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BAC 3624

Advanced Auditing

Tutorial 5

QUESTION 1:
Bistro and Co, Chartered Accountants, recently held a staff training session on quality control.
The session concluded with staff being invited to raise matters from their experience relating
to the ethical rules on independence. Some of these matters are given below.
(a) Shortly before commencing the final audit of a public listed company, a junior staff member
on the audit team inherited a substantial number of shares in that company. No action was
taken because, although representing a large investment for the staff member concerned, the
number of shares was totally immaterial with respect to the company. Moreover, the audit
partner knew that, when the company's results were announced after the audit, the share
price would rise and he did not think it was fair to require the staff member to sell them now.
(b) The management accountant of another public listed company client had an accident and
was away from work for three months. At the time of the accident the audit senior was winding
up the prior year's audit and, because of his familiarity with the company's management
accounting system, it was agreed that the audit senior would take over as management
accountant for the three months.
(c) In its management letter to another audit client, Bistro and Co warned the company that
their computer system lacked essential controls. The company decided to install a totally new
computer system and Bistro and Co's management consultancy department was appointed to
design the new system.
Required:
Discuss the possibility that Bistro and Co had impaired their independence or otherwise acted
unprofessionally in each of the situations described.

BAC 3624

Advanced Auditing

Tutorial 5

ANSWER
(a) Shareholding by audit staff member
While partners are not allowed to hold shares in client companies there is no specific
prohibition in the MIAs By-Laws on Professional Conduct and Ethics on the holding of shares
in audit clients by audit staff providing the service. However, some audit firms have adopted a
prohibition on the holding of shares in audit clients by audit staff as an in-house rule.
The argument that independence is not impaired because the holding is insignificant is
incorrect. If the holding is of such a size as is likely to influence the behaviour of the audit staff
member, then it is material. If the staff member was allowed to retain the shares then he or
she should not have been included in the audit team.
If the partner advised the staff member not to sell the shares until after the audit was
completed, then this would have been unethical and possibly illegal in that it constitutes
insider dealing the use of privileged information to secure a personal advantage in the
trading of shares.
(b) Management accounting services
Preparation of accounting records on behalf of a listed or public interest company is normally
prohibited (self review threat).
However, in some jurisdictions, an exception to this Rule allows such work to be performed in
an emergency situation which does not extend beyond the minimum period necessary and
where every care was taken that management accepted full responsibility for the work of the
audit firms staff member.
It is more reasonable, however, to argue that the assignment of a staff member to the position
of management accountant is likely to breach the rules on independence self review threat.
It amounts to a staff member of the firm being engaged in making management decisions on
behalf of the client.

BAC 3624

Advanced Auditing

Tutorial 5

The firm will thus be reporting on a statement of financial performance in which one of its own
employees had played an active part.
A user of the financial statements might conclude that the audit firm might have an incentive
to conspire with management in concealing poor performance attributable, in part, to the
actions of its own staff member.
(c) Advice on controls
This raises a controversial area in auditor independence. While the reporting of control
weaknesses discovered during the audit is a required procedure, advising on the
development of new systems to overcome those weaknesses is seen by some critics as a
possible threat to independence.
There is both a general and a specific issue. The general issue is that audit firms generate
revenues from clients for both audit and non-audit work. However, contracts for non-audit
work are given by management.
In performing the audit, the auditors may be reluctant to disagree with management for fear of
losing non-audit contracts.
The specific issue is that known as self-review. Since the firm designed the new internal
control system, there is a presumption, when evaluating control effectiveness at the next
audit, that there will be no weaknesses in the system.
The implementation of advice is the responsibility of management over which the auditor has
no control. At the next audit the auditor must check that the system has been properly put into
operation and that it is being operated effectively.

