week 5- audit quality

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Audit Quality: Ethics, Independence

& corporate governance

Advanced Assurance and Attestation

Week 5

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Professional Ethics and Independence: Introduction

1. Audit quality, governance & the expectation gap 2. Recent scandals and the reaction by regulators 3. Auditor competence 4. The perception of independence is as important as

actual independence 5. Code of Professional Conduct (CPC) replaced by

ethical standards Code of Professional Conduct and Ethics for Public Accountants and Accounting Entities

6. ACRA: New independence requirements under Corporations Act

7. Ethical issues change with the changing expectations of society

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Audit Quality

Technical standards Accounting concepts and standards (SACs,

IASBs, UIG consensus views) Auditing standards and guidance

statements (SSAs) Standards for taxation, insolvency and

management consulting services Compliance with standards SSA100

preamble to applying standards

3.1 Audit quality, governance & the expectation gap

jansonUIG = Urgent Issues Group

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Components of the Audit Expectation Gap

Unreasonable expectations of users

Inadequate performance by auditors

Acceptable standards

Approved standards

Expectations of users

Service provided by auditor


jansonAudit Quality = how well an audit detects and reports material misstatements in financial reporting

Driven by corporate failure, audit program

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Audit expectation gap

Gap between auditors stated objectives and users perceptions as to the role of an audit. Eg: Belief that an unqualified audit report guarantees

the accuracy of financial statements; or There is no fraud or error; or It is an opinion on the economy, efficiency and

effectiveness of management. True and fair is not defined, hence public and

professional expectations differ.


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Expectations gap

1.The roles and responsibilities of auditors 2.The performance of auditors

The gap results from differences between the views of auditors and

other stakeholders regarding:


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Expectations gap

The nature of auditing Application of hindsight Self-interest of complainants Self-interest of auditors Changes in social expectations Misunderstanding/ignorance of roles

The gap is attributed to many different causes:


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Expectations gap Lack of understanding by financial

statement users of :

Business Failure vs Audit Failure

Audit Failure and Audit Risk


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Corporate governance: serving client and public interests What is corporate governance?

The system by which companies are directed and controlled Sir Adrian Cadbury (Chair of the Cadbury Committee,

U.K.) The manner in which an organisation is managed

and governed in order to achieve its strategic and operational objectives

The cornerstone of good stewardship and effective management


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Corporate governance: serving client and public interests What is corporate governance?

the conduct of the board of directors and the relationships between the board, management and shareholders. The transparency of major corporate decisions and accountability to shareholders is at the core of governance issues

A corporate governance system can be thought of as the processes and structures used to direct a corporations business. A key objective of a corporate governance system should be the enhancement of shareholder value.


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Corporate governance: processes and structures

Board of Directors

Audit committee

Internal audit

External audit


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Corporate governance: serving client and public interests Why is corporate governance important?

When companies are not run properly, many people can be disadvantaged e.g., shareholders, creditors, employees, suppliers, customers.

Large corporate collapses have focused attention on weaknesses in corporate governance;

Widespread demand for greater accountability and transparency;

Boards, CEOs, Auditors all have faced strong criticism.

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Corporate governance: regulations

Increased legislation and regulatory requirements In Australia:

CLERP 9 Principles of Good Corporate Governance and Best

Practice Recommendations, ASX Corporate Governance Council

In the United States: Sarbanes-Oxley Act

In the United Kingdom: The Combined Code on Corporate Governance,

The Financial Reporting Council (FRC) 3.1 Audit quality, governance & the expectation gap

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Corporate governance: audit committee The audit committee is an important function:

Has oversight responsibility for: the outside reporting of the company risk monitoring and control processes both internal and external audit functions

Consists of directors (ideally independent directors) and is a monitor of management;

Auditors should communicate with the audit committee frequently;

Must operate effectively i.e. should have members with accounting and finance expertise and should meet frequently.


