AG309 Week 8 Audit Regulation from University of Strathclyde Business School

UK Definition of Audit

The auditor's objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor's report that includes the auditor's opinion.

Financial Reporting Council (FRC)

* The Financial Reporting Council (FRC) promotes transparency and integrity in business. It regulates auditors, accountants and actuaries, and sets the UK's Corporate Governance and Stewardship Codes. FRC is an executive non-departmental public body, sponsored by the Department for Business and Trade.

Materiality

There are 2 main types of financial statement materiality: Quantitative - concerned with the numbers eg £5,000 in a £2m net assets is not material Qualitative - concerned with non-material items e.g. the £5,000 was a loan to the chief exec's student son which has never been repaid to the company.

Assurance Engagement

'Responsible Party' 'Practitioner' Management Auditors Produce Review Conclude based on Gather Financial Statements Sufficient Appropriate Evidence Criteria? 'Subject Matter' Shareholders 'Intended Users'

Auditor Qualities

What qualities/characteristics would we expect of an auditor?

Credibility

Needed for trust in the audit opinion. Relies on 2 things: · Independence · Professional ability

Independence

Needed so that the auditor can give an objective opinion on the truth and fairness of the financial statements. Must take steps to ensure maintain independence from the responsible party e.g. management. Critically, perception is as important as actual independence. More on guidance and rules around independence next week.

Professional Ability

We would expect all auditors to have the capability to understand the financial statements and be able to judge them by the appropriate GAAP they are prepared under. An accounting qualification is obviously useful. Surprisingly anyone can work on an audit, however to lead or signoff an audit opinion requires that a person is a statutory auditor.

Statutory Auditor Qualifications

Must be qualified with one of the Recognised Qualifying Bodies (RQBs):

1. ACCA (Association of Chartered Certified Accountants)
2. AIA (Association of International Accountants)
3. ICAS (Institute of Chartered Accountants of Scotland
4. ICAEW (Institute of Chartered Accountants of England and Wales)
5. ICAI (Institute of Chartered Accountants of Ireland)

Statutory Auditor Registration

Must register as a member of a Recognised Supervisory Body (RSB):

1. ACCA
2. ICAEW
3. ICAS
4. ICAI

Must maintain membership whilst practising as an auditor.

Audit Practising Certificate

Must gain a practising certificate with the Institute registered with. This requires: · Varying levels of audit training and post qualified experience in audit. · Holding professional indemnity insurance - this would pay out if an auditor caused loss by negligence (more on this later) · Able to comply with the Continuing Professional Development (CPD) requirements of the institution

Audit Practising Certificate - cont'd

Must also be a: . 'Fit and proper person' · Member of a registered firm

Registered Firm Requirements

A principal is a director or partner . Each of the principals should be a member of an RSB · The majority of the principals should be audit qualified . The firm should have appropriate professional indemnity insurance . The firm should be 'fit and proper' · The firm should appoint an Audit Compliance Partner

Audit Compliance Partner

The audit compliance partner is the person within an audit firm responsible for ensuring that that the firm complies with any relevant rules and regulations.

Summary of Audit Profession

The auditing profession therefore requires a high degree of qualification. This ensures that the profession has a degree of competence and should also mean that the reputation and credibility of the profession is maintained .... But

Regulation of the Profession

The auditing profession is regulated in a number of ways: · By the supervisory bodies · By common law (precedent) · By statute (law) · By government and other bodies

Recognised Supervisory Bodies (RSBs)

Each of the supervisory bodies have their own rules and discipline. All members of these bodies must comply with the rules of their institute. The RSBs are required to regularly monitor audit firms under their supervision to ensure that regulations are being followed and work is taking place to a reasonable standard. Failure to comply with these rules can lead to discipline and even expulsion.

