BUSI2090 Audit and Assurance 1

Lecture 3:
Ethical principles governing an
Auditor
 Learning Objectives
• The role and importance of professional accounting body
• Ethical codes of practice under the Malaysian Institute of
Accountants
• Basic principles of ethics and professional conduct under
the MIA By-laws
– Independence concepts and its importance
– Conditions effecting independence in fact and in appearance
– Audit committee
– Peer review and joint audit
 Ethics and Professionalism
• What is Ethics?
– Ethics refers to a system or code of conduct based on
moral duties and obligations that indicates how an
individual should behave.

• What is Professionalism?
– Professionalism refers to the conduct, aims, or qualities
that characterize or mark a profession or professional
person.
 Ethics and Professionalism
•The public rely on the objectivity and integrity of the
professional accountants and this reliance imposes a public
interest responsibility on the profession.

•For accounting profession, the public consists of clients,

creditors, governments, investors, employers, employees and
the other sectors of the business community.

•Accordingly, the standards of the accounting profession must be

determined by the public interest and the economic well-being
of the community.
 Ethics and Professionalism
• A respectable professional body must guide its members what
acceptable professional behaviour is and it must also be able
to show the public that it is willing to monitor the actions of
its members.

• Such self-regulation is essential in ensuring high moral

behaviour among the professionals , upholding the public
respect and confidence in the profession and in maintaining
cordial relationship among its members

• Establishment of rules or codes of conduct that define what is

ethical behaviour for members of the profession is essential.
Fundamental principles of professional
ethics
 Confidentiality
We need to look at this in more detail because there are
exceptions!
• Disclosure is permitted by law and is authorised by the
client or employer.
• Disclosure is required by law.
• There is a professional duty or right to disclose, when not
prohibited by law.
• Compliance with Personal Data Protection Act (Malaysia)/
General Data Protection Regulation
– Sources of risks of accidental disclosure of information
– Steps to comply with PDPA/GDPR & prevent disclosure of
information
 Independence
• The fundamental principles require that members behave
with integrity in all professional and business relationships
and they strive for objectivity in all their professional and
business judgements.
• An auditor must remain impartial and independent of
management, so that he can give an objective view on the
financial statements of an entity.
• An auditor must not only be ethical (independence in
mind), but must also be seen to be ethical (independence in
appearance).
• This raises questions about what threats an auditor faces in
relation to independence and objectivity, and what
safeguards can be put in place to protect against those
threats.
 Question
Independence is one of the key rules of conduct for an
auditor.

(a) Discuss why it is so important for auditors to be

independent when carrying out a financial audit.
[5 marks]

(b) Distinguish between independence of mind and

independence in appearance. Illustrate with appropriate
examples.
[8 marks]
Threats & Safeguards
 Question:
Gloria Coffee & Tea Sdn. Bhd. (Gloria) is a company involved in planting, manufacturing
and distributing authentic coffee beans and tea leaves. The quality of coffee beans and
tea leaves are for upmarket retailers and priced at a high price. The company has been
audited by Heng & Co, a firm of Chartered Certified Accountants for the past 7 years, and
the audit manager is Andrew Droughty (Andrew). You are one of the audit assistants
reporting to Andrew, you become aware of the following issues:

(a) Andrew is dating the Chief Financial Officer, Rosella Tan. They have known each other
for a long time and they went to college together. Rosella is also a distance cousin of
Heng, the audit partner. Furthermore, Gloria has not paid the audit fees for the last two
years because Rosella said that it is acceptable since Heng (the audit partner) is her
distant cousin and Heng will understand that the company needs cash to pay other
suppliers first.

(b) Because of the long-term relationship between the company and the auditor, Andrew
is offered the position of Non-Executive Director with the company.

(c) After the annual physical count of inventory at the company’s principal warehouse,
you and another two audit assistants attending the count are invited to try the new
recipe invented by the company. The audit team members are treated to a cup of freshly
brewed coffee or tea of his/her choice. After a long day of hard work in auditing the
inventory count, Rosella approaches you and offers to take you and your audit team out
for a Japanese buffet dinner in Hong Kong using her private jet.
 Question (cont):
(d) An investor intended to purchase two of the 29 plantations owned by the company,
Gloria. All the coffee and tea trees need to be fair valued using “mark-to-market” value so
that Gloria can get a better price from the sale. The audit firm, Heng & Co has undertaken
the valuation work. The valuation method used and the fair valued amount are disclosed
in the notes to the financial statements. Rosella asks your audit firm to make sure that the
valuation method gives the highest value otherwise she will not sign the cheque for the
outstanding audit fees of two years.

