Reading Package Advanced Auditing (ACCT 352) Wagar Ali Fall Semester 2016 Suleman Dawood School of Business Lahore University of Management SciencesLahore University of Management Sciences ACCT 352 — Advanced Auditing Fall Semester 2016 ae ar | Room No. 222 | Office Hours TBA Email wager al | Telephone ‘TBA | TA Toa | "Ta Office Hours TBA. | Course URL (fan surajlums-edu pk/-To/ COURSE BASICS | Credit Hours 3 Lecture(s) ‘Nbr of tecis) Per Week [2 Duration | One hour and fifty minutes, each. Recitation/Lab (per week) | Norof Lec|s) Per Week _| N/A, Duration | N/A | Tutorial (per week) Nbr of Lees) Per Week | Onneed basis | Duration | Appropriate to cover the content. | ‘COURSE DISTRIBUTION ‘Core Elective (Open for Student Category _| ACF Uunlors & Seniors), Open for Allin phase It Close for Student Category ‘COURSE DESCRIPTION ‘Advanced Auditing aims to build on students’ principles level understanding by delving deeper into its key assurance/audit dynamics, | | critically analyzing auditing practices end understanding the role of assurance in enhancing governance of businesses and managing their risks. The analyses in the course flow from acceptance, planning, managing through to concluding stages of the audit process. ‘The course introduces @ conceptual regulatory framework by elucidating key legal, professional and social/ethical concerns and then discusses how pre-audit and planning phases must comply with cautious quality and independence concerns on part of the assurance provider. This pursuit is governed by a set of professional procedures which the course highlights. Students shall apply leaned International Auditing Standards (ISAs) and Intemational Accounting Standards (IASs) under an IFRS (international Financial Reporting) framework to business scenarios, thereby invoking specialist knowledge gained from auditing and financial reporting courses. Statutory aucit being a pivotal sub-set of assurance will feature majorly in the course. However, a variety of other engagements, also falling under the umbrella of assurance will be surveyed, These entail other audit-related assurances, forensic audits, review of prospective information and internal audit genres, ‘COURSE PREREQUISITE(S) acct 250 | AuditingLahore University of Management Sciences [LEARNING OUTCOMES & OBJECTIVES | On completion ofthis course, students should be able to: Understand and advise on regulatory, professional and ethical issues relevant to those carrying out assurance engagements; Understand the processes involved in accepting and managing assurance engagements and how quality assurance processes mitigate risks; | plan assurance engagements in accordance with the terms of the engagements and appropriate standards; | formulate the work required to meet the objectives of auait assignments and apply the international Standards on Auditing; conclude and report on audit and various other assurance engagements in accordance with the terms of the engagements and appropriate standards; and Discuss current assurance/auiting developments (Financial press / specialist publications by industry experts). [ UNDERGRADUATE PROGRAM LEARNING GOALS & OBJECTIVES | General Learning Goals & Objectives Goal 1-Effective Written and Oral Communication Objective: Students will demonstrate effective writing and oral communication skis Goal 2 ~Ethical Understanding and Reasoning Objective: Students will éemonstrate that they are able to ldentiy and address ethical Issues In an organizational context Goal 3~ Analytical Thinking and Problem Solving Skils Objective: Students will demonstrate that they are able Goal 4— Application of Information Technology Objective: students will demonstrate that they are able to use current technologies in business and management context Goal 5— Teamwork in Diverse and Multicultural Environments Objective: students wil demonstrate that they are able to work effectively in diverse environments Goal 6 ~ Understanding Organizational Ecosystems | “Objective: students wll demonstrate that they have an understanding of Economic, Political, Regulatory, Lega, | Technologie, nd Social environment of erganeations ntify key problems and generate viabie solutions. ‘Malor Specific Learning Goals & Objectives Goal 7 (a) - Program Specific Knowledge and Understanding Objective: Students will demonstrate knowledge of key business disciplines and how they interact including application to real world situations (Including subject knowledge}, Goal 7 (b) - Understanding the “sclenco” behind the decision-making process (for MGS Majors) Objective: Students will demonstrate ability to analyze a business problem, design and apply appropriate | decision-support tools, interpret results and make meaningful recommendations to support the decision-makerLahore University of Management Sciences ‘engagements; + plan assurance engagements in accordance with the terms of the engagements and appropriate standards; + formulate the work required to meet the objectives of audit assignments and apply the International Standards ‘on Auditing: « conclude and report on audit and various other assurance engagements in accordance with the terms of the engagements and appropriate standards; and « discuss current assurance/auditing developments (financial press / specialist publications by industry experts). PROGRAM LEARNING GOALS AND | COURSE LEARNING OBJECTIVES ‘COURSE ASSESSMENT OBJECTIVES fe Goal 1 -Effective Written and Oral ‘> understand and advise on regulatory, professional and | CP, Quizzes, Aid Term Communication c’thical issues relevant to those carrying out assurance | Exam, Final Goal 2 Ethical Understanding and Reasoning "> understand and advise on regulatory, professional and ‘ethical issues relevant to those carrying out assurance engagements; + understand the processes involved in accepting and ‘managing assurance engagements and how quality assurance processes mitigate risks; « discuss current assurance/auditing developments (financial press / specialist publications by industry experts. GP, Quizzes, Mid Term Exam, Final Goal 3 Analytical Thinking and Problem Solving Skills * formulate the work required to meet the objectives of | ‘audit assignments and apply the International Standards ‘on Auditing; + conclude and report on audit and various other ‘assurance engagements in accordance with the terms of ‘the engagements and appropriate standards; and # discuss current assurance/auditing developments (financlal press / specialist publications by industry experts). CP, Quizzes, Mid Term Exam, Final “Goal 4— Application of information Technology Goal 5 ~ Teanworkin Diverse and Multicultural Environments Goal 6 - Understanding Organizational Ecosystems ~ understand and advise on regulatory, professional and cthical issues relevant to those carrying out assurance engagements, ©, Quizzes, Mid Term Exam, Final Goal 7 (a) ~ Discipline Specific Knowledge and Understanding "understand and advise on regulatory, professional and ‘ethical issues relevant to those carrying out assurance ‘engagements; + understand the processes involved in accepting and ‘managing assurance engagements and how quality assurance processes mitigate risks; « plan assurance engagements In accordance with the terms of the engagements and appropriate standards: CP, Quizzes, Mid Term Exam, FinalLahore University of Management Sciences ~ formulate the work required to meet the objectives of audit assignments and apply the International Standards on Auditing; + conclude and report on audit and various other _assuranee engagements In accordance with the terms of ‘the engagements and appropriate standards; and « discuss current assurance/auditing developments (financial press / specialist publications by industry experts). Goal 7 (b) ~ Understanding the “science” behind the decision-making process ‘GRADING BREAKUP / COURSE MOTIVATION / PEDAGOGY Quizes: 20% Class Participation: 10% Midterm: 30% Final: 40% Course Motivation The role of audit has evolved as 2 pivotal riskmanagement function not only regulating businesses but rather first ethically evalu ‘acceptance and proper management of engagements’ from providers of auait/assurance (an accountancy practice e.g. one of the "Big 4] using practical methodologies. This course bears direct relevance to studerits aspiring for chartered accountancy and will also consolidate learning of students having interned at one of the accounting firms or looking forward to it in the coming year. There may also be @ supportive case for ‘exemptions with professional examination bodies such as the ACCA in Pakistan and ICAEW internationally towards Aucit modules. Further there isa strong practical dimension to the course which lends efficacy to students intending to pursue a career in industry | (businesses and nat an advisory firm). This is because business analysts and managerial accountants aren rect ison with ‘auditors; and this course would equip students with business risk-related vocabulary and strong analytical skis. roy ‘There will be high emphasis on class participation due to the nature of the course content requiring comprehensive application of standards and audit methodology to business specific scenarios. Audit discussions would extend to group audits, financial instruments, and similar and more applied reporting areas. Exercising professional judgment and skepticism will be key towards demonstrating 2 cogent understanding of the assurance/audit methodology. Greater than three absences would tantamount to an enrolment review by the instructor due to the inter-related nature of subsequent lectures building on previous sessions. Quizzes would help develop strong assurance vocabulary and technical understanding of the content which will be more rigorously tested in the midterm and the final using @ mix of structured written style and scenario based questions, Core technical material will be applied to key practitioner case-lets and augmented by contemporary developments in the assurance and audit profession using readings from the Economic magazine/ICAEW publications, Accountancy Age and ACCA articles in addition ta the ISAs and mainstream reading material.Lahore University of Management Sciences [EXAMINATION DETAIL | Yes/No: Yes | Midterm | Combine Separate: Combined Bam | uration 41.5 hours Exam Specifications Structured written-response questions {scenario based) Yes/No Yes Final Beam | combine Separate: Combined Duration: 2hours | Exam Specifications ‘Structured written-response questions (scenario based) COURSE OVERVIEW oe SESSION OBJECTIVES / PARTICULARS | WEEK TOPICS / READINGS {Please not there may be overlap between weekly | sessions in terms of session objectives, 1 Tntcoduction: Legal & Regulatory Framework = What are auditing ond assurance services and | Session 1: wht rote do they playin society? | Outline Overview * Discuss the purposes and consequences of laws | Enlightening Professions (Audit Futures Article: Abridged) and other regulatory requirements surrounding Session 2: ‘assurance work. ‘Chapter 4 (Kaplan) +Money Laundering -Judge when to roise legal Chapter 7 (Kaplan) ‘and ethical matters arising from assurance work with senior colleagues for review and possible referral to externol parties «Describe audit considerations of compliance with laws and regulations and plan oualt procedures. 2 Tetroduction: Legal & Regulatory Framework [continued] | + IFAC, IAASB & Standard setting procedures Session 3: + Management & Auditor Responsibilties in 0 CChapter 1 p3-12 (Alan Milichamp & John Taylor) Finacial Statements’ Audit when possible Chapter 2 916-18, 21 (Alan Milichamp & John Taylor) noncompliance is discovered Chapter 8 p151-152, 153-156 (Kaplan) + Recognize the professional and ethical issues thot ‘may arise during on assurance engagement, Professional Ethics exploin the relevance and importance of these Session 4 issues and evaluate the relative merits of Chapter 6 75-80 (Alan Millichamp & John Taylor) Aifecent standpoints taken in debate. The Expectation Gap in Auditing (ResearchGate Article) |» assess whether an engagement has been planned and performed with an attitude of 7 : professional skepticism Eihies continued) * Describe the principal causes of audit failure and their effects and the gap between outcomes Chapter 8 remainder (Kaplan) delivered by audit engagements and the Chapter 2 (Kaplan) expectations of users of audit reports * When companies fai shorty ofter receiving an unmodified auditors’ report, there is nearly always criticism of the auditors. To what extent do you think such erticism may be valid?Lahore University of Management Sciences ‘Compare and contrast the respective responsibilities of monagement ond auditors for {froud and error. Identify the sources of liablty including professional negligence) arising from an ‘assurance engagement and their Impact upon the conduct of the engagement. “ecepting & Managing Engagements Session 7 & 8: Chapters 7 ~8 (Alan Milichamp & John Taylor) Chatpers 36 (Kaplan) Procedures for accepting new appointments Discuss the issues which underlie the agreement of the scope and terms of an assurance ‘engagement (new or continuing). Explain the principles and purpose of quolity control of audit and other assurance engagements, Discuss the reasons why entities change their auditors/erofessional accountants. ‘Aavenced Topics: Audit Planning Sessions 9 & 10: ‘Chapter 10 (Alan Milichamp & John Taylor) Chapter 9 (Kaplan) ‘Identify the components of audit risk for @ specified audit engagement, including the breakdown of audit risk into inherent risk, control risk and detection risk Define materiality and performance materiality ‘and demonstrate how it should be applied in {financial reporting and auditing. Evaluate the impact of risk and materiality in preparing the audit plan, including the nature, timing and extent of audit procedures. Recognize matters that are not relevant to the plonning of an assignment. Discuss the benefits ond limitations of analytical procedures at the planning stage._ ing Audit Evider Chapters 11, 14, 23 (Alan Millichamp & John Taylor) Chapter 11, 12 (Kaplan) Identify and describe audit procedures to obtain sufficient audit evidence from identified sources. Identify and evaluate the audit evidence ‘expected to be available to (i) support the {financial statement assertions and accounting treatments (i) support disclosures made in the nates to the financial statements, Apply analytical procedures to financial and non- financial data Evoluote, quantitatively and qualitatively {including use of onalytical procedures), the results and conclusions obtained from assurance procedures. Explain the specific audit problems and procedures concerning related parties and related party transactions, Evoluate the use of written management representations to support other audit evidence. Recognize when it is justifiable to place reliance ‘on the work of an expert and internal auditors.Lahore University of Management Sciences ] *Deserbe the nature ard timing of specific procedures designed to identiy subsequent | | vents thot may equlre adjustment or | | disclosure. © Describe the nature and timing of specific procedures designed to ldently the : tpproproteness ofthe going concer assumation [ 7 ‘Advonced Topics: Fieldwork - Gathering Audit Evidence ‘© Demonstrate comprehensive application of (contd) & Responses to Assessed Risk IFRS/IAS to audit of key areas of oud. Session 13 «Evaluate oudit implications (.. materiality, risk Chapter 22 (Kaplan) relevant accounting standards, audi evidence) | midterm (Out of cass) relating to specialist FS line tems: Inventory, | Statement of cash lows, changes in accounting | polices, post-bolance sheet events, PPE and teases 5] Advanced Toples: Feldwark Gathering Audeudence |» Demonstrate comprehensive application of (cont'd) & Responses to Assessed Risk IFRS/IAS to oudit of key areas of audit. | Session 14/35: © Evaluate cudlt implications e.g. material sk Chapter 2 (remainder) (Kaplan) relevent eccounting standards, oud evidence) | session 16 teloting to specialist FS line tems: segmental Chapter 2 (Alan Mlchamp & John Taylor) reporting, flr value, revenue from contract with Chapter 10 (Kaplan) customer, Impairments, contingencies, intangible assets, financial instrument, | Investment properties, share-bosed payment | transactions and business combinations + Consider how the group oudltor should evaluate the cudle work performed by a component aucitor. " __| 3 | Noncoudi Assurance Enaoaements > Aualt related and assurance services: interim | Session 17 & 18 Review, Treasury Assurance & Due Diligence | Chapters 15 & 16 (Kaplan) © Levels of Assurance ftile on Treasury Advisory (PriceweterhouseCoopers) | « Prospective Financial Information _ fatile on Board Effectiveness Review (Grant Thorton) 70] Non-cudle Assurance Engoaements [continued > Forensie Audis Session 19 & 20: © Internal Aucts Chapters 1,29, 21 (Kaplan) © Cutsourcing ‘niles on Forensic Aualt (Grant Thorton) ‘Publ Sector Audits TH | Advanced Topi: Reporting ; + Demonstrate understanding of miscellaneous Session 24 & 22: 1 concluding acintes such a review checks, Chapter 26 (Alan Millichamp & John Taylor) | quality reviews, concluding analytics and close- | Chapter 12 (remainder) (Kaplan) | outmeetings. | | «Moke reasoned decisions toward efficacy of controls testing and substantive work + Recognte factors tobe taken into account when forming an audit opinion ina given situation ond justify audit opinions that ae consistent with he | results of oud procedures. «Recognize when the use ofan emphasl of matter paragraph and other matter paragraph - _ ‘would be appropriate. -Lahore University of Management Sciences ‘Draw conelusions on the ability to report on on ‘audit engagement, including the opinion for @ statutory auait, which ore consistent with the results of the audit work. 2 ‘Advanced Topics: Concluding Activities & Reporting | (continued) | Session 23 & 24: Chapter 25 & 27 (Alan Millichamp & John Taylor) Chapter 14 (Kaplan) Critically assess the quality of o report to those charged with governance and management. ‘Advice on the content of reports to those charged with governance and management in a given situation. ‘Analyze the form and content of the professional | ‘accountant’s report for an assuronce engagement as compared with an auditor's report B Tontemporary ssues surrounding Assurance/Auditing Session 25 & 26: Chapter 31 & 32 (Alan Millchamp & Joha Taylor) Explain, ia non-technical language, significant current assurance issues being declt with by the national standard-setting body and the IAASB. Explain the auaitor’s main considerations in respect of social and environmental matters ond how they impact on entities and their financial “statements (e.g. Impairment of assets, provisions ‘and contingent liabilities) Explain current developments in auditing standards including the need for new and revised standards ond evaluate their impact on the conduct of audits. 1m Contemporary Issues surrounding Assurance/Auditing Review of assorted literature (continued) © Review of assorted literature from Session 27: ICAEW/Economia magazine, ACCA articles and Enlightening Professions (Audit Futures Article: Full ‘Accountancy Age to assess current issues around | | Version) ‘ossurance/audlting. Revision and Consolidation of Learning + Review and consolidation of learning : Session 28 _ ‘TEXTBOOK(S)/SUPPLEMENTARY READINGS Text Books Other Texts International Standards on Auditing Recommended Supplementary Readings = The Economia Magazine Excerpts Selected Articles (ICAEW & ACCA websites) + Accountancy Age Website AuditFutures Website + Alan Miilichamp & John Taylor, (2014) Auditing (10* Edition). Cengage Learning EMEA (Selected Chapters) + Kaplan Publishing UK (2015) Advanced Audit and Assurance (Selected Chapters)ACCT 352 Advanced Auditing (Wagar Ali)cyCONTA E (ON Le] TT ae HLLJatio Aueur Aq pareys are sane] 31 sansst aq ing ‘Hqnd Atjensnun st eSBs oy, “MaqD0s pue ABojouypay ‘ssauisng ur saZueyp u2a}-8u9] Jo saouanbasuoa ay) Yat Burddeas st 7 ‘sisi fepueUy 8002 au) Aq IUBIods ayy oyUT UMOIYL ‘suorjsanb Butyaseas saves uolssajord Taq) ety aremve Auaay{ azam sour pue ‘sioypne arom Ayrofeut au yoaford ayy OU! pay YM 10 pamataraquT am afdoad 00z Wey a1our amp JO “poour annrayar ® UT Uolssajord jIpne ay} punoy am, “uotssajoud e 40 ‘sonaeid © se sauna ‘Ammyuao asiz atp ut Ayato0s 0 Sutq prod ype anges yey Jo mata B aye} Pue amNY at} 0} Foot 07 aydoad parAut am “pafod aun jo areme aureraq YM uorssayord ypNe axp jo apisno pue apisut a[doad wos suornqnqu0s jo Maite v pur smazsazut pammonnys “juias ‘diysmoyied Vsu ay Y8nomyp goUapina 40} yno [Jeo B ‘Mazaad amneTayT| e uo smegp 71 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(ii). the role of audit committees and impact on audit and assurance practice. (ii) UK syllabus only: Discuss the provision of the UK Corporate Governance Cade and its impact on audit and assurance practice. Explain current developments in auditing standards including the need for new and revised standards and evaluate their impact on the conduct of audits. Discuss other current legal, ethical other professional and practical matters that affect accountants, auditors, their employers and the profession.E Regulation in a glo! m s es | This chapter considers the reasons behind the mechanisms for regulating assurance services and how standards of corporate governance are maintained, including much of the background to developments in the profession. You need to have an awareness of recent developments in the profession, which will require you to read around the topic to develop your understanding and develop an ability to form your own opinion and reach your own conclusions. " 4 The need for assurance services Assurance professionals provide reports that give an independent opinion as to whether subject matter complies with pre-determined criteria. This enables the end user of that information to place more or less reliance on that information when making decisions. ° Decision makers within financial markets need to have the confidence to make informed decisions. In order to make these decisions they need information that they can trust. The main investment decisions that take place concern the buying and selling of shares. Without credible, reliable information at their disposal investors cannot make those decisions. ~~ Itis not just shareholders that rely on this information, there are a range of "other stakeholders who also rely on assurance services. For example, itis ‘common for banks to seek audited financial statements and independently examined forecasts before making lending decisions. Many companies request audited financial statements before buying from or supplying a particular company, in case that company is nearing insolvency. swell as investments in businesses other stakeholders must make © decisions about how to deploy resources: suppliers, customers, employees ~ and prospective lenders all need information before making significant decisions that could have damaging financial repercussions. Confidence in the reliability of financial information is essential to the i functioning of these markets. Whilst itis not the only factor in helping to achieve that confidence, good quality, independent audit and assurance has a key role to play. A series of recent and high profile corporate failures has eroded trust in the assurance market and as a result mechanisms for increased regulation of the auditing profession have been introduced.2 The need for regulation Business failures, particularly large, high-profile businesses, cause loss of confidence within global financial markets. The requirement for audited financial