Professional Ethics - Auditor Independence and embedded conflicts Flashcards
The importance of Auditor Independence - Achieving the objective of an audit
Objective of an audit (International Standard on Auditing 200, para 11) … and therefore the basis of the audit opinion (2)
What is it fundamentally linked with and what is that?
Objective of an audit (International Standard on Auditing 200, para 11) … and therefore the basis of the audit opinion
(a) To obtain reasonable assurance that the financial statements as a whole are free from material misstatement, whether due to fraud of error, thereby enabling the auditor to express an opinion 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.
Fundamentally linked with concept of Audit Quality
The probability that the auditor will both discover a breach in the client’s accounting system and report a breach in the client’s accounting system (DeAngelo, 1981)
The importance of auditor independence
” FRC Ethical Code, para I1)
Audit is a vital element in achieving _________________ (from who, for what, to whom, by what means), and ________________ can only be effectively given by persons (auditors) who are _________________ of the ______________ ____________ being audited.
Auditors audit the _____________ _______________ prepared by _______________ and report to ________________ their ___________ as to the ________ and ____________ of financial statements
“a fundamental objective of any such engagement is that the intended users trust and have confidence that the audit opinion is professionally sound and objective. This in turn should enhance the credibility for users of the information the opinion covers” FRC Ethical Code, para I1)
Audit is a vital element in achieving accountability (from who, for what, to whom, by what means), and credibility can only be effectively given by persons (auditors) who are independent of the subject matter being audited.
Auditors audit the financial statements prepared by directors and report to shareholders their opinion as to the truth and fairness of financial statements
The importance of auditor independence - ‘a true and fair view’
- The auditor exercises ______________ ____________________ and maintains _______________ ________________
- The auditor must act with ____________, exercise _______________
- These behaviours support each other, and support the auditor maintaining _______________ ….. and being ________________ supports the ____________ of _______________
Carillion audit opinion story
Auditor responsibility to form an opinion; essential behaviours:
- The auditor exercises professional judgement and maintains professional scepticism
- The auditor must act with integrity, exercise objectivity
- These behaviours support each other, and support the auditor maintaining independence ….. and being independent supports the exercise of behaviours!
Carillion audit opinion
The controversial case of Carillion, whose auditors gave an unqualified opinion, stating: “In our opinion, the financial statements give a true and fair view of the state of the Group’s and Parent Company’s affairs as at 31 December 2016 and of the Group’s profit for the year then ended.”
This became highly contentious when Carillion faced financial collapse shortly after, raising doubts about the robustness of the audit and the auditors’ adherence to the essential behaviours.
The importance of auditor independence - Independence: IFAC Code of Ethics
IFAC Code: defines independence of _______ and ________________: (2)
IFAC Code: defines independence of mind and appearance:
(a) Independence of mind – the state of mind that permits the expression of a conclusion without being affected by influences that compromise professional judgment, thereby allowing an individual to act with integrity, and exercise objectivity and professional scepticism.
(b) Independence in appearance – the avoidance of facts and circumstances that are so significant that a reasonable and informed third party would be likely to conclude that a firm’s, or an audit team member’s, integrity, objectivity or professional scepticism has been compromised
Therefore, the auditor must be, and appear to be, independent
The importance of auditor independence - Independence: FRC (UK) Code of Ethics
What is the FRC Ethical Standard?
“Integrity or objectivity (and therefore independence) would be compromised if it is probable that: (5)
FRC Ethical Standard: “Freedom from conditions and relationships which, in the context of an engagement, would compromise the integrity or objectivity of the firm or covered persons”.
“Integrity or objectivity (and therefore independence) would be compromised if it is probable that:
- an objective, reasonable and informed third party would conclude that
- the threats, arising from any conditions or relationships that exist
- (….having regard to any safeguards implemented),
- would impair integrity or objectivity to such an extent that it would be inappropriate for the firm to accept or continue to perform the audit unless
- the threats were eliminated or further reduced or unless more, or more effective, safeguards were implemented”
(reference: FRC Ethical Standard and FRC Glossary of Terms)
The importance of auditor independence - Practitioner independence
Independence into three key categories:
Built-in anti-independence factors (3)
Independence into three key categories:
Programming independence:
- The ability for auditors to design their own audit programmes without external influence.
