The Independence Problem in a Small Market
You are the engagement partner for the audit of a mid-sized bank in Baku. Your firm has audited the bank for four years. The bank's chief financial officer is the brother-in-law of your firm's managing partner. In addition, the firm provides tax-compliance services to the bank and has just been asked to design and implement the bank's new internal control system over financial reporting. The audit fee for the current year is AZN 180,000, of which AZN 60,000 relates to the tax and advisory work. The bank is listed and has a public-interest profile. The audit committee has approved the additional engagement and says 'everyone in Baku knows everyone'.
1. Assess the threats to independence arising from the family relationship, the non-audit services and the fee dependency.
Read the worked answer
Family relationship (CFO / managing partner's brother-in-law): Under the IESBA Code, a close family member of a firm leader in a key position at the client creates a familiarity and intimacy threat. Because the CFO is in a position to influence the financial statements, the threat is significant. Safeguards (e.g., removing the individual from the engagement) may be insufficient where the relationship is at partner level; the firm should consider whether the engagement can continue.
Non-audit services:
- Tax compliance: Generally permissible if the firm does not assume management responsibility and the tax work is not material to the financial statements.
- Designing and implementing internal controls over financial reporting: This is a prohibited service for a public-interest entity audit client. It creates a self-review threat because the firm would be auditing controls it designed. This is a clear breach.
Fee dependency: Total fees of AZN 180,000, with AZN 60,000 from non-audit work, create a self-interest threat if the client is significant to the firm. The firm must assess whether fees from this client exceed a threshold (commonly 15% for PIEs) and disclose/apply safeguards.
Conclusion: The control-design engagement must be declined or the audit resigned. The family relationship requires escalation.
2. What actions should the firm take, and what are the consequences if the bank insists on the control-design engagement?
Read the worked answer
Actions:
- Decline or withdraw from the internal-control design and implementation engagement - it is prohibited for a PIE audit client under the IESBA Code and the EU/ Azerbaijani rules on auditor independence.
- Escalate the family relationship to the firm's ethics partner and the audit committee. Consider removing the managing partner from any role influencing the engagement; if the relationship cannot be managed, resign from the audit.
- Assess fee dependency and document the safeguards; if fees exceed the threshold, disclose to the audit committee and consider whether safeguards are adequate.
- Obtain audit committee confirmation in writing of its approval of the remaining non-audit services and its understanding of the independence position.
If the bank insists on the control-design engagement: The firm cannot continue as auditor. Resign and communicate the reasons to the audit committee and, where required, to the regulator. Continuing would breach the Code and could expose the firm to disciplinary action and the audit report to challenge.
Documentation: Record the assessment, the communications and the decision in the engagement file.