3. Auditor Independence and Ethics

Question 1

What are the five fundamental principles as per the ICAS Code of Ethics?

(COPIP)

Answer 1

1) Confidentiality

2) Objectivity

3) Professional competence and due care

4) Integrity

5) Professional behaviour

Question 2

What does “Confidentiality” mean, as per the ICAS Code of Ethics?

Answer 2

A professional accountant should respect the confidentiality of information acquired as a result of professional or business relationships and should not disclose any such information (intentionally or otherwise) to third parties without proper and specific authority unless there is a legal or professional right or duty to disclose.

Confidential information acquired as a result of professional and business relationships should not be used for the personal advantage of the professional accountant or third parties.

Question 3

What does “Objectivity” mean, as per the ICAS Code of Ethics?

Answer 3

A professional accountant should not allow bias, conflict of interest or undue influence or other factors to override professional or business judgements.

Question 4

What does “Professional competence and due care” mean, as per the ICAS Code of Ethics?

Answer 4

a CA has a continuing duty to maintain professional knowledge and skill at the level required to ensure that a client or employer receives competent professional services based on current technical and professional standards and relevant legislation.

Question 5

What does “Integrity” mean, as per the ICAS Code of Ethics?

Answer 5

A professional accountant should be straightforward and honest in all professional and business relationships.

Question 6

What does “Professional behaviour” mean, as per the ICAS Code of Ethics?

Answer 6

A professional accountant should comply with relevant laws and regulations, behave in a manner consistent with the profession’s responsibility to act in the public interest, and should avoid any action that discredits the profession.

Question 7

What is independence? Is it different from objectivity?

Answer 7

Definition: Independence is “Freedom from conditions and relationships which make it probable that a reasonable and informed third party would conclude that integrity or objectivity either is or could be impaired.”

Independence underpins objectivity. It is freedom from situations and relationships that could impair objectivity.

where objectivity is a state of mind that excludes bias and prejudice.

Question 8

What are Companies Act 2006’s provisions to safeguard auditor independence?

Answer 8

• The shareholders appoint the auditor rather than the board.
• The auditor’s remuneration is fixed by shareholders.
• Publication of the detail of amounts paid to the auditor within the financial statements to enable consideration of the balance of non-audit and audit work in the context of auditor independence.
• There are penalties in place for failing to provide the auditor with information relevant to the audit (eg on matters concerning independence). The auditor is given the investigative and reporting freedom needed to perform his duties.

Question 9

What are the overarching principles according to the FRC Ethical Standard?

Answer 9

Integrity, objectivity and independence.

That is:
 The audit firm, its partners and all staff shall behave with integrity and objectivity in all professional and business activities and relationships.
 In relation to each engagement, the firm and each covered person shall ensure that they are free from conditions which would make it probable that an objective, reasonable and informed third party would conclude that independence is compromised.

Question 10

What are the six categories of threats which may affect independence according to the FRC Ethical Standard?

(MASSIF)

Answer 10

• Management
• Advocacy
• Self-interest
• Self-review
• Intimidation
• Familiarity

Question 11

Explain the “Management” threat to auditor independence, according to the FRC Ethical standard?

Answer 11

A management threat arises when the audit firm undertakes work that involves making judgements and taking decisions that are the responsibility of management.

e.g. the interests and views of the auditor may become closely aligned with those of the directors and management, resulting in their objectivity and independence potentially being, or being seen to be, impaired.

Question 12

Explain the “Advocacy” threat to auditor independence, according to the FRC Ethical standard?

Answer 12

An advocacy threat arises when the audit firm undertakes work that involves acting as an advocate for an audited entity and supporting a position taken by management in an adversarial or promotional context.

e.g. Acts on the client’s behalf to negotiate a reduction in tax liability thus adopting a position closely aligned to that of management. This creates both actual and perceived threats to the auditor’s objectivity.

Question 13

Explain the “Self-interest” threat to auditor independence, according to the FRC Ethical standard?

Answer 13

A self-interest threat arises when auditors have financial or other interests which may cause them to be, or be perceived to be, reluctant to take actions that would be adverse to the interests of the audit firm or any individual in a position to influence the conduct or outcome of the audit.

e.g. Has an investment in the client;

Question 14

Explain the “Self-review” threat to auditor independence, according to the FRC Ethical standard?

Answer 14

A self-review threat arises when the results of a non-audit service performed by the auditors or by others within the audit firm are reflected in the amounts included or disclosed in the financial statements.

Self-review therefore refers to a situation whereby an auditor is assigned the task of auditing his own work or the work of a colleague. Such an assignment would make it difficult for the auditor to maintain objectivity.

Question 15

Explain the “Intimidation” threat to auditor independence, according to the FRC Ethical standard?

Answer 15

An intimidation threat arises when the auditor’s conduct is influenced by fear or threats.

e.g. Threat of replacement as auditor due to disagreement with the client.

Question 16

Explain the “Familiarity” threat to auditor independence, according to the FRC Ethical standard?

Answer 16

A familiarity (or trust) threat arises when the auditor is predisposed to accept, or is insufficiently questioning of, the client’s point of view.