statements was seen as a way to reduce this risk and to protect: + the owners of a business from unscrupulous management + the world at large from abuse of limited liability status. Selfrequlation Initially the system relied on self-regulation. In the 1970s the accountancy profession began to introduce standards to regulate financial reporting and shortly afterwards auditing standards were introduced. Standards were set by the accounting profession for the accounting profession to follow. Self-regulation seemed to make sense because: * the accountancy organisations usually had a ‘public interest’ remit written into their constitutions * _ they understood the business of financial reporting and auditing better than anyone, However, two factors have led to the questioning of self-regulation as a satisfactory mechanism, which are: + globalisation * high profile corporate failures, such as Enron. Globalisation, The globalisation‘of business, professions and investment markets has been rapid. Once businesses started to cross national borders it soon became clear that the variation of laws and regulations in different countries made life rather difficult, both for the multinationals and the professions trying to provide services to them, uBLISAING 3Global Regulation . : This realisation led to the foundation of IFAC — the international Federation 2 of Accountants in 1977. IFAC is structured to operate through a network of boards and committees. ‘AC COUNCIL | INTERNATIONAL AUDIT AND ASSURANCE STANDARDS BOARD [PROFESSIONAL ACCOUNTING ORGANISATION DEVELOPMENT COMMITTEE INTERNATIONAL ACCOUNTING EDUCATION STANDARDS BOARD INTERNATIONAL ETHICS ‘STANDARDS BOARD FOR ACCOUNTANTS, PROFESSIONAL ACCOUNTANTS IN BUSINESS COMMITTEE INTERNATIONAL PUBLIC SECTOR ACCOUNTING STANDARDS BOARD International Federation of Accountants The International Federation of Accountants (IFAC) is the global 1 organisation for the accountancy profession. It was formed in 1977 and is based in New York. As at 1 January 2015, IFAC has more than 175 member bodies of accountants (including the ACCA), representing 2.5 ‘million accountants from 130 separate countries. OS ASLAN PUBLISHING !IFAC’s overall mission is to serve the public interest, strengthen the |, worldwide accountancy profession, and contribute to the development of || strong international economies by establishing and promoting | | adherence to high-quality professional standards. ‘The structure of IFAC is as follows: | The IFAC Council comprises one representative from each member body. It meets once a year and elects the board. The IFAC Board comprises 22 individuals, elected on three-year terms and responsible for setting policy and overseeing the work of the various committees. ‘The IFAC Nominating Committee makes recommendations regarding | the composition of IFAC boards, committees and task forces. It ‘The main bodies to be aware of are: + The International Auditing and Assurance Standards Board (IAASB): they develop and promote ISAs and other assurance standards to improve the uniformity of auditing practices and related services throughout the world | + The International Ethics Standards Board for Accountants: they promote the Code of Ethics. Significantly, the committee continually monitors and stimulates debate on a wide range of ethical issues to ensure that its guidance is responsive to the expectations and challenges of individuals, businesses, financial institutions and others relying on accountants’ work. + The Transnational Auditors Committee (TAC): they deal with issues arising due to cross-border auditing, It is the executive committee of the Forum of Firms (FoF), open to all firms performing of wishing to perform transnational audits. The TAC is discussed in more detail in chapter 10, | | Other constituent bodies include: | + The Compliance Advisory Panel (CAP) + The Professional Accountancy Organisation Development Committee I + The international Accounting Education Standards Board + The Professional Accountants in Business Committee (PAIB) + The International Public Sector Accounting Standards Board + The Small and Medium Practices Committee ZAP PURLISHING 56 Although companies have had their securities listed in both the | European and US markets for a number of years, the ability to be based | virtually anywhere in the world, and to manufacture, sell and manage businesses on a truly global basis is a more recent phenomenon. Global | businesses need global professional firms to support, advise and audit | them. The emergence of the ‘big 4’ global practices has been an | accelerating process that has its origins in the 1970s. Similar | | globalisation has happened in the banking and assurance industries and | | the introduction of external shareholders into the securities markets has Jed to, e.g. Nasdaq from the US investing in the London Stock i Exchange. | The trouble with IFAC. IFAC has encountered a number of difficulties in carrying out its role: + Itwas set up by, and continues to be financed by, the accountancy profession worldwide. It therefore represents a seff regulatory body. itis suggested that this is an inappropriate mechanism for regulating the ‘ audit profession. + «National interests stil apply leading to the implementation of international standards being bogged down in arguments between different national approaches. + Its members are the professional accountancy bodies, whose authority has been eclipsed to some extent by the power of the largest accountanoy firms, Enron. The fraudulent financial reporting at the heart of the Enron collapse has had major repercussions for the accountancy profession worldwide. It was one of the largest and most complex bankruptcy cases the world has ever witnessed. Consequent investigations identified numerous creative accounting techniques designed to improve reported profits and hide significant debts from investors. Ultimately the scandal that followed in the wake Enron's bankruptcy led to the collapse of one of the "Big 5" accountancy firms, Arthur Andersen, itself massive multinational employer. The role of Arthur Andersen in the financial fraud came under close public scrutiny and much of the already fragile trust in the auditing profession, due to other high profile frauds, was lost.| + Enron used an accounting technique known as marking to market "+ Share prices began to fall and Enron's massive liabilities started to top or was the flaw endemic within the whole business? Before its bankruptcy, Enron employed approximately 22,000 people | and was one of the world's leading electricity, natural gas, and communications companies. in 2001 its revenue peaked at nearly $101 billion. Much of the reported profit and position was sustained by institutionalised and systematic accounting fraud. | The scandal also caused the dissolution of Arthur Andersen, at that point one of the "Big 5" global accounting firms. The firm was found guilty of obstruction of justice for destroying documents related to the Enron audit and was forced to stop auditing public companies (although the conviction was thrown out by the US Supreme Court in 2008). The story can be briefly summarised as follows:” + Asignificant portion of Enron's profits were the result of deals with special purpose entities (SPE's), which it controlled, + many of the entities were offshore, which allowed Enron to avoid taxes, move currency and hide overall company losses. (MTM), which effectively meant that Enron could recognise revenue and earnings on deals a long time before the actual revenue was realised. + The huge profits Enron reported drove up its share price. This allowed executives (who knew about the offshore accounts and i hidden losses!) to trade millions of dollars worth of Enron stock to | their own benefit. | | exert pressure on its liquidity. This eventual led to problems with Its | debt agreements and credit downgrades. + The lower credit rating increased the cost of Enron's borrowing to unsustainable limits. + Wall Street analyst queries exposed a number of inconsistencies and problems with Enron's accounts until finally the veil was lifted and'the extent of earnings management exposed. Weak ethical leadership was partly to blame. However there was a deep flaw running right the way through Enron's corporate culture. Were these failures in ethical and business judgment caused by a few people at the ictal este eeaa eens‘The fallout for the regulation of audits As a result of the financial scandals, and the public concern that followed, many changes were implemented in the global auditing and accountancy profession. Examples of developments include: * The IAASB's International Standards on Auditing have been adopted or are being used as a basis for national standards in over 100 countries. worldwide. + The World Federation of Exchanges endorsed the IAASB's standard setting process and ISA's. * The Code of Ethics for Professional Accountants has been adopted by many member institutions. + The largest accountancy firms have all committed to auditing in accordance with ISA's and to apply relevant sections of the Code of Ethics. + Legislative changes have been established to introduce new corporate governance requirements. The most famous of these, The Sarbanes Oxley Act (SOX) in the US, led to the creation of the Public Company Accounting Oversight Board, who create standards for listed entities and conduct inspections of audit firms’ work. * The Public Interest Oversight Board (in conjunction with the Intemational Organisation of Securities Commissions, the Basel Committee on Banking Supervision, the Financial Stability Forum and the World Bank) was set up in 2005 to oversee IFAC’s auditing and assurance, ethics, and education standard setting activities and its membership compliance programme The trouble with regulation in a global market Going global - Regulation The main problem is that harmonisation requires national regimes to adopt International Standards on Auditing. IFAC cannot Impose them on a global scale, Many countries have adopted ISAs but they have been adapted to suit local customs/laws and as a result many differences still exist in the quality of audits worldwide. The most recent attempt to encourage worldwide harmonisation was the Clarity Project. This simplified the structures of ISAs and made them more prescriptive so that they are easier to understand and apply in practice.ten se seh = . e KAPLAN PUBLISHING | IFIAR - a postscript | In September 2006, the national regulatory bodies from Australia, Austria, Brazil, Canada, Denmark, France, Germany, Ireland, Italy, Japan, Mexico, the Netherlands, Norway, Singapore, South Africa, Spain, Sweden, and the United Kingdom, announced the establishment | ofthe Intemational Forum of Independent Audit Regulators (IFIAR). The EU also sent observers. Is first meeting took place in Tokyo in | March 2007. | | | PCAOB from the US was an observer, as were the bodies behind PIOB. | Itis possible, therefore, that a global regulatory authority may emerge. It | is possible that it will set its own assurance standards, thereby | supplanting IFAC and the ISA setting process. But then again Introduction | The chapter has so far looked at mechanisms external to the audit firm | ‘and their clients (auditing standards, company law and the regulatory framework) that aid confidence and stability in the market place. The | | next section introduces an internal mechanism, namely corporate | governance, and how its principles are enforced. | | | i10 Corporate governance is about ensuring that public companies are: + managed effectively + for the benefit of the company and its shareholders, Why all the fuss? Corporate governance pronouncements tend to happen in response to corporate scandals that arise because unscrupulous management has: + manipulated the share price for personal gain + disguised poor results /mismanagement : + extracted funds from the company i * raised finance fraudulently. i kama PUBUSIH )What does good corporate governance entail? | Good corporate governance entails: + effective management | + supportfoversight of management by non-executive directors * fair appraisal of performance + fair remuneration and benefits + fair financial reporting * sound systems of internal control * — constructive relationship with shareholders. | Broadly speaking there are two models of board structure adopted around the world: | * _ the ‘unitary board’ structure, as used in the UK and Ireland and | jurisdictions whose company law systems have a similar basis * the 2 tier, ‘supervisory board’ structure, as used in the US and similar jurisdictions. | Features of a unitary board include: | + collective board responsibility * _ nodistinetion in law between the responsibilities of executive and | Torrexecutive directors | ¢ the need to distinguish between the function of executive and non- | executive directors the need to establish board committees to monitor and act on different functions — nominating committee, remuneration committee, audit committee, etc. | Features of a 2tier system include: + Lower level management (operating) board i - Comprises executive management - CEO, CFO, Vice presidents, etc. — Operational responsibilty for running the business. | = Co-ordinated by the CEO. apa puausHIne "2 Upper level supervisory board — Comprises non-executives, employee representatives, environmental groups and other stakeholders. — Appoints, supervises and advises the management board. | i i — Strategic oversight of the organisation. i - Members elected by shareholders at the AGM. | = Receives information and reports from the management board. | i Co-ordinated by the chairman. Examples of | I | In the US corporate governance is enshrined in law, namely the | Sarbanes Oxley Act. As well as dealing with the oversight of auditors the act enforces certain governance responsibilities, such as: | | i | * sound systems of controls. * _ clear documentation of financial processes, procedures, risks, and controls. * evidence that management has evaluated the adequacy of the design and the effectiveness of operation of procedures and | controls. * evidence that the auditor has adequately evaluated the design and | operation of financial controls. | * — evidence that the audit committee has taken a keen interest in the effectiveness of controls + explicit ‘sign off procedures by the chief executive and chief financial officer (see ‘Sarbanes Oxley). i Overview of the Act "The primary benefit is to provide the company, its management, its board and audit committee, and its owners and other stakeholders with a reasonable basis to rely on the company's financial reporting. The integrity of financial reporting represents the foundation upon which | this country's public markets are bull” apLan PUBLISIING ¢ce The key characteristics of Section 302 CEO and CFO need to certify that: * the SEC report being filed has been reviewed. * the report does not contain any untrue statements or omit any material facts, + the financial statements fairly present the financial position, results of operations and cash flows of the registrant. + they are responsible for, and have designed, established, and and reported on the effectiveness of those controls and procedures within 90 days of the report filing date, * deficiencies and material weaknesses in disclosure controls and procedures have been disclosed to the registrant's audit committee and external auditors. * _ significant changes in internal control affecting transactions in the period have been reported. The key characteristics of Section 404 With the filing of their accounts, companies are required to include an annual internal control report of management over financial reporting including: + responsibilities for establishing and maintaining adequate internal | controls and procedures ' * conclusions about the effectiveness of the company’s intemal | controls and procedures | + anattestation by the company's registered public accounting firm on management's evaluation. | 3 Audit committees The broad objectives of an audit committee are threefold: + Toincrease public confidence in the credibility and objectivity of published financial information. * Toassist directors in meeting their responsibilities in respect of financial reporting. * To strengthen the independent position of a company’s external auditor. spun puBLSHING maintained disclosure controls and procedures as well as evaluated | 3Membership of audit committees * Agroup of independent, non-executive directors, > + The committee should have at least 3 members (2 for smaller companies). * Atleast one member should have recent and relevant financial ny experience with an appropriate professional accountancy qualification. * Committee members should be independent of operational management. * Appointments to the audit committee should be made by the board on | the recommendation of the nomination committee. | * Appointments should be for a period of up to 3 years, extendable by no | more than two additional 3 year periods. | functions of an audit committee cotinine These could include the following. + Monitor the integrity of the financial statements. + Review the internal financial controls and risk management systems. * Monitor and review the effectiveness of the internal audit function. oO + Make recommendations in relation to the appointment of the extemal auditor and to approve the remuneration and terms of engagement of the external auditor. a + Review and monitor the external auditor's independence and objectivity and the effectiveness of the audit process. + Develop and implement a policy on the engagement of the external, auditor to supply non-audit services. * Providing a reporting channel for ‘whistleblowing’. Benefits: * Improved credibility of the financial statements, through an impartial ° review of the financial statements, monitoring of the independence of the external auditors, and discussion of significant issues with the external auditors. | * Better quality of management accounting, as the audit committee is better placed to criticise internal functions. * Stronger control environment, as the internal audit function will report to. , | the audit committee increasing their independence and adding weight to their recommendations. * They should lead to better communication between the directors, external auditors and management. iThey help to avoid'conflicts arising between management and auditors. * The skills, knowledge and experience (and independence) of the audit committee members can be an invaluable resource for a business. + Itmay be easier and cheaper to arrange finance, as the presence of an audit committee can give a perception of good corporate governance. + Itwould be less burdensome to meet listing requirements if an audit committee (which is usually a listing requirement) is already established Drawbacks: * Difficulties recruiting the right non-executive directors who have relevant skills, experience and sufficient time to become effective members of the committee. + A fear that their purpose is to police executive management. * Non-executive directors being over-burdened with detail. + Additional cost. Non-executive directors are normally remunerated, and their fees can be quite expensive. | © This guidance is designed to assist company boards when implementing the Corporate Governance Code. Ce |-* Companies with a premium listing are required to comply with the Code or explain why they have not done so, i : | * Audit committee arrangements should be proportionate to the task | ¢ and will vary according to size and complexity of the company. i * There should be a frank, open working relationship and a high level | of mutual respect between audit committee chairman and board | ‘ chairman, the chief executive and the finance director. | i * Management is under an obligation to ensure the audit committee is kept properly informed. All directors must cooperate with the audit as committee. | * The core functions of audit committees are oversight, assessment | and review. Itis not the duty of the audit committee to carry out 7 functions that belong to others. For example, they should make sure | there is a proper system in place for monitoring of internal controls | but should not do the monitoring themselves. * The board should review the audit committee's effectiveness annually. ¢ vanuan puBUsHING 56 | The audit committee should: | | receive induction and training for new members and continuing training as required, * hold as many meetings as the roles and responsibilities require and it is recommended that no fewer than three meetings are held. * meet the external and internal auditors without management at least annually to discuss any issues arising from the audit us * report to the board on how it has discharged its responsibilities. + ensure the interests of the shareholders are properly protected in | | relation to financial reporting and internal control. > | | + review and report to the board on the significant financial reporting issues and judgements in connection with the preparation of the . financial statements. |. 8 | + consider the appropriateness of significant accounting policies, i significant estimates and judgements. * receive reports from management on the effectiveness of systems and the conclusions of any testing carried out by internal and external auditors. L + review the systems established by management to identify, assess, |< ' manage and monitor financial risks. * monitor and review the effectiveness of the-company's internal audit function. Where there is no internal audit function the audit : committee should consider annually the need for one and make a recommendation to the board. | + review whistleblowing arrangements by which staff of the company |...) may raise concerns about possible improprieties in financial i reporting and other matters, in confidence. Annual report committee. Specifically: | i | Aseparate section of the annual report should describe the work of the . | ; | * Asummary of the role of the audit committee, | | * The names and qualifications of all members of the audit committee during the period. * The number of audit committee meetings. The significant issues that the committee considered in relationto | ~ the financial statements and how these issued were addressed. + Anexpianation of how it has assessed the effectiveness of the external audit process and the approach taken to the appointment or reappointment of the extemal auditor. eee |, eee ee ee eee Yartan PUBLISHING( vet puausis Ifthe external auditor provides non-auait services, how aucitor objectivity and independence is safeguarded. | Where there is a disagreement between the audit committee and | the board which cannot be resolved, the audit committee should =| have the right fo report the issue to shareholders as part ofits report | within the annual report. | The chairman of the audit committee should be present atthe AGM to answer questions. | | External audit matters The audit committee is responsible for making a recommendation on the appointment, reappointment and removal of the external auditors. | | FTSE 350 companies should put the audit outto tender atleast once | every ten years to enable the audit committee to compare the quality and i effectiveness of the services provided by the incumbent auditor with | those of other firms. | i | | The audit committee should: annually assess and report to the board on the qualification, | expertise and resources, and independence of the external auditors and the effectiveness of the audit process. | investigate reasons for the resignation of the external auditor and consider whether any action is required. assess the independence and objectivity of the external auditor annually. set and apply a formal policy specifying the types of non-audit service which are pre-approved, require approval or are not allowed. agree a policy for employment of former employees of the external auditor taking into account the Ethical Standards, paying particular attention to people who were part of the audit team. The audit committee should consider whether there has been any impairment of the auditors independence and objectivity in respect of the audit. monitor the external audit firm's compliance with ethical standards | relating to partner rotation and fee levels, i 7| Regulation of auditing ‘Aucit and Assurance in the United Kingdom is regulated | Financial Reporting Council (FRC). | The FRC has two divisions, one of which is the Codes and Standards the Accounting Council * the Actuarial Council. | The Auditing and Assuran ‘ouncil considers and advises the FRC Board and the Codes and Standards Committee on audit and | assurance matters. The FRC issues International Standards on Auditing { ‘ingdom and Republic of Ireland. The standards are suppleméfted and revised before issuing them, mainly in order to ensure that they remain compliant with national laws, such as. oo) ing accountants’ integrity, objectivity and independence to the adoption of the Code of Ethics in the UK. boeoF i byAhe Professional Oversight team, part of the Conduct division. = |p 1: lonitors the quality of the audits of listed and other major public i | /interest entities. This is the responsibility of the Audit Quality Review team. Ensures that appropriate standards are maintained by members | and member firms, by operating an independent professional disciplinary scheme for accountants, overseen by the Conduct division. 