Category: Audit

Introduction

Ethics is a system of moral norms for individual or any social or professional group. The term ‘Medical ethics’ is known for a very long time and the role of an auditor could be easily compared with the role of a doctor. Only with a difference that auditor’s beneficial effect is not aimed for an individual but a company (organization). The auditor’s code of ethics sets multiple professional standards for auditors to act upon accordingly. To act ethically not only for the individual interest or the company but for the interest of the public.

1.0 Auditor’s independence and objectivity

The word ‘independence’ can be described along with words like unbiased or uninfluenced. From auditors perspective the independence for a conclusion which is free from conflict of interest and influence from third parties. This conclusion comes from the auditor’s independence of mind which acts from point of integrity, objectivity and scepticism.

Independence from the clients` company assures that the auditor gives shareholders an honest opinion about the financial statements, which are not influenced by any kind of relationship between the auditor and the company of the client. The necessity for auditor’s independence and honesty arises from third parties who do not possess either the knowledge or information to understand the financial statements or what is actually contained in the annual accounts of the company. Unbiased reports and opinions provided by the auditors offer confidence and reliability for entities of the public.(Code of Ethics for Professional Accountants, 2005)

The auditor’s objectivity which can be described as an obligation to act and take decisions which are taken fairly. Auditor’s objectivity takes into consideration all the necessary tasks and evidence which is available and draws conclusions from this evidence. Combining it with professional competency which is free from conditions, and from influences of other people.

A threat to the fair objectivity of an auditor through influencing the auditors` decision can threaten the compliancy with the fundamental principles.(CPA Irelands Code of Ethics for Certified Public Accountants, 2019)

2.0 Independence in the auditor-client relationship

Independence in the auditor’s and client relationship has high importance if the auditors aim is to provide high standard service and reports which are developed through honesty. Service with an expression of professional responsibility carried out without interruptions to auditor’s objectivity. Interruptions or influences that might bend the auditor’s judgements could arise from the client`s desire to have a certain outcome. To achieve this outcome the client could offer adirect financial benefit or certain other types of beneficial offering. Auditor’s decision to accept the offering and return a favour to the client for this offering means that the auditor’s work has been compromised. Regardless of how big or small are the actions made for the benefits of the client, the quality of this work is no longer by the standards. Work ethics of the auditor’s profession in such case has been breached. Any work carried out by the auditor for this client should not be taken as valid due to being purposely biased. The auditor’s work could also become biased if the audit firm is offering service to one major client who is responsible for the biggest part of the audit firm’s profit. Such dependant relation has a high risk of influences due to the risk of having major financial losses if the audit firm should be in a position of losing the client. The auditor and the management of the audit must continuously evaluate the independence from the client. Not only factors like financial and personal relationships, but as well previous obligations and tasks carried out with the client in the past must be taken into consideration.

3.0 Five threats to the conduct and outcome of the audit

The author is presenting five different scenarios which could appear as a threat or be a potential threat to external auditor’s objectivity.

3.1 The audit firm is heavily financially dependent on one significant client

Threat which arises from such a scenario is the client powerful influence over the audit firm due to being their biggest financial beneficiary. Such financial dependency inevitably might result in a loss of independence and biased objectivity. Often a big client does not only act as a provider of profit but also a provider of reputation. If an audit firm has a well-known big company as a client it offers also a possibility to show the firm as trusted.

This trust, however, is a double-edged sword. A threat could emerge that the company which hired the audit firm, could potentially direct the firm to act or make decisions in certain ways which are beneficial to them but might go against the audit standards or ethics. In this case, the audit firm is in a cross-road of choices. Either to stick to the route of integrity and unbiased work or a road where their work had elements of influence and direction by the client. One road has the potential to lose the client and the revenue it brings and the other could have a threat of being exposed and found guilty in consciously conducting un-ethical work practices. Getting exposed would result in a loss of reputation and potentially a loss of other smaller clients and as well public’s trust. Loss of trust and loss of clients would potentially mean an outcome of going out of business.

3.2 The audit firm, its partners or staff have a financial interest in the audit client

A possibility of a threat of an audit firm, its partners or employees having a financial interest in the company where an audit is performed could be taken as one of the more common threats in the opinion of the author. Due to access to confidential financial information, a direction of the company can be interpreted. This interpretation can be used either for individual financial gain or for the benefit of third parties outside the company who would use the inside information for their financial benefit.

An example from a real-life scenario where two men executed such actions mentioned above:

Scott London a former partner of KPMG and Bryan Shaw a jeweller, two friends who traded inside information between each other which allowed Mr Shaw to gain financially in amounts over 1 million Dollars. According to the investigation, Mr Shaw was offering Mr London bribes in exchange for inside information. These bribes were either in a form of cash or expensive offerings such as a Rolex watch. One of the companies (Herbalife Ltd.) which London oversaw was at the time closely monitored by the authorities due to its controversies of fraudulent activities. When the FBI started to investigate the trades made concerning Herbalife, they found out a connection between London and Shaw. Shaw was taken into custody by the FBI and he gave up everything that was going on between him and London. Scott London had no room to argue based on the testimony and evidence gathered by the FBI and pleaded guilty in court. (Hamilton and Chang, 2013)

Scott London was sentenced in 2014 for 14 months in prison for the insider trading charges and a $100,000 fine. Which consequentially also destroyed Mr London’s career after 29 years of work in KPMG and a public disgrace for his actions. (Stemple, 2014)

3.3 There are family relationships between the firm, its partners, staff and the audit client

In a scenario where an auditor is being appointed to a client’s company to conduct an audit, the most important element before this is the prevention of potential threats. According to IFACs Code of Ethics for Professional Accountants, an investigation is required before engaging with the client. An investigation into owners of the business, and its activities.

