3-1 chapter 3 ethics, independence and corporate governance copyright © 2012 mcgraw-hill australia...

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Chapter 3

Ethics, independence and corporate governance

Copyright © 2012 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 5e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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Learning objectives

3.1 Explain the nature and importance of professional ethics and describe the three main categories of ethical theory.

3.2 Outline the essence of the accounting bodies’ code of ethics.

3.3 Apply sound ethical decision-making techniques.

3.4 Explain the concept of corporate governance

3.5 Explain the auditor’s role as a whistleblower.

3.6 Explain the concept and importance of audit independence.

3.7 Explain fee determination and acceptable ways of obtaining clients.


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Learning objective 3.1 Professional ethics and ethical theory

• Ethics are concerned with the requirements for the general well-being, prosperity, health and happiness of people.

• It requires knowledge of moral principles and skills in applying them to problems and decisions.


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Ethical codes and disciplinary rules

• The establishment of ethical codes and disciplinary rules does not necessarily create an ethical culture or ensure the moral integrity of employees.

• APES 110 ‘Code of Ethics for Professional Accountants’, issued by the Accounting Professional and Ethical Standards Board (APESB), indicates that members are expected to comply with the spirit as well as the letter of the rules.

• Ethics are principally attitudes of mind rather than compliance with written rules of conduct.


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Ethical theory

• Teleological ethics: deal with the consequences or outcomes of actions:

– Generally, if the benefits of a proposed action outweigh the costs, the decision is morally correct.

• Deontological ethics: based on duties and rights:– Duties and rights set down in rules that must be followed.

• Virtue ethics: focus on personal qualities, such as the integrity of the decision maker.


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Learning objective 3.2 Accounting bodies’ codes of ethics

• APES 110 sets out main ethical pronouncements that relate to the undertaking of an audit.

• ASA 200.14/ISA 200.14 and ASA 102.5 require that auditors comply with relevant ethical requirements.

• APES 110 consists of three sections:1. Part A: General Application of the Code

2. Part B: Members in Public Practice

3. Part C: Members in Business

• There are also a number of APES standards and Miscellaneous Professional Statements promoting ‘competence’.


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Purpose of the code of ethics

• Code of ethics: formal, systematic statement of rules, principles, regulations or laws developed by a community to promote its well-being and punish undermining behaviour.

• The code therefore:– makes explicit the values implicitly required– indicates how members should act towards

one another– provides an objective basis for sanctions.


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Virtues of an auditor

Distinguishing mark of accountancy profession

is its acceptance to act in the public interest, defined

as ‘the collective well-being of the community of

people that the members serve’.

(APES 110, s 100.1)


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Fundamental principles

• Five fundamental principles contained in the code of ethics:1. integrity

2. objectivity

3. professional competence and due care

4. confidentiality

5. professional behaviour (APES 110, s 100.5).

• APES 110, s 290 provides specific guidance on independence requirements for audit and review engagements, while s 291 provides similar requirements for other assurance engagements.


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Learning objective 3.3Applying ethics

• Sound ethical decision making is dependent on:

– knowledge of the basic principles on which moral values and rules are based

– competence in decision-making skills

– the ability to choose appropriate policies and decision procedures in different situations.


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Ethical decision models

• There are three main models:

1. American Accounting Association Model

2. Mary Guy Model

3. Laura Nash Model


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Learning objective 3.4 Corporate governance

• Corporate governance: system by which companies are directed and managed.

• Covers the conduct of the Board of Directors and the relationship between the Board, management and shareholders.

• Board of Directors normally composed of a few corporate executives (such as CEO and CFO) and a majority of non-executive (preferably independent) directors.


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Independent director

A director will not be independent if he/she:– is, or is associated with, a substantial shareholder– has been an employee in an executive capacity in the last three

years, or a director after such employment– has been a principal or employee of a material adviser or

consultant to the company in the last three years – has been a material supplier or customer– has a material contractual relationship with the company – has served on the board for a period which could be reasonably

perceived as materially affecting the director's ability to act in the best interests of the company

– has an interest or relationship which could be reasonably perceived as materially interfering with the director's ability to act in the company’s best interests.


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Corporate Governance—OECD • In 1998 the OECD developed a set of corporate

governance standards covering six key areas—Principles of Corporate Governance:

– ensuring an effective corporate governance framework– rights of shareholders and key ownership functions– equitable treatment of shareholders– role of stakeholders in corporate governance– disclosure and transparency– responsibilities of the board.


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Corporate Governance—the UK

• In 1992 the Committee on the Financial Aspects of Corporate Governance issued what is known as the Cadbury Report, a code of best practice designed to achieve high standards of corporate behavior.

• The Cadbury Report describes the annual audit as one of the cornerstones of corporate governance.

• Companies on the London Stock Exchange are required to publish a statement of compliance with the code in their annual report.


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Corporate Governance—Australia

• The first Australian attempt to set out corporate governance standards of best practice was Corporate Practices and Conduct in 1991.

• Corporate governance is primarily the responsibility of a company’s directors and senior officers, although accountants have an important role to play.

– Accountants are concerned with ensuring that internal control policies and procedures are in place and working.


