Ethical threats from non-audit services, fee dependence and a family relationship
You are the ethics partner at a mid-tier UK audit firm. The firm audits Widget Group Ltd, a private UK group with revenue £120m. The audit fee is £350,000. The firm also earns £300,000 per year from tax compliance and transfer pricing advice for the group, and the group has asked the firm to implement a new ERP accounting system for £150,000. Total firm income is £9m. The audit engagement partner has led the audit for nine years. The group finance director is the audit partner's brother-in-law. The audit partner has no direct financial interest in the group. The firm's independence manual says tax compliance is acceptable for audit clients and that long association is managed by annual partner reviews. The client is not a public interest entity.
1. Identify and evaluate the ethical threats arising from the fee dependence, the non-audit services and the family relationship. Which threats are so significant that no safeguard can reduce them to an acceptable level?
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Fee dependence. Total fees of £650,000 are 7.2% of £9m; the audit fee alone is 3.9%. The audit fee is recurring and the firm is not a PIE, so this is not automatically prohibited, but it creates a self-interest threat. Safeguards include an independent quality control review, disclosure to those charged with governance, and monitoring of the firm's dependence.
Non-audit services. Tax compliance can be acceptable if it is not management and does not create a self-review threat over significant accounting estimates. Transfer pricing advice is more sensitive because it affects the tax provision and may be material. The ERP implementation is the clearest problem: designing and implementing an accounting system creates a self-review threat and a management threat, because the firm would later audit the system it designed. For an audit client this is normally prohibited unless clearly immaterial, which £150,000 and an ERP are not.
Family relationship. The finance director is the audit partner's brother-in-law. This is a close personal relationship with key management and creates a familiarity threat. Even if not a direct financial interest, the partner's objectivity is threatened. Removing the partner from the engagement is the most effective safeguard; annual reviews are not enough.
2. Recommend the actions the firm should take before accepting the ERP engagement, including documentation and communication.
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Before accepting. The firm should decline the ERP implementation. If the client insists, the firm must consider resigning from the audit or declining the non-audit work. The audit partner should be rotated off the engagement immediately, and an independent partner should review the relationship. The tax and transfer pricing work should be performed by a separate team with no audit involvement, and the audit team should not rely on the firm's own tax advice without independent evidence.
Documentation and communication. Document the threats, the safeguards considered and the conclusion. Discuss the matter with those charged with governance and obtain their views. Consider whether the fee dependence requires an engagement quality control review. The firm's independence manual should be updated because 'annual partner reviews' do not adequately address a nine-year tenure with a close family relationship.
3. If the firm accepts the ERP engagement and retains the audit partner, what are the likely consequences under the FRC Ethical Standard and the ICAEW Code?
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Consequences. Accepting the ERP engagement while retaining the audit partner would breach the FRC Ethical Standard and the ICAEW Code. The self-review and management threats would be so significant that no safeguard could reduce them to an acceptable level. The audit would be compromised because the firm would be auditing its own system design.
Regulatory and practical effects. The firm could face disciplinary action, and the audit report could be challenged. The firm should either resign from the audit or withdraw from the ERP work. If it continues, it should disclose the breach and consider whether the audit opinion can be supported. In practice, the safest course is to decline the ERP engagement and rotate the partner.