Ethics, legal liability and client acceptance w2 PDF

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practice questions for audit and assurance...

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Solutions In-class questions (Week 2) Auditing and Assurance (ACC3AUD) Ethics, legal liability and client acceptance Online lectures/activities- It is recommended that student should complete the online learning activities before attending the weekly class. These include the online lectures and pre-class questions. Reading guide References: Moroney, Campbell and Hamilton - Chapter 2 Auditing standards: ASA 210: Agreeing the Terms of Audit Engagements APES 110: Code of Ethics for Professional Accountants ASA 610: Using the Work of Internal Auditors Review questions: 1. What are threats to compliance with the fundamental principles? Explain the five categories of threats identified in APES 110, and include examples. Members of the professional accounting bodies are required to comply with the five fundamental principles of integrity, objectivity, professional competence and due care, confidentiality and professional behaviour. There may be circumstances which make it more difficult for accountants to comply with the principles because they create specific threats to compliance. The circumstances can be the result of many different factors, and can produce more than one type of threat to compliance. The Code of Ethics for Professional Accountants identifies five key threats to auditor independence (APES 110, s. 120). They are the self-interest, self-review, advocacy, familiarity and intimidation threats. Self-interest: the threat that a financial or other interest of the accountant will inappropriately influence the accountants' judgment or behaviour. Examples include: owning shares in the client, having loans to or from the client and fee dependence.

Self-review: the threat that an accountant will not appropriately evaluate the result of previous judgements made by themselves or another member of the firm. Examples include auditing the results of a financial system that they designed or installed, a member of the audit team having recently been a director of officer of the client (senior staff) or in a position to exert significant influence over the subject matter of the engagement. Advocacy: the threat that the accountant will promote a client's position to the point that the accountant's objectivity is compromised. Examples include promoting shares 1

in an audit client, or acting as an advocate on behalf of an audit client in disputes or legal cases. Familiarity: the threat that due to a long or close relationship with a client, the accountant will be too sympathetic to their interests or too accepting of their work. Examples include having a close family member who is a director or officer of the client, or senior personnel having a long association with the assurance client. Intimidation: the threat that an accountant will be deterred from acting objectively because of actual or perceived pressure or attempts to exert undue influence. Examples include being threatened with dismissal, or an accountant having accepted a significant gift from a client and being threatened that acceptance of this gift will be made public. 2. Why are there procedures governing the client acceptance or continuance decision? Explain why auditors do not accept every client. 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. 3. Explain the difference between independence of mind and independence in appearance. Independence of mind is the way an auditor thinks when conducting an audit, such that their professional judgment is not impacted, and they can make decisions using appropriate levels of professional scepticism, integrity and objectivity. 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. 2

For example, an independent auditor will not be persuaded by the client to ignore a piece of evidence because of the auditor's friendship with the client. Acting independently is essential for a high-quality audit. Independence in appearance is the way an auditor seems to others when conducting an audit and whether others believe that the auditor looks able to make decisions using appropriate levels of professional scepticism, integrity and objectivity. It is the perception of the auditor's independence. If outside parties believe that the auditor will not be unbiased because of a friendship with the auditor, the auditor will not appear independent. Both independence of mind and independence in appearance are important for every auditor on every audit engagement. 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. Professional Application Questions (PAQs) 4. Jason is at a neighbourhood Christmas party with several of his flatmates. Over a few beers, Jason gets into a conversation with a neighbour, Tony, about mutual acquaintances. Jason is a junior auditor with a large accounting firm (although he tells Tony that he is a partner at the firm) and Tony works for a large bank. During the conversation Jason and Tony discover that they have both had professional dealings with a particular family-owned manufacturing company. Tony reveals that the company’s line of credit is about to be cancelled because of some irregularities with the security documents. Jason is concerned to hear this news because he has just participated in the company’s financial report audit and there was no indication of any problems with its borrowings. Jason tells Tony that he believes that the founder of the family-owned company (and the current CEO) is having an affair with his personal assistant, and has quietly increased his shareholdings in a listed company that supplies components to the family manufacturing company. The components manufacturing company is about to announce to the share market that it has just won a very large, and very profitable, contract with a Chinese company. Required: Discuss the ethical principles that are potentially breached by Jason’s behaviour at the party.

