Ethics and Terms of Audit Engagements PDF

## CHP 2 - ETHICS AND TERMS OF AUDIT ENGAGEMENTS 1. **Write about meaning and need of ethics in audit** * **Meaning of ethics** The term "Ethics" means moral principles which govern a person's behaviour or his conducting of an activity. It is the branch of knowledge that deals with moral principl...

## CHP 2 - ETHICS AND TERMS OF AUDIT ENGAGEMENTS 1. **Write about meaning and need of ethics in audit** * **Meaning of ethics** The term "Ethics" means moral principles which govern a person's behaviour or his conducting of an activity. It is the branch of knowledge that deals with moral principles. Ethics is something which comes from an individual intrinsically. It has to be inculcated in the habit and temperament of an individual, so that there is an overall culture of ethics: the force has to be strong enough to withstand any selfish motive or temptation. It is a state of mind to act and perform in accordance with moral principles. Ethics is the science of morals in human conduct. Such moral principles and rules of conduct impose obligations upon individuals. * **Need of ethics** Professional ethics seek to protect the interests of the profession as a whole and act as a shield that enables us to command respect. A CA, either in practice or in service, has to abide by ethical behaviour and principles. They are expected to follow the fundamental principles of professional ethics while performing their duties. Users of our service should be able to feel secure that there exists a framework of professional ethics which governs the provision of those services. Any deviation from the ethical responsibilities brings the disciplinary mechanism into action against the CA which may result into fines, suspension of membership, removal from membership or other disciplinary actions. 2. **Write about principles based approach vs rules based approach to ethics?** * **Principal based approach** * The essence of principles-based approach to ethics requires compliance with spirit of ethics. * It requires accountants to use professional judgment to evaluate every situation to arrive at conclusions. * It requires accountants to exercise professional judgment in every situation based upon their professional knowledge, skill and expertise. * **Rules based approach** * This approach to ethics strictly follows clearly established rules. * Further, rules- based approach is somewhat rigid as it may not be possible to deal with every practical situation relying upon rules. Therefore, it is necessary that spirit of code is followed. * It may lead to a narrow outlook and spirit. 3. **What are the fundamental principles of professional ethics?** The fundamental principles of ethics establish the standard of behaviour expected of a professional accountant. A professional accountant shall comply with each of the fundamental principles. The fundamental principles of professional ethics are as under: * **INTEGRITY**: Honesty * A professional accountant shall comply with the principle of integrity, which requires an accountant to be straight forward and honest in all professional and business relationships. Integrity implies fair dealing and truthfulness. * A professional accountant shall not knowingly be associated with reports, returns, communications or other information where the accountant believes that the information contains: * A materially false or misleading statement. * Contains statements or information provided negligently or with less alertness * Omits or obscures required information where such omission or obscurity would be misleading. * **OBJECTIVITY**: * The principle of objectivity requires an auditor not to compromise professional judgment because of bias, conflict of interest or undue influence of others. * It requires that a professional accountant shall not undertake a professional activity if a circumstance or relationship unduly influences the accountant's professional judgment regarding that activity. * **PROFESSIONAL COMPETENCE AND DUE CARE**: * A professional accountant shall comply with the principle of professional competence and due care, which requires an accountant to: * Attain and maintain professional knowledge and skill at the level required to ensure that a client or employing organization receives competent professional service, based on current technical and professional standards and relevant legislation and * Act diligently and in accordance with applicable technical and professional standards. Diligence includes responsibility to act carefully, thoroughly and on a timely basis in accordance with requirements of an assignment. * **CONFIDENTIALITY**: * Confidentiality principle requires a professional accountant to respect the confidentiality of information acquired as a result of professional or business relationships. * Confidentiality serves the public interest because it facilitates the free flow of information from the professional accountant's client or employing organization to the accountant with the understanding that the information will not be disclosed to a third party. * However, such confidential information may be disclosed, for example, when it is required by law, when it is permitted by law and is authorised by the client or employer or there is a professional duty or right to disclose when not prohibited by law. * **PROFESSIONAL BEHAVIOUR**: * It requires an accountant to comply with relevant laws and regulations and avoid any conduct that the accountant knows or should know might discredit the profession. A professional accountant shall not knowingly engage in any employment, occupation or activity that impairs or might impair the integrity, objectivity or good reputation of the profession, and as a result would be incompatible with the fundamental principles. 