1. Topic 2 Governance and Ethics
The focus of this chapter is APES 110 ‘The Code of Ethics for Professional Accountants’. We point out to students that any professional organisation must indicate to its members what is acceptable behaviour and must also demonstrate to the public that it is willing to monitor the actions of its members.
You should outline the learning objectives for this chapter, and also walk them through how this chapter fits into the flowchart of the overall auditing and assurance framework.

2. Learning objectives
explain the concept of corporate governance and the relationships between the auditor, the client and the public;
discuss the nature and responsibilities of audit committees;
gain an appreciation of how the quality of professional services is assured
demonstrate an understanding of auditing standards
gain an appreciation of the need for a professional code of conduct;
apply the ethical rulings of the accounting bodies using sound ethical decision-making techniques;
explain the concept of independence
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

3. Professional ethics and ethical theory
Ethics are concerned with the requirements for the general well-being, prosperity, health and happiness of people.
It requires both knowledge of moral principles and also skills in applying them to problems and decisions.
We believe that it is important for students to understand the nature of ethics and recognise its importance. This requires some theoretical understanding of ethics. The text presents elements of the following three theories of ethical behaviour:
teleological ethics;
deontological ethics;
virtue ethics.
We start by describing each theory and try to impress upon students that auditors regularly face ethical dilemmas and that ethical auditors must find a way to do the right thing.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

4. Ethical codes and disciplinary rules
APES 110 ‘Code of Ethics for Professional Accountants’, issued by the Accounting Professional and Ethical Standards Board (APESB), indicates that members are expected to comply with the spirit as well as the letter of the rules.
APES 110 sets out the main ethical pronouncements that relate to the undertaking of an audit.
ASA /ISA and ASA require that auditors comply with relevant ethical requirements.
Ethics are principally attitudes of mind rather than compliance with written rules of conduct.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

5. Purpose of the code of ethics
Code of ethics: formal, systematic statement of rules, principles, regulations or laws developed by a community to promote its well-being and punish undermining behaviour.
The code therefore:
makes explicit the values implicitly required
indicates how members should act towards one another
provides an objective basis for sanctions.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

6. Ethical theory
Teleological ethics: deal with the consequences or outcomes of actions:
Generally, if the benefits of a proposed action outweigh the costs, the decision is morally correct.
Deontological ethics: based on duties and rights:
Duties and rights set down in rules that must be followed.
Virtue ethics: focus on personal qualities, such as the integrity of the decision maker.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

7. Virtues of an auditor
A distinguishing mark of the accountancy profession is its acceptance to act in the public interest, defined as ‘the collective well-being of the community of people that the members serve’ (APES 110, s 100.1).
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

8. Figure 3.2 Fundamental principles
APES 110, s 290 provides specific guidance on independence requirements for audit and review engagements, while s 291 provides similar requirements for other assurance engagements.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

9. Ethical decision models
There are a number of ethical decision-making models that have been developed to assist in sound ethical decision making.
The key factors to be considered in ethical conflict resolution are:
relevant facts
ethical issues involved
fundamental principles related to the matter in question
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

10. American Accounting Association Model
Determine the facts
Define the ethical issues
Identify the major principles, rules and values
Specify the alternatives
Compare values and alternatives
Assess the consequences
Make your decision
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

11. Auditor independence
Independence is a key characteristic of an audit or assurance service provider.
In order for auditors to add credibility to financial reports or other subject matter, they need to remain independent.
Independence is one of the fundamental ethical virtues or principles required by APES 110.
When we discuss independence, we first discuss the principles of independence and the importance of both actual and perceived independence. Then we cover the detailed guidance in the Corporations Act 2001 and APES 110, including the conceptual framework, of threats and safeguards contained in APES 110 s 290. We believe that it is also important that students are made aware of recent developments in auditor independence.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

12. Legislative requirements: Corporations Act 2001
Section 307C: Independence declaration
Auditors must give directors a written declaration of their independence and this is to be included in the directors’ report.
Section 324CA: Conflict of interest
Auditor must take reasonable steps to ensure conflict of interest situations cease to exist as soon as possible. Conflict of interest is where members of audit team are not capable of exercising objective and impartial judgment, as judged by a reasonable person Continued
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

13. Legislative requirements: Corporations Act 2001 (continued)
Section 300(1)(ca): Former auditors.
Directors’ report is to include names of each officer of client who was a former partner or director of current auditor.
Section 324CI: Member of audit firm
Cannot become director, company secretary or member of senior management of a client until two years after ceasing to be with audit firm.
Section 324DA: Rotation of audit partners.
Lead or review partner for five successive years cannot play a significant role in the audit of that entity for at least another two successive years.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

14. Independence: Corporations Act 2001
Section 300(11)(B): Non-audit services.
Boards of all listed companies are required to provide a statement in their annual report that identifies all non-audit services provided by an audit firm, the fee for each service and an explanation of why provision of the service did not impair independence.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

