C H A P T E R

3 Ethics, Independence
and Corporate
Governance
LEARNING OBJECTIVES
After studying this chapter you should be able to:

explain the nature and importance of professional

1
ethics;

describe the three main categories of ethical theory;

2
outline the essence of the accounting bodies’ code of
3
ethics and describe the individual rules;

apply sound ethical decision-making techniques;

4
explain the concept of corporate governance;
5
explain the auditor’s role as a whistleblower;
6
explain the importance of audit independence;
7
describe recent developments in auditor
8
independence;

explain the major threats to auditor independence;

9
outline suggestions for improving auditor
10
independence; and

explain fee determination and obtaining clients.

11
 Chapteroutline
As discussed in Chapters 1 and 2, the auditor is a One fundamental ethical requirement for an auditor is
member of a time-honoured profession, and the status independence. This chapter explains the concept of
of the profession and the responsibilities that independence and how it is supported by legislation
accompany this status affect the audit and assurance and the ethical rules. There have been a number of
services function and the structure of the profession. developments in auditor independence as a result of
The independent auditor is subject to regulations the recent corporate crises both in Australia and
imposed by the profession and by society in general. overseas, and these are outlined in the chapter. The
The imposition of ethical standards on members by a major threats to auditor independence are explained
profession is one aspect of this regulation. and suggestions for improving auditor independence
This chapter outlines the nature and importance of are discussed. Also discussed is the concept of
ethics, and the responsibilities imposed on auditors by corporate governance and the part played by audit
the profession through the code of professional ethics. committees in this function.

Relevantprofessionalguidance
Australian International
CPC Joint Code of Professional Conduct IFAC Code of Ethics for Professional Accountants
APS Miscellaneous professional statements —
AUP 32 Independence —
AUS 210 The Auditor’s Responsibility to Consider Fraud ISA 240 The Auditor’s Responsibility to Consider Fraud
and Error in an Audit of a Financial Report and Error in an Audit of Financial Statements
Audit and Assurance Alert No. 6: Auditors’ Responsibilities in —
Relation to Reporting Contraventions of the Corporations Law
Audit and Assurance Alert No. 11: Communicating with —
Entities in Relation to Auditor Independence
Audit and Assurance Alert No. 13: The Implications of the —
US Sarbanes-Oxley Act 2002 for Auditors and their Clients

learning
objective 1
THE NATURE AND IMPORTANCE OF
PROFESSIONAL ETHICS
Ethics is concerned with the requirements for the general wellbeing, prosperity, health and
happiness of people, and with things that promote or prevent them.
Paragraph 3(f) of the Royal Charter of The Institute of Chartered Accountants in Australia
(ICAA) states that one of the ICAA’s principal objects is to do all things that may advance the
profession of accountancy, whether in relation to the practices of public accountants or in relation
to industry, commerce, education or the public service. Similarly, paragraph 3(1) of the
Constitution of CPA Australia establishes one of its objects as protecting, supporting and
advancing the status, character and interests of the accountancy profession generally. Community
wellbeing includes the flourishing of business and industry. The objectives of the accounting
bodies support an environment of personal and corporate integrity that promotes community
wellbeing. This necessarily involves defining what is right and what is wrong.
The ICAA’s Royal Charter and CPA Australia’s Constitution give them the power to prescribe
high standards of practice and professional conduct for their members, and to prescribe
disciplinary procedures and sanctions.
In practice, ethics requires both knowledge of moral principles and skill in applying them to
problems and decisions. In addition, sound ethical practice presupposes the development in
individuals and society of the virtues or good habits that ensure the moral health of the community.

78 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
 Establishing codes of ethics and disciplinary rules does not necessarily create an ethical culture
in an organisation or business, nor does it ensure the moral integrity of its individual members. It is
necessary to promote not only competence in ethics but also the personal qualities of responsibility
and moral conscientiousness. Codes of ethics, rules, regulations and laws do not have meaning or
moral legitimacy in themselves. Rather, their authority and legitimacy depend on whether they are
perceived as helping to promote people’s wellbeing. If rules are considered to be unjust,
discriminatory or oppressive, people are likely to disregard them or demand they be changed.
A.1 of the Joint Code of Professional Conduct indicates that the ethical rules of the accounting
bodies do not cover all aspects of ethical conduct and that members are expected to comply with
the spirit as well as the letter of the rules. They recognise that ethics is principally an attitude of
mind rather than compliance with written rules of conduct.
Society is governed by rules, regulations and laws. From an auditing viewpoint, this tends to
place the focus on ‘black letter’ law. However, it needs to be remembered that it is always possible
to question whether a rule is a good rule. Value judgments need to be made about rules as to
whether they are fair, respect the rights of all parties and protect those parties who are unable to
defend their rights. Sound statutory law must be based on and consistent with common law and
natural justice if it is to promote human wellbeing.

learning
ETHICAL THEORY 2
objective

There are three main categories of ethical theory that will be discussed in this chapter: teleological
ethics, deontological ethics and virtue ethics.

Teleological ethics
Teleological theories are also called consequential theories because they deal with the
consequences or outcomes of actions. Generally, if the benefits of a proposed action outweigh the
costs, then the decision is considered morally correct. The two most important teleological
theories are egoism and utilitarianism.
According to Singer (1993) egoism states that the dominant guide to a person’s behaviour should
be the action that will benefit them the most. This approach has been criticised as promoting
selfishness. However, it has been argued that self-interest also considers the effect on others, although
only insofar as it affects the decision maker. Therefore, some proponents of ethical egoism have
argued for a restricted egoism where the pursuit of self-interest should be constrained by the law and
the conventions of fair play. It has been argued that this sanctions corporate self-interest, encourages
competition and leads to a maximisation of utility, which is in the interests of society as a whole.
Jeremy Bentham (1784–1832) and John Stuart Mill (1806–73) are generally acknowledged as
developing the theory of utilitarianism, which states that ethical decision making should maximise
the greatest good for the greatest number. This involves an assessment of costs and benefits, not only
in economic terms but also in terms of human costs and benefits. Therefore, it involves a value judg-
ment and needs to consider all the stakeholders who are affected by a decision. The outcomes are
measured in both economic terms and psychological terms, such as pain and happiness. Therefore,
measuring and assigning a numeric value to the consequences of an action will often be difficult.

Deontological ethics
Deontological theories are based on duties and rights. Duties are an obligation and are actions
that a person is expected to perform, while rights are an entitlement and are actions that a person

CHAPTER 3 Ethics, independence and corporate governance 79

 expects of others. These duties and rights are set down in rules that must be followed regardless of
the consequences. Hence, these theories are also sometimes called non-consequential theories.
Deontological theory is particularly important to auditors in understanding their duties based on
the ethical rules of the accounting bodies.
Immanuel Kant (1724–1804) placed high value on personal rights and personal moral
autonomy and the basis of his ethical theory is the principle of respect for persons. This
acknowledges the intrinsic value of all persons and recognises that we should not use people to
achieve our own ends. Further, we should recognise a duty of care to others as expressed in the
golden rule or principle of reciprocity: ‘Do unto others as you would have them do unto you’.
This rule leads to the principle of beneficence, which advocates that we should do good to
others rather than harm. Kant suggested the categorical imperative as a universal ethical law. This
means that when considering the validity of a rule, you need to consider whether you would be
happy to have this action applied in all similar circumstances regardless of the consequences. This
leads to the need for the principle of justice.
John Rawls (1957) argued that the fundamental idea underlying the concept of justice is that of
fairness. He argued that there are two principles which serve as the basis of justice and fairness:
The first principle is that each person participating in a practice, or affected by it, has an
equal right to the most extensive liberty compatible with a like liberty for all; and the second
is that inequalities are arbitrary unless it is reasonable to expect that they will work out for
everyone’s advantage and unless the offices to which they attach, or from which they may be
gained, are open to all.
Thus, Rawls argues that ethical rules should seek equality and the maximum degree of liberty that
does not conflict with the liberty of others or increase inequalities or disadvantage to others.

Virtue ethics
Virtue ethics, which dates back to Aristotle, is concerned primarily with integrity, which is an
essential characteristic of an auditor. Virtue ethics focuses on the person undertaking the action.
Virtues are personal qualities which enable us to do what is ethically desirable and generally
include traits of character such as courage, fairness, honesty, integrity, loyalty, courtesy and
fidelity. Virtue ethics emphasises what makes up a morally good person, but does not necessarily
make it clearer what should be done to solve an ethical conflict.

learning
objective 3
ACCOUNTING BODIES’ CODE OF ETHICS
The Joint Code of Professional Conduct (CPC) sets out the main ethical pronouncements of the
ICAA and CPA Australia and is supported by their By-Laws. The Code consists of six sections.
Arguably the most important are Section B, Fundamental Principles of Professional Conduct,
applicable to all members, and Section F, Professional Statements, which contain the following
series of ethical statements:
■ F.1 Professional Independence
■ F.2 Prospectuses and Reports on Profit Forecasts
■ F.3 Changes in Professional Appointments
■ F.4 Referrals
■ F.5 Opinion Requests
■ F.6 Professional Fees
■ F.7 Incompatible Business.

80 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
 The ethical rules play an important part in an auditor’s behaviour. The written code of appro-
priate professional conduct is designed to enable members to arrive at the proper conclusion
when making ethical decisions. As a result, the ethical rules comment upon different types of
relationships faced by auditors and spell out some of the auditor’s responsibilities. A.2 states that
compliance with the CPC is mandatory for all members, affiliates and registered graduates.
There are also 11 Miscellaneous Professional Statements, not all of which are relevant to
auditors, but which are mandatory for members of both accounting bodies. In general, these
statements seek to promote the fundamental principle of ‘competence’. The statements consist of:
■ APS 1 Conformity with Accounting Standards
■ APS 1.1 Conformity with Auditing Standards
■ APS 2 Engagement Letters to Clients
■ APS 3 Compatibility of Australian Accounting Standards and International Accounting
Standards
■ APS 4 Statement of Quality Control Standard
■ APS 5 Quality Control Policies and Procedures
■ APS 6 Statement of Taxation Standards
■ APS 7 Statement of Insolvency Standards
■ APS 8 Statement of Management Consulting Services Standard
■ APS 9 Statement on Compilation of Financial Reports
■ APS 10 Client Money and the Maintenance and Audit of a Member’s Trust Account.

The purpose of the code of ethics

A code of ethics is a formal and systematic statement of rules, principles, regulations or laws,
developed by a community to promote its wellbeing and to exclude or punish any undermining
behaviour. Therefore, a code of ethics may serve several purposes. It may:
■ make explicit those values that may be implicitly required (e.g. the underlying core values or
principles in CPC B, which is discussed later in this chapter);
■ indicate how members should act towards one another (e.g. the responsibilities to professional
colleagues exhibited through the protocol to be followed when superseding another auditor
(CPC F.3), discussed in Chapter 5, and permissible forms of advertising (CPC D.5), discussed
later in this chapter);
■ provide an objective basis for sanctions against people who violate the rules (e.g. disciplinary
action under the ICAA’s Supplemental Royal Charter and CPA Australia’s Constitution, discussed
in Chapter 2). An individual member’s behaviour can be judged, in part, by reference to the rules
laid down in the CPC. An established code of ethics is one mechanism of self-regulation.
In addition, the CPCs communicate the profession’s responsible attitude of accountability to
the community at large.
Like many professional codes, the ethical rules of the ICAA and CPA Australia endeavour to
promote standards of competence, proficiency and personal moral integrity in their members.
These qualities are similar to those that Thomson et al. (1976) referred to as Aristotle’s intellectual
and moral virtues, discussed earlier in this chapter. Aristotle’s intellectual virtues included science
(knowledge), techne (practical skill and competence, intelligence, judgment, understanding,
persistence and resourcefulness) and wisdom. His moral virtues included courage (loyalty and
integrity), temperance (discipline, friendliness, generosity, magnanimity, communication and
social skills) and justice. Thomson et al. (1976) indicated that these virtues can be depicted as an

CHAPTER 3 Ethics, independence and corporate governance 81

 arch with intellectual values on one side and the moral virtues on the other. The keystone holding
them together is the virtue of prudence or acquired practical wisdom.
However, written codes of conduct should not be viewed as the panacea for the profession’s
ethical problems. As mentioned previously, these codes do not by themselves make people behave
‘ethically’.

The virtues of an auditor

CPC B sets out eight fundamental principles or virtues that should guide the behaviour of
members of CPA Australia and the ICAA, and which underlie the remaining CPCs:

1 The public interest Auditors should safeguard the interests of their clients and employers
provided they are not in conflict with the public interest and the duties and loyalties owed to
the community, its laws and social and political institutions. This principle represents a public
statement of the ‘service ideal’.
2 Integrity Auditors should act with consistency, treating like cases in a like manner. Honesty
is an integral part of this value. Integrity is supported by the fundamental ethical principle of
respect for persons.
3 Objectivity Auditors must be fair and must not allow bias or prejudice to override their
objectivity. They need to maintain an impartial attitude and not represent vested interests
when auditing a financial report.
4 Independence Auditors should both be, and appear to be, free of any interest which might be
regarded as incompatible with objectivity and integrity. Without independence, the auditor’s
opinion is worthless. Independence, however, can be easily compromised.
5 Confidentiality Auditors hold positions of trust and have access to many valuable and private
pieces of information in the course of their work. They should respect the confidentiality of
information obtained during the course of their work and should not disclose such
information to a third party without authority or unless there is a legal or professional duty to
do so. This duty to protect the interests of clients means that confidentiality reflects the
fundamental ethical principle of beneficence.
6 Technical and professional standards Auditors should carry out their professional work in
accordance with the relevant technical and professional standards. Compliance with the
required standards of proficiency protects clients by ensuring that members of the accounting
bodies have the level of technical expertise required to render various specialised services.
7 Competence and due care Auditors have a duty to maintain their level of competence and
should only undertake work that they can expect to complete with professional competence
and due care. Accepting work for which the auditor is incompetent could lead to damage to
the client.
8 Ethical behaviour Auditors should display ethical behaviour and conduct themselves in a
manner consistent with the good reputation of their profession and refrain from any conduct
which could bring discredit to it.

Objectivity, independence and technical standards equate with Aristotle’s intellectual virtues.
Honesty, integrity, confidentiality and ethical behaviour equate with Aristotle’s moral virtues.
Professional competence equates with what Aristotle called prudence or the practical wisdom
necessary to apply abstract general principles to specific situations.
Auditors are both legally and morally accountable to their clients. Therefore, competence in
ethics is an important requirement of a good auditor.

82 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
 Q u i c k r e v i e w
1 Ethics requires knowledge of moral principles and decision-making skills.
2 The ethical rules of the ICAA and CPA Australia provide important guidance to members.
3 Ethical rules cannot cover all aspects of ethical conduct.
4 Ethics is principally an attitude of mind.
5 The key ethical principles of the accounting bodies are public interest, integrity, objec-
tivity, independence, confidentiality, technical and professional standards, competence
and due care and ethical behaviour.

APPLYING ETHICS 4 learning

objective

Sound ethical practice requires responsible people with a critical understanding of sound decision
making based on fundamental ethical principles. This requires:
■ knowledge of the basic principles on which moral values and rules are based;
■ competence in decision-making skills; and
■ ability to choose appropriate policies and decision procedures in different situations.
To act ethically is to act appropriately and responsibly in different situations, providing a clear,
coherent and reasoned justification for decisions and actions, based on commonly accepted
values or standards.
An auditor needs to combine ethical rules with skills in making decisions and setting policies.
As indicated by Leung and Cooper (1995, p. 32):
The complexity of the different ethical problems encountered by accountants requires not
only a good knowledge of a set of ethical principles, but also the skills and competence to
handle conflicting roles and interests relating to accountancy practice.

Ethical decision models

Because the basic steps in problem solving are the same, the various ethical decision models that
have been developed to assist in sound ethical decision making have many common features. The
features of three commonly used models are discussed below. These models should not be
followed slavishly but rather used as a framework for decision making.
Ethical decision making involves consideration of the three aspects of moral theory discussed
earlier in this chapter:
1 Fundamental principles and rules or rights and duties Deontological ethics focuses on the
principles and causes, intentions and motives to be considered prior to action. Fundamental
ethical principles include the principle of beneficence (duty to do good to or protect others),
the principle of justice (duty to treat all people fairly) and the principle of respect for persons
(duty to respect the rights of other people). In an ethical decision model this involves
specifying the facts, including the stakeholders involved, and identifying the ethical principles
and the rights and duties of all parties.
2 Means, methods and the role of the agent Virtue ethics focuses on the moral character of the
agent. The integrity and competence of the agent (auditor) are vital to their capacity to act
ethically. In an ethical decision model this involves identifying all the options available,
considering possible outcomes and knowing the right means to achieve your goals based on
intellectual and moral virtues.
3 Ends or consequences Teleological ethics focuses on the consequences of actions and their
outcomes relative to goals. If the ultimate end of human life is happiness, this approach can

CHAPTER 3 Ethics, independence and corporate governance 83

 translate into the utilitarian rule of always acting so that your action brings the greatest
amount of happiness to the greatest number of people. However, this has to be balanced by
considering the rights of minorities. An assessment of the costs and benefits for all
stakeholders is required. In an ethical decision model this involves the assessment of results in
terms of achieving both short-term and long-term goals.

American Accounting Association model

The American Accounting Association (AAA) published a case book, Ethics in the Accounting
Curriculum: Cases and Readings, in May 1990. Each case is analysed using a seven-step model,
shown in Exhibit 3.1.
E X H I B I T

1. Determine the facts

What? Who? Where? When? How?
What do we know or need to know that will help define the problem?
2. Define the ethical issue
3.1 List the significant stakeholders.
• Define the ethical issues.
American 3. Identify the major principles, rules and values
Accounting (For example, integrity, quality, respect for persons, profit)
Association
4. Specify the alternatives
model
List the major alternative courses of action, including those that represent some form of
compromise or point between simply doing or not doing something.
5. Compare values and alternatives — see if clear decision
Determine if there is one principle or value, or combination, which is so compelling that the
proper alternative is clear.
6. Assess the consequences
Identify the short and long, positive and negative consequences for the major alternatives.
The common short-run focus on gain or loss needs to be measured against the long-run
considerations. This step will often reveal an unanticipated result of major importance.
7. Make your decision
Balance the consequences against your primary principles or values and select the alternative
that best fits.

Source: Courtesy of the American Accounting Association.

Laura Nash model

In 1981 Laura Nash put forward a model for ethical decision making, consisting of a checklist of
questions (Exhibit 3.2). Each question is accompanied by an example or further question to
challenge the decision maker’s assumptions about the correctness of the decision being taken.

Mary Guy model

In 1990 Mary Guy listed ten core values as a checklist for reference when making ethical decisions.
The values are: caring, honesty, accountability, promise keeping, pursuit of excellence, loyalty,
fairness, integrity, respect for others and responsible citizenship.
Guy also suggested five rules which integrate these values and assist in ethical decision making:
■ Rule 1: Consider the wellbeing of others, including non-participants. This rule emphasises
caring and respect for others.
■ Rule 2: Act as a member of the community, not as an isolated individual. This emphasises
loyalty, integrity, respect for others and responsible citizenship.

84 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
■ Rule 3: Obey the law, but do not depend solely on it. This emphasises integrity and responsible
citizenship.
■ Rule 4: Ask, ‘What sort of person would do such a thing?’ This emphasises all the values by
calling each into question.
■ Rule 5: Respect the customs of others, but not at the expense of your own ethics. This
emphasises accountability, fairness, integrity and respect for others.

E X H I B I T
1. Have you defined the problem accurately?
Gain precise facts and many of them.
2. How would you define the problem if you stood on the other side of the fence?
Consider how others perceive it (alternative viewpoints).
3. How did this situation occur in the first place? 3.2
Consider the history, problem or symptoms. •
Laura Nash
4. To whom and what do you give your loyalties as a person and as a member of the model
corporation?
Consider private duty versus corporate policy or norms.
5. What is your intention in making this decision?
Can you take pride in your action?
6. How does this intention compare with the likely results?
Are the results harmful even with good intentions?
7. Whom could your decision or action injure?
A good idea resulting in a bad result? Wanted A, got B.
8. Can you engage the affected parties in a discussion of the problem before you make a
decision?
For example, can you talk to workers before you close the plant?
9. Are you confident that your position will be as valid over a long period of time as it seems
now?
For example, what are the long-term consequences of your action?
10. Could you disclose without qualm your decision or action to your boss/CEO, Board of
Directors, your family or society as a whole?
For example, would you feel comfortable with this reported on TV?
11. What is the symbolic potential of your action if understood? If misunderstood?
For example, will you be perceived to be sincere in the eyes of other people?
12. Under what condition would you allow exceptions to your stand?
For example, breaking the speed limit driving a heart attack victim to hospital.

Source: Courtesy of the American Accounting Association.

Q u i c k r e v i e w
1 An auditor needs to combine knowledge of ethical rules with skills in ethical decision making.
2 There are several ethical decision models that can assist in ethical decision making by
providing a framework for decision making.
3 Three ethical decision models that are commonly used are the American Accounting
Association model, the Laura Nash model and the Mary Guy model.

learning
CORPORATE GOVERNANCE 5
objective

There has recently been a greater emphasis placed on proper corporate governance or
management and the roles to be played by directors, accountants and auditors. Corporate
governance is the system by which companies are directed and controlled. Therefore, corporate
governance is concerned primarily with management and stewardship issues such as:

CHAPTER 3 Ethics, independence and corporate governance 85

 ■ adoption of a corporate strategy;
■ succession planning, including appointing, monitoring and training senior management;
■ maintaining the integrity of the internal control structure and the management information
system; and
■ setting a remuneration policy that is normally based on performance.
It is important to distinguish the roles played by different groups in corporate governance. The
board of directors is responsible to shareholders for the formulation of overall business policies
and strategies in the running of the company. Its duties generally include such matters as:
■ taking responsibility for protecting the rights of shareholders;
■ setting officers’ salaries;
■ recommending dividends;
■ authorising long-term borrowing, additional share issues and major capital projects;
■ reviewing the internal control structure; and
■ identifying and monitoring strategic business risks.
The board of directors is normally composed of corporate executives, such as the chief
executive officer (CEO), known as executive directors, and representatives of large shareholders.
In addition, it normally includes a number of outside or part-time directors, known as non-
executive directors, to ensure a more objective evaluation of management performance. The chair
should in principle be separate from the CEO and be preferably a non-executive director.
Ultimately, corporate governance tries to ensure that an entity operates at the highest level of
efficiency and effectiveness. Skills in ethical decision making are an important factor in good
corporate governance.
In April 1998, the Organisation for Economic Cooperation and Development (OECD)
developed a set of corporate governance standards and guidelines. The five key areas covered by
the OECD Principles of Corporate Governance are:
■ the protection of shareholder’s rights;
■ the equitable treatment of shareholders;
■ the role of stakeholders in corporate governance;
■ disclosure and transparency; and
■ the responsibilities of the board.
The OECD recommendations require that ‘the corporate governance framework should ensure
the strategic guidance of the company, effective monitoring of management by the board, and the
board’s accountability to the company and shareholders’ (OECD, 1999, p. 9).
In the UK, the Committee on the Financial Aspects of Corporate Governance issued its report
in 1992. Known as the Cadbury Report, it advocated a code of best practice designed to achieve
high standards of corporate behaviour. The code has been endorsed by the London Stock
Exchange, which requires companies to publish a statement of compliance with the code in their
annual report.
The Combined Code: Principles of Good Governance and Code of Best Practice was issued by
the London Stock Exchange Committee on Corporate Governance in June 1998 and has been
appended to the London Stock Exchange Listing Rules. It builds on the Cadbury and Hampel
Reports, while making certain changes.
Subsequently, the Institute of Chartered Accountants in England and Wales issued a report,
‘Internal Control: Guidance for Directors on the Combined Code’ (Turnbull Report) (1999) to more
clearly define the accountability of company directors and management.

