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Learning objectives

After studying this presentation you should be able to:

2.1 explain the fundamental principles of professional
Chapter 2
ethics
2.2 describe and assess auditor independence
Ethics, legal liability and client
2.3 describe the relationship between an auditor and key
acceptance
groups they have a professional link with during the
audit engagement

Fundamental principles of
Learning objectives professional ethics

2.4 illustrate the auditors legal liability to their client, All members of the professional accounting bodies are
contributory negligence and the extent to which an to comply with the fundamental ethical principles
auditor is liable to third parties (APES 110, S. 100.4):
2.5 categorise the factors to consider in the client 1. integrity
acceptance or continuance decision. 2. objectivity
3. professional competence and due care
4. confidentiality
5. professional behaviour.

Fundamental principles of Fundamental principles of

professional ethics professional ethics

Integrity:
To the obligation that all members of the professional
bodies be straightforward and honest.
A member shall not knowingly be associated with
reports, returns, communications or other
information where the Member believes that the
information:
contains a materially false or misleading statement
Integrity:
A member shall not knowingly be associated with
reports, returns, communications or other
information where the Member believes that the
information:
contains statements or information furnished
recklessly
omits or obscures information required to be
included where such omission or obscurity would
be misleading.

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Fundamental principles of Fundamental principles of

professional ethics professional ethics

Objectivity: Professional competence and due care:

Not allow personal feelings or prejudices to influence Maintain knowledge and skill at a level required by
professional judgement. professional bodies.
Be unbiased. Keep up-to-date with changes in regulations and
Not allow conflict of interest or influence of others to standards.
impair decision process. Continue education and work experience.
Act diligently, taking care to complete each task
thoroughly, document all work, finish on a timely
basis.

Fundamental principles of Fundamental principles of

professional ethics professional ethics

Confidentiality: Professional behaviour:

Refrain from disclosing information to people outside
the workplace that is learned as a result of
employment.
Exception if legal requirement to disclose.
Not allowed to use confidential information to their
advantage or advantage of another person.
Comply with rules and regulations and do not harm
reputation of the profession.
Be honest in representations to current and
prospective clients.
Do not claim to provide services they cannot provide,
or qualifications they do not possess, or experience
they do not have.

Fundamental principles of
Independence
professional ethics

Professional behaviour: Independence is the ability to act with integrity,

Do not undermine reputation of, or quality of work
produced by, others.
objectivity and with professional scepticism (questioning
mind).
Lack of auditor independence impacts on credibility and
reliability of the financial report.
The auditor must be, and be seen to be, independent.

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Independence Independence

Independence of mind: Threats to independence:

ability to act independently self-interest
ability to make a decision free from bias self-review
personal belief and client pressures. advocacy
Independence in appearance: familiarity
belief that independence of mind intimidation.
has been achieved.

Independence Independence

Threats to independence: Threats to independence:

Self-interest threat: Self-interest threat:
Can occur if the audit firm or its staff have financial Can occur if the audit firm or its staff have financial
interest in audit client. interest in audit client.
Examples: Examples:
Bank account held with the client. Fee dependence, where the fees from a client
Shares owned in the client. form a significant proportion of all fees of the
A loan to or from the client. firm.
Close business relationship with the client.

Independence Independence

Threats to independence: Threats to independence:

- Self-review threat: - Self-review threat:
Can occur when the assurance team need to form Examples:
an opinion on their own work or work done by Performing services for the client that are then
others in their firm. assured.
Examples:
Assurance team member has recently been an
employee or director of the client.
Preparing information for the client that is then
assured.

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Independence Independence

Threats to independence: Threats to independence:

Advocacy threat: Advocacy threat:
Can occur when an audit firm or assurance staff Examples:
act, or is believed to act, on behalf of assurance Encouraging others to buy clients shares or
client. bonds.
Can lead to questioning of auditors objectivity. Representing client in negotiations with third
party.
Representing the client in a legal dispute.

Independence Independence

Threats to independence: Threats to independence:

Familiarity threat: Familiarity threat:
Can occur when close relationship exists or Examples:
develops between assurance firm and client, or Long association between assurance firm and
firm and client personnel. client.
Assurance staff can become too sensitive to needs Long association between assurance firm and
of client and lose objectivity. client personnel.

Independence Independence

Threats to independence: Threats to independence:

Familiarity threat: Familiarity threat:
Close personal relationships between assurance firm Acceptance of hospitality by members of assurance
staff and senior client personnel. team from client (other than minor gestures).
Former partner of assurance firm holding senior
position at the client.
Acceptance of gifts by members of assurance team
from their client (other than minor tokens).

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Independence Independence

Threats to independence: Threats to independence:

Intimidation threat: Intimidation threat:
Can occur when member of assurance team feels Examples:
threatened by the clients staff or directors. Threat that client will use different assurance
Assurance team member unable to act objectively, firm next year.
fearing negative consequences. Undue pressure to reduce audit hours to reduce
fees paid.

Independence Independence

Safeguards to independence: Safeguards to independence:

Created by profession, legislation or regulation: Created by accounting firms:
quality control standards quality control procedures
code of ethics client acceptance and continuance.
legislative requirement to be independent.
Created by clients:
corporate governance
policies and procedures.

The auditors relationship with others The auditors relationship with others

Auditors and shareholders: Auditors and the board of directors:

Audit report addressed to them. Represents shareholders.
Attendance at AGM. Executive and non-executive directors.
Formal responsibility for auditor appointment. Large companies have committees made up of
several directors to deal with specific issues.