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Corporate governance: audit committee

Research evidence shows that audit committees comprised of independent directors are associated with auditors resisting pressure from management E.g. auditors appear to be more willing to issue a going

concern opinion when the audit committee is comprised of independent directors;

Auditors are less likely to be dismissed after issuing a going concern opinion when the audit committee is more independent, has greater governance expertise and lower shareholdings in the company;

Affiliated directors (those with ties to the company) are more likely to side with management in disputes with the auditor.


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Corporate governance: internal audit Internal audit

Internal audit is growing in importance as a governance mechanism;

Internal audit can support and enhance the work of the audit committee;

The audit committee can strengthen the independence of internal auditors; The internal audit function should report to the audit committee; Regular meetings between the committee and the chief internal auditor

The audit committee should review the work of internal auditors;

The audit committee should be involved in hiring and firing the chief internal auditor.


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Corporate governance: internal audit

Internal audit External auditors can rely on the work of internal

auditors. Before doing so, they should evaluate: the organisational status of internal auditors

the scope of the internal audit function

the technical competence of internal auditors

External auditors should also test the work they plan to rely on to ensure that due professional care has been taken. 3.1 Audit quality, governance & the expectation gap

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Corporate governance: serving client and public interests

Auditors have responsibilities not only to their clients (board and audit committee) but to society at large: through ethical framework and professional bodies Auditors are viewed by the public as trusted

professionals in the provision of assurance services. Quality assurance services are ensured through:

professional and firm standards ethics quality reviews and certification


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Accounting Quality Scandals HIH Insurance Ltd

Placed into provisional liquidation in March 2001 estimated losses were 5 billion.

Overstated profits, understated liabilities, errors made in recognising future tax benefits, capitalised information technology expenses and acquisition costs (treated as tangible assets), errors on goodwill recognition, use of one-off year-end entries, undisclosed going concern uncertainty.

Under-provisioning & Financial reinsurance. Dominant CEO & weak board of directors Poor internal systems for : strategic planning, corporate

governance, risk management and accounting information.

3.2 Recent scandals and the reaction by regulators

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The auditor (Arthur Andersen) gave in to management on controversial accounting issues, breached professional standards and didnt display independence.

3 former partners of AA sat on the board with a range of consultancy arrangements.

However, auditor was also misled by management.

Auditor & board lack of sceptical questioning and analysis when and where it mattered (HIH report).


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HIH founder pleaded guilty to criminal charges of misleading & reckless corporate behaviour, faces max 12 years jail.

One former director (civil proceedings) fined $900k, to pay $8m compensation and banned from managing or being a director of a corporation for 20 years. Criminal proceedings still in progress.

Former chairman of board & other FAI officers sued by ASIC.


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Accounting Quality Scandals One.Tel

Placed into voluntary administration on 30 May 2001. Failure to disclose insolvency. Management failed to fully & frankly inform non-executive

directors of companys problems. Managing director sentenced to 10 year ban, liable for $92m

compensation and to pay ASICs costs of $750k. Chairman sentenced to 4 year ban, liable for $20m

compensation and to pay ASICs costs of $350k. Note: ASIC is equivalent to ACRA in Singapore


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Accounting Quality Scandals Harris Scarfe

Began in Adelaide in 1850 Administrator in January 2001 found that net assets were

overstated by $48 million. An overstatement of inventories by 22 million and understatement of accounts payable by$26 million.

Net cash flow was disclosed as $5.5 million and later found to be negative.

False entries to inflate profit since 1994, e.g., capitalise advertising & promotion costs. Revalue assets above purchase price.

Chief financial officer sentenced to 6 years jail (later reduced to 5.5 years)


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Accounting Quality Scandals Harris Scarfe

Auditor Ernst & Young replaced by PricewaterhouseCoopers in 1998.

Both auditors sued by ANZ Bank (Harris Scarfes largest financier) for negligence and for misleading and deceptive conduct in $70m lawsuit.


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Accounting Quality Scandals - Overseas

Enron special purpose entities to hide debt WorldCom capitalisation of expenses Tyco disclosure of loans Xerox- long term leases and cookie jar reserves-

overstating reserves, over accruing expenses and using one-time write-offs. Allows companies to stash accruals in cookie jars during good times and reach them when needed in bad time by reversing previously overstated accruals.

