chapter

Professional practice and ethics

Chapter learning objectives
Upon completion of this chapter you will be able to: Explain the role of the auditor and the responsibilities of directors and auditors Appreciate the relevance of ethics for the professional accountant, explain ethical issues and make ethical judgements, and propose appropriate solutions to ethical problems Discuss the key concepts of corporate governance

Professional practice and ethics

Professional practice and ethics

Introduction This section of the A&A syllabus reintroduces the concepts of audit and assurance, then considers the legal and ethical framework for the profession. Although many of the topics covered here have been covered in your earlier studies, the questions at Advanced Stage are less likely to be clear cut, so you will need to exercise more judgement. ICAEW Chapter 1 Role and context of modern auditing Much of the background knowledge here is revision from Professional Stage. ICAEW Chapter 2 Ethics Ethical issues are likely to be embedded in questions throughout the Advanced Stage papers, and the problems and solutions may be less obvious than in your previous studies. ICAEW Chapter 3 Governance Corporate Governance is a topical issue, and has a real impact on the way businesses are run. It is therefore of significance to the auditor when they assess the control environment, and if you are faced with a question dealing with a listed company you should always consider the impact of Governance. This section also revises Sarbanes Oxley.

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Role and context of modern auditing

Overview of the audit process Client acceptance / continuance Establish engagement terms Plan the audit Develop the audit approach Obtain audit evidence Evaluate results Issue audit report

Auditors responsibilities (CA 2006) Form opinion on truth and fairness of the financial statements Confirm financial statements adequately prepared in accordance with Companies Act Confirm that directors report is consistent with the financial statements Report by exception on Returns from branches not visited received Accounts agree with the underlying records Proper accounting records kept Information and explanations received Directors transactions properly disclosed

Professional practice and ethics

Directors responsibilities (CA 2006) Responsibility Enlightened shareholder value Comments Promote the success of the company for the benefits of the members as a whole

Duty of skill and care Conflicts of interest To be avoided. If the company suffers loss as result of a directors conflict of interest the director is personally liable to the company. See Insolvency section. If company deceives with consent of directors then both company and directors will be liable.

Fraudulent and wrongful trading Theft

Keep adequate accounting records Prepare and file annual accounts Safeguard assets Implement system of internal controls.

Directors loans and other transactions (CA 2006) The aim of CA 2006 is to prevent directors abusing their position, by requiring disclosure to, and approval by, the members of the company when significant loans or other transactions between the company and its directors take place (otherwise transactions voidable by company). Audit risk high due to: Materiality Complexity of rules Potential lack of formal documents

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All companies

Relevant companies (plc or member of plc group) Rules extended to connected persons (spouse, minor children, business partner, company of which director owns >20% voting power) The following transactions with a director or connected person require member approval: Loans >10,000 Credit transactions >15,000 Quasi-loans >10,000

Loans >10,000 to directors must be approved by members of company (need to be given details of loan and purpose) Advances for legitimate business expenses allowed but must not exceed 50,000 (approval of members not required)

Disclosure of directors transactions For all transactions: Statement that loan etc. made / existed in year Name of director / connected person Principal terms Amount of loan and any amount repaid

Other transactions and contracts Directors interests in contracts Declare interests to board Substantial property transactions between company and directors require approval by members o o Value at least 100,000 or Value at least 10% of companys net assets (de minimis 5,000)

Directors interests must be disclosed in the financial statements if material

Long service contracts must be approved by members (>2 years)

Professional practice and ethics

Ethics

Sources of ethical guidance IFAC Code of Ethics governs audits carried out under ISAs ICAEW Code of Ethics to be followed by ACAs, but is practically identical to the IFAC code APB Ethical Standards

Fundamental principles IFAC Code of Ethics (in ISA 200) Integrity Objectivity Professional competence and due care Confidentiality Professional behaviour

General threats to objectivity Self-interest Self-review Management Advocacy Familiarity or trust Intimidation

Detailed guidance APB Ethical Standards

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ES1 Integrity, Objectivity and Independence ES2 Financial, Business, Employment and Personal Relationships ES3 Long Association with the Audit Engagement ES4 Fees, Remuneration and Evaluation Policies, Litigation, Gifts and Hospitality ES5 Non-Audit Services Provided to Audit Clients ES Provisions Available for Small Entities (ESPASE)

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ICAEW Code of Ethics Confidentiality Conflicts of interest Changes in professional appointment

ES1 Integrity, Objectivity and Independence Sets out requirement for firms to have policies and procedures relating to ethics. The firm should appoint an ethics partner. For listed clients, compliance with ethical standards should be reviewed by an independent partner. Matters that bear on the auditors objectivity and independence should be communicated to client management.

