Breaches to the code of ethics: A case study for PAIPs

This is the second of two case studies in A Plus, developed by the Institute’s Ethics Committee. The first case study, covered in last month’s issue, covered a situation in business, while this covers one in practice.

Case 2: Engagement quality control reviewer

John was the sole proprietor of a firm and the engagement partner of DEF Limited, a Hong Kong-listed company. The firm audited the consolidated financial statements of DEF Limited for the year ended 31 December 2018 and expressed an unmodified auditor’s opinion thereto. Arthur was the engagement quality control reviewer (EQCR) of the audit.

During 2018, DEF Limited entered into a sale transaction which allowed the buyer to settle the payment by interest-free instalments over a period of 20 years. DEF Limited recognized the revenue and trade receivable of the transaction at the invoiced amount without taking into account the discounting effect of the transaction.

DEF Limited had two overseas subsidiaries that were a substantial portion of the net assets of the group. The overseas subsidiaries were audited by a local branch of an international accounting firm (the overseas auditor).

During the audit:

• The firm did not identify the company’s non-compliance with the relevant accounting standard on the treatment of the transaction.
• The audit documentation did not contain evidence that John had discussed significant matters of the audit, in particular the discounting effect of the transaction, with Arthur.
• In response to the firm’s group audit instructions, the overseas auditor provided the firm a summary of audit procedures performed on the overseas subsidiaries and the corresponding findings.
• As John was simultaneously working on multiple engagements and work commitments, he requested Arthur to consider and review the overseas auditor’s summary of work and findings, without first evaluating them himself as the engagement partner. At John’s request, Arthur recorded his review and conclusion with respect to the overseas auditor’s work in a working paper and reported his findings to John.
• John considered Arthur’s review of the overseas auditor’s work and findings to be part of Arthur’s work as an EQCR to review significant judgements made, as opposed to the responsibilities of the engagement team.
• John asserted that the independence of Arthur from the engagement team could be assured because the overseas subsidiaries had been audited by a Big Four accounting firm.

Consider the following with reference to the code:
1. Which fundamental principles did John and Arthur fail to comply with?
2. What were the deficiencies committed by John and Arthur in carrying out the audit engagement?
3. Do you agree with John that Arthur’s review of the overseas auditor’s work and findings was part of the work of an EQCR? Why or why not?
4. Do you agree with John’s explanation that Arthur’s independence as an EQCR could be assured? Why or why not?

John and Arthur had breached the fundamental principle of professional competence and due care as well as the independence requirements.

• They failed to identify the accounting non-compliance of DEF Limited’s consolidated financial statements but expressed an unmodified auditor’s opinion, which might have a bearing on users of the audited financial statements.

– John failed to challenge the appropriateness of the accounting treatment of the transaction with a sceptical mind and evaluate whether accounting estimates pertaining to the transaction were reasonable in the context of the applicable financial reporting framework and perform adequate audit procedures thereof. The investigation also noted that John did not communicate to the audit committee his views on the qualitative aspects of the transaction, which involved significant judgement and estimation.
– Arthur failed to act competently and diligently, i.e. he did not objectively evaluate the significant judgements made and the conclusions reached by the engagement team in the capacity of an EQCR.

• Arthur violated the independence and objectivity of an EQCR by reviewing the audit work and findings by the overseas auditor. This involved significant judgements and was an integral part of the audit procedures to be carried out by the engagement team in a group audit, being far more extensive than an evaluation by an EQCR. Consequently, this gave rise to a self-review threat because Arthur involved in the significant judgements made in the audit engagement that were subsequently reviewed by him in the capacity of an EQCR.
• John’s view of the role and responsibilities of the engagement team and EQCR in a group audit engagement demonstrates his lack of understanding of the relevant requirements. He failed to ensure that the work required for a group audit engagement was properly performed. He also failed to ensure the EQCR was independent from the audit engagement team.

What does the code say?

According to paragraph R113.1 in Chapter A, a professional accountant shall comply with the principle of professional competence and due care, which requires an accountant to:

(a) Attain and maintain professional knowledge and skill at the level required to ensure that a client or employing organization receives competent professional service, based on current technical and professional standards and relevant legislation; and

(b) Act diligently and in accordance with applicable technical and professional standards.

What do the professional standards say?

Paragraph 40 of Hong Kong Standard on Quality Control (HKSQC) 1 Quality Control for Firms that Perform Audits and Reviews of Financial Statements, and Other Assurance and Related Services Engagements requires a firm to establish policies and procedures designed to maintain the objectivity of the EQCR. Paragraph A49 continues that such policies and procedures provide that the EQCR:

• Where practicable, is not selected by the engagement partner;
• Does not otherwise participate in the engagement during the period of review;
• Does not make decisions for the engagement team; and
• Is not subject to other considerations that would threaten the reviewer’s objectivity.

