Testbank

to accompany

Audit and assurance

1st edition
by

Leung et al.

© John Wiley & Sons Australia, Ltd 2019

 Chapter 3: Professional ethics, regulation and liability

Chapter 3: Professional ethics, regulation and liability

Multiple-choice questions

1. Which of these bodies in Australia established a code of professional conduct?

a. AARF and AASB.

b. ASIC and CALDB.
c. CAANZ and CPA Australia.
*d. APESB

The correct option is d.

Learning objective 3.3 ~ explain the principles to be used for ethical threats and apply the
Code of Ethics for Professional Accountants.

2. According to Greenwood which of these is not necessarily an attribute of a profession?

*a. Self-regulation.
a. A culture.
b. Community sanction.
d. Authority.

The correct option is a.

Learning objective 3.1 ~ explain the role and duties of the professional auditor.

3. Which of the following would characterise a duty of a professional person?

a. Holding membership of a professional body.

b. The objective and confidential provision of their services.
c. Accepting the enforceability of the professional body’s code of conduct.
*d. All of the above would characterise a duty of a professional person.

The correct option is d.

Learning objective 3.1 ~ explain the role and duties of the professional auditor.

4. Which of these views consider moral values to be relative in regard to a particular

environment?

a. Teleology.
b. Deontology.
c. Virtue ethics.
*d. Ethical relativism.

The correct option is d.

Learning objective 3.2 ~ Discuss the basic ethical principles for auditors.

© John Wiley & Sons Australia, Ltd 2019 3.2

Testbank to accompany Audit and assurance 1e

5. The word 'ethics' is derived from the Greek word ethos, meaning character. Which of
these is not a doctrine or theory of ethics?

a. Consequentialism.
*b. Theology.
c. Utilitarianism.
d. Deontology.

The correct option is b.

Learning objective 3.2 ~ discuss the basic ethical principles for auditors.

6. The view that ethics is not just a matter of what people do but what people are, is known
as:

a. teleology.
b. consequentialism.
*c. virtue ethics.
d. ethical relativism.

The correct option is c.

Learning objective 3.2 ~ discuss the basic ethical principles for auditors.

7. John resigned from an assurance engagement because his independence was impaired. He
was concerned that if he did not resign then ASIC would have a case against the firm and
its reputation would suffer as a result. This is an example of:

*a. consequentialism.
b. non-consequentialism.
c. virtue ethics.
d. ethical relativism.

The correct option is a.

Learning objective 3.2 ~ discuss the basic ethical principles for auditors.

8. The main area of practice covered in the IFAC Code of Ethics for Professional
Accountants is:

a. fundamental principles applicable to all professional accountants.

b. fundamental principles applicable to professional accountants in public practice.
c. fundamental principles applicable to professional accountants in business.
*d. all the above.

The correct option is d.

Learning objective 3.3 ~ explain the principles to be used for ethical threats and apply the
Code of Ethics for Professional Accountants.

© John Wiley & Sons Australia, Ltd 2019 3.3

 Chapter 3: Professional ethics, regulation and liability

9. Which of these is not identified as a type of threat to compliance with the fundamental
principles in the IFAC Code applicable to professional accountants in public practice?

*a. Advertising.
b. Self-review.
c. Self-interest.
d. All are identified as a threat to compliance.

The correct option is a.

Learning objective 3.3 ~ explain the principles to be used for ethical threats and apply the
Code of Ethics for Professional Accountants.

10. What is not a category of safeguards that can be used by professional accountants?

a. Safeguards created by the profession, by legislation or by regulation.

*b. Safeguards developed by CALDB.
c. Safeguards which are engagement specific.
d. Safeguards within the client’s systems.

The correct option is b.

Learning objective 3.3 ~ explain the principles to be used for ethical threats and apply the
Code of Ethics for Professional Accountants.

11. The fundamental ethical characteristics required of professional accountants are:

*a. competence, objectivity and integrity.

b. professionalism, experience and expertise.
c. self-interest, self-review and familiarity.
d. authority, community sanction and knowledge.

The correct option is a.

Learning objective 3.3 ~ explain the principles to be used for ethical threats and apply the
Code of Ethics for Professional Accountants.

12. The purpose of ethical decision making models is to:

a. direct the auditor on which action to take.

*b. help the auditor arrive at a well-informed and ethical decision.
c. supplement the code of ethics.
d. identify the appropriate standard to use.

The correct option is b.

Learning objective 3.2 ~ discuss the basic ethical principles for auditors.

© John Wiley & Sons Australia, Ltd 2019 3.4

Testbank to accompany Audit and assurance 1e

13. The conceptual approach to independence requires that there is:

a. independence in mind and actions.
b. independence in fact and appearance.
c. independence in mind and appearance.
d. independence in actions and appearance.

The correct option is c.

Learning objective 3.4 ~ describe the regulatory and conceptual framework of professional
independence and the key guidelines.

14. Threats to auditor independence can come from various sources. Which of these is
referred to in the Code of Ethics as a self-interest threat?

a. A loan or guarantee from an officer of an assurance client to the auditor.

b. Undue dependence of the audit firm on total fees from an assurance client.
c. Long association of a senior member of an assurance team with the assurance client.
*d. a and b.

