ACCA P7 (INT) Advanced Audit & Assurance - Study Text

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Paper P7 (INT)

Advanced audit and assurance

CHAPTER

Current issues I

Contents

1 Ethical issues

2 The accountancy and auditing profession

3 Transactional audits

4 Small companies

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Ethical issues

 Introduction

 Regulation of auditing: an ethical framework or a rulebook?

 Auditor independence

 The provision of non-audit services to audit clients

 Auditor rotation

1 Ethical issues

1.1 Introduction

You need to be aware of current issues in auditing. These issues include ethical

issues and the problem of auditing and exemption from audit of small companies.

You should monitor the professional press for further developments over the course

of your studies.

1.2 Regulation of auditing: an ethical framework or a rulebook?

There are generally recognised to be two methods of regulating the behaviour of

individuals:

 a rulebook approach: this sets out the rules about what must and what must not

be done - ‘you must not do that’

 a framework approach: this sets out principles that should govern behaviour,

with reasoned arguments to support the principles - ‘you should understand

why it is not acceptable to do that’.

Both approaches may be enforced by sanctions against individuals who do not

comply.

There are a number of advantages of adopting a framework approach as opposed to

a rulebook approach for regulating the behaviour of accountants and auditors.

 It is impossible to develop rules that will deal with all situations.

 In a rules-based system, the rules may be interpreted too narrowly. If so, the

rules cease to be of practical value, because they cannot be applied with

confidence in practice (unless there is a very detailed set of rules).

 An ethical framework is therefore more flexible. It sets out general principles,

and requires accountants to apply the general principles to the circumstances of

each case that arises.

 It may also be argued that accountants are professionals with an ethical code of

conduct: consequently they do not need to have their behaviour regulated by

detailed and strict rules and regulations.

Chapter 15: Current issues

1.3 Auditor independence

It is well established that independence is fundamental to the credibility of the audit

process. Much of the current thinking on independence has been developed by the

Securities and Exchange Commission (SEC) in the USA. The work of the SEC has

followed on from the corporate scandals in the US in 2001 and 2002, such as Enron

and WorldCom. Similar proposals have been put forward in the UK and in other

countries.

In January 2003, the SEC adopted rules to implement the Sarbanes-Oxley Act 2002

on corporate governance. The rules aim to strengthen auditor independence and

require additional disclosures to investors about the services provided to

corporations by an independent accountant.

The SEC approved the following measures:

 The rules relating to non-audit services were revised, in cases where the

independence of the audit firm would be impaired if it provided the non-audit

services to the audit client.

 Rules for the rotation of audit partners. Certain partners on the audit

engagement team should be ‘rotated’ (= changed) after no more than five or

seven consecutive years, depending on the partner’s involvement in the audit.

However, some small accounting firms may be exempt from this requirement.

 Establish rules that an accounting firm would not be considered to be

independent if certain members of management of the clients had been members

of the accounting firm’s audit engagement team within the one-year period

preceding the commencement of the audit.

 An audit firm should not be considered to be independent from an audit client if

any audit partner involved in the audit has obtained payment (for the firm) for

services relating to engagements with the client for services other than audit,

review and attestation services.

 The auditors should be required to report certain matters to the client’s audit

committee, including reports on any ‘critical’ accounting policies that are being

used by the client.

 The audit committee of the client should be required to approve in advance all

audit and non-audit services provided to the client by the auditor.

 There should be disclosure to shareholders of information about audit and non-

audit services provided to the client by the auditor, and the fees for those

services.

1.4 The provision of non-audit services to audit clients

Non-audit services that might impair the firm’s independence

The Sarbanes-Oxley Act (mentioned above) lists nine non-audit services that are

considered to impair the audit firm’s independence if they are provided to the client

by the audit firm. These are set out below.

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(1) Book-keeping or other services related to the accounting records or financial

statements of the audit client

The rules prohibit an accountant from auditing the book-keeping work

performed by his or her accounting firm on behalf of a client.

(2) Financial information systems design and implementation

The rules prohibit an audit firm from providing any service related to the

information systems of the audit client, unless it is reasonable to conclude that

the results of these services will not be audited.

These rules do not prevent an audit firm from working on the hardware or

software systems of an audit client, if these are unrelated to the client’s

financial statements or accounting records and provided that the provision of

these services by the audit firm is approved in advance by the audit

committee.

(3) Appraisal or valuation services, fairness opinions, or contribution-in-kind

reports

All these activities are essentially services involving a report from an

accountancy firm on the valuation used in a transaction.

The rules prohibit an audit firm from providing such services, unless the

results of these services will not be audited as part of the audit of the financial

statements.

(4) Actuarial services

The rules prohibit an audit firm from providing any actuarial advisory service

to an audit client that involves a decision about amounts to be recorded in the

financial statements (and related accounts) of the audit client.

