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Trustees where there is an audit connection

This article is not intended to be a part of, or a substitute for reading, the relevant parts of the APB Ethical Standards (ES) that apply to audits in accordance with ISAs (UK and Ireland).

This article is not intended to be a part of, or a substitute for reading, the relevant parts of the APB Ethical Standards (ES) that apply to audits in accordance with ISAs (UK and Ireland). 

Its aim is to set out the thought process that should be adopted when considering who, within an audit firm, can or should act as a trustee of a trust which has an investment in an audit client. In particular it considers who would be likely to be in a position to influence the audit partner.

Background

The ES (The ES referred to are those applying at April 2013) set out the auditor independence rules which must be followed by auditors in the UK and Ireland. In essence, the auditor must conduct the audit with actual and perceived independence, which means freedom from situations and relationships which make it probable that a reasonable and informed third party would conclude that objectivity is or could be impaired (ES1, paragraphs 6 and 13).

To support the underlying requirement there is a framework of considering threats (actual and perceived) and applying relevant safeguards if available. There are also detailed requirements that apply in particular circumstances. Where circumstances are the same as, or similar to, those described in the detailed requirements, those requirements must be applied ahead of general threats and safeguards considerations, except in the very rare circumstances where they would result in the opposite of the fundamental principles being achieved. The detailed requirements relating to trustees are included within the discussion on financial relationships with the audited entity.

Basic requirements

Trustees have a financial interest in the companies in which the trusts they are trustees of, hold investments. The default position in the detailed requirements of the ES (and for that matter the IESBA code which ICAEW’s own code of ethics is based on) is that auditors should not hold investments in audit clients. Auditors are for these purposes defined as the audit firm, any partner in the audit firm, a person in a position to influence the conduct and outcome of the audit or an immediate family member of such a person.

It follows that, in the absence of any other provisions, neither the audit firm nor any of those people listed above, could be a trustee of a trust directly or indirectly owning any shares in an audited entity, unless the only holdings are immaterial and indirect, and neither the audit firm nor the person in question is in a position to influence the investment.

However, there are two reliefs:

  • for the audit firm and for individuals within it who are not in a position to influence the audit, the relief is quite generous. The only condition, assuming the general threats and safeguards analysis required by ES1 does not reveal any insuperable threats, is that the trustee must not be a beneficiary (ES2, paragraph 21).
  • for those who are in a position to influence the audit, clearly the actual and perceived threats would be greater. The relief is therefore much more restrictive. As well as the trustee not being a beneficiary, there is a significance/materiality threshold (the trust must not be able to exercise significant influence over the audited entity, and the investment in the audited entity must not be material to the trust), and the relevant trustee must not have significant influence over the decisions re the investment in the audited entity (ES2, paragraph 19).

For privately held audited entities in particular, the relationships between the trust and the audited entity are frequently significant in at least one direction so the paragraph 19 relief is  clearly of much less value than that in paragraph 21. Therefore, if it is desired that an individual within the firm act as the trustee rather than the firm, it is clearly advantageous for that individual not be in, or be seen to be in, a position to influence the audit.

Note that this article does consider only the position relating to audited entities that are not listed on a stock exchange, or otherwise considered to be public interest entities. There are a significant number of extra requirements relating to these, which would be relevant to the discussion.

Who is in a position to be able to influence the audit?

Like most other aspects of the ethical standards, there are three tiers of questions to be asked when applying the ES:

  1. Are there any specific requirements in the ES that apply in the particular circumstances and have they been complied with?
  2. Is there an actual significant threat to objectivity and independence?
  3. Would a reasonable and informed third party (otherwise known as the man on the Clapham omnibus) consider that objectivity and independence could be compromised?

As regards the first of these questions, which in this instance relates to the financial interest requirements of ES2, there is a definition of those in a position to be able to influence the audit, to be used. This includes: a) those actually involved in the audit (including oversight and quality control); b) those in the chain of command (also defined); and c) anyone else who in a position to influence as a result of the specific circumstances (bringing in the last two questions above) (ES – Glossary - person in a position to influence the conduct and outcome of the audit)

The chain of command is defined to include everyone with a direct supervisory, management or other oversight responsibility (including performance appraisals) over the audit partner or the conduct of audit work. (ES- Glossary – chain of command). The definition includes the phrase ‘This includes all … who may prepare, review or directly influence the performance appraisal of any audit partner of the audit team as a result of that partner’s involvement with the audit engagement’.