The correct option is d.

Learning objective 3.3 ~ explain the conceptual principles of the Code of Ethics for
Professional Accountants.

15. Threats to auditor independence can come from various sources. Which of these is
referred to in the Code of Ethics as a self-review threat?

a. The possibility of potential employment with the audit client.

*b. Preparation of original data used to generate a financial statement that is the subject
matter of the audit engagement.
c. Concern on the part of the auditor about the possibility of losing the engagement.
d. Pressure to reduce inappropriately the extent of work performed in order to reduce
fees.

The correct option is b.

Learning objective 3.3 ~ explain the conceptual principles of the Code of Ethics for
Professional Accountants.

16. The statement about auditor independence that is true is:

a. statutory law does not recognise the need for audit independence.
*b. statutory law recognises the need for audit independence.
c. all auditor appointments must be made by the shareholders in the AGM.
d. the auditor has no right to be heard at the AGM.

The correct option is b.

Learning objective 3.4 ~ describe the regulatory and conceptual framework of professional
independence and the key guidelines.

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 Chapter 3: Professional ethics, regulation and liability

17. Which of these jeopardises audit independence?

a. Extensive educational requirements for entry into the profession.

b. Monitoring and disciplinary procedures.
*c. Familiarity with a client and their systems.
d. None of the above would jeopardise audit independence.

The correct option is c.

Learning objective 3.4 ~ describe the regulatory and conceptual framework of professional
independence and the key guidelines.

18. The significance of economic, financial or other relationships in determining

independence in appearance is evaluated by:

*a. what a reasonable and informed third party would conclude as unacceptable.
b. what the auditor general decides is significant.
c. what the auditor believes is unacceptable.
d. what the company deems to be unacceptable.

The correct option is a.

Learning objective 3.4 ~ e describes the regulatory and conceptual framework of professional
independence and the key guidelines.

19. Using the same senior personnel on an assurance engagement over a long period may
create what type of threat to audit independence?

a. Advocacy.
b. Intimidation.
*c. Familiarity.
d. Self-interest.

The correct option is c.

Learning objective 3.4 ~ describe the regulatory and conceptual framework of professional
independence and the key guidelines.

20. In relation to specific threats to auditor independence, taxation services supplied to audit
clients:

a. create a threat.
*b. generally not seen to create a threat.
c. create a threat only in public practice.
d. create a threat if they are performed by a subsidiary.

The correct option is b.

Learning objective 3.4 ~ describe the regulatory and conceptual framework of professional
independence and the key guidelines.

© John Wiley & Sons Australia, Ltd 2019 3.6

Testbank to accompany Audit and assurance 1e

21. Which of these would not be a basis for disciplinary action by the National Council of the
CPA Australia?

a. An auditor failed to observe a proper standard of professional care and skill.

b. An auditor has become insolvent under administration.
c. An auditor has breached the By-Laws of the CPA Australia.
*d. An auditor has resigned due to a dispute with a client over accounting policies.

The correct option is d.

Learning objective 3.4 ~ describe the regulatory and conceptual framework of professional
independence and the key guidelines.

22. A possible form of discipline not found in CPA Australia’s Articles of Association for
members failing to meet required standards is:

a. fines.
*b. imprisonment.
c. forfeiture of membership.
d. suspension from membership.

The correct option is b.

Learning objective 3.4 ~ describe the regulatory and conceptual framework of professional
independence and the key guidelines.

23. The so-called 'deep-pockets' theory in relation to alleged audit failures, refers to:

*a. the auditor being the only party left with sufficient funds to indemnify the plaintiff's
losses.
b. the requirement to hold a public practice certificate.
c. several widely-reported business failures that resulted in significant loss to investors.
d. the gap between the potential liability and the available insurance cover.

The correct option is a.

Learning objective 3.5 ~ describe the legal framework for auditor liability.

24. Auditors are accountable in law for their professional conduct. This accountability arises
under:
a. Tort law.
b. Common law.
c. Statute law.
*d. all of the above.

The correct option is d.

Learning objective 3.5 ~ describe the legal framework for auditor liability.

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 Chapter 3: Professional ethics, regulation and liability

25. In respect of the provision of auditing services, the auditor will be liable to compensate
the plaintiff if:

a. a duty of care is owed to the plaintiff.

b. the audit is negligently performed or the opinion negligently given.
c. the plaintiff has suffered a quantifiable loss as a result of the auditor's negligence.
*d. all of the above.

The correct option is d.

Learning objective 3.6 ~ explain the auditor’s liabilities to shareholders and auditees.

26. The term 'privity of contract' refers to:

*a. the contractual relationship that exists between two or more contracting parties.
b. the fact that an audit is to be performed in accordance with professional standards.
c. the fact that an auditor appointed to conduct a statutory audit cannot reduce their
liability by contract (s. 241).
d. the mandatory requirement that there must be an engagement letter setting out the
terms of the audit contract.

The correct option is a.

