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REVIEW QUESTION 2.1
The fundamental ethical principles that apply to all members of the professional bodies
are to act with integrity, objectivity, professional competence and due care,
confidentiality and professional behaviour.
The requirement to act in the public interest means that auditors should consider how
their actions impact the client and their employer. They must also consider the impact of
their actions on others such as the client‘s employees, investors, credit providers, and
those without direct financial interests in the client such as the broader business and
financial community and members of the public. All these people could be reliant on the
quality of the auditor‘s work, even though they are not party to the contract between the
client and the audit firm.
The reliability of the financial statements and the audit report is potentially damaged if
the auditor does not act with integrity (honesty), objectivity (being independent), with
professional competence and due care (executing the work with the required level of
skill and attention), confidentiality (discussing the client‘s affairs with others
inappropriately), and professional behaviour (protecting their reputation and the
profession‘s reputation). A dishonest auditor could knowingly help publish a materially
false, misleading, or reckless financial statement. Auditors who compromise their
objectivity could be biased or unduly influenced to publish an inappropriate audit
opinion. Auditors who do not uphold professional competence and due care principles
could give incompetent professional service or fail to act diligently in accordance with
the applicable technical standards. Disclosures of the client‘s confidential information
with proper or specific authority from the client or without a legal duty to disclose could
disadvantage the client in the conduct of its affairs. Unprofessional behaviour brings
discredit to the profession.
REVIEW QUESTION 2.2
Both aspects of independence are important. If an auditor has independence of mind
the auditor will act independently. Acting independently means that the auditors are free
of the clients‘ influence and will perform their duties as required by the auditing
standards and codes of ethics, even if the clients do not agree. Acting independently is
essential for a high quality audit.
REVIEW QUESTION 2.2 (Continued)
However, despite how independently the auditors may act, the audit reports will not be
credible if the outside parties do not believe that the auditors acted independently. That
is, the outside parties do not believe the audit reports have any credibility because they
believe that the clients have influenced the auditor. Therefore, the auditor must be seen
to be independent by outside parties. That is, the auditor must be independent in
appearance for the audit report to be believed.
If the auditor is seen to be independent but is really not independent, then the audit
reports will have credibility, but if later events reveal that the auditor did not act
independently, the outside parties could suffer a loss from relying on an inappropriate
audit opinion. Therefore, both independence of mind and independence in appearance
are required for effective auditing.
REVIEW QUESTION 2.3
An auditor has a self-interest problem if the outcome of the audit (and/or the success of
the company) affects the auditor‘s (i.e., the audit firm or the auditor as an individual)
financial interests. The closeness in this case is manifested through the auditor‘s share
ownership in the client, the client producing a very large part of the audit firm‘s audit or
other services revenue, or the existence of loans or other financial interests between the
auditor and the client. It is a problem for the audit‘s value because the auditor knows
that a qualified audit report could adversely affect the client‘s share price, or a tough
audit decision (e.g., requiring the client to write down the value of its assets) could
encourage the client to seek another auditor. These concerns could prompt the auditor
to act inappropriately during the audit.
The self-review problem arises when the auditor, as part of the audit, has to test
transactions or systems that were recorded or provided by another part of the audit firm
or by a previous employee of the audit firm, or the testing is performed by a previous
employee of the client. The closeness is manifested by the fact that self-review means
that there is too little separation between the client and the auditor with respect to that
part of the audit, that is, the auditor is testing or reviewing itself. It is a problem for the
audit because self-review impairs the primary source of value of a financial statements
audit, that is, the independence of the auditor from the client. The lack of independence
could mean that the auditor acts inappropriately during the audit.
Familiarity refers to a general closeness between the auditor (including the whole audit
team) and the client. The closeness in this case is manifested in a relationship that is
more one of friendship than that between independent auditor and client. The auditor
could lose their objectivity during the audit and act inappropriately.
