Earlier this year, the International Ethics Standards Board for Accountants issued a revised and restructured ethics code, “International Code of Ethics for Professional Accountants, including International Independence Standards.” The case study below demonstrates application of the new code’s independence standards, including the conceptual framework, when a firm proposes to perform certain non-assurance services to an audit client.
Case study
JKL Accountants audits CLA Financial Services and proposes to provide the following non-assurance services to the client:
- Tax compliance;
- Tax planning; and,
- Risk advisory services.
Before accepting these engagements, JKL must evaluate whether the proposed services create threats to independence, and apply any relevant requirements and application material. “Threats” are professional services, interests or relationships that might compromise compliance with the code’s fundamental principles. When analyzing threats, JKL considers the following factors (among others):
- The degree of reliance JKL will place on the outcome of the NAS in performing CLA’s audit;
- The level of client expertise regarding the non-assurance service;
- The extent of CLA’s involvement in making significant judgments related to the service;
- The impact of the service on CLA’s financial statements, accounting records, internal control over financial reporting or other information on which JKL will provide assurance; and,
- Whether CLA is a public interest entity -- for example, a company whose securities are listed on a public stock exchange.
By considering these factors and others, JKL determines whether self-review, self-interest, familiarity, advocacy or intimidation threats to the firm’s independence might arise in connection with the services, including the combined effect of performing multiple services. Briefly, each type of threat means:
- Self-review: The threat that, in performing the audit, JKL will not appropriately review the result of a firm member’s previous judgment or activity performed.
- Self-interest: The threat that a financial or other interest will inappropriately influence JKL’s behavior or professional judgment.
- Familiarity: The threat that due to a long or close relationship with the personnel of CLA, JKL will be too sympathetic to their interests or overly accepting of their work.
- Advocacy: The threat that JKL will promote the client’s positions, impairing its objectivity (for example, a tax position).
- Intimidation: The threat that CLA will attempt to exert undue influence over JKL if audit issues are raised
When identifying and evaluating threats, JKL may consider the environment in which the firm conducts its business -- for example, professional requirements for accountancy licensure, disciplinary processes, and policies and procedures that foster an ethical climate.
If threats, alone or in combination, are significant and not at an acceptable level, JKL is required to determine what actions should be taken to address them. That is, JKL might be able to eliminate the circumstance creating the threat or apply “safeguards” to reduce the threats to an “acceptable level.” Compliance with the code’s fundamental principles is presumed when threats are at an acceptable level. The code requires that JKL judge the situation from the viewpoint of a “reasonable and informed third party” (not necessarily an accountant) who is aware of the relevant facts known at that time. It is also critical that JKL understand the specific facts and circumstances involved in performing the non-assurance service in order to make those judgments. If JKL cannot effectively reduce the specific threats to an acceptable level (i.e., via safeguards), then JKL is required to end or decline to perform the service or resign as auditor.
If the non-assurance service would involve assuming a management responsibility for CLA, then JKL is prohibited from providing it. JKL may provide advice and recommendations to assist CLA in discharging its responsibilities. To do so, JKL is required to ensure that CLA has assigned a person who is sufficiently skilled, knowledgeable and experienced to make decisions and oversee the service. That person, preferably someone in senior management, is required to take responsibility for the adequacy and results of the service and any follow-up actions.
The list of non-assurance services specifically addressed in the code is not all-inclusive; in this case, the code addresses tax compliance and planning (generally), but risk advisory services are not explicitly addressed. As for the non-assurance services specifically addressed in the code, the application would generally be as follows:
1. Tax return preparation services, as described in the code, normally do not create a threat to independence. This is because tax preparation is usually based on historical information and principally involves analysis and presentation of such historical information under existing tax law, including precedents and established practice. If the nature of JKL’s proposed services, or the way they will be delivered, go beyond the code’s description of tax preparation services, JKL should identify, evaluate and address any threats to independence that are created. In such case, JKL would need to look to provisions of the code, not just the material that deals with tax preparation. For example, the provisions in the code for preparing tax calculations’ underlying accounting entries that will be reported in the client’s financial statements might be applicable.
2. Tax planning and other tax advisory services, as described in the code, might create a self-review or advocacy threat to independence. The code provides examples of several factors to help JKL evaluate the level of possible threats, including, for example, the degree of subjectivity inherent in determining how its tax advice will be disclosed in CLA’s financial statements. Other questions JKL should consider are:
- Is the tax advice clearly supported by the relevant taxing authority or other precedent, an established practice, or basis in law that’s likely to prevail under scrutiny?
- Does the outcome of JKL’s tax advice materially impact CLA’s financial statements?
- Does the effectiveness of the tax advice depend on the accounting treatment or presentation in CLA’s financial statements; if so, is the appropriate treatment or presentation under the relevant financial reporting framework unclear?
Assume the tax position’s validity and appropriate treatment in CLA’s financial statements is not clear and its effectiveness depends on a certain financial statement treatment. JKL believes this situation creates significant self-review and advocacy threats to independence and that the following safeguards will adequately address the threats:
- Using separate teams to perform the audit and tax advisory services; and,
- Requesting or obtaining pre-clearance from the taxing authority on the tax treatment’s validity.
If JKL concludes that applying the above safeguards is effective in reducing the self-review and advocacy threats to independence to an acceptable level, then JKL would proceed in providing the tax planning and/or tax advisory services to CLA.
What if JKL determines that the accounting treatment of the tax transaction is material to CLA’s financial statements? When impact to the financial statements is material, the code precludes JKL from providing both the audit and tax planning or advisory services. This is because, unlike the first situation, this fact pattern creates threats to independence that are so significant that safeguards are incapable of reducing them to an acceptable level.
3. Risk advisory services are not specifically addressed in the code, so JKL will be required to apply the conceptual framework to identify, evaluate and address any threats to independence, and the applicable general and possibly other provisions in the code. Among other things, the scope of the services, the circumstances under which they are performed, and management’s competence, involvement and oversight will be critical factors. As already mentioned, JKL is prohibited from assuming any management responsibilities for CLA.
In reviewing the proposed services, CLA’s audit partner raises a concern that one activity would be considered a prohibited management responsibility. JKL is proposing to help CLA determine whether there are any gaps in the company’s risk management policies and to provide periodic updates to CLA’s board of directors on management’s behalf. The audit partner informs JKL’s advisory team that the firm could accompany management to the meetings but that the CFO of CLA and her team will be responsible for briefing the board about the project. With this adjustment in scope, JKL has confirmed that the firm will not be assuming a management responsibility and provided that any threats created are addressed, then firm may provide the non-assurance service.
Documentation
Although the code doesn’t require it, once JKL has formed its conclusions on the above matters, as a best practice the firm should prepare documentation to support significant judgments made and explain its rationale for conclusion(s) reached. Such documentation might include summaries of relevant discussions, descriptions of facts and circumstances relevant to the identification of specific types of threats, as well as how those threats are evaluated and addressed. When safeguards are applied, a synopsis of how JKL determined that such safeguards are effective might be useful to inform future discussions with others about the firm’s compliance with independence requirements (e.g., peer reviews or audit inspections).
Further information about the IESBA Code is available at
