Chapter 11: Ethics and Terms of Audit

Engagements – Summary
1. Meaning of Ethics
Ethics refers to moral principles that guide a person’s behavior in professional and
personal life. In auditing, ethics ensures trust and integrity.

Example: If a Chartered Accountant (CA) manipulates financial statements to favor a

client, it violates ethical principles.

2. Need for Professional Ethics

• The auditing profession demands a high level of trust and responsibility from the
public.
• Users of financial statements, including investors, regulators, and businesses,
rely on auditors for fair financial reporting.

Example: If auditors fail to report financial misstatements, investors may suffer losses
due to unreliable financial statements.

3. Fundamental Principles of Professional Ethics

The ICAI Code of Ethics defines five fundamental principles:

1. Integrity – Auditors must be honest and transparent.

2. Objectivity – They should not allow bias to affect their judgment.
3. Professional Competence & Due Care – Maintain professional knowledge and
apply diligence.
4. Confidentiality – Keep client information private unless required by law.
 5. Professional Behavior – Avoid actions that harm the profession’s reputation.

Example: A CA issuing a false report to help a client evade tax violates integrity and
professional behavior.

4. Independence of Auditors
Auditor independence is critical for maintaining credibility. There are two key aspects:

1. Independence of Mind – The ability to make an unbiased judgment.

2. Independence in Appearance – The auditor must not be seen as influenced by
external factors.

Example: If an auditor owns shares in a company they audit, it affects both

independence of mind and appearance.

5. Threats to Independence
Auditors face several threats that can compromise their independence:

1. Self-Interest Threats – When personal financial interest influences the audit.

2. Self-Review Threats – When auditors review their own previous work.
3. Advocacy Threats – When auditors promote a client’s position, reducing
objectivity.
4. Familiarity Threats – When auditors develop close relationships with clients,
leading to bias.
5. Intimidation Threats – When clients pressure auditors with threats of dismissal or
legal action.

Example: If a company offers excessive hospitality to an auditor, it creates a

familiarity threat.
6. Safeguards to Independence
To mitigate threats, auditors must implement safeguards, including:

✔ Strict ethical guidelines and quality control measures.

✔ Rotation of auditors to avoid familiarity threats.

✔ Limiting non-audit services provided to audit clients.

✔ Audit committees overseeing auditor independence.

Example: The Companies Act, 2013 mandates auditor rotation every 5 years
(individual) and 10 years (firm) to prevent familiarity threats.

7. Professional Skepticism
• Professional skepticism means maintaining a questioning mindset throughout the
audit.
• It helps in detecting fraud, errors, or misstatements.

Example: If management claims an expense is valid but the auditor finds inconsistent
invoices, they should investigate further.

8. Agreeing to the Terms of Audit Engagements (SA 210)

• Before starting an audit, auditors must agree on terms of engagement with
management.
• SA 210 outlines key requirements:
✔ Establishing that preconditions for an audit exist.
✔ Confirming that both parties understand the scope and responsibilities.
✔ Recording the agreement in an engagement letter.
 Example: If management refuses to provide access to records, the auditor should not
accept the engagement.

9. Preconditions for an Audit

The auditor must ensure:

✔ Acceptable financial reporting framework is used.

✔ Management understands its responsibility for financial statements.

✔ Unrestricted access to necessary records and personnel is provided.

Example: If a company refuses to disclose legal disputes affecting financials, the

auditor should not accept the engagement.

10. Audit Engagement Letter

• The audit engagement letter confirms:
✔ Objective & scope of the audit.
✔ Responsibilities of the auditor & management.
✔ Reference to applicable financial reporting framework.
✔ Form and content of the auditor’s report.

Example: If a company later disputes the auditor’s role, the engagement letter serves
as proof of agreed-upon terms.

11. Limitations on Scope and Changes in Terms of Audit

Engagement
• If management limits the scope of work, auditors must withdraw from the
engagement if the limitation prevents a proper audit.
 • Any changes in engagement terms must have reasonable justification.

Example: If a company refuses access to bank records, an auditor should decline the
engagement.

12. Audit Quality (SQC 1 & SA 220)

• SQC 1 (Standard on Quality Control 1) ensures audit firms establish:
✔ Leadership for audit quality.
✔ Ethical guidelines for all personnel.
✔ Acceptance and continuation of client relationships.
✔ Engagement performance monitoring.
• SA 220 focuses on audit quality at the engagement level, ensuring:
✔ Ethical compliance.
✔ Proper planning and supervision.
✔ Documentation of key audit matters.

Example: A firm must retain audit documentation for at least 7 years, as required by
SQC 1.

13. Key Takeaways

Ethics in auditing is crucial for trust and reliability.

The five fundamental principles of ethics guide auditor behavior.

Independence must exist in both mind and appearance.

Threats to independence (self-interest, familiarity, intimidation, etc.) must be

mitigated with safeguards.

Professional skepticism helps in detecting fraud and misstatements.

SA 210 requires agreeing on engagement terms before starting an audit.

 Audit engagement letters clarify scope, responsibilities, and reporting format.

SQC 1 and SA 220 ensure high-quality audits through firm-level and engagement-level
controls.