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Arens, Auditing and Assurance Services in Australia, 11e Chapter 1: Demand for audit and assurance services Learning Objectives 1.1 Describe assurance services, and distinguish audit services from other assurance and non-assurance services provided by public accountants. 1.2 Explain the importance of auditing in reducing information risk. 1.3 List the causes of information risk, and explain how this risk may be reduced. 1.4 Describe auditing. 1.5 Distinguish between auditing and accounting. 1.6 Differentiate the three main types of audits. 1.7 Identify the primary types of auditors. 1.8 Describe the nature of public accounting firms, what they do and their structure. 1.9 Describe the key functions performed by the professional accounting bodies. 1.10 Use auditing standards as a basis for further study. 1.11 Identify quality control standards and practices within the accounting profession. 1.12 Summarise the role of the Corporations Act 2001 in accounting and auditing. 1.13 Describe the impact of e-commerce on public accountants. Copyright © 2025 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655713449/Arens/Auditing, Assurance Services & Ethics in Australia,11e 1

Review Questions 1.1

The relationships among audit services, attestation services and assurance

services are reflected in Figure 1.1 of the text. Audit services are a form of attestation service in which the auditor expresses a written conclusion about the degree of correspondence between information and established criteria. An attestation service is a form of assurance service in which the public accounting firm issues a written conclusion about an assertion made by a third party. An assurance service is an independent professional service to improve the quality of information for decision makers. The most common form of audit service is an audit of historical financial statements in which the auditor expresses an opinion as to whether the financial statements are presented in conformity with accounting standards and other mandatory disclosure requirements. An example of an attestation service is attesting to the information in an entity’s projected financial statements, which are often used to obtain financing. There are many possible forms of assurance services, including services related to business performance measurement, health care performance and information system reliability. 1.2

An independent audit is a means of satisfying the need for reliable

information on the part of decision makers. Factors of a complex society which contribute to this need are: 1.

Remoteness of information a.

Owners (shareholders) divorced from management

Directors not involved in day-to-day operations or decisions

Dispersion of the business among numerous geographical locations and complex corporate structures

Biases and motives of the provider a.

Information will be biased in favour of the provider when his or her goals are inconsistent with the decision maker’s goals

Voluminous data a.

Possibly millions of transactions processed daily via sophisticated computerised systems (the advent of more sophisticated and efficient technology has reduced the risk associated with the increased volume of data)

Multiple product lines

Multiple transaction locations

Complex exchange transactions a.

New and changing business relationships lead to innovative accounting and reporting problems

Potential impact of transactions not quantifiable, leading to increased disclosures

Increased international trade and online commerce a.

Trade between companies on an international level

Increase in trade occurring across international borders with differing laws applicable to trade in each jurisdiction

1.3 1.

Risk-free interest rate: This is approximately the rate the bank could earn by investing in government bonds for the same length of time as the business loan.

Business risk for the customer: This risk reflects the possibility that the business will not be able to repay its loan because of economic or business conditions such as a recession, poor management decisions or unexpected competition in the industry.

Information risk: This risk reflects the possibility that the information upon which the business risk decision was made was inaccurate. A likely cause of information risk is the possibility of inaccurate financial statements.

Auditing has no effect on either the risk-free interest rate or business risk. However, auditing can significantly reduce information risk. 1.4

Information risk represents the risk that the information presented in a set

of financial statements may contain misstatements that could adversely influence decision making. Information risk represents the key factor driving the audit function. Financial statements are used to make financial decisions—the implication being that that financial information must be free of information risk (material misstatement). It is therefore of primary importance to the auditor that the risk that the financial statements are free of material misstatement and information risk is minimised, so that any misstatements still present in a set of published financial statements are not sufficient to influence the decision making process of the users of those financial statements. It is important for a reporting entity to minimise information risk, because the responsibility for issuing the published set of financial reports lies with the management of that reporting entity. 1.5

The four primary causes of information risk are the remoteness of

information, the biases and motives of the provider, voluminous data, and the existence of complex exchange transactions (refer to the section ‘Economic demand for auditing’ in the text). The three main ways to reduce information risk are: 1.

The user verifies the information.

The user shares the information risk with management.

Audited financial statements are provided.

The advantages and disadvantages of each are as follows:

ADVANTAGES

DISADVANTAGES

USER VERIFIES

1. The user obtains the

THE

1. High cost of obtaining

information desired.

INFORMATION

information.

2. The user can be more

2. Inconvenience to the person

confident of the qualifications

providing the information

and activities of the person

because a large number of

getting the information.

users would be on the premises.

USER SHARES

1. No audit costs incurred.

1. The user may not be able to

THE

collect on any losses. For

INFORMATION

example, if a loss is incurred

RISK WITH

due to the company

MANAGEMENT

becoming insolvent, the user may find it difficult to get his or her loss repaid.

AUDITED

1. Multiple users obtain the

FINANCIAL

1. May not meet the needs of

information.

STATEMENTS

certain users.

2. The information risk can

ARE PROVIDED

2. The cost may be higher than

usually be reduced sufficiently

the benefits in some

to satisfy users at a

situations, such as for a

reasonable cost.

small company.

3. Minimal

inconvenience

management by having only one auditor.

1.6

To do an audit, there must be information in a verifiable form and some

standards (criteria) by which the auditor can evaluate the information. Examples of established criteria include accounting standards and the Income Tax Assessment Act.

Determining

the

degree

correspondence

between

information

and

established criteria entails determining whether a given set of information is in accordance with the established criteria. The information for Jones Co. Ltd’s tax return audit is the income tax returns filed by the company. The established criteria are

found

the

Income

Tax

Assessment

Act

and

all

its

accompanying

interpretations (public rulings). For the actual audit of Jones Co. Ltd’s financial statements, the information is the financial statements being audited, and the established criteria are accounting standards. 1.7

The primary evidence the tax auditor will use in the audit of Jones Co. Ltd’s

tax return includes all of the available documentation along with other information available in Jones’s office or from other sources. For example, when the tax auditor audits taxable income, the major sources of information will be bank statements, invoices, the cash receipts journal and deposit slips. The tax auditor is likely to emphasise unrecorded receipts and revenues. For expenses, the major sources of evidence likely to be presented are cheques, vendors’ invoices and other supporting documentation. 1.8

This question focuses on the need for a financial reporting framework. It is

not intended to be an in-depth discussion, but a reminder of the role and importance of mandatory guidelines for financial reporting. Accounting standards are required to allow for a formalised structure for the preparation of financial reports. They provide for a consistent basis of reporting between ‘reporting entities’ that will allow for reliable comparison of financial reports. Being able to compare financial reports allows the users of financial statement to make informed decisions about the allocation of their scarce resources. Standards aim to provide financial information

that

‘relevant,

complete,

reliable,

free

from

bias,

and

understandable’. It is at least a minimum set of standards to provide reasonable confidence in financial reports. Making standards mandatory therefore encourages compliance with all of these criteria in financial statements to ensure consistency and comparability, and to provide a set of minimum standards to be followed, thereby reducing the potential for manipulation of financial information by the management of reporting entities.

1.9

This apparent paradox arises from the distinction between the function of

auditing and the function of accounting. The accounting function is the recording, classifying and summarising of economic events to provide relevant information to decision makers. The rules of accounting are the criteria used by the auditor for evaluating the presentation of economic events in the financial statements, and he or she must therefore have an understanding of accounting standards as well as auditing standards. The accountant need not, and frequently does not, understand what auditors do, unless he or she is involved in doing audits or has been trained as an auditor. However, it has become increasingly apparent in recent times that accountants have a greater understanding of the role of the external auditor and acknowledge that the role of the external auditor complements the accounting role rather than conflicting with the accounting role. This allows the accountants to take advantage of the benefits accruing from the undertaking of the auditing function (e.g. gaining a better understanding of the internal control structure of the organisation). 1.10

‘Recognition’ refers to the element(s) that need to be identified and recorded

in the financial reports. For example, if an entity purchases a leased asset with the express purpose of purchasing the asset at the end of the life of the lease, the entity will need to recognise that leased asset in the financial statements (in the balance sheet). Recognition criteria are contained in the Australian Accounting Standards framework—it is probable the event will occur and the event can be reliably measured. Once it has been established that an element(s) needs to be recorded in the financial statements, it must then be established how that element will be shown in the financial statements. This is known as ‘disclosure’. Disclosure requirements are also found in the Australian Accounting Standards. 1.11

AUDITS OF

COMPLIANCE

PERFORMANCE

FINANCIAL

AUDITS

To determine

To determine whether

To evaluate whether

whether the overall

the client is following

operating procedures

financial

specific procedures set

are efficient and

statements are

by higher authority

effective

STATEMENTS PURPOSE

presented in accordance with specified criteria (accounting standards) USERS OF AUDIT

Different groups for

Authority setting down

Management of

REPORT

different purposes

procedures, internal or

organisation

—many outside

external

entities NATURE

Highly standardised

Not standardised, but

Highly non-standard;

specific and usually

often subjective

objective PERFORMED BY: PUBLIC ACCOUNTANTS

Almost universally

Occasionally

Frequently

Occasionally

Frequently

Never

Universally

Never

Frequently

OFFICERS SERVING AUDITORGENERAL TAX AUDITORS INTERNAL AUDITORS

1.12

Five examples of specific performance audits that could be conducted by an

internal auditor in a manufacturing company are: 1.

Examine computerised employee timesheets and personnel records to determine whether sufficient information is available to maximise the effective use of personnel.

Review the procedures of sales invoices to determine whether they could be done more efficiently.

Review the acquisitions of goods, including costs, to determine whether they are being purchased at the lowest possible cost considering the quality needed.