Over-familiarity with a client could lead to the auditor becoming sympathetic to the client and therefore being more likely to blindly accept the client’s judgement.

e.g. Has a family relationship with senior client staff.

Question 17

What are the 3 additional requirements of section 1 of the FRC Ethical Standard?

Answer 17

1) Ethics partner - Audit firms should nominate a partner in the firm as an ethics partner, who is responsible for the adequacy of the policies and procedures and for ensuring that they are communicated to the other partners and staff within the firm

2) Communication with those charged with governance - Auditor is required to communicate all significant facts and matters that impact on auditor integrity, objectivity and independence, including known threats or actual breaches of the ethical principles, to those charged with governance; either the audit committee, where one exists, or the board of directors.

3) Documentation - The engagement partner must also ensure that their consideration of objectivity and independence (including threats identified and safeguards put in place) is adequately documented in the audit file on a timely basis.

Question 18

What is a covered person?

Answer 18

A person in a position to influence the conduct or outcome of the engagement.

Question 19

What are the 6 different sections of the Ethical standard?

Answer 19

Section 1 – General Requirements and Guidance

Section 2 – Financial, Business, Employment and Personal Relationships

Section 3 – Long Association with Engagements and with Entities Relevant to Engagements

Section 4 – Fees, Remuneration and Evaluation Policies, Gifts and Hospitality, Litigation

Section 5 – Non-audit/Additional Services

Section 6 – Provisions Available for Audits of Small Entities (not examinable in Assurance)

Question 20

Once threats have been identified to the auditors independence, what should they do?

Answer 20

1) Eliminate the threat; or

2) reduce the threat to an acceptable level, that is, a level at which it is not probable that a reasonable and informed third party would conclude that the auditor’s objectivity is impaired or likely to be impaired.

3) Resign/decline the engagement if those 2 couldn’t be achieved.

Question 21

What are the common ethical situations covered by section 2 of the FRC Ethical Standard?

Answer 21

 Financial relationships
 Business relationships
 Employment relationships
 Family and other personal relationships

Question 22

What are the common ethical scenarios and which threats to independence arise for:
- Financial relationships?
- Business relationships?
- Employment relationships?
- Family and other personal relationships?

[SCENARIO AND THREAT]

Answer 22

Financial Relationships:
- Financial interest [Threat = Self-interest]
- Loans and guarantees [Threat = Self-interest and Intimidation]

Business relationships:
- Threats: Self-interest, Intimidation & Advocacy

Employment relationships:
- Audit staff on loan to audit client [Threat = Management and Self-review]
- Audit staff potentially leaving to join an audit client [Threat = Self-interest, Familiarity and Intimidation]
- Audit staff leaving to join an audit client [Threat = Familiarity, Self-interest and Intimidation]
- Former audit client staff joins the audit firm [Threat = Self-interest, Self-review and Familiarity]

Familiarity and other personal relationships:
- Threats: Familiarity, Self-interest and Intimidation

Question 23

What are the exceptions for:
- Financial relationships? (Financial interest and Loans & Guarantees)
- Business relationships?
- Employment relationships?
- Family and other personal relationships?

Answer 23

Financial relationships:
- Financial interest - No exception for direct holdings. Only an exception where the interest is an immaterial indirect investment where the holder has no influence over investment decisions.
- Loans and guarantees - Exception when the client is a bank or similar deposit-taking institution; The loan is made in the ordinary course of business on normal business terms; and it is not material to the audit firm and client.

Business relationships:
- Where the transaction is: In the normal course of business, on an arm’s-length basis; and The transaction is clearly not material to either party.

Employment relationships:
- Audit staff on loan to audit client - The only exception relates to staff employed by a UK national audit agency. In this case, an exception would be made assuming the seconded role:
 Included no line management or management responsibilities;
 Was for a period of no longer than 3 months (6 months if the employee
is on a training contract);
 Did not include the provision of a prohibited service.
For all other audit firms, there are no exceptions.

• Audit staff potentially leaving to join an audit client - no exception
• Audit staff leaving to join an audit client - A former engagement partner joining the client, who has not been connected with the client for at least 2 years, may be an acceptable threat, but should be carefully considered. or

A partner from the firm, who has had no involvement in the engagement or with any of the members of the engagement team for at least 2 years would likely be acceptable.

• Former audit client staff leaving to join audit firm - No exception to exclusion rule.

Family and personal relationships:
- The significance of the threat depends on:
 The audit member’s involvement in the engagement;
 The nature of the family relationship; and
 The family member’s relationship with the entity.
A distinction is made between persons closely associated and close family.

Question 24

What are the common ethical situations covered by sections 3 and 4 of the FRC Ethical Standard?

