Provision of Non Audit Services by the Auditor to the Audit Client as a Threat to Auditors' Independence - Essay Example

?Provision of Non Audit Services by the Auditor to the Audit Client is a Threat to Auditors' Independence. Evaluate the Seriousness of this Threat Compared With Other Threats to Auditors' Independence and Identify the Effective Means of Strengthening Auditors' Independence Table of Contents Table of Contents 2 1.Introduction 3 2. Literature Review 4 2.1 Non Audit Services of Auditors 4 2.2 Threat to Auditor’s Independence 5 2.3 Comparison between Non Audit Services and Other Threats to Auditor’s Independence 6 2.4 Effective Means of Strengthening Auditor Independence 8 3.Data Collection 9 4.Findings 9 5.Conclusion 10 References 11 1. Introduction The value of an audited financial statement depends on the auditor’s independence. Accounting scandals such as Enron of the United States as well as HIH Insurance of Australia have created doubts regarding auditor’s independence and the value of their audit. The familiarity that is developed from the long audit tenure and the economic dependence arising from the non audit services and social bond developed between the auditor and the auditor’s client through long-term association have raised questions regarding auditor independence (Carson & Simnett, 2006). Non Audit Services (NAS) are also identified as ‘management advisory services’. Regulators believe that non audit services provided to audit clients is a serious threat to the auditors’ independence. Regulators believe that conflicts of interest occur and fee dependence has a damaging affect on auditor independence. Audit firms often defend themselves by saying that fee dependence does not influence them and audit and non audit services are performed independently by separate staff (Houghton & Ikin, 2001). It is also opined that non auditing services help in reduction of total costs, improve technical competence and intensify competition. The audit firms, the audit clients and regulatory bodies can bring about efficient services mix through market interaction (Arrunada, 1999). 2. Literature Review 2.1 Non Audit Services of Auditors The services that external auditors provide to their clients can be categorised into consulting, tax and audit. Consulting and tax are often referred as non audit services. Section 201 of the Sarbanes Oxley Act lays down the services which the external audit firm should not perform. They cannot perform bookkeeping services related to financial statements and accounting records. They cannot design or implement financial information systems. They cannot perform valuation or appraisal services, actuarial services, management functions, legal services, litigation or administration related expert services. The auditor is also prohibited from providing marketing and planning related non audit services to the audit client and tax services to the management team or the family members of the team (Burke & et. al., 2008). 2.2 Threat to Auditor’s Independence It is believed that NAS services of auditors change their role from that of an outsider who can take a transparent view to that of an insider who actively participates in the decision making and acts as an advisor. The economic bond that is created between the audit client and the auditor through their contract hampers the auditor’s independence. In order to carry out a comprehensive analysis of the independence of auditors, it is essential to examine the marginal fee dependence that results from the NAS services in addition to the total fee dependence. It has been stated that auditors should factually as well as in terms of appearance, be independent. NAS has an impact on the perception regarding the independence of auditors and it creates doubt regarding the authenticity of the auditor’s information (Francis, 2006). Legislations have banned the provision of several NAS by auditors for preserving the auditor’s independence. Regulators believed that auditors could go to the extent of sacrificing their independence in order to retain clients who pay large non audit fees (Defond & et. al., 2002) The various threats to which the auditors are exposed can be classified into self review threats, self interest threats, familiarity threats, advocacy threats and intimidation threats. Self interest threat arises from the possibility of getting certain benefit from the audit client. Self review threats arise when the auditor while carrying out the audit is required to judge a few previous works he had carried out for his audit client or the auditor might have had a past association with the audit client. Advocacy threat occurs when the auditor advocates the opinion of his client. A sympathetic relation and familiarity developed over the course of time results in familiarity threat. Intimidation threat occurs because the auditor is not able to act objectively due to threats from the client. When an auditor receives a very high fee from the client then the auditor would not want to displease the client and lose the future incomes from his association with the client. This however cannot occur if the auditor’s appointment and removal is determined by shareholder vote and not according to management discretion (Campbell & Houghton, 2005). 