According to ES1 guidance, auditors should be straightforward, honest and sincere in their approach to their professional work (ES 1 (Revised) Integrity, objectivity and independence). They should conduct the audit of the financial statements of an entity with integrity, objectivity and independence.
Integrity is considered to be the core value of a Code of Ethics. It refers to honesty in dealing with business partners. Auditors are expected to maintain impartiality of professional service and maintain objectivity in the professional judgment. For instance, an auditor reviewing the financial records of a company must reveal any important information to company management and be honest regarding potential problems that may exist in accounting books. According to auditors have a duty to adhere to high standards of behaviour in the course of their work and in their relationships with the staff of audited entities. Therefore, it is essential that they act, and are seen to act, with integrity, which requires not only honesty but a broad range of related qualities such as fairness, candour, courage, intellectual honesty and confidentiality.
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As far as objectivity is concerned, it is a state of mind that excludes bias, prejudice and compromise and that gives fair and impartial consideration to all matters that are relevant to the task in hand, disregarding those that are not. Like integrity, objectivity is a fundamental ethical principle and requires that the auditors judgment is not affected by conflicts of interest.
The need for auditors to be objective arises from the fact that many of the important issues involved in the preparation of financial statements do not relate to questions of fact but rather to questions of judgment. For example, there are choices to be made by the board of directors in deciding on the accounting policies to be adopted by the entity: the directors have to select the ones that they consider most appropriate and this decision can have a material impact on the financial statements.
The purpose of auditing is to provide an independent review of a company's financial statements, in order to add creditability to the assertions made by the company's management. Therefore the auditor's independence can be seen as one of the fundamental concepts of auditing. Important regulation dealing with auditor's independence includes: the EU Commission Recommendation's Statutory Auditors' Independence in the EU: A Set of Fundamental Principles, the IFAC Code of Ethics for Professional Accountants and the International Standards on Quality Control 1 (ISQC1). Independence is related to and underpins objectivity. However, whereas objectivity is a personal behavioural characteristic concerning the auditor's state of mind, independence relates to the circumstances surrounding the audit, including the financial, employment, business and personal relationships between the auditor and the audited entity and its connected parties.
One should note the difference between independence of mind and independence in appearance. It is not enough for the auditor to be independent; it must also be perceived by the users of auditing that the auditor is independent. Even if auditors act independently but are perceived to be not independent, the auditor's work will not be seen as credible and therefore the purpose of providing reliable assurance will not be fulfilled.
One reason why it is especially important for auditors to remain independent is the fact that auditors can be held legally accountable for their work. If it is found that they have not been independent or have not undertaken their work in accordance with auditing standards, they can be sued by the client or by the users of the financial statements who made financial decisions based on those statements. Regardless of whether the auditor is guilty or not, the damage to their reputation can have severe consequences and even lead to bankruptcy for the audit firm. This is because an auditor without a reputation of being independent will not receive business in the future. An example of this can be seen in the case of Arthur Anderson; even though they were eventually cleared of wrong-doing, it was too late because the damage to their reputation had already put them out of business (Eilifsen, A., Messier Jr. W. F., Glover, S. M., & Prawitt D.F. (2010) Auditing & Assurance Services, Second international edition. McGraw-Hill Education, p. 134).
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Many believe that mandatory rotation of auditors may improve problems related to auditor independence. This is because after a number of years working with the same client, auditors form relationships with the managers and can also become blind to potential misstatements because they feel so familiar with the firm. According to IFAC/ IAASB, public companies must change their auditor every seven years (Carrington (2009) Lecture 5: Auditor Independence (Lecture at Uppsala University on 3rd February 2009).
Auditors must comply with a series of premises and fundamental principles. The fundamental principles comprise of independence, objectivity, integrity, professional competence, due care, confidentiality, professional conduct and technical principles.
While analysing the case of the audit firm, the following ethical issues have been recognized as being a serious threat affecting the auditor's objectivity, integrity and independence:
self-interest threat - which arises when the auditor has financial or other interests which might cause the auditor 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. In the case of the audit firm in question the threat relates to the possible desire not to lose one of the biggest clients. Moreover, the existence of the overdue fees and the need to recover some of them, as it has been identified in the reviewed case, can be seen as a threat of appear to the auditor's objectivity and become a serious self-interest threat.
Additionally, as per the APB guidance, auditors should be careful not to fall foul of ethical standards in their efforts to work with clients facing difficulties. The main risk in the reviewed case is related to the fact that the auditors might be drawn into an advocacy role in assisting clients in dealing with funding requirements. Appropriate safeguards are recommended to ensure that audit independence is not impaired.
self-review threat - which arises when the results of a non-audit service performed by the auditor or by others within the audit firm are reflected in the amounts included or disclosed in the financial statements. In the reviewed case, the audit firm has been involved in designing, selecting and implementing the company's accounting system. As a result of such actions, the audit firm can be associated with aspects of the preparation of the financial statements, at the same time the auditor may be (or may be perceived to be) unable to take an impartial view of relevant aspects of those financial statements.