18 AmLAN PUBLISHING; )Money laundering Chapter learning objectives When you have completed this chapter you will be able to: * Define ‘money laundering’. * Explain how international efforts seek to combat money laundering, + Explain the scope of criminal offences of money laundering and how professional accountants may be protected from criminal and civil liability, + Explain the need for ethical guidance in this area, * Describe how accountants meet their obligations to help prevent and detect money laundering including record keeping and reporting of suspicion to the appropriate regulatory body. * Explain the importance of customer due diligence (CDD)/know your customer (KYC) information. + Recognise potentially suspicious transactions and assess their impact on reporting duties. * — Describe with reasons the basic elements of an anti-money laundering program. 137138 Exa Money laundering can be examined as part of professional issues to be considered when deciding whether or not to accept an engagement, or as a distinct requirement. Money laundering requirements may be knowledge based, in which you are required to explain the basic elements of an anti- money laundering program or define and give examples of money laundering offences. You may also need to identify a potentially suspicious transaction and explain the requirement to report knowledge or suspicion of money laundering. 4 Definition of money laundering Money laundering is the process by which criminals attempt to conceal the true origin and ownership of the proceeds generated by illegal means, allowing them to maintain control over the proceeds and, ultimately, providing a legitimate cover for their sources of income. Money laundering involves 3 main stages: (1) Placement - where cash obtained through criminal activity is first placed into the financial system. i (2) Layering - where the illegal cash is disguised by passing it through complex transactions making it difficult to trace. (3) Integration - where the illegally obtained funds are moved back into the legitimate economy and is now ‘clean’. ‘ Consider the following scenarios. + Whilst preparing or auditing accounts you realise that aclienthas | incorrectly reciaimed value added tax (or other national recoverable | taxes) on the purchase of a motor car. You point this out to the client and propose an adjustment to the financial statements to provide for the additional tax that is due. You also advise the client that they must rectify this with the tax authorities. However, the client tells you that they have just had an Inspection by the tax authorities that did not reveal the error and they do not wish to do anything further. | + An auditor knowingly receives payment for one invoice twice (Le. payment has been duplicated). The sole director has told the | accounts department to ignore negative balances when they issue statements of account to customers hoping that they fail to notice.Errors and mistakes of the type illustrated above may not constitute criminal conduct, provided that they are corrected. However, in both ‘cases there appears to be an intention to gain a permanent benefit from another's mistake or to avoid a legal liability. In the UK, for example, this is criminal conduct. As such, each of these cases would result in the accountant knowing or suspecting that a client is involved in money laundering, Le 2 International efforts to combat money laundering ‘The Financial Action Task Force (FATF) is an international body that promotes policies globally to combat money laundering and terrorist financing. FATF issued recommendations to combat money laundering, The recommendations included: * Intemational co-operation including extradition of suspects. Implement relevant international conventions on money laundering. Criminalise money laundering and enable authorities to confiscate the proceeds of money laundering. Implement customer due diligence, record keeping and suspicious transaction reporting requirements for financial institutions and designated non-financial businesses and professions. Establish a financial intelligence unit to receive suspicious transaction reports. As an example, the UK Financial Intelligence Unit (UKFIU) is run by the National Crime Agency (NCA).The NCA became operational in October 2013 and replaced the Serious Organised Crime Agency (SOCA). FATE focuses on three principal areas: | + Setting standards aimed at combating money laundering and terrorist financing. | + Evaluating the degree to which countries have implemented measures that meet those standards. * Identifying and studying money laundering and terrorist financing | techniques {ela peBusHNG 139140 | In 1990, FATF drew up a document entitled “The Forty Recommendations’ as an initiative to combat the misuse of financial | ones noted above) were endorsed by over 130 countries worldwide and 1 i | | systems to launder drug money. These recommendations (including the 2 | | have been introduced since the 2001 September 11 attacks. ene | | | + the Bank Secrecy Act 1970: this requires all cash deposits, : | now form the benchmark against which national anti-money laundering systems are assessed. Although different countries have moved forward, in different ways. | In addition, 9 further special recommendations on terrorism financing The UK has adopted the recommendations of FATF. The USA has a number of similar Acts: withdrawals and transfers above $10,000 to be reported to the Inland Revenue Service + the Money Laundering Control Act 1986 * the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (USA PATRIOT) Act 2001: this requires alll financial institutions to establish an anti- money laundering program, including the development of internal | «» policies arid the designation of a compliance officer. 1 3 Money laundering regulatory requirements The main legislation and requirements below relate to the money laundering regulatory regime as it stands in the UK. The principles, however, are appropriate on an international basis. © Following the 1993 Criminal Justice Act, four further laws have tightened | | up the regulations in the UK: pen | * Terrorism Act 2000 Pot + Proceeds of Crime Act 2002 (POCA) in| * Money Laundering Regulations 2007 (the Regulations) | les | +. Serious Organised Crime Police Act (SOCPA) 2005 io in December 2007 the ACCA issued Technical Fact Sheet 145 ‘Anti- I money Laundering Guidance for the accountancy sector. ! xaPianpuBuisiesMoney laundering off ‘There are five basic money laundering offences: Acquiring, possession or use of criminal property. Concealing or disguising or transferring criminal property, or removing it from the UK. Failure to disclose knowledge or suspicion of money laundering. Tipping off. Failure by a financial services business to meet their obligations under money laundering regulations. "Tipping off means to carry out any action that may make suspected money launderers aware that they are under investigation, or prejudicing the outcome of an investigation. Failure to disclose knowledge or suspicion of money laundering may include: Criminal property is property that has arisen from criminal conduct. Examples include: failure by an individual in the regulated sector to inform the Financial Intelligence Unit (FIU) or the firm's Money Laundering Reporting Officer (MLRO), as soon as practicable, of knowledge or suspicion that another person is engaged in money laundering; or failure by MLROs in the regulated sector to make the required report to the FIU as soon as practicable if an internal report leads them to know or suspect that a person is engaged in money laundering. Property acquired by theft The proceeds of tax evasion Bribery or corruption ‘Saved costs arising from a criminal failure to comply with a regulatory requirement | ‘can pususis stI : i i uae 4 Anti-money laundering program: basic elements Money Laundering Regulations impose certain obligations on financial © services businesses, which are designed to assist in detecting money laundering and preventing the financial services organisations being used for money laundering purposes. 6) ‘Ata minimum, an anti-money laundering program should incorporate: * Customer identification procedures. + Enhanced record keeping for: = alltransactions - the verification of clients’ identities. ‘ * Appointment of a Money Laundering Reporting Officer MLRO}). + Establishing internal reporting procedures to the MLRO. el * Procedures for the reporting of suspicious transactions to the Financial Intelligence Unit (FIU). * Communication and training of all staff in the main requirements of the <.’ legislation. + Systems and controls that effectively manage the risk that the firm is exposed to in relation to money laundering activities and ensure an compliance with the legislation. In the UK, for example, these measures are covered by the Money a Laundering Regulations 2007 (MLR 2007) with reporting to the National Crime Agency (NCA). Accountants are required to establish that new clients are who they claim to be by obtaining satisfactory evidence of identity from the client, This is often referred to as ‘customer due diligence’ or 'know your customer' procedures. Customer due diligence is an essential part of the’anti-money laundering | requirements. It ensures that accountants: : * know who their clients are, and * donot unknowingly accept clients which are too high risk, It may be helpful for the auditor to explain to the client the reason for | requiring evidence of identity and this can be achieved by including this fi matter in the engagement letter. apse pugusHiGIt may also be helpful to inform clients of the auditor's responsibilities to report knowledge or suspicion that a money laundering offence has been committed and the restrictions created by the ‘tipping off rules on the auditor's ability to discuss such matters with their clients. Customer due diligence must be performed as soon as is reasonably practicable after contact is first made between the two parties. Where satisfactory evidence of identity is not obtained by the accountant, the business relationship or one-off transaction must not proceed any further. Basic identification procedures include: + For individuals (including key management personnel where the client is an entity): inspection of evidence to establish the fullname and permanent address of the client, e.g. a driving licence ora passport (which include a photograph) and a recent utlty bill to confirm the address. + For businesses: inspection of evidence including: the certificate of incorporation; lists of registered members and directors; certificate of registered address. + For trusts: inspection of evidence to establish and confirm: the:nature and purpose of the trust; its original source of funding; and the identities of the trustees, controllers and beneficiaries. ‘In accordance with the Proceeds of Crime Act 2002 and Money | Laundering Regulations 2007 you agree to waive your right to confidentiality to the extent of any report made, document provided or information disclosed to the National Crime Agency (NCA). You also acknowledge that we are required to report directly to the NCA without prr reference to you or your representatives i during the course | | of undertaking any assignment the person undertaking the role of Money | | Laundering Reporting Officer becomes suspicious of money laundering. As a specific requirement of the Money Laundering Regulations we may require you to produce evidence of identity of the company and its owners and managers, This will include for the business proof of registration and address and for the individuals proof of identity and address. Copies of such records will be maintained by us for @ period of at least five years after we cease to act for the business. | | Note: The above clauses include references to the relevant legislation and regulatory bodies in the United Kingdom. The references would be amended for the specific jurisdiction(s) LW ‘ara eveusnie chapter 7 143144 Enhanced record keeping Itis very important that accountants keep comprehensive records to show that they have complied with money laundering regulations, and protect themseives if there is an investigation into one of their clients. Records must be kept of: * All customer due diligence completed, including copies of the evidence inspected, * — Transactions with each client. * Internal and external money laundering/suspicious activity reports. Records must be held for five years after a relationship with a client has ended or the date a transaction is completed. The MLRO ‘The MLRO should be an individual of suitable seniority and experience. Alternative arrangements must be made when the MLRO is unavailable (on holiday, sick, jury service, etc). The MLRO receives and assesses money laundering reports from colleagues, and passes on valid suspicions to a regulatory agency on a standard form that identifies: + the suspect's name, address, date of birth and nationality + any identification or references seen + the nature of the activities giving rise to suspicion * any other information that may be relevant. Sole practitioners with no employees or associates are exempt from the requirement to appoint an MLRO, since clearly they would be reporting to themselves. ing procedures The FATF recommend reporting procedures. In the UK these are codified in the MLR 2007 that are typical of procedures adopted internationally. This requires that: * Aperson in the organisation is nominated to receive disclosures under this regulation (usually an MLRO). * Anyone in the organisation, to whom information comes in the course of the relevant business as a result of which he suspects that a person is engaged in money laundering, must disclose it to the MLRO. area+ Where a disclosure'is made to the MLRO, they must consider it in the light of any relevant information which is available to the organisation and determine whether it gives rise to suspicion. + Where the MLRO does so determine, the information must be disclosed to a regulatory body authorised for the purposes of these regulations (the FIU), such as the NCA in the UK. Note that in the UK the obligation to report does not depend on the amount involved or the seriousness of the offence. There are no de minimis concessions. Potentially suspicious transactions There is no formal definition of "suspicious". A suspicious transaction will often be inconsistent with the client's known or usual legitimate activities. Examples include: * Unusually large cash deposits, * Frequent exchanges of cash into other currencies. * Overseas business arrangements with no clear business purpose. Remember itis a criminal offence not to report knowledge or suspicion of money laundering, Communication and training Financial services firms in the conduct of relevant business must take appropriate measures to ensure that employees are: + made aware of the provisions of anti-money laundering regulations, and + are given training in how to recognise and deal with transactions which may be related to money laundering. Systems and controls ‘The systems and controls described above (client due diligence, record keeping, reporting and communication and training of employees) should be tested periodically to ensure that they comply with the relevant money laundering laws and regulations. This would include checking that employees are completing available training, and testing their understanding of it. "su pause 145146 5 The need for ethical guidance on money laundering ACCA provides guidance in iis Code of Ethies and Conductin the area of money laundering, This is needed because there is a clear conflict between: (1) the accountant’s professional duty of confidentiality in relation to his client's business, and (2) the duty to report suspicions of money laundering to the appropriate authorities is required by law. Professional accountants are not in breach of their professional duty of confidentiality if they report in good faith their knowledge or suspicions of money laundering to the appropriate authority. Disclosure in bad faith or without reasonable grounds would possibly lead to the accountant being sued for breach of confidence.aru pupusiin Legislation (UK example) Proceeds of Crime Act 2002 Money Laundering Regulations 2007, Offences Money laundering Tipping off Not setting up procedures Not complying with procedures Ethical guidance Conflict with ‘confidentiality Duties Client identification + Client due ctigence ‘Appointing a MLRO + With specified responsibilities Staff training + For all relevant personnel Reporting + Internal to MLRO + Extemal to FIU Enhanced record keepingMoney laund APL PuRUSHNGy 148ACCT 352 Advanced Auditing (Wagar Ali)usa AQ G f) 6. INTRODUCTION The genesis of modecn Corporate Governance can be dated to 1992 with the publication of the Cadbury Report. During the 1980s there had been a prolonged period of economic growth which, by the early 1990s, was beginning to go into reverse. ‘Companies which had previously shown signs of spectacular success were shown to be builr on sand, or ai lease very high borrowings, and the successive collapses, in the UK, of Coloroll, Polly Peck and Maxwell Communications Corporation, which took with ic the pension fund of Mirror Group Newspapers, prompted public concern This was exacerbated by the £8bn collapse of the Bank of Credit and Commercé International, which was subsequently revealed to be 2 hotbed of fraud and illicit dealings, and the debacle of the Delorean Motor Company which took with it about £80m of public money. Thousands of individuals had lost their savings and public concer was mounting, “The City reacted quickly and commissioned Sir Adrian Cadbury to come up with some good practice pro- posals which would: reinforce the responsibilities of executive directors; ‘strengthen the role of the non-executive director; make the case for audit committees of the board; restate the principal responsibilities of auditors; and reinforce the links between shareholders, boards and auditors. Cadbury was charged with creating a list of recommended changes. His 90-page report, The Financial “Aspects of Corporate Governance, outlined a code of conduct for listed companies that attempted to address ethical as well as legal questions. These ultimately, emerged as the basis for the UK Corporate Governance Code, which we look at below. WHAT IS CORPORATE GOVERNANCE? Ik was Cadbury who first defined what we know today as Corporate Governance and the definition of Corporate Governance most often quoted is the one contained in the Cadbury Report: ‘the system by which companies are directed and controlled’. This definition was all very well for the time but as the various reports post-Cadbury have refined and enhanced his initial concepts, so the definition of what corporate governance actually is has also been refined, In research carried out in 2000 among UK institutional investors the definition which found the most favour was: ‘the process of supervision and control intended to ensure that the company's management acts in accordance with the interests of shareholders’ (Parkinson, 1995) This, as you see, goes right to the heart of the problems of something called Agency Theory which we wi fook at below. Agency Theory is fundamental to an understanding of corporate governance and students should be sure to understand the conceptual framework and the rationale which underpins good corporate governance. ENCY THEORY AGENCY THEORY Agency is the name given co the practice by which productive resources owned by one person or group managed by anothér person or group of persons.iach | CHAPTE w Acits simplest, agency theory is the recognition that the inclination of agents is to ace rather more in their own interests than those of their employers, in this case the shareholders. What this means to us in practice is that agency theory recognizes the tendency of company managers, or directors, to tend to make decisions which are more favourable to their own objectives than to those of their principals, in this case the owners, or shareholders, of che business. Agency theory is relatively simple principle to grasp but its ramifications are extensive and they have im- portant implications for how organizations conduct themselves and to their operational culture. ‘The differing objectives can be summarized in Fig 2.1. FIGURE 2.1 Agency theory Party Objective Sate investment Regular dividends Long term canital growth Maintenance of value Selaty and benefits Maximum bonus ‘Share options Personal success of successful business ‘measured by share orice Principal ‘The Institute of Chartered Accountants in England & Wales, in November 2006, put it this way: ‘In principle the agency model assumes that no agents are trustworthy and if they can make themselves richer at the expense of their principals they will. The poor principal, so the argument goes, has no al- ternative but to compensate the agent well for their endeavours so that they will not be tempted to go into business for themselves using the principal's assets to do so. The origin of auditing goes back to times scarcely less remote than that of accounting ... Whenever the advance of civilization brought about the necessity of one man being entrusted to some extent with the property of another the advisability of some kid of check upon the fidelity of the former would become apparent.’ Clearly this is not universally true, but the extent to which principals don’t trust their agents will tend to determine the level of the monitoring mechanisms created for the overview of agents’ activities and the extent to which agents’ compensation levels are determined to be acceptable. Upon this principle rests the foundation of not only the auditing profession, but ultimately, in the latter part of the twentieth century and the early part of the twenty-first, the establishment of modern corporate governance. PRINCIPLES OF CORPORATE GOVERNANCE The underlying principles of good Corporate Governance are based around the actions of the board of direc- tors, how it is constituted, how it operates. how ic sets the values for the organization and how it governs itself. The fundamental principles of good governance, which underpin all che detailed rules contained in the UK Corporate Governance Code and in many others around the world are: ® accountability ~ this orinciple rect outcome of those actions; a board to take responsibilty ‘or actions with the obligation to report the8 2 CORPORATE GOVERNANCE ‘8 transparency - this encompasses ideas of openness, willingness to communicate and is an accompaniment to ty, Thus @ board should respond positively to requests for information and disserrinate more than an annual set of accounts; probity ~ which goes leyond the strict legal definition of compliance with laws and regulations and incorporates ideals of honesty, truthfulness and ethical behaviour in complance with some form of moral code; and © focus on the sustainable success of an entity over the longer term ~ which denies the Agency Theory tendency for managers to teke short term decisions which benefit themselves instead oftheir principals, the shareholders. This pénciple acknowledges the rights of shareholders, both large and smal, to be treated equaly and to have thei interests recognized, There are many Corporate Governance codes around the world. One of the international codes which set out some basic principles is the Organization for Economic Co-operation and Development (OECD) code which is a model for many of the international codes, particularly those adopted by developing coun- tties, This code is supported by IFAC, the International Federation of Accountants and can be adopted as 2 suitable alternative to the UK Code when students are thinking internationally. In other countries Singa- pore has its own code as does South Africa, with its King III Report. However, as most of chese codes are broadly similar we will concentrate on the principles contained in the UK Corporate Governance Code for our purposes. Firstly, however we must deal with a fundamental difference in the approach to corporate governance berween the conceptual fremework used in many countries such as the UK, and the legislative basis adopted by other countries, principally the USA. ‘COMPLY OR EXPLAIN’ - FRAMEWORK V LEGISLATIVE APPROACHES ‘The approach to corporate governance adopted in the UK, and in many other countries, is what has become known as a framework approach. The principles of Cadbury and its successors have not been enforced by legislation on either companies listed on the London Stock Exchange or on any other. Instead listed com- panies are required to abide by the UK Corporate Governance Code or to state in their accounts why they don’t comply ~ the so-called ‘comply or explain’ basis. “This leaves open the door ro non-compliance by listed companies, which may only have to suffer @ note in the Auditors’ Report and perhaps @ stern word from the Stock Exchange for a first offence, and, of course, it has no effect at all, other than a persuasive one, on unlisted companies. Seudents should contrast this principles-based approach with the purely legalistic approach adopted by the USA in the wake of the Enron and other corporate scandals there. The USA passed the Sarbanes-Oxley legislation (see later) which sets out detailed prohibitions and rules for both companies and audit firms to follow. Clearly there are advantages and disadvantages on both sides set out in Fig 2.2 below. FIGURE 2.2 corporate governance — principles-based v legal approach Prinoiples-based Legal approach Lawyers spend time trying to get around the legal rules Everyone knows where they are and should be able to A anply the rules ‘Thelegal epprozch leads toa ‘ick box’ approach to ——_—Principles are hard to explain so can be vague and ‘corporate govemance cifficuit to interpret Principies-based approaches can be aoplied to ary —_—Principles-based approaches are dificult to enforos in jurisdition and any legal system any meaningful way wthout egistaton or sanctionswot ee ee 19 Ir has to be said that most countries have preferred to adopt a principles-based approach because of its flexibility but this does require a commitment on the part of company directors to those principles outlined above, of accountability, transparency and probity. A code which is largely voluntary in nature can only be policed by consensus and if organizaticns are determined to flout the principles there are few practical sanc- tions. However, in most cases the advantages of good governance have proved ro outweigh the disadvantages so principles-based codes are proving to be effective around the world. AFTER CADBURY Cadbury's report was followed by several others. Seadernts need to be aware ofthe basic principles of these repors: Greenbury - 1995 — which looked at the question of directors pay, in particular the role of the Remu- neration Committee in setting remuneration levels, guidelines on remuneration policy, the level of dis- closure in financial statements and the question of terms in service contracts allowing firms to pay compensation when directors are dismissed for poor performance. Hampel - 1998 ~ which reinforced points made in the original Cadbury Report, in particular the sep- aration of the roles of Chairman and Managing Director and the balance of the composition of the Board between executive and non-executive directors, Turnbull- 1999 — which offered guidance on how directors should comply with corporate governance, focusing on internal controls and risk management. This report emphasized the importance of good internal and external reporting: ‘This requires the maintenance of proper records and processes that generate a flow of timely, relevant and reliable infor- ‘mation froma withir and outside the organization,’ it stated. The report also noted the key role that IT plays in creating internal controls and in assessing accurately the risks faced by an organization. Higgs ~ 2003 — which set out measures designed to improve the structure and accountability of board- rooms in the UK. It argued that boards should be free co criticize company management, and suggested limiting the number of directors that hold managerial positions to no more than half the board ~ the re- ‘mainder being non-executive directors. This proved controversial and Higgs has since admitted that his recommendations were too harsh. UK CORPORATE GOVERNANCE CODE ‘The UK Corporate Governance Code (‘the Code’), formerly known as the Combined Code, was, as we have seen, derived originally from the Cadbury Report and sets out good practice for directors in the areas of leader- ship, remuneration, performance monitoring and relationships with shareholders. ‘The Financial Reporting Council drew up revised guidelines that were published in June 2010 which updated the existing guidelines. These, as they apply to directors, are set out below in the section on ‘Directors’ duties’ ‘The Code is underpinned by a Financial Services Authority rule that requires companies listed on the Lon- don Stock Exchange to state, in their annual report, how they have complied with its provisions or to explain why they have not done so. This is the ‘comply or explain’ basis outlined above. ‘The headings ser out below are the key requirements of the Code. This is not a book on Corporate Gover- nance 30 they are not expanded upon here but each of the headings is underpinned by guidelines and sugges- tions as to how boards should interpret the particular requirement of the Code. Directors’ duties ‘The Code sets out the key principles of good Corporate Governance. Listed companies are supposed to abide by shis, but itis good practice for all companies ro abide by as many of these principles as are practicable.OvERNEN. 2 This leads us into the fundamental doctrine of ‘substance over form’ (see below) which seudents need to understand so they can appreciate the cheoretical framework on which corporate governance in the UK is built. VALUE OF GOOD CORPORATE GOVERNANCE One of the problems auditors may initially face when dealing with companies where corporate governance is not enforced through something like the Stack Exchange listing agreement (see later), is to convince manage- ment of the value of good corporate governance. Smaller organizations, in particular, may not accept the conditions around the structure of the board and may baulk at appointing non-executive directors. They will see the visible expense and, to some extent, the bureaucracy involved in corporate governance compliance and not be able to see the benelits which are, pechaps, rather more intangible. However, the benefits of increased accountability and transparency have been demonstrated by academic research which has shown that companies who adopt best practice corporate governance find it much easier to raise finance and are generally more profitable and less prone ro fluctuations in trading paterns than those run by small groups of owner managers. The benefits of appointing experienced non executives for example can bring a wealth of experience and knowledge to the board, which benefits the business in the longer term and the general improvements in inter- nal control and relationships with external audit increases the trust investors have in the financial statements, SUBSTANCE OVER FORM ‘The approach to regulating the activities of companies has been, at least in the UK, largely principles-baseds that is legislation is kept vo a minimum and directors, managers and auditors are expected to conform to a standard of ethical behaviour rather than be dominated by detailed regulations. In the USA the approach is quite the opposite. They tend to adopr a stringent regulatory approach, which has in the past, encouraged accountants and lawyers in the USA to devote a lot of time to trying to circum- vent the rules! ‘As the UK does not have that many cules, other than those considered necessary, such as the Companies Act, the Corporate Governance Code and the various accounting and auditing standards, accountants, and in particular auditors, tend to concentrate on the nature of each type of transaction or activity rather than how it is described. ‘This is known as substance over form. For example: The directors may have found a way to describe a small flightless bird with a beak and feathers as a chicken despite the noise it makes and the way it walks. ‘The auditor will look past the directors’ description and say ‘if it walks like a duck and it quacks like a duck = i's a duck!" In other words the auditors look past the form of the transaction, i. what it appears tobe or what it has been described as (chicken) o its substance, i. what i eally is (duck), This doctrine of substance over form is fundamental co corporate ceporting but is also a fundamental as- pect of coxporate governance ~ it requires the directors to cell the truth about what has happened and not to attempt to present or disguise financial information, for whatever reason. COMPANIES ACT 2006 The Companies Act 2006 incorporates within it specidic duties of disectors, Among other things s 172 down a specific duty on a company director to: © actin the way he considers, in good faith, would be most ikely to promote the success of the company for the ‘benefit of its members as & whole and to have regard to: © the interests othe company’s employess:Ww{ G CHAPTER + NTRODUC of 1855, Arguments advanced at the time against financial disclosure included the following, cather wonder- ful, propositions: ‘© AS there is no totally refabie way of accounting forthe sucess or otherwise of a business itis best not to attempt I ‘¢ The books could easily be manipulated by dishonest directors lathough quite why this was an argument against even attempting disclosure is hard to see) Disclosure would prejudice commercial secrecy and operators of companies would not lke their operations to be known ~ even by their own shareholders. ¢ Too much disclosure would create a false sense of securty among investors. Thar is not to say there was no accountability at all, but it was rather selective. Put simply, the financially ascute, the ‘insiders’, were very much of the same social class or milieu and moved in the same circles. They didn’t need publicly available information, in fact they tended to rather discourage the idea. ‘Outside’ share- holders, those not in the know, were simply seen as passive investors who took the risk of losing their invest- ment ifthe business failed. ‘Accountability really began in 1900 with the requirement to publish an audited balance sheet. The audit itself was first introduced in 1879 when banking companies were required to have an audit, a con- cept which was not generally extended until 1900. A Balance Sheet was not required to be submitted to the Reg- istrar of Companies until 1908, following the passing of the 1907 Companies Act, end private companies were exempted from this requirement. The 1929 Act required a Balance Sheet and Profit & Loss Account to be pre- sented to the shareholders annually but it was the 1948 Act, following the recommendations of the Cohen Report, that required greatly increased disclosure of che company's financial affairs and the actions of directors. ‘A key aspect of the Companies Act 1948 was that, for the firs time, auditors were required to have a pro- fessional qualification and it was that Act which laid the foundations of the modern auditing profession. Various Companies Acts have followed since then. In turn each one made its mark by: tightening the legal restrictions on directors and on the company itself setting rules concerring the issues of shares and the payment of dividends; setting the rules for minimum capital requirements for pubic companies; and ‘most partinently to our purpose, regulating the content of accounts, increasing accounting disclosure, the requirs- rents for accounts preparation ani the records to be kept. ee ee ‘The expansion of legislation has increased the level of compliance required and the consequent need for companies to create financial systems to both gather and present the information legally required and to con- trol its internal financial procedures Legislation has continued to this day, culminating in che mammoth Companies Act 2006, che largest piece of legislation ever passed in the UK. ~~ AUDITING THEORY, POSTULATES AND CONCEPTS ‘As with most topics in business, auditing has been the subject of a good deal of academic discussion in an attempt to divine a ‘theory of auditing” and to fit auditing into the context of the business world. These theo- nies consider the social purpose of auditing and attempt co establish some fundamental theories or truths. There are three basic academic writings which are considered fundamental to this area. 1) Theory of Rational Expectations In 1926 Professor Theodore Limperg of the University of Amsterdam developed a theory, known as the Theory of Inspired Confidence, which, eventually, became known as the ‘Theory of Rational Expectations. The theory holds thac the value of the auditor's report derives from the expert nature of the auditor as an independent, competent professional. Broadly, this is a dynamic cheory which holds that asthe business community changes so the expectations it has of the auditors’ function also changes. Limperg held that the wack carried ont by the auditor should be governed by the rational expectations of those who use their reports so auditors should not disappoint those expectations. Further, auditors should not seek to raise those expectations by any more than the work they do justifies.— THE WHY OF AUDITING INTRODUCTION TO AU Limperg's theory states that the usefulness of the anditor’s opinion is based on the general understanding society has about the usefulness of audic, Legal considerations aside, the necessity and cost of an audit is borne by companies because of the need of investors and lenders for reliable information to aid their decision making, If the audit process changed so that it ceased to inspire a uniform level of confidence in society, but instead inspized different levels of confidence in different users, society's confidence in the audit process would decline as the social usefulness of the audit was reduced. Limperg emphasized the social usefulness of auditors in meeting sociery’s expectations for reliable finan- cial information, The audizor must meet the expectations of the reasonably well informed layman but should not create any greater expectations than can be justified by the work carried out. The auditor thus has a wider responsibility to society and is not simply a watchdog for the shareholders. 2) The Philosophy of Auditing The key text in this particular field is probably that of RK Mautz and HLA. Sharaf who in 1961 published a monograph called The Philosophy of Auditing in the USA. This was the beginnings of attempts to codify a coherent theory of auditing and included discussion on the phi- losophy of auditing, methodology and auditing postulates or assumptions. They attempted to create order out of a somewhat chaotic mix of practices and ideas. ‘They held that auditing is based on scientific logic where the auditing process is a rational process of ex- amination, observation and evaluation of evidence. A full discussion of these ideas is not appropriate for this book but the essence of Mautz and Sharaf’s approach is that auditing practice should be built on a sound philosophy of auditing because basing actions on an underpinning philosophy means: ‘¢ going back to frst principles of what an aucitis, what purpose it serves and what usefulness it has for society, (¢ that knowledge has to be ordered in a systematic way; and it ‘¢ defines ausiting’s place in and usefulness to society, Broadly, Mautz and Sharaf adopted a scientific approach to auditing claiming that auditing practice, with its heavy emphasis on probability and a scientific approach to evidence, has much in common with scientific method. They developed eight tentative postulates or factors necessary for audits to achieve the desired result. These will be familiar to any student who has studied auditing or will become familiar to students who study this book: These postulates or assumptions are: 1. Financial statements and financial data are vettiable, There is no necessary contict of interest between the auditor and the management ofthe enterprise under aud 3 The financial statements and other information submitted for verfcation are free from collusive and other unusual irequierties. “The existence of 2 satisfactory system of internal control eliminates the probabil of regularities. Consistent application of general accepted principles of acoounting result infer presentation of the fancial posi- ‘ion ani the results of operations. 6 _ Inthe absence of clear evidence to the contrary, what has held true in the past forthe enterprise under examination wil nol true inthe future 7 When examining financial data for the purpose of expressing an opinion thereon, the auditor acts exclusively in the capacity of an auditor. ‘8 The professional status ofthe independent auditor imposes commensurate professional abigations, Whilst practitioners may disagree with these assumptions remember they are the basis of a theory, they are not definitive statements defining an audit. In practice they are there as a foundation or basis for inference and discussion, they are nor statements of universal uth. ‘Whilse these postulates or factors are useful in many ways, there are several key factors which Mautz and Sharaf did not consider which are of fundamental importance today. These ar ® The questions af risk end control which were nat considered to be as important in the 1960s as we. obs today, © Mauzz and Sheraf do not aay much attention to the concept of accountablity between oarties ¢.9. the accountabil- ity of the entity to the pubic or to investors. This was considered more by Flint (see below). Sider themOTN. 5 a ©The basis of Mautz and Sharat's approach is founded in scientific method which refers to evidence gathering pro- ‘cesses, the testing of hypotheses and probebilty theory. There are problems with this, particularly in the exercise cof an auditors’ judgement in the absence of conclusive evidence, and the fact that scientists are often able to repeat experiments when trying to vaidate an hypothesis, whereas auditors only get cne opportunity to gather the evidence they need, ‘© The ationships between auciting concepts in order to develop a general ramework of auditing. Whilst Mautz and Sharaf undoubtedly contributed greatly to the philosophy of auditing they were very much grounded in the idea of scientific method and paid less attention to the idea of auditing as a social phe- nomenon, ie. that it had a value to society generally and not just to those involved in the commercial entity. Iwas Professor Flint who added this dimension. 3) Flint ~ Philosophy and Principles of Auditing In 1988 Professor David Flint published Philosophy and Principles of Auditing: An Introduction which built on and updated the work of Mautz and Sharaf, He also developed a series of postulates as a basis for the development of a theory of auditing, Fline’s postulates or assumptions ar 11 The fundemental congition for the existenos of an aust is accountability, either private (e.g, between management and shareholders), or public accountability. 2. The subject matter of accountaiy is too remote, 1o0 complex anclor of too great a signifcance for the discharge of the duty to be accountable} to be demonstrated without the process of auc 3 Essential cistingushing characteristics of aucit are the independence of is status and its freedom from investiga tory and reporting constraints, All aspects of an aust, ts conduct, the work carried Gut and tts conclusions must be capable of being evidenced. ‘There have to be standards of accountability for those who carry cut auclts which form the standard by which actual performance can be measured. This means: ‘¢ that there are standards of accountabity for conduct, performance, achievernent and quality of information, i ‘© actual conduct, performance, achievement, cualty and s0 on can be measured and compared with these 2 standards by reference to known criteria, and ° ‘® that the process of measurement and comparison requires skill and the exercise of judgement. 6 The meaning, significance and intention of financal and other statements and data which are gudited are suff ‘ently clear thatthe crecibilty which is given to it as a resuit of audit can be clearly expressed and communicated. 