Chapter 3

Ethics, independence and corporate governance

3-1Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Learning objective 1: The nature and importance of

professional ethics

• 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.

3-2Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Ethical 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.

3-3Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Learning objective 2: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.

3-4Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Learning objective 3: Accounting bodies’ codes of ethics

• APES 110 sets out main ethical pronouncements that relate to the undertaking of an audit. [Revised version issued December 2010; effective July 2011]

• 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’.

3-5Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Purpose of the code of ethics

• Code of ethics: formal, systematic statement of rules and principles 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.

3-6Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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)

3-7Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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 [Previously 100.4]).

• Specific guidance on independence requirements for assurance engagements provided in APES 110, s 290.

3-8Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Learning objective 4:Applying 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.

3-9Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Ethical decision models

• There are three main models:

1. American Accounting Association Model

2. Mary Guy Model

3. Laura Nash Model

3-10Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Learning objective 5: 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.

3-11Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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.

3-12Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Corporate Governance – The UK• In 1999 the Institute of Chartered Accountants in

England and Wales issued what is known as the Turnbull Report, specifying the accountability of company directors and management.

– Principle D.2 states that ‘the board should maintain a sound system of internal control to safeguard shareholders’ investment’.

– 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’.

– 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’.

3-13Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Corporate Governance – The UK(cont.)

– Paragraph 12.43A 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 … providing explanation which enables its shareholders to evaluate how the principles have been applied;

a statement as to whether or not it has complied throughout the accounting period with the Code provisions.’

• Effective monitoring on a continuous basis is an essential component of a sound system of internal control.

3-14Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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.

3-15Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Groups in Australia advocating improved corporate governance

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

• Investors

• Australian Securities Exchange (ASX)

• Australian Securities and Investments Commission (ASIC)

• The three professional accounting bodies; CPA Australia, the Institute of Chartered Accountants in Australia and the National Institute of Accountants.

3-16Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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

3-17Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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 as a director

– Must not take improper advantage of their position– Must properly manage any conflict of interests– Must not improperly use confidential information– Must not engage in conduct likely to discredit the

company; and– 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.

3-18Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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 financialreporting

3-19Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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

3-20Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Audit committees

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

3-21Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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

3-22Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Learning objective 6: Whistleblowing

Defined in 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.

3-23Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Whistleblowing responsibility

In Australia 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.

3-24Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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.

3-25Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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.

3-26Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Learning objective 7: The importance of 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.

3-27Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Independence: Corporations Act 2001

• s 307C: Independence declaration– Auditors must give directors a written declaration

of their independence, and this is to be included in the directors’ report.

• s 324CA: Conflict of interest– Auditor must take reasonable steps to ensure conflict

of interest situation ceases to exist. Conflict of interest is where members of audit team are not capable of exercising objective and impartial judgment, as judged by a reasonable person.

3-28Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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.

3-29Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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, fees, and explanation why provision of service did not impair independence.

3-30Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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).

3-31Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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.

3-32Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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, 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.

3-33Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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 [Previously 290.9])

• Ethical rules emphasise both (APES 110, s 290.6 [Previously 290.8]) :– 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.

3-34Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Learning objective 8:Developments in auditor

independence

• Ramsay Report (Australia):

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

• APES 110: based on IFAC independence rules

• Sarbanes-Oxley Act (USA)

3-35Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Learning objective 8: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)

3-36Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

APES 110, s 290: 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.

3-37Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

APES 110, s 290: Safeguards

• Safeguards fall into three 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 audit client — competent employees, robust corporate governance structures.

3. Safeguards within the audit firm — independence and quality control policies and procedures.

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

3-38Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Learning objective 9: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.

3-39Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Learning objective 9: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

3-40Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Learning objective 10: 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

• Audit firm independence boards

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

3-41Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

Learning objective 11: 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.

3-42Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett

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.

3-43Copyright 2010 McGraw-Hill Australia Pty Ltd PPTs t/a Auditing and Assurance Services in Australia 4e by Grant Gay and Roger SimnettSlides prepared by Roger Simnett