(e) During a conversation over dinner with friends, you found out that the investor in item
(d) has also appointed Heng & Co to act on his behalf but you didn’t disclose that fact to
anyone. Rosella also heard that Heng & Co acts on behalf of the investor in the negotiation
and threatens to sue the audit firm for breach of its professional duty of care.

(f) The company’s Board of Directors decided to apply to be listed in the Stock Exchange of
Malaysia. One of the Directors discussed the plan with you and offers you a commission if
you can help to promote the shares to your friends and family members.

Required:
For each of the scenarios above, identify and explain any potential threats to the auditor’s
independence and suggest safeguards which might be put in place by Heng & Co and/or
Gloria.
[50 marks]
Self Interest Threats
Self Review Threats
Advocacy Threats
Familiarity Threats
Intimidation Threats
 Andersen & Enron Case
• Arthur Andersen (Houston office) was the auditor of Enron for
many years. However, the relationship between audit firm and
client seems to have become rather too close. Consider the
following facts:
• The auditors had permanent office space at Enron's headquarters.
• Auditors and client staff shared in social occasions (birthdays, meals
out, weekend fund-raisers, ski trips).
• Many Arthur Andersen staff were employed by Enron in the late
1990s, shortly before Enron's collapse in 2001. Many Enron staff
were also employed by Arthur Andersen.
• Arthur Andersen earned $25million from audit services provided to
Enron compared to $27million from non-audit services provided to
Enron.
• Non-audit services included internal audit, off-balance sheet
financing schemes, tax avoidance schemes, fronting offshore
companies, designing internal controls…
• These are clearly indicative of familiarity, self-interest, self-review
and intimidation threats!
 Question
Alliance & Co. (Alliance), an audit firm, is about to sign an engagement letter
to perform the following non-audit services for three separate clients to
which the firm has been providing and independent audit for a couple of
years.
Alliance is expected to continue as the auditor and the details of the three
clients are as follows:
(i) Client AA Ltd: Providing bookkeeping services for the financial year end 31
December 2017 in which Alliance expects to continue providing audit
services.
(ii) Client BB Ltd: Providing taxation consultancy services which include
preparation of the tax computation for the current financial year and future
tax planning advisory services.
(iii) Client CC Ltd: Providing design services for a new financial information
system.

Required:
For each of the non-audit services above, discuss whether Alliance should
sign the engagement letter or not.
[12 marks]
 Question:
Carz Wash Sdn. Bhd. (Carz) has 38 outlets in Klang Valley. The company uses an App so
customers can choose the type of services they require and make payment. The
services include wash and vacuum, normal polish, and 3-layer wax and polish. You are
the audit manager for the audit firm, Chong & Partners. During the audit of Carz, you
become aware of the following issues:

(a) You found a suspicious transaction of RM110,000. You asked the owner, Carl about
the details of the transaction. He mentioned to you that it is from illegal gambling and
asks you to help classify it as other income in the financial statements. If you refuse,
he says he will inform your audit partner and demand that they terminate your
employment.

(b) Two months before the financial year end, Carz agreed to acquire another car wash
company, Shine Shine Sdn. Bhd. The Chief Financial Officer of Shine Shine is your
spouse. However, the legal contract is not signed until three months after the financial
year end. You have discussed this matter with your audit partner on current and
future audit engagements.

(c) During the non-current assets inspection, you are offered the opportunity to
purchase a car-wax machine for 10% of the initial purchase price. The machine is 3
years-old and has a net book value of 50% of the initial purchase price. You are also
given two complimentary car wash vouchers to be used anytime during the year.
 Question (cont):
(d) Carz bought two huge machines that allow automation of the car wash process.
The car will be driven by the driver to where washing and drying is done without the
need for the driver to get out of the car. The machines were first recorded using cost
method two years ago. During the audit of the current year, Carz decided to revalue
the machines, and have asked you to assist in determining the valuation method and
the market value.

(e) You found out that Carl pays a salary to his wife and it is classified in the Salary and
Wages expense account. From the inquiry process, you found out that his wife is a
housewife and knows nothing about the car wash business. It is mainly to avoid paying
hefty tax on business profits to the tax authorities. Carl tells you not to mention this
matter to your audit partner. Furthermore, Carl’s wife is your cousin.

