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Chapter 3

Ethics, Independence and Corporate Governance

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The Nature and Importance of Professional Ethics

• Ethics:– Concerned with the requirements for the general well-

being, prosperity, health and happiness of people.– Requires knowledge of moral principles, and skills in

applying them to problems and decisions.

Learning Objective 1:

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Ethical rules

• The establishment of ethical codes and disciplinary rules does not necessarily create an ethical culture or ensure the moral integrity of employees.

• A.1 of the Joint Code of Professional Conduct (CPC) of ICAA and CPA Australia (from 1 July 2006 reference is to Section A of APES 110 “Code of Ethics for Profession Accountants” issued by the Accounting Professional and Ethical Standards Board - APESB) indicates that members are expected to comply with the spirit as well as the letter of the rules.

• Failure to observe expected standards can result in disciplinary procedures and sanctions.

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Ethical Theory

• Teleological ethics – deals with consequences or outcomes of actions

– generally, if benefits of proposed action outweighs costs, the decision is morally correct.

• Deontological ethics – based on duties and rights– duties and rights set down in rules which must be

followed.

• Virtue ethics – focus on personal qualities, such as the integrity of the decision-maker.

Learning Objective 2:

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Accounting Bodies’ Code of Ethics

• Joint CPC (APES 110) sets out main ethical pronouncements that relate to the undertaking of an audit.

• AUS 202 (ISA 200) requires that auditors comply with ethical rules.

• Joint CPC consists of six sections, including:– Section B: Fundamental Principles of Professional

Conduct;– Section F: Professional Statements, including F1

Professional Independence, and F7 Incompatible Business

(APES 110 covers similar issues to the CPC, but in a different structure)

Learning Objective 3:

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Purpose of the code of ethics

• Code of Ethics — formal, systematic statement of rules and principles developed by the community to promote its well-being and punish undermining behaviour.

• The code therefore:– makes explicit the values implicitly required;– indicates how members should act toward one another;– provides basis for sanctions.

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CPC Section B (APES 110Section 100): Fundamental Principles

Eight fundamental principles contained in the codes of ethics:

1. Public interest

2. Integrity

3. Objectivity

4. Independence

5. Confidentiality

6. Compliance with technical and professional standards

7. Professional competence and due care

8. Ethical behaviour

(Part A of APES 110 includes integrity, objectivity, professional competence and due care, confidentiality and professional behaviour).

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Applying Ethics

• Sound ethical decision making is dependent on:– knowledge of the basic principles on which moral values

and rules are based; – competence in decision making; and– the ability to choose appropriate policies and decision

procedures in different situations.

Learning Objective 4:

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Ethical decision models

• Three main models:– American Accounting Association Model– Mary Guy Model– Laura Nash Model.

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Corporate Governance

• Corporate Governance — system by which companies are directed and controlled. Concerned primarily with management and stewardship issues including:

– corporate strategy– succession planning– integrity of internal control structure and– remuneration policy.

Learning Objective 5:

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Parties in corporate governance

• Board of directors• Management• Auditors

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Groups advocating improved corporate governance

• The business community• Investors• Australian Stock Exchange (ASX)• Australian Securities and Investments Commission

(ASIC)• CPA Australia and Institute of Chartered Accountants

Australia (ICAA)

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ASX Corporate Governance Council’s Principles of Good Corporate Governance

• Principle 1: Lay solid foundation for management and oversight;

• Principle 2: Structure the board to add value;• Principle 3: Promote ethical and responsible decision

making;• Principle 4: Safeguard integrity in financial

reporting;• Principle 5: Make timely and balanced disclosure.

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ASX Corporate Governance Council’s Principles of Good Corporate Governance (Cont.)

• Principle 6: Respect the rights of shareholders;• Principle 7: Recognise and manage risks;• Principle 8: Encourage enhanced performance;• Principle 9: Remunerate fairly and responsibly; and• Principle 10: Recognise the legitimate interests of

stakeholders.

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Audit committees

• Sub-committee of board of directors, which should consist mainly of non-executive directors;

• Auditor’s major dealings with the board of directors are normally through this sub-committee;

• Important component of corporate governance, with most listed companies in Australia having an audit committee;

• Top 500 companies on ASX now required to have an audit committee.

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Functions of audit committees

• Assist the board of directors;• Add to credibility and objectivity of financial reports;• Enhance auditor independence and effectiveness;• Consider appropriateness of accounting policies;• Consider policies for unethical or illegal activities;• Consider internal and management controls; and• Communication link between management, board and

auditors.

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Whistleblowing in Australia

• s. 311 of the Corporations Act imposes a responsibility on auditors to inform the ASIC of any significant contraventions of the Act discovered in the normal course of their duties, and any other contraventions which cannot be remedied by comment in the audit report or by bringing the matter to the attention of directors. Arguably, this places an obligation on the auditor to whistleblow.

Learning Objective 6:

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Whistleblowing defined

• A person ‘who discloses information he (or she) reasonably believes evidences a violation of any law, rule, or regulation, or mismanagement, a gross waste of public funds, an abuse of authority, or a substantial or specific danger to public health or safety’ is a whistleblower.’

• United States Civil Service Reform Act of 1978

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Auditor’s responsibilities regarding whistleblowing

• Auditor does not have to actively look for contraventions of the Corporations Act;

• Decision to blow the whistle is not easy for an auditor;• AUS 210/ASA 240 (ISA 240) also provide guidance.