Investigative independence:
- The freedom to examine any information that auditors consider relevant to their work.
Reporting independence:
- Ensures that the contents of an audit report are driven solely by the audit’s scope and findings, free from outside pressure.
Built-in anti-independence factors
Close relationship with business:
- Auditors often face conflicts due to their financial dependence on clients, the need to maintain confidentiality, and their role in serving management.
Organisation of the profession:
- The audit profession is dominated by a few large firms. Inter-firm competition and the focus on “salesmanship” can potentially undermine objectivity.
Understanding the conflicts:
- To fully grasp these challenges, it’s important to understand the structure and dynamics of the audit profession.
Auditors as commercial agents and guardians of society - Guardian v’s commercial function
Auditors operate at the cusp between the __________ and _____________ function – ____________ ___________; remember audit is a ____________ ______________ for ___________ ___________ _____________.
- Auditors operate at the cusp between the guardian and commerce function – embedded conflict; remember audit is a statutory requirement for limited liability companies.
Guardian function
- Skill and competence and judgement to issue an audit opinion
- Acting for shareholders and acting in the public interest
Commerce function
- Reliance of fees from the client – audit and non-audit fees
- Reliance on repeat business
- Need to sustain a professional working relationship (with shareholders, directors, stakeholders)
Auditors as commercial agents and guardians of society - Auditing in the public interest
Why is defining “public interest” in auditing considered complex?
How do corporate audits benefit the public interest economically? (3)
What is the primary focus of audits in relation to public interest?
What critical question does the slide raise about the role of audits in public interest?
Why is defining “public interest” in auditing considered complex?
- Defining public interest is complex because it involves ideological nuances and varying perspectives on what constitutes the public good.
How do corporate audits benefit the public interest economically?
Corporate audits provide several economic benefits to the public interest, such as:
- Protection from corporate collapse, which helps stabilize the economy and protects stakeholders.
- Credibility of capital markets, ensuring that investors and participants trust the system.
- Reliability of financial statements from Limited and Plc companies, enabling sound economic decision-making.
What is the primary focus of audits in relation to public interest?
- The primary focus of audits in public interest has been on economic aspects, such as supporting financial stability and market credibility.
What critical question does the slide raise about the role of audits in public interest?
- The slide questions whether this narrow economic focus is sufficient and asks if audits should address broader socio-economic concerns to serve a more holistic societal purpose.
Auditors as commercial agents and guardians of society - Professional bodies acknowledging their ‘Public Interest’ role
What is the role of ICAEW in acting in the public interest?
How does ICAEW draw on its members’ experience to serve the public interest?
What broader benefits does ICAEW aim to achieve by protecting the public interest?
What critical questions does the slide raise about the “public” in public interest? (3)
What is the role of ICAEW in acting in the public interest?
- ICAEW works to protect the public interest by ensuring its firms, members, students, and affiliates maintain the highest standards of professional competency and conduct.
How does ICAEW draw on its members’ experience to serve the public interest?
- ICAEW uses the experience of its members and technical expertise to develop policies that serve the public interest.
What broader benefits does ICAEW aim to achieve by protecting the public interest?
- ICAEW’s actions are aimed at benefiting the economy and protecting the integrity of the accountancy profession.
What critical questions does the slide raise about the “public” in public interest?
The slide questions:
- Who are the public?
- Are some groups more impacted than others?
- Are some groups more privileged than others?
Auditors as commercial agents and guardians of society - Public Interest Entities (PIEs)
PIEs defined by law to have a significant public impact. It categorizes PIEs into three types:
The disastrous effects that can occur if a PIE fails—particularly after _____________ _________ or _____________ _____________. In such cases, ___________ often bears the ____________ of these failures, showing why public interest is a ____ ___________.
Example
- Entities with transferable securities traded on a UK regulated market.
- Credit institutions like banks or financial institutions.
- A person who would be an insurance undertaking
The disastrous effects that can occur if a PIE fails—particularly after financial crises or corporate collapses. In such cases, society often bears the burden of these failures, showing why public interest is a key priority.