REVIEW QUESTION 2.4
The audit report is addressed to the shareholders of the audited company. However,
there is very little contact between an auditor and the shareholders. One exception is
that the auditor is required to attend the company‘s Annual General Meeting where
there could be some dialogue between the members and the auditor. In addition, the
auditor could meet large shareholders, for example those on the board of the directors
or who work for the company.
Shareholders are responsible for the appointment and removal of the auditor, but in
practice the selection of the auditor is done by the board who then recommend the
appointment to the shareholders for their approval. It would be more realistic to regard
the board of directors as the auditor‘s client because they are in charge of the
company‘s governance. The CEO or CFO will be in charge of the client‘s financial
reporting process and the auditor may have most contact with them and the finance
department, but they are not the client to whom the auditor reports.
REVIEW QUESTION 2.5
Executive directors are employees of the company who are also members of the board
of directors. Non-executive directors are members of the board who are not employees
of the company, but they could be ex-employees and/or major shareholders. Executive
directors are generally regarded as being less independent with respect to the audit
because they are part of the subject of the audit. That is, the executives, such as the
CEO or CFO are in charge of the company‘s operations and financial statements and so
their work is being audited.
The audit committee is a sub-committee of the board of directors and its responsibilities
include selection of the company‘s auditors and overseeing the contract with the
external auditors (and sometimes the internal audit department). The external auditors
need to feel confident about bringing issues and difficulties they encounter during the
audit to the attention of the audit committee. The auditors need to believe that the audit
committee will not attempt to cover up the problems and will not try to persuade the
external auditors to drop any major issue. If an executive director is on the audit
committee they are regarded as being more likely to try to cover up any problems
because such problems would reflect badly in the executive director‘s performance as
an employee. Not allowing executive directors to be part of the audit committee avoids
such potential conflicts of interest.
REVIEW QUESTION 2.6
Outsourcing an internal audit function could provide the advantages of potentially better
qualified auditors and a better resourced auditing function. It also allows small
companies that would not be able to justify the establishment of a fully functioning
internal audit department to have an internal audit function. An outsourced internal audit
function is also likely to be more independent because they are not employees of the
company and will not have the familiarity problems that could arise when one employee
of a company is required to audit another employee‘s work.
Outsourcing has the disadvantage that the internal auditors would have less knowledge
about the company and its systems. Such lack of knowledge may mean that employees
could find it easier to hide problems from the internal auditors. Outsourced internal
auditors are removed from employee social networks and thus may not be alert to
problems known by employees. For example, employees may know of another
employee‘s gambling problems which could tempt them to steal from the company.
REVIEW QUESTION 2.7
A client may bring an action against an auditor under contract or tort law. The contract is
between the client and the auditor. Damages under a breach of contract can only be
claimed by a party to the contract.
Tort law allows any party to bring an action for negligence, provided the following three
conditions are established:
ï‚· A duty of care was owed by the auditor
ï‚· There was a breach of the duty of care
ï‚· Loss was suffered as a consequence of that breach.
Therefore, tort law allows another party to bring an action (not just a party to the
contract) if it can be shown that there was a duty of care to that party. This means that
the client and other parties could potentially bring an action for negligence. The first
condition appears to be the most difficult to prove.
For example in the Pacific Acceptance case report, it was noted that the auditor could
owe a duty of care to the client and its shareholders. The report discusses the problems
facing plaintiffs when seeking to establish that the client or shareholders had suffered a
loss as a result of the auditor‘s negligence. To ascertain a causal relationship between
the negligent act and the loss suffered, reasonable forseeability must be proven. This
means that the auditor must have been aware that any negligence on their part could
cause a loss to the client or their shareholders.
REVIEW QUESTION 2.7 (Continued)
In Hercules Management Ltd. (1997) the courts ruled that for a third party to be able to
establish that an auditor owes them a duty of care, they would need to show the
following:
ï‚· The report was prepared on the basis that it would be communicated to a third party.