4. **CA P. Suryakantam has conducted audit of accounts of an entity for a particular year. ICAI has issued a letter to him relating to certain matters concerning audit. He didn't even bother to reply to the letter despite reminders. Discuss which fundamental principle governing professional ethics is disregarded by him?** Failure to reply to professional body smacks of lack of courtesy and professional responsibility. The principle of "Professional behaviour" is disregarded. 5. **A Chartered accountant in practice issued a certificate showing original cost of plant and machinery installed in premises of a client for Rs. 9 crores to save some regulatory fees for his client. However, original cost of plant and machinery was Rs.15 crore as per records of client. Which fundamental principle governing professional ethics is violated in this case?** "Integrity" requires that a professional accountant shall not knowingly be associated with reports, returns, communications or other information where the accountant believes that the information contains a materially false information where the accountains statements or information provided negligently of omits misleading statement information where such omission or obscurity would be misleading. In the given case, a false certificate is knowingly issued showing misstated original cost of machinery. Therefore, fundamental principle of "integrity" is violated. 6. **Write about independence of auditors?** Independence implies that the judgement of a person is not subordinate to the wishes or direction of another person who might have engaged him, or to his own self-interest. It is not possible to define "independence" precisely. Independence is a condition of mind as well as personal character and should not be confused with the superficial and visible standards of independence which are sometimes imposed by law. There are 2 interlinked perspectives of independence of auditors: * **INDEPENDENCE OF MIND**: * The state of mind that permits the provision of an opinion without being affected by influences that compromise professional judgment, allowing an individual to act with integrity and exercise objectivity and professional skepticism, * **INDEPENDENCE IN APPEARANCE**: * The avoidance of facts and circumstances that are so significant that a reasonable and informed third party, having knowledge of all relevant information, including any safeguards applied, would reasonably conclude a firm's, or a member of the assurance team's, integrity, objectivity or professional skepticism had been compromised. Thus, Independence of the auditor has not only to exist in fact, but also appear to so exist to all reasonable persons. 7. **Write about threats to auditor's independence** * **SELF-INTEREST THREATS**: Occurs when an auditing firm or any partner benefiting from a financial interest in the audit client. * Examples: * Direct financial interest or materially significant indirect financial interest in a client. * Loan or guarantee to or from the concerned client. * Undue dependence on a client's fees and, hence, concerns about losing the engagement. * Close business relationship with an audit client. * Potential employment with the client. * Contingent fees for the audit engagement * **SELF-REVIEW THREATS**: Self-review threats occur when during a review, an auditor performs services that are themselves subject matters of audit, or when a member of the audit team was previously a director or senior employee of the client. Non audit services include any professional services provided to an entity by an auditor, other than audit or review of the financial statements. These include management services, internal audit, investment advisory service etc. * Examples: * When an auditor having recently been a director or senior officer of the client company, or * When auditors perform services that are themselves subject matters of audit * **ADVOCACY THREATS**: Occurs when the auditor promotes a client's opinion to a point where people may believe objectivity is compromised. In following situations, auditor can be perceived as backing and championing causes of auditee client and it may lead to belief that auditor is not acting and working objectively. Auditor has not only to be independent but also appear to be acting so. * Examples: * When an auditor deals with shares or securities of the audited company, or * Becomes the client's advocate in litigation and third-party disputes * **INTIMIDATION THREATS**: Which occur when auditors are deterred from acting objectively with an adequate degree of professional skepticism. * Examples: * Threat of replacement over disagreements with the application of accounting principles, or * Pressure to disproportionately reduce work in response to reduced audit fees or being threatened with litigation * **FAMILIARITY THREATS**: * These are self-evident and occur when auditors form relationships with the client where they end up being too sympathetic to the client's interests. * Example: When auditors have a close personal or business relationship with the client, such as being a close friend or relative, or when they have worked for the client for a long period of time. These relationships can make it difficult for the auditor to remain objective and exercise professional skepticism. **If the preconditions for an audit are not present, the auditor shall discuss the matter with management. Unless required by law or regulation to do so, the auditor shall not accept the proposed audit engagement:** * If the auditor has determined that the financial reporting framework to be applied in the preparation of the financial statements is unacceptable or * If the agreement of management is not obtained on matters relating to understanding of responsibility of management on preparation of financial statements, internal controls for preparation of financial statements, providing access to all information to auditor and unrestricted access to persons within the entity. * If management or TCWG impose a limitation on the scope of the auditor's work in the terms of a proposed audit engagement such that the auditor believes the limitation will result in the auditor disclaiming an opinion on the financial statements, the auditor shall not accept such a limited engagement as an audit engagement, unless required by law or regulation to do so. 17. **Write a short note on Audit Engagement Letter** The audit engagement letter is sent by the auditor to his client. It is in the interest of both the auditor and the client to issue an engagement letter so that the possibility of misunderstanding is reduced to a great extent. The auditor shall agree the terms of the audit engagement with management or those charged with governance, as appropriate. * ** Such a letter includes: ** * The objective and scope of the audit of the financial statements * The responsibilities of the auditor * The responsibilities of management * Identification of the applicable financial reporting framework for the preparation of the financial statements and * Reference to the expected form and content of any reports to be issued by the auditor and a statement that there may be circumstances in which a report may differ from its expected form and content. If law or regulation prescribes in sufficient detail the terms of the audit engagement, the auditor need not record them in a written agreement, except for the fact that such law or regulation applies and that management acknowledges and understands its responsibilities. (Refer ICAI Study material Page 11.17 for sample format of EL) 18. **Chirag, as part of articled training, is part of an engagement team conducting audit of a company. He has read somewhere that engagement letter issued by auditor to client also includes expected form and content of the auditor's report. He was at a loss to understand how could an auditor include form and content of the report beforehand. Try to help Chirag by making things clear to him. ** Engagement letter includes reference to expected form and content of audit report. It merely states that auditor would provide opinion in this form. However, engagement letter also includes statement that the form and content of report may need to be amended in the light of oudit findings. Therefore, if in light of audit findings, auditor needs to give a modified opinion, he shall do so. 19. **The management of an entity feels that it is not necessary for it to give in writing explicitly to the auditor that it understands its responsibilities for preparation of financial statements in accordance with applicable financial reporting framework. Discuss, whether, it is necessary for the management to do so. In case management refuses, why should an auditor not accept the proposed engagement?** It is necessary for management to give in writing explicitly to the auditor that it understands its responsibilities for preparation of financial statements in accordance with applicable financial reporting framework. It is a necessary precondition for an audit in accordance with SA 210. If the preconditions for an audit are not present, the auditor shall discuss the matter with management. Unless required by law or regulation to do so, the auditor shall not accept the proposed audit engagement: a. If the auditor has determined that the financial reporting framework to be applied in the preparation of the financial statements is unacceptable or b. If the agreement of management is not obtained on matters relating to understanding of responsibility of management on preparation of financial statements, internal controls for preparation of financial statements, providing access to all information to auditor and unrestricted access to persons within the entity. Unless required by law or regulation to do so, such a refusal on the part of auditor is necessary as management is not willing to accept its responsibility for preparation of financial statements in accordance with applicable financial reporting framework. An audit is conducted on this basic premise according to SA 210. When basic premise on which audit is conducted is not fulfilled, refusal by auditor is necessary. 