Learning objective 3.7 ~ explain the concept of due care and the circumstances giving rise to
negligence in the conduct of an audit.

27. What is the term used when a failure on the part of a plaintiff to meet certain required
standards of care is a factor leading to a loss by the plaintiff?

a. Damages.
b. Negligence.
*c. Contributory negligence.
d. Reasonable foreseeability.

The correct option is c.

Learning objective 3.7 ~ explain the concept of due care and the circumstances giving rise to
negligence in the conduct of an audit.

© John Wiley & Sons Australia, Ltd 2019 3.8

Testbank to accompany Audit and assurance 1e

28. As a result of the rulings in Kingston Cotton Mill and the London and General Bank
cases:

a. overall audit quality improved.

*b. too literal an interpretation has retarded the development of improved auditing
practices.
c. auditors stopped designing procedures that would detect fraud.
d. auditors became more vigilant in the detection of fraud.

The correct answer is b.

Learning objective 3.7 ~ explain the concept of due care and the circumstances giving rise to
negligence in the conduct of an audit.

29. Which of these is not a primary element of a fiduciary relationship?

a. The fiduciary has undertaken to act in the interests of another.

*b. The fiduciary is properly certified.
c. The person to whom the fiduciary duty is owed is vulnerable to the fiduciary’s abuse
of his or her position.
d. All of the above are primary elements of a fiduciary relationship.

The correct answer is b.

Learning objective 3.7 ~ explain the concept of due care and the circumstances giving rise to
negligence in the conduct of an audit.

30. The two cases that formed the basis for most subsequent decisions as to the
determination of auditor negligence were:

a. JEB Fasteners and Twomax.

b. Caparo Industries and Esanda.
c. Hedley Byrne and AWA.
*d. Kingston Cotton Mill and London and General Bank.

The correct answer is d.

Learning objective 3.7 ~ explain the concept of due care and the circumstances giving rise to
negligence in the conduct of an audit.

31. The party that is unable to sue the auditors under contract law is:

a. the directors (on behalf of the company).

b. the liquidator.
*c. individual shareholders.
d. the receiver.

The correct answer is c.

Learning objective 3.8 ~ identify the issues and rulings of major legal cases with respect to
the auditor’s liability to third parties.

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 Chapter 3: Professional ethics, regulation and liability

32. In an audit engagement, which of the following would be considered to be one stage
removed from the privity of contract?

a. The auditor.
b. Future creditors.
*c. Shareholders.
d. The company.

The correct answer is c.

Learning objective 3.7 ~ explain the concept of due care and the circumstances giving rise to
negligence in the conduct of an audit.

33. In an audit engagement, which of the following would be considered to be two stages
removed from the privity of contract?

a. The company.
b. The auditor.
c. Shareholders.
*d. Future creditors.

The correct answer is d.

Learning objective 3.7 ~ explain the concept of due care and the circumstances giving rise to
negligence in the conduct of an audit.

34. In Segenhoe Ltd, the company claimed that the auditors’ negligence caused them to pay
a dividend out of capital. What was the outcome of this case?

*a. The auditors were found to be liable for the dividends.

b. The shareholders were ordered to return the dividends.
c. The company lost as there was no causal relationship.
d. The company was found to have contributed to the negligence.

The correct answer is a.

Learning objective 3.7 ~ explain the concept of due care and the circumstances giving rise to
negligence in the conduct of an audit.

35. The landmark case for the principle of contributory negligence is:

a. Segenhoe Ltd.
b. Pacific Acceptance.
*c. AWA Ltd.
d. Kingston Cotton Mill.

The correct answer is c.

Learning objective 3.7 ~ explain the concept of due care and the circumstances giving rise to
negligence in the conduct of an audit.

© John Wiley & Sons Australia, Ltd 2019 3.10

Testbank to accompany Audit and assurance 1e

36. Which of the following is true regarding damages?

a. Damages are only available under tort.

*b. Damages are available under tort and contract.
c. Damages are limited to the audit fees paid.
d. Damages are unquantifiable.

The correct answer is b.

Learning objective 3.7 ~ explain the concept of due care and the circumstances giving rise to
negligence in the conduct of an audit.

37. The more exacting auditor responsibility showing the evolving expectations in respect to
higher standards of reasonable care was set forth in the:

a. London and General Bank case.

*b. Pacific Acceptance case.
c. Kingston Cotton Mills case.
d. Donoghue v Stevenson case.

The correct option is b.

Learning objective 3.7 ~ explain the concept of due care and the circumstances giving rise to
negligence in the conduct of an audit.

38. The judgement in the Pacific Acceptance case was wide-ranging and covered
procedures that should exist in a normally competent audit. Which of the following is
not accurate concerning procedures listed in the judgement?

a. Promptly report fraud or warn of suspicion of fraud whether material or not.

b. Closely supervise and review the work of inexperienced staff.
*c. Be very wary about reporting bad news to shareholders always keeping in mind it
can affect the value of their investment.
d. Audit the whole of the year, not just the year-end balances.

The correct option is c.

Learning objective 3.7 ~ explain the concept of due care and the circumstances giving rise to
negligence in the conduct of an audit.