Answer 24

• Long Association with Engagements and with Entities Relevant to Engagements? (section 3)
• Fees, Remuneration and Evaluation Policies, Gifts and Hospitality, Litigation? (section 4)
• Dependence on audit clients & remuneration for selling non-audit services? (section 4)
• Gifts from an audit client & litigation? (section 4)

Question 25

What are the common ethical scenarios and which threats to independence arise for:
- Long Association with Engagements and with Entities Relevant to Engagements?
(section 3)
- Fees, Remuneration and Evaluation Policies, Gifts and Hospitality, Litigation? (section 4)
- Dependence on audit clients & remuneration for selling non-audit services? (section 4)
- Gifts from an audit client & litigation? (section 4)

Answer 25

Long association’: [Threats = Familiarity, Self-interest and Self-review]

Fees, remuneration and evaluation policies, gifts and hospitality, litigation:
- Contingent fees upon outcomes [Threats = Self-interest]
- Overdue audit fees: [Threats = Self-interest]

Dependence on audit clients & remuneration for selling non-audit services:
- Non-audit fees [Threat = Self-interest and Intimidation.]
- One client [Threat = Self-interest
and Intimidation]
- Remuneration for non-audit work [Threat = Self-interest]

Gifts:
- Receiving gifts - [Threat = Familiarity
and Self-interest.]
- Litigation from the client [Threat = Self-interest , Advocacy and Intimidation]

Question 26

What are the requirements surrounding long association on audits?

Time on engagement and time before return

Answer 26

Time on engagement and time before return

Engagement partner – non-PIE - Consider after 10 years, Return = Not specified

Engagement partner – PIE - 5 years
(with limited flexibility to extend to 7 years maximum) and 5 years no return

Engagement Quality Reviewer – PIE
7 years on engagement, 5 years no return

Other key partner – PIE 7 years
and 2 years no return

Other audit staff (PIE) Consider after 7 years, Return = Not specified

Question 27

What are the additional CA 2006 requirements on audit rotation of Public interest entities (PIEs)?

Answer 27

A maximum period of 10 years has been introduced which can be extended to 20 years provided that an appropriate tender process takes place at least every 10 years.

Question 28

What are the Exceptions/Safeguards for FRC ES 4:
- Long Association with Engagements and with Entities Relevant to Engagements
- Fees, Remuneration and Evaluation Policies, Gifts and Hospitality, Litigation
- Dependence on audit clients & remuneration for selling non-audit services
- Gifts from an audit client & litigation

Answer 28

• Long association: Go to time requirement FC’s for different people and no return within x years.
• Fees: No exceptions for contingent fees. Exception for overdue audit fees if amount is trivial/ Engagement partner applies safeguards such as external reviewer and notifies ethics partner.

Dependence:
- Non-audit fees: Public interest 70% cap on non-audit fees of past 3yr average audit fee.
- One client: If total fees (audit and non-audit) are expected to regularly exceed 10% (public interest and other listed clients) or 15% (non-listed clients) of the annual fee income of the audit firm, then the auditor should resign or not stand for reappointment.
- Remuneration for non-audit work: No exceptions. No link between non-audit selling and bonuses etc!

Gifts and litigation:
- Gifts and hospitality can only be accepted where the value is clearly trivial to all parties (ie to the individual, the firm and the client).

Consideration should also be made of hospitality offered to audit clients by audit firms/auditors, to ensure that auditor independence is not impaired or seen to be impaired.

• If litigation is in progress or is probable, the firm should either not continue with or not accept the audit engagement.

Question 29

What are the common ethical situations covered by section 5 of the FRC Ethical Standard?

Answer 29

Providing non-audit services to clients.

Question 30

Before a non-audit client is taken on what should the audit firm do?

Answer 30

Before a non-audit service is accepted the audit firm should:

• Identify and assess the significance of any threat to integrity, objectivity and independence;
• Identify and assess the available safeguards to eliminate or reduce the threats; and
• Consider whether an objective, reasonable and informed third party would consider that the objectivity of the firm or covered persons is compromised considering applicable threats and safeguards.

If an objective, reasonable and informed third party would conclude there exists an impairment to independence, then the non-audit service should not be undertaken, or the auditor should resign from the audit engagement.

Question 31

What are the common ethical scenarios and which threats to independence arise for non-audit services?

Answer 31

Scenario: Providing non-audit services [Threat = Self interest, Self-review, Advocacy and Management]

Question 32

What are common safeguards/ES requirements for non-audit services?

Answer 32

• Having a separate team from the audit engagement team perform the non-audit service;
• Completing an independent engagement quality review on the audit engagement.

Question 33

State some prohibited non-audit services to Public interest entities to the year being audited and the preceding year.

Answer 33

• Services that involve undertaking the role of management (management threat).
• Book-keeping and accounts preparation (self-review and management threat).
• Payroll services (self-review threat).
• Valuation services (self-review threat).
• Legal services (advocacy threat).

Question 34

What are some of the permitted non-audit services that an auditor is allowed to do, according to the ES?

Answer 34

• Reporting on internal financial controls when required by law or regulation.
• Reporting on government grants.
• Reviews of interim financial information and providing verification of interim profits not otherwise required by law or regulation.
• Reporting required by a competent authority or regulator under law (eg reporting on client assets).
• Reporting on the iXBRL (Inline eXtensible Business Reporting Language) tagging of financial statements has been developed to communicate information between businesses and other users of financial information, such as regulators, investors, analysts etc