Review and evaluate the efficiency of the manufacturing process.

Review the processing of cash receipts to determine whether they are being deposited as quickly as possible.

1.13

This question allows the instructor to emphasise the three things the auditor

is focused on in an audit: 1. the financial information contained in the financial statements is free from misstatements (the numbers shown in the reports are correct). 2. The information contained in the financial statements is disclosed in accordance

with

all mandatory requirements (e.g.

the

Australian

Accounting Standards). 3. The entity has been assessed as a going concern and can meet its shortterm and long-term obligations and commitments in the next 12 months (the reporting period). Covid-19 had a significant impact on the third task shown above. Many entities were suddenly exposed to increased business risk and hence the risk of financial failure (e.g. Virgin Airline went into administration with a month of the Covid outbreak in March 2020).

The Covid-19 outbreak also made it very difficult for auditors to collect the evidence required to do their job. This is referred to as a ‘limitation of scope’, and is explained in more detail in coming chapters. For the time being, it is important to recognise that the task of conducting an audit was made harder because of lockdowns and other issues associated with not being able to physically collect the necessary evidence to complete an audit. 1.14

The major characteristics of public accounting firms that permit them to fulfil

their social function competently and independently are: 1.

Organisational form: A public accounting firm exists as a separate entity to avoid an employer–employee relationship with its clients. The public accounting firm employs a professional staff of sufficient size to prevent one client from constituting a significant portion of total revenue and thereby endangering the firm’s independence.

Conduct: A public accounting firm employs a professional staff of sufficient size to provide a broad range of expertise, continuing education and the promotion of a professional, independent attitude and competence.

Peer review: This practice evaluates the performance of public accounting firms in an attempt to keep competence high.

1.15

Australian Auditing Standards (ASAs) establish the mandatory requirements

of an audit, and provide explanatory guidance to auditors in fulfilling their professional responsibilities in the audit of financial reports. The standards apply in addition to any ethical and legal requirements relevant to a particular engagement. Examples may be any of the ASAs. Australian Accounting Standards (AASBs) are specific rules for accounting for transactions occurring in a business organisation. They are produced by the Australian Accounting Standards Board, and examples may be any of the AASBs. Auditing standards have the ‘force of law’ under the Corporations Act 2001. Section 307A of that Act requires auditors to conduct audits

and reviews of the financial reports prepared under Part 2M.3 of the Act in accordance with auditing standards. The Australian Auditing Standards outline the set of rules an auditor must follow in conducting an audit. These rules represent the minimum level of conduct expected of an auditor in ensuring he or she has successfully carried out the task of conducting an audit. In legal terms, the reasonable person’s test is established by saying that for auditors to conduct an audit using what would be considered a reasonable professional approach, they must ensure that they have adhered to the set of requirements contained in the Auditing Handbook. The

Australian

Accounting

Standards

represent

the

equivalent

for

accountants to use when preparing the set of financial statements to be published. The accounting standards represent the rules that must be followed to:  

recognise (record) the events occurring during the reporting period measure the events that must be recognised in the financial



statements disclose the events that must be recognised in the financial statements.

1.16

An audit in accordance with the Australian Auditing Standards (ASAs)

provides reasonable assurance, and not a guarantee, that the financial report is free

from

material

misstatement.

What

‘reasonable’

depends

the

circumstances. An audit involves the application of professional judgment in planning the audit, the selection of audit procedures and the conclusions drawn. Audits also have inherent limitations, including the use in their tests of samples rather than complete populations, the limitations of internal control structures, the possibility of collusion, and the fact that most evidence is persuasive rather than conclusive. 1.17

For the most part, auditing standards are general rather than specific. Many

practitioners, along with critics of the profession, believe that the standards should provide more clearly defined guidelines as an aid in determining the extent of evidence to be accumulated. This would eliminate some of the difficult audit

decisions and provide a source of defence if the auditor is charged with conducting an inadequate audit. On the other hand, highly specific requirements could turn auditing into mechanistic evidence-gathering, void of professional judgment. From the point of view of both the profession and the users of auditing services, there is probably a greater harm from defining authoritative guidelines too specifically than too broadly. Auditing standards take a substance over form approach consistent with the approach taken in the accounting standards framework. This allows the auditor to have greater control over the auditing of financial information. The imposition of specific rules governing specific situations would give rise to a need for a greater volume of changes and updates in the Australian Auditing Standards to ensure they adequately cover all of the situations prevailing in the financial reports. An example of this is the rules-based approach required for assessing taxation, and the subsequent voluminous level of taxation rulings and taxation determinations published. 1.18

Quality controls are established by individual public accounting firms to help

ensure that their firm meets its professional responsibilities to clients. Quality controls are the procedures used by a firm that help it meet the auditing standards consistently on every engagement. Quality controls are therefore established for the entire firm as opposed to individual engagements. The element of quality control the procedure affects is human resources— assignment of engagement teams. The purpose of the requirement is to help assure that all new personnel in public accounting firms are qualified to perform their work competently. A firm must have competent employees conducting the audits if quality audits are to result. 1.19

A peer review is a review, by public accountants, of a public accounting

firm’s compliance with its quality control procedure system. A mandatory peer review means that such a review is required periodically by the relevant professional accounting body.

Peer reviews can be beneficial to the profession and to individual firms. By helping firms meet quality control standards, the profession gains if the reviews result in practitioners doing higher-quality audits. A firm having a peer review can also gain if the review improves the firm’s practices and thereby enhances its reputation and effectiveness, and reduces the likelihood of law suits. Of course, peer reviews are costly. There is always a trade-off between cost and benefits. A public accounting firm also gives up some independence of activities when it is reviewed by another firm. The peer review is an effort at self-regulation. Its longterm success cannot yet be evaluated. 1.20

The role of the Corporations Act 2001 is to ensure that investors are

provided with adequate reliable information upon which to make investment decisions. It has considerable authority in setting and enforcing disclosure and auditing requirements, as well as the qualifications, appointments, removal, powers and duties of auditors. Auditors are required to report failures to comply with accounting and other statutory requirements.

Discussion Questions and Problems 1.24

The relationships among audit services, attestation services and assurance services are reflected in Figure 1.1 of the text. Audit services are a form of attestation service, and attestation services are a form of assurance service. In a diagram, audit services are located within the attestation service area, and attestation services are located within the assurance service area.

(1)

Audit of historical financial statements

(2)

An attestation service other than an audit service; or

(3)

An assurance service that is not an attestation service (WebTrust developed from the AICPA Special Committee on Assurance Services, but the service meets the criteria for an attestation service.)

(2)

An attestation service other than an audit service

(2)

An attestation service other than an audit service

(3)

An assurance service that is not an attestation service

(2)

An attestation service other than an audit service (review services are a form of attestation but are performed according to ASRE 2410.)

1.25

(2)

An attestation service other than an audit service

(3)

An assurance service that is not an attestation service

The interest rate for the loan that requires a review report is lower than the loan that did not require a review because of lower information risk. A review report provides moderate assurance to financial statement users, which lowers information risk. An audit report provides further assurance and even lower information risk. As a result of that reduced information risk, the interest rate is lowest for the loan with the audit

report. b.

Given these circumstances, Vial-tek should select the loan from Westpac that requires an annual audit. In this situation, the additional cost of the audit is less than the reduction in interest due to lower information risk. The following is the calculation of total costs for each loan:

LENDER

Existing loan National

Australia

SERVICE

COST OF

ANNUAL

SERVICES

INTEREST

LOAN COST

None

$142,500

Review

$12,000

$127,500

$139,500

Audit

$20,000

$112,500

$132,500

Bank Westpac

Vial-tek should select the loan from National Australia Bank due to the higher cost of the audit and the reduced interest rate for the loan from National Australia Bank. The following is the calculation of total costs for each loan:

LENDER

Existing loan National

Australia

SERVICE

COST OF

ANNUAL

SERVICES

INTEREST

LOAN COST

None

$142,500

Review

$12,000

$120,000

$132,000

Audit

$25,000

$112,500

$137,500

Bank Westpac

Vial-tek may wish to have an audit because of the many other positive benefits that an audit provides. The audit will provide Vial-tek’s management with assurance about the annual financial information used for decision-making purposes. The audit may detect errors or fraud, and provide management with information about the effectiveness of its

controls. In addition, the audit may result in recommendations to management that will improve efficiency or effectiveness. 1.26

The services provided by Consumers Union are very similar to the assurance services provided by public accounting firms. The services provided by Consumers Union and the assurance services provided by public accounting firms are designed to improve the quality of information for decision makers. Public accountants are valued for their independence, and the reports provided by Consumers Union are valued because Consumers Union is independent of the products tested.

The concepts of information risk for the buyer of a motor vehicle and for the user of financial statements are essentially the same. They are both concerned with the problem of unreliable information being provided. In the case of the auditor, the user is concerned about unreliable information being provided in the financial statements. The buyer of a motor vehicle is likely to be concerned about the manufacturer or dealer providing unreliable information.

The four causes of information risk are essentially the same for a buyer of a motor vehicle and a user of financial statements: (1)

Remoteness of information: It is difficult for a user to obtain much information about either a motor vehicle manufacturer or the vehicle itself without incurring considerable cost. The motor vehicle buyer does have the advantage of possibly knowing other users who are satisfied or dissatisfied with a similar vehicle.

(2)

Biases and motives of the provider: There is a conflict between the motor vehicle buyer and the manufacturer. The buyer wants to buy a high-quality product at minimum cost, whereas the seller wants to maximise the selling price and the quantity sold.