ï‚· The report was likely to be relied upon by that third party.
ï‚· The third party ran the risk of suffering a loss if the report was negligently prepared.
The judgement in the Hercules case provided some relief for auditors as it made it far
more difficult for a third party to establish that a duty of care was owed by the auditor.
Today, it is advisable that a third party take steps to establish proximity before using an
audited report to make a decision. They can request that an auditor provide them with a
privity letter, which can be used to prove that a duty of care was owed to them.
The plaintiff must also show that the auditor breached its duty of care, for example, by
conducting a poor quality audit. Mere non-compliance with auditing standards may not
be sufficient to show a breach of the duty of care. Finally, the plaintiff must establish that
they suffered loss as a result of the breach of the duty of care. For example, the plaintiff
must show that they relied on the audit report to make their investment which
subsequently lost value.
REVIEW QUESTION 2.8
For a case brought by a client or another party to succeed against an auditor it must be
shown that they breached the terms of the contract and/or were negligent. An auditor
will use internal documentation to show that all duties were conducted to a reasonable
standard. Failure to follow auditing standards would imply that the work was not
conducted to a reasonable standard, but it is still possible that an auditor could be found
to be negligent even if the strict letter of the auditing standards was followed. This is
because the test is not whether or not the standards were followed, but whether it was
reasonable to expect an auditor to act in a particular way. All circumstances must be
examined on a case-by-case basis, and there could be conditions which would create a
reasonable expectation that the auditor would have performed additional procedures or
acted differently in some way. Therefore, compliance with auditing standards is
generally regarded as a minimum, not a maximum, requirement to avoid legal liability.
REVIEW QUESTION 2.9
Client acceptance and continuance procedures are performed for the purpose of
evaluating whether the auditor can service the client and still meet the relevant ethical
and legal requirements. This is to protect the client and the auditor as well as those who
will rely on the audit report. The client needs to be assured that the auditor has the
appropriate skills and capacity to provide the audit at the appropriate level of quality and
within the required time frame. The auditor needs to be sure that it can service the client
in this way and protect itself from any conflicts of interest that could arise during the
engagement. The public and other parties need to be assured that the audit was
conducted appropriately and the auditor was able to exercise the required level of
independence.
An auditor will not accept every client, even if it has capacity, because they would not
be able to provide the required level of expertise to service the client‘s needs. Refusal to
accept a client (or continue with an existing client) does not mean that the client is not
auditable or lacks integrity. Another auditor could be better able to service the client
because of capacity or expertise issues. However, the auditor‘s right to refuse a client
means that the more difficult to audit clients find it hard to get an auditor and so have
the incentive to either improve their systems and/or integrity, or go out of business. As
such, the quality of financial reporting across the economy is likely to be higher.
REVIEW QUESTION 2.10
An engagement letter is the contract between the client and the auditor. It contains
clauses that make the responsibilities of each party clear, and can provide a method of
handling disputes. CAS 210 Agreeing the Terms of Audit Engagements provides
guidance on the preparation of engagement letters. An engagement letter is prepared
by an auditor and acknowledged by a client before the commencement of an audit.
The purpose of an engagement letter is to set out the terms of the audit engagement, to
avoid any misunderstandings between the auditor and their client. The letter will confirm
the obligations of the client and the auditor in accordance with the various standards.
While the engagement letter can expand upon the requirements that appear in
legislation and standards, it cannot limit or contradict those requirements.
An engagement letter includes an explanation of the scope of the audit, the timing of the
completion of various aspects of the audit, an overview of the client‘s responsibility for
the preparation of the financial statements, the requirement that the auditor have access
to all information required, independence considerations and fees.
SOLUTIONS TO PROFESSIONAL APPLICATION QUESTIONS
PROFESSIONAL APPLICATION 2.1 – Ethical principles
The fundamental ethical principles that apply to all members of the professional bodies
are to act with integrity, objectivity, professional competence and due care,
confidentiality and professional behaviour (according to the code of professional
conduct for the appropriate professional body).
