Audit is an independent review of the Financial Statements by external auditors. The auditors are professionals that are not related or connected to the company’s operations and that is why their opinion matters to existing and potential shareholders, and other stakeholders.
The engagement should be conducted independently due to the reliance of many groups on the audit report. That being said, obstacles that might affect the judgment of external auditors should be eradicated. These obstacles are called ethical threats to objectivity in accounting and audit.
The ethical threat in an audit is when an auditor is tempted to not follow the professional codes and compromise their objectivity while undertaking the audit engagement. This will result in a biased audit opinion and misguide the users of financial statements. There are five ethical threats in audit engagement and for each threat, a safeguard or a code of action is implemented. The five threats are:
- Familiarity threat
- Self Review threat in audit
- Intimidation threat
- Self Interest threat
- Advocacy threat
Familiarity Threat
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 his actions which would affect his professional skepticism (questioning things), judgments made on the audit, and ultimately the audit report.
Being familiar may also result in intentionally ignoring the client’s mistakes, frauds, and other material misstatements which would lead to a bogus audit opinion. Therefore, certain safeguards are implemented in audit engagements to remove the effect of familiarity.
Other familiarity threats include family & personal relations and ex-auditors working for the client.
Safeguards for Familiarity threats
| Familiarity threat | Safeguards |
|---|---|
| Association of the auditors with Client | Association arises from working together for a long period of time. If the same audit team and partners render their services to a client for a long time, it will create familiarity and the auditors will become sympathetic towards the client which will affect the objectivity. For listed companies, audit partners are rotated every seven years and they cannot be on board for 2 years. While auditing non-listed clients, senior audit team members are rotated and in addition, their work should be reviewed by independent professional auditors. {Code of ethics for professional accountants section 290.148} A >1-year extension is given to partners in exceptional circumstances to maintain the quality of the audit. |
| Ex-auditors working for the client | If an auditor leaves the firm and becomes an employee or director of the client, he will have connections in the audit firm and can influence the audit procedures. In cases where the personnel is still entitled to the benefits of the audit firm or participates in the firm’s business activities, the threat becomes significant. For non-listed entities, an experienced team should conduct the audit and their work should be reviewed by independent auditors. If the entity is listed and an ex audit partner or senior audit manager holds a significant position in the client, the firm cannot proceed with the audit. An exception to this is where before the joining of the ex-auditor, the company publishes its audited financial statements of >12 months, and the individual does not take any role in the audit of the client. |
| Family & Personal relationships | If an audit team member or key audit partner has family or personal relationships with an employee of the client, the individual should either be removed from the team or the audit engagement structured in such a way so that the individual does not deal with the matters of the employee. The threat is significant where the employee’s actions/decisions have a direct impact on the financial statements. |
Self-Interest Threats
Self-interest threat in an audit engagement arises when the audit firm, its partners, or associates (audit team members) could benefit from a financial or other interest, be it direct or indirect, in an audit client. This includes materially significant gifts or other financial gains to the audit firm, its partners, or team members.
Self-interest threats also include:
- If the audit firm plans to take a loan or has already taken a loan from the client. There is an exception to this. If the client is a bank and the loan is on normal terms, there’s nothing to worry about.
- The audit firm heavily relies on the audit fee of the audit in question. This is usually considered a threat if the audit fee is more than 15% of the audit firm’s total income. The auditors wouldn’t want to lose the client in the future and might ignore misstatements in the financial statements.
- An audit team member has a potential employment opportunity in the client.
- Contingent audit fees.
- Gifts and rewards to audit team members from the client.
- Personal & Family relationships between auditor and client. There are no specific guidelines for allowed and non-allowed relatives. However, if the relationship is strong or influencing enough to disrupt the auditor’s objectivity, it is a threat and should be dealt with.
- An auditor or close family member owning shares in the client.
