Independence of Audit Firms - Dissertation Example

Independence of Audit Firms Independence of Audit Firms Independence of an auditor aims at ensuring there are integrity and objectivity. Auditor independence involves the creation of an environment that ensures both the internal and external auditor performs duties with objectivity and integrity. Objectivity is defined by IFAC as the state of mind lacking bias, compromise, prejudice, and provides a fair and impartial deliberation of all matters relevant to the task being done. Integrity entails having honesty, candour, fairness, confidentiality, and intellectual honesty in the course of any work. The internal and external auditor has to lack any relation to the company under audit or any other firm/entity that has financial interest in the business in which the auditor is tasked to audit (Gul, 2008, 104). Ensuring auditor independence in a auditor-client relationship is a responsibility of both the auditors and the firm being audited owing to the presence of negative impacts on the firm for lack of auditor independence including limited access to the capital market, distraction of the management from effective performance of their duties, and significant costs to the company. The issue in the case deals with audit independence, and it is the aim of this study to make an in-depth analysis of the various issues that relate to audit independence and the measures that can be undertaken by an audit firm as well as those provided under law and statutes in ensuring audit independence. The issue has merit because it touches on the ability of the audit firm to perform its audit duties in an objective manner and maintenance of integrity that can impact the firm negatively if not handled well. The engagement of an external auditor has to be independent both in appearance and fact to ensure the objective exercising of duties and the impartial judgement on issues. There are various ways in which the independence of an external auditor can be compromised including the direct or indirect relationship with the audited firm in terms of employment, financial, or business. The effect of these relationships are that they result in conflicting interest between the auditor and the company, result in the auditor auditing his/her own work reducing objectivity and impartial judgement, an auditor becomes an advocate for the company, and that the auditor becomes an employee or manager for the company. The independence of the auditor is compromised in such a situation, and the auditor is not fit to audit the financial statements of the company. Audit independence is envisaged in a number of regulations by law including the International Standard on Auditing (ISA), which clearly demonstrates the importance of independence for an auditor. ISA envisages the nature and scope of an audit and the need for an independence of an auditor as one of the tenets of meeting objectives and goals of an audit engagement (Gray and Manson, 2011). Independence is an important aspect of each audit firm and has to be achieved at all times through following the set rules by different regulating bodies in different global regions operated by the audit firm or the financial entity on audit. The failure of Enron, WorldCom, and Global Crossing are case in point for the need to have auditor independence, and this has been discussed by policy makers and academicians for a long time. The effect resulted in the need to have partner rotations as envisaged in the article by Jenkins and Vermeer stating the actions by US General Accounting Office (GAO) and US Public Company Accounting Oversight Board (PCAOB) to enforce partner rotation in auditing (Jenkins & Vermeer, 2013, p. 77). Further, the reviewing partner is also prohibited from the provision of such services after five years through the requirement for rotation of audit partners after five years. Other members of the audit team have to be rotated after seven years and will not be allowed to audit the firm within the next two years after the seven years of being a member of the audit team. In Europe, the need for auditor independence has been considered after the European Union had to provide a three billion bailouts of banks. The effect of audit firm rotation, as documented by Orlik, is an augmented quality of audit and the reduction in pressure on partners for the loss of long-term clients (Orlik, 2011, p. 1). There are two stages in the auditor-client relationship starting from auditor learning resulting in augmented audit quality owing to the increased familiarity with the firm under the audit. The second stage is referred to as audit closeness characterized by audit quality deterioration owing to a challenge to objectivity and independence (Jenkins & Vermeer, 2013, p. 78). The demonstration is that there is a need for partner rotation to avoid the auditor-client relationship reaching the audit closeness phase to allow for the maintenance of auditor independence. Partner rotation has also been implemented in New Zealand by with the requirement for a change of the lead audit partner each five years allowing for independence of an auditor (NZX 2004 3.6.3). Partner rotation is not enough to result in the independence of audit firms according to the European Commission. After ten years of engagement, the European Union requires the rotation of audit firms with the possibility of an additional ten years when tenders are conducted. In case firms engage joint auditors, the period can be extended to 14 years without compromising the auditor’s independence in carrying out audit duties. Confirmation to these rules allows for the ensuring that audit firms are independent and in a position to provide objective services and maintain an integrity in their duties. Two potential benefits for audit firm rotation according to PCAOB are the increased incentive of an auditor to resist management pressure owing to decreased tenure, and the fresh viewpoint brought fought by a new auditor. The main problem that was noted with audit firm rotation are the increased costs to firms for having to look for new auditors after each end of tenure and the familiarity and learning needed within the first two years of audit tenure. However, for the benefit of audit independence, audit and partner rotation are important to allow auditors perform their duties as required. Audit rotation is not mandatory in the United States, but partner rotation is mandatory. There are a number of provisions that are stipulated to ensure that the independence of auditors is maintained at all times ensuring