2.3 Comparison between Non Audit Services and Other Threats to Auditor’s Independence Two components of auditor independence have been identified namely practitioner independence and professional independence. The former is also known as factual independence and the latter as ‘independence in appearance’. The practitioner independence arises from the outlook of the auditor in terms of objectivity and integrity. The professional independence refers to the independence as projected to the public. The various factors that impact the independence of auditors are namely non audit services, the small size of the audit firm, extensive competitiveness in the audit services market, high audit fees, the lengthy duration of the audit service and absence of audit committee in the client’s firm. The government regulators, in an aim to curb the threat arising from NAS are trying to segregate consulting services from audit services. According to Schulte Jr (1966), “as a consultant auditor becomes logically and emotionally involved in the decision outcome and this affects auditor independence”. It was observed that NAS services reduce stakeholder confidence. However, regulatory bodies like Malaysian Institute of Accountants (MIA) and The Malaysian Institute of Certified Public Accountants (MICPA) of Malaysia held the opinion that total prohibition of NAS will hamper audit quality. When the size of the audit firm is small then there is an inherent tendency to develop intimate relationship with the client. In contrast, large audit firms are more independent. It is believed that they carry out better audits since they cannot be easily influenced or pressurised. The audit services industry is increasingly becoming more competitive so it is creating a potential threat to independence since it is very easy for the audit client to switch over and take up the services of a competitor. At times, clients resort to ‘opinion shopping’ whereby they resort to the services of the other auditor who might be willing to carry out the audit according to the clients’ wish. A long relationship between the auditing firm and the client developed over an extended course of time results in similar interests of the auditing firm and the client. Audit procedures become less rigorous, auditors become complacent and blind faith on the client develops with time. Often auditors sacrifice their independence in order to raise their fees or to obtain future assignments. Existence of audit committee can also ensure auditor independence. Audit committee acts like an auditor to the auditors, which gives an assurance to third parties regarding auditor independence. Auditor independence is also affected when the client provides exorbitantly high fees, which creates an economic independence. The auditors willingly compromise to retain the client who might be a source of higher revenue for their firm. The European Federation of Accountants and Auditors, keeping this in consideration, had declared that the total charge from a particular client should not go beyond a specific percentage of the total turnover of the audit firm. If the fees from one client is more than 15% of the total fees received by the firm consecutively for two years then economic dependency is said to exist which creates a ‘self interest threat’ to auditor independence. NAS will not hamper audit quality only if there are sufficient regulations to ensure auditor independence. NAS is not the primary reason that reduces auditor independence. The various other factors discussed above also determine to a large extent the independence of auditors (Abu Bakar, 2006). 2.4 Effective Means of Strengthening Auditor Independence The Sarbanes Oxley Act has helped in strengthening auditor independence by a considerable extent. The act has placed a ban on those kinds of NAS services that create conflicts of interest of financial nature. The act stresses on the importance of ‘audit partner rotation’ and enhanced role of audit committees. The act also ensured that financial disclosures should be made in real time (U.S House of Representatives, 2006). Effective internal control can ensure auditor independence. Mandatory reporting to the board of directors and the audit committee by the auditor helps in strengthening auditor independence. The American Institute of Certified Public Accountants (AICPA) needs to make an annual report to the audit committee regarding the total fees that has been received for NAS during the course of the year and a detailed description regarding the services that have been rendered. It has been obligated for auditors by certain auditing standards to report all disagreements and conflicts with the management or other accountants and also the difficulties encountered. It has been made mandatory to make disclosures to the Securities and Exchange Commission (SEC) when an auditor is replaced (Chapin & Gramling, 1996). 