of certain

financial institutions in the UK

3.2.4 Disclosure to non-governmental bodies

Disclosure must be made to a recognised non-governmental body where the body has statutory powers

requiring disclosure, but where the body does not have these powers then the professional accountant

must obtain the client's consent to disclose.

3.3 Responding to illegal acts/non-compliance with laws and

regulations

3.3.1 2012 ED: Responding to a suspected illegal act

In August 2012 the IESBA issued an Exposure Draft (ED), Responding to a Suspected Illegal Act. The ED

described the circumstances in which a professional accountant is required or expected to override

confidentiality and disclose a suspected illegal act to an appropriate authority.

The ED proposed adding two new sections addressing illegal acts to the Code of Ethics, in order to clearly

delineate the expected course of action for an accountant to take if those charged with governance do not

respond to the issue appropriately.

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68 2: Code of ethics and conduct  Part B Professional and ethical considerations

If they suspect that an illegal act has taken place, accountants must take reasonable steps to confirm this

(or dispel the suspicion). They must discuss it with management, and escalate it to higher levels of

management if the response received is inadequate.

If an appropriate response is still not received, then the accountant's next action depends on whether they

are dealing with an audit client or not:

 Audit client: disclose to relevant authority

 Non-audit client/'professional accountant in business': disclose to the entity's external auditor

and, if possible, to a relevant authority

It may be necessary to terminate the professional relationship or, if the accountant is an employee,

resign from the organisation.

3.3.2 2015 ED: Responding to Non-Compliance with Laws and Regulations

In May 2015 a further Exposure Draft was issued, Responding to Non-Compliance with Laws and

Regulations, as a result of feedback from the 2012 ED on 'illegal acts'. A new framework was proposed

which focused more on achieving outcomes that were in the public interest, ie trying to discourage

professional accountants from 'turning a blind eye' to non-compliance.

We now have a new acronym: NOCLAR, or Non-Compliance with Laws And Regulations.

The objectives of the framework are:

 To comply with the fundamental principles of integrity and professional behaviour

 By alerting management, to seek to:

– Enable them to rectify, remediate or mitigate the consequences of the identified or

suspected NOCLAR; or

– Deter the commission of NOCLAR

 To take such further action as may be needed in the public interest.

The laws and regulations covered by the framework are those within the scope of the accountant's

expertise, ie which are fundamental to the financial statements or to the client's business. Outside the

scope are: matters which are clearly inconsequential; personal misconduct unrelated to a client's

business, and; NOCLAR acts committed by someone other than the client.

Requirements of Auditors include:

 Raise the identified or suspected NOCLAR with management/TCWG.

 Fulfill professional responsibilities, eg comply with professional standards.

 Determine if further action (eg disclosure to relevant authority) is needed to achieve the objectives,

depending on management's response.

 Document how the objectives have been met.

4 Specific guidance: conflicts of interest 6/09, 6/11

Auditors should identify potential conflicts of interest, as they could result in the ethical codes being

breached.

There are two kinds of conflict of interest:

 Conflicts between the interests of different clients

 Conflicts between members' and clients' interests

Audit firms should take reasonable steps to identify circumstances that could pose a conflict of interest.

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Part B Professional and ethical considerations  2: Code of ethics and conduct 69

Examples of conflicts of interest

Using confidential information obtained during an audit to help another client to acquire the audit client

Advising two clients at the same time who are competing to acquire the same company

Providing services to both a vendor and a purchaser in relation to the same transaction

Representing two clients who are in a legal dispute with each other (eg during divorce proceedings)

Advising a client to invest in a business in which, for example, the spouse of the professional accountant

in public practice has a financial interest

The test of whether a threat is significant is whether a reasonable and informed third party, weighing all

the specific facts and circumstances available to the professional accountant at the time, would be likely to

conclude that compliance with the fundamental principles is not compromised.

The Code emphasises the importance of considering potential conflicts of interest before accepting a new

client. An issue here is first identifying that there is a conflict – it may be that, for example, the

engagement partner for a new client is not aware that there is a conflict because they do not know all of

the firm's other clients. It is therefore necessary to have an effective conflict identification process.

As with all threats, safeguards should be applied if necessary. If safeguards would not be enough, then

the engagement should be declined or discontinued.

Examples of safeguards

Disclosure of the nature of the conflict of interest (and related safeguards) to clients affected, to obtain

their consent to the professional accountant performing the services

Mechanisms to prevent unauthorised disclosure of confidential information, such as:

 Separate engagement teams

 Creating separate areas of practice for specialty functions within the firm

Establishing policies and procedures to limit access to client files

Review of safeguards by a senior individual not involved with the engagement(s)

External review by a professional accountant

Consulting with third parties, such as a professional body, legal counsel or another professional

accountant

Disclosure is the key safeguard here. If the client refuses to give consent, then the engagement giving

rise to the conflict should be discontinued.

5 Conflicts in application of the fundamental principles

The Codes give some general guidance to members who encounter a conflict in the application of the

fundamental principles.

5.1 The problem

Both the IESBA and ACCA Codes are principles-based. The application of the principles they contain

requires a degree of judgement (much like the application of an ISA). As a result of this judgemental

aspect, it is possible to have more than one 'right answer' in a given situation – more than one

reasonable judgement of how the fundamental ethical principles should be applied.

Contrast this to the situation with a rules-based code of ethics. There, applying the rules strictly should

result in only one possible outcome. It might not be an outcome that is ethical, eg because it is a result of

a loophole, but it will be the only correct outcome (assuming that the rules themselves are not

ambiguous). By contrast, a principles-based code may allow for several outcomes that are equally

'correct'.

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70 2: Code of ethics and conduct  Part B Professional and ethical considerations

What is at issue here is that there may be conflict between different ethical principles. The aim here must

be to use judgement to resolve the conflict, or to try to balance the principles involved.

5.2 Matters to consider

The resolution process should include consideration of:

 Relevant facts – do I have all the relevant facts? Eg an organisation's policy and procedures

 Relevant parties – who is affected by the ethical issue? Eg shareholders, employees, employers,

the public

 Ethical issues involved – what kinds of issues are these? Would they affect the profession's

reputation? Eg professional ethical issues, personal ethical issues

 Fundamental principles related to the matter in question – what are the threats? Refer to ethical

code

 Established internal procedures – are there procedures for dealing with this sort of situation? Eg

discuss with your supervisor, or firm's legal department

 Alternative courses of action – have all the consequences been evaluated? Consider laws and

regulations, long-term consequences, public consequences

5.2.1 Unresolved conflict

If the matter is unresolved, the member should consult with other appropriate persons within the firm.

They may then wish to obtain advice from the ACCA or legal advisers. If after exhausting all relevant

possibilities the ethical conflict remains unresolved, members should consider withdrawing from the

engagement team, a specific assignment, or to resign altogether from the engagement.

5.3 Example

An auditor encounters a fraud

Conflict: duty to report could

conflict with confidentiality

Take legal advice to

determine whether there is a

requirement to report

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Part B Professional and ethical considerations  2: Code of ethics and conduct 71

Chapter Roundup

 Accountants require an ethical code because they hold positions of trust, and people rely on them.

 The ACCA's guidance complies with the requirements of the IESBA Code.

 The ACCA and IESBA Codes give examples of a number of situations where independence might be

threatened and suggest safeguards to independence.

 The ACCA and IESBA Codes recognise a duty of confidence and several exceptions to it.

 Auditors should identify potential conflicts of interest, as they could result in the ethical codes being

breached.

 The Codes give some general guidance to members who encounter a conflict in the application of the

fundamental principles.

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72 2: Code of ethics and conduct  Part B Professional and ethical considerations

Quick Quiz

1 Match the fundamental principle to the characteristic.

(a) Integrity

(b) Objectivity

(i) Members should be straightforward and honest in all professional and business

relationships.

(ii) Members should not allow bias, conflict of interest or undue influence of others to override

professional or business judgements.

2 Name five general threats to independence.

(1) ………………………

(2) ………………………

(3) ………………………

(4) ………………………

(5) ………………………

3 Name four relevant safeguards against a financial interest in a client.

(1) ………………………

(2) ………………………

(3) ………………………

(4) ………………………

4 Complete the definition:

………… …………… are fees calculated on a predetermined basis relating to the outcome or result of a

transaction or the result of the work performed.

5 Name four exceptions to the duty of confidentiality in which voluntary disclosure may be made.

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Part B Professional and ethical considerations  2: Code of ethics and conduct 73

Answers to Quick Quiz

1 (a)(i), (b)(ii)

2 (1) Self-review

(2) Self-interest

(3) Familiarity

(4) Intimidation

(5) Advocacy

3 (1) Disposing of the interest

(2) Removing the relevant individual from the assurance team

(3) Informing the audit committee of the situation

(4) Independent partner review of work undertaken

4 Contingent fees

5 In certain cases a professional accountant is free to disclose information, whatever its nature:

 When it is in the public interest

 In order to protect a professional accountant's interests

 Where it is authorised by statute

 To non-governmental bodies

Now try the questions below from the Practice Question Bank.

Number Level Marks Time

Q2 Examination 15 29 mins

Q3 Examination 15 29 mins

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74 2: Code of ethics and conduct  Part B Professional and ethical considerations

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75

Topic list Syllabus reference

1 Legal liability B3

2 Negligence B3

3 Restricting liability B3

4 Current issues in auditor liability B3

5 Fraud and error B2

6 The expectations gap B3

Professional liability

Introduction

Auditors have responsibilities to several parties. This chapter explores the

various responsibilities and the liability that can arise in respect of them. It

also looks at ways of restricting liability, including professional indemnity

insurance.

The auditors' responsibility to members and other readers of the accounts in tort

and contract can give rise to liability, particularly in the event of negligence.

Case law on this matter is complex and not wholly satisfactory. It results in

auditors being liable to some readers and not others. However, auditors' liability

is a dynamic issue in that it evolves as cases are brought to court.

There are some interesting issues for auditors with regard to liability, for

example limited liability partnerships. This and other current issues pertaining

to the topics covered in this chapter are discussed in Section 4.

Critically, and contrary to widespread public belief, auditors do not have a

responsibility to detect and prevent fraud. The responsibilities that auditors do

have with regard to fraud and error are outlined in Section 5. Auditors are

required to follow the guidance of ISA 240 The auditor's responsibilities relating

to fraud in an audit of financial statements.

Reasons for audit failure and other factors contributing to the 'expectation gap'

are covered in Section 6.

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76 3: Professional liability  Part B Professional and ethical considerations

Study guide

Intellectual level

B2 Fraud and error

(a) Define and clearly distinguish between the terms 'error', 'irregularity', 'fraud'

and 'misstatement'.

2

(b) Compare and contrast the respective responsibilities of management and

auditors for fraud and error.

2

(c) Describe the matters to be considered and procedures to be carried out to

investigate actual and/or potential misstatements in a given situation.

2

(d) Explain how, why, when and to whom fraud and error should be reported

and the circumstances in which an auditor should withdraw from an

engagement.

2

(e) Discuss the current and possible future role of auditors in preventing,

detecting and reporting error and fraud.

2

B3 Professional liability

(a) Recognise circumstances in which professional accountants may have legal

liability.

2

(b) Describe the factors to determine whether or not an auditor is negligent in

given situations.

2

(c) Explain the other criteria for legal liability to be recognised (including 'due

professional care' and 'proximity') and apply them to given situations.

2

(d) Compare and contrast liability to client with liability to third parties. 3

(e) Evaluate the practicability and effectiveness of ways in which liability may be

restricted.

3

(f) Discuss liability limitation agreements. 2

(g) Discuss and appraise the principal causes of audit failure and other factors

that contribute to the 'expectation gap' (eg responsibilities for fraud and

error).

3

(h) Recommend ways in which the expectation gap might be bridged. 2

Exam guide

Auditor liability is a key issue facing the profession globally, and is linked in with ongoing debate about the

role of audit in the future. This area can be examined in topical discussion questions, or in practical

scenarios considering whether an auditor may be held to have been negligent in specific circumstances.

The extent of the auditor's responsibilities in relation to fraud and error is a critical element of the public's

perception of the auditor's role. The requirements of ISA 240 in this regard are core knowledge for this

paper and may have to be applied in practical scenarios.

1 Legal liability

Professional accountants may have professional liability under statutory law.

The auditor has a contractual relationship with their client. If they breach the contract then they can be

sued. In addition to this, auditors have a duty to carry out their work with reasonable skill and care.

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Part B Professional and ethical considerations  3: Professional liability 77

Under certain legislation, notably insolvency legislation, auditors may be found to be officers of the

company and could be charged with criminal offences or found liable for civil offences in connection with

the winding up of the company.

Auditors may also be found guilty of financial market abuse offences, such as insider dealing, since they

are privy to inside information and may use this information for their own gain.

Auditors could be found guilty of a criminal offence if they knew or suspected a person was laundering

money and they failed to report their suspicions to the proper authority.

2 Negligence 6/10, 6/13

Auditors may have professional liability in the tort of negligence.

Negligence is a common law concept. It seeks to provide compensation to a person who has suffered loss

due to another person's wrongful neglect. To succeed in an action for negligence, an injured party must

prove three things:

(a) That a duty of care which is enforceable by law existed

(b) This duty of care was breached

(c) The breach caused the injured party loss. In the case of negligence in relation to financial

advisers/auditors, this loss must be pecuniary (ie financial) loss.

2.1 Who might bring an action for negligence?

The parties likely to want to bring an action in negligence against the auditors, for example, if they have

given the wrong audit opinion through lack of care, include:

 The company

 Shareholders

 The bank

 Other lenders

 Other interested third parties

A key difference between the various potential claimants is the extent of the proximity between the auditor

and the potential claimant, and whether the relationship is sufficiently proximal for the auditor to owe

them a duty of care.

2.2 The audit client

The auditor owes a duty of care to the audit client automatically under law.

The audit client is the company. It is a basic maxim of company law that the company is all of the

shareholders acting as a body. In other words, the 'company' cannot be represented by a single

shareholder.

COMPANY = SHAREHOLDERS AS A BODY

COMPANY = SHAREHOLDER + SHAREHOLDER

The company has a contract with the auditor. In the law of many countries, a contract for the supply of a

service such as an audit contains a duty of reasonable care implied by statute.

In other words, whatever the express terms of any written contract between the company and the audit

firm, the law always implies a duty of care into it. Therefore, if the company (all the shareholders acting as

a body) wants to bring a case for negligence, the situation would be as follows.

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78 3: Professional liability  Part B Professional and ethical considerations

Client

Duty of care exists? AUTOMATIC

Breached? MUST BE PROVED

Loss arising? MUST BE PROVED

In order to prove whether a duty of care had been breached, the court has to give further consideration to

what the duty of 'reasonable' care means in practice.

2.2.1 The auditor's duty of care

The standard of work of auditors is generally as defined by legislation. A number of judgements made in

law cases show how the auditor's duty of care has been gauged at various points in time because

legislation often does not state clearly the manner in which the auditors should discharge their duty of

care. It is also not likely that this would be clearly spelt out in any contract setting out the terms of an

auditor's appointment.

You are not expected to know all the precise details of the cases described in this section for your exam.

At Paper P7 level, you will not just be tested on your knowledge in the exam but also on your ability to

apply what you know – perhaps to specific scenarios. The cases here are useful illustrations of the issues

surrounding the professional liability of auditors, and will help you get to know the main principles which

you will then have to apply in your exam.

Case Study

Re Kingston Cotton Mill 1896

When Lopes L J considered the degree of skill and care required of an auditor he declared:

'... it is the duty of an auditor to bring to bear on the work he has to perform that skill, care and

caution which a reasonably competent, careful and cautious auditor would use. What is reasonable

skill, care and caution, must depend on the particular circumstances of each case.'

Lopes was careful to point out that what constitutes reasonable care depends very much on the facts of a

particular case. Another criteria by which the courts will determine the adequacy of the auditors' work is

by assessing it in relation to the generally accepted auditing standards of the day.

Case Study

The courts will be very much concerned with accepted advances in auditing techniques, demonstrated by

Pennycuick J in Re Thomas Gerrard & Son Ltd 1967 where he observed:

'... the real ground on which Re Kingston Cotton Mill ... is, I think, capable of being distinguished is

that the standards of reasonable care and skill are, upon the expert evidence, more exacting today

than those which prevailed in 1896.'

Case Study

Lord Denning in the case of Fomento (Sterling Area) Ltd v Selsdon Fountain Pen Co Ltd 1958 sought to

define the auditor's proper approach to their work by saying:

'... they must come to it with an inquiring mind – not suspicious of dishonesty ... – but suspecting

that someone may have made a mistake somewhere and that a check must be made to ensure that

there has been none.'

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Part B Professional and ethical considerations  3: Professional liability 79

The auditors have a responsibility to keep themselves abreast of professional developments. Auditing

standards are likely to be taken into account when the adequacy of the work of auditors is being

considered in a court of law or in other contested situations.

When the auditors are exercising judgement they must act both honestly and carefully. Obviously, if

auditors are to be 'careful' in forming an opinion, they must give due consideration to all relevant matters.

Provided they do this and can be seen to have done so, then their opinion should be above criticism.

However if the opinion reached by the auditors is one that no reasonably competent auditor would have

been likely to reach, then they would still possibly be held negligent. This is because however carefully the

auditors may appear to have approached their work, it clearly could not have been careful enough, if it

enabled them to reach a conclusion which would be generally regarded as unacceptable.

If the auditors' suspicions are aroused, they must conduct further investigations until such suspicions are

either confirmed or allayed. Over the years, there have been many occasions where the courts have had to

consider cases in which it has been held, on the facts of those cases, that the auditors ought to have been

put upon enquiry.

2.3 Third parties

The auditor only owes a duty of care to parties other than the audit client if one has been established.

'Third parties' in this context means anyone other than the company (audit client) who wishes to make a

claim for negligence. It therefore includes any individual shareholders in the company and any potential

investors. It also includes, importantly, the bank, who is very often a key financier of the company.

The key difference between third parties and the company is that third parties have no contract with the

audit firm, thus there is therefore no implied duty of care. The situation is therefore as follows.

Third parties

Duty of care exists? MUST BE PROVED

Breached? MUST BE PROVED

Loss arising? MUST BE PROVED

Traditionally the courts have been averse to attributing a duty of care to third parties to the auditor. We

can see this by looking at some past cases that have gone to court.

A very important case is Caparo Industries plc v Dickman and Others 1990, which is described here.

Case Study

The facts as pleaded were that in 1984 Caparo Industries purchased 100,000 Fidelity shares in the open

market. On 12 June 1984, the date on which the financial statements (audited by Touche Ross) were

published, they purchased a further 50,000 shares. Relying on information in the financial statements,

further shares were acquired. On 4 September, Caparo made a bid for the remainder and by October had

acquired control of Fidelity. Caparo alleged that the financial statements on which they had relied were

misleading in that an apparent pre-tax profit of some £1.3 million should in fact have been shown as a

loss of over £400,000. The plaintiffs argued that Touche owed a duty of care to investors and potential

investors.

The conclusion of the House of Lords hearing of the case in February 1990 was that the auditors of a

public company's financial statements owed no duty of care to members of the public at large who relied

on the financial statements in deciding to buy shares in the company. And as a purchaser of further

shares, while relying on the auditor's report, a shareholder stood in the same position as any other

investing member of the public to whom the auditor owed no duty. The purpose of the audit was simply

that of fulfilling the statutory requirements of the Companies Act. There was nothing in the statutory duties

of company auditors to suggest that they were intended to protect the interests of investors in the market.

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80 3: Professional liability  Part B Professional and ethical considerations

And in particular, there was no reason why any special relationship should be held to arise simply from the

fact that the affairs of the company rendered it susceptible to a takeover bid.

In its report The Financial Aspects of Corporate Governance, the Cadbury Committee gave an opinion on

the situation as reflected in the Caparo ruling. It felt that Caparo did not lessen auditors' duty to use skill

and care because auditors are still fully liable in negligence to the companies they audit and their

shareholders collectively. Given the number of different users of financial statements, it was impossible

for the House of Lords to have broadened the boundaries of the auditor's legal duty of care.

The decision in Caparo v Dickman considerably narrowed the auditor's potential liability to third parties.

The judgement appears to imply that members of various such user groups, which could include

suppliers, potential investors or others, will not be able to sue the auditors for negligence by virtue of their

placing reliance on audited annual financial statements, as their relationship with the auditor is

insufficiently proximate.

Case Study

In James McNaughton Paper Group Ltd v Hicks Anderson & Co 1990, Lord Justice Neill set out the

following position in the light of Caparo and earlier cases.

(a) 'In England a restrictive approach was now adopted to any extension of the scope of the duty of

care beyond the person directly intended by the maker of the statement to act upon it.

(b) In deciding whether a duty of care existed in any particular case it was necessary to take all the

circumstances into account.

(c) Notwithstanding (b), it was possible to identify certain matters which were likely to be of

importance in most cases in reaching a decision as to whether or not a duty existed.'

A more recent court case produced a development in the subject of audit liability. In December 1995, a

High Court judge awarded electronic security group ADT £65m plus interest and costs (£40m) in damages

for negligence against the former BDO Binder Hamlyn (BBH) partnership.

Case Study

The firm had jointly audited the 1988/89 financial statements of Britannia Security Group (BSG), which

ADT acquired in 1990 for £105m, but later found to be worth only £40m. Although, under Caparo,

auditors do not owe a duty of care in general to third parties, the judge found that BBH audit partner

Martyn Bishop, who confirmed that the firm stood by BSG's financial statements at a meeting with ADT in

the run-up to the acquisition, had thereby taken on a contractual relationship with ADT. This

development occurred, apparently, because (post-Caparo) solicitors and bankers were advising clients

intent on acquisitions to get direct assurances from the target's auditors on the truth and fairness of the

financial statements.

BBH appealed this decision; the liable partners, because of a shortfall in insurance cover, were left facing

the prospect of coming up with £34m. An out of court settlement was reached with ADT.

A case in 1997 appeared to take a slightly different line, although this case related to some management

accounts on which no written report had been issued.

Case Study

In Peach Publishing Ltd v Slater & Co 1997 the Court of Appeal ruled that accountants are not

automatically liable if they give oral assurances on accounts to the purchaser of a business. The case

involved management accounts, which the accountant stated were right subject to the qualification that

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Part B Professional and ethical considerations  3: Professional liability 81

they had not been audited. The Court held that the purpose of giving the assurance was not to take on

responsibility to the purchaser for the accuracy of the accounts. The purchaser's true objective in this case

was to obtain a warranty from the accountant's client, the target. Therefore the accountant was not

assuming responsibility to the purchaser by giving their client information on which it could decide

whether or not to give the warranty. The Court of Appeal also observed that the purchaser should not have

relied on the management accounts without having them checked by its advisers.

Case Study

In a further case, the Court of Appeal gave guidance on the effect of a disclaimer which stated that the

report had been prepared for the client only and no-one else should rely on it. In Omega Trust Co Ltd v

Wright Son & Pepper 1997 (which related to surveyors but the facts of which can be applied to

accountants) the court held that the surveyor was entitled to know who their client was and to whom their

duty was held. They were entitled to refuse liability to an unknown lender or any known lender with whom

he had not agreed.

All this case law raised some problems. In spite of the judgement in Caparo, the commercial reality is that

creditors and investors (especially institutional ones) do use audited financial statements. In the UK the

Companies Act requires a company to file financial statements with the Registrar. Why is this a statutory

requirement? It is surely because the public, including creditors and potential investors, have a need for a

credible and independent view of the company's performance and position.

It would be unjust if auditors, who have secondary responsibility for financial statements being prepared

negligently, bore the full responsibility for losses arising from such negligence just because they are

insured. It would also be unjust if the auditors could be sued by all and sundry. While the profession has

generally welcomed Caparo, two obvious problems are raised by the decision.

 Is a restricted view of the usefulness of audited financial statements in the profession's long-term

interests?

 For private companies there will probably be an increase in the incidence of personal guarantees

and warranties given by the directors to banks and suppliers.

Developments in the US in recent years appear to try to redress the balance of liability by highlighting the

responsibilities of management with regard to published financial statements. The Sarbanes-Oxley Act

requires chief executive officers and finance officers to certify that the financial statements of listed

companies are not misleading and present the company's financial position and results fairly. In addition,

they are required to confirm that they are responsible for internal controls and have reported significant

control deficiencies to the auditors/audit committee.

The UK Companies Act 2006 requires the directors' report to contain a statement to the effect that, in the

case of each director:

(a) So far as the director is aware, there is no relevant audit information of which the auditor is

unaware

(b) They have taken all the steps that they ought to have taken as a director in order to make

themselves aware of any relevant audit information and to establish that the auditor is aware of that

information

If the statement in the directors' report is false, every director who knew it was false or who was reckless

as to whether it was false, and failed to take reasonable steps to prevent the report from being approved,

commits an offence.

In addition, Companies Act 2006 now makes it possible for auditors to limit their liability by agreement

with a company. We will look at this issue in more detail in Section 4.

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82 3: Professional liability  Part B Professional and ethical considerations

2.3.1 Banks and other major lenders

Banks and other major lenders have generally been excluded from the extent of negligent auditor's liability

by the decision in Caparo.

Banks often include clauses in loan agreements referring to audited financial statements and requesting

that they have access to audited financial statements on a regular basis or when reviewing the loan facility.

In other words, banks may document a 'relationship' with the auditors to establish that there is sufficient

proximity and that a duty of care exists.

The following Scottish case involved a situation similar to this.

Case Study

In Royal Bank of Scotland v Bannerman Johnstone Maclay and Others 2002 the bank, who provided an

overdraft facility to the company being audited, claimed the company had misstated its position due to a

fraud and that the auditors were negligent in not discovering the fraud. The auditors claimed that they had

no duty of care to the bank. However, the judge determined that the auditors would have known that the

bank required audited financial statements as part of the overdraft arrangement and could have issued a

disclaimer to the bank. The fact that they had not issued a disclaimer was an important factor in deciding

that the auditors did owe a duty of care to the bank.

2.3.2 Assurance services

The audit firm might be able and prepared to offer assurances to the bank in relation to financial

statements, position, internal controls or other matters of interest to a primary lender. If this is the case,

and the service is required by the bank, the auditor should seek to create an engagement with the bank

itself.

You should bear in mind that providing assurance services to a lender could result in a conflict of interest

arising, of course.

It is vital that you use the right kind of language when answering questions in this area. Your correct use

of such terms as duty of care, liability, negligence, proximity and third party can help to demonstrate to

the marker that you are familiar with the subject matter and are simply applying it to the circumstances in

the question.

2.4 Disclaimers 6/08

Auditors may attempt to limit liability to clients. This may not always be effective in law.

The cases above suggest that a duty of care to a third party may arise when an accountant does not know

that their work will be relied on by a third party, but only knows that it is work of a kind which is liable in

the ordinary course of events to be relied on by a third party.