Such a service may apply, for example, to the valuation of pension funds

(which is connected to the valuation of pension fund liabilities).

An audit firm may, however, assist a client in understanding the methods,

models, assumptions and inputs used in computing an amount.

(5) Internal audit outsourcing services

The rules prohibit the audit firm from providing any internal audit service

that has been outsourced by the audit client, where the internal audit work

relates to the audit client’s internal accounting controls, financial systems or

financial statements.

This means that internal audit work relating to operational controls and

compliance (operational audits, VFM audits and compliance audits) by the

audit firm are permissible.

(6) Management functions or human resources

The rules prohibit an audit firm from:

 acting (even in a temporary capacity) as a director, officer or employee of

an audit client, or

 performing any decision-making, supervisory, or ongoing monitoring

function for the audit client.

Chapter 15: Current issues

The independence of an audit firm will also be impaired if the firm provides

assistance to the client in connection with any senior level management

appointment. An accountant’s independence is impaired with respect to an

audit client when the accountant:

 seeks out prospective candidates for managerial, executive or director

positions within the client company, or

 acts as negotiator, on the audit client’s behalf, with any person who has

applied for a senior management position, or

 undertakes reference checks of prospective candidates for a senior

management position.

Under this rule, an accountant’s independence will also be impaired when the

accountant:

 engages in psychological testing or other formal testing or evaluation

programmes, or

 recommends or advises the audit client to hire a specific candidate for a

specific job.

(7) Broker or dealer, investment adviser, or investment banking services

Acting as a broker-dealer, promoter or underwriter on behalf of an audit client

will make the accountant an advocate for the audit client and will impair his

independence.

(8) Legal services

A firm is prohibited from providing to an audit client any service that could

be provided only by someone qualified to practise law in the jurisdiction in

which the service is provided.

(9) Expert services unrelated to the audit

The rules prohibit an audit firm from providing expert opinions to an audit

client, for the purpose of advocating that audit client’s interests in litigation or

in any regulatory or administrative proceeding or investigation.

Advantages and disadvantages of the auditor providing non-audit services

Advantages

The audit firm is in an excellent position to provide its client with non-audit

services. This is because:

 it already has an extensive knowledge of its client, the client’s business and its

systems, and

 it should therefore be able to provide the additional non-audit services to the

client at a lower cost than other accountancy firms, and with less disruption to

the client.

Non-audit work also makes audit firms more attractive in the recruitment market,

because a wider range of work experience can be offered to trainees.

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Disadvantages

However, there are some obvious disadvantages to providing non-audit services.

 The audit firm may be seen by the world at large to lack independence from the

client, because of the large fees it receives for audit and non-audit work. (This

was a criticism levelled at the Houston office of audit firm Andersens, following

the collapse of Enron.)

 Accountants from the audit firm may find themselves in a position where they

are making management decisions. (If so, their independence is impaired.)

1.5 Auditor rotation

The need for auditor rotation has been a topic of discussion, following various

major corporate failures in recent years. There has been a general perception that in

many cases of corporate collapse, the audit firm was ‘too close’ to the audit client,

and had failed to detect the warning signs of collapse.

It has therefore been suggested that there should be a regular change in the

individuals who perform the audit of a client company. This should prevent the

auditor from becoming too familiar with the client and key members of the client’s

staff as a result of developing a long and ‘comfortable’ relationship.

There are two different suggestions about how auditor rotation should be achieved.

 Audit partner rotation.. The audit firm may remain as auditors of the same

client company for an unlimited number of years (or until the company decides

to change its auditors). However the ‘lead’ engagement partner and other key

members of the audit team should be ‘rotated’ regularly.

 Audit firm rotation. Alternatively the audit firm itself should remain as auditor

of a client company for no longer than a specified maximum number of years,

say five years or seven years.

Audit partner rotation has been adopted in most countries. However, audit partner

rotation is not visible to the world at large. In contrast, audit firm rotation would

provide a public demonstration of auditor independence.

Arguments in favour of audit firm rotation

There are several arguments in favour of the rotation of audit firms.

 In a long-term audit relationship, the auditors may become too close to

management of the client company. This may weaken their professional

scepticism and independence. They may be more likely to compromise when

disagreements with management occur, in order to preserve the relationship –

and the audit, and their fees.

 Even if audit firm rotation would not protect the independence of the audit firm,

it improves the public perception of independence, and so may increase

confidence in the quality of external audits.

Chapter 15: Current issues

Arguments against audit firm rotation

However, there are also a number of arguments against the rotation of audit firms.