There have been a number of views as to the relevance of the words at the end: ‘as a result of that partner’s involvement with the audit engagement’. One view is that only those who actually do exercise influence are intended to be included. However, in our view the partner referred to as ‘that partner’ is the audit partner, not the one in the chain of command. The intention is to catch not just those who are or are likely to be involved in the audit, but those who, because of their seniority, could exert influence over the audit partner.

This interpretation is reinforced by that in the IESBA code of ethics. That includes within its definition of ‘audit team’ (amongst others): ‘All others within a firm who can directly influence the outcome of the audit engagement, including … those who recommend the compensation of, or who provide direct supervisory, management or other oversight of the engagement partner in connection with the performance of the audit engagement including those at all successively senior levels above the engagement partner through to the individual who is the firm’s Senior or Managing Partner (Chief Executive or equivalent).’ Although the IESBA code s290 does not apply to audits in accordance with UK ISAs, as noted in ISA (UK and Ireland) 200, APB did not intend there to be any significant instances where the relevant parts of the IESBA Code of Ethics are more restrictive than the APB’s Ethical Standards, so in this instance we believe the additional discussion in the IESBA code to be relevant.

Examples

It is usually helpful to illustrate the thought process with a few likely examples. In this instance, let us consider a few examples based around a not-unlikely scenario where an audited entity is substantially owned by a family trust and the investment in the entity in turn forms a substantial part of the trust’s investments. The audit firm is asked to appoint a trustee and perhaps look after the accounts of the trust. There would be no beneficial interest.

The risk is that the audit partner might want to amend the accounts or qualify the audit report in a way which would financially disadvantage the trust. Were the trustee, who has a fiduciary duty to the trust, in a position to be able to influence the audit partner, he or she would be put in a very difficult position. At least part of the point of the ethical requirements is to avoid people ever having to be in such a position, as by then there is often a no-win situation.

Considering the three tier questions, could the trustee be, for example:

  • Someone directly involved in the audit? – based on all three questions above, the answer has to be no.
  • A manager or more junior person in the firm, who is not involved in the audit? – in principle the paragraph 21 relief would indicate that such a person could be a trustee. They have no direct influence and are unlikely to be in a position to be able to influence the personnel on the audit. However, as always, detailed circumstances would have to be considered both from an actual and perception perspective. The person involved might be, for example, the spouse of someone on the audit team, and it would be difficult to defend against a suspicion of influence. There may be a 360 degree appraisal scheme - though in practice it might not be unreasonable to suppose that comments from staff who are not senior to the individual are unlikely to have a significant influence.
  • A senior non-audit partner in a one office practice? – such a person is likely to be considered to be in the chain of command unless there were a very formalised and rigid ring-fencing arrangement – seldom possible in such circumstances. Even then, they would be likely to be caught by the “Any person .. who… may be in a position to exert such influence” part of the definition of those in a position to influence. If they were put in a position of knowing that a more junior partner was about to take steps to imperil the trust of which they were trustee, again they would be (and could certainly be perceived to be) put in an invidious position.
  • A partner or senior RI in another office of the practice, who is not involved in the audit and who is not in the direct line of command of the individual?  - the starting point would seem to be that they are not in a position to influence, assuming that the different location means there is relatively little involvement. But again, detailed circumstances need to be considered to establish if this is, and can reasonably be seen to be, the case: connections, internal appraisal arrangements, involvement with committees setting rewards, etc.
  • The firm itself, as a ‘corporate’ trustee? – this does not really address the fundamental issue where there would be one if the individual were the trustee. On the face of it, the detailed requirements are dealt with: having the firm as trustee allows advantage to be taken of the paragraph 21 relief rather than the more restrictive paragraph 19 relief. However, if used to circumvent paragraph 19, this would be a ‘form over substance’ solution. That does not of itself solve anything in a principles-based standard. The second and third questions still need to be considered and for that, the arrangement needs to be drilled down into in terms of who is actually acting as the trustee? Could that person actually exert, or be reasonably seen to be in a position to exert, influence?

Summary

The specific requirements in this area, following the ‘no financial interests’ starting point, necessarily work on the basis that those in a position to influence the audit should not be trustees of a trust with an interest in the audit client. There are reliefs and these are discussed above. But just because a situation does not breach a detailed requirement does not mean that there is not necessarily a problem. The core threats, actual and perceived, need to be considered and available safeguards assessed as to whether they are appropriate.

Trustee shareholdings in audit clients

You may also be interested in this article, Trustee shareholdings in audit clients, that appeared in Audit News 52, November 2012.