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

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Chapter 3: Rules of professional conduct

sympathetic. The form should strongly consider safeguards to independence in this

situation such as rotating Mr Tyre away from this engagement.

Situation 2

Mr Knapp takes no part in the management of Entity Y. However, if he is involved

with the audit there may be actual or perceived threats to his objectivity as his

immediate family members, his parents, are the director of Entity Y.

The firm must ensure that Mr Knapp is not part of the audit team and is not in a

position to influence any members of the audit team. If this cannot be demonstrated,

then the firm should not accept the audit engagement.

Situation 3

The key ethical issues that arise in this situation are familiarity and possible

intimidation.

There is a risk that if David is assigned to the audit over too long a period he might

become unduly familiar with the client and its staff and lose his objectivity in

relation to the assignment.

The finance director’s request could amount to intimidation if there is any question

that the audit would be withdrawn if the request was not complied with. Best

practice is that audit firms should not allow clients to dictate staffing issues as it is

important that audit firms staff their teams in the most appropriate way in terms of

safeguarding against ethical threats, quality control on the audit and technical

expertise.

If the firm considers it not appropriate to comply with the finance director’s request,

they should not do so, while assuring him that if different staff are assigned, they

are required by professional standards to have obtained a good knowledge of the

business and to be directed, supervised and reviewed well, hopefully therefore

causing minimum disruption to operations.

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Professional duty of confidentiality

 The basic principle

 Recognised exceptions to the duty of confidentiality

 Improper use of information

 Confidentiality of working papers

3 Professional duty of confidentiality

3.1 The basic principle

It is a fundamental principle of professional behaviour that information obtained in

the course of professional work should not be disclosed to others or used unless:

 consent has been obtained from the party to whom the duty of confidentiality is

owed, or

 there is a right or obligation to disclose.

Part of the rationale behind this requirement is that auditors need full and frank

disclosure of information from a client in order to carry out their duties. If the client

is not assured of confidentiality of this information, he may be unwilling to provide

all relevant information to the auditor.

3.2 Recognised exceptions to the duty of confidentiality

There are some recognised exceptions to the duty of confidentiality. Where one of

these exceptions applies, the auditor may be required to disclose the information to

a third party, or may voluntarily choose to disclose confidential information.

The detailed rules on permissible exceptions vary from one country to another, in

accordance with national laws.

Obligatory disclosure

An auditor/ACCA member is obliged to disclose relevant information to an

appropriate authority if he knows, or has reason to suspect that a client has

committed:

 treason

 terrorism

 drug trafficking, or

 money laundering.

In these circumstances, the requirements of the law override the duty of

confidentiality.

Chapter 3: Rules of professional conduct

Voluntary disclosure

Voluntary disclosure of confidential information is permitted in the following

circumstances:

 when it is reasonably necessary to protect the interests of the member (for

example, in making a defence against an official accusation of professional

negligence)

 when it is necessary in a legal process; for example, a court case might require

the production of audit documents for inspection by the court

 when disclosure is necessary in the public interest. This might apply, for

example, to making disclosures to the tax authorities of non-compliance by a

client company with tax regulations.

3.3 Improper use of information

An ACCA member should not use, or appear to use, confidential information

gained in the course of professional work for his personal advantage or for the

advantage of a third party.

For example:

 A member should not deal in the shares of a client company in such a way that it

might seem that information obtained in a professional capacity has been used

for his personal advantage (so-called ‘insider dealing’).

 Where a member has confidential information from Client 1, which affects an

assurance report on Client 2, he cannot provide an opinion on Client 2 that he

already knows, from this other source, to be untrue. If the member is to continue

as auditor to Client 2, he must carry out normal audit procedures to enable the

same information to be obtained from another source. Under no circumstances

should there be any disclosure of confidential information outside the firm.

Ultimately the auditor may have to resign.

3.4 Confidentiality of working papers

An accountant’s working papers, which contain confidential client information, are

the property of the accountant and should not normally be made available to

outside parties.

However, situations may arise where government agencies (for example, tax

authorities) ask to see the accountant’s working papers relating to a particular client.

In such situations, the accountant should act in the best interests of his client. If he

feels that releasing the papers is in the best interests of his client, and the client has

no objections, then the papers should be made available. Ultimately the tax

authorities are likely to have legislative powers to obtain the papers. Any lack of co-

operation on behalf of the auditor or his client may add to any existing suspicions.

Occasionally, the authorities may ask to see a sample of working papers from a firm

of accountants, but not in relation to any particular client. This may occur when the

authorities have doubts about the quality of the work performed by that practice.

Again, a ‘best interest’ approach should be adopted, allowing the authorities to

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review the papers if the accountant judges that this is in the best interests of the

practice and its clients.

An appropriate practical compromise may be achieved in this situation by

arranging for an independent accountant to review the work and issue a report to

the authorities.

Chapter 3: Rules of professional conduct

Corporate financial advice and conflicts of interest

 Advising clients involved in take-over bids or share issues

 Safeguards

4 Corporate financial advice and conflicts of interest

4.1 Advising clients involved in take-over bids or share issues

Auditors are often asked to give advice. However, where clients are involved in a

contested take-over bid, the auditors could find themselves in a position where they

are potentially acting for both parties.

In this situation:

 there is a danger that the firm cannot give objective professional advice in the

best interests of both parties (a possible lack of independence)

 the firm may be in possession of confidential information relating to each party,

with a risk that the information may inadvertently become available to the other

party (a possible breach of confidentiality).

