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Executive summary

This report aims to examine the importance of Auditor independence, the requirements of the Corporation Act 2001 and the ethical behavior detailed by the Code of Ethics to Professional Accountants. Based on these points it will identify and evaluate the issues which should be concerned whether to accept or reject the audit engagement with X Pty Ltd. The research draws attention to the fact that audit independence reflects audit quality. Therefore if independency is questionable those reports would not be credible ad investors would have little confidence in them. We also found evidence that companies that have an independent and active audit committee reduce the likelihood of fraudulent financial statements. Apply those fundamental principles of independent auditing to our case study; we have identified number of threats, possibility to breach the Corporations Act by engaging the client in the existing circumstances. Our report provides different outcome based on our Act. However I believe we should not engage with the client in the existing situation.

Contents
Contents...................................................................................................................2 Independence of audit..............................................................................................3 Corporation Act 2001, and Professional Independence APES 110.........................4 Safeguards............................................................................................................6 Researches ...............................................................................................................6 Number of studies has been on requirements relating to corporate governance and this increased demand for internal assurance on corporate governance processes including internal control and risk management. ....................................................7 Client acceptance concerns about X Pty Limited....................................................8 Whos affected? And how? ................................................................................9 Alternatives:.........................................................................................................9 Consequences:....................................................................................................10 Appropriate Action: ..........................................................................................10 Reference List:.......................................................................................................12

Independence of audit Corporate failure and corporate problems with financial reporting has been a major concern in accounting practice and sparked continuous debate between regulators, legislators, financial-statement users about the importance and the role of auditors. Independence is defined as the ability to withstand pressure from management influence when conducting an audit or providing audit-related services, so that the professional integrity of the auditor is not compromised. (Gay and Simnett, 2003, p. 745). It is essential that the individual be independent in both fact and appearance. The audit organization or the individual auditor must be free from personal, external and organizational impairments to independence, and must avoid the appearance of such impairments of independence. They must maintain independence therefore their opinions, conclusions, judgments will be impartial by objective third parties with knowledge of relevant information. Therefore auditors expected to not be unduly influenced by own or others interest when they forming judgments. They should not participate in any activity that may impair their unbiased assessment, or accept anything that may impair their professional judgment, and they must disclose any material facts known to them. They required following those rules as they play critical role in lending independent credibility to published financial statements used by investors, creditors and other stakeholders to make capital allocation decisions. Independence is fundamental to reliability of auditors report. The audit quality perception affected by publics and users expectation of auditing. Personal impairments of auditors result from relationship that might cause auditors to limit disclosure or weaken audit findings. An auditors failure to detect material misrepresentation in companies financial statements can lead not only losses by individual investors, but to an overall decline of trust in capitalist institutions. 3

Corporation Act 2001, and Professional Independence APES 110

Sections 324CA-324CC of the Corporation Act 2001 establishes general requirements for auditors independence and provides guidelines to auditors. The independence in the context of freedom from any interest incompatible with integrity and objectivity the Code of Ethics provides foundations. In the Code of Ethics for Professional Accountants (Code of Ethics) a members responsibility is acting in the public interest and complies with the ethical requirements of this code. The Code of Ethics describes the norms of behavior expected of auditors. Auditors should not engage in any business that impairs integrity, objectivity as a result would be incompatible with the rendering of Professional Services. The fundamental principles: Integrity, Objectivity, Professional competence and due care, Confidentiality, Professional behaviors. Integrity and Objectivity directly related to independence. As the principle of integrity is that the auditor to be straightforward and honest in professional and business relationship. The auditor should not be associated with any reports which contain a materially false or misleading statement. While the principle of objectivity imposes that the auditor should not compromise their professional or business judgment because of bias, conflict of interest or the undue influence of others. To avoid potential and actual conflicts of interest and bias at the individual level, audit assignments should be rotated periodically. Section 324CA-324CC of the Corporation Act prohibits an auditor from engaging in an audit activity of an entity while there is an unresolved conflict of interest in relation that entity. The requirements of independence in the Act are expressed in terms of circumstances that might impair an auditors objectivity and impartial judgment.

