Chapter 2 – Professional & Ethical Regulations

2.1 Fundamental Principles

P- Professional Competence & Due Care – Professional should attain and maintain
professional knowledge and skill required to provide a competent service to the client.
Professional should act diligently and in accordance with technical and professional
standards.
I – Integrity – Professional has to be honest and straightward in all professional and
business relationships. Professional should not knowingly be associated with any
information believed to be misleading, provided recklessly or omits/obscures information
which could be misleading.
C – Confidentiality- Professional should respect the confidentiality of information
acquired as a result of professional and business relationships.
O – Objectivity – Professional should not compromise professional or business
judgement due to bias, conflict of interest or undue influence of others.
P – Professional Behaviour – Professional must comply with the relevant laws and
regulations. Professionals should not knowingly engage in any business/activity that
impairs the integrity, objectivity or reptation of the professional.
2.2 Threats to Ethics
Threat is a situation that compromises the fundamental principles auditor must adhere
to.
1) Self Interest threat (personal or financial interest at the client that affect the auditors
judgement and auditor might overlook issues compromising their objectivity)
- Owning shares in the client’s business (the firm, audit team member or close
family member)
- Loans/guarantees with the bank which happens to be the audit client (threat only
if material)
- The fee from one client constitutes majority portion of the total income
Public companies – 15% of firm’s total fees for two consecutive years
Private companies – 30 % of firm’s total fees for five consecutive years.
- Situation of contingent fees ie, all or portion of audit’s fee is dependent on
another factor e.g. client’s profit. – NOT ALLOWED!
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 - Overdue fees- perceived to be loan to the client.
- Acceptance of gifts/hospitality – should be trivial & inconsequential in value.
- Close business relations with audit client.
- Close family member in influential position at the client/audit team.
- Potential employment with the audit client*.
- Purchasing goods/services from the client.
- Referral fee – providing recommendation of another firm that can provide the
requested service to the client in exchange of a fee. This is not prohibited by the
code but the issue is that the firm might recommend another firm without properly
evaluating the competence of the firm based on the requirements of the client.
- Long association with the client – A self interest threat might be created as a
result of an individual’s concern about losing a longstanding client or an interest
in maintaining a close relation with a senior member of the client/TCWG. Such a
threat might influence the individual’s judgement inappropriately.
- An auditor (not audit partner) might cross sell other services to the client in return
of a compensation. The level of self interest threat depends on:
 Proportion of the compensation or evaluation is based on the sale of the
service
 Role of the individual on the audit team and
 if the sale of the non assurance service influence promotion decisions.

2) Self Review threat – (The auditor providing a service to the client which form part of
FS which auditor will review and will fail to highlight any shortcomings of the work),
For all clients, firm can provide administrative services (word processing or doc
filling) since it is clerical in nature and hardly requires judgement as a result pose no
threat.
- A director/employee of the client joins audit firm.
- Providing accounting & assurance service to the same client.
- Providing internal audit service to the client if the audit team plans on replying on
the work of internal audit.
- Preparation of FS for audit client (NOT ALLOWED FOR LISTED CLIENTS).
- Calculation of tax figure to be included in FS (NOT ALLOWED FOR LISTED
CLIENTS).
- Newly hired assurance team member who was employed by the client.
- Secondment of an audit team member to the client for a short period of time.
- Valuation service requires making assumptions about future developments and/
or applying certain methodologies & techniques to compute a value or range of
values for the client. This is a self review threat if it affects the accounting records
or FS on which auditor will provide an opinion.
For a listed co., if the threat exists then valuation service can not be provided.