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Groups in Australia advocating improved corporate governance

• The business community, including the Australian Institute of Company Directors (AICD).

• Investors, in particular the Financial Services Council.

• Australian Securities Exchange (ASX), and the ASX Corporate Governance Council.

• Australian Securities and Investments Commission (ASIC).

• The three professional accounting bodies; CPA Australia, the ICAA and the IPA.


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Improved corporate governance—AICD

• The Australian Institute of Company Directors (AICD) has as one of its goals to ‘be the recognised advocate for corporate governance and directors’ issues’.

• Every member of the AICD is expected to comply with the AICD’s code of conduct. A director:

– must act honestly, in good faith and in the best interests of the company as a whole

– has a duty to use care and diligence in fulfilling the functions of office

– must use the powers of office in the best interest of the company as a whole


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Improved corporate governance—AICD (cont.)

– must recognise that their primary responsibility is to the company’s shareholders

– must not make improper use of information acquired– must not take improper advantage of their position– must properly manage any conflict of interests– obliged to be independent in judgment and actions– must not improperly use confidential information– must not engage in conduct likely to discredit the

company– has an obligation to comply with both the spirit and the

letter of the law and the spirit of the AICD’s code of conduct.


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ASX Corporate Governance Council’s Principles of Good Corporate

Governance

• Principle 1: Lay solid foundation for management and oversight.

• Principle 2: Structure the board to add value.

• Principle 3: Promote ethical and responsible decision making.

• Principle 4: Safeguard integrity in financial reporting.


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ASX Corporate Governance Council’s Principles of Good Corporate

Governance (cont.)

• Principle 5: Make timely and balanced disclosure.

• Principle 6: Respect the rights of shareholders.

• Principle 7: Recognise and manage risks.

• Principle 8: Remunerate fairly and responsibly.


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Audit committees

• Sub-committee of board of directors, which should consist mainly of non-executive/independent directors.

• Auditor’s major dealings with the board of directors are normally through this sub-committee.

• Important component of corporate governance, with most listed companies in Australia having an audit committee.

• Top 500 companies on ASX now required to have an audit committee.


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Effective audit committees

• Take an active role in overseeing company’s accounting and financial reporting.

• Maintain a direct line of communication between the board of directors and the auditors.

• Discuss sensitive matters with auditors such as controversial accounting issues, disagreements with management, and deficiencies in internal control.

• Discuss general scope and timing of external audit work.

• Involve themselves in nomination of external auditor, review reasonableness of audit fees, consider how provision of non-audit services affects auditor independence.

• Strengthen auditor independence by being independent communication link between management and auditors.


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Learning objective 3.5 Whistleblowing

Defined in the United States Civil Service Reform Act 1978 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’ is a whistleblower.


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Whistleblowing responsibility

In Australia it may be argued that the Corporations Act 2001, s 311, imposes a responsibility on auditors to inform ASIC of any significant contraventions of the Act discovered in the normal course of their duties and any other contraventions that cannot be remedied by comment in the audit report or by bringing the matter to the attention of directors. Arguably, this places an obligation on the auditor to whistleblow.


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Auditor’s responsibilities regarding whistleblowing (cont.)

• ASA 240.A65-66/ISA 240.A65-66 outlines that where an entity’s governing body fails to take appropriate action in regard to a fraud, the auditor may seek legal advice in deciding whether to report the fraud to a third party.

• Auditor may also have reporting responsibilities under the Crimes Act 1914.


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Auditor’s responsibilities regarding whistleblowing

• An auditor does not have to actively look for contraventions of the Corporations Act 2001.

• The decision to blow the whistle is not easy for an auditor.

• Whistleblowing requires resolution of the conflict between the principles of independence, objectivity, integrity and public interest on the one hand and client confidentiality on the other.


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Learning objective 3.6 Audit independence

• Independence is a key characteristic of an audit or assurance service provider.

• In order for auditors to add credibility to financial reports or other subject matter, they need to remain independent.

• Independence is one of the fundamental ethical virtues or principles required by APES 110.


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Independence: Corporations Act 2001

• s 307C: Independence declarationAuditors must give directors a written declaration of their independence and this is to be included in the directors’ report.

• s 324CA: Conflict of interestAuditor must take reasonable steps to ensure conflict of interest situations ceases to exist as soon as possible. Conflict of interest is where members of audit team are not capable of exercising objective and impartial judgment, as judged by a reasonable person.


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Independence: Corporations Act 2001 (cont.)

• s 300(1)(ca): Former auditors. Directors’ report is to include names of each officer of client who was a former partner or director of current auditor.

• s 324CI: Member of audit firm cannot become director, company secretary or member of senior management of a client until two years after ceasing to be with audit firm.

• s 324DA: Rotation of audit partners. Lead or review partner for five successive years cannot play a significant role in the audit of that entity for at least another two successive years.


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Independence: Corporations Act 2001 (cont.)

• s 300(11)(B): Non-audit services. Boards of all listed companies are required to provide a statement in their annual report that identifies all non-audit services provided by an audit firm, the fee for each service, and explanation why provision of service did not impair independence.