The circumstances of a conflict of interest must arising from any relationship existed, currently exist, or will exist between the company and the individual auditor or the auditor firm. Any material financial interest in clients, it will actually damage the likelihood of the perception of the auditors independence. It is prohibited to have any equity investments in clients, also prohibits an auditor to being a member of board of directors or being an employee of a client company. (Corporations Act, 2001) The Code of Ethics indicates that those principles may cause threats to auditors. It assumes those threats in the following category: Self-interest, Self-review, Advocacy, Familiarity, and Intimidation. While the Code of Ethics gives ethical behavior guideline to those threats, the Corporation Act 2001 is regulating some of them. I will underline some of them in following. There is a relationship between intimidation and audit fees. A set fee can have important implications for their ability to maintain audit independence. Auditors should not be conducted for agreed fees, as that can limit how the auditor carries out his work. Contingent fees are prohibited by the Corporation Act and subs 290.210-212 of the Code. A directors must include details in relation to each auditor who provided audit services and non audit to the company. To provide non-audit services raises two threats: Self-review threat as they review their own work and the sacrifice of the audit integrity. (Corporations Act s300, 2001) Familiarity can caused by the same auditor has been engaged with the client for several years. For listed companies there is a requirement by the Companies Act, that lead auditor must be rotated every five years. (Subsection 290.154 of the Code of Ethics).

Safeguards

The Code of Ethics identifies two groups of safeguards that may reduce threats. One of them is the profession, legislation and regulation safeguards. This includes educational, training and experience requirements for entry into the profession, and continuing professional developments, corporate governance regulations, professional standards, and professional monitoring. The other group is the work environment. This includes policies and procedures to implement and monitor quality control of engagement, internal policies, procedures requiring to compliance with the fundamental principles. There are engagement-specific safeguards, involving additional professional accountant to review, consulting, and discussing ethical issues.

Researches

Several journals provide researchers about literature on audit independence and objectivity. Main problem how to be able to carry out work as an employee to the company but also being as an internal auditor, enable to opinion. Internal auditors are in a unique situation as providers of both assurance services within the organization and consultancy services to managers. This dual role generates significant debate as it has a potential to create conflict of interest. As an employee of an organization, the ability of internal auditors to exercise true objectivity has also been questioned. (Paape,2007)

The institute of Internal Auditors (IIA) provides the professional standards and guidelines on independence and objectivity. However IIA stresses that internal audit function should be given the appropriate status to be able to exercise organizational independence and individual internal auditors to act objectively. Internal auditor has a responsibility to assess and monitor decision made by management and also advice management on the adequacy and effectiveness of internal controls (Sarens and Beelde, 2006a) internal auditors often face familiarity and social pressure threats stemming from their relationship with management. Audit committees can be viewed as a key safeguard mechanism for internal auditors in managing their professional objectivity. Firms with audit committees, which are composed of independent directors and which meet at least twice per year, are less likely to be sanctioned for fraudulent or misleading reporting. However audit committee independence is unlikely to result in effectiveness unless the committee is also active. There is indirect evidence supporting that an independent and active audit committee can deter financial reporting fraud. Audit committee which meets minimum levels of both activity and independence are more likely to engage higher quality external auditors. As audit quality defined as detecting and reporting material financial misstatement, it would appear that active and independent audit committees would be associated with a higher level of financial reporting quality (Abott, 2000) Number of studies has been on requirements relating to corporate governance and this increased demand for internal assurance on corporate governance processes including internal control and risk management. After the corporate scandals and the global financial crisis, corporate governance has received a significant attention from regulators and the public. Although scandals began earlier in Australia, the American response came sooner. Australia directly has been influenced by the provisions of Sarbanes-Oxley Act of July 2002. The principle, while auditors are financially dependent on auditees their 7

independence is impaired. Robins article found that the provision in 1998 amendment to the Corporation Act that employee remuneration be expensed has long been largely ignored. Also found that ethical standards, by their nature, are much less responsive to external influence from government or regulatory institutions then are technical standards or institutional conventions. He suggests that ethical standards should be monitor. It has been concluded that human frailty rather than human law lies at the heart of corporate governance problem (Robin, 2006).