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 For non listed co., if valuation will have a material effect then service can not be
provided.
- Tax calculation (non listed company only– can not provide to listed/public interest
company). Tax return service does not create any threat.
- Tax planning or other tax advisory services. If the tax authority permit such
services in any country then it doesn’t act as a threat.
- Internal audit service – degree of threat depends on:
the materiality of the related FS amounts
The degree of reliance auditors will place on the work of internal audit service.
Prohibited internal audit services:
The internal controls over financial reporting (listed co.)
Financial accounting systems that generate information for the client’s
accounting records or FS on which the firm will express an opinion.
Amounts or disclosures that relate to the FS on which firm will express an
opinion.
3) Familiarity threat (The threat where auditors built close relationships with the client
and becomes too sympathetic or too trusting of the client thereby loosing
professional scepticism)
- Acceptance of gifts/hospitality.
- Close family member in influential position at the client/audit team.
- A director/employee of the client joins audit firm.
- An audit team member involved in a particular clients engagement for a long
period of time.
- Financial interest
- Secondment of an audit team member to the client for a short period of time – As
per code of ethics, it is not prohibited but it is important to ensure that it is for a
period of less than one year & the personnel will not assume any management
responsibility and role (director or senior management role).
4) Intimidation threat (Actual or perceived pressure from the client where auditor is
keen to retain the client somehow and hence overlooks issues compromising their
objectivity)
- The fee from one client constitutes majority portion of the total income
- Acceptance of gifts/hospitality.
- Close family member in influential position at the client/audit team.
- A Litigation with the client.
- Financial interest
- Potential employment with the audit client.
5) Advocacy threat (This is a threat where auditor is acting on behalf of the client or
promoting the interest of the client or representing client and hence compromising
independence and objectivity)
- Acting as an advocate for the client
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 - Promoting client shares in stock exchange.
- Attending meetings on behalf of client to explain the transactions.
- Secondment of an audit team member to the client for a short period of time.
- Tax planning – auditor will be seen to promote the interest of the client to the third
party (tax authority) & auditors will be deemed to be biased and not independent.
- Acting as an expert witness on behalf of the audit client. – if it not a threat if
appointed by the court to do so.
Safeguards
- Disposal of shares (if owned by firm)
- Removal of individual from audit team to ensure that there are no financial
interest for the audit team or immediate family members.
- Review by an individual reviewer.
- Consider resigning
- Discuss the issue with Audit committee/ professional body e.g. ACCA.
- Gifts/hospitality is not acceptable unless the value is trivial. Document the details
of the gift/hospitality offered by the client in the audit files even if declined. Also,
disclose to TCWG as they monitor independence of the external auditors.
- Consider changing the responsibilities of the audit team members
- Rotate Senior staff/ audit partner.
- Refuse to perform the assurance engagement.
- Separate teams for each engagement agreements. Accounting and assurance
services can not be provided to listed clients.
- The total fees from a listed client shouldn’t be more than 15% of the firm’s total
income for a period of 2 consecutive years. Thus, disclose to TCWG that the total
fees exceeds 15% of the total fees returned as well as also carry out
independent review on the audit report pre and post issuance review.
- Review fees and try to reduce engagements to reduce the fee dependency.
- For other clients (not listed), the total fees shouldn’t be more than 30% of the
total income for a period of 5 consecutive years. The firm should carry out pre &
post independent review. For non audit work, the fees should be maximum
70% of the audit fee.
- Ensure outstanding fees is settled before starting any new work.
- Decline any offer to advocate the client.
- For referral fee – disclose to the client if there is a referral fee arrange from the
other firm as well and vise-versa.
- In case of loan from the client – review the loan terms to identify any preferential
terms provided that would compromise independence of the auditor. This should
also be disclosed to the TCWG.
- In case of secondment of audit personnel to the client – do not include the
personnel as an audit team member for 2 years.
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 - For listed clients, firm can not provide bookkeeping and assurance services both.
- Tax services – obtain preclearance from the tax authorities before commencing
the service.
* Potential employment with the audit client -level of threat depends on
- the position offered to the team member.
- the position of the team member in conducting the audit
- the period spent by the individual in doing the audit of the client.
Safegaurd
- modify the audit plan because the team member knows all the audit methodologies.
- Independent review