7 An audit produces an economic or social benef. Flint’s postulates are based on the fundamental idea chat auditing has a social benefit and is not simply a technical exercise for the purposes of regulation for example. It is not the place of this book to expand on these ideas but perhaps students could consider the value of reliable financial informacion to stakebolders in 2 companies, for example: ‘to doth potential investors; to regulators of companies; to employees; to suppliers and customers; @ to the taxation authorities, eeee In addition to the work of Limperg, Mautz and Sharaf, and Flint outlined above, there have been other academic writings on this topic. Interested students could, perhaps, consult the work of Professor Tom Lee in his book Corporate Audit Theory (1993) but this appears to be aimed largely at the American market and, é whilst of interes, is t00 complex and academic for chis work. He has expanded the number of postulates to ‘ 14 quite wordy ones which occupy too much space to detail here. Ichas to be said that, in practice, the major auditing bodies, the three Institutes of Chartered Accountancs and the ACCA, have nor really shown a great deal of interest in academic auditing theories and there is scill no real universally agzeed conceptual framework for auditing beyond some rather vague stacements broadiy drawn from the postulates and theories outlined above, Srudents taking professional level examinations are . unlikely to be examined on these ideas. Students undertaking university degree courses however may well meet chese in the course of their academic studies and are urged to read the original works,THE WHY OF ALOIING FINANCIAL STATEMENTS As soon as the ditectors were required by law to prepare annual financial statements shareholders were able to access some financial information about the company they owned. The question was, and to some extent still is: isthe information the directors supply reliable, given the basic teness of agency theory outlined in Chapter 2 which highlights the conflict between the objectives of the directors (agents) and the objectives of the shareholders (principals). In other words, can the directors be trusted to tell the shareholders the truth, and the whole truch, about what they have done with the money the shareholders have given them? In theory the directors act in a fiduciary capacity towards the shareholders, What that means is that they are in a special position of trust charged with preserving the assets of the business and, hopefully, running it for the benefit of the shareholders so that it increases shareholder value and pays them some dividend. The fiduciary relationship between the parties places the onus firmly on the shareholders to be accountable for their actions and to be transparent in their reporting. We look at this further in Chapter 2. Even in the modern era, despite the developments and expansion of disclosure in the financial starements and the growth of accounting standards, practical access to detailed financial information by shareholders semains limited, Shareholders, or potential shareholders, may come to believe that they are not getting al the information, or the right information to enable them to make investment decisions, Financial analysts work- ing for major institutional investors may have rather more access to the directors of major corporations than the small investor, but even they have made mistakes and many of them have still lost their employers’ money despite their abilities and the access to information granted to them. Consequently the role of the auditor, as agent for the shareholder, becomes crucial and the costs of the audit are as nothing compared with the comfort and reassurance the audit affords the shareholders. The auditor's report on the financial statements also becomes crucial to the managers of the business as a favour- able opinion from the independent auditor confirms their actions and reinforces their credibility and reputa- tion as agents for the shareholders. Owners who appoint managers to look after their property will be concerned so know what has happened to it, Inthe case of companies, reporting and accounting for their actions is by means of che annual financial statements which the managers must prepare, and ic is through these that, ultimately, the owners of the busi- ness monitor the activities of their agents. The independent audit is a crucial part of this process to ensure that the financial statements faithfully represent the activities of the managers during the financial period. Financial statements can take many forms. The best known are the Statement of Comprehensive Income (formerly the Profit & Loss Account) and Statement of Financial Position (Balance Sheet) of the business. In the specific case of limited companies, financial statements are produced annually and take the form of an Annual Report and Accounts which includes a Statement of Comprehensive Income and Statement of Financial Position and also other statements including the Directors’ Report, a cash flow statement and ancil- lary reports. Parties to financial statements Historically, annual reports and accounts of companies were produced by the directors (as managers) to the sharcholders (as owners), and other people were not expected to be interested in them, However, today, a much wider range of people are interested in the annual report and accounts of companies and other organizations, The following people or groups of people are likely co want to see and use financial statements. These are often described as stakeholders: '¢ Actual or potentia! ‘Owners or shareholders; Lenders or debenture holders;ess LNA ets a, ss & CHAPTER 1. NTRODUCTION TO AUDITING ~ THEY UOTNG 1 © People who achise the above - e.g. accountants, stockbrokers, credit rating agencies, nancial journaists, ade tnions and financial analysts. ‘© Competitors anc peop interested in mergers, ameloamations and takeovers. ‘® The government, including the tax authorties, and government bodies concerned with consumer protection and the control and reguition of business, ‘¢ The publ, including those who are interested in consumer protection, environmental protection, and poitcal and other pressure groups. ‘® Regulatory organizations, for exemple those set up under the Financial Services and Markets Act 2000, principally the Financial Services Authority (FSA), All these individuals or bodies must be sure that the financial statements can be relied upon. WHY IS THERE A NEED FOR AN AUDIT? ‘As mentioned above, the problem which emerged when owners began delegating the running of an entity in which they had invested to managers, and thus sacrificed any involvement in the day-to-day control of the organization, is: can the owners believe the financial report prepared by their managers? We examine this in more detail in Chapter 2 when we consider Agency Theory. The report may: conten errors; not disclose fraud; bbe inadvertently misieacing; be deliberately misleading; fail to disclose relevant information; fail to conform to regulations. Owners of companies must be protected from: ‘© Unscrupulous management who would use the owner's investment for their own benefit and not thet ofthe owner Abuse of lritedlabilty where companies are delverately set up for speculative or high risk ventures because the intial investors have very lite to lose, and the managers perhaps nothing at al apart from their employmet. flat investors are not aware of compeny activity they coud be induced to invest in a project which carries a much (greater level of risk than the rewards they might actieve would warrant, The audit helps to reduce these so called agency costs as it helps to protect investors from the actions of predatory managers. The solution to this problem of credibility in reports and accounts lies in appointing independent profes- sionals to investigate the report and report on their findings. ADVANTAGES AND DISADVANTAGES OF AN AUDIT ‘Whilst companies which are required by statute to have an audit (Chapter 3) will naturally do so, smaller companies and organizations below the statutory audit threshold do nor need to have one, but many do. Why is this? There are advantages and disadvantages for organizations in having an audit of their financial statements. Advantages ‘© The provider of finance, e.g, a bank usually requires audited accounts. if they were to ask for their own independent audits this might increase costs to the entity. ‘© Audits can haip protect creditors which is important because of ited labilty i.e, owner/menagers of faling compa- ries Could simoly abandon the business, anc ther investment, leaving it to colanse owing money to suppliers. WrisING = THE WHY OF 1 this undoubtedly hapoens from time to time an audit can reinforce financial dscipine and act as an early warning i suppers. Againif no Sttutory audit is performed major suppllers might ask fr thar own independent aut i An aut helps estabish the credibly of the company at a time when fraudsters are committing so-caled ‘ong fir frauds - Le, bulding up trust over a period of me and then disappearing wih a substantial amount of money cr goods having created 2 false picture of the activities of the company. ¢ There may be shareholders who are not involved in the business and their interests need to be protected by an in- | 1 cependent auc. ‘© It provides reassurance for directors that the figures they are using are reliable. © Itimproves crecibilty of the profits or losses with HMIRC and assists in setting tax and VAT liabilities, ~ Disadvantages ; q ‘© Theres an argument that an audit is only for compliance and doesn't assist management in running the business ~ i tisempy re tape. | ‘The costs of the aucit represent a non-productive expense and the money could be better used elsewhere, ° Banks and other lenders, including suppers, can make thelr own conditions for lending and! don't realy need his- torical audited accounts, For example: ‘© banks willlend on security and personal guarantees; ‘© they wil monitor performance of the bank accounts; ‘© they may require regular monthly management information; | ‘¢ suppliers wil deal on a pro-forma basis (.¢. cash before suppl} unt a depth of trust has been established, | © Historical accounts, taking advantage of limited disclosure requirements, are ofits value as they can be up to nine ‘months ald when they become publicly available, INTERNATIONAL PRESSURES AND GLOBALIZATION “% Companies or groups can be very large with multinational activities and comprising many subsidiaries and related activities. The preparation of the accounts of such entities is a very complex operation perhaps involy- ing the bringing together and summarizing of accounts of subsidiaries with differing conventions, legal sys- tems and accounting and control systems. The examination of such accounts by independent experts trained in the assessment of financial information is of benefit to those who control and operate such organizations as well as to owners and outsiders. The existence of a strong auditing profession is important to global mar- kets because: ‘©. Relable nancial reporting promotes confidence and stably in the market, ‘© Markets need the confidence and the assurance a strong aut function oan tring in order to enable participants in the market, including the entities themselves, investors and potential investors, to make informed decisions, ‘© This involves reducing rsk to potential investors by providing them with ‘sound’ information, Corporate fallures, peticulaly those involving fraud by serior management, reduces confidence and creates instabity. It also tends to encourage increased reguieion which mey restiet market operations or encourege furtner deception, ‘© The concepts of agency highiighted in Chapter 2 require an auclting profession which is able to enforce standards ‘of accountability on compeny managers though the mechanism ofthe auditors’ report (Chapter 26) We look at this in more detail in Chapter 28 where we look at the audit of group accounts. Students should, however, be aware that the developments in technology which bave made possible increasing global trading and the expansion of capital markets have resulted in: ‘¢ Regulators requiring en improved standard of information, in terms of accuracy and timeliness, in order (0 protect investors. This apoiies partiouery to barks. ‘© Greater accountabilty anc control over coroorate executives running companies which may have revenues consid- erably greater then some countries. Increased corporate govemance requirements nave ied to increased acccurt- abilty and disclosure. 'j ; j 4 REL, SONAR. HR AUOTNG 8 © Conficts between the USA's rules-based approach to controt audi fms, based on the Sarbaries-Onley legislation, and the UK and other countries which have adopted @ non-legal auc ramiework based on se regulation, The two approaches necesseriy confict which has caused prabiems where the US junsdiction and compliance require ments clash with non statutory aporoaches to audit regulation (Chapter 2) ‘¢ The need for aucitors to use technology and to develop new approaches to the aucit of large, mutational bus: nesses. ‘¢ The problems faced by auditors and accountants in producing consolidated fencial information in compfance with @n appropriate accounting framework where the component information is prepared under a range of differing standards of qualty and disclosure (Chapter 28). This has always been diffcutt but increased global trading means that eucit fis have experienced an increase in the range and! significance of group component companies trading inlow cost economies where standards of corporete govemance are low and which produce information that has ‘not been prepared under recognized accounting or auciting standards. ‘¢ The growth of Internet-based ‘on-ine' trading which has chalenged conventional auclt approaches. Companies may trade globally and, apart from huge technical problems in auditing computer-based entities (Chapter 17), it may be diffcut to estabish which legal jurisdiction applies to such businesses and which set of standards and rules applies to them, ¢ Audit fms being increesingly required to carry out assurance type assignments (Chapter 31), These require @ lower standard of evidence than does an audit, There are moves among intemmational regulators to separate the uit function from other types of audit workin order to reduce the inherent conflet of interest this creates in aucit firms ~ i.e. that of acting both as auctor and advisor. ‘¢ The development of auciting mega-frms who, they claim, ere the only rms which have the resources to audit modem corporate beherrioths. The aust profession is thus dominated by the 'Big 4" (Price WaterhouseCoopers, KPMG, Emst & Young and Deloitte). Smaller firms with a lower level of global reach end those which have devel- ‘oped international networks claim that this reduces competition in the audit market for the biggest clents. The ‘Big 4° claim that they compete ferociously between themselves, ‘We look ar all of these points in more derail in the relevant chapters. OBJECTIVES OF AUDITING In one of its International Standards on Auditing (ISAs) (Chapter 5) namely ISA 200: ‘Overall objectives of the independent auditor and the conduct of an audit in accordance with international standards on auditing’ the Auditing Practices Board(APB), which is the body responsible for issuing auditing standards and guide- lines in the UK and Ireland, states: ‘The purpose of an audit isto enhance the degree of confidence of intended users in the financial state- ‘ments. This is achieved by the expression of an opinion by the auditor on whether the financial state- ‘ments are prepared, in all material respects, in accordance with an applicable financial reporting framework. In the case of most general purpose frameworks, that opirtian is on whether the financial statements are presented fairly, in all material respects, or give a true and fair view in accordance with the frame- work.” Here are some definitions and fundamental concepts that you need to know: Inthe UK the financial reporting framework is the Companies Act 2006 together with all te associated accounting standards stc. which comprise UK Generally Accepted Accounting Practice (UK GAAP). ‘© “Entity is 2 general term embracing all types of business, enterprise or undertaking including comparies local authorities, government agencies, etc. Some are proft oriented andi some are not. ‘* Presented fairy’ instead of ‘true and fair applies mainly to pubic sector bodies such as local authorities in the ‘commercial world andl for the purpose of this book we wil generally take the view that the auattors’ report use the words ‘true and ir ‘¢ {tis important to understand that responsibilty for the preparation of the fnancial statements and the presentation of the information included therein rests with the management of the enterprise fn the case of a company, the directors), The auditor's responsibilty is to report on the financial statements as presented by management, aries,10 STON TO AUDITING ~THE WHY OF AUDMING ‘¢ In the UK financial statements must conform to statutory or ather requirements, All company accounts have to Conform to the requirements of the Companies Act 2006 but many other bodies (e.9. charities, building societies, financial services businesses, etc.) also have detailed accounting requirements. in adaition all accounts should con- form to the requirements of Financial Reporting Standards [FASs). We do not cover the various financial reporting standards in this book in detail except where they are relevant to the audit, for example in the valuation of inven tories oF the provisions relating to the treatment of research and development expenditure. Students should make ‘themselves aware of the relevant financial reporting recuirements. «In addition to carrying out the audit accountancy firms also assist cheir clients with accounting and finan- cial reporting systems, taxation, financial risk management, takeovers and mergers and even advice on such matters as recruitment and environmental issues. This type of consultancy activity can, however, give rise to ethical conflicts and we will discuss this further in Chapter 6, DIRECTORS’ RESPONSIBILITIES Remember that itis the directors who are responsible for producing ‘true and faic’ accounts; the auditors simply express their opinion on them. The directors are the individuals who, collectively, have to struggle with presenting an accounting of their dealings with the shareholder's assets in as balanced and impartial a ‘way as possible, It is their task to explain themselves in a way that can be understood and that represents what actually happened in the financial period, Remember the principles of Agency Theory outlined earlier - the directors are accounting to the share holders (the owners of the business) for their actions during the financial year. As with many seemingly simple tasks this can be quite complicated, hence the plethora of accounting standards, bulletins and guidelines! AUDITORS’ RESPONSIBILITIES The auditors should be an independent firm appointed to carry out what is, effectively, an investigation of the organization, its records and the financial statements prepared for which the directors are responsible. The auditors must gather sufficient reliable evidence so as to be able to form an opinion on the financial statements as to whether or not they are free from significant error or misstatement and thus represent fairly what has transpired during the financial period or, of course, whether they do not. Under ISA 200, referred to above, the audit objective is not simply the expression of an opinion on a set of financial statements. What ISA 200 requires is that the auditor’s report is designed to enhance the confi- dence of a reader of the report which requires more than a simple expression of opinion. In fact what ISA 200 goes on to say is that the auditor must achieve the objectives in all the relevant ISAs, Failure to achieve the objective of any of the auditing standards may mean that the auditor has failed co achieve their overall objective, which could have ramifications for theit auditors? report. ‘The problems the auditors face are different from those of the directors. Their problems lie outside the area of simple bookkeeping and arise when the financial statements incorporave judgements, estimates and opinions. For example, the accounts might contain an estimace ~ made by the directors to the best of their ability - of the potential loss on a contract — but is itt @ = too much? © too little? @ shouldn't te there at ail? ‘The auditors have to decide whar they chink, based on the evidence they can gather, Ic is straightforward enough for a company that all the «eansections in the books are properly processed fand, as we will see lacer in this book, there is an audic approach which doesn’t even bother chee ing that this is so}, But how do the auditors?Dasa ome ¥ OF AUDITING ” © allthetre how co they know that all the transactions thet are included are bona fide ones and not transactions invented oy the directors to make the results look good? tions that should be incliuaed have been included; and They have to check the undeflying financial records, together with all the adjustments the directors have made such as provisions and accruals, and form their opinion, So, because the auditors are expressing an opinion, they use a term of art ~ ‘true and fair’. This carries with it implications of honesty, integrity, impartiality and objectivity in the telling of a story, which is what the accounts do, in as understandable a way as possible for the benefit of the people who, after all, own the business or have a significant vested interest in it In practical terms, and taking into consideration both the requirements of ISA 200 and the relevant provi- sions of the Companies Act 2006, the primary and secondary tasks of the auditors are as follows, Primary ‘The primary audie objective is to gather sufficient reliable evidence so as to be able to express an opinion, in the form of a report to the shareholders, of the truth and fairness of a set of financial statements prepared by the directors so that any person reading and using them can have confidence in them, Secondary In addition to expressing an opinion on the financial statements the auditors have also to report: that the financial statements are in accordance with the undertying financial records; that they comply with the relevant financial eeporting framework; < ‘that all information and explanations they require have been made available to them. In addition they may also advise management of any defects or problems with the controls within their accounting systems and suggese ways of improving them, TYPES OF AUDIT There are three types of reporting assignment, of which an audit is che most common, that accountants carry out. Statutory audits These are audits carried out because the law requires them, Statutes which require audits to be done include the Companies Act 2006 and the Financial Services and Markets Act 2000. Internal audits Internal audits ace conducted by employees of a business or by external auditors acting as subcontractors. ‘They are becoming increasingly important because of the development of Corporate Governance (Chapter 2). ‘These differ from statutory audits because the priorities are set by the management who, to some extent, con- trol the work of internal auditors, Other assurance assignments These are enquiries into specific aspects of an enterprise - management, value for money, environmental met ters, etc. In recent years auditors have become involved with areas which take chem away from their zole as reporters on financial tesults. Two of the areas of emerging significance are Value for Money auditing end audits relating to Environmental and Social matters. We will discuss these further in Chapter 31.2 OF SUOTING: In addition, auditors are asked to carry out specific ‘one-off assignments such ast ‘© Reporting on a prospectus for a share issue. © Carrying out a fraud investigation «© Reviewing systems and procedures, This book is principally about the stacutory audit, but we will look specifically at internal auditing and we will also review the auditors’ duties with regard to assurance assignments other than the statutory audit in later chaprers, ‘© The creation of limited fabilty for investors has resulted in the separation of ownership from control and has _ ‘eated the requirement for an independent objective report of financial performance. ‘© Academic writers have developed a series cf abditing assumptions oF postulates. which contribute to audi: ing theory but so far no everiding theory of auctting has-been formed. ‘© Financial accounting is the means by which those who have day-to-day control af an entity report tothe, ‘owners. The reports produced are used by my other people such as investors and other stakenoders. A ‘those who use the reports need to be able to have confidence in them. “The audtis the means by which this confidence is obtained. Increased globalization anct increased regulation has placed bigger demands on aucit firs. ‘Auditing is. concerned also with improving accounting systems and the detaction and prevention of error and freud, ‘Auditors form independent fms and carry out numerous other services for their clents, ‘There ara statutory and internal aucits and other types of assignment. POINTS TO NOTE ‘The individual auciter must be independent, a person of integnty and competent to carry out their work. ‘Auxitors give an opinion in their report, They do not cert or guerantee. ‘Students should be aware of the acaclemic underpinning of the audit profession but itis less relevant to orofes- ‘Sonal examinations than for university courses. It would benefit students to read some of the academic iterature ‘on auc theory ast wil aid an understanding of the,rle and function of aucttors and their relationship to society. ‘©. Auditing is.a global profession and developments in the business world have a direct effect on aucitors and their actions and processes. ‘¢ Anumber of auciting issues are becoming subjects of debate and controversy. These include increased requiation of enterprises and the effect on autor, increased regulation of aucitors, the extent of auitors'resacnsbilties for the detection and prevention of fraud, euottors' responsibiliies for environmental reporting, the gap between the pub's expectations of aucltng and the legal poston of aucttors, risk management, corporate governance, auci- tor independence and the whole future of auciting 2s a professional activty. The accounting orass has many articles on these and other aung issues and! students should read as much as oossibie abcut them. We look at these in more detallin Chapter $2. ©The arguments for and against an auclt are good exam subjectsProfessional issues are usually examined alongside ethical issues but can be examined in their own right. in addition, professional liability can be examined in conjunction with quality control as an audit which hasn't complied with quality control standards would generally mean that the auditor has been negligent. Typical exam questions may ask for respective responsibilities in respect of fraud & error or laws and regulations, or could ask whether an auditor has been negligent in a scenario. 