Question

George Larkham (George) works as an audit partner at a mid-tier firm of Chartered Accountants, and is in the process of finalising the audit of the financial report of Rainbow Resources Limited (Rainbow Resources) for the year ended 31 December 2016. George has been approached by the company’s managing director with the proposal to process a journal entry to recognise an expense and a provision at 31 December 2016: Debit Credit Heavy maintenance expense 1,500,000 Provision for heavy maintenance expense 1,500,000 The managing director explains to George that he expects larger expenditure on heavy maintenance will be incurred in the 2018 financial year and it is prudent to recognise part of the expenditure in the 2016 financial year. George advises the managing director that the proposed entry does not conform with Generally Accepted Accounting Principles as in the 2016 financial year Rainbow Resources does not have a legal or constructive obligation to undertake the heavy maintenance in the 2018 financial year. As such, given the materiality of the expense and provision, if it is recognised, George will be required to modify the audit opinion. The managing director advises George that should he modify the audit opinion his firm will be removed as auditors in the 2017 financial year. George is worried by this as the audit fees generated from the audit of Rainbow Resources are material to the total fees which he generates for his firm. George is considering the managing director’s proposal and allow the journal entry to be processed to recognise an expense and a provision at 31 December 2016 without modifying the audit opinion. Required: (a) Provide three reasons why it is important for George to behave in an ethical manner. (b) Identify and explain the relevant fundamental ethical principles related to George's situation and the threats to these principles.

Answer 1

a.Three reasons why it is important for George to behave in an ethical manner:

i.Auditor is responsible to opine the true and fair view of the financial statements.If George allows the proposed entry without any modification in audit report, then the audit report will not state the true and fair view of the financial statements.

ii.The proposed entry does not confirm the Generally Accepted Accounting Principles as in 2016 there is no legal and constructive obligation to undertake heavy maintenance.Hence, George should not allow the proposed entry in the books of accounts at all.

iii.Honesty and integrity are the primary ethical values an auditor should demonstrate.Hence, George should not allow the proposed entry in the books of account to demonstrate honesty and integrity.

b.Fundamental ethical principles:and threats to these principles:

Fundamental ethical principles are:

Integrity

Objectivity

Professional competence and due care

Confidentiality

Professional behaviour

Threats:

1.Self-interest threat arises when stake of auditor or stake of any immediate or close family member of auditor is involved in the entity and thus he might cause the auditor to violate multiple ethical requirements.

2.Self-review threat arises when auditor is asked to examine or report on his own assessment, opinion, judgement or work and thus he is basically self reviewing his work. Its like asking student to assess his own exam script. Such situations may push auditor to give biased evaluation just to save reputation even if previous judgement was wrong.

3.Advocacy threat arises when auditor (most of the time unintentionally) supports the opinion or position (of the client most of the time) to the extent that it is not supported with relevant evidence or simply auditor supported the opinion beyond the degree of objectivity.

4.Familiarity threat arises when auditor due to the nature of relation with the other party become too sympathetic that it compromised the objective requirement of code.

5.Intimidation threat arises when auditor, directly or indirectly, threatened physically or mentally to keep him from working objectively.