6) Management threat – This is a threat where auditor is assuming management

responsibility, thereby compromising objectivity. As per code of ethics, management
responsibility is prohibited. However, if there is an informed management in place
then significance of the threat is reduced.
- Management requesting the auditor to draft the internal controls
- Tax calculation (non listed company only– can not provide to listed/public interest
company).
- Tax planning
- Internal audit service
Safegaurds
- Refuse to take any role that replicates the role of management.
- Written confirmation from client that the management decisions are solely their
responsibility – known as safeguard of informed management.
*If a single scenario relates to multiple threats, explain all of them! But if “Fee
dependency” is tested, explain self interest or intimidation -NOT BOTH!.
For listed audit clients:
Engagement Partner – Rotate after cumulative 7 years – Cooling off* Period is
consecutive 5 years.
Audit team member/ Engagement quality reviewer (EQR)– Rotate after 7 years –
Cooling off Period is 3 years.
Key audit Partner – Rotate after 7 years – Cooling off Period is 2 years.
*During Cooling off period, the individual shall not:

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- Be member of engagement team
-Provide quality control
- Exert direct influence on the outcome of the audit engagement.
If the local regulation states that the cooling off period should be less than 5 years then
we need to consider “higher of the mentioned period or 3 years”.
Example -Local law says that the cooling off period should be 2 years then it will be 3
years, or
Local law says that the cooling off period should be 4 years then it will be 4 years.
Exception by the code
For listed clients:
Due to any reason (e.g. death) the audit partner can not be rotated after 7 years, then
the audit partner can serve for an additional one year. However, this should be
communicated to TCWG.
For clients to be listed:
If the audit partner has served for 5 cumulative years or less then he can continue to
serve until the 7 years mark. If the audit partner has served for 6 years or more then as
an exception, he can continue to be the partner for 2 more years.

2.3 Conflict of Interest is a scenario in which an individual becomes unreliable because

his personal interests intertwine with professional interests. Due to the vested interests,
an individual may not be unbiased.
- Using confidential information from on client to assist another client with the acquisition
of the first.
-Advising two clients who are working on acquiring the same company.
- Providing services to both a vendor and purchaser in relation to the same transaction.
- Representing two clients in a legal dispute with each other.
Safeguards
- Notify both parties & obtain consent (Important!) If the client refuses to give
consent then the engagement giving rise to conflict of interest should be
discontinued based on commercial considerations.
- Engaging different teams for each client with different audit partner.
- Applying physical controls to prevent access to information.
- NDAs signed by employees so that confidential information is not shared
between teams.
- Advice client to seek additional independent advice.
- Review all the safeguards by an independent quality reviewer.

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2.4 BIAS (NEW TOPIC !)
Conscious or unconscious bias affects the exercise of professional judgement when
identifying, evaluating and addressing threats to compliance with the fundamental
principles.
Types of bias

2.5 Fraud and error

Fraud is an intentional act by the management, TCWG, employees whereas error is an
un-intentional mistake/oversight.
Two types of frauds:
- Misrepresentation of FS (FS being understated/overstated)
- Removal of funds and assets (misusing the assets of the company)

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ISA 240 Auditors responsibility towards fraud (mention the below for all fraud qns)
Management’s/TCWG primary responsibility to implement internal controls to prevent
and detect fraud.
Auditors responsibility to provide a reasonable assurance that FS are free from material
fraud & not to prevent fraud and error.
Fraud is well concealed in nature and hence difficult to identity.
When an auditor uncovers what he suspects might be a fraud or misstatement, he
should:
- Discuss the facts with the appropriate level of management & document these
facts and their response in audit file.
- Assess the impact on other areas of audit and the FS as a whole.
- Consider increasing testing on other areas of audit.
Reporting
If auditor suspects/ identifies fraud then it should be communicated to appropriate level
of management on timely basis.
If the auditor suspects fraud involving management or other employees whose actions
may have a material impact on the FS, the auditor shall communicate these suspicions
to TCWG and discuss with them the nature, timing and extent of audit procedures
necessary to complete the audit – this could have an impact on the audit as the time
spent by the auditors will be extended as well as the associated fees.
If the auditor has identified/suspected fraud, the auditor shall determine there is a
responsibility to report the occurrence or suspicion to an external party
(regulatory/enforcement authority). Although the auditor’s professional duty to maintain
confidentiality ma preclude such reporting, the auditor’s legal responsibilities may
override the duty of confidentiality in some circumstances.
2.6 Professional Liability
The auditor has contractual relationship with their client. If they breach the contract, they
can be sued. In addition to this, auditors have a duty to carry out their work with
reasonable skill and care.
To succeed in an action of negligence, an injured party* must prove the following:
1. A duty of care exists which is enforceable by law.
2. This duty of care was breached.
3. The breached caused the injured party loss.