According to, in the case of unlisted clients, auditors may provide certain accounting services to the client provided safeguards are applied. The accounting services that they can provide should not involve initiating transactions or making management decisions and should be of a mechanical nature.
The safeguards adopted in such cases should be as follows:
- Accounting services are provided by staff not involved in the audit
- Accounting services are reviewed by a partner who is not part of the audit team
- The audit is reviewed by another partner
It has been noted that it is highly likely that all of the above safeguards have been breached by the audit firm in question.
It is therefore recommended that the audit engagement partner ensure that the reasoning for a decision to undertake an engagement to provide non-audit services to an audit client, and any safeguards adopted, is appropriately documented. Matters to be documented include the following:
- Threats identified;
- Safeguards adopted and the reasons why they are considered to be effective and;
- Communication with those charged with governance management threat
Paragraph 30 prohibits partners and employees of the audit firm from taking decisions on behalf of the management of the audited entity. A management threat can also arise when the audit firm undertakes an engagement to provide non-audit services in relation to which management are required to make judgments and take decisions based on that work. In the case of the audit firm in question, the implementation of the new accounting system can result in the audit firm becoming closely associated with the views and interests of management and the auditor's objectivity and independence can be impaired.
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familiarity (or trust) threat which arises when the auditor is predisposed to accept, or is insufficiently questioning of, the audited entity's point of view. In the reviewed case, the threat is related to the close personal relationships which have been developed between the engagement partner and the management of WL through school connections.
Additionally, ES3 concerns itself with the potential threat to objectivity and independence where audit engagement partners, key audit partners and staff in senior positions have served for a considerable length of time. Although, according to .. , in the case of unlisted entities, careful consideration should be given to rotating the audit engagement partner after he or she has served for ten years, taking into account the close and long association between the sole engagement partner and the management, it is evident that the auditor should be rotated to eliminate the existing threat as soon as possible. Alternatively, as per guidance from .. if an individual is not rotated after ten years, safeguards must be applied such as:
- removing (rotating) the partners and the other senior members of the engagement team after a pre-determined number of years;
- involving an additional partner, who is not and has not recently been a member of the engagement team, to review the work done by the partners and the other senior members of the engagement team and to advise as necessary;
- applying independent internal quality reviews to the engagement in question.
In the case of listed company clients, the rules are more strict and the audit engagement partner is not allowed to act for a continuous period exceeding five years .
An intimidation threat arises when the auditor's conduct is influenced by fear or threats. It has been noted, that in the case of the audit firm in question, one of the owners J. Dowling appeared to be an aggressive and dominating individual.
Furthermore, as it has been mentioned before the audit firm may wish to retain the fee income from WL which has become one of their biggest clients and the auditor's personal relations with Mr Dowling and its character can be considered as a self-interest as well as an intimidation threat.
Limits on fees
According to where total fees for audit and non-audit services from non-listed clients, regularly exceeds 15% of the annual fee income of the audit firm, then the firm should not act as auditor. In case of a listed client the threshold is 10% .
An initial assessment of fee income of the audit firm in question, shows that the total fees received from WL accounts for over 22% which is an evident breach of the regulations.
In the light of the above threats, it is recommended that before issuing the auditor's report, the firm should review its policies and practices and either:
(a) eliminate the threat by adopting the appropriate safeguards (for example, by removing the sole engagement partner from the WL audit team as well as disposing part of a financial interest in the audited entity); or
(b) reduce the threat to an acceptable level, that is a level at which it is not likely to affect and impaired the auditor's ethical principles (for example, by having the audit work reviewed by another partner or by another audit firm).
It is also crucial for the audit firm in question that when identifying and assessing threats to its objectivity and independence, the audit engagement partner takes into account not only current relationships with the audited entity (including all non-audit service engagements and known relationships with connected parties of the audited entity) but also those existed prior to the current audit engagement and any known to be in prospect following the current audit engagement.
Furthermore, it is recommended that the audit firm in question should review their ethical issues and policies and where no conclusions are reached, advice should be sought from other professional body, or through discussion with a practitioner from another firm.
In my opinion, the level of threats existing in the reviewed case and their level cannot be ignored as they affect the core ethic principals and the ability of the engagement partner to fulfil its work with the appropriate, complete and required integrity, objectivity and independence.
Q3 Going concern
Going concern FRC's Going Concern and Liquidity Risk: Guidance for Directors of UK Companies 2009 (October 2009) (refer www.frc.org.uk) and the recently published Chartered Accountants Ireland's derivative information booklet: "Going concern and liquidity risk".