Client acceptance concerns about X Pty Limited

I have major concerns about the relationship of X Pty Ltd (X) and Tick, Hope & Co. There are ethical issues involved, also I have concern about the engagement with client will lead us to breach the Corporations Act certain points. Relevant facts: X Pty Ltd has been involved in interior designing in our audit company. The Job was completed, out of $4 million, $2.6 million is still outstanding. Therefore there is a direct relationship exists between our company and the client. The outstanding fee indicates that there is financial liability exists for our company. As the audit fee is substantial, this must be documented and be consistent with industry practice. The Managers holds equity of X. There is a financial interest in the client. The audit partner will be appointed to the board of directors. Involvement with the management is more likely to affect how the financial statements users perceive the auditors independence. More facts: Information has been collected by previous auditor is the following: Breaches of the Corporation Act - however were not related to the financial statements, it was the main reason to change auditor. Under the Corporation Act the change of auditor circumstances should be written down, and disclosed to the shareholders. The fee is still outstanding for previous auditing and litigation going 8

on between the previous auditor and X Pty Ltd. Subsection 290.208 recommends that this should be discussed with the audit committees and the audit work should review by professionals. Accounting standards There were breaches in respect of the standards, but being immaterial nature of the amounts. The previous audit firm indicates the client has been breached the Corporations Act several times. However we dont know about the materiality as we havent conducted any audit yet. However the outstanding fees can indicates us that the audit hasnt been carried out promptly; therefore we can assume that not enough evidence has been collected to obtain the true opinion.

Whos affected? And how?

Tick, Hope & Co There is a direct relationship with the client. Money is still owing to X Pty Ltd for previous work. And will be a future relationship by joining the board of directors. If the audit is completed independence will questioned, Shareholders will not trust in the opinion objectivity. It can be a possibility to breach the Corporations Act the above mentioned rules regarding independency. Me as senior auditor - Possibility of violation with Code, breach of the Corporations Act by overseeing the facts, not disclosing the existing relationship with the client. Also the future with firm can be affected. Performance evaluation may be affected. X Pty Ltd Shareholders will questioning the audit quality, knowing about the financial interest exists between them and the auditor firm. Chance that if there is error or misstatements exist it wont be detected therefore wont be corrected. They can sue the auditor firm not carrying out their job as required. Alternatives: Engagement with client in this circumstances 9

Not accepting the client, refuse to work on engagement Engagement with the client after all payment made to previous work, and not join the board of directors

Quite the firm

Consequences: Firm may be sued because the breach of Corporations Act or because they may not detect misstatements or errors. Can be action against the firm regarding the outstanding amount. They may lose the client, if they are not agreed upon those conditions If I quit, I will lose all the hard work I putted to get to the senior level.

Appropriate Action: Concluded all these matters, I would not suggest engaging with this client. There are relevant facts that there is conflict of interest. By engaging with this client we could breach the Corporations Act. There are ethical issues, such as self-interest, self-review. Acknowledge these threats it is more likely to have difficulties to manage the professional objectivity. I will advise my firm about those threats and suggest them, if we want to engage with them, first to pay all outstanding fee, refuse to be part of the board, therefore it will not be any relationship with the client.

To conclude, independency is a fundamental requirement of auditing. We need carefully conduct a pre-engagement with the client. Analyze if there is any relationship between our firm and the client that can lead us to breach the Corporations Act. We need to collect information about the client to see if there 10

any threat can arise by engaging with them. If we find there are number of threat of independency or if there is any possibility to have any obligation by accepting the client and carrying out the auditing, we should not accept the client, or we should make the necessary steps to establish safeguards.

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Reference List: Abbott, L Park, Y Parker, S 2000, The Effects of Audit Committee Activity and Independence on Corporate Fraud, Managerial Finance, vol. 26, no. 11. Al-Ajmi, J Saudagaran,S 2011, Perceptions of auditors and financial-statement users regarding auditor independence in Bahrain, Managerial Auditing Journal, vol. 26, no. 2, pp. 130-160. Arens , A Elder, Rajdal, J Beasley, M 2010, Auditing Assurance Services & Ethics in Australia, Pearson, French Forest. APES 110, Code of Ethics for Professional Accountants, Accounting Professional & Ethical Standards Board, 2006 Robins, F 2006, Corporate Governance after Sarbanes_oxley: an Australian perspective, Corporate governance, vol. 6, no. 1, pp. 34-48. Soh, D Martinov-Bennie, N 2011, The internal audit function, Managerial Audit Journal, vol. 26, no. 7, pp. 605-622. Stewart, J Subramaniam, N 2010, Internal audit independence and objectivity: emerging research opportunities, Managerial Auditing Journal, vol. 25, no. 4, pp. 328-360.

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