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*Injured party is like to be either the client who is having the work performed or a third
party, such as an investor who has purchased shares in the company based on the
accountants report give.
Duty of care exists in case the injured party is the client & all other points need to be
proven. Whereas, in case the injured party is a third party where there is no contractual
agreement, all the points must be proven!
An accountant may sometimes be informed or be aware before they carry out a certain
work that a third party will rely on the results. In such cases, the accountant should
assume that they will be held to owe the same duty to the third party as to their client.
Case study Page 20.
CASE STUDY: ARE AUDITORS LIABLE ?
1. CAPARO V ROSS
Caparo Industries took over Fidelity plc in 1984 on the basis of Fidelity’s accounts,
audited by Touché Ross. Caparo sued Touché Ross for alleged negligence in the audit,
claiming that the stated £1.3m profit for the year to March 1984 should have been
reported as a loss of £460,000.
The auditors are not liable here as there was no duty of care between auditors and any
third party who will make investments in a company as this creates a wider liability to
the auditors which is not fair. And hence auditors will not be liable to any prospective
SH if they have made a bad investment decision.

2. ADT V BDO BINDER HAMLYN

BDO Binder Hamlyn were the auditors of Co X. Before the audit was finished, ADT were
considering bidding for Co X, so an ADT representative met the BDO audit partner and
asked him to confirm that the audited accounts gave a true and fair view and that he
had learnt nothing subsequently which cast doubt on the accounts. The partner said
that BDO “stood by” the accounts and there was nothing else that ADT should be told.
ADT then bought Co X for £105m. It was subsequently determined that Co X was worth
only £40m.
In this case the auditors confirmed to the third party that they are standing by the
accounts and that they have disclosed all the relevant info regarding the client and later
since the third party suffered a loss – the auditors are liable here.

How can auditors limit their liability?

1. Insurance against losses:
Professional indemnity insurance – Insurance against civil claims made by clients
and third party arising from work undertaken by the firm.
Fidelity guarantee insurance – Insurance against liability arising through any acts of

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 fraud or dishonesty by any partner, director or employee.

2. Auditors may reduce the chances of litigation by ensuring they have good
procedures over:
- Client acceptance
- Quality management/audit
- Compliance with standards
- Performance of audit work.
3. Incorporation/LLPs – this protects the partner from personal bankruptcy.
4. Capping liability – set a maximum limit on the amount that the auditor would have to
pay out under any claim.
5. Restrict the use of auditor’s report to their intended purpose

Fraud Questions – The below flow of points to be considered

1. Management’s responsibility & auditor’s responsibility as per ISA 240.
2. Materiality of the fraud (calculate if numbers mentioned!!!)
3. Difficulty in identifying fraud & tests conducted by auditors- What & how?
4. Professional skepticism of auditors
5. Negligence by auditors – if all 3 criteria are fulfilled?

2.7 Audit Failure & expectation gap

Audit failure is when there is a serious distortion on the FS which was missed to be
highlighted by the auditor or the auditor has made a material error in the conduct of the
audit.
The expectation gap is the difference in the perception of people regarding auditor’s
work and what auditors actually do. Example- it is auditors responsibility to detect and
prevent fraud!
How to bridge the gap?
1. Improving the quality of auditor’s report to explicitly include management and
auditors responsibilities.
2. Reiterating the same responsibilities in engagement letter.

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Questions

1. BEAUFORT CO (March 2020 – AAA)

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2. Matters to be communicated in terms of Fraud
Qn 24 Groom & co, 2013 pg 53 QB

Answers

1. Beaufort co

5. Board Structure
The Board of directors are members of the family which raises questions on theindependence of the boar
[Link], there is only one non-executive director which implies that there is lack ofindependent oversight &
since the other directors are family members, there would be les:value addition by the NED as the sugges
tions will be overridden in the interest of thedirectors.