(f) Carl told you that Carz will be promoting a new car wash package for Chinese New
Year and asked you to help promote the package to your family members and friends.
For each person that you recommend, you will be given a RM50 car wash voucher per
person signed up via the App, as a reward for your efforts.

Required:
For each of the scenarios above identify and explain any potential threats to the
auditor’s independence and suggest safeguards which might be put in place by Chong
& Partners and/or Carz.
[Total: 50 marks]
 Safeguards

Three categories of safeguard

Created by
In the Created
the profession,
work by the
legislation
environment individual
or regulation

Specific examples of safeguards are found in the Reading

i.e. IESBA Code of Ethics for Professional Accountants
 Question
You are an audit senior of Beech & Co and have been
allocated to the audit of Willow Wands Co (Willow), a listed
company which has been an audit client for eight years and
specialises in manufacturing musical instruments.

Bethan Oak was the audit engagement partner for Willow and
as she had completed seven years as the audit engagement
partner, she has recently been rotated off the audit
engagement. The current audit partner, Sandeep Pine, has
suggested that in order to maintain a close relationship with
Willow, Bethan should undertake the role of independent
review partner this year. In addition Willow has requested
that Bethan assist them by attending their audit committee
meetings, as a non-executive director has recently left the
company.
 Question (cont.)
Willow has also asked Sandeep and the other partners at
Beech & Co to help them in recruiting a new non-executive
director.

The total fees received by Beech & Co for last year equated to
16% of the firm’s total fee income. The current year’s audit fee
has not yet been confirmed, but along with taxation and other
possible non-audit fees the total income from Willow this year
could be greater than for last year. Last year’s audit fee was
being paid monthly by Willow but no payments have been
made for the last three months.

The audit manager for Willow has just announced that he is

leaving Beech & Co to join Willow as the financial controller.
 Question (cont.)
Required:
(i) Explain five ethical threats which may affect the
independence of Beech & Co’s audit of Willow Wands Co.

(ii) For each threat, explain how it might be reduced to an

acceptable level.
 Think & plan first
• Before you do anything, look at the requirements and the mark
allocation
• Next, think about how you are going to present your answer. This
type of question would best be answered using a two column
format so you can link the threats and safeguards together: i.e.
present the 'threats' in the left-hand column, and then in the right
hand column explain how each threat could be avoided.
• Use a ruler for your table and for the headings.
• Now, go through the scenario line-by-line and jot down the possible
threats.
 Suggested Answer
Threat Safeguards
Bethan Oak was the audit engagement partner of As Willow is a listed company, then Bethan Oak
Willow Wands Co (Willow) for the last seven years should not serve as the independent review partner
and has recently rotated off the audit. for a period of two years. An alternative review
It has been proposed that she should now become partner should be appointed instead.
the independent review partner. This represents a
familiarity threat as the partner will have been
associated with Willow for a long period of time
and so may not retain professional scepticism
and objectivity.
Willow has requested the previous engagement The firm should politely decline this request from
partner, Bethan Oak, attend audit committee Willow, as it represents too great a threat to
meetings as a non-executive director of Willow has independence.
recently left.
This represents a self-interest threat as the audit
firm may be perceived as performing the role of
management by attending these meetings and this
threatens objectivity.
 Suggested Answer (cont.)
Threat
The management of Willow have asked whether
the partners of Beech & Co can assist them in
recruiting to fill a vacancy for a non-executive
director.
This represents a self-interest threat as the audit
firm cannot undertake the recruitment of senior
management of Willow, especially as non-
executive directors have a key responsibility in
appointing the audit firm.
The total fees received from Willow for last year
equated to 16% of the firm’s total income. The fees
for this year have not been finalised, but it is
anticipated that they could be greater than 16%.
There is a potential self-interest threat as the total
fees could represent a significant proportion of
Beech & Co’s income.
Safeguards
Beech & Co is able to assist Willow in that they can
undertake roles such as reviewing a shortlist of
candidates. However, they
must ensure that they are not seen to undertake
management decisions and so must not make the final
decision on who is appointed.
Beech & Co should assess whether total fees would
represent more than 15% of gross practice income for
two consecutive years.
If the recurring fees are likely to exceed 15% of annual
practice income this year, additional consideration
should be given as to whether the taxation and non-
audit assignments should be undertaken by the firm. If
the fees do exceed 15% then this should be disclosed
to those charged with governance at Willow.
 Suggested Answer (cont.)
Threat
Last year’s audit fee was being paid monthly,
however, the last 3 months’ payments are
outstanding.
A self-interest threat can arise if the fees remain
outstanding, as Beech & Co may feel pressure to
agree to certain accounting adjustments in order
to have the previous year and this year’s audit fee
paid.
In addition, outstanding fees could be perceived as
a loan to a client which is strictly prohibited.
The audit manager of Willow is leaving Beech & Co
to become the financial controller at Willow. This
represents a self-interest and familiarity threat as
the audit manager is familiar with the audit plan
which is to be adopted at Willow and he may also
have commenced work on this year’s audit.
Safeguards
Beech & Co should discuss with those charged with
governance the reasons why the last three months’
payments have not been made. They should agree a
revised payment schedule which will result in the fees
being settled before much more work is performed for
the current year audit.
A new audit manager should be appointed to Willow
and any work already undertaken by the previous
manager should be independently reviewed.
In addition, it would be advisable to modify the audit
plan so that the manager would not be overly familiar
with the
approach to be adopted.
 Tips
• Remember that more than one threat can apply to a given
situation. For example, familiarity and self-interest threats
are often linked and may both be applicable.
• Remember also that resigning from the audit is usually a
last resort! You need to first consider whether there are any
safeguards that could reduce the threat(s) to an acceptable
level. There is a tendency for students to suggest
resignation without thinking about the possible safeguards
that could be applied.
• When suggesting safeguards, make sure they are relevant to
the scenario in the question.
Mechanism use in maintaining audit independence