(3)

Voluminous data: There is a large amount of available information

about motor vehicles that users might like to have in order to evaluate a vehicle. Either that information is not available or it is too costly to obtain. (4)

Complex exchange transactions: The acquisition of a motor vehicle is expensive and certainly a complex decision because of all the components that go into making a good motor vehicle and choosing between a large number of alternatives.

The three ways users of financial statements and buyers of motor vehicles reduce information risk are also similar: (1)

The user verifies the information him- or herself: That can be obtained

driving

different

vehicles,

examining

their

specifications, talking to other users and doing research in various magazines. (2)

The

user

information

risk

with

management:

The

manufacturer of a product has a responsibility to meet its warranties and to provide a reasonable product. The buyer of a motor vehicle can return the vehicle for the correction of any defects. In some cases a refund may be obtained. (3)

Examine the information prepared by Consumer Reports: This is similar to an audit in the sense that independent information is provided by an independent party. The information provided by Consumer Reports is comparable to that provided by a public accounting firm that has audited a company’s financial statements.

1.27

The following parts of the definition of auditing are related to the narrative: (1)

Susan Virms is being asked to issue a report containing qualitative and quantitative information about Regional Delivery Service’s trucks. The trucks are therefore the information with which the auditor is concerned.

(2)

There are four established criteria which must be evaluated and reported by Virms: the existence of the trucks on the night of 30 June 20X6, the ownership of each truck by Regional Delivery Service, the physical condition of each truck, and the fair market value of each truck.

(3)

Susan Virms will accumulate and evaluate four types of evidence: (a) Count the trucks to determine their existence. (b) Use the registration documents held by Owens for comparison to the serial number on each truck to determine ownership. (c) Examine the

trucks to

determine

each truck’s physical

condition. (d) Examine the blue book to determine the fair market value of each truck. (4)

Susan Virms, public accountant, appears qualified to undertake the audit, as a competent, independent person. She is a CPA, and she spends most of her time auditing used motor vehicles and truck dealerships, and has extensive specialised knowledge about used trucks that is consistent with the nature of the engagement.

(5)

The report results are to include: (a) which of the 35 trucks are parked in Regional’s parking lot the night of 30 June (b) whether all of the trucks are owned by Regional Delivery Service (c) the condition of each truck, using established guidelines (d) the fair market value of each truck, using the current blue book for trucks.

The only parts of the audit which will be difficult for Virms are: (1)

Evaluating the trucks’ condition, using the guidelines of ‘poor’, ‘good’ and ‘excellent’. It is highly subjective to do so. If she uses a different criterion than that used by the blue book, the fair market

value will not be meaningful. Her experience will be essential in using this guideline. (2)

Determining the fair market value, unless it is clearly defined in the blue book for each condition.

1.28

a.The major advantages and disadvantages of a career as a tax auditor,

public accountant, officer serving the Auditor-General or internal auditor are:

EMPLOYMENT TAX AUDITOR

ADVANTAGES 1. Extensive training in individual, corporate, GST

DISADVANTAGES 1. Experience limited to taxes. 2. No experience with

and other taxes is available,

performance or financial

with concentration in the

statement auditing.

particular area chosen.

3. Training is not extensive with

2. Hands-on experience with

any business enterprise.

sophisticated selection techniques. PUBLIC ACCOUNTANT

1. Extensive training in the

1. Exposure to taxes and to the

audit of financial statements,

business enterprise may not be

compliance auditing and

as in-depth as the tax auditor

performance auditing.

or the internal auditor,

2. Opportunity for experience in auditing, tax consulting and

respectively. 2. Likely to be less exposed to

management consulting

performance auditing than is

practices.

likely for internal auditors.

3. Experience in a diversity of enterprises and industries with the opportunity to specialise in a specific industry.

OFFICER

1. Increasing opportunity for

SERVING

experience in performance

AUDITOR-

auditing.

GENERAL

1. Little exposure to a diversity of enterprises and industries. 2. Bureaucracy of Federal

2. Exposure to highly

Government.

sophisticated statistical sampling and computer auditing techniques. INTERNAL AUDITOR

1. Extensive exposure to all

1. Little exposure to taxation and

segments of the enterprise with which employed.

the audit thereof. 2. Experience is limited to one

2. Constant exposure to one

enterprise, usually within one

industry presenting

or a limited number of

opportunity for expertise in

industries.

that industry. 3. Likely to have exposure to compliance, financial and performance auditing.

Other auditing careers that are available are:  auditors within many of the branches of the Federal Government (e.g. Department of Defence)  auditors for many State and local government units (e.g. State Main Roads Department)

1.29

The most likely type of auditor and the type of audit for each of the examples are:

EXAMPLE

TYPE OF AUDITOR

TYPE OF AUDIT

Tax auditor

Compliance

Auditor-General

Performance

Internal auditor or public

Performance

accountant 4.

Public accountant or internal

Financial statements

auditor 5.

Auditor-General

Performance

Public accountant

Financial statements

Auditor-General

Financial statements

Tax auditor

Compliance

Public accountant

Financial statements

10.

Internal auditor or public

Compliance

accountant 11.

Internal auditor or public

Financial statements

accountant 12.

1.30

Auditor-General

Compliance

The conglomerate should engage either the management advisory services division of a public accounting firm or its own internal auditors to conduct the performance audit.

The auditors will encounter problems in planning the audit, identifying suitable criteria for evaluating the activities to be audited, and determining what should constitute sufficient appropriate audit evidence. The auditor should refer to ASAE 3500 (Performance Engagements) for guidance. In writing the report, the auditors must use proper wording in accordance with ASAE 3500 (Performance Engagements).

1.31

The comments on the problem do summarise the beliefs of many

practitioners about quality control and peer review. The arguments against quality control and peer review are stated in the comments and can be summarised as five basic arguments: 1.

The relative cost for local firms is excessively high.

Smaller firms have less need for quality control because of partner involvement.

Quality

control

advantage

regulations local

firms,

eliminate

the

which

major

simple

competitive and

efficient

organisational structure. 4.

Quality control standards are not needed because they have already been implemented by quality firms.

Three other things already provide assurance of adequate quality: auditing standards, legal liability and a competitive economic environment.

To support these comments it can be argued that the profession has

functioned well with relatively little controversy and criticism. A major reason many practitioners choose the profession is the relative freedom to operate their professional practice as they see fit. The arguments against these comments are primarily as follows: 1.

Certain critics of the profession have argued strongly against selfregulation of the profession. Many public accountants believe that only through self-regulation will it be possible to minimise government interference. Even if the elements of quality control are already in existence, the quality control and peer review requirements may be necessary to avoid government interference.

For those firms that already meet the elements of quality control in their practice, the additional implementation costs should be minimal. Those lacking such elements will incur more cost, but

presumably are lacking in certain elements needed for a highquality practice. 3.

Partner involvement on engagements does not necessarily assure that all quality control requirements have been met. For some smaller firms, top partners may spend relatively little time on audits and therefore not be as knowledgeable about auditing as may be necessary.

There is no correct answer to this question. Different people reach different conclusions, depending on the weights they put on each of the arguments stated in part (a) for and against quality controls and peer reviews. The authors believe that both quality control and peer review are worth the cost.

1.32

Assignment of engagement teams

Leadership responsibilities; engagement performance

Ethical requirements

Monitoring

Client acceptance and continuance

Assignment of engagement teams

Monitoring

1.33

AUDITING STANDARDS

ACTIONS OF HARRIS RESULTING IN FAILURE TO COMPLY

ASA 220

There is a lack of professional independence. Because of the financial interest in whether the bank loan is granted, Harris is independent neither in fact nor appearance with respect to this assignment.

ASA 210

No reference to an audit engagement letter.

ASA 220

It was inappropriate for Harris to hire the two students to conduct the audit. Audit assistants may help in the conduct of the audit provided that there is proper supervision and review.

ASA 220

Harris did not properly supervise nor review the work and judgments of the assistants.

ASA 230

There was no documentation of the audit plan, audit procedures and the results of the work conducted.

ASA 300

Harris accepted the engagement without considering the availability of competent staff. Knowledge of the client’s business was not obtained. The audit was not adequately planned and supervised.

ASA 315

Harris did not assess risk nor obtain an understanding of the internal control structure. No audit has been conducted. The work performed was more an accounting service than an audit.

ASA 500

Harris acquired no evidence to support the financial statements. Harris merely checked the mathematical accuracy of the records and summarised the accounts. Standard audit procedures linked to audit objectives were not performed.

ASA 700

Harris’s report made no reference to accounting standards. Because a proper audit was not conducted, the report should state that no opinion can be expressed as to the fair presentation of the financial statements in accordance with accounting standards. No reference was made to the Corporations Act 2001. By not properly planning and conducting the audit, Harris did not obtain a proper understanding of the client and could not assess the consistency of the financial statements

with such knowledge.

1.34

The public accounting firm for the Internet retailer described in this problem could address these customer concerns by performing a WebTrust attestation engagement. The WebTrust assurance service was created by the profession to respond to the growing need for assurance resulting from the growth of business transacted over the Internet.

b. The appropriate WebTrust principle for each of the customer concerns noted in the problem is as follows: 1.

Accuracy of product descriptions and adherence to stated return policies: (3) Processing Integrity.

Credit card and other personal information: (1) Online Privacy and (2) Security.

Selling information to other companies: (1) Online Privacy and (2) Security.

System failure: (4) Availability.