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The auditors relationship with others
Auditors and the audit committee:
A special committee of the board of directors.
Acts on behalf of board in financial reporting and
audit matters.
Top 500 listed companies must have audit
committee, top 300 must follow ASX guidelines.
The auditors relationship with others
Auditors and internal auditors:
Viewed by external auditor as part of client.
External auditor can reduce scope of testing if
effective internal audit function (ASA 610: ISA 610).
Depends on internal auditors:
objectivity
technical competence
due professional care
communication with external auditors.
Legal liability
Legal liability to clients:
Liability under either contract or tort law.
Negligence: failed in performance of audit by being
careless and breaching duty of care.
Contract: failed duty of care implicit in acting as
auditor and explicit in engagement letter.
Case law shows change in definition of reasonable
care and skill over time as standards change.
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The auditors relationship with others
Auditors and the audit committee:
Aid to auditor independence:
Non-executive directors, majority independent.
Financial accounting knowledge desirable.
Meets with external and internal auditors.
Legal liability
External auditor must exercise due care, be diligent in
applying standards and documenting work.
Auditor can be found negligent and liable for damages
under tort law if it is established that:
1. A duty of care was owed by the auditor.
2. There was a breach of the duty of care.
3. A loss was suffered as a consequence of that breach.
Legal liability
Legal liability to clients:
Key cases:
London and General Bank Ltd (1895).
Kingston Cotton Mill (1896).
Pacific Acceptance (1970).
HIH Royal Commission Report (2003).
Centro Properties Group (2011-12).
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Legal liability
Contributory negligence:
Contributory negligence applied in AWA (1992) case.
If directors are also negligent, each party is held
accountable in proportion to their guilt.
Legal liability
Legal liability to third parties:
Key cases:
Candler (1951):
Auditors liable to third parties that the auditors
know their clients will show the accounts to.
Scott Group (1978):
Auditors liable to third parties that they can
reasonably foresee may rely on the financial
report of their client.
Legal liability
Legal liability to third parties:
Key cases:
Columbia Coffee and Tea (1992):
Audit firm had manual stating they
acknowledge that third parties would rely on
audited accounts.
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Legal liability
Legal liability to third parties:
No contract between auditor and third parties, they
must rely on tort law and show duty of care.
Duty of care less likely with third parties.
Legal liability
Legal liability to third parties:
Key cases:
Caparo (1990):
Reasonable proximity between auditor and
third parties, auditor must be aware of third
party group and the decisions they intend to
make.
Legal liability
Legal liability to third parties:
Key cases:
Esanda (1997):
Judge argued against Columbia finding.
Australian High Court ruled that for a third
party to establish duty of care, they must
show:
The report was prepared on the basis that it
would be communicated to a third party.
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Legal liability Legal liability

Legal liability to third parties: Legal liability to third parties:

Key cases: Key cases:
Esanda (1997): Esanda (1997):
Australian High Court ruled that for a third Australian High Court ruled that for a third
party to establish duty of care, they must party to establish duty of care, they must
show: show:
The report was likely to be relied upon by The third party ran the risk of suffering a
that third party. loss if the report was negligently prepared.

Legal liability Legal liability

Legal liability to third parties: Avoidance of litigation:

Key cases: Hire competent staff, regular training.
Esanda (1997): Comply with ethical and auditor regulations.
Third parties can request privity letter.

Legal liability Legal liability

Avoidance of litigation: Avoidance of litigation:

Implement policies and procedures: Auditor can take steps to avoid litigation:
Client acceptance. Meet with clients audit committee to discuss
Staff allocation. significant issues arising in audit.
Ethical and independence issue identification and Follow up any significant weaknesses in clients
rectification. internal control procedures from previous year
Adequate work documentation. audit.
Gather adequate and appropriate evidence to
support opinion.

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Client acceptance and continuance
decisions
The first stage in any audit is client acceptance or
continuance decision.
Step 1: assess client integrity.
Step 2: assess audit firms ability to meet ethical
requirements, service client.
Step 3: prepare client engagement letter.
Client acceptance and continuance
decisions
Client integrity - auditor should consider:
Appropriateness of the clients interpretation of
accounting rules.
Clients willingness to allow auditor full access to
information required to form an opinion.
Clients attitude and willingness to pay fair amount
for audit work.
Client acceptance and continuance
decisions
Ethical requirements:
Consider if any threats to fundamental principles
arise from appointment (APES 110 s.210).
Auditor must ensure it has sufficient staff available
with required knowledge to complete audit
(professional competence and due care).
Consider potential safeguards and remedies.
Decline appointment if threat insurmountable.
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Client acceptance and continuance
decisions
Client integrity - auditor should consider:
Reputation of client, management, directors, key
stakeholders.
Clients reason for switching auditor.
Clients attitude to risk exposure and management.
Clients attitude to using internal controls to mitigate
risk.
Client acceptance and continuance
decisions
Auditor can obtain information from:
Communication with prior auditor (with clients
permission, APES 110), client personnel, third parties,
key competitors.
Review of press articles.
Client acceptance and continuance
decisions
Engagement letter (ASA 210; ISA 210):
Prepared by auditor, acknowledged by client.
Form of contract, can expand on obligations in
Corporations Act.
Explains scope of audit, timing of various aspects of
audit, overview of client responsibilities.
Confirms auditors right of access to information,
independence considerations.
Sets fees.
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Summary Summary

The fundamental principles of professional ethics include Factors to consider include the integrity of a client, such
integrity, objectivity, professional competence and due as its reputation and its attitude to risk, accounting
care, confidentiality and professional behaviour. policies and internal controls.
Independence is the ability to make a decision that is free
from bias, personal beliefs and client pressures.
Auditors report to their clients shareholders.
To successfully sue an auditor, a plaintiff must prove a
number of things.

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