Tax, Audit and Corporate Governance

Corporation tax is the amount of tax a business organisation pays to the government on its profits. However, the accounting profits are often different from the taxable total profit on which the corporation tax is charged because certain incomes and expenditures that are allowed for accounting purposes are often not allowable for the tax purposes.

1.1 Computation of taxable total profits

Overview of the tax computation

Trading income

Property income

Non-trading loan relationships (NTLR)

Miscellaneous income

Chargeable gains

Qualifying donations

Taxable total profits

£

X

X

X

X

X

(X)

X

Trading income could be defined as the profit for the period of accounts adjusted for tax purposes (ICAEW, 2012a).

Property income refers to the income and expenses related to property and accounted on accruals basis. Property income is added to the trading income, whereas property expenses are deducted from the trading income to arrive at the total taxable profits. Interest paid on loans acquired to buy a property or make improvements to the let property are classified under non-trading loan relationships.

Interest received or paid for purposes other than trading are classified under non-trading loan relationships. Gross amount of interest is added or subtracted to the tax computation irrespective of whether a company receives or pays interest after any tax deductions.

Miscellaneous income is the income received from sources that cannot be classified into three categories highlighted above.

Chargeable gains refer to the gain or loss made on the disposal of items of capital nature. The detailed rules for chargeable gains for a company will be discussed in the section 1.3 below.

Gross donations made to qualifying charity are deductable for computing taxable total profits.

Dividends received by a UK company are exempt for corporation tax purposes.

In order to calculate the corporation tax amount, the taxable total profits is multiplied with the corporation tax rate applicable in the financial year of calculation. The corporation tax rate for the tax year that began on 1st April 2016 is 20% for all companies (Gov.Uk, 2015).

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1.2 Worked example: computation of corporation tax

ABC Ltd prepares its accounts to 31st March each year and has the following results (ICAEW, 2012a):

Trading income before interest and capital allowances

£1,000,000

Capital allowances

£19,900

Interest received from building society

£295,000

Chargeable gains

£350,000

Interest received on loan advanced to XYZ Plc

£61,400

Qualifying donations

9,240

Interest paid on loan for trading purpose

100,000

Dividend received from E plc

8,000

Dividend Paid

40,000

Trading income (W1):   £880,100

NTLR (W2):                      £356,400

Chargeable gains:           £350,000

Qualifying Donations:   (£9,240)

Total taxable profit:     £1,577,260

Corporation tax: £1,577,260 * 20% = £315,452

W1: Trading income

Trading income before interest and capital allowances

£1,000,000

Trading loan

(£100,000)

Capital allowances

(£19,900)

Trading income

£880,100

W2: NTLR

Interest received from building society

£295,000

Interest received on loan advanced to XYZ Plc

£61,400

Total

£356,400

Since dividends received by companies are exempt, it is ignored for the calculation of corporation tax.

1.3 Chargeable gains

Chargeable gains for companies are calculated by deducting costs of acquiring capital assets from the proceeds from the disposal of capital assets. Companies benefit from the use of indexation allowance because it inflates the actual cost of purchase by accounting for the impact of inflation.

The indexation factor is calculated as: (Retail price index for the month of disposal - Retail price index for the month of purchase)/ Retail price index for the month of purchase

The indexation factor is usually rounded to three decimal places. Furthermore, if the retail price index for the month of disposal is greater than the retail price index for the month of purchase, then the indexation factor is deemed to be nil. Indexation factor cannot be negative.

Lastly, companies can benefit from the substantial share exemption if the gains arise out of disposal of shares in a company in which the beneficiary owned at least 10% of the share capital. In order to benefit from the substantial shareholding exemption, the 10% rule must be satisfied for a continuous period of 12 months for the two years prior to the disposal.

1.4 Value added tax

The value added tax (VAT) is charged by businesses on their products and services. There are three different VAT rates that could apply to the products and the services of a business: standard rate, reduced rate and zero rate.

The standard rate VAT is 20% and is charged on most goods and services in the UK.

The reduced rate charge is 5% and is charged on specific products, such as domestic fuel and mobility aids for older people.

The zero rate VAT requires businesses to charge 0% VAT on certain products, such as books and newspapers. The difference between zero-rated VAT and exempted products and services is that on the former, businesses can claim input VAT, whereas on the latter, input VAT cannot be claimed.

For a complete list of exempt, zero-rated and reduced rate products and services, refer to the HMRC website suggested in the recommended reading at the end of the chapter.

The net VAT position is calculated by deducting input VAT from output VAT.

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1.5 Partially exempt companies

It is common for businesses to make both taxable and exempt supplies. In such a situation, input VAT is not fully recoverable unless it meets certain thresholds.