3. Data Collection The data collection has been done from various sources which included journals on auditing and threats to auditing. An elaborate study of various pre-existing research papers on auditing and the challenges and threats faced by auditors have also been studied. Various books on auditing have also been referred to collect relevant data. 4. Findings The paper has clearly established the fact that independence of auditors is an absolute necessity in order to ensure transparency in the auditing carried out by auditors. Non auditing services provided by auditors can create an economic dependence on the client and may create conflicts of interest as well. However, it cannot be said that NAS services are solely responsible in making the auditor compromise on his independence. Several other factors have also been identified which may force the auditor to sacrifice his independence. It has been seen that factors that contribute to economic dependence of the auditor on his client reduce his independence. However, audit firms believe that NAS actually helps in cost reduction, improves competition and technical competence. The crucial finding of this research paper is that with the implementation of proper regulations it can be ensured that NAS does not hamper auditor independence. 5. Conclusion The credibility of an audited financial statement depends totally on the auditor’s independence and competence. Auditor’s independence has two dimensions namely factual independence and independence by appearance. Independence by appearance addresses the perception regarding the audit. The fact that auditors provide NAS to their clients creates doubt regarding the credibility of their audit although actually they may be independent. The provision of NAS creates an economic dependence on the client. There exist various threats to an auditor’s independence namely self review threats, self interest threats, familiarity threats, advocacy threats and intimidation threats. The paper has explored the relative importance of the various threats. NAS is a significantly important threat and but it is not the only important threat to auditor independence. The sizes of the audit firm, existence of audit committee and intimacy through long term relationship with the client are a few other factors that impact auditor independence. Several regulations have ensured the strengthening of auditor independence. Compliance with these regulations can help to ensure transparent auditing by the auditors. References Abu Bakar, N., 2006. Threats to Auditor Independence. The Malaysian Accountant. [Online] Available at: http://iium.academia.edu/NurBarizahAbuBakar/Papers/204279/Threats_to_Auditor_Independence [Accessed March 03, 2012]. Arrunada, B., 1999. Abstract. The Provision on Non-Audit Services by Auditors: Let the Market Evolve and Decide. [Online] Available at: http://ideas.repec.org/p/upf/upfgen/423.html [Accessed March 03, 2012]. Burke, F. M. & et. al., 2008. Audit Committees: A Guide for Directors, Management, and Consultants. CCH. Campbell, T. & Houghton, K., 2005. Ethics and Auditing. ANU E Press. Carson, E. & Simnett, R., 2006. Introduction. Threats to Auditor Independence: The Impact of Non-Audit Services, Tenure and Alumni Affiliation. [Online] Available at: http://aaahq.org/audit/midyear/07midyear/papers/Ye_ThreatsToAuditorIndependence.pdf [Accessed March 03, 2012]. Chapin, D. H. & Gramling, R. W., 1996. The Accounting Profession: Major Issues: Progress and Concerns. Diance Publishing. Defond, M. L. & et. al., 2002. Abstract. Do Non-Audit Service Fees Impair Auditor Independence? Evidence from Going Concern Audit Opinions. [Online] Available at: http://www.uic.edu/classes/actg/actg593/Readings/Audit-Fees/Do-Non-Audit-Service-Fees-Impair.pdf [Accessed March 03, 2012]. Francis, J. R., 2006. What Do We Know from Extant Research? Are Auditors Compromised by Non Audit Services? Assessing the Evidence. [Online] Available at: http://www.uic.edu/classes/actg/actg593/Readings/Auditing/Are-Auditors-Compromised.pdf [Accessed March 03, 2012]. Houghton, K. A. & Ikin, C. C., 2001. The Stakeholders. Auditor Provided Non-Audit Services: Modelling Fees and Willingness to Buy. [Online] Available at: http://cbe.anu.edu.au/staff/info/ikinchris/34-APNAS.pdf [Accessed March 03, 2012]. Schulte Jr., A. A., 1966. Management Services: A Challenge to Audit Independence? The Accounting Review, Vol. 41, No. 4. U.S House of Representatives, 2006 Sarbanes Oxley at Four: Protecting Investors and Strengthening Markets: Hearing. Diane Publishing. Read More