integrity and objectivity in job performance. One of these provisions in Company Law is the CA2006 S493 that requires the publication of auditor’s remuneration in financial statements. The effect is that the remuneration received from the audited company is common knowledge ensuring the stakeholders know the amount charged by auditors and allows for regulation of audit fees amount. Having tenure of office from one annual general meeting to the nest, as stipulated in the Company Ordinance (Chapter 32), aims at improving the independence of an auditor. Several provisions are outlined for the removal of an auditor including passing of a simple resolution (s. 131(6)) (Gul, 2008, 104). The shareholders have a say in the engagement of the auditor reducing the ability of the management to influence the auditor augmenting auditor independence. Having background checking before the assumption of duty by a new auditor, communicating with the previous auditor and sharing correspondence, and making the decision to accept or decline the nomination by the new auditor (Gul, 2008, 104). The effect is that a professional misunderstanding by an existing auditor and the management will make it difficult finding a new auditor allowing auditors to have less influence on the management. The endorsement of the European Union in Brussels on December 17, 2013 on the need for regulation of the Audit sector is another manner in which auditor independence has been strengthened in recent years. The agreement requires that audit firms rotate every ten years to avoid over familiarity with audit clients and the maintenance of independence. The other manner of ensuring independence for audit firms is an encouragement of joint audits by different firms that allows for augmented objectivism and independence by the joint audits. The implementation of joint audits allows for the implementation of all the requirements for compliance by auditors and the company and ensures the presence of objectivity and impartial performance of duties. The independence of the audit firm can be ensured through lack of service provision that is required to be paid through contingent fees. Direct or indirect payment of commission from the company to the audit firm is prohibited in ensuring the independence of an auditor as envisaged in the SEC no. 34-53677 and PCAOB- 2011-06 (PCAOB, 2011). The International Federation of Accountants (IFAC) prohibits audit firms from the provision of tax services to the firms they are involved with as auditors (IFAC, December 2010). The aim of the revision of the IFAC code of ethics is an improvement on the independence of an auditor and avoids being swayed by tax decisions through their involvement as tax advisors or other tax related services preventing them from being objective and impartial in their judgement. In case an auditor has shareholding in an audited firm, the auditor of partner of an auditing firm is required to have disposed of the shares in a timely basis to avoid having financial interest in a firm he/she is involved as an auditor (Roxburgh, 29 May 2013). There are certain non-audit services that an audit firm or any of the partners in the firm cannot provide to the financial firm it is engaged to as an auditor as a measure of ensuring its independence is not compromised. Some of these services prohibited by both the PCAOB and IFAC include marketing, tax treatment opinions, planning, or tax transactions in the financial statements. Another non-audit service that cannot be provided by an audit firm to the financial firm it is auditing is services that relate to the financial statements, and that relate to the investment strategy of the firm. The provision of aggressive tax services for the purposes aimed at evading the payment of taxes through taking aggressive tax positions is prohibited for the audit firm or any member of the audit firm for the client under audit or within the audit engagement. The other manner through which the audit firm can be independent is through the lack of provision of tax services to financial reporting personnel in the client firm or an immediate family person to the person. However, services can be provided when the financial statements of an entity to which the person reports to the firm are immaterial to that of the client firm and the financial statements of the related entity are audited by a different audit firm or person. The firm can ensure it is independent by complying with these provisions on non-audit services. The actions of an audit firm despite the provision of allowed non-audit services shall ensure that the audit firm of any of its employees does not take on responsibilities reserved for the client firm’s management. These judgements and decisions that cannot be undertaken by an audit firm include acquisition, control and deployment of human resources, physical, financial, and intangible resources control. Compliance to [the prohibition involves the audit firm and its partners or employees desist from deciding policies and setting strategic direction, authorising directions, direction and being responsible for employees of the client firm under audit, preparation or direction of financial statements preparation, and internal control practices in the firm. Having a separate entity providing consulting services but with the audit firm having financial and management control. The independence of the audit firm will be impaired, and both entities cannot be allowed to engage in the same financial entity for the sake of objectivity and integrity of audits. There are threats that arise in relation to the independence of an auditor including managerial, advocacy, familiarity, self-interest, and self-review. Avoidance of management threat by an audit firm in terms of the engagement in the provision of non-audit services that have to be decided on by the management ensure audit firm independence augmenting objectivity. An example of this service is the design of a financial technology system, selection, and implementation creates a management threat to the audit firm of partners and has to be avoided. Advocacy threat arises when an audit firm acts as an advocate for the client firm against an adversary exemplified by advocating in favour of a firm in a regulatory investigation. Familiarity threat arises when there is the close association with the firm under audit review resulting in insufficient questioning of financial entries compromising the quality of the audit. Having family relations with the management or people having financial responsibility in the client company also