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The Concept of Auditor's Independence

You are an audit manager with Clarke & Johnson (CJI). For the past years CJ has been the auditor of luxury Travel Holidays LTD (LTH), a travel company. Geoff, the audit partner, has asked you the to contact Chris, LTH’s CEO, with a view to CJ being re-engaged as the auditor for the upcoming audit of the 30 June 2015 financial report.

Geoff has also indicated that intends to allocate Michael, a first-year accountant, and Annette, an accountant in CJ’s tax advisory department, to the LTH audit for the first time. Geoff suggested that you discuss the audit with each of these staff, with a view to identifying any independence issues. You held talks with Chris, Michael and Annette of these conversations were as follows:

1. Conversation with Chris, situation 1

Chris stated: ‘The board of directors were impressed with last year’s audit and would like to propose reappointing CJ as the auditor of the 30 June 2015 financial report audit. The board would also like to invite Geoff to give a speech about LTH at the next travel agency seminar, to assist in promoting LTH’s business to attract more investors. I understand that this is outside CJ’s normal practice; however, the board expressed the view that it will be very difficult for LTH to continue any business engagements with CJ should Geoff refuse to provide such assistance’.

2. Conversation with Chris, situation 2

Chris stated: ‘ To express our sincerity towards CJ and Geoff, and to maintain the good relationship in anticipation of another smooth audit for 2015, LTH would like to present a complimentary 14-day holiday package voucher for four people to the Greek isles for both Geoff’s and your family. All expenses, including accommodation and travelling cost, will be paid by LTH’.

3. Conversation with Michael

Michael stated: ‘I am very excited to be part of the audit team. I believe that I will be a valuable asset to the team, as my dad is LTH’s financial controller. He is responsible for the preparation of LTH’s financial report.’

4. Conversation with Annette

Annette stated: ‘I am glad that I have been allocated to this year’s LTH’s audit team. It’s going to be a very efficient audit this year! I was on a temporary assignment at LTH’s just a month ago, helping LTH with its tax calculations and preparing accounting entries that will be reflected in the 30 June 2015 financial report, so I don’t think there will be much audit work required around the tax accounts. It will be great to catch up with everybody at LTH again, as they are so easy to work with.’

Required:

(a)For each situation, identify and evaluate any threats in relation to auditor independence.
(b)Identify any safeguards to those threats identified above.

2. You are an audit senior with Crampton and Hasaad and you are planning the audit of Mining supplies LTD (MSL) for the year ended 30 June 2015. MSL sells mining equipment and spare parts to mining companies across Australia. MSL has operational centres in Perth, Newcastle, and Mt. Isa. Each operational centre warehouses the equipment and spare parts and provides sales and maintenance services. MSL’s head office is located in Melbourne where finance, IT and other corporate services are provided.

MSL has equipment purchase order contracts with a number of manufacturing suppliers based in Europe, Us and China. These manufactures build the specialised, made- to-order equipment and spare parts and ship them to MSL’s operational centres.

Each item of equipment purchased by a customer comes with a two-year spare parts and labour warranty from MSL. The warranty entitles the customer to a maximum of one free maintenance service per year during the warranty period.

Depending on the type of equipment and customer’s location, a maintenance service can take between one day and one week. MSL uses contracted mobile mechanics who travel to the customer’s location to carry out all maintenance services. Some services require the mechanic to travel long distances, due to the remote locations. Any maintenance services that are inside that are outside the warranty conditions are billed to the customer. The billing covers a daily labour rate for the mechanic’s time, any parts replaced and reimbursement for travel, accommodation and living expenses incurred by the mechanic.

Required:

(a)In relation to the purchasing of equipment and spare parts, describe two business risks to MSL that Crampton and Hasaad will consider in planning the 2015 audit.
(b)For each business risk identified in (a) describe a specific audit risk that could arise. Each responses should include the identification of account balances that are impacted directly by the audit risk.

