The Conflicting Engagement: Audit Client and Prospective Acquirer
You are the engagement partner on the statutory audit of Ridgeway Components Ltd, an unlisted UK company with a 31 December year end. Total assets are £18m and revenue is £24m. During November fieldwork, the finance director tells you that Ridgeway is in advanced talks to be acquired by Halden Group plc, a listed company. Halden has asked your firm to perform financial due diligence on Ridgeway and to advise on the purchase price allocation. The proposed fee for the due diligence work is £140,000, compared with the recurring audit fee of £55,000. The acquisition is expected to complete in March, before the audit report is signed. Your firm has no other relationship with Halden. The audit partner's performance bonus is partly based on total fees generated from clients in the region.
1. Identify the threats to independence arising from accepting the due diligence engagement and evaluate whether safeguards could reduce them to an acceptable level.
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Self-interest threat. The due diligence fee (£140,000) is more than 2.5 times the audit fee and is contingent on the deal proceeding. The partner's bonus linked to regional fees intensifies the threat that the audit team is reluctant to challenge management or to qualify the report, because a qualified report could derail the acquisition and the due diligence fee. This is significant and, combined with the bonus, hard to safeguard.
Self-review threat. Advising on purchase price allocation requires the firm to value Ridgeway's assets and liabilities - figures that feed directly into the financial statements the firm will audit. Using our own valuation work as audit evidence is a self-review threat.
Advocacy threat. Advising Halden on price effectively promotes Ridgeway's position to the acquirer. If a dispute arises between Ridgeway and Halden over completion accounts, the firm cannot act for both.
Intimidation threat. Management knows the firm wants the due diligence fee; this gives them leverage.
Conclusion. Safeguards (separate teams, independent partner review, disclosure to those charged with governance) can address self-review and some self-interest, but cannot eliminate the advocacy conflict of acting for both buyer and target on the same transaction. The firm should decline the due diligence work, or resign the audit if the due diligence is more valuable and permitted by ethical standards. The bonus arrangement should be removed from the partner's remuneration for this engagement.
2. If the firm proceeds with both engagements, what specific safeguards and disclosures would you put in place, and what would cause you to conclude that no safeguard is sufficient?
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Safeguards:
- Use entirely separate engagement teams with no overlapping personnel, and a different engagement partner for the due diligence.
- Prohibit the audit team from accessing the due diligence working papers and vice versa (information barriers).
- Obtain written acknowledgement from Ridgeway's audit committee (or board) of the threat and their consent, documenting the rationale.
- Independent quality control review of the audit by a partner unconnected with either engagement.
- Remove the due diligence fee from the audit partner's bonus calculation.
- Disclose the relationship in the audit report if required by the applicable ethical code.
When no safeguard is sufficient:
- If the due diligence involves expressing an opinion on the fair value of the very balances that are material to the audit (e.g. inventory or intangibles), the self-review threat becomes so significant that the firm cannot objectively audit its own conclusions.
- If the firm is asked to negotiate price on Ridgeway's behalf, that is advocacy - prohibited.
- If the audit team is asked to keep the due diligence findings from the audit file, integrity is compromised.
- If the total fees from Ridgeway and Halden combined become so large relative to the firm's total income that independence is threatened (fee dependence), the firm should decline one engagement.