Solutions of workshop 2 - The Complete Academic Support Hub

Solutions of workshop 2

What are the five fundamental principles in APES 110? Who must comply with them?

APES 110 Code of Ethics for Professional Accountants is issued by the Accounting Professional & Ethical Standards Board Limited (APESB), which was established in 2006 by the three main professional accounting bodies in Australia. All members of those bodies are required to comply with the APES (Accounting Professional and Ethical Standards). The overriding requirement is that members act in the public interest. Compliance with the fundamental principles of professional ethics should ensure that members are able to act in the public interest.

The fundamental ethical principles that apply to all members of the professional bodies are to act with integrity, objectivity, professional competence and due care, confidentiality and professional behaviour (APES 110, 110.1).

The requirement to act in the public interest means that auditors should consider how their actions impact the client and their employer. They must also consider the impact of their actions on others such as the client’s employees, investors, credit providers, and those without direct financial interests in the client such as the broader business and financial community and members of the public. All these people could be reliant on the quality of the auditor’s work, even though they are not party to the contract between the client and the audit firm.

What is more important, independence of mind or independence in appearance? Explain.

Both aspects of independence are important. If an auditor has independence of mind the auditor will act independently. Acting independently means that the auditors are free of the clients’ influence and will perform their duties as required by the auditing standards and codes of ethics, even if the clients do not agree. Acting independently is essential for a high quality audit.

However, despite how independently the auditors may act, the audit reports will not be credible if the outside parties do not believe that the auditors acted independently. That is, the outside parties do not believe the audit reports have any credibility because they believe that the clients have influenced the auditor. Therefore, the auditor must be seen to be independent by outside parties. That is, the auditor must be independent in appearance for the audit report to be believed.

If the auditor is seen to be independent but is really not independent, then the audit reports will have credibility, but if later events reveal that the auditor did not act independently, the outside parties could suffer a loss from relying on an inappropriate audit opinion. Therefore, both independence of mind and independence in appearance are required for effective auditing.

Explain how an auditor would use auditing standards to avoid legal liability.

For a case brought by a client or another party to succeed against an auditor it must be shown that they breached the terms of the contract and/or were negligent. An auditor will use internal documentation to show that all duties were conducted to a reasonable standard. Failure to follow auditing standards would imply that the work was not conducted to a reasonable standard, but it is still possible that an auditor could be found to be negligent even if the strict letter of the auditing standards was followed. This is because the test is not whether or not the standards were followed, but whether it was reasonable to expect an auditor to act in a particular way. All circumstances must be examined on a case-by-case basis, and there could be conditions which would create a reasonable expectation that the auditor would have performed additional procedures or acted differently in some way. Therefore, compliance with auditing standards is generally regarded as a minimum, not a maximum, requirement to avoid legal liability.

What are the three conditions that must be proven for an auditor to be found negligent under tort law? Which conditions appear to be most difficult to prove?

A client may bring an action against an auditor under contract or tort law. The contract is between the client and the auditor. Damages under a breach of contract can only be claimed by a party to the contract.

Tort law allows any party to bring an action for negligence, provided the following three conditions are established:

a duty of care was owed by the auditor
there was a breach of the duty of care
loss was suffered as a consequence of that breach.

Therefore, tort law allows another party to bring an action (not just a party to the contract) if it can be shown that there was a duty of care to that party. This means that the client and other parties could potentially bring an action for negligence. The first condition appears to be the most difficult to prove.

For example in the HIH Royal Commission Report, it was noted that the auditor could owe a duty of care to the client and its shareholders. The report discusses the problems facing plaintiffs when seeking to establish that the client or shareholders had suffered a loss as a result of the auditor’s negligence. To ascertain a causal relationship between the negligent act and the loss suffered, reasonable foreseeability must be proven. This means that the auditor must have been aware that any negligence on their part could cause a loss to the client or their shareholders.

In Esanda (1997) the High Court of Australia ruled that for a third party to be able to establish that an auditor owes them a duty of care, they would need to show the following.

The report was prepared on the basis that it would be communicated to a third party.
The report was likely to be relied upon by that third party.
The third party ran the risk of suffering a loss if the report was negligently prepared.

The judgement in the Esanda case provided some relief for auditors as it made it far more difficult for a third party to establish that a duty of care was owed by the auditor. Today, it is advisable that a third party take steps to establish proximity before using an audited report to make a decision.