Safeguards for Self-interest threats
| Self-interest threat | Safeguards |
|---|---|
| Loan and Guarantees | Any loan taken by audit team members from the client that is not on normal terms is not allowed. The member should not be allowed to participate in the audit. If the audit firm has taken a loan from the client, the loan must be immaterial to both the firm and the client. If it is material, an external review of the audit should be performed by a third party assurance provider. |
| Business relationships between the auditors and the Client | The audit firm sometimes enters into business relationships with the client. It could be a joint venture or any other business arrangement. If the venture is material to the audit firm or partners, the engagement cannot be performed by the firm. If the venture is material to any other audit team member, the individual should be removed. {section 290.123} |
| Potential employment with the Client | Like any other corporate professional, an auditor can also work for a company. If any member of the audit team has reasons to believe that they might be employed by the client, they should not be part of the audit engagement. If they have already performed some work, it should be reviewed to ensure no ethical breach has occurred. |
| Overdue audit fees | No work should be performed and no report issued until the fees are paid. In addition, the work should be reviewed by a third-party assurance provider. |
| Gifts to auditors | Gifts may lead to familiarity and the auditors feeling indebted to the clients. Therefore, material gifts are not permitted. An exception to this is when the gift is trivial (of a little value), offered in the normal course of business, and a partner approves it. In addition, gifts and hospitality offers must be disclosed in the audit file even if refused. |
| Shareholding | If an auditor owns shares in the client, they will ignore misstatements in order to maximize the return on the shares. It is a threat to objectivity and the auditor can only be part of the team if the shares are disposed of before the audit. The same goes for family members owning shares. |
| Contingent Fees | If the audit fee is based on a particular outcome such as profit percentage, the auditors will work towards achieving the outcome, and objectivity will be compromised. It creates a self-interest threat and that is why a contingent audit fee is not permitted. |
Self-Review threats
Self-review threat occurs when the auditor has provided services other than audit and review of the financial statements to the client. The auditors will be self reviewing their work and chances are that they will ignore their errors and misstatements. This occurs when the audit firm has provided services like internal control services, consultancy, advisory, and other accounting & taxation services to the client.
Other self-review threats include:
- If an auditor on the team was recently been employed with the client and held a significant position such as a director or senior departmental manager. The auditor will be reviewing his own work and it’s unlikely that he will degrade it.
- If the auditors have provided business services of any kind that are reflected in the financial statements including the internal audit of the client.
Safeguards for Self-Review threats
Many small companies have a limited number of employees on board and sometimes lack an accountant responsible for preparing accounts and other services like taxation, payroll, or consultation. These firms outsource such services. If the audit firm has provided these services and the company is listed, the firm cannot proceed with the audit. If the company is not listed, the audit firm can proceed with the audit provided that it uses a different team for the audit.
As far as the previous employment of the auditor is concerned, the auditor cannot be part of the audit team if he had a significant influence on the operations and financial statements of the client during his employment period.
Advocacy threats
An advocacy threat arises when an audit firm promotes or represents an audit client in a court dispute or other legal litigations that are material to the financial statements of the client. It means the audit firm will protect the client’s position and lose sight of professional skepticism.
If the client makes such an offer, the audit firm should politely decline it where the amount is material. Where the amount is not material, the following safeguards should be implemented to conduct the audit:
- Use professionals on the service that are not part of the audit team.
- The audit team should be informed about the service provided and the financial statements’ treatments reviewed by a professional who wasn’t part of the legal service(s).
Section 290.214 of the ethics for professional accountants states that providing services involving promoting, dealing in, or underwriting an audit client’s shares would create an advocacy or self-review threat so significant that no safeguards could reduce the threat to an acceptable level. Therefore, a firm should not provide such services.
Intimidation threats
Intimidation threats arise in an audit engagement when the client has the power to pressurize or influence the assurance provider. It is a significant threat to the objectivity of the audit and if proper safeguards cannot be implemented, the assurance provider should resign from the audit.
It mostly occurs in cases where the client has an edge over the audit firm and can exert undue influence (the power or ability to persuade another’s decisions due to the relationship between the parties OR one is more powerful than the other) over their activities and decisions.
Intimidation threat is inherent in cases where:
- Audit Fees are dependent on certain outcomes.
- Ex Audit Partners joining the client
- Litigation/Disputes between the audit firm and the client.
- Auditors having family or personal relationships.
These threats are already mentioned above and the safeguards to reduce these threats to an acceptable level are the same as above. However, if the threat cannot be reduced to an acceptable level, the audit firm should immediately resign from the audit.
What happens when an ethical threat is not safeguarded?
A company is owned by shareholders and operated by managers. In most cases, shareholders are unaware of the day-to-day business operations and rely on the reports and financial statements prepared by managers. This relationship of trust is called a fiduciary relationship.
To ensure the managers are faithfully performing their duties, auditors are hired to authorize the financial statements prepared by the company. Once authorized, the statements become a reliable source to judge the performance of the company. Shareholders, potential investors, financial institutions, and other lenders heavily rely on the financial statements and make decisions accordingly.
That being said, the audit report is critical for the parties involved and therefore, should reflect the actual performance of the company. If any ethical breach occurs in the audit engagement, the report will no longer achieve its objectivity and misguide the decision-makers.
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