Posted on April 9, 2021April 12, 2021 by MJ — Leave a comment

(ESRA) APB Ethical Standard for Reporting Accountants

INTRODUCTION

1.1 APB Ethical Standards for Auditors require an auditor to be independent from the entity that it is appointed to audit. There is a substantial degree of similarity between an audit opinion and the nature of assurance provided by accountants reporting for the purposes of an investment circular prepared in accordance with the statutory or regulatory requirements of a recognised stock exchange. Accordingly, the Auditing Practices Board (APB) believes that users of investment circulars will expect an equivalent standard of independence of reporting accountants to that required of auditors.

1.2 This standard is based on the APB Ethical Standards for Auditors and applies to all engagements:

that are subject to the requirements of the Standards for Investment Reporting (SIRs) issued by the APB, and
which are in connection with an investment circular in which a report from the reporting accountant is to be published.

This standard applies to all public reporting engagements undertaken in accordance with the SIRs. It also applies to all private reporting engagements that are directly linked to such public reporting engagements.

Where a private reporting engagement is undertaken, but it is not intended that the reporting accountant will issue a public report, the reporting accountant follows the ethical guidance issued by the professional accountancy body of which the reporting accountant is a member. The APB is not aware of any significant instances where the relevant parts of the ethical guidance issued by professional accountancy bodies in the UK and Ireland are more restrictive than this standard.

An investment circular is a document issued by an entity pursuant to statutory or regulatory requirements relating to securities on which it is intended that a third party should make an investment decision, including a prospectus, listing particulars, a circular to shareholders or similar document.

Public confidence in the operation of the capital markets and in the conduct of public interest entities depends, in part, upon the credibility of the opinions and reports issued by reporting accountants in connection with investment circulars. Such credibility depends on beliefs concerning the integrity, objectivity and independence of reporting accountants and the quality of work they perform. The APB establishes quality control, investment reporting¹ and ethical standards to provide a framework for the practice of reporting accountants.

Reporting Accountants should conduct an investment circular reporting engagement with integrity, objectivity and independence.

Integrity

1.7 Integrity is a prerequisite for all those who act in the public interest. It is essential that reporting accountants act, and are seen to act, with integrity, which requires not only honesty but a broad range of related qualities such as fairness, candour, courage, intellectual honesty and confidentiality.

1.8 It is important that the directors and management of an engagement client can rely on the reporting accountant to treat the information obtained during an engagement as confidential, unless they have authorised its disclosure, it is already known to third parties or the reporting accountant has a legal right or duty to disclose it. Without this, there is a danger that the directors and management will fail to disclose such information to the reporting accountant and that the outcome of the engagement will thereby be impaired.

Objectivity

1.9 Objectivity is a state of mind that excludes bias, prejudice and compromise and that gives fair and impartial consideration to all matters that are relevant to the task in hand, disregarding those that are not. Objectivity requires that the reporting accountant’s judgment is not affected by conflicts of interests. Like integrity, objectivity is a fundamental ethical principle.

1.10 The need for reporting accountants to be objective arises from the fact that the important issues involved in an engagement are likely to relate to questions of judgment rather than to questions of fact. For example, in relation to historical financial information included in an investment circular directors have to form a view as to whether it is necessary to make adjustments to previously published financial statements. If the directors, whether deliberately or inadvertently, make a biased judgment or an otherwise inappropriate decision, the financial information may be misstated or misleading.

1.11 It is against this background that reporting accountants are engaged to undertake an investment circular reporting engagement. The reporting accountant’s objectivity requires that it expresses an impartial opinion in the light of all the available information and its professional judgment. Objectivity also requires that the reporting accountant adopts a rigorous

¹ SIR 1000 paragraph 18 states ‘In the conduct of an engagement involving an investment circular, the reporting accountant should comply with the applicable ethical standards issued by the Auditing Practices Board’.

and robust approach and is prepared to disagree, where necessary, with the directors’ judgments.

Independence

1.12 Independence is freedom from situations and relationships which make it probable that a reasonable and informed third party would conclude that objectivity either is impaired or could be impaired. Independence is related to and underpins objectivity. However, whereas objectivity is a personal behavioural characteristic concerning the reporting accountant’s state of mind, independence relates to the circumstances surrounding the engagement, including the financial, employment, business and personal relationships between the reporting accountant and its engagement client and other parties who are connected with the investment circular.

1.13 The need for independence arises because, in most cases, users of the financial information and other third parties do not have all the information necessary to assess whether reporting accountants are, in fact, objective. Although reporting accountants themselves may be satisfied that their objectivity is not impaired by a particular situation, a third party may reach a different conclusion. For example, if a third party were aware that the reporting accountant had certain financial, employment, business or personal relationships with the engagement client, that individual might reasonably conclude that the reporting accountant could be subject to undue influence from the engagement client or would not be impartial or unbiased. Public confidence in the reporting accountant’s objectivity could therefore suffer as a result of this perception, irrespective of whether there is any actual impairment.

1.14 Accordingly, in evaluating the likely consequences of such situations and relationships, the test to be applied is not whether the reporting accountant considers that its objectivity is impaired but whether it is probable that a reasonable and informed third party would conclude

that the reporting accountant’s objectivity either is impaired or is likely to be impaired. There are inherent threats to the level of independence (both actual and perceived) that the reporting accountant can achieve as a result of the influence that the board of directors and management have over its appointment and remuneration. The reporting accountant considers the application of safeguards where there are threats to their independence (both actual and perceived).

COMPLIANCE WITH ETHICAL STANDARDS

1.15 The reporting accountant should establish policies and procedures, appropriately documented and communicated, designed to ensure that, in relation to each investment circular reporting engagement, the firm, and all those who are in a position directly to influence the conduct and outcome of the investment circular reporting engagement, act with integrity, objectivity and independence.

1.16 For the purposes of the APB Ethical Standard for Reporting Accountants, a person in a position directly to influence the conduct and outcome of the investment circular reporting engagement is:

any person within the firm who is directly involved in the investment circular reporting engagement (‘the engagement team’), including:
- the partners, managers and staff from assurance and other disciplines involved in the engagement (for example, taxation specialists, IT specialists, treasury management specialists, lawyers, actuaries);^[1]
- those who provide quality control or direct oversight of the engagement;
any person within the firm who can directly influence the conduct and outcome of the investment circular reporting engagement through the provision of direct supervisory, management or other oversight of the engagement team in the context of the investment circular reporting engagement.

1.17 Because investment circulars may relate to transactions that are price sensitive and therefore confidential, the fact that a firm has been engaged to undertake an investment circular reporting engagement is likely to be known by only a limited number of individuals within the firm. For this reason, the requirements of this standard apply only to:

individuals within the engagement team and those with a direct supervisory, management or other oversight responsibility for the engagement team who have actual knowledge of the investment circular reporting engagement; and
where required by this Standard, the firm.

Compliance with the requirements regarding the reporting accountant’s integrity, objectivity and independence is a responsibility of both the firm and of individual partners and professional staff. The firm establishes

[1] Where external consultants are engaged by the reporting accountant and involved in the engagement, the reporting accountant should evaluate the objectivity of the expert in accordance with paragraphs 2.53 to 2.55 of this Standard.

policies and procedures, appropriate to the size and nature of the firm, to promote and monitor compliance with those requirements by any person who is in a position directly to influence the conduct and outcome of the investment circular reporting engagement.^[1]

The leadership of the firm should take responsibility for establishing a control environment within the firm that places adherence to ethical principles and compliance with the APB Ethical Standard for Reporting Accountants above commercial considerations.

The leadership of the firm influences the internal culture of the organisation by its actions and by its example (‘the tone at the top’). Achieving a robust control environment requires that the leadership gives clear, consistent and frequent messages, backed up by appropriate actions, which emphasise the importance of compliance with the APB Ethical Standard for Reporting Accountants.

In order to promote a strong control environment, the firm establishes policies and procedures (including the maintenance of appropriate records) that include:

reporting by partners and staff as required by the APB Ethical Standard for Reporting Accountants of particular circumstances including:
- family and other personal relationships involving an engagement client of the firm;
- financial interests in an engagement client of the firm; and
- decisions to join an engagement client;

[1] Monitoring of compliance with ethical requirements will often be performed as part of a broader quality control process. ISQC (UK & Ireland) 1 ‘Quality Control for firms that perform audits and reviews of historical financial information and other assurance and related services engagements’ establishes the basic principles and essential procedures in relation to a firm’s responsibilities for its system of quality control for engagements in connection with an investment circular.

monitoring of compliance with the firm’s policies and procedures relating to integrity, objectivity and independence. Such monitoring procedures include, on a test basis, periodic review of the engagement partners’ documentation of their consideration of the reporting accountant’s objectivity and independence, addressing, for example:
- financial interests in engagement clients;
- contingent fee arrangements;
- economic dependence on clients;
- the performance of other service engagements for the engagement client;
a mechanism for prompt communication of possible or actual breaches of the firm’s policies and procedures to the relevant engagement partners;
evaluation by engagement partners of the implications of any identified possible or actual breaches of the firm’s policies and procedures that are reported to them;
prohibiting members of the engagement team from making, or assuming responsibility for, management decisions for the engagement client;
operation of an enforcement mechanism to promote compliance with policies and procedures; and
empowerment of staff to communicate to senior levels within the firm any issue of objectivity or independence that concerns them; this includes establishing clear communication channels open to staff, encouraging staff to use these channels and ensuring that staff who use these channels are not subject to disciplinary proceedings as a result.

1.22 Save where the circumstances contemplated in paragraph 1.24 apply, the firm should designate a partner in the firm (‘the ethics partner’^[1]) as having responsibility for:

the adequacy of the firm’s policies and procedures relating to integrity, objectivity and independence, their compliance with the APB Ethical Standard for Reporting Accountants, and the effectiveness of their communication to partners and staff within the firm; and
providing related guidance to individual partners.

In assessing the effectiveness of the firm’s communication of its policies and procedures relating to integrity, objectivity and independence, ethics partners consider whether these matters are properly covered in induction programmes, professional training and continuing professional development for all partners and staff with direct involvement in investment circular reporting engagements. Ethics partners also provide guidance on matters referred to them and on matters which they otherwise become aware of, where a difficult and objective judgment needs to be made or a consistent position reached.

In firms with three or less partners, it may not be practicable for an ethics partner to be designated. In these circumstances all partners will regularly discuss ethical issues amongst themselves, so ensuring that they act in a consistent manner and observe the principles set out in the APB Ethical Standard for Reporting Accountants. In the case of a sole practitioner, advice on matters where a difficult and objective judgment needs to be made is obtained through the ethics helpline of their professional body, or through discussion with a practitioner from another firm. In all cases, it is important that such discussions are documented.

[1] This individual may be the same person who is designated as the ethics partner for the purposes of the APB Ethical Standards for Auditors.

To be able to discharge his or her responsibilities, the ethics partner is an individual possessing seniority, relevant experience and authority within the firm and is provided with sufficient staff support and other resources, commensurate with the size of the firm. Alternative arrangements are established to allow for:

the provision of guidance on those engagements where the ethics partner is the engagement partner; and
situations where the ethics partner is unavailable, for example due to illness or holidays.

Whenever a possible or actual breach of the APB Ethical Standard for Reporting Accountants, or of policies and procedures established pursuant to the requirements of the APB Ethical Standard for Reporting Accountants, is identified, the engagement partner, in the first instance, and the ethics partner, where appropriate, assesses the implications of the breach, determines whether there are safeguards that can be put in place or other actions that can be taken to address any potential adverse consequences and considers whether there is a need to withdraw from the investment circular reporting engagement.

An inadvertent violation of this Standard does not necessarily call into question the firm’s ability to undertake an investment circular reporting engagement, provided that:

the firm has established policies and procedures that require all partners and staff to report any breach promptly to the engagement partner or to the ethics partner, as appropriate;
the engagement partner or ethics partner promptly notifies the relevant partner or member of staff that any matter which has given rise to a breach is to be addressed as soon as possible and ensures that such action is taken;
safeguards, where appropriate, are applied, (for example, having another partner review the work done by the relevant partner or member of staff or removing him or her from the engagement team); and
the actions taken and the rationale for them are documented.

IDENTIFICATION AND ASSESSMENT OF THREATS

1.28 Reporting accountants identify and assess the circumstances, which could adversely affect their objectivity (‘threats’), including any perceived loss of independence, and apply procedures (‘safeguards’), which will either:

eliminate the threat (for example, by eliminating the circumstances, such as removing an individual from the engagement team or disposing of a financial interest in the engagement client); or
reduce the threat to an acceptable level; that is a level at which it is not probable that a reasonable and informed third party would conclude that the reporting accountant’s objectivity is impaired or is likely to be impaired (for example, by having the work reviewed by another partner or by another firm).

When considering safeguards, where the engagement partner chooses to reduce rather than to eliminate a threat to objectivity and independence, he or she recognises that this judgment may not be shared by third parties and that he or she may be required to justify the decision.

Threats to objectivity and independence

1.29 The principal types of threats to the reporting accountant’s objectivity and independence are: • self-interest threat;

self-review threat;
management threat;
advocacy threat;
familiarity (or trust) threat; and
intimidation threat.

A self-interest threat arises when reporting accountants have financial or other interests which might cause them to be reluctant to take actions that would be adverse to the interests of the firm or any individual in a position directly to influence the conduct or outcome of the engagement (for example, when the engagement partner has a financial interest in the company issuing the investment circular).

A self-review threat arises when the results of a service performed by the engagement team or others within the firm are reflected in the amounts included or disclosed in the financial information that is the subject of the investment circular reporting engagement (for example, when reporting in relation to an initial public offering for a company where the firm has been involved in maintaining the accounting records of that company). A threat to objectivity arises because, in the course of the investment circular reporting engagement, the reporting accountant may need to re-evaluate the work performed in the course of the other service previously provided by the firm. As, by virtue of providing the other service, the firm is associated with aspects of the financial information being reported upon, the reporting accountant may be (or may be perceived to be) unable to take an impartial view of relevant aspects of that financial information.

There is a self-review threat where a firm prepares an accountant’s report on historical financial information which has been included in, or formed part of, financial statements which have already been subject to audit by the same firm. In such situations, where the two engagement teams are not completely independent of each other, the engagement partner evaluates the significance of the self-review threat created. If this is other than clearly insignificant, safeguards are applied, such as the appointment of an engagement quality control reviewer who has not been involved in the audit.

In assessing the significance of the self-review threat in relation to an investment circular reporting engagement, the reporting accountant considers the extent to which the other service will: involve a significant degree of subjective judgment; and

have a material effect on the preparation and presentation of the financial information that is the subject of the investment circular reporting engagement.

Where a significant degree of subjective judgment relating to the financial information is involved in an other service engagement, the reporting accountant may be inhibited from questioning that judgment in the course of the investment circular reporting engagement. Whether a significant degree of subjective judgment is involved will depend upon whether the other service involves the application of well-established principles and procedures, and whether reliable information is available. If such circumstances do not exist because the other service is based on concepts, methodologies or assumptions that require judgment and are not established by the engagement client or by authoritative guidance, the reporting accountant’s objectivity and the appearance of its independence may be adversely affected. Where the provision of the other service during the relevant period also has a material effect on the financial information that is the subject of the investment circular reporting engagement, it is unlikely that any safeguard can eliminate or reduce to an acceptable level the selfreview threat.

A management threat arises when the firm undertakes work that involves making judgments and taking decisions, which are the responsibility of the management of the party responsible for issuing the investment circular containing the financial information or the party on whose financial information the firm is reporting (the engagement client) in relation to:

the transaction (for example, where it has been working closely with a company in developing a divestment strategy); or
the financial information that is the subject of the investment circular reporting engagement (for example, deciding on the assumptions to be used in a profit forecast).

A threat to objectivity and independence arises because, by making judgments and taking decisions that are properly the responsibility of management, the firm erodes the distinction between the engagement client and the reporting accountant. The firm may become closely aligned with the views and interests of management and this may, in turn, impair or call into question the reporting accountant’s ability to apply a proper degree of professional scepticism in performing the investment circular reporting engagement. The reporting accountant’s objectivity and independence therefore may be impaired, or may be perceived to be, impaired.

1.36 Factors to be considered in determining whether an other service does or does not give rise to a management threat include whether:

the other service results in recommendations by the firm justified by objective and transparent analyses or the engagement client being given the opportunity to decide between reasonable alternatives;
the reporting accountant is satisfied that a member of management (or senior employee) has been designated by the engagement client to receive the results of the other service and make any judgments and decisions that are needed; and
that member of management has the capability to make independent management judgments and decisions on the basis of the information provided (‘informed management’).

Where there is ‘informed management’, the reporting accountant assesses whether there are safeguards that can be introduced that would be effective to avoid a management threat or to reduce it to a level at which it can be disregarded. Such safeguards would include the investment circular reporting engagement being provided by partners and staff who have no involvement in those other services. In the absence of ‘informed management’, it is unlikely that any safeguards can eliminate the management threat or reduce it to an acceptable level.

An advocacy threat arises when the firm undertakes work that involves acting as an advocate for an engagement client and supporting a position taken by management in an adversarial context (for example, by undertaking an active responsibility for the marketing of an entity’s shares). In order to act in an advocacy role, the firm has

to adopt a position closely aligned to that of management. This creates both actual and perceived threats to the reporting accountant’s objectivity and independence. For example, where the firm, acting as advocate, has supported a particular contention of management, it may be difficult for the reporting accountant to take an impartial view of this in the context of its review of the financial information.

Where the provision of an other service would require the reporting accountant to act as an advocate for the engagement client in relation to matters that are material to the financial information that is the subject of the investment circular reporting engagement, it is unlikely that any safeguards can eliminate or reduce to an acceptable level the advocacy threat that would exist.

A familiarity threat arises when reporting accountants are predisposed to accept or are insufficiently questioning of the engagement client’s point of view (for example, where they develop close personal relationships with client personnel through long association with the engagement client).

An intimidation threat arises when the conduct of reporting accountants is influenced by fear or threats (for example, where they encounter an aggressive and dominating party).

These categories may not be entirely distinct: certain circumstances may give rise to more than one type of threat. For example, where a firm wishes to retain the fee income from a large client, but encounters an aggressive and dominating individual, there may be a self-interest threat as well as an intimidation threat.

When identifying threats to objectivity and independence, reporting accountants consider circumstances and relationships with a number of different parties. The engagement client may constitute one or more parties, dependent on the circumstances of the transaction which is the subject of the investment circular^[1]. Where the party responsible for issuing the investment circular is different from the party whose financial information is included in the investment circular, the reporting accountant makes an assessment of independence with respect to both these parties, applying the alternative procedures set out in paragraph 1.44 as necessary.

Where either:

an investment circular reporting engagement is undertaken to provide a report on the financial information relating to an audit client but the reporting accountant’s report is to be published in an investment circular issued by another entity that is not an audit client; or
the reporting accountant’s report is to be published in an investment circular issued by an audit client but the reporting accountant’s report is on financial information relating to another entity that is not an audit client,

it may not be practicable in the time available to identify all relationships and other service engagements recently undertaken by the firm for the non-audit client and its significant affiliates. In such instances the reporting accountant undertakes those enquiries⁶ that are practical in the time available into the relationships and other service engagements that the firm has with the non-audit client and, having regard to its obligations to maintain confidentiality, addresses any identified threats. Having done so, the reporting accountant discloses to those charged with governance

[1] For example, where a report on a target company’s financial statements is prepared by that company’s auditors for inclusion in the acquiring company’s investment circular. ⁶ For example, these enquiries are likely to include reviewing the list of engagements recorded in the firm’s accounting systems and an enquiry of individuals within the firm who are responsible for maintaining such systems as to whether any confidentially coded engagements could be relevant.

of the issuing engagement client that a consideration of all known threats has been undertaken and, where appropriate, safeguards applied, but this does not constitute a full evaluation of all relationships and other services provided to the nonaudit client.

1.45 The firm should establish policies and procedures to require persons in a position directly to influence the conduct and outcome of the investment circular reporting engagement to be constantly alert to circumstances and relationships with:

the engagement client, and
other parties who are connected with the investment circular, that might reasonably be considered threats to their objectivity or the perceived loss of their independence, and, where such circumstances or relationships are identified, to report them to the engagement partner or to the ethics partner, as appropriate.

Such policies and procedures require that threats to the reporting accountant’s objectivity and independence are communicated to the appropriate person, having regard to the nature of the threats and the part of the firm and the identity of any person involved. The consideration of all threats and the action taken is documented. If the engagement partner is personally involved, or if he or she is unsure about the action to be taken, the matter is resolved through consultation with the ethics partner.

In addition to considering independence in the context of the engagement client, the reporting accountant also considers relationships with other parties who are connected with the investment circular. These parties will include the sponsor or nominated advisor, other parties from whom, in accordance with the engagement letter, the reporting accountant takes instructions and other entities directly involved in the transaction which is the subject of the investment circular.^[1] The reporting accountant considers the circumstances involved and uses judgment to assess whether it is probable that a reasonable and informed third party would conclude that the reporting accountant’s objectivity either is impaired or is likely to be impaired as a result of relationships held with any of these parties.

In the case of established financial institutions or advisers, the reporting accountant may have extensive relationships with these parties, including for the provision of other services or the purchase of goods and services in the ordinary course of business. These relationships will not generally give rise to a significant threat to the reporting accountant’s objectivity.

Relationships with other parties who are connected with the investment circular which are outside the ordinary course of business or which are material to any party are more likely to give rise to a significant threat to the reporting accountant’s objectivity. Consideration of the threats to the reporting accountant’s objectivity in relation to other entities will primarily be concerned with matters that could give rise to self-interest and intimidation threats, for example:

where there is financial dependence on the relationship with the other party arising from fees (including any contingent element) for investment circular reporting engagements undertaken by the firm as a result of connections with the other parties;
joint ventures or similar relationships with the other party or with a senior member of their management;
significant purchases of goods or services which are not in the ordinary course of business or are not on an arm’s length basis;

[1] Where such entities are part of a complex group or corporate structure, the reporting accountant considers issues relating to the wider group and not just the entity directly involved in the transaction.

personal relationships between engagement team members and individuals in senior positions within the other party; or
large direct financial interests in, or loans made by, the other party.

1.50 The firm should establish policies and procedures to require the engagement partner to identify and assess the significance of threats to the reporting accountant’s objectivity, including any perceived loss of independence:

(a) when considering whether to accept an investment circular reporting engagement and planning the work to be undertaken; (b) when signing the report;

when considering whether the firm can accept or retain an engagement to provide other services to an engagement client during the relevant period; and
when potential threats are reported to him or her.

An initial assessment of the threats to objectivity and independence is required when the engagement partner is considering whether to accept an investment circular reporting engagement and planning the engagement. At the end of the engagement, when reporting on the work undertaken but before issuing the report, the engagement partner draws an overall conclusion as to whether any threats to objectivity and independence have been properly addressed in accordance with the APB Ethical Standard for Reporting Accountants. If, at any time, the reporting accountant is invited to accept an engagement to provide other services to an engagement client for which the firm is undertaking an investment circular reporting engagement, the engagement partner considers the impact this new engagement may have on the reporting accountant’s objectivity and independence.

When identifying and assessing threats to their objectivity and independence, reporting accountants take into account their current relationships with the engagement client (including other service engagements) and those that existed prior to the current engagement in the relevant period. The relevant period covers the period during

which the engagement is undertaken and any additional period before the engagement period but subsequent to the balance sheet date of the most recent audited financial statements^[1]. This is because those prior relationships may be perceived as likely to influence the reporting accountant in the performance of the investment circular reporting engagement or as otherwise impairing the reporting accountant’s objectivity and independence.

A firm’s procedures will include reference to records of past and current engagements whenever a new investment circular reporting engagement is proposed.

Where the engagement client or a third party calls into question the objectivity and independence of the firm in relation to a particular client, the ethics partner carries out such investigations as may be appropriate.

IDENTIFICATION AND ASSESSMENT OF SAFEGUARDS

1.55 If the engagement partner identifies threats to the reporting accountant’s objectivity, including any perceived loss of independence, he or she should identify and assess the effectiveness of the available safeguards and apply such safeguards as are sufficient to eliminate the threats or reduce them to an acceptable level.

[1] In the case of newly incorporated clients (not part of an established group of companies), where there has been no financial statement audit, this period is from the date of incorporation.

The nature and extent of safeguards to be applied depend on the significance of the threats. Where a threat is clearly insignificant, no safeguards are needed.

1.57 Sections 2 and 3 of this Standard address specific circumstances which can create threats to the reporting accountant’s objectivity or loss of independence. They give examples of safeguards that can, in some circumstances, eliminate the threat or reduce it to an acceptable level. In circumstances where this is not possible, either the reporting accountant does not accept (or withdraws from) the investment circular reporting engagement or, in the case of threats arising from the current provision of other services, does not undertake the engagement to provide the other service.

1.58 The engagement partner should not accept or should not continue an investment circular reporting engagement if he or she concludes that any threats to the reporting accountant’s objectivity and independence cannot be reduced to an acceptable level.

1.59 If during the conduct of the investment circular reporting engagement the engagement partner becomes aware of a threat and concludes that it cannot be reduced to an acceptable level, the firm withdraws immediately from the engagement, save in circumstances where a reasonable and informed third party would regard ceasing to act as the reporting accountant would be contrary to the public interest. In such cases withdrawal from the investment circular reporting engagement may not be appropriate. The firm discloses on a timely basis full details of the position to those charged with governance of the issuing engagement client and those the reporting accountant is instructed to advise, as set out in paragraphs 1.68 to 1.76, and establishes appropriate safeguards.

ENGAGEMENT QUALITY CONTROL REVIEW

1.60 Paragraph 22 of SIR 1000 requires the reporting accountant to comply with applicable standards and guidance set out in ISQC (UK and Ireland) 1 ‘Quality control for firms that perform audits and reviews of historical financial information and other assurance and related services engagements’ and ISA (UK and Ireland) 220 ‘Quality control for audits of historical financial information’. This includes the appointment of an engagement quality control reviewer for all public reporting engagements.

1.61 The engagement quality control reviewer should:

consider the firm’s compliance with the APB Ethical Standard for Reporting Accountants in relation to the investment circular reporting engagement;
form an independent opinion as to the appropriateness and adequacy of the safeguards applied; and
consider the adequacy of the documentation of the engagement partner’s consideration of the reporting accountant’s objectivity and independence.

1.62 The requirements of paragraph 1.61 supplement the requirements relating to the engagement quality control review established by ISA (UK and Ireland) 220. The engagement quality control reviewer will be a partner or other person performing the function of a partner who is not otherwise involved in the engagement. The experience required of the engagement quality control reviewer is determined by the nature of the engagement and the seniority and experience of the engagement partner.

OVERALL CONCLUSION

1.63 At the end of the investment circular reporting engagement, when reporting on the work undertaken but before issuing the report, the engagement partner should reach an overall conclusion that any threats to objectivity and independence have been properly addressed in accordance with the APB Ethical Standard for Reporting Accountants. If the engagement partner cannot make such a conclusion, he or she should not report and the firm should withdraw from the investment circular reporting engagement.

1.64 If the engagement partner remains unable to conclude that any threat to objectivity and independence has been properly addressed in accordance with the APB Ethical Standard for Reporting Accountants, or if there is a disagreement between the engagement partner and the engagement quality control reviewer, he or she consults the ethics partner.

1.65 In concluding on compliance with the requirements for objectivity and independence, the engagement partner is entitled to rely on the completeness and accuracy of the data developed by the firm’s systems relating to independence (for example, in relation to the reporting of financial interests by staff), unless informed otherwise by the firm.

OTHER ACCOUNTANTS INVOLVED IN AN INVESTMENT CIRCULAR REPORTING ENGAGEMENT

1.66 The engagement partner should be satisfied that other accountants (whether a network firm or another firm) involved in the investment circular reporting engagement, who are not

subject to the APB Ethical Standard for Reporting Accountants, are objective and document the rationale for that conclusion.

1.67 The engagement partner obtains written confirmation from the other accountants that they have a sufficient understanding of and have complied with the applicable provisions of the IFAC Code of Ethics for Professional Accountants, including the independence requirements.^[1]

COMMUNICATION WITH THOSE CHARGED WITH GOVERNANCE

1.68 The engagement partner should ensure that those charged with governance of the issuing engagement client, and any other persons or entities the reporting accountant is instructed to advise, are appropriately informed on a timely basis of all significant facts and matters that bear upon the reporting accountant’s objectivity and independence.

1.69 Those charged with governance of the issuing engagement client are responsible for oversight of the relationship between the reporting accountant and the entity and of the conduct of the investment circular reporting engagement. This group therefore has a particular interest in being informed about the reporting accountant’s ability to report objectively on the engagement.

1.70 The aim of these communications by the reporting accountant is to ensure full and fair disclosure to those charged with governance of the issuing engagement client and to those from whom, in accordance with the engagement letter, the reporting accountant takes instructions of matters in which they have an interest.

[1] The International Federation of Accountants Code of Ethics for Professional Accountants (the IFAC Code) establishes a conceptual framework for ethical requirements for professional accountants and includes independence requirements for assurance engagements. No Member Body of IFAC is allowed to apply less stringent standards than those stated in the IFAC Code. In addition, members of the IFAC Forum of Firms have agreed to apply ethical standards, which are at least as rigorous as those of the IFAC Code.

71 It may be that all of the parties to the engagement letter wish to be informed about all significant facts and matters that bear upon the reporting accountant’s objectivity and independence. In other cases, however, the parties to the engagement letter (other than the engagement client) may not wish to be directly involved and may appoint one or more of their number to review these matters on their behalf. At the time of appointment, the reporting accountant ensures that it is clear in the engagement letter to whom these communications are provided. If no such provision is included in the engagement letter, the reporting accountant will make disclosures to all those from whom, in accordance with the engagement letter, the reporting accountant takes instructions.

1.72 Matters communicated will generally include the key elements of the engagement partner’s consideration of objectivity and independence, such as:

the principal threats, if any, to objectivity and independence identified by the reporting accountant, including consideration of relationships between the firm and: o the engagement client, its affiliates and directors, and o the sponsor and such other parties from whom the reporting accountant takes instructions, and

o other entities directly involved in the transaction which is the subject of the investment circular;

any safeguards adopted and the reasons why they are considered to be effective;
the considerations of the engagement quality control review;
the overall assessment of threats and safeguards;
information about the general policies and processes within the firm for maintaining objectivity and independence.

1.73 The reporting accountant, as a minimum:

(a) discloses in writing to those charged with governance of the issuing engagement client, and any other persons or entities the reporting accountant is instructed to advise:

details of all relationships that the reporting accountant considers may reasonably be thought to bear on the objectivity and independence of the reporting accountant,^[1] having regard to its relationships with the engagement client, its directors and senior management and its affiliates;
details of all relationships that the reporting accountant considers give rise to a threat to its objectivity between the reporting accountant and:
- the sponsor and such other parties from whom the reporting accountant takes instructions^[2];
- other entities directly involved in the transaction which is the subject of the investment circular;
whether the total amount of fees that the reporting accountant is likely to charge to the engagement client and its significant affiliates for the provision of services relating to the transaction which is the subject of the investment circular during the relevant period is greater than 5% of the fee income of the firm in the relevant period or the part of the firm by reference to which the engagement partner’s profit share is calculated during the relevant period; and
the related safeguards that are in place; (b) confirms in writing that:

[1] Relationships include significant services previously provided by the firm and network firms involved in the investment circular reporting engagement to the engagement client and its significant affiliates. In considering the significance of such services the reporting accountant takes into account whether those services have been the subject of independent review after they were provided.

[2] Where a party to the engagement letter is an established financial institution or adviser, a generic disclosure that the firm has extensive relationships entered into in the ordinary course of business with these parties is sufficient with specific disclosure only being made in the case of relationships which are outside the ordinary course of business or which are material to any party.

1.72 Matters communicated will generally include the key elements of the engagement partner’s consideration of objectivity and independence, such as:

the principal threats, if any, to objectivity and independence identified by the reporting accountant, including consideration of relationships between the firm and: o the engagement client, its affiliates and directors, and o the sponsor and such other parties from whom the reporting accountant takes instructions, and

o other entities directly involved in the transaction which is the subject of the investment circular;

any safeguards adopted and the reasons why they are considered to be effective;
the considerations of the engagement quality control review;
the overall assessment of threats and safeguards;
information about the general policies and processes within the firm for maintaining objectivity and independence.

1.73 The reporting accountant, as a minimum:

(a) discloses in writing to those charged with governance of the issuing engagement client, and any other persons or entities the reporting accountant is instructed to advise:

details of all relationships that the reporting accountant considers may reasonably be thought to bear on the objectivity and independence of the reporting accountant,^[1] having regard to its relationships with the engagement client, its directors and senior management and its affiliates;
details of all relationships that the reporting accountant considers give rise to a threat to its objectivity between the reporting accountant and:
- the sponsor and such other parties from whom the reporting accountant takes instructions^[2];
- other entities directly involved in the transaction which is the subject of the investment circular;
whether the total amount of fees that the reporting accountant is likely to charge to the engagement client and its significant affiliates for the provision of services relating to the transaction which is the subject of the investment circular during the relevant period is greater than 5% of the fee income of the firm in the relevant period or the part of the firm by reference to which the engagement partner’s profit share is calculated during the relevant period; and
the related safeguards that are in place; (b) confirms in writing that:

1.72 Matters communicated will generally include the key elements of the engagement partner’s consideration of objectivity and independence, such as:

the principal threats, if any, to objectivity and independence identified by the reporting accountant, including consideration of relationships between the firm and: o the engagement client, its affiliates and directors, and o the sponsor and such other parties from whom the reporting accountant takes instructions, and

o other entities directly involved in the transaction which is the subject of the investment circular;

any safeguards adopted and the reasons why they are considered to be effective;
the considerations of the engagement quality control review;
the overall assessment of threats and safeguards;
information about the general policies and processes within the firm for maintaining objectivity and independence.

1.73 The reporting accountant, as a minimum:

(a) discloses in writing to those charged with governance of the issuing engagement client, and any other persons or entities the reporting accountant is instructed to advise:

details of all relationships that the reporting accountant considers may reasonably be thought to bear on the objectivity and independence of the reporting accountant,^[1] having regard to its relationships with the engagement client, its directors and senior management and its affiliates;
details of all relationships that the reporting accountant considers give rise to a threat to its objectivity between the reporting accountant and:
- the sponsor and such other parties from whom the reporting accountant takes instructions^[2];
- other entities directly involved in the transaction which is the subject of the investment circular;
whether the total amount of fees that the reporting accountant is likely to charge to the engagement client and its significant affiliates for the provision of services relating to the transaction which is the subject of the investment circular during the relevant period is greater than 5% of the fee income of the firm in the relevant period or the part of the firm by reference to which the engagement partner’s profit share is calculated during the relevant period; and
the related safeguards that are in place; (b) confirms in writing that:

Relationships include significant services previously provided by the firm and network firms involved in the investment circular reporting engagement to the engagement client and its significant affiliates. In considering the significance of such services the reporting accountant takes into account whether those services have been the subject of independent review after they were provided.

[1] Where a party to the engagement letter is an established financial institution or adviser, a generic disclosure that the firm has extensive relationships entered into in the ordinary course of business with these parties is sufficient with specific disclosure only being made in the case of relationships which are outside the ordinary course of business or which are material to any party.

it complies with the APB Ethical Standard for Reporting Accountants and that it is independent and its objectivity is not compromised, and
where relevant, the circumstances contemplated in paragraph 1.44 exist and a consideration of all known threats and safeguards has been undertaken, but this does not constitute a full evaluation of all business relationships and other services provided to the entity.

1.74 The reporting accountant seeks to discuss these matters with those charged with governance of the issuing engagement client and those others the reporting accountant is instructed to advise.

1.75 The most appropriate time for final confirmation of such matters is usually at the conclusion of the investment circular reporting engagement. However, communications between the reporting accountant and those charged with governance of the issuing engagement client and those others the reporting accountant is instructed to advise will also be needed at the planning stage and whenever significant judgments are made about threats to objectivity and independence and the appropriateness of safeguards put in place, for example, when accepting an engagement to provide other services.

1.76 Transparency is a key element in addressing the issues raised by the provision of other services by reporting accountants to their clients. This can be facilitated by timely communication with those charged with governance of the issuing engagement client. In the case of companies that are seeking a listing, ensuring that the audit committee is properly informed about the issues associated with the provision of other services will assist the audit committee to comply on an ongoing basis with the provisions of the Combined Code on Corporate Governance^[1] relating to reviewing and monitoring the external auditors’ independence and objectivity.

DOCUMENTATION

1.77 The engagement partner should ensure that his or her consideration of the reporting accountant’s objectivity and independence is appropriately documented on a timely basis.

1.78 The requirement to document these issues contributes to the clarity and rigour of the engagement partner’s thinking and the quality of his or her judgments. In addition, such documentation provides evidence that the engagement partner’s consideration of the reporting accountant’s objectivity and independence was properly performed and provides the basis for the engagement quality control review.

1.79 Matters to be documented include all key elements of the process and any significant judgments concerning:

threats identified (in relation to the engagement client, those from whom, in accordance with the engagement letter, the reporting accountant takes instructions and other entities directly involved in the transaction which is the subject of the investment circular) and the process used in identifying them;
safeguards adopted and the reasons why they are considered to be effective;
the engagement quality control review;
overall assessment of threats and safeguards; and

[1] Provision C.3.2 provides that ‘the main role and responsibilities of the audit committee should be set out in written terms of reference and should include … to develop and implement a policy on the engagement of the external auditor to supply non-audit services …’

communication with those charged with governance of the issuing engagement client and those others the reporting accountant is instructed to advise.

SECTION 2 – SPECIFIC CIRCUMSTANCES CREATING THREATS TO A REPORTING ACCOUNTANT’S OBJECTIVITY AND INDEPENDENCE

INTRODUCTION

2.1 Paragraphs 1.50 and 1.55 require the engagement partner to identify and assess the circumstances which could adversely affect the reporting accountant’s objectivity (‘threats’), including any perceived loss of independence, and to apply procedures (‘safeguards’) which will either:

eliminate the threat; or
reduce the threat to an acceptable level (that is, a level at which it is not probable that a reasonable and informed third party would conclude that the reporting accountant’s objectivity and independence is impaired or is likely to be impaired).

2.2 This section of the APB Ethical Standard for Reporting Accountants provides requirements and guidance on specific circumstances arising out of relationships with the engagement client, which may create threats to the reporting accountant’s objectivity or a perceived loss of independence. It gives examples of safeguards that can, in some circumstances, eliminate the threat or reduce it to an acceptable level. In circumstances where this is not possible, either the relationship in question is not entered into or the reporting accountant either does not accept or withdraws from the investment circular reporting engagement, as appropriate.

FINANCIAL RELATIONSHIPS

General considerations

2.3 A financial interest is an interest in an equity or other security, debenture, loan or other debt instrument of an entity, including rights and obligations to acquire such an interest and derivatives directly related to such an interest.

2.4 Financial interests may be:

owned directly, rather than through intermediaries (a ‘direct financial interest’); or
owned through intermediaries, for example, an open ended investment company or a pension scheme (an ‘indirect financial interest’).

2.5 Where a firm is engaged to undertake an investment circular reporting engagement for a client, the firm, a person in a position directly to influence the conduct and outcome of the investment circular reporting engagement or an immediate family member of such a person should not hold during the engagement period:

any direct financial interest in the engagement client or an affiliate of the engagement client; or
any indirect financial interest in the engagement client or an affiliate of the engagement client, where the investment is material to the firm or the individual and to the intermediary; or
any indirect financial interest in the engagement client or an affiliate of the engagement client, where the person holding it has both:
- the ability to influence the investment decisions of the intermediary; and
- actual knowledge of the existence of the underlying investment in the engagement client.

The threats to the reporting accountant’s objectivity and independence, where a direct financial interest or a material indirect financial interest in the engagement client is held by the firm or by one of the individuals specified in paragraph 2.5 are such that no safeguards can eliminate them or reduce them to an acceptable level. If the existence of the transaction which is connected with the investment circular is price sensitive information then disposal of the financial interest may not be possible and the firm either does not accept the engagement or the relevant individuals are not included in the engagement team. Where a partner with one of the financial interests specified normally has direct supervisory or management responsibility over the engagement team, he or she is excluded from this responsibility for the purposes of the particular investment circular reporting engagement.

Where one of the financial interests specified in paragraph 2.5 is held by:

the firm: the entire financial interest is disposed of, a sufficient amount of an indirect financial interest is disposed of so that the remaining interest is no longer material, or the firm does not accept (or withdraws from) the investment circular reporting engagement;
a person in a position directly to influence the conduct and outcome of the investment circular reporting engagement: the entire financial interest is disposed of, a sufficient amount of an indirect financial interest is disposed of so that the remaining interest is no longer material, or that person does not retain a position in which they exert such direct influence on the investment circular reporting engagement;
an immediate family member of a person in a position directly to influence the conduct and outcome of the investment circular reporting engagement: the entire financial interest is disposed of,

a sufficient amount of an indirect financial interest is disposed of so that the remaining interest is no longer material, or the person in a position directly to influence the conduct and outcome of the investment circular reporting engagement does not retain a position in which they exert such direct influence on the investment circular reporting engagement.

2.8 Where the firm or one of the individuals specified in paragraph 2.5 holds an indirect financial interest but does not have both:

the ability to influence the investment decisions of the intermediary; and
actual knowledge of the existence of the underlying investment in the engagement client,

there may not be a threat to the reporting accountant’s objectivity and independence. For example, where the indirect financial interest takes the form of an investment in a pension fund, the composition of the funds and the size and nature of any underlying investment in the engagement client may be known but there is unlikely to be any influence on investment decisions, as the fund will generally be managed independently on a discretionary basis. In the case of an ‘index tracker’ fund, the investment in the engagement client is determined by the composition of the relevant index and there may be no threat to objectivity. As long as the person holding the indirect interest is not directly involved in an investment circular reporting engagement involving the intermediary, nor able to influence the individual investment decisions of the intermediary, any threat to the reporting accountant’s objectivity and independence may be regarded as insignificant.

Where the firm or one of the individuals specified in paragraph 2.5 holds a beneficial interest in a properly operated ‘blind’ trust, they are (by definition) completely unaware of the identity of the underlying investments. If these include an investment in the engagement client, this means that they are unaware of the existence of an indirect financial interest. In these circumstances, there is no threat to the reporting accountant’s objectivity and independence.

Where a person in a position directly to influence the conduct and outcome of the investment circular reporting engagement becomes aware that a close family member holds one of the financial interests specified in paragraph 2.5, that individual should report the matter to the engagement partner to take appropriate action. If it is a close family member of the engagement partner, or if the engagement partner is in doubt as to the action to be taken, the engagement partner should resolve the matter through consultation with the ethics partner.

Financial interests held as trustee

2.11 Where a direct or an indirect financial interest in the engagement client or its affiliates is held in a trustee capacity by a person in a position directly to influence the conduct and outcome of the investment circular reporting engagement, or an immediate family member of such a person, a self-interest threat may be created because either the existence of the trustee interest may influence the conduct of the investment circular reporting engagement or the trust may influence the actions of the engagement client. Accordingly, such a trustee interest is only held when:

the relevant person is not an identified potential beneficiary of the trust; and
the financial interest held by the trust in the engagement client is not material to the trust; and
the trust is not able to exercise significant influence over the engagement client or an affiliate of the engagement client; and
the relevant person does not have significant influence over the investment decisions made by the trust, in so far as they relate to the financial interest in the engagement client.

2.12 Where it is not clear whether the financial interest held by the trust in the engagement client is material to the trust or whether the trust is able to exercise significant influence over the engagement client, the financial interest is reported to the ethics partner, so that a decision can be made as to the steps that need to be taken.

Financial interests held by firm pension schemes

2.13 Where the pension scheme of a firm has a financial interest in an engagement client or its affiliates and the firm has any influence over the trustees’ investment decisions (other than indirect strategic and policy decisions), the self-interest threat created is such that no safeguards can eliminate it or reduce it to an acceptable level. In other cases (for example, where the pension scheme invests through a collective investment scheme and the firm’s influence is limited to investment policy decisions, such as the allocation between different categories of investment), the ethics partner considers the acceptability of the position, having regard to the materiality of the financial interest to the pension scheme.

Loans and guarantees

2.14 Where reporting accountants, persons in a position directly to influence the conduct and outcome of the investment circular reporting engagement or immediate family members of such persons:

accept a loan^[1] or a guarantee of their borrowings from an engagement client; or
make a loan to or guarantee the borrowings of an engagement client,

a self-interest threat and an intimidation threat to the reporting accountant’s objectivity can be created or there may be a perceived loss of independence. No safeguards can eliminate this threat or reduce it to an acceptable level.

The firm, persons in a position directly to influence the conduct and outcome of the investment circular reporting engagement and immediate family members of such persons should not during the

[1] For the purpose of this standard, the term ‘loan’ does not include ordinary trade credit arrangements or deposits placed for goods or services (see paragraph 2.20).

engagement period have a loan outstanding to, or guarantee the borrowings of, an engagement client or its affiliates unless this represents a deposit made with a bank or similar deposit taking institution in the ordinary course of business and on normal business terms.

The firm should not during the engagement period have a loan from, or have its borrowings guaranteed by, the engagement client or its affiliates unless:
- the engagement client is a bank or similar deposit taking institution; and
- the loan or guarantee is made in the ordinary course of business on normal business terms; and
- the loan or guarantee is not material to both the firm and the engagement client.

2.17 Persons in a position directly to influence the conduct and outcome of the investment circular reporting engagement and immediate family members of such persons should not during the engagement period have a loan from, or have their borrowings guaranteed by, the engagement client or its affiliates unless:

the engagement client is a bank or similar deposit taking institution; and
the loan or guarantee is made in the ordinary course of business on normal business terms; and
the loan or guarantee is not material to the engagement client.

2.18 Loans by an engagement client that is a bank or similar institution to a person in a position directly to influence the conduct and outcome of the investment circular reporting engagement, or an immediate family member of such a person (for example, home mortgages, bank overdrafts or car loans), do not create an unacceptable threat to objectivity and independence, provided that normal business terms apply. However, where such loans are in arrears by a significant amount, this creates an intimidation threat that is unacceptable. Where such a situation arises, the person in a position directly to influence the conduct and outcome of the investment circular reporting engagement reports the matter to the engagement partner, or to the ethics partner, as appropriate and ceases to have any involvement with the investment circular reporting engagement. The engagement partner or, where appropriate, the ethics partner considers whether any work is to be reperformed.

BUSINESS RELATIONSHIPS

2.19 A business relationship between:

the firm or a person who is in a position directly to influence the conduct and outcome of the investment circular reporting engagement, or an immediate family member of such a person, and
the engagement client or its affiliates, or its management involves the two parties having a common commercial interest. Business relationships may create self-interest, advocacy or intimidation threats to the reporting accountant’s objectivity and perceived loss of independence. Examples include:
joint ventures with the engagement client or with a director, officer or other individual who performs senior managerial functions for the client;
arrangements to combine one or more services or products of the firm with one or more services or products of the engagement client and to market the package with reference to both parties;
distribution or marketing arrangements under which the firm acts as a distributor or marketer of any of the engagement client’s products or services, or the engagement client acts as the distributor or marketer of any of the products or services of the firm;
other commercial transactions, such as the firm leasing its office space from the engagement client.

Subject to the alternative procedures outlined in paragraph 1.44, a firm will identify all business relationships entered into by the firm, persons in a position directly to influence the conduct and outcome of the investment circular reporting engagement, or an immediate family member of such a person.

2.20 Where a firm is engaged to undertake an investment circular reporting engagement for a client, the firm, persons in a position directly to influence the conduct and outcome of the investment circular reporting engagement and immediate family members of such persons should not have business relationships with the engagement client, its management or its affiliates during the relevant period except where they:

are entered into in the ordinary course of business and are clearly trivial; or
involve the purchase of goods and services from the firm or the engagement client in the ordinary course of business and on an arm’s length basis.

2.21 Where a business relationship exists, that is not permitted under paragraph 2.20, and has been entered into by:

the firm: either the relationship is terminated before the start of the relevant period or the firm does not accept (or withdraws from) the investment circular reporting engagement;
a person in a position directly to influence the conduct and outcome of the investment circular reporting engagement: either the relationship is terminated before the start of the relevant period or that person does not retain a position in which they exert such direct influence on the investment circular reporting engagement^[1];

[1] If the existence of the transaction which is connected with the investment circular is price sensitive information then termination of the business relationship may not be possible and the firm either does not accept the engagement or the relevant individuals are not included in the engagement team. Where a partner with one of the business relationships specified normally has direct supervisory or management responsibility over the engagement team, he or she is excluded from this responsibility for the purposes of the particular investment circular reporting engagement.

If the existence of the transaction which is connected with the investment circular is price sensitive information then termination of the business relationship may not be possible and the firm either does not accept the engagement or the relevant individuals are not included in the engagement team. Where a partner with one of the business relationships specified normally has direct supervisory or management responsibility over the engagement team, he or she is

an immediate family member of a person in a position directly to influence the conduct and outcome of the investment circular reporting engagement: either the relationship is terminated before the start of the relevant period or that person does not retain a position in which they exert such direct influence on the investment circular reporting engagement¹⁴.

Where a person in a position directly to influence the conduct and outcome of the investment circular reporting engagement becomes aware that a close family member has one of the business relationships specified in paragraph 2.20, that individual should report the matter to the engagement partner to take appropriate action. If it is a close family member of the engagement partner or if the engagement partner is in doubt as to the action to be taken, the engagement partner should resolve the matter through consultation with the ethics partner.

Where there are doubts as to whether a transaction or series of transactions are either in the ordinary course of business or on an arm’s length basis, the engagement partner reports the issue to the ethics partner, so that a decision can be made as to the appropriate action that needs to be taken to ensure that the matter is resolved.