Audit Committees

An audit committee is a sub-committee of

the board of directors, usually containing
a number of non-executive directors.
 Responsibilities of Audit Committee
Key functions and responsibilities of the Audit Committee:

1. Review the external auditors’ audit plan, the scope of their audits and
audit report.
2. Review the evaluation of the system of internal control with the internal
and external auditors.
3. Review the internal audit plan and results of the internal audit plan or
investigation undertaken and follow up on the recommendations
contained in the audit reports of the internal audit function.
4. Review the Group’s quarterly results and the annual financial statements
prior to the approval by the Board of Directors
5. Discuss with the external auditors with regards to problems and
observations noted in their interim and final audits.
6. Assess the performance of the external auditors and make
recommendations to the Board of Directors on their appointment and
removal.
7. Recommend the nomination of a person or persons as external auditors.
8. Review any letter of resignation from the external auditors or suggestions
for their dismissal.
 Benefits of having an Audit Committee
• Improves the quality of financial reporting, by reviewing the financial
statements on behalf of the board
• Creates a climate of discipline and control which will reduce the opportunity
for fraud
• Enables the non-executive directors to contribute an independent judgement
and play a positive role
• Helps the finance director, by providing a forum in which he can raise issues of
concern, and which he can use to get things done which might otherwise be
difficult
• Strengthens the position of the external auditor by providing a channel of
communication and forum for issues of concern
• Provides a framework within which the external auditor can assert his
independence in the event of a dispute with management
• Strengthens the position of the internal audit function, by providing a greater
degree of independence from management
• Increases public confidence in the credibility and objectivity of financial
statements
 Drawbacks of having an Audit
Committee
• Executive directors may not understand the purpose of an
audit committee and may perceive that it detracts from
their authority.
• There may be difficulty selecting sufficient non-executive
directors with the necessary competence in auditing
matters for the committee to be really effective.
• The establishment of such a formalised reporting procedure
may dissuade the auditors from raising matters of
judgement and limit them to reporting only on matters of
fact.
• Costs may be increased.
Mechanism use in maintaining
audit independence

Partner Rotation

The lead and concurring audit partner

rotate off the audit engagement
after a period of five years.
 Rotation of Audit Firm or Auditor
Audit firm
• an increased level of skepticism is
brought to the audit;
• a fresh perspective and view is
brought to the audit;
• it provides incentives for auditors
to be more alert, as they know
that periodically their work will
be reviewed by another audit
firm; and
• it removes the tendency for over-
reliance on prior-year audit work
papers.
Auditor
• there is no evidence that audit firm
rotation will enhance auditor
independence;
• loss in client-specific knowledge will
adversely affect audit quality;
• the rotation of key audit personnel
brings most of the benefits without
the increased costs
• of changing audit firms; and
• auditing standards and rules of
ethical conduct already require
professional skepticism,
• and cover threats to independence.
 Enforcement of Ethics and Disciplinary Actions
To be effective, a code of ethics must contain not only attainable rules but must
also enforceable.