4 Laws-and regulations Guidance regarding responsibility to consider laws and regulations in an audit of financial statements is provided in ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements. Responsibilities are considered from the perspective of both auditors and management. ISA 250 clearly states that itis the responsibility of management, with the oversight of those charged with governance, to ensure that the entity's operations are conducted in accordance with relevant laws and regulations, particularly those that determine the reported amounts and disclosures in the financial statements. In order to help prevent and detect non-compliance, management can implement the following policies and procedures: ensuring that operating procedures are designed to meet these y of conduct. | * Monitoring compliance with the code of conduct and acting appropriately to discipline employees who fall to comply with it, + Engaging legal advisors to assist in monitoring legal requirements. * Maintaining a register of significant laws and regulations with which | the entity has to comply. : yi <7 Monitoring egal requirements appeaba tothe company and | requirements. 4 * _Instituting and operating appropriate systems of internal control. | | * — Developing, publicising and following a code of conduct. | * Ensuring employees are properly trained and understand the code “ _thapter 8 151ee ee ‘The auditor is responsible for obtaining reasonable assurance that the t | In larger entities, these policies and procedures may be supplemented by assigning appropriate responsibilities to: | Anaudit committee | + Acompliance function, | + Aninternal audit function | | financial statements taken as a whole, are free from material misstatement, whether caused by fraud or error (ISA 200). Therefore, in conducting an audit of financial statements the auditor must perform audit procedures to - help identify non-compliance with laws and regulations that may have a material impact on the financial statements. The auditor must obtain sufficient, appropriate evidence regarding ; compliance with: + laws and regulations generally recognised to have a direct effect on the determination of material amounts and disclosures in the financial statements (e.g. company law, tax law, IFRSs). * other laws and regulations that may have a material impact on the financial statements (e.g. environmental legislation, employment laws). "Non-compliance! means acts of omission or commission by the entity, either intentional or unintentional, which are contrary to the prevailing laws or | regulations. Non-compliance must specifically relate to the business | activities i.e, transactions entered into on behalf of the company. It does not | include personal misconduct, | | | Non compliance with laws and regulations may lead to material misstatement if liabilities for non-compliance are not recorded, contingent liabilities are not disclosed, or if they lead to going concern issues which -, would require disclosure or affect the basis of preparation of the financial | statements. _ IFAC recognises that the auditors have a role in relation to non- | compliance with laws and regulations. Auditors plan, perform and evaluate their augit work with the aim of providing reasonable, though | not absolute, assurance of detecting any material misstatement in the | financial statements which arises from non-compliance with laws or | regulations.“i ieee cacti ek oe oO However, auditors cannot be expected to be experts in all the many different laws and regulations where non-compliance might have such an | effect. There is also an unavoidable risk that some material | misstatements may not be detected due to the inherent limitations in auditing (a 2 Audit procedures The auditors should perform procedures to help identify instances of non- compliance with those laws and regulations by: + Obtaining a general understanding of the legal and regulatory framework applicable to the entity and the industry, and of how the entity is complying with that framework. + Inspecting correspondence with relevant licensing or regulatory authorities. + Enquiring of the management and those charged with governance as to whether the entity is in compliance with such laws and regulations. + Remaining alert to the possibility that other audit procedures applied may bring instances of non-compliance to the auditors attention. + Obtaining written confirmation from the directors that they have disclosed to the auditors all those events of which they are aware which involve possible non-compliance, together with the actual or contingent consequences which may arise from such non-compliance. ISA 250 pro ist auditors when obtaining an understanding of their clients’ legal and regulatory environments. The | standard provides the following examples: + Using the auditor's existing understanding of the industry. * Updating the auditor's understanding of laws and regulations that directly determine reported amounts and disclosures in the financial statements. | | + Enquiry of management as to other laws and regulations that may be expected to have a fundamental effect on the operations of the entity. * Enquiry of management concerning the entity's policies and | procedures regarding compliance. | ray punusin 153154 Enquiry of management regarding the policies or procedures adopted for identifying, evaluating and accounting for litigation daims. (ISA 250, A7) The appendix to ISA 250 sets out examples of the types of information or situations that may come to the attention of the auditor and may | Indicate non-compliance with laws or regulations. These include: * Investigation by government department. + Payment of fines or penalties. + Loans or payments for unspecified services to consultants, related parties, employees or government employees. | + Sales commissions or agents’ fees that appear excessive in relation to those normally paid by the entity or in Its industry. ; + Unusual payments in cash. + Unusual transactions with companies registered in tax havens. + Anaccounting system that falls to provide an adequate audit trail or sufficient evidence (either by design or by accident), i * Transactions that are unauthorised. + Improperty recorded transactions. + Comment in the media. When the auditors become aware.of information concerning a possible instance of non-compliance with laws or regulations, they should: * understand the nature of the act * understand the circumstances in which it has occurred * — obtain sufficient other information to evaluate the possible effect on the financial statements * document their findings + report their findings to an appropriate level of management (subject to any requirement to report directly to a third party). apLan sua SHNGAudit procedures when non-compliance is identified + Enquire of management of the penalties to be imposed. + Inspect correspondence with the regulatory authority to identify the consequences. + Inspect board minutes for management's discussion on actions to be taken regarding the non-compliance. * Enquire of the company's legal department as to the possible impact of the non-compliance. 3 Reporting non-compliance * The auditor should report non-compliance to management and those charged with governance. + Ifthe auiditor suspects management or those charged with governance are involved in the non-compliance, the matter should be reported to the audit committee or supervisory board. * _ Ifthe non-compliance has a material impact on the financial statements, Modified opinion should be issued. The auditor should also consider whether they have any responsibility to report non-compliance to third parties e.g. to a regulatory authority. | Confidentiality is an implied term of the auditors’ contract. The duty of | confidentiality, however, is not absolute. In certain exceptional circumstances auditors are not bound by the duty of confidentiality and have the right to report matters to a proper authority in the public interest, Auditors need to weigh the public interest in maintaining confidential | ' client relationships against the public interest in disclosure to a proper | authority. Determination of where the balance of public interest lies requires careful consideration. Auditors whose suspicions have been | aroused need to use their professional judgement to determine whether | their misgivings justify them in carrying the matter further or are too insubstantial to deserve report. ' The auditor may need to seek legal advice before deciding on a course | of action. | i | ‘eo BUSHING 154 Engagement withdrawal “ 2 ‘The auditor may decide that the non-compliance with laws and regulations is so serious that they need to withdraw from the engagement (i.e. resign as auditor. In addition, if there has been a breakdown of trust between the auditor and management, or the auditor has doubts about the competence of management, the auditor may consider resignation. The auditor should take legal advice before embarking on this course of action. 5 Laws and regulations - summary LAWS AND REGULATIONS MANAGEMENT RESPONSIBILITIES AUDITOR'S RESPONSIBILITIES. Auditors! Considerations and procedures Apply professional scepticism Obtain an understanding Inspect correspondence Discussions Representations 196 rasan rueusens |DARDS AND RULES O PROFESSIONAL CONDUCT LEARNING OBJECTIVES Atter studying the material in this chapter you should be eble to: © Understand the importance of an auctor being independent from their cent ‘Discuss the difference between a principles-besed approach and a rules-based approach ‘© Understand the five ethical principles ‘© Understand the threats which might compromise ethical behaviour ‘@ Explain the role of the Ethics Partner 788 @ Explain the various prohibitions which serve to maintain aucitorindependence 9... ‘© Explain what is meant by the ‘Expectation Gap" a Understand contingency fee arrangements and the provision of non-audit services to audit clients. Understand the rules relating to insider trading and money laundering Appreciate the principles surrounding whistleblowing and the public interest INTRODUCTION Auditing, as we have seen, is carried out by accountants in public practice. A vital feature of auditing, for obvious reasons, is that the auditors must be independent from the management who are responsible for the financial statements and the owners who eeceive them. In the case of companies, the auditors must not be connected with either the directors or the shareholders. They must also be independent of government agencies or other groups who have contact with the business, For these reasons external auditors form themselves into independent firms willing to perform audits for a fee for whoever is able and willing to employ them. Some of these firms are very large with worldwide con- nections and employing thousands of people. Others are very small with sometimes only one or two princi- pals and a low number of staff Auditors have to conduct their audits, not only taking into account the relevant sections of the Companies ‘Act 2006, or any appropriate legislation, but also as instructed by Auditing Standards, Guidelines and Bulle- tins issued by, in the United Kingdom, the Auditing Practices Board. (Chapter 5) Accountancy is a profession and all professions have certain distinguishing characteristics which include an ethical code and rules of conduct. This chapter is concerned with the rules of conduct prescribed by the professional accounting bodies. ~ Questions on professional standards are frequently found in auditing examinations, as examiners see auditing papers as a suitable vehicle for examining ethics, even when they do not specifically relate to audit- ing. For the reasons set our in Chapter 2 in respect of agency theory, if for no other reasons, it is imperative that auditors retain their professional credibility and respect in the eyes of the investing public. Loss of trust. would be devastating to the financial world and it is for this reason that the recognized supervisory bodies (Chapter 3) place such a great emphasis on ethical behaviour by their members and inéractions of the rules are heavily punished. The standards are found in the handbooks issued to all members of their professional body. Students should be aware of the Ethical Code of the professional body they are trying to join as it applies to registered students as well as qualified members. In any case there are some generic ethical standards which are included in the ethical codes of al the professional accountancy bodies. ‘The Auditing Practices Board (‘APB’) has a Code of Ethics which sets out the standards of behaviour audi- tors are expected to meet and also includes standards applicable to auditors of smaller companies where there are particulae problems. The ethical codes adopted by the various accountancy bodies generally follow the APB’s pronouncements The APB's ethical codes were revised in December 2010 and most of the provisions apply from April 2011. The revisions are mainly poinis of detail for practicing accountants and che general principles are not alfected. We will incorporate the new provisions as appropriate in ths text In this chapter we will look at the fundamental ethical principles which underpin the auditor's day-to-day work. These principles are primarily based on the Auditing Practices Board’s Ethical Standard ES1 lnéegrity, Objectivity and Independence, Ethical behaviour in connection with certain specific circumstances, C3pamgeomee niin neti Seti iis ANDARDS AND A cu principally fraud, changes in professional appointments professional eriquetce) and professional liability will be deait wich in separate chapters. PRINCIPLES-BASED OR RULES-BASED APPROACH? Before we consider the ethical code in detail it is instructive to consider the approach taken by the APB and the accountancy bodies. We have used the word ‘rules’ in outlining the cequirements but, in some way, this is slightly misleading. ‘Whilst chese are rules inthe sense that they set out a series of ‘Do's and Don’ts' for practicing auditors they are not prescriptive set of requirements which attempt to cover every situation. Rather they form a conceptual framework based on fundamental principles. What this means in practice is that there are five fun- damental principles which, taken together as a code of conduct will enable the auditor to retain the required level of independence from their client and observe appropriate standards of competence and behaviour. For example, one of the fundamental principles is integrity. The ethical code defines it and says auditors ‘must have it and behave in an appropriate way. The rules point out one obvious problem, that of conflicts of interest, defines what they are and requires auditors to avoid them; and that is about it. ‘A rules-based approach would attempt to define for the auditor how to behave in specific situations cor when dealing with specific types of client. The accountancy bodies in the USA tend to adopt this kind of approach. Such rules-based codes tend to be much bigger and contain pages and pages of prescriptive requirements, There are advantages and disadvantages on both sides of course which can be summed up in Figure 6.1 ‘Ascan be seen from Fig. 6.1 rules-based codes are generally seen as inflexible and encouraging of legalistic style quibbling and ‘bending’ of the cules. Principles-based approaches are seen as flexible and place the onus ‘on the auditor to demonstrate compliance, rather than simply ticking a box, but their very imprecision may lead co misinterpretation or rule bending without there being much in the way of possible sanctions. Its dif- ficult ro discipline an auditor when the rules they are sapposed to observe are ambiguous or imprecise and use words such as ‘appropriate’. For example, what might be considered to be an ‘appropriate’ level of corporate hospitality from a client? Is it none at all, which is the rule in the public sector, lunch in the pub, a box at the opera, tickers to the Cup Final, a holiday in the Maldives; clearly that last one would be inappropriate but what about the others? If FIGURE 6.1. Approaches to ethical codes ~ principles- or rules-based? Conceptual framework - principles-based Rules-based ‘Advantages ‘Advantages ‘+ Flexible ~ capable of fitiig changing situations and + Provides certainty ~ auditor are told what to do circumstances * Contains definite prohibitions which reduces ambi- ‘+ Cane applied scross boundaries uily and the scope for personal ‘interpretations’ of + Crus is on the auditor to prove they have consid- the requirements ered everything and comply + Caninclude speciic prohibitions Disadvantages Disadvantages + Lack of precision may leed to ‘interpretations’ of + Encourages a approach to redefining or cles celta to ft stuation where there + Recuires judgement on the part of the auditor sreno ue ‘which can lead to cffering interpretations. + Can't clea ith every situation + Infexbie7 OMA you are the senior partner of a multinational accountancy firm dealing with a huge client, Cup Final tickets may not be classed as inappropriate, bur if you are a parmer in a small auditing firm dealing with a small client with financing issues it might well be torally inappropriate to accept an expensive gift from them. The auditor is alwajs required ro exercise judgement and discretion in such matcers, Whether a code is based on a conceptual framework or contains a prescriptive set of rules they both require the auditor to maintain their independence from their client and any action which might possibly compromise that must be resisted whether itis technically permitted by the rules or not, FUNDAMENTAL ETHICAL PRINCIPLES ‘These fundamental principles apply to all members of the professional bodies in some form and are the basis for the way auditors carry out their work and in their dealings with other people. Students must have a full understanding of these principles and should conduct their work in accordance with them. Ie is important to bear in find that auditors cannot give unbiased opinions untess they are independent from all the pasties involved, in particular their client. There is a dilemma, which we referred to briefly in Chapter 3 and which we will discuss in more detail later, in that auditors receive their fees from their client, ive, the entity they are auditing, and not from the shareholders to whom they report. Nonetheless, independ: ence from the client is crtical'to the carrying out of an audit and not only must audicors be independent in fact and in attirude of mind but chey must also be seen to be independent. Curiously independence is not one of the Fundamental Ethical Principles ~ but the ethical principles taken together are designed to ensure that auditors become and remain independent enough to be able to give a clear and unbiased opinion, The five Fundamental Principles aret Integrity Auditors should behave with integrity in all professional, business and personal financial relationships. Integ- rity includes not merely honesty but fair dealing, cruthfulness, courage and confidentiality. One of the issues which might compromise integrity is the question of a conflic of interest. This can arise whe: ‘¢ The duty of an auctor to be impartial confiots with some personal interest they may have inthe cent. This confict may arise in the context of both business and personal relationships. For example, auctors a farily companies ay develop a personal relationship with cirecter/shareholders over time which may compromise the auditor's abi- ity or wilingness to challenge their cients actions if this is warranted and speak honestly to ther, © Auditors or acoountants find themselves advising both sides in a dispute. Clearly they cennot act impartaly for both partes and must take steps to extricate themselves ftom that situation. Objectivity Auditors should strive for objectivity in all professional and business judgements. Objectivity is the state of mind which has regard to all considerations relevant to the task in hand but no other. It presupposes intellec- tual honesty and excludes bias, prejudice and compromise, Auditors must give fair and impartial considera- tion to all matters relevant to their task and disregard all those that are not. Objectivity must not be impaired by conflicts of interest (see above}. Confidentiality The auditor must treat all and any information gathered during the cousse of their audit as confidential and should aot disclose any isformation to thisd parcies withour their cliene’s permission or unless there is a legal or professional duty to disclose, Iris important that management of an audit client can rely onac, FOF ONAL 79 ALS the auditors so teat the information obtained during the audit as confidential, unless they have authorized its disclosure