A firm should not act as reporting accountant to any entity or person able to influence the affairs of the firm or the performance of any investment circular reporting engagement undertaken by the firm.

This prohibition applies to:

any entity that owns any significant part of a firm, or is an affiliate of such an entity; or
any shareholder, director or other person in a position to direct the affairs of such an entity or its affiliate.

A significant ownership is one that carries the ability materially to influence the policy of an entity.^[1]

EMPLOYMENT RELATIONSHIPS

MANAGEMENT ROLE WITH ENGAGEMENT CLIENT

2.26 A firm undertaking an investment circular reporting engagement should not have as a partner or employ a person in a position directly to influence the conduct and outcome of the investment circular reporting engagement any person who is also employed by the engagement client or its affiliates (‘dual employment’).

Loan staff assignments

2.27 A reporting accountant should not enter into an agreement with an engagement client to provide a partner or employee to work for a temporary period as if that individual were an employee of the engagement client or its affiliates (a ‘loan staff assignment’) during the relevant period or for a period of one year before it, unless the client:

agrees that the individual concerned will not hold a management position in relation to the transaction or the financial information that is the subject of the investment circular reporting engagement, and

[1] For companies, competition authorities have generally treated a 15% shareholding as sufficient to provide a material ability to influence policy.

acknowledges its responsibility for directing and supervising the work to be performed, which will not include such matters as:
- making management decisions; or
- exercising discretionary authority to commit the engagement client to a particular position or accounting treatment.

Where a firm agrees to assist an engagement client by providing loan staff, threats to objectivity and independence may be created. A management threat may arise if the employee undertakes work that involves making judgments and taking decisions that are properly the responsibility of management of the engagement client in relation to the transaction or the financial information that is the subject of the investment circular reporting engagement. Thus, for example, interim management arrangements involving participation in the financial reporting function involved in producing the financial information that is the subject of the investment circular reporting engagement are not acceptable.

A self-review threat may also arise if the individual, during the loan staff assignment, is in a position directly to influence the preparation of the engagement client’s financial information and then, on completion of that assignment, is assigned to the engagement team for that client.

Where a partner or employee returns to the firm on completion of a loan staff assignment, that individual should not be given any role on an investment circular reporting engagement for the engagement client which involves a review of, or any work in relation to, any function or activity that he or she performed or supervised during that assignment.

In considering for how long this restriction is to be observed, the need to realise the potential value to the effectiveness of the investment circular reporting engagement of the increased knowledge of the client’s business gained through the assignment has to be weighed against the potential threats to objectivity and independence. Those threats increase with the length of the assignment and with the intended level of responsibility of the individual within the engagement team. As a minimum, this restriction will apply to at least the period until an audit has been undertaken of the financial statements following the completion of the loan staff assignment.

Partners and engagement team members joining an engagement client

2.32 Where a former partner in the firm joins the engagement client, the firm should take action before any further work is done by the firm in connection with the investment circular reporting engagement to ensure that no significant connections remain between the firm and the individual.

2.33 Ensuring that no significant connections remain between the firm and the individual requires that:

all capital balances and similar financial interests be fully settled (including retirement benefits) unless these are made in accordance with pre-determined arrangements that cannot be influenced by any remaining connections between the individual and the firm; and
the individual does not participate or appear to participate in the firm’s business or professional activities.

2.34 Reporting accountants should establish policies and procedures that require:

senior members of the engagement team to notify the firm of any situation involving their potential employment with the engagement client; and
other members of the engagement team to notify the firm of any situation involving their probable employment with the engagement client; and
anyone who has given such notice to be removed from the engagement team; and
a review of the work performed by the resigning or former engagement team member in relation to the investment circular reporting engagement.

Objectivity and independence may be threatened where a director, an officer or an employee of the engagement client who is in a position to exert direct and significant influence over the preparation of the financial information has recently been a partner in the firm or a member of an engagement team. Such circumstances may create selfinterest, familiarity and intimidation threats, particularly when significant connections remain between the individual and the firm. Similarly, objectivity and independence may be threatened when an individual knows, or has reason to believe that he or she will or may be joining the engagement client at some time in the future.

Where a partner in the firm or a member of the engagement team for a particular client has left the firm and taken up employment with that client, the significance of the self-interest, familiarity and intimidation threats is assessed and normally depends on such factors as: the position that individual had in an engagement team or the firm;

the position that individual has taken at the engagement client;
the amount of involvement that individual will have with the engagement team (especially where it includes former colleagues with whom he or she worked);
the length of time since that individual was a member of an engagement team or employed by the firm.

Following the assessment of any such threats, appropriate safeguards are applied where necessary.

Any review of work is performed by a more senior professional. If the individual joining the engagement client is a partner, the review is performed by a partner who is not involved in the engagement. Where, due to its size, the firm does not have a partner who was not involved in the engagement, it seeks either a review by another firm or advice from its professional body.

Where a partner leaves the firm and is appointed as a director (including as a non-executive director) or to a key management position with an engagement client, having acted as an audit engagement partner, engagement quality control reviewer, key audit partner, reporting accountant or a partner in the chain of command at any time in the two years prior to such appointment, the firm should not accept an appointment as reporting accountant for a period of two years commencing when the former partner ceased to act for the engagement client or the former partner ceases employment with the engagement client, whichever is the sooner.

Where a partner (other than as specified in paragraph 2.38) or an employee joins the engagement client as a director (including as a non-executive director) or in a key management position, the firm should consider whether the composition of the engagement team is appropriate.

In such circumstances, the firm evaluates the appropriateness of the composition of the engagement team by reference to the factors listed in paragraph 2.36 and alters or strengthens the team to address any threat to the reporting accountant’s objectivity and independence that may be identified.

Family members employed by an engagement client

2.41 Where a person in a position directly to influence the conduct and outcome of the investment circular reporting engagement becomes aware that an immediate or close family member is employed by the engagement client in a position to exercise influence on the accounting records or financial information, that individual should either:

in the case of an immediate family member, cease to hold a position in which they exert such direct influence on the investment circular reporting engagement; or
in the case of a close family member, report the matter to the engagement partner to take appropriate action. If it is a close family member of the engagement partner or if the engagement partner is in doubt as to the action to be taken, the engagement partner should resolve the matter in consultation with the ethics partner.

GOVERNANCE ROLE WITH ENGAGEMENT CLIENT

2.42 A firm that undertakes an investment circular reporting engagement should not have as a partner or employ a person who during the engagement period is:

on the board of directors of the engagement client;
on any subcommittee of that board; or
in such a position in an entity which holds directly or indirectly more than 20% of the voting rights in the engagement client, or

in which the engagement client holds directly or indirectly more than 20% of the voting rights.

2.43 Where a person in a position directly to influence the conduct and outcome of the investment circular reporting engagement has an immediate or close family member who holds a position described in paragraph 2.42, the firm should take appropriate steps to ensure that the relevant person does not retain a position in which they exert direct influence on the conduct and outcome of the investment circular reporting engagement.

EMPLOYMENT WITH FIRM

2.44 Objectivity and independence may be threatened where a former director or employee of the engagement client becomes a member of the engagement team. Self-interest, self-review and familiarity threats may be created where a member of the engagement team has to report on, for example, financial information which he or she prepared, or elements of the financial information for which he or she had responsibility, while with the client.

2.45 Where a former director or a former employee of an engagement client, who was in a position to exert significant influence over the preparation of the financial information, joins the firm, that individual should not be assigned to a position in which he or she is able directly to influence the conduct and outcome of an investment circular reporting engagement for that client or its affiliates for a period of two years following the date of leaving the client.

2.46 In certain circumstances, a longer period of exclusion from the engagement team may be appropriate. For example, threats to objectivity and independence may exist in relation to an investment circular reporting engagement relating to the financial information of any period which was materially affected by the work of that person whilst occupying his or her former position of influence with the engagement client. The significance of these threats depends on factors such as:

the position the individual held with the engagement client;
the length of time since the individual left the engagement client;
the position the individual holds in the engagement team.

FAMILY AND OTHER PERSONAL RELATIONSHIPS

2.47 A relationship between a person who is in a position directly to influence the conduct and outcome of the investment circular reporting engagement and another party does not generally affect the consideration of the reporting accountant’s objectivity and independence. However, if it is a family relationship, and if the family member also has a financial, business or employment relationship with the engagement client, then self-interest, familiarity or intimidation threats to the reporting accountant’s objectivity and independence may be created. The significance of any such threats depends on such factors as:

the relevant person’s involvement in the investment circular reporting engagement;
the nature of the relationship between the relevant person and his or her family member;
the family member’s relationship with the engagement client.

A distinction is made between immediate family relationships and close family relationships. Immediate family members comprise an individual’s spouse (or equivalent) and dependents, whereas close family members comprise parents, non-dependent children and siblings. While an individual can usually be presumed to be aware of matters concerning his or her immediate family members and to be able to influence their behaviour, it is generally recognised that the same levels of knowledge and influence do not exist in the case of close family members.

When considering family relationships, it needs to be acknowledged that, in an increasingly secular, open and inclusive society, the concept of what constitutes a family is evolving and relationships between individuals which have no status formally recognised by law may nevertheless be considered as significant as those which do. It may therefore be appropriate to regard certain other personal relationships, particularly those that would be considered close personal relationships, as if they are family relationships.

The reporting accountant should establish policies and procedures that require:

partners and professional staff to report to the firm where they become aware of any immediate family, close family and other relationships involving an engagement client of the firm and which they consider might create a threat to the reporting accountant’s objectivity or a perceived loss of independence;
the relevant engagement partners to be notified promptly of any immediate family, close family and other personal relationships reported by partners and other professional staff.

2.51 The engagement partner should:

assess the threats to the reporting accountant’s objectivity and independence arising from immediate family, close family and other personal relationships on the basis of the information reported to the firm;
apply appropriate safeguards to eliminate the threat or reduce it to an acceptable level; and
where there are unresolved matters or the need for clarification, consult with the ethics partner.

2.52 Where such matters are identified or reported, the engagement partner or the ethics partner assesses the information available and the potential for there to be a threat to the reporting accountant’s objectivity and independence, treating any personal relationship as if it were a family relationship.

EXTERNAL CONSULTANTS INVOLVED IN AN INVESTMENT CIRCULAR REPORTING ENGAGEMENT

2.53 Reporting accountants may employ external consultants as part of their investment circular reporting engagement. There is a risk that an expert’s objectivity and independence will be impaired if the expert is related to the entity, for example by being financially dependent upon or having an investment in, the entity.

2.54 The engagement partner should be satisfied that any external consultant engaged by the reporting accountant in the investment circular reporting engagement will be objective and document the rationale for that conclusion.

2.55 The engagement partner obtains information from the external consultant as to the existence of any connections that they have with the engagement client including:

financial interests;
business relationships;
employment (past, present and future); family and other personal relationships.

ASSOCIATION WITH AN ENGAGEMENT CLIENT

2.56 Where partners and staff in senior positions have been part of engagement teams acting for a client on a number of audit, corporate finance or other transaction related engagements they gain a deep knowledge of the client and its operations. This association may also create close personal relationships with client personnel, which may create threats to the reporting accountant’s objectivity or perceived loss of independence.

2.57 The firm should establish policies and procedures to monitor the extent of involvement of partners and staff in senior positions where the firm acts in connection with investment circulars on a regular basis for an engagement client.

2.58 Where partners and staff in senior positions in the engagement team have had extensive involvement with the engagement client, the firm should assess the threats to the reporting accountant’s objectivity and independence and, where the threats are other than clearly insignificant, should:

disclose the engagements previously undertaken by the reporting accountant for the engagement client to those charged with governance of the issuing engagement client and any other persons or entities the reporting accountant is instructed to advise, and
apply safeguards to reduce the threats to an acceptable level. Where appropriate safeguards cannot be applied, the firm should either not accept or withdraw from the investment circular reporting engagement as appropriate.

Where partners and staff in senior positions in the engagement team have had extensive involvement with a particular engagement client, self-interest, self-review and familiarity threats to the reporting accountant’s objectivity may arise. Similarly, such circumstances may result in an actual or perceived loss of independence.

To evaluate such threats, the reporting accountant gives careful consideration to which individual is appointed as the engagement partner on an investment circular reporting engagement. This consideration will reflect the need for relevant expertise^[1] as well as factors such as:

the nature of the investment circular reporting engagement and whether it will involve the reappraisal of previously audited financial information,
the length of time that the audit engagement partner has been associated with the audit engagement,
the length of time that other partners have acted for the client on corporate finance and other transaction related engagements,

[1] Paragraph 25 of SIR 1000 requires that a partner with appropriate experience should be involved in the conduct of the work.

whether the objectivity of the engagement partner on a subsequent audit could be adversely affected by an opinion on a profit forecast included in the investment circular, and
the scope of the engagement quality control

2.61 A self-interest threat may be created where a partner in the engagement team:

is employed exclusively or principally on an investment circular reporting engagement that extends for a significant period of time; or
is remunerated on the basis of the performance of a part of the firm which is substantially dependent on fees from that engagement client.

2.62 In order to address those threats that are identified, firms apply safeguards to reduce the threat to an acceptable level. Appropriate safeguards may include:

appointing a partner who has no previous involvement with the engagement client as the engagement partner;
arranging an engagement quality control review of the investment circular reporting engagement by a partner who is not involved with the client and, if relevant, is not remunerated on the basis of the performance of part of the firm which is substantially dependent on fees from that client;
arranging an external engagement quality control review of the investment circular reporting engagement.

FEES

2.63 The engagement partner should be satisfied and able to demonstrate that the investment circular reporting engagement has assigned to it sufficient partners and staff with appropriate time and skill to perform the investment circular reporting engagement in accordance with all applicable Investment Reporting and Ethical Standards, irrespective of the fee to be charged.

2.64 Paragraph 2.63 is not intended to prescribe the approach to be taken by reporting accountants to the setting of fees, but rather to emphasise that there are no circumstances where the amount of the fee can justify any lack of appropriate resource or time taken to perform an investment circular reporting engagement in accordance with applicable Investment Reporting and Ethical Standards.

2.65 An investment circular reporting engagement should not be undertaken on a contingent fee basis.

2.66 A contingent fee basis is any arrangement made at the outset of an engagement under which a pre-determined amount or a specified commission on or percentage of any consideration or saving is payable to the firm upon the happening of a specified event or the achievement of an outcome (or alternative outcomes). Differential hourly fee rates, or arrangements under which the fee payable will be negotiated after the completion of the engagement, do not constitute contingent fee arrangements.

2.67 Contingent fee arrangements in respect of investment circular reporting engagements create self-interest threats to the reporting accountant’s objectivity and independence that are so significant that they cannot be eliminated or reduced to an acceptable level by the application of any safeguards.

2.68 The fee ordinarily reflects the time spent and the skills and experience of the personnel performing the engagement in accordance with all the relevant requirements.

2.69 The basis for the calculation of the fee is agreed with the engagement client prior to the commencement of the engagement. The engagement partner explains to the engagement client that the estimated fee is based on the expected level of work required and that, if unforeseen problems are encountered, the cost of any additional work found to be necessary will be reflected in the fee actually charged. This is not a contingent fee arrangement.

2.70 Investigations into possible acquisitions or disposals (‘due diligence engagements’), particularly those performed in relation to a prospective transaction, typically involve a high level of risk and responsibility. A firm carrying out a due diligence engagement may charge a higher fee for work relating to a completed transaction than for the same transaction if it is not completed, for whatever reason, provided that the difference is related to such additional risk and responsibility and not the outcome of the due diligence engagement.

2.71 Where the reporting accountant is aware that the engagement client has a record of seeking substantial discounts to the fee payable where a transaction is unsuccessful or abortive, the engagement partner discusses the position with the ethics partner. An appropriate safeguard may involve arranging an engagement quality control review of the investment circular reporting engagement.

2.72 The firm should establish policies and procedures to ensure that the engagement partner and the ethics partner are notified where others within the firm have agreed contingent fee arrangements in relation to the provision of other services to the engagement client or its affiliates.

2.73 Contingent fee arrangements in respect of other services provided by the firm to an engagement client may create a threat to the reporting accountant’s objectivity and independence. Where fees for other services are calculated on a contingent fee basis, the perception may be that the firm’s interests are so closely aligned with the engagement client that it threatens the reporting accountant’s objectivity and independence. Any contingent fee that is material to the firm, or that part of the firm by reference to which the engagement partner’s profit share is calculated, will create an unacceptable self-interest threat and the firm does not undertake such an engagement at the same time as an investment circular reporting engagement.

2.74 Where fees for professional services from the engagement client are overdue and the amount cannot be regarded as trivial, the engagement partner, in consultation with the ethics partner, should consider whether the firm should not accept or should withdraw from the investment circular reporting engagement.

2.75 Where fees due from an engagement client, whether for audit, investment circular reporting engagements or for other professional services, remain unpaid for a long time a self-interest threat to the reporting accountant’s objectivity and independence is created because the signing of a report may enhance the firm’s prospects of securing payment of such overdue fees.

2.76 Where the outstanding fees are in dispute and the amount involved is significant, the threats to the reporting accountant’s objectivity and independence may be such that no safeguards can eliminate them or reduce them to an acceptable level. The engagement partner therefore considers whether the firm can continue with the investment circular reporting engagement.

2.77 Where the outstanding fees are unpaid because of exceptional circumstances (including financial distress), the engagement partner considers whether the engagement client will be able to resolve its difficulties. In deciding what action to take, the engagement partner weighs the threats to the reporting accountant’s objectivity and independence if the firm were to continue with the investment circular reporting engagement, against the difficulties the engagement client would be likely to face in finding a successor, and therefore the public interest considerations, if the firm were to withdraw from the investment circular reporting engagement.

2.78 In any case where the firm does not withdraw from the investment circular reporting engagement, the engagement partner applies appropriate safeguards (such as a review by a partner who is not involved in the engagement) and notifies the ethics partner of the facts concerning the overdue fees.

THREATENED AND ACTUAL LITIGATION

2.79 Where litigation in relation to professional services between the engagement client or its affiliates and the firm, which is other than insignificant, is already in progress, or where the engagement partner considers such litigation to be probable, the reporting accountant should either not continue with or not accept the investment circular reporting engagement.

2.80 Where litigation actually takes place between the firm (or any person in a position directly to influence the conduct and outcome of the investment circular reporting engagement) and the engagement client, or where litigation is threatened and there is a realistic prospect of such litigation being commenced, self-interest, advocacy and intimidation threats to the reporting accountant’s objectivity and independence are created because the firm’s interest will be the achievement of an outcome to the dispute or litigation that is favourable to itself. In addition, an effective investment circular reporting engagement requires complete candour and full disclosure between the engagement client management and the engagement team: such disputes or litigation may place the two parties in opposing adversarial positions and may affect management’s willingness to make complete disclosure of relevant information. Where the reporting accountant can foresee that such a threat may arise, it informs those charged with governance of the issuing engagement client and any other persons or entities the reporting accountant is instructed to advise of its intention to withdraw from the investment circular reporting engagement.

2.81 The reporting accountant is not required to withdraw from the investment circular reporting engagement in circumstances where a reasonable and informed third party would not regard it as being in the public interest for it to do so. Such circumstances might arise, for example, where:

the litigation was commenced as the investment circular reporting engagement was about to be completed and stakeholder interests would be adversely affected by a delay in the completion of the work (for example where the engagement relates to the

restructuring of a company to avoid its imminent collapse);

on appropriate legal advice, the firm deems that the threatened or actual litigation is vexatious or designed solely to bring pressure to bear on the opinion to be expressed by the reporting accountant.

GIFTS AND HOSPITALITY

2.82 The reporting accountant, those in a position directly to influence the conduct and outcome of the investment circular reporting engagement and immediate family members of such persons should not accept gifts from the engagement client, unless the value is clearly insignificant.

2.83 Those in a position directly to influence the conduct and outcome of the investment circular reporting engagement and immediate family members of such persons should not accept hospitality from the engagement client, unless it is reasonable in terms of its frequency, nature and cost.

2.84 Where gifts or hospitality are accepted from an engagement client, selfinterest and familiarity threats to the reporting accountant’s objectivity and independence are created. Familiarity threats also arise where gifts or hospitality are offered to an engagement client.

2.85 Gifts from the engagement client, unless their value is clearly insignificant, create threats to objectivity and independence which no safeguards can eliminate or reduce.

2.86 Hospitality is a component of many business relationships and can provide valuable opportunities for developing an understanding of the client’s business and for gaining the insight on which an effective and successful working relationship depends. Therefore, the reporting accountant’s objectivity and independence is not necessarily impaired as a result of accepting hospitality from the engagement client, provided it is reasonable in terms of its frequency, its nature and its cost.

2.87 The firm should establish policies on the nature and value of gifts and hospitality that may be accepted from and offered to clients, their directors, officers and employees, and should issue guidance to assist partners and staff to comply with such policies.

2.88 In assessing the acceptability of gifts and hospitality, the test to be applied is not whether the reporting accountant considers that its objectivity is impaired but whether it is probable that a reasonable and informed third party would conclude that it is or is likely to be impaired.

2.89 Where there is any doubt as to the acceptability of gifts or hospitality offered by the engagement client, members of the engagement team discuss the position with the engagement partner. If the cumulative amount of gifts or hospitality accepted from the engagement client appears abnormally high or there is any doubt as to the acceptability of gifts or hospitality offered to the engagement partner, or if the engagement partner has any residual doubt about the acceptability of gifts or hospitality to other individuals, the engagement partner reports the facts to the ethics partner, for further consideration regarding any action to be taken.

SECTION 3 – THE PROVISION OF OTHER SERVICES

INTRODUCTION

3.1 The provision of other services by reporting accountants to the engagement client may create threats to their objectivity or perceived loss of independence. The threats and safeguards approach set out in Section 1 sets out the general approach to be adopted by reporting accountants in relation to the provision of other services to their clients. This approach is applicable irrespective of the nature of the services, which may be in question in a given case. This Section illustrates the application of the general approach to a number of commonly provided services.

3.2 In this Standard, ‘other services’ comprise any engagement in which a reporting accountant provides professional services to an engagement client other than pursuant to:

any investment circular reporting engagement;
the audit of financial statements; and
those other roles which legislation or regulation specify can be performed by the auditors of the entity (for example, considering the preliminary announcements of listed companies, complying with the procedural and reporting requirements of regulators, such as requirements relating to the audit of the client’s internal controls and reports in accordance with Section 151 or 173 of the Companies Act 1985).

3.3 Where the engagement client is a member of a group, other services, for the purposes of this Standard, include:

services provided by the firm, to the parent company or to any of its significant affiliates; and
services provided by a network firm which is involved in the investment circular reporting engagement to the engagement client or any of its significant affiliates.

3.4 The provisions of this section apply only to those other services provided by the reporting accountant to the engagement client during the relevant period. The relevant period covers the period during which the engagement is undertaken and any additional period subsequent to the date of the most recent audited financial statements. Other services provided prior to that date are unlikely to create threats to the reporting accountant’s objectivity because:

where the reporting accountant undertook the last audit of the engagement client’s financial statements and complied with the APB Ethical Standards for Auditors, the requirements applicable to the provision of other services will have been observed; or
where the last audit of the engagement client’s financial statements was undertaken by a different firm, the work done by the reporting accountant in providing other services will have been the subject of independent review in the course of the audit.

The firm should establish policies and procedures, including the alternative procedures outlined in paragraph 1.44, that enable it to identify circumstances where others within the firm and network firms involved in the investment circular reporting engagement have accepted an engagement to provide during the relevant period, an other service to an engagement client or any of that client’s significant affiliates.

The firm establishes appropriate policies and procedures to ensure that, in relation to an engagement client, any engagement to provide an other service to the client or any of its significant affiliates during the relevant period is identified so that the engagement partner can consider the implications for the reporting accountant’s objectivity and independence before the investment circular reporting engagement is accepted. Such policies and procedures are likely to involve: i) enquiries of the engagement client;

reference to records of past and current other service engagements provided by the firm;

enquiries of network firms involved in the investment circular reporting engagement as to whether they have provided any other service engagement to the client or any of its significant affiliates during the relevant period.

Such enquiries are undertaken in a manner which seeks to protect confidentiality.

Where the engagement partner considers that it is probable that a reasonable and informed third party would regard the objectives of an other service engagement^[1] undertaken during the relevant period as being inconsistent with the objectives of the investment circular reporting engagement, the firm should not accept or withdraw from the investment circular reporting engagement.

The objectives of engagements to provide other services vary and depend on the specific terms of the engagement. In some cases these objectives may be inconsistent with those of the investment circular reporting engagement, and, in such cases, this may give rise to a threat to the reporting accountant’s objectivity and to the appearance of its independence. Firms do not undertake other service engagements during the relevant period, where the objectives of such engagements are inconsistent with the objectives of the investment circular reporting engagement, or do not accept or withdraw from the investment circular reporting engagement.

Similarly, in relation to a possible new investment circular reporting engagement, consideration needs to be given to recent and current engagements to provide other services by the firm to the client and whether the scope and objectives of those engagements are consistent with the proposed investment circular reporting engagement. In making this assessment, the engagement partner gives consideration to the provisions and guidance given on specific other services in paragraphs 3.13 to 3.89.

[1] This includes consideration of any private reporting engagements associated with the transaction which is the subject of the investment circular that were undertaken before the investment circular was contemplated.

When tendering for a new investment circular reporting engagement, the firm ensures that relevant information on recent other services is drawn to the attention of those charged with governance of the issuing engagement client and any other persons or entities the reporting accountant is instructed to advise, including: when recent services were provided to the client;

the materiality of those services to the proposed investment circular reporting engagement;
whether those services would have been prohibited if the firm had been undertaking an investment circular reporting engagement at the time when they were undertaken; and
the extent to which the outcomes of other services have been reviewed by another firm.

Where both an investment circular reporting engagement and an engagement to undertake other services are provided concurrently the initial assessment of the threats to objectivity and independence and the safeguards to be applied are reviewed whenever the scope and objectives of the other service or the investment circular reporting engagement change significantly. If such a review suggests that safeguards cannot reduce the threat to an acceptable level, the firm withdraws from the other service engagement, or withdraws from the investment circular reporting engagement.

The following paragraphs provide requirements and guidance on the provision of specific other services by the reporting accountant during the relevant period to the engagement client once the assessment of threats to independence and objectivity at the time of appointment has been made.

INTERNAL AUDIT SERVICES

3.13 The range of ‘internal audit services’ is wide and they may not be termed as such by the engagement client. For example, the firm may be engaged:

to outsource the engagement client’s entire internal audit function; or
to supplement the engagement client’s internal audit function in specific areas (for example, by providing specialised technical services or resources in particular locations); or
to provide occasional internal audit services to the engagement client on an ad hoc

All such engagements would fall within the term ‘internal audit services’.

The main threats to the reporting accountant’s objectivity and independence arising from the provision of internal audit services are the self-review threat and the management threat.

Engagements to provide internal audit services – other than those prohibited in paragraph 3.17 – may be undertaken, provided that the reporting accountant is satisfied that ’informed management’^[1] has

been designated by the client and provided that appropriate safeguards are applied.

Examples of safeguards that may be appropriate when internal audit services are provided to an engagement client include ensuring that:

internal audit projects undertaken by the firm are performed by partners and staff who have no involvement in the investment circular reporting engagement;
the work of the reporting accountant is reviewed by a partner who is not involved in the engagement, to ensure that the internal audit work performed by the firm has been properly and effectively assessed in the context of the investment circular reporting engagement.

[1] See paragraph 1.36.

3.17 The firm should not undertake an engagement to provide internal audit services to an engagement client where it is reasonably foreseeable that:

for the purposes of the investment circular reporting engagement, the reporting accountant would place significant reliance on the internal audit work performed by the firm; or
for the purposes of the internal audit services, the firm would undertake part of the role of management of the engagement client in relation to the transaction or the financial information that is the subject of the investment circular reporting engagement.

The self-review threat is unacceptably high where the reporting accountant cannot perform the investment circular reporting engagement without placing significant reliance on the work performed for the purposes of the internal audit services engagement. For example, the provision of internal audit services on the internal financial controls for an engagement client which is a large bank, is likely to be unacceptable as the reporting accountant is likely to place significant reliance on the work performed by the internal audit team in relation to the bank’s internal financial controls.

The management threat is unacceptably high where the firm provides internal audit services that involve firm personnel taking decisions or making judgments which are properly the responsibility of management. For example, such situations can arise where the nature of the internal audit work involves the firm in taking decisions in relation to the transaction or the financial information that is the subject of the investment circular reporting engagement, as to:
- the scope and nature of the internal audit services to be provided to the engagement client, or
- the design of internal controls or implementing changes thereto.

During the course of an investment circular reporting engagement the reporting accountant may evaluate the design and test the operating effectiveness of some of the entity’s internal financial controls, including the operation of any internal audit function and provide management with observations on matters that have come to their attention, including comments on weaknesses in the internal control systems (including the internal audit function) and suggestions for addressing them. This work is a by-product of the investment circular reporting engagement rather than the result of a specific engagement to provide other services and therefore does not constitute internal audit services for the purposes of this Standard.

In some circumstances, additional internal financial controls work is performed during the course of the investment circular reporting engagement in response to a specific request. Whether it is appropriate for this work to be undertaken by the firm will depend on the extent to which it gives rise to a management threat to the reporting accountant’s objectivity and independence. The engagement partner reviews the scope and objectives of the proposed work and assesses the threats to which it gives rise and the safeguards available.

INFORMATION TECHNOLOGY SERVICES

3.22 Design, provision and implementation of information technology (including financial information technology) systems by firms for their clients creates threats to the reporting accountant’s objectivity and independence. The principal threats are the self-review threat and the management threat.

3.23 Engagements to design, provide or implement information technology systems that are not important to any significant part of the accounting system or to the production of the financial information that is the subject of the investment circular reporting engagement and do not have significant reliance placed on them by the reporting accountant, may be undertaken, provided that ‘informed management’¹⁸ has been designated by the engagement client and provided that appropriate safeguards are applied.

3.24 Examples of safeguards that may be appropriate when information technology services are provided to an engagement client include ensuring that:

information technology projects undertaken by the firm are performed by partners and staff who have no involvement in the investment circular reporting engagement;
the work undertaken in the course of the investment circular reporting engagement is reviewed by a partner who is not involved in the engagement to ensure that the information technology work performed has been properly and effectively assessed.

3.25 The firm should not undertake an engagement to design, provide or implement information technology systems for an engagement client where:

the systems concerned would be important to any significant part of the accounting system or to the production of the financial information that is the subject of an investment circular reporting engagement and the reporting accountant would place significant reliance upon them as part of the investment circular reporting engagement; or
for the purposes of the information technology services, the firm would undertake part of the role of management of the engagement client in relation to the transaction or the financial information that is the subject of the investment circular reporting engagement.

Where it is reasonably apparent that, having regard to the activities and size of the engagement client and the range and complexity of the system, the management lacks the expertise required to take responsibility for the systems concerned, it is unlikely that any safeguards would be sufficient to eliminate these threats or to reduce them to an acceptable level. In particular, formal acceptance by management of the systems designed and installed by the firm is unlikely to be an effective safeguard when, in substance, the firm has been retained by management for its expertise and has made important decisions in relation to the design or implementation of systems of internal control and financial reporting in relation to the transaction or the financial information that is the subject of the investment circular reporting engagement.

The provision and installation of information technology services associated with a standard ‘off the shelf accounting package’ (including basic set-up procedures to make the package operate on the client’s existing platform and peripherals, setting up the chart of accounts and the entry of standard data such as the client’s product names and

prices) is unlikely to create a level of threat to the reporting accountant’s objectivity and independence that cannot be addressed through applying appropriate safeguards.

VALUATION SERVICES

3.28 The firm should not undertake an engagement to provide a valuation to an engagement client where the valuation would both:

involve a significant degree of subjective judgment; and
have a material effect on the financial information that is the subject of the investment circular reporting engagement.

The main threats to the reporting accountant’s objectivity and independence arising from the provision of valuation services are the self-review threat and the management threat. The self-review threat is considered too high to allow the provision of valuation services which involve the valuation of amounts with a significant degree of subjectivity that may have a material effect on the financial information that is the subject of the investment circular reporting engagement.

It is usual for the reporting accountant to provide the management with accounting advice in relation to valuation matters that have come to its attention during the course of the investment circular reporting engagement. Such matters might typically include:

comments on valuation assumptions and their appropriateness;
errors identified in a valuation calculation and suggestions for correcting them;
advice on accounting policies and any valuation methodologies used in their application.

Advice on such matters does not constitute valuation services for the purpose of this Standard.

3.31 Where reporting accountants are engaged to collect and verify the accuracy of data to be used in a valuation to be performed by others, such engagements do not constitute valuation services under this Standard.

ACTUARIAL VALUATION SERVICES

3.32 The firm should not undertake an engagement to provide actuarial valuation services to an engagement client, unless the firm is satisfied that either:

all significant judgments, including the assumptions, are made by ’informed management’¹⁸; or
the valuation has no material effect on the financial information that is the subject of the investment circular reporting engagement.

Actuarial valuation services are subject to the same general principles as other valuation services. Where they involve the firm in making a subjective judgment and have a material effect on the financial information that is the subject of the investment circular reporting engagement, actuarial valuations give rise to an unacceptable level of self-review threat and so may not be performed by reporting accountants for their clients.

However, in cases where all significant judgments concerning the assumptions, methodology and data for the actuarial valuation are made by ‘informed management’ and the firm’s role is limited to applying proven methodologies using the given data, for which the management takes responsibility, it may be possible to establish effective safeguards to protect the reporting accountant’s objectivity and the appearance of its independence.

TAX SERVICES

3.35 The range of activities encompassed by the term ‘tax services’ is wide. Three broad categories of tax service can be distinguished. They are where the firm:

provides advice to the engagement client on one or more specific matters at the request of the client; or
undertakes a substantial proportion of the tax planning or compliance work for the engagement client; or
promotes tax structures or products to the engagement client, the effectiveness of which is likely to be influenced by the manner in which they are accounted for in the financial information that is the subject of the investment circular reporting engagement.

Whilst it is possible to consider tax services under broad headings, such as tax planning or compliance, in practice these services are often interrelated and it is impracticable to analyse services in this way for the purposes of attempting to identify generically the threats to which specific engagements give rise. As a result, firms need to identify and assess, on a case-by-case basis, the potential threats to the reporting accountant’s objectivity and independence before deciding whether to undertake an engagement to provide tax services to an engagement client.

The provision of tax services by firms to their engagement clients may give rise to a number of threats to the reporting accountant’s objectivity and independence, including the self-interest threat, the management threat, the advocacy threat and, where the work involves a significant degree of subjective judgment and has a material effect on the financial information that is the subject of the investment circular reporting engagement, the self-review threat.

Where the firm provides advice to the engagement client on one or more specific matters at the request of the client, a self-review threat may be created. This self-review threat is more significant where the firm undertakes a substantial proportion of the tax planning and compliance work for the engagement client. However, the reporting accountant may be able to adopt appropriate safeguards.

Examples of such safeguards that may be appropriate when tax services are provided to an engagement client include ensuring that:
- the tax services are provided by partners and staff who have no involvement in the investment circular reporting engagement;
- the tax services are reviewed by an independent tax partner, or other senior tax employee;
- external independent advice is obtained on the tax work;
- tax computations prepared by the firm are reviewed by a partner or senior staff member with appropriate expertise who is not a member of the investment circular reporting engagement team; or
- a partner not involved in the engagement reviews whether the tax work has been properly and effectively addressed in the context of the investment circular reporting engagement.

The firm should not promote tax structures or products or undertake an engagement to provide tax advice to an engagement client where the engagement partner has, or ought to have, reasonable doubt as to the appropriateness of the related accounting treatment involved, having regard to the requirement for the financial information to give a true and fair view in the context of the relevant financial reporting framework.

Where the firm promotes tax structures or products or undertakes an engagement to provide tax advice to the engagement client, it may be necessary to adopt an accounting treatment about which there is reasonable doubt as to its appropriateness, in order to achieve the desired result. A self-review threat arises in the course of an investment circular reporting engagement because the reporting accountant may be unable to form an impartial view of the accounting treatment to be adopted for the purposes of the proposed arrangements. Accordingly, this Standard does not permit the promotion of tax structures or products by firms to their engagement clients where, in the view of the engagement partner, after such consultation as is appropriate, the effectiveness of the tax structure or product depends on an accounting treatment about which there is reasonable doubt as to its appropriateness.

The firm should not undertake an engagement to provide tax services to an engagement client wholly or partly on a contingent fee basis where:
- the engagement fees are material to the firm or the part of the firm by reference to which the engagement partner’s profit share is calculated; or
- the outcome of those tax services (and, therefore, the entitlement to the fee) is dependent on:
  - the application of tax law which is uncertain or has not been established; and
  - a judgment made by the reporting accountant in relation to a material aspect of the investment circular reporting engagement.

Where tax services, such as advising on corporate structures and structuring transactions to achieve a particular effect, are undertaken on a contingent fee basis, self-interest threats to the reporting accountant’s objectivity and independence may arise. The reporting accountant may have, or may appear to have, an interest in the success of the tax services, causing it to make a judgment about which there is reasonable doubt as to its appropriateness. Where the contingent fee is determined by the outcome of the application of tax law, which is uncertain or has not been established, and a judgment

made by the reporting accountant in relation to a material aspect of the investment circular reporting engagement, the self-interest threat cannot be eliminated or reduced to an acceptable level by the application of any safeguards.

The firm should not undertake an engagement to provide tax services to an engagement client where the engagement would involve the firm undertaking a management role for the engagement client in relation to the transaction or the financial information that is the subject of the investment circular reporting engagement.

When providing tax services to an engagement client, there is a risk that the reporting accountant undertakes a management role, unless the firm is working with ’informed management’¹⁸ and appropriate safeguards are applied, such as the tax services being provided by partners and staff who have no involvement in the investment circular reporting engagement.

The firm should not undertake an engagement to provide tax services to an engagement client where this would involve acting as an advocate for the client, before an appeals tribunal or court^[1] in the resolution of an issue:
- that is material to the financial information that is the subject of the investment circular reporting engagement; or
- where the outcome of the tax issue is dependent on a judgment made by the reporting accountant in relation to a material aspect of the investment circular reporting engagement.

Where the tax services to be provided by the firm include representing the client in any negotiations or proceedings involving the tax authorities, advocacy threats to the reporting accountant’s objectivity and independence may arise.

The firm is not acting as an advocate where the tax services involve the provision of information to the tax authorities (including an explanation of the approach being taken and the arguments being advanced by the client). In such circumstances effective safeguards may exist and the tax authorities will undertake their own review of the issues.

Where the tax authorities indicate that they are minded to reject the client’s arguments on a particular issue and the matter is likely to be determined by an appeals tribunal or court, the firm may become so closely identified with management’s arguments that the reporting accountant is inhibited from forming an impartial view of the treatment of the issue in the financial information that is the subject of the investment circular reporting engagement. In such circumstances, if the issue is material to the financial information or is dependent on a judgment made by the reporting accountant in relation to a material aspect of the investment circular reporting engagement, the firm discusses the matter with the engagement client and makes it clear to the engagement client that it will have to withdraw from that element of the engagement to provide tax services that requires it to act as advocate for the engagement client, or withdraw from the investment circular reporting engagement from the time when the matter is formally listed for hearing before the appeals tribunal.

The firm is not, however, precluded from having a continuing role (for example, responding to specific requests for information) for the engagement client in relation to the appeal. The firm assesses the threat associated with any continuing role in accordance with the provisions of paragraphs 3.50 to 3.52 of this Standard.

LITIGATION SUPPORT SERVICES

3.50 The firm should not undertake an engagement to provide litigation support services to an engagement client where this would involve the estimation by the firm of the likely outcome of a pending legal matter that could be material to the amounts to be included or the disclosures to be made in the financial information that is the subject of the investment circular reporting engagement and there is a significant degree of subjectivity involved.

3.51 Although management and advocacy threats may arise in litigation support services, such as acting as an expert witness, the primary issue is that a self-review threat will arise where such services involve a subjective estimation of the likely outcome of a matter that is material to the amounts to be included or the disclosures to be made in the financial information that is the subject of the investment circular reporting engagement.

3.52 Litigation support services that do not involve such subjective estimations are not prohibited, provided that the firm has carefully considered the implications of any threats and established appropriate safeguards.

LEGAL SERVICES

3.53 The firm should not undertake an engagement to provide legal services to an engagement client where this would involve acting as the solicitor formally nominated to represent the client in the resolution of a dispute or litigation which is material to the amounts to be included or the disclosures to be made in the financial information that is the subject of the investment circular reporting engagement.

3.54 Although the provision by reporting accountants of certain types of legal services to their clients may create advocacy, self-review and management threats, this Standard does not impose a general prohibition on the provision of legal services. However, in view of the degree of advocacy involved in litigation or other types of dispute resolution procedures and the potential importance of any assessment by the reporting accountant of the merits of the client’s position when reviewing the financial information, this Standard prohibits a reporting accountant from acting as the formally nominated representative for an engagement client in the resolution of a dispute or litigation which is material to the financial information that is the subject of the investment circular reporting engagement (either in terms of the amounts recognised or disclosed in the financial information).

RECRUITMENT AND REMUNERATION SERVICES

3.55 The firm should not undertake an engagement to provide recruitment services to an engagement client in relation to the appointment of:

any director or
any employee of the engagement client who will be involved in an area that is directly concerned with the transaction which is the subject of the investment circular.

A management threat arises where firm personnel take responsibility for any decision as to who should be appointed by the engagement client. Furthermore, a familiarity threat arises if the firm plays a significant role in relation to the identification and recruitment of senior members of management within the company, as the engagement team may be less likely to be critical of the information or explanations provided by such individuals than might otherwise be the case. Accordingly, the firm does not undertake engagements that involve the recruitment of individuals for key management positions during the relevant period.

Where the firm has played a significant role in relation to the identification and recruitment of a senior member of management within the company, including all directors, prior to the relevant period, the engagement partner considers whether a familiarity threat exists, taking account of factors such as:

the closeness of personal relationships between the firm’s partners and staff and client personnel;
the length of time since the recruitment of the individual in question;
the position held by the individual at the engagement client;
the extent of involvement that the individual will have with the transaction which is the subject of the investment circular;
whether the individual is in a position to exercise influence on the accounting records or financial information.

Following the assessment of any such threats, appropriate safeguards are applied where necessary, such as ensuring that the engagement team does not include individuals with a close relationship to the senior member of management or who were involved in the recruitment exercise.

Recruitment services involve a specifically identifiable, and separately remunerated, engagement. Reporting accountants may contribute to an entity’s recruitment process in less formal ways. The prohibition set out in paragraph 3.55 does not extend to senior members of an engagement team interviewing prospective employees of the engagement client or to the entity using information gathered by the firm, including that relating to salary surveys.

The firm should not undertake an engagement to provide advice on the quantum of the remuneration package or the measurement criteria on which the quantum is calculated, for a director or key management position of an engagement client.

The provision of advice on remuneration packages (including bonus arrangements, incentive plans and other benefits) to existing or prospective employees of the engagement client gives rise to familiarity threats. The significance of the familiarity threat is considered too high to allow advice on the overall amounts to be paid or on the quantitative measurement criteria included in remuneration packages for directors and key management positions.

For other employees, these threats can be adequately addressed by the application of safeguards, such as the advice being provided by partners and staff who have no involvement in the investment circular reporting engagement.

In cases where all significant judgments concerning the assumptions, methodology and data for the calculation of remuneration packages for directors and key management are made by ’informed management’¹⁸ or a third party and the firm’s role is limited to applying proven methodologies using the given data, for which the management takes responsibility, it may be possible to establish effective safeguards to protect the reporting accountant’s objectivity and independence.

Advice on tax, pensions and interpretation of accounting standards relating to remuneration packages for directors and key management can be provided by the firm, provided they are not prohibited by the requirements of this Standard relating to tax, actuarial valuations and accounting services.

CORPORATE FINANCE SERVICES

3.64 The range of services encompassed by the term ‘corporate finance services’ is wide. For example, the firm may be engaged:

to identify possible purchasers for parts of the client’s business and provide advisory services in the course of such sales; or
to identify possible ‘targets’ for the client to acquire; or
to advise the client on how to fund its financing requirements, including advising on debt restructuring and securitisation programmes; or
to act as sponsor on admission to listing on the London Stock Exchange or the Irish Stock Exchange, as Nominated Advisor on the admission of the client on the Alternative Investments Market (AIM), or as an IEX Adviser on the admission of the client to the Irish Enterprise Exchange (IEX) of the Irish Stock Exchange; or
to act as financial adviser to client offerors or offerees in connection with public takeovers.

The potential for the reporting accountant’s objectivity and independence to be impaired through the provision of corporate finance services varies considerably depending on the precise nature of the service provided. The main threats to reporting accountant’s objectivity and independence arising from the provision of corporate finance services are the self-review, management and advocacy threats. Selfinterest threats may also arise, especially in situations where the firm is paid on a contingent fee basis.

When providing corporate finance services to an engagement client, there is a risk that the firm undertakes a management role, unless the firm is working with ’informed management’¹⁸ and appropriate safeguards are applied.
Examples of safeguards that may be appropriate when corporate finance services are provided to an engagement client include ensuring that:

the corporate finance advice is provided by partners and staff who have no involvement in the investment circular reporting engagement,
any advice provided is reviewed by an independent corporate finance partner within the firm,
external independent advice on the corporate finance work is obtained,
a partner who is not involved in the investment circular reporting engagement or the corporate finance services reviews the work performed in the investment circular reporting engagement.

Where the firm undertakes an engagement to provide corporate finance services to an engagement client in connection with conducting the sale or purchase of a material part of the client’s business, the engagement partner should inform those charged with governance of the issuing engagement client and any other person or entity the reporting accountant is instructed to advise about the engagement, as set out in paragraphs 1.68 to 1.76.

The firm should not undertake an engagement to provide corporate finance services to an engagement client where:
- the engagement would involve the firm taking responsibility for dealing in, underwriting or promoting shares; or
- the engagement partner has, or ought to have, reasonable doubt as to the appropriateness of an accounting treatment that is related to the advice provided, having regard to the requirement for the financial information to give a true and fair view in accordance with the relevant financial reporting framework; or
- such corporate finance services are to be provided on a contingent fee basis and:
  - the engagement fees are material to the firm or the part of the firm by reference to which the engagement partner’s profit share is calculated; or

the outcome of those corporate finance

services (and, therefore, the entitlement to the fee) is dependent on a judgment made by the reporting accountant in relation to a material aspect of the investment circular reporting engagement^[1]; or

(d) the engagement would involve the firm undertaking a management role for the engagement client in relation to the transaction or the financial information that is the subject of the investment circular reporting engagement.

[1] A reporting accountant judgment made in relation to a material aspect of the investment circular reporting engagement would be one which could adversely affect the successful completion of the transaction to which the investment circular relates, for example, where a reporting accountant is considering a qualification to an accountant’s report as a result of a disagreement in relation to an accounting treatment which would affect revenue recognition and where a qualified opinion would be likely to render the company unsuitable for listing. ²¹ In the United Kingdom, the UK Listing Authority’s publication the ‘Listing Rules’. In the Republic of Ireland, the Irish Stock Exchange’s publication the ‘Listing Rules’.

[1] The restriction applies to the first level of Tax Court that is independent of the tax authorities and to more authoritative bodies. In the UK this would be the General or Special Commissioners of the Inland Revenue or the VAT and Duties Tribunal.

An unacceptable advocacy threat arises where, in the course of providing a corporate finance service, the firm promotes the interests of the engagement client by taking responsibility for dealing in, underwriting, or promoting shares.

Where the firm acts as a Sponsor under the Listing Rules²¹, or as Nominated Adviser on the admission of the engagement client to the AIM or as an IEX Adviser on the admission of the engagement client to IEX, the firm is required to confirm that the client has satisfied all applicable conditions for listing and other relevant requirements of the

Listing Rules, AIM rules or IEX Rules, respectively. Where there is, or

there ought to be, reasonable doubt that the firm will be able to give that confirmation, it does not enter into such an engagement.

Advice to engagement clients on issues such as funding and banking arrangements, where there is no reasonable doubt as to the appropriateness of the accounting treatment, is not prohibited provided this does not involve the firm in taking decisions or making judgments which are properly the responsibility of management.

Where a corporate finance engagement is undertaken on a contingent fee basis, self-interest threats to the reporting accountant’s objectivity and independence also arise as the reporting accountant may have, or may appear to have, an interest in the success of the corporate finance services. The significance of the self-interest threat is primarily determined by the materiality of the contingent fee to the firm, or to the part of the firm by reference to which the engagement partner’s profit share is calculated. Where the contingent fee and the outcome of the corporate finance services is dependent on a judgment made by the reporting accountant in relation to a material aspect of the investment circular reporting engagement, the self-interest threat cannot be eliminated or reduced to an acceptable level by the application of any safeguards.

In situations where a reporting accountant can see at the outset of the investment circular reporting engagement that there is likely to be a judgment that will be made in relation to a material aspect of the investment circular reporting engagement which could adversely affect the successful completion of the transaction to which the investment circular relates, the firm will not agree to undertake any corporate finance engagements in relation to the transaction on a contingent fee basis, or will not accept the investment circular reporting engagement. Where corporate finance engagements are entered into on a contingent fee basis and a judgment needs to be made in relation to a material aspect of the investment circular reporting engagement during the course of an investment circular reporting engagement, then the firm changes the terms of the corporate finance engagement so that it no longer involves a contingent fee or withdraws from either the relevant corporate finance engagement or the investment circular reporting engagement.

