Assignment Question You are an audit manager with Clarke & Johnson (CJI). For the past years CJ has been the auditor of luxury Travel Holidays LTD (LTH), a travel company. Geoff, the audit partner, has asked you the to contact Chris, LTH’s CEO, with a view to CJ being re-engaged as the auditor for the upcoming audit. Geoff has also indicated that intends to allocate Michael, a first-year accountant, and Annette, an accountant in CJ’s tax advisory department, to the LTH audit for the first time. Geoff suggested that you discuss the audit with each of these staff, with a view to identifying any independence issues. You held talks with Chris, Michael and Annette of these conversations were as follows: 1. Conversation with Chris, situation 1 Chris stated: ‘The board of directors were impressed with last year’s audit and would like to propose reappointing CJ as the auditor of the 30 June 2015 financial report audit. The board would also like to invite Geoff to give a speech about LTH at the next travel agency seminar, to assist in promoting LTH’s business to attract more investors. I understand that this is outside CJ’s normal practice; however, the board expressed the view that it will be very difficult for LTH to continue any business engagements with CJ should Geoff refuse to provide such assistance’. 2. Conversation with Chris, situation 2 Chris stated: ‘ To express our sincerity towards CJ and Geoff, and to maintain the good relationship in anticipation of another smooth audit for 2015, LTH would like to present a complimentary 14-day holiday package voucher for four people to the Greek isles for both Geoff’s and your family. All expenses, including accommodation and travelling cost, will be paid by LTH’. 3. Conversation with Michael Michael stated: ‘I am very excited to be part of the audit team. I believe that I will be a valuable asset to the team, as my dad is LTH’s financial controller. He is responsible for the preparation of LTH’s financial report.’ 4. Conversation with Annette Annette stated: ‘I am glad that I have been allocated to this year’s LTH’s audit team. It’s going to be a very efficient audit this year! I was on a temporary assignment at LTH’s just a month ago, helping LTH with its tax calculations and preparing accounting entries that will be reflected in the 30 June 2015 financial report, so I don’t think there will be much audit work required
Independence of auditors
To be independent, it requires the auditors to carry on their audit job in compliance with true and fair view and as per their past experience and level of expertise knowledge. To comply with the true and fair aspect, the auditor shall perform the audit in accordance with the code of ethics and the required guidance of auditing standards. The term independence with regard to the auditor states the independency of the internal as well as the external auditor from the users of financial statements, interested parties and the management and executives of the organization who may have considerable influence on the financial statement of the organization that is under audit (Porter, Simon and Hatherly 2014). While carrying out the audit, the auditors shall apply the objectivity and integrity approach. The main objective of the audit is to present the financial statement of the organization with transparency and reasonable assurance that the reports are free from any error, fraud and misstatement. The independency of the internal auditors is exposed to threat from the internal interested parties like shareholders, managers and directors whereas the external auditor is exposed to threat from the external parties like lender, debtors and creditors (Austin and Herath 2014).
(a) Associated threat with the auditor’s independence
Apart from the services that are regarded as the regular service under audit, if the auditors provides any other additional services like management consulting, tax consultant, or business promotion are stated as the non-audit services (NAS). However, when the auditor takes up the job of promoting the business of the client, the independency of the auditor is exposed to the Advocacy threat. The non-audit service, if offered by the auditor, it will have a great impact on the judgemental and independency approach of the auditor. Moreover, the independency issue is exceptionally significant as it is frequently questioned by the creditors, lenders, shareholders, government and different other users of the annual reports. Thus, the audit while auditing, must give his conclusion in view of the best knowledge accessible to him and with genuine and reasonable approach (Causholli, Chambers and Payne 2015). In the given conditions, the CJ, the audit firm, was approached by the customer LTH to give a speech in favour of the company in the seminar of travel agency in exchange of their appointment as auditor of LTH. To keep up their independency, CJ shall not acknowledge the offer or it will undermine their independency as promotion of client’s business falls under the category of NAS, which in turn, will endanger their independency.