86 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
 Some key requirements of the Combined Code are:
■ Principle D.2 states that ‘The board should maintain a sound system of internal control to
safeguard shareholders’ investment and the company’s assets’.
■ Provision D.2.1 states that ‘The directors should, at least annually, conduct a review of the
effectiveness of the group’s system of internal control and should report to shareholders that
they have done so. The review should cover all controls, including financial, operational and
compliance controls, and risk management’.
■ Provision D.2.2 states that ‘Companies which do not have an internal audit function should
from time to time review the need for one’.
■ Paragraph 12.43A of the London Stock Exchange Listing Rules states that ‘in the case of a
company incorporated in the United Kingdom, the following additional items must be
included in its annual report and accounts:
• a narrative statement of how it has applied the principles set out in Section 1 of the
Combined Code, providing explanation which enables its shareholders to evaluate how the
principles have been applied; [and]
• a statement as to whether or not it has complied throughout the accounting period with the
Code provisions set out in Section 1 of the Combined Code. A company that has not
complied with the Code provisions, or complied with only some of the Code provisions or (in
the case of provisions whose requirements are of a continuing nature) complied for only part
of an accounting period, must specify the Code provisions with which it has not complied,
and (where relevant) for what part of the period such non-compliance continued, and give
reasons for any non-compliance’.
The Preamble to the Code, which is appended to the Listing Rules, makes it clear that there is
no prescribed form or content for the statement setting out how the various principles in the Code
have been applied. The intention is that companies should have a free hand to explain their
governance policies in the light of the principles, including any special circumstances that have
led to them adopting a particular approach.
The guidance is based on the adoption by a company’s board of a risk-based approach to
establishing a sound system of internal control and to reviewing its effectiveness. This should be
incorporated by the company within its normal management and governance processes. It should
not be treated as a separate exercise undertaken to meet regulatory requirements.
Effective monitoring on a continuous basis is an essential component of a sound system of
internal control. However, the Turnbull Report points out that the board cannot rely solely on the
embedded monitoring processes within the company to discharge its responsibilities. It should
regularly receive and review reports on internal control. In addition, the board should undertake
an annual assessment for the purposes of making its public statement on internal control to
ensure that it has considered all significant aspects of internal control for the company for the year
under review and up to the date of approval of the annual report and accounts.
The Turnbull Report imposes the following requirements on the board:
a) When reviewing reports during the year:
• identify the significant risks and assess how they have been identified, evaluated and
managed;
• assess the effectiveness of the related system of internal control in managing the significant
risks;
• consider whether necessary actions are being taken promptly to remedy any significant
failings or weaknesses; and

CHAPTER 3 Ethics, independence and corporate governance 87

 • consider whether the findings indicate that more extensive monitoring of the system of
internal control is required.
b) When reviewing the board’s annual assessment:
• consider the changes since the last annual assessment in the nature and extent of signifi-
cant risks, and evaluate the company’s ability to respond to changes in its business and the
external environment;
• consider the scope and quality of management’s ongoing monitoring of risks and of the
system of internal control, and, where applicable, the work of its internal audit function and
other providers of assurance;
• consider the extent and frequency of the communication of the results of the monitoring to
the board (or board committee(s));
• consider the incidence of significant control failings or weaknesses that have been
identified during the period and the extent to which they have resulted in unforeseen
outcomes or contingencies that have had, could have had, or may in the future have, a
material impact on the company’s financial performance or condition; and
• evaluate the effectiveness of the company’s public reporting processes.
In Australia, a working group chaired by Henry Bosch (the Bosch Committee) put forward a
guide, Corporate Practices and Conduct, in 1991 with revised versions in 1993 and 1995. This guide
was the first Australian attempt to set out corporate governance standards of best practice. The
guide considered the function of the public company board, its structure, the role of company
accountants and auditors, the conduct of directors, the role of shareholders and codes of ethics.
While corporate governance is primarily the responsibility of the directors and senior officers
of a company or other organisation, accountants have an important part to play. Accountants may
hold directorships or management positions or may be involved in auditing. Therefore, they are
concerned with ensuring that internal control policies and procedures are in place and working.
Auditors must inform management and directors about internal control problems. This
position is supported by the AWA case, which is discussed in Chapter 4. However, auditors cannot
force these groups to act upon their recommendations, which can create ethical dilemmas for the
auditor. The problems that face an auditor in issuing a report on a client’s internal control
structure will be discussed in Chapter 14.
Lynn (1996) has argued that corporate governance is concerned with maintaining an
appropriate accountability system. Management is accountable to the board of directors for its
actions and the board is accountable to the owners for their supervision of management. The
auditor attests to the credibility of the financial information given to the owners, to enable them
to assess the quality of the stewardship being exercised on their behalf. The Cadbury Report
stresses the importance of the annual audit, describing it as one of the cornerstones of corporate
governance. The report argues that audits are a reassurance to all those who have a financial
interest in the company, quite apart from their value to the board of directors.

Groups advocating corporate governance in

Australia
In Australia, several different groups have advocated the importance of corporate governance.

Business community
The Business Council of Australia, in its booklet, Corporate Practices and Conduct, stated:

88 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
 Public accounting practices and auditing firms should have rigorous and effective quality
control procedures which should include the following:
• continuing in-house reviews of practices and performance, and
• systematic independent reviews of the effectiveness of the profession’s established quality
control procedures within individual firms, including a confidential examination of work files.
Codes of conduct have a role to play in the area of corporate governance, and the booklet had
two objectives:
1 to guide directors, officers and professional advisers as to what is acceptable conduct and
practice; and
2 to spread and reinforce high standards of corporate conduct.
It recognised that accountants and auditors must maintain their professionalism at all times and
strongly endorsed the ICAA and CPA Australia principles of independence. It also recommended
the adoption of a company code of ethics, which should contain specific requirements dealing
with the following matters:
■ a general statement signed by the chairman and/or the chief executive emphasising the
board’s, and management’s, commitment to the code;
■ a section dealing with responsibilities to shareholders and the financial community generally;
■ a section on relations with customers and consumers;
■ a section on relations with suppliers;
■ a section on employment practices;
■ a section on responsibilities to the community (e.g. environmental policy, donations); and
■ a section on personal conduct (e.g. bribery, policy on gifts, confidential information, conflicts
of interest).

Investors
The Australian Investment Managers’ Association published a booklet in 1995, entitled Corporate
Governance: A Guide for Investment Managers and a Statement of Recommended Corporate Practice,
to provide guidelines to assist its members in their voting and other practices in relation to
Australian public companies. The membership consists of more than 50 investment management
firms, which hold about 45 per cent of the available capital of companies listed on the Australian
Stock Exchange (ASX). The booklet provides information about what investors perceive to be best
practice in corporate governance. Among the 14 guidelines is a recommendation that a code of
ethics should be adopted by all companies, directors and employees. However, no details are
provided about what matters should be addressed in a code of ethics.

Australian Stock Exchange

Until recently the ASX has not imposed any requirements in regard to ethical matters and
corporate governance. However, in 1996 the ASX amended its listing rules to include the following
disclosure rule in s. 4.10.3:
for annual reporting periods ending on or after 30 June 1996, a statement of the main corporate
governance practices that the company has in place during the reporting period. Where the
statement identifies a corporate governance practice that has been in place for only part of the
reporting period, the part of the period for which it has been in place must be disclosed.
Appendix 4A, ‘List of Corporate Governance Matters’ (Exhibit 3.3, overleaf) is included in the
listing rules. It provides a list of the types of corporate governance matters that should be considered

CHAPTER 3 Ethics, independence and corporate governance 89

 when preparing the disclosure under s. 4.10.3, such as the company’s policy on the establishment
and maintenance of appropriate ethical standards.

E X H I B I T
Below is an indicative list of corporate governance matters. A company may take them into
account when making the statement in its annual report under Listing Rule 4.10.3.
1. Executive/non-executive directors
Whether individual directors, including the chairman, are executive or non-executive directors.
3.3 2. Board membership
• The main procedures the company has in place for:
Appendix 4A, • devising the criteria for board membership;
ASX listing • reviewing the membership of the board; and
rules, ‘List of • nominating directors.
Corporate If any of these procedures involve a nomination committee, a summary of the main
Governance responsibilities of the committee, and the names of committee members. If one or more
Matters’ members are not directors of the company, their positions in the company.
3. Non-executive directors
The company's policies on the terms and conditions relating to the appointment and
retirement of non-executive directors.
4. Independent advice provisions
The main procedure(s), if any, by which directors in the furtherance of their duties can seek
independent professional advice at the company's expense.
5. Compensation arrangements for management and non-executive directors
The main procedures for establishing and reviewing the compensation arrangements for:
• the chief executive officer and other senior executives; and
• non-executive members of the board.
If these procedures involve a remuneration committee, a summary of the main responsibilities
and core rights of the committee, and the names of committee members. If one or more
members are not directors of the company, their positions in the company.
6. Auditors and audit committees
The main procedures that the company has in place for:
• the nomination of external auditors; and
• reviewing the adequacy of existing internal audit arrangements, with particular emphasis
on the scope and quality of the audit.
If any of these procedures involves an audit committee, a summary of the main responsibilities
and core rights of the committee, and the names of committee members. If one or more
members are not directors of the company, their positions in the company. (Refer to Listing
Rule 4.10.2.)
7. Risks and risk management
The board's approach to identifying areas of significant business risk and putting
arrangements in place to manage those risks.
8. Ethical standards
The company's policy on the establishment and maintenance of appropriate ethical standards.

The ASX-co-ordinated Corporate Governance Council met for the first time on 15 August 2002.
The new body represents a broad cross-section of business and professional groups with an interest
in best practice corporate governance and disclosure. The objectives of the group will be to:
■ identify and support best practice principles of corporate governance;
■ identify legislative deficiencies and convey those to government;
■ co-ordinate input to facilitate improved Stock Exchange listing rules; and
■ endorse the specific requirements/rules of participating members.
The Corporate Governance Council have expressed strong support for the establishment of
audit committees with appropriate expertise, disclosure of when the audit firm was appointed
and the dates of rotation of audit engagement partners.

90 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
Australian Securities and Investments Commission
ASIC is involved primarily with enforcing the provisions of the Corporations Act and related
legislation. ASIC does not involve itself in the promulgation of codes of ethics or conduct, which it
believes is the responsibility of self-regulatory organisations such as the ICAA and CPA Australia.
Rather, ASIC’s role is one of regulatory supervision.

Accounting bodies
The CPA Australia and ICAA report on the ‘expectation gap’ in Australia in 1993 saw:
a role for new statements to exhort members ‘to take all reasonable steps within their power’
to ensure that various reporting initiatives relevant to corporate governance are carried
through into action.
This report recommends that members of the ICAA and CPA Australia take a proactive role in
corporate governance. This view is reinforced by the follow-up taskforce report issued in June 1996
and the issue of a Best Practice Guide on Audit Committees.

Audit committees
One result of the focus on corporate governance that has affected the auditor has been the setting
up of audit committees. An audit committee is a sub-committee of the board of directors or other
governing body, comprising a majority of independent/non-executive members of the governing
body of an entity and represents owners rather than management. Amongst other functions, it is
usually assigned the oversight of the financial reporting and auditing process, and the auditor’s
major dealings with the governing body will be through the audit committee, although the auditor
will usually meet with the full governing body at least once per year. An audit committee is
therefore an important component of corporate governance.
According to Schelluch (1991), audit committees have been established primarily to:
■ assist the board of directors to fulfil its legal fiduciary responsibilities;
■ add to the credibility and objectivity of financial reports;
■ enhance the independence and effectiveness of auditors;
■ oversee the application of appropriate accounting policies and procedures and ensure
appropriate disclosure;
■ establish and monitor corporate policies to prohibit unethical or illegal activities;
■ establish and monitor effective internal and management controls; and
■ provide a communication link between management, auditors and the board.
While there is no legislative requirement in Australia to have an audit committee, since 1993
the ASX has required disclosure of the existence of an audit committee or reasons why such a
committee was not formed. The importance of audit committees has been strongly advocated by
the accounting profession, the Australian Institute of Company Directors and the Institute of
Internal Auditors. Empirical research has revealed that the number of Australian listed companies
with audit committees has increased from less than 50 per cent in 1990 to over 80 per cent today.
The number of audit committees in the public sector is also growing.
However, Baxter and Pragasam (1999) and Arkley-Smith (1999) found that while publicly listed
Australian companies disclose the existence of audit committees, in general they fall well short of
the recommended best practice procedures for audit committee disclosures. Arkley-Smith (1999)
considered whether firms had disclosed information on eight items for which there was significant
support in the reports and best practice guides reviewed. The eight items considered were:

CHAPTER 3 Ethics, independence and corporate governance 91

 ■ the number of non-executive directors on the committee;
■ the terms of reference of the committee;
■ frequency of meetings with the external auditor; and
■ whether the core duties included:
• an overview of the entity’s financial reporting process;
• monitoring the external audit process;
• making recommendations on appointment and remuneration of the external auditor;
• reviewing the effectiveness of the control environment established by management; and
• reviewing the activities of the internal audit function.
She found that no company disclosed every item considered important. Eleven companies
(3.5 per cent) disclosed seven of the possible eight items and 104 companies (33.5 per cent)
disclosed none of the items. Exhibit 3.4 provides a summary of the results.
An effective audit committee takes an active role in overseeing the company’s accounting and
financial reporting. The audit committee should maintain a direct line of communication between
the board of directors and the company’s auditors, permitting open discussion of sensitive matters
like controversial accounting issues, disagreements with management, deficiencies in the design
of the internal control structure, failures in the operation of the internal control structure and
difficulties encountered in performing the audit. The audit committee normally discusses the
general scope and timing of external audit work, although it does not review the detailed audit
program. The audit committee also normally involves itself in the nomination of the external
auditors, reviews the reasonableness of the audit fees and considers how the provision of non-
audit services affects the auditor’s independence.
E X H I B I T

Percentage of
Disclosure companies disclosing

Number of non-executive directors 54.35

Terms of reference of committee 42.26
3.4
• Duties include overview of financial report process 38.06
Audit Duties include monitoring the external auditor 31.61
Committee
Duties included reviewing effectiveness of control environment 23.87
disclosures
Duties include monitoring the internal auditor 16.77
Frequency of meeting with external auditor 00.84
Duties include recommending appointment and remuneration of external auditor 00.68

Source: Arkley-Smith, 1999.

The audit committee serves to strengthen the auditor’s independence by providing a reference
point, independent of executive management, to which problems of audit scope, contentious
issues and conflicts arising during the audit can be referred on a timely basis.
The external auditor, as an independent party with a detailed knowledge of the entity’s
financial affairs, is able to provide substantial input to the audit committee by reporting relevant
matters to it. Therefore, the external auditor is a major contributor to achieving an effective audit
committee. The external auditor should also assist the audit committee by informing it of any
developments such as legislative changes or new accounting standards.
The second edition of Audit Committees: Best Practice Guide was issued by the AuASB,
Australian Institute of Company Directors (AICD) and the Institute of Internal Auditors—

92 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
Australia (IIA) in September 2001. The guide states that ‘the audit committee can play a key role
in assisting the board of directors to fulfil its corporate governance and overseeing
responsibilities in relation to an entity’s financial reporting, internal control structure, risk
management systems, and the internal and external audit functions’.

Q u i c k r e v i e w
1 There is an increasing emphasis on the importance of corporate governance, with good
corporate governance procedures being advocated by many different groups.
2 While directors have the primary responsibility for corporate governance, accountants
and auditors have a role to play.
3 An important aspect of corporate governance is the role of the audit and the audit
committee.

learning
WHISTLEBLOWING 6
objective

If the auditor concludes that unethical behaviour has occurred, they need to consider whether it
is necessary to whistleblow on the offender and, if so, to whom to report. A typical definition in
the US Civil Service Reform Act of 1978 defines a whistleblower as a person
who discloses information he (or she) reasonably believes evidences a violation of any law,
rule, or regulation, or mismanagement, a gross waste of public funds, an abuse of authority,
or a substantial or specific danger to public health or safety.
The main characteristics of whistleblowing are:
■ a disclosure of information showing objectionable misconduct, which is not otherwise known
or visible;
■ a reasonable belief that disclosure of this information will allow stakeholders to determine that
there has been misconduct;
■ the disclosure is made in good faith, without malice;
■ the disclosure is made in the public interest; and
■ the disclosure is not specifically prohibited by law or contrary to considerations of national
security or defence (Starke, 1991, p. 210).
It may be argued that auditors have a whistleblowing role imposed upon them by s. 311 of the
Corporations Act. The auditor’s primary responsibility is to the shareholders, and the auditor has a
duty to report to ASIC any contravention of the Corporations Act which they discover in the normal
course of their duties and which cannot be remedied by comment in their audit report or by
bringing it to the attention of the directors.
Audit and Assurance Alert No. 6, issued in October 1999, points out that s. 311 does not require
the auditor to actively look for contraventions of the Corporations Act. The responsibility of the
auditor under s. 311 is not to detect contraventions per se but rather to act upon those matters that
come to the auditor’s attention during the course of the audit. Section 311 requires an auditor to
take action where the auditor has ‘reasonable grounds’ to suspect a contravention of the
Corporations Act. This requires that there must be some facts or some evidence that would lead a
reasonable auditor to hold that suspicion.
Before reporting suspected contraventions of the Corporations Act to ASIC, auditors must be
able to demonstrate that they have asked questions of directors or considered the impact of any
comment that might be made in the audit report. The auditor’s belief that the contravention could
not be ‘adequately dealt with’ in the auditor’s report or by raising the matter with directors must

CHAPTER 3 Ethics, independence and corporate governance 93

 be based on more than just the auditor’s personal feelings and should be capable of withstanding
subsequent scrutiny. The auditor’s reporting responsibilities are discussed further in Chapter 13.
Accountants in business who uncover wrongdoing by corrupt management also face the
problem of blowing the whistle on their employer. To assist professionals and others in reporting
unethical behaviour, ASIC has published a booklet entitled How to Report Suspected Breaches of
the Corporations Act. It contains guidance on:
■ what you should report to ASIC;
■ ASIC’s responsibility;
■ what to include in your report;
■ confidentiality;
■ what ASIC does with your information;
■ what ASIC cannot deal with;
■ steps ASIC may take in assessing your report; and
■ action which may follow ASIC investigations.
AUS 210.70–.72 (ISA 240.70–.72) recognises that, in the absence of any specific mandatory
reporting requirement, where an entity’s governing body fails to take appropriate action in regard
to a fraud, an auditor may seek legal advice as to whether to report the fraud to a third party.
Further discussion of the auditor’s reporting of fraud is included in Chapters 4 and 13.
The decision to blow the whistle is seldom easy, and it often involves both anguish and cost to
the whistleblower. Accountants who make known their opposition to unethical practices may risk
their jobs, but if they do nothing they risk action from their professional body and regulatory
authorities. In the case of Enron, it was vice president Sherron Watkins who blew the whistle on
the lack of disclosure of related party transactions and ‘off-balance-sheet’ financing and expressed
her fear that the company would ‘implode under a series of accounting scandals’.
An auditor who is considering going public with some information needs to resolve the
conflict between the principles of independence, objectivity, integrity and public interest on the
one hand, and the principle of confidentiality, on the other. Legislative requirements aside, the
principle of beneficence appears to be the main force driving whistleblowers. Not only should one
not participate in causing harm, but one should also act to prevent harm.

Q u i c k r e v i e w
1 Auditors have a whistleblowing role imposed on them by s. 311 of the Corporations Act.
2 Whistleblowing requires resolution of the conflict between the principles of independence,
objectivity, integrity and public interest on the one hand, and confidentiality on the other.

learning
objective 7
THE IMPORTANCE OF AUDIT INDEPENDENCE
As mentioned earlier, for an audit or other assurance service to add credibility to a financial report
or other subject matter, an auditor needs to remain independent. Independence is one of the eight
fundamental ethical virtues or principles named in section B of the CPC and discussed earlier in
this chapter. In Australia, the requirement of independence for auditors has been reinforced
through the Corporations Act and the ethical rules of the accounting bodies.

Legislative requirements
The Corporations Act contains some provisions which give formal recognition to the need for audit
independence. Section 308 indirectly attempts to promote audit independence by requiring

94 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
auditors to report to the members of the company rather than to management, while s. 327
requires that members appoint the auditor. Further, s. 324(1) states that a person shall not consent
to appointment or act as auditor of a company if the person:
■ is indebted to the company or to a related entity in an amount exceeding $5000;
■ is a substantial shareholder in a corporation which is indebted to the company or to a related
entity in an amount exceeding $5000; or
■ except where the company is a proprietary company,
• is an officer of the company,
• is a partner, employer or employee of an officer of the company, or
• is a partner or employee of an employee of an officer of the company.
In addition, s. 324(2) states that a firm shall not consent to be appointed, or act, as auditor of a
company if any member of the audit firm violates the above restrictions or, except where the
company is a proprietary company, if an officer of the company receives any remuneration from
the audit firm for acting as a consultant to it on accounting or auditing matters.
Section 324(4) deems a person to be an officer of a company if they are an officer of a related
entity or, unless ASIC grants an exemption, if they have been an officer of the company or a related
entity within the previous 12 months.
Further statutory support is given to audit independence by s. 329. These provisions attempt
to augment the auditor’s position by attempting to reduce management’s influence on the auditor.
This is done by appointing an auditor until death, removal or resignation, rather than annually.
Removal from office requires a resolution of the company at a general meeting of which special
notice has been given. The auditor is entitled to make a written representation to all shareholders,
at the company’s expense, and to speak at the general meeting. A copy of the notice of removal
must be sent to ASIC.
Further, while an auditor can resign, the auditor must have prior consent from ASIC,
unless it is a proprietary company (s. 329(9)). The application for that consent must contain
reasons for the auditor’s request, and the auditor must notify the company of the application
(s. 329(5)). If ASIC approves the resignation, it is effective from the date specified in the notice
of resignation, the date the consent was given or the date fixed by ASIC, whichever occurs
last (s. 329(8)).
ASIC Policy Statement 26, issued in June 1992, sets out the policies and principles which
influence ASIC in the exercise of the power conferred on it by s. 329(6) to consent to the
resignation of auditors. ASIC’s overriding concern is to ensure that the independence and integrity
of the audit function are maintained. The appointment of an auditor is primarily a matter for the
members. As a result, ASIC will not consent to a resignation that does not take effect at the annual
general meeting, unless there are exceptional circumstances.
Further, ASIC will consent to a resignation that takes effect at the next annual general meeting
only if all of the following conditions apply:
■ ASIC believes that the auditor’s reasons for resignation are acceptable.
■ The auditor states that all s. 311 matters have been reported to ASIC at the date of the
application and that any further such matters which come to their attention before resignation
will be reported.
■ The auditor states that there are no disputes with company management connected with the
relinquishment of office.
■ The auditor states that there are no other circumstances connected with the relinquishment of
office which should be brought to ASIC’s attention.