The plaintiff must also show that the auditor breached its duty of care, for example, by conducting a poor-quality audit. Mere non-compliance with auditing standards may not be sufficient to show a breach of the duty of care. Finally, the plaintiff must establish that they suffered loss as a result of the breach of the duty of care. For example, the plaintiff must show that they relied on the audit report to make their investment which subsequently lost value.

Why is it so important that an audit committee not have any executive directors as members?

Executive directors are employees of the company who are also members of the board of directors. Non-executive directors are members of the board who are not employees of the company, but they could be ex-employees and/or major shareholders. Executive directors are generally regarded as being less independent with respect to the audit because they are part of the subject of the audit. That is, the executives, such as the CEO or CFO are in charge of the company’s operations and financial reports and so their work is being audited.

The audit committee is a sub-committee of the board of directors and its responsibilities include selection of the company’s auditors and overseeing the contract with the external auditors (and sometimes the internal audit department). The external auditors need to feel confident about bringing issues and difficulties they encounter during the audit to the attention of the audit committee. The auditors need to believe that the audit committee will not attempt to cover up the problems and will not try to persuade the external auditors to drop any major issue. If an executive director is on the audit committee they are regarded as being more likely to try to cover up any problems because such problems would reflect badly in the executive director’s performance as an employee. Not allowing executive directors to be part of the audit committee avoids such potential conflicts of interest.

What is the purpose of an engagement letter? Are all engagement letters the same? Explain.

An engagement letter is the contract between the client and the auditor. It contains clauses that make the responsibilities of each party clear, and can provide a method of handling disputes.

The purpose of an engagement letter is to set out the terms of the audit engagement, to avoid any misunderstandings between the auditor and their client. The letter will confirm the obligations of the client and the auditor in accordance with the Corporations Act. While the engagement letter can expand upon the requirements that appear in legislation and standards, it cannot limit or contradict those requirements.

An engagement letter includes an explanation of the scope of the audit, the timing of the completion of various aspects of the audit, an overview of the client’s responsibility for the preparation of the financial report, the requirement that the auditor have access to all information required, independence considerations and fees.

Discuss the procedures governing the client acceptance or continuance decision? Explain why auditors do not accept every client.

Client acceptance and continuance procedures are performed for the purpose of evaluating whether the auditor can service the client and still meet the relevant ethical and legal requirements. This is to protect the client and the auditor as well as those who will rely on the audit report. The client needs to be assured that the auditor has the appropriate skills and capacity to provide the audit at the appropriate level of quality and within the required time frame. The auditor needs to be sure that it can service the client in this way and protect itself from any conflicts of interest that could arise during the engagement. The public and other parties need to be assured that the audit was conducted appropriately and the auditor was able to exercise the required level of independence.

An auditor will not accept every client, even if it has capacity, because they would not be able to provide the required level of expertise to service the client’s needs. Refusal to accept a client (or continue with an existing client) does not mean that the client is not auditable or lacks integrity. Another auditor could be better able to service the client because of capacity or expertise issues. However, the auditor’s right to refuse a client means that the more difficult to audit clients find it hard to get an auditor and so have the incentive to either improve their systems and/or integrity, or go out of business. As such, the quality of financial reporting across the economy is likely to be higher.

Some companies outsource their internal audit function to a public accounting firm. Explain how this would affect the external auditor’s evaluation of the reliability of the internal audit function.

Outsourcing an internal audit function could provide the advantages of potentially better qualified auditors and a better resourced auditing function. It also allows small companies that would not be able to justify the establishment of a fully functioning internal audit department to have an internal audit function. An outsourced internal audit function is also likely to be more independent because they are not employees of the company and will not have the familiarity problems that could arise when one employee of a company is required to audit another employee’s work.

Outsourcing has the disadvantage that the internal auditors would have less knowledge about the company and its systems. Such lack of knowledge may mean that employees could find it easier to hide problems from the internal auditors. Outsourced internal auditors are removed from employee social networks and thus may not be alert to problems known by employees. For example, employees may know of another employee’s gambling problems which could tempt them to steal from the company.

What are threats to compliance with the fundamental principles? Explain the five categories of threats identified in APES 110, and include examples.