The thresholds are laid down by HMRC in the form of two tests. A business needs to pass either of the two tests in order to recover the full amount of input VAT on exempt supplies.

The first test stipulates that the total input VAT is not greater than £625 per month on average and the value of exempt supplies is at most 50% of the value of all supplies.

The second test stipulates that the difference between the total output VAT and the input VAT directly attributable to taxable supplies is no more than £625 per month on average and the value of the exempt supplies is at most 50% of the value of all supplies (ICAEW, 2012a).

The application of the two rules above is illustrated in the example below:

A trader sells following items during a quarter:

Standard rated supplies: £80,000

Exempt supplies: £50,000

The total input VAT for the quarter: £1,500

Application of test 1:

Average input VAT per month = £1,500/3 = £500

Value of exempt supplies as a % of the value of total supplies: 50,000/130,000 = 38%

Since the criteria for the test 1 is satisfied, the entire input VAT of £1,500 is recoverable.

In case a business does not meet the thresholds specified by the two tests above, then the amount of input VAT attributable to the taxable supplies can be recovered in full and the amount of VAT attributable to the exempt supplies cannot be recovered.

Think of all the products you have purchased in the past one-month in order to learn about the different VAT categories that different products fall into.

Once you have identified a few number of products under each of the VAT categories, try to think of businesses that would always file a VAT return with a net input VAT?

1.6 Inheritance tax

Inheritance tax arises when a transfer of chargeable property is made by a chargeable person (ICAEW, 2012a). The charge could arise either during the lifetime of a person or upon their demise.

A property is deemed to be chargeable for inheritance tax purpose unless it is an excluded property. A typical example of an excluded property is foreign assets owned by a non-UK domiciled person.

All people in the UK are deemed to be chargeable for the purposes of inheritance tax, but the extent of the liability depends on the domicile status of an individual. An individual who is domiciled in the UK is liable to inheritance tax on all his worldwide property. However, an individual who is not domiciled in the UK is only liable to inheritance taxes on his properties situated in the United Kingdom.

Exempt transfers

HMRC classifies a number of transfers of assets as exempt transfers for the purposes of inheritance tax. Typical examples of exempt transfers include transfer to spouse or civil partner, gift to charities or gift to political parties. For a detailed list of exempt transfer, kindly refer to the HMRC link included in the recommended readings section at the end of the chapter.

Furthermore, transfer of certain chargeable assets during the lifetime is also exempt, which is subject to the terms laid out by HMRC.

Transfers made in any one year amounting to a value of £3,000 are allowed as annual exemption limit for inheritance tax purposes. If the value of transfers made in any one years exceed the £3,000 annual exemption limit, any amount exceeding the £3,000 threshold will not be exempted for inheritance tax purposes. Furthermore, a cash gift of £5,000 to children on their marriage is also classified as a potentially exempt transfer for parents.

Lastly, if a transferor is not able to use his annual exemption limit in any particular year, any unused excess could be carried forward to be used in the subsequent year only. In any year, the current year’s annual exemption limit has to be used before using the carried forward excess from the prior year.

Lifetime transfers

This section highlights the list of rules relating to the treatment of lifetime transfers for the purposes of inheritance tax:

  • A lifetime transfer of value could be classified into two categories: chargeable lifetime transfers (CLT) or potentially exempt transfers (PET)
  • A CLT is subject to inheritance tax at the time it is made. Furthermore, there could be further tax liabilities on a CLT if the transferor dies within seven years of making a CLT.
  • A PET is exempt as a lifetime transfer if the transferor does not die within seven years of making a transfer. In such a scenario, it does not have any inheritance tax implications. However, if the transferor dies within seven years of making a transfer, there could be inheritance tax consequences.
  • Nil rate band is the threshold amount up to which 0% tax is charged. The nil rate band is £325,000 for the financial year 2016-2017.
  • Inheritance tax is a cumulative tax in the sense that an individual needs to look back seven years from the date of a chargeable transfer to assess whether all or part of the nil rate ban has been used
  • When a transferor dies within seven years of making a CLT, any leftover nil rate band could be used to reduce the amount of the chargeable value that is subject to the inheritance tax.
  • The inheritance tax for the financial year 2016-17 is 40%.
  • Taper relief: if the transferor survives more than 3 years after making a chargeable lifetime transfer, but less than seven years, the additional tax on death is charged at the following rates:

Time period between CLT and death

Rate charged

Greater than 3 years and less than 4 years

80%

Greater than 4 years and less than 5 years

60%

Greater than 5 years and less than 6 years

40%

Greater than 6 years and less than 7 years

20%


The example below highlights the application of the rules discussed above:

Mr. X made the following cash lifetime transfers (ICAEW, 2012a):

Date

Amount

21st May 2005

£268,000

18th November 2008

£59,600

21st August 2010

£15,000

15th July 2013

£300,000

12th April 2014

£25,000

Mr. X dies on 9th October 2014. Furthermore, cash transfers were made on the 21st August 2010 to his daughter on her wedding, on the 15th July 2013 to his son for his birthday and on the 12th April 2014 to a registered charity.