Charles overstates his importance at the audit firm – he states that he is a partner but
he is a ̳senior‘ (which is less senior than a partner). This is a breach of integrity.
Charles tells William that the patriarch (male leader of the family) is having an affair with
his personal assistant – this is gossip. Even if it is true, it is not professional behaviour
to reveal private matters about a client to another party. Charles also states that he has
his ̳doubts‘ about this person – this apparently means that Charles believes that the
person is dishonest or unethical or incompetent (it is not clear what he means but he is
saying something negative). Once again, this is not professional behaviour.
Charles tells William that the family has increased its shareholding in another company,
with potential benefits to the company. This information appears to have been gained as
part of the audit so revealing it to William is a breach of confidentiality. It is not relevant
that William works for a bank which lends to the client, Charles does not have the
client‘s permission to discuss this matter.
PROFESSIONAL APPLICATION 2.2 – Receiving shares through inheritance
Prior to the uncle‘s death, the shares were not held by Kerry or his wife – the connection
through her uncle is too remote for a self-interest threat to have existed prior to his
death.
After the uncle‘s death, Kerry‘s wife is the owner of the shares, which appears to give
her material ownership in the client, creating a potential self-interest threat for Kerry.
Therefore now that Kerry is aware of the inheritance, he should inform the partner for
this engagement in writing. The shares should be disposed of, or Kerry removed from
the audit. If Kerry stays on the audit,additional safeguardsshould be considered such as
discussing the matter with the client‘s audit committee or having Kerry‘s work reviewed
by another member of the firm that has not been a member on the Darcy Industries
engagement team. Kerry will not get fired from the audit firm provided he follows the
above procedures.
PROFESSIONAL APPLICATION 2.3 – Provision of non-audit services to audit clients
(a)
It is possible that increasing the profitability of the audit firm would increase Elise‘s
reputation within the firm. However, if the growth in revenue creates any conflicts of
interest or other ethical problems it could damage Elise‘s reputation. If providing of non-
assurance services creates a threat to the auditor‘s independence, safeguards would
need to be applied to eliminate or reduce the threat.
(b)As Hertenstein Ltd, is a large public company, there are additional prohibitions.
Prohibited services also include legal services, management functionshuman resources
services, corporate financial services, litigation support, or expert service. Generally it is
not acceptable for the auditor to act as a manager of the entity.It is also not appropriate
for Elise to suggest providing bookkeeping, actuarial, internal audit valuation, financial
statement systems design and implementation where the results of these services will
be audited.
(c)
Yes. Auditors can provide more non-audit services to a private company than to a listed
public company. As mentioned in Part B, there are additional prohibited services for
firms with listed entities.
Auditors of private companies may perform accounting, bookkeeping, and payroll
services provided that these services are routine in nature. If a self- review threat
presents itself as a result of performing these services, it must be reduced too an
acceptable level. Possible safeguards to reduce such a threat are:
ï‚· Ensure the Audit Client approves all account classifications
ï‚· Having the client sign off on all adjusting journal entries
ï‚· Ensuring the client understand and takes responsibility for the financial statements
PROFESSIONAL APPLICATION 2.4 – Unpaid audit fees
If fees are outstanding the auditor could be perceived to have a conflict of interest because
the auditor is more likely to be paid if the client survives and is happy with the auditor. In
these cases, the auditor could be perceived as being more interested in the client‘s survival
than an accurate audit report. Therefore, this gives rise to a self- interest threat.
The auditor should take steps to have the fees paid before the next audit. Other
possible safeguards include advising the audit committee of the outstanding fees, or
have another auditor review the engagement file. If the fees are significant and
outstanding long enough that they may be consider similar to a loan, the firm should
consider removing itself from the audit.
.
