Independence Threat from a Longstanding Audit Partner and Non-Audit Fees
A partner has served as engagement partner on the audit of Meghna Pharma Ltd for seven consecutive years. In the current year the firm also earned BDT 18,000,000 in non-audit fees from the client for tax structuring and system implementation, against audit fees of BDT 9,000,000. The client's total fee base to the firm is significant but the office has other large clients. The partner's spouse has recently been appointed as a non-executive director of the client, receiving only director's fees. The audit committee has asked the firm to confirm its independence in writing. The partner argues that long service improves quality and that the non-audit work is unrelated to the audit. The firm's ethics partner must respond.
1. Identify and evaluate the independence threats arising from the facts, applying the conceptual framework of identifying, evaluating and addressing threats.
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Threats identified.
- Familiarity threat from seven years as engagement partner: long association can lead to over-identification with the client and reduced professional scepticism.
- Self-interest threat from non-audit fees of BDT 18,000,000 being double the audit fee of BDT 9,000,000: economic dependence and the incentive to retain lucrative work can compromise objectivity.
- Self-review threat from the system implementation engagement, because the firm may later audit the systems it designed or implemented.
- Close family threat from the spouse's non-executive directorship: a close family member in a position to influence the entity's decisions creates a familiarity and self-interest threat.
Evaluation.
- The fee ratio is the most serious quantitative indicator: non-audit fees at twice the audit fee suggest the audit relationship is subordinate to the consulting relationship.
- The system implementation is a direct self-review threat if the systems affect financial reporting; tax structuring may be acceptable if it does not involve assuming management responsibility.
- The spouse's directorship is a close family relationship with a director, which is generally not permitted for an audit engagement partner.
- Long association alone may be manageable, but combined with the other threats it compounds the familiarity risk.
Conclusion. The threats are not at an acceptable level without safeguards, and the partner's assertion that long service and unrelated non-audit work resolve the matter is not supportable.
2. Recommend the safeguards the firm should apply and draft the substance of the independence confirmation to the audit committee.
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Safeguards recommended.
- Rotate the engagement partner and, if required by the applicable rotation rules, the engagement quality reviewer, so that the seven-year association ends.
- Separate the teams: ensure the non-audit engagement is performed by a different team with separate reporting lines, and that the audit team does not rely on work it performed itself without independent review.
- Refer the system implementation to another firm if it affects financial reporting systems, eliminating the self-review threat.
- Engagement quality review by an independent partner for the current year and for the first year after rotation.
- Remove the partner from any decisions affecting the client, given the spouse's directorship, and consider whether the spouse's role can be structured so that she does not influence financial reporting; if not, the partner must be removed from the engagement entirely.
- Fee monitoring: report the fee ratio to the audit committee and to the firm's ethics partner, and set a policy threshold for non-audit fees relative to audit fees.
- Document the evaluation and safeguards in the independence file.
Substance of the confirmation. The firm should confirm that it has identified the threats, that the partner has been rotated, that the non-audit work is either referred out or ring-fenced with separate teams and independent review, that the partner with the family connection is excluded from the engagement, and that the firm considers its objectivity and independence to be maintained subject to those safeguards. It should not give an unqualified confirmation without those actions, because the combination of a close family director, a seven-year partner and non-audit fees double the audit fee cannot be described as independent without safeguards.