The Concept of Auditor's Independence

The independence of the auditor explains the independency of the all the auditors irrespective of external or internal from the interested persons who may have a significant influence on the financial report of any entity. The auditors to be independent must apply the integrity and objectivity approach while performing the audit process. The independency of the auditor requires them to perform the audit with true and fair manner and with the best available knowledge of the auditor (Abbott et al. 2016). The auditor while performing the audit must utilise the auditing standards guidance and various code of ethics during the process. The internal auditors independency is threatened from the influence of the interested users of the financial statement and the external auditor’s independency is threatened from the external users like the creditors, lenders and debtors. The aim of auditing the financial reports is to increase its transparency level and offer reasonable assurance to the users of these statements. The independency also depends on the state of mind of the auditor. An auditor must be strong enough to not be influenced by the interested parties and shall not compromise his judgement and act with integrity and objectivity (Ahlawat and Nouri 2015). In addition of the compliance of accounting standards, auditor’s independency is another key factor for making the financial statements reliable.

In addition of the regular service that is agreed by the auditors in the audit engagement to be provided, sometimes the auditors agree to provide other services in exchange of additional non-monetary or monetary benefits. These services are known as the non-audit services (NAS). NAS generally covers the services related to outsourcing of internal auditor, actuary services, management consultant services and promotion of the business of client by any means. Moreover, when the auditor in any way promotes or is perceived to promote the client’s business, it raises the advocacy threat that means the auditor is promoting the business of the client to attract more investors. If the auditor agrees to offer non-audit services to the client, it will definitely affect their independency and judgemental approach (Porter et al. 2014). Further, the independency issue is very crucial as it is often questioned by the government, stakeholders, creditors and other users of the finance reports.  Therefore, the auditor must give his opinion based on the best knowledge available to him and with true and fair approach. In the stated circumstances, the audit firm CJ has been approached by the client LTH for giving a speech in the travel agency seminar for getting reappointed as auditor in LTH. To maintain their independency, the audit firm CJ must not accept the offer or it will threaten their independency as promoting the business of the client is highly unethical (Olson, David and Desheng 2015).

Apart from the contracted fees mentioned in the audit engagement, the auditor is not supposed to receive any additional amount in form of fees, commission or any other non-monetary or monetary benefits that may endanger his independency. The auditor must keep him free from any kind of controversies that may raise question on his performance and judgement. Therefore, while performing the audit, he must give his judgement that is free from misstatement and error and shall be presented as per the best knowledge of the auditor (Khlif and Samaha 2014). As per the given circumstance, in addition to the prescribed fees the client LTH communicated that they will like to present a complimentary package for holiday to the audit partner Geoff and his family in expectation of smooth audit during the year 2015. If the offer is accepted by the auditor, it will raise the self-interest threat as the auditor will get additional benefit in exchange of carrying out smooth audit. Moreover, the auditor shall keep himself away from any kind of controversies that may raise question regarding his integrity.   Therefore, to protect his independency and maintain the integrity of the audit firm, Geoff shall not accept the offer given by LTH and carry his task with professional approach (Dogui, Boiral and Heras?Saizarbitoria 2014).  

Threats to Auditor's Independence in Scenario 1

If the close family member of the auditor or any partner of the audit firm is in the control of financial matters or associated with direct ownership through holding the shares, he must hold back himself from giving any judgement on the financial report of the client. The close family members here mean the parents, spouse, dependent child, non-dependent child or siblings. The financial interest also covers giving suggestions for the investment portfolio of the client, giving guarantee for the client’s debt or any borrowing and making any finance related decisions on behalf of the client. In given circumstance, Michel, who is to be appointed as the Auditor of LTH on behalf of the audit firm CJ is in the view that his engagement will be valuable for the audit team as his dad is engaged as the financial controller of LTH and is under the obligation of preparing the financial report of the client. Accepting the offer of CJ for appointment of Michel as the auditor of LTH will not only threaten his independency, but also will endanger the independency of the audit firm as a whole. Therefore, Michel shall not be appointed as the auditor for carrying out the audit of LTH.

