Audit - Ethical Standards saga continues

The ICAEW's Tony Bromell looks at a few myths about the controversial new Ethical Standards for auditors, and asks for your help in resolving remaining problems.

Tony Bromell, head of Accountancy Markets & Ethics, at the ICAEW.

There have been articles in Accountancy before about the Auditing Practices Board's (APB) Ethical Standards on auditor independence, but here's another, and there will probably be more.

No apologies: there remain problems with the way the standards are written for which we need your help, and there are also a lot of myths still to be debunked about what these standards mean, particularly for SME markets.

I am going to concentrate here on two issues which have caused great concern for differing reasons: whether accountancy work can be carried out for private company audit clients, and whether it is possible for more than 15% of your total practice income to come from one audit client.

Accountancy work

First, this article is not about the audit of listed companies (or other entities with a wide range of stakeholders, where it has been decided to treat them as if they were listed) for which there are different requirements in many areas, including this one.

So, you have (or are) an audit client where the auditor has typically prepared the statutory accounts from your underlying invoices, cash books and so on. Alternatively, for a slightly larger client, the auditor uses the client's core accounting records to prepare periodic management accounts and then uses them to produce the year-end audited accounts. Can these services still be provided by the auditor?

The basic answer is yes, with a few caveats. A lot of rhetoric has suggested otherwise and one or two organisations with expensive solutions to sell continue to assert this. The problem stems from the overall tone of the standards, which suggests that the answer to any question is likely to be 'no, unless …', or even 'no'. That is certainly true in several areas, but the requirements for accounting work are actually not dissimilar in substance to those in the institute's existing guidance for audits that is now being superseded.

What are 'a few caveats'? The underlying premise is that the auditor has to be independent and should not therefore be put in the position of reviewing his or her own work. Auditors may not take key decisions that are part of management's role, and this includes initiating transactions and taking responsibility for the year-end audited accounts.

However, this does not mean the auditor cannot prepare those accounts or prepare the journals/accounting records that feed into them, from the underlying transaction documents. Neither does it mean the auditor cannot give accountancy advice. It does mean that management should be informed and that the auditor should consider whether in these circumstances the self-review threat is significant, and that safeguards therefore need to be applied.

Informed management

So, what does 'informed management' mean? It does not mean that management must understand the intricacies of accounting standards, or that every accounting entry the auditor has proposed must be discussed with management on a detailed line-by-line basis. Most accounting entries will be very straightforward and mechanical in nature.

However, a few may be material and subjective. Management needs to have the issues, consequences and alternatives explained to them so that they can understand the key points at hand and make the ultimate decision as to which alternative to adopt: a reasonable idea, given that they are going to sign the accounts before filing. Although the APB permits an exemption from having informed management for very small audits, we would recommend it as an important safeguard in any audit client for any non-audit work that will end up being audited.

Whether there is a significant self-review threat depends on whether there have been material subjective entries by the auditor and on the extent of the involvement (there would, for example, be less of a threat if the auditor were preparing the accounts from the client's own trial balance and other information, than if the auditor was doing everything from base documents).

If there is such a threat, what types of safeguards may be appropriate?

The APB does have a slightly narrower view of what constitutes a safeguard than our ethics guidance.

The purpose of an audit, among other things, is to check that the accounting is sufficiently correct to allow the accounts to give a true and fair view of what has happened over a period and at a given point in time.

Therefore, if the auditor has prepared the accounts as well, there has not really been an independent check. However well informed management are, they are not verifying the accountant's work - if they could do that, the auditor would not be preparing the accounts in the first place. Therefore, and particularly if there are significant subjective issues, the auditor needs to apply safeguards to provide that element of review and minimise the self-review threat.

It may be that the audit firms can have separate teams for the accounting and audit work, but this is often impractical. In that case those significant subjective issues, at least, need to be subject to review/discussion, perhaps with another partner or an external reviewer.

Thus it follows that the work probably can be done, but it may cost more.

If there is a significant extra cost to business let us know. We cannot hope to persuade the APB to amend these standards more than we already achieved last winter, without evidence.

Fee dependency

This is a different issue with a different problem. The underlying principle is, as it was in the existing guidance, that an auditor should not be economically dependent on one audit client: a wholly reasonable proposition to preserve independence.

The problem is that the APB has chosen to translate that principle into an inflexible rule, regardless of the circumstances. The institute's outgoing guidance advised that total income from one client representing more than 15% of practice income (or individual partner or office income depending on how profit was allocated), was presumed to compromise dependency, but that presumption could be rebutted with suitable safeguards (typically review by someone outside the dependent firm or partner, or office).

Unfortunately, and despite repeated representation by the institute, the APB has removed the rebuttability, if that word exists. Although the original 10% was changed at the last minute to 15% (for unlisted entities), that 15% is an absolute rule.

There are caveats in that the 15% limit must be exceeded 'regularly', and it strictly applies only to the client and its subsidiaries, rather than all connected parties, but if the total income is more than 15%, the income must be reduced by giving up non-audit work, or the audit must be given up: end of discussion.

We believe this underestimates the strength of the review safeguard and is incompatible with the principles-based approach the standards purport to follow. However, the real issue is the impact on firms and their clients.

Are SMEs having to use different auditors and/or accountants, at extra cost, as a result of this new rule? Are, as we have begun to hear, audit firms being pushed out of audits as a result of the domino effect - firm has to resign from largest client: second largest client becomes more than 15% of the reduced income so the firm has to resign; and so on?

MORE ON ETHICAL STANDARDS

Further information on the standards is available at www.icaew.co.uk/ethics and frequently asked questions are being added to the website for institute members at www.icaew.co.uk/ethicsadvice. The standards themselves are available at www.frc.org.uk/apb/publications/ethical.cfm.

ASSISTANCE NEEDED As noted in the article, to achieve change, we need evidence.

Please let us know, by email to

tony.bromell@icaew.co.uk or anne.davis@icaew.co.uk, or by post to Silbury Court, 412-416 Silbury Boulevard, Milton Keynes MK9 2AF.
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