Where the firm provides a range of corporate finance services to the engagement client, including acting as a Sponsor, Nominated Advisor or IEX Adviser on terms that involve a contingent fee, and that firm also undertakes a public reporting engagement for the engagement client, the self-interest threat caused by contingent fee arrangements may be reduced to an acceptable level by the application of safeguards, such as the corporate finance services being provided by partners and staff who have no involvement in the investment circular reporting engagement. In such circumstances the reporting accountant ensures that the situation is fully disclosed to the Financial Services Authority,

the Irish Stock Exchange or the London Stock Exchange and any related regulatory requirements have been complied with.²²

TRANSACTION RELATED SERVICES

3.77 In addition to corporate finance services, there are other services associated with transactions that a firm may undertake for an engagement client. For example:

investigations into possible acquisitions or disposals (‘due diligence’ engagements); or
investigations into the tax implications of possible acquisitions or disposals.

3.78 When providing transaction related services to an engagement client, unless the firm is working with ’informed management’¹⁸ and appropriate safeguards are applied, there is a risk that the firm undertakes a management role.

²² At the date of issue:

FSA Listing Rule 8.7.12 states that a sponsor must provide written confirmation to the

UKLA that it is independent of the issuer or new applicant by way of a ‘Sponsor’s Confirmation of Independence’ form;

Irish Stock Exchange Listing Rule 2.2.1(2) requires that for each transaction in respect of which a firm acts as sponsor in accordance with the listing rules, the sponsor must submit to the Exchange at an early stage a confirmation of independence in the form set out in ‘Schedule 1’.
Part Two of the AIM Nominated Adviser eligibility criteria states that a nominated adviser may not act as both reporting accountant and nominated adviser to an AIM company unless it has satisfied the London Stock Exchange that appropriate safeguards are in place.
Part Two of the IEX Adviser Eligibility Criteria states that an IEX adviser may not act as both reporting accountant and IEX adviser to an IEX company unless it has satisfied the Irish Stock Exchange that appropriate safeguards are in place.

3.79 Examples of safeguards that may be appropriate when transaction related services are provided to an engagement client include ensuring that:

the transaction related advice is provided by partners and staff who have no involvement in the investment circular reporting engagement,
any advice provided is reviewed by an independent transactions partner within the firm,
external independent advice on the transaction related work is obtained,
a partner who is not involved in the investment circular reporting engagement reviews the work performed in relation to the subject matter of the transaction related service provided to ensure that such work has been properly and effectively reviewed and assessed in the context of the investment circular reporting engagement.

3.80 The reporting accountant should not undertake an engagement to provide transaction related services to an engagement client where:

the engagement partner has, or ought to have, reasonable doubt as to the appropriateness of an accounting treatment that is related to the advice provided, having regard to the requirement for the financial information to give a true and fair view in accordance with the relevant financial reporting framework; or
such transaction related services are to be provided on a contingent fee basis and:
- the engagement fees are material to the firm or the part of the firm by reference to which the engagement partner’s profit share is calculated; or
- the outcome of those transaction related services (and, therefore, the entitlement to the fee) is dependent on a judgment made by the reporting accountant in relation to a material aspect of the investment circular reporting engagement; or

(c) the engagement would involve the firm undertaking a management role for the engagement client in relation to the transaction or the financial information that is the subject of the investment circular reporting engagement.

3.81 A self-review threat arises where the outcome of the transaction related service undertaken by the firm may be material to the financial information that is the subject of the investment circular reporting engagement. Where the engagement client proposes to undertake a transaction, it may be necessary to adopt an inappropriate accounting treatment in order to achieve the desired result. A self-review threat is created if the reporting accountant undertakes transaction related services in connection with such a transaction. Accordingly, this Standard does not permit the provision of advice by firms to their engagement clients where there is reasonable doubt about the appropriateness of the accounting treatments related to the transaction advice given.

3.82 Where a transaction related services engagement is undertaken on a contingent fee basis, self-interest threats to the reporting accountant’s objectivity and independence also arise as the reporting accountant may have, or may appear to have, an interest in the success of the transaction. The significance of the self-interest threat is primarily determined by the materiality of the contingent fee to the firm, or to the part of the firm by reference to which the engagement partner’s profit share is calculated. Where the contingent fee and the outcome of the transaction related services is dependent on a judgment made by the reporting accountant in relation to a material aspect of the investment circular reporting engagement, the self-interest threat cannot be eliminated or reduced to an acceptable level by the application of any safeguards, other than where the transaction is subject to a preestablished dispute resolution procedure.

ACCOUNTING SERVICES

3.83 In this Standard, the term ‘accounting services’ is defined as the provision of services that involve the maintenance of accounting records or the preparation of financial statements or information that is then subject to review in an investment circular reporting engagement. Advice on the implementation of current and proposed accounting standards is not included in the term ‘accounting services’.

3.84 The range of activities encompassed by the term ‘accounting services’ is wide. In some cases, the client may ask the firm to provide a complete service including maintaining all of the accounting records and the preparation of the financial information. Other common situations are:

the firm may take over the provision of a specific accounting function on an outsourced basis (for example, payroll);
the client maintains the accounting records, undertakes basic bookkeeping and prepares trial balance information and asks the firm to assist with the preparation of the necessary adjustments and financial information.

The provision of accounting services by the firm to the engagement client creates threats to the reporting accountant’s objectivity and independence, principally self-review and management threats, the significance of which depends on the nature and extent of the accounting services in question and upon the level of public interest in the client.

The firm should not undertake an engagement to provide accounting services in relation to the financial information that is the subject of the investment circular reporting engagement save where the circumstances contemplated in paragraph 3.89 apply.

Even where there is no engagement to provide any accounting services, it is usual for the reporting accountant to provide the management with accounting advice on matters that have come to its attention during the course of an engagement. Such matters might typically include:

comments on weaknesses in the accounting records and suggestions for addressing them;
errors identified in the accounting records and in the financial information and suggestions for correcting them;
advice on the accounting policies in use and on the application of current and proposed accounting standards.

This advice is a by-product of the investment circular reporting engagement rather than the result of any engagement to provide other services. Consequently, as it is part of the reporting accountant’s engagement, such advice cannot be regarded as giving rise to any threat to the reporting accountant’s objectivity and independence.

The threats to the reporting accountant’s objectivity and independence that would be created are too high to allow the firm to undertake an engagement to provide any accounting services in relation to the financial information that is the subject of the investment circular reporting engagement, save where the circumstances contemplated in paragraph 3.89 apply.

In emergency situations, the firm may provide an engagement client, or a significant affiliate of such a company, with accounting services to assist the company in the timely preparation of its financial statements or information. This might arise when, due to external and unforeseeable events, the firm personnel are the only people with the necessary knowledge of the client’s systems and procedures. A situation could be considered an emergency where the firm’s refusal to provide these services would result in a severe burden for the client (for example, withdrawal of credit lines), or would even threaten its going concern status. In such circumstances, the firm ensures that:

any staff involved in the accounting services have no involvement in the investment circular reporting engagement; and
the engagement would not lead to any firm staff or partners taking decisions or making judgments which are properly the responsibility of management.

SECTION 4 – EFFECTIVE DATE

4.1 Effective for investment circular reporting engagements commencing on or after 1 April 2007.

4.2 Firms may complete investment circular reporting engagements commenced prior to 1 April 2007 in accordance with existing ethical guidance applicable to them at the time of their engagement from the relevant professional body.

4.3 Business relationships existing at 31 October 2006 that were permissible in accordance with existing ethical guidance from the relevant professional body, but are prohibited by the requirements of paragraph 2.20, may continue until 31 December 2007 provided that:

no new contracts (or extensions of contracts) under the business relationship are entered into;
the reporting accountant satisfies itself that there are adequate safeguards in place to reduce the threat to acceptable levels; and
disclosure is made to those charged with governance of the issuing engagement client and those the reporting accountant is instructed to advise.

4.4 Loan staff assignments existing at 31 October 2006 that are prohibited by the requirements of paragraph 2.27, may continue until the earlier of:

the completion of the specific task or the end of the contract term, where this is set out in the contract; or
31 December 2007, where a task or term is not defined, as long as the following apply:
the investment circular reporting engagement was permitted by existing ethical guidance from the relevant professional body;
any safeguards required by existing ethical guidance continue to be applied;
the need for additional safeguards is assessed, including where possible safeguards specified in section 3, and if considered necessary, those additional safeguards are applied; and
disclosure is made to those charged with governance of the issuing engagement client and those the reporting accountant is instructed to advise.

4.5 The requirements of paragraph 2.38 in respect of employment with the engagement client do not apply if:

the relevant person has notified an intention to join the client, or has entered into contractual arrangements, prior to 31 October 2006;
undertaking the investment circular reporting engagement was permitted by existing ethical guidance from the relevant professional body; and
disclosure is made to those charged with governance of the issuing engagement client and those the reporting accountant is instructed to advise.

4.6 Where compliance with the requirements of section 3 would result in an investment circular reporting engagement or other service not being supplied, other services contracted before 31 October 2006 may continue to be provided until the earlier of:

the completion of the specific task or the end of the contract term, where this is set out in the contract; or
31 December 2007, where a task or term is not defined, as long as the following apply:
the investment circular reporting engagement was permitted by existing ethical guidance from the relevant professional body;
any safeguards required by existing ethical guidance continue to be applied;
the need for additional safeguards is assessed, including where possible safeguards specified in section 3, and if considered necessary, those additional safeguards are applied; and
disclosure is made to those charged with governance of the issuing engagement client and those the reporting accountant is instructed to advise.

APPENDIX 1 – GLOSSARY OF TERMS

accounting services The provision of services that involve the maintenance of accounting records or the preparation of financial statements or information that is then subject to review in an

investment circular reporting engagement

affiliate	Any undertaking which is connected to another by means of common ownership, control or management.
audit engagement partner	The partner or other person in the firm who is responsible for the audit engagement and its performance and for the report that is issued on behalf of the firm, and who, where required, has the appropriate authority from a professional, legal or regulatory body.
chain of command	All persons who have a direct supervisory, management or other oversight responsibility for the engagement team who have actual knowledge of the investment circular reporting engagement. This includes all partners, principals and shareholders who prepare, review or directly influence the performance appraisal of any partner of the engagement team as a result of their involvement with the investment circular reporting engagement.
close family	A non-dependent parent, child or sibling.

contingent fee basis	Any arrangement made at the outset of an engagement under which a pre-determined amount or a specified commission on or percentage of any consideration or saving is payable to the firm upon the happening of a specified event or the achievement of an outcome (or alternative outcomes). Differential hourly fee rates, or arrangements under which the fee payable will be negotiated after the completion of the engagement, do not constitute contingent fee arrangements.
engagement client	The party responsible for issuing the investment circular containing the financial information^[1] (the issuing engagement client) and, if different the party on whose financial information the firm is reporting.
engagement partner	The partner or other person in the firm who is responsible for the investment circular reporting engagement and its performance and for the report that is issued on behalf of the firm, and who, where required, has the appropriate authority from a professional, legal or regulatory body.
engagement period	The engagement period starts when the firm accepts the investment circular reporting engagement and ends on the date of the report.
engagement team	All professional personnel who are directly involved in the acceptance and performance of a particular investment circular reporting engagement. This includes those who provide quality control or direct oversight of the engagement.

ethics partner	The partner or other person in the firm having responsibility for the adequacy of the firm’s policies and procedures relating to integrity, objectivity and independence, their compliance with APB Ethical Standards and the effectiveness of their communication to partners and staff within the firm and providing related guidance to individual partners.
financial interest	An interest in an equity or other security, debenture, loan or other debt instrument of an entity, including rights and obligations to acquire such an interest and derivatives directly related to such an interest.
firm	The sole practitioner, partnership, limited liability partnership or other corporate entity engaged as a reporting accountant. For the purpose of APB Ethical Standards, the firm includes network firms in the UK and Ireland, which are controlled by the firm or its partners.
immediate family	A spouse (or equivalent) or dependent.
issuing engagement client	The party responsible for issuing the investment circular containing the financial information being reported on.
investment circular	An investment circular is a document issued by an entity pursuant to statutory or regulatory requirements relating to securities on which it is intended that a third party should make an investment decision, including a prospectus, listing particulars, a circular to shareholders or similar document.
investment circular reporting engagement	Any public or private reporting engagement in connection with an investment circular where the engagement is undertaken in accordance with Standards for Investment Reporting (SIRs).

key audit partner

An audit partner, or other person performing the function of an audit partner, of the engagement team (other than the audit engagement partner) who is involved at the group level and is responsible for key decisions or judgments on significant matters, such as on significant subsidiaries or divisions of the audit client, or on significant risk factors that relate to the audit of that client.

key management position

Any position at the engagement client which involves the responsibility for fundamental management decisions at the client (e.g. as a CEO or CFO), including an ability to influence the accounting policies and the preparation of the financial statements of the client. A key management position also arises where there are contractual and factual arrangements which in substance allow an individual to participate in exercising such a management function in a different way (e.g. via a consulting contract).

network firm

Any entity:

(i) controlled by the firm or

(ii) under common control, ownership or management or

(iii) otherwise affiliated or associated with the firm through the use of a common name or through the sharing of significant common professional resources.

person in a position directly to influence the conduct and outcome of the investment circular reporting engagement:	(a) Any person who is directly involved in the investment circular reporting engagement (the engagement team), including: (i) professional personnel from all disciplines involved in the engagement, for example, lawyers, actuaries, taxation specialists, IT specialists, treasury management specialists; (ii) those who provide quality control or direct oversight of the engagement; (b) Any person within the firm who can directly influence the conduct and outcome of the investment circular reporting engagement through the provision of direct supervisory, management or other oversight of the engagement team in the context of the investment circular reporting engagement.
private reporting engagement	An engagement, in connection with an investment circular, in which a reporting accountant does not express a conclusion that is published in an investment circular.
public reporting engagement	An engagement in which a reporting accountant expresses a conclusion that is published in an investment circular and which is designed to enhance the degree of confidence of the intended users of the report about the ‘outcome’ of the directors’ evaluation or measurement of ‘subject matter’ (usually financial information) against ‘suitable criteria’.
relevant period	The engagement period and any additional period before the engagement period but subsequent to the balance sheet date of the most recent audited financial statements of the engagement client.

reporting accountant An accountant engaged to prepare a report for inclusion in, or in connection with, an investment circular. The reporting accountant may or may not be the auditor of the entity issuing the investment circular. The term “reporting accountant” is used to describe either the engagement partner or the engagement partner’s firm^[2]. The reporting accountant could be a limited company or a principal employed by the company.

[1] The financial information is described in SIR 1000 as being the ‘outcome’ of a reporting engagement.

[2] Where the term applies to the engagement partner, it describes the responsibilities or obligations of the engagement partner. Such obligations or responsibilities may be fulfilled by either the engagement partner or another member of the engagement team.

Posted on April 9, 2021 by MJ — Leave a comment

ES APB ETHICAL STANDARD PROVISIONS AVAILABLE FOR SMALL ENTITIES (REVISED)

INTRODUCTION

The APB issues Ethical Standards which set out the standards that auditors are required to comply with in order to discharge their responsibilities in respect of their integrity, objectivity and independence.

The Ethical Standards 1 to 5 address such matters as:

How audit firms set policies and procedures to ensure that, in relation to each audit, the audit firm and all those who are in a position to influence the conduct and outcome of an audit act with integrity, objectivity and independence;
Financial, business, employment and personal relationships;
Long association with the audit engagement;
Fees, remuneration and evaluation policies, litigation, gifts and hospitality;
Non-audit services provided to audited entities.

These Ethical Standards apply to all audit firms and to all audits and must be read in order to understand the alternative provisions and exemptions contained in this Standard.

The APB is aware that a limited number of the requirements in Ethical Standards 1 to 5 are difficult for certain audit firms to comply with, particularly when auditing a small entity. Whilst the APB is clear that those standards are appropriate in the interests of establishing the integrity, objectivity and independence of auditors, it accepts that certain dispensations, as set out in this Standard, are appropriate to facilitate the cost effective audit of the financial statements of Small Entities (as defined below).

This Standard provides alternative provisions for auditors of Small Entities to apply in respect of the threats arising from economic dependence and where tax or accounting services are provided and allows the option of taking advantage of exemptions from certain of the requirements in APB Ethical Standards 1 to 5 for a Small Entity audit engagement. Where an audit firm takes advantage of the exemptions within this Standard, it is required to:
take the steps described in this Standard; and
disclose in the audit report the fact that the firm has applied APB Ethical Standard – Provisions Available for Small Entities.

4 (i) In this Standard, for the UK a ‘Small Entity’ is:

any company, which is not a UK listed company or an affiliate thereof, that qualifies as a small company under Section 382 of the Companies Act 2006;
where group accounts are produced, any group that qualifies as small under Section 383 of the Companies Act 2006;
any charity with an income of less than the turnover threshold applicable to small companies as identified in Section 382 of the Companies Act 2006;
any pension fund with less than 100 members (including active, deferred and pensioner members)^[1];
any firm regulated by the FSA, which is not required to appoint an auditor in accordance with chapter 3 of the FSA Supervision Manual which forms a part of the FSA Handbook^[2];
any credit union which is a mutually owned financial cooperative established under the Credit Unions Act 1979 and the Industrial and Provident Societies Act 1965 (or equivalent legislation), which meets the criteria set out in (a) above;

any entity registered under the Industrial and Provident Societies Act 1965, incorporated under the Friendly Societies Act 1992 or

[1] In cases where a scheme with more than 100 members has been in wind-up over a number of years, such a scheme does not qualify as a Small Entity, even where the remaining number of members falls below 100.

[2] This relates to those firms that are not required to appoint an auditor under rule SUP 3.3.2R of the FSA Supervision Manual.

registered under the Friendly Societies Act 1974 (or equivalent legislation), which meets the criteria set out in (a) above;
any registered social landlord with less than 250 units; and
any other entity, such as a club, which would be a Small Entity if it were a company.

(ii) In this Standard, for the Republic of Ireland a ‘Small Entity’ is: (a) any company, which is not an Irish listed company or an affiliate thereof, that meets two or more of the following requirements in both the current financial year and the preceding financial year:

not more than €7.3 million turnover;
not more than €3.65 million balance sheet total;
not more than 50 employees.

any charity with an income of less than €7.3 million;
any pension fund with less than 1,000 members (including active, deferred and pensioner members)^[1]; and
any other entity, such as a club or credit union, which would be a Small Entity if it were a company.

Where an entity falls into more than one of the above categories, it is only regarded as a ‘Small Entity’ if it meets the criteria of all relevant categories.

ALTERNATIVE PROVISIONS

ECONOMIC DEPENDENCE

When auditing the financial statements of a Small Entity an audit firm is not required to comply with the requirement in APB Ethical Standard 4, paragraph 39 that an external independent quality control review is performed.

[1] In cases where a scheme with more than 1,000 members has been in wind-up over a number of years, such a scheme does not qualify as a Small Entity, even where the remaining number of members falls below 1,000.

APB Ethical Standard 4, paragraph 39 provides that, where it is expected that the total fees for both audit and non-audit services receivable from a non-listed audited entity and its subsidiaries audited by the audit firm will regularly exceed 10% of the annual fee income of the audit firm or the part of the firm by reference to which the audit engagement partner’s profit share is calculated, but will not regularly exceed 15% the firm shall arrange an external independent quality control review of the audit engagement to be undertaken before the auditors’ report is finalised. Although an external independent quality control review is not required, nevertheless the audit engagement partner discloses the expectation that fees will amount to between 10% and 15% of the firm’s annual fee income to the Ethics Partner and to those charged with governance of the audited entity.

SELF-REVIEW THREAT – NON-AUDIT SERVICES

When undertaking non-audit services for a Small Entity audited entity, the audit firm is not required to apply safeguards to address a self-review threat provided:
- the audited entity has ‘informed management’; and
- the audit firm extends the cyclical inspection of completed engagements that is performed for quality control purposes.

APB Ethical Standard 5 requires that, when an audit firm provides nonaudit services to an audited entity, appropriate safeguards are applied in order to reduce any self-review threat to an acceptable level. APB Ethical Standard 5 provides examples of safeguards that may be appropriate when non-audit services are provided to an audited entity (for example in paragraphs 92 for tax services and 168 for accounting services). In the case of an audit of a Small Entity, alternative procedures involve discussions with ‘informed management’, supplemented by an extension of the firm’s cyclical inspection of completed engagements that is performed for quality control purposes.

The audit firm extends the number of engagements inspected under the requirements of ISQC (UK and Ireland) 1 ‘Quality Control for Firms that Perform Audits and Reviews of Financial Statements, and other Assurance and Related Services Engagements’^[1] to include a random selection of audit engagements where non-audit services have been provided. Particular attention is given to ensuring that there is documentary evidence that ‘informed management’ has made such judgments and decisions that are needed in relation to the presentation and disclosure of information in the financial statements.

Those inspecting the engagements are not involved in performing the engagement. Small audit firms may wish to use a suitably qualified external person or another firm to carry out engagement inspections.

In addition to the documentation requirements of ISQC (UK and Ireland) 1, those inspecting the engagements document their evaluation of whether the documentary evidence that ‘informed management’ made such judgments and decisions that were needed in relation to the presentation and disclosure of information in the financial statements.

EXEMPTIONS

MANAGEMENT THREAT – NON-AUDIT SERVICES

When undertaking non-audit services for Small Entity audited entities, the audit firm is not required to adhere to the prohibitions in APB Ethical Standard 5, relating to providing non-audit services that

[1] ISQC (UK and Ireland) 1 requires audit firms to establish policies and procedures which include a periodic inspection of a selection of completed engagements. Engagements selected for inspection include at least one engagement for each engagement partner over the inspection cycle, which ordinarily spans no more than three years.

involve the audit firm undertaking part of the role of management, provided that:
- it discusses objectivity and independence issues related to the provision of non-audit services with those charged with governance, confirming that management accept responsibility for any decisions taken; and
- it discloses the fact that it has applied this Standard in accordance with paragraph 24.

APB Ethical Standard 5, paragraph 38 provides that where an audit firm provides non-audit services to an audited entity where there is no ‘informed management’, it is unlikely that any other safeguards can eliminate a management threat or reduce it to an acceptable level with the consequence that such non-audit services may not be provided to that audited entity. This is because the absence of a member of management, who has the authority and capability to:
- receive the results of the non-audit services provided by the audit firm; and
- make any judgments and decisions that are needed, on the basis of the information provided,

means that there is an increased management threat since the audit firm will be closer to those decisions and judgments which are properly the responsibility of management and more aligned with the views and interests of management.

An audit firm auditing a Small Entity is exempted from the requirements of APB Ethical Standard 5, paragraphs 63(b) (internal audit services), 73(b) (information technology services), 97 (tax services), 131(c) (corporate finance services), 140(b) (transaction related services), 145(a) (restructuring services) and 160(b) (accounting services) in circumstances when there is no ‘informed management’ as envisioned by APB Ethical Standard 5, provided it discusses objectivity and independence issues related to the provision of non-audit services with those charged with governance, confirming that management accept responsibility for any decisions taken and discloses the fact that it has applied this Standard in accordance with paragraph 24.

ADVOCACY THREAT – NON-AUDIT SERVICES

The audit firm of a Small Entity is not required to comply with APB Ethical Standard 5, paragraphs 104 and 145(b) provided that it discloses the fact that it has applied this Standard in accordance with paragraph 24.

APB Ethical Standard 5, paragraph 104 provides that ‘the audit firm shall not undertake an engagement to provide tax services to an audited entity where this would involve acting as an advocate for the audited entity, before an appeals tribunal or court in the resolution of an issue:
- that is material to the financial statements; or
- where the outcome of the tax issue is dependent on a future or contemporary audit judgment’.

Such circumstances may create an advocacy threat which it is unlikely any safeguards can eliminate or reduce to an acceptable level.

APB Ethical Standard 5, paragraph 145(b) provides that ‘the audit firm shall not undertake an engagement to provide restructuring services in respect of an audited entity where the engagement would require the auditor to act as an advocate for the entity in relation to matters that are material to the financial statements’.

Such circumstances may create an advocacy threat which it is unlikely any safeguards can eliminate or reduce to an acceptable level.

Where an audit firm auditing a Small Entity takes advantage of the dispensation in paragraph 15, it discloses the fact that it has applied this Standard in accordance with paragraph 24.

PARTNERS JOINING AN AUDITED ENTITY

The audit firm of a Small Entity is not required to comply with APB Ethical Standard 2, paragraph 49 provided that:
- it takes appropriate steps to determine that there has been no significant threat to the audit team’s integrity, objectivity and independence; and
- it discloses the fact that it has applied this Standard in accordance with paragraph 24.

APB Ethical Standard 2, paragraph 49 provides that where a former partner ‘is appointed as a director (including as a non-executive director) or to a key management position with an audited entity, having acted as audit engagement partner (or as an engagement quality control reviewer, key partner involved in the audit or a partner in the chain of command) at any time in the two years prior to this appointment, the firm shall resign as auditors. The firm shall not accept re-appointment until a two-year period, commencing when the former partner ceased to have an ability to influence the conduct and outcome of the audit, has elapsed or the former partner ceases employment with the former audited entity, whichever is the sooner’. Such circumstances may create self-interest, familiarity and intimidation threats.

An audit firm takes appropriate steps to determine that there has been no significant threat to the audit team’s integrity, objectivity and independence as a result of the former partner’s employment by an audited entity that is a Small Entity by:
- assessing the significance of the self-interest, familiarity or intimidation threats, having regard to the following factors:
  - the position the individual has taken at the audited entity;
  - the nature and amount of any involvement the individual will have with the audit team or the audit process;
  - the length of time that has passed since the individual was a member of the audit team or firm; and
  - the former position of the individual within the audit team or firm, and
- if the threat is other than clearly insignificant, applying alternative procedures such as:
  - considering the appropriateness or necessity of modifying the audit plan for the audit engagement;
  - assigning an audit team to the subsequent audit engagement that is of sufficient experience in relation to the individual who has joined the audited entity;
  - involving an audit partner or senior staff member with appropriate expertise, who was not a member of the audit team, to review the work done or otherwise advise as necessary; or
  - undertaking an engagement quality control review of the audit engagement.

When an audit firm auditing a Small Entity takes advantage of paragraph 20 it discloses the fact that it has applied this Standard in accordance with paragraph 24 and documents the steps that it has taken to comply with this Standard.

DISCLOSURE REQUIREMENTS

Where the audit firm has taken advantage of an exemption provided in paragraphs 12, 15 or 20 of this Standard, the audit engagement partner shall ensure that:
- the auditors’ report discloses this fact, and
- either the financial statements, or the auditors’ report, discloses the type of non-audit services provided to the audited entity or the fact that a former audit engagement partner has joined the audited entity.

The fact that an audit firm has taken advantage of an exemption from APB Ethical Standard – Provisions Available for Small Entities is set out in a separate paragraph of the audit report as part of the Basis of audit opinion. It does not affect the Opinion paragraph. An illustrative example of such disclosure is set out in the Appendix.

The audit engagement partner ensures that within the financial statements reference is made to the type of non-audit services provided to the audited entity or the fact that a former partner has joined the audited entity. An illustration of possible disclosures is set out in the Appendix. Where such a disclosure is not made within the financial statements it is included in the auditors’ report.

EFFECTIVE DATE

This revised Ethical Standard becomes effective on 30 April 2011.

APPENDIX: Illustrative disclosures

(a) Illustrative disclosure of the fact that the audit firm has taken advantage of an exemption within the auditor’s report

Respective responsibilities of directors and auditor

As explained more fully in the Directors’ Responsibilities Statement [set out [on page …]], the directors are responsible for the preparation of the financial statements and for being satisfied that they give a true and fair view. Our responsibility is to audit and express an opinion on the financial statements in accordance with applicable law and International Standards on Auditing (UK and Ireland). Those standards require us to comply with the Auditing Practices Board’s (APB’s) Ethical Standards for Auditors, including “APB Ethical Standard – Provisions Available for Small Entities (Revised)”, in the circumstances set out in note [x] to the financial statements.

Scope of the audit of the financial statements

Either:

A description of the scope of an audit of financial statements is [provided on the APB’s website at … ] / [set out [on page …] of the Annual Report].

Or:

An audit involves obtaining evidence about the amounts and disclosures in the financial statements …

Opinion on financial statements

In our opinion the financial statements:

give a true and fair view of the state of the company’s affairs as at …and of its profit [loss] for the year then ended; …

[Date of the auditor’s report, auditor’s signature and address]

(b) Illustrative disclosure of relevant circumstances within the financial statements

Note [x] In common with many other businesses of our size and nature we use our auditors to prepare and submit returns to the tax authorities and assist with the preparation of the financial statements^[1].

Note [x] In common with many other businesses of our size and nature we use our auditors to provide tax advice and to represent us, as necessary, at tax tribunals^[2].

Note [x] XYZ, a former partner of [audit firm] joined [audited entity] as [a director] on [date]^[3].

[1] Where exemption in paragraph 12 (Management threat in relation non-audit services) is applied.

[2] Where exemption in paragraph 15 (Advocacy threat – tax services) is applied.

[3] Where exemption in paragraph 20 (Partners joining an audited entity) is applied.

[1] Where exemption in paragraph 12 (Management threat in relation non-audit services) is applied.

[1] Where exemption in paragraph 15 (Advocacy threat – tax services) is applied.

[1] Where exemption in paragraph 20 (Partners joining an audited entity) is applied.

Posted on April 9, 2021 by MJ — Leave a comment

ES-5 APB ETHICAL STANDARD 5 (REVISED) NON-AUDIT SERVICES PROVIDED TO AUDITED ENTITIES

INTRODUCTION

APB Ethical Standard 1 requires the audit engagement partner to identify and assess the circumstances which could adversely affect the auditor’s objectivity (‘threats’), including any perceived loss of independence, and to apply procedures (‘safeguards’) which will either:
- eliminate the threat; or
- reduce the threat to an acceptable level (that is, a level at which it is not probable that a reasonable and informed third party would conclude that the auditor’s objectivity and independence either is impaired or is likely to be impaired).

When considering safeguards, where the audit engagement partner chooses to reduce rather than to eliminate a threat to objectivity and independence, he or she recognises that this judgment may not be shared by users of the financial statements and that he or she may be required to justify the decision.

This Standard provides requirements and guidance on specific circumstances arising from the provision of non-audit services by audit firms to entities audited by them which may create threats to the auditor’s objectivity or perceived loss of independence. It gives examples of safeguards that can, in some circumstances, eliminate the threat or reduce it to an acceptable level. In circumstances where this is not possible, either the non-audit service engagement in question is not undertaken or the auditor either does not accept or withdraws from the audit engagement, as appropriate.

Whenever a possible or actual breach of an APB Ethical Standard is identified, the audit engagement partner, in the first instance, and the Ethics Partner, where appropriate, assess the implications of the breach, determine whether there are safeguards that can be put in place or other actions that can be taken to address any potential adverse

consequences and consider whether there is a need to resign from the audit engagement.

An inadvertent violation of this Standard does not necessarily call into question the audit firm’s ability to give an audit opinion provided that:
the audit firm has established policies and procedures that require all partners and staff to report any breach promptly to the audit engagement partner or to the Ethics Partner, as appropriate;
the audit engagement partner promptly notifies the partner or member of staff that any matter which has given rise to a breach is to be addressed as soon as possible and ensures that such action is taken;
safeguards, if appropriate, are applied (for example, by having another partner review the work done by the relevant partner or member of staff or by removing him or her from the engagement team); and
the actions taken and the rationale for them are documented.

GENERAL APPROACH TO NON-AUDIT SERVICES

Paragraphs 6 to 53 of this Standard set out the general approach to be adopted by audit firms and auditors in relation to the provision of nonaudit services to entities audited by them. This approach is applicable irrespective of the nature of the non-audit services, which may be in question in a given case. (Paragraphs 54 to 168 of this Standard illustrate the application of the general approach to a number of common non-audit services.)

An audit is the term used to describe the work that is undertaken by the auditor to enable him or her to express an independent audit opinion on an entity’s financial statements and, where the entity is a parent company, on the group financial statements and/or the separate financial statements of its components^[1].

^[2] International Standards on Auditing (UK and Ireland) require that the auditor exercise professional judgment and maintain professional scepticism throughout the planning and performance of the audit and, among other things:

Identify and assess risks of material misstatement, whether due to fraud or error, based on an understanding of the entity and its environment, including the entity’s internal control.
Obtain sufficient appropriate audit evidence about whether material misstatements exist, through designing and implementing appropriate responses to the assessed risks.
Form an opinion on the financial statements based on conclusions drawn from the audit evidence obtained².

[1] In the public sector the statutory scope of an audit can extend beyond expressing an independent opinion on an entity’s financial statements to include reporting on an entity’s arrangements to ensure the proper conduct of its financial affairs, manage its performance or use of its resources. 2 ISA (UK and Ireland) 200 ‘Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with International Standards on Auditing (UK and Ireland)’ paragraph

[2] .

Judgments regarding the nature and extent of evidence necessary to support the audit opinion are a matter for the auditor but will include:
- Identifying, evaluating and testing, where appropriate, those internal control systems the effectiveness of which is necessary for the audit of the financial statements and where, if any control weaknesses are identified, extended testing will be required; and
- additional work undertaken to respond to risks identified by management or the audit committee that the auditor considers could impact the auditor’s opinion on the financial statements.

Other work undertaken by the engagement team at the request of management or those charged with governance will not be categorised as part of the audit irrespective of whether it forms part of the audit proposal or engagement, unless it is clear that the predominant rationale for the performance of the work in question is to enable a soundly based audit opinion on the financial statements to be expressed. Therefore, an audit of financial statements does not include work where:
- The objective of that work is not to gather evidence to support the auditor’s opinion on the financial statements; or
- The nature and extent of testing is not determined by the external auditor, or in the case of a group, the component auditors, in the context of expressing an opinion on the financial statements; or  The principal terms and conditions differ from that of the audit.

If additional work on financial information^[1] and/or financial controls is authorised by those charged with governance, but the objective of that work is not to enable the auditor to provide an audit opinion on the entity’s financial statements, it will be considered as an ‘audit related service’ for the purpose of this Standard provided that it:
- is integrated with the work performed in the audit and performed largely by the existing audit team; and
- is performed on the same principal terms and conditions as the audit.

As a consequence of these factors, any threats to auditor independence arising from the performance of such additional work are considered to be clearly insignificant.

Other additional work that:
- does not relate to financial information and/or financial controls; or
- is not integrated with the work performed in the audit, or is not performed largely by the existing audit team, or
- is not on the same principal terms and conditions as the audit;

will be regarded as an ‘other non-audit service’ for the purpose of this Standard.

‘Non-audit services’ comprise any engagement in which an audit firm provides professional services to:
- an audited entity;,
- an audited entity’s affiliates; or
- another entity in respect of the audited entity^[2]; other than the audit of financial statements of the audited entity.

There may be circumstances where the audit firm is engaged to provide a non-audit service and where that engagement and its scope are determined by an entity which is not audited by the firm. However, it might be contemplated that an audited entity may gain some benefit from that engagement^[3]. In these circumstances, whilst there may be no threat to the audit firm’s objectivity and independence at the time of appointment, the audit firm considers how the engagement may be expected to develop

[1] This does not include accounting services.

[2] For example, where an engagement is undertaken to assist in the preparation of listing particulars for a company acquiring the audited entity

[3] For example, in a vendor due diligence engagement, the engagement is initiated and scoped by the vendor before the purchaser is identified. If an entity audited by the firm undertaking the due diligence engagement is the purchaser, that audited entity may gain the benefit of the report issued by its auditor, it may be a party to the engagement letter and it may pay an element of the fee.

whether there are any threats that the audit firm may be subject to if additional relevant parties which are audited entities are identified, and whether any safeguards need to be put in place.

The audit firm shall establish policies and procedures that require others within the firm, when considering whether to accept a proposed engagement to provide a non-audit service to an audited entity or any of its affiliates, to communicate details of the proposed engagement to the audit engagement partner.

The audit firm establishes appropriate channels of internal communication to ensure that, in relation to an entity audited by the firm, the audit engagement partner (or their delegate) is informed about any proposed engagement to provide a non-audit service to the audited entity or any of its affiliates and that he or she considers the implications for the auditor’s objectivity and independence before the engagement is accepted. Additionally, when addressing services provided to another entity in respect of the audited entity, the procedures address any requirement to preserve client confidentiality.

In the case of a listed company, the group audit engagement partner establishes that the company has communicated its policy on the engagement of the external auditor to supply non-audit services to its affiliates and obtains confirmation that the auditors of the affiliates will comply with this policy.^[1] The group audit engagement partner also requires that relevant information on non-audit services provided by network firms is communicated on a timely basis.

IDENTIFICATION AND ASSESSMENT OF THREATS AND SAFEGUARDS

[1] The UK Corporate Governance Code requires audit committees to develop the company’s policy on the engagement of the external auditor to supply non-audit services.

Before the audit firm accepts a proposed engagement to provide a non-audit service, the audit engagement partner shall:
- consider whether it is probable that a reasonable and informed third party would regard the objectives of the proposed engagement as being inconsistent with the objectives of the audit of the financial statements; and
- identify and assess the significance of any related threats to the auditor’s objectivity, including any perceived loss of independence; and
- identify and assess the effectiveness of the available safeguards to eliminate the threats or reduce them to an acceptable level.

When assessing the significance of threats to the auditor’s objectivity and independence, the audit engagement partner considers the following factors:
- The likely relevance and impact of the subject matter on the financial statements;
- The extent to which performance of the proposed engagement will involve the exercise of professional judgment;
- The size of the engagement and the associated fee;
- The basis on which the fee is to be calculated;
- The staff who would be carrying out the non-audit service^[1];
- The staff from the audited entity who would be involved in the nonaudit service⁸.

To ensure that this assessment is made with a proper understanding of the nature of the engagement, it may be necessary to refer to a draft

[1] For example, where those handling the non-audit service engagement are particularly expert so that the audit team (or persons advising it) may have difficulty in reviewing effectively the advice given or the work undertaken by the non-audit service team in the course of conducting a subsequent audit, with the result that the effectiveness of the audit might be compromised. 8 For example, the safeguards necessary to address any self-review threat will require careful consideration where those involved are particularly senior and can be expected to be actively involved in any audit discussion as this may also create an intimidation threat.

engagement letter in respect of the proposed non-audit services or to discuss the engagement with the partner involved.

The assessment of the threats to the auditor’s objectivity and independence arising from any particular non-audit engagement is a matter for the audit engagement partner. The audit engagement partner may decide to delegate some information gathering activities to senior personnel on the audit team and may allow such personnel to make

decisions in relation to routine non-audit services. If this is the case, the audit engagement partner will:

provide specific criteria for such decisions that reflect both the requirements of APB Ethical Standards and the audited entity’s policy for the purchase of non-audit services; and
monitor the decisions being made on a regular basis.

Where the audit engagement partner is not able to undertake the assessment of the significance of threats in relation to a proposed engagement to provide a non-audit service to an audited entity, for example due to illness or holidays, alternative arrangements are established (for example, by authorising the engagement quality control reviewer to consider the proposed engagement).

The objective of the audit of financial statements is to express an opinion on the preparation and presentation of those financial statements. For example, in the case of a limited company, legislation requires the auditor to make a report to the members on all annual accounts laid before the company in general meeting during its tenure of office. The report must include a statement as to whether, in the auditor’s opinion, the accounts have been properly prepared in accordance with the requirements of the legislation, and, in particular, whether they give a true and fair view of the state of the affairs and profit or loss for the year

Where the audit engagement partner considers that it is probable that a reasonable and informed third party would regard the objectives of the proposed non-audit service engagement as being inconsistent with the objectives of the audit of the financial statements, the audit firm shall either:

(a) not undertake the non-audit service engagement; or

(b) not accept or withdraw from the audit engagement.

The objectives of engagements to provide non-audit services vary and depend on the specific terms of the engagement. In some cases these objectives may be inconsistent with those of the audit, and, in such cases, this may give rise to a threat to the auditor’s objectivity and to the appearance of its independence. Audit firms do not undertake non-audit service engagements where the objectives of such engagements are inconsistent with the objectives of the audit, or they do not accept or withdraw from the audit engagement as appropriate.

Similarly, in relation to a possible appointment as auditor to an entity that the audit firm has not audited before, consideration needs to be given to recent, current and potential engagements to provide non-audit services by the audit firm and whether the scope and objectives of those engagements are consistent with the proposed audit engagement. In the case of listed companies, when tendering for a new audit engagement, the audit firm ensures that relevant information on recent non-audit services is drawn to the attention of the audit committee, including:
- when recent non-audit services were provided;
- the materiality of those non-audit services to the proposed audit engagement;
- whether those non-audit services would have been prohibited if the entity had been an audited entity at the time when they were undertaken; and
- the extent to which the outcomes of non-audit services have been audited or reviewed by another audit firm.

Threats to objectivity and independence

The principal types of threats to the auditor’s objectivity and independence are:
- self-interest threat;
- self-review threat;
- management threat;
- advocacy threat;
- familiarity (or trust) threat; and  intimidation threat.

The auditor remains alert to the possibility that any of these threats may occur in connection with non-audit services. However, the threats most commonly associated with non-audit services are self-interest threat, self-review threat, management threat and advocacy threat.

A self-interest threat exists when the auditor has financial or other interests which might cause the auditor to be reluctant to take actions that would be adverse to the interests of the audit firm or any individual in a position to influence the conduct or outcome of the audit. In relation to non-audit services, the main self-interest threat concerns fees and economic dependence and these are addressed in APB Ethical Standard

Where substantial fees are regularly generated from the provision of non-audit services and the fees for non-audit services are greater than the annual audit fees, the audit engagement partner has regard to the possibility that there may be perceived to be a loss of independence resulting from the expected or actual level of fees for non-audit services. The audit engagement partner determines whether there is any risk that there will be an actual loss of independence and objectivity by the engagement team. In making that assessment, the audit engagement partner considers matters such as whether the engagement or engagements giving rise to the fees for non-audit services were:
- audit related services;
- provided on a contingent fee basis;
- consistent with the engagements undertaken and fees received on a consistent basis in previous years;
- in the case of a group, disproportionate in relation to any individual group entity;
- unusual in size but unlikely to recur; and/or
- of such a size and nature that a reasonable and informed third party would be concerned at the effect that such engagements would have on the objectivity and independence of the engagement team.

Having made that assessment, the audit engagement partner determines whether the threats to independence from the level of fees for non-audit services are at an acceptable level (or can be reduced to an acceptable level by putting in place appropriate safeguards) and appropriately informs those charged with governance of the position on a timely basis in accordance with paragraphs 48 to 50 of this Standard.

In the case of listed companies where the fees for non-audit services for a financial year are expected to be greater than the annual audit fees, the audit engagement partner shall provide details of the circumstances to the Ethics Partner and discuss them with him or her. Where the audit firm provides audit services to a group, the obligation to provide information to the Ethics Partner shall be on a group basis for all services provided by the audit firm and its network firms to all entities in the group.

Discussing the level of fees for non-audit services with the Ethics Partner ensures that appropriate attention is paid to the issue by the audit firm. The audit firm’s policies and procedures will set out whether there are circumstances in which the audit engagement partner discusses the level of non-audit fees with the Ethics Partner for non-listed audited entities as described in paragraph 47 of APB Ethical Standard 1.

Where fees for non-audit services are calculated on a contingent fee basis, there is a risk that a reasonable and informed third party may regard the audit firm’s interests to be so closely aligned with the audited entity that it threatens the auditor’s objectivity and independence. Consequently, the audit firm does not accept a non-audit services engagement on a contingent fee basis where:
- that contingent fee is material to the audit firm, or that part of the firm by reference to which the audit engagement partner’s profit share is calculated; or
- the outcome of the service (and, therefore, the amount of the fee) is dependent on a future or contemporary audit judgment relating to a material matter in the financial statements of an audited entity.

A self-review threat exists when the results of a non-audit service performed by the engagement team or by others within the audit firm are reflected in the amounts included or disclosed in the financial statements.

A threat to objectivity and independence arises because, in the course of the audit, the auditor may need to re-evaluate the work performed in the non-audit service. As, by virtue of providing the non-audit service, the audit firm is associated with aspects of the preparation of the financial statements, it may be (or may appear to be) unable to take an impartial view of relevant aspects of those financial statements.

In assessing the significance of the self-review threat, the auditor considers the extent to which the non-audit service will:
- involve a significant degree of subjective judgment; and
- have a material effect on the preparation and presentation of the financial statements.

Where a significant degree of judgment relating to the financial statements is involved in a non-audit service engagement, the auditor may be inhibited from questioning that judgment in the course of the audit. Whether a significant degree of subjective judgment is involved will depend upon whether the non-audit service involves the application of well-established principles and procedures, and whether reliable information is available. If such circumstances do not exist because the non-audit service is based on concepts, methodologies or assumptions that require judgment and are not established by the audited entity or by authoritative guidance, the auditor’s objectivity and the appearance of its independence may be adversely affected. Where the provision of a proposed non-audit service would also have a material effect on the financial statements, it is unlikely that any safeguard can eliminate or reduce to an acceptable level the self-review threat.

A management threat exists when the audit firm undertakes work that involves making judgments and taking decisions that are properly the responsibility of management.

Paragraph 33 of APB Ethical Standard 1 prohibits partners and employees of the audit firm from taking decisions on behalf of the management of the audited entity. A threat to objectivity and independence also arises where the audit firm undertakes an engagement to provide non-audit services in relation to which management are required to make judgments and take decisions based on that work. The auditor may become closely aligned with the views and interests of management and this may erode the distinction between the audited entity and the audit firm, in turn, impairing or calling into question the auditor’s ability to apply a proper degree of professional scepticism in auditing the financial statements. The auditor’s objectivity and the appearance of its independence therefore may be, or may be perceived to be, impaired.

In determining whether a non-audit service does or does not give rise to a management threat, the auditor considers whether there is informed management. Informed management exists when:
- the auditor is satisfied that a member of management (or senior employee of the audited entity) has been designated by the audited entity to receive the results of the non-audit service and has been given the authority to make any judgments and decisions of the type set out in paragraph 34 of APB Ethical Standard 1 that are needed;
- the auditor concludes that that member of management has the capability to make independent management judgments and decisions on the basis of the information provided; and
- the results of the non-audit service are communicated to the audited entity and, where judgments or decisions are to be made they are supported by an objective analysis of the issues to consider and the audited entity is given the opportunity to decide between reasonable alternatives.

In the absence of such informed management it is unlikely that any other safeguards can eliminate a management threat or reduce it to an acceptable level.

An advocacy threat exists when the audit firm undertakes work that involves acting as an advocate for an audited entity and supporting a position taken by management in an adversarial context.

A threat to objectivity and independence arises because, in order to act in an advocacy role, the audit firm has to adopt a position closely aligned to that of management. This creates both actual and perceived threats to the auditor’s objectivity and independence. For example, where the audit firm, acting as advocate, has supported a particular contention of management, it may be difficult for the auditor to take an impartial view of this in the context of the audit of the financial statements.

Where the provision of a non-audit service would require the auditor to act as an advocate for the audited entity in relation to matters that are material to the financial statements, it is unlikely that any safeguards can eliminate or reduce to an acceptable level the advocacy threat that would exist.

Threats to the auditor’s objectivity, including a perceived loss of independence, may arise where a non-audit service is provided by the audit firm to a third party which is connected (through a relationship) to an audited entity, and the outcome of that service has a material impact on the financial statements of the audited entity. For example, if the audit firm provides actuarial services to the pension scheme of an audited entity, which is in deficit and the audit firm subsequently gives an opinion on financial statements that include judgments given in connection with that service.

Safeguards

Where any threat to the auditor’s objectivity and the appearance of its independence is identified, the audit engagement partner assesses the significance of that threat and considers whether there are safeguards that could be applied and which would be effective to eliminate the threat or reduce it to an acceptable level. If such safeguards can be identified and are applied, the non-audit service may be provided. However, where no such safeguards are applied, the only course is for the audit firm either not to undertake the engagement to provide the non-audit service in question or not to accept (or to withdraw from) the audit engagement.

When considering what safeguards, if any, would be effective in reducing the threats to independence and objectivity to an acceptable level, the audit engagement partner has regard to the following safeguards which, individually or in combination, may be effective, depending on the circumstances:

The non-audit services are provided by a separate team from the engagement team, and:
- if circumstances require, to address the threat identified, there is effective physical and electronic segregation of the individuals in each team, and of their documentation, at all times during the provision of the audit and non-audit services; and/or
- the team providing the non-audit services avoids taking any action or making any statement that compromises the independence or objectivity of the engagement team, for example, expressing any opinion about the approach that the engagement team might take or the conclusion it might reach when considering the appropriateness of accounting or other audit judgments.

The Ethics Partner establishes policies and procedures to ensure that, where safeguards of this nature are considered appropriate, the arrangements put in place are effective at all times. This will involve the Ethics Partner being satisfied that there are effective arrangements in place for each member of the non-audit services team to acknowledge their responsibilities and for each member of the engagement team to notify him or her of any breach of this requirement that the team member becomes aware. Where notified of a breach, the Ethics Partner considers together with the audit engagement partner the significance of the breach and the implications for the independence and objectivity of the engagement team, including whether any further safeguards are necessary and whether the matter should be reported to those charged with governance of the audited entity;

b The Engagement Quality Control Reviewer, or another audit partner of sufficient relevant experience and seniority who is, and is seen to be, an effective challenge to both the audit engagement partner and the partner leading the non-audit services engagement, reviews the work and conclusions of the engagement team in relation to their consideration of the audit judgments, if any, relating to the subject matter of the non-audit service, having regard to the self-review threat identified, and determines and documents his or her conclusions as to whether the work is sufficient and the conclusions of the engagement team are appropriate. Where the review partner has concerns, the audit engagement partner does not sign the audit opinion until those concerns have been subject to full consultation, including escalation through any processes required by the audit firm’s policies. Where this safeguard is considered appropriate, the Ethics Partner is satisfied that the review partner undertaking this role is appropriate, that the review partner is aware of the circumstances leading to the conclusion that there is a significant self-review threat and that any concerns raised by the review

partner have been satisfactorily resolved before signature of the audit opinion.