It raises the familiarity threat when the auditor is not able to behave professionally owing to his previous engagement with the client or the auditor has good knowledge about the financial reports of the client.  Annette was engaged with LTH just one month back for preparation of their accounts and calculations of their tax. It seems that she has knowledge about the weaknesses and strength of the client and the members of the organization. It is more likely that Annette will feel that all the staffs of LTH are performing their duties pretty well and does not require any observation. Further, it will raise the threat of self-review as the auditor in no circumstances can audit his own work that is done previously. Auditing her own work will more likely to be involved with manipulation and thereby will impair the independency while auditing. Thus, the audit firm CJ shall not appoint Annette as the auditor for auditing the financial statements of LTH.

The services provided by the auditors to the client must contain a list of services that shall not be provided as providing those services may impair their independency. Different measures that can be taken to protect the auditor’s independency are:

  • Consistent with the auditor’s requirement – while carrying out the audit, the auditors must use the code of ethics and the auditing standards. The internationally accepted standards for maintaining the ethics will assist in reducing the difficulty of audit process.
  • Overlooking the other issues – an independent auditor can assist in providing the error free report and maintaining the transparency of report.  They must be able to ignore the political influence and shall provide the judgement with true and fair approach, enhance the transparency of report and share the data of the client with due care.
  • Rotation of the audit team member – rotation of the key partners among the audit team will reduce the chances of self-interest and familiarity threat and will enhance the integrity and objectivity aspect among the team members and it will not involve high amount of cost. Moreover, the past data of the entity whose audit is to be performed will be available with all the partners, which in turn, will help for quality maintenance.
  • Transparency level and efficient audit team – the efficient team of audit plays important role for achieving the auditor’s independence. The team members must be well versed with the guidelines of audit and with regard to the quality they must carry out their job with integrity and objectivity (Sarwoko and Agoes 2014).

The auditing standard guidelines state the auditor’s responsibility regarding identifying and analysing the associated risk associated with the financial statement’s material misstatement through identifying the client’s internal control, business environment and organizational system. The auditor’s main aim is to evaluate the risk level of the financial statement that taken place due to fraud, error or any kind of material misstatement. The auditing of the financial statements enables the auditor to present those statements in transparent and true and fair manner (Krishnan and Wang 2014). To attain these objectives, the auditors must:

  • Evaluate the likelihood of material misstatement and the impact of those misstatement that could lead to error or fraud
  • Analyse the all over risks of the client’s business and getting clear idea of the client’s business environment, transaction classes, method of accounting, disclosures of accounting policies.
  • Analyse the identified risk and the effect of those risk on the financial reports (Yoon et al. 2015).

Various business risk related to the purchase of spare-parts and equipment that shall be considered by Hassad and Crampton while planning for the audit are:  

Safeguards to the Threats in Scenario 1

Strategic risk – The strategic risk states about the risk of managing inventories and is associated with the system of stock management. There are mainly two options, the 1st option is to exchange the available inventory with the purchase of another product and in this case they will not have to follow any regulated policy (Tepalagul, Nopmanee and Ling Lin 2015). The business can simply ask the opinions experienced managerial personnel to comment on this matter. The 2nd option is to manage the inventories as per the regulated approach of managing inventories. The selection of option is based upon the investment associated with the inventories and the probable loss that may take place with the inventory management. If the client’s business can take-up the consequences of loss comfortably, then they can go for the 1st option and if they cannot take-up the risk of downtime then they have to find for any other appropriate strategy to minimise the impact of probable loss (Causholli, Chambers and Payne 2015).