Conversely, an accountant may sometimes be informed or be aware, before they carry out certain work, that

a third party will rely on the results. An example is a report on the business of a client which the accountant

has been instructed to prepare for the purpose of being shown to a potential purchaser or potential creditor

of that business. In such a case, an accountant should assume that they will be held to owe the same duty to

the third party as to their client. The Bannermann case suggests this will also be necessary for audit work.

Since the Bannermann case, many audit firms have included a disclaimer in their audit report.

When ACCA's Council considered the use of disclaimers, its view was:

'Standard disclaimers are not an appropriate or proportionate response to the Bannermann decision. Their

incorporation as a standard feature of the audit report could have the effect of devaluing that report.'

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Part B Professional and ethical considerations  3: Professional liability 83

However, there are areas of professional work (for example when acting as an auditor under the

Companies Act on behalf of shareholders and no liability limitation agreement is in place) where it is not

possible for liability to be limited or excluded. There are other areas of professional work (for example

when preparing reports on a business for the purpose of being submitted to a potential purchaser) where,

although such a limitation or exclusion may be included, its effectiveness will depend on the view that a

court may subsequently form of its reasonableness.

2.5 Litigation avoidance

The other aspect of how firms are trying to deal with litigation is what they are trying to do to avoid

litigation. This strategy has various aspects.

 Client acceptance procedures. These are very important, particularly the screening of new clients

and the use of engagement letters. This is covered in more detail in Chapter 5.

 Performance of audit work. Firms should make sure that all audits are carried out in accordance

with professional standards and best practice.

 Quality control. This includes not just controls over individual audits but also stricter 'whole-firm'

procedures. This is considered in more detail in Chapter 4.

 Issue of appropriate disclaimers. We discussed above the importance of these.

In ACCA's view the best way of restricting liability is for auditors to carry out their audit work in

accordance with auditing standards. Where work is properly conducted the auditor should not need to

subject it to blanket disclaimers.

Read the financial and accountancy press on a regular basis between now and your examination and note

any new cases or developments in the question of auditor liability.

Question Negligence claims

Although auditors can incur civil liability under various statutes, it is far more likely that they will incur

liability for negligence under the common law, as the majority of cases against auditors have been in this

area. Auditors must be fully aware of the extent of their responsibilities, together with the steps they must

take to minimise the danger of professional negligence claims.

Required

(a) Discuss the extent of an auditor's responsibilities to shareholders and others during the course of

their normal professional engagement.

(b) List six steps which auditors should take to minimise the danger of claims against them for

negligent work.

Answer

(a) Responsibility under statute

An auditor of a limited company has a responsibility, imposed upon him by statute, to form

and express a professional opinion on the financial statements presented by the directors to

the shareholders. He must report upon the truth and fairness of such statements and the fact

that they comply with the law. In so doing, the auditor owes a duty of care to the company

imposed by statute. But such duty also arises under contract and may also arise under the

common law (law of tort).

Responsibility under contract

In the UK the Companies Act does not state expressly the manner in which the auditor should

discharge their duty of care; neither is it likely that this would be clearly spelt out in any contract

setting out the terms of an auditor's appointment (eg the engagement letter). Although the articles of

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84 3: Professional liability  Part B Professional and ethical considerations

a company may extend the auditor's responsibilities beyond those envisaged by the Companies Act,

they cannot be used so as to restrict the auditor's statutory duties; neither may they place any

restriction upon the auditor's statutory rights which are designed to assist them in the discharge of

those duties.

The comments of Lopes L J when considering the degree of skill and care required of an auditor in

Re Kingston Cotton Mill 1896 are still relevant.

'... It is the duty of an auditor to bring to bear on the work he has to perform the skill, care and

caution which a reasonably competent, careful and cautious auditor would use. What is

reasonable skill, care and caution must depend on the particular circumstances of each case.'

Clearly, with the advent of auditing standards, a measure of good practice is now available for the

courts to take into account when considering the adequacy of the work of the auditor.

Responsibility in tort

The law of tort has established that a person owes a duty of care and skill to 'our neighbours'

(common and well-known examples of this neighbour principle can be seen in the law of trespass,

slander, libel and so on). In the context of the professional auditor the wider implications, however,

concern the extent to which the auditor owes a duty of care and skill to third parties who rely on

financial statements upon which they have reported but with whom he has no direct contractual or

fiduciary relationship.

Liability to third parties

In Caparo Industries plc v Dickman & Others 1990, it was held that the auditors of a public

company's financial statements owed no duty of care to members of the general public who relied

upon the financial statements in deciding to buy shares in the company. Furthermore as a

purchaser of more shares, a shareholder placing reliance on the auditor's report stood in the same

position as any other investing member of the public to whom the auditor owed no duty. This

decision appeared to radically reverse the tide of cases concerning the auditor's duty of care. The

purpose of the audit was simply that of meeting the statutory requirements of the Companies Act.

There was nothing in the statutory duties of a company auditor to suggest that they were intended

to protect the interests of investors in the market. In particular, there was no reason why any

special relationship should be held to arise simply from the fact that the affairs of the company

rendered it susceptible to a takeover bid.

The case between BDO Binder Hamlyn and ADT seems to have moved the argument on. In this

case, it was argued that proximity between a prospective investor and the auditor of a company

could be created if the investor asked the auditor whether they stood by their last audit. An appeal

is likely in this case, as the auditor involved face a large shortfall in the proceeds of an insurance

claim. The Scottish Bannerman case suggests that judges may be more likely to impute a duty of

care to the auditors if they were aware that the bank made use of audited financial statements and

did not disclaim liability to them.

(b) In order to provide a means of protection for the auditor arising from the comments in (a) above,

the following steps should be taken.

(i) Agreements concerning the duties of the auditor should be:

(1) Clear and precise

(2) In writing

(3) Confirmed by a letter of engagement, including matters specifically excluded

(ii) Audit work should be:

(1) Relevant to the system of internal control, which must be ascertained, evaluated and

tested. Controls cannot be entirely ignored: for the auditor to have any confidence in

an accounting system, there must be present and evident the existence of minimum

controls to ensure completeness and accuracy of the records

(2) Adequately planned before the audit commences

(3) Reviewed by a senior member of the firm to ensure quality control of the audit and

to enable a decision to be made on the form of audit report

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Part B Professional and ethical considerations  3: Professional liability 85

(iii) Any queries arising during the audit should be:

(1) Recorded on the current working papers

(2) Cleared and filed

(iv) A management letter should be:

(1) Submitted to the client or the board of directors in writing immediately following an

audit

(2) Seen to be acted on by the client

(v) All members of an auditing firm should be familiar with:

(1) The standards expected throughout the firm

(2) The standards of the profession as a whole by means of adequate training, which

should cover the implementation of the firm's audit manual and the

recommendations of the professional accountancy bodies

(vi) Insurance should be taken out to cover the firm against possible claims.

3 Restricting liability 6/10

ACCA requires that auditors take out professional indemnity insurance.

Whether an auditor can restrict their liability to clients depends on the jurisdiction in question. Historically

it has been rare for liability to be restricted, but there are now some important exceptions to this such as

the UK (see section 4.1 below).

3.1 Professional indemnity insurance (PII)

Professional indemnity insurance (PII) is insurance against civil claims made by clients and third parties

arising from work undertaken by the firm.

Fidelity guarantee insurance is insurance against liability arising through any acts of fraud or dishonesty

by any partner, director or employee in respect of money or goods held in trust by the firm.

These types of insurance do not actually restrict the auditor's liability, but rather provide compensation to

the auditor for liabilities that are incurred.

It is important that auditors have insurance so that if negligence occurs:

 The audit firm does not find itself with a liability that is too big for it to pay; and

 The client can be compensated for the error. An insurance policy would enable this to happen even

where the compensation is greater than the resources of the firm.

Remember that accountants usually trade as partnerships, so all the partners are jointly and severally

liable to claims made against individual partners.

3.2 ACCA requirements

ACCA requires that all firms which hold practising and auditing certificates have PII with a reputable

insurance company. If the firm has employees, it must also have fidelity guarantee insurance.

The insurance must cover 'all civil liability incurred in connection with the conduct of the firm's business

by the partners, directors or employees'.

The cover must continue to exist for six years after a member ceases to engage in public practice.

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86 3: Professional liability  Part B Professional and ethical considerations

3.3 Advantages and disadvantages

The key advantage of such insurance is that it provides funds for an innocent party to be compensated in

the event of a wrong having been done to it.

An advantage to the auditor is that it provides some protection against bankruptcy in the event of

successful litigation against the firm. This is particularly important for a partnership, as partners may be

sued personally for the negligence of their fellow partners.

A key disadvantage is that the existence of insurance against the cost of negligence might encourage

auditors to take less care than:

 Would otherwise be the case

 Their professional duty requires

Another problem associated with such insurances are that there are limits of cover (linked with the cost of

buying the insurance) and any compensation arising from a claim could be higher than those limits. This

could lead to partners being bankrupted despite having insurance. A simple disadvantage associated with

the above is the regular cost of the insurance to the partnership.

3.4 Incorporation

The major accountancy firms have been interested in methods of reducing personal liability for partners in

the event of negligence for some time. For example, some years ago KPMG (one of the Big Four

accountancy firms) incorporated its UK audit practice. This was allowed under the UK's Companies Act

1989.

The new arrangement created 'a firm within a firm'. KPMG Audit plc is a limited company wholly owned by

the partnership, KPMG. The reason behind this is to protect the partners from the crushing effects of

litigation. The other side of incorporation means that KPMG Audit plc is subject to the statutory disclosure

requirements of companies.

An alternative to incorporation as a company is incorporation as a limited liability partnership.

Limited liability partnership can be operated in some countries, for example some US states and the UK,

which we will look at briefly below.

3.5 Limited liability partnerships

The Limited Liability Partnership Act 2000 enabled UK firms to establish limited liability partnerships as

separate legal entities. These combine the flexibility and tax status of a partnership with limited liability for

members.

The effect of this is that the partnership, but not its members, will be liable to third parties. However,

the personal assets of negligent partners will still be at risk.

Limited liability partnerships could be formed from 6 April 2001. Several prominent professional

partnerships have incorporated as LLPs.

Limited liability partnerships are set up by similar procedures to those for incorporating a company. An

incorporation document is sent to the Registrar of Companies. The Registrar will issue a certificate of

incorporation to confirm that all statutory requirements have been fulfilled.

In a similar way to traditional partnerships, relations between partners will be governed by internal partner

agreements, or by future statutory regulations. Each member of the partnership will still be an agent of the

partnership unless they have no authority to act and an outside party is aware of this lack of authority.

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Part B Professional and ethical considerations  3: Professional liability 87

3.6 Advantages and disadvantages of different structures

Advantages Disadvantages

Partnership  Less regulation than for companies

 Financial statements not on public

record

 Joint and several liability

 Personal assets at risk

Incorporation  Limited liability  Public filing of audited financial

statements

 Management must comply with

Companies Acts

LLP  Protection of personal assets

 Limited liability of members

 Similar tax effect of partnership

 Flexible management structures

 Public filing of audited financial

statements

4 Current issues in auditor liability

Auditor liability is an important practical issue.

Even with PII and other means of restricting liability there has been great concern throughout the audit

profession globally about the remaining risks to firms' survival in the face of claims which might exceed

their insurance cover.

The profession has lobbied for further protection in the form of proportionate liability or capping

liability.

Proportionate liability allows claims arising from successful negligence claims to be split between the

auditors and the directors of the client company, the split being determined by a judge on the basis of

where the fault was seen to lie. This would require the approval of shareholders.

Capping liability sets a maximum limit on the amount that the auditor would have to pay out under any

claim.

4.1 UK Companies Act 2006

The Companies Act 2006 made it possible for auditors to limit their liability by agreement with a company.

It does this by defining a liability limitation agreement, which is a contractual limitation of the auditor's

liability to a company, requiring shareholder agreement by resolution and only effective if it is fair and

reasonable.

The agreement can cover liability for negligence, default, breach of duty or breach of trust by the auditor in

relation to the audit of financial statements for a particular year. For the agreement to be valid it cannot

cover more than one financial year. The company can also withdraw its authorisation of the agreement by

passing an ordinary resolution.

It is currently open to negotiation between auditors and their client companies as to what form the

agreement will take, for example a liability cap (fixed or variable), or proportionate liability but the Act

leaves it open for the Government to issue regulations in future as to the nature of these agreements.

Under current legislation, it is possible for auditors to suffer the entire liability for corporate collapse even

if they are found to be only partly to blame. The Big Four firms lobbied the then Department of Business,

Enterprise and Regulatory Reform (BERR) to get a limit on their exposure in the event of claims from

investors and others in the event of a company failure. This was prompted by fears that a blockbuster

lawsuit, if successful, could put one or more of them out of business, which in turn could trigger a

collapse of the audit market and cause chaos for business.

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The Big Four have been pushing for proportionate liability ever since the collapse of Arthur Andersen, then

one of the world's five biggest accounting firms, over its involvement in the Enrol scandal in 2002.

4.2 Ongoing debate

There have been concerns that regulations such as the UK Companies Act 2006 may distort competition in

the audit market. If the biggest firms set caps at very high levels, mid-tier firms could be disadvantaged. In

the UK the Government has left a provision for the relevant government ministers to issue specific rules

specifying what can and cannot be included in agreements in case competition problems arise.

There are also arguments that capping liability will reduce the value of the audit to investors and may put

pressure on firms to reduce fees.

Overall, the profession has reacted positively to these rules. The reaction was less positive to the other

major effect of the bill, introducing a criminal offence of 'knowingly or recklessly' including in the auditor's

report any matter that is misleading, false or deceptive in a material particular. The Government saw this

as being a necessary change in order to maintain audit quality.

4.3 Network firms

Several accountancy firms have moved towards network models over recent years. This is where member

firms are part of a larger structure, often sharing a name (or using a similar name) and professional

resources. As part of a global network, member firms have been able to sell services based on the value

and reputation of their global brand name. However in recent liability cases, some network firms have

claimed the network is not liable for negligence in an individual member firm even though they appear to

be operating under the same brand.

Case Study

BDO Seidman, a member firm of the global network BDO International, faced audit negligence claims to

the sum of $500m over the audit of ES Bankest, a company owned by the Portuguese bank Banco Espirito

Santo. Auditors from BDO Seidman had been accused of being grossly negligent in audits some seven

years previously. BDO International had claimed that they should not be held liable as member firm audits

are conducted independently.

It is possible that the network model may disappear or be modified in future years. The current situation

where network firms advertise under one brand and then claim they are separate firms when things go

wrong may not be sustainable given the outcome of current legal activity.

There is a useful article on auditor liability on the ACCA website, entitled 'Auditor liability: 'fair and

reasonable' punishment?'

5 Fraud and error 6/09, 6/13

Misunderstanding of the auditor's responsibilities in respect of fraud is a major component of the

'expectations gap'.

The key difference between fraud and error is that fraud is intentional.

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Part B Professional and ethical considerations  3: Professional liability 89

5.1 What is fraud?

Fraud is an intentional act by one or more individuals among management, those charged with

governance (management fraud), employees (employee fraud) or third parties involving the use of

deception to obtain an unjust or illegal advantage. Fraud may be perpetrated by an individual, or in

collusion with people internal or external to the business.

Fraud is a wide legal concept, but the auditor's main concern is with fraud that causes a material

misstatement in financial statements. Specifically, there are two types of fraud causing material

misstatement in financial statements:

 Fraudulent financial reporting

 Misappropriation of assets

Fraud is distinguished from error, which is when a material misstatement is caused by mistake, for

example in the application of an accounting policy. Other examples of errors are mistakes in gathering or

processing financial data, and errors in making accounting estimates.

5.1.1 Fraudulent financial reporting

This may include:

 Manipulation, falsification or alteration of accounting records/supporting documents

 Misrepresentation (or omission) of events, transactions or other significant information in the

financial statements

 Intentional misapplication of accounting principles

Such fraud may be carried out by overriding controls that would otherwise appear to be operating

effectively, eg by recording fictitious journal entries or improperly adjusting assumptions or estimates

used in financial reporting.

Aggressive earnings management is a topical issue and, at its most aggressive, may constitute fraudulent

financial reporting. Auditors should consider such issues as unsuitable revenue recognition, accruals,

liabilities, provisions and reserves accounting and large numbers of immaterial breaches of financial

reporting requirements to see whether together, they constitute fraud.

Revenue recognition is perhaps the single most common area of fraudulent financial reporting, and is an

area that your examination team has highlighted as important. If a scenario in your exam features complex

or material revenue recognition, immediately think 'risk of fraudulent financial reporting'.

5.1.2 Misappropriation of assets

This is the theft of the entity's assets (for example, cash, inventory). Employees may be involved in such

fraud in small and immaterial amounts; however, it can also be carried out by management for larger items

who may then conceal the misappropriation, for example by:

 Embezzling receipts (for example, diverting them to private bank accounts)

 Stealing physical assets or intellectual property (inventory, sales data)

 Causing an entity to pay for goods not received (payments to fictitious vendors)

 Using assets for personal use

From the auditor's point of view, the main problem with theft is while it is ongoing and undiscovered, it

may result in the accounting records being misstated. For example, if inventory is stolen then the

accounting records will show more items in inventory than there really are.

5.2 Responsibilities with regard to fraud

Management and those charged with governance are primarily responsible for preventing and detecting

fraud.

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90 3: Professional liability  Part B Professional and ethical considerations

It is up to management to put a strong emphasis within the company on fraud prevention, putting in place

systems to prevent fraud.

Management must also establish a strong control environment, with an emphasis on the principles of

good corporate governance but also a culture of honesty and ethical behaviour. In relation to fraud in

particular, this would mean eg putting policies in place to help ensure that employees are aware of their

responsibilities regarding fraud, issuing guidance for employees on what they should do if they encounter

or suspect a fraud.

Auditors are responsible for carrying out an audit in accordance with international auditing standards, one

of which is ISA 240 The auditor's responsibilities relating to fraud in an audit of financial statements,

which we shall look at now. The auditor is not responsible for preventing fraud; the auditor may be

deemed responsible only if they have not conducted their audit properly.

5.3 The auditor's approach to the possibility of fraud

5.3.1 General

The key responsibility of an auditor is set out early in ISA 240: essentially the auditor is only concerned

about fraud if it causes the financial statements to be misstated. The auditor's concern is with

misstatements, whatever their cause. The main objective is to obtain reasonable assurance that there are

no material misstatements, whether they are caused by fraud or by error.

Fraud and error are, however, different. If the auditor is to detect misstatements caused by fraud, then

they must focus on the risks that are specific to fraud. ISA 240 therefore gives the following objectives,

which are specific to fraud.

ISA 240.10

The objectives of the auditor are:

(a) To identify and assess the risks of material misstatement of the financial statements due to fraud;

(b) To obtain sufficient appropriate audit evidence regarding the assessed risks of material

misstatement due to fraud, through designing and implementing appropriate responses; and

(c) To respond appropriately to fraud or suspected fraud identified during the audit.

Fraud may be harder to detect than error, because with a fraud the fraudster is actively trying to hide

what they have done.

An overriding requirement of the ISA is that auditors are aware of the possibility of there being

misstatements due to fraud. The mindset of professional scepticism is important here, with the auditor

always being alert to the possibility that things are not as they seem, and that the management who have

always appeared honest may not really be.

5.3.2 Discussion with the engagement team

ISA 240 requires there to be discussion by members of the engagement team of the susceptibility of the

entity's financial statements to material misstatement due to fraud, including how fraud might occur.

The engagement partner must consider what matters discussed should be passed on to other members of

the team not present at the discussion. The discussion itself usually includes consideration of:

 How fraud could be done

 Circumstances that might be indicative of aggressive earnings management

 Known factors that might give incentive to management to commit fraud

 Management's oversight of employees with access to cash/other assets

 Any unusual/unexplained changes in lifestyle of management/employees

 How to maintain professional scepticism throughout the audit

 The types of circumstance that might indicate fraud

 How unpredictability will be incorporated into the audit

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Part B Professional and ethical considerations  3: Professional liability 91

 What audit procedures might be carried out to answer any suspicions of fraud

 Any allegations of fraud that have come to the auditors' attention

 The risk of management override of controls.

5.3.3 Risk assessment procedures

The auditor would undertake risk assessment procedures as set out in ISA 315 Identifying and assessing

the risks of material misstatement through understanding the entity and its environment (see Chapter 6)

which would include assessing the risk of fraud. These will include:

 Inquiries of management and those charged with governance

 Consideration of whether fraud risk factors are present

 Consideration of results of analytical procedures

 Consideration of any other relevant information

In identifying the risks of fraud, the auditor is required by the ISA to carry out some specific procedures.

The auditor must ask management about:

 Management's assessment of the risk of misstatement due to fraud

 How management identifies and responds to fraud risks, and details of any specific risks identified

 Whether they know of any actual or suspected fraud.

If the entity has an internal audit function, the auditor must ask it for its views on the risks of fraud, and

whether fraud has taken place.

The size, complexity and ownership characteristics of the entity have a significant influence on the

consideration of relevant fraud risk factors. For example in the case of a large entity there may be factors

that generally constrain improper conduct by management including effective oversight by those charged

with governance, an effective internal audit function and a written code of conduct. These considerations

are less likely in the case of a small entity.

Examples of fraud risk factors

ISA 240 does not attempt to provide a definitive list of risk factors but, in an appendix, identifies and gives

examples of two types of fraud that are relevant to auditors:

 Fraudulent financial reporting

 Misstatements arising from misappropriation of assets

For each of these, the risk factors are classified according to three conditions that are generally present

when misstatements due to fraud occur:

 Incentives/pressures

 Opportunities

 Attitudes/rationalisations

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ISA 240.26

When identifying and assessing the risks of material misstatement due to fraud, the auditor shall, based

on a presumption that there are risks of fraud in revenue recognition, evaluate which types of revenue,

revenue transactions or assertions give rise to such risks.

ISA 240.27

The auditor shall treat those assessed risks of material misstatement due to fraud as significant risks and

accordingly, to the extent not already done so, the auditor shall obtain an understanding of the entity's

related controls, including control activities, relevant to such risks.

Generally, the auditor:

 Identifies fraud risks

 Relates this to what could go wrong at a financial statement level

 Considers the likely magnitude of potential misstatement

Fraudulent financial

reporting

Incentives/pressures Opportunities Attitudes/rationalisations

 Financial stability/profitability

is threatened

 Pressure on management to

meet the expectations of third

parties

 Personal financial situation of

management threatened by the

entity's financial performance

 Excessive pressure on

management or operating

personnel to meet financial

targets

 Significant related-party

transactions

 Assets, liabilities,

revenues or expenses

based on significant

estimates

 Domination of

management by a single

person or small group

 Complex or unstable

organisational structure

 Internal control

components are deficient

 Ineffective communication

or enforcement of the entity's

values or ethical standards

by management

 Known history of violations

of securities laws or other

laws and regulations

 A practice by management

of committing to achieve

aggressive or unrealistic forecasts

 Low morale among senior

management

 Relationship between

management and the current

or predecessor auditor is strained

Misappropriation

of assets

Opportunities

 Personal financial obligations

 Adverse relationships between

the entity and employees with

access to cash or other assets

susceptible to theft

 Large amounts of cash on

hand or processed

 Inventory items that are

small in size, of high value,

or in high demand

 Easily convertible assets,

such as bearer bonds,

diamonds, or computer chips

 Inadequate internal control

over assets

 Overriding existing controls

 Failing to correct known

internal control deficiencies

 Behaviour indicating

displeasure or dissatisfaction

with the entity

 Changes in behaviour or

lifestyle

Incentives/pressures Attitudes/rationalisations

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Part B Professional and ethical considerations  3: Professional liability 93

Question Fraud risk factors

You are an audit manager for Elle and Emm, Chartered Certified Accountants. You are carrying out the

planning of the audit of Sellfones Co, a listed company, and a high street retailer of mobile phones, for the

year ending 30 September 20X7. The notes from your planning meeting with Pami Desai, the financial

director, include the following.

(1) One of Sellfones' main competitors ceased trading during the year due to the increasing pressure

on margins in the industry and competition from online retailers.

(2) A new management structure has been implemented, with 10 new divisional managers appointed

during the year. The high street shops have been allocated to these managers, with approximately

20 branch managers reporting to each divisional manager. The divisional managers have been set

challenging financial targets for their areas, with substantial bonuses offered to incentivise them to

meet the targets. The board of directors have also decided to cut the amount that will be paid to

shop staff as a Christmas bonus.

(3) In response to recommendations in the prior year's Report to Management, a new inventory

system has been implemented. There were some problems in its first months of operation but a

report has been submitted to the board by Steven MacLennan, the chief accountant, confirming

that the problems have all been resolved and that information produced by the system will be

accurate. Pami commented that the chief accountant has had to work very long hours to deal with

this new system, often working at weekends and even refusing to take any leave until the system

was running properly.

(4) The company is planning to raise new capital through a share issue after the year-end in order to

finance expansion of the business into other countries in Europe. As a result, Pami has requested

that the auditor's report is signed off by 15 December 20X7 (six weeks earlier than in previous

years).

(5) The latest board summary of results includes:

9 months to 30 June 20X7 (unaudited) Year to 30 September 20X6 (audited)

$m $m

Revenue 320 Revenue 280

Cost of sales 215 Cost of sales 199

Gross profit 105 Gross profit 81

Operating expenses (89) Operating expenses (70)

Exceptional profit on sale

of properties 30 –

Profit before tax 46 11

(6) Several shop properties owned by the company were sold under sale and leaseback arrangements.

Required

Identify and explain any fraud risk factors that the audit team should consider when planning the audit of

Sellphones Co.

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94 3: Professional liability  Part B Professional and ethical considerations

Approaching the answer

Look for key words and ask questions of the information given to you. This is illustrated below.

Question Fraud risk factors

You are an audit manager for Elle and Emm, Chartered Certified Accountants. You are carrying out the

planning of the audit of Sellfones Co, a listed company, and a high street retailer of mobile phones, for the

year ending 30 September 20X7. The notes from your planning meeting with Pami Desai, the financial

director, include the following.

(1) One of Sellfones' main competitors ceased trading during the year due to the increasing pressure

on margins in the industry and competition from online retailers.

(2) A new management structure has been implemented, with 10 new divisional managers appointed

during the year. The high street shops have been allocated to these managers, with approximately

20 branch managers reporting to each divisional manager. The divisional managers have been set

challenging financial targets for their areas, with substantial bonuses offered to incentivise them to

meet the targets. The board of directors have also decided to cut the amount that will be paid to

shop staff as a Christmas bonus.

(3) In response to recommendations in the prior year's Report to Management, a new inventory

system has been implemented. There were some problems in its first months of operation but a

report has been submitted to the board by Steven MacLennan, the chief accountant, confirming

that the problems have all been resolved and that information produced by the system will be

accurate. Pami commented that the chief accountant has had to work very long hours to deal with

this new system, often working at weekends and even refusing to take any leave until the system

was running properly.

(4) The company is planning to raise new capital through a share issue after the year-end in order to

finance expansion of the business into other countries in Europe. As a result, Pami has requested

that the auditor's report is signed off by 15 December 20X7 (six weeks earlier than in previous

years).