Hong Kong Standard on Quality Management (HKSQM) 2 Engagement Quality Reviews is effective for audits and reviews of financial statements for periods beginning on or after 15 December 2022, and effective for other assurance and related services engagements beginning on or after 15 December 2022. When HKSQM 2 becomes effective, it replaces the extant provisions relating to engagement quality reviews in extant HKSQC 1 and Hong Kong Standard on Auditing (HKSA) 220 Quality Control for an Audit of Financial Statements.

• According to paragraph 9 of HKSQM 2, the EQCR is not a member of the engagement team. The performance of an engagement quality review does not change the responsibilities of the engagement partner for managing and achieving quality on the engagement, or for the direction and supervision of the members of the engagement team and the review of their work. The EQCR is not required to obtain evidence to support the opinion or conclusion on the engagement, but the engagement team may obtain further evidence in responding to matters raised during the engagement quality review.
• According to paragraph 13(a) of HKSQM2, an engagement quality review is an objective evaluation of the significant judgements made by the engagement team and the conclusions reached thereon, performed by the EQCR and completed on or before the date of the engagement report.
• According to paragraph A14 of HKSQM2, a self-review threat may be created when the EQCR previously was involved with significant judgements made by the engagement team, in particular as the engagement partner or other engagement team member.

What should John have done?

John, as the engagement partner, should have:

• Determined that sufficient and appropriate resources to perform the engagement are assigned or made available to the engagement team in a timely manner, taking into account the nature and circumstances of the audit engagement, the firm’s policies or procedures, and any changes that may arise during the engagement (paragraph 25 of HKSA 220 (Revised) Quality Management for an Audit of Financial Statements).
• Taken reasonable steps to ensure members of the engagement team collectively have the appropriate competence and capabilities to perform the audit engagement (paragraph 26 of HKSA 220 (Revised)).
• Applied professional knowledge and skill with sound judgement and professional scepticism, including the application of HKSA 540 (Revised) Auditing Accounting Estimates and Related Disclosures in auditing accounting estimates and requirements in HKSA 600 Special Considerations – Audits of Group Financial Statements (Including the Work of Component Auditors) with respect to a group audit engagement.
• Ensured relevant ethical requirements including those relating to independence have been fulfilled (paragraph 21 of HKSA 220 (Revised)).
• Determined that sufficient appropriate audit evidence has been obtained to support the conclusions reached and for the auditor’s report to be issued, through review of audit documentation and discussion with the engagement team (paragraph 32 of HKSA 220 (Revised)).
• Ensured a consultation is undertaken on difficult or contentious matters (paragraph 35(a) of HKSA 220 (Revised)), such as the accounting treatment of the transaction.
• Ensured that significant matters and significant judgements arising during the audit engagement are discussed with the EQCR (paragraph 36(c) of HKSA 220 (Revised)).
• Communicated the auditor’s views about significant qualitative aspects of the entity’s accounting practices and significant matters arising during the audit with those charged with governance (paragraph 16 of HKSA 260 (Revised) Communication with Those Charged with Governance).

What should Arthur have done?

Arthur, as an EQCR, should have:

• Applied the conceptual framework of the code to identify, evaluate and address threats to his independence and objectivity as an EQCR.
• Acted competently and diligently as an EQCR in accordance with the relevant professional requirements, including but not limited to:

– Notified the appropriate individual in the firm when he becomes aware of circumstances that impair the EQCR’s eligibility (paragraph 23 of HKSQM 2).
– Discussed with the engagement partner and other members of the engagement team significant matters and significant judgements made in planning, performing and reporting the engagement (paragraph 25(b) of HKSQM 2).
– Evaluated the basis for the engagement partner’s determination that relevant ethical requirements relating to independence have been fulfilled (paragraph 25(d) of HKSQM 2).
– Evaluated whether the engagement partner’s involvement was sufficient and appropriate throughout the audit engagement to provide the basis for significant judgements made and the conclusions reached (paragraph 25(f) of HKSQM 2).

This article was contributed by the Institute’s Standard Setting Department. This guidance is for general reference only. The Institute, Ethics Committee and the staff of the Institute do not accept any responsibility or liability in respect of the guidance and any consequences that may arise from any person acting or refraining from action as a result of any materials in the guidance. The department welcomes your comments and feedback on this guidance, which should be sent to commentletters@hkicpa.org.hk.