PROFESSIONAL APPLICATION 2.5 – Using the work of internal auditors
The internal audit department focuses on efficiency and effectiveness of production (i.e.
operational or performance auditing) and compliance with government regulations
(compliance auditing). The head of the internal audit department is a Chartered
Professional Accountant and a member of the Institute of Internal Auditors and the other
members of the department have performance auditing and compliance relevant
experience and qualifications. The internal audit department is highly regarded within
the business, reports to the board of directors as well as the CEO, and the reports
appear to be acted upon. All these factors suggest that the internal audit department is
well run and effective. However, they also suggest that it does not concentrate on
issues directly relevant to financial reporting and auditing.
The external auditors are likely to review the internal audit department‘s work,
particularly where it is relevant to operational indicators which are reflected in the
accounts. They are likely to review the internal auditor‘s reports and their evaluations of
internal control systems, particularly in production and inventory issues and general
management issues. However, most of the internal audit department‘s findings on
waste regulations and efficiency matters will not be directly relevant to the external
auditors‘ audit of accounting transactions and balances.
PROFESSIONAL APPLICATION 2.6 – Legal implications of client acceptance
(a)
Steps to take to avoid the threat of litigation (in addition to the client continuation
decision issues in part (b) below) include:
ï‚· Hiring competent staff
ï‚· Training staff and updating their knowledge regularly
ï‚· Ensuring compliance with ethical regulations
ï‚· Ensuring compliance with auditing regulations
ï‚· Implementing policies and procedures that ensure:
o Appropriate procedures are followed when accepting a new client (or client
continuance)
o Appropriate staff are allocated to clients
o Ethical and independence issues are identified and dealt with on a timely basis
o All work is fully documented
o Adequate and appropriate evidence is gathered before forming an opinion
 Meeting with a client‘s audit committee to discuss any significant issues identified as
part of the audit
 Following up on any significant weaknesses in the client‘s internal control
procedures in a previous year‘s audit.
PROFESSIONAL APPLICATION 2.6 (Continued)
(b)
The client continuation decision is critical. Rebecca should evaluate and document the
firm‘s ability to service the major client, Carolina Company Ltd., and any other major
clients for the coming year. Canadian Standard on Quality Control (CSQC 1) “Quality
control for firms that perform audits and reviews of financial statements, and other
assurance engagements” and CAS 220 Quality Control for an Audit of Financial
Statements provide guidance on the procedures to be followed when making the client
acceptance or continuance decision.
The key factors to be evaluated are client integrity and any threats to the auditor‘s
compliance with the fundamental principles of professional ethics (integrity, objectivity,
professional competence and due care, confidentiality and professional behaviour).
Although Carolina Company Ltd. has been a client of the firm for several years, its
integrity must still be re-evaluated. Rapid growth can create pressures within the client
that could compromise its integrity. This is particularly so in the case of Carolina
Company Ltd. because there is already evidence of difficulties in its financial systems.
A major problem confronting the audit firm is its ability to comply with the fundamental
principles of professional ethics.
PROFESSIONAL APPLICATION 2.7 – Independence safeguards
1. Having the client approve proposed journal entries provides evidence that the client
has reviewed and accepts responsibility for the adjustments (and the resulting
changes to the financial statement balances). Therefore in having the client take
responsibility for adjustments, it is a safeguard for a Self Review Threat.
2. By having staff review a client list, it ensures they are aware of engagement clients
they may not be assigned to. As firm members should limit and disclose the shares
they hold in an audit client, this is a safeguard for the Self Interest Threat.
3. By participating in the same engagement over a number of years, the auditor
may develop a close relationship with the client and client staff. This may lead to
a familiarity threat. Therefore, rotating staff is a safeguard to a Familiarity Threat.
4. By having a policy indicating it is not acceptable for engagement staff and client
personnel to establish close relationships; it reduces the likelihood of a familiarity threat.
5. Auditors should regularly review fees per client to total fees to identify if the fees
from one client are so significant that it leads to a Self Interest Threat.