“National Audit Office (NAO) report published in June 2018 estimated it would cost UK taxpayers an estimated £148m, warning of wider costs to the economy, Carillion’s customers, staff, the supply chain and creditors” (https://www.icaew.com/insights/viewpoints-on-the-news/2023/jan-2023/carillion-anniversary-prompts-calls-for-audit-reform-push)
Auditors as commercial agents and guardians of society - Public Interest Entities (PIEs)
What is the expanded definition on PIEs (2)
Impact of this and what it includes (2)
Audit Proposal Changes (2)
….. But, ramifications of audit failure have broad societal impacts, for example …
Is the auditing profession and the auditor an effective guardian of society? (what happened in 2018 and then 2022)
Recent audit and corporate governance reform proposals designed to enhance the oversight of such entities. Here’s a summary of the key points:
Expanded Definition of PIEs: The scope of PIEs will now include entities with:
- £750 million+ turnover.
- 750 (global) employees or more.
Impact:
- Approximately 600 new entities will be classified as PIEs, based on an estimate by BEIS (Department for Business, Energy, and Industrial Strategy).
- This includes private limited companies and AIM-listed companies.
Audit Changes:
- All auditors and responsible individuals wishing to audit PIE entities must register with the FRC’s PIE Auditor Register (Financial Reporting Council).
- Proposed reforms aim to restore public trust through increased scrutiny and improved oversight.
….. But, ramifications of audit failure have broad societal impacts, for example …
After BHS, after Carillion …
The CMA’s chairman, Andrew Tyrie, said: “Addressing the deep-seated problems in the audit market is now long overdue. … tens of millions of people depend on robust and high-quality audits. If a company’s books aren’t properly examined, people’s jobs, pensions or savings can be at risk.”
…… the importance of serving the public interest!!!
Over 150 recommendations arising from independent reviews in 2018:
Kingman report - Independent Review of the Financial Reporting Council
Brydon report - The quality and effectiveness of audit: Independent review
CMA investigation - Statutory audit market services study
Governments response:
BEIS: Restoring trust in audit and corporate governance white paper, May 2022
Auditor Independence and embedded conflicts - FRC: Key Facts and Trends in the Accountancy Profession
Key facts and trends
Fact about big 4?
Larger audit firms are highlighted along with key aspects like ______________ ___________, ________________ (students, gender, age, sector), and their fee income.
-
Big 4’s Market Share:
- They audit 99% of FTSE 100 companies - essentially an oligopoly in this space.
-
Registered Audit Firms:
- Larger audit firms are highlighted along with key aspects like corporate structure, demographics (students, gender, age, sector), and their fee income.
-
Analysis of Fee Income in 2022:
- The slide provides detailed fee income figures for each firm, categorized into:
- Audit services.
- Non-audit services (NAS) for audit clients.
- Non-audit services for other clients.
- The slide provides detailed fee income figures for each firm, categorized into:
Here’s a snapshot of the fee income data for 2022 (in £ millions):
| KPMG | 709 | 98 | 1,916 |
| EY | 626 | 163 | 2,440 |
| Deloitte| 649 | 209 | 2,309 |
| BDO | 324 | 73 | 411 |
| Grant Thornton (GT) | 167 | 52 | 428
|PwC | 818 | 195 | 2,862 |
Firm | Audit | NAS to Audit Clients | NAS to Other Clients |
Auditor Independence and embedded conflicts - Embedded conflicts
Why is auditor independence a challenge?
How does the organization of the auditing profession affect auditor independence?
What is required to address these challenges in auditing?
Profession independence “auditing suffers from ‘built-in anti-independence factors’”
- Auditor independence is challenging due to their close financial relationships with clients, competition among audit firms, and the pressure to cater to management needs. These factors can compromise objectivity.
- The profession is dominated by a few large firms, leading to competition that emphasizes salesmanship, which can hinder the objectivity of audits.
- To tackle these challenges, a deeper understanding of the audit profession and its inherent conflicts is necessary to improve auditor independence and integrity.
Auditor Independence and embedded conflicts - Embedded conflicts 2
What are Management Advisory Services (non-audit services), and how do they affect auditor independence?
How does inter-firm competition threaten auditor independence?
Why does the length of an auditor’s tenure pose a risk?
How does the relative size of an audit firm influence independence?
What are Management Advisory Services (non-audit services), and how do they affect auditor independence?