Arens, Auditing and Assurance Services in Australia, 11e Chapter 2: Auditors’ legal environment Learning Objectives 2.1 Describe the main elements of the complex and dynamic regulatory environment in which auditors practise. 2.2 Describe the main elements of statutory regulation relevant to auditors and auditing. 2.3 Specify what constitutes criminal liability for auditors. 2.4: Define the primary legal concepts affecting auditors’ liability. 2.5 Describe the auditor’s liability to clients and duties to management. 2.6 Describe the auditor’s liability to third parties under common law. 2.7 Describe the auditor’s responsibilities for detecting and reporting fraud and error. 2.8 Discuss how individual auditors and firms can manage legal liability exposure.

Review Questions 2.1

Important regulatory changes in Australia since 2001 affecting auditor

liability include: the United States Sarbanes–Oxley Act 2002, which applies to all companies (and their subsidiaries) registered with the Securities and Exchange Commission (a requirement for listing securities on a US exchange: e.g. BHP Billiton, which is registered on the US Stock Exchange and needs to comply with Copyright © 2025 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9780655713449/Arens/Auditing and Assurance Services in Australia,11e

Sarbanes-Oxley); the Corporate Law Economic Reform Program (CLERP 9) changes to the Corporations Act 2001; the establishment of Auditing Standards issued by the AUASB (Auditing and Assurance Standards Board, under the Financial Reporting Council) as legislative instruments in 2003; limits to liability introduced with authorised audit companies and liability caps with the passage of the Treasury Legislation Amendment (Professional Standards) Act 2004. Also in 2004, the Australian Securities and Investments Commission (ASIC) Act 2001 and the Corporations Act were amended to ensure that proportionate liability applies to claims for damages for economic loss arising from misleading or deceptive conduct (also reflected in the Competition and Consumer Act 2010). Students might also discuss ASIC’s auditor surveillance program. CLERP 9 also provided for the Australian Auditing Standards to become legally enforceable for financial reporting periods commencing 1 July 2006. 2.2

The main Commonwealth statutes affecting auditor regulation in Australia

are the Corporations Act 2001 and the Competition and Consumer Act 2010. Students might also mention the Crimes Act 1914 (or State criminal codes), but these are much less directly relevant to auditors. 2.3

ASIC can initiate prosecutions of auditors or refer them to the Companies

Auditors and Liquidators Disciplinary Board (CALDB) for action. The CALDB can levy sanctions ranging from fines to suspension or cancellation of an auditor’s registration. Students might also discuss ASIC’s auditor surveillance program. 2.4

‘Proportionate liability’ means that the various parties whose negligence

contributed to a loss are liable for an appropriate share of the damages. This means that auditors should not carry the full burden for losses resulting from a misstatement when other parties contributed to the level of losses incurred by failing to take adequate precautions. This was introduced by State legislation because there was a common perception that the courts were placing insufficient weight on the reasonableness of taking precautions to prevent or reduce the risks.

2.5

‘Vicarious liability’ means that a person (or entity) is liable for the acts of a

subordinate, agent or employee. This means an audit partner or firm (or AAC) can be liable for acts or omissions by a person who is member, employee or agent of the firm. This requires the person to have acted within the actual or apparent scope of his or her authority or employment. (Also see question 2.8.) 2.6

The ‘reasonable person’ concept states that a person is responsible for

conducting a job in good faith and with integrity, but is not infallible. Therefore, the auditor is expected to conduct an audit using due care, but does not claim to be a guarantor or insurer of financial statements. This is achieved by following the requirements of the Australian Auditing Standards (ASAs). The ASAs establish the minimum level of conduct during an audit. If auditors have conducted an audit in accordance with the requirements of the ASAs, they can say with confidence that they have performed their task at a professional level (performance). This flows into the establishment of negligence in a court case: an auditor can be open to potential litigation if he or she has not conducted an audit in accordance with the ASAs, and negligence can be established by showing that the auditor has not followed the ASAs in conducting the audit. 2.7 Groups for whose work a public accounting firm partner may be held liable include: his or her partners or employees; other public accounting firms engaged to do part of the work; and outside specialists contracted to provide technical expertise. (Also see question 2.6.) 2.8

‘Contributory negligence’ means another person (usually the plaintiff) has

contributed to his or her own loss by failing to take sufficient reasonable care. An example is the claim by the auditor that management knew of the potential for fraud because of weaknesses of internal control but refused to correct them. The auditor thereby claims that the client contributed to the losses caused by the fraud by not correcting material weaknesses in the internal control structure. This was

employed successfully in Australia for non-statutory audit work in AWA Ltd v. Daniels (t/a Deloitte Haskins & Sells) (No. 1) (1992) 10 ACLC 933; (No. 2) (1992) 10 ACLC 1643. Since then, various States have legislated requirements for damages to be apportioned according to a ‘negligence calculus’ that can recognise the duties of parties additional to the auditor. This is known as proportionate liability. 2.9

An auditor’s legal liability to the client under common law can result from

the auditor’s failure to properly fulfil his or her contract for services. The legal actions can be for breach of contract, which is a claim that the contract was not performed in the manner agreed upon, or it can be a tort action for negligence. An example would be the client’s detection of an error in the financial statements, which would have been discovered if the auditor had performed all of the audit procedures required in the circumstances (e.g. misstatement of inventory account resulting from an inaccurate physical inventory not properly observed by the auditor). Liability to clients under statutory law occurs under both the Corporations Act 2001 and the Competition and Consumer Act 2010. The auditor has a duty to the corporation (such as to notify management of errors or problems) and to members of the corporation in the expression of an opinion in the audit report. Failure to detect and disclose a material misstatement is likely to render the auditor liable on this basis. The auditor’s liability to third parties under common law results from any loss incurred by the claimant due to reliance upon misleading financial statements. An example would be a bank that has loans outstanding to an audited company. If the audit report did not disclose that the company had contingent liabilities that subsequently became real liabilities and forced the company into bankruptcy, the bank could proceed with legal action against the auditors for the material omission —the bank would have to establish that it enjoyed sufficient proximity and its reliance was reasonably foreseeable.

Liability to third parties under statutory law is most likely to arise under the Fair Trading legislation regarding misleading or deceptive statements. Because silence can be construed as misstatement, this may leave auditors exposed to third-party claims for failure to detect and report misstatements. However, this is yet to be tested in court. Where it can be established that a third party has privity of contract, then they will be able to take action. 2.10

This question is introducing students to the importance of following the

Australian Auditing Standards (ASAs) in conducting an audit. The text will focus on explaining the underlying concepts and procedures encapsulated by the ASAs, so students will need to become familiar with the underlying principles of the key ASAs discussed in the text. This is not a comprehensive list, but provides a good framework to introduce students to the key ASAs. Students will benefit from having access to this summary throughout the study period, and so are strongly encouraged to put together something similar or be given a copy of this.

Standard

Focus

ASA 200

Establishes the primary objective and

ASA 210

function of an external audit Documents the responsibilities of the external auditor and management. Documentation

fundamental

principle in auditing. Everything the ASA 220

auditor does needs to be documented. This is a key standard, and focuses on the underlying principles that establish the quality of the audit conducted. For example: ensuring the audit staff have the

necessary

expertise,

knowledge

and experience; monitoring the work of staff; supervising staff during an audit; establishing ASA 230

clear

processes

conducting an audit. Audit documentation: objective

appropriate

the

auditor’s

collect

sufficient

evidence

form

opinion. With this in mind, the auditor must ensure they can show that this has been achieved—this means the ASA 240

auditor documents everything. Fraud: the auditor must ensure there is an assessment of the risk of fraud when conducting an audit. The auditor is responsible for fraud to the extent that it was reasonable for the auditor to detect fraud in undertaking the audit in accordance

ASA 300

with

the

ASAs

(the

‘reasonable person’s test’). The auditor must plan an audit to ensure

that

sufficient

appropriate

evidence can be collected and tested to ASA 315

form an opinion. Another very important standard. The auditor

uses

risk-assessment

approach in conducting an audit (and to minimise the amount of evidence that needs to be collected and tested). ASA 315 establishes the risks that will be assessed by the auditor; namely, inherent risk and control risk. These risks are then used to establish the

ASA 500

evidence mix. The audit opinion is based on collecting sufficient appropriate evidence to form an opinion. This standard establishes what evidence is, and how it should be

ASA 501

collected by the auditor How to conduct the audit of inventory

ASA 502

in an entity. The auditor must consider any legal issues which can give rise to potential misstatement(s)

ASA 570

the

financial

statements. The auditor is charged with assessing whether an entity is considered a going concern: the entity is able to meet its short-term

and

commitments

long-term

and

when

they

become due for the next 12 months ASA 700

(the next reporting period). Forming an opinion—an unmodified opinion indicating that the financial statements

ASA 705

are

free

misstatement(s). This covers the

from

material

situation

where

misstatements are identified in the financial statements and are contained in

published

statements.

set such

financial

situations,

modified opinion must be issued. Source: Data from https://auasb.gov.au/standards-guidance/auasb-standards/auditing-standards/.