6. There should be a cooling off period before engagement staff becomes
employed at a clients. This is to reduce the Self Review Threat.
PROFESSIONAL APPLICATION 2.8 – Independence threats and safeguards
(a)
Personal relationships between a partner of the audit firm and the two directors poses a
familiarity threat. This applies even if the partner is not part of the engagement team
because the partner is a senior member of the audit firm.
(b)
KFP should prepare and adopt a Quality Assurance Manual (QAM), that specifies the
firm‘s policies with respect to independence. The QAM should include how the firm will
identify independence threats for all assurance engagements. It should also list
acceptable safeguards to reduce any identified threats to an acceptable level. . The
requirements of the Quality Assurance Manual should be explained to all firm members
and compliance expected.
In this case, the relationship between the partner and the majority shareholders would
be identified. The firm should not use Justin on the Featherbed engagement, and
should not accept the audit Justin is required on the audit.
PROFESSIONAL APPLICATION 2.9 – Independence threats and safeguards
Issues raised in the case:
ISSUE # 1
(a)
The client‘s internal audit department is headed by an ex-partner of KFP.
The rules of professional conduct generally place restrictions on audits where a former
audit partner has a senior role within the client. The restrictions include a cooling off
period, which is usually a two to five year period after the leaving the audit form and the
current audit. On this basis, there does not appear to be a contravention of the rules of
professional conduct. In addition, the restriction sometimes applies to ex-auditors who
become an officer of the company. In the case of Securimax, Rydell Creek does not
appear to be an officer of the company (e.g., a director or senior manager) – he is the
head of the internal audit department. This would certainly include the CFO or CEO, but
it is unlikely to include the head of the internal audit department.
(b)
Safeguards:
ï‚· Ensure that Rydell Creek is not regarded as able to exert direct and significant
influence over the subject matter of the external audit.
 Ensure that there wasn‘t a significant and personal relationship between Rydell
Creek and the other members of the audit team based on their previous
association as colleagues (to deal with the general familiarity threat).
PROFESSIONAL APPLICATION 2.9 (Continued)
An excerpt from the rules of professional conduct states that examples of circumstances that
may create familiarity threats include, but are not limited to:
ï‚· A former Partner of the Firm being a Director or Officer of the Client or an employee in a
position to exert direct and significant influence over the subject matter of the
Engagement.
ISSUE # 2
(a)
Clarke Field has been the partner for 5 years and will remain as review partner when Sally
Woodrow is appointed as partner for the audit.
CPAB and many rules of professional conduct with respect to independence require rotation of
senior audit personnel as follows stating that using the same:
ï‚· Lead Engagement Partner, or
ï‚· Audit Review Partner (if any), or
ï‚· Engagement Quality Control Revieweron an audit over a prolonged period may create
a familiarity threat.
This threat is particularly relevant in the context of a Financial Statement audit of a Listed Public
Entity and safeguards should be applied in such situations to reduce such threat to an
acceptable level. Accordingly in respect of the Financial Statement audit of Listed Public
Entities: (a) The Lead Engagement Partner, the Audit Review Partner (if any) and the
Engagement Quality Control Reviewer should be rotated after serving in any of these
capacities, or a combination thereof, for a pre-defined period, no longer than five financial years
within a seven year period; and, (b) Such an individual rotating after a pre-defined period should
not participate in the Audit Engagement until a further period of time, no less than two years,
since the end of the financial year following the end of the pre-defined period has elapsed.
(b)
Safeguards:
Clarke Field should not participate in the audit for two years.
ISSUE # 3
(a)
Appointment of Sally Woodrow to position of partner and as partner in charge of the Securimax
audit.
Is Sally Woodrow experienced enough to lead the audit? She is being promoted to partner to
enable her to take over the audit. If she is not sufficiently experienced and qualified to lead the
audit there is a risk that the independence of the audit will be compromised.