A step-by-step approach is suggested to solve the inheritance tax questions.

  • Students are suggested to layout a table as shown below with each column reflecting the date of transfer and each row reflecting the gift or exemptions claimed.
  • Use of a table helps students to take account of any unused annual exemption and nil rate bands in a systematic way without the risk of omitting one or the other.
  • It is recommended to use all exemptions before using the annual exemption. The advantage of doing so is that if the other exemptions reduce the value of the chargeable transfers below £3,000, any unused annual exemption could be carried forward to the subsequent year, whereas using annual exemption before using other exemptions might not allow individuals to benefit from any unused exemption because other exemptions cannot be carried forward to the subsequent years.
  • The purpose of the illustration below is to give an overview of the systematic method to approach a question. Advanced level reliefs, such as taper’s relief are ignored for the purpose of the illustration.
  • The nil rate bands for various years are obtained from the HMRC website and reflected in the table below:

Year

Nil Rate Band

April 2004 - March 2005

263,000

April 2005 - March 2006

275,000

April 2006 - March 2007

285,000

April 2007 - March 2008

300,000

April 2008 - March 2009

312,000

April 2009 - March 2017

325,000

(Source: HM Revenue and Customs, 2016)

21st May 2005

18th Nov 2008

21st Aug 2010

15th July 2013

12th April 2014

Cash

268,000

59,600

15,000

300,000

25,000

Charity exemption

(25,000)

Wedding exemption

(5,000)

Annual exemption current year

(3,000)

(3,000)

(3,000)

(3,000)

Annual exemption past year

(3,000)

(3,000)

(3,000)

(3,000)

Gross Chargeable Transfers

262,000

53,600

4,000

294,000

Nil

Nil rate band

(262,000*)

(50,000)**

(4,000)***

(267,400)****

Nil

Excess over nil rate band

Nil

3,600

Nil

26,600

Nil

Inheritance tax  @ 40%

Nil

1,440

Nil

10,640

Nil

* Nil rate band for the year 2005-2006 was £275,000. Since nil rate band cannot generate a negative tax liability, it is used to the extent so as to reduce the chargeable value to nil.

** Nil rate band for 2008 - 2009 was £312,000. Gross value of transfers seven years before CLT was £262,000. Thus the available nil rate band is (£312,000 - £262,000) £50,000

*** Nil rate band for 2009 - 2010 was £325,000. Gross value of transfers seven years before CLT was (£262,000+£53,600) £315,600. Thus, the available nil rate band is (£325,000 - 315,600) £9,400.

**** Nil rate band for 2013 - 2014 was £325,000. Gross value of transfers seven years before CLT was (£53,600 + £4,000) £57,600. Since the gross CLT of £262,000 in May 2005 is beyond the seven-year window, it does not reduce the nil rate band. The available nil rate band is (£325,000 - £57,600) £267,400

Lastly, the inheritance tax on death estate is charged at the rate of 40%. The death estate consists of all the assets that a deceased was entitled to at his death less the funeral expenses and debts.

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The example below illustrates the calculation of inheritance tax on the death estate (ICAEW, 2012a):

Mr. X dies on 1st July 2016. His death estate was as follows:

House: £500,000

Cash: £163,000

Investments: £120,000

Chattels: £50,000

Funeral expenses incurred upon the death of Mr. X were £20,000 and he had a debt of £20,000 when he died.

Furthermore, Mr. X made a gross chargeable transfer of £41,000 in July 2010 and a potentially exempt transfer of £67,000 in September 2014.

In his will, Mr. X donated £10,000 from his estate to a registered charity and his house and chattel to his wife. Calculate the inheritance tax payable upon Mr. X’s death.

Gross value of estate:

House: £500,000

Cash: £163,000

Investments: £120,000

Chattels: £50,000

Total: £833,000

Funeral expenses: (£20,000)

Debts: (£20,000)

Net value of estate: £793,000

Spouse exemption for house and chattel: (£550,000)

Charity exemption: (£10,000)

Total chargeable estate: £233,000

Nil rate band for 2016: £325,000

Gross transfer of value in 7 years before death:

July 2010: £41,000

September 2014: 67,000

Total: £108,000

Available nil rate band (£325,000 - £108,000): £217,000

Excess over nil rate band (£233,000 - £217,000): £16,000

Inheritance tax payable: £16,000 * 40% = £6,400

1.7 Capital gains tax

A capital gains tax is paid by a chargeable person on the disposal of a chargeable asset.

