The Independence of Audit Committees - Term Paper Example

Student’s Name: Instructor’s Name: Course Code & Name: Date of Submission Words: 2977 Table of Contents Table of Contents ii The annual report and independence 1 Ethics and audit expectation-performance gap 3 Analytical procedures 5 Auditor’s independence and liability 8 Audit planning and assertions 9 Reference: 11 Appendices: 13 The annual report and independence The analysis concentrates on financial statements for Brambles Limited for the year ended 30th June 2015. The company has audit and risk committee which is composed of three members and a chairperson, all of whom are non-executive directors. According to the financial report, the audit committee is independent. The ASX recommends that audit committees be independent for several reasons. First, the independence of the members of the audit committee ensures that they do not have any conflict of interests between them and the management. This ensures that the management cannot bestow any restrictions on the work of the audit committee such as freedom of access to financial records and staff. Second, the independent audit committee is objective rather subjective since the members are not responsible for daily company operations. The most important characteristic of the audit committee is independence as it enables the committee to execute its obligation of making sound and unbiased judgements that best suit the interests of the entity’s shareholders (GAA, 1990). The independence of audit committees enhances their effectiveness as well as improving the overall corporate governance. According to the directors’ report, the non-audit service fee paid by Brambles exceeds10% of the annual external audit engagement fee. The external audit firm was paid US$0.95 million as the fees for non-audit services while the external audit was US$6.291. Hence, the non-audit service fee is about 15.1% of the total external audit service fees. According to Brambles’ annual report, the audit committee clearly explains the provision of non-audit services by PwC. In the financial year ended 300th June 2015, PwC provided no-audit services to Brambles related strategy-based consultations, due diligence for acquisitions, tax consulting advice, finance and compliance tracking system. The directors justified the employment of PwC by Brambles to perform the non-audit duties citing detailed knowledge of the company by PwC and the perspective of effectiveness, efficiency, and cost-saving. However, such undertaking the non-audit assignments was well balanced with external auditors’ independence and objectivity. The Audit Committee made a thorough review of the provision of non-audit services and other, related services by the external auditor and presented a detailed written advice showing the resolutions arrived at by the audit committee (GAA, 1990). According to the advice, the Audit Committee had expressed its satisfaction with the provision of non-audit services and other related practices by the external auditor. They emphasized that the proportion of the non-audit fees, the nature of the non-audit services and the continuous monitoring of the non-audit work by the Audit Committee was well in line with the Audit Committee Charter and the Charter of Audit Independence as required. There are various problems associated with a company when the non-audit fees paid by the company to the external auditor are considerably high as compared with the engagement audit fee. Experts have raised the concerns that high non-audit service fees can greatly compromise the objectivity and independence as required by regulators. The auditors may wish to retain the additional high income they receive as fees for the non-audit work which is like a gift from the company’s management, and thereby not be able to stand up to the management. Also, the auditors get very close to the management in the provision of such services. There might develop a close identification with the management. Further, it makes the auditors lose independence and objectivity in their audit work. Non-independence of auditors leads to negation and reduction in the value of the audit provided. This has a consequential impact on the shareholders and other stakeholders of the company who rely on audited financial statements for crucial decision making. The high information risk posed by such reports might lead to a reduction in the company’s share prices and an increase in the premium for risk in the debt market. The firm that provided external audit service to Brambles Limited is PricewaterhouseCoopers (PwC). According to Brambles 2015 annual report, the Auditor’s Independence Declaration was signed by Paul Bendall, a partner with PricewaterhouseCoopers, on 20th August 2015 in Sydney. The Auditor’s Report was signed jointly signed on 20th August 20o15 by Bendall and Susan Horlin, both of whom are partners with PricewaterhouseCoopers, based in Sydney. In the auditor’s report, PricewaterhouseCoopers refers to the standards based on Australian Accounting Standards and the regulations stipulated in the Corporations Act 2001. Ethics and audit expectation-performance gap The attitude of auditors that enables them to question the reliability of information and be alert to conditions that may result in possible financial misstatement is known as professional scepticism. This attitude is useful for auditors it forms the basis for ethical considerations for the objectivity and independence of auditors. The attitude enables the auditors to be sensitive to unusual circumstances or not to adopt unworthy assumptions. Otherwise, audits done without professional scepticism would be considered of low quality (Chukwunedu, n.d.). The actions of Leeson at Barings bank to bypass the bank’s controls by settling his trades would pose the threat of self-review to independence. This threat occurs when an auditor has participated in the preparation of the financial documents being audited. The main cause of this threat is the desire by an individual audit professional to satisfy own selfish interests at the expense of the whole organization (GAA, 1990). As reported in the case, Leeson intentionally misstated financial data in his statements to record the highest abnormal profits of about $10 million in one week as the head of settlement operations. This threat to independence was eventually manifested in the bankruptcy of Barings Bank in 1995. The