Are there any potential threats in present or occurred in the past? Has the company or the owners of the company involved in any scandals or controversial subjects?

Are there any members of staff working in the area closely related to the financial department who would have either family or friendship relationship with the auditor? Taking into consideration all these elements will reduce potential threats for the integrity of the audit. In the course of an investigation, all such threats will be taken into consideration and evaluated. Raised alert on specific potential threat will not automatically mean rejection of the client. The evaluation will determine if there is a major risk or a minor risk which could be acceptable. Comparison on the seriousness of risks such as: A family member of an auditor working in the finance department, where an audit would be performed versus a family member working in the area of company’s facilities maintenance. The difference comes from the fact that a member of staff working in the financial department could be directly related to the work which will be performed in such an area. Facilities maintenance, however, does not handle or have access to the financial data or related information through which the auditor`s work could be potentially influenced.

Influences could arise for various reasons. Auditor finding irregularities in the work of the finance department, or perhaps, even evidence of fraud. If the findings have an impact to the well-being or professional position of the auditor’s family member, a possibility might occur that the auditor will attempt to hide or ignore certain evidence in order to maintain the well-being of the family member.

A potential possibility could be also the family member him/herself taking a course of action to individually approach the auditor and influence a certain course of action. Regardless of which side takes influential action to the conduct of an audit. The end result will still be work which was carried out beyond the range of work ethics of the auditor.

3.4 The audit firm provides non-audit services to the audit client

The audit firm providing non-audit services to a client who is serviced also with an audit has a potential threat of conflict of interest. There can be multiple ways as to how this conflict of interest or just a perception of it can emerge. The audit firm could be providing non-audit services and receiving large financial benefits. This, in turn, could potentially influence their service of audit, if a possibility occurs that the client for some reason wants to twist the outcome of this audit and threatens to stop using all non-audit services with the firm, if their requests are not met. In such cases, the audit firm has lost its independence unless they are willing to accept the losses and conduct their audit service objectively. A conflict of interest can also occur when a non-audit service is offered to look over the work of an audit service. In a case of KPMG and a fashion retailer Ted Baker, such situation happened when KPMG provided services as an expert witness in the court case which dealt with Ted Bakers overstated inventory in tens of millions of Euros. KPMG provided audit services for Ted Baker since 2001 and had continuously given Ted Baker reports that show no issues with the company.

Due to KPMG being and audit firm for Ted Baker and also provided expert witness services, a conflict of interest occurred. According to the FRC (The Financial Reporting Council), KPMG was basically conducting a self-review which is un-ethical behaviour. KPMG admitted in breaching ethical standards and was fined in a settlement for over 2 million Pounds. (Sembhy, 2018)

3.5 The audit firm has been the external auditor of the client for the past 10 years

Long time relation between the auditor firm and the client over time builds familiarity. The familiarity which could result in a trust where there is no reason of doubt. Such trust could become a threat if the client should choose to take advantage of this situation. While there are benefits of long-term relationships due to knowing the clients business activity, operation and methods of financial reporting. The trust and knowledge of how things are could also lead to a certain routine which becomes a one-way path of doing things. Such a path could lead to a comfort point where certain duties won’t be conducted with much effort and quality in mind.

Long term working relationship has a threat to build up to a point where smaller issues could be ignored and bigger issues worked around to look better than they are.

In order to safeguard the independence of an audit in the client relationship, rotation of audit firms after 10 years have been deemed as mandatory in 2016 EU Directive and Regulation (S.I 312).

4.0 Recommended actions to reduce threats to auditors objectivity

Steps to take in order to safeguard auditor’s independence in 5 different scenarios.

4.1 Safeguards for audit firm heavily financially dependent on one significant client

The audit firm should aim to diversify its business with a wider selection of clients. Eliminating reliance on one company allows stronger independence not only in decision making but also in finances. Variety of clients also ensures that you stay in business if one of the client`s company should happen to go out of business.

4.2 Audit firm, its partners or staff have a financial interest in the audit client

Conduct an investigation before assigning an auditor to the client. Acquire information through interviews and questioning from the auditors about their involvement with the client from either social or financial aspect which could pose an influence to the audit.

Continuous monitoring to be implemented in order to have updates on any changes.

4.3 There are family relationships between the firm, its partners, staff and audit client

Assessment of positions and placement of the family members inside the client company to be taken into consideration. If the family members position poses a threat to auditors objectivity then as a safeguard a different auditor should be appointed for this particular client.

