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Topic 2 Ethics, Legal liability and client acceptance

The purpose of this topic is to provide an overview of the current audit environment (ethics, auditor
independence, legal liability to client and third parties, auditors client acceptance/continuation).

Learning Objectives:
After studying this chapter you should be able to:

1. Describe the fundamental principles of professional ethics

2. Define auditor independence. Explain the threats to auditor independence and explain the
safeguards to reduce the risk of those threats.
3. Explain the relationship between an auditor and key groups they have a professional link
with during the audit engagement
4. Explain the auditors legal liability to their client and the concept of contributory negligence
5. Explain the extent to which an auditor is liable to third parties.
6. Identify why auditors need to do a careful client acceptance and continuance process and
the factors to consider client acceptance and continuance decision.

Set readings for this topic

Chapter 2 Moroney, Campbell and Hamilton 1st Edition.

APES 110 Code of Ethics for Professional Accountants - section 290 Independence and section
300.7 to 300.17

What you need to do this week

1. Read this Topic Guide

2. Complete the set reading for this topic from Moroney, Campbell and Hamilton with reference
to the listed learning objectives of the topic. Make sure you achieve ALL the listed learning
objectives after reading the chapter.

3. Complete the Interteaching Questions before attending your tutorial class.

You are required to present your answers carefully in writing. Your notes will be exchanged with
other group members to be read and commented at the beginning of your group discussion in
the tutorials. The second part of the group discussion will be focused on issues raised by group
members for discussion or more explanation. To prepare for this part, during your preparation at
home you should note down all the points that (you are not sure or not fully understand) you want
to seek further clarification from your groups. You are supposed to have gained most (if not all)
understandings of the topic after the tutorials. If there is/are are any remaining issues that cannot
be solved in the group discussion, you should note down as questions to be addressed in the
lectures. In the Interteaching Session you will also be expected to apply the information you have
learnt from your reading to address a real world issue.
Interteaching Questions - To be completed before class

1) The textbook often refers to the term members of professional bodies? Who does it refer
to? What are the professional bodies?

Members of the professional bodies here mean the professional accountants (among those
are the external auditors). The professional bodies are those organisations that are
overseeing the accounting profession. There are three such organisations in Australia,
including CPA Australia, ICAA and NIA.

2) In what circumstance(s) does the auditor commit a legal liability? Who are they potentially
liable to?

If the auditor fails to exercise due care when conducting the audit, they may be sued and be charged
with negligent. When found to be negligent, the auditor may be asked to compensate for damages
suffered as a consequence of the negligence. The parties that the audit may owe the legal liability to
include the client and the third parties who have used the financial statements and suffered the

3) Who must comply with the fundamental ethical principles included in the APES 110?

The professional accountants (e.g public accountants such as auditors)

4) What does independence mean for auditors? Independence is required between which

Auditors are required by both the law (the Corporations Act 2001) and the Code of Ethics to
be independent . They are required to be independent from their client whenever they carry
out and engagement. Being independent means that the auditor needs to make a decision
that is free from bias, personal belief and client pressures. The auditor is required to be
independent in mind (actually independent) and also independent in appearance, meaning
that they need to always be seen by others as independent from their client.

Practical application 1:

A & Y is a small, 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, Taramine
Company Ltd, is now listed on the ASX and must comply with additional reporting regulations.
Taramine Company Ltds rapid growth has meant that it is financially stretched and its accounting
systems are struggling to keep up with the growth in business. The client continuance decision is
about to be made for the next financial year.

The managing partner of A & Y, Christine Stevenson, has recognised that the audit firm needs to
make some changes to deal with the issues created by the charging circumstances of its major client
and the audit firms overall growth. She is particularly concerned that the audit firm could be legally
liable if Taramine Company Ltds financial situation worsens and it fails.

a) What actions should A&Y takes to avoid the potential threat of litigation if Taramine
Company Ltd fails.

b) What should Christine consider when making the client continuance decision for Taramine
Company Ltd for the next financial year.