(5) The latest board summary of results includes:

9 months to 30 June 20X7 (unaudited) Year to 30 September 20X6 (audited)

$m $m

Revenue 320 Revenue 280

Cost of sales 215 Cost of sales 199

Gross profit 105 Gross profit 81

Operating expenses (89) Operating expenses (70)

Exceptional profit on sale

of properties 30 –

Profit before tax 46 11

(6) Several shop properties owned by the company were sold under sale and leaseback arrangements.

Required

Identify and explain any fraud risk factors that the audit team should consider when planning the audit of

Sellphones Co.

Identify the stage of the

audit

Nature of industry –

very competitive

Indication of level of

competition

Is it effective? Do they

have the expertise?

Increased risk? Morale?

Pressure on

management to be

successful

Reliability? Under

pressure?

Suspicious? Pressure on results

Increased audit risk?

Changes in margin

in line with

expectations?

Substance

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Part B Professional and ethical considerations  3: Professional liability 95

Answer plan

Not all the points you notice will necessarily be relevant and you may also find that you do not have time

to mention all the points. You may also notice that certain issues are related and should be dealt with

together. Prioritise your points in a more formal plan and then write out your answer.

Risk factors:

 Nature of industry and operating conditions

 Management structure and incentives

 New inventory system/chief accountant

 Results

 Exceptional gain

 Time pressure

 Theft of assets

Answer

In this scenario there are a large number of factors that should alert the auditors to the possibility of

misstatements arising from fraudulent financial reporting, and others that could indicate a risk of

misstatements arising from misappropriation of assets.

(1) Operating conditions within the industry

The failure of a competitor in a highly competitive business sector highlights the threat to the

survival of a business such as Sellphones and this could place the directors under pressure to

overstate the performance and position of the company in an attempt to maintain investor

confidence, particularly given the intention to raise new share capital.

(2) Management structure and incentives

It is not clear in the scenario how much involvement the new divisional managers have in the

financial reporting process but the auditors would need to examine any reports prepared or

reviewed by them very carefully, as their personal interest may lead them to overstate results in

order to earn their bonuses.

(3) New inventory system/chief accountant

The problems with the implementation of the new inventory system suggest that there may have

been control deficiencies and errors in the recording of inventory figures. Misstatements, whether

deliberate or not, may not have been identified. The amount of time spent by the chief accountant

on the implementation of the new inventory system could be seen as merely underlining the

severity of the problems, but the fact that they have not taken any leave should also be considered

as suspicious and the auditors should be alert to any indication that they may have been involved in

any deliberate misstatement of figures.

(4) Results

The year on year results look better than might be expected given the business environment. The

gross profit margin has increased to 32.8% (20X6 25.3%) and the operating profit margin has

increased to 5% (20X6 3.9%). This seems to conflict with what is known about the industry and

should increase the auditor's professional scepticism in planning the audit.

(5) Exceptional gain

The sale and leaseback transaction may involve complex considerations relating to its commercial

substance. It may not be appropriate to recognise a gain or the gain may have been miscalculated.

(6) Time pressure on audit

The auditors should be alert to the possibility that the tight deadline may have been set to reduce

the amount of time the auditors have to gather evidence after the end of the reporting period,

perhaps in the hope that certain deliberate misstatements will not be discovered.

(7) Risk of misappropriation of assets

The nature of the inventory held in the shops increases the risk that staff may steal goods. This risk

is perhaps increased by the fact that the attitude of the staff towards their employer is likely to have

been damaged by the cut in their Christmas bonus. The problems with the new inventory recording

system increase the risk that any such discrepancies in inventory may not have been identified.

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96 3: Professional liability  Part B Professional and ethical considerations

5.3.4 Responding to assessed risks

The auditor must then come up with responses to the assessed risks.

ISA 240.28

In accordance with ISA 330 the auditor shall determine overall responses to address the assessed risks of

material misstatement due to fraud at the financial statement level.

In determining overall responses to address the risks of material misstatement due to fraud at the financial

statement level the auditor should:

(a) Consider the assignment and supervision of personnel

(b) Consider the accounting policies used by the entity

(c) Incorporate an element of unpredictability in the selection of the nature, timing and extent of audit

procedures

ISA 240.30

In accordance with ISA 330, the auditor shall design and perform further audit procedures whose nature,

timing and extent are responsive to the assessed risks of material misstatement due to fraud at the

assertion level.

The auditor may have to amend the nature, timing or extent of planned audit procedures to address

assessed risks. The auditor should also consider the following.

 Audit procedures responsive to management override of controls

 Journal entries and other adjustments

 Accounting estimates

 Business rationale for significant transactions

Examples: specific audit procedures

The auditor might to choose to attend previously unvisited branches to carry out inventory or cash checks.

The auditor might perform detailed analytical procedures using disaggregated data, for example,

comparing sales and costs of sales by location.

The auditor might use an expert to assess management estimates in a subjective area.

5.4 Evaluation of audit evidence

The auditor evaluates the audit evidence obtained to ensure it is consistent and that it achieves its aim of

answering the risks of fraud. This will include a consideration of results of analytical procedures and any

misstatements found. The auditor must also consider the reliability of written representations.

The auditor must obtain written representation that management accepts its responsibility for the

prevention and detection of fraud and has made all relevant disclosures to the auditors.

5.5 Documentation

The auditor must document:

 The significant decisions reached as a result of the team's discussion of fraud

 The identified and assessed risks of material misstatement due to fraud

 The overall responses to assessed risks

 Results of specific audit tests

 Any communications with management

 Reasons for concluding that the presumption that there is a risk of fraud related to revenue

recognition is not applicable

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Part B Professional and ethical considerations  3: Professional liability 97

5.6 Reporting

There are various reporting requirements in ISA 240.

ISA 240.40

If the auditor has identified a fraud or has obtained information that indicates a fraud may exist, the auditor

shall communicate these matters on a timely basis to the appropriate level of management in order to

inform those with primary responsibility for the prevention and detection of fraud of matters relevant to

their responsibilities.

ISA 240.41

Unless all of those charged with governance are involved in managing the entity, if the auditor has

identified or suspects fraud involving:

(a) management;

(b) employees who have significant roles in internal control; or

(c) others, where the fraud results in a material misstatement in the financial statements,

the auditor shall communicate these matters to those charged with governance on a timely basis. If the

auditor suspects fraud involving management, the auditor shall communicate these suspicions to those

charged with governance and discuss with them the nature, timing and extent of audit procedures

necessary to complete the audit.

The auditor should also make relevant parties within the entity aware of significant deficiencies in the

design or implementation of controls to prevent and detect fraud which has come to the auditor's

attention, and consider whether there are any other relevant matters to bring to the attention of those

charged with governance with regard to fraud.

The auditor may have a statutory duty to report fraudulent behaviour to regulators outside the entity. If no

such legal duty arises, the auditor must consider whether to do so would breach their professional duty of

confidence. In either event, the auditor should take legal advice.

5.7 Auditor unable to continue

The auditor should consider the need to withdraw from the engagement if they uncover exceptional

circumstances with regard to fraud.

Remember the confidentiality issues from Chapter 2. When you are considering whether to make a public

interest disclosure, you should always bear it in mind.

Question Detection of fraud

Required

(a) Discuss what responsibility auditors have to detect fraud.

(b) Explain how the auditors might conduct their audit in response to an assessed risk of:

(i) Misappropriation

(ii) Fraudulent financial reporting

Answer

(a) The primary responsibility for the prevention and detection of fraud and irregularities rests with

management and those charged with governance. This responsibility may be partly discharged by

the institution of an adequate system of internal control including, for example, authorisation

controls and controls covering segregation of duties.

Exam focus

point

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98 3: Professional liability  Part B Professional and ethical considerations

The auditors should recognise the possibility of material irregularities or frauds which could,

unless adequately disclosed, distort the results or state of affairs shown by the financial

statements. ISA 240 states that the auditor is responsible for obtaining reasonable assurance that

the financial statements taken as a whole are free from material misstatement whether caused by

fraud or error. Auditors are required to carry out their audit with professional skepticism.

Auditors are required to carry out risk assessment procedures in respect of fraud. This will involve

making enquiries of management, considering if any risk factors (such as the existence of pressure

for management to meet certain targets) are present and considering the results of analytical

procedures if any method or unexpected relationships have been identified.

If there is an assessed risk of fraud, the auditor must make suitable responses. Overall responses

include considering the personnel for the assignment (for example, using more experienced

personnel), considering the accounting policies used by the entity (have they changed? Are they

reasonable?) and incorporating an element of unpredictability into the audit.

Specific responses to the risk of misstatement at the assertion level due to fraud will vary

depending on the circumstances but could include:

(i) Changing the nature of audit tests (for example, introducing computer-assisted audit

techniques if more detail is required about a computerised system)

(ii) Changing the timing of audit tests (for example, testing throughout an audit period, instead

of extending audit conclusions from an interim audit)

(iii) Changing the extent of audit tests (for example, increasing sample sizes)

(b) (i) Misappropriation

Employee frauds such as misappropriation are likely to take place when controls are weak.

If controls are weak, auditors may not test controls and therefore evidence of employee

fraud might go undetected. However, if auditors have identified a risk of employee fraud,

they might as a response test controls in the relevant area (such as purchases or sales) in

order to identify any unexplained patterns in the company's procedures. For example, if a

purchase fraud is suspected, auditors might scrutinise authorisation controls to see if a

particular member of staff always authorises certain items/for certain people, where the

system does not require that.

Many substantive procedures normally performed by the auditors may assist in isolating

employee frauds, if they are occurring. For example, tests performed on the receivables

ledger may be aimed at revealing overstatement or irrecoverable receivables, but the design

of such tests also assists with cash understatement objectives and may reveal irregularities

such as 'teeming and lading'.

(ii) Fraudulent financial reporting

If the auditors conclude that there is a high risk of fraudulent financial reporting by

management, they will concentrate on such techniques as analytical procedures, scrutiny of

unusual transactions and all journal entries, review of events after the reporting period

(including going concern evaluation), and review of the financial statements and accounting

policies for any changes or material distortions.

6 The expectations gap

The 'expectations gap' refers to the difference between the public's and auditors' expecations of the audit

process.

The 'expectations gap' can be narrowed either by educating the users of audited financial statements, or

by extending the auditor's role.

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Part B Professional and ethical considerations  3: Professional liability 99

ISA 240 sets out the current position on the auditor's responsibility to consider fraud. There remains a

debate as to whether this is sufficient, as the area of fraud is a key part of the expectations gap between

what users of auditors' reports believe to be the purposes of the audit compared with the actual nature of

the assurance reported to them by auditors.

The issue of the expectations gap is consistently in and out of the financial press. In recent years, there

has been a focus on the role of auditors in evaluating whether a company is a going concern. In the USA,

the collapse of Lehman Brothers brought with it accusations from some quarters that its auditor, Ernst &

Young, had failed to discharge its responsibilities as auditor.

A recent example of such coverage relates to auditors Ernst & Young (EY) and its audit client, the

Olympus Corporation. A scandal was precipitated when Olympus's recently-appointed chief executive was

ousted from his position after having exposed what was described as a loss-hiding arrangement of

fraudulent financial reporting. A succession of auditors had issued unmodified reports throughout this

period. An internal Olympus inquiry into the fraud concluded that the scheme had been too well-concealed

for the auditors to detect it:

'The masterminds of this case were hiding the illegal acts by artfully manipulating experts'

opinions…'

Reuters report, at www.webcitation.org/65x0p5rgR

High profile cases such as these have brought up the question of the extent to which auditors should be

responsible for detecting fraud, and how this differs from the way that the responsibilities of the auditor

are perceived.

6.1 Narrowing the expectations gap

Logically, the expectations gap could be narrowed in two ways.

(1) Educating users – The auditor's report as outlined in ISA 700 Forming an opinion and reporting on

financial statements includes an explanation of the auditor's responsibilities, but also quite

extensive discussions of the key matters arising from the audit.

(2) Extending the auditor's responsibilities – Research indicates that extra work by auditors with the

inevitable extra costs is likely to make little difference to the detection of fraud because:

 Most material frauds involve management

 More than half of frauds involve misstated financial reporting but do not include diversion of

funds from the company

 Management fraud is unlikely to be found in a financial statement audit

 Far more is spent on investigating and prosecuting fraud in a company than on its audit

Suggestions for expanding the auditor's role have included:

 Requiring auditors to report to boards and audit committees on the adequacy of controls to

prevent and detect fraud

 Encouraging the use of targeted forensic fraud reviews (see Chapter 14)

 Increasing the requirement to report suspected frauds

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100 3: Professional liability  Part B Professional and ethical considerations

Chapter Roundup

 Professional accountants may have professional liability under statutory law.

 Auditors may have professional liability in the tort of negligence.

 The auditor owes a duty of care to the audit client automatically under law.

 The auditor only owes a duty of care to parties other than the audit client if one has been established.

 Auditors may attempt to limit liability to clients. This may not always be effective in law.

 ACCA requires that auditors take out professional indemnity insurance.

 Auditor liability is an important practical issue.

 Misunderstanding of the auditor's responsibilities in respect of fraud is a major component of the

'expectations gap'.

The key difference between fraud and error is that fraud is intentional.

 Management and those charged with governance are primarily responsible for preventing and detecting

fraud.

 The 'expectations gap' refers to the difference between the public's and auditors' expectations of the audit

process.

The 'expectations gap' can be narrowed either by educating the users of audited financial statements, or

by extending the auditor's role.

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Part B Professional and ethical considerations  3: Professional liability 101

Quick Quiz

1 Define fraud.

2 Draw a table showing the reporting requirements of ISA 240 The auditor's responsibilities relating to fraud

in an audit of financial statements.

3 Determine whether each of the following is an example of fraud or of error.

Fraud or error?

Clerical mistake resulting in overstatement of profit before taxation ……..

Theft of cash from the company ……..

Failing to consolidate a loss-making subsidiary in order to improve group results ……..

Misinterpretation of facts resulting in incorrect accounting estimate ……..

4 What three matters must an injured party satisfy to the court in an action for negligence?

(1) ........................................

(2) ........................................

(3) ........................................

5 Name four aspects of litigation avoidance.

(1) ........................................

(2) ........................................

(3) ........................................

(4) ........................................

6 Professional indemnity insurance is insurance against liability arising through any acts of fraud or

dishonesty by partners in respect of money held in trust by the firm.

True

False

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102 3: Professional liability  Part B Professional and ethical considerations

Answers to Quick Quiz

1 Fraud is the use of deception to obtain unjust or illegal financial advantage and intentional

misrepresentation by management, employees or third parties.

2 Management If the auditors suspect or detect any fraud (even if immaterial) they

should tell management as soon as they can.

Those charged with governance If the auditor has identified fraud involving management, employees

with significant roles in internal control, or others, if it results in a

material misstatement, they must report it to those charged with

governance.

Third parties Auditors may have a statutory duty to report to a regulator. Auditors

are advised to take legal advice if reporting externally to the company.

3

Clerical mistake resulting in overstatement of profit before taxation Error

Theft of cash from the company Fraud

Failing to consolidate a loss-making subsidiary in order to improve group results Fraud

Misinterpretation of facts resulting in incorrect accounting estimate Error

4 (1) A duty of care existed

(2) Negligence occurred

(3) The injured party suffered pecuniary loss as a result

5 (1) Client acceptance procedures

(2) Performance of audit work in line with ISAs

(3) Quality control

(4) Disclaimers

6 False. That is fidelity guarantee insurance. Professional indemnity insurance is insurance against civil

claims made by clients and third parties arising from work undertaken by the firm.

Now try the questions below from the Practice Question Bank.

Number Level Marks Time

Q4 Examination 15 29 mins

Q5 Examination 20 39 mins

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103

Practice management

P

A

R

T

C

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104

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105

Topic list Syllabus reference

1 P rinciples and purpose C1

2 Quality control at a firm level C1

3 Quality control on an individual audit C1

Quality control

Introduction

The role performed by auditors represents an activity of significant public

interest. Quality independent audit is crucial, both to users and to the audit

profession as a whole. Poor audit quality damages the reputation of the firm and

may lead to loss of clients and thus fees, as well as an increased risk of litigation

and concomitant professional insurance costs.

Although there are specific standards giving guidance on how auditors should

perform their work with satisfactory quality, these can never cater for every

situation. Two standards deal with quality at a general level. These are ISQC 1

Quality control for firms that perform audits and reviews of financial statements,

and other assurance and related services engagements, and ISA 220 Quality

control for an audit of financial statements.

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106 4: Quality control  Part C Practice management

Study guide

Intellectual level

C1 Quality control

(a) Explain the principles and purpose of quality control of audit and other

assurance engagements.

1

(b) Describe the elements of a system of quality control relevant to a given firm. 2

(c) Select and justify quality control procedures that are applicable to a given

audit engagement.

3

(d) Assess whether an engagement has been planned and performed in

accordance with professional standards and whether reports issued are

appropriate in the circumstances.

3

Exam guide

Issues relating to quality control can be linked with almost any area of the P7 syllabus, from ethics and

auditor liability covered in Part B to any of the specific areas covered in Part D of this Study Text. You

could be asked to suggest quality control procedures that a firm should implement in specific

circumstances; to review a firm's procedures and assess their adequacy; or to assess procedures planned

or performed, and evidence obtained, for a specific engagement.

1 Principles and purpose

There is no simple definition of audit quality because there is no one 'correct' way to audit. It is often a

matter of conducting an audit in line with the spirit as well as the letter of professional guidance.

Audit quality is not defined in law or through regulations, and neither do auditing standards provide a

simple definition.

Although each stakeholder in the audit will give a different meaning to audit quality, at its heart it is about

delivering an appropriate professional opinion supported by the necessary evidence and judgements.

Many principles contribute to audit quality, including good leadership, experienced judgement, technical

competence, ethical values and appropriate client relationships, proper working practices and effective

quality control and monitoring review processes.

The standards on audit quality provide guidance to firms on how to achieve these principles.

2 Quality control at a firm level Pilot, 6/09, 12/11, 6/14

The International Standard on Quality Control (ISQC 1) helps audit firms to establish quality standards for

their business.

The fact that auditors follow international auditing standards provides a general quality control framework

within which audits should be conducted. There are also specific quality control standards.

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Part C Practice management  4: Quality control 107

2.1 Purpose of ISQC 1

ISQC 1.11

The objective of the firm is to establish and maintain a system of quality control to provide it with

reasonable assurance that:

(a) The firm and its personnel comply with professional standards and applicable legal and regulatory

requirements; and

(b) Reports issued by the firm or engagement partners are appropriate in the circumstances.

All quality control policies and procedures should be documented and communicated to the firm's

personnel.

We have already considered the sections of this standard relating to ethics in Chapter 2 and those relating

to client acceptance will be covered in Chapter 5 of this Study Text. We shall now consider the

requirements of the rest of the standard, which fall into the following areas.

 Firm and leadership responsibilities for quality within the firm

 Human resources

 Engagement performance (see also below, the requirements of ISA 220)

 Monitoring

2.2 Firm and leadership responsibilities for quality within the firm

ISQC 1.13

Personnel within the firm responsible for establishing and maintaining the firm's system of quality control

shall have an understanding of the entire text of this ISQC, including its application and other explanatory

material, to understand its objective and to apply its requirements properly.

Firms are required to ensure that the appropriate training is provided to ensure there is complete

understanding of the objectives and procedures under ISQC 1. The standard stipulates further that some

firms may need to apply additional procedures (beyond those of the standard) to ensure that the

objectives are met.

The standard requires that the firm implements policies such that the internal culture of the firm is one

where quality is considered to be essential. Such a culture must be inspired by the leaders of the firm,

who must promote this culture by the example of their actions and messages. In other words, the entire

business strategy of the audit firm should be driven by the need for quality in its operations.

The firm may appoint an individual or group of individuals to oversee quality in the firm. Such individuals

must have:

 Sufficient and appropriate experience

 The ability to carry out the job

 The necessary authority to carry out the job

2.3 Human resources

The firm's overriding desire for quality will necessitate policies and procedures on ensuring excellence in

its staff, to provide the firm with 'reasonable assurance that it has sufficient personnel with the

capabilities, competence, and commitment to ethical principles necessary to perform its engagements

in accordance with professional standards and regulatory and legal requirements, and to enable the firm

or engagement partners to issue reports that are appropriate in the circumstances'.

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108 4: Quality control  Part C Practice management

These will cover the following issues.

 Recruitment  Performance evaluation

 Capabilities  Competence

 Career development  Promotion

 Compensation  The estimation of personnel needs

The firm is responsible for the ongoing excellence of its staff, through continuing professional

development, education, work experience and coaching by more experienced staff.

2.3.1 Assignment of engagement teams

The assignment of engagement teams is an important matter in ensuring the quality of an individual

assignment.

This responsibility is given to the audit engagement partner. The firm should have policies and procedures

in place to ensure that:

 Key members of client staff and those charged with governance are aware of the identity of the

audit engagement partner

 The engagement partner has appropriate capabilities, competence, authority and time to perform

the role

 The engagement partner is aware of their responsibilities as engagement partner

The engagement partner should ensure that they assign staff with sufficient capabilities, competence and

time to individual assignments so that they will be able to issue an appropriate report.

2.4 Engagement performance

The firm should take steps to ensure that engagements are performed correctly, that is, in accordance

with standards and guidance. Firms often produce a manual of standard engagement procedures to give

to all staff so that they know the standards they are working towards. These may be in an electronic

format.

Ensuring good engagement performance involves a number of issues:

 Direction  Consultation

 Supervision  Resolution of disputes

 Review

Many of these issues will be discussed in the context of an individual audit assignment (see Section 3

below).

ISQC 1.34

The firm shall establish policies and procedures designed to provide it with reasonable assurance that:

(a) Appropriate consultation takes place on difficult or contentious matters

(b) Sufficient resources are available to enable appropriate consultation to take place

(c) The nature and scope of, and conclusions resulting from, such consultations are documented and

are agreed by both the individual seeking consultation and the individual consulted

(d) Conclusions resulting from consultations are implemented

This may involve consulting externally, for example with other firms, or the related professional body

(ACCA), particularly when the firm involved is small.

When there are differences of opinion on an engagement team, a report should not be issued until the

dispute has been resolved. This may involve the intervention of the quality control reviewer.

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Part C Practice management  4: Quality control 109

A peer review is a review of an audit file carried out by another partner in the assurance firm.

A hot review (also known as a pre-issuance review) is a peer review carried out before the audit report is

signed.

A cold review (also known as a post-issuance review) is a peer review carried out after the audit report is

signed.

The firm should have policies and procedures to determine when a quality control reviewer will be

necessary for an engagement. This will include all audits of financial statements for listed companies.

When required, such a review must be completed before the report is signed.

The firm must also have standards as to what constitutes a suitable quality control review (the nature,

timing and extent of such a review, the criteria for eligibility of reviewers and documentation requirements).

Quality control reviews

Nature, timing and extent It ordinarily includes discussion with the engagement partner, review of the

financial statements/other subject matter information and the report, and

consideration of whether the report is appropriate. It will also involve a

selective review of working papers relating to significant judgements made.

Eligibility The reviewer must have sufficient technical expertise and be objective

towards the assignment.

Documentation Documentation showing that the firm's requirements for a review have been

met, that the review was completed before the report was issued and a

conclusion that the reviewer is not aware of any unresolved issues.

Listed companies The review should include:

 The engagement team's evaluation of the firm's independence in relation

to the specific engagement

 Significant risks identified during the engagement and the responses to

those risks

 Judgements made, particularly with respect to materiality and significant

risks

 Whether appropriate consultation has taken place on matters involving

differences of opinion or other difficult or contentious matters, and the

conclusions arising from those consultations

 The significance and disposition of corrected and uncorrected

misstatements identified during the engagement

 The matters to be communicated to management and those charged with

governance and, where applicable, other parties such as regulatory

bodies

 Whether working papers selected for review reflect the work performed

in relation to the significant judgements and support the conclusions

reached

 The appropriateness of the report to be issued

2.5 Monitoring

The standard states that firms must have policies in place to ensure that their quality control procedures are:

 Relevant  Operating effectively

 Adequate  Complied with

In other words, they must monitor their system of quality control. Monitoring activity should be reported

to the management of the firm on an annual basis.

Key terms

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There are two types of monitoring activity, an ongoing evaluation of the system of quality control and

periodic inspection of a selection of completed engagements. An ongoing evaluation might include such

questions as, 'have we kept up to date with regulatory requirements?'

A periodic inspection cycle would usually fall over a period such as three years, in which time at least one

engagement per engagement partner would be reviewed.

The people monitoring the system are required to evaluate the effect of any deficiencies found. These

deficiencies might be one-offs. Monitors will be more concerned with systematic or repetitive

deficiencies that require corrective action. When evidence is gathered that an inappropriate report might

have been issued, the audit firm may want to take legal advice.

Corrective action

 Remedial action with an individual

 Communication of findings with the training department

 Changes in the quality control policies and procedures

 Disciplinary action, if necessary

Read the requirements of any quality control questions carefully. If you are asked to comment on the

procedures relevant to the individual audit, firm-wide procedures will not be relevant. This point has been

made in a number of recent Examiner's Reports.

3 Quality control on an individual audit 12/07, 6/08, 6/09

6/11, 12/12, 6/13, 6/14, 12/14, 6/15

ISA 220 requires firms to implement quality control procedures over individual audit engagements.

The requirements concerning quality control on individual audits are found in ISA 220 Quality control for

an audit of financial statements. This international auditing standard (ISA) applies the general principles of

the ISQC we looked at in the previous section to an individual audit.

ISA 220.6

The objective of the auditor is to implement quality control procedures at the engagement level that

provide the auditor with reasonable assurance that:

(a) The audit complies with professional standards and applicable legal and regulatory requirements;

and

(b) The auditor's report issued is appropriate in the circumstances.

The burden of this falls on the audit engagement partner, who is responsible for the audit and the ultimate

conclusion.

3.1 Leadership responsibilities

The engagement partner is required to set an example with regard to the importance of quality.

ISA 220.8

The engagement partner shall take responsibility for the overall quality on each audit engagement to which

that partner is assigned.

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3.2 Ethical requirements

ISA 220.9

Throughout the audit engagement, the engagement partner shall remain alert, through observation and

making inquiries as necessary, for evidence of non-compliance with relevant ethical requirements by

members of the engagement team.

This includes the ACCA Code of Ethics and Conduct, with its fundamental principles and all the other

detailed requirements. The ISA also contains some detailed guidance about independence in particular.

ISA 220.11

The engagement partner shall form a conclusion on compliance with independence requirements that

apply to the audit engagement. In doing so, the engagement partner shall:

(a) Obtain relevant information from the firm and, where applicable, network firms, to identify and

evaluate circumstances and relationships that create threats to independence;

(b) Evaluate information on identified breaches, if any, of the firm's independence policies and

procedures to determine whether they create a threat to independence for the audit engagement;

and

(c) Take appropriate action to eliminate such threats or reduce them to an acceptable level by applying

safeguards, or, if considered appropriate, to withdraw from the audit engagement, where

withdrawal is possible under applicable law and regulation. The engagement partner shall promptly

report to the firm any inability to resolve the matter for appropriate action.

