AUDIT TEST 1 on threats to independece (answers/solution)

      

TEST ONE
with solution 

ACADEMIC YEAR 2015/2016

You are an audit manager in Mtavangu & Associates (an Auditing Firm) responsible for allocating staff to the following three audits of financial statements for the year ending 31 December 2014:

(a)    Hapa Kazi Co is a new audit client. This private company is a local manufacturer and distributor of sportswear. The company’s finance director, John, sees little value in the audit and put it out to tender last year as a cost-cutting exercise. In accordance with the requirements of the invitation to tender your firm indicated that there would not be an interim audit.

(b)   Makontena Co, a long-standing client, operates a national supermarket chain. Your firm provided Makontena Co with corporate financial advice on obtaining a listing on a recognised stock exchange in 2013. Senior management expects a thorough examination of the company’s computerised systems, and are also seeking assurance that the annual report will not attract adverse criticism.

(c)    Uraisi Co has been an audit client since 2005 after your firm advised management on a successful buyout. Uraisi provides communication services and software solutions. Your firm provides Uraisi with technical advice on financial reporting and tax services. Most recently you have been asked to conduct due diligence reviews on potential acquisitions.

Required:

For these assignments, compare and contrast:

(i)       the threats to independence (60 Marks)

(ii)     the other professional and practical matters that arise; and (20 Marks) 

(iii) the implications for allocating staff. (20 Marks)

             

Threats to independence

Self-interest

Tutorial note: This threat arises when a firm or a member of the audit team could benefit from a financial interest in, or other self-interest conflict with, an assurance client.

•       A self-interest threat could potentially arise in respect of any (or all) of these assignments as, regardless of any fee restrictions (e.g. per NBAA’s ‘Code of Ethics for Professional Accountants’), the auditor is remunerated by clients for services provided.

•       This threat is likely to be greater for Makontena Co (larger/listed) and Uraisi Co (requires other services) than for Hapa Kazi Co (audit a statutory necessity).

•       The self-interest threat may be greatest for Makontena Co. As a company listed on a recognised stock exchange it may give prestige and credibility to

Mtavangu&Associates (though this may be reciprocated). Mtavangu&Associates could be pressurised into taking evasive action to avoid the loss of a listed client (e.g.

concurring with an inappropriate accounting treatment).

Self-review

Tutorial note: This arises when, for example, any product or judgment of a previous engagement needs to be re-evaluated in reaching conclusions on the audit engagement.

•       This threat is also likely to be greater for Makontena and Uraisi where Mtavangu&Associates is providing other (non-audit) services.

•       A self-review threat may be created by Mtavangu&Associates providing Makontena with a ‘thorough examination’ of its computerised systems if it involves an extension of the procedures required to conduct an audit in accordance with International Standards on Auditing (ISAs).

•       Appropriate safeguards must be put in place if Mtavangu&Associates assists Makontena in the performance of internal audit activities. In particular, Mtavangu&Associates’s personnel must not act (or appear to act) in a capacity equivalent to a member of Makontena’ management (e.g. reporting, in a management role, to those charged with governance).

•       Mtavangu&Associates may provide Uraisi with accounting and bookkeeping services, as Uraisi is not a listed entity, provided that any self-review threat created is reduced to an acceptable level. In particular, in giving technical advice on financial reporting, Mtavangu&Associates must take care not to make managerial decisions such as determining or changing journal entries without obtaining Uraisi’s approval.

•       Taxation services comprise a broad range of services, including compliance, planning, provision of formal taxation opinions and assistance in the resolution of tax disputes. Such assignments are generally not seen to create threats to independence.

Tutorial note: It is assumed that the provision of tax services is permitted in the jurisdiction (i.e. that Mtavangu &Associates are not providing such services if prohibited).

•       The due diligence reviews for Uraisi may create a self-review threat (e.g. on the fair valuation of net assets acquired).However, safeguards may be available to reduce these threats to an acceptable level.

•       If staff involved in providing other services are also assigned to the audit, their work should be reviewed by more senior staff not involved in the provision of the other services (to the extent that the other service is relevant to the audit).

•       The reporting lines of any staff involved in the audit of Makontena and the provision of other services for Makontena should be different. (Similarly for Uraisi.) Familiarity

Tutorial note: This arises when, by virtue of a close relationship with an audit client (or its management or employees) an audit firm (or a member of the audit team) becomes too sympathetic to the client’s interests.