or itis already known to a third party or the auditors have a legal right co disclose it. ‘Accountants should not use any information gathered during the course of their professional work for their own personal gain Competency ‘Aitditors should not accept or perform work which they are not competent to undertake unless they obtain such advice and assistance as will enable them to carry out the work competently. Auditors should carry out their professional work with due ski, care, diligence and expedition and with proper regard for the technical and professional standards expected of ther. Professionat behaviour Auditors should behave with courtesy and consideration to all with whom they come into contact during the course of performing their work. They should also comply with relevant laws and regulations and avoid any behaviour which might bring their profession into disrepute. ETHICS — GENERAL RULES Professional accountants are required to observe proper standards of professional conduct whether or aot the standards required are written in the requirements or are effectively unwritten rules of implied standards of behaviour and conduct, Each professional body issues its own ethical standards for its members based on the Auditing Practices Board (APB) model. Clearly, auditors are specifically required to refrain from misconduct, which is difficult to define precisely, but which includes any act or default which is likely to bring discredit on themselves, their professional body. or the profession generally. Several general points can be made: ‘*Aswe have already saic professional independence is exceedingly important, Tis is very much an attitude of mind ralher than a set of rules but there are many speciic requiements which we wil describe later. Auditors who ‘observe the general princioles outlined above will be able to act independently without any further prompting from. their professional body. ‘© Integrity is vital. Synonyms for intagrty include honesty, uprightness, probity, moral soundness and rectitude. Aud {os ere required to have the intelectual honesty to come to their own conctusions and the courage to defend their opinions in the case of any dispute. An important aspect of integrity is confidently '® Accountants must not only be people of integrty and independence; they must also be seen to be so. Any interest (eg. owning shares in a cient company) which might diminish an accountant's objectivity of approach, or which ‘might appear to, mast be avoided. ‘© When auditors have ethical ciffculies or are unsure of what course of conduct to follow, they should consuit their professional body or take lagal advice. fin doubt always seek advice. Ethics pariner Audie fi ms should appoint an Ethics Parmner, whose role is © to ensure that standards of professional conciuct are maintained: ‘® — toorganize training for staff and parwners cr directors on ethical matters; © to ensure client review procedures are progerly carried out: ° xich as contingency fee arrangements or treats to indepencience caused by involernent with to review clients.20 GENERAL ETHICAL THREATS Compliance with these fundamental principles may potentially be threatened by a broad range of ciscum- scances. Many threats fall into the following categories: © Self-interest threats, which may occur as a resut of the financial or other interests of a professional accountant (or of an immediate or close family member. ‘@ Self-review threats, which may occur when a previous judgement needs to bs re-evaluated by the accountant ‘originally responsible for that judgement. © Advocacy threats, which may occur when an accountant promotes a position cr opinion to the point thet subse- quent abjectivty may be compromised. ‘© Familiarity threats, which may occur when, because of a close relationship, a professional accountant becomes ‘too sympathetic to the interests of others. ‘® Intimidation threats, which may occur when a professional accountant may be deterrad from acting objectively by threats, actual or perceived. Safeguards that may eliminate or reduce these sorts of threats to an acceptable level fall into two broad categories: ‘© sslequards oreated by the profession, leglsleton or raguaton; and safeguards in the work envionment, Safeguards created by the profession, legislarion or regulation include, but are not restricted to: Educational, training and experience requirements for entry into the profession, ‘Continuing Professional Development, Corporate governance regulations. Professional standards. Professionel or regulatory monitoring and ciscipinary procedures by the ASB. Safeguards in the work environment include generally avoiding or minimizing threats to auditor objectiv- ity and independence. We discuss these in more detail below. . THREATS TO INDEPENDENCE As we have seen the auditors’ independence and objectivity must be beyond question when conducting an audit, The’audicors’ must always approach their work with their integrity and objectiviey unimpaired by any of the threats to their independence outlined above. There are a number of matters which may threaten or appear to threaten the independence of an auditor. These include: Undue dependence on an audit client Public perception of independence may be put in jeopardy if the fees from any one client or group of con- nected clients dominate the auditors’ practice. To avoid this happening the RSB's have a rule which states that the income from any one client must not exceed 15 per cent of gross practice income or 10 per cent in the case of listed or other public interest companies. This is generally known as the 15 per cent rule, This general observation needs modifying in the cases of new practices. Clearly this is a guideline and a certain amount of flexibility is permissible in practice, but audit firms must be prepared co resign from a client's audit where the fee income from that client starts to exceed this 15 per cent {or 10 per cer limit. Firms would be wise not to have one client which dominates their practice as the consequences of this, the intimida- tion threat detailed above, could lead the individual auditor on to some very unsavoury, unethical paths. Care should also be taken by individual audit parmers within firms where theie potfolic of work is nated by one of two clients, Iti for this reason, if for no other, that regular cotation of audit parsners period of time, suggested to be five years, isa recommended practice,Jeane, TaN Spence RAN, Sane “Pesce Demerien! _ ies ewe _Jitionint._ Sac CHAPTER 6 ETHICAL STANDARDS AND ULES OF PROFESSIONAL CONDUC a Family or other personal relationships It is essential r0 avoid professional relationships where personal relationships exist. Examples of personal relationships include ritual business interests between members of the group comprising the client, the audit ficm, officers or employees of the client, parmers or members of staff of the audit firm. In addition, family ot personal relationships must be avoided, For example it would be extremely unethical for an auditor to audit a company where: ‘¢ Members of thet family had @ maior interest even if they did not ¢ A.cose relative or the aucitor's spouse was a sanior officer or director ofthe company. @ The aucitor had worked for the company prior to joining the audit frm or a member of the aucit team had joined the client in senior capacity. We look at this situation in more detail below. Involvement in the audit in these circumstances could give rise to the familiarity or intimidation threats outlined above so this must be avoided. Beneficial interests in shares and other investments Partners, their spouses and minor children should not hold shares in or have other investments in client com- panies. This extends to investments in pension funds or family trusts as well as individual holdings by them- selves or by a close relative. ‘An audit staff member should not be employed on an audit if thar staff member or some person connected with him or her has a beneficial interest in the audit client. In most firms the rules which apply to partners are extended to all staff and audit firms will take steps to ensure that none of their staff or families have any interest in audit clients. Loans to and from clients ‘An auditing practice or anyone closely connected with it should not make loans to its clients, Firms or indi- viduals within audit firms should not receive loans from clients, unless they are on the same commercial terms as an ordinary member of the public would receive, ie. on an arm's-Length commercial basis. The same applies to guarantees. ‘Note that not collecting fees for an unrealistic amount of time could be interpreted as a loan to a client so fees should be collected under normal trade terms. Acceptance of goods and services Goods and services should not be accepted by an audit practice or by anyone closely connected with it unless the value of any benefit is modest. Acceptance of undue corporate hospitality poses a similar threat; a box of chocolates as a gift is probably acceptable, but a weekend in Paris would not be. Acceptance of continuing or excessive corporate hospitality, for example regular attendance at football matches with a client, may well lead to the perception that the auditor’s objectivity has been compromised. Actual or threatened litigation Litigation or threatened litigation (e.g. on auditor negligence} becween a client company and an audit firm would mean the parties being placed in an adversarial situation which clearly undermines the auditor's objectivity Influences outside the practice There is a risk of loss of objectivity due to pressures from associated practices, bankers, solicitors, govern- ment or thase introducing business.Provision of other services This is acceptable in principle, but care must be taken to ensure that the quality of audit work is not compro- mised because of the urge to cross-sell other, more lucrative, secvices to the client. In previous years the urge to cross-sell advisory services t0 clients led to the practice of ‘lowballing’ where audit firms would quote unfeasibility low fees to a potential audit client so they could sell additional services at a later date. This is, generally, prohibited by the regulatory bodies and auditors must be pre- pared to justify the fees charged to the client in terms. of work done, hours spent and rates at which staff are charged out. In the case of audit fees there is a specific requirement, in Ethical Standard ES4, thar the size of the audit fee should not be influenced by fees charged to the client for other services. There is no evidence that ‘lowballing’ compromises audit quality as the regulations and the fear of litiga- tion generally ensures that auditors try and deliver a quality service to their client irrespective of the size of the fee charged. The problem is one of independence. Firms must ensure that advisory and other services sup- plied to clients: © Are separate and cistinct from audit services, ie, that there are no common personnel involved in both activities. © Donot inckide any form of management decision making. ‘® Donot include the design of any systems which ight later be audited by the same firm, ‘We look at this in more detail below. COMMISSIONS AND FEES Auditors should not allow their judgement to be swayed by the receipt of a commission, fee or other reward from third parry as a result of advising a client to pursue one course rather than another, IAS 220 ‘Quality control for an audit of financial statements’ requires audit firms to review their relation- ship with every client on an annual basis to determine if itis proper to accept or continue an audit engage- ment, bearing in mind actual or apparent threats to audit objectivity. ‘Warnings are included in the ethical guides of the professional bodies of the risks to objectivity in per- forming non-audit services, but these all fall a long way short of prohibition, Fees The normal basis for charging for professional work is on the time spent on the work calculated at appropri- ate hourly rates for principals, senior and other staff. The hourly rate may vary according to the difficulty o complexity of the work involved. Iris up to the accountants to decide upon their hourly rates depending on cost structures, the complexity of the work, the timetable for completion, market conditions, ec. It is not permissible to charge on a percentage basis except where statute or custom allows, ¢.g, in liquida- tion and receivership work, nor should audits be cazried out on a contingency fee basis. Accontingency fee is one based on the achievement of some goal or target, for example, a fee based on the successful raising of finance. I is possible for accountants to charge for non-audit services on a contingency fee basis, however, the basis of charging such fees must be notified co the client in writing and agreed by the client. This practice is, however, discouraged by the RSBs. Accountants who receive commissions from stockbrokers, insurance brokers, et. for transactions effected for clients or for trusts of which the accountant is a trustee should either: ‘* ass on the cornmissicns to the clent or trust by deducting the amounts received irom their fees and showing the deduction on the invoice: or p the commissions # specifcaly authori 0 t0 do 80 by the client,epg AR PRIN, eet Memmi RI meron jiieemioe Hermann SUPPLY OF NON-AUDIT SERVICES One of the major problems which the audit profession is wrestling with is this question of true independence from the audic client where they supply additional consultancy type services. This topic is continually under review by the professional bodies. It was a contributory factor in several recent financial scandals where the audit firms in question seemed to lose their objectivity and become unnecessarily involved in the affairs of their clients. The most shocking example of this was the demise of auidit mega firm Arthur Andersen following the collapse of Enron and WorldCom in the USA. The question to be answered by the profession and by individual audic firms involved in the supply of such services is this. Can an audit firm offer a totally dispassionave opinion if it and/or an associated firm are sup- plying services such as: © financial accounting; ‘© assistance with preparing the annual accounts; © intemal aust; textion and tax planning; management advisory senices; © HR consultancy; selecting comouter system litigation support; © corporate financial advice e.g. on capital raising or takeovers? Generally the rules clearly require a separation of the staff providing advisory services from those carrying cout the audit. There should be a system of what have become known as ‘chinese walls’ within the accounting firm to ensure that information disclosed in an advisory capacity is not revealed to audit staff and vice versa. ‘This may seem perverse, but it retains the independence of each set of staff to carry out their defined soles as if they were from separate firms and not merely different departments of the same firm. This does pose difficulties ro very small firms, but chey have to find a way of abiding by chese principles and retaining their objectivity and independence. In most cases small firms carry out litle or no statutory audit work because of the size limits on firms which no longer have to have a statutory audit, so much of their work is advisory rather than audit based. Te is understood that the nature of preparing complex accounts must necessarily require that some services (eg, finalizing the financial statements) should be performed by che auditors. However, any such assistance should be solely of a technical or mechanical nature and any advice given must be of an informative nature only, The auditor can advise on issues but must not take part in making any management decisions. The over- riding rule is that the auditor should not be involved in decision-making and, where there is a threat to inde- pendence, the risk has to be reduced to an acceptable level. Where non-audit work is taken on a contingency fee basis the audit firm should consider the effect on the firm and should notify an Ethics Partner that such an arrangement is contemplated. The audit firm should not undertake an engagement to provide non-auiit services in respect of an audited entity on a contingency fee basis where: ‘8 the contingency fee is significant to the aucit fm, or that part ofthe frm by reference to which the aucit engage- ment partner’ proft share is calculated or '® the outcome of those non-aucit services (and, therefore, the amount of the fee) is dependent on a future or con- temporary audit judgement relating toa material matter in the financial statements of an aucited ently. CONFLICTS OF INTEREST Conflicts of interest can arise between accountants and their client. Conflicts of interest can also arise berw: acclient and another client, and accountants should not act for both parties if the parties are in dispute,RULES OF PRO pucT Conflicts can arise where auditors have some kind of personal or business involvement with their client, The specific prohibitions outlined above will prevent financial involvement in the client's affairs but the de- velopment of personal relationships is more problematic. Auditors should be aware of the familiarity threat shown above which can create conflicts and compromise independence, For example, the accountants may be called upon to advise two clients who are tendering for the same contract; or they may be advising a company and also one of its directors who are in dispute. In all such cases the accountants should not accept assignments where chey are put in a position where they are being asked to-advise both sides. On the other hand they may well be able to put forward proposals to settle the dispute. Specific examples of conilict of interest include: ‘© Provision of other services to aust clients. Its customary for auciters in many cases to provide other services as well as the audit, for exemple preparing tax computations. This is perfectly acceptable providing the service does ‘ot involve performing executive functions or making executive decisions, For example, discussing the annual cii- ddend decision with the board would be an executive action and hence unacceptable, '® Preparation of accounting records, Care should be taken thet the cient takes responsiblity for the work done and that objectivity in auditing is not impaired. The accounting records of publc company clents should not be pre- pared by the auditor. © Apractioe should not report on a compary if company associated with the practice is the company secretary to the cent, However, itis acceptable to provide assistance to the compeny secretary. Aswe have seen no person in an accounting firm should take part in the audit of a compary ithe or she has, inthe accounting period or, it is fecommended, in the previous two years been an officer or employee of that cornpany. ‘This may cause a confit of some description so the postion is best avoided. ¢ There is no similar rule regarding a senior member of the aucit staff or @ partner joining an audit cient, however, where an individual is indicating an intention to join a cent they should be taken away ftom any invohement with that cients affairs as soon as practicable, Again it is recommended that a ‘cooing-of? period be instituted where the individual who proposes to join.an audit cent is taken away both from the aut and from any possibilty of infiu- encing the course of the uci or the aucit fms approach to the aucit, The more senior the individual the more probiernatic this becomes. {fit is not possible to have any sort of cooling-off period; the aucit team should be changed and, if possible, a ‘new audit approach instituted with a diferent tearn, The involvement of the former employes should be monitored to ensure there is no question of undue influence being brought to bear on the auait work, ‘¢ Receivershio, liquidation and audits. In general, auctors should not accsot receiverships or appointment as a liqu- detor of cent companies without a thres year gap between the assignments, Clearly a fquidator of a company ‘would be inhibited from taking 2 negligence action against the aucitorifhe had himself been the auciter. ADVERTISING AND PUBLICITY There are still considerable restrictions on advertising. Any advertisement should not: bring into disrepute themselves, any member of the professional body, the fim or the accountancy profession generaly; discresit the services of others by, for example, claiming superiority; contain comparisons with other members or rms; beristeading, ether crecty or by impication: ‘all short of the Advertising Standards Authority as to legality, decency, honesty and truthfulness. Adverts may refer to the basis on which fees are calculated, but this is often best avoided. Firms must be careful about comparisons with other audie tirms to avoid being misleading. Under certain sitcumstances they may offer free consultations and possibly discounts, but this has to be handled very care- fully. Audits may not be carried out free of charge or ata discount! None of this means thar accountants’ advertiserscats need be dull or unimaginative; many firms have put our exciting adverts but whether they are also ‘attractive’ is a different macter.ROFESSION Accountants may advertise for work and engage in other forms of publicity, for example, by posters or hoardings or on movor vehicles, on sportswear or by sports sponsorship providing that the advertising itself is considered concomitant with the dignity of the profession, Accountants may not make any unflattering references to, or comparisons with, competitors or other professional service providers. Accountants may pay an introductory commission, fee or reward to a third party for introducing clients, however, itis advisable that such payments are declared to the client. ETHICS AND QUALITY ISSUES The professional bodies require strict adherence to the ethical codes and have considerable enforcement mechanisms, Of course ethical codes should be obeyed in the spirit as well a5 the lever but this intention sometimes crumbles in the face of commercial pressures. The use of aggressive accounting practices in order to maintain profits (and often, coincidentally, bonus payments}, can put auditors under severe pressure. No firm is willing to lose a large client and the temptation must be to bend and stretch the cules as far as possible 10 accommodate the client. This is not to say that audit firms succumb to pressure, but the reality is tha the audit world is very com- petitive and results have to be maintained, The inczeased use of risk management approaches must not change ethical behaviour that the truth stops being truth and starts becoming the fact that no one found out you lied There are three key issues: @ The profession had a severe shock following the destruction of the giant auditing firm of Arthur Andersen, post- Enron, and it is that which prompted the regulators to look closely at quality control and to ensure that lapses in ethical behaviour are punished. The reguiation of the profession is moving away from the RSBs towards government based regulators such as the Financial Reporting Council (‘FRC’) who ere demanding a greater say in how the profession is regulated but ‘whether this wil result in the public's having any greater perception of the independence of the profession remains to be seen. © Research Indicates that the ‘expectation gap’ (see below) 's stil a real issue, The question of trust remains vital. A major loss of trust by the investing public could result in a severe shock to the financial worid and