Required:
(a) Using your knowledge of APES 110, identify and explain the potential type of threat to Chan and Partners' independence in situations (1) and (2) above.
(b) What action should Chan and Partners take to eliminate the potential threats to independence in situations (1) and (2) above? What safeguards should be instituted to reduce the risk of similar independence threats occurring in the future?
One of the accountants intended to be part of the audit team owns shares in MSHG. The accountant’s interest is not material to him.
APES 110 states that a financial interest in a client may create a self-interest threat. Owning shares in an engagement client creates a direct financial interest. The auditor is required to consider the nature of the financial interest in order to determine the significance of the threat and the appropriate safeguards. Matters to consider are whether the shareholding is direct or indirect, how material is the holding, and the role of the member of the assurance team.
Therefore, what duties does the member of the assurance team perform? How senior is his role? How much judgement will he be required to exercise? If the person is very junior and/or the amount of the financial interest is very small, the threat is lower and fewer safeguards are required. However, if the person is more senior and/or the amount of the financial interest is greater, the safeguards would need to be more significant.
Section 290 states that if a member of the assurance team has a direct financial interest, as in this case, the only safeguards available to eliminate the threat are to dispose of the direct financial interest prior to the individual becoming a member of the assurance team, or to remove the member of the assurance team from the engagement (see also APES110.200.4; 290.102-116 (pre 2018) or APES 110.200.6 A1 and 110.510 post 2018)).
Chan and Partners was previously engaged by MSHG to value its intellectual property. The consolidated balance sheet as at 30 June 2016 includes intangible assets of $30 million, which were valued by Chan and Partners on 1 March 2016 following MSHG’s acquisition of the subsidiary Shady Oaks Hospital. The intangibles are considered material to MSHG.
APES 110 address the issues surrounding the provision of valuation services to an assurance client. The problem arises because in a financial report audit the auditor is required to gather evidence about the client’s valuation of the assets. If the auditor provided the valuation to the client, then the auditor has to audit their own work. (See APES 110.290.172-175 (pre 2018) or APES 110.603).
A self-review threat may be created when an audit firm performs a valuation for an audit client that is to be incorporated into the client’s financial statements. Specifically, this is a problem if the valuation service involves the valuation of matters material to the financial statements and the valuation involves a significant degree of subjectivity. Safeguards include having another accountant, not involved with the valuation, review the audit or valuation work, or making arrangements so that personnel providing such services do not participate in the audit. The audit firm should not provide valuation services to an audit client that is a public interest entity if the valuations would have a material effect on the financial statements.
Therefore, the key questions are whether the item is material, whether there is a significant degree of subjectivity in the valuation service. The intangibles are stated to be material. Valuation of intangible assets is likely to be subjective, or at least more subjective than valuation of real property (land and buildings). This implies that Chan and Partners should withdraw from the audit or the client should obtain another independent valuation for the intangibles.
However, the question appears to state that the valuation services were provided prior to the audit engagement being accepted. If so, at this time, there was no conflict between Chan and Partners' duties as valuer and auditor. However, now, as auditor, Chan and Partners is required to provide an opinion on the valuation which it previously provided (self-review threat).
At a minimum, Chan and Partners should apply the safeguards against independence being compromised with respect to the intangible assets valuation. The valuation should be reviewed by an additional professional accountant, who is outside the audit team, and should not use the personnel involved in the valuation on the financial report audit. However, it is likely that these safeguards would not be enough, given the high level of subjectivity in the intangible assets valuation. Therefore, the client will either have to obtain another independent valuation or Chan and Partners should withdraw from the audit.
In the future, the audit firm should not perform valuations for audit clients that are likely to be the subject of the financial report audit, unless they are immaterial and/or have a very low degree of subjectivity.