A chargeable person could be individuals, business partners, trustees or companies (ICAEW, 2012a).

Chargeable assets include all capital assets other than those exempted from the capital gains tax. Typical examples of exempt assets include qualifying corporate bonds, national savings certificates and premium bonds, investments held in ISA, gilt edged securities amongst many others. For an exhaustive list of assets that are exempt from the capital gains text, kindly refer to the recommended reading on capital gains tax.

An overview of capital gains tax calculation is provided below:

Proceeds from disposal of chargeable assets

Less: Allowable cost

Capital gains

Allowable costs include costs that are directly attributed to the acquisition or disposal of assets and incidental costs of acquisitions such as legal fees or expenditure relating to enhancing the assets.

Individuals are entitled to an annual exemption limit on the capital gains. The annual exemption amount since 6th April 2015 has been £11,100 for individuals.

If an individual is a higher rate taxpayer, the capital gains tax is 28% on the disposal of a residential property and 20% on other chargeable assets. However, if an individual is a basic rate taxpayer, the capital gains tax is 18% on the disposal of a residential property and 10% on other chargeable assets.

If adding the capital gains of an individual after allowing for all the possible exemptions to the total taxable income makes him/her a higher rate tax payer, the proportion of capital gains that when added to the total taxable income is below the higher rate tax slab is charged at 10% for gains on all chargeable assets (18% for residential) and the portion of capital gains that takes the total taxable income of an individual above the higher rate tax slab is charged at 20% for gains on all chargeable assets (28% for residential). 

An illustration of the capital gains tax is provided below:

Mr. X has a taxable income (after personal allowance) of £20,000 and taxable gains of £12,100 from non-residential chargeable assets. What is the capital gain tax liability of Mr. X?

Proceeds from disposal of chargeable assets: £12,100

Less: Allowable cost: Nil

Capital gains: £12,100

Annual exemption: £11,100

Chargeable gains: £1,000

Capital gains tax liability: £1,000*10% = £100

Note: Since adding chargeable gains of £1,000 to taxable income of £20,000 did not make Mr. X a higher rate taxpayer, capital gains taxis charged at the rate of 10% on non-residential chargeable assets.

An individual is allowed to deduct losses on disposal of assets from the chargeable gains. In a year, if an individual has made both chargeable gains and losses on disposal of chargeable assets, he/she must offset those losses against the chargeable gains to the fullest possible extent. An unused loss is carried forward and utilised in the subsequent years. In situations where losses are carried forward to the subsequent financial years, any brought forward losses are set off against the first available capital gains to the extent that the net gains are not taken below the annual exempt amount.

1.8 Tax avoidance and tax evasion

Tax evasion could be defined as concealing information from the tax authorities or deliberately providing them with false information with the motive of evading taxes.

Typical examples of tax evasion include:

  • Not notifying tax authorities about tax liabilities
  • Understating incomes or gains
  • Omitting disclosing facts to the tax authorities with the motive of evading taxes
  • Overstating expenses
  • Claiming false capital allowances

Identify with reasons whether the examples below constitute tax evasion or tax avoidance.

A business that sold its capital assets for a gain of £1,000,000 and immediately used these to purchase a new capital asset in order to claim the rollover relief and avoid the capital gains taxes.

A business sold its capital assets for £750,000 that it purchased for £500,000. In order to generate capital losses, the business took £300,000 in cash and disclosed the sales proceeds as only £450,000 to HMRC.

Although there is no formal definition of tax avoidance, it could be defined as the careful tax planning with a motive of reducing the tax liability in a lawful way. Typical examples of tax avoidance include taking advantage of various exemptions permitted by the HMRC and taking advantage of tax shelters in the form of ISA.

Based on the definitions of tax avoidance and tax evasion, the primary difference between the two is that the formal is deemed to be legal, whereas the latter is deemed to be illegal.

The difference between the tax evasion and tax avoidance is usually apparent, as the intention of an individual who is seeking to avoid taxes is not to mislead HMRC or conceal information from them. Thus, when facing ethical dilemmas with regards to tax evasion and tax avoidance, understanding the intention of an individual could help to resolve the dilemma to a certain extent.

1.9 Money laundering

Money laundering could be defined as engaging in activities in which the proceeds from illegal means are used.

When an individual engages in tax evasion, he could be charged under the money-laundering act.