PROFESSIONAL APPLICATION 2.9 (Continued)
(b)
Safeguards:
An independent (i.e., not previously involved with Securimax) senior audit partner should be
appointed as review partner to assist Sally Woodrow.
Rebecca should be particularly concerned with the firm‘s ability to be objective given its
dependence on the large client‘s fees. Although, Carolina Company Ltd. is only one of the
major clients experiencing rapid growth, fee dependence arises when a client‘s fees form a
significant proportion of the audit firm‘s overall revenue. Many professional accounting bodies’
rules of professional conduct provide guidance about safeguards when this proportion reaches
15%.
Rebecca should also be concerned about the firm‘s ability to use professional competence and
due care in audits for rapidly growing clients at a time when the audit firm is growing rapidly and
the client is undergoing major changes to its reporting requirements. Does the audit firm have
the expertise to audit listed clients? What sort of auditing difficulties are likely to be created by
the stretched financial systems at Carolina Company Ltd.?
The client continuation decision must be properly documented and the engagement letter
drafted to reflect the responsibilities of both parties.
PROFESSIONAL APPLICATION 2.10 – Ethics of accepting engagements
The fundamental principles of professional ethics include integrity (being straightforward and
honest), objectivity (not allowing personal feelings or prejudices to influence professional
judgment), professional competence and due care (maintaining knowledge and skill at an
appropriate level), confidentiality (not sharing information that is learned at work), and
professional behaviour (upholding the reputation of the profession).
The CEO of TLCL has requested the auditor provide an opinion that the laser machines are fit for
use without charging a fee as a gesture of goodwill, in the context of the future negotiations about
the audit tender. There is an implicit invitation to provide a favourable opinion to ensure that the
audit tender is awarded to Fellowes and Associates again.
If Tania provides the opinion without obtaining appropriate and sufficient evidence she would be
compromising her integrity because the favourable opinion would not be honest, and her
objectivity because her professional judgement would be influenced by the desire to win the
tender again. There does not seem to be any threat to confidentiality, although her professional
competence and behaviour on this particular engagement would be compromised because she
would not be exercising her skill at an appropriate level (and she may not be qualified to provide
the opinion on the lasers) and her actions could damage the profession‘s reputation.
PROFESSIONAL APPLICATION 2.10 (Continued)
Accepting an engagement without appropriate remuneration is also likely to create a
conflict of interest. Fees should reflect the work involved and be set at a level that
ensures that adequate staffing are assigned to the engagement and sufficient work
done to complete the engagement.
PROFESSIONAL APPLICATION 2.11 – Independence issues in accepting
engagements
One of the accountants intended to be part of the 2016 audit team owns shares in HCHG.
The accountant‘s interest is not material to him.
Most rules of professional conduct and independence guidelines state that a financial interest
in a client may create a self-interest threat. Owning shares in an engagement client creates a
direct financial interest. Independence rules generally require the auditor to consider the
nature of the financial interest in order to determine the significance of the threat and the
appropriate safeguards. Matters to consider are whether the shareholding is direct or indirect,
how material is the holding, and the role of the member of the assurance team.
Therefore, what duties does the member of the assurance team perform? How senior is his
role? How much judgement will he be required to exercise? If the person is very junior and/or
the amount of the financial interest is very small, the threat is lower and fewer safeguards are
required. However, if the person is more senior and/or the amount of the financial interest is
greater, the safeguards would need to be more significant.
Most independence rules also state that if a member of the assurance team has a direct
financial interest, as in this case, the only safeguards available to eliminate the threat are to
dispose of the direct financial interest prior to the individual becoming a member of the
assurance team, or to remove the member of the assurance team from the engagement.
