Professional Ethics, Independence & Audit Quality (Chapter 3)

Professional Application Question 3.22

3.22 Conflict of interests

Your firm, Earnest, Devoid and Couples, has been the auditor for many years of Barley
Gordon Ltd, which operates a large chain of electrical goods retailers across Australia
and New Zealand. The electrical goods retailing business is dominated by two major
players in the market, Barley’s, as they are affectionately known by the buying public,
and Duck Guys Ltd, or Duckies as they are known.
The market is very competitive with both companies engaged in significant television
advertising, price competition and other marketing activities in order to gain market
share, largely by attracting the customers from the other company.
You have recently been approached by the CFO of Duckies to carry out its year-end
audit. Duckies was attracted to your firm because of your extensive experience in the
industry.

Required
Explain the safeguards that could be put in place in relation to the conflict of interest arising
from the above.

Barley Gordon Ltd and Duck Guys Ltd should be advised that the firm would be acting for both parties.
It is likely that Duckies is aware of the existing relationship with Barley’s but this will still need to be
formally confirmed. As a part of this disclosure the companies should be advised to seek independent
advice so that they aware of any implications.

In order to alleviate any worries that sensitive information could be passed from one company to
another the firm can implement the following processes:

 Separate engagement teams for each audit including different engagement partners, this would
include one team member not being allowed to transfer the other audit team for future audits
(a time limit may be set after which a transfer could be done)
 Maintaining control over security and access to audit files to prevent information leaking
between teams
 Staff training will be required to remind them of their responsibility for confidentiality, this
includes non-disclosure to those within the firm that are not directly connected with the audit
- this may include all staff signing confidentiality agreements
 These processes should be reviewed annually, before the commencement of the next year’s
audit work, by a senior member of the audit firm not connected to either client
Professional Application Question 3.25

3.25 Code of Ethics for Professional Accountants

The following circumstances raise questions about an auditor’s ethical conduct:

1. An auditor accepts an engagement knowing that she does not have the specialist
knowledge required.
2. A public accounting firm states in a newspaper that it has had fewer lawsuits than its
main competitors have had.
3. An auditor discloses confidential information about a client to a successor auditor.
4. A public accountant pays a commission to a solicitor to obtain a client.
5. A public accountant agrees to be the committee chairperson for a local fundraising
activity.
6. An auditor accepts a Christmas gift from a client.
7. An auditor accepts a commission from an insurance company for recommending it
to one of its audit clients.
8. An auditor has a bank loan with a bank that is an audit client.
9. An auditor retains a client’s records as a means of enforcing payment of an overdue
audit fee.

Required

(a) Discuss the fundamental principles of the Code of Ethics for Professional Accountants in relation
to the above.
(b) Indicate in each of the above circumstances whether the effect on professional ethics is (i) a
violation; (ii) not a violation or (iii) indeterminate, and explain.

The fundamental principles of the Code of Ethics for Professional Accountants are:

1.14a Integrity – should be straightforward and honest in all professional and business
relationships

1.14b Objectivity – not allow prejudice or bias, conflict of interest or undue influence of others to
override professional or business judgements.

1.14c Professional Competence and Due Care – a continuing duty to maintain professional
knowledge and skill at the level required of the professional accountant.

1.14d Confidentiality – should respect the confidentiality of information acquired.

1.14e Professional Behaviour – should comply with relevant laws and regulations and should avoid
any action that discredits the profession.

Effect Rule Reason

1 Violation 1.14c An accountant should only undertake work that he or

she can expect to complete with professional
competence.
2 Indeterminate - Ensure the advertising is truthful and without naming
the competitor. Advertising should be on the services
provided.

3 Violation 1.14d Only when there is no consent from the client. If

client’s consent is obtained, it can be part of the
professional clearance procedures.

4 Violation - Any commission must be disclosed. Solicitation of

client should not normally be allowed.

5 Not a violation - Does not constitute incompatible business.

6 Not a violation - Reasonable courtesy or social commitments can be

allowed. Disclosure is required.

7 Not a violation - Commission should be disclosed. The client’s consent

must be in writing and the public accountant must
take care to ensure that the advice is in the best
interests of the client.