(a) Steps to take to avoid the threat of litigation (in addition to the client continuation decision
issues in part b below) include:
hiring competent staff
training staff and updating their knowledge regularly
ensuring compliance with ethical regulations
ensuring compliance with auditing regulations
Implementing policies and procedures that ensure:
o appropriate procedures are followed when accepting a new client
o appropriate staff are allocated to clients
o ethical and independence issues are identified and dealt with on a timely basis
o all work is fully documented
o adequate and appropriate evidence is gathered before forming an opinion
meeting with a clients audit committee to discuss any significant issues identified as part of the
following up on any significant weaknesses in the clients internal control procedures in a
previous years audit
dealing with privity letter requests in accordance with the guidance provided in AGS 1014
Privity Letter Requests.

(b) The client continuation decision is critical. Christine should evaluate and document the firms
ability to service the major client, Taramine Company Ltd, and any other major clients for the
coming year. APES 320 Quality Control for Firms and ASQC 1 provide guidance on the procedures
to be followed when making the client acceptance or continuance decision.
The key factors to be evaluated are client integrity and any threats to the auditors compliance with
the fundamental principles of professional ethics (integrity, objectivity, professional competence
and due care, confidentiality and professional behaviour). Although Taramine Company has been a
client of the firm for several years, its integrity must still be reevaluated. Rapid growth can create
pressures within the client that could compromise its integrity. This is particularly so in the case of
Taramine Company because there is already evidence of difficulties in its financial systems.

A major problem confronting the audit firm is its ability to comply with the fundamental principles
of professional ethics.
Christine should be particularly concerned with the firms ability to be objective given its
dependence on the large clients fees. Although, Taramine Company is only one of the major clients
experiencing rapid growth, fee dependence arises when a clients fees form a significant proportion
of the audit firms overall revenue. APES 110 provides guidance about safeguards when this
proportion reaches 15%.
Taramine should also be concerned about the firms ability to use professional competence and due
care in audits for rapidly growing clients at a time when the audit firm is growing rapidly and the
client is undergoing major changes to its reporting requirements. Does the audit firm have the
expertise to audit listed clients? What sort of auditing difficulties are likely to be created by the
stretched financial systems at Taramine?
The client continuation decision must be properly documented and the engagement letter drafted to
reflect the responsibilities of both parties.

Practical Application 2

1. You are a manager in the audit firm of Ali & Co; and this is your first time you have worked
on one of the firms established clients, Stark Co. The main activity of Stark Co is providing
investment advice to individuals regarding saving for retirement, purchase of shares and
securities and investing in tax efficient savings schemes. Stark is regulated by the relevant
financial services authority. You have been asked to start the audit planning for Stark Co, by
Mr Son, a partner in Ali & Co. Mr Son has been the engagement partner for Stark Co, for
the previous nine years and so has excellent knowledge of the client. Mr Son has informed
you that he would like his daughter Zoe to be part of the audit team this year; Zoe is
currently studying for her first set of fundamentals papers for her ACCA qualification. Mr
Son also informs you that Mr Far, the audit senior, received investment advice from Stark
Co during the year and intends to do the same next year. In an initial meeting with the
finance director of Stark Co, you learn that the audit team will not be entertained on Stark
Cos yacht this year as this could appear to be an attempt to influence the opinion of the
audit. Instead, he has arranged a balloon flight costing less than one-tenth of the expense of
using the yacht and hopes this will be acceptable. The director also states that the fee for
taxation services this year should be based on a percentage of tax saved and trusts that your
firm will accept a fixed fee for representing Stark Co in a dispute regarding the amount of
sales tax payable to the taxation authorities.

(i) Explain the ethical threats which may affect the auditor of Stark Co.

(ii) For each ethical threat, discuss how the effect of the threat can be mitigated.


