External auditor objectivity
(a) Why external auditor objectivity may be, or appear to be, threatened
Undue dependence
If the auditor depends, or relies on a particular client or group of connected clients because
the firm takes a large part of its fee income from the client, the auditor may be less likely
to challenge accounting policies or disclosures proposed by the client, for fear of upsetting
them. This typically happens when the firm is small, but the client is large.
Where the firm feels that an audit qualification may be necessary, it may be reluctant to
issue it for fear of losing the client and the fee income. This applies regardless of whether
the fee income is audit fee income or income for other work. The issue is important because
if the auditor does not issue a qualified audit report where appropriate, the firm may be sued
for negligence. Where a large client is involved, the firm’s professional indemnity insurance
may not cover the claim.
Financial interest
Where a partner or member of staff in a firm (or the firm itself) holds shares in a client, they
have an interest in the client’s performance. If the client performs well, the value of the
shares may rise. A qualified audit report is not usually associated with good performance
and the firm may therefore be reluctant to issue one where appropriate. This is important for
the reasons noted above.
Even if there is no question of a qualified audit report, there may be a temptation to help the
client present the results in the best possible light, instead of presenting a balanced view.
There is also a financial interest where partners, staff or the firm make loans to, or guarantee
the borrowings of the client or vice versa. Significantly overdue fees of amounts that are
significant to either auditor or client are akin to loans.
Family or other close personal or business relationships
Where there is family or other close personal or business relationships between client and
audit firm, the individuals concerned may try to influence the firm in its dealings with the
client in order to protect the family or personal relationship, or the mutual business interest.
If, for example, an audit partner is married to the finance director of a client, it is less likely that
the client will receive a qualified audit report than it would be if the relationship did not exist.
This is important in any case but more so where the effect of a qualified (or modified) audit
report is likely to result in, say, withdrawal or non-renewal of banking facilities which might
result in the business ceasing to be a going concern. If the firm does not issue a modified
audit report in such circumstances, the firm may be exposed to claims of negligence by the
bank.
If there are close business relationships between client and auditor, both parties have an
interest in each other’s performance and there is therefore a double pressure to present the
results in the best possible light and not to issue a qualified audit report.
Other services
Many audit firms provide their audit clients with services other than audit services. It is very
common for auditors to provide their very small audit clients with accountancy services, for
example.
Other services that can be provided include tax, management consulting, IT and human
resources advice. Some firms not only provide consulting advice, but also perform IT and
other functions for some of their clients.
There are two threats to objectivity where other services are provided. Firstly, the firm may
find that it is reporting on a system that the firm itself has set up or advised on, or reporting
on information that the firm itself has prepared. This means that it is reporting on its own
work and it may be difficult to be objective in such circumstances. Secondly, the fee income
from other services may well exceed the fee income from the audit and the client may
pressure the firm to give an unqualified audit report by threatening to take the other services
to another firm if a qualified report is given.
(b) Requirements
Most of the following are requirements of rules of professional conduct.
(i) Undue dependence
A firm should put in place additional safeguards where the recurring fee income from
one client or group exceeds 15% of the gross practice income (10% for clients listed
on a stock exchange or where the public interest is involved). Additional safeguards
include supplementary reviews and the rotation of the engagement partner and senior
staff.
There are exceptions where a practice is being set up or run down. The rules are also
applied to members practicing part-time.
A review mechanism should be triggered within the firm where the gross fee income
exceeds 10% (5%) of gross practice income.
More generally, there is a requirement for firms to carry professional indemnity insurance
to cover professional negligence claims and ACCA monitors practicing firms to ensure
that they are complying with, amongst other things, the independence requirements.
Firms are also required to keep up with changes in independence requirements as a
condition of being permitted to practice.
(ii) Financial interest
No partner in a firm, or any member of staff working on a particular audit, or any person
closely connected with them, should hold any shares in an audit client.
There are exceptions where collective investments are held by third parties, where the
individual concerned has no control over the composition of investments.
Where such shares or interests are acquired through marriage or inheritance, for
example, the shares should be disposed of at the earliest possible opportunity, provided
that the disposal does not involve insider trading. Where shares are held by the auditor
because the company’s constitution requires it, the minimum level should be held and
the votes attaching to the shares should not be exercised.
There are some exceptions for transactions on normal commercial terms with money
lending institutions – a normal mortgage from a bank, for example.
Firms, their partners and staff should not make loans to, or guarantee the borrowings
of, any audit client, or vice versa.
(iii) Family or other close personal or business relationships
An officer (such as a director) or employee of an audit client, or a partner or employee
of such a person, is prohibited from accepting appointment as auditor of that client.
Problems can also arise if an officer or senior employee of an audit client is closely
connected with a partner or senior staff member responsible for the conduct of the audit
(or anyone closely connected with them).
Closely connected persons generally include minor children and spouses. In this case,
adult children and their spouses, siblings, and any other relative to whom regular
financial assistance is given (or who is otherwise indebted to the partner or employee)
are also included. A member should not personally take part in the audit where he or she has been an
officer or employee of a company within the two years prior to the commencement of
the first day of the period reported on.
(iv) Other services
A firm should not participate in the preparation of the accounting records of a company listed
on a stock exchange or a public interest company except in relation to the finalization of the
statutory accounts (assistance of a mechanical nature) or in an emergency situation.
Where a firm does provide such assistance to a smaller firm, care should be taken not
to take on management functions, to ensure that the client accepts responsibility for the
accounting records, and to ensure that adequate audit tests are performed and properly
recorded.
A firm may advertise for and interview prospective staff for a client and produce a short list
and recommendations, but the client must make the final decision.
A firm should not audit a client’s financial statements which include the product of specialist
valuations performed by the firm (such as the valuation of intangible assets or pension
funds).
Where a firm provides other services to audit clients, it is important that the audit team should
be entirely independent of the team providing the other service. One method of achieving
this is by setting up internal structures whereby the two teams do not communicate with one
another
Wilfykil answered the question on April 12, 2019 at 08:24