2.11

The auditor should assess the risk that errors and irregularities may cause a

client’s financial statements to contain a misstatement. Based on this assessment,

the auditor should design the audit to provide reasonable assurance of detecting any errors and irregularities that are material to the financial statements. Because of the nature of irregularities (including defalcations), properly designed and executed audit procedures that are effective for detecting error may not be appropriate in the context of an identified risk of material misstatement due to fraud. The decision in Pacific Acceptance Corporation Ltd v. Forsyth (1970) 92 WN (NSW) 29 confirmed the auditor’s duty to audit with due care and skill, including a duty to design the audit with due regard to the possibility of fraud. WA Chip and Pulp Co. Pty Ltd v. Arthur Young (1987) 12 ACLR 25 highlighted the irrelevance of materiality in considering the need to further pursue indicators of fraud. The auditing standards establish the minimum level of competency expected of the auditor during the conduct of the audit. An auditor should not be held responsible for identifying all fraud, however. Sophisticated fraud, for example, should not be the responsibility of the auditor to identify. This is the responsibility of management. The concept of reasonable assurance is established by acknowledging that it is impossible for an auditor to provide a guarantee that the published financial statements are free of material misstatement(s). To place the responsibility of identifying all fraud on an auditor would result in prohibitive insurance premiums, and would make the task of conducting a successful audit almost impossible. (The incentive would be created for the client to commit fraud, knowing that the responsibility would be with the auditor to identify it.) 2.12

Cases are normally settled out of court for two main reasons: 

The reputation of an audit firm can be seriously affected by ongoing cases against them. An example of this was Arthur Anderson’s and Enron Corporation and WorldCom. These two high profile cases saw the



eventual decline and closure of Arthur Anderson’s Court cases can takes years to settle – this creates unnecessary issues for both the auditor and clients – it is beneficial to all parties to establish

compromise and settle disputes well before they are presented before a judge to decide an outcome.

Discussion questions and problems 2.16

Although the auditor meant well, the underlying principle for an auditor is to

document all fraud, and when fraud is identified (no matter the amount) notify management of this fraud. WA Chip and Pulp Co. Pty Ltd v. Arthur Young (1987) 12 ACLR 25 established the principle that fraud is material due to its nature, and the amount is secondary. In this situation, even though the fraud was ‘only’ $2,000, it still needed to be documented and then management notified. It is then management’s responsibility to deal with the employee. Fraud is assessed differently to misstatements occurring inadvertently. The auditor must always use professional scepticism when assessing fraud. The presence of fraud will always be seen as potentially indicting that there is more fraud that has not been uncovered. It is the auditor’s duty to investigate further to remove all doubt that the fraud identified is not reflective of a deeper issue within the client. 2.17

Crosden & Sykes should use the defences of meeting generally accepted auditing standards and contributory negligence. The fraud perpetuated by Posh Manikins Ltd was a reasonably complex one and difficult to uncover except by the procedures suggested by Crosden. In most circumstances it would not be necessary to physically count all inventory at different locations on the same day. Furthermore, the president of the company contributed to the failure to find the irregularity by refusing to follow Crosden’s suggestion. There is evidence of that through his signed statement.

There are two defences Crosden & Sykes should use in an action by National Commercial Bank. First, there is a lack of privity of contract. Although this was a known third party, it does not mean that there is any duty to that party in this situation (see Esanda Finance Corporation Ltd v. Peat Marwick Hungerfords (1994) 13 ACSR 164 (SASC); (1997) 188 CLR 241; 142 ALR 750 (HCA)). This defence is very likely to succeed if it is an audit under the Corporations Act 2001. The second defence is that the auditor followed appropriate auditing standards in the audit of inventory, including the employment of due care. Ordinarily it is unreasonable to expect an auditor to find such an unusual problem in the course of an ordinary audit. The fact that the auditor did not uncover the fraud does not mean the auditor has any responsibility for it.

The auditor is more likely to be successful in her defence against the client using contributory negligence defence if it is a non-statutory audit. But the failure of the plaintiff to take appropriate reasonable steps is considered in the calculus. The company has responsibility for instituting an

adequate

internal

control

structure.

The

managing

director’s

statement that it was impractical to count all inventory on the same day because

personnel

shortages

and

customer

preferences

puts

considerable burden on the company for its own loss. It is also unlikely that National Commercial Bank will be successful in an action. The court is likely to conclude that Crosden & Sykes followed due care in the performance of their work. The fact that there was not a count of all inventory on the same date is unlikely to be sufficient for a successful action.

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The issues and outcomes should be essentially the same if the action is brought under the Competition and Consumer Act 2010, except the contributory negligence defence may be less persuasive.

2.18

It is likely the auditor will be liable to the shareholders and the

company. Because the financial statements were fraudulently prepared, liability may run to third parties under Fair Trading legislation. Fraud can be either actual or constructive. Here, there was no actual fraud on the part of Ji or the firm, in that there was no deliberate falsehood made with the requisite intent to deceive. However, it would appear that constructive fraud may be present. Constructive fraud is found where the auditor’s performance is found to be grossly negligent. That is, the auditor really had either no basis or so flimsy a basis for his or her opinion that he or she has manifested a reckless disregard for the truth. Ji’s disregard for standard auditing procedures would seem to indicate such gross negligence and, therefore, the firm may be liable to any third parties who relied on the financial statements and suffered a loss as a result. A contributory negligence defence may succeed if it is not the statutory audit. 2.19

The answers provided in this section assume that the traditional legal

relationship exists between the audit firm and the third-party user; that is, there is no privity of contract, the known versus unknown third-party user is not a significant issue, and clear negligence is required before there can be liability. a.

False. Gross negligence (constructive fraud) will probably be treated as actual fraud in determining who may recover from the firm.

False. There was no privity of contract between Spitz & Resuello and Ditipu. Therefore, negligence will not be sufficient for recovery. An action under Fair Trading legislation might succeed.

False. Ditipu is an unknown third party and will probably be able to recover damages only in the case of fraud.

True. See b.

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2.20

The over-valuation of Sydney inventory would probably have been discovered using standard audit procedures for valuing inventory. Auditors have an obligation to see for themselves, and so should have verified the Bathurst inventory—especially given its materiality. The auditors are unlikely to be liable to the client for any subsequent losses, even though they appear to have been negligent.

The principle defence is lack of privity of contract. A secondary defence based on contributory negligence (which would only affect the auditors’ share of Cornerd’s losses) could be used as a fallback should they be unsuccessful with the lack of privity defence.

Case 2.21

The accounting firm Watts & Ampage is potentially liable to its client

because of the possible negligence of the partner in charge. Should there be a finding of negligence, liability would be limited to those losses that would have been avoided had reasonable care been exercised. There being no evidence of the assumption of a greater responsibility, the partner’s conduct is governed, as a minimum, by the profession’s prevailing standards of conduct. The question arises as to whether the duty of reasonable care was breached when the partner failed to investigate further after being apprised by a competent subordinate of exceptions to 6% of the vouchers payable examined. Moreover, a question of causation arises; i.e. whether further actions by the partner would have disclosed the fraud. If both lack of due care and causation are established, recovery for negligence will be available.

1 2

2.22

The legal issues involved in this case revolve around the auditor’s compliance with the auditing standards and contributory negligence. Statements on the Australian Auditing Standards indicate that accounts receivable should be confirmed by the auditor. This procedure was employed in the case, and the legal issue is whether or not the auditor used due care in following up the confirmation replies received. As a defence in the legal action, the auditor would claim to have followed generally accepted auditing standards by properly confirming accounts receivable. In addition, the auditor may defend him- or herself by

testifying

that

the

company

controller

was

responsible

for

investigating the reason for the differences reported on the confirmation replies. The auditor may state that he or she had a right to conclude that the controller had reviewed the explanations provided by the assistant accountant, and concluded they were correct. The auditor might also use the defence that there was contributory negligence. The controller should not have delegated the work to the assistant accountant and should have recognised the potential for intentional wrongdoing by the assistant accountant.

The auditor’s deficiency in conducting the audit of accounts receivable was his or her failure to investigate and obtain evidence to substantiate the explanations provided by the assistant accountant. The auditor should have investigated each of the timing differences, through which he or she may have discovered that no sales allowance had been granted to the customer, but, in fact, the customer had mailed payment for the merchandise which the assistant accountant had stolen.

2.23

Yes, Smith is liable to the bank, as he was a party to the issuance of false financial statements (joint tortfeasor). The elements necessary to

1 3

establish an action for common law fraud are present. There was a material misstatement of fact, knowledge of falsity (scienter), intent that the plaintiff bank rely on the false statement, actual reliance, and damage to the bank as a result thereof. If the action is based on fraud, there is no requirement that the bank establish privity of contract with the auditor. Moreover, if the action by the bank is based on ordinary negligence, which does not require a showing of scienter, the bank may recover as a third-party beneficiary (an exception to the strict privity requirement), thus satisfying the proximity test. Thus, the bank should be able to recover its loss from Smith under either theory.

No, Smith is not liable to the lessor, as the lessor was a party to the secret agreement. As such, the lessor cannot claim reliance on the financial statements and cannot recover uncollected rents. Even if he or she was damaged indirectly, his or her own fraudulent actions led to his or her loss, and the equitable principle of ‘unclean hands’ precludes him or her from obtaining relief.

Yes, there is potential for criminal action against Smith. Smith had knowledge that the financial statements did not follow appropriate accounting principles and willingly prepared an unqualified opinion. The financial statements were not in accordance with accounting standards. That is a criminal act because there was intent to deceive.

2.24

Students need to refer back to the auditing framework. The following list

is not comprehensive, and students can come up with requirements not contained in the list below.

APPLICABLE ASA

PLANNING

BRIEF EXPLANATION

1 4

PROCEDURE

WHY

THIS

REQUIRED

PROCEDURE

UNDERTAKEN ASA 500 (Audit evidence)

The auditor is required to

Students need to give

collect

examples of what this

sufficient

appropriate evidence.

would be using the facts of

the

case

(e.g.

discussing the details of the merger with NBA’s legal ASA

315

(Risk

assessment)

team.

(Link

also

with ASA 502.) Susceptibility to fraud is

appropriate inherent and

a material inherent risk

control risk assessment,

in this case.