Ethical threat Mitigation of threat

Mr Son, the engagement partner has been Mr Son should be rotated from being
involved with the client for the last nine years. engagement partner.
This means he may be too familiar with the client He can still contact the client but should not be
to be able to make objective decisions due to this in the position of signing the audit report.
long association.
There is no ethical rule which stops Mr Son To show complete independence, Zoe should not
recommending Zoe for the audit, or letting Zoe be part of the audit team. However, if Mr Son is
take part in the audit. no longer the engagement partner then this
However, there may be the impression of lack of removes the ethical threat and Zoe could be
independence as Zoe is related to the engagement included in the audit team.
Zoe could be tempted not to identify errors in
case this prejudiced her fathers relationship with
the client.
As long as Mr Far paid a full fee to Stark Co for To show independence from the client, Mr Far
the investment advice, then there is no ethical could be asked not to use the services of Stark
threat. This would be a normal commercial Co again unless this is first agreed with the
transaction and Mr Far would not gain any engagement partner.
However, continued use of client services could
imply a lack of independence especially if Mr Far
is not paying a full fee and therefore receiving a
benefit from the client.
The audit team have been offered a balloon flight The balloon flight should not be accepted.
at the end of the audit. Investigation would also be needed to find out
Acceptance of gifts from a client, unless of an why hospitality was accepted in previous years.

insignificant amount, is not allowed. The fact that
the flight costs less than the yacht expense is
irrelevant, independence could still be impaired.
Agreeing to accept taxation work on the The audit firm must confirm that assistance with
percentage of the tax saved is essentially taxation work is acceptable, although the fee
accepting a contingent fee. must be based on time and experience for the
There will be pressure to gain the highest tax job, not the contingent fee.
refund for the client and this could tempt the
audit firm to suggest illegal tax avoidance
Representing Stark Co in court could be seen as To remain independent, the audit firm should
an advocacy threat that is the audit firm is decline to represent the client in court.
promoting the position of the client.
Objectivity could be compromised because the
audit firm is seen to take the position that the
client is correct, affecting judgement on the tax

Practical Application 3
(a) State the FIVE threats contained within the Code of Ethics for Professional Accountants and
for each threat list ONE example of a circumstance that may create the threat.


Examples for each category (Only one example required per threat):
Undue dependence on fee income from one client
Close personal or business relationships
Financial interest in a client
Incentive fee arrangements
Concern over employment security
Commercial pressure from outside the employing organisation
Inappropriate personal use of corporate assets.
-Member of assurance team being or recently having been employed by
the client in a position to influence the subject matter being reviewed
Involvement in implementation of financial system and subsequently
reporting on the operation of said system
Same person reviewing decisions or data that prepared them
An analyst, or member of a board, audit committee or audit firm being in
a position to exert a direct or significant influence over the financial
The discovery of a significant error during a re-evaluation of the work
undertaken by the member
Performing a service for a client that directly affects the subject matter of
an assurance engagement.

Acting as an advocate on behalf of a client in litigation or disputes
Promoting shares in a listed audit client
Commenting publicly on future events in particular circumstances
Where information is incomplete or advocating an argument which is
Long association with a client
Acceptance of gifts or preferential treatment (significant value)
Over familiarity with management
Former partner of firm being employed by client
A person in a position to influence financial or non-financial reporting or
business decisions having an immediate or close family member who is
in a position to benefit from that influence.

b) The following situations may violate the Code of Ethics for Professional Accountants.
Assume, in each case that the public accountant is a partner

1. Baker, CA, approaches a new client and tells the general manager she has an idea that could
result in a substantial tax refund in the prior years tax return by application of a technical
provision in the tax law that the client had overlooked. Baker adds that the fee will be 50%
of the tax refund after it has been resolved by the ATO. The client agrees to the proposal.

2. Contel, CPA, advertises in the local paper that his firm does the audit of six of the eight
largest finance companies in the city. The advertisement also states that the average audit
fee, as a percentage of total assets for the companies he audits, is lower than that of any
other public accounting firm in the city.

3. Finigan, CPA, does the audit, tax return, bookkeeping and management services work for
Gilligan Construction Pty Ltd. Mildred Gilligan follows the practice of calling Finigan
before she makes any major business decision to determine the effect on her companys
taxes and the financial statement. Finigan attends continuing education courses in the
construction industry to make sure she is technically competent and knowledgeable about
the industry. Finigan normally attends board of directors meetings and accompanies Gilligan
when she is seeking loans. Milidred Gilligan often jokingly introduces Finigan with this
statement: I have my three business partners- my bankers, the government and my
accountant; but Finnys the only one who is on my side.

4. Marie Janes, while auditing a large car dealer ship company is being invited to and attends
the companys annual Christmas party. When presents are handed out, she is surprised to
find her name included. The present has a value of approximately $200.


