Kadiann Malcolm 06001930 Auditing 1 September 22, 2008

1. Discuss the concept of independence and list 5 ways the auditor or firm can lose this independence. The value of auditing depends heavily on what users deem as the independence of auditors both in appearance and fact. Independence means taking an unbiased viewpoint in performing audit tests. It is important that auditors seem to be independent as well as, being independent in reality. Simply put, auditors must appear independent throughout the audit, in addition to how well others interpret independence in fact. There are various things which can compromise the independence of an auditor, they include but are not exempted to financial interests, ownership interest, bookkeeping and other services, fees, and the preparation or reconstruction of data, records or reports. The International Code of Ethics (ICAJ) prohibits members from owning any direct investments in audit clients whether material or immaterial (1 or 1 million shares) under section 9.3 to 9.8. In essence individuals on the auditing team or their close family members should not have any shares in the company in which they are auditing since this would appear to the public as a conflict of interest that will eventually lead to their independence being compromised. SEC rules adopted in 2000 on financial relationships narrow the restrictions on ownership in clients to those persons who can influence the audit. Thus, if there is any ownership of capital it must be provided by partners and should not exclude others, consequently members of the auditing team or have any influence on the audit should not hold majority shares, as well as, they, cannot have voting rights. The American Institute of Certified Public Accountants (AICPA) permits a Certified Public Accountant (CPA) to do both bookkeeping and auditing for the same non-public client, however, the client must accept full responsibility for the financial statements, CPAs must not assume the role of employee or of management and the audit must conform to GASS. However the SEC and the

Sarbanes Oxley act expressly forbids bookkeeping and other services. It poses as a self review threat particularly in areas such as accounting. Fees charged for other services can be very costly to the firms independence. Basically, other services provided should be significant portion of the firms income, which may be innocent in truth but may appear detrimental to how individuals perceive the independence of the firm. Auditors should not hold management positions in the clients organization. This will prevent them from being objective and unbiased while auditing.

2. Each of the following five situations involves a possible violation of section 9 of the ICAJ Code of Ethics Independence. For each situation, (1) decide whether the Code has been violated, and (2) briefly explain how the situation violates (or does not violate) the Code. Reference may be made to the relevant sections of the Code. a. Greshen Fosh, a certified accountant, is a partner in the firm of Speedy Gonzalez & Associates, Chartered Accountants. Greshens sister is employed as an inventory warehouse supervisor (an audit-sensitive position) by Supersinger Appliances, a company listed on the Jamaica Stock Exchange (JSE). Supersinger Appliances is an audit client of Speedy Gonzalez & Associates. Neither Greshen nor his branch of Speedys is involved in the audit of Supersinger Appliances.

Answer: This does not violate the ICAJ Code of ethics as Greshen is not involved in the auditing of Supersinger Appliances because his branch is not involved, however he must disclose the fact that his sister works at the company in an audit sensitive position thus it will not compromise his independence. Section 9.2.1 supports this Section 9.2.1 of the code supports this claim, it states that an accountant in public practice should not be involved in an audit where closely connected family members are employed to the client company.

b. Jordan Woodard is an audit manager with Anderson & Zelken, Chartered Accountants, a one-office firm. Jordan owns 100 shares of common stock in one of the firms audit clients, but she does not participate in the audit of the company.

Answer:

Ms Woodards independence is contingent upon the fact that she has no influence in the audit of the firm. This may not be possible, seeing that she is an audit manager if this occurs then Jordan would be forfeiting her independence especially since she would have shares in the company and as such violating the Code of Ethics Section 8.2.2 states that where an employee of the audit firm has a beneficial interest in shares in a client company, the employee should not take part in the audit of that company.. As well as Section 9.3 of the code states that any beneficial interest on the part of a member in public practice or anyone closely connected with a member in public practices audit firm, in a client company will constitute an impairment of independence. A member in public practice therefore should not hold shares in a client company, thus as a member of the auditing team her independence would be compromised, and even more when she owns shares in the company.

c. The accounting firm of Finke & Hersley provides book-keeping and tax services for Hendershot Limited, a privately held company. Finke and Hersley also perform the annual audit of Hendershot Corporation.

Answer: The US AICPA states that members of the audit team are able to perform bookkeeping provided that certain provisions are met, the SEC believes that they cannot correlate, section 9.1.3 of the code were met. This states that the auditor should not assume the role of employee, assign staff to the audit who were not involved in the preparation of accounting records, have a reporting partner or

manager other than the partner or manager responsible for accounting assignments, ensure that there is no conflict of interest which would impair integrity, not assume the role of management nor participate in the decisionmaking process within the enterprise. That is except for the Chinese wall which makes provision for the audit firm to separate the services that they provide to clients. If the same teams that are doing Hendeshot Corporations book-keeping and tax services are doing their annual audit then Finke and Hersley are in violation of the Code of Ethics. If however they are using the Chinese wall then they have not violated the Code of Ethics.