 There may be negative effects on audit quality and effectiveness in the first years

following a change. This is because the new auditors may take several years to

familiarise themselves with their new client and its procedures. There is some

evidence to suggest that there may be a higher instance of audit failures in the

first years following a change of auditors. If this evidence is valid, the connection

between company failures and a change of auditors might reflect an inability of

the newly-appointed auditor to identify problems in the client company.

 There are also substantial costs from changing auditors regularly, as the auditor

attempts to familiarise himself with the new client. More management time is

also needed to assist the new auditor to learn about the client company, its

operations and its systems.

 There is no evidence that compulsory audit firm rotation has a positive impact

on auditor independence and audit quality.

 The market for auditing listed companies is dominated by the ‘Big Four’

accountancy firms. If this domination of the audit market continues (which is

probable), it may be difficult to change auditors easily. The other large firms

may not have available resources to take on the audit, or may not be

‘independent’ because of other non-audit services that they already provide.

Paper P7: Advanced audit and assurance (International)

The accountancy and auditing profession

 The current structure of the auditing profession

 Incorporation and the problem of auditors’ liability

2 The accountancy and auditing profession

2.1 The current structure of the auditing profession

Because of increasing globalisation of companies, the auditing profession now has

three tiers:

 the ‘Big Four’ international firms (Deloitte, Ernst & Young, KPMG, and

PricewaterhouseCoopers (PwC)

 the second tier – smaller firms but still with numerous offices and international

resources

 the small firms.

The ‘Big Four’ came about from mergers and take-overs within the profession. They

have the resources, expertise and geographical coverage to be able to audit the

largest global entities. However, this level of amalgamation has left little choice for

the largest clients and little competition for those firms.

2.2 Incorporation and the problem of auditors’ liability

In most countries, accountancy and auditing practices were originally established as

sole practitioners or (where permitted by local law) partnerships.

With these business structures (sole practitioner and partnership) the owner or

owners have unlimited liability for the liabilities of the practice. This would include

liabilities arising from legal claims against the firm for negligent audit work. The

owners’ personal assets as well as business assets are at risk if the firm itself cannot

pay claims against it.

This principle of unlimited liability was intended to promote public confidence in

the auditing profession and to encourage auditors to carry out their work with due

care.

However, problems began to emerge as businesses grew and the size of claims

against auditors increased.

One response to this was the introduction of requirements for practising

accountants to carry professional indemnity insurance, so that liabilities arising

from legal claims against a practitioner or partners can be met through an insurance

policy. However the premiums for professional indemnity insurance began to rise

as the size of claims increased. This has imposed an increasing financial burden on

accountancy firms, particularly on smaller firms.

Chapter 15: Current issues

A more recent development for giving financial protection to accountants has been a

movement towards removing ‘unlimited liability’ status of auditors. A number of

approaches are available to achieve this. They include the following:

 accountancy practices may be permitted by law to trade as limited liability

companies

 accountancy practices may be permitted by law to trade as limited liability

partnerships (this is permitted, for example, under UK law)

 statute law may place a maximum limit on the size of legal claims against the

auditor

 the auditor may be able to agree with the audit client a maximum limit on legal

claims (by the client company), as a formal term in the written contract under

which the audit is performed.

Paper P7: Advanced audit and assurance (International)

Transnational audits

 Definition

 Transnational Audit Committee

3 Transnational audits

3.1 Definition

A transnational audit is an audit of financial statements which are or may be relied

upon outside the audited entity’s home jurisdiction for the purposes of significant

lending, investment or regulatory decisions; this will include audits of all financial

statements of companies with listed equities or debt and other public interest

companies which attract particular public attention due to their size, products or

services provided.

IFAC’s Transnational Audit Committee (TAC) gives the following illustrations of

transnational audits:

Example 1: US Company raising debt finance in Canada.

This will qualify as a transnational audit as it is reasonable to assume that providers

of debt finance in Canada will use the financial statements of the company,

prepared and audited by American standards, in making decisions.

Example 2: International charity taking donations through various national

branches and making grants around the world.

This will qualify as a transnational audit as it is operating across national

boundaries and is public interest (being a charity). There is a reasonable expectation

that the financial statements of this charity will be used by someone, perhaps

donors, in countries other than the one it is domiciled in.

As companies subject to transnational auditing are generally listed, they will have a

large amount of regulation in terms of listing requirements and corporate

governance requirements which the auditors must be aware of.

Their listed status may also affect the standards by which their financial statements

are prepared and audited, for example, if they are listed on a European stock

market, the financial statements will have to be prepared according to international

financial reporting standards and audited in accordance with international

standards on auditing.

Such audits demonstrate the need for harmonised global standards in accounting

and auditing.

ACCA P7 (INT) Advanced Audit &amp; Assurance - Study Text - 2010 (Emile Woolf Publishing)

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ACCA P7 (INT) Advanced Audit & Assurance - Study Text - 2010 (Emile Woolf Publishing)