Where the audit engagement partner concludes that no appropriate safeguards are available to eliminate or reduce to an acceptable level the threats to the auditor’s objectivity, including any perceived loss of independence, related to a proposed engagement to provide a non-audit service to an audited entity, he or she shall inform the others concerned within the audit firm of that conclusion and the firm shall either:

(a) not undertake the non-audit service engagement; or (b) not accept or withdraw from the audit engagement.

If the audit engagement partner is in doubt as to the appropriate action to be taken, he or she shall resolve the matter through consultation with the Ethics Partner.

An initial assessment of the threats to objectivity and independence and the safeguards to be applied is required when the audit engagement partner is considering the acceptance of an engagement to provide a non-audit service. The assessment of the threats and the safeguards applied is reviewed whenever the scope and objectives of the non-audit service change significantly. If such a review suggests that safeguards cannot reduce the threat to an acceptable level, the audit firm withdraws from the non-audit service engagement, or does not accept or withdraws from the audit engagement as appropriate.

Where there is doubt as to the appropriate action to be taken, consultation with the Ethics Partner ensures that an objective judgment is made and the firm’s position is consistent.

COMMUNICATION WITH THOSE CHARGED WITH GOVERNANCE

The audit engagement partner shall ensure that those charged with governance of the audited entity are appropriately informed on a timely basis of:
- all significant facts and matters that bear upon the auditor’s objectivity and independence, related to the provision of non-audit services, including the safeguards put in place; and
- for listed companies, any inconsistencies between APB Ethical Standards and the company’s policy for the supply of non-audit services by the audit firm and any apparent breach of that policy.⁶

Transparency is a key element in addressing the issues raised by the provision of non-audit services by audit firms to the entities audited by them. This can be facilitated by timely communication with those charged with governance of the audited entity (see APB Ethical Standard 1, paragraphs 63 to 71). Such communications are addressed to the audit committee, where there is one; in other circumstances, they are addressed to the board of directors (or those in an equivalent position). In the case of listed companies, ensuring that the audit committee is properly informed about the issues associated with the provision of nonaudit services will assist them to comply with the provisions of the UK Corporate Governance Code relating to reviewing and monitoring the external auditor’s independence and objectivity and to developing a policy on the engagement of the external auditor to supply non-audit services. This will include discussion of any inconsistencies between the company’s policy and APB Ethical Standards and ensuring that the policy is communicated to affiliates.

Communications with those charged with governance regarding the impact on auditor objectivity of non-audit services are likely to be facilitated if disclosure of such non-audit services distinguishes between

audit related services and other non-audit services (as defined in this Standard).

DOCUMENTATION

The audit engagement partner shall ensure that the reasoning for a decision to undertake an engagement to provide non-audit services, and any safeguards adopted, is appropriately documented.

Matters to be documented include any significant judgments concerning:
- threats identified;
- safeguards adopted and the reasons why they are considered to be effective; and
- communication with those charged with governance.

In situations where a management threat is identified in connection with the provision of non-audit services, this documentation will include the auditor’s assessment of whether there is informed management. The documentation of communications with the audited entity where judgments and decisions are made by management may take a variety of forms, for example an informal meeting note covering the matters discussed.

APPLICATION OF GENERAL PRINCIPLES TO SPECIFIC NONAUDIT SERVICES

AUDIT RELATED SERVICES

Audit related services are those non-audit services specified in this Standard that are largely carried out by members of the engagement team and where the work involved is closely related to the work performed in the audit and the threats to auditor independence are clearly insignificant and, as a consequence, safeguards need not be applied.

Audit related services are:
Reporting required by law or regulation to be provided by the auditor;
Reviews of interim financial information;
Reporting on regulatory returns;
Reporting to a regulator on client assets:
Reporting on government grants;
Reporting on internal financial controls when required by law or regulation;
Extended audit work that is authorised by those charged with governance performed on financial information^[1] and/or financial controls where this work is integrated with the audit work and is performed on the same principal terms and conditions.

The audit engagement partner shall ensure that only those nonaudit services listed in paragraph 55 are described as audit related services in communications with those charged with governance of the audited entity.

There may be other services that the auditor considers are closely related to an audit. However the threats to auditor independence arising from such services are not necessarily clearly insignificant and the auditor considers whether such services give rise to threats to independence and, where appropriate, the need to apply safeguards.

INTERNAL AUDIT SERVICES

The range of ‘internal audit services’ is wide and they may not be termed as such by the audited entity. For example, the audit firm may be engaged:
- to outsource the audited entity’s entire internal audit function; or
- to supplement the audited entity’s internal audit function in specific areas (for example, by providing specialised technical services or resources in particular locations); or
- to provide occasional internal audit services to the audited entity on an ad hoc

All such engagements would fall within the term ‘internal audit services’.

The nature of possible internal audit services is also wide. While the internal audit remit will vary from company to company, it often involves assurance activities designed to assess the design and operating effectiveness of existing or proposed systems or controls and advisory activities where advice is given to an entity on the design and implementation of risk management, control and governance processes.

The nature and extent of the threats to the external auditor’s independence when undertaking internal audit services vary depending on the nature of the services provided. The main threats to the auditor’s objectivity and independence arising from the provision of internal audit services are the self-review threat and the management threat. Generally these will be lower for activities that are primarily designed to provide assurance to those charged with governance, for example that internal controls are operating effectively, than for advisory activities designed to assist the entity in improving the effectiveness of its risk management, control and governance processes.

Engagements to provide internal audit services – other than those prohibited in paragraph 63 – may be undertaken, provided that the auditor is satisfied that there is informed management and appropriate safeguards are applied to reduce the self-review threat to an acceptable level.

Examples of safeguards that may be appropriate when internal audit services are provided to an audited entity include ensuring that:
- internal audit projects undertaken by the audit firm are performed by partners and staff who have no involvement in the external audit of the financial statements;
- the audit of the financial statements is reviewed by an audit partner who is not involved in the audit engagement, to ensure that the internal audit work performed by the audit firm has been properly and effectively assessed in the context of the audit of the financial statements.

The audit firm shall not undertake an engagement to provide internal audit services to an audited entity where it is reasonably foreseeable that:
- for the purposes of the audit of the financial statements, the auditor would place significant reliance on the internal audit work performed by the audit firm; or
- for the purposes of the internal audit services, the audit firm would undertake part of the role of management.

The self-review threat is unacceptably high where substantially all of the internal audit activity is outsourced to the audit firm and this is significant to the audited entity or the auditor cannot perform the audit of the financial statements without placing significant reliance on the work performed for the purposes of the internal audit services engagement. In the case of listed companies the provision of internal audit services in relation to the following examples is likely to be unacceptable as the external audit team is likely to place significant reliance on the work performed by the internal audit team in relation to the audited entity’s internal financial controls:
- a significant part of the internal controls over financial reporting;
- financial accounting systems which generate information that is significant to the client’s accounting records;
- amounts or disclosures that are material to the financial statements of the audited entity.

The management threat is unacceptably high where the audit firm provides internal audit services that involve audit firm personnel taking decisions or making judgments, which are properly the responsibility of management. For example, such situations arise where the internal audit function is outsourced to the audit firm and this is significant to the audited entity or where the nature of the internal audit work involves:
- Taking decisions on the scope and nature of the internal audit services to be provided to the audited entity;
- Designing internal controls or implementing changes thereto;
- Taking responsibility for risk management decisions;
- Undertaking work to evaluate the cost effectiveness of activities, systems and controls;
- Undertakingpre-implementation work on non-financial systems.

During the course of the audit, the auditor generally evaluates the design and tests the operating effectiveness of some of the entity’s internal financial controls, and the operation of any relevant internal audit function, and provides management with observations on matters that have come to the attention of the auditor, including comments on weaknesses in the internal control systems and/or the internal audit function together with suggestions for addressing them. This work is a by-product of the audit service rather than the result of a specific engagement to provide non-audit services and therefore does not constitute internal audit services for the purposes of this Standard.

In some circumstances, additional work is undertaken to respond to risks identified by management or those charged with governance. Where the auditor considers that such risks could impact their opinion on the financial statements, such work is considered to be audit work for the purposes of this Standard (see paragraphs 10 and 11).

If extended audit work on financial information and/or financial controls is authorised by those charged with governance, it will be considered as an ‘audit related service’ provided that it is integrated with the work performed in the audit and performed largely by the existing audit team, and is performed on the same principal terms and conditions as the audit.

Additional work will not be considered an audit related service if it:
- does not relate to financial information and/or financial controls; or
- is not authorised by those charged with governance; or
- is not integrated with the work performed in the audit, or is not performed largely by the existing audit team; or
- is not on the same principal terms and conditions as the audit.

In such circumstances the threats and the safeguards will be communicated to those charged with governance. The audit engagement partner reviews the scope and objectives of the proposed work and assesses the threats to which it gives rise and the safeguards available. Whether it is appropriate for this work to be undertaken by the audit firm will depend on the extent to which it gives rise to threats to the auditor’s objectivity and independence.

INFORMATION TECHNOLOGY SERVICES

Design, provision and implementation of information technology (including financial information technology) systems by audit firms for entities audited by them creates threats to the auditor’s objectivity and independence. The principal threats are the self-review threat and the management threat.

Engagements to design, provide or implement information technology systems that are not important to any significant part of the accounting system or to the production of the financial statements and do not have significant reliance placed on them by the auditor, may be undertaken, provided that there is informed management and appropriate safeguards are applied to reduce the self-review threat to an acceptable level.

Examples of safeguards that may be appropriate when information technology services are provided to an audited entity include ensuring that:
- information technology projects undertaken by the audit firm are performed by partners and staff who have no involvement in the external audit of the financial statements;
- the audit of the financial statements is reviewed by an audit partner who is not involved in the audit engagement to ensure that the information technology work performed has been properly and effectively assessed in the context of the audit of the financial statements.

The audit firm shall not undertake an engagement to design, provide or implement information technology systems for an audited entity where:
- the systems concerned would be important to any significant part of the accounting system or to the production of the financial statements and the auditor would place significant reliance upon them as part of the audit of the financial statements; or
- for the purposes of the information technology services, the audit firm would undertake part of the role of management.

Where it is reasonably apparent that, having regard to the activities and size of the audited entity and the range and complexity of the proposed system, management lacks the expertise required to take responsibility for the systems concerned, it is unlikely that any safeguards would be sufficient to eliminate these threats or to reduce them to an acceptable level. In particular, formal acceptance by management of the systems designed and installed by the audit firm is unlikely to be an effective safeguard when, in substance, the audit firm has been retained by management as experts and makes important decisions in relation to the design or implementation of systems of internal control and financial reporting.

The provision and installation of information technology services associated with a standard ‘off the shelf accounting package’ (including basic set-up procedures to make the package operate on the audited entity’s existing platform and peripherals, setting up the chart of accounts and the entry of standard data such as the audited entity’s product names and prices) is unlikely to create a level of threat to the auditor’s objectivity and independence that cannot be addressed through applying appropriate safeguards.

VALUATION SERVICES

A valuation comprises the making of assumptions with regard to future developments, the application of appropriate methodologies and techniques, and the combination of both to compute a certain value, or range of values, for an asset, a liability or for a business as a whole.

The audit firm shall not undertake an engagement to provide a valuation to:
- an audited entity that is a listed company or a significant affiliate of such an entity, where the valuation would have a material effect on the listed company’s financial statements, either separately or in aggregate with other valuations provided; or
- any other audited entity, where the valuation would both involve a significant degree of subjective judgment and have a material effect on the financial statements either separately or in aggregate with other valuations provided.

The main threats to the auditor’s objectivity and independence arising from the provision of valuation services are the self-review threat and the management threat. In all cases, the self-review threat is considered too high to allow the provision of valuation services which involve the valuation of amounts with a significant degree of subjectivity and have a material effect on the financial statements.

For listed companies, or significant affiliates of such entities, the threats to the auditor’s objectivity and independence that would be perceived to be created are too high to allow the audit firm to undertake any valuation that has a material effect on the listed company’s financial statements.

The audit firm’s policies and procedures will set out whether there are circumstances in which valuation services are not undertaken for nonlisted audited entities as described in paragraph 47 of APB Ethical Standard 1.

In circumstances where the auditor is designated by legislation or regulation as being required to carry out a valuation the restrictions in paragraph 77 do not apply. In such circumstances, the audit engagement partner applies relevant safeguards.

It is usual for the auditor to provide management with accounting advice in relation to valuation matters that have come to the auditor’s attention during the course of the audit. Such matters might typically include:
- comments on valuation assumptions and their appropriateness;
- errors identified in a valuation calculation and suggestions for correcting them;
- advice on accounting policies and any valuation methodologies used in their application.

Advice on such matters does not constitute valuation services for the purpose of this Standard.

Where the auditor is engaged to collect and verify the accuracy of data to be used in a valuation to be performed by others, such engagements do not constitute valuation services under this Standard.

ACTUARIAL VALUATION SERVICES

The audit firm shall not undertake an engagement to provide actuarial valuation services to:
- an audited entity that is a listed company or a significant affiliate of such an entity, unless the firm is satisfied that the valuation has no material effect on the listed company’s financial statements, either separately or in aggregate with other valuations provided; or
- any other audited entity, unless the firm is satisfied that either all significant judgments, including the assumptions, are made by informed management or the valuation has no material effect on the financial statements, either separately or in aggregate with other valuations provided.

Actuarial valuation services are subject to the same general principles as other valuation services. In all cases, where they involve the audit firm in making a subjective judgment and have a material effect on the financial statements, actuarial valuations give rise to an unacceptable level of selfreview threat and so may not be performed by audit firms for entities audited by them.

In the case of non-listed companies where all significant judgments concerning the assumptions, methodology and data for the actuarial valuation are made by informed management and the audit firm’s role is limited to applying proven methodologies using the given data, for which the management takes responsibility, it may be possible to establish effective safeguards to protect the auditors’ objectivity and the appearance of its independence.

For listed companies, or significant affiliates of such entities, the threats to the auditor’s objectivity and independence that would be perceived to be created are too high to allow the audit firm to undertake any actuarial valuation unless the firm is satisfied that the valuation has no material effect on the listed company’s financial statements.

The audit firm’s policies and procedures will set out whether there are circumstances in which actuarial valuation services are not undertaken for non-listed audited entities as described in paragraph 47 of APB Ethical Standard 1.

TAX SERVICES

The range of activities encompassed by the term ‘tax services’ is wide. Three broad categories of tax service can be distinguished. They are where the audit firm:
- provides advice to the audited entity on one or more specific matters at the request of the audited entity; or
- undertakes a substantial proportion of the tax planning or compliance work for the audited entity; or
- promotes tax structures or products to the audited entity, the effectiveness of which is likely to be influenced by the manner in which they are accounted for in the financial statements.

Whilst it is possible to consider tax services under broad headings, such as tax planning or compliance, in practice these services are often interrelated and it is impracticable to analyse services in this way for the purposes of attempting to identify generically the threats to which specific engagements give rise. As a result, audit firms need to identify and assess, on a case-by-case basis, the potential threats to the auditor’s objectivity and independence before deciding whether to undertake a proposed engagement to provide tax services to an audited entity.

The provision of tax services by audit firms to entities audited by them may give rise to a number of threats to the auditor’s objectivity and independence, including the self-interest threat, the management threat, the advocacy threat and, where the work involves a significant degree of subjective judgment and has a material effect on the financial statements, the self-review threat.

Where the audit firm provides advice to the audited entity on one or more specific matters at the request of the audited entity, a self-review threat may be created. This self-review threat is more significant where the audit firm undertakes a substantial proportion of the tax planning and compliance work for the audited entity. However, the auditor may be able

to undertake such engagements, provided that there is informed management and appropriate safeguards are applied to reduce the selfreview threat to an acceptable level.

Examples of such safeguards that may be appropriate when tax services are provided to an audited entity include ensuring that:
- the tax services are provided by partners and staff who have no involvement in the audit of the financial statements;
- the tax services are reviewed by an independent tax partner, or other senior tax employee;
- external independent advice is obtained on the tax work;
- tax computations prepared by the audit team are reviewed by a partner or senior staff member with appropriate expertise who is not a member of the audit team; or
- an audit partner not involved in the audit engagement reviews whether the tax work has been properly and effectively addressed in the context of the audit of the financial statements.

The audit firm shall not promote tax structures or products or undertake an engagement to provide tax advice to an audited entity where the audit engagement partner has, or ought to have, reasonable doubt as to whether the related accounting treatment involved is based on well established interpretations or is appropriate, having regard to the requirement for the financial statements to give a true and fair view in accordance with the relevant financial reporting framework.

Where the audit firm promotes tax structures or products or undertakes an engagement to provide tax advice to the audited entity, it may be necessary to adopt an accounting treatment that is not based on well established interpretations or may not be appropriate, in order to achieve the desired result. A self-review threat arises in the course of an audit because the auditor may be unable to form an impartial view of the accounting treatment to be adopted for the purposes of the proposed arrangements. Accordingly, this Standard does not permit the promotion of tax structures or products by audit firms to entities audited by them where, in the view of the audit engagement partner, after such consultation as is appropriate, there is reasonable doubt as to whether the effectiveness of the tax structure or product depends on an accounting treatment that is well established and appropriate.

The audit firm shall not undertake an engagement to provide tax services wholly or partly on a contingent fee basis where the outcome of those tax services (and, therefore, the amount of the fee) is dependent on the proposed application of tax law which is uncertain or has not been established.

Where tax services, such as advising on corporate structures and structuring transactions to achieve a particular effect, are undertaken on a contingent fee basis, self-interest threats to the auditor’s objectivity and independence may arise. The auditor may have, or may appear to have, an interest in the success of the tax services, causing the audit firm to make an audit judgment about which there is reasonable doubt as to its appropriateness. Where the contingent fee is determined by the outcome of the application of tax law which is uncertain or has not been established, the self-interest threat cannot be eliminated or reduced to an acceptable level by the application of any safeguards.

The audit firm shall not undertake an engagement to provide tax services to an audited entity where the engagement would involve the audit firm undertaking a management role.

When providing tax services to an audited entity, there is a risk that the audit firm undertakes a management role, unless the firm is working with informed management.

Where an audited entity is a listed company or a significant affiliate of such an entity, the audit firm shall not undertake an engagement to prepare current or deferred tax calculations that are or may reasonably be expected to be used when preparing accounting entries that are material to the financial statements of the audited entity, save where the circumstances contemplated in paragraph 164 apply.

For listed companies or significant affiliates of such entities, the threats to the auditor’s objectivity and independence that would be created are too high to allow the audit firm to undertake an engagement to prepare calculations of current or deferred tax liabilities (or assets) for the purpose of preparing accounting entries that are material to the relevant financial statements, together with associated disclosure notes, save where the circumstances contemplated in paragraph 164 apply.

Paragraph 99 is not intended to prevent an audit firm preparing tax calculations after the completion of the audit for the purpose of submitting tax returns.

For entities other than listed companies or significant affiliates of listed companies, the auditor may undertake an engagement to prepare current or deferred tax calculations for the purpose of preparing accounting entries, provided that:
- such services:
  - do not involve initiating transactions or taking management decisions; and
  - are of a technical, mechanical or an informative nature; and (b) appropriate safeguards are applied.

The audit firm’s policies and procedures will set out whether there are circumstances in which current or deferred tax calculations for the purpose of preparing accounting entries are not prepared for non-listed audited entities as described in paragraph 47 of APB Ethical Standard 1.

The audit firm shall not undertake an engagement to provide tax services to an audited entity where this would involve acting as an advocate for the audited entity, before an appeals tribunal or court^[2] in the resolution of an issue:
- that is material to the financial statements; or
- where the outcome of the tax issue is dependent on a future or contemporary audit judgment.

Where the tax services to be provided by the audit firm include representing the audited entity in any negotiations or proceedings involving the tax authorities, advocacy threats to the auditor’s objectivity and independence may arise.

The audit firm is not acting as an advocate where the tax services involve the provision of information to the tax authorities (including an explanation of the approach being taken and the arguments being advanced by the audited entity). In such circumstances effective safeguards may exist and the tax authorities will undertake their own review of the issues.

Where the tax authorities indicate that they are minded to reject the audited entity’s arguments on a particular issue and the matter is likely to be determined by an appeals tribunal or court, the audit firm may become so closely identified with management’s arguments that the auditor is inhibited from forming an impartial view of the treatment of the issue in the financial statements. In such circumstances, if the issue is material to the financial statements or is dependent on a future or contemporary audit judgment, the audit firm discusses the matter with the audited entity and makes it clear that it will have to withdraw from

that element of the engagement to provide tax services that requires it to act as advocate for the audited entity, or resign from the audit engagement from the time when the matter is formally listed for hearing before the appeals tribunal.

The audit firm is not, however, precluded from having a continuing role (for example, responding to specific requests for information) for the audited entity in relation to the appeal. The audit firm assesses the threat associated with any continuing role in accordance with the provisions of paragraphs 109 to 112 of this Standard.

LITIGATION SUPPORT SERVICES

Although management and advocacy threats may arise in litigation support services, such as acting as an expert witness, the primary issue is that a self-review threat will arise in all cases where such services involve a subjective estimation of the likely outcome of a matter that is material to the amounts to be included or the disclosures to be made in the financial statements.

The audit firm shall not undertake an engagement to provide litigation support services to:
- an audited entity that is a listed company or a significant affiliate of such an entity, where this would involve the estimation by the audit firm of the likely outcome of a pending legal matter that could be material to the amounts to be included or the disclosures to be made in the listed company’s financial statements, either separately or in aggregate with other estimates and valuations provided; or
- any other audited entity, where this would involve the estimation by the audit firm of the likely outcome of a pending legal matter that could be material to the amounts to be included or the disclosures to be made in the financial statements, either separately or in aggregate with other estimates and valuations provided and there is a significant degree of subjectivity involved.

In the case of non-listed entities, litigation support services that do not involve such subjective estimations are not prohibited, provided that the audit firm has carefully considered the implications of any threats and established appropriate safeguards.

The audit firm’s policies and procedures will set out whether there are circumstances in which litigation support services are not undertaken for non-listed audited entities as described in paragraph 47 of APB Ethical Standard 1.

LEGAL SERVICES

The audit firm shall not undertake an engagement to provide legal services to an audited entity where this would involve acting as the solicitor formally nominated to represent the audited entity in the resolution of a dispute or litigation which is material to the amounts to be included or the disclosures to be made in the financial statements.

Although the provision by the auditor of certain types of legal services to its audited entities may create advocacy, self-review and management threats, this Standard does not impose a general prohibition on the provision of legal services. However, in view of the degree of advocacy involved in litigation or other types of dispute resolution procedures and the potential importance of any assessment by the auditor of the merits of the audited entity’s position when auditing its financial statements, this Standard prohibits an audit firm from acting as the formally nominated representative for an audited entity in the resolution of a dispute or litigation which is material to the financial statements (either in terms of the amounts recognised or disclosed in the financial statements).

RECRUITMENT AND REMUNERATION SERVICES

The audit firm shall not undertake an engagement to provide recruitment services to an audited entity that would involve the firm taking responsibility for the appointment of any director or employee of the audited entity.

A management threat arises where audit firm personnel take responsibility for any decision as to who is appointed by the audited entity.

For an audited entity that is a listed company, the audit firm shall not undertake an engagement to provide recruitment services in relation to a key management position of the audited entity, or a significant affiliate of such an entity.

A familiarity threat arises if the audit firm plays a significant role in relation to the identification and recruitment of senior members of management within the company, as the engagement team may be less likely to be critical of the information or explanations provided by such individuals than might otherwise be the case. Accordingly, for listed companies, and for significant affiliates of such entities, the audit firm does not undertake engagements that involve the recruitment of individuals for key management positions.

The audit firm’s policies and procedures will set out whether there are circumstances in which recruitment services are not undertaken for nonlisted audited entities as described in paragraph 47 of APB Ethical Standard 1.

Recruitment services involve a specifically identifiable, and separately remunerated, engagement. Audit firms and engagement teams may contribute to an entity’s recruitment process in less formal ways. The prohibition set out in paragraph 117 does not extend to:
- senior members of an audit team interviewing prospective directors or employees of the audited entity and advising on the candidate’s technical financial competence; or
- the audit entity using information gathered by the audit firm, including that relating to salary surveys.

The audit firm shall not undertake an engagement to provide advice on the quantum of the remuneration package or the measurement criteria on which the quantum is calculated, for a director or key management position of an audited entity.

The provision of advice on remuneration packages (including bonus arrangements, incentive plans and other benefits) to existing or prospective employees of the audited entity gives rise to familiarity threats. The significance of the familiarity threat is considered too high to allow advice on the overall amounts to be paid or on the quantitative measurement criteria included in remuneration packages for directors and key management positions.

For other employees, these threats can be adequately addressed by the application of safeguards, such as the advice being provided by partners and staff who have no involvement in the audit of the financial statements.

In cases where all significant judgments concerning the assumptions, methodology and data for the calculation of remuneration packages for directors and key management are made by informed management or a third party and the audit firm’s role is limited to applying proven methodologies using the given data, for which the management takes responsibility, it may be possible to establish effective safeguards to protect the auditor’s objectivity and independence.

Advice on tax, pensions and interpretation of accounting standards relating to remuneration packages for directors and key management can be provided by the audit firm, provided they are not prohibited by the requirements of this Standard relating to tax, actuarial valuations and accounting services. Disclosure of the provision of any such advice would be made to those charged with governance of the audited entity (see APB Ethical Standard 1, paragraphs 63 to 71).

CORPORATE FINANCE SERVICES

The range of services encompassed by the term ‘corporate finance services’ is wide. For example, the audit firm may be engaged:
- to identify possible purchasers for parts of the audited entity’s business and provide advisory services in the course of such sales; or
- to identify possible ‘targets’ for the audited entity to acquire; or
- to advise the audited entity on how to fund its financing requirements; or
- to act as sponsor on admission to listing on the London Stock Exchange, or as Nominated Advisor on the admission of the audited entity on the Alternative Investments Market (AIM); or
- to act as financial adviser to audited entity offerors or offerees in connection with public takeovers.

The potential for the auditor’s objectivity and independence to be impaired through the provision of corporate finance services varies considerably depending on the precise nature of the service provided. The main threats to auditor’s objectivity and independence arising from the provision of corporate finance services are the self-review, management and advocacy threats. Self-interest threats may also arise, especially in situations where the audit firm is paid on a contingent fee basis.

When providing corporate finance services to an audited entity, there is a risk that the audit firm undertakes a management role, unless the firm is working with informed management. Appropriate safeguards are applied to reduce the self-review threat to an acceptable level.

Examples of safeguards that may be appropriate when corporate finance services are provided to an audited entity include ensuring that:
- the corporate finance advice is provided by partners and staff who have no involvement in the audit of the financial statements;
- any advice provided is reviewed by an independent corporate finance partner within the audit firm;
- external independent advice on the corporate finance work is obtained;
- an audit partner who is not involved in the audit engagement reviews the audit work performed in relation to the subject matter of the corporate finance services provided to ensure that such audit work has been properly and effectively reviewed and assessed in the context of the audit of the financial statements.

Where the audit firm undertakes an engagement to provide corporate finance services to an audited entity in connection with conducting the sale or purchase of a material part of the audited entity’s business, the audit engagement partner informs the audit committee (or equivalent) about the engagement, as set out in paragraphs 63 to 71 of APB Ethical Standard 1.

The audit firm shall not undertake an engagement to provide corporate finance services in respect of an audited entity where:
- the engagement would involve the audit firm taking responsibility for dealing in, underwriting, or promoting shares; or
- the audit engagement partner has, or ought to have, reasonable doubt as to whether an accounting treatment that is subject to a contemporary or future audit judgment relating to a material matter in the financial statements of the audited entity, and upon which the success of the related transaction depends:
  - is based on well established interpretations; or
  - is appropriate, having regard to the requirement for the financial statements to give a true and fair view in accordance with the relevant financial reporting framework; or

(c) the engagement would involve the audit firm undertaking a management role in the audited entity.

An unacceptable advocacy threat arises where, in the course of providing a corporate finance service, the audit firm promotes the interests of the audited entity by taking responsibility for dealing in, underwriting, or promoting shares.

Where the audit firm acts as a sponsor under the Listing Rules^[3], or as Nominated Adviser on the admission of the audited entity to the AIM, the audit firm is required to confirm that the audited entity has satisfied all applicable conditions for listing and other relevant requirements of the listing (or AIM) rules. Where there is, or there ought to be, reasonable doubt that the audit firm will be able to give that confirmation, it does not enter into such an engagement.

A self-review threat arises where the outcome or consequences of the corporate finance service provided by the audit firm may be material to the financial statements of the audited entity, which are, or will be, subject to audit by the same firm. Where the audit firm provides corporate finance

[1] This does not include accounting services.

[2] The restriction applies to the first level of Tax Court that is independent of the tax authorities and to more authoritative bodies. In the UK this would be the General or Special Commissioners of HM Revenue & Customs or the VAT and Duties Tribunal.

[3] In the United Kingdom, the UK Listing Authority’s publication the ‘Listing Rules’. In the

Republic of Ireland, the United Kingdom ‘Listing Rules’ as modified by the ‘Notes on the Listing Rules’ published by the Irish Stock Exchange.

services, for example advice to the audited entity on financing arrangements, it may be necessary to adopt an accounting treatment that is not based on well established interpretations or which may not be appropriate, in order to achieve the desired result. A selfreview threat is created because the auditor may be unable to form an impartial view of the accounting treatment to be adopted for the purposes of the proposed arrangements. Accordingly, this Standard does not permit the provision of such services by audit firms in respect of entities audited by them where there is or ought to be reasonable doubt as to whether an accounting treatment that is subject to a contemporary or future audit judgment relating to a material matter in the financial statements of the audited entity and on which the success of a transaction depends is well established and appropriate.

Advice to audited entities on funding issues and banking arrangements, where there is no reasonable doubt as to the appropriateness of the accounting treatment, is not prohibited provided this does not involve the audit firm in taking decisions or making judgments which are properly the responsibility of management.

These restrictions do not apply in circumstances where the auditor is designated by legislation or regulation as being required to carry out a particular service. In such circumstances, the audit engagement partner establishes appropriate safeguards.

TRANSACTION RELATED SERVICES

In addition to corporate finance services, there are other non-audit services associated with transactions that an audit firm may undertake for an audited entity. For example:
- investigations into possible acquisitions or disposals (‘due diligence’ investigations); or
- investigations into the tax affairs of possible acquisitions or disposals; or
- the provision of information to management or sponsors in relation to prospectuses and other investment circulars (for example, long form reports, comfort letters on the adequacy of working capital); or
- agreed upon procedures or reports provided to management in relation to particular transactions (for example, securitisations).

When providing transaction related services to an audited entity, there is a risk that the audit firm may face a management threat, unless the firm is working with informed management. Appropriate safeguards are applied to reduce the self-review threat to an acceptable level.

Examples of safeguards that may be appropriate when transaction related services are provided to an audited entity include ensuring that:
- the transaction related advice is provided by partners and staff who have no involvement in the audit of the financial statements;
- any advice provided is reviewed by an independent transactions partner within the audit firm;
- external independent advice on the transaction related work is obtained;
- an audit partner who is not involved in the audit engagement reviews the audit work performed in relation to the subject matter of the transaction related service provided to ensure that such audit work has been properly and effectively reviewed and assessed in the context of the audit of the financial statements.

The audit firm shall not undertake an engagement to provide transaction related services in respect of an audited entity where:

(a) the audit engagement partner has, or ought to have, reasonable doubt as to whether an accounting treatment that is subject to a contemporary or future audit judgment relating to a material matter in the financial statements of the audited entity, and upon which the success of the related transaction depends;

is based on well established interpretations; or
is appropriate, having regard to the requirement for the financial statements to give a true and fair view in accordance with the relevant financial reporting framework; or

(b) the engagement would involve the audit firm undertaking a management role in the audited entity.

A self-review threat arises where the outcome of the transaction related services undertaken by the audit firm may be material to the financial statements of the audited entity which are, or will be, subject to audit by the same firm. Where the audited entity proposes to undertake a transaction, it may be necessary to adopt an accounting treatment that is not based on well established interpretations or may not be appropriate, in order to achieve the desired result of the transaction (for example, to take assets off the balance sheet). A self-review threat is created if the auditor undertakes transaction related services in connection with such a transaction. Accordingly, this Standard does not permit the provision of services by audit firms in respect of entities audited by them where there is or ought to be reasonable doubt as to whether an accounting treatment, that is subject to a contemporary or future audit judgment relating to a material matter in the financial statements of the audited entity and on which the success of a related transaction depends, is well established and appropriate.

These restrictions do not apply in circumstances where the auditor is designated by legislation or regulation as being required to carry out a particular service. In such circumstances, the audit engagement partner establishes appropriate safeguards.

RESTRUCTURING SERVICES

Restructuring services are any non-audit services provided to an audited entity in connection with the entity’s development or implementation of a transaction or package of transactions (a ‘restructuring plan’) designed to change its equity or debt financing structure, its corporate structure, or its operating structure. There are a variety of possible purposes for developing a restructuring plan, for example to address financial or operating difficulties, to support tax planning, to improve operating efficiency, or to improve the cost of capital. The range of non-audit services that may be regarded as ‘Restructuring Services’ is extensive, and the nature of those services may encompass many of the other types of non-audit services discussed in this Ethical Standard. Where applicable, the related requirements and guidance covered elsewhere in this standard apply to Restructuring Services.

The services that an entity may engage an audit firm to provide may vary considerably and may range from the incidental and routine to advice that is fundamental to the efficacy of the restructuring plan. Consequently, where such services are provided by the entity’s auditor, the audit engagement partner evaluates
- the threats that the services may present to the audit firm’s ability to conduct any contemporary or future audit with objectivity and independence; and
- the likelihood that a reasonable and informed third party would conclude that the auditor’s objectivity and independence would be compromised.

The audit firm shall not undertake an engagement to provide restructuring services in respect of an audited entity where:
- the engagement would involve the audit firm undertaking a management role in or on behalf of the audited entity; or
- the engagement would require the audit firm to act as an

advocate for the audited entity in relation to matters that are material to the financial statements.

The potential for the auditor’s objectivity and independence to be impaired through the provision of restructuring services varies depending on the nature of the service provided. Two of the main threats to auditor objectivity and independence arising from the provision of restructuring services arise where the auditor undertakes a management or advocacy role:
- An audit firm undertakes a management role if the entity does not have informed management capable of taking responsibility for the decisions to be made.
- To avoid undertaking an advocacy role on behalf of the audited entity, the audit firm takes particular care not to assume (or seen to be assuming) responsibility for the entity’s proposals or being regarded as negotiating on behalf of the entity or advocating the appropriateness of the proposals such that its independence is compromised. This is particularly important when the auditor attends meetings with the entity’s bank or other interested parties.

If the audit firm undertakes a management role or acts as advocate for the audited entity, the threats to that auditor’s objectivity and independence are such that no safeguards can reduce the threat to an acceptable level^[1].

The audit firm shall not undertake an engagement to provide restructuring services in respect of an audited entity where that engagement may give rise to a self review threat in the course of a contemporary or future audit unless it is satisfied that such threats can be reduced to an acceptable level by appropriate safeguards and that such safeguards have been put in place.

[1] ‘ES – Provisions Available for Small Entities (Revised)’ provides exemptions relating to informed management and the advocacy threat for auditors of small entities.

The provision of restructuring services gives rise to a self review threat where the restructuring services to be provided involve advice or judgments which are likely to be material to a contemporary or future audit judgment.

Examples of restructuring services that the audit firm may be requested to undertake and which may give rise to a self review threat include:
- Providing preliminary general advice on the options and choices available to management or stakeholders of an entity facing urgent financial or other difficulties.
- Undertaking a review of the business of the entity with a view to advising the audited entity on liquidity management or operational restructuring options.
- Advising on the development of forecasts or projections, for presentation to lenders and other stakeholders, including assumptions.
- Advising the audited entity on how to fund its financing requirements, including equity and debt restructuring programmes.
- Participating in the design or implementation of an overall restructuring plan including, for example, participating in the preparation of cash flow and other forecasts and financial models underpinning the overall restructuring plan.

The self review threat arising from the provision of such services is particularly significant where it has potential to impact the auditor’s assessment of whether it is appropriate to prepare the entity’s financial statements on a going concern basis. Where the audit firm has been involved in aspects of the preparation of a cash flow, a forecast or a financial model, it is probable that a reasonable and informed third party would conclude that the auditor would have a significant self-review threat in considering the going concern assumption.

The self review threat arising from the provision of such services is also particularly significant where the restructuring services are provided in respect of an audited entity and involve developing or implementing a restructuring plan to address the actual or anticipated financial or operational difficulties that threaten the survival of that entity as a going concern (an ‘audited entity in distress’).

The audit firm puts in place those safeguards that it regards as appropriate to reduce the threats to its objectivity and independence to an acceptable level. If the audit firm concludes that the threats arising from some or all of the restructuring services involved cannot be addressed by putting appropriate safeguards in place, it declines the engagement, or those parts of the engagement affected by those threats that cannot be addressed.

Where an audited entity in distress is a listed company or a significant affiliate of a listed audited entity, the restructuring services provided by the audit firm shall be limited to providing:
- preliminary general advice to an entity in distress;
- assistance with the implementation of elements of an overall restructuring plan, such as the sale of a non-significant component business, provided those elements are not material to the overall restructuring plan;
- challenging, but in no circumstances developing, the projections and assumptions within a financial model that has been produced by the audited entity;
- reporting on a restructuring plan, or aspects of it, in connection with the proposed issue of an investment circular; and
- where specifically permitted by a regulatory body with oversight of the audited entity.

Except to the extent identified in paragraph 153, the significance of the self-review threat is too high to permit the provision of other restructuring services to an audited entity in distress that is a listed company or a significant affiliate of a listed audited entity because there are no safeguards that would be sufficient to reduce the resultant threats to an acceptable level.

The audit firm’s policies and procedures will set out whether there are circumstances in which restructuring services are not undertaken for non-listed audited entities in distress as described in paragraph 47 of APB Ethical Standard 1.

ACCOUNTING SERVICES

In this Standard, the term ‘accounting services’ is defined as the provision of services that involve the maintenance of accounting records or the preparation of financial statements that are then subject to audit. Advice on the implementation of current and proposed accounting standards is not included in the term ‘accounting services’.

The range of activities encompassed by the term ‘accounting services’ is wide. In some cases, the audited entity may ask the audit firm to provide a complete service including maintaining all of the accounting records and the preparation of the financial statements. Other common situations are:
- the audit firm may take over the provision of a specific accounting function on an outsourced basis (for example, payroll);
- the audited entity maintains the accounting records, undertakes basic bookkeeping and prepares a year-end trial balance and asks the audit firm to assist with the preparation of the necessary adjustments and the financial statements.

The provision of accounting services by the audit firm to the audited entity creates threats to the auditor’s objectivity and independence, principally self-review and management threats, the significance of which depends on the nature and extent of the accounting services in question and upon the level of public interest in the audited entity.

When providing accounting services to an audited entity, unless the firm is working with informed management, there is a risk that the audit firm undertakes a management role.

The audit firm shall not undertake an engagement to provide accounting services to:
- an audited entity that is a listed company or a significant affiliate of such an entity, save where the circumstances contemplated in paragraph 164 apply; or
- any other audited entity, where those accounting services would involve the audit firm undertaking part of the role of management.

Even where there is no engagement to provide any accounting services, it is usual for the auditor to provide the management with accounting advice on matters that have come to the auditor’s attention during the course of the audit. Such matters might typically include:
- comments on weaknesses in the accounting records and suggestions for addressing them;
- errors identified in the accounting records and in the financial statements and suggestions for correcting them;
- advice on the accounting policies in use and on the application of current and proposed accounting standards.

This advice is a by-product of the audit service rather than the result of any engagement to provide non-audit services. Consequently, as it is part of the audit service, such advice is not regarded as giving rise to any threat to the auditor’s objectivity and independence.

For listed companies or significant affiliates of such entities, the threats to the auditor’s objectivity and independence that would be created are

too high to allow the audit firm to undertake an engagement to provide any accounting services, save where the circumstances contemplated in paragraph 164 apply.

The audit firm’s policies and procedures will set out whether there are circumstances in which accounting services are not undertaken for nonlisted audited entities as described in paragraph 47 of APB Ethical Standard 1.

In emergency situations, the audit firm may provide a listed audited entity, or a significant affiliate of such a company, with accounting services to assist the company in the timely preparation of its financial statements. This might arise when, due to external and unforeseeable events, the audit firm personnel are the only people with the necessary knowledge of the audited entity’s systems and procedures. A situation could be considered an emergency where the audit firm’s refusal to provide these services would result in a severe burden for the audited entity (for example, withdrawal of credit lines), or would even threaten its going concern status. In such circumstances, the audit firm ensures that:
- any staff involved in the accounting services have no involvement in the audit of the financial statements; and
- the engagement would not lead to any audit firm staff or partners taking decisions or making judgments which are properly the responsibility of management.

For entities other than listed companies or significant affiliates of listed companies, the auditor may undertake an engagement to provide accounting services, provided that:

(a) such services:

do not involve initiating transactions or taking management decisions; and
are of a technical, mechanical or an informative nature; and

(b) appropriate safeguards are applied to reduce the self-review threat to an acceptable level.

The maintenance of the accounting records and the preparation of the financial statements are the responsibility of the management of the audited entity. Accordingly, in any engagement to provide the audited entity with accounting services, the audit firm does not initiate any transactions or take any decisions or make any judgments, which are properly the responsibility of the management. These include:
- authorising or approving transactions;
- preparing originating data (including valuation assumptions);
- determining or changing journal entries, or the classifications for accounts or transactions, or other accounting records without management approval.

Examples of accounting services of a technical or mechanical nature or of an informative nature include:
- recording transactions for which management has determined the appropriate account classification, posting coded transactions to the general ledger, posting entries approved by management to the trial balance or providing certain data-processing services (for example, payroll);
- assistance with the preparation of the financial statements where management takes all decisions on issues requiring the exercise of judgment and has prepared the underlying accounting records.

Examples of safeguards that may be appropriate when accounting services are provided to an audited entity include:
- accounting services provided by the audit firm are performed by partners and staff who have no involvement in the external audit of the financial statements;
- the accounting services are reviewed by a partner or other senior staff member with appropriate expertise who is not a member of the audit team;
- the audit of the financial statements is reviewed by an audit partner who is not involved in the audit engagement to ensure that the accounting services performed have been properly and effectively assessed in the context of the audit of the financial statements.

EFFECTIVE DATE

This revised Ethical Standard becomes effective on 30 April 2011.

Firms may complete audit engagements relating to periods commencing on or before 31 December 2010 in accordance with existing ethical standards, putting in place any necessary changes in the subsequent engagement period.

Where compliance with the requirements of ES 5 would result in a service not being supplied, services contracted before 31 December 2010 may continue to be provided until the earlier of either:
- the completion of the specific task or the end of the contract term, where this is set out in the contract; or
- 31 December 2011 (or, in the case of services prohibited under paragraph 95, 31 December 2014),

as long as the following apply:

the engagement was permitted by existing ethical standards

(including transitional provisions);

any safeguards required by existing ethical standards continue to be applied; and
the need for additional safeguards is assessed, including where possible any additional safeguards specified by ES 5, and if considered necessary, those additional safeguards are applied.

In the first year of appointment as auditor to an audited entity, an audit firm may continue to provide non-audit services which are already contracted at the date of appointment, until the earlier of either:
the completion of the specific task or the end of the contract term, where this is set out in the contract; or
one year after the date of appointment, where a task or term is not defined,

provided that the need for additional safeguards is assessed and if considered necessary, those additional safeguards are applied.

Posted on April 9, 2021 by MJ — Leave a comment

ES-4 APB ETHICAL STANDARD 4 (REVISED) FEES, REMUNERATION AND EVALUATION POLICIES, LITIGATION, GIFTS AND HOSPITALITY

INTRODUCTION

APB Ethical Standard 1 requires the audit engagement partner to identify and assess the circumstances which could adversely affect the auditor’s objectivity (‘threats’), including any perceived loss of independence, and to apply procedures (‘safeguards’) which will either:
- eliminate the threat; or
- reduce the threat to an acceptable level (that is, a level at which it is not probable that a reasonable and informed third party would conclude that the auditor’s objectivity and independence either is impaired or is likely to be impaired).

This Standard provides requirements and guidance on specific circumstances arising out of fees, economic dependence, litigation, remuneration and evaluation of partners and staff, and gifts and hospitality, which may create threats to the auditor’s objectivity or perceived loss of independence. It gives examples of safeguards that can, in some situations, eliminate the threat or reduce it to an acceptable level. In circumstances where this is not possible, either the situation is avoided or the auditor either does not accept or withdraws from the audit engagement, as appropriate.

Whenever a possible or actual breach of an APB Ethical Standard is identified, the audit engagement partner, in the first instance, and the Ethics Partner, where appropriate, assesses the implications of the breach, determines whether there are safeguards that can be put in place or other actions that can be taken to address any potential adverse consequences and considers whether there is a need to resign from the audit engagement.

An inadvertent violation of this Standard does not necessarily call into question the audit firm’s ability to give an audit opinion provided that:
- the audit firm has established policies and procedures that require all partners and staff to report any breach promptly to the audit engagement partner or to the Ethics Partner, as appropriate;
- the audit engagement partner or Ethics Partner ensures that any matter which has given rise to a breach is addressed as soon as possible;
- safeguards, if appropriate, are applied (for example, having another partner review the work done by the relevant partner or member of staff or by removing him or her from the engagement team); and
- the actions taken and the rationale for them are documented.

FEES

The audit engagement partner shall be satisfied and able to demonstrate that the audit engagement has assigned to it sufficient partners and staff with appropriate time and skill to perform the audit in accordance with all applicable Auditing and Ethical Standards, irrespective of the audit fee to be charged.

Paragraph 5 is not intended to prescribe the approach to be taken by audit firms to the setting of audit fees, but rather to emphasise that there are no circumstances where the amount of the audit fee can justify any lack of appropriate resource or time taken to perform a proper audit in accordance with applicable Auditing and Ethical Standards.

The audit engagement partner shall ensure that audit fees are not influenced or determined by the provision of non-audit services to the audited entity.

The audit fee ordinarily reflects the time spent, the skills and experience of the personnel performing the audit in accordance with all the relevant requirements, and the competitive situation in the audit market. Paragraph 7 is intended to prevent any relationship between the appropriate cost of the audit and the actual or potential provision of nonaudit services.

Paragraph 7 is not intended to prohibit proper cost savings that can be achieved as a result of providing non-audit services in accordance with APB Ethical Standard 5 to the audited entity, for example, where information gained through undertaking a non-audit service is referred to by audit staff when carrying out the audit of the financial statements.

An audit shall not be undertaken on a contingent fee basis.

A contingent fee basis is any arrangement made under which a fee is calculated on a pre-determined basis relating to the outcome or result of a transaction, or other event, or the result of the work performed. A fee that is established by a court or other public authority is not a contingent fee.

Contingent fee arrangements in respect of audit engagements create self-interest threats to the auditor’s objectivity and independence that are so significant that they cannot be eliminated or reduced to an acceptable level by the application of any safeguards.

The audit fee does not depend on whether the auditor’s report on the financial statements is qualified or unqualified. The basis for the calculation of the audit fee is agreed with the audited entity each year before significant audit work is undertaken. Arrangements under which estimated audit fees are agreed with the audited entity on terms where the fees may be varied based on the level of audit work required do not constitute contingent fee arrangements.

Contingent fee arrangements in respect of non-audit services provided by the auditor in respect of an audited entity can create significant selfinterest threats to the auditor’s objectivity and independence as the auditor may have, or may appear to have, an interest in the outcome of the non-audit service.

The audit firm shall not undertake an engagement to provide nonaudit services in respect of an audited entity on a contingent fee basis where:
the contingent fee is material to the audit firm, or that part of the firm by reference to which the audit engagement partner’s profit share is calculated; or
the outcome of those non-audit services (and, therefore, the amount of the fee) is dependent on a future or contemporary audit judgment relating to a material matter in the financial statements of an audited entity.

Where non-audit services are provided on a contingent fee basis, there may be a perception that the audit firm’s interests are so closely aligned with the audited entity that the auditor’s objectivity and independence is threatened. The significance of the self-interest threat is primarily determined by the materiality of the contingent fee to the audit firm or to the part of the firm by reference to which the audit engagement partner’s profit share is calculated. Where the contingent fee and the outcome of the non-audit service is dependent on a future or contemporary audit judgment on a material matter included in the financial statements of an audited entity, the self interest threat cannot be eliminated or reduced to an acceptable level by the application of safeguards.

Paragraph 15 is not intended to prohibit an audit firm from charging a lower fee where the engagement relates to a transaction or engagement that was either aborted or prematurely terminated for whatever reason and where the rationale for the lower fee is to take account of either the reduced risk and responsibility involved or the fact that less work was undertaken than had been anticipated.

For non-audit services provided on a contingent fee basis, other than those prohibited under paragraph 15, the audit engagement partner assesses the significance of the self-interest threat and considers whether there are safeguards that could be applied which would be effective to eliminate the threat or reduce it to an acceptable level. The significance of the self-interest threat will depend on factors such as:
- the range of possible fee amounts;
- the nature of the non-audit service;
- the effect of the outcome of the non-audit service on the financial statements of the audited entity.

