We are an audit firm and have been approached by a local accountancy firm that does not perform audits to see if we’d be interested in having audit opportunities referred from them. The accountancy firm would like to receive a referral fee or commission for any audit work introduced to us for which we are appointed statutory auditors. Is the payment of referral fees for audit work permitted?

While the Financial Reporting Council (FRC) Ethical Standard does not strictly prohibit referral fees being paid for audit work, there may be threats to independence arising from such arrangements. Unless those threats can be eliminated or reduced to a level at which independence is not compromised, audits should not be accepted with a referral fee arrangement in place.

A self-interest threat may arise from the payment of such a referral fee. It may be perceived that the audit firm will seek to recoup those initial costs, potentially over more than one audit cycle. This may mean that the audit firm is less willing to challenge or have difficult conversations with management, including about potential qualifications to the audit report, if it is keen to continue as statutory auditor in future periods. The FRC Ethical Standard paragraph 4.4 states that audit fees should usually reflect the time spent, skills and experience of the audit team as well as the competitive situation in the market – this could imply that audit fees could be expected to be higher than usual to cover the additional referral fees incurred in securing the audit.

There may also be perceived self-interest and familiarity threats arising from the relationship with the accountancy firm. Where a number of referrals are being made, such that the audit firm is, or could be seen to be, reliant on the other firm to win more work or even retain clients, the audit firm may be keen to foster a good relationship with the accountancy firm. This may result in less challenge to draft financial statements prepared by that accountancy firm, for example. Similarly, if a lot of work is referred from the accountancy firm, the working relationship could result in insufficient scrutiny of draft financial statements based on the audit firm’s previous experience with the accountancy firm.

If these, and any other identified threats to independence, can be appropriately managed to eliminate or reduce them to a level at which independence is not compromised, the considerations and safeguards applied should be clearly documented on the audit file. In making this assessment, auditors should consider the ‘third-party test’ and whether an objective, reasonable and informed third party would come to the same conclusion. Where referral fees are paid or received the requirements of the ICAEW Code of Ethics Section 330 must also be complied with.

Key links

Referral fees and commissions: client consent is your responsibility

During an audit, we’ve identified a material error in respect of the carrying value of stock. If posted, the adjustment would result in the company reporting a loss rather than the profit it currently shows in the draft financial statements. It would also move the balance sheet into a net liability position from the net asset position currently reported. The client does not wish to post the adjustment. Do we need to issue an adverse opinion?

As the error identified is material, and assuming the client cannot be convinced to adjust for it, under the International Standard on Auditing (ISA) (UK) 705 Modifications to the Opinion in the Independent Auditor’s Report we know that the auditor will need to modify their report.

In deciding on the form of the modification, the auditor needs to consider whether the error is both material and pervasive, or whether it is just material. If it is both material and pervasive, then the auditor must issue an adverse opinion (ISA (UK) 705 para 8). If the error is material, but not pervasive, then a qualified opinion shall be issued (ISA (UK) 705 para 7).

ISA (UK) 705 para 5 tells us that ‘pervasive’ is a term used to describe the effect of an error on the financial statements. Pervasive errors are ones that, in the auditor’s judgment, are not confined to a specific element, account or item of the financial statements or, if so confined, represent a substantial proportion of the financial statements, or (in relation to disclosures) are fundamental to a users’ understanding of the financial statements.

Auditor’s judgement is key here, and ultimately it will come down to the judgement of the responsible individual (RI) on the matter. The RI may take the view that while the adjustment may be confined to specific elements of the financial statements (the stock balance and cost of sales), the significance of the impact of the adjustment on the results presented in the profit and loss account (changing the reported profit into a loss) and the impact on the financial position of the company (changing the balance sheet from a net asset to net liability position) means that this error is both pervasive and material if left unadjusted.

As with any key judgements, the audit file should clearly document the considerations and conclusions drawn by the audit team, and the impact on the audit report.

Key links

Understanding audit reports

During COVID-19 we completed a lot of stocktakes remotely. We’ve continued to do this in the years after COVID-19 restrictions have been lifted as it is more convenient than visiting locations in person. Is virtual attendance at stocktakes acceptable under ISAs, or do we need to attend stocktakes in person?

ISA (UK) 501 Audit Evidence – Specific Considerations for Selected Items requires (in para 4) that where inventory is material the auditor shall attend a physical inventory count (unless impracticable). The ISA does not specify whether ‘attendance’ needs to be in person or remote. The ISA also permits alternative procedures to be performed if attendance at physical inventory counts is impracticable, if these alternative procedures allow the auditor to obtain sufficient appropriate audit evidence over the existence and condition of inventory. 

This meant that auditors were generally able to comply with ISA (UK) 501 during COVID-19 restrictions by attending stocktakes virtually. Now the restrictions have been lifted, auditors need to consider the most appropriate approach to gathering audit evidence. 

The selection of an audit approach is based on auditor judgement, and the appropriate approach will be unique to each audit’s facts, circumstances and risk assessment. However, auditors should bear in mind when making this judgement that para 5 of ISA (UK) 500 Audit Evidence defines that ‘sufficiency’ and ‘appropriateness’ is the measure of the quantity and quality, respectively, of audit evidence.

Auditors should therefore consider the approach to stocktake attendance that gives them sufficient, appropriate audit evidence. In many cases, physical attendance may give the best quality audit evidence.

If virtual attendance is planned, additional work and/or safeguards may be required to make sure that it generates sufficient, appropriate audit evidence. This may include higher sample sizes (to make sure that sufficient audit evidence is obtained) and involving more senior members of staff given the heightened risk that the inventory count could be manipulated off camera (to make sure it is appropriate).

The audit approach should be clearly documented on the file, including the auditor’s assessment as to whether their planned approach will generate sufficient, appropriate audit evidence. 

Auditors should challenge themselves as the most appropriate approach may be different to the perceived most efficient approach, or the approach that was taken in the prior period. Taking account of additional safeguards that may be needed to ensure that virtual attendance generates sufficient, appropriate audit evidence, it is possible that this may be neither the most efficient approach to stocktake attendance nor the approach that generates the highest quality of evidence.

Key links

Considerations for remote inventory audit testing