affects the independence of an audit firm. An audit firm has to ensure the team performing an audit on a certain client have no family relations that could affect their objectivity. Another prohibition that affects the independence of audit firms is the outsourcing of long-term contracting services to the client resulting in the development of close or contractual relationships with the client on audit. An audit firm comply with the set guidelines in published audit surveys on the proportion of audit fees paid by a company to the total audit income of the firm. There are some factors that have resulted in the increased threats of audit independence around the globe. These factors include the reduction in audit firms reducing the competition and demand for quality audits affecting the need for objectivity and independence. The other effect is a reduction in the possibility of effective audit rotation for the achievement of the required auditor independence. A good example is the reduction of audit firms in the United Kingdom by 22% in 2010 compared to the total number of firms in 2005. The factor that has complicated the independence of auditors globally is the augmented use of a few audit firms like Deloitte in the United States by large firms and generation of large sums from these firms. The other evidence of the augmented use of a few large audit firms by financial institutions is that six firms in the United Kingdom audit all FTSE 350 firms with BDO International. Grant Thornton has only 11 audits depicting the other factor that could result in the reduction of independence of audit firms in different global locations owing to pressure to succeed. The other factor evident in the case that complicates or affects the independence of an auditor is the growth of audit fees for the provision of non-audit services (Lee, 2008, 24). The problem of increases in non-audit fees was present before the collapse of Enron blamed on lack of auditor independence and had continued to be an issue over the issues. The independence of auditor independence is the increase percentage of non-audit fees as a total percentage of income generated by an audit fee. The main example is the fees earned by the big four audit firms comprises of only 25% of audit services, and the figure is reducing with time while the non-audit services make up 75% of the fees. The big four audit firms include Deloitte, Ernest & Young, PwC (PricewaterhouseCoopers), and KPMG (Guidance on audit committees, 2011). The need to regulate non-audit fees has never been greater because of the increased exposure of audit firms to manipulation by financial institutions to affecting their independence. Other provisions listed for the compliance by auditors is to make a written submission to show their objectivity and independence, ensure the audit firm show the non-audit services provided and the amount of fees charged. A compliance with all the requirements for independence has to be provided in written form on the independence of the auditors. The policy of the client on non-audit service provision has to be taken into consideration in the provision of these services, and the audit committee have to ensure compliance. A discussion of auditor independence with the audit committee is the other manner in which the auditor and the client can be able to ensure the independence and objectivity of the auditor are maintained (Spira, 2002, 132). Instances where an audit firm and the entity to be audited in terms of the provision of audit and non-audit services, the choice has to be made by both the audit and the audited firm to provide either audit and anon-audit services to avoid conflict of interest of affecting auditor independence (United States, 2002, 16). Analysing the independence of a firm requires the concerted effort of FRC to have inspections done and a review of the set procedures and policies of an audit firm including its culture. Individual audit inspections and reviews can be done by ASIC meaning that FRC takes reviews on the policy level while ASIC on individual audit levels. The effect would have been an ability to realise concerns the policy and culture level by FRC before the collapse of United States firm, Arthur Andersen (Campbell & Houghton, 2005, 232). Subcontracting staff to the client company for the performance of internal audit functions is also prohibited since it results in a negative effect on audit independence (Arens, 2010, 94). In conclusion, the point raised in the case has merit because of the importance of independence of an audit firm, its partners, and employees for the success of the audit in terms of quality, objectivity, and integrity. There are various ways through which the firm can ensure its independence is not affected by its involvement in large firms paying considerable sums of money and being provided by non-audit services. The measures emanating from the research include ensuring the non-performance of duties that are the sole responsibility of the management, non-audit services should not result in self-audit, evasion of tax payment, or fall in the realm of the services prohibited by regulating bodies. The fees payment for non-audit services should not be so substantial to exceed the set limit and should not result in these fees being more than the audit fees that could compromise the quality of the auditor and independence of the audit firm. Despite the fact that the query has merit the measures and regulations set by the regulating bodies and the ethical guidelines for auditors as envisaged in the Ethics Code provide the guidelines for ensuring the independence of the firm is not affected. A small or big firm is affected by the independence issue as evidenced by the research and these guidelines have to be followed no matter the size of the firm; hence, the query does not only apply to the large firm alone. References ANAND, A., & MOLONEY, N. (2004). Reform of the Audit Process and the Role of Shareholder Voice: Transatlantic Perspectives This article is based on Anita Indira Anand, & lsquo. 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(March 29, 2013). FRC Warns Over Audit Fee Pressure. Economia. SPIRA, L. F. (2002). The audit committee performing corporate governance. Boston, Kluwer Academic Publishers UNITED STATES. (2002). Government auditing standards answers to independence standard questions. [Washington, D.C.], U.S. General Accounting Office. XU, Y., CARSON, E., FARGHER, N., & JIANG, L. (2013). Responses by Australian auditors to the global financial crisis. Accounting & Finance. 53, 301-338. Read More