Examples of safeguards that might be applied to reduce to an acceptable level any self-interest threats arising from the provision of non-audit services on a contingent fee basis (other than those set out in paragraph 15 above) include:
- the provision of such non-audit services by partners and staff who have no involvement in the external audit of the financial statements;
- review of the audit of the financial statements by an audit partner who is not involved in the audit engagement to ensure that the subject matter of the non-audit service engagement has been properly and effectively addressed in the context of the audit of the financial statements.

The audit firm shall establish policies and procedures to ensure that the audit engagement partner and the Ethics Partner are notified where others within the audit firm propose to adopt contingent fee arrangements in relation to the provision of nonaudit services to the audited entity or its affiliates.

Contingent fee arrangements in respect of non-audit services provided by the auditor may create a threat to the auditor’s objectivity and independence. The circumstances in which such fee arrangements are not permitted for non-audit services are dealt with in paragraph 15 of this standard and paragraph 95 of APB Ethical Standard 5.

In the case of listed companies the audit engagement partner shall disclose to the audit committee, in writing, any contingent fee arrangements for non-audit services provided by the auditor or its network firms.

In the case of a group audit of a listed company, which involves other auditors, the letter of instruction sent by the group audit engagement partner to the other auditors requests disclosure of any contingent fees for non-audit services charged or proposed to be charged by the other auditors.

The actual amount of the audit fee for the previous audit and the arrangements for its payment shall be agreed with the audited entity before the audit firm formally accepts appointment as auditor in respect of the following period.

Ordinarily, any outstanding fees for the previous audit period are paid before the audit firm commences any new audit work. Where they are not, it is important for the audit engagement partner to understand the nature of any disagreement or other issue.

Where fees for professional services from the audited entity are overdue and the amount cannot be regarded as trivial, the audit engagement partner, in consultation with the Ethics Partner, shall consider whether the audit firm can continue as auditor or whether it is necessary to resign.

Where fees due from an audited entity, whether for audit or for non-audit services, remain unpaid for a long time – and, in particular, where a significant part is not paid before the auditor’s report on the financial statements for the following year is due to be issued – a self-interest threat to the auditor’s objectivity and independence is created because the issue of an unqualified audit report may enhance the audit firm’s prospects of securing payment of such overdue fees.

Where the outstanding fees are in dispute and the amount involved is significant, the threats to the auditor’s objectivity and independence may be such that no safeguards can eliminate them or reduce them to an acceptable level. The audit engagement partner therefore considers whether the audit firm can continue with the audit engagement.

Where the outstanding fees are unpaid because of exceptional circumstances (including financial distress), the audit engagement partner considers whether the audited entity will be able to resolve its difficulties. In deciding what action to take, the audit engagement partner weighs the threats to the auditor’s objectivity and independence, if the audit firm were to remain in office, against the difficulties the audited entity would be likely to face in finding a successor, and therefore the public interest considerations, if the audit firm were to resign.

In any case where the audit firm does not resign from the audit engagement, the audit engagement partner applies appropriate safeguards (such as a review by an audit partner who is not involved in the audit engagement) and notifies the Ethics Partner of the facts concerning the overdue fees.

Where it is expected that the total fees for both audit and non-audit services receivable from a listed audited entity and its subsidiaries audited by the audit firm^[1] will regularly exceed 10% of the annual fee income of the audit firm² or, where profits are not shared on a firm-wide basis, of the part of the firm by reference to which the audit engagement partner’s profit share is calculated, the firm shall not act as the auditor of that entity and shall either resign as auditor or not stand for reappointment, as appropriate.^[2]

Where it is expected that the total fees for both audit and non-audit services receivable from a non-listed audited entity and its

[1] Total fees will include those billed by others where the audit firm is entitled to the fees, but will not include fees billed by the audit firm where it is acting as agent for another party. ² In the case of a sole practitioner, annual fee income of the audit firm includes all earned income received by the individual.

[2] Paragraphs 31 to 40 do not apply to the audits of those public sector bodies where the responsibility for the audit is assigned by legislation. In such cases, the auditor cannot resign from the audit engagement, irrespective of considerations of economic dependence.

subsidiaries audited by the audit firm will regularly exceed 15% of the annual fee income of the audit firm or, where profits are not shared on a firm-wide basis, of the part of the firm by reference to which the audit engagement partner’s profit share is calculated, the firm shall not act as the auditor of that entity and shall either resign as auditor or not stand for reappointment, as appropriate.

Where it is expected that the total fees for both audit and non-audit services receivable from an audited entity and its subsidiaries that are audited by the audit firm will regularly exceed 10% in the case of listed companies and 15% in the case of non-listed entities of the annual fee income of the part of the firm by reference to which the audit engagement partner’s profit share is calculated, it may be possible to assign the engagement to another part of the firm.

Paragraphs 31 and 32 are not intended to require the audit firm to resign as auditor or not stand for reappointment as a result of an individual event or engagement, the nature or size of which was unpredictable and where a reasonable and informed third party would regard ceasing to act as detrimental to the shareholders (or equivalent) of the audited entity. However, in such circumstances, the auditor discloses full details of the position to the Ethics Partner and to those charged with governance of the audited entity and discusses with both what, if any, safeguards may be appropriate.

Where it is expected that the total fees for both audit and non-audit services receivable from a listed audited entity and its subsidiaries audited by the audit firm will regularly exceed 5% of the annual fee income of the audit firm or the part of the firm by reference to which the audit engagement partner’s profit share is calculated, but will not regularly exceed 10%, the audit engagement partner shall disclose that expectation to the Ethics Partner and to those charged with governance of the audited entity and consider whether appropriate safeguards need to be applied to eliminate or reduce to an acceptable level the threat to the auditor’s objectivity and independence.

It is fundamental to the auditor’s objectivity that the auditor be willing and able, if necessary, to disagree with the directors and management, regardless of the consequences to its own position. Where the auditor is, to any significant extent, economically dependent on the audited entity, this may inhibit the auditor’s willingness or constrain the auditor’s ability to express a qualified opinion on the financial statements, since this could be viewed as likely to lead to the auditor losing the audit engagement and the entity as a client.

An audit firm is deemed to be economically dependent on a listed audited entity if the total fees for audit and all other services from that entity and its subsidiaries which are audited by the audit firm represent

10% of the total fees of the audit firm or the part of the firm by reference to which the audit engagement partner’s profit share is calculated. Where such fees are between 5% and 10%, the audit engagement partner and the Ethics Partner consider the significance of the threat and the need for appropriate safeguards.

Such safeguards might include:
- taking steps to reduce the non-audit work to be undertaken and therefore the fees earned from the audited entity;
- applying independent internal quality control reviews.

Where it is expected that the total fees for both audit and non-audit services receivable from a non-listed audited entity and its subsidiaries audited by the audit firm will regularly exceed 10% of the annual fee income of the audit firm or the part of the firm by reference to which the audit engagement partner’s profit share is calculated, but will not regularly exceed 15%, the audit engagement partner shall disclose that expectation to the Ethics Partner and to those charged with governance of the audited entity and the firm shall arrange an external independent quality control review of the audit engagement to be undertaken before the auditor’s report is finalised.

A quality control review involves discussion with the audit engagement partner, a review of the financial statements and the auditor’s report, and consideration of whether the report is appropriate. It also involves a review of selected working papers relating to the significant judgments the engagement team has made and the conclusions they have reached. The extent of the review depends on the complexity of the engagement and the risk that the report might not be appropriate in the circumstances. The review includes considering the following:
- Significant risks identified during the audit and the responses to those risks.
- Judgments made, particularly with respect to materiality and significant risks.
- Whether appropriate consultation has taken place on matters involving differences of opinion or other difficult or contentious matters, and the conclusions arising from those consultations.
- The significance and disposition of corrected and uncorrected misstatements identified during the audit.
- The appropriateness of the report to be issued.

Where the quality control reviewer makes recommendations that the audit engagement partner does not accept and the matter is not resolved to the reviewer’s satisfaction, the report is not issued until the matter is resolved by following the audit firm’s procedures for dealing with differences of opinion.

A new audit firm seeking to establish itself may find the requirements relating to economic dependence difficult to comply with in the short term. In these circumstances, such firms would:
- not undertake any audits of listed companies, where fees from such an audited entity would represent 10% or more of the annual fee income of the firm; and
- for a period not exceeding two years, require external independent quality control reviews of those audits of unlisted entities that represent more than 15% of the annual fee income before the audit opinion is issued.

The firm might also develop its practice by accepting work from entities not audited by the firm so as to bring the fees payable by each audited entity below 15%.

A self-interest threat may also be created where an audit partner in the engagement team:
- is employed exclusively or principally on that audit engagement; and
- is remunerated on the basis of the performance of part of the firm which is substantially dependent on fees from that audited entity.

Where the circumstances described in paragraph 42 arise, the audit firm assesses the significance of the threat and applies safeguards to reduce the threat to an acceptable level. Such safeguards might include:
reducing the dependence of the office, partner or person in a position to influence the conduct and outcome of the audit by reallocating the work within the practice;
a review by an audit partner who is not involved with the audit engagement to ensure that the auditor’s objectivity and independence is not affected by the self-interest threat.

REMUNERATION AND EVALUATION POLICIES

The audit firm shall establish policies and procedures to ensure that each of the following is true in relation to each audited entity:
- the objectives of the members of the engagement team do not include selling non-audit services to the entity they audit;
- the criteria for evaluating the performance or promotion of members of the engagement team do not include success in selling non-audit services to the entity they audit; and
- no specific element of the remuneration of a member of the engagement team is based on his or her success in selling non-audit services to the entity they audit.

This requirement does not apply to those members of the engagement team from specialist practice areas where the nature and extent of their involvement in the audit is clearly insignificant.

Where the auditor identifies areas for possible improvement in an audited entity the auditor may provide general business advice, which might include suggested solutions to problems. Before discussing any non-audit service that might be provided by the audit firm or effecting any introductions to colleagues from outside the engagement team, the audit engagement partner considers the threats that such a service would have on the audit engagement, in line with the requirements of APB Ethical Standard 5.

The last sentence of paragraph 44 recognises the fact that an engagement team may include personnel from specialist practice areas and that it would be inappropriate to limit the business development activities of such persons where their involvement in the audit is clearly insignificant.

The policies and procedures required for compliance with paragraph 44 are not intended to inhibit normal profit-sharing arrangements. However, such policies and procedures are central to an audit firm’s ability to demonstrate its objectivity and independence and to rebut any suggestion that an audit that it has undertaken and the opinion that it has given are influenced by the nature and extent of any non-audit services that it has provided to that audited entity. Because it is possible that, despite such policies and procedures, such factors may be taken into account in the evaluation and remuneration of members of an engagement team, the Ethics Partner pays particular attention to the actual implementation of those policies and procedures and is available for consultation when needed.

THREATENED AND ACTUAL LITIGATION

Where litigation in relation to audit or non-audit services between the audited entity or its affiliates and the audit firm, which is other than insignificant, is already in progress, or where the audit engagement partner considers such litigation to be probable, the audit firm shall either not continue with or not accept the audit engagement.^[1]

Where litigation (in relation to audit or non-audit services) actually takes place between the audit firm (or any person in a position to influence the conduct and outcome of the audit) and the audited entity, or where litigation is threatened and there is a realistic prospect of such litigation being commenced, self-interest, advocacy and intimidation threats to the auditor’s objectivity and independence are created because the audit firm’s interest will be the achievement of an outcome to the dispute or litigation that is favourable to itself. In addition, an effective audit process requires complete candour and full disclosure between the audited entity’s management and the engagement team: such disputes or litigation may place the two parties in opposing adversarial positions and may affect management’s willingness to make complete disclosure of relevant information. Where the auditor can foresee that such a threat may arise,

[1] Paragraphs 48 to 50 do not apply to the audits of those public sector bodies where the responsibility for the audit is assigned by legislation. In such cases, the auditor cannot resign from the audit engagement: the auditor reports significant litigation to the relevant legislative authority.

the auditor informs the audit committee of its intention to resign or, where there is no audit committee, the board of directors.

The auditor is not required to resign immediately in circumstances where a reasonable and informed third party would not regard it as being in the interests of the shareholders for it to do so. Such circumstances might arise, for example, where:
- the litigation was commenced as the audit was about to be completed and shareholder interests would be adversely affected by a delay in the audit of the financial statements;
- on appropriate legal advice, the audit firm deems that the threatened or actual litigation is vexatious or designed solely to bring pressure to bear on the opinion to be expressed by the auditor.

GIFTS AND HOSPITALITY

The audit firm, those in a position to influence the conduct and outcome of the audit and immediate family members of such persons shall not accept gifts from the audited entity, unless the value is clearly insignificant.

Those in a position to influence the conduct and outcome of the audit and immediate family members of such persons shall not accept hospitality from the audited entity, unless it is reasonable in terms of its frequency, nature and cost.

Where gifts or hospitality are accepted from an audited entity, selfinterest and familiarity threats to the auditor’s objectivity and independence are created. Familiarity threats also arise where gifts or hospitality are offered to an audited entity.

Gifts from the audited entity, unless their value is clearly insignificant, create threats to objectivity and independence which no safeguards can eliminate or reduce.

Hospitality is a component of many business relationships and can provide valuable opportunities for developing an understanding of the audited entity’s business and for gaining the insight on which an effective and successful working relationship depends. Therefore, the auditor’s objectivity and independence is not necessarily impaired as a result of accepting hospitality from the audited entity, provided it is reasonable in terms of its frequency, its nature and its cost.

The audit firm shall establish policies on the nature and value of gifts and hospitality that may be accepted from and offered to audited entities, their directors, officers and employees, and shall issue guidance to assist partners and staff to comply with such policies.

In assessing the acceptability of gifts and hospitality, the test to be applied is not whether the auditor considers that the auditor’s objectivity is impaired but whether it is probable that a reasonable and informed third party would conclude that it is or is likely to be impaired.

Where there is any doubt as to the acceptability of gifts or hospitality offered by the audited entity, members of the engagement team discuss the position with the audit engagement partner. If there is any doubt as to the acceptability of gifts or hospitality offered to the audit engagement partner, or if the audit engagement partner has any residual doubt about the acceptability of gifts or hospitality to other individuals, the audit engagement partner reports the facts to the Ethics Partner, for further consideration regarding any action to be taken.

Where the cumulative amount of gifts or hospitality accepted from the audited entity appears abnormally high, the audit engagement partner reports the facts to both:
- the Ethics Partner; and
- the audit committee (or, where there is no audit committee, the board of directors),

together with other significant facts and matters that bear upon the auditor’s objectivity and independence.

EFFECTIVE DATE

This revised Ethical Standard becomes effective on 30 April 2011.

Firms may complete audit engagements relating to periods commencing on or before 31 December 2010 in accordance with existing ethical standards, putting in place any necessary changes in the subsequent engagement period.

An audit firm may continue to provide non-audit services that would be prohibited under paragraph 15, where these have already been contracted at 31 December 2010, until the earlier of either:
1. the completion of the specific task or the end of the contract term, where one is set out in the contract; or
2. 31 December 2011.

Posted on April 9, 2021 by MJ — 1 Comment

ES-3 APB ETHICAL STANDARD 3 (REVISED) LONG ASSOCIATION WITH THE AUDIT ENGAGEMENT

INTRODUCTION

APB Ethical Standard 1 requires the audit engagement partner to identify and assess the circumstances which could adversely affect the auditor’s objectivity (‘threats’), including any perceived loss of independence, and to apply procedures (‘safeguards’) which will either:
- eliminate the threat; or
- reduce the threat to an acceptable level (that is, a level at which it is not probable that a reasonable and informed third party would conclude that the auditor’s objectivity and independence either is impaired or is likely to be impaired).

This Standard provides requirements and guidance on specific circumstances arising out of long association with the audit engagement, which may create threats to the auditor’s objectivity or perceived loss of independence. It gives examples of safeguards that can, in some circumstances, eliminate the threat or reduce it to an acceptable level. In circumstances where this is not possible, the auditor either does not accept or withdraws from the audit engagement, as appropriate.

Whenever a possible or actual breach of an APB Ethical Standard is identified, the audit engagement partner, in the first instance, and the Ethics Partner, where appropriate, assesses the implications of the breach, determines whether there are safeguards that can be put in place or other actions that can be taken to address any potential adverse consequences and considers whether there is a need to resign from the audit engagement.

An inadvertent violation of this Standard does not necessarily call into question the audit firm’s ability to give an audit opinion provided that:
the audit firm has established policies and procedures that require all partners and staff to report any breach promptly to the audit engagement partner or to the Ethics Partner, as appropriate;
the audit engagement partner or Ethics Partner ensures that any matter which has given rise to a breach is addressed as soon as possible;
safeguards, if appropriate, are applied (for example, by having another partner review the work done by the relevant partner or member of staff or by removing him or her from the engagement team): and
the actions taken and the rationale for them are documented.

GENERAL PROVISIONS

The audit firm shall establish policies and procedures to monitor the length of time that audit engagement partners, key partners involved in the audit and partners and staff in senior positions, including those from other disciplines, serve as members of the engagement team for each audit.

Where audit engagement partners, key partners involved in the audit, and partners and staff in senior positions have a long association with the audit, the audit firm shall assess the threats to the auditor’s objectivity and independence and shall apply safeguards to reduce the threats to an acceptable level. Where appropriate safeguards cannot be applied, the audit firm shall either resign as auditor or not stand for reappointment, as appropriate.^[1]

Where audit engagement partners, key partners involved in the audit, other partners and staff in senior positions have a long association with the audited entity, self-interest, self-review and familiarity threats to the auditor’s objectivity may arise. Similarly, such circumstances may result

[1] In the case of those public sector bodies where the responsibility for the audit is assigned by legislation, the auditor cannot resign from the audit engagement and considers alternative safeguards that can be put in place.

in an actual or perceived loss of independence. The significance of such threats depends upon factors such as:
- the role of the individual in the engagement team;
- the proportion of time that the audited entity contributes to the individual’s annual billable hours;
- the length of time that the individual has been associated with that audit engagement.

In order to address such threats, audit firms apply safeguards.

Appropriate safeguards may include:

removing (‘rotating’) the partners and the other senior members of the engagement team after a pre-determined number of years;
involving an additional partner, who is not and has not recently been a member of the engagement team, to review the work done by the partners and the other senior members of the engagement team and to advise as necessary;
applying independent internal quality reviews to the engagement in question.

Once an audit engagement partner has held this role for a continuous period of ten years, careful consideration is given as to whether a reasonable and informed third party would consider the audit firm’s objectivity and independence to be impaired. Where the individual concerned is not rotated after ten years, it is important that:
safeguards other than rotation, such as those noted in paragraph 8, are applied; or
(i) the reasoning as to why the individual continues to participate in the audit engagement without any safeguards is documented; and

(ii) the facts are communicated to those charged with governance of the audited entity in accordance with paragraphs 63 – 71 of APB Ethical Standard 1.

The audit firm’s policies and procedures set out whether there are circumstances in which the audit engagement partners, engagement quality control reviewers and key partners involved in the audit of nonlisted entities are subject to accelerated rotation requirements, such as those set out in paragraph 12, as described in paragraph 47 of APB Ethical Standard 1.

Any scheme of rotation of partners and other senior members of the engagement team needs to take into account the factors which affect the quality of the audit work, including the experience and continuity of members of the engagement team and the need to ensure appropriate succession planning.

ADDITIONAL PROVISIONS RELATED TO AUDITS OF LISTED COMPANIES

The audit engagement partner

In the case of listed companies, save where the circumstances contemplated in paragraph 15 and 16 apply, the audit firm shall establish policies and procedures to ensure that:
- no one shall act as audit engagement partner for more than five years; and
- anyone who has acted as the audit engagement partner for a particular audited entity for a period of five years, shall not subsequently participate in the audit engagement until a further period of five years has elapsed.

The roles that constitute participating in an audit engagement for the purposes of paragraph 12(b), include providing quality control for the engagement, advising or consulting with the engagement team or the client regarding technical or industry specific issues, transactions or events, or otherwise directly influencing the outcome of the audit engagement. This does not include responding to queries in relation to any completed audit engagement. This is not intended to preclude partners whose primary responsibility within a firm is to be consulted on technical or industry specific issues from providing such consultation to the engagement team or client after a period of two years has elapsed from their ceasing to act as audit engagement partner, provided that such consultation is in respect of new issues or new types of transactions or events that were not previously required to be considered by that individual in the course of acting as audit engagement partner.

Where an audit engagement partner continues in a non-audit role having been rotated off the engagement team, the new audit engagement partner and the individual concerned ensure that that person, while acting in this new role, does not exert any influence on the audit engagement. Positions in which an individual is responsible for the firm’s client relationship with the particular audited entity would not be an acceptable non-audit role.

When an audited entity becomes a listed company, the length of time the audit engagement partner has served the audited entity in that capacity is taken into account in calculating the period before the audit engagement partner is rotated off the engagement team. However, where the audit engagement partner has already served for four or more years, that individual may continue to serve as the audit engagement partner for not more than two years after the audited entity becomes a listed company.

In circumstances where the audit committee (or equivalent) of the audited entity decide that a degree of flexibility over the timing of rotation is necessary to safeguard the quality of the audit and the audit firm agrees, the audit engagement partner may continue in this position for an additional period of up to two years, so that no longer than seven years in total is spent in the position of audit engagement partner. An audit committee and the audit firm may consider that such flexibility safeguards the quality of the audit, for example, where:
- substantial change has recently been made or will soon be made to the nature or structure of the audited entity’s business; or
- there are unexpected changes in the senior management of the audited entity.

In these circumstances alternative safeguards are applied to reduce any threats to an acceptable level. Such safeguards may include ensuring that an expanded review of the audit work is undertaken by the engagement quality control reviewer or an audit partner, who is not involved in the audit engagement.

Where it has been determined that the audit engagement partner may act for a further period (not to exceed two years) in the interests of audit quality, this fact and the reasons for it, are to be disclosed to the audited entity’s shareholders as early as practicable and in each of the additional years. If the audited entity is not prepared to make such a disclosure, the audit firm does not permit the audit engagement partner to continue in this role.

In the case of joint audit arrangements for listed companies, audit firms will make arrangements for changes of audit engagement partners over a five-year period so that the familiarity threat is avoided, whilst also taking into consideration factors that affect the quality of the audit work.

Engagement quality control reviewers and key partners involved in the audit

19 In the case of listed companies, the audit firm shall establish policies and procedures to ensure that:

no one shall act as the engagement quality control reviewer or a key partner involved in the audit for a period longer than seven years;
where an engagement quality control reviewer or a key partner involved in the audit becomes the audit engagement partner, the combined period of service in these positions shall not exceed seven years; and (c) anyone who has acted:
- as an engagement quality control reviewer for a particular audited entity for a period of seven years, whether continuously or in aggregate, shall not participate in the audit engagement until a further period of five years has elapsed;
- as a key partner involved in the audit for a particular audited entity for a period of seven years, whether continuously or in aggregate, shall not participate in the audit engagement until a further period of two years has elapsed; (iii) in a combination of roles as:
- the engagement quality control reviewer,

•a key partner involved in the audit, or

the audit engagement partner for a particular audited entity for a period of seven years, whether continuously or in aggregate, shall not participate in the audit engagement until a further period of five years has elapsed.

Other partners and staff in senior positions

In the case of listed companies, the audit engagement partner shall review the safeguards put in place to address the threats to the auditor’s objectivity and independence arising where partners and staff have been involved in the audit in senior positions for a continuous period longer than seven years and shall discuss those situations with the engagement quality control reviewer. Any unresolved problems or issues shall be referred to the Ethics Partner.

The significance of the threats arising where partners and staff have been involved in the audit in senior positions for a continuous period longer than seven years will depend on:
- the total period of time that the individual has been involved in the audit;
- changes in the nature of the work and the role performed by the individual during that period; and

the portion of time the individual has spent on the audit and non-audit engagements with the audited entity during that period.

Following the assessment of any such threats, appropriate safeguards are applied where necessary. Safeguards that address these threats might include:
- changes in the roles within the engagement team;
- an additional review of the work done by the individual by the audit engagement partner or other partners in the engagement team;
- additional procedures carried out as part of the engagement quality control review.

If such safeguards do not reduce the threats to an acceptable level, the partner or member of staff is removed from the engagement team.

EFFECTIVE DATE

Revisions to this Ethical Standard become effective for audits of financial statements for periods commencing on or after 15 December 2009.

Earlier adoption of the revisions is permitted.

Where a partner becomes a key partner involved in the audit as a result of the change in definition introduced with effect from 6 April 2008 the transitional arrangements in the previous version of ES 3 (Revised) continue to apply.

Posted on April 9, 2021 by MJ — Leave a comment

ES-2 APB ETHICAL STANDARD 2 (REVISED) FINANCIAL, BUSINESS, EMPLOYMENT AND PERSONAL RELATIONSHIPS

APB Ethical Standard 1 requires the audit engagement partner to identify and assess the circumstances which could adversely affect the auditor’s objectivity (‘threats’), including any perceived loss of independence, and to apply procedures (‘safeguards’) which will either:
- eliminate the threat; or
- reduce the threat to an acceptable level (that is, a level at which it is not probable that a reasonable and informed third party would conclude that the auditor’s objectivity and independence is impaired or is likely to be impaired).

This Standard provides requirements and guidance on specific circumstances arising out of financial, business, employment and personal relationships with the audited entity, which may create threats to the auditor’s objectivity or perceived loss of independence. It gives examples of safeguards that can, in some circumstances, eliminate the threat or reduce it to an acceptable level. In circumstances where this is not possible, either the relationship in question is not entered into or the auditor either does not accept or withdraws from the audit engagement, as appropriate.

Whenever a possible or actual breach of an APB Ethical Standard is identified, the audit engagement partner, in the first instance, and the Ethics Partner, where appropriate, assesses the implications of the breach, determines whether there are safeguards that can be put in place or other actions that can be taken to address any potential adverse consequences and considers whether there is a need to resign from the audit engagement.

An inadvertent violation of this Standard does not necessarily call into question the audit firm’s ability to give an audit opinion provided that:
- the audit firm has established policies and procedures that require all partners and staff to report any breach promptly to the audit engagement partner or to the Ethics Partner as appropriate;
- the audit engagement partner or Ethics Partner promptly notifies the partner or member of staff that any matter which has given rise to a breach is to be addressed as soon as possible and ensures that such action is taken;
- safeguards, if appropriate, are applied (for example, having another partner review the work done by the relevant partner or member of staff or by removing him or her from the engagement team); and
- the actions taken and the rationale for them are documented.

FINANCIAL RELATIONSHIPS

General considerations

A financial interest is an equity or other security, debenture, loan or other debt instrument of an entity, including rights and obligations to acquire such an interest and derivatives directly related to such an interest.

Financial interests may be:
- owned directly, rather than through intermediaries (a ‘direct financial interest’); or
- owned through intermediaries, for example, an open ended investment company or a pension scheme (an ‘indirect financial interest’).

Save where the circumstances contemplated in paragraphs 9, 10, 12, 19 or 21 apply, the audit firm, any partner in the audit firm, a person in a position to influence the conduct and outcome of the audit or an immediate family member of such a person shall not hold:
- any direct financial interest in an audited entity or an affiliate of an audited entity; or
- any indirect financial interest in an audited entity or an affiliate of an audited entity, where the investment is material to the audit firm or the individual, or to the intermediary; or
- any indirect financial interest in an audited entity or an affiliate of an audited entity, where the person holding it has both:
  - the ability to influence the investment decisions of the intermediary; and
  - actual knowledge of the existence of the underlying investment in the audited entity.

The threats to the auditor’s objectivity and independence, where a direct financial interest or a material indirect financial interest in the audited entity is held by the audit firm or by one of the individuals specified in paragraph 7, are such that no safeguards can eliminate them or reduce them to an acceptable level.

Where a person joins the audit firm as a partner, he or she or an immediate family member is not required to dispose of financial interests held where:
- the financial interests were acquired before the new partner joined the audit firm; and
- the individual is not able to influence the affairs of the audited entity; and
- either there is no market for such interests, or the individual does not have the power to sell or direct the sale of the interest; and (d) the new partner:
- is not in a position to influence the conduct and outcome of the audit;
- does not work in the same part of the firm as the audit engagement partner; and
- is not involved in the provision of a non-audit service to the audit client.

Such a financial interest is disposed of as soon as possible after the individual becomes able to make a disposal. The audit firm ensures that:

such financial interests are approved by the Ethics Partner;
a record is maintained of such individuals, including a description of the circumstances; and
this information is communicated to the relevant audit engagement partner.

Where an immediate family member of a partner who is not in a position to influence the conduct and outcome of the audit holds a financial interest in an audited entity or an affiliate of an audited entity as a consequence of:
- their compensation arrangements (for example, a share option scheme, where the shares have not vested); or
- a decision made, or a transaction undertaken, by an entity with whom that immediate family member has a contractual business or employment arrangement (for example, a partnership agreement);

such financial interests are not generally considered to threaten the auditor’s objectivity and independence. However, where such interests are significant or the relevant partner has close working contacts with the engagement team, the Ethics Partner considers whether any safeguards need to be put in place.

For the purposes of paragraph 7, where holdings in an authorised unit or investment trust, an open ended investment company or an equivalent investment vehicle which is audited by the audit firm, are held by a partner in the audit firm, who is not in a position to influence the conduct and outcome of the audit, or an immediate family member of such a partner, these are to be treated as indirect financial interests. Such interests can therefore be held as long as:
- they are not material to the individual; and
- the individual has no influence over the investment decisions of the audited entity.

Where a person in a position to influence the conduct and outcome of the audit or a partner in the audit firm, or any of their immediate family members are members or shareholders of an audited entity, as a result of membership requirements, or equivalent, the audit firm ensures that no more than the minimum number of shares necessary to comply with the requirement are held and that this shareholding is not material to either the audited entity or the individual. Disclosure of such shareholdings will be made to those charged with governance of the audited entity, in accordance with APB Ethical Standard 1, paragraph 63.

Where one of the financial interests specified in paragraph 7 is held by: (a) the audit firm, a partner in the audit firm or an immediate family member of such a partner: the entire financial interest is disposed of, a sufficient amount of an indirect financial interest is disposed of so that the remaining interest is no longer material, or the firm does not accept (or withdraws from) the audit engagement;
- a person in a position to influence the conduct and outcome of the audit: the entire financial interest is disposed of, a sufficient amount of an indirect financial interest is disposed of so that the remaining interest is no longer material, or that person does not retain a position in which they exert such influence on the audit engagement;
- an immediate family member of a person in a position to influence the conduct and outcome of the audit: the entire financial interest is disposed of, a sufficient amount of an indirect financial interest is disposed of so that the remaining interest is no longer material,

or the person in a position to influence the conduct and outcome of the audit does not retain a position in which they exert such influence on the audit engagement.

Where one of the financial interests specified in paragraph 7 is acquired unintentionally, as a result of an external event (for example, inheritance, gift, or merger of firms or companies), the disposal of the financial interest is required immediately, or as soon as possible after the relevant person has actual knowledge of, and the right to dispose of, the interest.

Where the disposal of a financial interest does not take place immediately, the audit firm adopts safeguards to preserve its objectivity until the financial interest is disposed of. These may include the temporary exclusion of the person in a position to influence the conduct and outcome of the audit from such influence on the audit, or a review of the relevant person’s audit work by an audit partner having sufficient experience and authority to fulfill the role who is not involved in the audit engagement.

Where the audit firm or one of the individuals specified in paragraph 7 holds an indirect financial interest but does not have both:
- the ability to influence the investment decisions of the intermediary; and
- actual knowledge of the existence of the underlying investment in the audited entity;

there may not be a threat to the auditor’s objectivity and independence. For example, where the indirect financial interest takes the form of an investment in a pension fund, the composition of the funds and the size and nature of any underlying investment in the audited entity may be known but there is unlikely to be any influence on investment decisions, as the fund will generally be managed independently on a discretionary basis. In the case of an ‘index tracker’ fund, the investment in the audited entity is determined by the composition of the relevant index and there may be no threat to objectivity. As long as the person holding the indirect interest is not directly involved in the audit of the intermediary, nor able to influence the individual investment decisions of the intermediary, any threat to the auditor’s objectivity and independence may be regarded as insignificant.

Where the audit firm or one of the individuals specified in paragraph 7 holds a beneficial interest in a properly operated ‘blind’ trust, they are (by definition) completely unaware of the identity of the underlying investments. If these include an investment in the audited entity, this means that they are unaware of the existence of an indirect financial interest. In these circumstances, there is no threat to the auditor’s objectivity and independence.

Where a person in a position to influence the conduct and outcome of the audit or a partner in the audit firm becomes aware that a close family member holds one of the financial interests specified in paragraph 7, that individual shall report the matter to the audit engagement partner to take appropriate action. If it is a close family member of the audit engagement partner, or if the audit engagement partner is in doubt as to the action to be taken, the audit engagement partner shall resolve the matter through consultation with the Ethics Partner.

Financial interests held as trustee

Where a direct or an indirect financial interest in the audited entity or its affiliates is held in a trustee capacity by a person in a position to influence the conduct and outcome of the audit, or an immediate family member of such a person, a self-interest threat may be created because either the existence of the trustee interest may influence the conduct of the audit or the trust may influence the actions of the audited entity. Accordingly, such a trustee interest is only held when:
- the relevant person is not an identified potential beneficiary of the trust; and
- the financial interest held by the trust in the audited entity is not material to the trust; and
- the trust is not able to exercise significant influence over the audited entity or an affiliate of the audited entity; and
- the relevant person does not have significant influence over the investment decisions made by the trust, in so far as they relate to the financial interest in the audited entity.

Where it is not clear whether the financial interest held by the trust in the audited entity is material to the trust or whether the trust is able to exercise significant influence over the audited entity, the financial interest is reported to the Ethics Partner, so that a decision can be made as to the steps that need to be taken.

A direct or an indirect financial interest in the audited entity or its affiliates held in a trustee capacity by the audit firm or by a partner in the audit firm (other than a partner in a position to influence the conduct and outcome of the audit), or an immediate family member of such a person, can only be held when the relevant person is not an identified potential beneficiary of the trust.

Financial interests held by audit firm pension schemes

22 Where the pension scheme of an audit firm has a financial interest in an audited entity or its affiliates and the firm has any influence over the trustees’ investment decisions (other than indirect strategic and policy decisions), the self-interest threat created is such that no safeguards can eliminate it or reduce it to an acceptable level. In other cases (for example, where the pension scheme invests through a collective investment scheme and the firm’s influence is limited to investment policy decisions, such as the allocation between different categories of investment), the Ethics Partner considers the acceptability of the position, having regard to the materiality of the financial interest to the pension scheme.

Loans and guarantees

Where audit firms, persons in a position to influence the conduct and outcome of the audit or immediate family members of such persons:
- accept a loan^[1] or a guarantee of their borrowings from an audited entity; or
- make a loan to or guarantee the borrowings of an audited entity, a self-interest threat and an intimidation threat to the auditor’s objectivity can be created or there may be a perceived loss of independence. In a number of situations, no safeguards can eliminate this threat or reduce it to an acceptable level.

Audit firms, persons in a position to influence the conduct and outcome of the audit and immediate family members of such persons shall not make a loan to, or guarantee the borrowings of, an audited entity or its affiliates unless this represents a deposit made with a bank or similar deposit taking institution in the ordinary course of business and on normal business terms.

Audit firms shall not accept a loan from, or have their borrowings guaranteed by, the audited entity or its affiliates unless:
- the audited entity is a bank or similar deposit taking institution; and
- the loan or guarantee is made in the ordinary course of business on normal business terms; and

[1] For the purpose of this standard, the term ‘loan’ does not include ordinary trade credit arrangements or deposits placed for goods or services, unless they are material to either party (see paragraph 29).

the loan or guarantee is not material to both the audit firm and the audited entity.

Persons in a position to influence the conduct and outcome of the audit and immediate family members of such persons shall not accept a loan from, or have their borrowings guaranteed by, the audited entity or its affiliates unless:
- the audited entity is a bank or similar deposit taking institution; and
- the loan or guarantee is made in the ordinary course of business on normal business terms; and
- the loan or guarantee is not material to the audited entity.

Loans by an audited entity that is a bank or similar institution to a person in a position to influence the conduct and outcome of the audit, or an immediate family member of such a person (for example, home mortgages, bank overdrafts or car loans), do not create an unacceptable threat to objectivity and independence, provided that normal business terms apply. However, where such loans are in arrears by a significant amount, this creates an intimidation threat that is unacceptable. Where such a situation arises, the person in a position to influence the conduct and outcome of the audit reports the matter to the audit engagement partner or to the Ethics Partner, as appropriate and ceases to have any involvement with the audit. The audit engagement partner or, where appropriate, the Ethics Partner considers whether any audit work is to be reperformed.

BUSINESS RELATIONSHIPS

28 A business relationship between:

the audit firm or a person who is in a position to influence the conduct and outcome of the audit, or an immediate family member of such a person; and
the audited entity or its affiliates, or its management; involves the two parties having a common commercial interest. Business relationships may create self-interest, advocacy or intimidation threats to the auditor’s objectivity and perceived loss of independence. Examples include:
joint ventures with the audited entity or with a director, officer or other individual who performs a management role for the audited entity;
arrangements to combine one or more services or products of the audit firm with one or more services or products of the audited entity and to market the package with reference to both parties;
distribution or marketing arrangements under which the audit firm acts as a distributor or marketer of any of the audited entity’s products or services, or the audited entity acts as the distributor or marketer of any of the products or services of the audit firm;
other commercial transactions, such as the audit firm leasing its office space from the audited entity.

Audit firms, persons in a position to influence the conduct and outcome of the audit and immediate family members of such persons shall not enter into business relationships with an audited entity, its management or its affiliates except where they:
- involve the purchase of goods and services from the audit firm or the audited entity in the ordinary course of business and on an arm’s length basis and which are not material to either party; or
- are clearly inconsequential to either party.

Where a business relationship exists, that is not permitted under paragraph 29, and has been entered into by:
- the audit firm: either the relationship is terminated or the firm does not accept (or withdraws from) the audit engagement;
- a person in a position to influence the conduct and outcome of the audit: either the relationship is terminated or that person does not retain a position in which they exert such influence on the audit engagement;
- an immediate family member of a person in a position to influence the conduct and outcome of the audit: either the relationship is terminated or the person in a position to influence the conduct and outcome of the audit does not retain such a position.

Where there is an unavoidable delay in the termination of a business relationship, the audit firm adopts safeguards to preserve its objectivity until the relationship is terminated. These may include a review of the relevant person’s audit work or a temporary exclusion of the relevant person from influence on conduct and outcome of the audit.

Compliance with paragraph 29 is not intended to prevent an audit firm giving advice in accordance with regulatory requirements^[1] to a third party in relation to investment products or services, including those supplied by an audited entity. In such circumstances, the audit firm considers the advocacy and self-interest threats that might be created by the provision of this advice where it gives rise to commission or similar payments by the audited entity to the audit firm and assesses whether any safeguards are required.

Where a person in a position to influence the conduct and outcome of the audit becomes aware that a close family member has entered into one of the business relationships specified in paragraph 28, that individual shall report the matter to the audit engagement partner to take appropriate action. If it is a close family member of the audit engagement partner or if the audit engagement partner is in doubt as

[1] Firms providing such services will be authorised either by the Financial Services Authority or by their professional accountancy body acting as a Designated Professional Body.

to the action to be taken, the audit engagement partner shall resolve the matter through consultation with the Ethics Partner.

Where there are doubts as to whether a transaction or series of transactions are either in the ordinary course of business and on an arm’s length basis or of such materiality that they constitute a threat to the audit firm’s objectivity and independence, the audit engagement partner reports the issue:
- to the Ethics Partner, so that a decision can be made as to the appropriate action that needs to be taken to ensure that the matter is resolved; and
- to those charged with governance of the audited entity, together with other significant facts and matters that bear upon the auditor’s objectivity and independence, to obtain their views on the matter.

Where there are doubts about whether a reasonable and informed third party would conclude that a business relationship is clearly inconsequential to either party and would not therefore present a threat to independence, then it is not clearly inconsequential.

An audit firm shall not provide audit services to any entity or person able to influence the affairs of the audit firm or the performance of any audit engagement undertaken by the audit firm.

This prohibition applies to:
- any entity that owns any significant part of an audit firm, or is an affiliate of such an entity; or
- any shareholder, director or other person in a position to direct the affairs of such an entity or its affiliate.

A significant ownership is one that carries the ability to influence materially the policy of an entity.^[1]

EMPLOYMENT RELATIONSHIPS

MANAGEMENT ROLE WITH AN AUDITED ENTITY

37 An audit firm shall not admit to the partnership, or employ a person to undertake audit work, if that person is also employed by the audited entity or its affiliates (‘dual employment’).

Loan staff assignments

An audit firm shall not enter into an agreement with an audited entity to provide a partner or employee to work for a temporary period as if that individual were an employee of the audited entity or its affiliates (a ‘loan staff assignment’) unless:
- the agreement is for a short period of time and does not involve staff or partners performing non-audit services that would not be permitted under APB Ethical Standard 5; and
- the audited entity agrees that the individual concerned will not hold a management position, and acknowledges its responsibility for directing and supervising the work to be performed, which will not include such matters as:
  - making management decisions; or
  - exercising discretionary authority to commit the audited entity to a particular position or accounting treatment.

[1] For companies, competition authorities have generally treated a 15% shareholding as sufficient to provide a material ability to influence policy.

Where an audit firm agrees to assist an audited entity by providing loan staff, threats to objectivity and independence may be created. A management threat may arise if the employee undertakes work that involves making judgments and taking decisions that are properly the responsibility of management. Thus, for example, interim management arrangements involving participation in the financial reporting function are not acceptable.

A self-review threat may also arise if the individual, during the loan staff assignment, is in a position to influence the preparation of the audited entity’s financial statements and then, on completion of that assignment, is assigned to the engagement team for that entity, with responsibility to report on matters for which he or she was responsible whilst on that loan staff assignment.

Where a partner or employee returns to the firm on completion of a loan staff assignment, that individual shall not be given any role on the audit involving any function or activity that he or she performed or supervised during that assignment.

In considering for how long this restriction is to be observed, the need to realise the potential value to the effectiveness of the audit of the increased knowledge of the audited entity’s business gained through the assignment has to be weighed against the potential threats to objectivity and independence. Those threats increase with the length of the assignment and with the intended level of responsibility of the individual within the engagement team. As a minimum, this restriction will apply to at least the first audit of the financial statements following the completion of the loan staff assignment.

Partners and engagement team members joining an audited entity

Where a former partner in the audit firm joins the audited entity, the audit firm shall take action as quickly as possible – and, in any event, before any further work is done by the audit firm in connection with the audit – to ensure that no significant connections remain between the firm and the individual.

Ensuring that no significant connections remain between the firm and the individual requires that:
all capital balances and similar financial interests be fully settled (including retirement benefits) unless these are made in accordance with pre-determined arrangements that cannot be influenced by any remaining connections between the individual and the firm; and
the individual does not participate or appear to participate in the audit firm’s business or professional activities.

Audit firms shall establish policies and procedures that require:
- all partners in the audit firm to notify the firm of any situation involving their potential employment with any entity audited by the firm; and
- senior members of any engagement team to notify the audit firm of any situation involving their potential employment with the relevant audited entity; and
- other members of any engagement team to notify the audit firm of any situation involving their probable employment with the relevant audited entity; and
- anyone who has given such notice to be removed from the engagement team; and
- a review of the audit work performed by the resigning or former engagement team member in the current and, where appropriate, the most recent audit.

Objectivity and independence may be threatened where a director, an officer or an employee of the audited entity who is in a position to exert direct and significant influence over the preparation of the financial statements, has recently been a partner in the audit firm or a member of the engagement team. Such circumstances may create self-interest, familiarity and intimidation threats, particularly when significant connections remain between the individual and the audit firm. Similarly, objectivity and independence may be threatened when an individual knows, or has reason to believe, that he or she will or may be joining the audited entity at some time in the future.

Where a partner in the audit firm or a member of the engagement team for a particular audited entity has left the audit firm and taken up employment with that entity, the significance of the self-interest, familiarity and intimidation threats is assessed and normally depends on such factors as:
- the position that individual had in the engagement team or firm;
- the position that individual has taken at the audited entity;
- the amount of involvement that individual will have with the engagement team (especially where it includes former colleagues with whom he or she worked);
- the length of time since that individual was a member of the engagement team or employed by the audit firm.

Following the assessment of any such threats, appropriate safeguards are applied where necessary.

Any review of audit work is performed by a more senior audit professional. If the individual joining the audited entity is an audit partner, the review is performed by an audit partner who is not involved in the audit engagement. Where, due to its size, the audit firm does not have a partner who was not involved in the audit engagement, it seeks either a review by another audit firm or advice from its professional body.

Where a partner leaves the firm and is appointed as a director (including as a non-executive director) or to a key management position with an audited entity^[1], having acted as audit engagement partner (or as an engagement quality control reviewer, key partner involved in the audit or a partner in the chain of command) at any time in the two years prior to this appointment, the firm shall resign as auditor.^[2] The firm shall not accept re-appointment as auditor until a two-year period, commencing when the former partner ceased to have an ability to influence the conduct and outcome of the audit, has elapsed or the former partner ceases employment with the former audited entity, whichever is the sooner.

Where a former member of the engagement team (other than an audit engagement partner, a key partner involved in the audit or a partner in the chain of command) leaves the audit firm and, within two years of ceasing to hold that position, joins the audited entity as a director (including as a non-executive director) or in a key management position, the audit firm shall consider whether the composition of the audit team is appropriate.

In such circumstances, the audit firm evaluates the appropriateness of the composition of the audit team by reference to the factors listed in

[1] UK legislation provides that each of the Recognised Supervisory Bodies must have adequate rules and practices to ensure that a key audit partner (the individual responsible for the statutory audit and individuals responsible for a parent undertaking or a material subsidiary undertaking) of a firm appointed by a public interest entity as auditor is prohibited from being appointed as a director or other officer of the entity during a period of two years commencing on the date on which his or her work as key audit partner ended.

[2] The timing of the audit firm’s resignation as auditor is determined in accordance with paragraph 50 of APB Ethical Standard 1. In the case of those public sector bodies where the responsibility for the audit is assigned by legislation, the auditor cannot resign from the audit engagement and considers alternative safeguards that can be put in place.

paragraph 47 and alters or strengthens the audit team to address any threat to the auditor’s objectivity and independence that may be identified.

Family members employed by an audited entity

52 Where a person in a position to influence the conduct and outcome of the audit, or a partner in the audit firm, becomes aware that an immediate or close family member is employed by an audited entity in a position to exercise influence on the accounting records or financial statements, that individual shall either:

in the case of an immediate family member of a person in a position to influence the conduct and outcome of the audit, cease to hold a position in which they exert such influence on the audit; or
in the case of a close family member of a person in a position to influence the conduct and outcome of the audit, or any family member of a partner in the audit firm, report the matter to the audit engagement partner to take appropriate action. If it is a close family member of the audit engagement partner or if the audit engagement partner is in doubt as to the action to be taken, the audit engagement partner shall resolve the matter in consultation with the Ethics Partner.

GOVERNANCE ROLE WITH AN AUDITED ENTITY

Paragraphs 54 to 56 are supplementary to certain statutory or regulatory provisions that prohibit directors of entities from being appointed as their auditor.^[1]

[1] For example, in the case of limited companies and certain other organisations, section 1214 of the Companies Act 2006 contains detailed provisions. Amongst other things, these state that:

‘…A person may not act as statutory auditor of an audited person if [he] is (a) an officer or employee of the audited person, or (b) a partner or employee of such a person, or a partnership of which such a person is a partner.’

The audit firm or a partner or employee of the audit firm shall not accept appointment or perform a role:

(a) as an officer^[1] or member of the board of directors of the audited entity;

(b) as a member of any subcommittee of that board; or

(c) in such a position in an entity which holds directly or indirectly more than 20% of the voting rights in the audited entity, or in an entity in which the audited entity holds directly or indirectly more than 20% of the voting rights.

Where a person in a position to influence the conduct and outcome of the audit becomes aware that an immediate or close family member holds a position described in paragraph 54, the audit firm shall take appropriate steps to ensure that the relevant person does not retain a position in which they exert influence on the conduct and outcome of the audit engagement.

Where a partner or employee of the audit firm, not being a member of the engagement team, becomes aware that an immediate or close family member holds a position described in paragraph 54, that individual shall report that fact to the audit engagement partner, who shall consider whether the relationship might be regarded by a reasonable and informed third party as impairing, or being thought to impair, the auditor’s objectivity. If the audit engagement partner concludes that the auditor’s objectivity may be impaired, that individual shall consult with the Ethics Partner to determine whether

[1] As defined in Section 1173 of the Companies Act 2006 as including a director, manager or secretary.

appropriate safeguards exist. If no such safeguards exist, the audit firm withdraws from the audit engagement.

EMPLOYMENT WITH AUDIT FIRM

Objectivity and independence may be threatened where a former director or employee of the audited entity becomes a member of the engagement team. Self-interest, self-review and familiarity threats may be created where a member of the engagement team has to report on, for example, financial statements which he or she prepared, or elements of the financial statements for which he or she had responsibility, while with the audited entity.

Where a former director or a former employee of an audited entity, who was in a position to exert significant influence over the preparation of the financial statements, joins the audit firm, that individual shall not be assigned to a position in which he or she is able to influence the conduct and outcome of the audit for that entity or its affiliates for a period of two years following the date of leaving the audited entity.

In certain circumstances, a longer period of exclusion from the engagement team may be appropriate. For example, threats to objectivity and independence may exist in relation to the audit of the financial statements of any period which are materially affected by the work of that person whilst occupying his or her former position of influence with the audited entity. The significance of these threats depends on factors such as:
- the position the individual held with the audited entity; the length of time since the individual left the audited entity;
- the position the individual holds in the engagement team.