CHAPTER 3 Ethics, independence and corporate governance 95

 Examples of such circumstances are:
■ the independence of the audit function is not being preserved; or
■ the outgoing auditor is aware that the resignation may be connected with opinion shopping,
which is discussed later in this chapter.
ASIC will consent to a resignation that does not take effect at the next annual general meeting
only if all of the following conditions apply:
■ ASIC considers that there are exceptional circumstances and that a day other than the next
annual general meeting is appropriate.
■ The auditor states all s. 311 matters concerning breaches of the Corporations Act have been
reported to ASIC at the date of the application and that any further such matters which come
to their attention before resignation will be reported. For the purposes of determining whether
a matter should be reported pursuant to s. 311, the auditor assumes that the matter will not be
dealt with adequately by comment in the audit report on the financial report, because they are
unlikely to have any control over the content of the audit report, which will be the
responsibility of the new auditor.
■ The application includes a copy of a directors’ resolution appointing a replacement auditor
and a confirmation from the proposed replacement auditor stating willingness to accept the
appointment, both subject to ASIC’s approval of the resignation.
■ The auditor states that there are no disputes with company management connected with the
relinquishment of office.
■ The auditor states that there are no other circumstances connected with the relinquishment of
office which should be brought to ASIC’s attention.
Examples of exceptional circumstances include:
■ loss of independence of the auditor;
■ the failing health of the auditor;
■ the company is not audited by the auditor of its parent entity; or
■ a relocation of the company’s or auditor’s principal place of business resulting in
circumstances where it would be impractical for the auditor to perform the audit.
Section 310 provides further protection to the auditor by giving the right of access at all
reasonable times to the accounting and other records and registers, and an entitlement to require
from any officer of the company such information and explanations as required for the purposes
of audit. Section 331 states that the auditor is entitled to receive reasonable fees and expenses for
the work carried out.
Collectively, these provisions assist an auditor to maintain actual and perceived independence,
and attempt to create, as far as possible, a suitable environment for an audit process that is free
from undue influence and obstruction. These provisions provide some protection to the auditor
in resisting management pressure. The practical effectiveness of the provisions varies with the
circumstances and the extent of management control.

Ethical requirements
A number of areas related to independence are not covered in the legislation. These
independence requirements have been provided for in the ethical rulings of the professional
accounting bodies. The overriding principle in the ethical rules is the reasonable person test
outlined in CPC F.1.10: would a reasonable person having access to all the facts consider that the
auditor was independent?

96 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
 CPC F.1.9 states that independence is a fundamental concept to the profession and requires a
member to approach their work with integrity and objectivity. Further, CPC F.1.10 states that a
member in public practice must both be, and be seen to be, free of any interest that is
incompatible with objectivity. Therefore, the ethical rules emphasise that the auditor’s perceived
independence is as important as the auditor’s actual independence.
Perceived independence is described in CPC F.1 as ‘independence in appearance’ and is the
belief of financial report users that actual independence has been achieved. It is this perception
that is responsible, in part, for the credibility of the auditor’s report. Users will not derive any
assurance from the auditor’s work unless they believe the auditor is independent.
Actual independence is described in CPC F.1 as ‘independence of mind’ and is the
achievement of actual freedom from bias, personal interest, prior commitment to an interest, or
susceptibility to undue influence or pressure. Independence cannot be achieved simply by the
application of a series of rules or regulations alone, but rather is built upon the auditor’s belief in,
and support for, the concept and its application during audit engagements. Three factors that
contribute to an independent attitude of mind are:
1 integrity;
2 objectivity; and
3 strength of character.

Q u i c k r e v i e w
1 Actual and perceived independence is critical if an audit or other assurance engagement
is to add credibility to the subject matter concerned.
2 The Corporations Act contains provisions that are directed toward maintaining the
auditor’s independence.
3 Detailed independence rules and guidance are provided in the CPCs.

learning
RECENT DEVELOPMENTS IN AUDITOR 8
objective

INDEPENDENCE
Ramsay Report
Interest in the issue of audit independence has been increased recently by speculation about what
role, if any, audit independence matters played in a number of high-profile corporate failures
during the first half of 2001. As a result, the federal government commissioned a report by
Professor Ian Ramsay on audit independence in Australia. The Ramsay Report, which was issued
in October 2001, examines Australia’s existing legislative and professional requirements on the
independence of company auditors and compares them with equivalent overseas requirements.
Where appropriate, the report proposes measures for strengthening the Australian requirements.
The recommendations cover five key issues concerned either directly with audit independence
(employment relationships, financial relationships and provision of non-audit services) or with
matters designed to enhance audit independence (audit committees and a board to oversee audit
independence issues). These issues will be discussed later in this chapter.
The Ramsay Report recommendations envisage the continuation of the existing co-regulatory
regime under which some requirements are included in the corporations legislation and others
are in the ethical rules of the professional accounting bodies. The federal government will provide

CHAPTER 3 Ethics, independence and corporate governance 97

 a response to the Ramsay Report recommendations as part of CLERP 9, which was referred to in
Chapter 1 and will be discussed later in this chapter.

IFAC independence rules

In addition, there have been a number of developments internationally, including the release of
new ethical rules by the International Federation of Accountants (IFAC). In June 2000, IFAC issued
an exposure draft containing significant revisions of its rules on professional independence
including the adoption of a conceptual framework approach. The exposure draft was re-exposed
in April 2001 and revised ethical rules were finally issued in November 2001.
IFAC has adopted a conceptual approach to independence that uses a framework, built on
principles for identifying, evaluating and responding to threats to independence. The framework
establishes principles that the auditor should use to identify threats to independence, evaluate the
significance of those threats, and identify and apply safeguards to eliminate the threats or reduce
them to an acceptable level.

CPC F.1
CPA Australia and the ICAA approved a new professional independence standard, CPC F.1, in May
2002. The new CPC F.1 is based on the IFAC ethical rules and is tailored to reflect Australian
community expectations. The new CPC F.1 becomes mandatory on 31 December 2003, although
earlier adoption is encouraged. Audit Practice Statement AUP 32, which was issued in August 1992,
will not be withdrawn until the new CPC F.1 becomes mandatory.
CPC F.1 now requires the auditor to identify and evaluate threats to independence and to
respond by applying safeguards which eliminate the identified threats or which reduce them to an
acceptable level.
Threats to independence are described in CPC F.1 as:
■ Self-interest threats: the possibility that the firm or individuals within it could benefit from a
financial interest in the client.
■ Self-review threats: the possibility that the firm or individuals within it would have to re-
evaluate their own work to form a judgment.
■ Advocacy threats: situations where the firm or individuals within it could promote the audit
client’s point of view in a manner which compromises objectivity.
■ Familiarity threats: the possibility that the firm or individuals within it have become too
sympathetic to the client’s interests.
■ Intimidation threats: the possibility that the firm or individuals within it may be deterred from
acting objectively by actual or perceived threats from the client.
Safeguards fall into three broad categories. For an auditor, these are:
■ Safeguards created by the profession, legislation or regulation, such as education, profes-
sional standards, monitoring and disciplinary processes, and inspections and review.
■ Safeguards within the audit client, including competent employees and robust corporate
governance structures.
■ Safeguards within the audit firm, including policies and procedures to implement and
monitor independence and quality control.
The principles and rules set out in CPC F.1 allow an auditor to evaluate any circumstance and
to determine procedures and actions necessary to avoid or resolve those circumstances that pose
threats or risks to objectivity.

98 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
 An auditor should set up and maintain a safeguarding system that is an integral part of the
firm-wide management and internal control structure. This safeguarding system, which
encompasses all aspects of independence and quality control and not just the provision of other
services to an audit client, may include:
■ written independence policies that address current independence standards, threats to
independence, and related safeguards;
■ active and timely communication of policies;
■ appropriate procedures to be applied by partners and staff in order to meet independence
standards;
■ documentation that summarises conclusions that have been drawn from the assessment of
threats to independence and the related evaluation of the independence risk; and
■ internal monitoring of compliance with safeguarding policies.
The system will apply to the engagement team and audit firm and to all other partners and staff
within the audit firm. There may be differing restrictions and requirements on partners and staff
within the firm depending on the nature of their work and their relationship with the audit client
or engagement team. These aspects are discussed in full in F.1, Appendix 1.28–37.

Sarbanes-Oxley Act 2002

In the USA, in response to the collapse of Enron, WorldCom and other high-profile business
failures the new Sarbanes-Oxley Act was signed into law on 30 July 2002. The Sarbanes-Oxley Act of
2002 dramatically affects the accounting profession and provides more stringent independence
requirements and more severe penalties for breaches. Among other things, it restricts greatly the
ability of auditors to provide non-audit services, mandates audit partner rotation and strengthens
the role of the audit committee. These issues were outlined in Audit and Assurance Alert No. 13,
issued in September 2002 and will be discussed in more detail in this chapter.
The Sarbanes-Oxley Act 2002 also extends the statute of limitations for the discovery of fraud
to two years from the date of discovery and five years after the act (previously one year and three,
respectively). The Act establishes harsh penalties for securities law violations, corporate fraud and
document shredding and requires the Chief Executive Officer (CEO) and Chief Financial Officer
(CFO) to certify that the financial report fairly presents in all material respects the operations and
condition of the company.
The Sarbanes-Oxley Act 2002 affects not only US companies and US auditors, but any audit
firm actively working as an auditor of, or for, a publicly traded US company or its subsidiary.
Therefore the Act covers any Australian audit firm that does the audit of a subsidiary of a US listed
company. In addition, it is likely to affect our jurisdiction, as it is currently seen as best practice; at
the time of writing there have already been calls for similar legislation in Australia.

Joint Committee of Public Accounts and Audit

Due to the major corporate collapses both within Australia and overseas, the JCPAA resolved to
review independent auditing by registered company auditors. They issued their recommendations
in August 2002 in Report 391. Similar to the Sarbanes-Oxley Act 2002, it recommends that the Corpo-
rations Act 2001 be amended to require the CEO and CFO to sign a statutory declaration that the
company’s financial reports comply with the Act and are ‘materially truthful and complete’. It also
recommends that audit firms submit an annual report to ASIC on how the audit firm has managed
independence issues, and that ASIC be empowered to investigate such independence issues.

CHAPTER 3 Ethics, independence and corporate governance 99

 Corporate Law Economic Reform Program
In September 2002, the federal government issued a policy paper, CLERP 9, as part of its Corporate
Law Economic Reform Program, seeking stakeholder comments on proposals for legislative
amendments. The paper reviewed, among other things, auditor independence. The government
has advised that the final implementation of reforms will take account of any relevant
recommendations of the HIH Royal Commission and the JCPAA, as well as developments overseas
and stakeholder feedback. These proposed reforms, which include an annual independence
declaration by auditors and an independence requirement in the Corporations Act, will be referred
to when discussing various independence issues throughout this chapter.

Q u i c k r e v i e w
1 The Ramsay Report reviewed audit independence requirements in Australia and made
recommendations concerning auditor–client employment relationships, financial
relationships, provision of non-audit services, audit committees and a board to oversee
audit independence issues.
2 A revised CPC F.1 has been issued based on the IFAC Ethical Code; it adopts a conceptual
approach to independence based on identifying threats to independence and
implementing adequate safeguards.
3 The Sarbanes-Oxley Act 2002 in the USA has introduced more stringent independence
requirements and there are calls for similar requirements in Australia.
4 In Australia, the JCPAA and CLERP 9 have made a number of recommendations for
improving auditor independence.

learning
objective 9
MAJOR THREATS TO AUDITOR INDEPENDENCE
The Ramsay Report identified three major threats to auditor independence: auditor employment
relationships; financial and business relationships; and provision of non-audit services.

Auditor employment relationships

The existence of employment relationships between an audit firm and an audit client can give
the impression that an auditor is not independent of the client, irrespective of the actual
situation. Consequently, legislators worldwide have tended to include provisions in corporate
legislation that prohibit or restrict employment relationships. The professional accounting
bodies have also amended their ethical codes to include prohibitions or restrictions on employ-
ment relationships.
CPC F.1 Appendix 2.42 prohibits a member of the assurance team from remaining a member
of the assurance team if they are employed by the client, as it creates too great a self-interest, self-
review, familiarity and intimidation threat to independence. Further, CPC F.1 Appendix 2.47
similarly prohibits any partner or employee of the audit firm serving as an officer of the client.
A particular concern recently has been retired audit partners joining the boards of their audit
clients (commonly referred to as the alumni threat). The Ramsay Report noted that where this
occurs, it is often seen as a particular threat to the independence of the audit firm, particularly if
the former audit partner retains some financial arrangement with his or her audit firm or
continues to exercise influence with the audit firm.
In the USA, the Independence Standards Board (2000) stated that the potential threats to
independence when professionals leave firms to join audit clients are generally:

100 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
 ■ That partners or other audit team members who resign to accept positions with audit
clients may not have exercised an appropriate level of scepticism during the audit process
prior to their departure.
■ That the departing partner or other professional may be familiar enough with the audit
approach and testing strategy so as to be able to circumvent them once he or she begins
employment with the client.
■ That remaining members of the audit team, who may have been friendly with, or
respectful of a former partner or other professional when he or she was with the firm,
would be reluctant to challenge the decisions of the former partner or professional and,
as a result, might accept the client’s proposed accounting without exercising appropriate
scepticism or maintaining objectivity.
If the former partner or professional has retirement benefits or a capital account with the
audit firm:
■ It may appear that ties between the audit firm and the partner or other professional have
not been severed … and the audit firm is in effect auditing the results of its own work.
■ If the retirement benefits of the former partner or other professional vary based on the
firm’s profits, then the former partner or other professional may be inclined to pay the
firm higher fees to inflate his or her retirement benefits …
■ [if the firm] is experiencing cash flow problems, the firm may be less rigorous in its audit
of the client’s financial statements in exchange for forbearance on the amounts owed to
the former partner or other professional.
In the USA, it was noted in the Waste Management Inc. case, which will be discussed later, that
from the time it became a public company until 1997, every chief financial officer and chief
accounting officer of Waste Management had previously worked as an auditor for their audit firm,
Arthur Andersen. During the 1990s, 14 former Arthur Andersen employees worked for Waste
Management Inc., most often in key financial and accounting positions.
Also, in Australia, in the HIH Insurance case, it was noted that the Chairman and Finance
Director were former partners of HIH’s audit firm, Arthur Andersen. In addition, one of the other
directors, who was also a former Arthur Andersen partner, was previously the auditor of FAI
Insurance in the 1980s before it became a subsidiary of HIH Insurance in 1998.
The Ramsay Report recommended that an auditor should not be considered independent if a
former partner or professional employee of an audit firm is:
■ a director of the client; or
■ an officer or employee of the client who is in a position to affect the subject matter of the audit
engagement;
unless the individual:
■ does not influence the audit firm’s operations or financial policies and does not participate or
appear to participate in the audit firm’s business or professional activities;
■ has no capital balances in the audit firm; and
■ has no financial arrangement with the audit firm other than one providing for regular payment
of a fixed pre-determined dollar amount that is not dependent on the revenues, profits or
earnings of the audit firm.
In relation to the threat to independence when a retired audit partner joins the board of an audit
client, the Ramsay Report recommended that there be a mandatory period of two years following
resignation from the audit firm before a former partner of an audit firm who is directly involved in

CHAPTER 3 Ethics, independence and corporate governance 101

 the audit of a client can become a director of the client. This recommendation has been adopted in
CPC F.1 Appendix 2.42, and a similar legislative restriction is recommended in CLERP 9.
In the USA, the Sarbanes-Oxley Act 2002 has made it unlawful for an audit firm to perform any
audit service if a chief executive officer, controller, chief financial officer, chief accounting officer,
or any person serving in an equivalent position of the client, was employed by the audit firm and
participated in the audit in any capacity during the 1 year period preceding the date of the
initiation of the audit.

Financial and business relationships

Investments in audit clients
The Ramsay Report recommended that an auditor will be deemed not to be independent if:
■ the audit firm, any member of the audit engagement team, or any of his or her immediate
family (or any entity which the firm or person controls) has any direct financial investment in
the client, such as shares, notes, options, or other securities; or any material indirect financial
investment in the client;
■ the audit firm, any member of the audit engagement team, or any of his or her immediate
family (or any entity which the firm or person controls), has a material financial interest in an
entity that has a controlling interest in the client;
■ any partner, principal or professional employee of the audit firm, or any of his or her
immediate family (or any entity which the person controls) controls the client; or
■ any other client service personnel, or any of his or her immediate family (or any entity that the
person controls) has a direct financial interest or a material indirect financial interest in the client.
This recommendation has been adopted in CPC F.1 Appendix 2.5, which prohibits an auditor or
their immediate family member from having a direct financial interest or a material indirect
financial interest in an audit client, as it creates too great a self-interest threat. CLERP 9 proposes
adopting similar legislative restrictions.

Loans to and from audit clients

The Ramsay Report recommended that an auditor should not be considered to be independent if
a partner of the audit firm, or an entity which the partner controls, or a body corporate in which
the partner has a substantial holding, owes more than $10 000 (or such other amount as may be
prescribed by regulation) to the client. In addition, independence should be considered to be
breached if the audit firm, any member of the audit engagement team, or any of his or her
immediate family (or an entity which the firm or person controls) accepts or makes or guarantees
a loan to or from the client, except for a loan that is ‘made in the ordinary course of the client’s
business’ and the loan is made under normal lending procedures, terms and conditions. CLERP 9
has supported this recommendation, although it proposes retaining the current $5000 limit.
CPC F.1 Appendix 2.28 prohibits loans from audit clients that are not financial institutions
unless they are immaterial to the auditor and the institution, as they create too great a self-interest
threat. Loans from a financial institution are allowed provided they are under normal lending
procedures and, if it is material, that there are adequate safeguards.

Business relationships
The Ramsay Report recommended that an auditor should not be considered to be independent if
a member of the audit engagement team has a business relationship with the client or any of its

102 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
officers; or the audit firm has a business relationship with the client or any of its officers which is
not clearly insignificant to both the audit firm and the client.
A business relationship for this purpose does not include professional services provided by the
audit firm, or the audit firm or members of the audit engagement team being a consumer in the
ordinary course of business.
CPC F.1 Appendix 2.31 points out that a close business relationship between the auditor and
the client will involve a commercial or common financial interest and may create self-interest and
intimidation threats.

Goods and services from clients

CPC F.1.27 states that the auditor should not accept goods or services from a client on terms more
favourable than those generally available to others. Gifts or hospitality beyond normal social
courtesies should not be accepted, as they would create unacceptable self-interest and familiarity
threats.

S N I P P E T
3.1 AUDITING IN THE NEWS
Audit surveys disagree on independence issue
3.1
N ew research on whether non-audit fees compromise the performance of auditors was
presented at an international symposium on audit research this week, and the
findings were mixed.
Source: Buffini, F.
(2002) ‘Audit
•

Surveys Disagree on
The influence of non-audit fees on audit has become an important issue following Independence
recent corporate collapses, and due to the large amounts clients pay their auditors for Issue’, Australian
Financial Review,
other services. 5 July, p. 66.
With audit fees routinely accounting for less than half of the total fees paid by listed
companies to their auditors, the perception of a conflict of interest is widespread.
However, whether independence is actually compromised is harder to prove.
A US study presented at the symposium in Sydney this week found that a high level
of non-audit fees increased reliance on internal audit, potentially compromising the
detection of financial statement errors and intentional misstatements.
‘External auditors appear to be more affected by client pressure and less concerned
about internal audit quality when making internal audit reliance decisions at clients for
whom significant non-audit services are also provided’, the paper, by William Felix of the
University of Arizona, Audrey Gramling of Georgia State University and Mario Maletta of
Northeastern University said.
‘Taken together, our findings indicate that non-audit service revenues have an effect
on decisions that are integral to the evidence-gathering and evaluation components of
the audit process and, as a result, these revenues potentially affect the likelihood that the
audit will [fail to] identify material errors and intentional misstatement.’
However, another US study, also presented at the symposium, found that non-audit
fees had no impact on the willingness of auditors to issue going concern opinions.
‘Our tests find no evidence of a significant association between the fee ratio and the
auditors’ propensity to issue a going-concern opinion’, the paper from Mark DeFond,
K. Raghunandan and K. Subramanyam from the University of California and Texas A&M
University said.
Their findings were backed by a third study on the impact of non-audit services and
earnings conservatism, which was also presented this week.

Continued…

CHAPTER 3 Ethics, independence and corporate governance 103

 Caitlin Ruddock, Sarah Taylor and Stephen Taylor of the University of Technology,
Sydney, found that clients of the big audit firms had more conservative earnings than
clients of smaller audit firms.
They said their results did not support the conclusion that the provision of non-audit
services by the big audit firms had resulted in less independence.
Instead, their results showed that earnings conservatism of the audit clients of the big
firms increased with the extent of non-audit services.