Discuss whether these facts in any of the situations indicate violations of the ethical rules. If so,
identify the nature of the violation(s).


1. Contingent fee arrangements between the public accountant and the client are a
violation of the rules for clients receiving attestation services. While the Code indicates that
contingent fees are permitted for services that do not require independence, it also
indicates that preparation of tax returns requires independence.

2. Advertising is permitted as long as it is not false, misleading, or deceptive. It is

probably not acceptable to make comparison of those accounting firms, unless they're
based upon verifiable facts. The information of the advertising expressly states two facts: 6
of 8 of the largest finance companies are audited by their firm and second, the average
audit fee, as a percentage of total assets, is lower than any of the other public accounting
firms in the city. Contel must be able to support those factual statements. Assuming he
can, there is no violation.

3. It is essential that Finigan retains both an attitude of independence in fact and in

appearance. It is not possible to determine if Finigan is maintaining an attitude of
independence in fact, given her involvement in the company, but it is certainly possible that
she is. Finigan is not necessarily violating the Code. She does the audit, tax return,
bookkeeping and management services work for the client, but that is not a violation. It is
questionable whether Finigan is maintaining an attitude of independence in appearance,
especially given the comments by Gilligan. It is essential that she maintain an attitude of
independence throughout all her work. So she must be careful that she is not on the side
of Gilligan without consideration of her professional responsibilities in conducting the
audits and in all other aspects of her professional responsibilities.
(cf p90 'providing accounting services to audit clients)

4. Accepting such a gift is likely to be a violation of the rules of conduct. That gift is
reasonably large and would be considered by many employees as equivalent to a bonus.
Ideally Jane should not accept the gift and state that since she is not an employee, she
would prefer not to take it. If she believes that it would be embarrassing to the company,
she should graciously accept it and return it with an explanation of her reasons as soon as

Practical Application 4

Elise Dallimore is a partner in charge of the audit of Hertenstein Ldt, a large listed public company.
Elise took over the audit from Marjorie Platt, who has recently retired from the audit firm. Marjorie
was a very experienced auditor and the author of several reports into ethical standards in business,
but Elise did not regard her highly for her ability to grow non-audit service fee revenue. Elise sees
an opportunity to increase the provision for non-audit services to Hertenstein Ltd and thus increase
her reputation within the audit firm.

a) Give 3 examples of non-audit services that may be performed by the audit firm such as

b) Which non-audit services would you advise Elise to avoid trying to sell to Herstenstein Ltd
because of the potential ethical issues for the audit firm?

c) Would it make any difference to your answers if Herstenstein was a propriety company, not
a listed public company?


a) Examples of non-audit services include: Bookkeeping service (recording transactions,
preparation of the financial statements for clients), consulting services on various
business/financial matters, tax service (help clients prepare the tax returns).

(b) See 290.159 of APES 110 for a guide to which services to avoid. This section states that the
auditor should avoid acting as an executive of the client company. The auditor should not be
involved in transactions, making decisions about the audit firms recommendations, management
reporting to directors, or acting as manager of the client within the previous two years.
s. 290.161 discusses less significant threats, which should only be offered after careful
consideration because they could create self-review or self-interest threats. These include having
custody of a clients assets, supervising client employees, and preparing source documents. The
section also discusses examples of safeguards, such as making arrangements so that personnel
providing such services do not participate in the audit, and gaining additional advice on the impact
of such services.

(c) Yes. Auditors can provide more non-audit services to a proprietary company than to a listed
290.170 The Firm, or a Network Firm, may provide an Audit Client that is not a Listed Entity with
accounting and bookkeeping services, including payroll services, of a routine or mechanical nature,
provided any self-review threat created is reduced to an acceptable level.
Examples of such services include:
Recording transactions for which the Audit Client has determined or approved the appropriate
account classification;
Posting coded transactions to the Audit Client's general ledger;
Preparing Financial Statements based on information in the trial balance; and
Posting the Audit Client approved entries to the trial balance.

The section continues by explaining that the significance of any threat created should be evaluated
and, if the threat is other than Clearly Insignificant, safeguards should be considered and applied as
necessary to reduce the threat to an acceptable level.