20. **Write a short note on: change in terms of engagement as per SA 210?** The reason to change terms may result from: 1. Change in circumstances. 2. Misunderstanding of nature of an audit or services originally requested or agreed. 3. A restriction on the scope of engagement imposed by management or caused bycircumstances. If, prior to completing the audit engagement, the auditor is requested to change the audit engagement to an engagement that conveys a lower level of assurance, the auditor shall determine whether there is reasonable justification for doing so. * ** ACCEPTANCE OF CHANGE IN TERMS OF ENGAGEMENT BY AUDITOR:** * If there is a reasonable justification and if the audit work performed complied with the SAs applicable to the changed engagement, the report issued would be appropriate for the revised terms of engagement. * Further, the report would not include reference to: * The original engagement * Any procedures that may have been performed in the original engagement. * **Further the auditor and management shall agree and record the new terms of the engagement in a new engagement letter.** * **NON-ACCEPTANCE OF CHANGE IN TERMS OF ENGAGEMENT BY AUDITOR:** * The auditor shall not agree for changes in the terms of the audit engagement where there is no reasonable justification for doing so. * **WITHDRAWAL FROM ENGAGEMENT:** * If the auditor is unable to agree to a change of the terms of engagement and is not permitted by management to continue the original audit engagement: * The auditor shall withdraw from the audit engagement and * Determine whether there is any obligation, either contractual or otherwise, to report the circumstances to other parties, such as those charged with governance, owners or regulators. 21. **State the circumstances where sending a new engagement letter, would be appropriate in recurring audits.** A Chartered accountant is conducting audit of a client for last two years. Before proceeding to start audit for next year, he notices that there is substantial change in management. Besides, client has ventured into areas of business activity which were not present at time of accepting initial audit engagement. Discuss responsibility of auditor in this regard in context of SA 210. On recurring audits, the auditor shall assess whether circumstances require the terms of the audit engagement to be revised and whether there is a need to remind the entity of the existing terms of the audit engagement. The auditor may decide not to send a new audit engagement letter or other written agreement each period. However, the following factors may make it appropriate to revise the terms of the audit engagement or to remind the entity of existing terms: * Any indication that the entity misunderstands the objective and scope of the audit. * Revised or special terms of Engagement. * A change in legal or regulatory requirements. * A change in the Applicable financial reporting framework. * A change in audit reporting requirement. * A recent change of Top management. * A significant change in nature or size of the entity's business. **SQC 1 - QUALITY CONTROL FOR FIRMS THAT PERFORMER ASSURANCE TEWS OF HISTORICAL FINANCIAL INFORMATION, AND OTHER ASSURANCE AND RELATED SERVICES ENGAGEMENTS ** **Scope and Objectivel** SQC 1 requires that the firm should establish a system of quality control designed to provide it with reasonable assurance that 1. The firm and its personnel comply with professional standards and regulatory andlegal requirements and 2. Reports issued by the firm or engagement partner's are appropriate in the circumstances. * **Firm's system of quality control should consist of policies designed to achieve these objectives.** * **Firm's system of quality control should include policies and procedures addressing each of the following elements: (HTR - A HELMET)** * Acceptance and continuance of client relationships and specific engagements * Human resources * Engagement performance * Leadership responsibilities for quality within the firm * Monitoring * Ethical requirements * Quality control policies and procedures should be documented and communicated to the firm's personnel. By communicating, the firm recognizes the importance of obtaining feedback on its quality control system from its personnel. Therefore, the firm encourages its personnel to communicate their views or concerns on quality control matters. **23. LEADERSHIP RESPONSIBILITIES FOR QUALITY WITHIN THE FIRM** SQC 1 requires firms to establish policies and procedures designed to promote an internal culture based on the recognition that quality is essential in performing