threat of self-review can be eliminated from an accounting entity by separating the internal accounting and auditing functions (Mahadevaswamy and Salehi, 2009). The two services should be provided by two distinct teams who have a high degree of independence. Audit performance expectation gap exists where there is a difference between the auditor’s performance as perceived by the society and the society’s expectations of auditor’s performance. It mainly results from an unqualified audit as in the case of Barings Bank. Unqualified audit results when the auditors fail to discover or disclose fraud in the misstatement of an entity’s financial statements (Bhugaloo, n.d.). As in Barings Bank case, exaggeration of profits by Nick Leeson painted a false image of the bank to the shareholders and the general public. It could have led to excessive borrowing by the bank, as creditors got lured by the fraudulently prepared financial statements. Most stakeholders rely on audited financial reports of companies to make investment decisions, and an unqualified audit could have detrimental impacts on Barings Bank, leading to its bankruptcy in 1995. Analytical procedures Solvency In the analysis of solvency ratios, the quick ratio is 11.66 which is a 132% increase from 5.02 of 2014. It shows that the liquid assets of the client are 11.66 times greater than its current liabilities. Therefore, the client can pay its short-term liabilities using the most cash available (inventories excluded). The client has a current ratio of 18.64, and it shows that the business’ short-term assets (inventories included) are readily available to meet its current obligations as and when they fall due (Onome Imoniana et al., 2012). It is also healthier compared to the industry benchmark that has a current ratio of 15.00. The debt ratio 0.30 for 2015 shows that more of the business financing comes from shareholder’s equity than debt and thus the business is stable. However, it is greater than that of 2014 (0.11) and the benchmark (0.33) indicating that the client borrowed more in 2015 than in 2014 and needed to reduce the debt or increase equity to increase stability and become more competitive in the industry (GAA, 1990). The time interest earned ratio for 2015 is 9.44 and 18.50 for 2014 (-49% decrease) while the benchmark is 20.00. The company is, therefore, able to pay its interest expense 9.44 times using its earnings before interest and tax. Based on these findings on the client’s solvency, some accounts need to be investigated during the audit. The first account is the interest expense account. The reason is that there is a decline in the time interest earned ratio by 49% from 18.50 in 2014 to 9.44 in 2015. The other two accounts that need investigation are long-term debt and equity accounts. It justifies that the increase in the debt to equity ratio by 173% from 0.11 in 2014 to 0.3 in 2015 and compared with that of the industry benchmark of 0.2. To further understand the client’s solvency, some more information is required. It includes the amount of accounts receivable, total credit sales and the number of days in sales (Onome Imoniana et al., 2012). It would help in calculating the number of days the company takes to collect payments from credit sales. The information on total assets is also important in determining the total debt-to-total assets ratio of the business. Efficiency An analysis of the client’s efficiency shows that the account receivables turnover is 2.40 for 2015 and 11.50 for 2014 (79% decline) and that for the benchmark is 10.00. The client collected accounts receivables fewer times in 2015 than in 2014 and the benchmark. This causes concern on the client’s ability to efficiently collect receivables to meet liquidity needs. The inventory turnover ratio is 2.67 for 2015, an increase of 34% from 2.00 of 2014. This indicates that the client can efficiently manage its merchandise. The asset turnover declined by 14% compared to 2014 0.21. This means that the client’s ability to use its assets efficiently to generate sales declined below the industry benchmark (GAA, 1990). Based on the findings from efficiency analysis, three accounts need to be investigated during the audit. One of such accounts is the accounts receivables account, citing the decline in the accounts receivables turnover ratio (GAA, 1990). The other accounts are the sales account and the cash account since the analysis shows a decline in asset turnover ratio for 2015. More information would be needed to understand the efficiency of the client. Such information includes average net fixed assets to use in determining the fixed asset turnover. Others are average accounts payable and operating expenses for the determination of accounts payable turnover and operating expenses turnovers respectively. Profitability In profitability analysis, the return on sales is 71% for 2015, an increase of 48% from 48% of 2014, while the benchmark has 50%. This shows that the client is more efficient in cutting down expenses to increase profits. The return on assets for 2015 is 13%, a 30% increase from the 10% of 2014 while the benchmark has 12%. This indicates that the client is efficiently in converting the money invested in assets into profits. The return on shareholder’s equity is 12%, a 50% increase from 8% of 2014 while the benchmark has 9%. This shows that the client is efficient in utilizing shareholder’s equity to generate profits for the business. Three accounts need to be investigated throughout the audit. They include the expenses accounts to assess the validity of the return on sales ratio and revenue account that is used to assess the client’s profitability. (Onome Imoniana et al., 2012) The other account is the capital account, necessary for validating the return on shareholder’s equity. More information that would be needed to further understand the client’s profitability include the capital employed to use in assessing the return on employed capital. The other information required is the management quality, the business net worth, and opportunity costs for use in determining the economic profitability of the business. Auditor’s independence and liability The internal audit and external audit function are both complimentary services and should, therefore, be coordinated to enhance an efficient assurance framework within an organization. However, the two functions are totally different professions and have different values