Provision of non-audit services by auditors

The issue of whether audit firms should provide non-audit or other services to their audit clients
generates a wide range of views from stakeholder groups, ranging from calls for a total prohibition
on the provision of such services to claims that there is no evidence that providing the services
impairs independence. Audit independence studies examined during the course of the Ramsay
Report have reached different conclusions concerning whether the provision of non-audit
services impairs audit independence.
The growth of non-audit services for the largest audit firms has been substantial. In the USA, the
Panel on Audit Effectiveness (2000) stated in its report that for SEC audit clients, the ratio of accounting
and auditing revenues to consulting revenues dropped from approximately 6:1 in 1990 to 1.5:1 in 1999.
Further, 4 per cent of Big Four firms’ SEC audit clients had consulting fees that exceeded audit fees.
ASIC recently conducted a survey of Australia’s largest 100 listed companies to obtain evidence
on the extent of non-audit services provided by the auditors of these companies. The results,
which were released in January 2002, showed that the provision of non-audit services in Australia
was widespread with just over half (53 per cent) of fees to audit firms being for audit services.
In a speech in the USA in June 2001, acting Securities and Exchange Commission (SEC) chief
Laura Unger (2001) said conflicts of interest for auditors may be greater than regulators suspected.
Unger pointed to new proxy disclosures and the SEC’s recent settlement with Arthur Andersen
over Waste Management Inc. as evidence of potential conflicts that can occur when large
accounting firms provide non-audit services to the companies they audit.
On 19 June 2001, the SEC settled actions in connection with Andersen’s audits of the annual
financial reports of Waste Management Inc. for the years 1992 through 1996. Those financial
reports, on which Andersen issued unqualified audit opinions, overstated Waste Management’s
pre-tax income by more than $1 billion. However, contrary to auditing standards, Andersen only
quantified in their working papers the effect of certain of the identified misstatements. Andersen
also allowed Waste Management to ‘bury’ certain charges by improperly netting them against
unrelated, one-time gains to avoid SEC disclosure requirements.
Unger (2001) called the case ‘the smoking gun that everyone was looking for’ during the debate on
the SEC’s auditor independence rules. ‘This is one very significant case that we can point to’ as
evidence of the pitfalls that can occur when an auditor provides other services to audit clients, Unger
said in the speech. Andersen billed Waste Management about $11.8 million for non-audit services, far
more than the $7.5 million it charged for its audit services over the 7 year period. In addition, a related
entity, Andersen Consulting, also billed Waste Management $6 million in additional non-audit fees.
Further, the SEC’s analysis of the new proxy reports have shown higher-than-expected
payments for non-audit services. Based on a review of 563 proxy statements, the SEC found
companies spending $2.69 for non-audit services for every $1 in audit services, with about 73 per
cent of fees to auditors generated by non-audit work.

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 ‘The numbers alone don’t prove that there is a conflict,’ Unger acknowledged. But she said the
SEC was ‘very surprised’ by the results. However, Unger indicated that she believes disclosure of
such payments is better than prohibiting auditors from providing non-audit services.
The Panel on Audit Effectiveness (2000) noted that there were several arguments both for and
against auditors providing non-audit services to their clients. The main argument for opposing
the provision of non-audit services by auditors to their clients is that when an audit firm provides
non-audit services to a client it is serving two different sets of clients: management in the case
of non-audit services and the audit committee, the shareholders and all those who rely on the
audited financial statements in the case of the audit. As a result, the audit firm is subject to
conflicts of interest. On the other hand, the main arguments supporting the provision of non-
audit services by auditors to their clients are that there is no solid evidence of any specific link
between audit failures and the provision of non-audit services; non-audit services have been
provided by audit firms to their clients for many years; and many non-audit services are both in
the public interest and beneficial to audit effectiveness. For example, a company may seek the
assistance of its auditors to correct control weaknesses identified during the audit.
However, it is generally agreed that there are some services that an audit firm cannot provide
to its client. For example, CPC F.1 Appendix 2.55 indicates that in all cases, engagements for an
audit client that involve the following activities must be refused:
■ authorising, executing or consummating a transaction, or otherwise executing authority on
behalf of the assurance client, or having the authority to do so;
■ determining which recommendation of the firm should be implemented;
■ reporting in a management role to those charged with governance; and
■ any other activity barred by legislation.
CPC F.1 also identifies a number of situations where specific safeguards may be required and
identifies examples of such safeguards. Some of these situations and safeguards are summarised
below. However, CPC F.1 Appendix 2 must be referred to for a full explanation of these matters.
CLERP 9 supports the immediate application of CPC F.1.

Preparing accounting records and financial reports

A self-review threat exists where an auditor participates in the preparation of the audit client’s
accounting records or financial reports. The significance of the threat depends upon the
individual’s involvement in the preparation process and upon the public involvement in the
audit client.
Appropriate services that may be offered by the auditor include technical assistance, for
example, on accounting standards or principles, disclosures, or appropriateness of controls,
assisting in the preparation of consolidated financial reports and proposing adjusting journal
entries. These services promote the fair presentation of the financial report and do not
generally threaten independence. For other accounting and bookkeeping services, including
payroll, the significance of the self-review threat is high and safeguards are required if the
service is offered.
For non-listed audit clients, CPC F.1 Appendix 2.67 indicates that the self-review threat from
providing accounting or bookkeeping services on financial information that forms the basis of the
financial report is too high to allow the auditor to undertake the service unless the assistance
provided is solely of a routine or mechanical nature. Examples of acceptable services include
recording transactions the client has authorised, posting coded transactions to a general ledger or
preparing a financial report based on the client’s trial balance.

CHAPTER 3 Ethics, independence and corporate governance 105

 For listed audit clients, CPC F.1 Appendix 2.68 states that accounting or bookkeeping services
on financial information, which forms the basis of the financial report, cannot be undertaken as
there is no safeguard that reduces the threat to an acceptable level. The only exceptions to this are:
■ an emergency situation where it is impractical for the audit client to make other arrangements.
In this instance, the auditor must not take any managerial role or make managerial decisions,
the audit client must take responsibility for the results and the personnel undertaking the work
must not be members of the audit engagement teams; and
■ where the services are required by statute or regulations.
In no circumstances must the auditor originate, authorise or approve transactions on behalf of
an audit client.

Valuation services
A self-review threat exists whenever an auditor provides the audit client with valuation services that
result in the preparation of a valuation that is to be incorporated into the client’s financial report.
CPC F.1 Appendix 2.73 states that the significance of the self-review threat is considered too
high to allow the provision of services where the valuation relates to amounts that are material in
relation to the financial report and where the valuation involves a significant degree of
subjectivity. In these circumstances, which include Independent Expert Reports, the valuation
service should be refused, or the auditor must withdraw from the audit.
In all other cases, the auditor may undertake the service only after considering whether
additional safeguards are needed to mitigate a remaining self-review threat. Such safeguards may
include using an expert team with different individuals (including engagement partner) and
different reporting lines to those of the audit engagement team. The auditor should also obtain the
audit client’s acceptance of their responsibility for the results of the work.

Taxation
Services relating to taxation include compliance and advisory services that assist entities to
determine, plan and report on tax consequences related to their activities. As they are advisory
services, this work should not usurp the management function of an audit client provided the
client takes responsibility for decisions. Under CPC F.1, the provision of such services would not
create a threat to independence.

Internal audit
Self-review threats may arise in certain circumstances where an auditor provides internal audit
services to an audit client. CPC F.1 Appendix 2.80–1 indicates that where the auditor assists in the
performance of an audit client’s internal audit activities or undertakes outsourcing of some of these
activities, the self-review threat needs to be mitigated by safeguards. These safeguards include:
■ ensuring that the audit client at all times has responsibility for:
• the overall system of internal control (i.e. the establishment and maintenance of internal
controls, including the day to day controls and processes in relation to the authorisation,
execution and recording of accounting transactions);
• determining the scope, risk and frequency of the internal audit procedures to be performed
and assessing their adequacy;
• ensuring a competent employee is responsible for the internal audit activities;
• considering and acting on findings and recommendations; and

106 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
■ the auditor not accepting the outcomes of internal auditing processes for statutory audit
purposes without adequate review.
Internal audit services that are appropriate with such safeguards include specialist
assignments on behalf of an audit client’s internal audit department and undertaking internal
audit procedures determined or approved by the entity.
Providing services that involve the audit firm having responsibility for devising, undertaking
and monitoring the whole of the internal audit activity or taking management decisions in respect
to internal audit activity should not be undertaken by the auditor.

Design and implementation of financial information

technology systems
The provision of services by the auditor to an audit client that involve the design and
implementation of financial information technology systems used to generate information
forming part of the audit client’s financial report may give rise to a self-review threat. CPC F.1
Appendix 2.85 indicates that the significance of the self-review threat is considered too high to
permit an auditor to provide such services unless:
■ the audit client acknowledges that they take responsibility for the overall system;
■ the audit client appoints a senior employee to take all management decisions with respect to
the design and implementation;
■ the audit client makes management decisions and evaluates the adequacy and results of the
design and implementation; and
■ the audit client is responsible for the operation of the system and information generated.
The auditor needs to consider whether additional safeguards are required to mitigate a
remaining self-review threat. In particular, whether services should only be provided by an expert
team with different individuals (including engagement partner) and different reporting lines to
those of the audit engagement team.

Temporary staff assignments

Lending staff, or secondments, to audit clients may create a self-review threat where the individual
is in a position to influence the preparation of the client’s accounts or financial report. CPC F.1
Appendix 2.89 indicates that safeguards that must be in place for any temporary staff assignment
are that the individual:
■ must not make management decisions;
■ must not approve or sign agreements; and
■ must not exercise discretionary authority to commit the client.

Litigation support services

CPC F.1 Appendix 2.90 acknowledges that an advocacy threat exists whenever an auditor acts for
the audit client in the resolution of a dispute or litigation. A self-review threat may also arise where
such a service includes the estimation of the audit client’s chances in the resolution of litigation,
and thereby affects the amounts to be reflected in the financial report.
The significance of both the advocacy and the self-review threat is considered too high to allow
an auditor to act in the resolution of litigation that involves matters that would reasonably be
expected to have a material impact on the audit client’s financial report and where a significant
degree of subjectivity is inherent in the case concerned. The threats are also considered too high

CHAPTER 3 Ethics, independence and corporate governance 107

 to be capable of being reduced to an acceptable level through safeguards when the role involves
the auditor making managerial decisions on behalf of the audit client.

Legal services
Legal services encompass a wide and varied range of roles. Work involving matters not expected
to have a material effect on the financial report is not considered to create a threat to
independence. Legal advice such as contract support, legal due diligence and restructuring may
create self-review threats, but CPC F.1 Appendix 2.95 indicates that these threats may be able to be
reduced to an acceptable level by implementing safeguards such as using individuals not involved
with the audit and ensuring the client takes responsibility for decisions.
Advocacy work not material to the financial report may be undertaken if appropriate
safeguards are in place. These would include prohibiting audit firm individuals making
managerial decisions on behalf of the client and using individuals who are not involved with the
audit for the legal work.
It is appropriate for the auditor to undertake dispute analysis, investigation and resolution
services for an audit client. However, this work should not be undertaken in relation to matters
with a material impact on the financial report.
CPC F.1 Appendix 2.98 states that the auditor should not act as General Counsel for an audit
client.

Recruiting senior management

Before accepting any engagement to assist in the recruitment of senior or key staff, the auditor
should assess the current and future threats to independence that may arise and consider
appropriate safeguards to mitigate such threats. Generally it is acceptable for the audit firm to
advertise for and interview candidates and produce a list of potential candidates against a client’s
specifications. CPC F.1 Appendix 2.99 states that the decision as to who should be engaged must
always be taken by the audit client.
When recruiting staff to senior financial posts, the significance of threats to independence is
high. As such, the auditor should carefully consider whether there might be circumstances where
even the provision of a list of potential candidates for such posts may cause an unacceptable level
of independence risk.

Corporate finance and similar activities

Corporate finance encompasses a wide and varied range of services. Safeguards that are generally
available to counter potential advocacy or self-review threats include:
■ prohibiting the auditor making managerial decisions on behalf of the client;
■ using individuals not involved in the audit to undertake the work; and
■ ensuring the auditor does not commit the audit client to a transaction or the terms of a
transaction.
Within these safeguards, services such as advice on corporate reorganisations or deal
structures, may be appropriate services for the auditor to undertake, provided the auditor is able
to reduce the risks to an acceptable level.
Promoting, dealing in, or underwriting an audit client’s shares, including Initial Public
Offerings, however, should not be undertaken, in accordance with CPC F.1 Appendix 2.100, as the
threats to independence are too great. This does not include preparing a report as required by the
Corporations Act, for example prospectus reporting undertaken in accordance with AUS 810.

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Activities that involve the auditor committing the audit client to the terms of a transaction or
agreeing to a transaction are also prohibited under CPC F.1 Appendix 2.100.
Providing non-audit services consistent with the auditor’s skills and expertise is an acceptable
activity for an auditor and often provides additional value for an audit client. However, the
provision of such services to an audit client may create real or perceived threats to independence.
The auditor may provide services beyond the audit as long as any threats to independence have
been reduced to an acceptable level.
Whenever an auditor provides services other than statutory audit work to an audit client, the
significance of any threat must be evaluated. In some cases it may be possible to eliminate or
reduce the threat by applying suitable safeguards. In other cases no safeguard will be available to
reduce the threat to an acceptable level and in these situations, one of the services (the audit or
non-audit service) must be refused.
The Ramsay Report (2001, p. 10) also recommended ‘mandatory disclosure through the
Australian accounting standards or the Corporations Act of non-audit services by category of
service, as well as the dollar amount of fees paid for these services’. This proposal has been
supported by CLERP 9.
For auditors of US listed companies or their subsidiaries, the Sarbanes-Oxley Act 2002 provides
a much greater restriction on the provision of non-audit services and lists eight types of services
that are now ‘unlawful’ if provided to a publicly held company by its auditor: bookkeeping,
information systems design and implementation, appraisals or valuation services, actuarial
services, internal audits, management and human resources services, broker/dealer and
investment banking services, and legal or expert services related to audit services. It also has one
catch-all category authorising the board to determine by regulation any service it wishes to
prohibit. Other non-audit services—including tax services—require pre-approval by the audit
committee on a case-by-case basis. Pre-approved non-audit services must be disclosed to
investors in periodic reports. In Australia, CLERP 9 has recommended amending the law to require
a statement in the annual report of whether the audit committee is satisfied the provision of non-
audit services is compatible with auditor independence.

EXAMPLE 3.1 Independence

Alberto Foods Pty Ltd is a fast growing company and has now become by far your largest audit client.
During the last year the services your firm has provided included completing the annual financial
report audit, preparing the company’s tax returns, deciding on the new computer system to be
installed and preparing an independent valuation of a major investment to be included in the financial
report. However, due to the need for funds for its expansion the company has not paid its audit fee for
the last two years.
As a result of the expansion, the chairman has asked that you serve as a director for the current
year, as he believes that your financial expertise will be invaluable in assisting the company through
some very difficult times. The company’s constitution requires each director to hold a minimum of
100 ordinary shares in the company.

Required
Identify any professional standards and regulatory requirements that may have been breached.

Solution
1. Although there is no information on the exact quantum of fees from Alberta Foods Pty Ltd, the fact
that it is your largest client and is fast growing suggests that there may be a fee dependence issue.
CPC F.1 Appendix 2.102–4 indicates that where the fees from one client constitute a large propor-
tion of a firm’s total fees, it may create a self-interest threat. Where the fees exceed 15 per cent of
the firm’s total fees, safeguards are necessary to reduce the proportion to an acceptable level.
Continued…

CHAPTER 3 Ethics, independence and corporate governance 109

 2. CPC F.1 Appendix 2.106 states that where the fees for an audit client remain unpaid for a long
time it creates a self-interest threat that would require adequate safeguards. Further, the auditor
needs to consider whether the unpaid fees have taken on the characteristic of a loan, which if
material, would be prohibited under CPC F.1 Appendix 2.28 due to self-interest threats.
3. CPC F.1 Appendix 2.77 states that taxation services are generally not seen as threats to
independence. In addition, the work being done for Alberto Foods Pty Ltd is only tax compliance
work and is allowed.
4. CPC F.1 Appendix 2.85 states that where the auditor is providing services involving the design and
implementation of information technology systems, a necessary safeguard is that the audit client
should make all the management decisions regarding the design and implementation process. In
this case the auditor is deciding on the new computer system, which is prohibited as it creates an
unacceptable self-review threat.
5. CPC F.1 Appendix 2.73 states that preparing a valuation of matters that are material to the
financial report creates a self-review threat that cannot be reduced to an acceptable level.
Therefore, the auditor should not prepare the valuation for use in the financial report of Alberto
Food Pty Ltd.
6. As Alberto Foods Pty Ltd is a proprietary company you are not specifically precluded from being
a director under s. 324 of the Corporations Act. However, CPC F.1 Appendix 2.47 states that being
a director creates self-interest and self-review threats that no safeguard could reduce to an
acceptable level and so being a director of Alberto Foods Pty Ltd is prohibited.
7. CPC F.1 Appendix 2.12 states that an auditor should have no direct financial interest in an audit
client. The 100 ordinary shares would constitute a direct investment and therefore would also
create a threat so significant that you would not be able to undertake the audit.

Q u i c k r e v i e w
1 Auditors being employed by a client, or serving as an officer of a client, creates an
unacceptable independence threat.
2 Auditors having a direct financial interest or material indirect financial interest creates
too great a self-interest threat to independence.
3 The provision of non-audit services by auditors to clients is now severely restricted, and
the auditor is not permitted to take part in the decision-making process.

learning
objective 10 SUGGESTIONS FOR IMPROVING AUDITOR
INDEPENDENCE
Establishment of an Oversight Board
During August 2001, IFAC released a proposal for the establishment of a Public Oversight Board
(POB) to oversee the public interest activities of IFAC, including:
■ the setting of auditing, ethical, public sector and educational standards;
■ the obligations of membership and compliance processes applicable to its member bodies;
and
■ the quality assurance, compliance and other self-regulatory processes applicable to
membership of a new body called the Forum of Firms (FOF).
The FOF was established by IFAC to promote consistently high standards of financial reporting
and auditing worldwide. Its membership is open to any firm that has or is interested in accepting
transnational audit appointments, provided the firm:
■ agrees to conform to the Forum’s Global Quality Standard; and
■ agrees to subject its assurance work to periodic external quality assurance reviews.

110 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
 In performing its role, the POB will focus on whether the interests of users of financial reports
are being appropriately reflected in the processes and outputs of IFAC and its committees, and on
those activities of the FOF that impact financial reporting.
The UK is currently implementing a system of non-statutory independent regulation for its
accountancy profession. The key feature of the system is its independence from control or undue
influence by the accountancy profession. Its aim is to ensure that the public interest in the way the
profession operates is fully met, and thus to secure public confidence in the impartiality and
effectiveness of the profession’s systems of regulation and discipline. The new system of regulation
involves the establishment of five new bodies, including a Review Board.
In the USA, the Sarbanes-Oxley Act 2002 has created a five-member Public Company
Accounting Oversight Board (PCAOB), which has the authority to set and enforce auditing,
attestation, quality control, and ethics (including independence) standards for public companies.
It is also empowered to inspect the auditing operations of public accounting firms that audit
public companies as well as impose disciplinary and remedial sanctions for violations of the
board’s rules, securities laws and professional auditing standards.
Canada has also established a new system to oversee the auditors of public companies. It will
be administered and enforced by the new Canadian Public Accountability Board.
The Ramsay Report recommends that an independent supervisory board is an essential instru-
ment in addressing the challenge of implementing new auditor independence requirements in
Australia. Ramsay argued that the establishment of an Auditor Independence Supervisory Board
(AISB) will play a vital role in ensuring public confidence in the independence of auditors by
monitoring implementation of the new regime, compliance with it, and important international
developments in the area of auditor independence.
The Ramsay Report stated that the AISB must not be controlled by the accounting profession.
Although the expertise of the profession will provide a valuable contribution to the AISB, the
majority of members must be independent of the professional accounting bodies. All key
stakeholders should have board representation.
The ICAA has supported the creation of an Australian Public Oversight Board in its submission
to the JCPAA. CPA Australia has also recommended the creation of a single public oversight board
with a charter to extend across corporate governance, financial reporting and auditing. CLERP 9
has recommended that the government expand the responsibilities of the FRC to oversee auditor
independence requirements in Australia. It has been proposed to reconstitute the AuASB with a
government-appointed chairman under the auspices of the FRC, similar to the AASB.