Members of the professional accounting bodies are required to comply with the five fundamental principles of integrity, objectivity, professional competence and due care, confidentiality and professional behaviour. There may be circumstances which make it more difficult for accountants to comply with the principles because they create specific threats to compliance. The circumstances can be the result of many different factors, and can produce more than one type of threat to compliance. The threats fall into one or more of the following categories (APES 110, 120.6 ): self-interest, self-review, advocacy, familiarity, intimidation.

Self-interest: the threat that a financial or other interest of the accountant will inappropriately influence the accountants’ judgment or behaviour. Examples include: owning shares in the client, having loans to or from the client, undue reliance on fees from the client, discovering an error in the work of another member of the accountant’s firm.

Self-review: the threat that an accountant will not appropriately evaluate the result of previous work by themselves or another member of the firm. Examples include auditing the results of a financial system that they designed or installed, a member of the audit team being, or having recently been, a director of officer of the client (senior staff) or in a position to exert significant influence over the subject matter of the engagement. That is, the auditor is not allowed to audit their own work.

Advocacy: the threat that the accountant will promote a client’s or employer’s position to the point that the accountant’s objectivity is compromised. Examples include promoting shares in an audit client or acting as an advocate on behalf of an audit client in disputes or legal cases.

Familiarity: the threat that due to a long or close relationship with a client or employer, the accountant will be too sympathetic to their interests or too accepting of their work. Examples include having a close family member who is a director or officer of the client, or an employee who is a position of significant influence over the subject matter of the engagement, accepting gifts or preferential treatment (unless the value is trivial or inconsequential), or senior personnel having a long association with the assurance client.

Intimidation: the threat that an accountant will be deterred from acting objectively because of actual or perceived pressure or attempts to exert undue influence. Examples include being threatened with dismissal, the suggestion that they will not get additional work if they continue to disagree with the client, the threat of legal action by the client, pressure to reduce fees.

Professional Application Questions (PAQs)

Q. 2.23

Charles is at a neighbourhood Christmas party with several of his flatmates. Over a few beers, Charles gets into a conversation with a neighbour, William, about mutual acquaintances. Charles is a junior auditor with a large accounting firm (although he tells William that he is a partner at the firm) and William works for a large bank. During the conversation Charles and William discover that they have both had professional dealings with a particular family-owned manufacturing company. William reveals that the company’s line of credit is about to be cancelled because of some irregularities with the security documents. Charles is concerned to hear this news because he has just participated in the company’s financial report audit and there was no indication of any problems with its borrowings. Charles tells William that he believes that the founder of the family-owned company (and the current CEO) is having an affair with his personal assistant, and has quietly increased his shareholdings in a listed company that supplies components to the family manufacturing company. The components manufacturing company is about to announce to the share market that it has just won a very large, and very profitable, contract with a Chinese company.

Required

Discuss the ethical principles that are potentially breached by Charles’s behaviour at the party.

Charles overstates his importance at the audit firm – he states that he is a partner but he is a ‘senior’ (which is less senior than a partner). Breach of integrity

Charles tells William that the patriarch (male leader of the family) is having an affair with his personal assistant – this is gossip. Even if it is true, it is not professional behaviour to reveal private matters about a client to another party. Charles also states that he has his ‘doubts’ about this person – this apparently means that Charles believes that the person is dishonest or unethical or incompetent (it is not clear what he means but he is saying something negative). Once again, this is not professional behaviour.

Charles tells William that the family has increased its shareholding in another company, with potential benefits to the company. This information appears to have been gained as part of the audit so revealing it to William is a breach of confidentiality. It is not relevant that William works for a bank which lends to the client, Charles does not have the client’s permission to discuss this matter.

Q 2.29

Kerry is a senior auditor and a member of the team auditing a long-standing client, the listed public company Darcy Industries Ltd. Darcy Industries has just announced a takeover bid for Blacklight Ltd. Kerry has a substantial shareholding in Blacklight through his self-managed superannuation fund. Kerry did not know about the takeover bid until he read it in the paper over breakfast one morning. Kerry’s wife is very worried because she knows that Kerry must abide by strict rules laid down by his audit firm about holding shares in client companies. She asks him if he will be dismissed because of this.

Required

Advise Kerry’s wife of the options available to Kerry to avoid any conflict of interest, and thus avoid being dismissed from the audit firm.