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Auditors’ appointment• s 327B: Shareholders are responsible for the

appointment of auditor:– Auditor is in breach of independence requirements

if, while auditing at a time that a s 324CH(1) relationship exists, the auditor is aware of relationship and does not take all reasonable steps to discontinue the audit.

• s 324CH(1) Relationships include:– Auditor or immediate family member being an officer

or audit-critical member (influencing financial report) of client.

– Auditor cannot provide remuneration to officer or audit-critical employee for acting as consultant.

– Auditor cannot have an investment in client.– Auditor cannot owe money to a client (unless a housing or

commercial loan on normal terms and conditions).


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Auditors’ removal and resignation

• Removal: Difficult to remove auditor.

• s 329: Requires a resolution of company at a general meeting of which special notice has been given. Auditor entitled to make written representation and speak at general meeting. A copy of notice must be sent to ASIC.

• Resignation (s 329(9)): Auditor can resign. Must have written consent from ASIC if a public company. Application outlines reason and ASIC must approve the reason. Designed to ensure independence and integrity of audit function is maintained.


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Right of access to records and reasonable fees

• s 310: Auditor has 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.

• s 331: Auditor is entitled to receive reasonable fees and expenses for the work carried out.

• Collectively, all these provisions assist an auditor to maintain actual and perceived independence, and attempt to create a suitable environment for an audit process that is free from undue influence and obstruction.


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Independence: ethical requirements

• Test for independence is a reasonable person test: Would a reasonable person having access to all facts consider that the auditor was independent? (APES 110, s 290.6)

• Ethical rules emphasise both (APES 110, s 290.6):– Perceived independence (independence in

appearance)—how others will view the auditor.– Actual independence (independence of mind)—

state of mind of the auditor. Whether the auditor can actually eliminate bias and personal interest from his or her decisions and not succumb to any undue pressures or influences. Related to integrity, objectivity and strength of character.


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Developments in auditor independence

• Ramsay Report (Australia).

• IFAC independence rules: conceptual approach using a framework for identifying, evaluating and responding to threats to independence.

• APES 110: based on IFAC independence rules.

• APES 320 and ASQC 1.23 (ISQC 1.23): audit firm policies and procedures.

• Sarbanes-Oxley Act (USA).


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Developments in auditor independence (cont.)

• Joint Committee of Public Accounts and Auditors (Australia).

• HIH Royal Commission (Australia).

• Corporate Law Economic Reform Program (CLERP 9) (Australia).


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APES 110, s 200: Threats to independence• Self-interest threats: Auditor could benefit

from a financial interest in the client.

• Self-review threats: Auditor could have to re-evaluate his or her own work.

• Advocacy threats: Auditor could promote the audit client’s point of view and compromise objectivity.

• Familiarity threats: Auditor may become too sympathetic to the client’s interests.

• Intimidation threats: Auditor may be deterred from acting objectively by actual or perceived threats from client.


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APES 110, s 200: Safeguards

• Safeguards fall into two broad categories. For an auditor these are:1. Safeguards created by the profession, legislation

or regulation—education, professional standards, monitoring and disciplinary processes, and inspections and reviews.

2. Safeguards within the work environment (firm wide and engagement specific)—independence and quality control policies and procedures.

• The safeguards are aimed at reducing or resolving circumstances that pose threats.


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Major threats to auditor independence

• Auditor employment relationships– Member of the assurance team cannot be employed

by the client.

• Financial and business relationships, including:– investments in audit clients– loans to and from clients– business relationships– goods and services from clients.


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Major threats to auditor independence (cont.)

• Provision of non-audit services, including:– preparing financial reports– valuation services– taxation– internal audit– design of systems– temporary staff assignments– litigation support services– legal services– recruiting senior management– corporate finance.


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Suggestions for further improving auditor independence

• Use of an oversight board. In Australia, the FRC now acts as a public oversight board for the AUASB (AUASB still has a number of practising auditors as members).

• Rotation of audit firms (EC Green Paper).

• Audit firm independence boards.

• Client auditor policies, such as restricting other services provided by audit firm.


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Learning objective 3.7 Fee determination and obtaining

clients• Audit fees should be commensurate with the

service provided. Thus, they should reflect the time taken to audit and the knowledge, skills and expertise required.

• An auditor should not enter into fee arrangements that may compromise his or her independence.

• Fees for a period should not be dependent on fees from the provision of future audits or other services.


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Obtaining clients

• Advertising, publicity and solicitation are permitted provided they are not false, misleading, deceptive or otherwise reflect adversely on the profession.

• Competing for prospective clients through tenders is now quite common.

• Auditors should be careful of audit clients that are opinion shopping.


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Summary• ICAA, CPA Australia and IPA have ethical rules.• Ethical principles and skills in ethical decision making

are an important aspect of corporate governance.• To be, and to be seen to be, independent is at the

centre of the ethical rules of the auditing profession.• Corporate failures and the GFC have increased interest

in auditor independence.• Auditor independence has been strengthened through

amendments to the Corporations Act 2001 (through CLERP 9) and the revision of ethical rules APES 110.


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