Detailed guidance in ES 2-5 Ethical Specific standard threats 2 Beneficial interest in shares Mutual business interest Staff moving from audit firm to client Safeguards Audit partner and staff cannot hold shares in audit client. Should not go into business with audit client. Partner becomes client management within 2 years of being involved in the audit firm should resign as auditors. Other staff firm must consider implications for independence. All partners and staff should disclose intention to move to client and be removed from the audit team. 2 Client staff joining audit firm Should not be allowed to work on the audit for 2 years.

Acting for a prolonged period for

Rotate staff as follows:

Professional practice and ethics

Ethical Specific standard threats listed clients

Safeguards Engagement partner 5 years Key audit partners and senior staff 7 years

Acting for a prolonged period for non-listed clients

Rotate staff as follows: Engagement partner 10 years Rules more relaxed might be able to make a case that partner should remain for longer

Dependence on client

Fees for services to clients should not exceed following % of firms fee income: Listed: 10% (review at 5%) Non-listed: 15% (review at 10%)

Loans, etc.

Not allowed loans or guarantees. Overdue fees akin to a loan.

Hospitality or other benefits Litigation

Firm should have a policy. Basic idea is that they should be modest. Firm should resign as auditor if there is actual or potential litigation between audit firm and client. Consider the impact of non-audit services. Establish safeguards to counter any threats. Communicate with those charged with governance. Document rationale for decisions taken. Do not help PLCs prepare accounts except in an emergency. Do not carry out IA / IT / Valuation work where the external audit opinion will place heavy reliance upon this other work.

Other services

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ICAEW Guidance Confidentiality Auditors should keep client information confidential unless there is a right or duty to disclose. Right to disclose Client permission obtained Public interest To defend the audit firm Duty to disclose Money laundering Ordered to by a court Required by a regulator

ICAEW Guidance Conflicts of interest Firm vs client E.g. where the auditor recommends another service to a client and receives a commission for doing so Disclose to client Obtain client consent

Client vs client E.g. the firm audits clients who are competitors Main issue is confidentiality Separate teams with separate reporting lines Maintain confidentiality (Chinese walls) Independent partner review If sufficient safeguards cannot be implemented, consider resigning / refusing to act

ICAEW Guidance Changes in Professional Appointment Outgoing auditor Reply to requests for information from incoming auditor assuming client gives permission

Incoming auditor Write to client asking for permission to contact the previous auditors If client declines, do not accept engagement If client allows, write to previous auditor asking them about matters that may be relevant to acceptance
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Professional practice and ethics

Follow up if no reply Consider reply e.g. unpaid fees, disagreements about accounting treatment If no reply, can accept the engagement but be sceptical

Duty to report misconduct ICAEW members have duty to report possible misconduct of other members: To ICAEW Professional Conduct Directorate In writing May wish to seek legal advice first No need to investigate before reporting, but need facts rather than just suspicion Examples of when to report Committed offence involving dishonesty, fraud, or cheating Breach of regulations e.g. IA86, Money laundering Gross incompetence Failure to report is grounds for disciplinary action

Current issues in ethics The following issues are being considered as part of a consultation paper on revisions to the Ethical Standards: Rotation period for the audit engagement partner should it be 5 or 7 years? Potential conflict of interest when auditor also provides restructuring advice Existing financial interests of potential new partners which are difficult to dispose of, that may currently restrict the ability of firms to appoint new partners externally Clarification of the definition in ES4 of the 'audit team' when considering remuneration and evaluation policies

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Governance

Underlying concepts of Corporate Governance Concept Fairness Transparency Independence Explanation Decisions / systems of co should be fair to all stakeholders. Financial statement and other, voluntary, disclosure helps shareholders understand the company. Independent non-execs promote the interests of shareholders and other stakeholders by challenging the executive. Dont mislead stakeholders. System in place that penalises mismanagement and takes corrective action. Board accountable to shareholders who should also exercise their voting rights and take some responsibility. Co reputation is often very valuable so should be promoted. Board should make decisions that enhance the companys prosperity. Straightforward dealing, which requires personal honesty and professionalism.