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 Chapter 3: Professional ethics, regulation and liability

39. Which case laid down the fundamental auditing principles of the ‘watchdog’ role and
the notion of taking reasonable skill and care?

*a. Kingston Cotton Mill.

b. Pacific Acceptance.
c. AWA.
d. London and General Bank.

The correct option is a.

Learning objective 3.7 ~ explain the concept of due care and the circumstances giving rise to
negligence in the conduct of an audit.

40. Which case prompted the development of more specific and comprehensive Auditing
Standards in Australia?

a. McKesson and Robbins.

*b. Pacific Acceptance.
c. Cambridge Credit.
d. AWA.

The correct option is b.

Learning objective 3.7 explain the concept of due care and the circumstances giving rise to
negligence in the conduct of an audit.

41. Under the Hedley Byrne principle, auditors’ liability to third parties to whom they owe a
duty of care:

*a. is no different from their liability to their clients.

b. is more onerous than their liability to their clients.
c. does not exist.
d. none of the above.

The correct option is a.

Learning objective 3.8 ~ identify the issues and rulings of major legal cases with respect to
the auditor’s liability to third parties.

42. The decision in the Caparo case (1990) reduced the duty of care of auditors to:

a. all users known to the auditor.

b. all users that ought reasonably to have been known to the auditor.
*c. the shareholders as a group.
d. all users of the financial statements, except for investors.

The correct option is c.

Learning objective 3.8 ~ identify the issues and rulings of major legal cases with respect to
the auditor’s liability to third parties.

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Testbank to accompany Audit and assurance 1e

43. Which of the following cases did not extend the liability of auditors in regard to the
concept of proximity?

a. Shaddock and Associates.

b. Jeb Fasteners.
*c. Caparo Industries.
d. Twomax.

The correct answer is c.

Learning objective 3.8 ~ identify the issues and rulings of major legal cases with respect to
the auditor’s liability to third parties.

44. Which case does not appear to support the recent narrowing of the exposure of auditors
to third parties?

a. Lowe Lippmann.
b. Esanda Finance.
c. Royal Bank of Scotland.
*d. Columbia Coffee.

The correct answer is d.

Learning objective 3.8 ~ identify the issues and rulings of major legal cases with respect to
the auditor’s liability to third parties.

45. Which of these precautions taken by auditors would avoid or minimise the
consequences of litigation?

a. Using an engagement letter for all professional services offered by the firm.
b. Thoroughly investigating all potential clients before accepting an engagement.
c. Ensuring professional pronouncements are fully complied with by the firm.
*d. All the above.

The correct answer is d.

Learning objective 3.9 ~ enumerate the precautions the auditor should take to avoid litigation.

46. The outcome in the Hedley Byrne case was:

a. the bank was not found liable as no duty of care was owed.
b. the advertising agency was found to have contributed to the loss.
c. the bank was found liable for the loss.
*d. the bank was not found liable due to the disclaimer.

The correct answer is d.

Learning objective 3.8 ~ identify the issues and rulings of major legal cases with respect to
the auditor’s liability to third parties.

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 Chapter 3: Professional ethics, regulation and liability

47. Why has the reaction to the verdict in Caparo Industries generally been unfavourable?

a. It is strongly thought that the loss was not quantifiable.

*b. The verdict appears to treat auditors more favourably than it treats other experts on
whom third parties rely.
c. The principle of proximity was not sufficiently established.
d. It is felt that the auditors were not responsible.

The correct answer is b.

Learning objective 3.8 ~ identify the issues and rulings of major legal cases with respect to
the auditor’s liability to third parties.

48. Which of these is not a precaution auditors take to avoid litigation?

a. Comply fully with professional pronouncements.

*b. Never issue a privity letter.
c. Maintain adequate professional indemnity cover.
d. All of the above are precautions auditors take to avoid litigation.

The correct answer is b.

Learning objective 3.9 ~ enumerate the precautions the auditor should take to avoid litigation.

49. To determine risks and potential exposure to litigation, professional accountants

commonly use an inspection program. An inspection program should be flexible and
could contain:

a. routine inspection of all risks.

b. routine inspection of a particular area of risk.
c. inspections as a result of incidents or accidents.
*d. all of the above.

The correct answer is d.

Learning objective 3.9 ~ enumerate the precautions the auditor should take to avoid litigation.