ISA 220.24

The auditor shall include in the audit documentation … conclusions on compliance with independence

requirements that apply to the audit engagement, and any relevant discussions with the firm that support

these conclusions.

3.3 Acceptance/continuance of client relationships and specific audit

engagements

The partner is required to ensure that the requirements of ISQC 1 in respect of accepting and continuing

with the audit are followed. If the engagement partner obtains information that would have caused them to

decline the audit in the first place they should communicate that information to the firm so that swift

action may be taken. They must document conclusions reached about accepting and continuing the audit.

3.4 Assignment of engagement teams

As discussed in the previous section, this is also the responsibility of the audit engagement partner. They

must ensure that the team is appropriately qualified and experienced as a unit.

3.5 Engagement performance

Several factors are involved in engagement performance, as discussed above (Section 2.4).

3.5.1 Direction

The partner directs the audit. They are required by other auditing standards to hold a meeting with the

audit team to discuss the audit, in particular the risks associated with the audit. This ISA suggests that

direction includes 'informing members of the engagement team of:

(a) Their responsibilities (including objectivity of mind and professional scepticism)

(b) Responsibilities of respective partners where more than one partner is involved in the conduct of

the audit engagement

(c) The objectives of the work to be performed

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112 4: Quality control  Part C Practice management

(d) The nature of the entity's business

(e) Risk-related issues

(f) Problems that may arise

(g) The detailed approach to the performance of the engagement'

3.5.2 Supervision

The audit is supervised overall by the engagement partner, but more practical supervision is given within

the audit team by senior staff to more junior staff, as is also the case with review (see Section 3.5.3

below). It includes:

 Tracking the progress of the audit engagement

 Considering the capabilities and competence of individual members of the team, and whether they

have sufficient time and understanding to carry out their work

 Addressing significant issues arising during the audit engagement and modifying the planned

approach appropriately

 Identifying matters for consultation or consideration by more experienced engagement team

members during the audit engagement

3.5.3 Review

Review includes consideration of whether:

 The work has been performed in accordance with professional standards and regulatory and legal

requirements

 Significant matters have been raised for further consideration

 Appropriate consultations have taken place and the resulting conclusions have been documented

and implemented

 There is a need to revise the nature, timing and extent of work performed

 The work performed supports the conclusions reached and is appropriately documented

 The evidence obtained is sufficient and appropriate to support the auditor's report

 The objectives of the engagement procedures have been achieved

Before the audit report is issued, the engagement partner must be sure that sufficient and appropriate

audit evidence has been obtained to support the audit opinion. The audit engagement partner need not

review all audit documentation, but may do so. They should review critical areas of judgement, significant

risks and other important matters.

3.5.4 Consultation

The partner is also responsible for ensuring that if difficult or contentious matters arise the team takes

appropriate consultation on the matter and that such matters and conclusions are properly recorded.

If differences of opinion arise between the engagement partner and the team, or between the engagement

partner and the quality control reviewer, these differences should be resolved according to the firm's

policy for such differences of opinion.

3.5.5 Quality control review

The audit engagement partner is responsible for appointing a reviewer, if one is required. They are then

responsible for discussing significant matters that arise with the reviewer and for not issuing the audit

report until the quality control review has been completed.

A quality control review should include:

 An evaluation of the significant judgements made by the engagement team

 An evaluation of the conclusions reached in formulating the auditor's report

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ISA 220.25

The engagement quality control reviewer shall document, for the audit engagement reviewed, that:

(a) The procedures required by the firm's policies on engagement quality control review have been

performed;

(b) The engagement quality control review has been completed on or before the date of the auditor's

report; and

(c) The reviewer is not aware of any unresolved matters that would cause the reviewer to believe that

the significant judgements the engagement team made and the conclusions it reached were not

appropriate.

A quality control review for a listed entity will include a review of:

 Discussion of significant matters with the engagement partner

 Review of financial statements and the proposed report

 Review of selected audit documentation relating to significant audit judgements made by the audit

team and the conclusions reached

 Evaluation of the conclusions reached in formulating the auditor's report and consideration of

whether the auditor's report is appropriate

 The engagement team's evaluation of the firm's independence towards the audit

 Whether appropriate consultations have taken place on differences of opinion/contentious matters

and the conclusions drawn

 Whether the audit documentation selected for review reflects the work performed in relation to

significant judgements/supports the conclusions reached

Other matters relevant to evaluating significant judgements made by the audit team are likely to be:

 The significant risks identified during the engagement and the responses to those risks (including

assessment of, and response to, fraud)

 Judgements made, particularly with respect to materiality and significant risks

 Significance of corrected and uncorrected misstatements identified during the audit

 Matters to be communicated with management / those charged with governance

Quality control is often examined as one part of a requirement that also covers professional and ethical

matters. A typical requirement might be 'Comment on the quality control, ethical and professional issues

raised [by the scenario]'. The scenario might then depict an audit that had problems in each of these

areas.

Alternatively, whole questions (or parts of questions) may be set on quality control alone.

3.6 Monitoring

The audit engagement partner is required to consider the results of monitoring of the firm's (or network

firm's) quality control systems and consider whether they have any impact on the specific audit they are

conducting.

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Question Quality control issues

You are an audit senior working for the firm Addystone Fish. You are currently carrying out the audit of

Wicker Co, a manufacturer of waste paper bins. You are unhappy with Wicker's inventory valuation policy

and have raised the issue several times with the audit manager. They have dealt with the client for a

number of years and does not see what you are making a fuss about. They have refused to meet you on

site to discuss these issues.

The former engagement partner to Wicker retired two months ago. As the audit manager had dealt with

Wicker for so many years, the other partners have decided to leave the audit of Wicker in their capable

hands.

Required

Comment on the situation outlined above.

Answer

Several quality control issues are raised in the above scenario:

Engagement partner

An engagement partner is usually appointed to each audit engagement undertaken by the firm, to take

responsibility for the engagement on behalf of the firm. Assigning the audit to the experienced audit

manager is not sufficient.

The lack of an audit engagement partner also means that several of the requirements of ISA 220 about

ensuring that arrangements in relation to independence and directing, supervising and reviewing the audit

are not in place.

Conflicting views

In this scenario the audit manager and senior have conflicting views about the valuation of inventory. This

does not appear to have been handled well, with the manager refusing to discuss the issue with the senior.

ISA 220 requires that the audit engagement partner takes responsibility for settling disputes in accordance

with the firm's policy in respect of resolution of disputes as required by ISQC 1. In this case, the lack of

engagement partner may have contributed to this failure to resolve the disputes. In any event, at best, the

failure to resolve the dispute is a breach of the firm's policy under ISQC 1. At worst, it indicates that the

firm does not have a suitable policy concerning such disputes as required by ISQC 1.

The June 2013 exam contained a 13-mark requirement to evaluate the quality control, ethical and

professional matters in relation to the performance of a particular audit. When answering questions in this

area, many candidates are aware that there is something wrong with the scenario, but those who score

well are able to state precisely why it is wrong too.

3.7 Applying ISQC 1 proportionately with the nature and size of a firm

The International Auditing and Assurance Standards Board has issued guidance for small firms in applying

ISQC 1 in the form of a 'Questions & Answers' document. Small firms do have to apply ISQC 1 in full, but

this should not result in 'standards overload' because ISQC 1 is drafted in such a way that it can be

applied proportionately.

3.7.1 Only comply with relevant requirements

Importantly, firms only have to comply with requirements that are relevant to them and to the services

they are providing.

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Part C Practice management  4: Quality control 115

ISQC 1.14

The firm shall comply with each requirement of this ISQC unless, in the circumstances of the firm, the

requirement is not relevant to the services provided in respect of audits and reviews of financial

statements, and other assurance and related services engagements.

So a small practitioner who does not provide audit services would clearly not be required to follow ISQC

1's requirements in relation to audit services.

3.7.2 Structure and formality is proportionate

Smaller firms may use less structured means and simpler processes to comply with ISQC 1.

Communications may be more informal than in a larger firm.

Smaller firms still need to read ISQC 1, but they may legitimately use their judgement in tailoring it to

their circumstances. For example, it would not be necessary for a sole practitioner to establish an explicit

process for assigning personnel to engagement teams (because the 'process' in this case would be the

nonsensical statement that there is no process because there are no teams).

3.7.3 Using external resources

In order to comply with ISQC 1's requirements, it may be necessary to make use of the services of another

organisation, such as another firm or a professional or regulatory body. This may be particularly helpful

where ISQC 1 requires an engagement quality control review, or where there is a need for monitoring

processes which could be carried out by an external person or firm.

3.7.4 Documentation

ISQC 1 does require all firms to document the operation of its system of quality control. However, the

form and content of this documentation is a matter of judgement and would depend on the size of the firm

and complexity of its organisation. Smaller firms would therefore have less to document, and could make

use of less formal methods of documentation such as manual notes and checklists.

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Chapter Roundup

 There is no simple definition of audit quality because there is no one 'correct' way to audit. It is often a

matter of conducting an audit in line with the spirit as well as the letter of professional guidance.

 The International Standard on Quality Control (ISQC 1) helps audit firms establish quality standards for

their business.

 ISA 220 requires firms to implement quality control procedures over individual audit engagements.

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Part C Practice management  4: Quality control 117

Quick Quiz

1 The objective of a firm applying ISQC 1 is to:

'Establish and maintain a system of ………… …………. to provide it with ……………………….

assurance that

(a) The firm and its personnel comply with ...................... standards and .......................... and

........................... requirements and

(b) ......................................... issued by the firm or engagement partners are .................. in the

circumstances.'

2 List five issues relating to good engagement performance that should be addressed in an audit firm's

procedures manual.

(1)

(2)

(3)

(4)

(5)

3 Who reviews audit work in an audit of financial statements?

4 Who is responsible for the overall quality of an individual audit assignment?

(a) Ethics partner

(b) Pre-issuance reviewer

(c) Engagement partner

(d) Managing partner

5 ISQC 1 sets out requirements about the nature of the firm's internal culture.

True

False

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118 4: Quality control  Part C Practice management

Answers to Quick Quiz

1 Quality control, reasonable, professional, regulatory, legal, reports, appropriate

2 (1) Direction

(2) Supervision

(3) Review

(4) Consultation

(5) Resolution of disputes

3 Audit work is generally reviewed by the staff member who is more senior on the team than the person who

did the work. The partner must carry out a review to ensure there is sufficient and appropriate evidence to

support the audit opinion. It might also be necessary under the firm's quality control policies to obtain a

quality control review by a suitable person outside the audit team. This will be necessary if the audit is of a

listed entity.

4 (c) Engagement partner

5 True. ISQC 1 requires the firm to establish policies and procedures to promote an internal culture that

recognises that quality is essential in performing engagements.

Now try the question below from the Practice Question Bank.

Number Level Marks Time

Q6 Examination 15 29 mins

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119

Obtaining and

accepting professional

appointments

Introduction

It is a commercial fact that companies change their auditors. The question that

firms of auditors need to understand the answer to is: why do companies change

their auditors? We shall examine some of the common reasons here.

Related to the fact that entities change their auditors is the fact that many

auditing firms advertise their services. The ACCA has set out rules for

professional accountants who advertise their services. We shall examine these

rules and the reasons behind them in Section 2.

As we will discover in Section 1, the audit fee can be a very key item for an entity

when it makes decisions about its auditors. Determining the price to offer to

potential clients can be a difficult process, but it is just one part of the whole

process that is tendering. Audits are often put out to tender by companies. We

shall examine all the matters firms consider when tendering for an audit in

Section 3.

Linked in with the tendering process is the process of determining whether to

accept the audit engagement if it is offered. ISQC 1 Quality control for firms that

perform audits and reviews of financial statements, and other assurance and

related services engagements sets out some basic requirements for all audit

firms accepting engagements. This is discussed in Section 4.

ISA 210 Agreeing the terms of audit engagements sets out the agreement

necessary when an audit is accepted and this is covered in Section 5.

Topic list Syllabus reference

1 Change in auditors C3

2 Advertising and fees C2

3 Tendering C3

4 Acceptance C4

5 Terms of the engagement C4

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120 5: Obtaining and accepting professional appointments  Part C Practice management

Study guide

Intellectual level

C2 Advertising, publicity, obtaining professional work and fees

(a) Recognise situations in which specified advertisements are acceptable. 2

(b) Discuss the restrictions on practice descriptions, the use of the ACCA logo

and the names of practising firms.

2

(c) Discuss the extent to which reference to fees may be made in promotional

material.

2

(d) Outline the determinants of fee-setting and justify the bases on which fees

and commissions may and may not be charged for services.

3

(e) Discuss the ethical and other professional problems, for example,

lowballing, involved in establishing and negotiating fees for a specified

assignment.

3

C3 Tendering

(a) Discuss the reasons why entities change their auditors/professional

accountants.

2

(b) Recognise and explain the matters to be considered when a firm is invited to

submit a proposal or fee quote for an audit or other professional

engagement.

2

(c) Identify the information to be included in a proposal. 2

C4 Professional appointments

(a) Explain the matters to be considered and the procedures that an audit firm/

professional accountant should carry out before accepting a specified new

client/engagement including:

3

(i) Client acceptance

(ii) Engagement acceptance

(iii) Establish whether the preconditions for an audit are present

(iv) Agreeing the terms of engagement

(b) Recognise the key issues that underlie the agreement of the scope and

terms of an engagement with a client.

2

Exam guide

Many of the issues in this chapter are ethical. You could be faced with a change in appointment scenario

in the exam. The issues surrounding a change in auditor have often been examined in the past, with

scenarios featuring tendering and practical issues around audit planning.

1 Change in auditors 6/09

Common reasons for companies changing their auditor include audit fee, auditor not seeking re-election

and change in the size of company.

1.1 Why do companies change their auditor?

It is a fact of life that companies change their auditors sometimes. Not all new clients of a firm are new

businesses, some have decided to change from their previous auditors. Obviously, it is often not in the

interests of audit firms to lose clients. Therefore a key issue in practice management for auditors is to

understand why companies change their auditors so that, as far as they are able, they can seek to prevent

it.

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Part C Practice management  5: Obtaining and accepting professional appointments 121

Question Change of auditor

Before you read the rest of this chapter, spend a minute thinking about the reasons why companies might

change their auditors. You might want to close the Study Text and write them down and then compare

them with the reasons that we give in the rest of this section.

Answer

Read through the rest of Section 1 and compare your answer with ours.

The following diagram shows some of the more common reasons that companies might change their

auditors.

CHANGE IN AUDIT FIRM

Audit fee

Size

Audit firm does not

seek re-election Personality: client falls

out with audit staff

Audit rotation: relationship

ended for independence

reasons

Disagreement with

the client

Another client is

in competition

Audit firm has other ethical

reasons

Perceived not to

be value for money

Perceived to be

too high

Not competitive

Interested in whether

price is negotiable

Client falls below

exemption limit

Client's business

expands beyond

audit firm's capacity

Not wanting to

reduce fee

1.2 Audit fee

The audit fee can be a very sensitive issue. Audit is required by statute for many companies. Many people

perceive that it has very little intrinsic value. Therefore, when setting audit fees, auditors must take

account of the fact that clients may hold this opinion. Setting fees will be discussed later in the chapter.

Here, we shall explore some of the fee-related reasons why companies change their auditors.

1.2.1 Perceived to be too high

This is a common reason for auditors being changed. It is strongly linked to people's perception that audit

has no intrinsic value. If directors of a company believe that audit is a necessary evil, they will seek to

obtain it for as little money as they can.

Much of the 'value', in cost terms, of an audit is carried out away from a client's premises. This is because

the most expensive audit staff (managers and partners) often do not carry out their audit work on site. If

the client does not understand this, the following sort of situation may arise.

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122 5: Obtaining and accepting professional appointments  Part C Practice management

Case Study

Bob is the owner-manager of Fixings Co, a small business which manufactures metal fixings. It has a

revenue of $4.5 million and the auditors come in for the second week of October every year. Every

year a different senior is in charge and they ask similar questions to the ones asked the previous

year, because the business rarely changes and the audit is low risk. The partner and manager rarely

attend the audit itself because it is not considered cost-effective or necessary to do so.

Bob's audit fee was set at $4,500 five years ago when the business was incorporated for tax and

inheritance reasons, and has gone up at 3% a year ever since. It now stands at $5,200. During that time,

he has paid the same firm $1,200 a year to organise his tax return and deal with the tax authorities on his

behalf. He considers this service far more valuable, as he has no understanding of tax issues and is

exceedingly nervous of a taxation inspection.

Bob cannot understand how the audit fee is four times the size of the tax fee when the auditors attend for a

week and do the same work every year. He is also irritated that it continues to steadily rise while the

service does not change.

The example given above is a little exaggerated and generalisations have been made. However, there is

some truth in it. An auditor understands the costs that go in to making up the audit fee. It is essential that

the client does too.

1.2.2 Perceived not to be value for money

This often goes hand in hand with the audit fee being seen to be too high. In the above example of Bob

and Fixings Co, this was certainly the case. However, it is possible that a company could be paying its

audit firm a fee that it considers reasonable for an audit, but it just believes that another firm could give

them a better audit for a similar fee.

1.2.3 Not competitive

Again, this issue can be linked with the value for money perception. It is true to say that in some

cases, audit firms will offer audit services at low prices. This is on the grounds that they then sell

other services to the same clients at profitable prices. It is through practices like this that the

problem of lowballing can arise. You should remember the issue of lowballing from your earlier

studies. In such conditions, a well-set audit fee may not be competitive even if it is a reasonable fee

for the service provided.

1.2.4 Interest in whether price is negotiable

This reason may be linked to all the above fee-related issues, or it may just arise out of interest on the

client's part. It costs the client very little except some time on their part to put their audit out to tender.

They might even do this with every intention of keeping the present auditor.

Putting the audit out to tender would give them more insight into how competitive his audit fee is and keep

their auditor 'honest', in that they will have to justify their fee and risk it being higher than competitors in

the tender.

The by-product might be that they receive a competitive tender which offers them far more than they

receive from their current auditor and they change their auditor anyway. It could also mean that, when

forced to justify their position, the current auditor reassesses their service and comes up with a far more

competitive deal.

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1.3 The auditor does not seek re-election

Another key reason for the auditor changing is that the auditor chooses not to stand for election for

another year. You should be familiar with many of the reasons behind this:

 There could be ethical reasons behind the auditor choosing not to stand

 The auditor might have to resign for reasons of competition between clients

 The auditor might disagree with the client over accounting policies

 The auditor might not want to reduce their audit fee.

Question Ethical reasons

Name three ethical reasons why an auditor might not seek re-election or might resign, explaining the

nature of the problem and the reasoning behind the resignation.

Answer

As you know from your earlier studies and from Chapter 2, there are countless ethical issues that could

have arisen. Here are some common ones. Refer back to Chapter 2 if you have included any that do not

appear here.

(a) Fee level

The audit fee which is necessary to carry out the audit at a profit may have reached a level which is

inappropriate according to the ACCA's guidance on fee levels for a public interest entity. If the audit

fee constituted more than 15% of the total practice income, this would be considered to be an

independence problem. This is because the audit opinion might be influenced by a fear of losing

the client. The auditor should consider the need for a pre-issuance or post-issuance review.

In such a situation, or if the practice had a large client below the limits but whose forecast

suggested future growth, it might be necessary for the auditor to end the relationship to ensure

that they did not become dependent on the client.

(b) Integrity of management

The auditor might feel that they have reason to doubt the integrity of management. There are many

reasons why this could be the case. It could be as a result of a breakdown in the relationship, or an

unproven suspected fraud.

If the auditor does not feel that the client is trustworthy they should not continue their relationship

with them.

(c) Other services

The auditor may offer a number of services to the client. They may be offered some lucrative

consultancy work by the client which they want to undertake, but they feel that the independence of

the audit will be severely affected by the provision of the consultancy work because of the heavy

involvement this would require in the client's business.

As the audit fee is substantially lower than the fees associated with the consultancy work and the

auditor is trying to develop their business advice department, they may decide to resign from the

audit to take on the consultancy.

1.4 Size of the company

This can be a major reason for a change in auditors. There are two key reasons, one of which has been

touched on already:

 The client experiences rapid growth to the point where the audit is no longer practicable for the audit

firm.

 The client retrenches or restructures in such a way that it no longer needs a statutory audit.

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124 5: Obtaining and accepting professional appointments  Part C Practice management

In the first instance, the auditor may no longer be able to provide the audit for several reasons:

 Insufficient resources

 Staff

 Time

 Fee level issue

In the second instance, the client may choose not to have an audit.

In either situation, there is little that the auditor can do to prevent losing the work.

1.5 Other reasons

These reasons may have been touched on in relation to the other reasons given above. We shall consider

them briefly here.

1.5.1 Personality

For many small owner-managed companies, audit is almost a personal service. The relationship between

such a client and its auditor may be strongly based on personality and, if relationships break down, it may

be necessary for the audit relationship to discontinue.

Personality may not be such an issue for bigger entities and audit firms where the audit engagement

partner could be transferred if required, while the audit stayed within the firm.

1.5.2 Audit rotation

Rotation of audit staff was discussed in Chapter 2 as a safeguard to audit independence. However, the

partners in a firm may sometimes conclude that the firm as a whole has been associated with a client for

too long, and therefore give up the audit.

1.5.3 UK Corporate Governance Code requirements

The UK Corporate Governance Code requires some companies to put the audit out to tender at least every

ten years. This will not always result in a change in auditor – it is possible that the current auditor will win

the tender. But it means that management will have to consider whether the audit meets its needs

discussed above.

1.6 Statement of circumstances

Under the UK Companies Act 2006, for a quoted company an auditor must now always submit a statement

of circumstances surrounding their leaving office, even where there are no matters which the auditor

believes should be brought to the attention of members or creditors. (Previously the auditor was able to

submit a negative statement, ie that there were no relevant circumstances.)

From the nature of the issues raised above, it is clear that some of them will affect small firms and not

larger ones and some will more predominantly affect larger ones. You should bear that in mind when

approaching exam questions and, as usual, apply common sense.

Question Control over reappointment

(a) Of the reasons for a change in auditors given above, which do you feel that an auditor may have

control over and therefore guard against? Ignore the cases when the auditor does not seek reelection

or resigns.

(b) What should the auditor do to guard against the issues you have identified in part (a)?

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Answer

(a) Issues auditor may have control over

There are two key issues identified above that an auditor may have some control over:

(i) Fees

(1) Perception

(2) Competitiveness

(ii) Personality

(b) Actions to guard against issues arising

(i) With regard to fees, the auditor can ensure that the audit is conducted in such a way as to foster

the perception that the audit is good value for the fee. This can be done by encouraging the

attitude of audit staff and ensuring that a professional manner is always maintained. It also

requires a constant awareness by staff of the need to add value, and to ensure that the audit

provides more of a service than fulfilling a statutory requirement. This can be achieved by

offering relevant advice to the client as a by-product of the audit, predominantly through the

report to management, but also as an integral part of the culture of the audit.

Also with regard to fees, the auditor can ensure they are competitive in the first instance, by

setting reasonable fees and in the second instance by conducting research into what their

competitors charge. As companies have to file accounts and the audit fee must be

disclosed, this is readily available information.

(ii) Personality is obviously not an issue that an auditor can guard against. However, part of an

auditor's professionalism is to ensure that if personality problems arise, they are handled

sensitively and they only arise due to issues on the side of the client.

If serious conflict arises, firms should have a procedure for rotating audits between audit

partners.

2 Advertising and fees 12/09, 12/10

ACCA's general rule on advertising is 'the medium shall not reflect adversely on the professional

accountant, ACCA or the accountancy profession'.

2.1 ACCA guidance

Auditors are in business, and in business it is necessary to advertise. However, accountants are

professional people and people rely on their work. It is important therefore that their advertisements do

not project an image that is inconsistent with that fact.

ACCA gives guidance about advertising in the Code of Ethics and Conduct. This is one area in which ACCA

ethical guidance is considerably more detailed than that provided by the IESBA Code of Ethics alone. In general,

ACCA allows professional accountants to advertise their work in any way they see fit. In other words, it is a

matter of judgement for the professional accountant. This is subject to the following general principle.

ACCA Code of Ethics

'The medium shall not reflect adversely on the professional accountant, ACCA or the accountancy

profession.' (Code of Ethics, para 250A)

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Advertisements and promotional material should not:

 Bring ACCA into disrepute or bring discredit to the professional accountant, firm or the

accountancy profession

 Discredit the services offered by others whether by claiming superiority for the professional

accountant's or firm's own services or otherwise

 Be misleading, either directly or by implication

 Fall short of any local regulatory or legislative requirements, such as the requirements of the United

Kingdom Advertising Standard and Authority's Code of Advertising and Sales Promotion, notably

as to legality, decency, clarity, honesty and truthfulness

(Code of Ethics, para 250.2A)

2.2 Fees

It is generally inappropriate to advertise fees.

Three issues arise with regard to fees:

 Referring to fees in promotional material

 Commissions

 Setting and negotiating fees

The last two issues are interrelated and are also closely connected with tendering, which is discussed in

the next section.

2.2.1 Advertising fees

The fact that it is difficult to explain the service represented by a single fee in the context of an

advertisement and that confusion might arise as to what a potential client might expect to receive in

return for that fee means that it is seldom appropriate to include information about fees in short

advertisements.

In longer advertisements, where reference is made to fees in promotional material, the basis on which those

fees are calculated (hourly and other charging rates etc) should be clearly stated.

The key issue to remember with regard to advertising fees is that the greatest care should be taken not to

mislead potential clients. It is appropriate to advertise free consultations to discuss fee issues. This free

consultation will allow fees to be explained, thus avoiding the risk of confusion.

2.2.2 Setting and negotiating fees

As this is a key part of the tendering process, this is discussed in Section 3.

2.2.3 Commissions

Professional accountants may accept or pay referral fees if appropriate safeguards exist.

ACCA members may offer commission (and by implication receive commission) for introducing clients.

However, they should only do so if there are appropriate safeguards, such as making full disclosure.

Commissions could be a threat to objectivity – refer back to Chapter 2 for more information on this.

2.3 Practice descriptions and the ACCA logo

Members of the ACCA may be either associates or fellows, in which case they are allowed to use the

designatory letters ACCA or FCCA after their names.

A firm may describe itself as a firm of 'Chartered Certified Accountants' where:

 At least half the partners are ACCA members

 Those partners hold at least 51% of voting rights under the partnership agreement

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Such a firm may use the ACCA logo on its stationery and website.

A firm in which all the partners are Chartered Certified Accountants may use the description 'Members of

the Association of Chartered Certified Accountants'. A firm must not, however, use this term as part of its

registered practice name.

A firm which holds a firm's auditing certificate from ACCA may describe itself as 'Registered Auditors'.

Question Advertising and fees

Felicity Carr and Frank Harrison both qualified as Chartered Certified Accountants five years ago.