Guidelines in this area are as follows:

 There is no reason, in principle, why firms should not act for both parties when a

contested takeover bid occurs. However, a firm should not be the sole or main

advisor to both parties.

 If the accountants are in possession of material confidential information and feel

that their position in this respect is questionable, they should take advice from

the appropriate financial regulatory authority (for example, the stock exchange

involved in the take-over or the national regulator of the financial markets).

Similar conflicts of interest may arise in connection with issues of shares to the public,

because the accountants may be advising both the company issuing the shares and

potential investors (such as companies interested in buying an investment in the shares,

or investment institutions).

4.2 Safeguards

Accountant should have procedures in place to:

 identify possible conflict of interest situations

 evaluate the possible problem, and

 where necessary, take action to manage or avoid the conflict.

Possible procedures include the following:

 Review relationships with all clients on a regular basis.

 Take care to consider potential conflicts of interest when deciding whether to

take on new clients.

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 If a potential conflict is identified, decide on an appropriate course of action. An

appropriate course of action may be any of the following:

− Notify the clients involved and discuss the matter with them.

− Set up ‘Chinese walls’ to manage the problem. A Chinese wall is set up by

using different members of staff on the assignments for each of the clients,

and locating them in different offices. The two groups of staff act

independently of each other, and do not communicate with each other except

in an official capacity.

− Consider resigning (or declining the new engagement offered) in respect of

one of the two clients.

aper P7 (INT)

Advanced audit and assurance

CHAPTER

Professional responsibility

and liability

Contents

1 Auditors’ liability and the expectations gap

2 Fraud and error: ISA 240

3 The auditor’s liability

4 Managing the auditor’s liability

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Auditors’ liability and the expectations gap

 Introduction

 The expectations gap

 Closing the expectations gap

1 Auditors’ liability and the expectations gap

1.1 Introduction

This chapter deals with a number of aspects of law and regulation under which

auditors:

 may have penalties imposed on them for a criminal offence, or

 may have legal claims made against them (for ‘damages’) for negligence.

The potential liability of auditors has become an important topic in recent years, due

to the growing complexity of the business and legal environment and an increase in

legal actions against auditors.

One explanation put forward to explain the high number of legal actions against

auditors is the ‘expectations gap’.

1.2 The expectations gap

The expectations gap is the difference (or ‘gap’) between:

 what the users of financial statements and other members of the public think

that auditors do, and

 what auditors actually do.

There are three main elements in the expectations gap:

 A standards gap. This occurs because of a perception that auditing standards are

more prescriptive than they actually are, and that auditors have wide-ranging

rules that they must follow:

 A performance gap. This occurs because of a perception that audit work has

fallen below the required standards.

 A liability gap. This arises from a lack of understanding about the auditor’s

liability and who the auditor may be liable to.

In addition, there is a perception that auditors have a responsibility for detecting all

fraud, whenever this occurs.

Chapter 4: Professional responsibility and liability

High levels of expectation about what auditors should do may lead to legal action

against auditors if this level of expectation is not met. To reduce the frequency and

cost of legal action, and to maintain the image of the audit profession in the mind of

the public, it is in the interests of the profession to take steps to close the

expectations gap.

1.3 Closing the expectations gap

Ways of attempting to close the gap include the following:

 The profession should attempt to improve the general level of knowledge and

understanding about the audit process. One such attempt has been made with

ISA 700, the auditing standard on auditor’s reports. This requires the audit

report to include an explanation of the nature of an audit.

 The profession should improve the public’s knowledge of the auditor’s

responsibility in the area of fraud. (Responsibility for error and fraud is

discussed in more detail later.)

 Controls over the auditing profession may be improved, as a means of

enhancing public confidence. A problem arises, however, from the fact that

regulation is often at a national level and non-statutory. It is worth noting that

the European Union requires the audit of companies whose shares are quoted on

a stock market in the EU to be conducted in accordance with international

auditing standards (ISAs).

Paper P7: Advanced audit and assurance (International)

Fraud and error: ISA 240

 The distinction between fraud and error

 Responsibilities of management and auditors for fraud and error

 The auditor's procedures where fraud or error is suspected

2 Fraud and error: ISA 240

2.1 The distinction between fraud and error

ISA 240 The auditor’s responsibilities relating to fraud in an audit of financial statements

regulatesthisarea. It makes the following distinction between fraud and error:

Fraud: may be defined as intentional acts which may involve:

 fraudulent financial reporting (falsification of records or documents, a

deliberately incorrect application of accounting policies)

 misappropriation of assets.

Both types of fraud can result in material misstatements in the financial statements.

Error may be defined as:

 unintentional misapplication of accounting policies

 oversights

 unintentional clerical errors, or

 misinterpretation of facts.

The key distinction between fraud and error is therefore whether the effect on the

financial statements is deliberate (fraud) or unintentional (error). However, there

may be little or no difference between fraud and error as far as the impact on the

audit is concerned. In both cases the auditor will be concerned about the impact on

the ‘true and fair view’ presented by the financial statements.

The main difference between fraud and error may arise in relation to any national

reporting requirements. There may be requirements to report suspicions of fraud,

but not error.

2.2 Responsibilities of management and auditors for fraud and error

Responsibilities of management

Management is responsible for preparing financial statements that show a ‘true and

fair view’. This role is reinforced by principles of good corporate governance, which

require management to set up appropriate systems and controls.

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)