the role of the independent, ethically sound, technically competent auditor remains central to that trust. Whilst companies are undoubtedly responding to the rise in Corporate Social Responsibility their primary function is to create wealth and increase shareholder value, so their ethicel progress may well be corralled within financial realities. THE EXPECTATION GAP ‘The Expectation Gap is the difference between whar auditors actually do and what the public think they do. Research has shown that there is a wide misapprehension between the public, including some financial jour- nalists’ view of the auditors’ role and what it actually is. Typically public perceptions of the auditors role is that audito Prepare the fnencial statements. Check every ent in the bocks. Find fraud, Take responsibilty for nancial statements, Ensure financial statements are ‘accurate’ Give early warring of business faire, ‘The audit profession is attempting to reduce the expectation gap bur ench financial crash or failing always brings questions as to ‘why didi’t the auditors tell us?? The protession has, clearly, still some way to go.ESSIONEL CONDUCT ETHICAL STANDARDS — SMALLER COMPANIES ‘The Auditing Practices Board has issued a set of ethical standards applicable to the audit of smaller compa- nies, ‘Provisions Available for Small Entities’. ‘The standard recognizes that there are particular circumstances applicable to the auditing of smaller enti- ties, ‘Smaller entities’ are defined in the standard and include not only small companies and groups as defined above but also such organizations as small pension funds (less than 100 members) and registered social land lords with less than 250 units, The standard atremprs to take account of the close relationships which often exist berween auditors of small companies and their clients, in particular where the auditor may well provide some of the financial information such as tax liabilities or a limited amount of accountancy services. Init they point our a number of dangers the auditor faces when dealing with such clients. These are ‘The auditor is not required to carry out an external independent qualty control review of the kind detailed in Chapter 7. The frm must be awars of the ‘self review" threat where the audit firm is providing services in addition to carrying ‘out an audit. Auditors of small businesses often contribute to the preparation of the accounts and usually perform ‘other tasks for the business (tax matters, IT advice, etc.) and this close acquaintance with the business can consti tute good audit evidence in some circumstances. The danger is cbviously that the aucitor can be auditing their ‘own Work and that there is a lack of independence and no objective overview of the figures. The auditor should dis- ‘cuss the situation with what the standard describes as ‘informed management’ and include a review of the client in @ cycle of intemal quality control reviews to ensure that independence is not being compromised. © There is the danger that, in the absence of capable management, the audit frm will make what are, effectively, Management decisions. This is the 'manegement threat’. The ethical rules state that aucit firms should attempt to avoid any situation where it has to become invoived in the decision-making process, but the APB recognizes that ‘this may not always be possible. This standard creates an exemption frorn the ethical requirement providing the ‘frm explains to the management the need for it to retain its objectivity and independence. This can be difficult as ‘smaller organizations, lacking financial expertise, may well see the aucitor as some form of quasi financial director ‘and ask the auditor for their opinion on the merits of particular strategies or commercial activities. The auditor must ‘decline to give such an opinion as this would severely compromise their Independence, even if this results in some Cooling of the relationship with their client. ‘@ The APB Ethical Standerds require that the ausit frm should nat act as an advocate for its cllent in any tribunal or Court - this is the ‘advocacy’ threat. The danger is for example, where the audit firm provides, say, tax services, ‘that it will be drawn into an appeals procedure which will result in the firm appearing in the tribunal on behalf of the client. This will, again, reduce independence and objectivity. Again the standard creates an exemption from this requirement for the small client providing the ethical position is discussed with them. ‘There are provisions in the APB Ethical Standards regarding an audit partner leaving an audit firm and joining a client where at any time in the previous two years they have been a lead audit partner, an independ- ent review partner or in the chain of command of the firm. It states that in these situations the firm should re- sign as auditors and not accept reappointment for a two-year period, This provision is relaxed in the case of smaller entities providing the audit team can demonstrate that the employment of the former partner does nor present any threat co the integrity, independence and objectivity of the audit team, If the auditors take advantage of any of these exemptions they must disclose the fact in their Auditors? Report. INSIDER DEALING Jn addition to being totally contrary to the ethical rules, insider dealing is illegal under various statutes, prin- cipally Part V of the Criminal Justice Act 1993 and The Financial Services and Markets Act 2000 which defines market abuse. The fundamental rule is that individuals who, duriag the course of their work, come across ‘unpublished price-sensitive information’ are prohibited from dealing in securities to which that infor- mation relates. ee| | | | — mace. ICAL STANDARDS. 87 Unpublished price-sensitive information covers specific matters not generally known zo those who nor- mally deal on the Stock Exchange but which, if it were known to them, would alter the prices of those secur ities o which che information relates. The prohibition applies to anyone who has @ connection at present or had one at any time in the previous six months and to any third person whom the insider may wish to instruct ‘Anditors with their close connection with the accounts of a public company client are often in possession of insider information, For example, they may know that the profit is £12 million when the marker is expect- ing only £10 million. They must not take advantage of this information by buying shares in the company on the expectation of arise inthe price when the accounts are published, MONEY LAUNDERING Money laundering is the process by which criminals try to conceal the true nature of proceeds of illegal activ- ities. The term includes possessing, in any way dealing with or concealing the proceeds of any crime. This includes monies generated through tax evasion, bribery and corruption or the operation of gangs involved in more conventional criminal activities, such as drug or people smuggling, illegal arms trading, theft and robbery, etc. The relevant legislation is contained in: The Proceeds of Crime Act 2002. @ The Money Laundering Regulations 2007, @ Terrorism Act 2000. ‘The broad provisions are that firms must appoint a “Money Laundering Reporting Offices’ (MLRO) to deal with the whole matter. The job of the MLRO js to receive and assess reports about suspicious transac- tions from partners and staff and to make reports to the Serious Organized Crime Agency (SOCA). The reports must give full details of che suspicious transactions and the identities of the persons involved. Jn addition, firms must put in place systems and procedures which fundamentally ensure that staff are aware of their responsibilities under the legislation and thar the firm itself has procedures and internal controls ‘which will enable suspicions transactions to be identified and reported in accordance with the regulations. In particular these should include procedures which ensure that: © Before accepting an assignment they take all necessary steps to establish that their potential new client is who it claims to be. This can inciude proof of identity for individual clients and inspecting the company certificate of incorporation @ = Ifthey handle cients’ money accountants have controls which ensure that the identity of the client, the commercial purpose of the transaction, the source of the funds and their destination are known and verifiable, ‘Staff have training in the regulations and how to identity suspicious transactions, ‘The firm has procedures to review client's activities on an ongoing basis. “Suspicious transaction reports’ are madi to the MLRO should they be identified. ‘The MLRO reports these to the SOCA. eeoe Generally firms commit an offence under the regulations if they fail to implement these procedures, Jn addition, there are some other offences which can be committed under the regulations which the stu- dent should be aware of. These are: ‘¢ Attempting, conspting with or citing someone to commit an offence. Aicing or abetting an offence or achising on the commission of an offence, Cbiaining, concealing or investing funds or property knowing or suspecting that they are the proceeds of crime or ‘nds for terrorist activity ‘» Doing or disclosing anything that might prejudice en investigation inte morey ‘auncering a5 Tipping off. ‘© Proceecing with a transaction without the consent of the relevant authority after having submitted @ Suspicious Transection Report. ities this 's known88 Suspicious transactions © | ‘Whilst carrying out their work auditors are expected to be on the alert for suspicious transactions (see Chap- ter 20). Risk factors which can be associated with such transactions are: | ‘© ‘Secret’ or ‘confident’ transactions which are deat with outside the main accounting systems, possibly by one individual or 2 small group. Be aware, however, that secrecy cen be associated with cornmercal confidentalty and | be perfecty innocent. | i ‘¢ Routeing transactions through tax havens or counties with sx fiscal rules. ( i '» Routeing transactions through several countries or insttutions. { ; © Routeing transactions through @ country diferent from the one from which the underving transaction is sourced, | €.g, services are purported to be bought from Country A but payment is made to a bank in Country B. Note that =| there may be underlying commercial reasons for this such as foreign currency hedging or even tax evasion by the |” ‘supper, but itis suspicious and should be investigated. i © Frequent use of wire transfers or money transfers which do not disclose details of the ultimate recipients of the | funds, eg. transfers to overseas lawyers or nominee Dank accounts 4 ‘© Transactions wich invotve the use of large amounts of currency or ‘bearer’ financial instruments (nancial instru- ‘ments which can be cashed by the person who has physical possession of them. { @ Large movements of funds in and out of an account on the same day without any apparent commercial reason. | ¢ High value deposits or withdrawals which don't fit the normal pattems of the movement of funds through an 3) li account, especially in cash, ‘¢ Movement of funds ‘through’ (.e. in and straight out age) an account by electronic transfer. There are two important things for auditors to bear in mind: t ‘¢ Reporting suspicious transactions 10 the authorties does not breach the auto's duty of confidentially to their ' ent, Auditors wit have a statutory defence under these circumstances, * Aucitors encountering what they think might be suspicious transactions ave in a dificut postion. Having know! ' edge of transaction may include: actual knowledge; ‘¢ refraining from making enquires; ¢ deterring someone else from meking enquiries; ‘ ‘© dlesing one's mind to wet is obvious and ignoring it. | So auditors should make the sort of reasonable enquiries about a transaction which might be ex- pected of a careful and conscientious professional auditor and carefully note the client's response to their i questions. Heving said that auditors must be careful when making enquiries not ro ‘tip off their client that they have detected what they think is a suspicious transaction and are going to report it to the MLRO and thus, ult- mately, o SOCA, as they could be charged with an offence. | As noted in Chapter 5 above the APB revised their practice note PN12 ‘Money laundering - Guidance for auditors on UK legislation’ in September 2010 and this is a useful source of further advice and information on this topic. WHISTLEBLOWING | ‘Whistleblowing means informing the proper authorities of some significant breach of law or regulation, Itis an issue for employees who feel compelled xo tell the proper authorities of some wrong doing by their employers, but fears being dismissed if they do. In this case employees are protected under the Public Interest Disclosure Act 2003. ‘ Employees of compsnies, who are also members of professional accountancy bodies, may be required by their ethical code, particularly the aspects of icrelacing co integrity and objectivity, to make reportspemont abit | pment ibib ite mene ETHICAL STANDARDS © Protections are available if reports are made: Reports to an outside body, such a8 a regulatory authority, by professional accountants, be they auditors or employees, can be defended against any accusation of breaching client confidentiality as the matter would in the public interest; to the proper authority; without malice bein the public interest. There are additional isues for auditors: If eucitors become aware of a significant non-compliance they should report it to the rectors in the fst instance ‘with a recommendation that ite disclosed to the proper authority. Ifthe directors don't do that then the auditors should report, relying on the public interest defence to guard them ‘against accusations of breach of client confidence. Breaches of law or regulation may have an impact on the financial statements and the auditors should assess ‘what this effect might be and the aisclosures which might be required. This may have an infuencs on their audit report if suitable disclosures are not mace in the financial statements. We will look at this sort of issue later in Chapter 26. ‘The professional bodies require their members and stucdents-o behave in an ethicel manner. ‘There are significant threats to aucitor independence. These can be countered by. adherenos to professional standards and the regulatory regimes ofthe professional bodies. Codes of etics and concct are spelt out in cetal both by professional ces and the Aucsthg Practoes Board, ‘independence is of particular importance and detailed quidenoe is issued to members, Auditors bocce privy to all sorts of information in the course of their work, about both the organizations they auclt and the individuals who work fort, Audit staf must regard all such information as totaly privileged and not disclose ito third parties exceot in circumstances where there isa legal right or duty to cisclose it ‘They may not also use such information for personal gain; e.g. by insider trading, Partners and staff of audit firms can become so familiar with the management or staff of a client company. that they lose their objectivity. This must be avoided, perhaps by rotating the partners and staif involved, ‘There are particule ethical threats associated with the aut of smaller organizations and auditors should be aware ofthe risks. Disclosing unpublished price sensitive information in order. to make a gains a criminal offence under the insider trading rules. ‘Auditors should be aware of the Money Laundering Regulations and are alowed to make disclosures of sus- Piciots transactions without breacting their duty of confidéntiaty..POINTS TO NOTE oe ‘The ethical codes are mandatory, particularly in the area of dealing with clients and the designatory etters accourt- fants may use to describe the services they offer, In some areas they give guidance oni. For example, in the independence ethical guide, the 15 per cent fees rule is ‘or guidance only, a client ging 10 per cent of gross fees may influene auctors who fear the loss of income if they lose the client ‘n all these ethical maiters, accountants must not only behave correctly, they must be seen to be behaving correctly Ethics is taken very seriously by professional accountants ‘Small companies are often owned and run by entrepreneurs who are not interested in obeying bureaucratic rules ‘and see the company as an extension of themselves This can make Ke dificutt fr the aueitor. As a result audit risk can be higher in smell companies. The need for evi dence is stil paramount but the type of evidence avaliable may be diferent from that available in larger enterprises. Professional accountants are not alowed to give investment advice or conduct investment business uniess they are authorized to do so by their professional body under the Financial Services Act. Independence is a big issue and the practice of accounting fms performing other services for their auclt clients is constantly under review. These matters are frequently tested in examinations. Ticktt & Run are auidtors of McCol Holdings PLC, a chemical manufacturer. The financial director has itt tne company recenty to take up another cost and McColl have so far been unable fo find a sutable replace ment. They have therefore asked Tickitt & Fun to be responsible for the preparation of the financial stats- ‘ments for the year ending 31 December 2X70 as par of the auc, McCol have also asked Tickit & Run to: ‘+ in designing end selecting 2 new computerized management accounting system. ‘9 assist in finding @ new financial drector; and ‘© discuss at a bcard meeting the dividend to be paid. “The company is also subject to probable tekeover bid and wants Tick & Pun to aci for them in rebut- ting statements mad by the takeover bidder During the cud, the audit tear find that the company are systematically breaching safety guidetnes on chemicals shipped to a developing country and they suspect some bank transactions with an offshore based benk, Discussion What’are the etnica! mglcations for Ticktt they ethically go in assisting 7 — How iar cxy ResearchGate ‘se discussions, stats, and author profiles for this publication at ntp//vawwarasearchgate.net/pubcation/?35236085 The expectation gap in auditing [ARTICLE MANAGERIAL AUDITING JOURNAL MARCH 2998 ok eancanesseni oon Revos 2,668 corarions 43, 2 AUTHORS, INCLUDING: Hian Chye Koh SIM University (63 PUBLICATIONS 1,295 CTATIONS SEE PROFLE sabe oman Chye Koh fend or 12 Oba 218‘Thoreis concern that audl- ‘orsandthe public hold diferent ballets aboutthe auditors duties and responsi bites and the massages conveyed by audit reports. In recent years, some spectacu- lar and wll-publicised corpo- rate collapses and the subse- ‘quent implication ofthe reporting auditors have hgh Tigmted the audit expectation 2p. Apparent, public mis- perception ae a malor ‘eause ofthe legal blity cil facing the accounting profession. Gente sia cance of the expectation gp, itis not suprising therfore ‘that priorresearch on the expectations problems substantial. The objective of ‘this paperisto review the literature onthe audit expec tation gap along the folowing lines: definition ofthe expec- tation gp; nature and struc ture ofthe expectation gap; and waysto reduce the expectation gap. tishoped ‘thatsuch an attemptean rovde insights into the avelt expectation gap. Managerial auating ourar 37st e7-258 SNOB Unveraiy Pr iisswenereon i The expectation gap in auditing Hian Chye Koh Associate Professor, Nanyang Business School, Singapore E-Sah Woo Auditor, Price Waterhouse, Singapore roduction The audit expectation gap bas a long and persistent history There is widespread con- ‘cern with the existence of the “expectation ‘2ap" between the auditing profession and the public. The term “expectation gap” was first applied to auditing by Ligato (1974). Since ‘then, cumulative evidence has increasingly indicated the presence of an expectation gap (Godsell, 1992). The expectation gap exists ‘when auditors and the public hold different beliefs about the auditors’ duties and respon sibilities and the messages conveyed by audit, reports. Apparently there isa gap between ‘what the public expects and what it actually ets. In recent years the auditing profession has been involuntarily placed in the spotlight, particularly because of some spectacular and ‘well-publicised corporate collapses and the subsequent implication ofthe reporting audi- tors. As mentioned in Godsell (1992), there is ‘widespread belief that a person who has any Interest in a company (shareholders, poten- tial investors, take-over bidders, creditors ete.) should be able to rely om its audited accounts as a guarantee ofits solvency, pro- priety and business viability Hence, ifit transpires, without any warning that the ‘company is in serious financial difficulty itis ‘widely fle that somebody should be made accountable for these financial disasters, and this somebody is always perceived to be the auditors, These misperceptions by the public {feed the legal liability crisis facing the accounting profession (Maccarrone, 1993), However, any “accountability vacuum” is not something that can be placed on the auditors’ shoulders alone, forthe nature and objectives of auditing are differently perceived by differ- ent partes (Lim, 1993). Prior research on the expectations problem is substantial. Ths is not surprising given that the expectation gap between auditors fand financial statement users has existed for the past 100 years although the term has been introduced tothe auditing scene only during, the last 20 years or so (Humphrey ef a, 1952), TPhis paper aims 10 review the literature on the audit expectation gap, The issues that have been discussed in the literature can be classified into three main categories: 1 definition ofthe expectation gap; 2. mature and structure of the expectation gap: and 3. ways to reduce the expectation gap, tis hoped that this paper can provide sights into the audit expectation gap. Definition of the expectation, ‘The definition of the expectation gap varies ‘among researchers. Ligglo (1974) was the frst to apply the phrase “expectation gap” t0 ‘auditing. He defined the expectation gap as the difference between the levels of expected performance “as envisioned by the indepen= ent accountant and by the user of financial statements”. The Cohen Commission (Com- ‘mission on Auditors' Responsibilities, 1978) extended this definition by considering ‘whether a gap may exist between what the public expects or needs and what auditors ‘can and should reasonably expect ro accom- plish. ‘Monroe and Woodlif?(1993) defined the audit expectation gap as the difference in boliefs between auditors and the public about the duties and responsibilities assumed by auditors and the messages conveyed by audit reports, Jennings ef a, (1993), in their study fn the use of audit decision aids to improve auditor adherence toa “standard”, are of the ‘opinion that the audit expectation gap is the difference between what the public expects from the auditing profession and what the profession actually provides. This definition is also advocated by Lowe (1994) in his research on the expectation gap in the legal system. Porter (1995) did an empirical study of the audit expectation-performance gap and defined the expectation gap as the Bap between society's expectations of auditors find auditors? performance, as perceived by society It is seen to comprise two ‘components: 1 reasonableness gap (i.e. the gap between ‘what society expects auditors to achieve tnd what the auditors can reasonably be expected to accomplish); and (247)