• 20 Marks

AA – May 2023 – L2 – SA – Q4 – Ethical Issues in Auditing

Identify threats to auditor independence, assess circumstances affecting independence, and suggest safeguards.

Cringe Professional Services has been auditing Kogberegbe Limited for about 20 years. Being a limited liability company, no regulation imposed restriction on the tenure of the auditors.

The firm also provides taxation and valuation services for the company. The company has just adopted International Financial Reporting Standards and has employed the services of Cringe Professional Services for conversion services from local GAAP. The firm experienced a high staff turnover in the year and has no choice but to include the daughter of the Managing Director of the company as part of the engagement team, although as a support staff.

Management has indicated in confidence that the audit fee for the year will not be increased, except the firm can guarantee them that no adverse management letter will be issued and no loss will be made by the company as they are planning to go to the capital market to raise capital for expansion. With poor management letter and loss position, they believe that it will be difficult to achieve this.

At the end of the audit exercise, the company made a huge profit even with unfavorable economic climate, thanks to challenges associated with COVID-19. There was public outcry because it was believed that the financial statements of the company were misstated, and the auditor was accused of negligence. This necessitated the Financial Reporting Council to conduct an investigation on the company. It was found that the company restructured its debt portfolio, which was denominated in foreign currency with attendant foreign exchange risks to Naira.

The company restructured a huge intercompany loan to a 7-year principal payment holiday with principal repayment commencing September 30, 2025. The interest on the loan for the period was not brought into the books of account.

The company accrued for a NGN70.60m benefit from a transaction in 2019 from operating fees. This has been treated as income in the financial statements.

There were identified defaults by the company in relation to the payment of interests and principal on its outstanding loans and borrowings.

There were adverse ratios in the company’s financial performance ratios in the year due to interest on borrowings from financial institutions and related parties.

A revisit of the operating performance for the year revealed the following:

  • The entity made an operating loss of N1.22 billion.
  • It generated negative operating cashflows of N2.15 billion.
  • There was positive working capital as the current assets exceeded the current liabilities by N1.2 billion in the year.
  • The net assets position of the company was in the negative as the total liabilities exceeded the total assets by N9.8 billion.

The Financial Reporting Council concluded that there were threats to the auditors’ independence, hence the professional firm was penalized for that.

A concerned staff of the company asks you of the implications of the issues raised by the Financial Reporting Council.

Required:

a. Identify and explain the threats to independence of the auditor in the above scenario. (7 Marks)

b. Discuss circumstances that could give rise to threats to independence. (7 Marks)

c. Suggest appropriate safeguards which could be put in place to mitigate the identified threats. (6 Marks)

a. Threats to Auditor Independence:

  • Familiarity Threat: The long-standing relationship (20 years) with Kogberegbe Limited, which could impair objectivity.
  • Self-Review Threat: Arising from additional non-audit services provided, such as taxation, valuation, and IFRS conversion, potentially influencing the audit findings.
  • Intimidation Threat: Management’s suggestion of withholding fee increase unless favorable audit outcomes are guaranteed.
  • Self-Interest Threat: Involving the engagement team member’s relationship with company management (Managing Director’s daughter).
  • Advocacy Threat: The auditor’s role in aiding the company’s transition to IFRS, which might make the firm an advocate for the client’s financial reporting.

b. Circumstances Affecting Independence:

  • Fee Dependence: High reliance on fees from one client may risk auditor impartiality.
  • Provision of Non-Audit Services: Offering multiple services that impact financial statement preparation, introducing potential bias.
  • Personal Relationships: Including relatives of client management within the audit team, risking impartiality.
  • Prolonged Engagement: Long-term engagement without rotation increases the familiarity threat.
  • Management Pressure: Conditional or incentivized fees could sway the auditor’s objectivity and professional judgment.

c. Safeguards to Mitigate Threats:

  • Rotation of Senior Audit Team Members: Reduces familiarity threat by periodically changing personnel.
  • Independent Review Partner: Engaging a separate partner for audit review to ensure objectivity.
  • Segregation of Audit and Non-Audit Teams: Assign different teams to handle non-audit services, reducing self-review risk.
  • Limiting Scope of Non-Audit Services: Avoid providing advisory services that directly influence financial statement elements.
  • Monitoring Fee Levels: Periodically review and document fee structures to ensure fair compensation without dependency risks.
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