“Self-Interest Threat” occurs when a firm or a member of the assurance team could benefit
from a financial interest in, or other self-interest conflict with, an assurance client. An example
is that may create such a threat is when an engagement member holdsa direct financial
interest or material indirect financial interest in an assurance client;
A financial interest in an assurance client may create a self-interest threat. In evaluating the
significance of the threat, and the appropriate safeguards to be applied to eliminate the threat
or reduce it to an acceptable level, it is necessary to examine the nature of the financial
interest. This includes an evaluation of the role of the person holding the financial interest, the
materiality of the financial interest and the type of financial interest (direct or indirect).
Most independence rules also state that if a member of the assurance team, or their
immediate family member, has a direct financial interest, or a material indirect financial
interest, in the assurance client, the self-interest threat created would be so significant
PROFESSIONAL APPLICATION 2.11 (Continued)
The only safeguards available to eliminate the threat or reduce it to an acceptable level
would be to:
(a) Dispose of the direct financial interest prior to the individual becoming a member
of the assurance team;
(b) Dispose of the indirect financial interest in total or dispose of a sufficient amount
of it so that the remaining interest is no longer material prior to the individual
becoming a member of the assurance team; or
(c) Remove the member of the assurance team from the assurance engagement.
Fellowes and Associates was previously engaged by HCHG to value its intellectual
property. The consolidated balance sheet (statement of financial position) as at June
30, 2016 includes intangible assets of $30 million, which were valued by Fellowes and
Associates on March 1, 2016 following HCHG‘s acquisition of the subsidiary Shady
Oaks Centre. The intangibles are considered material to HCHG.
Independence rules generally address the issues surrounding the provision of valuation
services to an assurance client. The problem arises because in a financial statement audit
the auditor is required to gather evidence about the client‘s valuation of the assets. If the
auditor provided the valuation to the client, then the auditor has to audit their own work.
A self-review threat may be created when an audit firm performs a valuation for an audit
client that is to be incorporated into the client‘s financial statements. This is generally a
problem if the valuation service involves the valuation of matters material to the financial
statements and the valuation involves a significant degree of subjectivity. In this case,
the self-review threat created could not be reduced to an acceptable level by the
application of any safeguard, and the valuation services should not be provided, or
alternatively, the auditor should withdraw from the audit engagement.
Therefore, the key questions are whether the item is material, whether there is a
significant degree of subjectivity in the valuation service. The intangibles are stated to
be material. Valuation of intangible assets is likely to be subjective, or at least more
subjective than valuation of real property (land and buildings). This implies that Fellowes
and Associates should withdraw from the audit or the client should obtain another
independent valuation for the intangibles.
However, the question appears to state that the valuation services were provided prior
to the audit engagement being accepted. If so, at this time, there was no conflict
between Fellowes and Associates duties as valuator and auditor. However, now, as
auditor, Fellowes and Associates is required to provide an opinion on the valuation
which it previously provided.
PROFESSIONAL APPLICATION 2.11 (Continued)
Other safeguards that could apply to valuation situations include:
ï‚· Involving an additional professional accountant who was not a member of the
assurance team to review the work done or otherwise as necessary;
ï‚· Confirming with the audit client their understanding of the underlying assumptions of
the valuation and the methodology to be used and obtaining approval for their use;
 Obtaining the audit client‘s acknowledgement of responsibility for the results of the
work performed by the firm, and
ï‚· Making arrangements so that personnel providing such services do not participate in
the audit engagement.
At a minimum, Fellowes and Associates should apply the safeguards with respect to the
intangible assets valuation. The valuation should be reviewed by an additional
professional accountant, who is outside the audit team, they should obtain the client‘s
acknowledgement of responsibility for the valuation, and should not use the personnel
involved in the valuation of the financial statement audit. However, it is likely that these
safeguards would not be enough, given the high level of subjectivity in the intangible
assets valuation. Therefore, the client will either have to obtain another independent
valuation or Fellowes and Associates should withdraw from the audit.
In the future, the audit firm should not perform valuations for audit clients that are likely
to be the subject of a financial statement audit, unless they are immaterial and/or have a
very low