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Testbank to accompany Audit and assurance 1e

Short answer questions

50. Describe three different ethical theories.

Correct answer:
Answer should include three of the following with descriptions encompassing the main
differences:
Teleology or consequentialism: considers actions or behaviour according to the consequences
of that behaviour. An action is right because it produces some specified type of consequence,
i.e. welfare, wealth, happiness, pleasure or knowledge. Moral appraisal of an action involves
judging how well that behaviour produces the relevant consequences.
Utilitarianism: a form of consequentialism which states the ethically right thing to do is that
action which produces more utility (benefits) than other acts. Individuals do not merely look
to their own pleasure but are concerned with maximising pleasure for all. Modern
utilitarianism takes into account stakeholders’ interests and preferences, and an ethically right
decision gives the maximum amount of benefits which accord with the interests of the
greatest number of stakeholders.
Deontology or non-consequentialism: an action is considered right because of the process
(i.e. intention) rather than its outcome. For example, an action is right because it keeps a
promise that one made (backward-looking or past orientation) or because one’s duty is to be
honest, which is simply the ‘right thing to do’ (present). Under non-consequentialism, the
process is what determines the right thing to do regardless of the consequences.
Virtue ethics: a concept which stresses the ability of a person to act morally based on his or
her character, rather than having to deal with a problem by consciously and conscientiously
applying some moral theories in a systematic or mechanical way. Moral behaviour is a
natural result of one’s character and therefore ethics is not just a matter of what people do; it
is a matter of what people are.
Ethical relativism: a view that moral values are relative to a particular environment. Particular
moral values are not universal and therefore not absolute.

Reference: Learning objective 3.2 ~ discuss the basic ethical principles for auditors.

51. Katie is part of an audit team who have been sent to Eastern Europe to conduct an audit
of one of their client’s subsidiary companies. During the audit, Katie uncovers a series of
bribes that the company has paid to local authorities. Bribes are considered a normal part of
business in this particular city so the subsidiary company feels as though they have done
nothing wrong. It is likely that the bribes will not be uncovered but there is a chance that they
will be, and that the parent company, the audit firm, and Katie personally will all suffer
negative consequences if they are. If Katie does report the bribes, then the subsidiary
company will suffer and there will be a scandal for the parent company. However, the impact
of reporting the bribes is likely to be less than if they are discovered at a later date by other
authorities. Katie thinks of herself as an honest person and is trying to decide what the
ethically ‘right’ thing to do is.

Try to determine what decision Katie will make regarding whether or not she will report the
bribes by applying the ethical theories of teleology, deontology, virtue ethics, and ethical
relativism.

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 Chapter 3: Professional ethics, regulation and liability

Correct answer:
Teleology: As this theory is based on consequences Katie’s decision should be determined by
what she believes the consequences of her actions will be. As the consequences of reporting
the bribes are less severe than having them found out at a later date Katie should report the
bribes.
Deontology: This theory looks at the process of an action rather than the outcome. As Katie is
an auditor she is bound by the Code of Ethics for Professional Accountants which requires
integrity and professional behaviour. Therefore, she has a duty to be honest and report the
bribes.
Virtue ethics: This theory states that a person will act based on their inherent virtues. As
Katie thinks of herself as an honest person she will act honestly and report the bribes.
Ethical relativism: Using this theory, the ethical right thing to do is what is ethical in that
particular environment. As bribes are common business practice in this country there is an
argument that there is nothing wrong with them. Therefore, applying ethical relativism will
result in Katie not reporting the bribes.

Reference: Learning objective 3.2 ~ discuss the basic ethical principles for auditors.

52. For each of the following safeguards, identify whether they are:
 safeguards created by the profession, by legislation or by regulation
 safeguards developed by the firm
 safeguards which are engagement specific
 safeguards within the client’s systems.
1 disclosure of fees
2 competence of employees
3 using different partners and teams with separate reporting lines for the provision of non-
assurance services to an assurance client
4 professional standards and pronouncements
5 timely communication of policies and procedures to all partners and professional staff
6 internal procedures to ensure objective decisions on engagements
7 professional review by other professional accountants
8 involving another firm to perform or re-perform part of the engagement
9 corporate or other governance regulations
10 firm leadership which emphasises compliance and ethics.

Correct answer:
1 safeguards which are engagement specific
2 safeguards within the client’s systems
3 safeguards developed by the firm
4 safeguards created by the profession, by legislation or by regulation
5 safeguards developed by the firm
6 safeguards within the client’s systems
7 safeguards which are engagement specific
8 safeguards which are engagement specific
9 safeguards created by the profession, by legislation or by regulation
10 safeguards developed by the firm.

Reference: Learning objective 3.3 ~ explain the principles to be used for ethical threats and
apply the Code of Ethics for Professional Accountants.

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Testbank to accompany Audit and assurance 1e

53. Classify each of the following threats as either; self-interest, self-review, advocacy,
familiarity or intimidation.

1 The CEO threatens to change auditors unless an unqualified opinion is issued

2 Each member of the audit team received a holiday cruise as a gift from the client
3 The audit partner owns a significant amount of shares in the client company
4 The audit partner is the brother-in-law of the client company’s director
5 The audit firm is promoting a new issue of shares from the client company
6 The audit firm is acting as an advocate on behalf of the client in a dispute with a third
party
7 Management is pressuring the firm to reduce its audit hours in order to reduce the fees
8 The audit partner has been approached about becoming a board member with the client
company next year
9 A member of the audit team was recently a director of the client company
10 The audit must cover an inventory valuation system which was implemented by the audit
firm after last year’s audit.

Correct answer:
1 intimidation
2 familiarity
3 self-interest
4 familiarity
5 advocacy
6 advocacy
7 intimidation
8 self-interest
9 self-review
10 self-review.