They have now decided to set up in practice together. Their new firm holds an auditing certificate

from ACCA and they intend to undertake small audits and some tax work. They will charge

themselves out at $200 per hour initially. They will operate from Frank's home. They are a little rusty

on the rules concerning advertising and obtaining professional work and so have asked you to advise

them.

They have decided to call their practice Harrison Carr and to advertise in the local paper. As they are

launching themselves, they have decided to take out a full page advertisement one week and then run a

series of smaller adverts in the future. They have also decided to advertise in a local business

newspaper.

Required

(a) Explain the ACCA guidance on advertising, including advertising fees.

(b) Advise Harrison Carr how they should proceed in relation to:

(i) How they may describe the firm

(ii) The adverts in the paper

Answer

(a) General guidance on advertising

Generally professional accountants may not advertise in a manner that reflects adversely on

themselves and their profession. This means that they should consider the quality of the paper they

intend to advertise in. The local paper is appropriate. They should also ensure that they do not

discredit the services offered by others in their advert.

Advertising fees

The key issue of importance when advertising fees is to ensure that the reference to fees is not

misleading. Generally, it is seldom appropriate to mention fees in a small advert.

(b) (i) Description of firm

As both partners are Chartered Certified Accountants it is acceptable to advertise the

firm as being a member of the ACCA. They may also describe themselves as registered

auditors.

(ii) The proposed advertisements

While they are planning a larger advert followed by several smaller ones, it may still not be

appropriate to mention fees. This is because while they could refer to charge out rates, it

would be impossible in the paper to describe how much each service would cost without

estimating the time jobs would take. It is impossible to generalise such matters and the

reference to fees could therefore be misleading.

It would be more appropriate to advertise that they will give free consultations to discuss

fees. They may include all the details given above, their name, the membership of the ACCA

and their registered auditor status.

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3 Tendering 6/09, 12/11, 12/12, 12/14

When approaching a tender, it is important to consider both fees and practical issues.

3.1 Approach

A firm puts together a tender if:

 It has been approached by a prospective client

 The partners have decided that they are capable of doing the work for a reasonable fee

When approached to tender, the auditor has to consider whether they want to do the work. You should be

aware of all the ethical considerations that would go into this decision. The auditor will also have to

consider:

 Fees

 Practical issues

3.1.1 Fees

Determining whether the job can be done for a reasonable price will involve a substantial number of

estimates. The key estimate will be how long the partner thinks it will take to do the work. This will involve

meeting with the prospective client to discuss its business and systems and making the estimate from there.

The first stage of setting the fee is therefore to ascertain what the job will involve. The job should be

broken down into its respective parts, for example, audit and tax, or if it is a complex and/or pure audit,

what aspects of the job would be undertaken by what level of staff.

The second stage is therefore closely linked with the first. It involves ascertaining which staff, or which

level of staff, will be involved and in what proportions they will be involved.

Once estimates have been made of how long the work will take and what level of expertise is needed in

each area, the firm's standard charge out rates can be applied to that information, and a fee estimated.

Clearly, it is commercially vital that the estimates of time and costs are reasonable, or the audit firm will

be seeking to undertake the work at a loss. However, it is also ethically important that the fee estimate is

reasonable, or the result will be that the client is being misled about the sustainable fee level.

3.1.2 Lowballing

Problems can arise when auditing firms appear to be charging a fee level that is unsustainably low, or at

least less than the 'market rate' for the audit. The practice of undercutting, usually at tender for the audit of

large companies, has been called lowballing. In other cases, the audit fee has been reduced even though

the auditors have remained the same. The problem here is that, if the audit is being performed for less

than it is actually worth, then the auditors' independence is called into question.

This is always going to be a topical debate, but in terms of negotiating the audit fee the following factors

need to be taken into account.

(a) The audit is perceived to have a fluctuating 'market price' as any other commodity or service. In a

recession, prices would be expected to fall as companies aim to cut costs everywhere and as

auditors chase less work (supply falls). Audit firms are also reducing staffing levels and their own

overhead costs should be lower.

(b) Companies (especially groups of companies) can reduce external audit costs through various

legitimate measures:

(i) Extending the size and function of internal audit

(ii) Reducing the number of different audit firms used worldwide

(iii) Selling off subsidiary companies leaving a simplified group structure to audit

(iv) The tender process itself simply makes auditors more competitive

(v) Exchange rate fluctuations in audit fees

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(c) Auditing firms have increased productivity, partly through the use of more sophisticated

information technology techniques in auditing.

The ACCA's guidance on quotations states that it is not improper to secure work by quoting a lower fee

so long as the client has not been misled about the level of work that the fee represents.

In the event of investigations into allegations of unsatisfactory work, the level of fees would be considered

with regard to a member's conduct with reference to the ethical guidelines.

3.1.3 Practical issues

The firm will have to consider the practical points arising from the approach. Common considerations

include:

 Does the proposed timetable for the work fit with the current work plan?

 Does the firm have suitable personnel available?

 Where will the work be performed and is it accessible/cost effective?

 Are (non-accounting) specialist skills necessary?

 Will staff need further training to do the work?

 If so, what is the cost of that further training?

Certain information will be required to put together a proposal document. This has already been touched

on briefly, when discussing the audit fee. It is likely that audit staff would have to have a meeting with the

prospective client to discuss the following issues.

 What the client requires from the audit firm (for example, audit, number of visits, tax work)

 What the future plans of the entity are, for example:

– Is it planning to float its shares on an exchange in the near future?

– Is growth or diversification anticipated?

 Whether the entity is seeking its first auditors and needs an explanation of audit

 Whether the entity is seeking to change its auditors

 If the entity is changing its auditors, the reason behind this

The December 2011 paper examined this area with a twist, asking candidates to comment on the practice

management and quality control issues raised by a suggestion to guarantee to clients that all audits will be

completed quicker than last year.

3.2 Content of an audit proposal (tender document)

An audit proposal, or tender, does not have a set format. The prospective client will indicate the format

that they want the tender to take. This may be merely in document form, or could be a presentation by

members of the audit firm.

Although each tender will be tailored to the individual circumstances, there are some matters which are

likely to be covered in every one. These are set out below.

Matters to be included in audit proposal

 The fee, and how it has been calculated

 An assessment of the needs of the prospective client

 An outline of how the firm intends to meet those needs

 The assumptions made to support that outline

 The proposed approach to the engagement

 A brief outline of the firm

 An outline of the key staff involved

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If the tender is being submitted to an existing client, some of those details will be unnecessary. However,

if it is a competitive tender, the firm should ensure they submit a comparable tender, even if some of the

details are already known to the client. This is because the tender must be comparable to competitors and

must appear professional.

In their review of this Study Text, your examination team commented specifically that students must apply

the points above to the question scenario, and must not simply repeat them as pre-learned knowledge.

This area was examined in December 2014, with 8 marks available for 'explaining the specific matters to

be included in the audit proposal (tender document)'. The candidates who did best used the information

from this section as a starting point for their answers, picking up information from the scenario that was

relevant to each of the bullet points in the previous box.

4 Acceptance 6/08, 6/09, 6/11

ISQC 1 sets out what a firm must consider and document in relation to accepting or continuing an

engagement, which is the integrity of the client, whether the firm is competent to do the work, and

whether the firm meets the ethical requirements in relation to the work.

4.1 Ethical requirements

There are a number of ethical procedures associated with accepting engagements which you have studied

previously.

Knowledge brought forward from earlier studies

From Paper F8 Audit and Assurance (or equivalent)

Procedures before accepting nomination

(a) Ensure that there are no ethical issues which are a barrier to accepting nomination.

(b) Ensure that the auditor is professionally qualified to act and that there are no legal or technical

barriers.

(c) Ensure that the existing resources are adequate in terms of staff, expertise and time.

(d) Obtain references for the directors if they are not known personally to the audit firm.

(e) Consult the previous auditors to ensure that there are no reasons behind the vacancy which the

new auditors ought to know. This is also a courtesy to the previous auditors.

Procedures after accepting nomination

(a) Ensure that the outgoing auditors' removal or resignation has been properly conducted in

accordance with the law.

The new auditors should see a valid notice of the outgoing auditors' resignation, or confirm that

the outgoing auditors were properly removed.

(b) Ensure that the new auditors' appointment is valid. The new auditors should obtain a copy of the

resolution passed at the general meeting appointing them as the company's auditors.

(c) Set up and submit a letter of engagement to the directors of the company (see below).

4.2 Requirements of ISQC 1

We touched on the bulk of the requirements of ISQC 1 Quality control for firms that perform audits and

reviews of financial statements, and other assurance and related services engagements in Chapter 4.

However, it also sets out standards and guidance in connection with the acceptance and continuance of

client relationships and specific engagements, which we shall consider here.

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ISQC 1.26 and 1.27

The firm shall establish policies and procedures for the acceptance and continuance of client relationships

and specific engagements, designed to provide the firm with reasonable assurance that it will only

undertake or continue relationships and engagements where the firm:

(a) Is competent to perform the engagement and has the capabilities, including time and resources, to

do so

(b) Can comply with relevant ethical requirements; and

(c) Has considered the integrity of the client, and does not have information that would lead it to

conclude that the client lacks integrity.

Such policies and procedures shall require:

(a) The firm to obtain such information as it considers necessary in the circumstances before

accepting an engagement with a new client, when deciding whether to continue an existing

engagement, and when considering acceptance of a new engagement with an existing client.

(b) If a potential conflict of interest is identified in accepting an engagement from a new or an existing

client, the firm to determine whether it is appropriate to accept the engagement.

(c) If issues have been identified, and the firm decides to accept or continue the client relationship or a

specific engagement, the firm to document how the issues were resolved.

The firm should carry out the following steps.

Step 1 Obtain relevant information

Step 2 Identify relevant issues

Step 3 If resolvable issues exist, resolve them and document that resolution

4.2.1 Obtain information

The standard outlines three general sources of information:

 The communications auditors must make with the previous auditors according to the IESBA Code

 Other relevant communications, for example with other parties in the firm, bankers or legal counsel

 Searches on relevant databases

In deciding whether to continue an engagement with an existing client, or to accept a new engagement

with an existing client, the firm should also consider significant matters that have arisen in the course of

the previous/existing relationship, for example, expansion into a business area in which the audit firm has

no experience.

4.2.2 Identify issues

The standard gives a list of matters that the auditors might consider in relation to the acceptance decision.

Matters to consider

Integrity of a

client

The identity and business reputation of the client's principal owners, key management,

related parties and those charged with governance

Nature of the client's operations, including its business practices

Information concerning the attitude of the client's principal owners, key management, those

charged with governance towards matters such as aggressive interpretation of accounting

standards/internal control environment

Whether the client is aggressively concerned with maintaining the firm's fees as low as

possible

Indications of an inappropriate limitation in the scope of work

Indications that the client might be involved in money laundering or other criminal activities

The reasons for the proposed appointment of the firm and non-reappointment of the

previous firm

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Matters to consider

Competence

of the firm

Do firm personnel have knowledge of relevant industries / subject matters?

Do firm personnel have experience with relevant regulatory or reporting requirements, or the

ability to gain the necessary skills and knowledge effectively?

Does the firm have sufficient personnel with the necessary capabilities and competence?

Are experts available, if needed?

Are individuals meeting the criteria and eligibility requirements to perform the engagement

quality control review available where applicable?

Is the firm able to complete the engagement within the reporting deadline?

In addition, the firm needs to consider whether acceptance would create any conflicts of interest.

ISQC 1.28

The firm shall establish policies and procedures on continuing an engagement and the client relationship

addressing the circumstances where the firm obtains information that would have caused it to decline the

engagement had that information been available earlier. Such policies and procedures shall include

consideration of:

(a) The professional and legal responsibilities that apply to the circumstances, including whether there

is a requirement for the firm to report to the person or persons who made the appointment or, in

some cases, to regulatory authorities, and

(b) The possibility of withdrawing from the engagement or from both the engagement and the client

relationship.

Such procedures might include discussions with client management and those charged with governance

and, if required, discussions with the appropriate regulatory authority.

The examination team wrote an article on this area entitled 'Acceptance decisions for audit and assurance

engagements'. The article discussed the engagement acceptance process, but with a particular emphasis

on the importance of establishing whether the preconditions for an audit are present.

Preconditions for an audit (see Section 5.2 below) were then examined in the next exam sitting. So make

sure you read Student Accountant, as it is likely to give a good indication of the topics that will be

examined, and the areas that will be emphasised.

Question Accepting nomination

You are a partner in Hamlyn, Jones and Co, a firm of Chartered Certified Accountants. You have just

successfully tendered for the audit of Lunch Co, a chain of sandwich shops across West London. The

tender opportunity was received cold, that is, the company and its officers are not known to the firm. The

company has just been incorporated and has not previously had an audit. You are about ready to accept

nomination.

(a) Explain the procedures you should carry out prior to accepting nomination.

In the course of your acceptance procedures you received a reference from a business contact of

yours concerning one of the five directors of Lunch Co, Mr V Loud. It stated that your business

contact had done some personal tax work for Mr Loud ten years previously, when he had found Mr

Loud to be difficult to keep in contact with and slow to provide information and he had suspected

Mr Loud of being less than entirely truthful when it came to his tax affairs. As a result of this

distrust, he had ceased to carry out work for him.

(b) Comment on the effect this reference would have on accepting nomination.

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Answer

(a) The following procedures should be carried out.

(i) Ensure that my audit team and I are professionally qualified to act and consider whether

there are ethical barriers to my accepting nomination.

(ii) Review the firm's overall work programme to ensure that there are sufficient resources to

enable my firm to carry out the audit.

(iii) Obtain references about the directors, as they are not known personally by me or anyone

else in my firm.

(b) The auditor must use their professional judgement when considering the responses they get to

references concerning new clients. The guidance cannot legislate for all situations so it does not

attempt to do so. In the circumstance given above there is no correct answer, so in practice an

auditor would have to make a justifiable decision which they would then document.

Matters to be considered

The reference raises three issues for the auditor considering accepting nomination:

(i) The issue that the director has been difficult to maintain a relationship with in the past

(ii) The issue that the director was slow to provide information in the past

(iii) The suspicion of a lack of integrity in relation to his tax affairs

The auditor must consider these in the light of several factors:

(i) The length of time that has passed since the events

(ii) What references which refer to the interim time say

(iii) The difference between accepting a role of auditing a company and personal tax work

(iv) The director's role in the company and therefore the audit

(v) The amount of control exercised by the director

(1) Relationships with other directors

(2) Influence

At this stage they should not be considering how highly they value the opinion of the referee. That

should have been considered before they sent the reference. At this stage they should only be

considering the implications of the reference for their current decision.

Auditing a company is different from auditing personal affairs in terms of obtaining information and

contacting personnel. In this case, the key issue is the question over the integrity of the director.

As we do not have information about interim references and details of the business arrangements it

is difficult to give a definite answer to this issue. However, Mr Loud is likely to only have limited

control over decisions of the entity being one of five directors, which might lead to the auditor

deciding that the reference was insufficient to prevent him accepting nomination. If Mr Loud were

the finance director, the auditor would be more inclined not to take the nomination.

You can see from the answer above that there are no easy answers to ethical questions. You might be asked

questions in the exam similar to the one above as part of a scenario highlighting several ethical issues. It is

not enough just to state the rules at this level, you must explain what the practical issues are and try to draw

conclusions based on the facts you know. Once qualified, you may face issues like this in your working life

and will have to make judgements like this in practice. That is what the exam is trying to imitate.

4.3 Money laundering

As we discussed in Chapter 1, accountants are now required to carry out specific client identification

procedures when accepting new clients.

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'Know your client' (KYC) is an important part of being in a position to comply with the law on money

laundering, because knowledge of the client is at the bottom of 'suspicion' in the context of making

reports about money laundering.

It is important from the outset of a relationship with a new client to obtain KYC information, such as:

 Expected patterns of business

 The business model of the client

 The source of the client's funds

When the client's money is to be handled by the professional, there is a higher than normal risk to the

professional, so even more detailed KYC procedures will be required.

4.4 Politically exposed persons (PEPs)

Being involved with PEPs may be particularly risky for firms, particularly in terms of reputation risks if

things go wrong.

Politically exposed persons (PEPs) are individuals who are, or have been, entrusted with prominent

public functions in a foreign country (for example, heads of state or senior politicians and officials).

Firms and institutions should have risk management systems set up to determine whether an individual is

a PEP when client identification procedures are being carried out. When a person has been identified as a

PEP, a member of senior management should approve establishing a business relationship with that

person.

The firm should then take reasonable measures to establish the source of that individual's wealth and

funds and conduct enhanced ongoing monitoring of the firm's relationship with that individual.

4.5 Client screening

Many audit firms use a client acceptance checklist to assist them in making the decision and ensuring that

ISQC 1 requirements are met.

5 Terms of the engagement 6/11

The auditor must agree terms of the audit engagement with relevant personnel at the client and must

ensure that preconditions for an audit exist in order to agree to those terms.

5.1 Objective of ISA 210

ISA 210 Agreeing the terms of audit engagements sets out best practice concerning this issue.

ISA 210.3

The objective of the auditor is to accept or continue an audit engagement only when the basis on which it

is to be performed has been agreed, through:

(a) Establishing whether the preconditions for an audit are present, and

(b) Confirming that there is a common understanding between the auditor and management and,

where appropriate, those charged with governance of the terms of the audit engagement.

The preconditions for an audit are the use by management (those charged with governance in the UK) of

an acceptable financial reporting framework in the preparation of the financial statements and the

agreement of management and, where appropriate, those charged with governance to the premise on

which an audit is conducted.

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5.2 Preconditions for an audit

The auditor needs to carry out tests to ensure that the preconditions for an audit outlined above are met.

ISA 210.6

In order to establish whether the preconditions for an audit are present, the auditor shall determine

whether the financial reporting framework to be applied in the preparation of the financial statements is

acceptable.

ISA 210 then goes on to require the auditor to ensure that management understands its responsibilities:

ISA 210.6

(i) For the preparation of the financial statements in accordance with the applicable financial reporting

framework, including where relevant their fair presentation;

(ii) 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;

(iii) To provide the auditor with:

a. Access to all information of which management is aware that is relevant to the preparation of

the financial statements;

b. Additional information that the auditor may request from management for the purpose of the

audit; and

c. Unrestricted access to persons within the entity from whom the auditor determines it

necessary to obtain audit evidence.

This will all be confirmed in the engagement letter.

If any of these conditions does not exist (eg the framework used is unacceptable or management does not

acknowledge its responsibilities), the auditor shall not accept the audit unless legally required to so do.

In addition, the auditor should not accept the engagement if those charged with governance impose a

limitation on the scope of the auditor's work likely to result in a disclaimer of opinion, again, unless the

auditor is legally required to accept the audit.

5.3 Clarifying the agreement

It is important when entering into a contract to provide services to ensure that both parties fully

understand their respective responsibilities and what the agreed services are. Misunderstanding could lead

to a breakdown in the relationship, and eventually result in legal action being undertaken.

5.4 Engagement letter

An auditor will outline the basis for the audit agreement in their tender to provide services. However, once

they have accepted nomination, it is vital that the basis of their relationship is discussed with the new client

and laid out in contractual form. This is the role of the engagement letter, which you should be familiar

with from your earlier studies.

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136 5: Obtaining and accepting professional appointments  Part C Practice management

Matters which SHALL be clarified in the engagement letter

 Objective and scope of the audit

 Auditor's responsibilities

 Management's responsibilities

 Identification of applicable financial reporting framework

 Expected form and contents of reports to be issued by the auditor and statement that there may be

circumstances when a report may differ from this

Matters which MAY be clarified in the engagement letter

 More detail on the scope of the audit, including references to law, auditing and other standards the

auditor follows

 Form of other audit communications

 Limitation of audit and internal controls and resulting risk that material misstatements may not be

detected

 Composition of the audit team and other practical arrangements

 Expectation that the management will provide written representations

 Agreement of management to make draft financial statements and other documents available in

good time

 Agreement of management to inform the auditors of facts that may affect the financial statements

before the date of the audit report

 Basis on which fees are computed and billing arrangements

 A request for management to acknowledge receipt of audit engagement letter and agree to its

terms

 Arrangements concerning the use of experts or other auditors

 Arrangements concerning the use of internal auditors and other entity staff

 Arrangements to be made with predecessor auditors (in the case of a new audit)

 Any restrictions of the auditor's liability

 References to any other agreements between parties

 Any obligations to provide working papers to other parties

An auditor shall not agree to a change in the terms of the engagement letter where there is no reasonable

justification for the change. If the terms of the engagement are changed, this should be recorded. If the

auditor is unable to agree to a change, they shall withdraw from the engagement and consider whether

they have an obligation to report the circumstances to other parties.

In practice, the auditors and the new client will meet to negotiate the terms of the audit agreement which

the auditor will later clarify in the engagement letter.

Question Engagement letter

ISA 210 Agreeing the terms of audit engagements lists a series of matters which shall be referred to in an

engagement letter. What are they?

Answer

The International Auditing Standard (ISA) includes the following matters in paragraphs 10 and A22 to A24.

 The objective of the audit of financial statements

 Management's responsibility for the financial statements and auditor's responsibility

 The scope of the audit, including reference to applicable legislation, regulations, or

pronouncements of professional bodies to which the auditor adheres

 The form of any reports or other communication of results of the engagement

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Part C Practice management  5: Obtaining and accepting professional appointments 137

 The fact that because of the test nature and other inherent limitations of an audit, together with the

inherent limitations of internal control, there is an unavoidable risk that even some material

misstatement may remain undiscovered

 Unrestricted access to whatever records, documentation and other information requested in

connection with the audit

 The agreement of management to make available to the auditor draft financial statements and any

accompanying other information in time to allow the auditor to complete the audit in accordance

with the proposed timetable

 Arrangements regarding the planning and performance of the audit

 Expectation of receiving from management written confirmation concerning representations made

in connection with the audit

 Request for the client to confirm the terms of engagement by acknowledging receipt of the

engagement letter

 Description of any other letters or reports the auditor expects to issue to the client

 Basis on which fees are computed and any billing arrangements

 Arrangements concerning the involvement of other auditors and experts in some aspects of the audit

 Arrangements concerning the involvement of internal auditors and other client staff

 Arrangements to be made with the predecessor auditor, if any, in the case of an initial audit

 Any restriction of the auditor's liability when such possibility exists

 A reference to any further agreements between the auditor and the client

The June 2011 exam contained a scenario with a potential new audit client which had not been audited

before. To score well, candidates needed to spot that a number of preconditions for an audit did not

appear to be present: management did not acknowledge its responsibility for preparing the financial

statements (it did not want to prepare a statement of cash flows), and wanted to restrict access to the

company's books and records (management did not want auditors to see board minutes).

To score well on this question you need to know your auditing standards well enough to spot when a

standard is relevant, even though it has not been asked for specifically by the requirement.

5.4.1 Recurring audits

In a recurring audit, the auditor is not required to send a new letter for each audit, but must ensure that

the client still understands the existing terms.

It may be necessary to revise the terms in the event of new circumstances arising, as you are aware from

previous studies.

5.5 Other changes in agreement terms

ISA 210.14

The auditor shall not agree to a change in the terms of the audit engagement where there is no reasonable

justification for doing so.

If there is reasonable justification for changing the terms, the new terms should be agreed on and

recorded.

If the auditor is not able to agree to new terms, and management refuses to let the firm continue on the

basis of the old ones, the auditors should:

 Withdraw, if legally entitled to

 Consider if it is necessary to report the circumstances to other parties such as the shareholders or

regulators

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138 5: Obtaining and accepting professional appointments  Part C Practice management

Chapter Roundup

 Common reasons for companies changing their auditors include audit fee, auditor not seeking re-election

and change in the size of company.

 ACCA's general rule on advertising is 'the medium shall not reflect adversely on the professional

accountant, ACCA or the accountancy profession'.

 It is generally inappropriate to advertise fees.

 Professional accountants may accept or pay referral fees if appropriate safeguards exist.

 When approaching a tender, it is important to consider both fees and practical issues.

 ISQC 1 sets out what a firm must consider and document in relation to accepting or continuing an

engagement which is the integrity of the client, whether the firm is competent to do the work, and whether

the firm meets ethical requirements in relation to the work.

 The auditor must agree terms of the audit engagement with relevant personnel at the client and must

ensure that preconditions for an audit exist in order to agree to those terms.

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Part C Practice management  5: Obtaining and accepting professional appointments 139

Quick Quiz

1 Name three reasons why an auditor might not seek re-election.

2 Fill in the blanks:

Advertising and promotional material should not:

– …………………………. the service offered …………………………. ………………………….

– Be …………………………., either directly or by implication

– Fall short of the requirements of the …………………………. ………………………….

…………………………. …………………………. ………………………….

3 Why should accountants not usually advertise fees?

4 List six practical issues that an auditor should consider when approaching a tender.

5 Draw a diagram showing the key stages in a tender, explaining what happens at each stage.

6 List three sources of information about a new client given in ISQC 1.

7 According to ISQC 1, when considering whether to accept an engagement with a new or existing client, the

auditors must consider whether a …………………………. …….. …………………………. arises.

8 List five matters which may be referred to in an engagement letter.

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140 5: Obtaining and accepting professional appointments  Part C Practice management

Answers to Quick Quiz

1 (1) Ethical reasons (eg fees)

(2) Another client in competition

(3) Disagreement over accounting policy

2 Discredit, by others, misleading, United Kingdom Advertising Standard Authority's Code of Advertising

and Sales Promotion (or equivalent)

3 The advert is unlikely to be detailed, and facts given about fees could mislead potential clients.

4 (1) Does the timetable fit with current work plan?

(2) Are suitable personnel available?

(3) Where will work be performed? Is it cost effective?

(4) Are specialist skills needed?

(5) Will staff need further training?

(6) If so, what is the cost?

5 Auditor considers if it is possible to undertake work at a

reasonable fee

Arrange meeting to obtain information prior to tender

Obtain knowledge of the business and the service required

Allocate potential staff to work plan and calculate fee by

reference to standard charge out rates

This could be in the form of:

– Letter

– Report

– Presentation

6 (1) Communications with existing/previous auditors

(2) Communications with other third parties (eg bankers / legal counsel)

(3) Relevant databases

7 Conflict of interest

8 See the answer to the question in Section 5.4 in the body of the chapter.

Now try the question below from the Practice Question Bank.

Number Level Marks Time

Q7 Examination 20 39 mins

APPROACH BY CLIENT

AGREE TO TENDER

MEETING

ESTIMATE AND

PLAN WORK

REQUIRED

ESTIMATE

FEE

PRESENT TENDER

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141

Audit of historical financial

information

P

A

R

T

D

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142

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143

Planning and risk

assessment

Introduction

The issue of audit planning should not be new to you. You learnt how to plan an

audit in your previous auditing studies. Why, then, is this chapter here? There

are three key reasons:

 To provide you with a technical update

 To revise the details that should be included in an audit plan and the

general considerations included in planning

 To consider some of the finer points of planning from the point of view

of the engagement partner, specifically to consider the issue of the risk

associated with the assignment (which is a personal risk to the partner

in the event of litigation arising)

Risk is an important factor in the audit. It falls into two categories:

 Specific assignment risk (known as audit risk), which you have studied

previously

 Business risk associated with the client, which may form a part of

inherent risk and therefore impacts on the audit

Risk is a key issue in an audit, and the most common approach to audits

incorporates a recognition of those risks in the approach taken. This and other

audit methodologies are compared in Section 2.