The

auditor

does

relating to the change in CEO and CFO and the money issues (potential ASA 220 (Quality of the

laundering). The audit senior needs to

This

audit)

supervise

quality of the audit.

and

monitor

ensure

the

the staff undertaking the ASA (Documentation)

230

audit. The auditor must ensure

This shows that sufficient

there

adequate

appropriate evidence has

work

been collected.

during

the

documentation undertaken ASA 240 (Fraud)

ASA 240 (Fraud)

audit. Do an assessment of the

The

likelihood of fraud, due to

requires

the incident involving the

investigation on the part

$5,000 amounts. The auditor is required to

of the auditor. The auditor must ensure

presence

fraud further

1 5

inform when

management identifying

presence

they

always

any

reasonable

assessing

take

care the

risk

fraud/fraudulent

fraud in an engagement.

activities.

This can also fall under the requirements of ASA



ASA (Materiality)

320

The auditor must assess

220 (Audit Quality). The appropriate

materiality

when

materiality

then

will determine how much

planning

and

performing the audit.

assessment

evidence and what type of evidence to collect— given there might have been fraud, materiality in this instance will be set

ASA 570 (Going concern)

The

auditor

undertake procedures

must

as very low. The going-concern

sufficient

assumption provides the

assess

going concern status.

foundation

for

the

preparation

the

financial

reports,

and

reports

the

most

important assumption in accounting.

The

Corporations Act makes it clear that an entity cannot

trade

their

going-concern status is called into question. This is

where

companies administration

see enter and/or

1 6

ASA 620 (Work of an

The auditor needs to use

liquidation. Here, expert input will be

expert)

the work of an expert

required in relation to the

where the auditor does

crypto

not have the necessary

100% equity loans.

currency

and

skill and expertise.

2.25 This question is asking students to identify where the auditor, Mark, has done the job correctly—in other words it now flows on from Question 2.24. Having put together a list showing what an auditor should be doing, you can now use it to identify whether in this case Mark has done his job in compliance with the ASA framework. a. ASA 210: Mark has documented the responsibilities of both parties before commencing the audit. ASA 315: Mark toured the premises prior to the commencement of the audit to gain an understanding of the entity (risk assessment). ASA 220: Mark took a graduate with him to take notes. The graduate was supervised and the notes were reviewed at the end of each day by Mark, as the senior auditor. ASA 500/ASA 315: Mark arranged a meeting with the CFO and documented any key changes made by the CFO (ASA 230). ASA 315: Mark ascertained the appropriate assessment of control risk to use to determine the evidence mix. ASA 230/ASA 620: Mark documented the application of the patent, and acknowledged the complexity and hence the need to use an expert. ASA 220/ASA 315: Mark asked for, and received, documentation relating to the accounting department to help undertake an appropriate risk assessment of the accounting system: an assessment of the control environment and of the control risks associated with the accounting system. b. ASA 500/ASA 315: Mark did not collect sufficient evidence in relation to assessing the control environment and the control risk. Mark relied too much

1 7

on the information provided by the client in relation to the accounting system, and accordingly reduced the amount of evidence collected. ASA 620: Mark should have made use of an expert to assist. Mark has limited auditing experience in the motor industry, having previously focused on conducting audits relating to IT. ASA 502: Given the existence of litigation and claims, Mark should have collected more evidence relating to the pending court case; for example, speaking with both the client’s legal team and its accounting department (to determine the appropriate recognition and disclosure of the court case).

2.26

Students must use the process outlined in the tutorials/lectures to answer this question.

Establish a duty of care If the bank is suing, the duty of care needs to be established by looking at foreseeability and proximity. That is, the auditor must be aware that the bank is going to use the information (or it would be reasonable to assume that the bank would use the information), and that the bank is using this information to make its decision (or it would be reasonable to assume that a bank, in general, would require this information to make a decision). In this case, the bank has made it very clear that it requires a set of audited financial reports to establish the financial condition of the entity. Provision of the loan was contingent on the presentation of the financial reports. Establish negligence The major deficiencies in the audit and the reasons for their occurrence are: 

There doesn’t appear to be an engagement letter outlining the responsibilities of the auditor (ASA210). The importance of having an engagement letter stipulating the responsibilities of the auditor and the client should be reinforced to students.



There does not appear to have been an assessment of the risk of fraud for the entity (ASA 240).



A new accounting system was installed at the beginning of the current reporting period. This would have necessitated an assessment of the control environment and any risk associated with the installation of the accounting system. Although the IT manager was involved, the auditor had limited technical competency in the use of the accounting system and should have employed an expert to assist as per ASA 620.

1 8



The auditor assigned 20% less time to assessing the inventory without an appropriate assessment of control risk and the control environment in line with ASA 501/ASA 200 and ASA 220.



The auditor needed to undertake a comprehensive assessment of the entity’s ability to meet its short-term and long-term obligations to determine the client’s ability to continue as a going concern as per ASA 570. There does not appear to have been an appropriate assessment undertaken by the auditor. (Additional resources should have been assigned to assessing going concern status.)

Establish whether a loss has occurred The bank has lost the proceeds associated with the loan (recovering only $10,000). Establish whether the loss is as a result of the negligence of the auditor It would need to be established that the bank had given a loan to Liston Limited based on the audited information provided by Liston Limited. The bank would need to establish that it would be reasonable to assume that the information provided in good faith and used by the bank is within the normal business practices of a bank and, as such, relying on the quality of the information would be a significant factor in determining whether or not to give the loan. Students may identify other examples of deficiencies in the audit.

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Arens, Auditing, Assurance Services & Ethics in Australia,11e Chapter 3: Audit quality and ethics Learning Objectives 3.1 Understand the relevance of audit quality to corporate governance. 3.2 Explain the nature and consequences of an expectations gap regarding auditing and audit quality. 3.3 Explain what is meant by ‘auditor competence’. 3.4 Distinguish ethical from unethical behaviour in personal and professional contexts. 3.5 Identify ethical dilemmas and describe how they can be addressed. 3.6 Explain the purpose and content of the professional bodies’ ethical code. 3.7 Discuss issues pertaining to independence and the relevant ethical requirements. 3.8 Discuss aids to maintaining independence.

Review questions 3.1

An auditor is charged with providing users of financial information with the

confidence to use the information contained in a set of financial statements to make financial decisions. Confidence in the quality of the information presented in the set of financial statements can only be established if the party charged with assessing the accuracy and quality of the information is independent of the party who has created the financial statements. Society expects the auditor to act without bias or

incentive in assessing the quality of the information contained in the financial statements. Society does not need or expect the accountant to be independent because the accountant’s role is to prepare the reports. Society’s expectation of accountants is that they are competent in their job in preparing the financial reports. 3.2

Australian

regulatory

mechanisms

addressing

corporate

governance

emphasise accountability and transparency through disclosure and reporting requirements, including financial statements and related disclosures in the annual report.

Because

the

required

reports

are

produced

and

disseminated

management and the board of directors, the reliability of these disclosures is a persistent concern to users and regulators. The principal external monitor of the published financial reports is the external auditor. The auditor’s role in this regard is to act as an independent monitor who attests to the reliability of the financial statements and related disclosures intended for the use of existing shareholders. In general, the purpose of audit is to measure the degree of reliability of financial statements and thereby raise the confidence users can have in the financial reports. Audit quality means how well an audit detects and reports material misstatements in financial reports. The level of concern for audit quality is driven largely by corporate failures and related reporting deficiencies. In these cases, it is often perceived that the auditor has been ineffective because of either a lack of capacity or willingness to detect (and prevent) the deficiencies. Some of this is attributable to the ‘expectations gap’, but many argue that threats to an auditor’s independence have caused a major weakness in the overall process. This is an important issue in corporate governance because the financial statements are the representations of management to shareholders, who are concerned about their information risk. The independent audit is intended to reduce shareholders’ information risk by attesting to the reliability of the financial statements.

3.3 The audit expectations gap is the difference between the public’s and users’ expectations of auditing vis-à-vis either (1) the intended role of the auditor (as legally determined) or (2) the audit profession’s view of the role of the audit. This gap is variously perceived as real or imaginary and has been attributed to many different causes, including: 

the nature of auditing, including reliance on sampling and subjective evidence



the application of hindsight rather than what was known and reasonable at the time



the self-interest of complainants seeking compensation for losses



the self-interest of auditors protecting their profits



changes in social expectations



ignorance or misunderstanding of the roles of participants, including the auditor, in corporate governance.

Reducing this gap would therefore require addressing the perceived cause(s) by way of public (user) education as to the ‘true’ role and nature of auditing, improving on the audit process by appropriate regulation or training of auditors (to raise auditor competence), or by not rewarding apparent exercises in self-interest. 3.4

The Code contains five fundamental principles that members must follow: 1. 2. 3. 4. 5.

integrity objectivity professional competence and due care confidentiality, and professional behaviour.

These principles provide the framework establishing the expectations placed on all members charged with the task of preparing financial information for society. Establishing expectations requires mandatory compliance to ensure that all members are acting in accordance with the five principles at all times. Society’s

confidence is reflected by knowing that these principles are being followed by members of the profession. 3.5

An audit firm has several options when it recognises that it is not competent

to perform an audit:    

withdraw from the engagement obtain the expertise through education and training employ someone who has the expertise work on a consulting basis with another audit firm (i.e. subcontract).