4.4 The audit firm provides non-audit services to the audit client

Analysing of the services which are provided as part of non-audit service. If these services are posing as a threat to the audit objectivity then stopping of these services for the audit clients should be implemented.

4.5 The audit firm has been the external auditor of the client for the past 10 years

Rotation of auditors to the clients firm in order to minimize relations developing beyond the professional level. Occasional review of auditors work by another impartial auditor.

Conclusion

While the objectivity and independence of an auditor are guided by directives and ethical standards. The road to successfully carry out the duty with absolute integrity will require conscious efforts from the auditor. An auditor, a professional being, carrying out duties is still only a human being with everyday thoughts and emotions. Safeguards are implemented in order to minimise potential threats but are not capable of eliminating them entirely. Elimination of this threat starts from the auditors themselves. Which is taking decisions either to maintain the independence or let this independence get tarnished by other motives such as career, finance or relationships. The wrongful decisions made in the past by others in the profession and the awareness of consequences from these decisions will offer perhaps an opportunity for individual improvement. This individual improvement, in turn, will collectively benefit the overall structure of the business.

References:

1. 2005. CODE OF ETHICS FOR PROFESSIONAL ACCOUNTANTS. [ebook] IFAC, p.1210. Available at: [Accessed 22 March 2020].
2. 2019. CPA Irelands Code Of Ethics For Certified Public Accountants. [ebook] CPA Ireland, p.21. Available at: [Accessed 22 March 2020].
3. Hamilton, W. and Chang, A., 2013. In KPMG Insider Trading Case, Crime And Blunders Alleged. [online] Los Angeles Times. Available at: [Accessed 21 March 2020].
4. Stemple, J., 2014. Ex-KPMG Partner London Gets 14 Months For Insider Trading. [online] U.S. Available at: [Accessed 21 March 2020].
5. Sembhy, R., 2018. KPMG Slapped With £3M Penalty Over Ted Baker Audit Conflict. [online] Independent. Available at: [Accessed 21 March 2020].

Auditing is the process of locating and verifying information, evaluating it to predetermined criteria, and creating an audit report. According to (Marx, et al., 2011), In South Africa, the auditing profession evolved in tandem with the growth of corporate law and governance procedures. The auditing profession is an impartial, independent assurance and advising activity that contributes to and improves an organization’s functioning. In our work, we will discuss about ethical conduct fundamental principles, threats and mitigations, and Corporate governance.

The five fundamental principles of Ethical Conduct for Auditors

Integrity: In all professional and business interactions, a chartered accountant must be honest and truthful (Marx, et al., 2011). Integrity also implies fair dealing and truthfulness. Auditors’ integrity generates confidence and thus offers the foundation for relying on their assessment. E.g: Character is built based on integrity. A person with integrity has a spotless reputation in every aspect of his or her life.

Objectivity: Bias, conflicts of interest, or undue influence of others should not be allowed to affect professional or business decisions by a chartered accountant (Marx, et al., 2011). Auditors are the most impartial professionals when it comes to acquiring, assessing, and sharing information regarding the activity or process under investigation. An auditor performs their work and makes decisions based only on the evidence and an impartial examination of the conditions. Objectivity is threatened as soon as an auditor evaluates how their conclusions or views can affect them personally or other persons engaged in the audit. E.g: The auditors are not allowed to receive anything from the auditee, including gifts, fees, or anything else. Accepting such presents might compromise the auditor’s objectivity. If the auditee includes friends and relatives, the auditee’s neutrality will be harmed, resulting in a potential conflict of interest.

3. Professional competence and due care: When providing professional services, a chartered accountant has an ongoing obligation to preserve professional understanding and expertise at the necessary level to guarantee that a client or employer receives competent professional service based on current developments diligently and in accordance with applicable technical and professional standards (Marx, et al., 2011). E.g.: Acquire and demonstrate professional skills and ability at the level necessary to provide effective professional assistance to a customer or employing organization, depending on current standards of the profession and applicable regulations.

Confidentiality: Unless there is a legal or professional right or responsibility to reveal, a chartered accountant should protect the confidentiality of information obtained as a consequence of professional and business connections and should not divulge such information to other parties without adequate and explicit authorization. Confidential information obtained via professional and business interactions should not be exploited for the chartered accountant’s or third parties’ personal benefit (Marx, et al., 2011). For: After a professional engagement has terminated, do not utilize or reveal any sensitive information obtained or acquired as a part of that relationship.

Professional behavior: A chartered accountant must follow all applicable guidelines and restrictions and avoid taking any conduct that may bring the accounting profession into disrepute (Marx, et al., 2011). A professional accountant must adhere to the professional behavior concept, which compels an accountant to follow all applicable laws and regulations. A professional accountant must not intentionally participate in any activity, occupation, or action that compromises or may compromise the profession’s integrity, objectivity, or good image. E.g.: Defamatory allusions or unsupported analogies to other people’s work or Exaggerated statements for the accountant’s services, as well as his qualifications or experience. Therefore, the professional accountant would be in contradiction with the fundamental principles.