Reference: Learning objective 3.3 ~ explain the principles to be used for ethical threats and
apply the Code of Ethics for Professional Accountants.

54. Read the following scenario and identify any threats to compliance with the IFAC Code.

ABC firm is the auditor of Company Ltd and has been for 10 years. During this time, the
audit partner responsible has always been John. The other partner in the firm, Robert, has
been the review auditor for this assurance engagement. Robert has not been the lead audit
partner as his wife’s father is the CEO of Company Ltd.

Every year Company Ltd celebrates the end of the audit by throwing an all expenses paid
weekend away for their staff that worked on the audit and for the audit firm. This has led to a
good relationship between the auditors and the company that makes the audit less formal. The
staff all know each other well and the company believes it is money well spent.

Recently John was approached by the board of Company Ltd with an offer of employment as
a director starting in two years time. The only condition was that the audit fees have to be
reduced for the current and next year’s audit.

Correct answer:

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 Chapter 3: Professional ethics, regulation and liability

Familiarity:
 A possible threat due to the long tenure of ten years with no audit partner rotation
 Threat due to the review partner being a family member of the CEO
 Threat due to the weekend away as the value is probably not insignificant.
Self-interest:
 John’s potential employment with the client is a threat.
Intimidation:
 Pressure to reduce fees in exchange for future employment is a threat.

Reference: Learning objective 3.3 ~ explain the principles to be used for ethical threats and
apply the Code of Ethics for Professional Accountants.

55. i. Why would audit firms provide non-assurance services to assurance clients?
ii. List four types of non-assurance services.
iii. Identify safeguards which would eliminate or reduce the threat to
independence for non-assurance services.

Correct answer:
i. Audit firms usually have specialised knowledge of their client’s procedures and policies,
its controls and its risks. This greater knowledge can benefit their clients if they also
provide other services to them. The audit firm earns extra revenue as a result.

ii. Any four of the following: management responsibilities, preparation of accounting

records and financial statements, valuation services, taxation services, internal audit
services, IT systems services, litigation support services, legal services, recruiting
services, and corporate finance services.

iii. The following are safeguards that can be applied:

- Policies and procedures to prohibit professional staff from making management
decisions for the assurance client
- Discussing independence issues related to the provision of non-audit services with
those charged with governance, such as the audit committee
- Identifying responsibility for provision of non-assurance services by the firm
- Involving an additional professional accountant to advise on the potential impact of
the non-assurance engagement on the independence of the member of the assurance
team and the firm
- Involving an additional professional accountant to provide assurance on a discrete
matter of the assurance engagement
- Obtaining the assurance client’s acknowledgement of responsibility for the results of
the work performed by the firm
- Making arrangements so that personnel providing non-assurance services do not
participate in the assurance engagement.

Reference: Learning objective 3.4 ~ describe the regulatory and conceptual framework of
professional independence and the key guidelines.

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56. Identify the six threats to compliance with the IFAC code by professional accountants in
public practice and give an example of each.

Correct Answer:
Any one of the following examples for each threat is acceptable.

Self-interest:
 Financial interest in a client where the result of the professional services may affect the
value of that interest
 Loans to or from an assurance client
 Concern about possibility of losing a recurring client
 Potential employment with a client
 Inappropriate marketing of professional services
 Acceptance of clients with illegal dealings or questionable issues
 Accepting an engagement without the necessary competence or specialised knowledge to
carry out the engagement
 Temptation to accept gifts offered by client
 Conflict of interest such as performing services which are incompatible for the same
client
 Competing directly with client or having joint ventures with major competitors of client
posing objectivity threat.
Self-review:
 Discovery of a significant error in a re-evaluation
 Reporting on systems where the professional accountant has been involved in their design
or implementation
 A member of the engagement team being or having recently been a director or officer of
the client, or employed in an executive position by the client (with direct influence on the
assurance matter).
Advocacy:
 Promoting shares in a listed audit client
 Acting as an advocate on behalf of an assurance client in resolving disputes with third
parties.
Familiarity:
 Close or immediate family relationship with a director or officer of a client or with an
employee who has a position of influence over the subject matter of the engagement
(applies to any member of the engagement team)
 A former partner of the firm being a director or officer of the client, or an employee with
direct and significant influence over the subject matter of the assurance engagement
 Accepting gifts or preferential treatment, unless the value is clearly insignificant.
Intimidation:
 Being threatened with dismissal or replacement in a client engagement
 Being threatened with litigation
 Being pressured to reduce the extent of work required in order to reduce fees
 Accepting gifts with the possibility of it subsequently being made public.
Public practice behaviour:
 Inappropriate marketing of professional services and products
 Acceptance of inappropriate clients – client involved in illegal acts, client with
questionable issues.

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Reference: Learning objective 3.3 ~ explain the principles to be used for ethical threats and
apply the Code of Ethics for Professional Accountants.

57. Independence is made up of independence in mind and independence in appearance.

Describe these two aspects of independence.

Correct answer:
Independence of mind relates to the state of mind that permits the expression of a conclusion
without being affected by influences that compromise professional judgement. It requires the
professional accountant to exercise scepticism and act with integrity and objectivity.