Topic list Syllabus reference

1 Revision: overview of audit planning D1, D2

2 Audit methodologies D1

3 Materiality D1

4 Risk B1, D1

5 Analytical procedures D1

6 Planning an initial audit engagement D1

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144 6: Planning and risk assessment  Part D Audit of historical financial information

Study guide

Intellectual level

D Audit of historical financial information

D1 Planning, materiality and assessing the risk of misstatement

(a) Define materiality and performance materiality and demonstrate how it

should be applied in financial reporting and auditing.

2

(b) Identify and explain business risks for a given assignment. 3

(c) Identify and explain audit risks for a given assignment. 3

(d) Identify and explain risks of material misstatement for a given assignment. 3

(e) Discuss and demonstrate the use of analytical procedures in the planning of

an assignment.

3

(f) Explain how the result of planning procedures determines the relevant audit

strategy.

2

(g) Explain the planning procedures specific to an initial audit engagement. 2

(h) Identify additional information that may be required to assist the auditor in

obtaining an understanding of the entity.

2

(i) Recognise matters that are not relevant to the planning of an assignment. 2

D2 Evidence

(b) Identify additional information that may be required to effectively carry out a

planned assignment.

2

B1 Code of ethics for professional accountants

(e) Discuss the importance of professional scepticism in planning and

performing an audit.

2

(f) Assess whether an engagement has been planned and performed with an

attitude of professional scepticism, and evaluate the implications.

3

Exam guide

Exam case study questions are often set in the context of audit planning, identifying risk areas and

considering the audit strategy to apply to the audit. This would usually come up in Section A of the exam.

1 Revision: overview of audit planning

Auditors must plan their work so that it is done effectively.

One of the competences you require to fulfil Performance Objective 18 of the PER is the ability to

determine the level of audit risk and risk areas, including considering any internal or external information

that may have implications for the audit, and to use this to document the audit plan, designing audit

programmes and planning audit tests for an internal or external audit. You can apply the knowledge you

gain from this chapter of the Study Text to help demonstrate this competence.

FAST FORWARD

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Part D Audit of historical financial information  6: Planning and risk assessment 145

1.1 ISA 200 Overall objectives of the independent auditor and the conduct

of an audit in accordance with international standards on auditing

ISA 200.11

In conducting an audit of financial statements, the overall objectives of the auditor are:

(a) To obtain reasonable assurance about whether the financial statements as a whole are free from

material misstatement, whether due to fraud or error, thereby enabling the auditor to express an

opinion on whether the financial statements are prepared, in all material respects, in accordance

with an applicable financial reporting framework; and

(b) To report on the financial statements, and communicate as required by the ISAs, in accordance

with the auditor's findings.

ISA 200 states that the key requirements for the auditor to obtain reasonable assurance and to express an

opinion are:

 Ethics: comply with relevant ethical requirements (ISA 200.14)

 Professional scepticism: plan and perform an audit with professional scepticism, recognising that

circumstances may exist that cause the financial statements to be materially misstated (ISA

200.15)

 Professional judgement: exercise professional judgement in planning and performing an audit

(ISA 200.16)

 Sufficient appropriate audit evidence and audit risk: obtain sufficient appropriate audit evidence

to reduce audit risk to an acceptably low level (ISA 200.17)

The auditor then fulfils these requirements by conducting the audit in accordance with ISAs.

1.2 ISA 300 Planning an audit of financial statements

ISA 300 Planning an audit of financial statements states that the objective of the auditor is to plan the audit

so that it will be performed in an effective manner.

The International Auditing Standard (ISA) refers to two documents, the overall audit strategy and the

audit plan. The overall audit strategy sets out in general terms how the audit is to be carried out.

Considerations in establishing the overall audit strategy include:

 Characteristics of the engagement

 Reporting objectives, timing of the audit and nature of communications

 Significant factors, preliminary engagement activities and knowledge gained on other engagements

 Nature, timing and extent of resources

The audit plan details specific procedures to be carried out to implement the strategy and complete the audit.

In the case of a smaller entity the strategy is likely to be a brief memorandum and the audit plan a series of

tailored standard audit programmes.

ISA 300 tends to conceive of audit planning as a series of activities rather than as a single event: the

planning is not just something written out at the start of the audit, which is then stuck to rigidly, but is an

activity that goes on throughout the audit process. For example, audit procedures need to be performed

with their planned objectives in mind, and it may be necessary to revise the audit plan during the course of

the audit if significant new information or events come to light.

Amendments to ISA 200 and ISA 300 in 2015 emphasised that the financial statements include the

disclosures, and that audit planning should include considering how to audit disclosures. This then carries

advantages for the audit overall, helping the auditor to identify important issues such as changes in the

entity's environment, changes in the financial reporting framework, or the need to involve an auditor's

expert in relation to some disclosures.

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1.3 ISA 315 Identifying and assessing the risks of material misstatement

through understanding the entity and its environment 6/09, 6/12

The objective of ISA 315 (Revised) Identifying and assessing the risks of material misstatement through

understanding the entity and its environment is as follows.

ISA 315.3

The objective of the auditor is to identify and assess the risks of material misstatement, whether due to

fraud or error, at the financial statement and assertion levels, through understanding the entity and its

environment, including the entity's internal control, thereby providing a basis for designing and

implementing responses to the assessed risks of material misstatement.

The emphasis here is on risk and understanding. ISA 315 is all about getting away from the idea of the

audit as 'checking' transactions, and emphasises instead the need to gain a real understanding of the

entity first, and then to use this to work out where the greatest risks of material misstatement might be.

ISA 315 is examined indirectly in virtually every P7 exam Question One, where you are often required to

identify, explain or evaluate risks, be they audit risks, risks of material misstatement or simply business

risks.

1.3.1 What do we need to get an understanding of?

The ISA sets out a number of areas of the entity and its environment that the auditor should gain an

understanding of.

Areas to gain an understanding of

Industry, regulatory and other external factors

Nature of the entity

Selection, application and reasons for changes of accounting policies

Objectives, strategies and related business risks

Measurement and review of the entity's financial performance

Internal control

ISA 315 was revised in March 2012 as part of the IAASB's project on using the work of internal auditors to

require the external auditor to obtain an understanding of internal audit.

Amendments to ISA 315 (in 2015) point out that as well as understanding how information is obtained

from within the general and subsidiary ledgers, auditors must gain an understanding of the system

relating to information obtained outside of the ledgers.

Understand the entity, in order to ...

Design and

perform audit

procedures

Identify and assess

risks of material

misstatement

Provide a frame of

reference for

judgements

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Part D Audit of historical financial information  6: Planning and risk assessment 147

Paper P7 questions in this area are likely to give you a scenario, and then a requirement such as 'Identify

and explain the risks of material misstatement' in the scenario. You can use this list – and the one below –

to help you generate ideas when answering such a question. You can even show off to your marker by

stating that applying ISA 315 would require you to gain an understanding of these areas.

A word of warning, though: do not be tempted to simply recite these lists in the exam. Your answers need

to be very specific about addressing the requirement and the scenario. If your answer looks like a prelearned

list then your marker is not likely to give you many marks – if any at all!

1.3.2 How do we get this understanding?

The ISA sets out ways of getting this understanding:

Methods of obtaining an understanding of the entity

Enquiries of management (and others within the entity)

Analytical procedures (on both financial and non-financial data)

Observation and inspection

Audit team discussion of the susceptibility of the financial statements to material misstatement

Prior period knowledge (but should check that it is still relevant)

The auditors must use a combination of the top three techniques, and must engage in the discussion for

every audit. The auditor may use their prior period knowledge, but must carry out procedures to ensure

that there have not been changes in the year meaning that it is no longer valid.

For each risk identified, ISA 315 requires the auditor to take the following steps.

Step 1 Identify risks throughout the process of obtaining an understanding of the entity

Step 2 Assess whether the identified risks relate more pervasively to the financial statements as a

whole

Step 3 Relate the risks to what can go wrong at the assertion level, and assess the controls in

place to address each risk

Step 4 Consider the likelihood of misstatement and whether the risks are of a magnitude that

could result in a material misstatement

Throughout this process, the size of the entity being audited must be considered. For example, in a small

entity there is likely to be limited segregation of duties. This may be compensated for by increased

management oversight, however this in turn increases the risk of override of controls.

Case Study

The audit team at Ockey Co has been carrying out procedures to obtain an understanding of the entity. In

the course of making enquiries about the inventory system, they have discovered that Ockey Co designs

and produces tableware to order for a number of high street stores. It also makes a number of standard

lines of tableware, which it sells to a number of wholesalers. By the terms of its contracts with the high

street stores, it is not entitled to sell uncalled inventory designed for them to wholesalers. Ockey Co

regularly produces 10% more than the high street stores have ordered, in order to ensure that they meet

requirements when the stores do their quality control check. Certain stores have more stringent control

requirements than others and regularly reject some of the inventory.

The knowledge above suggests two risks, one that the company may have obsolescent inventory, and another

that if their production quality standards are not sufficiently high then they risk losing custom.

We shall look at each of these risks in turn and relate them to the assertion level.

Inventory

If certain of the inventory is obsolescent due to the fact that it has been produced in excess of the

customer's requirement and there is no other available market for it, then there is a risk that inventory as a

whole in the financial statements will not be carried at the appropriate value. Given that inventory is likely

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148 6: Planning and risk assessment  Part D Audit of historical financial information

to be a material balance in the statement of financial position of a manufacturing company, and the value

could be up to 10% of the total value, this has the capacity to be a material misstatement.

The factors that will contribute to the likelihood of these risks causing a misstatement are such matters as:

 Whether management regularly review inventory levels and scrap items that are obsolescent

 Whether such items are identified and scrapped at the inventory count

 Whether such items can be put back into production and changed so that they are saleable

Losing custom

The long-term risk of losing custom is that in the future the company will not be able to continue as a

going concern (we shall revise going concern in Chapter 8). A further risk is of customer disputes leading

to sales returns which may not be recognised, in which case sales and receivables could be overstated.

However, it appears less likely that this would be a material problem in either area, as the issue is likely to

be restricted to a few customers, and only a few sales to those customers.

Again, review of the company's controls over the recording of sales and the debt collection procedures of

the company would indicate how likely these risks to the financial statements are to materialise.

Some risks identified may be significant risks.

Significant risks are those that require special audit consideration.

The following factors indicate that a risk might be significant.

 Risk of fraud

 The degree of subjectivity in the financial information

 Unusual transactions

 Significant transactions with a related party

 Complexity of the transactions

Try to be on the lookout for these factors in exam questions/scenarios. If you spot one – and mentioning it

is relevant to the requirement – then try to use the term 'significant risk'. This will signal to the marker that

you are applying the ISA to the scenario.

Routine, non-complex transactions are less likely to give rise to significant risk than unusual transactions

or matters of director judgement because the latter are likely to have more management intervention,

complex accounting principles or calculations, greater manual intervention or there is less opportunity for

control procedures to be followed.

When the auditor identifies a significant risk, if they haven't done so already, they should evaluate the

design and implementation of the entity's controls in that area. If management has not implemented

appropriate internal controls, then this may point to a significant deficiency in internal control.

Additional information

The auditor will often need to obtain additional information in order to gain the required understanding of

the entity, and in order to perform planned procedures. Much of the time the auditor only has incomplete

information about the entity being audited, and it is important to be able to recognise when more is

needed.

This can be a bit like performing an audit procedure, because the auditor must go out and get the

information in order to find something out about the entity. The difference is that at this stage, the auditor

is obtaining preliminary information that it can then use to plan and perform the detailed audit procedures.

For instance, a client might have made an investment during the year which it classifies as an associate.

The auditor will need to obtain information about this purchase – eg the purchase agreement – in order to

determine whether it really is an associate. The auditor must also ask management why the purchase was

made, as part of understanding the entity's objectives and strategies. This must be all be done at the

planning stage because it will then determine the auditor's assessment of risk and the audit procedures

which must then be performed – these would be very different if the investment was actually a subsidiary,

for example.

Key term

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Part D Audit of historical financial information  6: Planning and risk assessment 149

One approach to questions in this area (to identify further information needed) is to think about:

1. What risks might there be in relation to a particular issue (eg that an investment is classified

incorrectly); then

2. What information would help us to plan our procedures (eg the purchase agreement).

P7 exams often contain a requirement to identify additional information needed, eg in relation to audit

risks identified in a scenario. These are often easy marks, and to get them you need to:

 Be specific about what information you need

 State why you need the information.

For example, Question One of the June 2014 paper featured a company which had material investment

properties. Further information was needed on whether there had been any additions or disposals during

the year.

It is not necessary at this stage to speculate in too much detail about what might go wrong in each area.

Questions will usually contain a little bit of information – eg that a company runs a bonus scheme for

managers – but with clear gaps in it – eg how the bonuses are determined will not be stated. All you need

to do is to point out this gap and say what information is needed to fill it.

Additional information does not have to be a document, but can be eg the reason why management has

done something in the scenario.

1.4 ISA 330 The auditor's responses to assessed risks

ISA 330 The auditor's responses to assessed risks states that the objective of the auditor is to 'obtain

sufficient, appropriate audit evidence regarding the assessed risks of material misstatement, through

designing and implementing appropriate responses to these risks'.

Overall responses include emphasising to the audit team the need for professional scepticism, assigning

additional/alternative staff to the audit, using experts, providing more supervision on the audit and

incorporating more unpredictability into the audit.

The evaluation of the control environment that will have taken place as part of the assessment of the

client's internal control systems will help the auditor determine whether they are going to take a

substantive approach (focusing mainly on substantive procedures) or a combined approach (tests of

control and substantive procedures).

In accordance with this approach, the auditor should then determine further audit procedures designed to

address the assessed risks.

The auditor must carry out substantive procedures on material items. In addition, the auditor must carry

out the following substantive procedures.

 Agreeing the financial statements to the underlying accounting records

 Examining material journal entries

 Examining other adjustments made in preparing the financial statements

1.5 Documentation requirements

ISAs 315 and 330 contain a number of documentation requirements. The following matters should be

documented.

 The discussion among the audit team concerning the susceptibility of the financial statements to

material misstatements, including any significant decisions reached

 Key elements of the understanding gained of the entity including the elements of the entity and its

control specified in the ISA as mandatory, the sources of the information gained and the risk

assessment procedures carried out

 The identified and assessed risks of material misstatement

 Significant risks identified and related controls evaluated

 The overall responses to address the risks of material misstatement

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150 6: Planning and risk assessment  Part D Audit of historical financial information

 Nature, extent and timing of further audit procedures linked to the assessed risks at the assertion

level

 If the auditors have relied on evidence about the effectiveness of controls from previous audits,

conclusions about how this is appropriate

Question Revision of audit planning

You have been informed by the senior partner of your firm that you are to be in charge of the audit of a

new client, Peppermint Chews, for the year ended 31 December 20X4. She tells you that the company is

engaged in the manufacture and wholesaling of sweets and confectionery, with revenue of approximately

$10,000,000 and a workforce of about 150. The company has one manufacturing location, sells mainly to

the retail trade but also operates ten shops of its own. The senior partner asks you to draw up an outline

audit plan for the assignment showing when you anticipate visits to the client will be made and what kind

of work will be carried out during each visit. The deadline for your audit report is 28 February 20X5.

Required

Draw up an outline plan for the audit of Peppermint Chews for the year ended 31 December 20X4,

including:

(a) Approximate timing in the company's year of each stage of the audit of this new client. State why

you have selected the approximate timing

(b) The objective of each stage

(c) The kind of work that will be carried out at each stage

Answer

Initial visit

(a) Timing. As this is a new client, this visit should take place as soon as possible after the terms of

engagement have been agreed with and accepted by the directors of Peppermint Chews.

(b) Objective. To build up a background knowledge of the company to assist in the more detailed

planning of audit work that will be required at a later stage.

(c) Audit work. We shall need to obtain details of the following:

(i) The history and development of the company

(ii) The nature of the commercial environment within which the company operates

(iii) The nature of the company's products and manufacturing processes

(iv) The plan of organisation within the company

(v) The accounting and internal control systems operating within the company

(vi) The accounting and other records of the company and how they are maintained

The above will be obtained using such techniques as interview, observation, reviewing the client's

systems documentation, and so on.

We shall not at this stage carry out detailed tests of controls on the company's systems, but we should

carry out 'walk-through' tests to gain confirmation that the systems outlined to us in theory appear to

operate that way in practice.

Interim visit(s)

(a) Timing. As this is the first audit of Peppermint Chews, it may, in view of the extra work involved, be

necessary to have more than one interim visit. If we decided that only one such visit would be

needed, however, then ideally it should take place reasonably close to the year end, in, say, October

20X4. If it were decided that more than one visit were needed, then perhaps the first interim visit

should take place in April/May 20X4.

(b) Objective. The purpose of interim audits is to carry out detailed tests on a client's accounting and

internal control systems to determine the reliance that may be placed thereon.

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Part D Audit of historical financial information  6: Planning and risk assessment 151

(c) Audit work. Following the initial visit to the client, we should have completed our documentation of

the client's systems using narrative notes and flowcharts. We should also have assessed the

strengths and deficiencies of the systems and determined the extent to which we wish to place

reliance on them.

Given effective controls, we shall select and perform tests designed to establish compliance with

the system. We shall therefore carry out an appropriate programme of tests of controls. The

conclusion from the results may be either:

(i) That the controls are effective, in which case we shall only need to carry out restricted

substantive procedures; or

(ii) That the controls are ineffective in practice, although they had appeared strong on paper, in

which case we shall need to carry out more extensive substantive procedures.

After carrying out tests of controls, it is normal practice, as appropriate, to send management a

letter identifying any deficiencies and making recommendations for improvements.

Final visit

(a) Timing. This may well be split into a pre-final visit in December 20X4 and a final audit early in

20X5, or it could be a continuous process.

(b) Objective. We should visit the client prior to the year end to assist in the planning of the final audit

so as to agree with the client detailed timings such as year-end inventory count and trade

receivables circularisation, preparation of client schedules, finalisation of accounts and so forth.

The object of the final audit is to carry out the necessary substantive procedures, these being

concerned with substantiating the figures in the accounting records and, eventually, in the financial

statements themselves. The completion of these tests, followed by an overall review of the financial

statements, will enable us to decide whether we have obtained 'sufficient appropriate audit

evidence to be able to draw reasonable conclusions' so that we are in a position to express an

opinion on the company's financial statements, the expression of an opinion in their audit report

being the primary objective of the audit.

(c) Audit work. The audit work to be carried out at this final stage would include:

 Consideration and discussion with management of known problem areas

 Attendance at inventory count

 Verification of assets and liabilities / income and expenditure

 Following up interim audit work

 Carrying out review of events after the reporting period

 Analytical procedures

 Obtaining representations from management

 Reviewing financial statements

 Drafting the audit report

2 Audit methodologies

The audit strategy document will describe the audit methodology to be used in gathering evidence. This

section describes the main methodologies currently used by auditors.

Exam questions in this area are as always likely to involve application to a scenario. There are unlikely to

be many marks available for pre-learned knowledge about the various kinds of audit methodology.

Instead, you will need to stick to the scenario to explain how the results of planning procedures determine

the audit strategy. The audit methodologies discussed in this section may be a good starting point for

doing this.

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152 6: Planning and risk assessment  Part D Audit of historical financial information

2.1 Risk-based audit

Risk-based auditing refers to the development of auditing techniques that are responsive to risk factors in

an audit. As we set out in Section 4, the auditors apply judgement to determine what level of risk pertains

to different areas of a client's system and devise appropriate audit tests.

This approach should ensure that the greatest audit effort is directed at the areas in which the financial

statements are most likely to be misstated, so that the chance of detecting misstatements is improved and

time is not spent on unnecessary testing of 'safe' areas.

The increased use of risk-based auditing reflects two factors.

(a) The growing complexity of the business environment increases the danger of fraud or

misstatement. Factors such as the developing use of computerised systems and the growing

internationalisation of business are relevant here.

(b) Pressures are increasingly exerted by audit clients for the auditors to keep fee levels down while an

improved level of service is expected.

The risk approach is best illustrated by a small case study.

Case Study

Audit risk approach

Your audit firm has as its client a small manufacturing company. This company owns the land and buildings

in its statement of financial position, which it depreciates over 50 years (buildings only) and has always

been valued at cost.

The other major item in the statement of financial position is inventory.

Looking at these two items from the point of view of the audit firm, the following conclusions can be

drawn.

(1) There is only a small chance that the audit engagement partner will draw an inappropriate

conclusion about land and buildings.

(2) In a manufacturing company, inventory is likely to be far more complex. There may be a significant

number of lines to count and value, the quantity will change all the time, inventory may grow

obsolete. The chance of the audit engagement partner drawing an inappropriate conclusion about

inventory is higher than the risk in connection with land and buildings.

The auditors will have to do less work to render audit risk acceptable for land and buildings than on

inventory. The audit risk approach will mean doing less work on land and buildings than on inventory.

2.2 'Top-down' approach 12/12

With a 'top-down' approach (also known as the business risk approach) controls testing is aimed at high

level controls, and substantive testing is reduced.

ISA 315 requires that auditors consider the entity's process for assessing its own business risks, and the

impact that this might have on the audit in terms of material misstatements. Auditors consider:

 What factors lead to the problems which may cause material misstatements?

 What can the audit contribute to the business pursuing its goals?

This 'business risk' approach was developed because it is sometimes the case that the auditors believe the

risk of the financial statements being misstated arises predominantly from the business risks of the

company.

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Part D Audit of historical financial information  6: Planning and risk assessment 153

The table below highlights some of the factors that exist.

Principal risk Immediate financial statement implications

(1) Economic pressures causing reduced unit sales

and eroding margins

Inventory values (IAS 2)

Going concern

(2) Economic pressures resulting in demands for

extended credit

Receivables recoverability

(3) Product quality issues related to inadequate

control over supply chain and transportation

damage

Inventory values – net realisable value and

inventory returns

(4) Customer dissatisfaction related to inability to

meet order requirements

Going concern

(5) Customer dissatisfaction related to invoicing

errors and transportation damage

Receivables valuation

(6) Unacceptable service response call rate related

to poor product quality

Going concern

Litigation – provisions and contingencies

Inventory – net realisable value

(7) Out of date IT systems affecting management's

ability to make informed decisions

Anywhere

The business risk audit approach tries to mirror the risk management steps that have been taken by the

directors. In this way, the auditor will seek to establish that the financial statement objectives have

been met, through an investigation into whether all the other business objectives have been met by the

directors.

This approach to the audit has been called a 'top-down' approach because it starts at the business and its

objectives and works back down to the financial statements, rather than working up from the financial

statements which has historically been the approach to audit.

The other key element of a business risk approach is that as it is focused on the business more fully,

rather than the financial statements, there is greater opportunity for the auditor to add value to the client's

business and to assist in managing the risks that the business faces.

2.2.1 Advantages of business risk approach

There are a number of reasons why firms who use the business risk approach prefer it to historic

approaches:

 Added value is given to clients, as the approach focuses on the business as a whole.

 Audit attention focused on high level controls with extensive use of analytical procedures,

increases audit efficiency and therefore reduces cost.

 It does not focus on merely routine processes, which technological developments have rendered

less prone to error than has historically been the case.

 It responds to the importance placed by regulators and the Government on corporate governance.

 Engagement risk (risk of auditor being sued) is lower as a result of broader understanding of the

client's business and practices.

2.3 Other audit strategies

In addition to the 'top-down' or business risk approach, a variety of different audit strategies may be

adopted. These have been covered in your previous studies, and will only be mentioned briefly here. They

include:

 Systems audit

 Balance sheet approach

 Transaction cycle approach

 Directional testing

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154 6: Planning and risk assessment  Part D Audit of historical financial information

2.3.1 Systems audit

An auditor may predominantly test controls and systems, but substantive testing can never be eliminated

entirely.

2.3.2 Balance sheet approach

This is the most common approach to the substantive part of the audit, after controls have been tested. It

is named after the old name for the statement of financial position, the 'balance sheet'.

The statement of financial position gives a snapshot of the financial position of the business at a point in

time. It follows that if it is not a misstatement, and the previous snapshot was fairly stated, then it is

reasonable to undertake lower-level testing on the transactions which connect the two snapshots, for

example, analytical procedures.

Under this approach, therefore, the auditors seek to concentrate efforts on substantiating the closing

position in the year, shown in the statement of financial position, having determined that the closing

position from the previous year (also substantiated) has been correctly transferred to the opening position

in the current year.

In some cases, particularly small companies, the business risks may be strongly connected to the fact that

management is concentrated on one person. Another feature of small companies may be that their

statement of financial position is uncomplicated and contains one or two material items, for example,

receivables or inventory. When this is the case, it is often more cost effective to undertake a highly

substantive statement of financial position audit than to undertake a business risk assessment, as it is

relatively simple to obtain the assurance required about the financial statements from taking that

approach.

However, when not undertaken in conjunction with a risk-based approach or systems testing, the level of

detailed testing can be high in a balance sheet approach, rendering it costly.

2.3.3 Transaction cycle approach

Cycles testing is in some ways closely linked to systems testing, because it is based on the same systems.

However, here we are looking at them in terms of substantive testing.

When auditors take a cycles approach, they test the transactions which have occurred, resulting in the

entries in the statement of profit or loss (for example, sales transactions, inventory purchases, wages

payments, other expenses).

They would select a sample of transactions and test that each transaction was complete and processed

correctly throughout the cycle. In other words, they substantiate the transactions which appear in the

financial statements.

The auditors may assess the systems of a company as ineffective. In this case, they would carry out

extensive substantive procedures. The substantive approach taken in this situation could be a transaction

cycles approach. In fact, if systems have been adjudged to be ineffective, the auditor is more likely to take

a transaction cycles approach than a balance sheet approach, as it will be essential that the auditor

substantiates that the transactions have been recorded properly in spite of the poor systems.

2.3.4 Directional testing

Directional testing is a method of undertaking detailed substantive testing. Substantive testing seeks to

discover misstatements and omissions, and the discovery of these will depend on the direction of the test.

Broadly speaking, substantive procedures can be said to fall into two categories:

(a) Tests to discover misstatements (resulting in over- or under-statement). These tests will start with

the accounting records in which the transactions are recorded and check from the entries to

supporting documents or other evidence. Such tests should detect any over-statement and also

any under-statement through causes other than omission.

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Part D Audit of historical financial information  6: Planning and risk assessment 155

(b) Tests to discover omissions (resulting in under-statement). These tests must start from outside

the accounting records and then check back to those records. Understatements through omission

will never be revealed by starting with the account itself, as there is clearly no chance of selecting

items that have been omitted from the account.