While these services can add value to the client, they may negatively impact the actual or perceived independence of the auditor. This reliance on the client could reduce the auditor’s scepticism or ability to withstand pressure.
How does inter-firm competition threaten auditor independence?
Intense competition, such as lowering fees to retain clients, can have a negative impact on both the actual and perceived independence of auditors.
Why does the length of an auditor’s tenure pose a risk?
Long tenures may lead to auditors identifying too closely with the client’s mindset, which could compromise their independence.
How does the relative size of an audit firm influence independence?
Larger firms may be less dependent on individual client fees, which can help maintain independence. On the other hand, smaller firms might have closer, more personal relationships with clients but could face challenges due to limited resources or skills.
Auditor Independence and embedded conflicts - Embedded conflicts 3
How can accounting flexibility in accounting standards impact auditor independence?
Why might auditors fear losing clients and reputation?
How do professional sanctions or discipline influence perceptions of auditor independence?
How can accounting flexibility in accounting standards impact auditor independence?
- Flexibility may lead to disagreements between management and auditors over accounting policies. This can make auditors more dependent on their clients.
Why might auditors fear losing clients and reputation?
- Such fear can affect their professional scepticism and reduce their ability to withstand pressure during the audit process.
How do professional sanctions or discipline influence perceptions of auditor independence?
- The extent and enforcement of professional sanctions can undermine how auditor independence is perceived if they are weak or inconsistent.
Auditor Independence and embedded conflicts - Critique from Lord Sikka (Sikka et al. 2009)
Three concerns deeply embedded within current audit practice (3 questions)
What does Lord Sikka describe the audit model as and why?
What factors contribute to these flaws in the auditing process? (4 factors)
What metaphor does the former ICAS President use to describe modern audits
- Can the contemporary audit model deliver an independent audit
- How can audit quality be truly assessed if focus on compliance without considering the organisational context of auditing
- Are new and emerging forms of complex transactions auditable?
He argues that the audit model is flawed because it makes auditors financially dependent on their clients, prioritizing their economic interests over the public good.
What factors contribute to these flaws in the auditing process?
The critique identifies several factors, including:
- Auditor dependence on fees from their clients.
- Ineffective shareholder participation in audit-related decisions.
- Auditor acquiescence to client demands.
- The use of audit relationships to sell non-audit services.
What metaphor does the former ICAS President use to describe modern audits?
The former ICAS President compares modern audits to “auditing in helicopters,” implying that auditors maintain a distant, superficial view without engaging deeply with their clients’ operations.
Auditor Independence and embedded conflicts - Suggestions for reform from Lord Sikka (Sikka et al. 2009) (11)
- Strengthen independence/ involve the state: Ban on selling non-audit services; Continuous audit - regulatory and financial matters
- Greater transparency and disclosure of audit practice – methodologies, budgets and staffing etc.
- Increased state regulation on ‘sensitive’ industries
- Acknowledgement that some types of transaction cannot be audited
- Extend accountability responsibilities Developments in audit technologies
- Extended audit reporting
- Audit Quality Review processes
- Transparency Reports
- Audit Firm Governance Code
- BEIS proposals – though timeline currently extended and indeterminate (BEIS disbanded; anticipating that replaced government department will take this forward)
- Ethical Codes developed and updated
Auditor Independence and embedded conflicts - IFAC Code of Ethics and FRC Ethical Standard
- What are the fundamental principles emphasized in the IFAC Code of Ethics and FRC Ethical Standard for audit engagements?
- How can independence be achieved in audit engagements?
- Who must comply with the ethical code outlined in these standards?
- What is the definition of a ‘covered person’?
Here’s the information presented in a question-and-answer format:
-
What are the fundamental principles emphasized in the IFAC Code of Ethics and FRC Ethical Standard for audit engagements?
- The fundamental principles are Integrity, Objectivity, and Independence.
-
How can independence be achieved in audit engagements?
- Independence is achieved through strict compliance with both Integrity and Objectivity.
-
Who must comply with the ethical code outlined in these standards?
- Both the audit firm and the ‘covered person’ are required to comply with the ethical code.
-
What is the definition of a ‘covered person’?
- A ‘covered person’ is someone who holds a position that can influence the conduct or outcome of the audit engagement.