15. Auditors’ appointment
s 327B: Shareholders are responsible for the appointment of auditor:
Auditor is in breach of independence requirements if, while auditing at a time that a s 324CH(1) relationship exists, the auditor is aware of relationship and does not take all reasonable steps to discontinue the audit.
s 324CH(1) Relationships include:
Auditor or immediate family member cannot be an officer or audit-critical member (influencing financial report) of client.
Auditor cannot provide remuneration to officer or audit-critical employee for acting as consultant.
Auditor cannot have an investment in client.
Auditor cannot owe money to a client (unless a housing or commercial loan on normal terms and conditions).
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

16. Auditors’ removal and resignation
Removal: Difficult to remove auditor.
Section 329: Requires a resolution of company at a general meeting of which special notice has been given. Auditor entitled to make written representation and speak at general meeting. A copy of notice must be sent to ASIC.
Resignation (s 329(9)): Auditor can resign. Must have written consent from ASIC if a public company. Application outlines reason and ASIC must approve the reason. Designed to ensure independence and integrity of audit function is maintained.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

17. Right of access to records and reasonable fees
Section 310: Auditor has right of access at all reasonable times to the accounting and other records and registers, and an entitlement to require from any officer of the company such information and explanations as required for the purposes of audit.
Section 331: Auditor is entitled to receive reasonable fees and expenses for the work carried out.
Collectively, all these provisions assist an auditor to maintain actual and perceived independence and create a suitable environment for an audit process that is free from undue influence and obstruction.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

18. Independence: ethical requirements
Test for independence is a reasonable person test: Would a reasonable person having access to all facts consider that the auditor was independent? (APES 110, s 290.6)
Ethical rules emphasise both (APES 110, s 290.6):
Perceived independence (independence in appearance)—how others will view the auditor.
Actual independence (independence of mind)—state of mind of the auditor. Whether the auditor can actually eliminate bias and personal interest from his or her decisions and not succumb to any undue pressures or influences. Related to integrity, objectivity and strength of character.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

19. APES 110, s 200: Safeguards
Safeguards fall into two broad categories. For an auditor these are:
Safeguards created by the profession, legislation or regulation—education, professional standards, monitoring and disciplinary processes, and inspections and reviews.
Safeguards within the work environment (firm wide and engagement specific)—independence and quality control policies and procedures.
The safeguards are aimed at reducing or resolving circumstances that pose threats.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

20. Quality control requirements for independence
APES –34 and ASQC 1.21–25 require that audit firms set up and maintain a safeguarding system that may include:
written independence policies
active and timely communication of policies
appropriate procedures to meet requirements
documentation of conclusions about threats and risks
internal monitoring of compliance
annual written confirmation from all assurance practice personnel.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

21. Figure 3.3 APES 110, s 200: Threats to independence
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

22. Major threats to auditor independence
Auditor employment relationships
Member of the assurance team cannot be employed by the client.
Financial and business relationships, including:
investments in audit clients
loans to and from clients
business relationships
goods and services from clients.
Continued
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

23. Major threats to auditor independence (continued)
Provision of non-audit services, including:
preparing accounting records and financial reports
valuation services
taxation
internal audit
design and implementation of financial IT systems
temporary staff assignments
litigation support services
legal services
recruiting senior management
corporate finance.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

24. Rotation of audit firms
Ramsay Report said it was not appropriate to mandate rotation of audit firms.
But recent proposals have suggested it would further improve auditor independence to rotate audit firms.
In 2014 the European Parliament voted to implement wide-ranging reforms to audit profession, including mandatory audit firm rotation by listed companies every 10 years.
Issue is now on agenda for other countries.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

25. Fee determination
Audit fees should be commensurate with the service provided. Thus, they should reflect the time taken to audit and the knowledge, skills and expertise required.
An auditor should not enter into fee arrangements that may compromise his or her independence.
Fees for a period should not be dependent on fees from the provision of future audits or other services.
Continued
Students should be made aware that audit fees should be commensurate with the service provided and that auditors should not take part in false or misleading advertising.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

26. Fee determination (continued)
Fees from clients must be collected promptly. Overdue fees may create a self-interest threat.
When total fees generated from a client represent a large proportion of the auditor’s total fees, real or perceived financial dependency on that client may create a self-interest or intimidation threat.
Audit clients must disclose in the financial report the amount of fees paid to the auditor, split between audit and non-audit services.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

27. Corporate governance
Corporate governance: system by which companies are directed and managed.
Covers the conduct of the Board of Directors and the relationship between the board, management and shareholders.
A Board of Directors is normally composed of a few corporate executives (such as CEO and CFO) and a majority of non-executive (preferably independent) directors.
Students might have heard the term ‘corporate governance’ as it has received a great deal of publicity in recent years. However, they probably have little understanding of its true meaning or its relevance to auditors.
We normally begin by explaining what is meant by corporate governance and outlining the ASX Corporate Governance Council’s Principles of Good Corporate Governance. We then explain the part auditors play in the process, particularly through the increased use of audit committees. It will be necessary to explain to students the functions of an audit committee and how they relate to the audit.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