Strengthening the role of audit committees

Communication on a number of issues with the Governance Body of an audit client is vital, as
explained in the Audit Committees: Best Practice Guide and reaffirmed in CPC F.1 Appendix 1.34.
One aspect of the audit committee role is review of the external auditor’s independence based on
the auditor’s relationships and services with the entity and others that may impair or appear to
impair the auditor’s independence.
As detailed in Auditing and Assurance Alert 11, the auditor of a listed client may provide to the
audit committee a declaration of independence and detailed disclosure of remuneration for audit
and other services that can be used for financial report disclosures. These items will contribute to
the discussions held by the audit committee.
In the USA, the Blue Ribbon Committee sponsored by the New York Stock Exchange (NYSE)
and the National Association of Securities Dealers (NASD) strongly endorsed the use of audit

CHAPTER 3 Ethics, independence and corporate governance 111

.
 committees. The Sarbanes-Oxley Act 2002 now requires all US listed companies to have an audit
committee and vests the audit committee with the responsibility for the appointment, compen-
sation and oversight of its auditor. The Act requires that audit committee members must be
members of the Board of Directors, but otherwise be independent. Furthermore, the audit com-
mittee must have a financial expert on the committee or disclose the reasons for not including such
an expert. In addition, the auditor is required to report to the audit committee on a timely basis:
■ all critical accounting policies and practices to be used;
■ all alternative accounting treatments discussed with management, together with the
treatment preferred by the auditor; and
■ other material written communications with management, such as any management letter or
schedule of unadjusted differences.
A recent survey in the USA by Earnscliffe Research and Communications (2000) of chief
executive officers of SEC registrant companies, chief financial officers of SEC registrant
companies, chairs of audit committees of these companies, investment analysts, and partners of
audit firms found that a strengthened oversight role for audit committees is important in ensuring
the independence of auditors. According to the Blue Ribbon Committee (1999, p. 22) (cited in
Psaros & Seamer, 2001, p. 47), ‘several recent studies have produced a correlation between audit
committee independence and two desirable outcomes: a higher degree of active oversight and a
lower incidence of financial statement fraud’.
Psaros and Seamer (2001, p. 47) have concluded that the corporate governance practices of the
recently collapsed Harris Scarfe ‘were less than ideal. Neither the board of directors nor the audit
committee possessed the recommended degree of independence to enable them to act at an
optimal level’. Further, Reuter’s news agency reported that:
the directors were shocked to discover critical financial management accounting
irregularities, which had given the board a deliberately false and misleading view of the
company’s true financial position over a period of up to six years
(Psaros & Seamer 2001, p. 44)

The executive chairman of Harris Scarfe, Adam Tescowthick, said in a press release that the
‘board had acted in good faith on financial information provided by senior management, and that
the accounts had been cleared by the auditors at least three times in the previous 15 months’
(Psaros & Seamer, 2001, p. 44).
The board of directors of Harris Scarfe had historically been composed of a majority of non-
independent or executive directors. In 1999 and 2000, the number of non-independent directors
was reduced so that there was an equal number of non-independent and independent directors.
This is contrary to international best practice as outlined in Audit Committees: Best Practice Guide,
which requires that the majority of individuals on the board should be genuinely independent.
In addition, the audit committee of Harris Scarfe had traditionally been composed of a
majority of non-independent directors. Accordingly, Psaros and Seamer (2001, p. 46) point out
that ‘as the majority of the Harris Scarfe audit committee comprised senior management, it was
arguably not possible to operate to its full potential’. Further, the audit committee only met twice
in 2000, 1999 and 1997, and three times in 1998. The Blue Ribbon Committee (1999)
recommended that the audit committee should meet at least four times annually, or more
frequently as circumstances dictate.
In the case of One.Tel, it has been claimed that the information that the executive management
was providing to the non-executive board of directors was different to that being released through
other sources. Thus, the issue of how much the non-executive management can rely on

112 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
information provided by executives, versus how much they have to question this information, is
an important issue for audit committees.
The Ramsay Report indicates that most stakeholders consulted during the preparation of the
report were of the view that requiring listed companies to have an appropriately constituted audit
committee would be a most effective way of enhancing the independence of auditors of such
companies. In line with this view, the Ramsay Report recommended that:
■ The ASX Listing Rules be ‘amended to require all listed companies to have an audit committee.
The new Listing Rule would be accompanied by an ASX Guidance Note’ that ‘should reflect
international best practice in audit committees’.
■ The Listing Rule should:
• ‘mandate the existence of a qualified audit committee’;
• ‘specify the composition of the audit committee’; and
• ‘require the board of directors to adopt a written charter to govern the audit committee’.
■ The Guidance Note should:
• ‘specify the general requirements, and duties and responsibilities, of a qualified audit
committee’; and
• ‘contain such other matters as are considered appropriate by ASX’.
CLERP 9 has recommended that audit committees be mandatory for the top 500 listed
companies. The ASX has announced that it will amend its rules to achieve this. Similarly, the JCPAA
recommended the Corporations Act be amended to require all publicly listed companies to have
an independent audit committee.
In relation to the responsibilities of the audit committee, the Ramsay Report (2001, pp. 81–2)
recommended that the audit committee should:
■ state in the annual report whether or not it believes the level of non-audit service provision by
the auditor is compatible with maintaining auditor independence, and should include reasons
where appropriate;
■ make recommendations to the board on the appointment, reappointment or replacement,
remuneration, monitoring of the effectiveness, and independence of the auditor;
■ review and agree on the terms of engagement for the auditor at the start of each audit;
■ review the scope of the external audit with the auditor, including identified risk areas and any
additional agreed-upon procedures;
■ review the auditor’s audit fee, and be satisfied that an effective, comprehensive and complete
audit can be conducted for that fee (this includes reviewing and assessing fees paid for non-
audit service provisions);
■ review with the auditor any significant disagreements between the auditor and management,
irrespective of whether they have been resolved;
■ monitor the number of former employees of the audit firm currently employed in senior
positions in the company and assess whether this impairs or appears to impair the auditor’s
judgment or independence in respect of the company;
■ consider whether, taken as a whole, the various relationships between the company and the
auditor impair or appear to impair the auditor’s judgment or independence in respect of the
company;
■ consider whether the compensation of the individuals employed by the auditor who are
performing the audit of the company is tied to the provision of non-audit services and, if so,
consider whether this impairs or appears to impair the auditor’s judgment or independence in
respect of the company;

CHAPTER 3 Ethics, independence and corporate governance 113

 ■ review the economic importance of the company (in terms of fees paid to the auditor for the audit
as well as fees paid to the auditor for the provision of non-audit services) to the auditor, and assess
whether the economic importance of the company to the auditor impairs or appears to impair the
auditor’s judgment or independence in respect of the company; and
■ at least annually, meet with the auditor without the presence of management.

Rotation of auditors
Rotation of audit partners
The Ramsay Report recommended that there be mandatory rotation of the audit partners responsible
for the audit of listed companies and that the rotation is to occur after a maximum of 7 years. This
leaves open the possibility that rotation may occur sooner if considered appropriate by those involved
in the audit. It is also recommended that there is to be a period of at least 2 years before the partner can
again be involved in the audit of the client. This recommendation of the Ramsay Report was adopted
by CPC F.1 Appendix 2.50 for listed companies. In the USA, the Sarbanes-Oxley Act 2002 has adopted a
shorter period of rotation: every 5 years. Similarly, CLERP 9 has recommended mandatory rotation of
partners every 5 years and that this requirement apply to both engagement and review partners.

Rotation of audit firms

S N I P P E T

AUDITING IN THE NEWS 3.2

Audit rotations give second-rate results
• 3.2
Source: Houghton,
K.A. (2002) ‘Audit
J ohn Shanahan’s proposal for five-year mandated rotation of audit firms (‘Five-year
rotation needed for audit firms’, AFR, June 12) is one often-cited ‘solution’ for the
concerns over auditor independence.
Rotations Give Shanahan’s contribution shows some interesting insights, but in my view the potential
Second-Rate
Results’, Australian for mandated rotation as an effective solution is limited and the likelihood of it producing
Financial Review, damaging unintended consequences is significant.
17 June, p. 52. Many in the profession acknowledge that the first year or two of an audit, even with
substantial costs in additional time spent learning about the client, produce results that are
significantly short of optimal.
Why would we want to institutionalise a sub-optimal audit for 20 to 40 per cent of all
audits market-wide if we were to have five-year rotations? There are cases where an
inappropriately ‘comfortable’ relationship between auditor and auditee arises with long-
term engagements, but why have a ‘one-size-fits-all’ solution when it is probably only a
problem for a small percentage of cases?
A fatal flaw of the mandated five-year rotation ‘solution’ is that it provides an incentive
for auditors, knowing that they have a five-year tenure, to do a minimal job for the five years
to maximise profitability until they lose the audit to the next profit-maximising firm.
Another concern is that rotation might provide an incentive to auditors to use the
mandated changes to gain short-term access to many companies—not to do a high-quality
audit but to build ‘relationships’ with company management so that they can sell
consulting services at the end of the five years.
Threats to independence are real, economically significant and often complex, diverse
and subtle in nature. I for one do not believe that a simple conventional solution, despite
its apparent attractions, will be effective.
We need creative solutions that will deliver appropriate incentives for a long-term
sustainable solution to the threats to auditor independence.

114 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
 The Ramsay Report did not believe it appropriate to mandate rotation of audit firms. It concurred
with the Audit Review Working Party, which stated that ‘the anticipated cost, disruption and loss of
experience to companies is considered unacceptably high, as is the unwarranted restriction on the
freedom of companies to choose their own auditors’. This view has been supported by CLERP 9.

Audit firm independence boards

Houghton and Jubb (2002) have recommended the establishment by each of the larger audit firms
of an Auditor Independence Board as a complement to the partnership structure. They have
recommended that members of the Board should be experts in fields such as auditing,
commercial law, professional services, accounting or auditing standard-setting or accounting
policy-making and should not be current or former partners of employees of the audit firm.
Houghton and Jubb (2002) argue that an internal independence board would be more
effective than an externally imposed board as:
■ independence issues and threats could be dealt with swiftly at the time of the audit;
■ the board could deal with commercially sensitive issues;
■ the quality-control processes of the board, and therefore of that firm, could be observed by the
market;
■ extremely subtle or difficult-to-measure issues could be dealt with sympathetically, yet
conclusively; and
■ reward structures within firms could take account of board decisions.
While the model proposed is a market-based solution, it would require an appropriate
legislative or regulatory framework that required, as a minimum, compulsion for auditors of
publicly traded entities to have an internal independence board.

Client auditor policies

Another market-based approach has been for some entities to designate the type of services that its
auditor may supply. For example, the ANZ Banking Group Ltd issued a media release listing the type
of non-audit services that its auditor may supply. A number of other companies have done likewise.

S N I P P E T
3.3 AUDITING IN THE NEWS
ANZ enhances governance standards

T he ANZ Board today announced measures to enhance ANZ’s corporate governance

procedures following a review of best practice by the ANZ Audit Committee.
ANZ Chairman, Mr Charles Goode, said the new measures would further strengthen
Source: ANZ
3.3
Media Release, 24
•

ANZ’s already high standard of corporate governance, disclosure and transparency. April 2002.
A number of measures will be introduced to enhance governance, including plain
English disclosure and expansion of discussion on critical accounting policies in ANZ’s
published results, disclosure of off-balance sheet structures and restrictions on the services
that may be provided by its auditor.
The review established clear definitions as to which services may or may not be provided
by ANZ’s auditor (see below). These fall into three categories:
• The auditing firm may provide audit and audit-related services that, while outside the
scope of the statutory audit, are consistent with the role of auditor.
• The auditing firm should not provide services that are perceived to be materially in
conflict with the role of auditor. Continued…

CHAPTER 3 Ethics, independence and corporate governance 115

 • The auditing firm may be permitted to provide non-audit services that are not
perceived to be materially in conflict with the role of auditor, subject to the approval
of the ANZ Audit Committee.
ANZ Audit Committee Chairman, Mr John Cahlsen, commented: ‘The Board wishes to
ensure ANZ has the highest standards of corporate governance. This review demonstrates in a
very tangible way the importance we place on open and transparent disclosure, on appropriate
accounting policies, and ensuring the ANZ audit is conducted without conflict of interest.’
ANZ does not plan to put its audit out to tender at this time.
ANZ policy on auditing and non-auditing services
This policy defines the services that may or may not normally be conducted by ANZ’s
external auditing firm. Implicit in this policy are the principles that:
The auditing firm may provide audit and audit-related services that, while outside the
scope of the statutory audit, are consistent with the role of auditor. These include audit
related services, and regulatory and prudential reviews requested by the Bank’s
regulators. Examples are:
• Financial audits
• Audits of regulatory returns (e.g. APRA)
• Reviews undertaken for regulatory purposes (e.g. APRA Targeted Review)
• Other prudential audits or reviews
• Completion audits
• Audit for dealers’ licences
The auditing firm should not provide services that are perceived to be materially in conflict
with the role of auditor. These include investigations and consulting advice and
subcontracting of operational activities normally undertaken by management, and where
the auditor may ultimately be required to express an opinion on its own work. Examples are:
• Investigating accountant work on new or increased lending transactions
• Due diligence on potential acquisitions or investments
• Advice on deal structuring and assistance in deal documentation
• Tax planning and strategy
• Designing or implementing new IT systems or financial controls
• Advice on product structuring
• Book-keeping
• Valuations
• Executive recruitment and appointments
• Senior Management secondments
The auditing firm may be permitted to provide non-audit services that are not perceived
to be materially in conflict with the role of auditor, subject to the approval of the ANZ
Audit Committee. The ANZ Audit Committee will specifically confirm activities in this
category. Examples are:
• Receiver or liquidator and related investigation work
• Junior secondments to ANZ
• Internal audit activities capped at 20 per cent of total internal audit work
• Advice on appropriate accounting standards
• Review of legislation and advice on its application to ANZ
• Compilation of accounting records to assist with queries from revenue authorities
• Tax compliance services
• Review of the adequacy of controls and recommendations for improvements
An exception can be made to the above policy where the variation is in the interests of the
Group and arrangements are put in place to preserve the integrity of the audit of the
Group’s accounts. Any such exception requires the specific approval of the Board.

116 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
.
 Q u i c k r e v i e w
1 Public Oversight Boards have been established overseas and there has been a strong call
for the establishment of some sort of auditor oversight board in Australia.
2 There has been a strong push to strengthen the role of audit committees.
3 Mandatory rotation of audit partners has now been introduced in Australia and overseas.
4 Houghton and Jubb (2002) have recommended the establishment of audit firm
independence boards.
5 Some companies have imposed restrictions on the non-audit services that their auditors
may supply.

learning
FEE DETERMINATION AND OBTAINING CLIENTS 11
objective

Fee determination
The value of services performed by the auditor is determined by the inherent characteristics of
personal integrity and professional competence. Typically, professionals are not hired primarily
on the basis of the reasonableness of their fees. The client is chiefly concerned with the calibre of
services to be received. Nevertheless, vigorous competition, including some fee competition, is
one of the realities of practice today.
The two primary determinants of the audit fee are the time required to perform the necessary
services properly and the rate to be charged for that time. Factors which significantly influence the
required time are the condition of the client’s records, the availability of the client’s personnel for
clerical assistance, the volume of the client’s transactions and operations, the nature of the client’s
business and the effectiveness of the client’s internal control structure. The appropriate hourly
rate reflects the full cost of operating an audit firm. CPC F.6, ‘Professional Fees’, indicates that fees
should be based on:
■ the knowledge and skill required for the work involved;
■ the level of training and experience of the persons necessarily engaged to complete the work;
■ the time necessarily occupied by each person engaged to complete the work; and
■ the degree of responsibility which the work entails.
Section 331 of the Corporations Act entitles the auditor to reasonable fees and expenses for the
work performed. As a result, it could be argued that the fees from the practice should permit the
auditor to:
■ remunerate the staff adequately to attract the highest calibre of young men and women to the
profession;
■ maintain a respectable office with good working conditions, modern equipment and a library
suitable to enable the best work to be performed; and
■ undertake a fair share of public service activities for the community, profession and civic
organisations.
The auditor should not enter into fee arrangements that might compromise or appear to
compromise independence. Therefore, the fee for the audit must be commensurate with the
service provided. Recovery of costs in one period should not be dependent upon an expectation
of recovery from fees of future audits or the provision of other services to the client. Yet research
such as De Angelo (1981) shows that the fees for initial audits are often lower than for continuing
audits. Low-balling occurs in a tender situation when a bid-price for audit services by an audit

CHAPTER 3 Ethics, independence and corporate governance 117

 firm is quoted at an unreasonably low level to win the tender, with any unrecovered audit costs
recovered subsequently through other services or by other means.
The hourly rate is naturally higher for members of the staff with greater skill and experience.
Rate determination, then, involves estimating the total annual cost of operating a practice and
estimating the total billable time in a year for the various levels of staff.
Fees must be commensurate with the work undertaken and be sufficient to enable appropriate
time to be spent by experienced staff. Fees charged for audit or assurance services must not be
calculated on a predetermined basis relating to the outcome or result of the work. CPC F.1
Appendix 2.108 prohibits contingency fees for assurance engagements. Fees for other services
however, may be subject to a contingent fee. The possibility of a self-interest or advocacy threat
must be assessed in these circumstances and safeguards applied as appropriate. The receipt of
commissions or other benefits as a result of the audit is prohibited under CFC F.1.25.
Fees from clients must be collected promptly. Overdue fees may create a self-interest threat,
especially if they are not paid before the issue of a subsequent audit or review report.
When total fees generated from an audit client represent a large proportion of the auditor’s
total fees, the real or perceived financial dependency on that audit client creates a self-interest
threat. The auditor must have policies in place to ensure that the threat is negated or reduced to
an acceptable level. CFC F.1 Appendix 2.103 indicates that specific safeguards, including
undertaking independent reviews of the services provided, must be in place if fees from an audit
client exceed 15 per cent of the audit firm’s total fees. Similar considerations must be undertaken
in relation to the fees generated by individual audit engagement partners and separate offices of
the audit firm.
AASB 1034 requires an audit client to disclose in the financial report the amount of fees paid to
the auditor, split between audit and other services. Audit and Assurance Alert No. 11, issued in May
2002, recommends that auditors provide more detailed analysis of the fees received for other
services. This analysis would distinguish between:
■ other audit-related work such as workers compensation reports;
■ other assurance and assurance-related services such as due diligence and risk management;
■ legal services;
■ advisory services including corporate finance;
■ taxation; and
■ consulting.
This disclosure allows the audit client and financial report users to understand the nature of
the other services provided and consider implications for the auditor’s objectivity based on
comprehensive information.

Obtaining clients
Since the services of public accounting firms are of a highly personal nature and involve individual
character traits such as competence and integrity, the auditor’s services cannot be offered in the
same manner that commercial goods and services are sold. The most effective way of obtaining
recommendations is to render services of a high quality. Until the accountant beginning in public
practice has built a nucleus of satisfied clients, they may work for other accountants on an hourly
basis. Another approach is to buy an existing practice or enter into partnership with an established
practitioner. There are also many ethical and intrinsically rewarding ways that an accountant can
attract favourable attention, such as participating in community activities and organisations and
accepting speaking engagements before business groups.

118 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
 Traditionally the profession has not supported the concept of members being able to promote
their services through advertising. However, in 1984 the two accounting bodies agreed to allow
members to advertise within the confines of rules issued by the profession. CPC D.5, ‘Advertising,
Publicity and Solicitation’, permits advertising provided that its content and nature is not false,
misleading, deceptive or otherwise reflects adversely on the profession. Potential clients may be
approached personally or through direct mailing to make known the range of services that the
audit firm offers. However, follow-up communications must be terminated when requested by the
recipient or it will be considered harassment, which is unprofessional conduct.
The International Federation of Accountants (IFAC) provides the following as examples of
false, misleading or deceptive advertising. These include advertising which:
■ creates false or unjustified expectations of favourable results;
■ implies the ability to influence any court, tribunal, regulatory agency or similar body or official;
■ consists of self-laudatory statements that are not based on verifiable facts;
■ makes comparisons with other accountants in public practice;
■ contains testimonials or endorsements; and
■ contains any other representation that would be likely to cause a reasonable person to
misunderstand or be deceived
(IFAC, Code of Ethics, section 14)

An issue that has been around for a number of years, but continues to occur frequently in practice
and has caused some concern within the audit profession, is the calling by companies for competitive
tenders for audit appointments, and the active involvement by audit firms in the tendering process.
This issue is symptomatic of the increased competition for audit work. While acknowledging the right
of companies to choose their auditors in order to obtain the most cost-efficient audit, there is a major
danger for the profession in the potential loss of credibility that could result from a real or perceived
loss of independence of the auditor by being placed in a position where there may be an unreasonable
threat of dismissal as a result of the auditor’s actions. An example is the practice of opinion shopping.
This may occur where an audit is put out to tender following the issue of a qualified opinion by the
previous auditor or where a new issue arises that may involve consideration of the issuing of a
qualified opinion and the client seeks the views of potential new auditors as to how they would
interpret the client’s action in terms of the application of a certain accounting practice. CPC F.5
indicates that when an auditor is requested by an entity to give an opinion on an actual or hypothetical
accounting issue, they should consider the potential effect on the professional responsibilities of the
auditor, the purpose of the request and the intended use of any response. The auditor whose opinion
is requested is also required to communicate with the existing auditor and provide a copy of the
opinion to them. Tendering may also subject an auditor to undue pressure because of the cost of the
audit examination and the ability to conduct the necessary audit procedures and the impact of low-
balling (discussed earlier). It is likely that the practice of audit tendering within the business
community will continue. However, audit firms must recognise that the tender they submit needs to
reflect the level of professional skill, knowledge and responsibility required for the audit work. Auditors
and management should also be aware of the increased audit risk and hidden costs associated with
changes of client as a result of the tendering process, for example the loss of audit continuity and the
extensive knowledge of a client’s business and personnel by the audit firm, which are beneficial to an
effective audit process. On the other hand, the tendering process appears to have led to some increases
in audit efficiency as auditors have implemented more efficient and effective audit techniques.
Evaluation of potential clients and ethical considerations in accepting an engagement are
discussed in Chapter 6.

CHAPTER 3 Ethics, independence and corporate governance 119

 Q u i c k r e v i e w
1 Audit fees should be commensurate with the services provided.
2 Advertising, publicity and solicitation are permitted provided they are not false,
misleading, deceptive or otherwise reflect adversely on the profession.

Summary
Ethics is concerned with what is good for the general Interest in audit independence has increased
wellbeing of individuals and the community. The ICAA dramatically in recent times due to the spate of
and CPA Australia have ethical rules to help promote corporate failures both in Australia and overseas. As a
high ethical standards among their members. result, we have seen the Ramsay Report into audit
However, as ethics is an attitude of mind, these rules independence in Australia, recommendations for audit
cannot by themselves make auditors act ethically. An reform from the JCPAA and CLERP 9, and the issue of a
auditor needs an ethical attitude, a good knowledge revised ethical rule CPC F.1, which is based on a new code
of ethical principles and ethical decision-making skills of ethics issued by IFAC. CPC F.1 adopts a conceptual
to handle ethical conflicts. The accounting bodies are approach that uses a framework based on identifying
strongly supporting the push for improved corporate and evaluating threats to independence and introducing
governance, including the establishment of audit safeguards to eliminate the threats or reduce them to an
committees. The number of companies with audit acceptable level. As a result, the ability of auditors to
committees is increasing steadily. Corporate gover- provide non-audit services has been greatly reduced.
nance is the set of rules or procedures that ensure that This has been reduced even further by the introduction
a company is managed in the best interests of the of the Sarbanes-Oxley Act 2002 in the USA and calls for
stakeholders. Ethical principles and skills in ethical similar legislation in Australia. In addition, a number of
decision making are important aspects of corporate Australian companies have imposed restrictions on the
governance. Auditors have an important role to play in non-audit services that their auditors may supply. There
the corporate governance process, through both the have also been calls for other means of improving
audit itself and reporting to the audit committee. At auditor independence, such as establishment of auditor
the centre of the ethical rules of the auditing oversight boards, strengthening the role of audit
profession is the need both to be, and to be seen as, committees, rotation of auditors and establishment of
independent. audit firm independence boards.

Keyterms
Actual independence 97 Independence in appearance 97
Advertising 119 Independence of mind 97
Appointment 95 Integrity 82
Audit committee 90 Low-balling 117
Code of ethics 81 Objectivity 82
Competence 82 Opinion shopping 119
Confidentiality 82 Perceived independence 97
Corporate governance 85 Public interest 82
Deontological theories 79 Reasonable person test 96
Due care 82 Removal 95
Egoism 79 Resignation 95
Ethical behaviour 82 Technical and professional standards 82
Ethical decision models 83 Teleological theories 79
Ethical pronouncements 80 Tendering 119
Ethics 78 Utilitarianism 79
Incompatible business 80 Virtue ethics 80
Independence 82 Whistleblow 93

120 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
References
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Australia (2001), Audit Committees: Best Practice Guide, 2nd
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Statement of Recommended Corporate Practice, June, AIMA, Grace, D. and Cohen, S. (1995) Business Ethics: Australian
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Gap (Middleton Report), December, ASCPA, Melbourne, and Houghton, K. and Jubb, C. (2002) ‘An Australian Response to
the ICAA, Sydney. Recent Developments in the Market for Audit Services’,
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Baxter, P. and Pragasam, J. (1999) ‘Audit committees: one size fits Joint Committee of Public Accounts and Audit (2002) ‘Review of
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Blue Ribbon Committee (1999) Report and Recommendations of accountancy practice’, Australian Accountant, May, 28–33.
the Blue Ribbon Committee on Improving the Effectiveness of Lynn, R.S. (1996) ‘The role of the auditor in corporate
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Bosch, H. (1995) Corporate Practices and Conduct, 3rd edn, Moroney, R. and Simnett, R. (1996) ‘Audit committee disclosure
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 Schelluch, P. (1991) ‘Audit Committees’, Accounting Commu- Thomson, J.A.K., Tredennick, H. and Barnes, J. (1976) Aristotle’s
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interest, The Text Publishing Company, Melbourne. Unger, L. (2001) ‘This year’s proxy season: Sunlight shines on
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Vol. 65, No. 4, April, 205–19.