APES 110:

510.10 A1 If a member of the Assurance Team, or their Immediate Family member receives, by way of, for example, an inheritance, gift or, as a result of a merger, a Direct Financial Interest or a material Indirect Financial Interest in the Assurance Client, a self-interest threat would be created. The following safeguards should be applied to eliminate the threat or reduce it to an acceptable level:

(a) Disposing of the Financial Interest at the earliest practical date; or

(b) Removing the member of the Assurance Team from the Assurance Engagement.

During the period prior to disposal of the Financial Interest or the removal of the individual from the Assurance Team, consideration should be given to whether additional safeguards are necessary to reduce the threat to an acceptable level. Such safeguards might include:

• Discussing the matter with those charged with governance, such as the audit committee; or

• Involving an additional professional accountant to review the work done, or otherwise advise as necessary.

Kerry was not a shareholder in his client Darcy Industries Ltd, but is at risk of becoming a shareholder in a member of the group if Darcy’s takeover of Blacklight is successful. Kerry would normally be regarded as an indirect shareholder rather than a direct shareholder because the shares are held by his self-managed superannuation fund (SMSF). A SMSF is a trust arrangement where Kerry cannot directly deal with the shares and will only benefit on his retirement (or his estate will benefit on his death). However, APES 110, s. 510.3A1 deems the financial interest to be direct if the beneficial owner has control over the investment vehicle. Kerry is aware of the investment of his SMSF in Blacklight if he is a director of the fund (which he would almost certainly be as it is ‘his’ fund according to the question). There is a potential for Kerry’s decision making to be affected because an increase in value of the shares would indirectly benefit him. He should take steps to dispose of the shares if it is likely that the takeover bid will be successful, if he has control over the investment vehicle. If he does not have control over the investment vehicle, he should still dispose of the shares if the interest is material.

Q 2.31

Bumpa Shopping Centres has borrowed heavily in recent years. The pressures of rapid expansion have been felt within its finance department, and the chief financial officer (CFO) has begun to make mistakes. The CFO neglected to reclassify some of its debts from non-current liabilities to current liabilities following default on some terms of the contract with an international banking syndicate, and omitted contingent liabilities from the notes to the accounts. The billion dollar mistakes were not detected by either the directors or the auditors, and the financial report and audit report were published. Following discovery of the mistake, the shares in Bumpa Shopping Centres lost value rapidly and the company was placed into liquidation.

Discuss the auditor’s liability for losses suffered by (a) Bumpa Shopping Centres investors, and (b) other parties.

The misclassification of liabilities as non-current instead of current potentially means that anyone analysing the financial position of Bumpa Shopping Centres would be misled. If the liabilities are current, it is likely that they are due to be paid within 12 months, although they could also be renegotiated, and the repayment date extended. The reader of the accounts would not be sure if Bumpa had to repay the debt, and would have doubt about the ability of the company to continue in business.

The directors and managers of Bumpa are likely to say that they relied on information provided to them by the finance department. The reports from the finance department probably did not state that the debts were due to be repaid soon. However, the directors and managers are under an obligation to ask questions about important matters such as large debts. They are also obliged to monitor the financial position of their company. They cannot just rely on others.

The auditors are likely to say that they relied on information provided by the managers about the due date for the debt repayments. However, the auditors should gather evidence about the repayment date, not just rely on what the managers tell them.

The investors in Bumpa could bring legal action against the auditors, arguing they suffered financial loss as a result of the misclassification of the debt. The auditors reported that the financial accounts were in accordance with the Corporations Act and accounting standards (which they were not, because the debt was misclassified), and that the accounts were true and fair (which they were not because they gave a misleading picture).

It is likely that the auditors are liable to the investors in Bumpa Shopping Centres because of their loss and the failure of the auditors to following auditing standards, such as those requiring auditors to gather sufficient and appropriate evidence about the liabilities and their disclosures. The auditor could be liable under both contract law (failure to perform the audit they were contracted to do) and tort of negligence. The investors would need to establish that the auditor owed them a duty of care and the duty of care was breached, and that the investors suffered a loss as a result of that negligence.