•       Long association of a senior member of an audit team with an audit client may create a familiarity threat. This threat is likely to be greatest for Makontena, a long-standing client. It may also be significant for Uraisi as Mtavangu&Associates have had dealings with this client for seven years now.

•       As Hapa Kazi is a new audit client this particular threat does not appear to be relevant.

•       Senior personnel should be rotated off the Makontena and Uraisi audit teams. If this is not possible (for either client), an additional professional accountant who was not a member of the audit team should be required to independently review the work done by the senior personnel.

•       The familiarity threat of using the same lead engagement partner on an audit over a prolonged period is particularly relevant to Makontena, which is now a listed entity. IFAC’s ‘Code of Ethics for Professional Accountants’ requires that the lead engagement partner should be rotated after a pre-defined period, normally no more than seven years. Although it might be time for the lead engagement partner of Makontena to be changed, the current lead engagement partner may continue to serve for the 2006 audit.

Tutorial note: Two additional years are permitted when an existing client becomes listed, since it may not be in the client’s best interests to have an immediate rotation of engagement partner. Intimidation

Tutorial note: This arises when a member of the audit team may be deterred from acting objectively and exercising professional skepticism by threat (actual or perceived), from the audit client.

•       This threat is most likely to come from Hapa Kazi as auditors are threatened with a tendering process to keep fees down.

•       John may have already applied pressure to reduce inappropriately the extent of audit work performed in order to reduce fees, by stipulating that there should not be an interim audit.

•       The audit senior allocated to Hapa Kazi will need to be experienced in standing up to client management personnel such as John.

Tutorial note: ‘Correct’ classification under ‘ethical’, ‘other professional’, ‘practical’ or ‘staff implications’ is not as important as identifying the matters. 

(ii) Other professional and practical matters

Tutorial note: ‘Other professional’ includes quality control.

•       The experience of staff allocated to each assignment should be commensurate with the assessment of associated risk. For example, there may be a risk that insufficient audit evidence is obtained within 

the budget for the audit of Hapa Kazi.Makontena, as a listed client, carries a high reputational risk.

•       Sufficient appropriate staff should be allocated to each audit to ensure adequate quality control (in particular in the direction, supervision, review of each assignment). It may be appropriate for a second partner to be assigned to carry out a ‘hot review’ (before the auditor’s report is signed) of:

– Hapa Kazi, because it is the first audit of a new client; and – Makontena, as it is listed.

•       Existing clients (Makontena and Uraisi) may already have some expectation regarding who should be assigned to their audits. There is no reason why there should not be some continuity of staff providing appropriate safeguards are put in place (e.g. to overcome any familiarity threat).

•       Senior staff assigned to Hapa Kazi should be alerted to the need to exercise a high degree of professional skepticism (in the light of John’s attitude towards the audit).

•       New staff assigned to Makontena and Uraisi would perhaps be less likely to assume unquestioned honesty than staff previously involved with these audits.

Logistics (practical)

•       All three assignments have the same financial year end, therefore there will be an element of ‘competition’ for the staff to be assigned to the year-end visits and final audit assignments. As a listed company, Makontena is likely to have the tightest reporting deadline and so have a ‘priority’ for staff.

•       Hapa Kazi is a local and private company. Staff involved in the year-end visit (e.g. to attend the physical inventory count) should also be involved in the final audit. As this is a new client, staff assigned to this audit should get involved at every stage to increase their knowledge and understanding of the business.

•       Makontena is a national operation and may require numerous staff to attend year-end procedures. It would not be expected that all staff assigned to year-end visits should all be involved in the final audit.

Time/fee/staff budgets

•       Time budgets will need to be prepared for each assignment to determine manpower requirements (and to schedule audit work).

(iii)   Implications for allocating staff

•       Mtavangu&Associates should allocate staff so that those providing other services to Makontena and Uraisi (that may create a self-review threat) do not participate in the audit engagement.

Competence and due care (Qualifications/Specialisation)  All audit assignments will require competent staff.

•       Makontena will require staff with an in-depth knowledge of their computerised system.

•       Uraisi will require senior audit staff to be experienced in financial reporting matters specific to communications and software solutions (e.g. in revenue recognition issues and accounting for internally-generated intangible assets).

•       Specialists providing tax services and undertaking the due diligence reviews for Uraisi may not be required to have any involvement in the audit assignment.