The concept of directional testing derives from the principle of double entry bookkeeping, in that for every

debit there is a corresponding credit (assuming that the double entry is complete and that the accounting

records balance). Therefore, any misstatement of a debit entry will result in either a corresponding

misstatement of a credit entry or a misstatement in the opposite direction, of another debit entry.

By designing audit tests carefully, the auditors are able to use this principle in drawing audit conclusions,

not only about the debit or credit entries that they have directly tested but also about the corresponding

credit or debit entries that are necessary to balance the books. Tests are therefore designed in the

following way.

The matrix set out below demonstrates how directional testing is applied to give assurance on all account

areas in the financial statements.

Primary test also gives comfort on

Type of account Purpose of primary test Assets Liabilities Income Expenses

Assets Overstatement (O) U O O U

Liabilities Understatement (U) U O O U

Income Understatement (U) U O O U

Expense Overstatement (O) U O O U

A test for the overstatement of an asset simultaneously gives comfort on understatement of other assets,

overstatement of liabilities, overstatement of income and understatement of expenses.

So, by performing the primary tests shown in the matrix, the auditors obtain audit assurance in other audit

areas. Successful completion of the primary tests will therefore result in them having tested all account

areas both for overstatement and understatement.

The major advantage of the directional audit approach is its cost effectiveness.

(a) Assets and expenses are tested for overstatement only, and liabilities and income for

understatement only, that is, items are not tested for both overstatement and understatement.

(b) It audits directly the more likely types of transactional misstatement, ie unrecorded income and

improper expense (arising intentionally or unintentionally).

Directional testing is particularly useful when there is a high level of detailed testing to be carried out, for

example, when the auditors have assessed the company's controls and accounting system as ineffective.

Question Audit strategy

As audit senior, you have recently attended a meeting with the managing director of Go Shop Co (audit

client) and the new audit partner assigned to the audit, Mike Kenton, who has recently joined your firm,

Eastlake and Pond. The audit partner is familiarising himself with the client.

Go Shop Co is a large limited liability building company set up by John Yeams, who has been managing

director since incorporation. It operates in the south of the country, purchasing land outside of major

towns and building retail parks, which the company then manages. You are familiar with the client, as you

have taken part in the audit for the last three years. The other key member of the board is Kathleen Hadley,

who set up the business with John Yeams and is finance director. Kathleen is a qualified accountant, and

the accounting systems and procedures at Go Shop Co have always appeared sound.

You took minutes of the meeting, which are given below.

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156 6: Planning and risk assessment  Part D Audit of historical financial information

Minutes of a meeting between Mike Kenton and John Yeams, 30 March 20X2

MK introduced himself to JY and asked for a brief history of the business, which was given. Currently, the

majority of income is from the property management side, as the building market is becoming saturated.

With interest rates set to rise, JY is less keen to borrow and build in the current climate.

MK asked JY whether a recent spate of terrorist bomb attacks had had any effect on business. JY

commented that he had been given the impression that retail was down and that customers were staying

away from the retail centres – but he felt that some of that could be attributed to a rise in interest rates and

was likely to be temporary. The first months of the year are always poor for retail …

MK asked whether there had been a rise in empty units in the retail centres. JY said there had been a small rise.

MK asked JY about his views in relation to the current proposed legislation before the Government

concerning quality standards in the building trade. JY commented that it seemed like a 'load of nonsense'

to him, and expressed some dissatisfaction with the current political situation … MK pressed the matter,

enquiring as to JY's opinion on the likely effects on his business were more stringent standards to be

required in the future. JY is of the firm belief that it would not be passed. MK expressed his fear that the

legislation was more than likely to be passed, and would have far-reaching and expensive effects on most

builders in the country. JY repeated some of his previous comments about politicians.

MK enquired as to whether there were any anticipated developments in the business that he should know

about. JY made reference to KH's plans to retire from full-time work in the business. MK asked how JY

was going to replace her. JY commented that he was hoping to persuade her to stay on as she deals with

all the financial side, and he'd be lost without her. MK tried to enquire how firm her retirement plans were,

but JY was not forthcoming.

After the meeting, Mike Kenton asked you to ring Kathleen and discuss her plans. She confirmed that she

does plan to retire. She informed you that she plans to emigrate to Australia, and is not keen to put back

her plans. She asked about the possibility of Eastlake and Pond assisting in the recruitment process for

her replacement, as she does not feel that John Yeams has the technical ability to recruit someone without

her, and has not accepted her plans enough to recruit before her retirement. She said that she has even

wondered about the possibility of someone being seconded to the company from Eastlake and Pond to

cover her position after she has left and before her replacement is found.

Mike is keen to reappraise the audit strategy taken towards the audit of Go Shop, as he feels the audit

could be conducted more efficiently than it has been in the past. Historically the audit has been highly

substantive.

Required

(a) Identify and explain the key business risks that exist at Go Shop.

(b) Explain what is meant by the 'business risk approach' to an audit.

(c) Propose and justify a strategy for the audit of Go Shop.

(d) Discuss the ethical implications for the audit of the two suggestions made by Kathleen.

Approaching the answer

Question Audit strategy

As audit senior, you have recently attended a meeting with the managing director of Go Shop Co (audit

client) and the new audit partner assigned to the audit, Mike Kenton, who has recently joined your firm,

Eastlake and Pond. The audit partner is familiarising himself with the client.

Go Shop Co is a large limited liability building company set up by John Yeams, who has been managing

director since incorporation. It operates in the south of the country, purchasing land outside of major

towns and building retail parks, which the company then manages. You are familiar with the client, as you

Volatile industry

Cumulative knowledge and

understanding

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Part D Audit of historical financial information  6: Planning and risk assessment 157

have taken part in the audit for the last three years. The other key member of the board is Kathleen Hadley,

who set up the business with John Yeams and is finance director. Kathleen is a qualified accountant, and

the accounting systems and procedures at Go Shop Co have always appeared sound.

You took minutes of the meeting, which are given below.

Minutes of a meeting between Mike Kenton and John Yeams, 30 March 20X2

MK introduced himself to JY and asked for a brief history of the business, which was given. Currently, the

majority of income is from the property management side, as the building market is becoming saturated.

With interest rates set to rise, JY is less keen to borrow and build in the current climate.

MK asked JY whether a recent spate of terrorist bomb attacks had had any effect on business. JY

commented that he had been given the impression that retail was down and that customers were staying

away from the retail centres – but he felt that some of that could be attributed to a rise in interest rates and

was likely to be temporary. The first months of the year are always poor for retail ...

MK asked whether there had been a rise in empty units in the retail centres. JY said there had been a small

rise.

MK asked JY about his views in relation to the current proposed legislation before the Government

concerning quality standards in the building trade. JY commented that it seemed like a 'load of nonsense'

to him, and expressed some dissatisfaction with the current political situation … MK pressed the matter,

enquiring as to JY's opinion on the likely effects on his business were more stringent standards to be

required in the future. JY is of the firm belief that it would not be passed. MK expressed his fear that the

legislation was more than likely to be passed, and would have far-reaching and expensive effects on most

builders in the country. JY repeated some of his previous comments about politicians.

MK enquired as to whether there were any anticipated developments in the business, which he should

know about. JY made reference to KH's plans to retire from full-time work in the business. MK asked how

JY was going to replace her. JY commented that he was hoping to persuade her to stay on as she deals

with all the financial side, and he'd be lost without her. MK tried to enquire how firm her retirement plans

were, but JY was not forthcoming.

After the meeting, Mike Kenton asked you to ring Kathleen and discuss her plans. She confirmed that she

does plan to retire. She informed you that she plans to emigrate to Australia, and is not keen to put back

her plans. She asked about the possibility of Eastlake and Pond assisting in the recruitment process for

her replacement, as she does not feel that John Yeams has the technical ability to recruit someone without

her, and has not accepted her plans enough to recruit before her retirement. She said that she has even

wondered about the possibility of someone being seconded to the company from Eastlake and Pond to

cover her position after she has left and before her replacement is found.

Good control

environment

Impact on

any

borrowing

Going concern

Knock on

going

concern

issues? Pressure on major

customers

Compliance risk if legislation is passed – likely?

And going concern?

Operational risk – loss of key staff member, and implications for FS

and control environment

Independence

issues

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158 6: Planning and risk assessment  Part D Audit of historical financial information

Mike is keen to reappraise the audit strategy taken towards the audit of Go Shop, as he feels the audit

could be conducted more efficiently than it has in the past. Historically the audit has been highly

substantive.

Answer plan

(a) Business risks (b) Business risk approach (BRA)

Operational – industry

(i) Building industry volatile and apparently

saturated

(ii) Retail management – retail industry

volatile and affected by bomb threats /

interest rates

Define BRA – link to Audit Risk Approach,

etc …

Indicator of going concern problem?

Receivables' recoverability

Tangible non-current assets impairment

Operational – personnel

About to lose key management on the financial

side and no current plans to replace her. Could

severely affect systems in the finance department

– could have knock-on effects on sales and

purchases relationships – suppliers/customers.

Effect on financial statements (FS)

themselves – more prone to error?

Also, impact on control environment?

Finance

Likely that Go Shop has high borrowings against

buildings built and managed – therefore increase

in interest rates could be bad – particularly if they

have borrowed lots while interest rates were low.

Going concern

Interest rates

Compliance

Potential statute concerning quality standards:

(i) Far reaching

(ii) Expensive

(iii) Going concern?

Going concern

(c) Strategy

BRA – have identified business risk

Key risks to financial statements as identified above – linked strongly … seems reasonable to

extend audit risk approach in this way.

Control environment strong – therefore reasonable to do controls testing – but question if this will

still be the case when KH leaves.

Also, senior has cumulative knowledge and understanding – therefore analytical procedures will be

good. Explanations available for analytical review.

BRA is generally more efficient than highly substantive – due to top-down procedures.

(d) Ethical implications

Recruitment mustn't make management decisions.

Secondment – must ensure that there are 'Chinese walls' between staff on audit team and

seconded staff – may represent too great a loss of objectivity due to familiarity.

Link with senior's cumulative knowledge and understanding – analytical

review? Use of business risk approach. Control environment is sound …

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Part D Audit of historical financial information  6: Planning and risk assessment 159

Answer

(a) Key business risks at Go Shop

Operational – industry

The building industry is generally considered to be a volatile industry and sensitive to changes in

economic climate. The managing director has identified that the particular market that the company

operates in, retail parks, has become saturated. Go Shop's business is therefore likely to be volatile

generally and the market for the services Go Shop provides is saturated. This is an operational risk

– what will Go Shop do if it does not do what it has done historically?

The company is not only strongly connected with the building industry but also the retail industry.

This is another industry that is volatile. It has recently been affected by higher interest rates and

reduced consumer spending. It has also suffered due to the bomb threats made against retail

parks, which have discouraged consumers from shopping.

Operational – personnel

The business is about to lose a key member of personnel on the financial side, and there appear to

be no current plans to replace her. This could severely affect systems in the finance department,

which could have a knock-on effect on crucial supplier and customer relations and therefore the

operations of the wider business.

Finance

It is likely that Go Shop has a high level of borrowings secured on the buildings that they have

built and now manage. If this is the case, the increase in interest rates will adversely affect their

business directly in the form of interest on these loans. This may be particularly severe if they have

overborrowed when interest rates were low.

Compliance

There is currently legislation before the Government that is likely to have far-reaching effects on the

operations of Go Shop's building arm. The law relates to quality standards in the building industry

and is likely to be costly to implement. It is possible that Go Shop will struggle to afford to

implement such standards. An even more significant concern is that it appears that the director

has taken no steps to mitigate this risk and has put no action plans into place to ensure that the

law would be complied with, if passed. This could mean that the company could be liable to legal

action and fines.

(b) Business risk approach

The business risk approach is an extension of the audit risk approach. When using an audit risk

approach, the auditors focus their attention on matters that they feel are the most significantly risky

to the financial statements so that they can provide a cost-effective audit.

The audit risk approach concentrates on three areas of risk; inherent risk, control risk and detection

risk.

In a business risk approach, the auditors determine that the risks that are most likely to adversely

affect the financial statements are the business risks of the company, hence they direct their testing

to the business risks apparent in the business.

This can be illustrated in the given scenario by looking at the significant links between the business

risks identified and the financial statements.

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160 6: Planning and risk assessment  Part D Audit of historical financial information

Operational – industry

Volatile

industry

Significant issues relating to going concern arising, auditors should direct their

audit work in this area.

Retail units

affected by

bomb threats

Potential issues relating to receivables' recoverability. Retail units may not be able

to pay rent/honour leases if they are not receiving sufficient income from sales.

The potential fall in income related to the retail units could affect the valuation of

tangible non-current assets – is there a need for an impairment review?

Operational – personnel

Loss of FD

This could have a significant impact on the calculation and presentation of the

financial statements if they are now drafted by an inexperienced person.

There is also a significant impact on the control environment, which will affect

assessment of control risk.

Finance

Interest rates The issues relating to high interest rates will affect the interest figure in the

statement of profit or loss. It may also affect the going concern assumption.

Compliance

New law Depending on the timing of the new legislation and the outcomes discussed above,

this could affect events after the reporting period, contingencies or provisions. It

could also potentially affect going concern.

(c) Audit strategy

The audit strategy will depend on certain matters, such as the date when Kathleen Hadley leaves

the business. Assuming that she leaves after the audit, a business risk approach would be

appropriate.

This is because business risks have already been identified and, as outlined above, there are

significant links between the business risks and the financial statements.

The control environment has historically been strong, so making use of controls testing would

appear to be appropriate. This in particular is highly dependent on the presence of Kathleen Hadley

at the audit date.

The audit senior has experience of the client and significant knowledge of the business therefore

it seems appropriate that a high use be made of analytical procedures. It also appears that strong

explanations will be available for movements on accounts over the period. Again, this is dependent

on the presence of Kathleen Hadley.

Lastly, the business risk approach is considered an efficient approach as it uses 'top-down'

procedures, so as strong evidence appears to be available, it is sensible to take the most efficient

approach possible, while ensuring that a quality audit is conducted.

(d) Ethical implications

(i) Recruitment

It is very important that the audit firm does not take management decisions on behalf of the

entity. Hence it would be appropriate for it to take an advisory role in the recruitment

process, perhaps reviewing CVs and advising as to qualifications and factors to look for.

However, it should not get heavily involved in the interviewing process, as this could lead it

to, in effect, make management decisions on behalf of the directors.

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Part D Audit of historical financial information  6: Planning and risk assessment 161

(ii) Secondment

If a staff member of the audit firm is to be seconded to the audit client to work in this

significant role, the firm would have to be very clear that there were boundaries in place

between that staff member and the audit team. This may in practice be impossible.

However, provided that objectivity can be retained for the audit team and that there is not a

problem of familiarity, a secondment might be appropriate.

A problem of familiarity could arise in either of the following scenarios.

(1) The person seconded had previously worked on the audit and the strategy and

approach were not changed.

(2) The audit team were familiar with the person seconded and had a personal

relationship with them that presented a significant risk to objectivity.

Your approach to scenario questions should be to read the scenario as closely as you can, making notes

of anything that will help you answer the requirement. However, although it is true that everything in the

scenario has been put there on purpose by the examination team, not all of it will be relevant to the

requirement. Some of it could have been put there as a distraction, so you will need to make a judgement

about whether it is relevant or not.

A common example of this is where information on the business's operations is included in a scenario,

but this is not relevant to the audit. You should bear in mind that operations only affect the audit if they

result in an audit risk. Another example of irrelevant information would be matters that are clearly

immaterial to the audit in question.

Finally, just as the scenario may include irrelevant information, it may also be missing out information that

is relevant to you. A common requirement is to identify and explain any further information that will be

required. It is important here that you think practically about the evidence you would need to address the

audit risks you have found in the scenario.

Question More information needed?

You are currently planning the audit of Howling Wolf Co, a logistics firm. One of Howling Wolf's trucks

was involved in an unfortunate accident which resulted in the deaths of a number of sheep that belonged

to a local farmer. The farmer is angry, and is threatening to take legal action against Wolf unless it agrees

to compensate them for the damage done.

Howling Wolf's financial statements include a provision for the cost of replacing the sheep.

Required

Identify and explain the additional information that you would require to obtain audit evidence in respect of

the provision.

Answer

Information required includes:

 The date of the incident with the sheep, which should already have happened. IAS 37 specifies that

a provision can only be created in relation to a present obligation arising as a result of a past event.

 The probability that Wolf will be required to pay compensation to the farmer. If Wolf is likely to win

in any legal action, then no provision should be set up.

 The number of sheep involved in the incident, along with an estimate of the cost of replacing them.

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162 6: Planning and risk assessment  Part D Audit of historical financial information

 An estimate of the amount most likely to be paid to the farmer as compensation (if payment is

likely).

 An estimate of the date by when the farmer is likely to paid. The time value of money is unlikely to

be material here, so the provision would be unlikely to be discounted.

 Whether Howling Wolf's truck suffered significant damage as a result of the accident, and if so

what the costs of rectifying this damage are likely to be.

3 Materiality 12/10, 12/11, 6/13, 12/13, 6/14

Materiality considerations are important in both planning and performing the audit. An item might be

material due to its nature, value or impact on the users of the financial statements as a group.

3.1 ISA 320 Materiality in planning and performing an audit

Materiality issues are dealt with in two standards:

 ISA 320 Materiality in planning and performing an audit

 ISA 450 Evaluation of misstatements identified during the audit

Materiality. Misstatements, including omissions, are considered to be material if they, individually or in

the aggregate, could reasonably be expected to influence the economic decisions of users taken on the

basis of the financial statements.

Performance materiality. The amount or amounts set by the auditor at less than materiality for the

financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of

uncorrected and undetected misstatements exceeds materiality for the financial statements as a whole. If

applicable, performance materiality also refers to the amount or amounts set by the auditor at less than

the materiality level or levels for particular classes of transactions, account balances or disclosures.

(ISA 320)

ISA 320 requires auditors to set materiality (and performance materiality) at the planning stage. The

assessment of materiality at this stage should be based on the most recent and reliable financial

information and will help to determine an effective and efficient audit approach. Materiality assessment will

help the auditors to decide:

 How many and what items to examine

 Whether to use sampling techniques

 What level of misstatement is likely to lead to a modified audit opinion

The resulting combination of audit procedures should help to reduce audit risk to an appropriately low

level.

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Part D Audit of historical financial information  6: Planning and risk assessment 163

Materiality criteria

An item might be material due to its:

Nature Given the definition of materiality as an item that would affect the readers of the financial

statements, some items might by their nature affect readers. Examples include

transactions related to directors, such as remuneration and contracts with the

company.

Value Some items will be significant in the financial statements by virtue of their size; for

example, if the company had bought a piece of land with a value which comprised threequarters

of the asset value of the company, that would be material. That is why

materiality is often expressed in terms of percentages (of assets, of profits).

Impact Some items may by chance have a significant impact on financial statements; for

example, a proposed journal which is not material in itself could convert a profit into a

loss. The difference between a small profit and a small loss could be material to some

readers.

3.1.1 Performance materiality

The concept of performance materiality allows an auditor to set different materiality levels for different

areas of the financial statements, according to their judgement of the audit risk that is particular to that

area. The idea is that overall materiality needs to be adjusted for the actual 'performance' of the audit in

particular areas, and cannot just be applied blindly. A better word for the concept might have been

'applied materiality', since it is mainly about how overall materiality is applied to particular areas.

The concept of performance materiality focuses in on the difference between the level of tolerable

misstatement and the level of actual misstatements detected. For example, if a misstatement were

detected that was just below overall materiality, then there is a difficulty for the auditor: the financial

statements are not materially misstated, but there is a risk that there may be undetected misstatements

which would push over the materiality threshold. The auditor should not just compare the amount of

detected misstatements with materiality as a whole, but should take into account the fact that only some

specific items have been tested (eg because sampling is used). Consideration of materiality needs to take

into account the possible undetected misstatements which might be lurking. Thinking in terms of

performance materiality means thinking of what the effect of individual misstatements might be on audit

risk for the financial statements as a whole. This provides the auditor with a margin of safety in relation to

any undetected misstatements, which are then less likely to exceed materiality as a whole.

Performance materiality therefore entails a prudent approach to materiality, and to determining the

procedures that are needed to conclude on whether or not the financial statements are materially

misstated. The higher the assessed risk, the lower the performance materiality must be set. This means

that the auditor will perform more audit work than if the concept of performance materiality did not exist.

As with overall materiality, setting performance materiality involves the use of professional judgement.

This judgement must take into account qualitative aspects, such as the level of risk attached to a particular

balance in the financial statements.

Example

An auditor might judge an entity's non-current assets to be a high-risk area. If non-current assets were

$20m and total assets $50m, then overall materiality might be set at 2% of total assets, ie $1m.

Performance materiality for non-current assets could then be set as a simple proportion of materiality, eg

$400,000 (= $20m/$50m × $1m).

Taking into account the auditor's judgement that non-current assets are higher risk, this could thus be

decreased to $300,000 in order to provide a greater margin of safety. Any misstatements above this level

would be judged material.

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3.2 Guidelines for materiality

It is clear from the points made about materiality criteria that materiality is judgemental, and an issue that

auditors must be aware of when approaching all their audit work.

However, you will know from your previous studies that generally accepted rules about materiality exist.

Examples are:

 Items relating to directors are normally always material.

 Percentage guidelines are often given for materiality.

While materiality must always be a matter of judgement for the auditor, it is helpful to have some

guidelines to bear in mind. Reasons for this are:

 The guidelines give the auditor a framework within which to base their thoughts on materiality.

 The guidelines provide a benchmark against which to assess the quality of auditing, for example, in

the event of litigation or disciplinary action.

The following figures are appropriate starting points for the consideration of materiality.

Value %

Profit before tax 5

Gross profit ½–1

Revenue ½–1

Total assets 1–2

Net assets 2–5

Profit after tax 5–10

3.2.1 Qualitative materiality

Most of the discussion on materiality focuses on quantitative materiality, but materiality must also be

applied to qualitative disclosures in the financial statements. ISA 320 and ISA 315 were revised in 2015

to include guidance here. Essentially the same concept of materiality applies, ie a misstatement must be

viewed in terms of its effect on the economic decisions of users.

Examples of disclosures to which misstatements might be material include:

 Liquidity/debt covenants

 Events leading to recognition of impairment losses

 Changes in accounting policies, eg because of a new IFRS, where this has a significant impact

 Share-based payments

 Related parties (and transactions with related parties)

3.3 Problems with materiality

As discussed above, materiality is a matter of judgement for the auditor. Therefore, prescriptive rules will

not always be helpful when assessing materiality. A significant risk of prescriptive rules is that a

significant matter, which falls outside the boundaries of the rules, could be overlooked, leading to a

material misstatement in the financial statements.

The percentage guidelines of assets and profits that are commonly used for materiality must be handled

with care. The auditor must bear in mind the focus of the company being audited.

In some companies, post-tax profit is the key figure in the financial statements, as the level of dividend is

the most important factor in the accounts.

In owner managed businesses, if owners are paid a salary and are indifferent to dividends, the key profit

figure stands higher in the statement of profit or loss, say at gross profit level. Alternatively in this

situation, the auditor should consider a figure that does not appear in the statement of profit or loss: profit

before directors' salaries and benefits.

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Part D Audit of historical financial information  6: Planning and risk assessment 165

Some companies are driven by assets rather than the need for profits. In such examples, higher

materiality might need to be applied to assets. In some companies, say charities, costs are the driving

factor, and materiality might be considered in relation to these.

While rules or guidelines are helpful to auditors when assessing materiality, they must always keep in

mind the nature of the business they are dealing with. Materiality must be tailored to the business and

the anticipated user of financial statements, or it is not truly materiality. Refer back to the definition of

materiality and consider all the elements of it.

In earlier studies, you may have calculated materiality by taking a weighted average of the calculated

percentages of revenue (½–1%), profit before tax (5%) and net assets (2–5%). This is appropriate when

calculating preliminary (planning) materiality. In this paper, you will often be calculating materiality in

relation to a specific item. You must only use the relevant comparator; for example, total assets if the

matter relates to the statement of financial position, profit before tax if the matter impacts on profit, and

both if it relates to the statement of financial position and impacts on profit; for example, a provision.

Question Materiality

You are the manager responsible for the audit of Albreda Co. The draft consolidated financial statements

for the year ended 31 March 20X2 show revenue of $42.2 million (20X1 $41.8 million), profit before

taxation of $1.8 million (20X1 $2.2 million) and total assets of $30.7 million (20X1 $23.4 million). In

March 20X2, the management board announced plans to cease offering 'home delivery' services from the

end of the month. These sales amounted to $0.6 million for the year to 31 March 20X2 (20X1

$0.8 million). A provision of $0.2 million has been made at 31 March 20X2 for the compensation of

redundant employees (mainly drivers).

Required

Comment on the materiality of these two issues.

Answer

Home delivery sales

The appropriate indicator of materiality with regard to the home delivery sales is revenue, as the home

delivery sales form part of the total revenue of the company.

$0.6 million is 1.4% of the total revenue for 20X2 (see Working 1).

An item is generally considered to be material if it is in the region of ½-1% of revenue, so the home

delivery services are material.

Provision

The appropriate indicators of materiality with regard to the provision are total assets and profit, as the

provision affects both the statement of financial position (it is a liability) and the statement of profit or loss

and other comprehensive income (it is a charge against profit).

$0.2 million is 0.65% of total assets in 20X2 (see Working 2). As an item is generally considered to be

material if it is in the region of 1–2% of total assets, the provision is not material to the statement of profit

or loss and other comprehensive income.

However, $0.2 million is 11% of profit before tax for 20X2 (see Working 3 below). An item is considered

material to profit before tax if it is in the region of 5%. Therefore, the provision is material to the statement

of financial position.

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166 6: Planning and risk assessment  Part D Audit of historical financial information

Working 1 Working 2 Working 3

$42.2million

$0.6million

× 100% = 1.4%

$30.7million

$0.2million

× 100 = 0.65%

$1.8million

$0.2million

× 100 = 11%

In the exam it is not necessary to comment, as in the question above, on the relevant indicator of

materiality. The bits that would have earned marks in the exam are shown in grey shade above. Note that

this question is for practice only, and is not representative of the actual P7 exam.

As a general rule, if an exam question gives you the information to calculate materiality then you should

calculate it. You should then think about whether there is anything else to think about in relation to

materiality or performance materiality – perhaps there will be a hint in the question that an item is material

by nature or impact? At P7 you will need to spot things, eg an immaterial misstatement that becomes

material by turning a profit into a loss.

Materiality is unlikely to be tested on its own, so once you have considered it you will probably need to go

on to consider other audit issues, eg further evidence or procedures required and the effect of a

misstatement on the audit report.

3.3.1 Revision as audit progresses

The auditor will revise the materiality level during the audit if they become aware of information that would

have caused a different materiality level to have been set in the first place.