The going concern assumption is important both for the management in preparation of financial statements and for the auditor at the planning stage of the audit and also in the end when he/she completes the audit because it is used when evaluating financial assessment. According to the International Standard on Auditing, ISA 570, a Going Concern assumption means that an entity is viewed as continuing in business for the foreseeable future, that it is likely to be able to keep doing business. When the use of the going concern assumption is appropriate, assets and liabilities are recorded on the basis that the entity will be able to realize its assets and discharge its liabilities in the normal course of business. (Eilifsen et al., 2009, p. 534)(ISA 570, 2009, p.559)
According to International Accounting Standard, IAS 1, management should make an assessment of an entity's ability to continue as a going concern (ISA 750, 2009, p. 559). This is a demand except if management intends to liquidate the entity or to stop trading, or has no realistic alternative but to do so. As pointed out above the going concern assumption is a fundamental principle in the preparation of financial statements and requires management to make an assessment of an entity's ability to continue as a going concern. This assessment involves making a judgment about essentially uncertain future outcomes. The following factors are important to be able to make that judgment (ISA 750, 2009, p.560);
- Degree of uncertainty- the going concern assessment should at least cover 12 month from the end of the reporting period.
- Entity specific factors- size and complexity of the entity, the nature and condition of its business and de degree to which it is affected by external factors affect the judgment regarding the outcome of events or conditions.
- Judgment based on the right information- Subsequent events may result in outcomes that are inconsistent with judgments that were reasonable at the time they were made.
The auditing standard, ISA 750, expresses that the auditor has the responsibility to evaluate management's use of the going concern assumption in the preparation of the financial statements and conclude whether a material uncertainty exists concerning the entity's opportunity to continue as a going concern. This responsibility exists even if the management doesn't have to do any going concern assessment. (Eilifsen et al., 2009, p.534)
The auditor cannot predict future events or conditions which may be seen as an important limitation when it comes to detecting material misstatements. This may cause an entity to stop to continue as a going concern. Therefore the auditor's report cannot be viewed as a guarantee as to the entity's ability to continue as a going concern. (ISA 750, 2009, p. 560)
The going concern guidance is based on three principles:
Rigorous and documented assessment of going concern;
All information about the future to be considered and usually the detailed review period covers at least twelve months from date of approval of financial statements;
Balanced, proportionate and clear disclosures.
This guidance has been designed to apply regardless of economic circumstances or size of entity. Therefore, in making the assessment of going concern there are circumstances that ought to alert directors that greater care than usual is required in arriving at their judgment as to whether the reporting entity is a going concern. These include:
potential breaches, or near breaches, of banking covenants (apparent in the review case);
liquidity problems due to insufficient headroom under borrowing facilities (likely to exist in the reviewed case);
the need to refinance facilities within the next twelve months (likely to exist in the reviewed case);
reliance on uncommitted bank facilities - they could be withdrawn at any time (likely to exist in the reviewed case);
non-binding support from shareholders - will it be forthcoming when needed?
transactions that flatter working capital at the year end and reverse thereafter;
payments being rescheduled until after the year end or being held back at the year end;
reduced stock levels - is the business running too lean, will it damage future revenues; have suppliers withheld credit so preventing restocking?
contingent liabilities - could these crystallise unexpectedly or are there long term liabilities that could become immediately repayable?
Steps in the Going-Concern Evaluation
There are three overall steps when making the going concern evaluation that the auditor follows. The first step is identifying and assessing going concern problems. During this step the auditor considers whether results of audit procedures performed during the audit process indicate whether there is significant doubt about the entity's ability to continue going concern. (Eilifsen et al., 2009, p. 534) This has occurred to be a problem because of the fact that the normally used period of 12 month may be too long in times of illiquid and volatile markets (Humprey et al., 2009, p.819). Another risk is that the judgment is made at the level of a single entity instead of a whole sector which indicates that the auditor easily can miss collapse of other institutions. There are therefore questions over the capacity of audit to be an effective early warning system of impending major corporate problems or even collapse. (Humprey et al., 2009, p.819)
Both Eilifsen et al.(2009) and Loyd and Crawford(2009) presents the following conditions or events that may act as indicators for doubt about going concern. The indicators can be categorized in four conditions or matters. The first category is negative financial trends, such as operating cash flow declines, which can be a good indicator of financial distress that can lead to a going-concern problem. The second category refers to other financial difficulties such as default on loans and restructuring of debt. The third category is internal matters such as excessively burdensome contracts, major work stoppages and labor disputes. The fourth and final category is external matters such as legal proceedings, the effect of natural disasters and loss of key franchise, license or patent.
If there is significant doubt about the ability of the entity to continue the auditor should take the text step and consider management's plans for dealing with the adverse effects of the conditions or events. Following management actions should be considered (Eilifsen et al., 2009, p. 535):
- Plans to dispose assets;
- Plans to borrow money or restructure debt;
- Plans to reduce or delay expenditures;
- Plans to increase ownership equity