Absence of audit committee raises questions on the corporate governance policy of thecompany. The fir
m will have to communicate the matters to the board (who are the familymembers) which also raises ques
tions on the independence of the [Link] may also reduce the effectiveness of the communication between
the auditor & thecompany, the audit committee is responsible for communicating relevant matters such as
deficiencies in internal control, to the board for their consideration. Without auditcommittee, matters of sig
nificance to the audit may not be given sufficient prominence bythe board. Further, the audit committee is
responsible for reviewing the integrity of the FS&internal controls & currently there is no one at the client t
o take up the role.

This also means that it will be difficult for the firm to discuss key audit matters with theclient.

6. Newly listing on Stock Exchange

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Since Beaufort Co. is in the process of being listed, management might be interested inmanipulating the
FS to improve the financial image of the company. This increases auditrisk and likely to have an improved
impact on the firm’s assessment of the risk of fraud andmanagement override.

As a listed company, Beaufort Co may be required to produce more detailed financialstatements probably
in a shorter time frame and as mentioned above, the lack of financialexpertise and lack of objective scruti
ny by an audit committee may result in errors oromissions. This again increases the level of audit risk fac
ed by Moritz & Co and a lot moredetailed testing may need to be performed to ensure compliance with ap
propriate accounting standards and listing rules.

7. New audit appointment

Currently, Beaufort is actively reviewing the audit appointment and looking for audit firmscapable of proce
eding with listing process and providing full service. This is an intimidationthreat for the firm to provide full
service which is against the code of ethics. Also, morethan 15% of the firm's income is from this client whi
ch they will not wish to loose. Thiscould impact their objectivity. The firm should clearly inform those charg
ed withgovernance their ethical duties which can not be compromised if they continue to beauditors for th
e next financial year.

2. Groom Co

As per ISA 240, itis the management's responsibility in preventing & identifying [Link]'s responsib
ility is to provide reasonable assurance that financial statements arefree from material fraud & not to dete
ct & prevent fraud.

In case of Spaniel Co, the payroll fraud was discovered in May 20X5 but was occurring
since May 20X4 implying that the fraud happened during the period of audit as the year
end was Dec 20X4.

The payroll fraud amounted to $4.5M which is 5.6% (4.5/80) of the total assets which is
material. The audit was for the period ending Dec 20X4, the amount of fraud till the period
would be $3M (4.5*8/12), 3.75% of the total assets which is still material (considering thefraud happened
consistently over the period of 12 months). As per the standards, 1-2% of
Total assets is the benchmark set for materiality & clearly the fraud was material as at Dec20X4.

Therefore, The auditor would be reasonably expected to discover this material fraud.

As per ISA, auditors can use previous year’s audit as audit evidence about the operatingeffectiveness of
specific controls provided they can prove that there have been nochanges since the last audit in the contr
ols or the operations of the business. In the caseof Spaniel Co, Groom & co. informed that no audit work
had been performed on payroll asno discrepancies were discovered in the previous year’s audit without p
roviding anyjustification/proof. No substantive testing had been done in a major high risk area by the
auditors which is unacceptable & clearly implying that the audit was incomplete.

To prove the negligence of the auditors, the injured party which is Spaniel Co. should provethe below thre
e points:

1. Existence of duty of care enforceable by law.

2. This duty of care has been breached.

3. This breach caused the injured party loss.

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Duty of care definitely exists between Spaniel Co. & Groom & Co. as thi eeappointed as the auditors & th
ere is an engagement letter specifying the parties which acts as a legal document.

Clearly, the payroll audit was not conducted without providing justifications & proofsindicates clear breach
of duty by Groom & Co. Auditors failed to practice professionalscepticism as Spaniel Co. had been a long
standing client but this doesn’t justify theignorance of not conducting complete audit.

Finally, financial loss had been suffered by the client which could have been reduced toless than $4.5 milli
on if it had been identified and raised during the audit procedures &could have saved the client about $1-
1.5M.

Thus, Spaniel Co can prove the negligence of Groom & co and Groom & ko are liabletowards the client.

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