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The Importance of Audit Independence

• Independence is a very key characteristic of an audit or assurance service provider;

• In order that auditors can add credibility to financial report or other subject matter, they needs to remain independent;

• One of the eight fundamental ethical requirements of CPC (APES 110); and

• Test for independence is a reasonable person test – would a reasonable person having access to all facts consider that the auditor was independent?

Learning Objective 7:

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Independence – Corporations Act 2001

• s 307C – Independence declaration. – Auditors must give directors a written declaration of their

independence, and this is to be included in the directors’ report.

• s 324CA – Conflict of interest. – Auditor must take reasonable steps to ensure conflict of

interest situation ceases to exist. Conflict of interest is where members of audit team are not capable of exercising objective and impartial judgment, as judged by a reasonable person.

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Independence – Corporations Act 2001 (Cont.)

• s 300 (1)(ca) - former auditors. Directors report is to include names of each officer of client who was a former partner or director of current auditor.

• s 324CI - member of audit firm cannot become director, company secretary or senior management of a client until two years after ceasing to be with audit firm.

• s 324DA - rotation of audit partners. Lead or review partner for five successive years cannot play a significant role in the audit of that entity for at least another two successive years.

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Independence – Corporations Act 2001 (Cont.)

• s 300(11)(B) - non audit services. Boards of all listed companies are required to provide a statement in their annual report identifying all non-audit services provided by an audit firm, fee, and explanation why provision of service did not impair independence.

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Auditor’s appointment

• S 327B - shareholders are responsible for the appointment of auditor:

– Auditor is in breach of independence requirements if, while auditing at a time that a s 324CH(1) relationship exists, auditor is aware of relationship and does not take all reasonable steps to discontinue audit.

• S 324CH(1) relationships include:– Auditor or immediate family member being an officer or audit-

critical member (influencing financial report) of client– Auditor cannot provide remuneration to officer or audit-critical

employee for acting as consultant– Auditor cannot have an investment in client– Auditor cannot owe more than $5,000 to a client (unless a

housing loan on normal terms).

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Auditors removal and resignation

• Removal – Difficult to remove auditor.• S 329 – Requires a resolution of company at a general

meeting of which special notice is given. Auditor entitled to make written representation and speak at general meeting. A copy of notice must be sent to ASIC.

• Resignation – Auditor can resign. Must have written consent from ASIC. Application outlines reason, and ASIC must approve the reason. Designed to ensure independence and integrity of audit function is maintained.

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Right of access to records and reasonable fees

• Section 310 provides further protection to the auditor by giving the right of access at all reasonable times to the accounting and other records and registers, and an entitlement to require from any officer of the company such information and explanations as required for the purposes of audit.

• Section 331 states that the auditor is entitled to receive reasonable fees and expenses for the work carried out.

• Collectively, these provisions assist an auditor to maintain actual and perceived independence, and attempt to create, as far as possible a suitable environment for an audit process that is free from undue influence and obstruction.

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Independence – ethical requirements

Emphasises both:– perceived independence – how others will view the

auditor; and– actual independence – state of mind of the auditor.

Whether the auditor can actually eliminate bias and personal interest from their decisions, and not succumb to any pressures or influences.

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Recent Developments in Auditor Independence

• Ramsay Report (Aust) – issued October 2001• IFAC independence rules – adopted in Australia in CPC

F.1 – 2002.• Sarbanes-Oxley Act (USA) – 2002.• Joint Committee of Public Accounts and Auditors

(Australia) – 2002• HIH Royal Commission – 2003• Corporate Law Economic Reform Program (CLERP 9)

(Australia) – 2002-4.

Learning Objective 8:

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CPC F1/ APES 110 Section 290: Threats to Independence

• Self-interest threats – auditor could benefit from a financial interest in the client.

• Self-review threats – auditor could have to re-evaluate their own work.

• Advocacy threats – auditor could promote the audit client’s point of view and compromise objectivity.

• Familiarity threats – auditor may become too sympathetic to the client’s interests.

• Intimidation threats –auditor may be deterred from acting objectively by actual or perceived threats from client.

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CPC F1 /APES 110 Section 290: Safeguards

Safeguards fall into three broad categories. For an auditor these are:

– Safeguards created by the profession, legislation or regulation – education, professional standards, monitoring and disciplinary processes, and inspections and reviews.

– Safeguards within the audit client – competent employees, corporate governance structures.

– Safeguards within the audit firm – quality control, policies and procedures.

– The safeguards are aimed at reducing or resolving circumstances that pose threats.

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Major Threats to Auditor Independence

• Auditor employment relationships• Financial and business relationships• Provision of non-audit services, including:

– preparing financial reports– taxation– internal audit– design of systems– legal services– corporate finance

• These threats are major reasons for recent changes to legislation

Learning Objective 9:

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Suggestions for Improving Auditor Independence

• Establishment of a Public Oversight Board, to reduce the perception of auditors setting standards for their own profession;

• In Australia, the FRC now acts as a Public Oversight Board;

• Strengthening the role of audit committee;• Rotation of audit partners and audit firms;• Audit firm independence boards;• Client policies, such as restricting other services

provided by audit firm.

Learning Objective 10:

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Fee Determination

• Audit fees should be commensurate with service provided. Thus, should reflect time taken to audit, and knowledge, skills and expertise required.

• Auditor should not enter into fee arrangements that may compromise independence.

• Fees for a period should not be dependent on fees from provision of future audits or other services.

Learning Objective 11:

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Obtaining clients

• Advertising, publicity and solicitation are permitted provided they are not false, misleading, deceptive or otherwise reflect adversely on the profession.

• Competing for prospective clients through tenders is now quite common.

• Auditors should be careful of audit clients that are opinion shopping.