3. The auditor should not be liable to parties who are not shareholders. Discuss. Include decided cases in your answer to highlight certain principles. The most common source of lawsuits against CPAs is from third parties which certainly imply that the auditor has legal liability to third parties. These include actual and potential stockholders, vendors, bankers and other creditors employees and customers. The Donoghue and Stephenson case established that a third party could claim damages for physical injury suffered even though he was not a party to the contract. The question which this raised was whether a third party could claim damages for financial injury suffered (losses suffered as a result of statement prepared by professionals even though he was not a party to the contract. The case that established such a standard was the Headlybyrne vs Heller Partners (UK1963) where third parties could claim financial damages if a special relationship exists, professional statements and advise was negligent and the third party used and relied on the statement and suffered financial loss as a consequence. This is especially relevant to professionals such as bankers investment advisor and accountants where they knew of an existent relationship between his client and third party. In 1963 a decision was taken in the UK and Commonwealth against auditors whom the accountant should have reasonably foreseen who would rely on his words. However this practice was becoming close to impossible since it may one day lead to an auditor being liable for an indeterminate amount for an indeterminate time to an indeterminate class (Ultramares Corporation vs Touche). Thus the three main criterions during the Headleybyrne case would be

used as a landmark. This would be further supported in the 1990 UK decision Caparo Industries plc vs Dickman.

The professional statement and advice given in the case of Pampellone v Royal Bank Trust (Trinidad 1999) followed the Headlybyrne criterias about the professional advice given by a banker. 4. Discuss the ways in which the Bannerman case is similar to/different from previous 3rd party liability cases. To better compare the two situations here is a summary of the situation involved in the Bannerman case; RBS was the principal lender to APC Limited. Facility letters required APC to provide audited financial statements to the bank within 6 months of the companys year end. Bannerman Johnstone Maclay, APC.s auditors, prepared audited accounts for the periods to 30 November 1995 and 31 March 1997. APC then sent the accounts to RBS. RBS claimed that, relying on the audited accounts, they made certain overdraft facilities and term loans available to APC. APC subsequently went into receivership. RBS sued Bannermans, arguing that their preparation of the audited accounts had been negligent and in breach of a duty of care Bannermans allegedly owed to RBS. Bannermans applied to strike out the proceedings on the basis that, even assuming the banks factual allegations to be true, they owed RBS no duty of care. The application was dismissed and the case will now proceed to trial.

Of the cases I previously discuss I will compare the Headlybyrne vs Heller and Partners as well as Pampellone v Royal Bank Trust with the Bannerman case. A companys auditors are capable of owing a duty of care to a creditor bank if they knew (or ought to have known) that the bank would rely on those accounts. This is emphasized in the Headleybyrne case where third parties could claim financial damages if a special relationship exists, professional statements and advise was negligent and the third party used and relied on the statement and suffered financial loss as a consequence. However it is apparent on the Bannerman case that the bank relied on the audited accounts for purposes other than the statutory purpose for which they were prepared; the auditors did not intend that the bank should rely on the accounts; and there was no direct contact between the bank and the auditors.

The auditors could be justified in the Bannerman case where a relationship did not exist with the bank and the auditors while in the Headleybyrne case a special relationship existed in which third parties are owed a duty of care not only is it contractual and fiduciary but also an assumption of responsibility in circumstances in which but for the absence of consideration there would be a contract. This is dependent on the fact that relationship existed between the two partys, based on the limited contact no relationship existed as such the could not be held liable seeing as they had no way of knowing that the statements would be used by the bank. However the Headleybyrne case has a duty of care the customer in the Headleybyrne case since the customers decision was based on the banks certificates and some interaction must have been apparent between the two as such they were held liable.

The professional advice and support given to the bank by Bannerman was nonexistent since they did not intend for the bank to use their assessment, knowing this, whatever liability the firm will incur will rest on their shoulder and not that of the auditors. Thus bannerman is relieved of all responsibility. On the other hand the Case of Pampellone illustrated that they specifically asked advice on an investment, a company called Pinnock from Kennedy the manager of Royal bank Trust (Trinidad). It was on his advise that they made the decision to invest in the company as such it was his expertise that the Pampellones was dependent on and his negligence in not telling them the limited time that the investment was high risk and advise was valid for only six months as such when it failed they had no leg to stand on as the Pampellones was not aware of the risks involved consequently they (the bank) are held liable.