Since tax evasion is classified as money laundering, the penalties associated with evading taxes could be extreme. Individuals found guilty of money laundering could be exposed to unlimited fine and the following imprisonment terms:

  • Up to 14 years, if an individual has engaged in the act of money laundering
  • Up to 5 years for individuals, who could be reasonable assumed to have knowledge of suspected money laundering, but failed to disclose it to the tax authorities or tipped of the individual engaging in money laundering. Typical example of such individual who could potentially be imprisoned for tipping off or disclosing suspected money laundering could be accountants because while inspecting the accounts, they are expected to exercise professional knowledge and judgment and report any instance of even suspected money laundering.
  • Up to two years imprisonment for the contravention of the system requirements of the regulation.

Key responsibilities of an accountant in cases of suspected money laundering

A professional accountant is obligated by the law to report any suspected incidents of money laundering to the money laundering reporting officer or to the serious organised crime agency. A professional accountant does not necessarily have to prove the occurrence of money laundering before reporting. A reasonable ground for suspicion is deemed sufficient to trigger an action by an accountant.

Secondly, if a professional accountant has identified a suspected incidence of money laundering, they should take care of not tipping off the client. Tipping off is deemed to be a serious crime because it might impede the investigations conducted by the regulatory authorities and provide time to the individual engaged in the process of the money laundering to tamper with the evidences.

Thirdly, in situations where professional accountants have reasonable grounds for money laundering, they are empowered by law to disclose even confidential information to the tax authorities without the client consent. It is important to note that a reasonable ground of suspicion is a bare minimum requirement to disregard the confidentiality clause with the client. Disclosing confidential information without a reasonable ground for suspicion would constitute as a breach of confidentiality and could have legal repercussions for an accountant.
2. Audit

An audit could be defined as the process that enables auditors to express an opinion whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework and reflect a true and fair view of a company’s financial affairs (ICAEW, 2013).

In order to understand the definition above, it is important to define materiality and true and fair view.

2.1 Materiality

Imagine you are planning to spend your day at a beach over the coming Saturday. You have made your decision based on the forecasted temperature of 30 degree Celsius. To what extent would you not mind the temperature dropping below 30 degree Celsius before you decide to change your decision of going to the beach because of unfavorable weather conditions?

Although different people might have different answers, but a vast majority of the people might change their plans should the temperature be below 20 degree Celsius.

Let’s apply the same concept to the audit of the financial statements. The key learning from the example above is that insignificant change in the forecasted weather condition is unlikely to impact the decision of the beach goers. Similarly, in financial context, materiality could be defined as the threshold that could influence the decision of an investor to invest in a business. For example, if a business that regularly reports a profit of £1,000,000, reports £25,000 less profit in a particular year, it is likely to be deemed immaterial by the investors. However, a business that regularly reports a profit of £100,000 reports a £25,000 negative variance in its profits, it is likely to be considered material by the investors.

Thus, auditors are primarily concerned with identifying those misstatements that could have a material impact on the financial statements. In other words, if the magnitude of the error is deemed to be so large that it could influence the decision of the investors to invest in a company if the errors were made known to them. The auditors might identify immaterial errors as a result of carrying out the audit procedures, however, one should not expect the auditors to identify such errors. The law does not require auditors to identify all the errors in a financial statement.

Which of the following errors would be deemed material and why?

a). A business with a turnover of £1,000,000 overstates its turnover by £20,000

b). A business with a turnover of £100,000 overstates its turnover by £20,000

c). A business with an operating expenses of £500,000 understates it by £30,000

2.2 True and fair view

The concept of true and fair view means that the auditors provide a reasonable assurance to the users of the financial statements that the financial statements are free from any material misstatements. True and fair view does not imply that the financial statements are completely accurate without any errors. True and fair view implies that financial statements are free from material errors but could include immaterial errors that are not deemed to be influencing the decision of the users of the financial statements to invest in a company.

2.3 Objectives of auditing

The key objectives of auditing are listed below:

  • Provide reasonable assurance to the users of the financial statements regarding the accuracy of the financial statements
  • To ensure financial statements are free from material fraud and error
  • Identifying key weaknesses in the internal control system of a business
  • To ensure that the qualitative information contained within the financial statements is consistent with the knowledge obtained during the audit

2.4 Importance of auditing

Auditing is important because of the following reasons:

  • Auditing enhances the credibility of the financial statements in the eyes of an external party. For example, banks often rely on audited financial statements to assess the financial stability of a company before making a decision regarding granting of loans.
  • Shareholders are primarily the owners of the company. However, they are often not involved with the day-to-day management of the company. Auditing provides confidence to the shareholders regarding the effective performance of the management of a company.
  • Due to the enormous size of many organisations, it becomes difficult for the top management to assess the deficiencies in controls and processes across the business. Auditing helps business managers to identify such key deficiencies that are crucial to the long-term performance of a business. 
  • Lastly, businesses operate in a regulated environment as a part of which they have to comply with a lot of requirements. Auditing helps to ensure that businesses comply with all general and industry specific laws, enabling them to avoid hefty penalties associated with non-compliance.