28. Independent director A director will not be independent if he or she:
is, or is associated with, a substantial shareholder
has been an employee in an executive capacity in the last three years, or a director after such employment
has been a principal or employee of a material adviser or consultant to the company in the last three years
has been a material supplier or customer
has a material contractual relationship with the company
has served on the board for a period which could be reasonably perceived as materially affecting the director's ability to act in the best interests of the company
has an interest or relationship which could be reasonably perceived as materially interfering with the director's ability to act in the company’s best interests.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

29. Corporate Governance—OECD
In 1998 the OECD developed corporate governance standards covering six key areas—Principles of Corporate Governance:
ensuring an effective corporate governance framework
rights of shareholders and key ownership functions
equitable treatment of shareholders
role of stakeholders in corporate governance
disclosure and transparency
responsibilities of the board.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

30. The UK Cadbury Report
In 1992 the Committee on the Financial Aspects of Corporate Governance issued what is known as the Cadbury Report, a code of best practice designed to achieve high standards of corporate behavior.
The Cadbury Report describes the annual audit as one of the cornerstones of corporate governance.
Companies on the London Stock Exchange are required to publish a statement of compliance with the code in their annual report.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

31. Corporate Governance—Australia
The first Australian attempt to set out corporate governance standards of best practice was Corporate Practices and Conduct in 1991.
Corporate governance is primarily the responsibility of a company’s directors and senior officers, although accountants have an important role to play.
Accountants are concerned with ensuring that internal control policies and procedures are in place and working.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

32. Groups in Australia advocating improved corporate governance
The business community, including the Australian Institute of Company Directors (AICD).
Investors, in particular the Financial Services Council.
Australian Securities Exchange (ASX), and the ASX Corporate Governance Council.
Australian Securities and Investments Commission (ASIC).
The three professional accounting bodies.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

33. Improved corporate governance — AICD
One of the goals of the Australian Institute of Company Directors (AICD) is to‘be the recognised advocate for corporate governance and directors’ issues’.
Every member of the AICD is expected to comply with the AICD’s code of conduct. A director:
must act honestly, in good faith and in the best interests of the company as a whole
has a duty to use care and diligence in fulfilling the functions of office
must use the powers of office in the best interest of the company as a whole
Continued
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

34. Improved corporate governance—AICD (continued)
must recognise that their primary responsibility is to the company’s shareholders
must not make improper use of information acquired
must not take improper advantage of their position
must properly manage any conflict of interests
obliged to be independent in judgment and actions
must not improperly use confidential information
must not engage in conduct likely to discredit the company
has an obligation to comply with both the spirit and the letter of the law and the spirit of the AICD’s code of conduct.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

35. ASX Corporate Governance Council’s Principles of Good Corporate Governance
Principle 1: Lay solid foundation for management and oversight.
Principle 2: Structure the board to add value.
Principle 3: Promote ethical and responsible decision making.
Principle 4: Safeguard integrity in financial reporting Continued
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

36. ASX Corporate Governance Council’s Principles of Good Corporate Governance (continued)
Principle 5: Make timely and balanced disclosure.
Principle 6: Respect the rights of security holders.
Principle 7: Recognise and manage risks.
Principle 8: Remunerate fairly and responsibly.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

37. Audit committees
Sub-committee of board of directors, which should consist mainly of non-executive/ independent directors.
Auditor’s major dealings with the board of directors are normally through this sub-committee.
Important component of corporate governance, with most listed companies in Australia having an audit committee.
Top 500 companies on ASX now required to have an audit committee.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

38. Effective audit committees
Take an active role in overseeing company’s accounting and financial reporting.
Maintain a direct line of communication between the board of directors and the auditors.
Discuss sensitive matters with auditors such as controversial accounting issues, disagreements with management and deficiencies in internal control.
Discuss general scope and timing of external audit work.
Involve themselves in nomination of external auditor, review reasonableness of audit fees, consider how provision of non- audit services affects auditor independence.
Strengthen auditor independence by being independent communication link between management and auditors.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e

39. Summary The three accounting bodies have ethical rules.
Ethical principles and skills in ethical decision making are an important requirement for auditors.
To be, and to be seen to be, independent is at the centre of the ethical rules of the auditing profession.
Auditor independence has been strengthened through amendments to the Corporations Act 2001 and the revision of ethical rules APES 110.
The accounting bodies and regulators have strongly supported the push for better corporate governance, including establishment of audit committees.
We provide a summary slide of the main learning takeaways in this chapter.
Adapted from McGraw-Hill Education (Australia) Pty Ltd Gay & Simnett, Auditing and Assurance Services in Australia 6e