BAC 3624

Advanced Auditing

Tutorial 5

Question 2
Explain what is meant by deep pocket syndrome.
Answer
"Deep pocket" syndrome refers to the tendency of injured parties to sue the individuals or
entities with the most ability to pay out compensation regardless of who is at fault. Since the
accounting professionals are required to carry professional indemnity insurance, they become
the target of lawsuits because other parties at fault are usually not in a position to pay large
compensation in cases of negligence or other actions.
Question 3
Nizar & Co., a medium-sized public accounting firm, was engaged to audit Bravo Melody Bhd.
Several members of the staff were involved in the audit, all of whom had attended the firm's
in-house training programme on effective auditing methods. Throughout the audit, Nizar the
audit partner spent most of his time in the field planning the audit, supervising the staff, and
reviewing their work.
A significant part of the audit entailed verifying the physical count, cost, and summarisation of
inventory. Inventory was highly significant to the financial statements and Nizar knew the
inventory was pledged (as collateral for a large loan) to Beruang Bank. In reviewing Bravo
Melody's inventory count procedures, Nizar told the Managing Director he believed the
method of counting inventory at different locations on different days was highly undesirable.
The Managing Director stated that it was impractical to count all inventory on the same day
because of personnel shortages and customer preference. After considerable discussion,
Nizar agreed to permit the practice, if the Managing Director would sign a statement that no
other method was practical. The accounting firm had at least two persons at each site to audit
the inventory count procedures and actual count. There were more than 10 locations.
Eighteen months later, Nizar found out that the worst had happened. Management below the
Managing Director's level had conspired to materially overstate inventory as a means of
covering up obsolete inventory and inventory losses resulting from mismanagement.
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BAC 3624

Advanced Auditing

Tutorial 5

The misstatement occurred by transporting inventory to other locations after it had been
counted in a given location. The accounting records were inadequate to uncover these illegal
transfers.
Both Bravo Melody Bhd and Beruang Bank sued Nizar & Co.
Required
Answer the following questions, setting forth reasons for any conclusion stated:
i. What should Nizar & Co. use as a defence in the suit by Bravo Melody Bhd.?
ii. What should Nizar & Co. use as a defence in the suit by Beruang Bank?
iii. Is Nizar likely to be successful in his defence?
Answer
(i) Nizar, & Co should use the defences of meeting generally accepted auditing standards and
contributory negligence. The fraud perpetuated by Bravo Melody Sdn. Bhd. was a reasonably
complex one and difficult to uncover except by the procedures suggested by Nizar.
In most circumstances it would not be necessary to physically count all inventory at different
locations on the same day. Furthermore the managing director of the company contributed to
the failure of finding the fraud by refusing to follow Nizar's suggestion. There is evidence of
that through his signed statement.
(ii).There are two defences Nizar & Co. should use in a suit by Beruang Bank.
First there is a lack of privity of contract. Even though this was a known third party, it does not
necessarily mean that there is any duty to that party in this situation. That defence is unlikely
to be successful in most jurisdictions today.
The second defence which Nizar, is more likely to be successful with is that the firm followed
generally accepted auditing standard in the audit of inventory, including the employment of
due care. Ordinarily it is unreasonable to expect an audit firm to find such an unusual problem
in the course of an ordinary audit. Because the audit firm did not uncover the fraud does not
mean it has responsibility of it.

BAC 3624

Advanced Auditing

Tutorial 5

iii. Nizar is likely to be successful in his defence against client because of the contributory
negligence. The company has responsibility for instituting adequate internal controls. The
managing director's statement that it was impractical to count all inventories on the same day
because of personnel shortages and customer preferences puts considerable burden on the
company for its own loss.
It is also unlikely that Beruang Bank will be successful in a suit. The court is likely to conclude
that Nizar, followed due care in the performance of his work. The fact that there was not a
count of all inventories on the same date is unlikely to be sufficient for a successful suit.
The success of Nizars defence is also heavily dependent upon the judiciary's attitude about
privity of contract. In this case there is likely to be a claim of extreme negligence.
Therefore it would be required for the court to ignore the privity of contract precedence and
find Nizar negligent for the suit to be successful.