8 Not a violation - Normal course of event allowed. Violation only if the

loan is obtained using favourable terms. (Note: The
Corporations Act has a limit of $5 000 on non-housing
loans)

9 Not a violation - An accountant has a legal right of lien, under certain

conditions, over clients’ records in his custody in the
event of non-payment of fees.
 Auditor’s Legal Liability (Chapter 5)

Professional Application Question 5.23

5.23 Negligence

StirMed sells a range of medical products mainly through representatives visiting

hospitals and doctors. StirMed has been going through lean times recently and
managing day-to-day cash flow has become a challenge.
In spite of the cash flow difficulties, the financial report to 30 June 2015 showed
reasonable revenue; however, there were high levels of both receivables and payables
and the bank overdraft was getting close to its agreed limit. The auditors, Brent, Date
and Co, completed their audit for the year ended 30 June 2015 and gave an unmodified
opinion.
Within seven months of the year end, StirMed went into liquidation — unable to pay its
debts. As part of the liquidator’s investigations, it became apparent that a major fraud
had been carried out by two of StirMed’s representatives who had created fictitious
sales in order to increase their commission. This resulted in both sales and receivables
being overstated by material amounts. The liquidator is questioning the conduct of the
auditors in not detecting this fraud. Sales and receivables testing was carried out by
Francis, the most junior member of the audit team.

Required
Discuss the legal problems and possible liability of Brent, Date and Co as a result of the above facts.

The firm will need to demonstrate that its audit procedures complied with auditing standards
and that the audit was generally carried out in a professional and orderly manner. If this cannot
be shown then it is likely that the firm is liable for negligence. Although the courts do not
always recognise adherence to auditing standards as a defence, they invariably hold that the
failure to follow customary practices constitutes negligence. The fact that material errors
existed and they were not detected would suggest that the audit procedures were inadequate.
There is no defence that the junior member of staff carried out the work, it is incumbent upon
the more senior audit staff to ensure work is properly planned and the work of junior staff is
reviewed. Any investigation into the auditors activities will centre on the planning, supervision
and review of the work on sales and receivables and the specific procedures followed. It would
appear that procedures about occurrence of sales and existence and valuation of receivables
were inadequate, otherwise the fraud would have been found.
The firm, if found to be negligent, could be liable for the actual loss arising from the fraud,
and also for losses incurred in the company continuing to trade because it probably would have
had to wind up earlier had the fraud been detected and reported.
It should be noted that it is likely that StirMed had inadequate internal controls in place that
allowed the fraud to occur. It is therefore likely that StirMed has contributed to the loss by not
implementing appropriate controls. This would give rise to contributory negligence and
therefore the responsibility for any loss suffered would be shared between StirMed and Brent,
Date and Co. This would reduce the amount of the loss Brent, Date and Co would be liable for.
Professional Application Question 5.28

5.28 Negligence, liability to third parties

Newsday Marketing Ltd’s financial statements for the year ended 30 June 2014 were
audited by Brian Lung and Partners. The unqualified auditor’s report was published
alongside the directors’ statements on 20 August 2014. Stephen Maine, a tycoon in the
publishing industry, put forward a bid to take over Newsday at $2.50 per share, based
on the net asset value of the audited accounts (which also showed a net profit for the
year of $18 million). The takeover was finalised on 30 September 2014. In October it
was leaked to the press that the financial statements of Newsday Marketing had
excluded a significant legal liability on a case, for a claim of $5 million. The case was
being appealed by Newsday in June 2015. The outcome of the damages claim caused the
company’s share price to plummet. Stephen Maine was extremely annoyed, partly
because he had examined the accounts but overlooked the lawsuit. He decided to sue
Brian Lung for negligence and compensation for not including an estimate for the likely
damages.

Required

Analyse Brian Lung’s legal liability and the likelihood that Stephen Maine may succeed in the
action.

The first issue is whether Brian Lung and Partners were negligent or not. It is difficult from the facts to
determine whether they were or not. We do not have enough information about the manner in which
the audit was conducted. The fact that some liabilities were not discovered does not mean that they
were negligent.

The more pressing issue in this case is whether they have a duty of care to Stephen Maine. The key
case that is most relevant to the facts of this case is the Caparo case (1990). On appeal to the House
of Lords it was found that a duty of care was owed only to third parties that were existing shareholders
to whom the auditor knew their report would be sent and relied upon. This approach was recently
endorsed by the High Court of Australia in 1997 in the Esanda case.

To owe a duty of care the following would have to be established according to Brennan, CJ, in Esanda
Finance (on the appeal to the High Court in 1997):

• The report was prepared on the basis that it would be conveyed to a third party.
• The report would be conveyed for a purpose that was likely to be relied upon by that third
party.
• The third party would be likely to act in reliance on that report, thus running the risk of suffering
the loss if the statement was negligently prepared.
There is no indication that there was any attempt by Stephen Maine to contact the auditors. It is
therefore very unlikely that Maine will win the case. Even if he did contact the auditors, it would still
be unlikely that he would win the case.
 Overview of the Audit of Financial Statements (Chapter 6)

Professional Application Question 6.23

6.23 Management and Auditor responsibilities

You are a newly qualified accountant who works for the audit firm Fulford & Co. You
have been approached by a potential new client, Bishopthorpe Electronics Pty Ltd, who
is looking for an audit firm to carry out an audit on its annual financial report prepared
in accordance with the Corporations Act. The managing director, Bob Fleming, is not
sure exactly what an audit involves and what are the responsibilities of the auditor.