Your ability to answer a question in the P7 exam often depends on little points like this. The December

2011 exam, for example, contained a scenario in which the audit manager stated that they wanted to 'fix

materiality at the planning stage for all audits'.

Most candidates could probably have guessed that this was wrong, but to score the two marks you

needed to state why it was wrong.

3.4 Documentation

The auditor must document:

 Materiality for the financial statements as a whole

 Materiality for particular balances, classes of transactions or disclosures

 Performance materiality

 Any revisions to the above

3.5 Evaluating material misstatements

ISA 450 Evaluation of misstatements identified during the audit provides more specific guidance on the

documentation and communication of misstatements identified.

ISA 450.5

The auditor shall accumulate misstatements identified during the audit, other than those that are clearly

trivial.

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Part D Audit of historical financial information  6: Planning and risk assessment 167

All misstatements (other than those that are clearly trivial) must be communicated on a timely basis to

management with a request that they are corrected. If management does not correct them, then the

auditor is obliged to communicate the individual uncorrected misstatements to those charged with

governance, together with the effect on the audit opinion. Finally, for those misstatements that remain

uncorrected, management must provide written representations that they believe that the effects of the

misstatements (individually and in aggregate) are immaterial.

ISA 450.15

The auditor shall include in the audit documentation:

(a) The amount below which misstatements would be regarded as clearly trivial;

(b) All misstatements accumulated during the audit and whether they have been corrected; and

(c) The auditor's conclusion as to whether uncorrected misstatements are material, individually or in

aggregate, and the basis for that conclusion.

One of the competences you require to fulfil Performance Objective 19 of the PER is the ability to evaluate

evidence collected, demonstrating professional scepticism, investigating areas of concern and ensuring

documentation is complete and all significant matters and areas of judgement are highlighted. You can

apply the knowledge you gain from this chapter of the Text to help demonstrate this competence.

4 Risk 12/07, 6/08, 6/09, 12/10, 12/11,

6/12, 12/12, 6/13, 12/13, 6/14, 12/14, 6/15

As you know from your earlier auditing studies, the auditor must be aware of two types of risk.

 Audit risk (sometimes known as assignment or engagement risk)

 Business risk

Risk is examined in virtually every P7 exam paper, usually in the first question.

4.1 Audit risk

Auditors must assess the risk of material misstatements arising in financial statements and carry out

procedures in response to assessed risks.

ISA 200 Overall objectives of the independent auditor and the conduct of an audit in accordance with

international standards on auditing states that 'the auditor shall obtain sufficient appropriate evidence to

reduce audit risk to an acceptably low level'. As discussed in Section 1, the way they do this is by carrying

out risk assessment procedures, and then further audit procedures to respond to the risk assessment. We

shall look in detail at audit risk here.

ISA 200.5

… ISAs require the auditor to obtain reasonable assurance about whether the financial statements as a

whole are free from material misstatement … It is obtained when the auditor has obtained sufficient

appropriate audit evidence to reduce audit risk to an acceptably low level.

Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial

statements are materially misstated. Audit risk is a function of the risk of material misstatement and

detection risk. Risk of material misstatement breaks down into inherent risk and control risk.

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168 6: Planning and risk assessment  Part D Audit of historical financial information

Inherent risk is the susceptibility of an assertion about a class of transaction, account balance or

disclosure to a misstatement that could be material, either individually or when aggregated with other

misstatements, before consideration of any related controls.

Control risk is the risk that a misstatement that could occur in an assertion about a class of transaction,

account balance or disclosure and that could be material, either individually or when aggregated with other

misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity's internal

control.

Detection risk is the risk that the procedures performed by the auditor to reduce audit risk to an

acceptably low level will not detect a misstatement that exists and that could be material, either

individually or when aggregated with other misstatements.

Case Study

Consider an oil company which has abandoned one of its oil rigs. This abandonment increases the risk of

material misstatement because the abandonment gives rise to an impairment in the value of the rig, which

might not be reflected in the financial statements. In other words, there is a risk that the financial

statements are misstated in respect of this oil rig.

You must be able to distinguish between audit risk and business risk. While many business risks will have

consequences for the audit by increasing audit risk, they are two separate issues. For example, the fact

that a company is exposed to foreign exchange risk is not an audit risk in itself. The audit risk is the

potential for material misstatement of the financial statements, especially in relation to IAS 21The effects

of changes in foreign exchange rates. This issue is discussed more fully in section 4.2.1 below.

4.1.1 Inherent risk

Although this section divides risks into inherent, control and detection risk, for your exam you will

generally only need to discuss the specific risks in the scenario in line with the requirement. For example,

if the requirement asks for a discussion of the audit risks in a scenario, then you should not spend time

trying to place risks into these categories (unless you are asked to do so). It is better focus instead on

describing the risks themselves.

Inherent risk is the risk that items will be misstated due to characteristics of those items, such as the fact

that they are estimates or that they are important items in the accounts. The auditors must use their

professional judgement and the understanding of the entity they have gained to assess inherent risk. If no

such information or knowledge is available then the inherent risk is assessed as high.

Factors affecting client as a whole

Integrity and attitude to risk of directors and

management

Domination by a single individual can cause problems

Management experience and knowledge Changes in management and quality of financial

management

Unusual pressures on management Examples include tight reporting deadlines, or market

or financing expectations

Nature of business Potential problems include technological

obsolescence or overdependence on single product

Industry factors Competitive conditions, regulatory requirements,

technology developments, changes in customer demand

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Part D Audit of historical financial information  6: Planning and risk assessment 169

Factors affecting client as a whole

Information technology Problems include lack of supporting documentation,

concentration of expertise in a few people, potential

for unauthorised access

Factors affecting individual account balances or transactions

Financial statement accounts prone to

misstatement

Accounts which require adjustment in previous period

or require high degree of estimation

Complex accounts Accounts which require expert valuations or are

subjects of current professional discussion

Assets at risk of being lost or stolen Cash, inventory, portable non-current assets (eg

laptop computers)

Quality of accounting systems Strength of individual departments (sales, purchases,

cash etc)

High volume transactions Accounting system may have problems coping

Unusual transactions Transactions for large amounts, with unusual names,

not settled promptly (particularly important if they

occur at period end)

Transactions that do not go through the system, that

relate to specific clients or are processed by certain

individuals

Staff Staff changes or areas of low morale

4.1.2 Control risk

Control risk is the risk that client controls fail to detect material misstatements. A preliminary assessment

of control risk at the planning stage of the audit is required to determine the level of controls and

substantive testing to be carried out.

If the auditor judges that the internal control system is good then control risk will probably be low. The

appendix to ISA 315 contains a summary of the components of a good system of internal controls. Here is

a summary of the summary.

Control environment. This encompasses:

 Communication and enforcement of integrity and ethical values

 Commitment to competence

 Participation by those charged with governance

 Management's philosophy and operating style

 Organisational structure

 Assignment of authority and responsibility

 Human resource policies and practices

Entity's risk assessment process. The entity should have a process for identifying risks that may affect its

financial reporting, assessing these risks and then responding to them. Examples of risks that might affect

financial reporting include:

 Changes in operating environment. Changes in the regulatory or operating environment can result

in changes in competitive pressures and significantly different risks.

 New personnel. New personnel may have a different focus on or understanding of internal control.

 New or revamped information systems. Significant and rapid changes in information systems can

change the risk relating to internal control.

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170 6: Planning and risk assessment  Part D Audit of historical financial information

 Rapid growth. Significant and rapid expansion of operations can strain controls and increase the

risk of a breakdown in controls.

Information system. The information system relevant to financial reporting objectives, which includes the

financial reporting system, encompasses methods and records that:

 Identify and record all valid transactions

 Describe on a timely basis the transactions in sufficient detail to permit proper classification of

transactions for financial reporting

 Measure the value of transactions in a manner that permits recording their proper monetary value

in the financial statements

 Determine the time period in which transactions occurred to permit recording of transactions in the

proper accounting period

 Present properly the transactions and related disclosures in the financial statements

Control activities. These include:

 Performance reviews. These control activities include reviews and analyses of actual performance

versus budgets, forecasts and prior period performance

 Information processing

 Physical controls, encompassing eg the physical security of assets

 Segregation of duties

Monitoring of controls. In addition to putting controls in place, management must monitor that they are

operating effectively, and that they continue to be appropriate when there are changes in circumstances.

4.1.3 Detection risk

Detection risk is part of audit risk, but it is not included in the risk of material misstatement.

Detection risk is the risk that audit procedures will fail to detect material misstatements. Detection risk

relates to the inability of the auditors to examine all evidence. Audit evidence is usually persuasive rather

than conclusive so some detection risk is usually present, allowing the auditors to seek 'reasonable

assurance'.

The auditors' inherent and control risk assessments influence the nature, timing and extent of

substantive procedures required to reduce detection risk and thereby audit risk.

The P7 examination team has commented again and again in examiner's reports that students often fail to

get the marks in questions on risk by not being specific enough about the audit risk being discussed.

The examiner's report for the December 2013 sitting is instructive in this regard. It identifies the following

common weaknesses in answers to a question asking for an evaluation of business risk in a scenario, and

identification and explanation of risks of material misstatement.

 Writing too little for the marks available

 Identifying issues but not explaining, evaluating or assessing the issues as required

 Lack of any real analytical or discursive skills

 Illegible handwriting and inadequate presentation

 Lack of audit knowledge

 Lack of basic accounting knowledge

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Part D Audit of historical financial information  6: Planning and risk assessment 171

4.2 Business risk Pilot paper, 6/09

Business risk is the risk arising to companies through being in operation.

One of the competences you require to fulfil Performance Objective 3 of the PER is the ability to evaluate

activities in your area and identify potential risks of fraud, error or other hazards assessing their

probability and impact. You can apply the knowledge you have obtained from this chapter of the Study

Text to help demonstrate this competence.

Business risk is the risk inherent to the company in its operations. It is risks at all levels of the business. It

is split into three components.

Financial risks are the risks arising from the financial activities or financial consequences of an operation,

for example, cash flow issues or overtrading.

Operational risks are the risks arising with regard to operations, for example, the risk that a major

supplier will be lost and the company will be unable to operate.

Compliance risk is the risk that arises from non-compliance with the laws and regulations that surround

the business. The compliance risk attaching to environmental issues, for example, is discussed in

Chapter 15.

The above components of business risk are the risks that the company should seek to mitigate and

manage.

The process of risk management for the business is:

 Identify significant risks that could prevent the business achieving its objectives

 Provide a framework to ensure that the business can meet its objectives

 Review the objectives and framework regularly to ensure that objectives are met

A key part of the process is therefore to identify the business risks. There are various tools used to do

this that you may have come across before. They are listed below.

 SWOT analysis

 The five forces model

 The PEST analysis

 Porter's value chain

The Study Guide states that you should be able to identify business risks in a question. If you have

previously used any of the above techniques they may be useful to you, but in the exam it will be better to

use common sense as you work through any given question, bearing in mind the three components of

business risk given above. You are unlikely to get many marks just for explicitly applying the above four

models to a scenario in P7.

4.2.1 Relationship between business risk and audit risk

On the one hand, business risk and audit risk are completely unrelated.

 Business risk arises in the operations of a business.

 Audit risk is focused on the financial statements of the business.

 Audit risk exists only in relation to an opinion given by auditors.

In other ways, the two are strongly connected. At the most basic level, almost everything that a

company does results in some sort of financial effect, and where there are financial transactions there is

always the risk that these transactions are reported wrongly. For example, if a business makes a sale,

then there is a risk that this sale will not be reported in accordance with IFRS 15 Revenue from

contracts with customers.

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The links between business risk and audit risk can be seen in the inherent and control aspects of audit

risk. In audit risk these are limited to risks pertaining to the financial statements, but the same risks that

are inherent audit risks can also be business risks. For example, a business with significant trade

receivables may have the business risk that cash is not recovered from receivables, and the audit risk that

trade receivables are overstated.

Likewise, control risk. In response to business risk, the directors put in place a system of controls. These

will include controls to help mitigate the financial aspect of business risk. These are the controls that audit

control risk incorporates.

Therefore, although audit risk is very financial statements focused, business risk does form part of the

inherent risk associated with the financial statements, not least because if the risks materialise, the going

concern basis of the financial statements could be affected.

Your examination team has stated that P7 students frequently confuse business risk with audit risk. If a

question asks for audit risks, do not write about business risks. The main way business risks directly

affect audit risk is through going concern, so if you are making a point about any other business risks in a

question on audit risk, then you need to be very clear and precise about the audit risk that the business

risk gives rise to.

It is important that you do not simply identify business risks if a question is to do with the risk of material

misstatement. In an article in Student Accountant, your examination team warns that 'the business risk

must be developed into a specific risk of material misstatement in the financial statements'.

4.3 Business risks from current trends in IT

4.3.1 The increasing risk of cyber incidents

Increasing connectivity and the openness of computer networks in the global business environment

exposes businesses to system and network failures and to cyber attack. The 2011 Norton Cyber Crime

report found that the total cost of cyber crime over the 24 countries being reported on was over $388bn,

with more than 1m people becoming victims of cyber crime every day. This figure is made up of £113bn

in lost cash (including the cost of repairing IT systems), along with $274bn in lost time.

4.3.2 Audit considerations

Auditors must assess their clients' procedures for identifying and addressing these risks. Some main

considerations are:

 Has management established an information and internet security policy?

 How does the entity identify critical information assets and the risk to these assets?

 Does the entity have cyber insurance (many general policies now exclude cyber events)?

 Is there a process for assuring security when linked to third-party systems (eg partners/

contractors)?

 What controls are in place to ensure that employees only have access to files and applications that

are required for their job?

 Are regular scans carried out to identify malicious activity?

 Are procedures in place to ensure that security is not compromised when the company's systems

are accessed from home or on the road?

 What plans are in place for disaster recovery in case of an incident?

These issues will be built into the auditor's assessment of the control environment of the entity and in

some cases may influence the auditor's view as to whether there are any uncertainties relating to the

going concern status of the entity.

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4.3.3 E-commerce

Where an entity undertakes e-commerce, risk identification is crucial. E-commerce has become

increasingly important in recent years, and to a large extent early fears about security have proven to be

unfounded. However, a number of recent high-profile security breaches in relation to e-commerce

systems have underlined that this is an area that can carry significant operational risks, to which auditors

must give specific consideration.

Specific business risks include:

 Loss of transaction integrity

 Pervasive e-commerce security risks

 Improper accounting policies

 Non-compliance with tax, legal and regulatory requirements (eg local laws in relation to protection

of customers' data)

 Overreliance on e-commerce

 Systems and infrastructure failures

 Damage to reputation if website fails or security is breached

Audit procedures regarding the integrity of the information in the accounting system relating to

e-commerce transactions will be concerned with evaluating the reliability of the system for capturing and

processing transactions.

Therefore in contrast to audit procedures for traditional business activities which focus separately on

control processes relating to each stage of transaction processing, audit procedures for sophisticated

e-commerce often focus on automated controls.

Case Study

Risk in an e-commerce environment

Tripper Co is a travel agency operating in three adjacent towns. The directors have recently taken the

decision that they should cease their operations and convert into a dot.com. The new operation,

Trippers.com, will benefit from enlarged markets and reduced overheads, as they will be able to operate

from single, cheaper premises.

Such a business decision has opened Tripper Co up to significant new business risks.

Customers

Converting to a dot.com company in this way enforces a loss of 'personal touch' with customers. Tripper

staff will no longer meet the customers face to face. In a business such as a travel agency, this could be a

significant factor. Customers may have appreciated the service given in branches and may feel that this

level of service has been lost if it is now redirected through computers and telephones. Trippers should be

aware of the possibility of, and mitigate against, loss of customers due to perceived reduction in service.

Competition

By leaving the local area and entering a wider market, Tripper is opening itself up to much more

substantial competition. Whereas previously Trippers competed with other local travel agents, it will now

be competing theoretically with travel agents everywhere that have internet facilities.

Technology issues

As Tripper has moved into a market that necessitates high technological capabilities, a number of

business risks are raised in relation to technological issues:

Viruses

There is a threat of business being severely interrupted by computer viruses, particularly if the staff of

Trippers are not very computer literate or the system the company invests in is not up to the standard

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174 6: Planning and risk assessment  Part D Audit of historical financial information

Viruses could cause interrupted sales and loss of customer goodwill, which could have a significant

impact on the going concern status of the company.

Loss of existing custom

Technology could be another reason for loss of existing customers. Their existing customers might not

have internet access or the ability to use computers. We do not know what Tripper's demographic was

prior to conversion.

However, if conversion means that Tripper loses its existing client base completely and has to rebuild

sales, the potential cost in advertising could be excessive.

Cost of system upgrades

Technology is a fast moving area and it will be vital that Tripper's website is kept up to current standards.

The cost of upgrade, both in terms of money and business interruption, could be substantial.

New supply chain factors

Tripper may keep existing links with holiday companies and operators. However, it will have new

suppliers, such as internet service providers, to contend with.

Personnel

Due to the conversion, Trippers.com will require technical staff and experts. It may not currently have

these staff. If this is the case, it could be at risk of severe business interruption and customer

dissatisfaction.

If the directors are not computer literate, they may find that they are relying on staff who are far more

expert than they are to ensure that their business runs efficiently.

Legislation

There are a number of issues to consider here. The first is data protection and the necessity to comply

with the law when personal details are given over the computer. It is important that the website is secure.

E-commerce is also likely to be an area where there is fast moving legislation as the law seeks to keep up

with developments. Tripper must also keep up with developments in the law.

Lastly, trading over the internet may create complications as to what domain Tripper are trading in for the

purposes of law and tax.

Fraud exposure

The company may find that it is increasingly exposed to fraud in the following ways.

 Credit card fraud relating from transactions not being face to face

 Hacking and fraud relating from the website not being secure

 Overreliance on computer expert personnel could lead to those people committing fraud

Tripper's auditors will be regarding the conversion with interest. The conversion will also severely affect

audit risk.

Impact on audit risk

Inherent risk

Many of the business risks identified above could have significant impacts on going concern.

Control risk

The new operations will require new systems, many of which may be specialised computer systems.

Detection risk

The conversion may have the following effects.

(a) Create a 'paperless office' as all transactions are carried out online – this may make use of

computer-assisted auditing techniques essential.

(b) The auditors may have no experience in e-commerce which may increase detection risk.

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Part D Audit of historical financial information  6: Planning and risk assessment 175

(c) There are likely to be significant impacts on analytical review, as results under the new operations

are unlikely to be very comparable to the old.

(d) There may be a significant need to use the work of experts to obtain sufficient, appropriate audit

evidence.

When answering questions, try to let key phrases trigger your thoughts about particular issues, such as

systems and going concern. Above all, think about the nature of the business in the scenario and the

strengths and deficiencies likely to exist within it.

4.4 Risk of material misstatement 12/08, 12/09, 6/11

4.4.1 Definition

Risk of material misstatement is risk that the financial statements are materially misstated prior to audit.

This consists of two components: inherent risk and control risk. (ISA 200)

The material misstatement could involve:

 Misstatements of the amounts recorded in the statement of profit or loss and other comprehensive

income or statement of financial position

 Misstatements of, or omissions from, the disclosure notes

4.4.2 Link with business risk

Many, if not all, business risks will produce a risk of material misstatement.

Using the information in the previous case study to illustrate the link:

Business risk Risk of material misstatement

The business may lose sales as a result of computer

viruses, which could threaten the company's going

concern status.

Uncertainties over going concern may not be

fully disclosed.

Breaches of data protection law and other regulations

could result in the company suffering financial

penalties.

Provisions relating to breaches of regulations

may be omitted or understated.

The business may suffer losses from credit card fraud. Losses arising from frauds may not be

recognised in the financial statements.

Note that the definition of 'risk of material misstatement' given in ISA 200 refers to a misstatement 'prior

to audit'. What is being referred to here is the risk of material misstatement in the financial statements as

prepared by the client, completely apart from anything the auditor does. In terms of the audit risk model,

this can result from either a control risk or an inherent risk, but not a detection risk. Detection risks are

not 'prior to the audit', and do not meet ISA 200's definition of a 'risk of material misstatement'.

Your examination team stated in its April 2012 Student Accountant article that:

'Candidates are therefore advised that when answering a requirement based on the risk of material

misstatement they should focus their answer on inherent risk and control risk factors only.

Detection risk is not part of the risk of material misstatement.'

In other words, when you are asked for risks of material misstatement, you are not being asked for

anything about the audit itself (detection risk), but about the financial statements and the risk that they are

materially misstated. This is then a question of inherent risk and control risk, so when you are answering

questions in this area you should be looking for these types of risk.

Point to note

Exam focus

point

Key term

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176 6: Planning and risk assessment  Part D Audit of historical financial information

Question Audit risk

Forsythia is a small limited liability company offering garden landscaping services. It is partly owned by

three business associates, Mr Rose, Mr White and Mr Grass, who each hold 10% of the shares. The major

shareholder is the parent company, Poppy Co. This company owns shares in 20 different companies,

which operate in a variety of industries. One of them is a garden centre, and Forsythia regularly trades with

it. Poppy Co is in turn owned by a parent, White Holdings Co.

The management structure at Forsythia is simple. Of the three non-corporate shareholders, only Mr Rose

has any involvement in management. He runs the day to day operations of the company (marketing, sales,

purchasing etc) although the company employs two landscape gardeners to actually carry out projects.

The accounts department employs a purchase clerk and a sales clerk, who deal with all aspects of the

function. The sales clerk is Mr Rose's daughter, Justine. Mr Rose authorises and produces the payroll.

The company ledgers are kept on Mr Rose's personal computer. Two weeks after the year end, the sales

ledger records were severely damaged by a virus. Justine has a single printout of the balances as at year

end, which shows the total owed by each customer.

Forsythia owns the equipment which the gardeners use and they pay them a salary and a bonus based on

performance. Mr Rose is remunerated entirely on a commission basis relating to sales and, as a

shareholder he receives dividends annually, which are substantial.

Forsythia does not carry any inventory. When materials are required for a project, they are purchased on

behalf of the client and charged directly to them. Most customers pay within the 60 day credit period, or

take up the extended credit period which Forsythia offers. However, there are a number of accounts that

appear to have been outstanding for a significant period.

Justine and her father do not appear to have a very good working relationship. She does not live at home

and her salary is not significant. However, she appears to have recently purchased a sports car, which is

not a company car.

The audit partner has recently accepted the audit of Forsythia. You have been assigned the task of

planning the first audit.

Required

Identify and explain the audit and engagement risks arising from the above scenario.

Approaching the answer

Question Audit risk

Look for key words and ask questions of the information given to you. This is illustrated here:

Forsythia is a small limited company offering garden landscaping services. It is partly owned by three

business associates, Mr Rose, Mr White and Mr Grass, who each hold 10% of the shares. The major

shareholder is the parent company, Poppy Co. This company owns shares in 20 different companies,

'which operate in a variety of industries. One of them is a garden centre, and Forsythia regularly trades

with it. Poppy Co is in turn owned by a parent, White Holdings Co.

Receivables

likely to be

significant

Complicated

corporate

structure –

why?

Controlling

party?

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Part D Audit of historical financial information  6: Planning and risk assessment 177

The management structure at Forsythia is simple. Of the three non-corporate shareholders, only

Mr Rose has any involvement in management. He runs the day-to-day operations of the company

(marketing, sales, purchasing etc) although the company employs two landscape gardeners to actually

carry out projects. The accounts department employs a purchase clerk and a sales clerk, who deal

with all aspects of the function. The sales clerk is Mr Rose's daughter, Justine. Mr Rose authorises and

produces the payroll. The company ledgers are kept on Mr Rose's personal computer. Two weeks

after the year end, the sales ledger records were severely damaged by a virus. Justine has a

single printout of the balances as at year end, which shows the total owed by each customer.

Forsythia owns the equipment which the gardeners use and they pay them a salary and a bonus based

on performance. Mr Rose is remunerated entirely on a commission basis relating to sales and as a

shareholder he receives dividends annually, which are substantial.

Forsythia does not carry any inventory. When materials are required for a project, they are purchased on

behalf of the client and charged directly to them. Most customers pay within the 60 day credit period, or

take up the extended credit period which Forsythia offers. However, there are a number of accounts that

appear to have been outstanding for a significant period.

Justine and her father do not appear to have a very good working relationship. She does not live at home

and her salary is not significant. However, she appears to have recently purchased a sports car, which is

not a company car.

The audit partner has recently accepted the audit of Forsythia. You have been assigned the task of

planning the first audit.

Answer plan

Not all the points you notice will necessarily be relevant and you may also find that you do not have time

to mention all the points in your answer. Now you should prioritise your points in a more formal answer

plan and then write your answer.

Is it slightly odd

that a landscape

gardening

business isn't

owned by

landscape

gardeners?

Poor controls

No segregation

of duties

Limitation? And given below, a suspicion of fraud?

Teeming and lading?

Any laws and

regulations

relevant?

Very profit

related focused

– management

bias?

How accounted

for?

Problem with

receivables fraud?

Fraud?

Detection risk

Opening balances

Comparatives – audited or not?

Any group

planning

issues?

Why not all the other group

companies? Why do they

have different auditors?

Key man?

Over reliance?

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178 6: Planning and risk assessment  Part D Audit of historical financial information

Audit risks

Inherent

Related party transactions/group issues

Receivables

Fraud – possible indicators, professional scepticism

Profit driven management

Credit extended – accounting/law and regs

Control

Lack of segregation of duties

PC/virus

Suspicion of fraud?

Key man insurance

Detection

First audit

Opening bals and comparatives – audited?

Engagement risks

Some questions raised which makes business look odd

 Group (complex/different auditors/who controls?)

 Nature of business – yet landscape gardeners hired

Indicators of potential fraud

Possible indicators of money laundering (complex structure/cash business)

These may be overstated, but auditor must (a) Consider them

(b) Be prepared for consequences

Answer

The following matters are relevant to planning Forsythia's audit.

Audit risks – inherent

Related parties and group issues

Forsythia is part of a complicated group structure. This raises several issues for the audit.

 There is a risk of related party transactions existing and not being properly disclosed in the

financial statements in accordance with IAS 24 Related party disclosures.

 Similarly, there is a risk that it will be difficult to ascertain the controlling party for disclosure.

 There is likely to be some group audit implications. My firm may be required to undertake

procedures in line with the group auditors' requirements if Forsythia is to be consolidated.

Receivables

Forsythia is a service provider, and it extends credit to customers. This is likely to mean that trade

receivables will be a significant audit balance. However, there is limited audit evidence concerning trade

receivables due to the effects of a computer virus. There are also indicators of a possible fraud.

Fraud

There are various factors that may indicate a sales ledger fraud has taken/is taking place.

 Lack of segregation of duties

 Extensive credit offered

 The virus only destroyed sales ledger information – too specific?

 Poorly paid sales ledger clerk – with expensive lifestyle

 Sales ledger clerk is daughter of a well-paid shareholder and they do not have a good relationship

None of these factors necessarily point to a fraud individually, but added together raise significant

concerns.

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