FAMILY AND OTHER PERSONAL RELATIONSHIPS

60 A relationship between a person who is in a position to influence the conduct and outcome of the audit and another party does not generally affect the consideration of the auditor’s objectivity and independence. However, if it is a family relationship, and if the family member also has a financial, business or employment relationship with the audited entity, then self-interest, familiarity or intimidation threats to the auditor’s objectivity and independence may be created. The significance of any such threats depends on such factors as:

the relevant person’s involvement in the audit;
the nature of the relationship between the relevant person and his or her family member;
the family member’s relationship with the audited entity.

A distinction is made between immediate family relationships and close family relationships. Immediate family members comprise an individual’s spouse (or equivalent) and dependents, whereas close family members comprise parents, non-dependent children and siblings. While an individual can usually be presumed to be aware of matters concerning his or her immediate family members and to be able to influence their behaviour, it is generally recognised that the same levels of knowledge and influence do not exist in the case of close family members.

When considering family relationships, it needs to be acknowledged that, in an increasingly secular, open and inclusive society, the concept of what constitutes a family is evolving and relationships between individuals which have no status formally recognised by law may nevertheless be considered as significant as those which do. It may therefore be appropriate to regard certain other personal relationships, particularly those that would be considered close personal relationships, as if they are family relationships.

The audit firm shall establish policies and procedures that require:
- partners and professional staff to report to the audit firm any immediate family, close family and other personal relationships involving an entity audited by the firm, to which they are a party and which they consider might create a threat to the auditor’s objectivity or a perceived loss of independence;
- the relevant audit engagement partners to be notified promptly of any immediate family, close family and other personal relationships reported by partners and other professional staff.

The audit engagement partner shall:
- assess the threats to the auditor’s objectivity and independence arising from immediate family, close family and other personal relationships on the basis of the information reported to the firm by persons in a position to influence the conduct and outcome of the audit;
- apply appropriate safeguards to eliminate the threat or reduce it to an acceptable level; and
- where there are unresolved matters or the need for clarification, consult with the Ethics Partner.

Where such matters are identified or reported, the audit engagement partner or the Ethics Partner assesses the information available and the potential for there to be a threat to the auditor’s objectivity and independence, treating any personal relationship as if it were a family relationship.

EXTERNAL CONSULTANTS INVOLVED IN THE AUDIT

Audit firms may employ external consultants as experts in order to obtain sufficient appropriate audit evidence regarding certain financial statement assertions.^[1] There is a risk that an expert’s objectivity and independence will be impaired if the expert is related to the entity, for example by being financially dependent upon or having an investment in, the entity.

The audit engagement partner shall be satisfied that any external consultant involved in the audit will be objective and document the rationale for that conclusion.

The audit engagement partner obtains information from the external consultant as to the existence of any connections that they have with the audited entity including:
- financial interests;
- business relationships;
- employment (past, present and future);
- family and other personal relationships.

EFFECTIVE DATE

This revised Ethical Standard becomes effective on 30 April 2011.

Firms may complete audit engagements relating to periods commencing prior to 31 December 2010 in accordance with existing ethical standards, putting in place any necessary changes in the subsequent engagement period.

[1] ISA (UK and Ireland) 620 ‘Using the Work of an Auditor’s Expert’ requires that the auditor shall evaluate whether the expert has the necessary objectivity.

appropriate safeguards exist. If no such safeguards exist, the audit firm withdraws from the audit engagement.

EMPLOYMENT WITH AUDIT FIRM

Objectivity and independence may be threatened where a former director or employee of the audited entity becomes a member of the engagement team. Self-interest, self-review and familiarity threats may be created where a member of the engagement team has to report on, for example, financial statements which he or she prepared, or elements of the financial statements for which he or she had responsibility, while with the audited entity.

Where a former director or a former employee of an audited entity, who was in a position to exert significant influence over the preparation of the financial statements, joins the audit firm, that individual shall not be assigned to a position in which he or she is able to influence the conduct and outcome of the audit for that entity or its affiliates for a period of two years following the date of leaving the audited entity.

In certain circumstances, a longer period of exclusion from the engagement team may be appropriate. For example, threats to objectivity and independence may exist in relation to the audit of the financial statements of any period which are materially affected by the work of that person whilst occupying his or her former position of influence with the audited entity. The significance of these threats depends on factors such as:
- the position the individual held with the audited entity; the length of time since the individual left the audited entity;
- the position the individual holds in the engagement team.

FAMILY AND OTHER PERSONAL RELATIONSHIPS

the relevant person’s involvement in the audit;
the nature of the relationship between the relevant person and his or her family member;
the family member’s relationship with the audited entity.

A distinction is made between immediate family relationships and close family relationships. Immediate family members comprise an individual’s spouse (or equivalent) and dependents, whereas close family members comprise parents, non-dependent children and siblings. While an individual can usually be presumed to be aware of matters concerning his or her immediate family members and to be able to influence their behaviour, it is generally recognised that the same levels of knowledge and influence do not exist in the case of close family members.

When considering family relationships, it needs to be acknowledged that, in an increasingly secular, open and inclusive society, the concept of what constitutes a family is evolving and relationships between individuals which have no status formally recognised by law may nevertheless be considered as significant as those which do. It may therefore be appropriate to regard certain other personal relationships, particularly those that would be considered close personal relationships, as if they are family relationships.

The audit firm shall establish policies and procedures that require:
- partners and professional staff to report to the audit firm any immediate family, close family and other personal relationships involving an entity audited by the firm, to which they are a party and which they consider might create a threat to the auditor’s objectivity or a perceived loss of independence;
- the relevant audit engagement partners to be notified promptly of any immediate family, close family and other personal relationships reported by partners and other professional staff.

The audit engagement partner shall:
- assess the threats to the auditor’s objectivity and independence arising from immediate family, close family and other personal relationships on the basis of the information reported to the firm by persons in a position to influence the conduct and outcome of the audit;
- apply appropriate safeguards to eliminate the threat or reduce it to an acceptable level; and
- where there are unresolved matters or the need for clarification, consult with the Ethics Partner.

Where such matters are identified or reported, the audit engagement partner or the Ethics Partner assesses the information available and the potential for there to be a threat to the auditor’s objectivity and independence, treating any personal relationship as if it were a family relationship.

EXTERNAL CONSULTANTS INVOLVED IN THE AUDIT

Audit firms may employ external consultants as experts in order to obtain sufficient appropriate audit evidence regarding certain financial statement assertions.^[1] There is a risk that an expert’s objectivity and independence will be impaired if the expert is related to the entity, for example by being financially dependent upon or having an investment in, the entity.

The audit engagement partner shall be satisfied that any external consultant involved in the audit will be objective and document the rationale for that conclusion.

The audit engagement partner obtains information from the external consultant as to the existence of any connections that they have with the audited entity including:
- financial interests;
- business relationships;
- employment (past, present and future);
- family and other personal relationships.

EFFECTIVE DATE

This revised Ethical Standard becomes effective on 30 April 2011.

Firms may complete audit engagements relating to periods commencing prior to 31 December 2010 in accordance with existing ethical standards, putting in place any necessary changes in the subsequent engagement period.

[1] ISA (UK and Ireland) 620 ‘Using the Work of an Auditor’s Expert’ requires that the auditor shall evaluate whether the expert has the necessary objectivity.

Posted on April 9, 2021 by MJ — 1 Comment

ES-1 APB ETHICAL STANDARD 1 (REVISED) INTEGRITY, OBJECTIVITY AND INDEPENDENCE

INTRODUCTION

The financial statements of an entity may have a number of different users. For example, they may be used by suppliers and customers, joint venture partners, bankers and other suppliers of finance, taxation and regulatory authorities, employees, trades unions and environmental groups. In the case of a listed company, the financial statements are an important source of information to the capital markets. But the primary purpose of the financial statements of an entity is to provide its owners – the shareholders (or those in an equivalent position) – with information on the state of affairs of the entity and its performance and to assist them in assessing the stewardship exercised by the directors (or those in an equivalent position) over the business that has been entrusted to them.

The financial statements of an entity are the responsibility of its board of directors and are prepared by them, or by others on their behalf, for the shareholders or, in some circumstances, for other third parties.

The primary objective of an audit of the financial statements is for the auditor to provide independent assurance to the shareholders that the directors have prepared the financial statements properly. The auditor issues a report that includes an opinion as to whether or not the financial statements give a true and fair view^[1]. Thus the auditor assists the shareholders to exercise their proprietary powers as shareholders in the Annual General Meeting.

Public confidence in the operation of the capital markets and in the conduct of public interest entities depends, in part, upon the credibility of the opinions and reports issued by the auditor in connection with the audit of the financial statements. Such credibility depends on beliefs concerning the integrity, objectivity and independence of the auditor and the quality of audit work performed. APB establishes quality control, auditing and ethical standards

to provide a framework for audit practice. The Auditors’ Code underlies APB’s standards and sets out the fundamental principles, which APB expects to guide the conduct of auditors.

APB Ethical Standards are concerned with the integrity, objectivity and independence of auditors. Ethical guidance on other matters, together with statements of fundamental ethical principles governing the work of all professional accountants, are issued by professional accountancy bodies.

Auditors shall conduct the audit of the financial statements of an entity with integrity, objectivity and independence.

Integrity

Integrity is a prerequisite for all those who act in the public interest. It is essential that auditors act, and are seen to act, with integrity, which requires not only honesty but a broad range of related qualities such as fairness, candour, courage, intellectual honesty and confidentiality.

[1] In the case of certain bodies in the public sector, the auditor expresses an opinion as to whether the financial statements ‘present fairly’ the financial position.

Integrity requires that the auditor is not affected, and is not seen to be affected, by conflicts of interest. Conflicts of interest may arise from personal, financial, business, employment, and other relationships which the audit engagement team, the audit firm or its partners or staff have with the audited entity and its connected parties.²

It is important that the directors and management of an audited entity can rely on the auditor to treat the information obtained during an audit as

² For this purpose an audited entity’s connected parties are:

its affiliates;
key members of management (including but not limited to directors and those charged with governance) of the audited entity and its significant affiliates; and
any person or entity with an ability to influence (other than in their capacity as professional advisor), whether directly or indirectly, key members of management and those charged with governance of the audited entity and its significant affiliates in relation to their responsibility for, or approach to, any matter or judgment that is material to the entity’s financial statements.

confidential^[1], unless they have authorised its disclosure, unless it is already known to third parties or unless the auditor has a legal right or duty to disclose it. Without this, there is a danger that the directors and management will fail to disclose such information to the auditor and that the effectiveness of the audit will thereby be impaired.

Objectivity

Objectivity is a state of mind that excludes bias, prejudice and compromise and that gives fair and impartial consideration to all matters that are relevant to the task in hand, disregarding those that are not. Like integrity, objectivity is a fundamental ethical principle and requires that the auditor’s judgment is not affected by conflicts of interest.

[1] The fundamental principle of confidentiality is addressed in the ethical guidance issued by the auditor’s professional accountancy body. This principle does not constrain the proper communication between the auditor and shareholders (or equivalent) of the audited entity.

The need for auditors to be objective arises from the fact that many of the important issues involved in the preparation of financial statements do not relate to questions of fact but rather to questions of judgment. For example, there are choices to be made by the board of directors in deciding on the accounting policies to be adopted by the entity: the directors have to select the ones that they consider most appropriate and this decision can have a material impact on the financial statements. Furthermore, many items included in the financial statements cannot be measured with absolute precision and certainty. In many cases, estimates have to be made and the directors may have to choose one value from a range of possible outcomes. When exercising discretion in these areas, the directors have regard to the applicable financial reporting framework. If the directors, whether deliberately or inadvertently, make a biased judgment or an otherwise inappropriate decision, the financial statements may be misstated or misleading.

It is against this background that the auditor is required to express an opinion on the financial statements. The audit involves considering the process followed and the choices made by the directors in preparing the financial statements and concluding whether the result gives a true and fair view. The auditor’s objectivity requires that an impartial opinion is expressed in the light of all the available audit evidence and the auditor’s professional judgment. Objectivity also requires that the auditor adopts a rigorous and robust approach and is prepared to disagree, where necessary, with the directors’ judgments.

Independence

Independence is freedom from situations and relationships which make it probable that a reasonable and informed third party would conclude that objectivity either is impaired or could be impaired. Independence is related to and underpins objectivity. However, whereas objectivity is a personal behavioural characteristic concerning the auditor’s state of mind, independence relates to the circumstances surrounding the audit, including the financial, employment, business and personal relationships between the auditor and the audited entity and its connected parties. Relationships with parties whose interests may be contrary to the interests of the audited entity (for example, a hostile bidder) may also be relevant to the appearance of the auditor’s independence.

The need for independence arises because, in most cases, users of the financial statements and other third parties do not have all the information necessary for judging whether the auditor is, in fact, objective. Although the auditor may be satisfied that the auditor’s objectivity is not impaired by a particular situation, a third party may reach a different conclusion. For example, if a third party were aware that the auditor had certain financial, employment, business or personal relationships with the audited entity, that individual might reasonably conclude that the auditor could be subject to undue influence from the directors or would not be impartial or unbiased.

Public confidence in the auditor’s objectivity could therefore suffer as a result of this perception, irrespective of whether there is any actual impairment.

Accordingly, in evaluating the likely consequences of such situations and relationships, the test to be applied is not whether the auditor considers that the auditor’s objectivity is impaired but whether it is probable that a reasonable and informed third party would conclude that the auditor’s objectivity either is impaired or is likely to be impaired. As a result of the influence that the board of directors and management have over the appointment and remuneration of the auditor absolute independence cannot be achieved or maintained. The audit engagement partner considers the application of safeguards where there are threats to auditor independence (both actual and perceived).

COMPLIANCE WITH ETHICAL STANDARDS

The audit firm shall establish policies and procedures, appropriately documented and communicated, designed to ensure that, in relation to each audit engagement, the audit firm, and all those who are in a position to influence the conduct and outcome of the audit, act with integrity, objectivity and independence.

For the purposes of APB Ethical Standards, a person in a position to influence the conduct and outcome of the audit is:

(a) any person who is directly involved in the audit (‘the engagement team’), including:

the audit partners, audit managers and audit staff (‘the audit team’);
professional personnel from other disciplines involved in the audit (for example, lawyers, actuaries, taxation specialists, IT specialists, treasury management specialists);^[1]
those who provide quality control or direct oversight of the audit;

any person who forms part of the chain of command for the audit within the audit firm;
any person within the audit firm who, due to any other circumstances, may be in a position to exert such influence.

Compliance with the requirements regarding the auditor’s integrity, objectivity and independence is a responsibility of both the audit firm and of individual partners and professional staff. The audit firm establishes policies and procedures, appropriate to the size and nature of the audit firm, to promote and monitor compliance with those requirements by any person who is in a position to influence the conduct and outcome of the audit.^[2]^{, [3]}

[1] Where external consultants are involved in the audit, ISA (UK and Ireland) 620 ‘Using the Work of an Auditor’s Expert’ states that the auditor shall evaluate the objectivity of the expert.

[2] Monitoring of compliance with ethical requirements will often be performed as part of a broader quality control process. ISQC (UK & Ireland) 1 ‘Quality Control for Firms that Perform Audits and Reviews of Financial Statements and other Assurance and Related Services Engagements’ establishes requirements in relation to a firm’s responsibilities for its system of quality control for audits.

[3] In addition, UK legislation provides that each of the Recognised Supervisory Bodies must have adequate rules and practices to ensure that the audit firm has arrangements to prevent any person from being able to exert any influence over the way in which a statutory audit is conducted in circumstances in which that influence would be likely to affect the independence or integrity of the audit.

The leadership of the audit firm shall take responsibility for establishing a control environment within the firm that places adherence to ethical principles and compliance with APB Ethical Standards above commercial considerations.

The leadership of the audit firm influences the internal culture of the firm by its actions and by its example (‘the tone at the top’). Achieving a robust control environment requires that the leadership gives clear, consistent and frequent messages, backed up by appropriate actions, which emphasise the importance of compliance with APB Ethical Standards.

In order to promote a strong control environment, the audit firm establishes policies and procedures that include:
- requirements for partners and staff to report where applicable:
  - family and other personal relationships involving an entity audited by the firm;
  - financial interests in an entity audited by the firm;  decisions to join an audited entity.
- monitoring of compliance with the firm’s policies and procedures relating to integrity, objectivity and independence. Such monitoring procedures include, on a test basis, periodic review of the audit engagement partners’ documentation of the consideration of the auditor’s objectivity and independence, addressing, for example:
  - financial interests in audited entities;
  - economic dependence on audited entities;
  - the performance of non-audit services;
  - audit partner rotation;

identification of the audited entities which partners in the chain of command and their immediate family need to be independent from^[1];
prompt communication of possible or actual breaches of the firm’s policies and procedures to the relevant audit engagement partners;
evaluation by audit engagement partners of the implications of any identified possible or actual breaches of the firm’s policies and procedures that are reported to them;
reporting by audit engagement partners of particular circumstances or relationships as required by APB Ethical Standards;

[1] Such identification is necessary for those in the chain of command to understand how their firm responsibilities result in connections with different entities audited by the firm. It can be achieved by listing the individual audited entities or by a broader statement regarding categories of audited entity, for example, those of a certain business unit.

operation of an enforcement mechanism to promote compliance with policies and procedures;
empowerment of staff to communicate to senior levels within the firm any issue of objectivity or independence that concerns them; this includes establishing clear communication channels open to staff, encouraging staff to use these channels and ensuring that staff who use these channels are not subject to disciplinary proceedings as a result.

Save where the circumstances contemplated in paragraph 26 apply, the audit firm shall designate a partner in the firm (‘the Ethics Partner’) as having responsibility for:
- the adequacy of the firm’s policies and procedures relating to integrity, objectivity and independence, its compliance with APB Ethical Standards, and the effectiveness of its communication to partners and staff on these matters within the firm; and
- providing related guidance to individual partners with a view to achieving a consistent approach to the application of the APB Ethical Standards.

In this role, the Ethics Partner has particular responsibility for engendering a culture in which the audit firm approaches ethical issues following the principles in the Ethical Standards. The Ethics Partner is an individual possessing seniority, relevant experience, and authority at leadership levels within the audit firm. Where the Ethics Partner undertakes this role together with a role such as Compliance or Risk Management he or she ensures that the responsibilities of the Ethics Partner set out in paragraph 22 above take precedence over the responsibilities of other functions.

In the case of audit firms that audit listed companies, the Ethics Partner has direct access to the independent non-executives^[1] where such roles are introduced in an audit firm or, alternatively, to the firm’s most senior governance body.

In assessing the effectiveness of the firm’s communication of its policies and procedures relating to integrity, objectivity and independence, Ethics Partners consider whether the ethics are covered properly in induction programmes, professional training and continuing professional development for all partners and staff. Ethics Partners also provide guidance on matters referred to them and on matters which they otherwise become aware of, where a difficult and objective judgment needs to be made or a consistent position reached. Ethics Partners are proactive in considering the ethical implications of developments in the business of the audit firm and the environment in which it operates and in providing advice and guidance to partners and staff where appropriate.

In audit firms with three or fewer partners who are ‘responsible individuals’^[2], it may not be practicable for an Ethics Partner to be designated. In these circumstances all partners will regularly discuss ethical issues amongst themselves, so ensuring that they act in a consistent manner and observe the principles set out in APB Ethical Standards. In the case of a sole practitioner, advice on matters where a difficult and objective judgment needs to be made is obtained through the ethics helpline of the auditor’s professional body, or through discussion with a practitioner from another firm. In all cases, it is important that such discussions are documented.

[1] Independent non-executives appointed in accordance with the Audit Firm Governance Code are not regarded as part of the Chain of Command for the purposes of these Ethical Standards.

[2] A ‘responsible individual’ is a partner or employee of the audit firm who is responsible for audit work and designated as such under the audit regulations of a Recognised Supervisory Body.

To be able to discharge his or her responsibilities, the Ethics Partner is provided with sufficient staff support and other resources, commensurate with the size of the firm. Alternative arrangements are established to allow for:
- the provision of guidance on those audits where the Ethics Partner is the audit engagement partner; and
- situations where the Ethics Partner is unavailable, for example due to illness or holidays.

Where such support is shared with other functions such as Compliance or Risk Management, the Ethics Partner establishes policies and procedures to ensure that:

matters delegated to support staff by the Ethics Partner, whether directly or indirectly through the operation of delegation policies established by the Ethics Partner, are clearly identified in internal documentation as relating to the Ethics Partner role and are addressed and supervised in a manner consistent with the Ethics Partner role, avoiding conflicts with other objectives; and
all matters required to be communicated to, consulted upon with, or approved by the Ethics Partner are communicated to him or her or an authorised delegate personally, on a timely basis.

Whenever a possible or actual breach of an APB Ethical Standard, or of policies and procedures established pursuant to the requirements of an APB Ethical Standard, is identified, the audit engagement partner, in the first instance, and the Ethics Partner, where appropriate, assesses the implications of the breach, determines whether there are safeguards that can be put in place or other actions that can be taken to address any potential adverse consequences and considers whether there is a need to resign from the audit engagement.

An inadvertent violation of this Standard does not necessarily call into question the audit firm’s ability to give an audit opinion, provided that:
- the audit firm has established policies and procedures that require all partners and staff to report any breach promptly to the audit engagement partner or to the Ethics Partner, as appropriate;
- the audit engagement partner or Ethics Partner promptly notifies the relevant partner or member of staff that any matter which has given rise to a breach is to be addressed as soon as possible and ensures that such action is taken;
- safeguards, where appropriate, are applied, (for example, having another partner review the work done by the relevant partner or member of staff or removing him or her from the engagement team); and
- the actions taken and the rationale for them are documented.

IDENTIFICATION AND ASSESSMENT OF THREATS

30 The auditor identifies and assesses the circumstances which could adversely affect the auditor’s objectivity (‘threats’), including any perceived loss of independence, and applies procedures (‘safeguards’), which will either:

eliminate the threat (for example, by eliminating the circumstances, such as removing an individual from the engagement team or

disposing of a financial interest in the audited entity); or

reduce the threat to an acceptable level, that is a level at which it is not probable that a reasonable and informed third party would conclude that the auditor’s objectivity is impaired or is likely to be impaired (for example, by having the audit work reviewed by another partner or by another audit firm).

Threats to objectivity and independence

The audit firm shall establish policies and procedures to require persons in a position to influence the conduct and outcome of the audit to be constantly alert to circumstances that might reasonably be considered threats to their objectivity or the perceived loss of independence and, where such circumstances are identified, to report them to the audit engagement partner or to the Ethics Partner, as appropriate.

Such policies and procedures require that threats to the auditor’s objectivity and independence are communicated to the appropriate person, having regard to the nature of the threats and to the part of the firm and the identity of any person involved. The consideration of all threats on an individual and cumulative^[1] basis and the action taken is documented. If the audit engagement partner is personally involved, or is unsure about the action to be taken, the matter is resolved through consultation with the Ethics Partner.

The audit firm shall establish policies and procedures which require that partners and employees of the firm, including those providing non-audit services to an audited entity or its affiliates, do not take decisions that are the responsibility of management of the audited entity.

It is not possible to specify all types of decision that are the responsibility of management, but they typically involve leading and directing the audited entity, including making significant judgments and taking decisions regarding the acquisition, deployment and control of human, financial, physical and intangible resources. Examples of judgments and decisions that are not made by the auditor include:
- Setting policies and strategic direction;

[1] For this purpose, ‘cumulative’ means all current relationships and any past completed relationships that may be expected to have a continuing relevance to the auditor’s independence and consideration of the threats that might exist.

Directing and taking responsibility for the actions of the entity’s employees;
Authorising transactions;
Deciding which recommendations of the audit firm or other third parties should be implemented;
Taking responsibility for the preparation and fair presentation of the financial statements in accordance with the applicable financial reporting framework; and
Taking responsibility for designing, implementing and maintaining internal control.

The principal types of threats to the auditor’s objectivity and independence are:
- self-interest threat
  - self-interest threat arises when the auditor has financial or other interests which might cause the auditor to be reluctant to take actions that would be adverse to the interests of the audit firm or any individual in a position to influence the conduct or outcome of the audit (for example, where the auditor has an investment in the audited entity, is seeking to provide additional services to the audited entity or needs to recover long-outstanding fees from the audited entity).
- self-review threat
  - self-review threat arises when the results of a non-audit service performed by the auditor or by others within the audit firm are reflected in the amounts included or disclosed in the financial statements (for example, where the audit firm has been involved in maintaining the accounting records, or undertaking valuations that are incorporated in the financial statements). In the course of the audit, the auditor may need to re-evaluate the work performed in the non-audit service. As, by virtue of providing the non-audit service, the audit firm is associated with aspects of the preparation of the financial statements, the auditor may be (or may be perceived to be) unable to take an impartial view of relevant aspects of those financial statements.  management threat

Paragraph 30 prohibits partners and employees of the audit firm from taking decisions on behalf of the management of the audited entity. A management threat can also arise when the audit firm undertakes an engagement to provide non-audit services in relation to which management are required to make judgments and take decisions based on that work (for example, the design, selection and implementation of a financial information technology system). In such work, the audit firm may become closely aligned with the views and interests of management and the auditor’s objectivity and independence may be impaired, or may be perceived to be, impaired.

advocacy threat

An advocacy threat arises when the audit firm undertakes work that involves acting as an advocate for an audited entity and supporting a position taken by management in an adversarial context (for example, by acting as a legal advocate for the audited entity in litigation or a regulatory investigation). In order to act in an advocacy role, the audit firm has to adopt a position closely aligned to that of management. This creates both actual and perceived threats to the auditor’s objectivity and independence.

familiarity (or trust) threat

A familiarity (or trust) threat arises when the auditor is predisposed to accept, or is insufficiently questioning of, the audited entity’s point of view (for example, where close personal relationships are developed with the audited entity’s personnel through long association with the audited entity).

intimidation threat

An intimidation threat arises when the auditor’s conduct is influenced by fear or threats (for example, where the auditor encounters an aggressive and dominating individual).

These categories may not be entirely distinct: certain circumstances may give rise to more than one type of threat. For example, where an audit firm wishes to retain the fee income from a large audited entity, but encounters an aggressive and dominating individual, there may be a self-interest threat as well as an intimidation threat. Furthermore, relationships with the audited entity’s connected parties may give rise to similar threats.

Threats to the auditor’s objectivity, including a perceived loss of independence, may arise where the audit firm is appointed to a non-audit service engagement for an entity not audited by the firm, but where an audited entity makes this decision. In such cases, even if the entity not audited by the firm pays the fee for the non-audit service engagement, the auditor considers the implication of the threats (especially the self-interest threat) that arise from the appointment.

Similarly threats may arise where the auditor has a relationship with any connected party of the audited entity. Where any member of the engagement team is aware of such relationships, an assessment of the threats and available safeguards is made.

The audit firm shall establish policies and procedures to require the audit engagement partner to identify and assess the significance of threats to the auditor’s objectivity on an individual and cumulative¹⁰ basis, including any perceived loss of independence:
- when considering whether to accept or retain an audit engagement;^[1]
- when planning the audit;

(c) when forming an opinion on the financial statements;^[2]

(d) when considering whether to accept or retain an engagement to provide non-audit services to an audited entity; and (e) when potential threats are reported to him or her.

[1] Consideration of whether to accept or retain an audit engagement does not arise with those bodies in the public sector where responsibility for the audit is assigned by legislation.

[2] In the case of listed companies, the auditor also assesses whether there is any threat to the auditor’s objectivity and independence when discharging responsibilities in relation to preliminary announcements and when reporting on interim results.

An initial assessment of the threats to objectivity and independence is required when the audit engagement partner is considering whether to accept or retain an audit engagement. That assessment is reviewed and updated at the planning stage of each audit. At the end of the audit process, when forming an opinion on the financial statements but before issuing the report, the audit engagement partner draws an overall conclusion as to whether all threats to objectivity and independence have been properly addressed on an individual and cumulative basis in accordance with APB Ethical Standards. If, at any time, the auditor is invited to accept an engagement to provide non-audit services, the audit engagement partner considers the impact this may have on the auditor’s objectivity and independence.

When identifying and assessing threats to the auditor’s objectivity and independence, the audit engagement partner takes into account current relationships with the audited entity (including non-audit service engagements and known relationships with connected parties of the audited entity) and with other parties in certain circumstances (see paragraph 41), those that existed prior to the current audit engagement and any known to be in prospect following the current audit engagement. This is because those prior and subsequent relationships may be perceived as likely to influence the auditor in the performance of the audit or as otherwise impairing the auditor’s objectivity and independence.

Threats to the auditor’s objectivity, including a perceived loss of independence, may arise where a non-audit service is provided by the audit firm to a third party which is connected (through a relationship) to an audited entity, and the outcome of that service has a material impact on the financial statements of the audited entity. For example, if the audit firm provides actuarial services to the pension scheme of an audited entity, which is in deficit, and the audit firm subsequently gives an opinion on financial statements that include judgments given in connection with that service.

Where the audited entity or a third party calls into question the objectivity and independence of the audit firm in relation to a particular audited entity, the Ethics Partner carries out such investigations as may be appropriate.

IDENTIFICATION AND ASSESSMENT OF SAFEGUARDS

If the audit engagement partner identifies threats to the auditor’s objectivity, including any perceived loss of independence, he or she shall identify and assess the effectiveness of the available safeguards and apply such safeguards as are sufficient to eliminate the threats or reduce them to an acceptable level.

The nature and extent of safeguards to be applied depend on the significance of the threats. Where a threat is clearly insignificant, no safeguards are needed.

Other APB Ethical Standards address specific circumstances which can create threats to the auditor’s objectivity or loss of independence. They give examples of safeguards that can, in some circumstances, eliminate the threat or reduce it to an acceptable level. In circumstances where this is not possible, the auditor either does not accept or withdraws from the audit engagement as appropriate.

APB Ethical Standards contain certain additional requirements or prohibitions that apply only in the case of listed company audited entities:
- ES 1, paragraphs 51 and 67;
- ES 3, paragraphs 12, 19 and 20;
- ES 4, paragraphs 22, 31 and 35;
- ES 5, paragraphs 28, 77, 84, 99, 110, 117, 153 and 160.

These additional requirements also apply where regulation or legislation requires that the audit of an entity is conducted in accordance with the auditing standards or ethical requirements that are applicable to the audit of listed companies.

The audit firm shall establish policies and procedures which set out the circumstances in which those additional requirements listed in paragraph 46 that apply to listed companies are applied to other audit engagements.

Such policies and procedures take into consideration any additional criteria set by the audit firm, such as the nature of the entity’s business, its size, the number of its employees and the range of its stakeholders. For example, a firm may decide to extend the additional requirements to audit engagements of certain regulated financial institutions such as large non-listed banks and insurance companies.

The audit engagement partner shall not accept or shall not continue an audit engagement if he or she concludes that any threats to the auditor’s objectivity and independence cannot be reduced to an acceptable level.

Where a reasonable and informed third party would regard ceasing to act as the auditor as detrimental to the shareholders (or equivalent) of the audited entity, then resignation may not be immediate. However, the audit firm discloses full details of the position to those charged with governance of the audited entity, and establishes appropriate safeguards.

ENGAGEMENT QUALITY CONTROL REVIEW

In the case of listed companies the engagement quality control reviewer^[1]shall:

[1] ISA (UK and Ireland) 220 ‘Quality Control for an Audit of Financial Statements’, requires the audit engagement partner to determine that an engagement quality control reviewer has been appointed for all audits of listed entities. The engagement quality control review involves consideration of the engagement team’s evaluation of the firm’s independence in relation to the audit engagement.

consider the audit firm’s compliance with APB Ethical Standards in relation to the audit engagement;
form an independent opinion as to the appropriateness and adequacy of the safeguards applied; and
consider the adequacy of the documentation of the audit engagement partner’s consideration of the auditor’s objectivity and independence.

The audit firm’s policies and procedures set out whether there are circumstances in which an engagement quality control review is performed for other audit engagements as described in paragraph 47.

Where the involvement of an engagement quality control reviewer provides a safeguard to reduce to an acceptable level those threats to independence that have been identified as potentially arising from the provision of nonaudit services, his or her review specifically addresses the related threat by ensuring that the work that was performed in the course of the non-audit service engagement has been properly and effectively assessed in the context of the audit of the financial statements.

OVERALL CONCLUSION

At the end of the audit process, when forming an opinion but before issuing the report on the financial statements, the audit engagement partner shall reach an overall conclusion that any threats to objectivity and independence on an individual and cumulative basis have been properly addressed in accordance with APB Ethical Standards. If the audit engagement partner cannot make such a conclusion, he or she shall not report and the audit firm shall resign as auditor.

In addition to assessing individual threats to auditor objectivity and independence, the audit engagement partner assesses the cumulative impact of all the threats identified on the audit engagement so as to reach a conclusion that the threats identified, when viewed individually and cumulatively, have been reduced to an acceptable level through the application of safeguards.

If the audit engagement partner remains unable to conclude that any individual threats to objectivity and independence, or all threats to objectivity and independence viewed on a cumulative basis, have been properly addressed in accordance with APB Ethical Standards, or if there is a disagreement between the audit engagement partner and the engagement quality control reviewer, he or she consults the Ethics Partner.

In concluding on compliance with the requirements for objectivity and independence, the audit engagement partner is entitled to rely on the completeness and accuracy of the data developed by the audit firm’s systems relating to independence (for example, in relation to the reporting of financial interests by staff), unless informed otherwise by the firm.

OTHER AUDITORS INVOLVED IN THE AUDIT OF GROUP FINANCIAL STATEMENTS

The group audit engagement partner shall be satisfied that other auditors (whether a network firm or another audit firm) involved in the audit of the group financial statements, who are not subject to APB Ethical Standards, are objective and document the rationale for that conclusion.

The group audit engagement partner obtains appropriate evidence^[1] that the other auditors have a sufficient understanding of and have complied with the

[1] ISA (UK and Ireland) 600 ‘Special Considerations – Audits of Group Financial Statements

(Including the Work of Component Auditors)’ requires that the group engagement team shall

current Code of Ethics for Professional Accountants, including the independence requirements¹⁵.

In the case of a listed company, the group audit engagement partner establishes that the company has communicated its policy¹⁶ on the engagement of the external auditor to supply non-audit services to its affiliates and obtains confirmation that the other auditors will comply with this policy.

NETWORK FIRMS NOT INVOLVED IN THE AUDIT

The audit firm shall establish that network firms which are not involved in the audit are required to comply with global policies and procedures that are designed to meet the requirements of the current IESBA

Code¹⁵.

The IESBA Code requires all network firms to be independent of the entities audited by other network firms¹⁷. International audit networks commonly meet this requirement through global independence policies and procedures

obtain an understanding of whether the component auditor understands and will comply with the ethical requirements that are relevant to the group audit and, in particular, is independent.

The Code of Ethics for Professional Accountants (the IESBA Code) issued by the International Ethics Standards Board for Accountants establishes a conceptual framework for applying the fundamental principles of professional ethics for professional accountants. Section 290 of the IESBA Code illustrates the application of the conceptual framework to independence requirements for audit engagements and represents the international standard on which national standards should be based. No Member Body of the International Federation of Accountants (IFAC) is allowed to apply less stringent standards than those stated in that section. In addition, members of the IFAC Forum of Firms have agreed to apply ethical standards, which are at least as rigorous as those of the IESBA Code.
The UK Corporate Governance Code requires audit committees to develop the company’s policy on the engagement of the external auditor to supply non-audit services.
Paragraph 290.13 of the IESBA Code, as updated in July 2009.

designed to comply with the current IESBA Code which are supported by appropriate monitoring and compliance processes within the network.

COMMUNICATION WITH THOSE CHARGED WITH GOVERNANCE

The audit engagement partner shall ensure that those charged with governance of the audited entity are appropriately informed on a timely basis of all significant facts and matters that bear upon the auditor’s objectivity and independence.

The audit committee, where one exists, is usually responsible for oversight of the relationship between the auditor and the entity and of the conduct of the audit process. It therefore has a particular interest in being informed about the auditor’s ability to express an objective opinion on the financial statements. Where there is no audit committee, this role is undertaken by the board of directors.^[1]^{, [2]}

The aim of these communications is to ensure full and fair disclosure by the auditor to those charged with governance of the audited entity on matters in which they have an interest. These will generally include the key elements of the audit engagement partner’s consideration of objectivity and independence, such as:
- the principal threats, if any, to objectivity and independence identified by the auditor, including consideration of all relationships between the audited entity, its affiliates and directors and the audit firm;
- any safeguards adopted and the reasons why they are considered to be effective, including any independent partner review;
- the overall assessment of threats and safeguards;
- information about the general policies and processes within the audit firm for maintaining objectivity and independence.

[1] Where there is no audit committee, references to communication with the audit committee are to be construed as including communication with the board of directors.

[2] Some bodies in the public sector have audit committees but others have different governance models.

Communications between the auditor and those charged with the governance of the audited entity will be needed at the planning stage and whenever significant judgments are made about threats to objectivity and independence and the appropriateness of safeguards put in place, for example, when accepting an engagement to provide non-audit services.

Additional provisions related to audits of listed companies

In the case of listed companies, the audit engagement partner shall ensure that the audit committee is provided with:
- a written disclosure of relationships (including the provision of non-audit services) that bear on the auditor’s objectivity and independence, the threats to auditor independence that these create, any safeguards that have been put in place and why they address such threats, together with any other information necessary to enable the auditor’s objectivity and independence to be assessed;
- details of non-audit services provided and the fees charged in relation thereto;
- written confirmation that the auditor is independent;
- details of any inconsistencies between APB Ethical Standards and the company’s policy for the supply of non-audit services by the audit firm and any apparent breach of that policy.
- an opportunity to discuss auditor independence issues.

The most appropriate time for these final written confirmations of independence is usually at the conclusion of the audit.

The auditor of a listed company discloses in writing details of all relationships between the auditor and the audited entity, and its directors and senior management and its affiliates, including all services provided by the audit firm and its network to the audited entity, its directors and senior management and its affiliates, and other services provided to other known connected parties that the auditor considers may reasonably be thought to

bear on the auditor’s objectivity and independence and the related safeguards that are in place

The auditor ensures that the total amount of fees that the auditor and its network firms have charged to the audited entity and its affiliates for the provision of services during the reporting period, analysed into appropriate categories are disclosed. The Appendix contains an illustrative template for the provision of such information to an audit committee^[1]. Separately, the auditor provides information on any contingent fee arrangements^[2], the amounts of any future services which have been contracted, and details of any written proposal to provide non-audit services that has been submitted.

The written confirmation that the auditor is independent indicates that the auditor considers that the audit firm complies with APB Ethical Standards and that, in the auditor’s professional judgment, the audit firm is independent and its objectivity is not compromised. If it is not possible to make such a confirmation, the communication will include any concerns that the auditor has that the audit firm’s objectivity and independence may be compromised (including instances where the group audit engagement partner does not consider an other auditor to be objective) and an explanation of the actions which necessarily follow from this.

DOCUMENTATION

The audit engagement partner shall ensure that his or her consideration of the auditor’s objectivity and independence is appropriately documented on a timely basis.

[1] When considering how to present this analysis of fees, the auditor takes account of any applicable legislation.

[2] Paragraph 22 of ES 4 requires the audit engagement partner to disclose to the audit committee, in writing, any contingent fee arrangements for non-audit services provided by the auditor or its network firms.

The requirement to document these issues contributes to the clarity and rigour of the audit engagement partner’s thinking and the quality of his or her judgments. In addition, such documentation provides evidence that the audit engagement partner’s consideration of the auditor’s objectivity and independence was properly performed and, for listed companies, provides the basis for review by the engagement quality control reviewer.

Matters to be documented^[1] include all key elements of the process and any significant judgments concerning:
- threats identified, other than those which are clearly insignificant, and the process used in identifying them;
- safeguards adopted and the reasons why they are considered to be effective;
- review by an engagement quality control reviewer or an independent partner;
- overall assessment of threats, on an individual and cumulative basis, and safeguards; and
- communication with those charged with governance.

EFFECTIVE DATE

This revised Ethical Standard becomes effective on 30 April 2011.

[1] The necessary working papers can be combined with those prepared pursuant to paragraph 24 of ISA (UK and Ireland) 220 ‘Quality Control for an Audit of Financial Statements’, which requires that: “The auditor shall include in the audit documentation conclusions on compliance with independence requirements that apply to the audit engagement, and any relevant discussions with the firm that support these conclusions.”

Firms may complete audit engagements relating to periods commencing on or before 31 December 2010 in accordance with existing ethical standards, putting in place any necessary changes in the subsequent engagement period.

APPENDIX: Illustrative template for communicating information on audit and non-audit services provided to the group

Current year Prior year

£m £m

Audit of company X X

Audit of subsidiaries X X

X	X
X	X
X	X
X	X
X	X
X	X
X	X
X	X
X	X
X	X
X	X
X	X
X	X

Total audit

Audit related assurance services^[1]

Other assurance services^[2] ^[3]

Total assurance services

Tax compliance services (i.e. related to assistance with corporate tax returns)

Tax advisory services

Services relating to taxation

Internal audit services

Services related to corporate finance transactions not covered above

Other non-audit services not covered above

Total other non-audit services

Total non-audit services

Total fees

Occupational pension scheme audits	X	X
Non-audit services in respect of the audited entity provided to a third party^[4].	X	X

[1] This will, and will only, include those services which are identified as audit related services in paragraph 55 of ES 5.

[2] This will not include any tax or internal audit services, all of which should be disclosed under those headings.

[3] The definition of an assurance engagement is provided in the Glossary of Terms included in APB’s

Compendium of Standards and Guidance which is published annually. Services provided under such engagements will include assurance engagements such as those which involve reporting on historical financial information which are included in an investment circular in accordance with the Standards for Investment Reporting 2000 (Revised): Investment reporting standards applicable to public reporting engagements on historical financial information.

[4] For the purposes of APB Ethical Standards non-audit services include services provided to another entity in respect of the audited entity, for example, where the audit firm provides transaction related services, in respect of an audited entity’s financial information, to a prospective acquirer of the audited entity (see paragraph 12 of ES 5). ²⁷ Disclosure requirements in the Republic of Ireland are set out in European Communities (Statutory Audits) (Directive 2006/43/EC) Regulations 2010. An information sheet on this topic “Disclosure of auditors’ remuneration” was developed by the Consultative Committee of Accountancy Bodies in Ireland and published by Chartered Accountants Ireland in January 2011: this is available at:

http://www.charteredaccountants.ie/Members/Technical1/Financial-Reporting/Resources/Disclosure-of-AuditorRemuneration/ .

Disclosure of contingent fee arrangements under paragraph 22 of ES 4 can also be facilitated through the use of a footnote to this template.

Disclosures required under UK company legislation²⁷ are indicated by those categories in bold type above. Fuller information can be provided by companies if desired.

Posted on April 4, 2021April 14, 2021 by MJ — Leave a comment

INTERNATIONAL STANDARDS IN AUDITING (ISA)

COMMUNICATION WITH THOSE CHARGED WITH GOVERNANCE

FORMING AN OPINION AND REPORTING ON FINANCIAL STATEMENTS

ACCOUNTS PAYABLE

AGREEING THE TERMS OF AUDIT ENGAGEMENTS

ASSURANCE ENGAGEMENTS OTHER THAN AUDITS OR REVIEWS OF HISTORICAL FINANCIAL INFORMATION

INTERNATIONAL FRAMEWORK FOR ASSURANCE ENGAGEMENTS

AUDIT EVIDENCE—ADDITIONAL CONSIDERATIONS FOR SPECIFIC ITEMS

MODIFICATIONS TO THE OPINION IN THE INDEPENDENT AUDITOR’S REPORT

CODE OF ETHICS

EMPHASIS OF MATTER PARAGRAPHS AND OTHER MATTER PARAGRAPHS IN THE INDEPENDENT AUDITOR’S REPORT

TERMS OF AUDIT ENGAGEMENTS

FRAUD IN AN AUDIT OF FINANCIAL STATEMENTS

FUNDAMENTAL PRINCIPLES OF PUBLIC-SECTOR AUDITING

USING THE WORK OF INTERNAL AUDITORS

IDENTIFYING AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT THROUGH UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT

USING THE WORK OF AN AUDITOR’S EXPERT

FORMING AN OPINION AND REPORTING ON FINANCIAL STATEMENTS

ENGAGEMENTS TO REVIEW FINANCIAL STATEMENTS

PERFORMANCE AUDIT GUIDELINES – KEY PRINCIPLES

NON-ASSURANCE SERVICES

PERFORMANCE AUDIT GUIDELINES:

FUNDAMENTAL PRINCIPLES OF FINANCIAL AUDITING

QUALITY CONTROL FOR AN AUDIT OF FINANCIAL STATEMENTS

UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT
WRITTEN REPRESENTATIONS

ES1 INTEGRITY, OBJECTIVITY AND INDEPENDENCE

ES2FINANCIAL, BUSINESS, EMPLOYMENT AND PERSONAL RELATIONSHIPS
ES3 LONG ASSOCIATION WITH THE AUDIT ENGAGEMENT

FEES, REMUNERATION AND EVALUATION POLICIES, LITIGATION, GIFTS AND HOSPITALITY

ES5 NON-AUDIT SERVICES PROVIDED TO AUDITED ENTITIES

PROVISIONS AVAILABLE FOR SMALL ENTITIES (REVISED)

Ethical Standard for Reporting Accountants

Posted on April 3, 2021April 3, 2021 by MJ — 1 Comment

WRITTEN PRESENTATION ISA 580

Introduction

Scope of this ISA

This International Standard on Auditing (ISA) deals with the auditor’s responsibility to request written representations, and the auditor’s actions when relevant parties do not provide the requested written representations, or when the auditor concludes that such written representations are not reliable. Appendix 1 lists other ISAs containing requirements and guidance for written representations. Those requirements do not limit the application of this ISA.

Effective Date

This ISA is effective for audits of financial statements for periods beginning on or after [date].^[1]

Objective

The objective of the auditor is to corroborate, by means of written representations:
- The validity of the premises, relating to management’s responsibilities, on which an audit is conducted;^[2] and
- Other audit evidence obtained with regard to specific assertions in the financial statements.

Definitions

For purposes of the ISAs, the following terms have the meanings attributed below:

Written representations – Written statements provided by relevant parties from within the entity to the auditor at the auditor’s request. Written representations are either general or specific. Written representations in the context of this ISA do not include financial statements, the assertions therein, and supporting books and records.
General written representations – Written representations regarding the premises, relating to management’s responsibilities, on which an audit is conducted.
Specific written representations – Written representations regarding specific assertions in the financial statements.

Relevant parties – Parties responsible for preparing and presenting the financial statements and assertions therein. Regarding specific assertions, relevant parties may also include individuals who have specialized knowledge about those specific

[1] This effective date will not be earlier than December 15, 2008.

[2] The term “management” has been used in this ISA to describe those responsible for preparing and presenting the financial statements. Other terms may be appropriate depending on the legal framework in the particular jurisdiction.

assertions and are part of the process followed in preparing and presenting the financial statements and assertions therein. (Ref: Para. A1-A2)
The premises, relating to management’s responsibilities, on which an audit is conducted – Those responsibilities of management and, where appropriate, those charged with governance that are fundamental to the conduct of an audit in accordance with the ISAs. They are explained in ISA 200, “Objective and General Principles Governing an Audit of Financial Statements.”

Requirements

Relevant Parties

The auditor shall determine the relevant parties from whom general and specific written representations shall be requested. (Ref: Para. A1-A3)
The auditor shall request that relevant parties provide written representations based on relevant parties’ knowledge and belief, having made appropriate inquiries for them to be able to provide such representations.

General Written Representations

The auditor shall request relevant parties to provide the general written representations about the financial statements, including internal control, and the completeness of information made available to the auditor set out in paragraphs 8-10 for all financial statements and periods covered by the auditor’s report. Such general written representations provide necessary audit evidence about the validity of the premises, relating to management’s responsibilities, on which an audit is conducted. However, by themselves, they do not constitute sufficient appropriate audit evidence about the validity of the premises. Accordingly, they do not relieve the auditor of the responsibility to obtain other audit evidence. (Ref: Para. A4-A11, A16)

Financial Statements

The auditor shall request relevant parties to provide written representations that they acknowledge and understand their responsibility for preparing and presenting the financial statements, and whether they believe that the financial statements are prepared in accordance with the applicable financial reporting framework (or are fairly presented in accordance with the applicable financial reporting framework, when that framework is a fair presentation framework). The representations shall include:

Whether the selection and application of accounting policies are appropriate;
Whether all transactions have been recorded; and
Whether the following matters, where relevant in view of the applicable financial reporting framework, have been recognized, measured or disclosed in accordance with that framework: o Plans or intentions that may affect the carrying value or classification of assets and liabilities;
- Liabilities, both actual and contingent;
- Title to or control over assets, and the liens or encumbrances on assets, and assets pledged as collateral;
- Aspects of contractual agreements that may affect the financial statements, including noncompliance; and o Events subsequent to the period end.

Internal Control

The auditor shall request relevant parties to provide a written representation that they acknowledge and understand their responsibility for designing, implementing and maintaining internal control relevant to preparing and presenting financial statements that are free from material misstatement, whether due to fraud or error, and whether they believe that the internal control they have maintained is adequate for that purpose.

Completeness of Information

The auditor shall request relevant parties to provide a written representation whether they believe that all records, documentation, unusual matters of which they are aware, and other information relevant to the audit have been made available to the auditor.