2.5 Audit Independence

Auditors are required to comply with the code of ethics issued by International Federation of Accountants (IFAC). Independence is a widely discussed code of ethics in the contemporary business environment because auditors often form multiple business relationships with their clients, which often poses a threat to their independence. IFAC has categorised the threats to auditors’ independence into 6 broad categories:

Self Interest Threat

A self-interest threat occurs when an auditor has an interest in the client’s performance or earns a significant amount of fees from the provision of non-audit services, such as consulting. For example, if an auditor earns a significant amount of fee from the provision of consulting services to a client, the independence of an auditor could be questioned because the auditors have an incentive to please the client during the audit as a result of the fear of losing consulting and the huge income associated with it.

Self-Review Threat

A self-review threat occurs when an auditor audits a work that it performed itself. For example, if an auditor is auditing a client’s tax return that was prepared by the auditor itself, they might be reluctant to find short comings in their own work because of having a negative reputational impact.

Advocacy Threat

Advocacy threat occurs when the auditors are required to represent their clients in the court. For example, if a company is sued over inaccuracies in the financial statements, appointing the company’s auditors as client’s representative is likely to encourage them to protect their client’s interest to a point that their objectivity and independence is compromised because the inability to do so would not only have a negative reputational impact for the auditor but also result in significant penalties.

Management Threat

Management threat occurs when auditors make decisions on behalf of the management. If an auditor is making a decision, they will try and justify it under any circumstance.

Familiarity Threat

Familiarity threat occurs when an auditor develops a very strong relationship with its client such that there is a risk that they become too trusting of their clients. Familiarity threat is particularly tricky because the more the number of years an auditor is engaged with a particular client, the more familiar they will be with their client’s business. Thus, auditors are in a better position to make informed decisions about audit risks. However, at the same time long association with a client could also increase the familiarity threat. IFAC have issued guidelines regarding the ways in which auditors could mitigate familiarity and other threats to independence. They will be discussed in the section below.

Intimidation Threat

An auditor’s independence is deemed to be compromised if there is a possibility that they could be threatened or bullied by their clients. For example, if a client threatens to dismiss an auditor if they issue a qualified report. In such an instance, the fear of losing a client might prompt them to compromise their independence.

Although allowing auditors to provide non-audit services to their clients could pose a threat to their independence, auditors could implement a number of safeguards to reduce the threat to their independence.

Some of the commonly used safeguards in practice are listed below:

  • Appointment of an ethics partner with a good deal of authority in the firm would enable the auditors to reduce the threat to independence to an acceptable level.
  • Ethical standards prohibit auditors from having a financial interest in their clients.
  • Auditors are prohibited to form a joint venture with their clients or accept commissions for facilitating deals.
  • If a senior partner occupies a position of influence within two years of being involved in the audit, the audit firm should resign as auditors at the company that the partner has joined.
  • Ethical standards require a mandatory rotation of an audit partner every five years for a listed client and ten years for a non-listed client because familiarity threat is deemed to be very high in such situations.
  • Ethical standards prohibit auditors from working on contingent fee arrangements because the self-interest threat is deemed to be very high and no safe safeguard is deemed to be sufficient to reduce the risk to an appropriate level.
  • In situations, where auditors provide non-audit services to their clients, self-review and advocacy threat could be reduced by employing separate engagement teams.

Based on the analysis above, it is evident that ethical standards prohibit auditors from forming certain relationships with their clients; however, it does allow them to provide non-audit services with adequate safeguards in place.

Think of the safeguard that you would apply if you were the partner of an audit firm:

  1. You have been asked to provide tax advisory services to your audit client.
  1. A close competitor of one of your close audit client has requested you to provide them with non audit services

2.6 Audit implication on the efficient market hypothesis

The concept of efficient market hypothesis states that the market price of a share incorporates all publicly available information (ICAEW, 2012). Thus, it is not possible for the investors to make abnormal returns by beating the market. Empirical evidence on the implication of the audit reports on the efficient market hypothesis has yielded mixed results (Hines, 2012). Work of some academicians highlight that the annual reports are issued too late to be of any use to the shareholders. However, investors have often indicated to benefit from the annual reports. Furthermore, there is evidence of the impact of the audit on efficient market hypothesis, particularly in cases where the expected performance of the company was expected to be strong based on the forecasts and mid year results, however, the audited results were significantly below the expectations.