Third parties cannot rely on contract law. Other parties would try to rely on tort law. In addition, to duty of care, breach of the duty and loss, they have to establish that there was reasonable foreseeability. This means that the other parties would have to establish that the auditor was aware, or should have been aware, that any negligence on their part could cause a loss to the third parties. This is more difficult than establishing foreseeability of the loss suffered by investors. Caparo (1990) established the concept of reasonable proximity, where the auditor must be aware of the third party as a group and the decision they intend to make when using the audited report. Third parties would have a better case if they obtain a Privity Letter* which can be used to prove that a duty of care was owed to them. Otherwise, there would need to be some special circumstances before the auditor was liable to them in this case.

*A privity letter is a letter from the auditor acknowledging a third party’s reliance on an audited report. The third party requests the privity letter from auditor.

13 Q. 2.33

Linda is the managing partner of Moss and Associates, a small audit firm. Linda’s role includes managing the business affairs of the firm, and she is very worried about the amount of fees outstanding from audit clients. One client, Dreamers Pty Ltd, has not paid its audit fees for two years despite numerous discussions between Linda, the audit partner, Bill, and the management of Dreamers Pty Ltd. Dreamers Pty Ltd’s management promised the fees would be paid before the audit report for this year was issued. Linda rang Bill this morning to ensure that the audit report was not issued because Dreamers Pty Ltd had paid only 10 per cent of the outstanding account. She discovers that Bill is about to sign the audit report.

Required

Explain the ethical problem in this case. Why is it a problem? What can be done about it?

If fees are outstanding the auditor could be perceived to have a conflict of interest because the auditor is more likely to be paid if the client survives and is happy with the auditor. In these cases, the auditor could be perceived as being more interested in the client’s survival than an accurate audit report.

The auditor should take steps to have the fees paid before the next audit or remove itself from the audit.

See APES 110:

410.7 A1 A self-interest threat may be created if fees due from an Assurance Client remain unpaid for a long time, especially if a significant part is not paid before the issue of the assurance report for the following year. Generally, the payment of such fees should be required before the report is issued.

The situation should be reviewed by another accountant (not involved with the audit) and determine if the unpaid fees amount to a loan to the client. The audit firm should consider whether it is appropriate to continue the audit or be reappointed in the next period.

14.Q 2.36

Dolphin Surf & Leisure Holidays Pty Ltd (Dolphin) is a resort company based on the Great Barrier Reef. Its operations include boating, surfing, diving and other leisure activities, a backpackers’ hostel, a family hotel and a five-star resort. Justin and Sarah Morris own the majority of the shares in the Morris Group which controls Dolphin. Justin is the chairman of the board of directors of both Dolphin and the Morris Group, and Sarah is a director of both companies as well as the CFO of Dolphin.

In February 2017, Justin Morris approached your audit firm, Clarke Partners, to carry out the Dolphin audit for the year ended 30 June 2017. Dolphin has not been audited before but this year the audit has been requested by the company’s bank and a new private equity investor group which has just acquired a 20 per cent share of Dolphin. You know that one of the partners at Clarke Partners went to school with Justin and has been friends with both Justin and Sarah for many years.

Required

Identify and explain the significant threats to independence for Clarke Partners in accepting the audit of Dolphin.
Explain any relevant and practical safeguards that Clarke Partners could implement to reduce the threats.

(a) Personal relationships between a partner of the audit firm and the two directors (Justin and Sarah) – familiarity threat. This applies even if the partner is not part of the engagement team because the partner is a senior member of the audit firm.

From APES 110:

300.6 A1 Examples of circumstances that may create familiarity threats include, but are not limited to:

A member of the Engagement Team having a Close or Immediate Family member who is a Director or Officer of the client.
A member of the Engagement Team having a Close or Immediate Family member who is an employee of the client who is in a position to exert significant influence over the subject matter of the engagement.
A Director or Officer of the client or an employee in a position to exert significant influence over the subject matter of the engagement having recently served as the Engagement Partner.
A Member accepting gifts or preferential treatment from a client, unless the value is trivial or inconsequential.
Senior personnel having a long association with the Assurance Client.

(b) APES 110 suggests that the audit firm should document the policies that relate to this type of threat to independence, the evaluation of the threat and the safeguards to reduce the threats. They should also have policies and procedures to prevent that partner from inappropriately influencing the outcome of the assurance engagement. The firm should not use that partner on the Dolphin engagement, and should not accept the audit if that partner is required on the audit.

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