Acceptance of the engagement without an appropriate assessment of the technical skills required suggests that the auditor does not have adequate quality control systems in place. Under ASA 220, the auditor is required to have appropriate policies and procedures for client acceptance and continuance. ASQC 1 requires the audit firm to obtain any information considered necessary in the circumstances before accepting an engagement with a new client or when deciding whether to continue an existing engagement; this information includes whether the engagement team is competent to perform the audit engagement and has the necessary capabilities, including time and resources. 3.6

An ethical dilemma is a situation that a person faces in which a decision

must be made about appropriate behaviour. There are many possible ethical dilemmas that one can face, such as what to do when you find a wallet containing money, or how to deal with a supervisor who asks you to work hours without recording them. An ethical dilemma can be resolved using the six-step approach outlined in the text under ‘Resolving ethical dilemmas’. The six steps are: 1. 2. 3.

Obtain the relevant facts. Identify the ethical issues from the facts. Determine who is affected by the outcome of the dilemma, and how each person or group is affected.

Identify the alternatives available to the person who must resolve the dilemma.

5. 6. 3.7

Identify the likely consequence of each alternative. Decide the appropriate action.

There is a special need for professionals to behave ethically in order to

maintain public confidence in the profession and in the services provided by the members of that profession. The ethical requirements for accountants are similar to the ethical requirements of other professions. 3.8 All professionals are expected to be competent, perform services with due professional care, and recognise their responsibility to clients. The major difference between other professional groups and auditors is the latter’s need to ensure independence. Because auditors have a responsibility to the users of financial statements, it is essential that auditors be independent in both fact and appearance. Most other professionals, such as lawyers, are expected to be an advocate for their clients. 3.9

Independence in fact exists when the auditor is actually able to maintain an

unbiased attitude throughout the audit, whereas independence in appearance is dependent on others’ interpretation of this independence and, consequently, their faith in the auditor. Activities that may not affect independence in fact but are likely to affect independence in appearance are: 1. 2. 3.

Ownership of a financial interest in the client. Having a directorship or being an officer of a client. Performance of management advisory or bookkeeping or accounting

4. 5.

services and audits for the same company. Dependence upon a client for a large percentage of audit fees. Engagement of the auditor and payment of audit fees by management.

(Notice that the first two are violations of the Code of Ethics for Professional Accountants.)

3.10

Independence in auditing means taking an unbiased viewpoint. The users of

the financial statements would be unlikely to rely on the statements if they believed auditors were biased in issuing their audit opinions. The external auditor is seen as exercising the quality control required to provide the assurance to users of the reliability of the information produced by the reporting entity. 3.11

The rules prohibit any practice from accepting or maintaining a company as

an audit client if any person (or their spouse or dependent) in the practice— whether a partner or a member of the professional staff—has a material shareholding in that company. 3.12

Ways to reduce the appearance of the lack of independence (in relation to

fee dependence) are: the use of an audit committee to select auditors that is made up of directors who are not a part of management; a requirement that all changes of auditors, and the reasons behind the change, be reported to ASIC; and approval of the nominated auditor by shareholders at the annual meeting. 3.13

Independence provides the cornerstone of the auditing profession. Without

independence, society will have limited confidence in the work undertaken by an auditor. APES 110 does not explicitly prohibit the ownership of shares in a client. However, the Code uses a principles-based approach rather than a rules-based approach, which allows the member to evaluate the facts of the situation before determining an appropriate course of action. To assist members in reaching a decision, the Code uses what are called ‘safeguards’. If a safeguard can be implemented so that the threat to independence is mitigated, the member will not be breaching the requirements of the Code. In this instance, the ownership of shares in a client could be seen as a threat to independence (self-review threat). However, if the amount held by the auditor is not considered material (i.e. the auditor has no impact on the day-to-day decisions made by the entity) it is reasonable to allow the auditor to keep the shares. From the information presented

in this case, it would appear that the parcels of shares are not substantial and are unlikely to be material in nature. In this situation, though, the audit firm has taken the stance that even a small parcel of shares is significant, and the safeguard that has been implemented is to ask for the auditor and family members to sell their holdings in the entity. Using a principles-based approach means that certain situations where a rules-based approach would result in a less-than-optimal outcome do not eventuate —such as where an auditor’s superannuation fund holds shares in the client. 3.14

A fee based on the amount of time it takes to complete the audit is not a

violation of the Code of Ethics for Professional Accountants. The Code states that professional services for clients receiving audit opinions shall not be offered or rendered under an agreement whereby no fee will be charged unless a specific finding or result is attained, or where the fee is otherwise contingent on the findings or results of such services. The purpose of the rule is to prevent sacrificing the quality of audits because of the pressure felt by the auditor to produce the required audit outcome. An example would be the fee being dependent on the issuance of an unqualified opinion or the obtaining of a loan by a client. 3.15

The following are exceptions to the confidentiality requirement for auditors’

working papers: 

The

confidentiality

requirement

cannot

interfere

with

the

member’s

obligation to follow auditing standards or accounting standards. 

A member must comply with a validly issued subpoena or summons enforceable by order of a court.



Where the working papers are formally requested by ASIC as part of an investigation into the auditee corporation.



Working papers can be provided, in confidence, to another firm conducting a peer review of the auditor.

3.16

appropriately

constituted

audit

committee

provides

means

communication for the auditor that can enhance management cooperation and reduce

pressures

auditor

independence.

can

also

reduce

executive

management involvement in auditor selection and contracting.

Discussion Questions and Problems

3.19

Section 600 of APES 110 requires the audit firm to determine whether

providing non-audit services to a client would create a threat to independence. If a threat is created so that the implantation of safeguards cannot sufficiently remove the threat to independence, the non-assurance services should not be provided. Students should be encouraged to focus on the use of safeguards as the fundamental tool for assessing whether a threat to independence is created. a.

Violation.

Section

600.12-20

generally

prohibit

the

provision

accounting services to audit clients. The Code allows for the provision of accounting and bookkeeping services of a routine or mechanical nature. b.

Providing information on a merger is not a violation if the audit firm is not providing external audit services to the entity.

It is not a violation to provide internal audit services to a public company that is not an audit client. There is no direct conflict of interest, as there is no relationship between the public company and the client.

It is a violation to implement a financial information system designed by the client private company’s management, unless it can be shown that the services are of routine or mechanical nature.

It is a violation of the Code to recommend a tax shelter to a client listed company. Where the advice provided will affect matters reflected in the financial statements (in this case, the amount of taxation recorded and reported), a self-review may be created. Once again, the self-review threat will be evaluated and if a safeguard cannot be implemented to sufficiently reduce the effect of the self-review threat, the provision of such services will be considered a violation of APES 110.

Violation. An audit firm shall not provide internal audit services to a listed company audit client, as outlined in section 605.

The focus on this question should not be whether a violation has occurred; rather, students should be looking at whether a safeguard can be implemented to ensure that any risk of a threat to independence can be minimised. If a safeguard cannot be implemented to adequately reduce the threat to independence, a violation is likely to occur. 3.20

Violation. A member who accepts a professional engagement implies that he or she has the necessary competence to complete the engagement according to professional standards. Bacon has violated the rule since he does not have the expertise to review the work of the consultant he has hired. Bacon should have suggested that the company hire the consultant directly.

No violation.

In most States, this will be a misdemeanour and would not likely be a violation.

Violation. The appearance of independence has been impaired by Bill Wendal’s

agency’s

financial

dealing

with

his

audit

clients

and

participation in a business which impairs his objectivity. It is also a conflict of duties to recommend his own firm to review the adequacy of the existing insurance coverage of existing clients.

3.21

No violation.

This appears to be a violation of sections 111 (integrity), 114 (confidentiality) and 115 (professional behaviour) of the Code.

No violation. The sale of block time may constitute a business dealing rather than a professional relationship, and so should be considered together with all other relationships to determine the effect on the Fenn’s independence.

No violation. This is normal practice and is done as a part of almost all audits.

Violation. The Code does not distinguish between audit, tax and management

services-related

confidential

information.

Pound

has

therefore violated the rules. f.

No violation. There are no longer rules restricting such practice.

3.22 a.

An audit committee is a special committee formed by the board of directors and made up of board members. It is ideally a group of outside directors who have no active day-to-day operations role in the firm, and who operate as a liaison between the independent auditor and the board of directors. The audit committee assists and advises the full board of directors and, as such, aids the board in fulfilling its responsibility for public financial reporting.

The functions of an audit committee may include the following: 1.

Select the independent auditor; discuss audit fee with the auditor; review the auditor’s engagement letter.

Review the independent auditor’s overall audit plan (scope, purpose and general audit procedures).

Review the annual financial statements before submission to the full board of directors for approval.

Review the results of the audit, including experiences, restrictions, cooperation received, findings and recommendations. Consider matters that the independent auditor believes should be brought to the attention of the directors or shareholders.

Review the independent auditor’s evaluation of the company’s internal controls.

Review the company’s accounting, financial and operating controls.

Review the reports of internal audit staff.

Review the interim financial reports to shareholders before they are approved by the board of directors.

Review

company

policies

concerning

political

contributions,

conflicts of interest and compliance with Federal, State and local laws and regulations, and investigate compliance with those policies.

10.

Review any financial statements that are part of prospectuses or offering circulars; review reports before they are submitted to regulatory agencies.

11.

Review the independent auditor’s observations of financial and accounting personnel.

12.

Participate in the selection and establishment of accounting policies; review the accounting for specific items or transactions, as well as alternative treatments and their effects.

13.

Review the impact of new or proposed pronouncements by the accounting profession or regulatory bodies.

14.

Review the company’s insurance program.

15.

Review and discuss the independent auditor’s management letter.

The audit committee can deal with the auditor in a less biased manner than can executive management. In addition, the board of directors has a legal responsibility to review the policies and actions of management, therefore there is considerable incentive for them to work closely with the auditor. A small committee of outside directors from the audit committee are therefore equipped to help the auditor maintain a more independent relationship with the client. If management exerts any pressure on the auditor, the auditor is likely to discuss that with the audit committee and thereby resolve the problem.