Operational risk – the operational risk involves the performance of various strategies. It is associated with the implementation of any strategy that is set-up for implementation. For instance, the entity prepare some policies for inventory management, however, at the time of implementation it is found that it cannot be implemented at the projected level. The reason for this may be the management is not taking due care for following the strategies or there is some inherent weaknesses in the strategies itself. If the organization does not follow the policies properly, it is regarded as they are not taking due care for following the strategies. For the inventory management of spare-parts, risk assessment ensures the analysis of appropriate measures for managing the inventory properly (Benjamin 2014).

   The above mentioned risk that is the strategic risk is the application risk. It takes place when the auditor fails to take any control or the entity fails to implement any strategy. The financial reports and the financial transactions are susceptible to application risk. The involvement of risk is directly related with the amount of risk. The accounts that are affected by this risk are the closing as well as opening balance of inventory, net profit and gross profit (Cohen et al. 2017).

   On the other hand, the operational risks are associated with the detection risk. This risk states that chances are there that the auditor will not be able to detect any inherent risk that could lead to material misstatement of the financial reports. It seemed that the auditor has not taken proper care while performing the audit. It has great effect on the accounting transactions of sales account, purchase account, inventories, revenue account and opening as well as closing stock (Bae et al. 2016).

References:

Abbott, Lawrence J. 2016. "Internal audit quality and financial reporting quality: The joint importance of independence and competence." Journal of Accounting Research 54: 3-40.

Ahlawat, S. and Nouri, H., 2015. An examination of accountants and non-accountants'perceptions of auditor not reporting a material misstatement. Journal of Business and Accounting, 8(1), p.51.

Bae, G.S., Choi, S.U., Dhaliwal, D.S. and Lamoreaux, P.T., 2016. Auditors and client investment efficiency. The Accounting Review, 92(2), pp.19-40.

Benjamin, S.J., 2014. Auditors’ Independence–A Practical Solution. Browser Download This Paper.

Causholli, M., Chambers, D.J. and Payne, J.L., 2015. Does Selling Non-Audit Services Impair Auditor Independence? New Research Says,“Yes”. Current Issues in Auditing, 9(2), pp.P1-P6.

Cohen, Jeffrey, Ganesh Krishnamoorthy, and Arnold Wright. 2017. "Enterprise risk management and the financial reporting process: The experiences of audit committee members, CFOs, and external auditors." Contemporary Accounting Research.

Dogui, K., Boiral, O. and Heras?Saizarbitoria, I., 2014. Audit fees and auditor independence: The case of ISO 14001 certification. International Journal of Auditing, 18(1), pp.14-26.

Khlif, H. and Samaha, K., 2014. Internal control quality, Egyptian standards on auditing and external audit delays: Evidence from the Egyptian Stock Exchange. International Journal of Auditing, 18(2), pp.139-154.

Krishnan, G.V. and Wang, C., 2014. The relation between managerial ability and audit fees and going concern opinions. Auditing: A Journal of Practice & Theory, 34(3), pp.139-160.

Okaro, S.C. and Okafor, G.O., 2014. Joint Provision of Audit and Non-Audit Services in Nigeria: An Empirical Study. IUP Journal of Accounting Research & Audit Practices, 13(1), p.30.

Olson, David L., and Desheng Dash Wu. 2015. Enterprise risk management. Vol. 3. World Scientific Publishing Co Inc,.

Porter, Brenda, Jon Simon, and David 2014. Hatherly. Principles of external auditing. John Wiley & Sons.

Sarwoko, I. and Agoes, S., 2014. An Empirical Analysis of Auditor's Industry Specialization, Auditor's Independence and Audit Procedures on Audit Quality: Evidence from Indonesia. Procedia-Social and Behavioral Sciences, 164, pp.271-281.

Tepalagul, Nopmanee, and Ling Lin. 2015. "Auditor independence and audit quality: A literature review." Journal of Accounting, Auditing & Finance 30.1: 101-121.

Yoon, Kyunghee, Lucas Hoogduin, and Li Zhang. 2015. "Big data as complementary audit evidence." Accounting Horizons 29.2: 431-438.

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