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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 (APES 110, 110.1 A1. Jason overstates his importance at the audit firm – he states that he is a partner but he is a junior auditor. Breach of integrity. Jason tells Tony that the founder 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. Jason tells Tony 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 Tony is a breach of confidentiality. It is not relevant that Tony works for a bank which lends to the client, Jason does not have the client’s permission to discuss this matter. 5. Linda is the managing partner of Moss and Associates, a small audit firm. Linda’s role includes managing the business affairs of the firm, and she is very worried about the amount of fees outstanding from audit clients. One client, Dreamers Pty Ltd, has not paid its audit fees for two years despite numerous discussions between Linda, the audit partner, Bill, and the management of Dreamers Pty Ltd. Dreamers Pty Ltd’s management promised the fees would be paid before the audit report for this year was issued. Linda rang Bill this morning to ensure that the audit report was not issued because Dreamers Pty Ltd had paid only 10 per cent of the outstanding account. She discovers that Bill is about to sign the audit report. Required: Explain the ethical problem in this case. Why is it a problem? What can be done about it? 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. The auditor should take steps to have the fees paid before the next audit or remove itself from the audit. See APES 110: 410.7 - A self-interest threat may be created if fees due from an assurance client remain unpaid for a long time, especially if a significant part is not paid before the issue of the assurance report for the following year. Generally, the payment of such fees should be required before the report is issued. Examples of actions that might be safeguards to address such a self-interest threat include: • obtaining partial payment of overdue fees, 4

• having an appropriate reviewer who did not take part in the audit engagement review the work performed. Where a significant part of the fees remain unpaid, the situation should be reviewed by to determine if the unpaid fees amount to a loan to the client. The audit firm should consider whether it is appropriate to continue the audit or be reappointed in the next period.

6. Arendelle Shopping Centres has borrowed heavily in recent years. The pressures of rapid expansion have been felt within its finance department, and the chief financial officer (CFO) has begun to make mistakes. The CFO neglected to reclassify some of its debts from non-current liabilities to current liabilities following default on some terms of the contract with an international banking syndicate and omitted contingent liabilities from the notes to the accounts. The billion-dollar mistakes were not detected by either the directors or the auditors, and the financial report and audit report were published. Following discovery of the mistake, the shares in Arendelle Shopping Centres lost value rapidly and the company was placed into liquidation. Required: Discuss the auditor’s liability for losses suffered by (a) Arendelle Shopping Centres investors, and (b) other parties. The misclassification of liabilities as non-current instead of current potentially means that anyone analysing the financial position of Arendelle Shopping Centres would be misled. If the liabilities are current, it is likely that they are due to be paid within 12 months, although they could also be renegotiated and the repayment date extended. The reader of the accounts would not be sure if Arendelle had to repay the debt, and would have doubt about the ability of the company to continue in business. The directors and managers of Arendelle are likely to say that they relied on information provided to them by the finance department. The reports from the finance department probably did not state that the debts were due to be repaid soon. However, the directors and managers are under an obligation to ask questions about important matters such as large debts. They are also obliged to monitor the financial position of their company. They cannot just rely on others. The auditors are likely to say that they relied on information provided by the managers about the due date for the debt repayments. However, the auditors should gather evidence about the repayment date, not just rely on what the managers tell them. (a) The investors in Arendelle could bring legal action against the auditors, arguing they suffered financial loss as a result of the misclassification of the debt. The auditors reported that the financial accounts were in accordance with the Corporations Act and accounting standards (which they were not, because the debt was misclassified), and that the accounts were true and fair (which they were not because they gave a misleading picture). 5