Form and Date of General Written Representations

The general written representations shall be in the form of a representation letter addressed to the auditor. The general written representations shall be as of the same date as the auditor’s report on the financial statements. (Ref: Para. A15)

Specific Written Representations

Other ISAs contain requirements for specific written representations. In addition to those, a specific written representation may be necessary to corroborate other audit evidence, particularly where judgment, intent or completeness is involved. The auditor shall determine whether specific written representations relating to specific assertions in the financial statements are necessary. Such specific written representations do not constitute sufficient appropriate audit evidence by themselves. Accordingly, they do not relieve the auditor of the responsibility to obtain other audit evidence. (Ref: Para. A12-A14, A16)
The auditor shall determine whether it is necessary to request relevant parties to provide an updated specific written representation when the specific written representation is as of a date earlier than that of the auditor’s report on the financial statements. (Ref: Para. A15)

Evaluating the Reliability of Written Representations

Circumstances such as the following may cause the auditor to doubt the reliability of one or more written representations:
- One or more written representations are inconsistent with other audit evidence; or
- The auditor has identified significant issues related to management’s commitment to competence, communication and enforcement of integrity and ethical values, or diligence.
When a written representation is inconsistent with other audit evidence, the auditor shall determine the reasons for the inconsistency. When the auditor’s doubt remains unresolved, the auditor shall reconsider the reliability of other written representations and take appropriate action. (Ref: Para. A17)
When the auditor has identified significant issues related to management’s commitment to competence, communication and enforcement of integrity and ethical values, or diligence, the auditor shall assess the effect of these issues on the reliability of written representations and take appropriate action. (Ref: Para. A18)
When the auditor concludes that the general written representations about the financial statements, including internal control, or the completeness of information made available to the auditor (see paragraphs 8-10) are not reliable, the premises, relating to management’s responsibilities, on which an audit is conducted are not valid, and the auditor shall follow the requirement in paragraph 19.

When Relevant Parties Do Not Provide Requested Written Representations

When relevant parties do not provide the general or specific written representations requested by the auditor, the auditor shall (a) ask for the reasons; (b) reconsider the assessment of the integrity of management and, where appropriate, those charged with governance; and (c) take appropriate actions, including determining the possible effects on the opinion in the auditor’s report, having regard to the requirements in paragraphs 19-20. (Ref: Para. A19)
When relevant parties do not provide the general written representations about the premises, relating to management’s responsibilities, on which an audit is conducted (see paragraphs 8-10) (or the auditor concludes that such general written representations are unreliable (see paragraph 17)), the auditor is unable to obtain sufficient appropriate audit evidence. The possible effects on the financial statements of such inability are pervasive. Therefore, in accordance with ISA 705, “Modifications to the Opinion in the Independent Auditor’s Report,” the auditor shall disclaim an opinion on the financial statements.
When relevant parties do not provide specific written representations requested by the auditor, it constitutes a scope limitation. Where this is the case, the auditor shall consider the effect on the opinion in the auditor’s report in accordance with ISA 705.

Documentation

Where an identified significant issue related to management’s commitment to competence, communication and enforcement of integrity and ethical values, or diligence exists (see paragraph 16), but the auditor concludes that a written representation is nevertheless reliable, the auditor shall document the reasons for the conclusion.

***

Application and Other Explanatory Material

Relevant Parties (Ref: Para. 4(d), 5)

A1. To identify relevant parties from whom general written representations are to be requested, it is important to consider the governance structure of the entity, relevant legislation, and circumstances of the engagement. Ordinarily, management is the party responsible for preparing and presenting the financial statements and the assertions therein. Relevant parties therefore include the entity’s chief executive officer and chief financial officer or other equivalent persons in entities that do not use such titles. In some circumstances, however, other individuals or bodies, such as those charged with governance, are also responsible.

A2. The auditor applies professional judgment in identifying relevant parties from whom specific written representations are to be requested. The auditor may identify individuals other than those described in paragraph A1 who have specialized knowledge relating to specific assertions in the financial statements and are part of the process followed in preparing and presenting the financial statements and assertions therein. For example:

An entity may employ an actuary who has responsibility for and specialized knowledge about actuarially determined accounting measurements.
Staff engineers may have responsibility for and specialized knowledge about environmental liability measurements.
Internal counsel may provide information essential to provisions for legal claims.

A3. Where uncertainty exists as to the identity of relevant parties, it may be necessary for the auditor to agree with the engaging party, prior to accepting the engagement, who the relevant parties are. This is discussed in ISA 210, “Terms of Audit Engagements.”

General Written Representations (Ref: Para. 7-11)

A4. Legislation, the applicable financial reporting framework, or custom may establish management’s responsibility for preparing and presenting the financial statements and for the assertions therein. However, the extent of this responsibility may differ across jurisdictions. Despite these differences, an audit in accordance with the ISAs is conducted on the premises that management is responsible for: preparing and presenting the financial statements in accordance with the applicable financial reporting framework; designing, implementing and maintaining internal control relevant to preparing and presenting financial statements that are free from material misstatement, whether due to fraud or error; and the completeness of information made available to the auditor. Audit evidence obtained during the audit may support or contradict the validity of these premises However, such evidence is not sufficient without obtaining the general written representations described in paragraphs 8-10. This is because the auditor may not be able to judge relevant parties’ knowledge, judgments or intentions based on other audit evidence. For example, an auditor could not conclude that all relevant information has been made available without asking whether all such information had been made available.

A5. The expression of relevant parties’ responsibilities in law and their signing of the financial statements do not, by themselves, provide sufficient other audit evidence, or serve as a substitute for the written representations required by the ISAs.

A6. Requesting representations about important matters is an effective auditing procedure for a number of reasons. When relevant parties do not provide the representations requested by the auditor, it may alert the auditor to possibly significant issues. Further, the requirement to make written, rather than oral, representations is likely to cause the relevant parties to pay greater attention to such matters. Having to make the general written representations reinforces relevant parties’ responsibilities in relation to the financial statements and the audit, and prompts them to consider specific issues more thoughtfully. Obtaining a representation letter may be particularly useful where there is a need to clarify the relevant parties’ understanding of the premises, relating to management’s responsibilities, on which an audit is conducted.

A7. The general written representations relating to relevant parties’ responsibility for (a) designing, implementing and maintaining internal control relevant to preparing and presenting financial statements that are free from material misstatement, whether due to fraud or error, and (b) the completeness of information made available to the auditor, are relevant for all audits. However, some general representations relating to relevant parties’ responsibility for preparing and presenting the financial statements in accordance with the applicable financial reporting framework may not always be relevant. For example, written representations relating to liabilities may not be necessary where the financial statements were prepared and presented on a cash basis in accordance with the applicable financial reporting framework.

A8. All periods covered by the auditor’s report on the financial statements need to be covered by the general written representations and specific written representations because relevant parties need to reaffirm that the representations they previously made with respect to prior periods remain appropriate. The auditor and relevant parties may agree to a form of representation letter that updates previous representations by addressing whether there are any changes to such representations and, if so, what they are.

A9. Situations may arise where relevant parties who were in place during the period being audited are not in place at the time the written representations are requested by the auditor. Relevant parties, who were not in place during the period being audited, may assert that they are not in a position to provide some or all of the representations requested by the auditor; however, this fact does not diminish their responsibilities. Accordingly, the auditor’s responsibility to obtain written representations from them is not affected.

A10. [Proposed] ISA 260 (Revised and Redrafted), “Communication with Those Charged with Governance” requires the auditor to communicate with those charged with governance the representations the auditor requested from relevant parties. In some circumstances, it may be appropriate for the auditor to request that the representation letter also be agreed by those charged with governance to ensure that all those charged with governance agree with the written representations that the auditor considers essential to forming an opinion on the financial statements.

Considerations Specific to Public Sector Entities

A11. The mandates for audits of the financial statements of public sector entities may be broader than those of other entities. As a result, the objectives of an audit of the financial statements of a public sector entity may give rise to additional general written representations. These may include representations acknowledging economy, efficiency and effectiveness of programs, projects and other activities, or that transactions and events have been carried out in accordance with legislation or proper authority.

Specific Written Representations (Ref: Para. 12)

A12. A specific written representation may be necessary to corroborate other audit evidence; in particular, where judgment, intent or completeness is involved. For example, when auditing the valuation of investments where management’s intent is crucial to the accounting treatment, it may not be possible to obtain sufficient appropriate audit evidence without a specific written representation from relevant parties in relation to their intentions.

A13. Evaluating judgment or intent is inherently subjective, and therefore uncertain. In some cases, the auditor may obtain audit evidence supporting, or which is inconsistent with, relevant parties’ assertions by considering matters directly or indirectly linked to the assertion. When evaluating relevant parties’ judgments and intentions the auditor may consider one or more of the following:

The entity’s past history in carrying out its stated intentions.
The entity’s reasons for choosing a particular course of action.
The entity’s ability to pursue a specific course of action.
The existence or lack of any other information that might have been obtained during the course of the audit that may be inconsistent with management’s judgment or intent.

A14. A specific written representation does not provide sufficient appropriate audit evidence by itself. For example, a written response to a specific inquiry in relation to the cost of an asset is not a substitute for the audit evidence in relation to such cost that the auditor would ordinarily expect to obtain. Furthermore, audit evidence is influenced by its source and nature. For example, where the source of a specific written representation is not independent from the entity.

Date of Written Representations (Ref: Para. 11, 13)

A15. Because the auditor is concerned with events occurring up to the date of the auditor’s report that may require adjustment to or disclosure in the financial statements, the general written representations are made as of the date of the auditor’s report. However, in some circumstances it may be appropriate for the auditor to obtain a specific written representation during the course of the audit. Where this is the case, it may be necessary to request relevant parties to provide an updated specific written representation.

Threshold Amounts (Ref: Para. 7, 12)

A16. In some circumstances, the auditor may decide that it would be more effective if general and specific written representations were limited to matters above threshold amounts established by the auditor for the purposes of such representations, having given effect to the possibility of immaterial matters aggregating to become material. Accordingly, any such threshold amount will be relatively small in relation to materiality. For this purpose, the auditor may consider agreeing on the threshold amounts with relevant parties. Threshold amounts may vary with different written representations. It may not be appropriate to subject some matters to a threshold amount. For example it may not be appropriate to limit representations to a threshold amount about the responsibilities of relevant parties or matters related to fraud because of qualitative considerations.

Evaluating the Reliability of Written Representations (Ref: Para 15-16)

A17. The appropriate action to be taken in relation to identified inconsistencies may include considering whether the auditor’s risk assessment remains appropriate and, if not, revising the risk assessment and determining the nature, timing and extent of further audit procedures to respond to the assessed risks. It may also include the actions referred to in paragraph A18 below.

A18. In the event that the auditor identifies issues related to management’s commitment to competence, communication and enforcement of integrity and ethical values, or diligence, appropriate action may include discussing the matter with those charged with governance and, where possible, withdrawing from the engagement unless those charged with governance put in place appropriate corrective measures. Such action may not be sufficient, however, to enable the auditor to issue an unmodified audit opinion.

A19. A written representation that has been modified from that requested by the auditor does not necessarily mean that relevant parties did not provide the written representation. However, such modification may affect the opinion in the auditor’s report. For example:

The general written representation relating to the financial statements may state that relevant parties believe that, except for material noncompliance with a particular requirement of the applicable financial reporting framework, the financial statements are prepared in accordance with that framework. The requirement in paragraph 19 does not apply because the auditor concluded that relevant parties have provided reliable general written representations. However, the auditor considers the effect of the noncompliance on the opinion in the auditor’s report in accordance with ISA 705.
The general written representation relating to internal control may state that relevant parties believe that, except for internal control over a particular account balance, it has maintained internal control adequate for preparing and presenting financial statements that are free from material misstatement, whether due to fraud or error. The requirement in paragraph 19 does not apply because the auditor concluded that relevant parties have provided reliable general written representations. Furthermore, the auditor may be able to obtain sufficient appropriate other audit evidence in relation to that account balance and, as a result, the statement in the general representation may not affect the opinion in the auditor’s report. However, the auditor considers whether a material weakness in internal control existed and the effect thereof on the audit.
The general written representation relating to completeness of information made available to the auditor may state that relevant parties believe that, except for information destroyed in a fire, all records, documentation, unusual matters of which they are aware, and other information relevant to the audit have been made available to the auditor. The requirement in paragraph 19 does not apply because the auditor concluded that relevant parties have provided reliable general written representations. The auditor considers the effects of the pervasiveness of the information destroyed in the fire on the financial statements and the effect thereof on the opinion in the auditor’s report in accordance with ISA 705. Depending on the pervasiveness of the effects, the auditor may disclaim an opinion.

Appendix 1

(Ref: Para. 1)

List of ISAs Containing Requirements for Written Representations

ISA 240 (Redrafted), “The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statement” – paragraph 39

ISA 250, “Consideration of Laws and Regulations” – paragraph 23

[Proposed] ISA 450 (Redrafted), “Evaluation of Misstatements Identified during the Audit” – paragraph 16

[Proposed] ISA 540 (Revised and Redrafted) (Combined ISA 540-545), “Auditing Accounting

Estimates, Including Fair Value Accounting Estimates, and Related Disclosures” – paragraph 20

[Proposed] ISA 550 (Revised and Redrafted), “Related Parties” – paragraph 24 ISA 570, “Going Concern” – paragraph 26(c)

Appendix 2

Illustrative Representation Letter

The following illustrative letter includes written representations (some of which are specific written representations) that are required by this and other ISAs in effect as of [date]. It is assumed in this example that the requirement of ISA 570, “Going Concern” to obtain a written representation is not relevant and that there are no exceptions to the representations requested by the auditor. If there were exceptions, the representations would need to be modified to reflect the exceptions as discussed in paragraph A19. Where the auditor determines that one or more additional specific written representations are sufficiently important, the auditor may conclude that the inclusion thereof in the representation letter is appropriate. Although such inclusion of specific written representations on a variety of matters may serve to focus relevant parties’ attention on those matters, and thus cause the relevant parties to specifically address those matters in more detail than would otherwise be the case, the auditor needs to be aware of the limitations of specific written representations as audit evidence as set out in this ISA.

(Entity Letterhead)

(To Auditor) (Date)

This representation letter is provided in connection with your audit of the financial statements of ABC Company for the year ended December 31, 20XX^[1] for the purpose of expressing an opinion as to whether the financial statements [give a true and fair view][are presented fairly, in all material respects,] in accordance with [specify the applicable financial reporting framework]. We confirm, to the best of our knowledge and belief, having made appropriate inquiries to be able to provide our representations, that:

Financial Statements

We acknowledge and understand our responsibility for preparing and presenting the financial statements and believe that the financial statements are prepared in accordance with [specify the applicable financial reporting framework] (or are fairly presented in accordance with [specify the applicable financial reporting framework]), including the following:
Our selection and application of accounting policies is appropriate. o All plans or intentions that may materially alter the carrying value or classification of assets and liabilities in the financial statements have been accounted for or disclosed in accordance with the applicable financial reporting framework.

[1] Where the auditor reports on more than one period, the auditor adjusts the date so that the letter pertains to all periods covered by the auditor’s report.

All liabilities, both actual and contingent, have been recorded and, where appropriate, disclosed in accordance with the applicable financial reporting framework.
The entity has satisfactory title to, or control over, all assets disclosed in the financial statements and, where appropriate, all liens or encumbrances on these assets have been disclosed in accordance with the applicable financial reporting framework.
We have complied with the aspects of contractual agreements that could have a material effect on the financial statements and instances of noncompliance have been disclosed in accordance with the applicable financial reporting framework.
All transactions have been recorded. o Significant assumptions used by us in making accounting estimates, including those measured at fair value, are reasonable. ([Proposed] ISA 540 (Revised and Redrafted)

(Combined ISA 540-545))

All events subsequent to the year end for which the applicable financial reporting framework requires adjustment or disclosure have been adjusted or disclosed.

o [A written representation with regard to related party transactions and the effects of related party relationships will be inserted when proposed ISA 550 (Revised and

Redrafted) is finalized.] o [A written representation with regard to related party disclosures in the financial statements will be inserted when proposed ISA 550 (Revised and Redrafted) is finalized.] o The effects of uncorrected misstatements are immaterial, both individually and in the aggregate, to the financial statements as a whole. A list of the uncorrected misstatements is attached to the representation letter. ([Proposed] ISA 450 (Redrafted))

Internal Control

We acknowledge and understand our responsibility for the design, implementation and maintenance of internal control relevant to the preparation and presentation of financial statements that are free from material misstatement, whether due to fraud or error, and believe that the internal control we have maintained is adequate for that purpose.

Completeness of Information

All records, documentation, unusual matters of which management is aware, and other information relevant to the audit have been made available to you.
We have disclosed to you the results of our assessment of the risk that the financial statements may be materially misstated as a result of fraud. (ISA 240 (Redrafted))
We have disclosed to you all information in relation to fraud or suspected fraud that we are aware of and that affects the entity and involves:
- Management;
- Employees who have significant roles in internal control; or
- Others where the fraud could have a material effect on the financial statements. (ISA 240

(Redrafted))

We have disclosed to you all information in relation to allegations of fraud, or suspected fraud, affecting the entity’s financial statements communicated by employees, former employees, analysts, regulators or others. (ISA 240 (Redrafted))
We have disclosed to you all known actual or possible noncompliance with laws and regulations whose effects should be considered when preparing financial statements. (ISA 250)

• [A written representation with regard to the completeness of related parties, related party relationships and related party transactions will be inserted when proposed ISA 550 (Revised and Redrafted) is finalized.]

(Relevant Party)

PROPOSED CONFORMING AMENDMENTS

ISA 200, “Objective and General Principles Governing an Audit of Financial Statements”

33a. ISAs are written, and audits are conducted, on the premises that management and, where appropriate, those charged with governance:

Acknowledge and understand their responsibility for preparing and presenting the financial statements in accordance with the applicable financial reporting framework;
Acknowledge and understand their responsibility for designing, implementing and maintaining internal control relevant to the preparation and presentation of financial statements that are free from material misstatement, whether due to fraud or error; and
Will provide complete information to the auditor.

ISA 210, “Terms of Audit Engagements”

Agreement on Written Representations

5a.

The auditor should obtain the acknowledgement and agreement of management and, where appropriate, those charged with governance that they understand their responsibilities for:

• Preparing and presenting the financial statements in accordance with the applicable financial reporting framework;

• Designing, implementing, and maintaining internal control relevant to the preparation and presentation of financial statements that are free from material misstatement, whether due to fraud or error; and

• Providing complete information to the auditor.

5b.

ISA 200, “Objective and General Principles Governing an Audit of Financial Statements” explains that audits are conducted on the premises that these responsibilities are acknowledged and understood by management and, where appropriate, those charged with governance. These premises are fundamental to the audit; however, there is a risk that they may not be understood by management or those charged with governance. To avoid misunderstanding, agreement is reached with management and, where appropriate, those charged with governance about their responsibilities as part of agreeing the terms of engagement. Since [proposed] ISA 580 (Revised and Redrafted), “Written Representations” requires the auditor to request written representations about the validity of these premises, it may also be appropriate to make management aware that receipt of such representations from relevant parties will be expected together with specific written representations. It also may be useful to agree with management, or those charged with governance, who the relevant parties are.

5c.

When management, or those charged with governance, will not make the necessary acknowledgement and agreement, or will not provide the requested general or specific

PROPOSED CONFORMING AMENDMENTS

written representations, the auditor will be unable to obtain sufficient appropriate audit evidence. In such circumstances, it may not be appropriate for the auditor to accept the engagement. In some cases, however, law or regulation prevents the auditor from refusing an engagement. In these cases, the auditor may need to explain to management and those charged with governance the importance of these matters, and the effect that they may have on the opinion in the auditor’s report.

Posted on April 3, 2021 by MJ — 1 Comment

UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT AND ASSESSING THE RISKS OF MATERIAL MISSTATEMENT

Introduction

The purpose of this International Standard on Auditing (ISA) is to establish standards and to provide guidance on obtaining an understanding of the entity and its environment, including its internal control, and on assessing the risks of material misstatement in a financial statement audit. The importance of the auditor’s risk assessment as a basis for further audit procedures is discussed in the explanation of audit risk in ISA 200, “Objective and General Principles Governing an Audit of Financial Statements.”
The auditor should obtain an understanding of the entity and its environment, including its internal control, sufficient to identify and assess the risks of material misstatement of the financial statements whether due to fraud or error, and sufficient to design and perform further audit procedures. ISA 500, “Audit Evidence,” requires the auditor to use assertions in sufficient detail to form a basis for the assessment of risks of material misstatement and the design and performance of further audit procedures. This ISA requires the auditor to make risk assessments at the financial statement and assertion levels based on an appropriate understanding of the entity and its environment, including its internal control. ISA 330, “The Auditor’s Procedures in Response to Assessed Risks” discusses the auditor’s responsibility to determine overall responses and to design and perform further audit procedures whose nature, timing, and extent are responsive to the risk assessments. The requirements and guidance of this ISA are to be applied in conjunction with the requirements and guidance provided in other ISAs. In particular, further guidance in relation to the auditor’s responsibility to assess the risks of material misstatement due to fraud is discussed in ISA 240, “The Auditor’s Responsibility to Consider Fraud in an Audit of Financial Statements.”
The following is an overview of the requirements of this standard:
- Risk assessment procedures and sources of information about the entity and its environment, including its internal control. This section explains the audit procedures that the auditor is required to perform to obtain the understanding of the entity and its environment, including its internal control (risk assessment procedures). It also requires discussion among the engagement team about the susceptibility of the entity’s financial statements to material misstatement.
- Understanding the entity and its environment, including its internal control. This section requires the auditor to understand specified aspects of the entity and its environment, and components of its internal control, in order to identify and assess the risks of material misstatement.
- Assessing the risks of material misstatement. This section requires the auditor to identify and assess the risks of material misstatement at the financial statement and assertion levels. The auditor:

◦ Identifies risks by considering the entity and its environment, including relevant controls, and by considering the classes of transactions, account balances, and disclosures in the financial statements; ◦ Relates the identified risks to what can go wrong at the assertion level; and

◦ Considers the significance and likelihood of the risks.

This section also requires the auditor to determine whether any of the assessed risks are significant risks that require special audit consideration or risks for which substantive procedures alone do not provide sufficient appropriate audit evidence. The auditor is required to evaluate the design of the entity’s controls, including relevant control activities, over such risks and determine whether they have been implemented.

Communicating with those charged with governance and management. This section deals with matters relating to internal control that the auditor communicates to those charged with governance and management.
Documentation. This section establishes related documentation requirements.

Obtaining an understanding of the entity and its environment is an essential aspect of performing an audit in accordance with ISAs. In particular, that understanding establishes a frame of reference within which the auditor plans the audit and exercises professional judgment about assessing risks of material misstatement of the financial statements and responding to those risks throughout the audit, for example when:
- Establishing materiality and evaluating whether the judgment about materiality remains appropriate as the audit progresses;
- Considering the appropriateness of the selection and application of accounting policies, and the adequacy of financial statement disclosures;
- Identifying areas where special audit consideration may be necessary, for example, related party transactions, the appropriateness of management’s use of the going concern assumption, or considering the business purpose of transactions;
- Developing expectations for use when performing analytical procedures;
- Designing and performing further audit procedures to reduce audit risk to an acceptably low level; and
- Evaluating the sufficiency and appropriateness of audit evidence obtained, such as the appropriateness of assumptions and of management’s oral and written representations.
The auditor uses professional judgment to determine the extent of the understanding required of the entity and its environment, including its internal control. The auditor’s primary consideration is whether the understanding that has been obtained is sufficient to assess the risks of material misstatement of the financial statements and to design and perform further audit procedures. The depth of the overall understanding that is required by the auditor in performing the audit is less than that possessed by management in managing the entity.

Risk Assessment Procedures and Sources of Information About the Entity and Its Environment, Including Its Internal Control

Obtaining an understanding of the entity and its environment, including its internal control, is a continuous, dynamic process of gathering, updating and analyzing information throughout the audit. As described in ISA 500, audit procedures to obtain an understanding are referred to as “risk assessment procedures” because some of the information obtained by performing such procedures may be used by the auditor as audit evidence to support assessments of the risks of material misstatement. In addition, in performing risk assessment procedures, the auditor may obtain audit evidence about classes of transactions, account balances, or disclosures and related assertions and about the operating effectiveness of controls, even though such audit procedures were not specifically planned as substantive procedures or as tests of controls. The auditor also may choose to perform substantive procedures or tests of controls concurrently with risk assessment procedures because it is efficient to do so.

Risk Assessment Procedures

The auditor should perform the following risk assessment procedures to obtain an understanding of the entity and its environment, including its internal control:
- Inquiries of management and others within the entity;
- Analytical procedures; and
- Observation and inspection.

The auditor is not required to perform all the risk assessment procedures described above for each aspect of the understanding described in paragraph 20. However, all the risk assessment procedures are performed by the auditor in the course of obtaining the required understanding.

In addition, the auditor performs other audit procedures where the information obtained may be helpful in identifying risks of material misstatement. For example, the auditor may consider making inquiries of the entity’s external legal counsel or of valuation experts that the entity has used. Reviewing information obtained from external sources such as reports by analysts, banks, or rating agencies; trade and economic journals; or regulatory or financial publications may also be useful in obtaining information about the entity.
Although much of the information the auditor obtains by inquiries can be obtained from management and those responsible for financial reporting, inquiries of others within the entity, such as production and internal audit personnel, and other employees with different levels of authority, may be useful in providing the auditor with a different perspective in identifying risks of material misstatement. In determining others within the entity to whom inquiries may be directed, and the extent of those inquiries, the auditor considers what information may be obtained that helps the auditor in identifying risks of material misstatement. For example:
- Inquiries directed towards those charged with governance may help the auditor understand the environment in which the financial statements are prepared.
- Inquiries directed toward internal audit personnel may relate to their activities concerning the design and effectiveness of the entity’s internal control and whether management has satisfactorily responded to any findings from these activities.
- Inquiries of employees involved in initiating, processing or recording complex or unusual transactions may help the auditor in evaluating the appropriateness of the selection and application of certain accounting policies.
- Inquiries directed toward in-house legal counsel may relate to such matters as litigation, compliance with laws and regulations, knowledge of fraud or suspected fraud affecting the entity, warranties, post-sales obligations, arrangements (such as joint ventures) with business partners and the meaning of contract terms.
- Inquiries directed towards marketing or sales personnel may relate to changes in the entity’s marketing strategies, sales trends, or contractual arrangements with its customers.
Analytical procedures may be helpful in identifying the existence of unusual transactions or events, and amounts, ratios, and trends that might indicate matters that have financial statement and audit implications. In performing analytical procedures as risk assessment procedures, the auditor develops expectations about plausible relationships that are reasonably expected to exist. When comparison of those expectations with recorded amounts or ratios developed from recorded amounts yields unusual or unexpected relationships, the auditor considers those results in identifying risks of material misstatement. However, when such analytical procedures use data aggregated at a high level (which is often the situation), the results of those analytical procedures only provide a broad initial indication about whether a material misstatement may exist. Accordingly, the auditor considers the results of such analytical procedures along with other information gathered in identifying the risks of material misstatement. See ISA 520, “Analytical Procedures” for additional guidance on the use of analytical procedures.
Observation and inspection may support inquiries of management and others, and also provide information about the entity and its environment. Such audit procedures ordinarily include the following:
- Observation of entity activities and operations.
- Inspection of documents (such as business plans and strategies), records, and internal control manuals.
- Reading reports prepared by management (such as quarterly management reports and interim financial statements) and those charged with governance (such as minutes of board of directors’ meetings).
- Visits to the entity’s premises and plant facilities.
- Tracing transactions through the information system relevant to financial reporting (walk-throughs).
When the auditor intends to use information about the entity and its environment obtained in prior periods, the auditor should determine whether changes have occurred that may affect the relevance of such information in the current audit. For continuing engagements, the auditor’s previous experience with the entity contributes to the understanding of the entity. For example, audit procedures performed in previous audits ordinarily provide audit evidence about the entity’s organizational structure, business and controls, as well as information about past misstatements and whether or not they were corrected on a timely basis, which assists the auditor in assessing risks of material misstatement in the current audit. However, such information may have been rendered irrelevant by changes in the entity or its environment. The auditor makes inquiries and performs other appropriate audit procedures, such as walk-throughs of systems, to determine whether changes have occurred that may affect the relevance of such information.
When relevant to the audit, the auditor also considers other information such as that obtained from the auditor’s client acceptance or continuance process or, where practicable, experience gained on other engagements performed for the entity, for example, engagements to review interim financial information.

Discussion Among the Engagement Team

The members of the engagement team should discuss the susceptibility of the entity’s financial statements to material misstatements.
The objective of this discussion is for members of the engagement team to gain a better understanding of the potential for material misstatements of the financial statements resulting from fraud or error in the specific areas assigned to them, and to understand how the results of the audit procedures that they perform may affect other aspects of the audit including the decisions about the nature, timing, and extent of further audit procedures.
The discussion provides an opportunity for more experienced engagement team members, including the engagement partner, to share their insights based on their knowledge of the entity, and for the team members to exchange information about the business risks^[1] to which the entity is subject and about how and where the financial statements might be susceptible to material misstatement. As required by ISA 240, particular emphasis is given to the susceptibility of the entity’s financial statements to material misstatement due to fraud. The discussion also addresses application of the applicable financial reporting framework to the entity’s facts and circumstances.
Professional judgment is used to determine which members of the engagement team are included in the discussion, how and when it occurs, and the extent of the discussion. The key members of the engagement team are ordinarily involved in the discussion; however, it is not necessary for all team members to have a comprehensive knowledge of all aspects of the audit. The extent of the discussion is influenced by the roles, experience, and information needs of the engagement team members. In a multi-location audit, for example, there may be multiple discussions that involve the key members of the engagement team in each significant location. Another factor to consider in planning the discussions is whether to include experts assigned to the engagement team. For example, the auditor may determine that including a professional possessing specialist information technology (IT)^[2] or other skills is needed on the engagement team and therefore includes that individual in the discussion.
As required by ISA 200, the auditor plans and performs the audit with an attitude of professional skepticism. The discussion among the engagement team members emphasizes the need to maintain professional skepticism throughout the engagement, to be alert for information or other conditions that indicate that a material misstatement due to fraud or error may have occurred, and to be rigorous in following up on such indications.
Depending on the circumstances of the audit, there may be further discussions in order to facilitate the ongoing exchange of information between engagement team members regarding the susceptibility of the entity’s financial statements

to material misstatements. The purpose is for engagement team members to communicate and share information obtained throughout the audit that may affect the assessment of the risks of material misstatement due to fraud or error or the audit procedures performed to address the risks.

Understanding the Entity and Its Environment, Including Its Internal Control

The auditor’s understanding of the entity and its environment consists of an understanding of the following aspects:
- Industry, regulatory, and other external factors, including the applicable financial reporting framework.
- Nature of the entity, including the entity’s selection and application of accounting policies.
- Objectives and strategies and the related business risks that may result in a material misstatement of the financial statements.
- Measurement and review of the entity’s financial performance.
- Internal control.

[1] See paragraph 30.

[2] Information technology (IT) encompasses automated means of originating, processing, storing and communicating information, and includes recording devices, communication systems, computer systems (including hardware and software components and data), and other electronic devices.

Appendix 1 contains examples of matters that the auditor may consider in obtaining an understanding of the entity and its environment relating to categories (a) through (d) above. Appendix 2 contains a detailed explanation of the internal control components.

The nature, timing, and extent of the risk assessment procedures performed depend on the circumstances of the engagement such as the size and complexity of the entity and the auditor’s experience with it. In addition, identifying significant changes in any of the above aspects of the entity from prior periods is particularly important in gaining a sufficient understanding of the entity to identify and assess risks of material misstatement.

Industry, Regulatory and Other External Factors, Including the Applicable

Financial Reporting Framework

The auditor should obtain an understanding of relevant industry, regulatory, and other external factors including the applicable financial reporting framework. These factors include industry conditions such as the competitive environment, supplier and customer relationships, and technological developments; the regulatory environment encompassing, among other matters, the applicable financial reporting framework, the legal and political environment, and environmental requirements affecting the industry and the entity; and other external factors such as general economic conditions. See ISA 250, “Consideration of Laws and Regulations in an Audit of Financial Statements” for additional requirements related to the legal and regulatory framework applicable to the entity and the industry.
The industry in which the entity operates may give rise to specific risks of material misstatement arising from the nature of the business or the degree of regulation. For example, long-term contracts may involve significant estimates of revenues and costs that give rise to risks of material misstatement. In such cases, the auditor considers whether the engagement team includes members with sufficient relevant knowledge and experience.
Legislative and regulatory requirements often determine the applicable financial reporting framework to be used by management in preparing the entity’s financial statements. In most cases, the applicable financial reporting framework will be that of the jurisdiction in which the entity is registered or operates and the auditor is based, and the auditor and the entity will have a common understanding of that framework. In some cases there may be no local financial reporting framework, in which case the entity’s choice will be governed by local practice, industry practice, user needs, or other factors. For example, the entity’s competitors may apply International Financial Reporting Standards (IFRS) and the entity may determine that IFRS are also appropriate for its financial reporting requirements. The auditor considers whether local regulations specify certain financial reporting requirements for the industry in which the entity operates, since the financial statements may be materially misstated in the context of the applicable financial reporting framework if management fails to prepare the financial statements in accordance with such regulations.

Nature of the Entity

The auditor should obtain an understanding of the nature of the entity. The nature of an entity refers to the entity’s operations, its ownership and governance, the types of investments that it is making and plans to make, the way that the entity is structured and how it is financed. An understanding of the nature of an entity enables the auditor to understand the classes of transactions, account balances, and disclosures to be expected in the financial statements.
The entity may have a complex structure with subsidiaries or other components in multiple locations. In addition to the difficulties of consolidation in such cases, other issues with complex structures that may give rise to risks of material misstatement include: the allocation of goodwill to business segments, and its impairment; whether investments are joint ventures, subsidiaries, or investments accounted for using the equity method; and whether special-purpose entities are accounted for appropriately.
An understanding of the ownership and relations between owners and other people or entities is also important in determining whether related party transactions have been identified and accounted for appropriately. ISA 550, “Related Parties” provides additional guidance on the auditor’s considerations relevant to related parties.
The auditor should obtain an understanding of the entity’s selection and application of accounting policies and consider whether they are appropriate for its business and consistent with the applicable financial reporting framework and accounting polices used in the relevant industry. The understanding encompasses the methods the entity uses to account for significant and unusual transactions; the effect of significant accounting policies in controversial or emerging areas for which there is a lack of authoritative guidance or consensus; and changes in the entity’s accounting policies. The auditor also identifies financial reporting standards and regulations that are new to the entity and considers when and how the entity will adopt such requirements. Where the entity has changed its selection of or method of applying a significant accounting policy, the auditor considers the reasons for the change and whether it is appropriate and consistent with the requirements of the applicable financial reporting framework.
The presentation of financial statements in conformity with the applicable financial reporting framework includes adequate disclosure of material matters. These matters relate to the form, arrangement, and content of the financial statements and their appended notes, including, for example, the terminology used, the amount of detail given, the classification of items in the statements, and the basis of amounts set forth. The auditor considers whether the entity has disclosed a particular matter appropriately in light of the circumstances and facts of which the auditor is aware at the time.

Objectives and Strategies and Related Business Risks

The auditor should obtain an understanding of the entity’s objectives and strategies, and the related business risks that may result in material misstatement of the financial statements. The entity conducts its business in the context of industry, regulatory and other internal and external factors. To respond to these factors, the entity’s management or those charged with governance define objectives, which are the overall plans for the entity. Strategies are the operational approaches by which management intends to achieve its objectives. Business risks result from significant conditions, events, circumstances, actions or inactions that could adversely affect the entity’s ability to achieve its objectives and execute its strategies, or through the setting of inappropriate objectives and strategies. Just as the external environment changes, the conduct of the entity’s business is also dynamic and the entity’s strategies and objectives change over time.
Business risk is broader than the risk of material misstatement of the financial statements, though it includes the latter. Business risk particularly may arise from change or complexity, though a failure to recognize the need for change

may also give rise to risk. Change may arise, for example, from the development of new products that may fail; from an inadequate market, even if successfully developed; or from flaws that may result in liabilities and reputational risk. An understanding of business risks increases the likelihood of identifying risks of material misstatement. However, the auditor does not have a responsibility to identify or assess all business risks.

Most business risks will eventually have financial consequences and, therefore, an effect on the financial statements. However, not all business risks give rise to risks of material misstatement. A business risk may have an immediate consequence for the risk of misstatement for classes of transactions, account balances, and disclosures at the assertion level or the financial statements as a whole. For example, the business risk arising from a contracting customer base due to industry consolidation may increase the risk of misstatement associated with the valuation of receivables. However, the same risk, particularly in combination with a contracting economy, may also have a longer-term consequence, which the auditor considers when assessing the appropriateness of the going concern assumption. The auditor’s consideration of whether a business risk may result in material misstatement is, therefore, made in light of the entity’s circumstances. Examples of conditions and events that may indicate risks of material misstatement are given in Appendix 3.
Usually management identifies business risks and develops approaches to address them. Such a risk assessment process is part of internal control and is discussed in paragraphs 76-79.
Smaller entities often do not set their objectives and strategies, or manage the related business risks, through formal plans or processes. In many cases there may be no documentation of such matters. In such entities, the auditor’s understanding is ordinarily obtained through inquiries of management and observation of how the entity responds to such matters.

Measurement and Review of the Entity’s Financial Performance

The auditor should obtain an understanding of the measurement and review of the entity’s financial performance. Performance measures and their review indicate to the auditor aspects of the entity’s performance that management and others consider to be of importance. Performance measures, whether external or internal, create pressures on the entity that, in turn, may motivate management to take action to improve the business performance or to misstate the financial statements. Obtaining an understanding of the entity’s performance measures assists the auditor in considering whether such pressures result in management actions that may have increased the risks of material misstatement.
Management’s measurement and review of the entity’s financial performance is to be distinguished from the monitoring of controls (discussed as a component of internal control in paragraphs 96-99), though their purposes may overlap. Monitoring of controls, however, is specifically concerned with the effective operation of internal control through consideration of information about the control. The measurement and review of performance is directed at whether business performance is meeting the objectives set by management (or third parties), but in some cases performance indicators also provide information that enables management to identify deficiencies in internal control.
Internally-generated information used by management for this purpose may include key performance indicators (financial and non-financial), budgets, variance analysis, segment information and divisional, departmental or other level performance reports, and comparisons of an entity’s performance with that of competitors. External parties may also measure and review the entity’s financial performance. For example, external information such as analysts’ reports and credit rating agency reports may provide information useful to the auditor’s understanding of the entity and its environment. Such reports often are obtained from the entity being audited.
Internal measures may highlight unexpected results or trends requiring management’s inquiry of others in order to determine their cause and take corrective action (including, in some cases, the detection and correction of misstatements on a timely basis). Performance measures may also indicate to the auditor a risk of misstatement of related financial statement information. For example, performance measures may indicate that the entity has unusually rapid growth or profitability when compared to that of other entities in the same industry. Such information, particularly if combined with other factors such as performance-based bonus or incentive remuneration, may indicate the potential risk of management bias in the preparation of the financial statements.
Much of the information used in performance measurement may be produced by the entity’s information system. If management assumes that data used for reviewing the entity’s performance are accurate without having a basis for that assumption, errors may exist in the information, potentially leading management to incorrect conclusions about performance. When the auditor intends to make use of the performance measures for the purpose of the audit (for example, for analytical procedures), the auditor considers whether the information related to management’s review of the entity’s performance provides a reliable basis and is sufficiently precise for such a purpose. If making use of performance measures, the auditor considers whether they are precise enough to detect material misstatements.
Smaller entities ordinarily do not have formal processes to measure and review the entity’s financial performance. Management nevertheless often relies on certain key indicators which knowledge and experience of the business suggest are reliable bases for evaluating financial performance and taking appropriate action.

Internal Control

The auditor should obtain an understanding of internal control relevant to the audit. The auditor uses the understanding of internal control to identify types of potential misstatements, consider factors that affect the risks of material misstatement, and design the nature, timing, and extent of further audit procedures. Internal control relevant to the audit is discussed in paragraphs 47-53 below. In addition, the depth of the understanding is discussed in paragraphs 54-56 below.
Internal control is the process designed and effected by those charged with governance, management, and other personnel to provide reasonable assurance about the achievement of the entity’s objectives with regard to reliability of financial reporting, effectiveness and efficiency of operations and compliance with applicable laws and regulations. It follows that internal control is designed and implemented to address identified business risks that threaten the achievement of any of these objectives.
Internal control, as discussed in this ISA, consists of the following components:
- The control environment.
- The entity’s risk assessment process.
- The information system, including the related business processes, relevant to financial reporting, and communication.
- Control activities.
- Monitoring of controls.

Appendix 2 contains a detailed discussion of the internal control components.

The division of internal control into the five components provides a useful framework for auditors to consider how different aspects of an entity’s internal control may affect the audit. The division does not necessarily reflect how an entity considers and implements internal control. Also, the auditor’s primary consideration is whether, and how, a specific control prevents, or detects and corrects, material misstatements in classes of transactions, account balances, or disclosures, and their related assertions, rather than its classification into any particular component. Accordingly, auditors may use different terminology or frameworks to describe the various aspects of internal control, and their effect on the audit than those used in this ISA, provided all the components described in this ISA are addressed.

The way in which internal control is designed and implemented varies with an entity’s size and complexity. Specifically, smaller entities may use less formal means and simpler processes and procedures to achieve their objectives. For example, smaller entities with active management involvement in the financial reporting process may not have extensive descriptions of accounting procedures or detailed written policies. For some entities, in particular very small entities, the owner-manager^[1] may perform functions which in a larger entity would be regarded as belonging to several

[1] This ISA uses the term “owner-manager” to indicate the proprietors of entities who are involved in the running of the entity on a day-to-day basis.

of the components of internal control. Therefore, the components of internal control may not be clearly distinguished within smaller entities, but their underlying purposes are equally valid.
For the purposes of this ISA, the term “internal control” encompasses all five components of internal control stated above. In addition, the term “controls” refers to one or more of the components, or any aspect thereof.

Controls Relevant to the Audit

There is a direct relationship between an entity’s objectives and the controls it implements to provide reasonable assurance about their achievement. The entity’s objectives, and therefore controls, relate to financial reporting, operations and compliance; however, not all of these objectives and controls are relevant to the auditor’s risk assessment.
Ordinarily, controls that are relevant to an audit pertain to the entity’s objective of preparing financial statements for external purposes that give a true and fair view (or are presented fairly, in all material respects) in accordance with the applicable financial reporting framework and the management of risk that may give rise to a material misstatement in those financial statements. It is a matter of the auditor’s professional judgment, subject to the requirements of this ISA, whether a control, individually or in combination with others, is relevant to the auditor’s considerations in assessing the risks of material misstatement and designing and performing further procedures in response to assessed risks. In exercising that judgment, the auditor considers the circumstances, the applicable component and factors such as the following:
- The auditor’s judgment about materiality.
- The size of the entity.
- The nature of the entity’s business, including its organization and ownership characteristics.
- The diversity and complexity of the entity’s operations.
- Applicable legal and regulatory requirements.
- The nature and complexity of the systems that are part of the entity’s internal control, including the use of service organizations.
Controls over the completeness and accuracy of information produced by the entity may also be relevant to the audit if the auditor intends to make use of the information in designing and performing further procedures. The auditor’s previous experience with the entity and information obtained in understanding the entity and its environment and throughout the audit assists the auditor in identifying controls relevant to the audit. Further, although internal control applies to the entire entity or to any of its operating units or business processes, an understanding of internal control relating to each of the entity’s operating units and business processes may not be relevant to the audit.
Controls relating to operations and compliance objectives may, however, be relevant to an audit if they pertain to data the auditor evaluates or uses in applying audit procedures. For example, controls pertaining to non-financial data that the auditor uses in analytical procedures, such as production statistics, or controls pertaining to detecting non-compliance with laws and regulations that may have a direct and material effect on the financial statements, such as controls over compliance with income tax laws and regulations used to determine the income tax provision, may be relevant to an audit.
An entity generally has controls relating to objectives that are not relevant to an audit and therefore need not be considered. For example, an entity may rely on a sophisticated system of automated controls to provide efficient and effective operations (such as a commercial airline’s system of automated controls to maintain flight schedules), but these controls ordinarily would not be relevant to the audit.
Internal control over safeguarding of assets against unauthorized acquisition, use, or disposition may include controls relating to financial reporting and operations objectives. In obtaining an understanding of each of the components of internal control, the auditor’s consideration of safeguarding controls is generally limited to those relevant to the reliability of financial reporting. For example, use of access controls, such as passwords, that limit access to the data and programs that process cash disbursements may be relevant to a financial statement audit. Conversely, controls to prevent the excessive use of materials in production generally are not relevant to a financial statement audit.
Controls relevant to the audit may exist in any of the components of internal control and a further discussion of controls relevant to the audit is included under the heading of each internal control component below. In addition, paragraphs 113 and 115 discuss certain risks for which the auditor is required to evaluate the design of the entity’s controls over such risks and determine whether they have been implemented.

Depth of Understanding of Internal Control

Obtaining an understanding of internal control involves evaluating the design of a control and determining whether it has been implemented. Evaluating the design of a control involves considering whether the control, individually or in combination with other controls, is capable of effectively preventing, or detecting and correcting, material misstatements. Further explanation is contained in the discussion of each internal control component below. Implementation of a control means that the control exists and that the entity is using it. The auditor considers the design of a control in determining whether to consider its implementation. An improperly designed control may represent a material weakness^[1] in the entity’s internal control and the auditor considers whether to communicate this to those charged with governance and management as required by paragraph 120.
Risk assessment procedures to obtain audit evidence about the design and implementation of relevant controls may include inquiring of entity personnel, observing the application of specific controls, inspecting documents and reports, and tracing transactions through the information system relevant to financial reporting. Inquiry alone is not sufficient to evaluate the design of a control relevant to an audit and to determine whether it has been implemented.
Obtaining an understanding of an entity’s controls is not sufficient to serve as testing the operating effectiveness of controls, unless there is some automation that provides for the consistent application of the operation of the control (manual and automated elements of internal control relevant to the audit are further described below). For example, obtaining audit evidence about the implementation of a manually operated control at a point in time does not provide audit evidence about the operating effectiveness of the control at other times during the period under audit. However, IT enables an entity to process large volumes of data consistently and enhances the entity’s ability to monitor the performance of control activities and to achieve effective segregation of duties by implementing security controls in applications, databases, and operating systems. Therefore, because of the inherent consistency of IT processing, performing audit procedures to determine whether an automated control has been implemented may serve as a test of that control’s operating effectiveness, depending on the auditor’s assessment and testing of controls such as those over program changes. Tests of the operating effectiveness of controls are further described in ISA 330.

Characteristics of Manual and Automated Elements of Internal Control Relevant to the Auditor’s Risk Assessment

Most entities make use of IT systems for financial reporting and operational purposes. However, even when IT is extensively used, there will be manual elements to the systems. The balance between manual and automated elements varies. In certain cases, particularly smaller, less complex entities, the systems may be primarily manual. In other cases, the extent of automation may vary with some systems substantially automated with few related manual elements and others, even within the same entity, predominantly manual. As a result, an entity’s system of internal control is likely to contain manual and automated elements, the characteristics of which are relevant to the auditor’s risk assessment and further audit procedures based thereon.
The use of manual or automated elements in internal control also affects the manner in which transactions are initiated, recorded, processed, and reported.^[2] Controls in a manual system may include such procedures as approvals and reviews of activities, and reconciliations and follow-up of reconciling items. Alternatively, an entity may use automated procedures to initiate, record, process, and report transactions, in which case records in electronic format replace such paper documents as purchase orders, invoices, shipping documents, and related accounting records. Controls in IT systems consist of a combination of automated controls (for example, controls embedded in computer programs) and manual controls. Further, manual controls may be independent of IT, may use information produced by IT, or may be limited to monitoring the effective functioning of IT and of automated controls, and to handling exceptions. When IT is used to initiate, record, process or report transactions, or other financial data for inclusion in financial statements, the systems and programs may include controls related to the corresponding assertions for material accounts or may be critical to the effective functioning of manual controls that depend on IT. An entity’s mix of manual and automated controls varies with the nature and complexity of the entity’s use of IT.
Generally, IT provides potential benefits of effectiveness and efficiency for an entity’s internal control because it enables an entity to:
- Consistently apply predefined business rules and perform complex calculations in processing large volumes of transactions or data;
- Enhance the timeliness, availability, and accuracy of information;
- Facilitate the additional analysis of information;
- Enhance the ability to monitor the performance of the entity’s activities and its policies and procedures;
- Reduce the risk that controls will be circumvented; and
- Enhance the ability to achieve effective segregation of duties by implementing security controls in applications, databases, and operating systems.
IT also poses specific risks to an entity’s internal control, including the following:
- Reliance on systems or programs that are inaccurately processing data, processing inaccurate data, or both.
- Unauthorized access to data that may result in destruction of data or improper changes to data, including the recording of unauthorized or nonexistent transactions, or inaccurate recording of transactions. Particular risks may arise where multiple users access a common database.
- The possibility of IT personnel gaining access privileges beyond those necessary to perform their assigned duties thereby breaking down segregation of duties.
- Unauthorized changes to data in master files.
- Unauthorized changes to systems or programs.
- Failure to make necessary changes to systems or programs.
- Inappropriate manual intervention.
- Potential loss of data or inability to access data as required.
Manual aspects of systems may be more suitable where judgment and discretion are required such as for the following circumstances:
- Large, unusual or non-recurring transactions.
- Circumstances where errors are difficult to define, anticipate or predict.
- In changing circumstances that require a control response outside the scope of an existing automated control.
- In monitoring the effectiveness of automated controls.
Manual controls are performed by people, and therefore pose specific risks to the entity’s internal control. Manual controls may be less reliable than automated controls because they can be more easily bypassed, ignored, or overridden and they are also more prone to simple errors and mistakes. Consistency of application of a manual control element cannot therefore be assumed. Manual systems may be less suitable for the following:
- High volume or recurring transactions, or in situations where errors that can be anticipated or predicted can be prevented or detected by control parameters that are automated.
- Control activities where the specific ways to perform the control can be adequately designed and automated.
The extent and nature of the risks to internal control vary depending on the nature and characteristics of the entity’s information system. Therefore in understanding internal control, the auditor considers whether the entity has responded adequately to the risks arising from the use of IT or manual systems by establishing effective controls.