– Investigation Committee
• The function of Investigation Committee is to investigate any complaints
made against any member of the profession body.

• The Investigation Committee has the power to call upon any person to
conduct preliminary inquiry and to demand the member against whom
the complaint was made to produce any books or documents for
inspection.

• The Investigation Committee will refer the complaint to the Disciplinary

Committee once it is satisfied that there are sufficient grounds for
disciplinary proceeding to be taken against the member.
 Enforcement of Ethics and Disciplinary Actions
• Disciplinary Committee
– If the Disciplinary Committee, after the necessary inquiry and proceedings,
finds that a member is guilty of unprofessional conduct, it can impose any one
or a compound of the following disciplinary punishment.

– Termination of membership
– Suspension ( not > 3 years)
– Cancellation of practicing certificate
– Fine

• Disciplinary Appeal Board

A member aggrieved by the decision of the Disciplinary Committee has
the right to appeal to the Disciplinary Appeal Board against such
decision. The Board after due consideration, may confirm, reverse or
vary the decision of the Disciplinary Committee. The decision of the
Board under these provisions, will be considered final
 Professional Skepticism (ISA 200)
• An attitude that includes a questioning mind, being alert to
conditions which may indicate possible misstatement due
to error or fraud, and a critical assessment of audit
evidence.
• As auditors, we exercise professional judgement and
maintain professional skepticism throughout the audit
• Professional skepticism includes being alert to, for example:
– Audit evidence that contradicts other audit evidence obtained
– Information that brings into question the reliability of
documents and responses to inquiries to be used as audit
evidence
– Conditions that may indicate possible fraud
– Circumstances that suggest the need for audit procedures in
addition to those required by the ISAs
 Professional Skepticism (ISA 200)
• Maintaining professional skepticism throughout the audit is
necessary:
– Overlooking unusual circumstances
– Over generalising when drawing conclusions from audit
observations
– Using inappropriate assumptions in determining the nature,
timing and extent of the audit procedures and evaluating the
results
• Six characteristics of scepticism as outlined by the CAQ
(2010) and Hurtt (2010):
1. Questioning mind.
2. Suspension of judgment
3. Search for knowledge
4. Interpersonal understanding
5. Autonomy
6. Self-esteem
 Professional Skepticism (ISA 200)
• The auditor shall plan and perform an audit with professional
skepticism recognising that circumstances may exist that cause the
financial statements to be materially misstated

• ISA 200 requires the auditor to adopt an attitude of professional

skepticism; this is necessary in all aspects of planning and
performing an audit but not repeated as a requirement of each ISA

• Independence enhances the auditor’s ability to act with integrity to

be objective and to maintain an attitude of professional skepticism

• The need for professional skepticism cannot be overemphasised and

that adopting and applying a skeptical mindset is ultimately a
personal and professional responsibility to be embraced by every
auditor….. IAASB Chairman
 Professional Judgement (ISA 200)
• The application of relevant training, knowledge and
experience within the context provided by auditing,
accounting and ethical standards, in making informed
decisions about the course of action that are
appropriate in the circumstances of the audit
engagement.

• Auditor to exercise professional judgement in planning

and performing an audit of financial statements

• Reasonable components of professional judgement:

– Logical, flexible, unbiased, consistent, reliable, and using
the right amount of relevant information (KPMG, 2011)
 Professional Judgement (ISA 200)
• Judgement is typically exercise in the following areas:
– Materiality and audit risk
– Nature, timing and extent of audit procedures
– Evaluation of whether sufficient appropriate audit
evidence has been obtained
– Estimating probabilities
– Deciding between options
– Evaluating management’s judgement in applying the
applicable financial reporting framework
– Drawing conclusions based on the audit evidence obtained
 Example: FlowTex
• FlowTex was a German company set up by two businessmen
which made machines for horizontal drilling. By 2000, they
had sold over 3,000 drilling machines worth millions.
• Actually they had only ever produced 181 machines which
were sold multiple times! Over ten years they managed to
secure loans worth more than €2billion for non-existent
drilling systems.
• Friends and family, as well as company employees, were all
involved in the fraud, which resulted in the two men being
arrested for fraud and tax evasion.
• This is the largest financial scandal in German history to date.
List of Corporate Scandals

https://en.wikipedia.org/wiki/List_of_corporate_collapses_and_scandals