2.7 Audit process

The audit process involves a number of stages. These stages are listed below

  • Engagement acceptance
  • Planning
  • Programming and performance
  • Audit completion

Engagement acceptance

This stage involves assessing the reputation of the client and the risk associated with accepting a client. For instance, most auditors would avoid a business that has had notoriously bad reputation, as auditors often don’t want to accept clients that could endanger their reputation. Furthermore, accepting clients with bad reputation also entails a greater risk of fraud and getting an incorrect audit opinion. It is also mandatory at this stage to perform anti money laundering checks on the clients.

Planning

This stage involves planning the audit engagement. Typical activities include identifying key audit risks, agreeing on the scope of the work, deadlines and arranging human resource to perform the work.

Programming and performance

This stage involves carrying out the audit procedures in response to the audit risks identified at the planning stage.

Audit Completion

This stage involves issuing the audit report, ensuring the independence and other regulatory requirement are not breached between accepting the engagement and completion stage and making sure that all the assessed risks at the planning stage have been adequately responded to.

2.8 Quality control

Quality control is at the heart of all stages of the auditing process. At the stage of accepting engagements, existence of strong quality control procedures would be evident in the form of policies and procedures designed to ensure that only appropriate clients are accepted. During planning, performance and completion stages, appropriate quality control procedures include documentation of all significant matter, ensuring proper communication within the team, adequate supervision and review of work. There are six elements of a quality control system:

  • Leadership
  • Ethical requirements
  • Acceptance and continuance of client relationship
  • Human resources
  • Engagement performance
  • Monitoring

Leadership

  • The engagement leader should ensure that commercial prospects do not take precedence over the quality of work.
  • Sufficient resources are allotted to the development, documentation and review of audit work
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Ethical requirements

  • An auditor must build appropriate policies and procedures to ensure compliance with independence and ethical requirements, as discussed in section 2.5 above.

Acceptance and continuance of client relationship

  • An audit firm should have established policies and procedures to ensure high-risk clients are not accepted.

Human Resources

  • Investment in human resources is deemed to be necessary to ensure strong quality control procedures within a firm. The international standard of quality control states that in order to ensure strong quality control, an audit form should have policies and procedures with regards to recruitment, training, compensation, career development and compensation.

Engagement Performance

  • The three key components of engagement performance are direction, supervision and review
  • Direction: The engagement leader is responsible for ensuring that his team understands the nature of the work, the client’s business, risks relevant to the engagement and planned audit procedures.
  • Supervision: ISA 220 states that adequate supervision is key to quality control and the four features of good supervision are progress tracking, addressing significant matters arising during the audit, ensuring appropriate consultation of significant matters with the experienced members of the audit team and considering the competence and capability of individual team members.
  • Review: The senior and experienced members of the team should review the work performed by the juniors. The purpose of the review should be to ensure that the work is performed in accordance with the professional, regulatory and legal requirements, appropriate consultation has taken place on significant matters, sufficient and appropriate audit evidence has been obtained, professional skepticism has been demonstrated and the objectives of the audit procedures have been achieved.

Poor quality control could have adverse consequences for the audit firm in terms of negative reputational impact, prosecutions, fines, disciplinary proceeding and being sued for professional negligence.


3. UK Corporate Governance Code

The UK corporate governance code was formulated in 1992 with the objective of improving the governance in businesses (FRC, 2016). Since shareholders do not actively participate in the day-to-day management of a business and rely on the directors to run the company, the purpose of the UK corporate governance code was to ensure that the interest of the shareholders is protected.

3.1 Objectives of Corporate Governance Code

The primary objective of the UK corporate governance code is to protect the interest of the shareholders of the company by governing and monitoring individuals that manage the resources owned by the shareholders.

The UK Corporate governance code seeks to ensure that the auditors are independent of the business.

The UK Corporate governance code also seeks to ensure a suitable balance of power on the board of directors by ensuring appointment of independent non-executive directors.

3.2 Importance of Corporate Governance Code

The primary importance of the UK corporate governance code is to ensure improved performance and accountability of the board of directors and improved long-term performance of a business.

Secondly, the code also contributes to increasing the level of confidence that shareholders have in the company by ensuring greater transparency.

Lastly, the corporate governance code helps to ensure that a business is run in a legal, professional and ethical manner.

3.3. Comply or explain approach

The UK corporate governance code is not a rigid set of rules, but a set of principles. The principles underpinning the UK corporate governance code are at the heart of the code and their manner of application is at the discretion of the directors.

The UK corporate code of governance offers a lot of flexibility to the board of directors in terms of how they choose to govern the company. The explain approach allows the businesses to choose not to apply the principles of the code if good governance could be achieved by applying alternative principles, however, in such a scenario the management should provide a careful explanation to the shareholders of the company for the reasons of the departure from the corporate code of governance and how the chosen principles contribute to good governance and attainment of business objectives.