Examples of Disciplinary Actions

In August 2021 a big 4 firm was fined £3.5m and a partner fined £100,000 for the poor quality audit of a Scottish transport group. In December 2017 an ACCA member was expelled for forging documents setting out that they had carried out work when in fact they had not. In July 2018 a student member of ICAEW was refused admission to membership for lying to their employer and ICAEW regarding their qualifications. Note these are made public and shared between the bodies. https://www.icas.com/regulation/regulatory-monitoring/disciplinary-notices

Common Law

Common law refers to the precedent set by previous legal cases. There are some cases which have an impact on auditors.

Duty of Care

Broadly speaking an auditor owes a duty of care to certain parties. This means that if the auditor owed a duty of care to another party, and the auditor acts negligently, and the other party suffers loss because of this, then the auditor would have to pay compensation to the other party.

What is Negligence?

This means acting without due care and attention - in audit terms this largely comes from an old case Kingston Cotton Mill (1896) In this case an auditor had accepted a stock certificate from a factory manager and based part of their audit opinion on this. The manager was later found to have overstated the stock - the auditor was sued.

Kingston Cotton Mill - Result

The auditor won the case. At the time there was no requirement in auditing standards for the auditor to attend a stockcount (there is now) therefore the auditor had complied with the auditing standards. This led to the principle that an auditor should follow applicable auditing standards to act with reasonable care and attention.

What is a Duty of Care?

This means that the auditor must know another party would rely on the financial statements and be reasonable able to foresee the loss.

Donoghue v Stevenson, 1932

Mrs Donoghue and a friend visited a café in Paisley for iced drinks. Her friend poured some ginger beer over Mrs Donoghue's ice- cream and out of the bottle popped the decomposing remains of a snail. She became unwell from the drink and sued the manufacturer of the ginger beer, Stevenson. The courts had to consider whether the manufacturer, Stevenson, was liable to Mrs Donoghue.

Donoghue v Stevenson, 1932 Outcome

The bottle of ginger had been purchased by Mrs Donoghue's friend from the owner of the cafe, Mr Minchella. Mrs Donoghue's friend had not purchased the bottle directly from the manufacturer, Stevenson. The House of Lords held that Mrs Donoghue was entitled to sue the manufacturer, Stevenson, because he owned a duty of care to Mrs Donoghue. https://www.solicitors-scotland.com/legal/duty-of-care/

Caparo v Dickman, 1990

Caparo Industries purchased shares in Fidelity Plc in reliance of the accounts which stated that the company had made a pre-tax profit of £1.3M. In fact, Fidelity had made a loss of over £400,000. Caparo brought an action against the auditors claiming they were negligent in certifying the accounts. Held: No duty of care was owed. There was not sufficient proximity between Caparo and the auditors since the auditors were not aware of the existence of Caparo nor the purpose for which the accounts were being used by them.

RBS v Bannerman Johnstone Maclay, 1995

Bannerman Johnstone Maclay were auditors of a company APC. RBS had lent a large amount of money to APC. An RBS manager asked a Bannerman Johnstone Maclay partner if they were any issues they should know about. The partner said that they "stood by the audit report". APC later went bankrupt and RBS lost the money lent.

RBS v Bannerman Johnstone Maclay, 1995 Ruling

The court ruled that as the auditor knew RBS were relying on the financial statements they owed them a duty of care. Crucial to the court's reasoning was the absence of any third party disclaimer in the audit report. For this reason most audit reports now have a paragraph disclaiming any duty of care to a third party, this is known as the 'Bannerman clause' https://www.macfarlanes.com/what-we-think/2023/auditor-s-disclaimer-may-not-have-prevented-liability-to- buyer/# :~: text=A%20Bannerman%20clause%20is%20a%20type%20of%20exclusion%20clause.,only%20if%20it%20is%20reasonabl e

Statute

A number of laws also have an impact on the auditing profession. The Companies Act 2006 as we know sets out an auditors' rights. It also codifies in law the responsibility of an auditor to express an opinion on the truth and fairness of the financial statements and sets out who can be an auditor.