The auditor is not supposed to accept any monetary or non-monetary benefits from the client apart from the prescribed fees that has been agreed under the audit engagement letter. This rule has been prescribed to keep the auditor free from the controversies that may arise upon his judgement and performance. The auditor shall therefore, give his opinion on the internal control, financial reports or any other aspects of the organization as per his knowledge and experience and the opinion must be free from error, fraud or misstatement (Fung, Zhou and Zhu 2016). In the given circumstance, the client LTH said that if the audit is carried out smoothly during 2015, then they shall provide the audit partner of CJ, Mr Geoff and his family with a complementary holiday package. If the given offer is accepted by Mr Geoff, it will increase the Self-interest threat as the auditor is expected receive additional benefit apart from the audit fees. Further, the auditor shall keep himself from such situation where the question may raise about his integrity and independency. Thus, Mr. Geoff shall not accept the offer provided by the client LTH.
In the occasion where any other partner of the audit firm or close relative of the auditor is in the control of financial affair or connected with direct possession through shareholding, he should keep himself down from giving any judgment on the finance related report of the organization. The close relatives here mean the life partner, parents, non-dependent or dependent siblings or child. The financial matters additionally covers giving recommendations for the capital arrangement of the customer, giving certification for the customer's obligation or any borrowings and settling on any decisions associated with finance in the interest of the client (Hay, Knechel and Willekens 2014). In the present situation, Michel, who is supposed to be auditor of LTH under the audit firm CJ, is expected to be precious for the audit team as his father was the financial controller of the client. If the Michel is appointed as the auditor of CJ for carrying out the audit of LTH, the independency of the auditor as well as the audit firm CJ will be under threat. Therefore, Michel shall not accept the offer of appointment.
If the auditor is in a position that he has prior knowledge regarding the financial status of the company under audit, it increases the Familiarity threatas the auditor will not be able to behave professionally in such circumstances. Moreover, if the auditor was previously engaged in the client’s organization to handle any post other than that of auditor, it will create the Self-review threat as the auditor is not supposed to review his own work under any circumstance (Rahmina and Agoes 2014). In the given case study, Annette, who was offered to undertake the audit of LTH, was in the service of the organization to calculate their tax and prepare the accounts just a month back. In such circumstance, it is probable that she is already aware about the weakness and strength of the organization and will carry out her job loosely. Further, auditing of own work are supposed to be manipulated which in turn will have a great impact on integrity and independency. Therefore, Annette shall not be appointed by CJ to carry out the audit of LTH.
(b) Safeguard from the threat of auditor’s independency
To protect himself against the threat of independence, the auditor shall comply with some rules and regulations and must carry out his job as per the standards. Various measures that can be applied to maintain the independency of auditor are as follows:
Management threat - The threat from management arises when the undertaken audit work involves making decisions and judgements that are actually the management’s responsibility. Therefore, the auditor shall keep himself away from making any decisions that are not covered under the audit engagement and that will be considered as non-audit services (Krishnan and Wang 2014).
Modifying the process of selection – Generally the auditors are appointed by management if the organization and further approved by the stakeholders that make the auditor more liable to the stakeholders as compared to the management. However, the auditors are supposed to represent the shareholders, therefore, if they are able to nominate, reappoint and appoint the auditors directly, it will increase the independency level of the auditor (Tepalagul, Nopmanee and Ling Lin 2015).
Better disclosure procedures - The disclosures of the organization shall be mandatory for disclosing the fees that are paid to the external auditor. Further, the fees shall be segregated under audit fees and non-audit fees. It will enable the potential investors and the shareholders of the organization to assess the independency level of the auditors (Yoon et al. 2015).
Corporate governance – If the client firm adopts better corporate governance then it will assist to increase the independence level of the auditor through minimising the conflicts between the management and the auditor (Abbott and Lawrence 2016).
(a) Business risks involved in equipment and spare-parts purchase
Through identification of the organizational system, business environment and the system of internal control, the auditor shall evaluate and recognize the risks associated with the material misstatement of the financial report. The main objective of the audit is to present the financial report of the client to the users that are transparent and free from any error and fraud. In this procedure, the auditor must follow the below mentioned activities:
Recognize the risk and evaluate the impact of those risks on financial information.