engagements. * Such policies and procedures should require the firm's chief executive officer or the firm's managing partners to assume ultimate responsibility for the firm's system of quality control. * The example set by firm's leadership encourages on inner culture that recognizes high quality audit work. * Further, persons assigned operational responsibilities for the firm's quality control system by the firm's chief executive officer or managing partners should have sufficient and appropriate experience, ability and the necessary authority to assume that responsibility. ** 24. ETHICAL REQUIREMENTS** The firm should establish policies and procedures designed to provide it with reasonable assurance that the firm and its personnel comply with relevant ethical requirements contained in the Code of ethics issued by ICAL. * The Code establishes the fundamental principles of professional ethics which include integrity, objectivity, professional competence and due care, confidentiality and professional behaviour. * Observance of "Independence" in all engagements is the basic requirement. * The firm should establish policies and procedures designed to provide it with reasonable assurance that the firm, its personnel and (including experts contracted by the firm and network firm personnel) maintain independence where required by the Code. Such policies and procedures should enable the firm to: * Communicate its independence requirements to its personnel. * Identify and evaluate circumstances and relationships that create threats to independence, and to take appropriate action to eliminate those threats or reduce them to an acceptable level by applying safeguards, or, if considered appropriate, to withdraw from the engagement. * There should exist a mechanism in the firm by which engagement partners provide the firm with relevant information about client engagements and personnel of firm promptly notify firm of circumstances and relationships that create a threat to independence. * All breaches of independence should be promptly notified to firm for appropriate action. Its objective is to ensure that independence requirements are satisfied. * At least annually, the firm should obtain written confirmation of compliance with its policies and procedures on independence from all firm personnel required to be independent in terms of the requirements of the Code. * Engagement documentation has to be retained for a period of time sufficient to permit those performing monitoring procedures to evaluate the firm's compliance with its system of quality control, or for a longer period if required by law or regulation. In the specific case of audit engagements, the retention period ordinarily is ne shorter than 7 years from the date of the auditor's report, or, if later, the date of the group auditor's report. **25. ACCEPTANCE AND CONTINUANCE OF CLIENT RELATIONSHIPS AND SPECIFIC ENGAGEMENTS:** A firm before accepting an engagement should acquire vital information about the client. Such an information should help firm to decide about: * Integrity of Client * Competence (including capabilities, time and resources) to perform engagement * Compliance with ethical requirements * The firm should obtain such information as it considers necessary in the circumstance before accepting an engagement with a new client, when deciding whether to continue an existing engagement, and when considering acceptance of a new engagement with an existing client. Where issues have been identified, and the firm decides to accept or continue the client relationship or a specific engagement, it should document how the issues were resolved. * With regard to the integrity of a client, matters that the firm considers include, for example: * Whether the client is aggressively concerned with maintaining the firm's fees as low as possible * The identity and business reputation of the client's principal owners, key management, related parties and those charged with its governance. * Indications of an inappropriate limitation in the scope of work * Indications that the client might be involved in money laundering or other criminal activities. * The nature of the client's operations, including its business practices. * Information concerning the attitude of the client's principal owners, key management and those charged with its governance towards such matters as aggressive interpretation of accounting standards and the internal control environment. * The reasons for the proposed appointment of the firm and non-reappointment of the previous firm. * If there is any conflict of interest between the firm and client, it should be properly resolved before accepting the engagement. * Where the firm obtains information that would have caused it to decline an engagement if that information had been obtainable earlier, policies and procedures on the continuance of the engagement and the client relationship should include consideration of: * The professional and legal responsibilities that apply to the circumstances, including whether there is a requirement for the firm to report to the person or persons whe made the appointment or, in some