Required
Prepare notes for a meeting with Bob Fleming which identifies the responsibilities of the auditor and
the responsibilities of management.

The notes should cover the following:

 Distribution of the annual report to shareholders.

 Delivery of the audit report to the entity.
 Obtaining and evaluating evidence concerning the financial report.
 Preparation and presentation of the financial report.
 Maintaining adequate internal controls.
 Testing internal control procedures.
 Expressing an opinion on the financial report.
 Selecting appropriate accounting policies.
 Ensuring the financial report is presented in accordance with standards.

Responsibilities of the auditor

• Understand internal control and test internal control procedures.
• Obtain and evaluate evidence concerning the financial reports.
• Verify that financial information has been presented fairly in accordance with an
identified financial reporting framework.
• Express an opinion on the financial report.
• Deliver the auditor’s report to the entity.

Responsibilities of management
• Analyse events and transactions.
• Measure and record transaction data.
• Select appropriate accounting policies.
• Classify and summarise recorded data.
• Maintain adequate internal controls.
• Prepare the financial reports and other reports in accordance with the identified
financial reporting framework.
• Distribute the annual report, including financial reports and the auditor’s report, to
shareholders.
Professional Application Question 6.25

6.25 Statutory and professional duties

You are an audit senior working in a Big Four accountancy practice in Australia. It is
April and not long until the ‘busy’ season, which generally starts from about May. A
number of audit managers and seniors will come from the United Kingdom on
secondment for the Australian busy season.
Your audit partner notes that you do not have much work at the moment and he
suggests that you prepare a memo for the new UK arrivals to help their acclimatisation
into the Australian audit environment. He wants the following outlined in the memo:
• statutory duties to report, as outlined in the Corporations Act
• a discussion of the purpose of Australian auditing standards.

Required

Prepare the memo as requested by the audit partner.

Memo

Date: 20 April

To: UK Audit managers and seniors on secondment

From: Audit senior

Re: Australian reporting requirements and auditing standards

1) Corporations Act reporting requirements

There are a number of duties for auditors to report in the Australian regulatory environment. The
main duties are outlined below:

The audit opinion

The auditor must express an opinion on whether the financial report is in accordance with the

Corporations Act and whether it complies with accounting standards (s.296) and gives a true

and fair view (s.297).

The opinions expressed in an auditor’s report must be in accordance with ASA 700 (ISA 700). The audit
opinion can be either ‘unqualified’ or ‘other than unqualified’. An ‘unqualified’ opinion may however
be modified by an ‘emphasis of matter’, namely there are matters that are brought to the attention
of members of the entity but which nevertheless do not affect the auditor’s opinion.

An ‘other than unqualified’ opinion, which is also a modified opinion, should be expressed as:

• a qualified opinion;

• a disclaimer of opinion; or
• an adverse opinion.

Duty to report
An auditor is under a statutory duty to report to members on the company’s financial statements for
an accounting period and on the accounting records relating to those financial statements (s.308). A
copy of the auditor’s report must be laid before the AGM of a public company and must be furnished
to the directors in sufficient time to reach members by the earlier of 21 days before the AGM after
the end of the financial year or 4 months after the end of the financial year (s.315).

Section 308 sets out the matters, which must be contained in an auditor’s report. The report

must state whether or not, in the auditor’s opinion, the financial statements are properly drawn

up:

• so as to give a true and fair view of the financial affairs of the company;

• in accordance with Corporations Law;

• in accordance with applicable Accounting Standards and the Corporations Regulations.

Section 308(3) also requires the report to describe any defect or irregularity in the financial reports.

Duty to report to the ASIC

The auditor conducting a financial report audit must notify the ASIC as soon as possible if

there are reasonable grounds to suspect that a contravention of the Corporations Act has taken

place. This is required unless the auditor believes the contravention will be adequately dealt

with by commenting on it in the auditor’s report or bringing it to the attention of the directors

(s.311).

2) Purpose of Auditing Standards

The Australian Auditing Standards (ASAs) contain:

• the basic principles and essential procedures with which the auditor is required to comply in
the planning, conduct and reporting of an audit;

• explanatory and other material to assist the auditor in interpreting and applying the basic
principles and essential procedures.