Independence in appearance means avoiding situations and facts that are so significant that a
reasonable person, knowing all relevant facts and having considered the safeguards in place,
would reasonably conclude that a firm’s or a professional accountant’s integrity and
objectivity had been impaired.

Reference: Learning objective 3.4 ~ describe the regulatory and conceptual framework of
professional independence and the key guidelines.

58. Describe the deep-pockets theory.

Correct answer:
When a company fails the shareholders or creditors often want to recoup their losses through
a lawsuit. Usually the only party that they may be able to recoup their losses from is the
auditor, as they are still financially sound. Auditors are also required to carry professional
indemnity insurance for possible liability which adds to their ability to pay any damages
awarded by the court. The deep pockets theory therefore states that not all lawsuits brought
against auditors are due to audit failure and some may only be due to the fact that the auditors
are the only party left with sufficient financial resources to indemnify the plaintiffs’ losses.

Reference: Learning objective 3.5 ~ describe the legal framework for auditor liability.

59. A. Explain the impact that the Pacific Acceptance case had on existing auditing
practice.
B. List four of the procedures or practices that were identified in the ruling as
being part of a competent audit.

Correct answer:
A. Pacific Acceptance established a more exacting auditor responsibility than what had
previously been established in the Kingston Cotton Mill and London and General Bank cases.
Previously auditors had relied on the rulings in those two cases in denying any legal
responsibility for the detection of fraud. This resulted in a heavy reliance on management
representation letters and a lack of objective auditor independence. Pacific Acceptance
acknowledged that the standard for reasonable skill and care had changed and that “standards
are more exacting today than in 1896”. The case also established some of the key features of
professional due care expected of an auditor.

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B. Any four of the following:

 Pay due regard to the possibility of material fraud or error in framing or carrying out audit
procedures so the auditor has a reasonable expectation that the fraud or error will be
detected.
 Promptly report fraud or warn of suspicion of fraud, whether material or not.
 Closely supervise and review the work of inexperienced staff.
 Properly document audit procedures in a written audit program which is to be amended as
necessary as the audit progresses.
 Audit the whole of the year, not just the year-end balances; the duty to audit encompasses
the client’s financial affairs throughout the period of appointment and is not confined to
reporting on the year-end balances as presented in the accounts.
 Carry out proper objective auditing procedures; reliance on independent sources or client
personnel is an aid but not a substitute for the auditor’s own procedures.
 Do not shirk reporting to shareholders on the pretext that some detriment would arise if
the matter were revealed.

Reference: Learning objective 3.7 ~ explain the concept of due care and the circumstances
giving rise to negligence in the conduct of an audit.

60. Name the elements necessary to be successful in a case of negligence and show how
these were applied in the case of Twomax Ltd v. Dickson, McFarlane & Robinson.

Correct answer:
The elements necessary to be successful are:
 The auditors must have owed a duty of care to the plaintiffs.
 The auditors must have breached that duty of care by being negligent in their audit.
 The plaintiff must have suffered a loss due to reliance on the negligently audited
accounts.
 The loss must be quantifiable.
 In the case of Twomax, the financial position of Kintyre Knitware made it reasonably
foreseeable that they would probably be a takeover target. The potential investors were
therefore owed a duty of care by the auditors on the basis of reasonable foreseeability.
 The auditors breached the duty of care by negligently performing the audit.
 The plaintiff lost their entire investment when Kintyre Knitware went into liquidation.
 The loss was quantifiable as the amount of the plaintiff’s investment.

Reference: Learning objective 3.8 ~ identify the issues and rulings of major legal cases with
respect to the auditor’s liability to third parties.

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61. Match the case with the ruling:

Cases: Rulings:
Caparo Industries Pty Ltd v. Dickman Duty of Care owed to third parties in the
absence of a contract where the plaintiff has
suffered physical injury
Kingston Cotton Mill Co. The standards for an auditor’s level of skill
and care are more exacting today than in
1896
Segenhoe Ltd v. Akins & Ors Third party liability for auditors under the
tort of negligence
AWA Ltd v. Daniels An auditor’s duty of care is owed to
shareholders as a group, not to individual
shareholders
Donoghue v. Stevenson An auditor is a watchdog, but not a
bloodhound
Twomax Ltd v. Dickson, McFarlane & Contributory negligence
Robinson
Pacific Acceptance Corporation Ltd v. Auditors are liable for any dividends paid out
Forsyth of capital due to auditor negligence

Correct answer:
Caparo Industries Pty Ltd v. Dickman An auditor’s duty of care is owed to
shareholders as a group, not to individual
shareholders
Kingston Cotton Mill Co. An auditor is a watchdog, but not a
bloodhound
Segenhoe Ltd v. Akins & Ors Auditors are liable for any dividends paid out
of capital due to auditor negligence
AWA Ltd v. Daniels Contributory negligence
Donoghue v. Stevenson Duty of Care owed to third parties in the
absence of a contract where the plaintiff has
suffered physical injury
Twomax Ltd v. Dickson, McFarlane & Third party liability for auditors under the
Robinson tort of negligence
Pacific Acceptance Corporation Ltd v. The standards for an auditor’s level of skill
Forsyth and care are more exacting today than in
1896

Reference: Learning objective 3.8 ~ identify the issues and rulings of major legal cases with
respect to the auditor’s liability to third parties.