Waste Management capitalisation rules Parmalat cash balance overstated.


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Lecture Example

What is meant by corporate governance and how does the auditing profession contribute to good governance?

What are some of the professional issues that have emerged in the last few years?

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Solution As a beginning strategy, focus of the elements of the task,

before worrying about answering. Definitions: Corporate governance any general definition Eg Corporate governance refers to the structure, policies,

systems and relationships among various stakeholders such as the board and its directors, the management, employees, auditors, regulators, shareholders and the public.

Auditing profession represented by registered auditors in Singapore (whether individual, firm or company, or represented by all those who are bound by the auditing standards with force of law in Singapore, s. 250.

Good governance is an evaluative term, need to focus the answer on what enhanced governance.

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Solution Task answer the question How does the auditing profession contribute

to good governance? Refer to several different ideas:

The principles of corporate governance identified by the SSX Corporate Governance

credibility problems concerning audit independence

Audit competence Expectation gap

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Solution Recent professional issues include: Global corporate audit failures such as Enron,

WorldCom, HIH and One.Tel and the demise of Andersen

Compromise of the audit independence Provision of non-audit services to audit clients

by audit firm that have, as well as issues with retiring partners and members of auditors

became employees of audit clients Recent reforms by the introduction of the

Sarbanes-Oxley Act and CLERP 9 Expectation Gap and the loss of public

confidence in the self-regulatory characteristics of the auditing profession.

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Characteristics of a profession

Knowledge through professional education Commitment to serving society Barriers to entry Regulation through a voluntary body Principles to guide members in their work Members are governed by the Code of

Professional Conduct & Ethics for Public Accountants & Accounting Entities

3.3 Auditor competence

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Quality assurance (SSA 220)

Leadership responsibilities Ethical requirements (independence) Accept/continue with engagements Assignment of engagement team Engagement performance Monitoring


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Auditors are encouraged to conduct themselves at a high level

Conduct of auditing firm personnel

Auditing Standards

Tertiary Study

Firms Quality Control

Auditor Registration

Professional Programs

Ethical Codes

Legal Liability

Continuing Education


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Professional Independence

Sources of independence guidance International/Singapore Professional and Ethical

Standards Board SSX Corporate Governance Principles Guidelines International Federation of Accountants (IFAC) is very

influential in directing ethical standards

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The requirements of the independence standard, Section 290, apply to all audit and assurance engagements. - expresses a conclusion designed to enhance the

degree of confidence of the intended users about the outcome of the evaluation or measurement of a subject matter against criteria.

- also includes guidance on what items are not assurance engagements compilations, agreed upon procedures tax and management consultancy work.

3.4 Independence

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General Standard of independence In all matters relating to the assignment, an independence in

attitude is to be maintained by the auditor or auditors.

See CPCE, par 290.8

Independence

in mind

An auditor must also be independent in

appearance

CPA

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Code of Professional conduct & Ethics

SSA200.7 auditor shall comply with ethical requirements Code of Professional Conduct & Ethics for Public

Accountants & Accounting, par.290.8: Independence of mind: The state of mind that permits the provision of

an opinion without being affected by influences that compromise professional judgment, allowing an individual to act with integrity, and exercise objectivity and professional scepticism.

Independence in appearance: The avoidance of facts and circumstances that are so significant a reasonable and informed third party ... would reasonable conclude that ... integrity /objectivity /professional scepticism had been compromised.