Analysing the probability of the material misstatement and its impact that can lead to the potential fraud or error related to the financial statement
Evaluate the overall risks of the organization under audit to get the comprehensive idea of the class of transactions, accounting approach used, disclosures policies and the environment of the business.
Risks associated with the equipment and spare-parts purchase and inventory that shall be taken into consideration by Crampton and Hassad at the time of audit plan are as follows:
Strategic risk – This risks focus on the about the danger of handling the inventories and is related with the arrangement of stock supervision. There are generally two choices, the first alternative is to trade the accessible stock with another item and for this situation they won't need to consider any regulation of the management. The second choice is to deal with the inventories as per the regulation of handling the inventories (Lam 2014). The option selection solely depends on the approach of the organization and the associated profit or loss with the inventories. If the organization is able to handle the risk then they shall choose the 1st alternative otherwise they shall go for the 2nd alternative.
Operational risk – This risk includes the execution of different approaches. It is related with the usage of any methodology that is set-up for execution. For example, the organization may set up a few approaches for the management of inventories, however, at the later stage it may be found out that all the approaches cannot be actually implemented at the anticipated level. The purpose behind this might be the management is not taking bothered about the implementation or there are some innate shortcomings in the approaches itself (Brigham and Ehrhardt 2013). For the equipment and spare-parts inventory management, assessing the risk will assist in evaluating the suitable measures for supervising the inventories properly.
(b) Audit risk categories and its impact on the account balance
Strategic risk – it takes place if the auditor is not able to take the proper internal control approach or fails to develop any approach and this risk is associated with the application risk. The amount of risk is directly correlated with the involvement of the amount. The financial statement is exposed to the application risk on a higher level (Olson and Wu 2015). The account balances that are generally affected by the strategic risk are the gross profit balance, net profit balance, beginning and ending balance of inventories.
Operational risk – this risk talks about the risk that the auditor will fail to detect the inherent material misstatement regarding the financial statement and are connected with the detection risk. It caused due to the loopholes in the performance of audit (Heizer 2016). It greatly impact the transactions related to inventories, purchases, sales, revenue and beginning as well as ending stock.
Abbott, Lawrence J. 2016. "Internal audit quality and financial reporting quality: The joint importance of independence and competence." Journal of Accounting Research 54: 3-40.
Austin, E. and Herath, S.K., 2014. Auditor independence: a review of literature. International Journal of Economics and Accounting, 5(1), pp.62-74.
Brigham, E.F. and Ehrhardt, M.C., 2013. Financial management: Theory & practice. Cengage Learning.
Causholli, M., Chambers, D.J. and Payne, J.L., 2015. Does Selling Non-Audit Services Impair Auditor Independence? New Research Says,“Yes”. Current Issues in Auditing, 9(2), pp.P1-P6.
Fung, S.Y.K., Zhou, G.S. and Zhu, X.K., 2016. Monitor objectivity with important clients: Evidence from auditor opinions around the world. Journal of international business studies, 47(3), pp.263-294.
Hay, D., Knechel, W.R. and Willekens, M., 2014. The Routledge Companion to Auditing. Routledge.
Heizer, J., 2016. Operations Management, 11/e. Pearson Education India.
Krishnan, G.V. and Wang, C., 2014. The relation between managerial ability and audit fees and going concern opinions. Auditing: A Journal of Practice & Theory, 34(3), pp.139-160.
Lam, J., 2014. Enterprise risk management: from incentives to controls. John Wiley & Sons.
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Rahmina, L.Y. and Agoes, S., 2014. Influence of auditor independence, audit tenure, and audit fee on audit quality of members of capital market accountant forum in Indonesia. Procedia-Social and Behavioral Sciences, 164, pp.324-331.
Tepalagul, Nopmanee, and Ling Lin. 2015. "Auditor independence and audit quality: A literature review." Journal of Accounting, Auditing & Finance 30.1: 101-121.
Yoon, Kyunghee, Lucas Hoogduin, and Li Zhang. 2015. "Big data as complementary audit evidence." Accounting Horizons 29.2: 431-438.
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