Limitations of Internal Control

Internal control, no matter how well designed and operated, can provide an entity with only reasonable assurance about achieving the entity’s financial reporting objectives. The likelihood of achievement is affected by limitations inherent to internal control. These include the realities that human judgment in decision-making can be faulty and that breakdowns in internal control can occur because of human failures, such as simple errors or mistakes. For example, if an entity’s information system personnel do not completely understand how an order entry system processes sales transactions, they may erroneously design changes to the system to process sales for a new line of products. On the other hand, such changes may be correctly designed but misunderstood by individuals who translate the design into program code. Errors also may occur in the use of information produced by IT. For example, automated controls may be designed to report transactions over a specified amount for management review, but individuals responsible for conducting the review may not understand the purpose of such reports and, accordingly, may fail to review them or investigate unusual items.
Additionally, controls can be circumvented by the collusion of two or more people or inappropriate management override of internal control. For example, management may enter into side agreements with customers that alter the terms and conditions of the entity’s standard sales contracts, which may result in improper revenue recognition. Also, edit checks in a software program that are designed to identify and report transactions that exceed specified credit limits may be overridden or disabled.
Smaller entities often have fewer employees which may limit the extent to which segregation of duties is practicable. However, for key areas, even in a very small entity, it can be practicable to implement some degree of segregation of duties or other form of unsophisticated but effective controls. The potential for override of controls by the owner-manager depends to a great extent on the control environment and in particular, the owner-manager’s attitudes about the importance of internal control.

Control Environment

The auditor should obtain an understanding of the control environment. The control environment includes the governance and management functions and the attitudes, awareness, and actions of those charged with governance and management concerning the entity’s internal control and its importance in the entity. The control environment sets the tone of an organization, influencing the control consciousness of its people. It is the foundation for effective internal control, providing discipline and structure.
The primary responsibility for the prevention and detection of fraud and error rests with both those charged with governance and the management of an entity. In evaluating the design of the control environment and determining whether it has been implemented, the auditor understands how management, with the oversight of those charged with governance, has created and maintained a culture of honesty and ethical behavior, and established appropriate controls to prevent and detect fraud and error within the entity.
In evaluating the design of the entity’s control environment, the auditor considers the following elements and how they have been incorporated into the entity’s processes:
- Communication and enforcement of integrity and ethical values – essential elements which influence the effectiveness of the design, administration and monitoring of controls.
- Commitment to competence – management’s consideration of the competence levels for particular jobs and how those levels translate into requisite skills and knowledge.
- Participation by those charged with governance – independence from management, their experience and stature, the extent of their involvement and scrutiny of activities, the information they receive, the degree to which difficult questions are raised and pursued with management and their interaction with internal and external auditors.
- Management’s philosophy and operating style – management’s approach to taking and managing business risks, and management’s attitudes and actions toward financial reporting, information processing and accounting functions and personnel.
- Organizational structure – the framework within which an entity’s activities for achieving its objectives are planned, executed, controlled and reviewed.
- Assignment of authority and responsibility – how authority and responsibility for operating activities are assigned and how reporting relationships and authorization hierarchies are established.
- Human resource policies and practices – recruitment, orientation, training, evaluating, counseling, promoting, compensating and remedial actions.
In understanding the control environment elements, the auditor also considers whether they have been implemented. Ordinarily, the auditor obtains relevant audit evidence through a combination of inquiries and other risk assessment procedures, for example, corroborating inquiries through observation or inspection of documents. For example, through inquiries of management and employees, the auditor may obtain an understanding of how management communicates to employees its views on business practices and ethical behavior. The auditor determines whether controls have been implemented by considering, for example, whether management has established a formal code of conduct and whether it acts in a manner that supports the code or condones violations of, or authorizes exceptions to the code.
Audit evidence for elements of the control environment may not be available in documentary form, in particular for smaller entities where communication between management and other personnel may be informal, yet effective. For example, management’s commitment to ethical values and competence are often implemented through the behavior and attitude they demonstrate in managing the entity’s business instead of in a written code of conduct. Consequently, management’s attitudes, awareness and actions are of particular importance in the design of a smaller entity’s control environment. In addition, the role of those charged with governance is often undertaken by the ownermanager where there are no other owners.
The overall responsibilities of those charged with governance are recognized in codes of practice and other regulations or guidance produced for the benefit of those charged with governance. It is one, but not the only, role of those charged with governance to counterbalance pressures on management in relation to financial reporting. For example, the basis for management remuneration may place stress on management arising from the conflicting demands of fair reporting and the perceived benefits of improved results. In understanding the design of the control environment, the auditor considers such matters as the independence of the directors and their ability to evaluate the actions of management. The auditor also considers whether there is an audit committee that understands the entity’s business transactions and evaluates whether the financial statements give a true and fair view (or are presented fairly, in all material respects) in accordance with the applicable financial reporting framework.
The nature of an entity’s control environment is such that it has a pervasive effect on assessing the risks of material misstatement. For example, ownermanager controls may mitigate a lack of segregation of duties in a small business, or an active and independent board of directors may influence the philosophy and operating style of senior management in larger entities. The auditor’s evaluation of the design of the entity’s control environment includes considering whether the strengths in the control environment elements collectively provide an appropriate foundation for the other components of internal control, and are not undermined by control environment weaknesses. For example, human resource policies and practices directed toward hiring competent financial, accounting, and IT personnel may not mitigate a strong bias by top management to overstate earnings. Changes in the control environment may affect the relevance of information obtained in prior audits. For example, management’s decision to commit additional resources for training and awareness of financial reporting activities may reduce the risk of errors in processing financial information. Alternatively, management’s failure to commit sufficient resources to address security risks presented by IT may adversely affect internal control by allowing improper changes to be made to computer programs or to data, or by allowing unauthorized transactions to be processed.
The existence of a satisfactory control environment can be a positive factor when the auditor assesses the risks of material misstatement and as explained in paragraph 5 of ISA 330, influences the nature, timing, and extent of the auditor’s further procedures. In particular, it may help reduce the risk of fraud, although a satisfactory control environment is not an absolute deterrent to fraud. Conversely, weaknesses in the control environment may undermine the effectiveness of controls and therefore be negative factors in the auditor’s assessment of the risks of material misstatement, in particular in relation to fraud.
The control environment in itself does not prevent, or detect and correct, a material misstatement in classes of transactions, account balances, and disclosures and related assertions. The auditor, therefore, ordinarily considers the effect of other components along with the control environment when assessing the risks of material misstatement; for example, the monitoring of controls and the operation of specific control activities.

The Entity’s Risk Assessment Process

The auditor should obtain an understanding of the entity’s process for identifying business risks relevant to financial reporting objectives and deciding about actions to address those risks, and the results thereof. The process is described as the “entity’s risk assessment process” and forms the basis for how management determines the risks to be managed.
In evaluating the design and implementation of the entity’s risk assessment process, the auditor determines how management identifies business risks relevant to financial reporting, estimates the significance of the risks, assesses the likelihood of their occurrence, and decides upon actions to manage them. If the entity’s risk assessment process is appropriate to the circumstances, it assists the auditor in identifying risks of material misstatement.
The auditor inquires about business risks that management has identified and considers whether they may result in material misstatement. During the audit, the auditor may identify risks of material misstatement that management failed to identify. In such cases, the auditor considers whether there was an underlying risk of a kind that should have been identified by the entity’s risk assessment process, and if so, why that process failed to do so and whether the process is appropriate to its circumstances. If, as a result, the auditor judges that there is a material weakness in the entity’s risk assessment process, the auditor communicates to those charged with governance as required by paragraph 120.
In a smaller entity, management may not have a formal risk assessment process as described in paragraph 76. For such entities, the auditor discusses with management how risks to the business are identified by management and how they are addressed.

Information System, Including the Related Business Processes, Relevant to Financial Reporting, and Communication

The information system relevant to financial reporting objectives, which includes the accounting system, consists of the procedures and records established to initiate, record, process, and report entity transactions (as well as events and conditions) and to maintain accountability for the related assets, liabilities, and equity.
The auditor should obtain an understanding of the information system, including the related business processes, relevant to financial reporting, including the following areas:
- The classes of transactions in the entity’s operations that are significant to the financial statements.
- The procedures, within both IT and manual systems, by which those transactions are initiated, recorded, processed and reported in the financial statements.
- The related accounting records, whether electronic or manual, supporting information, and specific accounts in the financial statements, in respect of initiating, recording, processing and reporting transactions.
- How the information system captures events and conditions, other than classes of transactions, that are significant to the financial statements.
- The financial reporting process used to prepare the entity’s financial statements, including significant accounting estimates and disclosures.
In obtaining this understanding, the auditor considers the procedures used to transfer information from transaction processing systems to general ledger or financial reporting systems. The auditor also understands the entity’s procedures to capture information relevant to financial reporting for events and conditions other than transactions, such as the depreciation and amortization of assets and changes in the recoverability of accounts receivables.
An entity’s information system typically includes the use of standard journal entries that are required on a recurring basis to record transactions such as sales, purchases, and cash disbursements in the general ledger, or to record accounting estimates that are periodically made by management, such as changes in the estimate of uncollectible accounts receivable.
An entity’s financial reporting process also includes the use of non-standard journal entries to record non-recurring, unusual transactions or adjustments. Examples of such entries include consolidating adjustments and entries for a business combination or disposal or non-recurring estimates such as an asset impairment. In manual, paper-based general ledger systems, non-standard journal entries may be identified through inspection of ledgers, journals, and supporting documentation. However, when automated procedures are used to maintain the general ledger and prepare financial statements, such entries may exist only in electronic form and may be more easily identified through the use of computer-assisted audit techniques.
Preparation of the entity’s financial statements include procedures that are designed to ensure information required to be disclosed by the applicable financial reporting framework is accumulated, recorded, processed, summarized and appropriately reported in the financial statements.
In obtaining an understanding, the auditor considers risks of material misstatement associated with inappropriate override of controls over journal entries and the controls surrounding non-standard journal entries. For example, automated processes and controls may reduce the risk of inadvertent error but do not overcome the risk that individuals may inappropriately override such automated processes, for example, by changing the amounts being automatically passed to the general ledger or financial reporting system. Furthermore, the auditor maintains an awareness that when IT is used to transfer information automatically, there may be little or no visible evidence of such intervention in the information systems.
The auditor also understands how the incorrect processing of transactions is resolved, for example, whether there is an automated suspense file and how it is used by the entity to ensure that suspense items are cleared out on a timely basis, and how system overrides or bypasses to controls are processed and accounted for.
The auditor obtains an understanding of the entity’s information system relevant to financial reporting in a manner that is appropriate to the entity’s circumstances. This includes obtaining an understanding of how transactions originate within the entity’s business processes. An entity’s business processes are the activities designed to develop, purchase, produce, sell and distribute an entity’s products and services; ensure compliance with laws and regulations; and record information, including accounting and financial reporting information.
The auditor should understand how the entity communicates financial reporting roles and responsibilities and significant matters relating to financial reporting. Communication involves providing an understanding of individual roles and responsibilities pertaining to internal control over financial reporting and may take such forms as policy manuals and financial reporting manuals. It includes the extent to which personnel understand how their activities in the financial reporting information system relate to the work of others and the means of reporting exceptions to an appropriate higher level within the entity. Open communication channels help ensure that exceptions are reported and acted on. The auditor’s understanding of communication pertaining to financial reporting matters also includes communications between management and those charged with governance, particularly the audit committee, as well as external communications such as those with regulatory authorities.

Control Activities

The auditor should obtain a sufficient understanding of control activities to assess the risks of material misstatement at the assertion level and to design further audit procedures responsive to assessed risks. Control activities are the policies and procedures that help ensure that management directives are carried out; for example, that necessary actions are taken to address risks that threaten the achievement of the entity’s objectives. Control activities, whether within IT or manual systems, have various objectives and are applied at various organizational and functional levels. Examples of specific control activities include those relating to the following:
- Performance reviews.
- Information processing.
- Physical controls.
- Segregation of duties.
In obtaining an understanding of control activities, the auditor’s primary consideration is whether, and how, a specific control activity, individually or in combination with others, prevents, or detects and corrects, material misstatements in classes of transactions, account balances, or disclosures. Control activities relevant to the audit are those for which the auditor considers

it necessary to obtain an understanding in order to assess risks of material misstatement at the assertion level and to design and perform further audit procedures responsive to the assessed risks. An audit does not require an understanding of all the control activities related to each significant class of transactions, account balance, and disclosure in the financial statements or to every assertion relevant to them. The auditor’s emphasis is on identifying and obtaining an understanding of control activities that address the areas where the auditor considers that material misstatements are more likely to occur. When multiple control activities achieve the same objective, it is unnecessary to obtain an understanding of each of the control activities related to such objective.

The auditor considers the knowledge about the presence or absence of control activities obtained from the understanding of the other components of internal control in determining whether it is necessary to devote additional attention to obtaining an understanding of control activities. In considering whether control activities are relevant to the audit, the auditor considers the risks the auditor has identified that may give rise to material misstatement. Also, control activities are relevant to the audit if the auditor is required to evaluate them as discussed in paragraphs 113 and 115.
The auditor should obtain an understanding of how the entity has responded to risks arising from IT. The use of IT affects the way that control activities are implemented. The auditor considers whether the entity has responded adequately to the risks arising from IT by establishing effective general IT-controls and application controls. From the auditor’s perspective, controls over IT systems are effective when they maintain the integrity of information and the security of the data such systems process.
General IT-controls are policies and procedures that relate to many applications and support the effective functioning of application controls by helping to ensure the continued proper operation of information systems. General IT-controls that maintain the integrity of information and security of data commonly include controls over the following:
- Data center and network operations.
- System software acquisition, change and maintenance.
- Access security.
- Application system acquisition, development, and maintenance.

They are generally implemented to deal with the risks referred to in paragraph 60 above.

Application controls are manual or automated procedures that typically operate at a business process level. Application controls can be preventative or detective in nature and are designed to ensure the integrity of the accounting records. Accordingly, application controls relate to procedures used to initiate, record, process and report transactions or other financial data. These controls help ensure that transactions occurred, are authorized, and are completely and accurately recorded and processed. Examples include edit checks of input data, and numerical sequence checks with manual follow-up of exception reports or correction at the point of data entry.

Monitoring of Controls

The auditor should obtain an understanding of the major types of activities that the entity uses to monitor internal control over financial reporting, including those related to those control activities relevant to the audit, and how the entity initiates corrective actions to its controls.
Monitoring of controls is a process to assess the effectiveness of internal control performance over time. It involves assessing the design and operation of controls on a timely basis and taking necessary corrective actions modified for changes in conditions. Management accomplishes monitoring of controls through ongoing activities, separate evaluations, or a combination of the two. Ongoing monitoring activities are often built into the normal recurring activities of an entity and include regular management and supervisory activities.
In many entities, internal auditors or personnel performing similar functions contribute to the monitoring of an entity’s activities. See ISA 610, “Considering the Work of Internal Auditing” for additional guidance. Management’s monitoring activities may also include using information from communications from external parties such as customer complaints and regulator comments that may indicate problems or highlight areas in need of improvement.
Much of the information used in monitoring may be produced by the entity’s information system. If management assumes that data used for monitoring are accurate without having a basis for that assumption, errors may exist in the information, potentially leading management to incorrect conclusions from its monitoring activities. The auditor obtains an understanding of the sources of the information related to the entity’s monitoring activities, and the basis upon which management considers the information to be sufficiently reliable for the purpose. When the auditor intends to make use of the entity’s information produced for monitoring activities, such as internal auditors’ reports, the auditor considers whether the information provides a reliable basis and is sufficiently detailed for the auditor’s purpose.

Assessing the Risks of Material Misstatement

The auditor should identify and assess the risks of material misstatement at the financial statement level, and at the assertion level for classes of transactions, account balances, and disclosures. For this purpose, the auditor:
- Identifies risks throughout the process of obtaining an understanding of the entity and its environment, including relevant controls that relate to the risks, and by considering the classes of transactions, account balances, and disclosures in the financial statements;
- Relates the identified risks to what can go wrong at the assertion level;
- Considers whether the risks are of a magnitude that could result in a material misstatement of the financial statements; and
- Considers the likelihood that the risks could result in a material misstatement of the financial statements.
The auditor uses information gathered by performing risk assessment procedures, including the audit evidence obtained in evaluating the design of controls and determining whether they have been implemented, as audit evidence to support the risk assessment. The auditor uses the risk assessment to determine the nature, timing, and extent of further audit procedures to be performed.
The auditor determines whether the identified risks of material misstatement relate to specific classes of transactions, account balances, and disclosures and related assertions, or whether they relate more pervasively to the financial statements as a whole and potentially affect many assertions. The latter risks (risks at the financial statement level) may derive in particular from a weak control environment.
The nature of the risks arising from a weak control environment is such that they are not likely to be confined to specific individual risks of material misstatement in particular classes of transactions, account balances, and disclosures. Rather, weaknesses such as management’s lack of competence may have a more pervasive effect on the financial statements and may require an overall response by the auditor.
In making risk assessments, the auditor may identify the controls that are likely to prevent, or detect and correct, material misstatement in specific assertions. Generally, the auditor gains an understanding of controls and relates them to assertions in the context of processes and systems in which they exist. Doing so is useful because individual control activities often do not in themselves address a risk. Often only multiple control activities, together with other elements of internal control, will be sufficient to address a risk.
Conversely, some control activities may have a specific effect on an individual assertion embodied in a particular class of transactions or account balance. For example, the control activities that an entity established to ensure that its personnel are properly counting and recording the annual physical inventory relate directly to the existence and completeness assertions for the inventory account balance.
Controls can be either directly or indirectly related to an assertion. The more indirect the relationship, the less effective that control may be in preventing, or detecting and correcting, misstatements in that assertion. For example, a sales manager’s review of a summary of sales activity for specific stores by region ordinarily is only indirectly related to the completeness assertion for sales revenue. Accordingly, it may be less effective in reducing risk for that assertion than controls more directly related to that assertion, such as matching shipping documents with billing documents.
The auditor’s understanding of internal control may raise doubts about the auditability of an entity’s financial statements. Concerns about the integrity of the entity’s management may be so serious as to cause the auditor to conclude that the risk of management misrepresentation in the financial statements is such that an audit cannot be conducted. Also, concerns about the condition and reliability of an entity’s records may cause the auditor to conclude that it is unlikely that sufficient appropriate audit evidence will be available to support an unqualified opinion on the financial statements. In such circumstances, the auditor considers a qualification or disclaimer of opinion, but in some cases the auditor’s only recourse may be to withdraw from the engagement.

Significant Risks that Require Special Audit Consideration

As part of the risk assessment as described in paragraph 100, the auditor should determine which of the risks identified are, in the auditor’s judgment, risks that require special audit consideration (such risks are defined as “significant risks”). In addition, ISA 330, paragraphs 44 and 51 describe the consequences for further audit procedures of identifying a risk as significant.
The determination of significant risks, which arise on most audits, is a matter for the auditor’s professional judgment. In exercising this judgment, the auditor excludes the effect of identified controls related to the risk to determine whether the nature of the risk, the likely magnitude of the potential misstatement including the possibility that the risk may give rise to multiple misstatements, and the likelihood of the risk occurring are such that they require special audit consideration. Routine, non-complex transactions that are subject to systematic processing are less likely to give rise to significant risks because they have lower inherent risks. On the other hand, significant risks are often derived from business risks that may result in a material misstatement. In considering the nature of the risks, the auditor considers a number of matters, including the following:
- Whether the risk is a risk of fraud.
- Whether the risk is related to recent significant economic, accounting or other developments and, therefore, requires specific attention.
- The complexity of transactions.
- Whether the risk involves significant transactions with related parties.
- The degree of subjectivity in the measurement of financial information related to the risk especially those involving a wide range of measurement uncertainty.
- Whether the risk involves significant transactions that are outside the normal course of business for the entity, or that otherwise appear to be unusual.
Significant risks often relate to significant non-routine transactions and judgmental matters. Non-routine transactions are transactions that are unusual, either due to size or nature, and that therefore occur infrequently. Judgmental matters may include the development of accounting estimates for which there is significant measurement uncertainty.
Risks of material misstatement may be greater for risks relating to significant non-routine transactions arising from matters such as the following:
- Greater management intervention to specify the accounting treatment.
- Greater manual intervention for data collection and processing.
- Complex calculations or accounting principles.
- The nature of non-routine transactions, which may make it difficult for the entity to implement effective controls over the risks.
Risks of material misstatement may be greater for risks relating to significant judgmental matters that require the development of accounting estimates, arising from matters such as the following:
- Accounting principles for accounting estimates or revenue recognition may be subject to differing interpretation.
- Required judgment may be subjective, complex or require assumptions about the effects of future events, for example, judgment about fair value.
For significant risks, to the extent the auditor has not already done so, the auditor should evaluate the design of the entity’s related controls, including relevant control activities, and determine whether they have been implemented. An understanding of the entity’s controls related to significant risks is required to provide the auditor with adequate information to develop an effective audit approach. Management ought to be aware of significant risks; however, risks relating to significant non-routine or judgmental matters are often less likely to be subject to routine controls. Therefore, the auditor’s understanding of whether the entity has designed and implemented controls for such significant risks includes whether and how management responds to the risks and whether control activities such as a review of assumptions by senior management or experts, formal processes for estimations or approval by those charged with governance have been implemented to address the risks. For example, where there are one-off events such as the receipt of notice of a significant lawsuit, consideration of the entity’s response will include such matters as whether it has been referred to appropriate experts (such as internal or external legal counsel), whether an assessment has been made of the potential effect, and how it is proposed that the circumstances are to be disclosed in the financial statements.
If management has not appropriately responded by implementing controls over significant risks and if, as a result, the auditor judges that there is a material weakness in the entity’s internal control, the auditor communicates this matter to those charged with governance as required by paragraph 120. In these circumstances, the auditor also considers the implications for the auditor’s risk assessment.

Risks for which Substantive Procedures Alone Do Not Provide Sufficient

Appropriate Audit Evidence

As part of the risk assessment as described in paragraph 100, the auditor should evaluate the design and determine the implementation of the entity’s controls, including relevant control activities, over those risks for which, in the auditor’s judgment, it is not possible or practicable to reduce the risks of material misstatement at the assertion level to an acceptably low level with audit evidence obtained only from substantive procedures. The consequences for further audit procedures of identifying such risks are described in paragraph 25 of ISA 330.
The understanding of the entity’s information system relevant to financial reporting enables the auditor to identify risks of material misstatement that relate directly to the recording of routine classes of transactions or account balances, and the preparation of reliable financial statements; these include risks of inaccurate or incomplete processing. Ordinarily, such risks relate to significant classes of transactions such as an entity’s revenue, purchases, and cash receipts or cash payments.
The characteristics of routine day-to-day business transactions often permit highly automated processing with little or no manual intervention. In such circumstances, it may not be possible to perform only substantive procedures in relation to the risk. For example, in circumstances where a significant amount of an entity’s information is initiated, recorded, processed, or reported electronically such as in an integrated system, the auditor may determine that it is not possible to design effective substantive procedures that by themselves would provide sufficient appropriate audit evidence that relevant classes of transactions or account balances, are not materially misstated. In such cases, audit evidence may be available only in electronic form, and its sufficiency and appropriateness usually depend on the effectiveness of controls over its accuracy and completeness. Furthermore, the potential for improper initiation or alteration of information to occur and not be detected may be greater if information is initiated, recorded, processed or reported only in electronic form and appropriate controls are not operating effectively.
Examples of situations where the auditor may find it impossible to design effective substantive procedures that by themselves provide sufficient appropriate audit evidence that certain assertions are not materially misstated include the following:
- An entity that conducts its business using IT to initiate orders for the purchase and delivery of goods based on predetermined rules of what to order and in what quantities and to pay the related accounts payable based on system-generated decisions initiated upon the confirmed receipt of goods and terms of payment. No other documentation of orders placed or goods received is produced or maintained, other than through the IT system.
- An entity that provides services to customers via electronic media (for example, an Internet service provider or a telecommunications company) and uses IT to create a log of the services provided to its customers, initiate and process its billings for the services and automatically record such amounts in electronic accounting records that are part of the system used to produce the entity’s financial statements.

Revision of Risk Assessment

The auditor’s assessment of the risks of material misstatement at the assertion level is based on available audit evidence and may change during the course of the audit as additional audit evidence is obtained. In particular, the risk assessment may be based on an expectation that controls are operating effectively to prevent, or detect and correct, a material misstatement at the assertion level. In performing tests of controls to obtain audit evidence about their operating effectiveness, the auditor may obtain audit evidence that controls are not operating effectively at relevant times during the audit. Similarly, in performing substantive procedures the auditor may detect misstatements in amounts or frequency greater than is consistent with the auditor’s risk assessments. In circumstances where the auditor obtains audit evidence from performing further audit procedures that tends to contradict the audit evidence on which the auditor originally based the assessment, the auditor revises the assessment and modifies the further planned audit procedures accordingly. See paragraphs 66 and 70 of ISA 330 for further guidance.

Communicating with Those Charged with Governance and Management

The auditor should make those charged with governance or management aware, as soon as practicable, and at an appropriate level of responsibility,

of material weaknesses in the design or implementation of internal control which have come to the auditor’s attention.

If the auditor identifies risks of material misstatement which the entity has either not controlled, or for which the relevant control is inadequate, or if in the auditor’s judgment there is a material weakness in the entity’s risk assessment process, then the auditor includes such internal control weaknesses in the communication of audit matters of governance interest. See ISA 260,

“Communications of Audit Matters with Those Charged with Governance.”

Documentation

The auditor should document:
- The discussion among the engagement team regarding the susceptibility of the entity’s financial statements to material misstatement due to error or fraud, and the significant decisions reached;
- Key elements of the understanding obtained regarding each of the aspects of the entity and its environment identified in paragraph 20, including each of the internal control components identified in paragraph 43, to assess the risks of material misstatement of the financial statements; the sources of information from which the understanding was obtained; and the risk assessment procedures;
- The identified and assessed risks of material misstatement at the financial statement level and at the assertion level as required by paragraph 100; and
- The risks identified and related controls evaluated as a result of the requirements in paragraphs 113 and 115.
The manner in which these matters are documented is for the auditor to determine using professional judgment. In particular, the results of the risk assessment may be documented separately, or may be documented as part of the auditor’s documentation of further procedures (see paragraph 73 of ISA 330 for additional guidance). Examples of common techniques, used alone or in combination include narrative descriptions, questionnaires, check lists and flow charts. Such techniques may also be useful in documenting the auditor’s assessment of the risks of material misstatement at the overall financial statement and assertions level. The form and extent of this documentation is influenced by the nature, size and complexity of the entity and its internal control, availability of information from the entity and the specific audit methodology and technology used in the course of the audit. For example, documentation of the understanding of a complex information system in which a large volume of transactions are electronically initiated, recorded, processed, or reported may include flowcharts, questionnaires, or decision tables. For an information system making limited or no use of IT or for which few transactions are processed (for example, long-term debt), documentation in the form of a memorandum may be sufficient. Ordinarily, the more complex the entity and the more extensive the audit procedures performed by the auditor, the more extensive the auditor’s documentation will be. ISA 230, “Audit Documentation” provides guidance regarding documentation in the context of the audit of financial statements.

Effective Date

This ISA is effective for audits of financial statements for periods beginning on or after December 15, 2004.

Public Sector Perspective

When carrying out audits of public sector entities, the auditor takes into account the legislative framework and any other relevant regulations, ordinances or ministerial directives that affect the audit mandate and any other special auditing requirements. Therefore in obtaining an understanding of the regulatory framework as required in paragraph 22 of this ISA, auditors will have regard to the legislation and proper authority governing the operation of an entity. Similarly in respect of paragraph 30 of this ISA the auditor should be aware that the “management objectives” of public sector entities may be influenced by concerns regarding public accountability and may include objectives which have their source in legislation, regulations, government ordinances, and ministerial directives.
Paragraphs 47-53 of this ISA explain the controls relevant to the audit. Public sector auditors often have additional responsibilities with respect to internal controls, for example to report on compliance with an established Code of Practice. Public sector auditors can also have responsibilities to report on the compliance with legislative authorities. Their review of internal controls may be broader and more detailed.
Paragraphs 120 and 121 of this ISA deals with communication of weaknesses. There may be additional communication or reporting requirements for public sector auditors. For example, internal control weaknesses may have to be reported to the legislature or other governing body.

[1] A material weakness in internal control is one that could have a material effect on the financial statements.

[2] Paragraph 9 of Appendix 2 defines initiation, recording, processing, and reporting as used throughout this ISA.

Appendix 1

Understanding the Entity and Its Environment

This appendix provides additional guidance on matters the auditor may consider when obtaining an understanding of the industry, regulatory, and other external factors that affect the entity, including the applicable financial reporting framework; the nature of the entity; objectives and strategies and related business risks; and measurement and review of the entity’s financial performance. The examples provided cover a broad range of matters applicable to many engagements; however, not all matters are relevant to every engagement and the list of examples is not necessarily complete. Additional guidance on internal control is contained in Appendix 2.

Industry, Regulatory and Other External Factors, Including the Applicable

Financial Reporting Framework

Examples of matters an auditor may consider include the following:

Industry conditions ◦ The market and competition, including demand, capacity, and price competition

◦ Cyclical or seasonal activity

◦ Product technology relating to the entity’s products

◦ Energy supply and cost

Regulatory environment

◦	Accounting principles and industry specific practices
◦	Regulatory framework for a regulated industry
◦	Legislation and regulation that significantly affect the entity’s operations – Regulatory requirements – Direct supervisory activities
◦	Taxation (corporate and other)
◦	Government policies currently affecting the conduct of the entity’s business – Monetary, including foreign exchange controls – Fiscal – Financial incentives (for example, government aid programs) – Tariffs, trade restrictions
◦	Environmental requirements affecting the industry and the entity’s business

Other external factors currently affecting the entity’s business

◦ General level of economic activity (for example, recession, growth)

◦ Interest rates and availability of financing

◦ Inflation, currency revaluation

Nature of the Entity

Examples of matters an auditor may consider include the following:

Business Operations

Nature of revenue sources (for example, manufacturer, wholesaler, banking, insurance or other financial services, import/export trading, utility, transportation, and technology products and services)
Products or services and markets (for example, major customers and contracts, terms of payment, profit margins, market share, competitors, exports, pricing policies, reputation of products, warranties, order book, trends, marketing strategy and objectives, manufacturing processes)
Conduct of operations (for example, stages and methods of production, business segments, delivery or products and services, details of declining or expanding operations)
Alliances, joint ventures, and outsourcing activities
Involvement in electronic commerce, including Internet sales and marketing activities
Geographic dispersion and industry segmentation
Location of production facilities, warehouses, and offices
Key customers
Important suppliers of goods and services (for example, long-term contracts, stability of supply, terms of payment, imports, methods of delivery such as “just-intime”)
Employment (for example, by location, supply, wage levels, union contracts, pension and other post employment benefits, stock option or incentive bonus arrangements, and government regulation related to employment matters)
Research and development activities and expenditures
Transactions with related parties

Investments • Acquisitions, mergers or disposals of business activities (planned or recently executed)

Investments and dispositions of securities and loans
Capital investment activities, including investments in plant and equipment and technology, and any recent or planned changes
Investments in non-consolidated entities, including partnerships, joint ventures and special-purpose entities

Financing

Group structure – major subsidiaries and associated entities, including consolidated and non-consolidated structures
Debt structure, including covenants, restrictions, guarantees, and off-balance-sheet financing arrangements
Leasing of property, plant or equipment for use in the business
Beneficial owners (local, foreign, business reputation and experience)
Related parties
Use of derivative financial instruments

Financial Reporting

Accounting principles and industry specific practices
Revenue recognition practices
Accounting for fair values
Inventories (for example, locations, quantities)
Foreign currency assets, liabilities and transactions
Industry-specific significant categories (for example, loans and investments for banks, accounts receivable and inventory for manufacturers, research and development for pharmaceuticals)
Accounting for unusual or complex transactions including those in controversial or emerging areas (for example, accounting for stock-based compensation)
Financial statement presentation and disclosure

Objectives and Strategies and Related Business Risks

Examples of matters an auditor may consider include the following:

Existence of objectives (i.e., how the entity addresses industry, regulatory and other external factors) relating to, for example, the following:

◦ Industry developments (a potential related business risk might be, for example, that the entity does not have the personnel or expertise to deal with the changes in the industry)

◦	New products and services (a potential related business risk might be, for example, that there is increased product liability)
◦	Expansion of the business (a potential related business risk might be, for example, that the demand has not been accurately estimated)
◦	New accounting requirements (a potential related business risk might be, for example, incomplete or improper implementation, or increased costs)
◦	Regulatory requirements (a potential related business risk might be, for example, that there is increased legal exposure)
◦	Current and prospective financing requirements (a potential related business risk might be, for example, the loss of financing due to the entity’s inability to meet requirements)
◦	Use of IT (a potential related business risk might be, for example, that systems and processes are incompatible)

Effects of implementing a strategy, particularly any effects that will lead to new accounting requirements (a potential related business risk might be, for example, incomplete or improper implementation)

Measurement and Review of the Entity’s Financial Performance

Examples of matters an auditor may consider include the following:

Key ratios and operating statistics
Key performance indicators
Employee performance measures and incentive compensation policies
Trends
Use of forecasts, budgets and variance analysis
Analyst reports and credit rating reports
Competitor analysis
Period-on-period financial performance (revenue growth, profitability, leverage)

Appendix 2

Internal Control Components

As set out in paragraph 43 and described in paragraphs 67-99, internal control consists of the following components:
- The control environment;
- The entity’s risk assessment process;
- The information system, including the related business processes, relevant to financial reporting, and communication;
- Control activities; and
- Monitoring of controls.

This appendix further explains the above components as they relate to a financial statement audit.

Control Environment

The control environment includes the attitudes, awareness, and actions of management and those charged with governance concerning the entity’s internal control and its importance in the entity. The control environment also includes the governance and management functions and sets the tone of an organization, influencing the control consciousness of its people. It is the foundation for effective internal control, providing discipline and structure.
The control environment encompasses the following elements:
- Communication and enforcement of integrity and ethical values. The effectiveness of controls cannot rise above the integrity and ethical values of the people who create, administer, and monitor them. Integrity and ethical values are essential elements of the control environment which influence the effectiveness of the design, administration, and monitoring of other components of internal control. Integrity and ethical behavior are the product of the entity’s ethical and behavioral standards, how they are communicated, and how they are reinforced in practice. They include management’s actions to remove or reduce incentives and temptations that might prompt personnel to engage in dishonest, illegal, or unethical acts. They also include the communication of entity values and behavioral standards to personnel through policy statements and codes of conduct and by example.
- Commitment to competence. Competence is the knowledge and skills necessary to accomplish tasks that define the individual’s job. Commitment to competence includes management’s consideration of

the competence levels for particular jobs and how those levels translate into requisite skills and knowledge.

Participation by those charged with governance. An entity’s control consciousness is influenced significantly by those charged with governance. Attributes of those charged with governance include independence from management, their experience and stature, the extent of their involvement and scrutiny of activities, the appropriateness of their actions, the information they receive, the degree to which difficult questions are raised and pursued with management, and their interaction with internal and external auditors. The importance of responsibilities of those charged with governance is recognized in codes of practice and other regulations or guidance produced for the benefit of those charged with governance. Other responsibilities of those charged with governance include oversight of the design and effective operation of whistle blower procedures and the process for reviewing the effectiveness of the entity’s internal control.
Management’s philosophy and operating style. Management’s philosophy and operating style encompass a broad range of characteristics. Such characteristics may include the following: management’s approach to taking and monitoring business risks; management’s attitudes and actions toward financial reporting (conservative or aggressive selection from available alternative accounting principles, and conscientiousness and conservatism with which accounting estimates are developed); and management’s attitudes toward information processing and accounting functions and personnel.
Organizational structure. An entity’s organizational structure provides the framework within which its activities for achieving entity-wide objectives are planned, executed, controlled, and reviewed. Establishing a relevant organizational structure includes considering key areas of authority and responsibility and appropriate lines of reporting. An entity develops an organizational structure suited to its needs. The appropriateness of an entity’s organizational structure depends, in part, on its size and the nature of its activities.
Assignment of authority and responsibility. This factor includes how authority and responsibility for operating activities are assigned and how reporting relationships and authorization hierarchies are established. It also includes policies relating to appropriate business practices, knowledge and experience of key personnel, and resources provided for carrying out duties. In addition, it includes policies and communications directed at ensuring that all personnel understand the entity’s objectives, know how their individual actions interrelate and contribute to those objectives, and recognize how and for what they will be held accountable.
Human resource policies and practices. Human resource policies and practices relate to recruitment, orientation, training, evaluating, counseling, promoting, compensating, and remedial actions. For example, standards for recruiting the most qualified individuals – with emphasis on educational background, prior work experience, past accomplishments, and evidence of integrity and ethical behavior – demonstrate an entity’s commitment to competent and trustworthy people. Training policies that communicate prospective roles and responsibilities and include practices such as training schools and seminars illustrate expected levels of performance and behavior. Promotions driven by periodic performance appraisals demonstrate the entity’s commitment to the advancement of qualified personnel to higher levels of responsibility.

Application to Small Entities

Small entities may implement the control environment elements differently than larger entities. For example, small entities might not have a written code of conduct but, instead, develop a culture that emphasizes the importance of integrity and ethical behavior through oral communication and by management example. Similarly, those charged with governance in small entities may not include an independent or outside member.

Entity’s Risk Assessment Process

An entity’s risk assessment process is its process for identifying and responding to business risks and the results thereof. For financial reporting purposes, the entity’s risk assessment process includes how management identifies risks relevant to the preparation of financial statements that give a true and fair view (or are presented fairly, in all material respects) in accordance with the entity’s applicable financial reporting framework, estimates their significance, assesses the likelihood of their occurrence, and decides upon actions to manage them. For example, the entity’s risk assessment process may address how the entity considers the possibility of unrecorded transactions or identifies and analyzes significant estimates recorded in the financial statements. Risks relevant to reliable financial reporting also relate to specific events or transactions.
Risks relevant to financial reporting include external and internal events and circumstances that may occur and adversely affect an entity’s ability to initiate, record, process, and report financial data consistent with the assertions of management in the financial statements. Once risks are identified, management considers their significance, the likelihood of their occurrence, and how they should be managed. Management may initiate plans, programs, or actions to address specific risks or it may decide to accept a risk because of cost or other considerations. Risks can arise or change due to circumstances such as the following:
- Changes in operating environment. Changes in the regulatory or operating environment can result in changes in competitive pressures and significantly different risks.
- New personnel. New personnel may have a different focus on or understanding of internal control.
- New or revamped information systems. Significant and rapid changes in information systems can change the risk relating to internal control.
- Rapid growth. Significant and rapid expansion of operations can strain controls and increase the risk of a breakdown in controls.
- New technology. Incorporating new technologies into production processes or information systems may change the risk associated with internal control.
- New business models, products, or activities. Entering into business areas or transactions with which an entity has little experience may introduce new risks associated with internal control.
- Corporate restructurings. Restructurings may be accompanied by staff reductions and changes in supervision and segregation of duties that may change the risk associated with internal control.
- Expanded foreign operations. The expansion or acquisition of foreign operations carries new and often unique risks that may affect internal control, for example, additional or changed risks from foreign currency transactions.
- New accounting pronouncements. Adoption of new accounting principles or changing accounting principles may affect risks in preparing financial statements.

Application to Small Entities

The basic concepts of the entity’s risk assessment process are relevant to every entity, regardless of size, but the risk assessment process is likely to be less formal and less structured in small entities than in larger ones. All entities should have established financial reporting objectives, but they may be recognized implicitly rather than explicitly in small entities. Management may be aware of risks related to these objectives without the use of a formal process but through direct personal involvement with employees and outside parties.

Information System, Including the Related Business Processes, Relevant to

Financial Reporting, and Communication

An information system consists of infrastructure (physical and hardware components), software, people, procedures, and data. Infrastructure and software will be absent, or have less significance, in systems that are exclusively or primarily manual. Many information systems make extensive use of information technology (IT).
The information system relevant to financial reporting objectives, which includes the financial reporting system, consists of the procedures and records established to initiate, record, process, and report entity transactions (as well as events and conditions) and to maintain accountability for the related assets, liabilities, and equity. Transactions may be initiated manually or automatically by programmed procedures. Recording includes identifying and capturing the relevant information for transactions or events. Processing includes functions such as edit and validation, calculation, measurement, valuation, summarization, and reconciliation, whether performed by automated or manual procedures. Reporting relates to the preparation of financial reports as well as other information, in electronic or printed format, that the entity uses in measuring and reviewing the entity’s financial performance and in other functions. The quality of system-generated information affects management’s ability to make appropriate decisions in managing and controlling the entity’s activities and to prepare reliable financial reports.
Accordingly, an information system encompasses methods and records that:
- Identify and record all valid transactions.
- Describe on a timely basis the transactions in sufficient detail to permit proper classification of transactions for financial reporting.
- Measure the value of transactions in a manner that permits recording their proper monetary value in the financial statements.
- Determine the time period in which transactions occurred to permit recording of transactions in the proper accounting period.
- Present properly the transactions and related disclosures in the financial statements.
Communication involves providing an understanding of individual roles and responsibilities pertaining to internal control over financial reporting. It includes the extent to which personnel understand how their activities in the financial reporting information system relate to the work of others and the means of reporting exceptions to an appropriate higher level within the entity. Open communication channels help ensure that exceptions are reported and acted on.
Communication takes such forms as policy manuals, accounting and financial reporting manuals, and memoranda. Communication also can be made electronically, orally, and through the actions of management.

Application to Small Entities

Information systems and related business processes relevant to financial reporting in small entities are likely to be less formal than in larger entities, but their role is just as significant. Small entities with active management involvement may not need extensive descriptions of accounting procedures, sophisticated accounting records, or written policies. Communication may be less formal and easier to achieve in a small entity than in a larger entity due to the small entity’s size and fewer levels as well as management’s greater visibility and availability.

Control Activities

Control activities are the policies and procedures that help ensure that management directives are carried out, for example, that necessary actions are taken to address risks that threaten the achievement of the entity’s objectives. Control activities, whether within IT or manual systems, have various objectives and are applied at various organizational and functional levels.
Generally, control activities that may be relevant to an audit may be categorized as policies and procedures that pertain to the following:
- Performance reviews. These control activities include reviews and analyses of actual performance versus budgets, forecasts, and prior period performance; relating different sets of data – operating or financial – to one another, together with analyses of the relationships and investigative and corrective actions; comparing internal data with external sources of information; and review of functional or activity performance, such as a bank’s consumer loan manager’s review of reports by branch, region, and loan type for loan approvals and collections.
- Information processing. A variety of controls are performed to check accuracy, completeness, and authorization of transactions. The two broad groupings of information systems control activities are application controls and general IT-controls. Application controls apply to the processing of individual applications. These controls help ensure that transactions occurred, are authorized, and are completely and accurately recorded and processed. Examples of application controls include checking the arithmetical accuracy of records, maintaining and reviewing accounts and trial balances, automated controls such as edit checks of input data and numerical sequence checks, and manual follow-up of exception reports. General IT-controls are polices and procedures that relate to many applications and support the effective functioning of application controls by helping to ensure the continued proper operation

of information systems. General IT-controls commonly include controls over data center and network operations; system software acquisition, change and maintenance; access security; and application system acquisition, development, and maintenance. These controls apply to mainframe, miniframe, and end-user environments. Examples of such general IT-controls are program change controls, controls that restrict access to programs or data, controls over the implementation of new releases of packaged software applications, and controls over system software that restrict access to or monitor the use of system utilities that could change financial data or records without leaving an audit trail. • Physical controls. These activities encompass the physical security of assets, including adequate safeguards such as secured facilities over access to assets and records; authorization for access to computer programs and data files; and periodic counting and comparison with amounts shown on control records (for example comparing the results of cash, security and inventory counts with accounting records). The extent to which physical controls intended to prevent theft of assets are relevant to the reliability of financial statement preparation, and therefore the audit, depends on circumstances such as when assets are highly susceptible to misappropriation. For example, these controls would ordinarily not be relevant when any inventory losses would be detected pursuant to periodic physical inspection and recorded in the financial statements. However, if for financial reporting purposes management relies solely on perpetual inventory records, the physical security controls would be relevant to the audit.

Segregation of duties. Assigning different people the responsibilities of authorizing transactions, recording transactions, and maintaining custody of assets is intended to reduce the opportunities to allow any person to be in a position to both perpetrate and conceal errors or fraud in the normal course of the person’s duties. Examples of segregation of duties include reporting, reviewing and approving reconciliations, and approval and control of documents.

Certain control activities may depend on the existence of appropriate higher level policies established by management or those charged with governance. For example, authorization controls may be delegated under established guidelines, such as investment criteria set by those charged with governance; alternatively, non-routine transactions such as major acquisitions or divestments may require specific high level approval, including in some cases that of shareholders.

Application to Small Entities

The concepts underlying control activities in small entities are likely to be similar to those in larger entities, but the formality with which they operate

varies. Further, small entities may find that certain types of control activities are not relevant because of controls applied by management. For example, management’s retention of authority for approving credit sales, significant purchases, and draw-downs on lines of credit can provide strong control over those activities, lessening or removing the need for more detailed control activities. An appropriate segregation of duties often appears to present difficulties in small entities. Even companies that have only a few employees, however, may be able to assign their responsibilities to achieve appropriate segregation or, if that is not possible, to use management oversight of the incompatible activities to achieve control objectives.

Monitoring of Controls

An important management responsibility is to establish and maintain internal control on an ongoing basis. Management’s monitoring of controls includes considering whether they are operating as intended and that they are modified as appropriate for changes in conditions. Monitoring of controls may include activities such as management’s review of whether bank reconciliations are being prepared on a timely basis, internal auditors’ evaluation of sales personnel’s compliance with the entity’s policies on terms of sales contracts, and a legal department’s oversight of compliance with the entity’s ethical or business practice policies.
Monitoring of controls is a process to assess the quality of internal control performance over time. It involves assessing the design and operation of controls on a timely basis and taking necessary corrective actions. Monitoring is done to ensure that controls continue to operate effectively. For example, if the timeliness and accuracy of bank reconciliations are not monitored, personnel are likely to stop preparing them. Monitoring of controls is accomplished through ongoing monitoring activities, separate evaluations, or a combination of the two.
Ongoing monitoring activities are built into the normal recurring activities of an entity and include regular management and supervisory activities. Managers of sales, purchasing, and production at divisional and corporate levels are in touch with operations and may question reports that differ significantly from their knowledge of operations.
In many entities, internal auditors or personnel performing similar functions contribute to the monitoring of an entity’s controls through separate evaluations. They regularly provide information about the functioning of internal control, focusing considerable attention on evaluating the design and operation of internal control. They communicate information about strengths and weaknesses and recommendations for improving internal control.
Application to Small Entities
Monitoring activities may include using information from communications from external parties that may indicate problems or highlight areas in need of improvement. Customers implicitly corroborate billing data by paying their invoices or complaining about their charges. In addition, regulators may communicate with the entity concerning matters that affect the functioning of internal control, for example, communications concerning examinations by bank regulatory agencies. Also, management may consider communications relating to internal control from external auditors in performing monitoring activities.

Ongoing monitoring activities of small entities are more likely to be informal and are typically performed as a part of the overall management of the entity’s operations. Management’s close involvement in operations often will identify significant variances from expectations and inaccuracies in financial data leading to corrective action to the control.

Appendix 3

Conditions and Events that may Indicate Risks of Material Misstatement

The following are examples of conditions and events that may indicate the existence of risks of material misstatement. The examples provided cover a broad range of conditions and events; however, not all conditions and events are relevant to every audit engagement and the list of examples is not necessarily complete.

Operations in regions that are economically unstable, for example, countries with significant currency devaluation or highly inflationary economies.
Operations exposed to volatile markets, for example, futures trading.
High degree of complex regulation.
Going concern and liquidity issues including loss of significant customers.
Constraints on the availability of capital and credit.
Changes in the industry in which the entity operates.
Changes in the supply chain.
Developing or offering new products or services, or moving into new lines of business.
Expanding into new locations.
Changes in the entity such as large acquisitions or reorganizations or other unusual events.
Entities or business segments likely to be sold.
Complex alliances and joint ventures.
Use of off-balance-sheet finance, special-purpose entities, and other complex financing arrangements.
Significant transactions with related parties.
Lack of personnel with appropriate accounting and financial reporting skills.
Changes in key personnel including departure of key executives.
Weaknesses in internal control, especially those not addressed by management.
Inconsistencies between the entity’s IT strategy and its business strategies.
Changes in the IT environment.
Installation of significant new IT systems related to financial reporting.
Inquiries into the entity’s operations or financial results by regulatory or government bodies.
Past misstatements, history of errors or a significant amount of adjustments at period end.
Significant amount of non-routine or non-systematic transactions including intercompany transactions and large revenue transactions at period end. Transactions that are recorded based on management’s intent, for example, debt refinancing, assets to be sold and classification of marketable securities.

Application of new accounting pronouncements.
Accounting measurements that involve complex processes.
Events or transactions that involve significant measurement uncertainty, including accounting estimates.
Pending litigation and contingent liabilities, for example, sales warranties, financial guarantees and environmental remediation.