3.5 Code of Professional Conduct

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Conceptual framework CPCE. It is impossible to anticipate every situation that might generate

an ethical problem for a professional accountant, so the Code provides a framework for identifying, evaluating and resolving threats to the fundamental principles

Fundamental principles of ethics (Part A) Section 110 Integrity Section 120 Objectivity Section 130 Professional Competence and Due Care . Section 140 Confidentiality Section 150 Professional Behaviour

Threat & safeguards in 100.10


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Threats & Safeguards

1. Self-interest 2. Self-review 3. Advocacy

5. Intimidation 4. Familiarity 2. The work

environment Part B

1. The profession, legislation or regulation

Safeguards Threats


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Specific guidance on professional conduct

Ideal conduct

Substandard conduct

Minimum conduct

Principles

Specific guidance

Part B - Standards of conduct for practitioners


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Code of professional conduct & Ethics

Specific threats to independence Financial relationships, 290,104 Employment relationships,290.143 Business relationships, 290.132 Personal relationships, 290.135 Non-assurance and non-audit services,

290.158 Fees and pricing, 290.206 Gifts, hospitality and other threats ,

290.260 & 213 3.5 Code of Professional Conduct

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Lecture example Scenario 1 Your client is a non-listed entity. The

books are prepared by the auditor of the entity. Scenario 2 - The tax return is prepared by staff. The

resulting pro forma financial statements are then audited by a partner in the firm.

Scenario 3 - you are asked to audit an existing client where financial planning advice has been provided by your firm. See Independence guide ISCA http://www.charteredaccountants.com.au/files/docume

nts/Co-RegulatoryIndependenceGuide.pdf

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Lecture example - framework When determining independence the first step is to identify the

threats to independence. Use threat matrix

Once the threats have been identified the next step is to determine whether there are any safeguards that will eliminate or reduce the threats.

There are 3 categories of safeguards: Those created by the profession, legislation or regulation; Those within the assurance client; or Those within the firms own systems and procedures.

The third step is to look at the threats and safeguards objectively and determine whether the assurance engagement can be undertaken independently.

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Statutory provisions (Corporations Act) Appointment &

removal of auditors Duties, rights

(access to info & assistance, reasonable fees) & qualified privilege

Auditors independence declaration

Auditor rotation for listed companies

General independence requirements -- conflict of interest situations

Specific independence requirements specific relationships

Directors declaration re non-audit services & fees

3.6 Auditors Independence

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Mandatory cooling off period before former audit partner can be an officer of the client. 2 years for persons directly involved in the audit.

Limit the number of former partners of an audit firm that can be a director or in a senior management position with an audit client

Protection of whistleblowers in the Corporations Act Expand responsibilities of Financial Reporting

Council

Corporate Law Economic Reform Program (CLERP9 in Australia)

3.6 CLERP 9

45 3.6 CLERP 9

46 3.6 CLERP 9

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Aids to maintaining Independence

Audit committees

Protection of working papers Audit integrity Personal gain

Client confidentiality Resignation

Auditor rotation

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Enforcement

ACRA (Accounting and Corporate Regulatory Authority) auditor surveillance program: 4 categories of audit deficiency: 1. Tendency to accept mgmt representations without

adequate verification, 2. Inadequate documentation of audit work, 3. Failure to report departures from accounting stds, 4. Uncritical acceptance of questionable accounting

practices.

ACRA power to suspend, deregister Lack of independence can result in substantial

losses. Cases: Pacific Acceptance, Cambridge Credit, WA Chip and Pulp, AWA

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The Significance of Ethical Values for Auditing

The environment affecting professional conduct Priority of duty and loyalty Professional competence The audit expectation gap

Unreasonable expectations Inadequate performance

3.7 Ethics

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Resolving ethical dilemmas

1. Obtain the relevant facts

2. Identify ethical issues from the facts

3. Determine who is affected 3.7 Ethics

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Resolving ethical dilemmas

4. Identify the alternatives available to the person who must resolve the dilemma

5. Identify the likely consequence of each alternative

6. Decide the appropriate action

3.7 Ethics

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Example 4.28

Barbara Whitley: instructed by audit supervisor to throw away audit documents and ignore misstatements

In what way is this an ethical dilemma? Use the 6 step approach

6. Appropriate Action: Only Barbara can decide. Discuss the matter further with Jack. contact a manager or partner.

3.7 Ethics

week 5- audit quality

Documents

audit risk

expectation gap jansonuig

gap results

unqualified audit report

professional expectations

auditors acceptable

standards sacs

corporate failure