Familiarity Threat in Auditing is one of the 5 types of ethical threats. These ethical threats are basically obstacles to the objectivity of the audit engagement and therefore, should be safeguarded.
What Is Familiarity Threat?
Familiarity threat is the type of ethical threat that arises from the association of the auditor and the client. The auditor will trust the client and become sympathetic to their actions which would affect the auditor’s professional skepticism (questioning mind), judgments made on the audit, and ultimately the audit report.
As the name suggests, familiarity threat is when the auditor has some kind of familiarity with the client which could affect his opinion about the financial statements.
There is a risk that the auditor may choose to intentionally ignore the client’s mistakes, frauds, and other material misstatements which would result in a bogus audit report.
For example: If the auditor is a childhood friend of the finance manager of the company, there is a familiarity threat that the auditor may not follow the ethical codes of the audit and not expose the mistakes or frauds of the finance manager.
Therefore, to perform an independent audit, it is extremely important to safeguard such threats.
How To Safeguard Familiarity Threat?
There are safeguards in audit that eliminate the effect of ethical threats such as changing the key audit partner after 7 years, keeping senior & experienced personnel on the team to avoid adverse influences, and regular quality control reviews.
These general safeguards ensure that the audit is undertaken in an independent and smooth manner. However, there are some specific safeguards to eliminate the effect of familiarity threat in an audit. These safeguards include:
1. Rotation of Key Audit Partner
Para 290.151 of the IFAC Agenda Paper states that an individual shall not be a key audit partner for more than 7 years. After completing 7 years, the individual shall not act as a key audit partner or be part of the engagement team for 2 years for the client.
The individual cannot even take part in consultations with the engagement team, or provide quality control for the engagement team or the client regarding technical or industry-specific issues. This rule is specifically created to safeguard familiarity threats in an audit engagement.
The rotation of the key audit partner varies across borders and every country has a different rotation period & cooling period (time period for which the partner cannot be a key audit partner or be part of the team) for key audit partners.
2. Rotation of Audit Firm
Just like partner rotation, the audit firm should also rotate in some countries like Turkey, Indonesia, and Italy. However, audit firm rotation is not mandatory in most countries. This type of rotation also helps eradicate threats like familiarity and self-interest threats.
The audit firm rotation is also called MFR rotation and is getting popular in various countries due to the bad reputation of the familiarity threat.
Specific Safeguards For Familiarity Threat
As the word “familiarity” is not limited to the professional capacity of the auditor and can arise from personal relations. Therefore, there are certain specific safeguards underpinned by IFAC to deal with familiarity threats.
To know which safeguard we should use, you must first understand the concept of influence. Whenever you are dealing with a familiarity threat, you should first identify the influence of both familiar parties ie the auditor and the client.
If the auditor is an internee, they may not have control over the major operations of the audit hence it is unlikely that their actions will impact the audit report. In the same way, if the employee is an internee or a laborer and does not have involvement in the preparation of the financial statements or decision-making, then it is unlikely that familiarity can affect the objectivity of the audit.
However, if the auditor is an audit manager or key audit partner of the audit firm, they will have involvement in major decisions and the familiarity can adversely affect the audit report.
In the same way, if the familiar party in the client is a finance manager or in another significant position, meaning that they have involvement in the preparation of the financial statements or other important decisions, then the familiarity can severely impact the objectivity of the audit engagement.