The shareholders have the freedom to challenge the alternative code or principles adopted by the board if they are not convinced with the effectiveness of the alternative principles. However, the departure of the code of conduct should not be automatically treated as breaches.

Some of the provisions of the code may not apply to the companies below the FTSE 350. Nonetheless, such companies are encouraged to adopt the principles of the code. Furthermore, it is not compulsory for unlisted companies to report on UK corporate governance code, however, private companies are encouraged to do so because it helps to improve the level of confidence that shareholders have in a business.

Although there are practical barriers for continued interaction between the shareholders and the board to facilitate the comply or explain approach, the efforts should be taken by both the concerned parties in order to improve the governance in businesses.

3.4 Principles of the corporate governance code

Financial Reporting Council highlights that the main principles of the code are as follows (FRC, 2016).

  • Leadership
  • Effectiveness
  • Accountability
  • Remuneration
  • Relations with shareholders

Leadership

This principle states that every business should be led by an effective team of leaders in the form of board of directors. To ensure effective governance, there should be a clear division of responsibility between running the board and running the business. Lastly, this principle encourages non-executive directors to constructively challenge the proposed strategies.

Effectiveness

The board of a company should have a formal procedure for the appointment of new directors and all directors of the company should devote sufficient time to execute business strategies. Secondly, this principle stresses the importance of having a good balance between skills and experience at the board level. Lastly, the board of directors should carry out a formal evaluation of their own performance to identify opportunities for continuous improvement.

Accountability

The board of directors is accountable to the shareholders of the company for the performance of a business. Thus, the board should present a fair and balanced assessment of the company’s future prospects and current performance. Furthermore, the board is accountable and responsible for adopting sound risk management systems.

Remuneration

The board of directors is responsible for ensuring a remuneration policy that is good enough to attract, retain and motivate directors. However, this principle strongly discourages board from paying remuneration more than that is necessary. This principle encourages businesses to have formal procedures for developing remuneration package of the directors and ensuring that no director is involved in deciding his own remuneration.

Relations with shareholders

The board of directors is responsible for ensuring effective communication and maintaining relationship with the shareholders Annual general meetings should be used to communicate with them and board should take steps to encourage the participation of the shareholders.

3.5. UK code of corporate governance vs. US code of corporate governance

The key differences between the UK code of corporate governance and the US code are listed below.

The primary difference between the UK code of corporate governance and that of the US is that the former is driven by comply or explain approach, whereas the latter is driven more by regulation. Following the Enron scandal, the Sarbanes-Oxley act was passed to improve the quality of financial reporting in the United States of America.

Another key difference between the UK and the US code of corporate governance is that chief financial officer and the chief executive officer of the company should attest to the veracity of the financial statements in the United States (ICAEW, 2013).

Thirdly, much greater disclosures are required if any amendments are made to the financial statements during the audit process in the United Stated than when adjustments are made during the audit in the United Kingdom.

Lastly, in the United States, the compensation of the CEO or the CFO could be forfeited incase of accounting restatements due to material non-compliance with financial laws and regulations, whereas there are no such provision in the UK code.


Recommended reading

Gov.UK, 2016, Businesses and charging VAT. Accessed on 25th October 2016 at: https://www.gov.uk/vat-businesses/vat-rates

Gov.UK, 2016, Inheritance Tax. Accessed on 26th October 2016 at: https://www.gov.uk/inheritance-tax/gifts

Gov.UK, 2016, Capital Gains Tax. Accessed on 27th October 2016 at: https://www.gov.uk/capital-gains-tax/what-you-pay-it-on

Reference

FRC, 2016, The UK Corporate Governance Code. Accessed on 23rd October 2016 at: https://www.frc.org.uk/Our-Work/Publications/Corporate-Governance/UK-Corporate-Governance-Code-April-2016.pdf

Gov.Uk, 2015, Corporation Tax: Main Rate. Accessed on 25th October 2016 at: https://www.gov.uk/government/publications/corporation-tax-main-rate/corporation-tax-main-rate

Hines, R., 2012, The usefulness of annual reports: the Anomaly between the efficient markets hypothesis and shareholder surveys, Accounting and Business Research, vol. 12 (no. 48), pp. 296-309.

HM Revenue & Customs, 2016, Inheritance tax nil rate bands, limits and rates. Accessed on 26th October 2016 at: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/497789/IHT400Rates_tables.pdf

ICAEW, 2012, Financial Management Study Manual, 6th Edition, Exeter, Polestar Wheatons.

ICAEW, 2012a, Taxation FA2012 Study Manual, 7th Edition, Exeter, Polestar Wheatons.

ICAEW, 2013, Audit and Assurance, 7th Edition, Exeter, Polestar Wheatons.


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