Assignments
MAXIMISE YOUR
MARKS! There are REVIEW QUESTIONS
approximately 30
interactive 3.1 For each of the following questions relating to ethics, select the best response.
questions on ethics, (a) Which of the following is not a doctrine or theory of ethics?
independence and A virtues
corporate B deontology
governance
C theology
available online at
www.mhhe. D egoism
com/au/gay2e (b) Which fundamental ethical principle provides that the auditor should safeguard the
interests of their clients provided it does not conflict with their duties and loyalties to
the community and its laws?
A objectivity
B confidentiality
C public interest
D whistleblowing
(c) Which of the following organisations has developed an ethical decision-making
model?
A American Accounting Association
B Auditing and Assurance Standards Board
C Australian Stock Exchange
D Business Council of Australia
3.2 For each of the following questions relating to independence, select the best response.
(a) The ethical rules state that independence of the external audit firm is considered to be
impaired if:
A the audit partner purchases the client’s product at normal retail prices
B the audit firm provides management advisory services to the client
C a near relative of one of the partners is the beneficial owner of shares forming a
material part of the share capital of the client
D the audit firm has served as the external auditor for many years
(b) A violation of the profession’s ethical standards would be least likely to occur when an
auditor:
A refers life insurance assignments to the auditor’s spouse, who is a life insurance
agent
B holds the position of company secretary with an audit client which is a public
company

122 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
 C is a member of the same golf club as the managing director
D undertakes a management advisory engagement and decides on the most appro-
priate computer system for a client
(c) Which of the following impairs an auditor’s independence regarding the client?
A The audit firm also prepares the client’s tax return.
B The client has not paid fees related to the previous year’s audit.
C The audit firm recommends a job description and candidate specifications for the
position of financial controller of a client.
D The audit firm trains client personnel during the implementation of a new com-
puter system.
(d) An auditor strives to achieve independence in appearance to:
A maintain an unbiased mental attitude
B maintain public confidence in the auditor
C become independent in fact
D comply with the Corporations Act
(e) To emphasise auditor independence from management, many entities follow the
practice of:
A having the auditor report to an audit committee of external members of the board
of directors
B appointing a partner of the audit firm conducting the audit to the entity’s audit
committee
C establishing a policy of discouraging social contact between employees of the
entity and the staff of the auditor
D requesting that a representative of the auditor be on hand at the annual general
meeting
(f ) Which of the following is not normally a part of an audit committee’s responsibilities?
A Nominating the independent auditors
B Discussing the detailed audit programs of the independent auditors
C Discussing the meaning and significance of the audited financial report
D Discussing the problems of the independent auditors in completing the audit of the
annual financial report
3.3 For each of the following questions relating to obtaining clients, select the best response.
(a) In determining the fees for an attestation service, an auditor may take into account
each of the following, except the:
A attainment of specific findings
B value of the service to the client
C degree of responsibility assumed by the auditor in undertaking the engagement
D skills required to perform the service
(b) Inclusion of which of the following in a promotional brochure published by an audit
firm would be most likely to result in a violation of the ethical rules?
A Testimonials and endorsements by existing clients
B Details of types of services offered
C List of fees for services, including hourly rates and fixed fees
D Educational and professional qualifications of partners

1 learning
Professional ethics objective

3.4 What is ethics?

2 learning
Ethical theory objective

3.5 Explain the relevance of virtue ethics to an auditor.

CHAPTER 3 Ethics, independence and corporate governance 123

 learning 3
objective Accounting bodies’ code of ethics
3.6 Why is it important to the accounting profession to have adopted a code of ethics?
learning 4
objective Applying ethics
3.7 How do ethical decision models assist in resolving ethical dilemmas?
learning 5
objective Corporate governance
3.8 Can an audit committee be used as a means of improving corporate governance?
learning 6
objective Whistleblowing
3.9 Indicate whether you believe that auditors have a responsibility to whistleblow in their
dealings with the ICAA or CPA Australia, their employing firms, their clients and each other.
learning
objective 7–10 Audit independence
3.10 Explain the difference between perceived and actual independence and indicate why both
are important to the auditor.
3.11 Should auditors be allowed to provide non-audit services?
3.12 What is an audit committee and what are its functions?
learning
objective 11 Fee determination and obtaining clients
3.13 How is the fee for an audit engagement determined?

DISCUSSION PROBLEMS AND CASE STUDIES

primary learning 3
objective Accounting bodies’ code of ethics
3.14 Moderate After recently completing professional examinations, you have formed a
partnership with an existing sole practitioner. Your partner is a registered company auditor
and has decided to move into partnership as a means of offering a wider range of services.
In particular he is looking to increase the amount of consultancy work the firm is
undertaking. The firm’s largest client is a small public company that originally joined the
firm when your partner commenced practice. Over the years the services that your firm
provides have grown to include taxation and financial advice.
You have just assisted this client to identify and negotiate an acquisition of a business.
As the financial year-end is approaching, the managing director approaches you to
undertake valuation of the brand names of the business acquired. The directors intend to
include your valuation in the statement of financial position of the company as an
independent valuation. They have indicated that it will save them a great deal of audit time
if this matter can be resolved before the audit.
After the acquisition, the company will be an even more important client of your firm
from both an audit fee and consulting perspective. There is also the prospect that they will
undertake some form of capital raising in the future to fund further expansion.
Required
Outline five ethical issues relevant in assessing the relationship with the company and in
deciding whether to continue offering the current range of services to this client. Cite
relevant references where appropriate.
primary learning 4
objective Applying ethics
3.15 Complex Fred and Barney are two audit seniors working for the same Big Four accounting
firm. Both started employment with the firm around the same time. They have mutual
respect for each other; however, they remain highly competitive, which has been the case
since they commenced work together.

124 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
 Fred is recently married and he and his wife are paying off their mortgage. Barney is
single with a reputation in the firm for playing hard but working hard too. They have both
been seniors for almost 18 months and are looking for promotion to audit supervisor. They
are both aware that there is only one supervisor position available.
Fred recently replaced Barney on a particular job and the reason given to both Fred and
Barney was that another assignment had arisen with a long-time client of Barney’s. Once
Fred had replaced Barney on that particular job, he realised that the client called the audit
manager to say they were not impressed with Barney, as he had missed a number of issues
within the audit and was arriving at work late. The audit manager had not discussed these
comments with either Fred or Barney. Fred, after going through the work that Barney had
done, realised that Barney had performed an excellent job, identifying a number of issues
that he thought he would have possibly missed. Furthermore, Fred suspects Barney and the
client had a personality conflict, and the client had misled the audit manager.
Fred realises that he can continue to finish off the audit, resolving the issues, and obtain
a good review from this assignment, which would help him in the promotion stakes. He
also knows that the audit manager is unlikely to bring the client’s unsupported allegations
to Barney’s attention.
(a) Using the AAA model, work through this scenario and decide what action Fred should
take.
(b) Consider the ten core values from the Mary Guy decision model to determine whether
your decision would be different using this decision model.
Source: This question was adapted from the Professional Year Programme of The Institute of Chartered
Accountants in Australia—1996 Ethics 1 Module.
3.16 Complex You are a senior auditor in a firm of auditors in a country town. The major client
of the firm is the town’s largest registered club. You are in charge of the audit and report
directly to the partner.
With the rural recession and the move of certain industries from the town, your firm is
dependent upon the continuance of the club as an audit client.
The secretary manager of the club has held this position for over 20 years, and is well
respected in the town. He has worked hard to build the club from humble beginnings. The
secretary manager has a strong personality and exerts influence on the board of directors
of the club. The audit partner and the secretary manager are members of the same golf club
and play regularly on Saturday mornings.
The club is currently undergoing major renovations with the work being undertaken by
ABC Builders.
To get home you have to drive past the secretary manager’s house. One night you
notice that the secretary manager is having more renovations done to his home and that
there is an ABC truck delivering materials to the house. Next day at lunchtime you drive
past the house and again see an ABC truck and this time there are tradespeople working
on the house.
You have just commenced the year-end audit work for the club and during your visit to
the club’s premises, you obtain copies of the tenders for the renovations and find that ABC
was the most expensive tenderer with the directors’ minutes revealing that the secretary
manager convinced the board to accept ABC’s tender based on their perceived quality.
You are concerned that there may be some impropriety on the part of the secretary
manager. You raise your suspicions with the audit partner, who dismisses them out of hand
and says that even if there was any substance to them, what could the firm do about them.
(a) What are the ethical issues?
(b) What should you do? Decide on your response by working through the Laura Nash model.
Source: This question was adapted from the Professional Year Programme of The Institute of Chartered
Accountants in Australia—1995 Ethics 3 Module.

CHAPTER 3 Ethics, independence and corporate governance 125

 3.17 Complex Steven Brown is a promising senior manager beginning his tenth year at his
firm. Steven has been a steady performer during his career and is known for his technical
and personal skills.
Not all the firm’s partners are enthusiastic about Steven. His track record for bringing in
new clients has been marginal. This weakness has not stopped Steven moving up the
ladder, but slow expansion in the client base has meant that the firm has not made a new
partner for three years. Steven is well aware that his ability to bring in new clients is critical
to his aspirations to become a partner.
BAC Manufacturing, a large ink manufacturer, has decided to put its audit and related
accounting services out for tender. BAC’s current auditor performs significant non-audit
services. In fact, fees for non-audit services are well in excess of the audit fee.
Steven has been given the primary responsibility for developing and presenting the
tender to BAC’s board of directors. He has nearly completed preparations for the
presentation and has discussed all the specifics with two partners who will have a
significant involvement in servicing the audit and related service needs of BAC, should the
firm be successful in its tender. As required by the board of BAC, a detailed outline of the
proposal presentation and itemised preliminary budget were submitted nine weeks in
advance of the presentation.
On the Monday evening before the presentation, Steven’s wife receives a call from her
sister, Cheryl. Cheryl’s flatmate, Maria, is the secretary of BAC’s managing director. Maria
noticed that one of the proposal presentations was going to be done by someone named
Steven Brown and asked if it was the same Steven Brown who was married to Cheryl’s sister.
Cheryl said it was and Maria began to tell her about some of the proposals.
Maria had said she noticed several things about the managing director’s evaluation of
the proposal submitted by Steven’s firm. First, the bid was significantly higher than one of
the other bids. Second, the managing director had mentioned two items of major
importance that had been left out of the proposal. Maria could not remember these items
‘off the top of her head’, but she told Cheryl she would be willing to run off a copy of the
memo if Cheryl wanted her to.
Steven’s wife tells him about the call from Cheryl at dinner that evening.
(a) Consider the ethical issues, utilising the AAA decision model.
(b) What should Steven do?
Source: This question was adapted from the Professional Year Programme of The Institute of Chartered
Accountants in Australia—1995 Ethics 1 Module.
primary learning 5
objective Corporate governance
3.18 Moderate ‘The requirement by the Australian Stock Exchange for companies to disclose
their main corporate governance practices in annual reports is capable of manipulation
and distortion by unethical boards of directors.’
In light of the above comment, consider whether the nature and disclosure of corporate
governance practices should be prescribed by the Corporations Law and form part of the
financial report upon which the company’s auditor expresses an opinion.
Source: This question was adapted from the Professional Year Programme of The Institute of Chartered
Accountants in Australia—1996 Ethics 3 Module)
primary learning 7–10
objective Audit independence
3.19 Moderate You are the auditor of XYZ Ltd, a company involved in gold exploration. Prior
to year-end you find that the company has the following characteristics:
• a net current liability position;
• borrowings and bank overdraft facilities approaching maturity, with uncertain
prospects of renewal or repayment;

126 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
 • excessive reliance on short-term borrowings to finance long-term assets; and
• funding commitments in relation to mining tenements which the company cannot
meet, with the result that the tenements will lapse.
Because of this information, you discuss with the directors the need to qualify the audit
report on the basis that there is uncertainty whether the company can continue as a going
concern. The company directors take exception to this view, because they intend to raise
funds through a share issue within the next year. Rather than have a qualified audit report,
the directors ask you to resign as auditor so that they can give the audit to another firm,
Friendly Auditors, who will not qualify the audit report in the current year.

Required
(a) What barriers are you (the auditor) likely to encounter in attempting to resign?
(b) If you are unable to resign, what steps can the directors take to remove you as auditor?
Source: This question was adapted from the Professional Year Programme of The Institute of Chartered
Accountants in Australia—1995 Accounting 2 Module.
3.20 Complex Winston Gould is the controlling shareholder of Gould Pty Ltd. He has expressed
dissatisfaction with his present auditors and informs Henry Cramer, a registered company
auditor and member of a professional accounting body, that he will be appointed auditor if
he agrees to the following proposals:
(a) Because Gould’s present dissatisfaction is related primarily to fees, which he feels are
too high in relation to the time the job should take and the services rendered, Cramer
is to quote a fee in advance and detail the services he would provide. This quotation
must, of course, be lower than the fee presently being paid by Gould Pty Ltd.
(b) Because Gould feels quite strongly that the company’s auditor should take an active
part in the operation of the business, Cramer is to serve as a director of Gould Pty Ltd.
While Gould appreciates that Cramer must maintain a position of financial
independence, he points out that the acquisition of one qualifying common share
would not interfere with his independence.
(c) Because Gould Pty Ltd has experienced financial difficulty during the past several
years, Cramer is to accept redeemable preference shares in lieu of fees for the first year
of the engagement. As these shares have no voting rights, Gould feels that Cramer’s
independence will not be affected. Moreover, if conditions improve significantly, the
shares will be redeemed.
(d) Because Gould has certain personal income tax problems, Cramer is to review his
affairs. As the possibility of refund is uncertain, Cramer’s fee is to be 40 per cent of all
recoveries.
(e) Because Gould is very impressed with a particular auditor who has been employed on
the audit for the past two years by the present firm of auditors, Cramer is to hire the
auditor and retain him on the audit. Gould knows that the auditor would be amenable
to such a suggestion.
With respect to each of the above proposals, what answers should Cramer give to
Gould? Give reasons to support these answers.
Source: CICA adapted
3.21 Complex Consider the following independent situations that arose in respect of your firm,
PTL Partners. In each case Mr Adams is the audit partner, Ms Tan is the tax partner and Mr
Brown is the business advisory partner.
(a) A longstanding friend and tax client, Mr Davis, recently approached Mr Adams and
said: ‘I’m worried about my son Leroy. He’s enrolled in an accounting degree but can’t
find vacation work and he’s getting a bit depressed about it. Do you have anything
available?’ In response to this request, Mr Adams organised vacation work for Leroy in
the firm’s audit division, even though the firm has a ‘no vacation work’ policy. Leroy

CHAPTER 3 Ethics, independence and corporate governance 127

 worked on the ZX Limited engagement, a company in direct competition with Mr
Davis’s employer, although neither Mr Adams nor Leroy knew this at the time. A few
weeks later, Mr Davis gave Mr Adams and his family free tickets to the Australian Open
tennis finals in gratitude.
(b) Mega Motels is a chain of 10 motels operating on the far south coast of NSW. Your firm
performs both audit and tax work for Mega Motels. The audit fees comprise around
10 per cent of total audit fee revenue, while the tax work comprises around 5 per cent
of total tax-related revenue. Mega Motels has not paid any of its fees for the last three
years, citing cash flow problems. However, in actual fact, Mega Motels has made
impressive profits over the last few years and has significant cash reserves. The
partners have been reluctant to push the issue further, as Mega Motels is a high-profile
client whom they wish to retain.
Last month, your firm agreed to hold their annual staff retreat at one of Mega
Motel’s motels, as a partial contra against the outstanding fees. Half of the outstanding
fees will be waived, even though the reasonable market value of the services to be
provided is only 30 per cent of the total outstanding amount.
(c) Ms Tan has just been appointed a director of XX Co. Pty Ltd, a small proprietary company
that is a travel agent. Mr Adams performs the audit of XX Co. in accordance with the rele-
vant legislation. Mr Brown recently assisted XX Co. in selecting and installing ABC brand
accounting software. ABC pay the firm a commission for every software package sold,
and this fact was verbally disclosed to XX Co. In addition, Mr Brown has just performed a
valuation of XX Co.’s business for the purposes of a Family Law Court dispute.
(d) Several of Mr Adams’s staff recently completed a review of the internal controls at FG
Pty Ltd, a large proprietary company which is also an audit client. The work was
charged at 120 per cent of the usual consulting fees to partially recoup the lower audit
fees brought about by a competitive tender. At the client’s request, audit staff
implemented all the recommended changes in procedures by updating the
company’s accounting manual and running a two-hour training session for the
accounting staff. As audit staff have already performed significant work on FG’s
internal controls, the audit manager has decided to assess control risk as low and not
perform any tests of control.
(e) Mr Brown prepares a compilation report for A Butchery, which supplies gourmet
meats to five-star hotels. A Butchery is currently in dispute with one of Mr Adams’s
clients, F Feedlots. A Butchery alleges that F Feedlots supplied substandard meat to
them on several occasions in the last few months. Accordingly, A Butchery have not
paid their account, which is material to F Feedlots’ receivables. F Feedlots are
currently unable to pay your firm’s audit fees, citing cash flow problems. Neither client
knows your firm acts for the other.
(f ) One of the firm’s audit clients is JK Limited, a credit union. During the audit, the financial
controller, Ms Vero, mentions to Mr Adams that she is looking for a new assistant
accountant. Mr Adams mentions this to his nephew, David, who applies for and is
subsequently appointed to the job. In gratitude at saving recruitment firm fees, Ms Vero
arranges to have all fees on Mr Adams’s home loan waived for the next 12 months. In all
other respects Mr Adams’s loan is on normal commercial terms. Since his appointment,
David has been assisting your firm by giving verbal confirmation of audit client account
balances held with JK. This has saved your firm money in bank audit certificate fees.

Required
For each of the above independent situations:
(i) Identify any professional standards and regulatory requirements which have been
breached.

128 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
 (ii) Recommend possible courses of action your firm could take to rectify these breaches.
Source: This question was adapted from the Professional Year Programme of The Institute of Chartered
Accountants in Australia—1999 Accounting 2 Module.
3.22 Complex The following are independent situations:
(i) Chad is an audit assistant currently undertaking university studies. While auditing the
books of DelTel, he comes across certain financial information that he believes will
assist him in completing one of his university assignments. He copies the information
and uses it in his assignment, carefully removing all reference to DelTel in order to
preserve the client’s confidentiality.
(ii) Ms Wang has been the engagement partner on the Plimsol Ltd audit for a number of
years. Some time ago, Plimsol Ltd’s longstanding company secretary retired and it took
six months to find a replacement. At Plimsol Ltd’s request, Ms Wang performed
company secretarial duties for this period of time. Ms Wang was not company secretary
at the time the annual audit report was signed.
(iii) Tim is the eldest son of the factory foreman of one of your firm’s major audit clients,
Enz Ltd. Enz Ltd operates in the manufacturing industry. During vacation work, Tim is
assigned to the audit of Enz Ltd. Tim’s work comprised testing the internal controls of
the cash payments system.
(iv) Caz is an audit supervisor at Goodsell Partners. For the last two years, Goodsell
Partners has been engaged by Sundew Pty Ltd to audit certain summarised financial
information for submission to Sundew Pty Ltd’s bankers. The summarised financial
information is prepared on a quarterly basis. While filing other work papers, Caz
notices that there is a typographical error in the report issued for the quarter ending
31 March 2002. This has resulted in a serious overstatement of net profit. As several
months have passed since March, and neither the client nor the banker has queried the
figures, Caz decides to ignore the error.

Required
For each of the independent situations (i) to (iv):
(a) List any professional standards and regulatory requirements breached.
(b) Advise as to possible alternative courses of action the auditor should have taken in
order to properly discharge their professional responsibilities.
(c) In general, outline the potential consequences of breaching the Code of Professional
Conduct for:
(i) an accounting practice
(ii) a member employee whose actions gave rise to breach.
Source: This question was adapted from the CA Program of The Institute of Chartered Accountants in
Australia—2002 Financial Reporting and Assurance Module.
3.23 Complex You are involved in the audit of Superdrug Ltd and have been examining the docu-
mentation associated with the purchase of the expensive and troublesome Acme Filling
Machine and Capper. However, the documentation is highly summarised and incomplete and
it is difficult to determine whether Superdrug’s capital purchasing policy has been followed.
Superdrug’s General Manager—Production, Robert Boyd, would ultimately have been
responsible for presenting the case for the Acme purchases to Superdrug’s Board. You have
a good relationship with Robert, including a common interest in the national football
competition. You approach Robert, who listens carefully to your concerns and seeks to
reassure you that all necessary procedures were followed. Also, he tells you not to be
concerned with the teething problems that they are having with the Acme equipment as he
used to work with them as an engineer prior to joining Superdrug and knows that they
build top-quality machines. He suggests that you join him for lunch as his guest at an
extremely expensive restaurant in the city so that you can discuss the matter further.