and levels of expertise. Therefore, the internal audit and external audit functions should be performed by different accounting firms. If an external audit firm is involved in internal auditing services, the independence and objectivity of the audit firm are compromised. Internal audit has services extended to governance, risk, and financial control and thus there is close identification with the management (GAA, 1990). It should be well understood that internal auditors provide assurance to the management within the governance boundary while the external auditors provide assurance to the shareholder. Hence, the two groups have different levels of confidentiality, objectivity, independence and competence. Claims of professional negligence can be filed by the company that hired the auditors, or by a third party who has been offended by material misrepresentation of an audit by the auditors. For instance, a potential purchaser of the company can bring a claim of negligence against the auditors. By giving a clean audit of a company that its financial statements do not have any material misstatement and that they present a true and fair position of the company, the Eraser’s auditors greatly influenced the decision by Pencil to take over Eraser. The negligence claims can be determined based on the auditors’ failure to unveil fraud or material financial disclosure resulting in an incorrect audit opinion by the auditors. These claims would be judged against the Auditing Standards, as well as the standards of a reasonably competent auditor. Assuming that Eraser’s auditors were negligent, some material facts need to be established. First, pencil has undergone financial distress caused by losses in property investment. The decision by Pencil to by Eraser was reached at after cross-examination of Eraser’s financial statements which were audited by the Eraser’s auditors. Indeed, Pencil had sent privity letters to the auditors prior to 2015 to notify them that they would rely on Eraser’s 2014 audited financial statements to make their takeover decision. Furthermore, the audit manual provided for the responsibilities of the auditors to parties who would rely on the audited reports beyond their employer, and these provisions who supersede the refusal of duty of care (GAA, 1990). It was a gross act of negligence by the auditors for not exercising professional scepticism to disclose that there was insufficient security for the property market’s loans advanced by Eraser. Had the auditors been competent in discharging their professional duties, Pencil would not have taken over Eraser and the consequential loss would not have been born. Audit planning and assertions Audit risk is an auditor’s risk to give an inappropriate opinion based on materially misstated financial statements. The audit risk is a subject detection risk and material misstatement. From Tables’ Property, Plant, and Equipment, the significant audit risk is the misstatement of the repairs and maintenance expense as the management is puzzled as to whether to capitalize or expense items (GAA, 1990). In the inventory and purchase transactions, the significant audit risk is a misstatement of the inventory at hand since it is subject to theft. The significant risk in trades payables transactions and balances is a misstatement of the accounts as employees may fail to record them in books. Under trade receivables and credit sales systems for Tables, the significant risk is a misstatement of allowance for doubtful debts account since they are based on estimation. The key assertion at risk of the significant risk of misstatement of the property, plant and equipment is classification. The transactions and events might not be recorded in the proper accounts. For the inventory balances and purchase transactions, the assertion at risk is accuracy. Stolen inventory may be incorrectly recorded in the accounts of inventory in hand. The key assertion at risk in the misstatement of trades payables transactions and balances is completeness since employees may fail to record all the transactions that should be recorded in the books of accounts. Under trade receivables and credit sales systems for Tables, the fundamental assertion at risk due to the estimation of doubtful debts is valuation and allocation as the appropriate amounts may not be recorded correctly (GAA, 1990). The various internal controls are about the audit which includes one of them is the segregation of duties of the employees. Assigning specific responsibilities to individuals will reduce the risk of valuation and allocation assertion. Another internal control is the security of assets. This restricts access to assets such as the inventory at hand, and thus reduces the risk of accuracy assertion (GAA, 1990). Approval and authorization are an internal control that would enable the management to permit a specific employee to undertake a particular transaction and record it appropriately. This would help reduce the risk of completeness and classification assertions. Reference: Arens, A., Elder, R. and Beasley, M. (2003). Auditing and assurance services. Upper Saddle River, N.J.: Prentice Hall. Bhugaloo, S. (n.d.). Commodities Trading: Nick Leeson, Internal Controls and the Collapse of Barings Bank. [online] TradeFutures Ltd. Chukwunedu, O. (n.d.). Bridging the Audit Expectation Gap: The Perception of ICAN Members. SSRN Electronic Journal. GAA, J. (1990). Discussion of “A theory of evidence based on audit assertions”. Contemporary Accounting Research, 6(2), pp.427-431. Mahadevaswamy, G. and Salehi, M. (2009). Audit Expectation Gap in Auditor Responsibilities: Comparison between India and Iran. IJBM, 3(11). Mariani, L., Tettamanzi, P. and Corno, F. (2010). External Auditing vs Statutory Committee Auditing: The Italian Evidence. International Journal of Auditing, 14(1), pp.25-40. Onome Imoniana, J., Thereza P. Antunes, M., Martins Mattos, S. and Maciel, E. (2012). The analytical review procedures in audit: an exploratory study. ASAA, pp.282-303. Percy, J. (1997). Auditing and Corporate Governance-a Look Forward into the 21st Century. International Journal of Auditing, 1(1), pp.3-12. Reding, K. (2007). Internal auditing. Altomonte Springs, Fla.: Institute of Internal Auditors, Research Foundation. Reserve Bank of Australia, (1995). Implications of the Barings Collapse for Bank Supervisors. [online] Reserve Bank of Australia. Appendices: Financial Statements Read More