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62. A. Identify who the parties are in the contractual relationship regarding an audit
and what this relationship is termed.
B. Identify who may sue the auditors under contract.

Correct answer:
A.
The parties to a contract to audit are the auditors and the company that is being audited. It is
important to note that the company is the party and not management, even though
management may make the actual contract. The relationship is termed ‘privity of contract’
B.
As the contract is between the company and the auditors, only the company may sue the
auditors. Usually this entails the directors, the liquidator, or the receiver suing the auditors on
behalf of the company.

Reference: Learning objective 3.7 ~ explain the concept of due care and the circumstances
giving rise to negligence in the conduct of an audit.

63. List five precautions auditors may take to avoid litigation.

Correct answer:
Any five of the following:
 Use engagement letters for all professional services – especially important for non-audit
engagements and where detection of fraud may be a particular issue
 Investigate prospective clients thoroughly
 Comply fully with professional pronouncements
 Recognise the limitations of professional pronouncements
 Establish and maintain high standards of quality control
- assignment of competent staff
- adequate documentation of procedures
- compliance with independence requirements
 Maintain adequate professional indemnity cover
 Be prepared to issue privity letter on request.

Reference: Learning objective 3.9 ~ enumerate the precautions the auditor should take to
avoid litigation.

64. What were the causes and results of the ‘hard insurance market’ in Australia?

Correct answer:
The insurance market was characterised by tougher risk selection by insurers. In Australia,
the collapse of HIH insurance directly affected the insurance market as it held around 35% of
the professional indemnity insurance market. Adding to this were the other corporate
collapses of Harris Scarfe, One Tel, Storm Financial and ABC Learning in Australia and
others, including Enron, WorldCom and Dynegy, around the world which made auditor
insurance riskier. The possibility of terrorism was also a concern that was adding to the risk.

The results of this ‘hard insurance market’ were:

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 Chapter 3: Professional ethics, regulation and liability

 A lack of availability of insurance in Australia

 Substantial increases in average premiums per audit partner for major accounting firms
 Larger excess payments and some areas of self-insurance as a result of gaps in the cover
 Inadequate insurance cover to meet some of the outstanding claims.

Reference: Learning objective 3.5 ~ describe the legal framework for auditor liability.

65. Why would the courts want to limit the ability of third parties to sue auditors who have
been negligent? Are there any arguments that this liability should not be limited?

Correct answer:
Possible answers:
 Auditing is seen to be in the public interest and therefore litigation against auditors is
argued to have an adverse effect.
 Cardozo CJ stated that if liability for negligence exists, a thoughtless slip or blunder, the
failure to detect a theft or forgery beneath the cover of deceptive entries may expose
accountants to a liability in an indeterminate amount for an indeterminate time to an
indeterminate class. It is therefore necessary to draw the line somewhere.

The argument against limiting third party liability is that the law appears to treat auditors
more favourably than other experts on whom third parties place reliance. It also appears to
reverse what is seen as a socially desirable development in the law of holding experts liable
for the consequences of negligent advice.

Reference: Learning objective 3.5 ~ describe the legal framework for auditor liability.

66. The Australian case of Esanda Corporation v. Peat Marwick Hungerfords established
the elements that would be necessary for a third party to succeed in an action of negligence
against the auditor due to reliance on the audited accounts. Identify what these elements are.

Correct answer:
In order for a third party to succeed they would have to establish:
 The report was prepared on the basis that it would be conveyed to a third party
 The report would be conveyed for a purpose that was likely to be relied on by that party
 The third party would be likely to act in reliance on that report, thus running the risk of
suffering the loss if the statement was negligently prepared.

Reference: Learning objective 3.8 ~ identify the issues and rulings of major legal cases with
respect to the auditor’s liability to third parties.

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67. Explain how engagement letters can be used to avoid litigation.

Correct answer:
Engagement letters are of particular importance in non-audit engagements where
misunderstandings may arise as to the nature of the public accountant’s association with the
financial statements. They are also important in engagements where there may be some
misunderstandings as to the extent of an auditor’s responsibilities, particularly as to the
detection of fraud. ASA 210/ISA 210 Agreeing the Terms of Audit Engagements requires the
auditor to record in writing the terms of the audit engagement that are agreed to with the
entity. Also, the auditor is required to forward a copy of the terms of the engagement to the
entity. The written terms of the engagement should help the auditor minimise any potential
risk of exposure which might arise as a result of any misunderstandings as to the auditor’s
responsibilities. Where relevant, the auditor should include in the engagement letter any
arrangements concerning the involvement of other auditors, internal auditors or predecessor
auditors and any restriction on the auditor’s liability when such a possibility exists.

Reference: Learning objective 3.9 ~ enumerate the precautions the auditor should take to
avoid litigation.

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