cases, to regulatory authorities, and * The possibility of withdrawing from the engagement or from both the engagement and the client relationship. **26 HUMAN RESOURCES:** The firm should establish policies and procedures designed to provide it with reasonable assurance that it has sufficient personnel with the capabilities, competence, and commitment to ethical principles necessary to perform its engagements in accordance with professional standards and regulatory and legal requirements and to enable the firm or engagement partners to issue reports that are appropriate in the circumstances. * Such policies and procedures should address relevant HR issues including: * Recruitment * Compensation * Training * Career development * Performance evaluation etc. * There should be emphasis on the continuing professional development of firm's personnel. **27. ENGAGEMENT PERFORMANCE** * Three topics to be studied Consultation, EQCR and documentation. __CONSULTATION:__ * Consultation should take place in difficult or contentious matters pertaining to an engagement. Consultation includes discussion, at the appropriate professional, with individuals within the firm or outside the firm who have specialized expertise, to resolve a difficult or contentious matter. * A firm needing to consult externally, for example, a firm without appropriate internal resources, may take advantage of advisory services provided by other firms or professional and regulatory bodies. **28. MONITORING** The firm should ensure that policies and procedures relating to the system of quality control are relevant, adequate, operating effectively and complied with in practice. * Such policies and procedures should include an ongoing consideration and evaluation of the firm's system of quality control, including a periodic inspection of a selection of completed engagements. **SA 220-QUALITY CONTROL FOR AN AUDIT OF FINANCIAL STATEMENTS** **SCOPE AND OBJECTIVE:** Engagement partner of a team is responsible for quality control procedures of a particular audit engagement in accordance with SA 220. Therefore, SA 220 is premised on the basis that the firm is subject to SQC 1. Within the context of the firm's system of quality control, engagement teams have a responsibility to implement quality control procedures that are applicable to the audit engagement and provide the firm with relevant information to enable the functioning of that part of the firm's system of quality control relating to independence. As per SA 220, the objective of the auditor is to implement quality control procedures at the engagement level that provide the auditor with reasonable assurance that: * The audit complies with professional standards and regulatory and legal requirements and * The auditor's report issued is appropriate in the circumstances. SA 220 is modelled on lines of SQC 1. It describes responsibilities of engagement partner in relation to following matters: * Leadership responsibilities for quality on audits * Relevant ethical requirements * Acceptance and continuance of client relationships and audit engagements **29. LEADERSHIP RESPONSIBILITIES FOR QUALITY ON AUDITS:** An engagement partner takes overall responsibility for maintaining audit quality in an audit engagement in accordance with SA 220. What are his objectives in taking and emphasizing such responsibility? Leadership responsibility of an engagement partner is to take responsibility for the overall quality on each audit engagement. The actions of the engagement partner and appropriate messages to the other members of the engagement team, in taking responsibility for the overall quality on each audit engagement, emphasise: * The importance to audit quality of: * Performing work that complies with professional standards and regulatory and legal requirements: * Complying with the firm's quality control policies and procedures as applicable: * Issuing auditor's reports that are appropriate in the circumstances and * The engagement team's ability to raise concerns without fear of reprisals. * The fact that quality is essential in performing audit engagements. **30. RELEVANT ETHICAL REQUIREMENTS:** The responsibilities of an engagement partner in relation to ethical requirements in an audit engagement are as under: * Identifying a threat to independence regarding the audit engagement that safeguards may not be able to eliminate or reduce to an acceptable level, * Reporting by engagement partner to the relevant persons within the firm to determine appropriate action, which may include eliminating the activity or interest that creates the threat, or withdrawing from the audit engagement, where withdrawal is legally permitted. **31. ACCEPTANCE AND CONTINUANCE OF CLIENT RELATIONSHIPS AND AUDIT ENGAGEMENTS:** Theresponsibility of an engagement partner in this regard in an audit engagement is on lines of SQC 1 which requires the firm should obtain such information as it considers necessary in the circumstances before accepting an engagement with a new client, when deciding whether to continue an existing engagement, and when considering acceptance of a new engagement with an existing client.