Honesty Responsibility Accountability

Reputation Judgement Integrity

The Combined Code UK incorporated companies listed on the main LSE must disclose in their annual reports how they have complied with the Code Overseas companies listed on the main LSE must disclose any significant differences between their corporate governance practice and those of the Code Reduced compliance allowed for companies below the FTSE 350 Does not apply to non-listed companies (including AIM) although provides measure of best practice for all companies

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Professional practice and ethics

The main provisions of the Combined Code Directors Effective Board should lead and control the company Chair and CEO roles should be separate public justification required for combining roles Balance of executive and non-executive Majority of non-executives independent Formal and transparent procedure for Board appointment Regular re-election Enough to attract high calibre candidates Not excessive Proportion linked to performance Formal and transparent procedure for fixing remuneration Annual report states remuneration policy and details of remuneration of each director Service contracts of more than 12 months require careful consideration Companies should be prepared to enter into a dialogue with institutional investors Board should use the AGM to communicate with private investors Annual report should show a balanced and understandable assessment of the companys position and prospects Maintain a good system of controls to safeguard shareholders investments Establish an Audit Committee Have a responsibility to use their votes Should be prepared to enter into a dialogue with companies

Directors remuneration

Relations with shareholders Accountability and audit

Institutional shareholders

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Combined Code Disclosure Requirements Requirement Statement of compliance with CC Assessment of position / prospects Combining Chairman / CEO Identify Chairman, CEO, other directors and committee members Directors responsibilities Auditors responsibilities Directors statement on going concern Auditors review of statement on compliance with CC Location in annual report CG statement or directors report Chairmans statement, OFR, or directors report CG statement or directors report CG statement or directors report Immediately before the audit report Audit report OFR Audit report

Turnbull report Key points Guidance on how to apply CC with regards to internal controls Encourages a risk based approach Directors should consider Control environment Risk assessment Information systems Control procedures Monitoring Disclosures Statement in annual report disclosing that there is a process for identifying, evaluating and managing risks Additional information on the ICS may be given

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Professional practice and ethics

Audit Committees Smith Report Guidance as follows: At least 3 members all independent non-executive directors At least 1 member with relevant financial experience All to be trained Review ICS Monitor and review IA effectiveness Monitor and review EA independence, objectivity and effectiveness Report in the directors report

APB advice on the relationship between auditors and the audit committee: Should be open communication Should be discussion at the end of the audit about Non-compliance with laws and regulations Control environment Significant adjustments to the financial statements How differences between management and EA were resolved

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Sarbanes-Oxley Act 2002 Principles Audit committee responsible for FR and accuracy Increases FS disclosures Required companies to have internal code of ethics Imposes restrictions on share trading by company officers Key provisions from audit point of view New regulator to set standards, with disciplinary power (Public Company Accounting Oversight Board) Auditing standards tightened Provision of other services severely restricted (ban on IA, bookkeeping, valuation; all others subject to audit committee review) Auditor to discuss accounting policies, management letter and unadjusted differences with audit committee Increased whistleblower protection in case of fraud

Auditors responsibilities with regards to Corporate Governance The auditor is required to review parts of the directors statement on the combined code. APB Bulletin 2006/5 identifies procedures to perform: General Review board minutes Review supporting documents prepared for the Board Make enquiries of directors Attend meetings of the audit committee at which the annual report is considered On the Board review and report on effectiveness of ICS Concentrate on the review carried out Review the statement by directors, make enquiries, review supporting documentation Communicate any weaknesses found during audit promptly
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Professional practice and ethics

Reporting responsibilities Bulletin 2006/5 recommends the following wording in the audit report: We are not required to consider whether the boards statement on internal controls covers all risks and controls, or form an opinion on the effectiveness of the companys corporate governance procedures or its risk and control procedures. Report by exception if problems arise e.g. Board have not conducted annual review of ICS Report will be an additional paragraph headed Other matter after the opinion paragraph an emphasis of matter as the audit opinion is not affected

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