It is likely that the auditors are liable to the investors in Arendelle Shopping Centres because of their loss and the failure of the auditors to following auditing standards, such as those requiring auditors to gather sufficient and appropriate evidence about the liabilities and their disclosures. The auditor could be liable under both contract law (failure to perform the audit they were contracted to do) and tort of negligence. The investors would need to establish that the auditor owed them a duty of care and the duty of care was breached, and that the investors suffered a loss as a result of that negligence. (b) Third parties cannot rely on contract law. Other parties would try to rely on tort law. In addition, to duty of care, breach of the duty and loss, they have to establish that there was reasonable foreseeability. This means that the other parties would have to establish that the auditor was aware, or should have been aware, that any negligence on their part could cause a loss to the third parties. This is more difficult than establishing foreseeability of the loss suffered by investors. Caparo (1990) established the concept of reasonable proximity, where the auditor must be aware of the third party as a group and the decision they intend to make when using the audited report. Third parties would have a better case if they obtain a Privity Letter which can be used to prove that a duty of care was owed to them. Otherwise, there would need to be some special circumstances before the auditor was liable to them in this case.

7. Rivets Ltd has an internal audit department that primarily focuses on audits of the efficiency and effectiveness of its production departments. The other main role of the internal audit department is auditing compliance with various government regulations surrounding correct disposal of waste and storage of raw materials at its five factories. Rivets Ltd’s internal audit department is run by Rusty Rydell, a CPA and a member of the Institute of Internal Auditors. There are three other members of the department, all of whom have experience in performance auditing and, in addition, have completed industry-run training courses in waste management and handling dangerous goods. Rusty meets regularly with the chief production manager and sends monthly reports to the CEO and the board of directors. Your initial investigations suggest that Rusty is highly regarded within Rivets Ltd, and his reports are often discussed at board meetings. In most cases, the board authorises the actions recommended in Rusty’s reports with respect to major changes to production and logistics. Required: Comment on the extent of reliance the external auditor should place on the work of the internal audit department at Rivets Ltd. Explain the likely impact of the internal audit department’s work on the audit plan. The internal audit department focuses on efficiency and effectiveness of production (i.e. performance auditing) and compliance with government regulations (compliance auditing). The head of the internal audit department is a CPA and the other members of the department have performance auditing and compliance relevant experience and 6

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. 8. Dolphin Surf & Leisure Holidays Pty Ltd (Dolphin) is a resort company based on the Great Barrier Reef. Its operations include boating, surfing, diving and other leisure activities, a backpackers’ hostel, a family hotel and a five-star resort. Justin and Sarah Morris own the majority of the shares in the Morris Group which controls Dolphin. Justin is the chairman of the board of directors of both Dolphin and the Morris Group, and Sarah is a director of both companies as well as the CFO of Dolphin. In February 2020, Justin Morris approached your audit firm, Clarke Partners, to carry out the Dolphin audit for the year ended 30 June 2020. Dolphin has not been audited before but this year the audit has been requested by the company’s bank and a new private equity investor group which has just acquired a 20 per cent share of Dolphin. You know that one of the partners at Clarke Partners went to school with Justin and has been friends with both Justin and Sarah for many years. Required: (a) Identify and explain the significant threats to independence for Clarke Partners in accepting the audit of Dolphin. Personal relationships between a partner of the audit firm and the two directors creates a familiarity threat. Personal relationships with client personnel can also potentially create self-interest or intimidation threats (s. 510.2). This applies even if the partner is not part of the engagement team because the partner is a senior member of the audit firm (s. R521.8). (b) Explain any relevant and practical safeguards that Clarke Partners could implement to reduce the threats. The firm should not use that partner on the Dolphin engagement, and should not accept the audit if that partner is required on the audit. See also 300.7 A5 for examples of firm-wide safeguards in the work environment. They include policies and procedures to implement and monitor compliance with fundamental ethical principles. 7

9. Andrews, Rubina & Associates is a small, but rapidly growing, audit firm. Its success is largely due to the growth of several clients that have been with the firm for more than five years. One of these clients, Tyler Trading Ltd, is now listed on the ASX and must comply with additional reporting regulations. Tyler Trading Ltd’s rapid growth has meant that it is financially stretc...