The basic principles and essential procedures are identified separately in bold type (black lettering)
in each of the Auditing Standards.
 The statements in the standards that are set in bold type must be complied with whenever a
financial report audit is conducted. (They have the authority of the law.) They must also be applied
(with adaptation as necessary) to audits of other financial and non-financial information and audit-
related services. A departure from the basic principles and procedures must be explained in the
auditor’s report (APS 1.1.05).

Auditing Guidance Statements (AGSs) have been issued to provide guidance in the application of
Auditing Standards. These are not mandatory.

I hope the above is of assistance.

Regards

Audit Senior
 Client Evaluation & Planning the Audit (Chapter 8)

Professional Application Question 8.22

8.22 Evaluating Independence

Prior to the appointment of Burberry Partners as the auditor of WeCare for the 2015
financial year, some preliminary analysis has identified the following situations:
 One of the accountants intended to be part of the 2015 audit team owns shares in
WeCare. The accountant’s interest is not material to him.
 Burberry was previously engaged by WeCare to value its intellectual property. The
consolidated balance sheet as at 30 June 2015 included intangible assets of $30
million, which were valued by Burberry on 1 March 2015 following WeCare’s
acquisition of HealthyGlow. The intangibles are considered material to WeCare.

Required
For each situation above:

(a) Identify and explain the potential type of threat to Burberry’s independence (your answer
should take into consideration the independence of individuals as well as the firm as a
whole).
(b) Explain the action that Burberry should take to eliminate the potential threat identified in
(a) above.

Shares

(a) s.324CH(1) of the Corporations Act prohibits a financial interest in the company by the
auditor. APES 290.113 states that a self-interest, familiarity or intimidation threat may
be created if a member of the audit team, or a member of that individual’s immediate
family has a financial interest in the entity. This can be mitigated if the person is not a
senior auditor and if the interest is not material.
(b) The action taken if this is decided to be a problem is to get the person to sell the shares
or remove the person from the audit engagement.

Generally, the audit firms have taken a conservative approach in recent years and prohibited
shareholdings in clients.

Intangibles

• This work was undertaken before Burberry was the auditor so the restrictions associated
with non-audit services do not apply. However, this is the provision of an accounting
service which the firm will now have to audit so it creates a self-review threat. The
significance of this threat in relation to valuation services includes a number of factors
included in APES 290.176, such as materiality, involvement of the client, subjectivity
etc.
• To eliminate this threat or reduce it to an acceptable level, safeguards include:
o Having a member who was not involved in performing the valuation service
 review the audit or the valuation work performed; or
o Making arrangements so that personnel providing such services do not
participate in the audit engagement.
Professional Application Question 8.23

8.23 Client evaluation

Dinfal Ltd is a company that manufactures a range of products for the electronics
industry. You work for a medium-sized firm of accountants, Ejo, Gam & Step. It is now
29 May 2015 and you have been approached by Dennis Launch, one of the directors of
Dinfal Ltd, to perform the financial report audit for the year ended 30 June 2015.
From your brief conversation with Dennis you establish the following:
Dinfal Ltd was set up by Dennis and his cousin Berty Drip, who are both directors and
each own 50% of the shares. Both Dennis and Berty consider themselves to be
entrepreneurs and have a range of experience in different industries. Since creating
Dinfal Ltd six years ago, the profits have increased very quickly, sales having nearly
doubled each year.
Dennis mentions that they left their previous two auditors due to differences of opinion
about accounting policies and accounting treatments for various transactions including
research and development expenditure.
Your firm has wide experience of the industry but no previous connection to the
company. You have explained to Dennis that there are certain procedures that need to be
followed before you can accept appointment as auditors. Dennis has indicated that Dinfal
Ltd is seeking additional financing and would like the audit to be completed as soon as
possible so that the audited financial report can be provided to the potential financiers to
prevent any delay in accessing additional funds.

Required

Highlight the issues that your firm should consider before accepting the appointment as the
auditor of Dinfal Ltd.

 Does the firm have the staff with appropriate skills to carry out the audit?
 Determine the firm’s ability to use due care in performing the audit.
 Are the staff available at what is likely to be a busy time for the firm?
 A check will need to be performed to ensure the firm has no connections with the firm that
would affect independence.
 The firm has clients in the same industry and should therefore ensure there are no conflicts
of interest.
 Permission should be sought to contact the previous auditors, the audit should not be
accepted if this is not received.
 Communicate with the outgoing auditor to establish if there are any reasons why you should
not accept appointment, review the response you receive from the auditors for any issues
that would prevent you accepting the audit.
 You should also ensure that the previous auditor has properly resigned.
 Obtain further details of the issues with the previous auditors, including the details of
accounting policies being followed.
 Review prior year financial reports and obtain copies of the most recent financial information.
 Consider the integrity of management.
 Obtain further details of the finance being sought, who the potential financiers are and how