CHAPTER 3 Ethics, independence and corporate governance 129

 As you are about to leave, Robert offers you two tickets to the upcoming football Grand
Final, which he says that he won in a competition and is unable to attend.
Required
(a) Identify and explain four (4) ethical issues you face.
(b) Recommend, with reasons, the most appropriate course of action that you should
take. Indicate how it will overcome the issues raised in part (a).
3.24 Complex The following are independent situations:
(a) Mink and Darvis was recently awarded the audit of Hilly Farms Foods Ltd for the year
ended 31 August 20X3. Bill Fox, senior-in-charge, and an assistant observed the inven-
tory on 31 August. Upon completion of the inventory observation, Wally Warp, Hilly
Farms Foods Ltd’s controller, informed Fox that the shipping supervisor had a small
gift for him and the assistant. Fox asked Warp what the gift was for, and Warp
responded that they had always given small gifts of food items to their previous
auditors upon completion of the inventory observation. Fox estimates that the value
of the food is less than $200.
(b) Julia Roberto, a sole practitioner, has provided extensive advisory services for her
audit client, Leather and Chains Ltd. She has interpreted financial reports, provided
forecasts and other analyses, counselled on potential expansion plans, and coun-
selled on banking relationships.
(c) Steve Rackwill has been asked by his audit client, Petry Plumbing Supply Pty Ltd, to
help implement a new control system. Rackwill will arrange interviews for Petry
Plumbing Supply Pty Ltd’s hiring of new personnel and instruct and oversee the
training of current client personnel.
(d) Bob Lanzotti is the partner-in-charge of the audit of Fleet Ltd. Over the years, he has
become a golfing buddy of Fleet Ltd’s CEO, Jim Harris. During the current year
Lanzotti and Harris jointly purchased an exclusive vacation home on the Gold Coast.
The vacation home represents more than 10 per cent of Lanzotti’s personal wealth.
Required
For each situation, indicate whether the Code of Professional Conduct has been breached.
Give reasons.
3.25 Complex The following are independent situations:
(a) Kraemeer and Kraemeer recently won the audit of Garvin Clothiers Ltd, a large
manufacturer of women’s clothing. Jock Kraemeer had a substantial investment in
Garvin Clothiers Ltd prior to bidding on the engagement. In anticipation of
winning the engagement, Kraemeer placed his shares in Garvin Clothiers Ltd in a
trust.
(b) Zeker and Associates audits a condominium association in which the parents of a
member of the firm own a unit. The unit is material to the parents’ net worth, and the
member participates in the engagement.
(c) Jimmy Saad, a sole practitioner, audited Dallas Conduit Pty Ltd’s financial report for
the year ended 30 June 20X2, and was issued shares by the client as payment of the
audit fee. Saad disposed of the shares before commencing field work planning for the
audit of the 30 June 20X3 financial report.
(d) Dip-It Paint Ltd requires an audit for the current year. However, Dip-It Ltd has not paid
Allen and Allen the fees due for tax-related services performed two years ago. Dip-It
Ltd issued Allen and Allen a note for the unpaid fees, and Allen and Allen proceeded
with the audit services.
(e) Maria Harrison, sole proprietor of an audit firm, plans to establish a separate business
that will provide management consulting services. She intends to operate both
businesses simultaneously.

130 PA R T O N E T h e a u d i t i n g a n d a s s u r a n c e s e r v i c e s p r o f e s s i o n
 Required
For each situation, indicate whether the Code of Professional Conduct has been breached.
Give reasons.
3.26 Complex ‘Auditors are to blame for the recent spate of major corporate collapses. They
have got too cosy with management instead of protecting shareholders and investors.’
Required
Discuss whether you agree or disagree with this statement. Your answer should consider
the role that lack of independence may have played in audit failures.
11 primary learning
Fee determination and obtaining clients objective

3.27 Basic Audit tendering has become common for large audits in an attempt to reduce
business costs in a competitive business environment. Discuss the advantages and
disadvantages of audit tendering.
3.28 Basic Auditors budget time required to perform specific audits. Sometimes budgeted
hours are exceeded in order to complete an examination.
(a) What factors might cause an auditor to exceed the time budget on an audit?
(b) Are the hours in excess of the budget charged to the client at the usual charge rate or
should they be absorbed by the auditor?
3.29 Basic Read the following extract:
KPMG’s Cameos
KPMG is paying up to $US17 000 a pop to have its name feature, even if only briefly,
in 18 movies in the next two years. Reuters reports KPMG has signed its first deal, in
which Robert De Niro will pass Dustin Hoffman a KPMG-branded coffee mug, in the
movie Wag the Dog. In Britain, the hero of a low-budget romantic comedy, The Sea
Change, will be a KPMG accountant.
(Business Review Weekly, 3 March 1997, p. 101)

Required
(a) Does this type of advertising and publicity comply with the guidelines set out in the
code of professional conduct in Australia? Provide reasons for your decision.
(b) Do you believe this form of advertising may endanger the quality of audits? Provide
reasons for your decision.
3.30 Moderate Vivian Lau is a sole practitioner specialising in audit and taxation services. In
an attempt to attract more clients, Vivian sent out a new brochure which advertised the
services she provided and followed up this mail-out with a telephone call to see if any of the
potential clients were interested in using her services. However, as this approach did not
attract much new business she decided to introduce a new professional service and
promote it in a series of advertisements in the newspapers. The advertisements stated that
she is able to provide expert advice in the franchising of a business, which she believes is a
growth area. Although she has no experience in franchising, Vivian believes that this new
marketing strategy will attract many new clients to her practice.
Indicate whether there are any problems arising from Vivian’s two advertising strategies.

CHAPTER 3 Ethics, independence and corporate governance 131

 Chapter 3
Ethics, Independence and Corporate Governance

Learning objectives

1. Explain the nature and importance of professional ethics;

2. Describe the three main categories of ethical theory;
3. Outline the essence of the accounting bodies' code of ethics and describe the
individual rules;
4. Apply sound ethical decision-making techniques;
5. Explain the concept of corporate governance;
6. Explain the auditor’s role as a whistleblower;
7. Explain the importance of audit independence;
8. Describe recent developments in auditor independence;
9. Explain the major threats to auditor independence;
10. Outline suggestions for improving auditors' independence; and
11. Explain fee determination and obtaining of clients.

Major chapter sections

Ethical Theory
Accounting Bodies' Cose of Ethics
Applying Ethics
Corporate Governance
Whistleblowing
Audit Independence
Fee Determination and Obtaining Clients

Lecture plan
The focus of this chapter is the joint Code of Professional Conduct. We point out to the
students that any professional organisation must indicate to its members what acceptable
behaviour is and must also demonstrate to the public that it is willing to monitor the actions
of its members.

Ethical theory
We believe that it is important for the students to understand the nature of ethics and
recognise its importance. This requires some theoretical understanding of ethics. The text
presents elements of the following three theories of ethical behaviour:

Teleological ethics
Deontological ethics
Virtue ethics

We start by describing each theory and try to impress upon the students that auditors
regularly face ethical dilemmas and that ethical auditors must find a way to do the right
thing.

[Use slides 2 and 3]

Accounting bodies' code of ethics

We discuss the purpose of a code of ethics and introduce students to the joint Code of
Professional Conduct of the two accounting bodies. We find that at this stage it's a good idea
to present each of the fundamental principles in Section B to the students.

[Use slides 4 to 7]

Applying ethics
Sound ethical practice requires sound ethical decision making. We introduce students to
three models that can be used to assist in the ethical decision-making process.

[Use slides 8 and 9]

Corporate governance
Students might have heard the term 'corporate governance' referred to as it has received a
great deal of publicity in recent years. However, they probably have little understanding of
its true meaning or its relevance to activities.

We normally begin by explaining what is meant by corporate governance and the part
auditors play in the process, particularly through the increased use of audit committees. It
will be necessary to explain to students the functions of an audit committee and how they
relate to the audit.

[Use slides 10 to 14]

Whistleblowing
We believe that students should be made aware that if the auditor becomes aware of
unethical behaviour, the auditor will need to consider whether it is necessary to whistleblow
on the offender and, if so, who to report to.

[Use slides 15 to 17]

Audit independence
When we discuss independence, we first discuss the principles of independence and the
importance of both actual and perceived independence. Then we cover the detailed
guidance in the Corporations Act and CPC, including the conceptual framework of threats
and safeguards contained in CPC.F.1. We believe that it is important that students are also
made aware of recent developments in auditor independence and of suggestions for
improving auditor independence.

[Use slides 18 to 25]

Fee determination and obtaining clients

Students should be made aware that audit fees should be commensurate with the service
provided and that auditors should not take part in false or misleading advertising.

Instructor’s Resource Manual t/a Gay, Auditing and Assurance Services in Australia 2
 [Use slides 26 and 27]

SOLUTIONS
CHAPTER 3: Ethics, Independence
and Corporate Governance
REVIEW QUESTIONS

3.1 (a) C Theology is the study of religion and not a theory of ethics.

(b) C Auditors should safeguard the interests of their clients, provided they are not in
conflict with the public interest.

(c) A The American Accounting Association has developed the AAA model.

3.2 (a) C CPC F1 Appendix 2.5 prohibits any person in the practice or any near relative from
having a direct interest in an audit client.

(b) C Being a member of the same golf club is just normal social contact.

(c) B Unpaid audit fees can take on the characteristics of a loan under CPC F.1 Appendix
2.105.

(d) B Users will not derive any assurance from the auditor’s work unless they believe that
the auditor is independent.

(e) A Having a direct line of communication to the audit committee improves the auditor’s
independence from management.

(f) B The auditor does not want the client to know exactly what the auditor is going to test.

3.3 (a) A CPC F6.8 states that contingency fee arrangements must not be entered into for
professional services requiring independence and objectivity.

(b) A Testimonials or endorsements are given as examples of inappropriate advertising in

the IFAC Code of Ethics, section 14.

3.4 Ethics is concerned with the requirements for the general well-being, prosperity, health and
happiness of people, and with things that promote or prevent these characteristics. Ethics
requires knowledge of moral principles and skill in applying them to problems or decisions.

3.5 Virtue ethics is concerned primarily with integrity, which is one of the most important
requirements of an auditor. CPC B sets out eight fundamental principles that should guide an
auditor's behaviour. These are very similar to the virtues expounded by Aristotle in Virtue
ethics.

3.6 The accounting profession has adopted a code of ethics to maintain the profession on a
dignified level; guide members in their relations with each other; and to assure the public
that the profession will maintain a high level of performance.

Instructor’s Resource Manual t/a Gay, Auditing and Assurance Services in Australia 3
3.7 Ethical decision models help to resolve ethical dilemmas by providing a framework for
decision making. Each of the models ensure that the auditor considers all the facts, the ethical
issues, the alternatives and the consequences, before making a decision.

3.8 An audit committee is a component of corporate governance. It should take an active role in
overseeing the company’s accounting and financial reporting. It can improve corporate
governance by establishing or monitoring corporate policies to prohibit unethical or illegal
activities and ensure effective internal and management controls.

3.9 Auditors have an ethical duty to be honest and objective in their dealings with clients,
members of the profession and others and not to undertake behaviour that would bring
discredit to the profession. It is in the interests of members and the general public that any
identified breach of the ethical rules is investigated and appropriate action taken. This
implies an ethical duty to whistleblow to the accounting body where a member knows that a
breach of ethical rules has occurred.

Auditors also have a statutory duty to whistleblow to ASIC under s. 311 if they become
aware of any contravention of the Corporations Act, which cannot be remedied by comment in
their audit report or by bringing it to the attention of the directors. In addition, the auditor
may have a reporting duty under the Crimes Act. AUS 210.67 also recognises that where an
entity’s governing body is involved in or fails to take appropriate action in regard to an
irregularity, the auditor should seek legal advice on whether or not to report the irregularity
to a third party.

Auditors might need to resolve a conflict between the principles of independence and
objectivity, on the one hand, and client confidentiality, on the other, when deciding whether
to whistleblow.

3.10 Actual independence is the achievement of actual freedom from bias and personal interest.
This is necessary if the auditor is to provide an independent opinion. Perceived
independence is the belief of financial report users that actual independence has been
achieved. This is necessary if the auditor’s opinion is to lend any credibility to the financial
report.

3.11 Provision of non-audit services by auditors to their audit clients is a controversial issue. The
main argument for opposing the provision of non-audit services by auditors to their clients is
that when an audit firm provides non-audit services to a client it is serving two different sets
of clients: management in the case of non-audit services and the audit committee, the
shareholders and all those who rely on the financial report in the case of audit services. This
has clearly created a problem with perceived independence for many users. On the other
hand, the main arguments supporting the provision of non-audit services by auditors to their
clients are that there is no solid evidence of any specific link between audit failures and the
provision of non-audit services; and many non-audit services are both in the public interest
and beneficial to audit effectiveness. However, there are some services that an audit firm
cannot provide to its client. For example, CPC F.1 prohibits activities where the auditor
would be involved in the decision-making process. In the USA, the Sarbanes-Oxley Act has
prohibited a number of services, while in Australia several companies have adopted policies
of limiting the non-audit services that their auditors may provide.

3.12 An audit committee is a sub-committee of the board of directors and usually consists solely
or mainly of non-executive directors. Audit committees have been established primarily to:
• assist the board of directors to fulfil its legal fiduciary responsibilities;
• add to the credibility and objectivity of financial reports;
• enhance the independence and effectiveness of auditors;
• oversee the application of appropriate accounting policies and procedures and ensure
appropriate disclosure;

Instructor’s Resource Manual t/a Gay, Auditing and Assurance Services in Australia 4
 • establish and monitor corporate policies to prohibit unethical or illegal activities;
• establish and monitor effective internal and management controls; and
• provide a communication link between management, auditors and the board.

3.13 The fee for an audit engagement is determined by the time necessarily spent by members of
the audit team, billed at a standard rate corresponding to the experience and qualifications of
the staff in accordance with CPC F.6.

DISCUSSION PROBLEMS AND CASE STUDIES

3.14 (Moderate)
The following list is not intended to be exhaustive.
1. Objectivity (CPC B.3, CPC F.1.26 and CPC F.1 Appendix 2.72) The client has been
with the firm since inception and now appears to represent a sizeable portion of the
firm’s activities. It is questionable whether the firm could view the brand name
valuation objectively, particularly given its involvement in the acquisition.
2. Independence (CPC B.4 and CPC F.1) The firm is providing audit, tax and financial
advice. Even if actual independence is maintained, perceived independence may be
violated.
3. Competence and due care (CPC B5) It is not clear whether you have relevant training
in valuations. From the material provided, it appears that you have completed
professional accounting exams only. Without further experience or training this is
unlikely to be sufficient to undertake a complex valuation.
4. Independent valuation (CPC F1 Appendix 2.73) This specifically prohibits a firm
from providing a valuation of a material item that is included in the financial report,
and undertaking the audit of that financial report.
5. Fee dependence (CPC F1.26 and CPC F.1 Appendix 2.102-104) Although there is no
information as to the quantum of fees from the client, the fact that it is your largest
client and it has grown substantially suggests there might be a fee dependence issue.
Where the receipt of recurring fees from a client represents a large proportion of total
gross fees, the practice should carefully consider its position.

3.15 (Complex)
(a) Using the AAA Model

Determine the facts

Fred and Barney are both audit seniors working for the same Big 4 firm. The client made
comments to the audit manager about Barney, but the audit manager didn’t discuss them
with either Barney or Fred.

Determine the ethical issue

• List the significant stakeholders:
− Barney
− Fred
− Fred’s family
− Audit client
− Big 4 accounting firm and its partners
• Define the ethical issues:
Should Fred act honestly and fairly by discussing his suspicions that Barney was treated
unfairly by the audit client with the audit manager and partner? Or should he remain
silent and potentially improve his career?

Identify the major principles, rules and values

• Refer to CPC B.

Instructor’s Resource Manual t/a Gay, Auditing and Assurance Services in Australia 5
 • Integrity—should be straightforward, honest and sincere in their approach to professional
work.
• Objectivity—must be fair and not allow prejudice or bias to override their objectivity.

Specify the alternatives

• Fred can inform the audit manager of the suspected personality conflict and the good
work that Barney has done on the assignment.
• Fred can discuss the situation with Barney and inform him that he might have been
misjudged by the audit manager and partners.
• Fred can do nothing.

Compare values and alternatives

If Fred does nothing, he would not honour the major principles of integrity and honesty.
However, there is a potential conflict with this duty to his wife/family.

Assess the consequences

Do nothing—short-term consequences:
• Fred might obtain promotion over Barney.
• Fred fails to uphold his ethical principles of integrity and objectivity.
• Barney might be unfairly treated by the audit manager and partnership.

Do nothing—long-term consequences:
• Manager/partners might subsequently discover that Fred took credit for work that Barney
performed.
• Subsequently, Fred’s honesty and integrity might be questioned.

Fred informs audit manager of his suspicions—short-term consequences:

• Fred upholds his principles of integrity and objectivity.
• Barney might receive credit for the good work, and obtain promotion instead of Fred.

Fred informs audit manager of his suspicions—long-term consequences:

• Fred might be well regarded for his integrity and objectivity.
• Barney might receive promotion ahead of Fred, and Fred remain on a senior’s wage, while
repaying a mortgage.

Fred discusses the situation with Barney:

• Consequences are the same as Fred informing the audit manager (assuming that Barney
acts upon the information to clear up any misunderstanding.)

Make your decision

Either informing the audit manager of his suspicions or discussing the situation with Barney
would appear to be appropriate solutions.

(b) Using the Mary Guy Decision Model

The 10 core values from the Mary Guy Model are: caring, honesty, accountability, promise
keeping, pursuit of excellence, loyalty, fairness, integrity, respect for others, and responsible
citizenship. Discuss these 10 core values and compare to the alternatives available to Fred.
For example, if Fred were to do nothing, does this conflict with, say, the core values of:
Caring can Fred say that he treats Barney courteously and with dignity if he does
nothing?
Fairness will Fred take undue advantage of Barney’s adversity if he does nothing?
Integrity will Fred be avoiding a conflict of interest and resisting economic pressure if he
does nothing?

Instructor’s Resource Manual t/a Gay, Auditing and Assurance Services in Australia 6
 Consideration should be given to whether there are conflicts with the accountability and
loyalty core values regarding, say, Fred’s wife and family?

It does not matter which model you used, you should still arrive at the same answer, as the
model only provides a framework for your decision-making process.

3.16 (Complex)
Have you defined the problems accurately?
You are the Senior in charge of the audit of the town’s largest registered club. You are
concerned that at the same time as renovations are being completed at the home of the
Secretary Manager of the Club, the same company is doing renovations at his home. You are
suspicious because the Secretary Manager had strongly recommended the firm currently
doing the renovations, notwithstanding they were more expensive than other quotes. You are
also aware of the significance of the audit to your firm, the relationship between the Secretary
Manager and the Audit Partner and the Secretary Manager's standing within the local
community.

How would you define the problem if you stood on the other side of the fence?
From the Club’s point of view (Board of Directors and members), the circumstances might
certainly appear to be suspicious.

How did this situation occur in the first place?

While driving past the Secretary Manager’s home you noticed that he was renovating his
home and that ABC Builders were delivering materials to the house. During the course of the
audit you reviewed club documents detailing tenders and the Secretary Manager’s
involvement in ABC Builders' selection process.

To whom do you owe your loyalties as a person and as a member of the profession?
Given your role as auditor you have a responsibility to the members of the club, the Board of
Directors of the club and any relevant statutory bodies that govern the operation of the
registered club.

What is your intention in making the decision?

Your intention is to:
(a) ascertain whether there is or is not a relationship between building works at the club
and building at the Secretary Manager’s home;
(b) ascertain whether, notwithstanding their higher prices, ABC’s selection was justified
on the basis of their work quality?

How does this intention compare with the likely results?

Obviously, there would need to be further investigation before a conclusion is reached. On
the basis of the facts as presented, it would appear that there might be potential conflict
between your expectations and what has actually happened.

Whom could your decision or action injure?

• The Secretary Manager: he might be totally innocent of any wrongdoing—yet your
investigations might be deemed to be accusations?
• The club: members might feel that there has been some impropriety and this might have
ramifications for the existing Board of Directors.
• Your firm: ignoring the matter and having it subsequently highlighted by another party
might bring into question the firm’s competence, independence and negligence. You must
also consider the commercial effect of upsetting the client and risking losing the audit.
• The Audit Partner: given his relationship with the Secretary Manager (members of the
same golf club).
• Yourself: your relationships with the Secretary Manager, Audit Partner and Board of
Directors might be placed in jeopardy.

Instructor’s Resource Manual t/a Gay, Auditing and Assurance Services in Australia 7
 Can you engage the affected parties in discussions of the problems before you make your
decision?
Yes, this clearly is the option to take. A meeting with the Secretary Manager, the Board of
Directors and the Audit Partner would provide a forum at which the Secretary Manager
could explain all the facts.

Are you confident that your position will be as valid over a long period of time as it seems
now?
Yes, because unless you resolve this issue, it will remain a point of contention for a long time.
People might continue to doubt the fact that there was no relationship between building
works at the Secretary Manager’s house and the club.

Could you disclose without any qualms your decision or action to your boss, your family
or society as a whole?
Given your role as an auditor, your responsibility to the club members, the Board of Directors
and your firm, and given the facts as they appear on face value, you could disclose your
decision without qualm. In the event of making no disclosure and the subsequent revelation
of impropriety by the Secretary Manager you might be deemed to have been negligent in
your duties, especially in view of the facts that are available to you.

What is the symbolic potential of your action if understood? If misunderstood?

If understood, you will be credited with trying to perform your duties as an auditor,
observing a situation and working through the facts to arrive at a conclusion -
notwithstanding the result.

If misunderstood, you might be characterised as a person who sought to tarnish the

reputation of a respected member of the community and bring into question the ability of the
club’s Board in the performance of its duties.

Under what conditions would you allow exceptions for your stand?
Given the facts, it is unlikely there can be any exceptions to your stand. If there is any
relationship between building works at the club and building works at the Secretary
Manager’s home, this amounts to an illegal action.

3.17 (Complex)
AAA Decision Model

Determine the facts

Work through the case, identifying essential facts. Known facts should be listed first. Then
determine what one would want to know if possible.

Identify the ethical issues

(a) List all stakeholders:
• the senior managers
• the competitor firms
• the Senior Manager’s firm
• the potential client
• the Managing Director’s secretary

(b) Identify the ethical issues

the Senior Manager’s promotion to v the Senior Manager’s integrity
partner s
the Senior Manager’s promotion to v the integrity of the bidding process
partner s
the Senior Manager’s promotion to v the reputation of his firm

Instructor’s Resource Manual t/a Gay, Auditing and Assurance Services in Australia 8
 partner s
the Senior Manager’s promotion to v promotion interests of other senior managers
partner s
the Senior Manager’s concern for the v secretary’s job security
audit firm’s financial success s

Identify major principles, rules, values

• integrity (professional)
• integrity (of the bidding process)
• honesty
• fairness (level playing field)
• career enhancement
• equity
• profit to firm

Specify the alternatives

• Identify major options and encourage creative solutions that might be closer to win-win, if
possible.
• Reject the offer to see the memo and let the matter drop.
• Reject the offer to see the memo and alert potential clients to the secretary’s offer.
• Apprise a senior partner in the audit firm of the offer.
• Accept the offered memo and revise the proposal.

Weighing alternatives and assessing consequences

Reject the offer to see the memo and let the matter drop:
• a competitor firm is likely to get the engagement;
• the Senior Manager’s chances for promotion will be damaged severely;
• the secretary’s indiscretion will not be reported;
• the Senior Manager’s integrity will be intact.