The criticism that audit committees may bias companies in favour of larger and potentially more expensive public accounting firms has been made by many smaller audit firms. There may be some validity to this view. At the same time, audit committees do have a responsibility to help a company control costs. Therefore, if the cost of a smaller audit firm is significantly less than that of a large firm, assuming equal quality, the audit committee would be obligated to use the lessexpensive firm.

In practice, the criticism has little impact. Only larger companies with outside directors are likely to form an audit committee. Typically these companies cannot be served adequately by small audit firms, especially if the client has multiple offices in different cities or nations. The criticism would likely be somewhat more valid if audit committees were used by small companies. Even then there is little evidence to support the statement that audit committee members’ primary concern is to reduce their exposure to legal liability. 3.23 In this situation, Jamie needs to be aware of the five principles outlines in APES 110. In particular: integrity (s. 111); confidentiality (s. 114); and professional behaviour (s. 115). Jamie should ensure that the information is not used in a manner which can give rise to questioning Jamie’s professionalism and behaviour. The only course of action in this situation is to maintain the confidentiality of the information and not use it to benefit Whimsical. As a side note, if Jamie acted on this information, it could be considered insider trading which would involve criminal charges against Jamie. 3.24 In answering questions of this type, the approach should be: 1. identify what the (ethical) issue is (e.g. self-review) 2. identify whether this issue is addressed by APES 110 3. identify whether a safeguard can be implemented so that the issue is no longer considered a threat to the independence of the auditor, and 4. recommend an appropriate approach. (a) The issue here is whether the graduate is breaching APES 110 requirements, given that they have previously worked for the client (self-review threat). Section 524 identifies the potential conflict of employment with an audit client.

As in this case the graduate did not participate in any decision making or day-to-day decisions made by Class A Diamonds, there would not be a selfreview threat. To ensure full disclosure, the auditor should enlist the available safeguards by documenting the employment history of the graduate or removing the graduate from the audit. (b) This relates to the possibility of an ethical issue related to financial interests —owning shares in a client (s. 510):

There is no indication that the holding of the shares represents the ability to influence the day-to-day decision making of Class A Diamonds. This is an example of where using a principles-based approach achieves a more effective outcome

compared to applying a rules-based approach. In this case, there are no issues in relation to an ethical dilemma or a breach of the Code. (c) The issue here relates to gifts and hospitality as per section 420 of the Code:

The issue is whether the appearance of independence would be affected by accepting

the

gift.

Independence

appearance

just

important

independence in fact—therefore, the appropriate action in this case would be to refuse the offer of the 5% discount. 3.25 The Code of Ethics for Professional Accountants is not clear as to what constitutes a violation in these three situations. A central point is that Jasmine Wang must maintain independence in fact and appearance because she is not an employee of the client company, and must not give the impression that she is one.

RULES OF CONDUCT VIOLATED?

APPROPRIATE ACTION?

The independence requirements in

Jasmine Wang should discuss the

the Code generally excludes auditors

discount with the audit firm’s

from accepting goods or services

managing partner if she intends or

from client companies on terms more

wants to buy a car. She should

favourable than those generally

certainly not feel compelled to buy

available to others. Jasmine Wang

the car, but she should also not

has likely not violated the rules; the

automatically turn it down.

discount is available to customers on a widespread basis. The situation would be different if the sale were limited to the client’s employees. In such a case it would likely be a violation. 2.

If Jasmine Wang were to eat in the

Jasmine Wang should eat elsewhere

client’s lunchroom on an ongoing

if it is practical to do so. But if the

basis that would likely be a violation

only practical place for her to eat is

of the rules of conduct. It would not

the client’s lunchroom, she should

likely be a violation if she

make arrangements with her own

occasionally eats with employees she

firm to make certain that the client

is dealing with during the audit.

company is reimbursed for the expenses involved.

Accepting such a gift is likely to be a

Ideally, Wang should not accept the

violation of the rules of conduct. The

gift, and state that, since she is not

gift is reasonably large and would be

an employee, she would prefer not to

considered by many employees as

take it. If she believes that it would

equivalent to a bonus.

be embarrassing to the company, she should graciously accept it and as soon as practicable return it with

an explanation of her reasons for doing so. 3.26 The answers to these questions involve the exercising of individual judgement more than most of the other questions in the chapter. The situations may, in some cases, be a violation of the spirit of the Code if the public accountant is acting in a particular manner, whereas they may not be a violation if the public accountant is acting in a different manner. For example, in scenario 4, if Tan is sending the business executives of small companies she audits to her small-loan company, there is likely to be a violation. If she recommends the small-loan company along with several others, and only to those clients who truly need the services of a small-loan company, she is not likely to be in violation. (Changing the facts throughout the discussion may increase the value of the case.) Although the question refers only to the Code, it is valuable to use the scenarios to reinforce the requirements of the Corporations Act as well. 1. This would not be a violation of the rules of conduct. In many cases the partners in a limited partnership do not know of the other investors in the partnership. If the auditor and the owner of Marshall Marine Company either earn or lose significant sums in the investment, it should have no effect on their relationship or on the audit of Marshall Marine Company. 2. Contingent fee arrangements between the public accountant and the client are a violation of the rules for clients receiving attestation services. While the Code indicates that contingent fees are permitted for services that do not require independence, it also indicates that the preparation of tax returns requires independence. 3. Advertising is permitted as long as it is not false, misleading or deceptive. It is probably not acceptable to compare those accounting firms, unless the comparisons are based on verifiable facts. The information in the advertising expressly states two facts: six of eight of the largest finance companies are audited by their firm; and the average audit fee, as a percentage of total assets, is lower than any of the other public accounting firms in the city.

Contel must be able to support those factual statements. Assuming he can, there is no violation. 4. The Code generally prohibits public accountants from engaging in any business

that

inconsistent

incompatible

with

the

provision

professional services. It prohibits members from concurrently engaging in a business or occupation that may create a conflict of interest in rendering professional services. Tan spends almost no time in the business and none of her accounting firm’s employees are involved. 5. There may be a material indirect interest in the client. Elbert owns a material amount of shares, and if the mutual fund in turn invests a large portion of its money in an audit client of Elbert’s, then Elbert effectively has a material investment in the client, although such indirect interests are not addressed in the Code. The fact that the mutual fund’s investment in the audit client has increased dramatically does not necessarily mean that there is a material investment. It may, for example, have increased from 1% to 3% of the total holdings of the mutual company. Elbert must evaluate whether the holding could impair his independence. 6. It is essential that Finigan retain an attitude of independence both in fact and in appearance. It is not possible to determine whether Finigan is maintaining an attitude of independence in fact, given her involvement in the company, but it is certainly possible that she is. So Finigan is not necessarily violating the Code. She does the audit, tax return, bookkeeping and management services work for the client, but that is not a violation. However, it is questionable whether Finigan is maintaining an attitude of independence in appearance, especially given the comments by Gilligan. It is essential that Finnigan maintain an attitude of independence while carrying out all of her work. So she must be careful that she is not on the side of Gilligan

without

consideration

her

professional

responsibilities

conducting the audits and in all other aspects of her professional responsibilities.

Cases 3.27 The nature of this corporation has the potential to be a violation of the Code (s. 220), although insurance services do not necessarily conflict with auditing. Practising auditing through a company is permitted, subject to stringent conditions (see Chapter 2 regarding authorised audit companies). The failure to issue a qualified or adverse opinion regarding the client’s failure to disclose the existence of, and terms of, the lien against assets can be viewed as a violation of section 110 of the Code (professional competence and due care: subs. 113). Adequate footnotes are an integral part of the financial statements, and a pledging of an asset of the nature described required disclosure. Finally, Gilbert is in violation of subsection 114 (confidentiality) of the Code for disclosing confidential client information to the finance company without Grandtime’s permission. 3.28 a.

It is an ethical dilemma for Barbara because she has a decision to make about what behaviour is appropriate. If she throws the schedules away, as suggested by her supervisor, she may not be carrying out her professional responsibility to the public or the client. If she does not throw the schedules away, she will likely cause a confrontation between herself and her supervisor.

Relevant facts: A number of misstatements were discovered. The aggregate of all discovered and undiscovered errors may be material. The audit supervisor wants Barbara to throw away some of her work.

Ethical issues: Is it ethical to throw away the schedules containing some small errors when her supervisor instructs her to do so?

Who is affected, and how?

WHO IS AFFECTED

HOW?

Barbara

1. Being asked to ignore misstatements is a possible violation of the Code. 2. Her performance evaluation may be affected.

Jack

3. Her future with firm may be affected 1. His future with firm may be affected.

Green, Thresher &

2. His performance evaluation may be affected. 1. If audit is completed late, the firm may lose the

Company

engagement. 2. The firm may be sued if material misstatements are not detected. 3. The client may be unhappy with the auditor if the

Delancey Fabrics

misstatements are subsequently discovered. 1. The firm may not have an opportunity to correct the misstatements if they are not brought to light. 2. The firm may be required to adjust its financial statements if misstatements exist.

4.     

Alternatives:

Throw away the schedules. Inform Jack that she will not throw schedules away. Talk to a manager or a partner about Jack’s request. Refuse to work on the engagement. Quit the firm. 5.

Consequences: The misstatements may be discovered subsequently and the firm may lose the client, or be sued. Even if the misstatements are not material, the client may be justifiably upset because the problems giving rise to the misstatements may have been solved sooner. Barbara informs Jack that she won’t throw away schedules. This may result in a confrontation. She may get an unfavourable review. If she talks to a manager or a partner, they may admire Barbara’s