Report the offer to see the memo and alert potential clients to the secretary’s offer:
• a competitor firm might get the engagement;
• the potential client might renew the entire bidding process to see if it is compromised, so
it could re-open bidding;
• the potential client might appreciate the Senior Manager’s integrity and award the
engagement to his firm;
• the potential client could thank the Senior Manager for his integrity, thus enhancing his
professional reputation;
• the secretary might be dismissed or reprimanded;
• the Senior Manager’s integrity will be intact.

Tell a senior partner in the audit firm of the offer:

• the firm might notify the potential client that the bidding process is compromised;
• the firm might notify its competitors that the bidding process is compromised;
• the Senior Manager’s standing at the firm might be enhanced, despite the probable loss of
the new client;
• the firm might decide to use the offered memo to revise its proposal, thus securing the
new client. (In this event, the Senior Manager would have to decide whether to go along
with the decision (and enhance his chances for promotion) or to notify the client (and
probably resign).)

Accept the offered memo and revise the proposal:

• the firm might win the engagement;
• neither the potential client nor competitors might learn of the tampering with the bidding
process;

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 • the Senior Manager might be promoted;
• the Senior Manager’s integrity will be compromised;
• the revision might be questioned by the potential client, and the secretary and Senior
Manager might be exposed;
• a partner of the firm might examine the revised proposal before it is submitted,
investigate and stop the process.

Make your decision

Reject the offer and advise senior partner and client.

3.18 (Moderate)
Under ASX Listing Rule 4.10.3, the annual report of a listed company must include a
statement of its main corporate governance practices. The purpose of the listing rule is to
ensure that shareholders receive relevant information about how the company is governed
and how decisions are made. To assist companies, the ASX has produced an indicative list of
corporate governance matters, which a company may take into account when making the
statement in its annual report under Listing Rule 4.10.3. The indicative list, included in the
ASX Listing Rules as Appendix 4A, deals with a company’s policies and procedures in
relation to:
• composition of the board of directors;
• appointment and retirement of non-executive directors;
• rights of directors to seek independent professional advice at the company’s expense;
• compensation arrangements for senior executives and non-executive directors;
• dealing with external auditors;
• identifying and managing business risks;
• ethical standards.

The board is responsible for the corporate governance statement, consequently all directors
must satisfy themselves as to the appropriateness of its content.

The corporate governance statement should be included in the annual report as a separate
statement. It does not form part of the directors’ report required by the Corporations Act, nor
does it form part of the financial report upon which the company’s auditor expresses an
opinion.

The primary role of shareholders in corporate governance is to approve the appointment of

the directors. Shareholders can also satisfy themselves that an appropriate governance
structure is in place by asking relevant questions at the annual general meeting.

In Australia, the ASX considered three possible approaches to corporate governance.

1. Leave things the way they were—any disclosure of corporate governance practices
would have remained an issue between the shareholders of an individual company
and its board.
2. Determine the set of practices that constitute ideal corporate governance, the
required disclosure of compliance with those parties, and reasons for non-
compliance either through ASX Listing Rules or through the Corporations Act
(prescriptive or regulatory approach). This approach has been adopted in the United
Kingdom based on the findings of the Cadbury Committee.
3. Require broad disclosure of corporate governance practices without prescribing what
best practice is (disclosure-based approach). This approach has been adopted in
Australia.

Prescriptive versus disclosure based approach to corporate governance

The following points could be raised against a prescriptive approach:

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 1. Regulation is not a free good—it has costs as well as benefits. There is a trade-off
between the economic benefits of free and competitive markets, and the social
benefits of protective regulations.
2. Intensive supervision can lead directors to focus more on meeting regulatory and
supervisory requirements than on identifying, managing and monitoring their
company’s business activities.
3. A prescriptive schedule of practices encourages directors of companies and investors
to focus on form rather than substance in judging corporate governance practices.
4. Under the prescriptive, checklist-based approach, failure to ‘tick a box’ to indicate
compliance with a particular recommended practice might be taken as evidence that
the company is doing something wrong when it could be doing something arguably
better than the Listing Rules were prescribing. A prescriptive approach might
therefore stifle innovation in corporate governance.
5. If ‘best practice’ were prescribed in a listing rule it could be regarded as an upper
limit further impeding innovation. Further, it might not be appropriate to have a
listing rule prescribing practices that are constantly subject to change. The disclosure-
based approach recognises that the appropriateness of corporate governance
practices can vary both between companies and over time.
6. Is it appropriate for corporate governance guidelines to dictate to company boards
and management on legitimate management prerogatives or decision-making
responsibilities?
7. Does the ASX have sufficient expertise in corporate governance to justify its
prescribing what constitutes ‘best practice’?
8. What is ‘best practice’ in corporate governance? In the United States, research
findings indicate that an independent board has a negative or neutral effect on
company performance, and companies with management dominated boards commit
fewer criminal offences.
9. Should the ASX then be prescribing a non-executive chairperson and independent
majorities as best practice—and, if it did, what about the small gold explorer whose
board consists of a couple of geologists and an accountant, who also comprise the
management? (The key aspect common to all companies, irrespective of size and
activities, is that the policies and relevant actions must be open and transparent.)
10. Auditors might find some difficulty in reporting in a meaningful way on a
company’s corporate governance practices. They might also bear considerable
commercial risk in doing so.

3.19 (Moderate)
(a) As XYZ Ltd is not a proprietary company, the auditor can resign by notice in writing
in accordance with s. 329(5), only if they have:
• applied to ASIC with the appropriate fee for consent to resign, stating the reason
for the application;
• notified the company in writing of the application made to ASIC;
• received consent from ASIC to resign.

ASIC Policy Statement 26: Resignation of Auditors indicates that ASIC will not
consent to a resignation that does not take effect at the annual general meeting unless
there are exceptional circumstances.

The Policy Statement states that in exercising its power to consent under s. 329(6)
ASIC’s overriding concern is to ensure that the independence and integrity of the
audit function are preserved. ASIC cites the following as examples of exceptional
circumstances:
• failing health of the auditor;
• loss of independence of the auditor;
• the company is not audited by the auditor of its parent entity; or

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 • a relocation of the company’s or auditor’s principal place of business such that it
would be impractical for the auditor to continue the audit.

Resignations as a result of tendering and opinion shopping are not considered to be

exceptional circumstances. On this basis it is unlikely that ASIC will consent to allow
the auditor to resign as no ‘exceptional circumstances’ exist. ASIC would wish to see
the auditors’ independence preserved—i.e.: it would expect the auditors to issue the
qualified opinion the auditors believe to be appropriate.

(b) The directors could remove you as auditor in accordance with s. 329(1) of the
Corporations Act. However, an auditor can only be removed from office by resolution
at a general meeting of which special (28 days) notice has been given. The special
notice must be given to the auditor and a copy lodged with ASIC (s. 329(2)). An
auditor may make written representations to the company within 7 days of receiving
a notice of removal and request that the company send a copy of such
representations to every member (s. 329 (3) and (4)). ASIC does not need to ‘consent’
to the removal of the auditor.

3.20 (Complex)
(a) Under CPC F.6 professional fees must be a fair reflection of the value of work
performed based on the time required and the necessary skill and experience.

A member may charge a fee lower than that previously charged by another
accountant, provided the fee has been calculated on the basis of the value of the
work. However, they should be aware that by quoting a fee lower than the existing
auditor their objectivity might appear to be impaired. Therefore, Cramer should base
his fee on the time and skill required.

(b) Under CPC F.1 Appendix 2.47, an auditor is specifically precluded from being a
director of an audit client. In addition, the auditor is unlikely to satisfy the
requirement of being seen to be independent if they are also a director. As Gould Pty
Ltd is a proprietary company, the auditor is not specifically precluded under s. 324 of
the Corporations Act. CPC F.1 Appendix 2.5 prohibits the auditor from having a direct
financial interest in a client. Therefore, Cramer should reject both the directorship
and the share.

(c) CPC F.1 Appendix 2.5 prohibits an auditor from having a direct financial interest in a
client. In addition, the auditor must also appear to be independent. Therefore,
Cramer should indicate that payment in the form of redeemable preference shares is
not appropriate.

(d) Under CFC F.6.8, a contingency fee arrangement must not be entered into for
professional services requiring independence and objectivity, such as income tax
returns. Therefore, Cramer should indicate that his fee will be based on the time and
skill required for the tax work.

(e) Cramer would need to consider whether hiring the previous audit staff would affect
the appearance of independence for the audit. In addition, CPC F.1 Appendix 2.49
recommends the periodic rotation of audit staff. Therefore, Cramer should not hire
the previous auditor and put him on Gould’s audit.

3.21 (Complex)
(a) (i) Breaches
• Mr Adams might have breached the confidentiality requirements of CPC B.5
and C.5 by assigning L to the ZX engagement. It is possible that confidential
information belonging to ZX was passed to Mr Davis owing to L’s

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 involvement in the audit. Ignorance of the relationship between Mr Davis
and ZX is no excuse.
• Mr Adams might have breached CPC F.1.27 and CPC F.1 Appendix 2.111 by
accepting the tennis tickets. However, this will depend on how the term
‘normal courtesies of social life’ is interpreted. Finals tickets have a
substantial value; family tickets to the finals could be considered different
from tickets for just Mr Adams and his wife, which might be considered
closer to ‘normal courtesies…’ Also, as Mr Davis is a tax client, not an audit
client, it might be reasonable to argue that a less stringent interpretation of
the rules applies.
(ii) Recommendations
• The firm’s ‘no vacation work’ policy should have been followed, thereby
avoiding confidentiality problems.
• All staff, including vacation workers, should sign confidentiality agreements
on commencement. In addition, they should be asked whether they know of
any existing conflicts of interest.
• The tickets should not have been accepted, or they could have been accepted
but paid for.

(b) (i) Breaches

• The firm might have breached fee dependence requirements, although given
the percentages stated in the question, this client’s fees might be below the
‘critical’ level suggested in CPC F.1 Appendix 2.103.
• MM still have significant fees outstanding. Need to consider whether the fees
have taken on the characteristics of a loan, and whether independence has
been compromised (CPC F.1 Appendix 2.105).
• The ‘discount’ of 20% given on the outstanding fees might also be seen to
compromise independence, as the fee received is arguably not commensurate
with the service given (CPC D.1/CPC F.6).
(ii) Recommendations
• The firm should consider and document the effect on independence of the
percentage of fees derived overall from MM, and also the effect on
independence of the amounts outstanding from MM.
• While it is unlikely the firm can reverse the decision to accept 20% less in
fees, it should not offer any further discounts.

(c) (i) Breaches

• The firm should not act as auditor of XX while Ms Tan is a director (CPC F.1
Appendix 2.47).
• The firm should not have accepted the commission from ABC for
recommendation of its software products (CPC D.2), unless the commission
arrangement was first disclosed to the client in writing.
• The valuation is prima facie within the guidelines, although given it is for a
Family Law court dispute the firm needs to take care it is not placing itself in
a potential conflict of interest position.
(ii) Recommendations
• Either Ms Tan should immediately resign as director, or the firm should
resign as auditors.
• The firm should develop a standard letter disclosing the relevant details of
commissions received on ABC Brand software. This should be sent to XX,
and any other relevant clients.
• The firm should check that neither actual nor perceived independence has
been breached by carrying out the valuation. The valuation should not be
used as part of audit evidence.

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 (d) (i) Breaches
• Independence might be breached by the fees charged: higher for consulting
to compensate for lower audit fees (CPC D.1/CPC F.6). (In practice, though,
this fee differentiation is common.)
• Fees from audit and other services combined might create a situation of fee
dependence (CPC F.1.26.
• Although the client requested the change in internal control procedures,
audit staff do appear close to being seen to be participating in the decision-
making functions of the client (CPC F.1 Appendix 2.55).
• The audit manager cannot assess control risk as low without performing tests
of controls, regardless of the other work staff have done on controls (AUS
402.39).
(ii) Recommendations
• The firm should assess and document whether fees charged affect
independence.
• The firm should consider and document the effect on independence of the
percentage of fees derived overall from FG.
• The firm should ensure the engagement letter and other relevant documents
are in place to back up the firm’s independence regarding the work
performed on controls. The firm should also ensure the client understands
the independence requirements and does not expect any reductions in audit
fees owing to work carried out on controls.
• The control risk assessment should be amended to high or alternatively tests
of controls should be performed. The audit file must stand alone, regardless
of any other work performed.

(e) (i) Breaches

• The firm has not disclosed the fact they act for both A Butchery and F
Feedlots to those clients (CPC F.1.22-23).
• Perceived independence might be breached owing to unpaid fees from F
Feedlots. The firm runs the risk of being seen to favour F Feedlots in any
potential disputes between them and A Butchery, because of the amount of
money owed. In addition, with the expiration of time these unpaid fees will
take on the characteristics of a loan, which state of affairs will be in breach of
CPC F.1 Appendix 2.105.
(ii) Recommendations
• The work done for each client needs to be disclosed to the other.
• The firm should consider and document the effect on independence of the
amounts outstanding from F Feedlots.

(f) (i) Breaches

• Mr Adams might have breached CPC F.1.27 as his loan is now on terms not
available to the general public.
• Using Mr Davis to obtain confidential information about clients appears to
breach CPC B.8. Although not specifically prohibited, this action, if known,
would be likely to bring discredit to the profession.
(ii) Recommendations
• Mr Adams should request that the fees on his loan be reinstated.
• The firm should cease using Davis to obtain information about client bank
balances, and should instead obtain this information through normal
channels.
3.22 (Complex)

Part a) - Professional standards/regulatory Part b) - Alternative courses of action the

requirements breached auditor should have taken

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 i) Chad has breached CPC B.5 Chad could have either have:
'Confidentiality', which states that he '...must • requested permission from the client to
respect the confidentiality of information use the information; or
acquired ... and should not disclose any such • not copied and used the information.
information to a third party without specific
authority...'
ii) Ms Wang has breached the following: Ms Wang should have either:
• s. 324(2)(g)(i) of the Corporations Act 2001, • refused the company secretary's position
which states that a firm shall not consent to maintain audit independence; or
to be an auditor of a company when a • resigned as auditor and accepted the
member of that firm is an officer of the company secretary's position.
company. As per s. 324(4)(b), a member
of a firm is deemed to be an officer if
they held the position of officer at any
time during the preceding 12 months.
• CPC F.1 Appendix 2.47, which requires
that irrespective of any legal prohibition
on such an appointment, a practice must
not act as auditor of a company if any
person in the practice is an officer of the
company.
iii) Tim's duties as an audit assistant on the Tim should have brought these
audit of Enz breaches CPC F.1 Appendix independence issues to the attention of the
2.34-40, which indicates that auditors should audit partner or manager.
not accept engagements if .any person in the
practice holds a close personal relationships The audit firm should have had appropriate
with clients, which could result in a quality control procedures in place to ensure
favourable bias. such breaches of independence did not
occur.
iv) Caz's actions in ignoring the error breach Caz should have taken action to report the
the following: incorrect figures to the partner responsible.
• CPC B.7 as Caz and the firm have not
performed their work with due care, In addition, the partner/manager on the
competence and diligence. engagement should have performed a more
• CPC B.8, which states 'Members must thorough review of the final document prior
conduct themselves in a manner to issuing it to the client.
consistent with the good reputation of
their profession and refrain from any
conduct which might bring discredit to
their profession'. Arguably Caz has
breached this by not taking action to
report the error.

c) i) Sanctions may be imposed against the practice. For example By-Law 45(g) of the
ICAA provides for:
• a fine not exceeding $100,000;
• a severe reprimand;
• a reprimand;
• a direction that the practice obtain such advice relating to the conduct of the practice
as the Disciplinary Committee prescribes, and/or
• a direction for payment of all or part of the costs and expenses incurred by the ICAA
in dealing with the Notice of Disciplinary Action.
The final outcome of the case is typically published.

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 c) ii) Sanctions may be imposed against the member. For example, By-Law 45(g) of the
ICAA provides for:
• exclusion from membership;
• suspension from membership for a period not exceeding five years;
• cancellation of their certificate of public practice (if held);
• a declaration that the member is ineligible for a certificate of public practice for a
period not exceeding five years;
• a fine not exceeding $100,000;
• a severe reprimand;
• a reprimand;
• a direction that the practice obtain such advice relating to the conduct of the practice
as the Disciplinary Committee prescribes;
• a direction that the member attend such continuing professional education course/s
as the Disciplinary Committee may prescribe, and/or
• a direction for payment of all or part of the costs and expenses incurred by the ICAA
in dealing with the Notice of Disciplinary Action.
Again, the final outcome of the case is typically published.

3.23 (Complex)
(a) The ethical issues include:
• Independence—independence might be breached if you accept the 'gifts' of an
expensive lunch and Grand Final tickets. CPC F.1.27 states that hospitality and
gifts should not be more than social courtesies.
• Objectivity—objectivity will be breached if you allow your close relationship with
Robert to bias your work.
• Integrity—you will have breached integrity if you suspect Robert has done
something wrong and do nothing about it.
• Competence—you must act with competence and due care to investigate whether
Robert has side-stepped Superdrug’s internal controls when purchasing the Acme
equipment because of his prior association with that company.

(b) You should not accept lunch and the tickets as this might compromise independence
and objectivity. You should also reject the offer of lunch and the tickets, or suggest a
lunch meeting in more modest surroundings and pay for the tickets. Although this
might offend Robert, it will maintain independence and objectivity. You should then
investigate the matter further by questioning Robert about the approval process that
was followed and his relationship with Acme. This is necessary if the validity of
internal controls is to be assessed. Failure to do so would not be acting with
independence, nor with competence and due care. Any weaknesses in internal
control would be reported to the audit committee.

3.24 (Complex)
(a) No. CPC F.1.27 allows an auditor to accept a 'token' gift from a client. In this
instance, the gift of food items valued at less than $200 would likely be considered a
token gift.

(b) No. CPC F.1 allows an auditor to provide such advisory services to an audit client.
Independence would be not considered impaired provided the auditor's role is
advisory in nature and he does not make any decisions (CPC F.1 Appendix 2.55).

(c) No. CPC F.1 Appendix 2.99 and 2.85 indicate that the auditor's independence is not
impaired under these circumstances provided the client makes all significant
management decisions related to the hiring of new personnel and the implementation
of the system. The auditor must also limit their supervisory activities to initial
instruction and training of personnel and should avoid direct supervision of the

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 actual operation of the system or related activities that would constitute undue
involvement in or identification with management functions.

(d) Yes. The auditor would not be independent because CPC F.1 Appendix 2.31 does not
allow an auditor to have investments with an officer of an audit client that are
material to the auditor's net worth.
3.25 (Complex)
(a) Yes. Under CPC F.1 Appendix 2.5 the auditor’s independence would be considered
impaired whether or not the financial interest is placed in a blind trust. An auditor is
not allowed to have any direct financial interest or a material indirect financial
interest.

(b) Yes. CPC F.1 Appendix 2.5 indicates that an auditor's independence would be
considered impaired if a close relative (e.g. a parent) has a material financial interest
in an enterprise in respect of which the auditor is participating in an engagement and
has knowledge of the financial interest.

(c) Yes. Independence under CPC F.1 Appendix 2.5 is impaired if a member has a direct
financial interest in a client during the period of the professional engagement or at
the time of expressing an opinion. The period of professional engagement starts when
the member begins to perform professional services requiring independence and
ends with the client's or member's notification of that relationship's termination.

(d) Yes. Independence under CPC F.1 Appendix 2.29 is impaired because the note is a
prohibited loan from the member to the client.

(e) No. However, Harrison will be in public practice with respect to the operation of the
management consulting firm and therefore must comply with the Code of Professional
Conduct in connection with both businesses.

3.26 (Complex)
Auditors do not cause companies to collapse. Usually collapses occur because of poor
management, fraud or external factors such as economic downturns and natural disasters.
However, the question is whether auditors should have warned users of the problems. Where
audit failure has occurred, the question is whether it has occurred because of lack of
competence or lack of independence. Clearly, in some corporate collapses, such as Waste
Management Inc, Enron and HIH Insurance, auditor independence is an issue. Although the
extent to which it contributed to the problems is unclear, there is a perception that lack of
auditor independence did play a role. As a result, there is a need for the profession and
regulators to toughen up independence requirements, which has occurred through the new
CPC F.1, the Sarbanes-Oxley Act and the recommendations of CLERP 9.

3.27 (Basic)
The advantages and disadvantages of audit tendering are as follows:
Advantages
• Should result in the most cost-efficient audit for the client.
• Increases competition within the industry, thus ensuring audit firms are operating
efficiently and using the most cost-effective techniques.
Disadvantages
• Might result in a loss of credibility of the profession owing to a real or perceived loss of
independence.
• Audit firms might reduce the quality of their work in order to provide the lowest tender,
thus endangering the reliability of the audit report.
• Might result in opinion shopping.

3.28 (Basic)

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 (a) The factors that could cause an auditor to exceed the time budget of an audit are:
• problems or inaccuracies are detailed that require follow up by the auditor;
• new issues might arise;
• the use of new or inexperienced audit staff; or
• the unavailability of client staff to resolve queries.

(b) Generally, if the budget is exceeded because of factors within the control of the client,
the client should be billed for the excess over budget. If the excess is the fault of the
audit firm, it should not be billed to the client but absorbed by the audit firm.

3.29 (Basic)
(a) The purpose of this question is to consider whether the content and nature of this type
of advertising and publicity complies with the guidelines set out in the code of
professional conduct, given that parts of the code contain ‘subjective’ terminology.
Further, CPC Section A.1 states that the ethical code does not purport to cover all
aspects of ethical and professional conduct and sets out minimum appropriate
requirements.

Therefore, while there is no right or wrong answer, the following matters should be
considered:
• Is this type of advertising and publicity 'consistent with the dignity of the
profession' [CPC D.5]? Whether a branded KPMG coffee cup in a movie or a hero,
portrayed as a KPMG accountant, in a low budget romantic comedy consistent with
the dignity of the profession is perhaps dependent upon one’s definition of dignity!
• Does the advertising contain any representations that would be considered
misleading or deceptive [CPC D5]? The likelihood of a reasonable person
misunderstanding any representation would be dependent upon one’s definition of
a reasonable person; and, the storyline of the heroic accountant.

(b) This type of advertising is unlikely to have any impact on the quality of audit. It may
be argued that forms of regulation such as quality control, peer reviews, oversight by
ASIC and legal exposure are adequate to ensure audit quality is maintained at an
acceptable level. However, advertising might result in greater competition in the
profession. Therefore, the profession does need to ensure that competitive pressures do
not result in a reduction in audit quality.

3.30 (Moderate)
In accordance with D.5, it is permissible for Vivian to send out a brochure advertising her
services and to follow up with a telephone call, provided that the follow-up is terminated if
she is requested to do so by the potential client. However, advertising expert franchising
services when she is not an expert in that area would constitute false and misleading
advertising and is in contravention of D.5.

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