Auditor Independence and Non-Audit Services: A Literature Review
Audit Independence
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Transcript of Audit Independence
Jason Cates Audit Independence
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Auditor Independence
The Way Forward
Written by
Jason Cates
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© Jason Cates, 2013
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Private and research study purposes, performance, copies or lending for educational
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Copyright Service.
This publication may be made available online at SlideShare.net/AdrJasonCates for public
use no earlier than 09:00hrs (GMT) on 18 April 2013 as deemed appropriate by the
acknowledged source.
This paper has referenced appropriate sources in line with Harvard Referencing.
Any queries regarding this publication should be sent to:
LinkedIn.com/in/AdrJasonCates
To be delivered to the University of Hertfordshire on or by
4 March 2013
Ordered by Jason Cates to be printed
4 March 2013
Printed in the United Kingdom
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‘Just like beauty, quality and independence are in the eye of the beholder, therefore
perception of audit quality and of auditor independence is paramount’
Michel Barnier, European Internal Market and Services Commissioner
Required: Critically evaluate the safeguards in place to enhance auditor independence and
the extent to which any proposed measures may enhance auditor independence in the
future.
Word count: 1200
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Table of Contents Background ....................................................................................................................................... 4
ISA 200 .......................................................................................................................................... 4
Framework .................................................................................................................................... 4
Ethical Standards 1 and 5 (Integrity and Non-audit Services) .......................................................... 5
Ethical Standards 2 and 3 and ISA 220 (Relationships and Long Association) .................................. 5
Ethical Standard 4 (Fee Dependence) ............................................................................................ 6
Proposed Safeguards ......................................................................................................................... 7
Audit Firm Rotation ....................................................................................................................... 7
Mandatory Audit Tendering ........................................................................................................... 7
Limit on Non-Audit Services ........................................................................................................... 7
Conclusions ....................................................................................................................................... 8
Signatories ........................................................................................................................................ 9
Harvard Referencing ........................................................................................................................ 10
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Background This report will evaluate the current safeguards in place to ensure audit independence with a focus
on the ethical standards. Furthermore, it will evaluate how proposals set forth by the European
Commission will address any current issues concerning such independence.
ISA 200
Ethical requirement remain at the heart of auditor independence as set out in ISA 200. This
includes auditors retaining “professional scepticism and judgement” when carrying out the audit.
(IFAC, 2009) These attributes are required to critically evaluate the evidence available and to make
appropriate judgements regarding issues such as materiality. Furthermore, these attributes are
essential when deciding upon appropriate interpretations and implementation of the standards. This
is particularly the case when standards of specific jurisdictions differ from those of the ISA’s. This can
create inconsistently across different jurisdictions in which clients and auditors may operate.
(ICAEW, 2013)(FRC, 2011a)
Another area requiring “professional judgement” is evidence requirements. Where there is
considered to be a high level of audit risk, greater levels of evidence may be required. This opens up
the evidence requirements to interpretation and differences depending on the audit firm used.
(Millichamp & Taylor, 2012)
Framework
The current ethical framework takes that of a principles-based approach. This includes five
fundamental principles; integrity, objectivity, confidentiality, competence and professional
behaviour. This is compared to a rules-based approach as seen in the USA which, by its nature,
cannot deal with every eventuality. Thus, having a principles-based approach places the
responsibility on auditors to ensure the standards are upheld. (Millichamp & Taylor, 2012)
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Ethical Standards 1 and 5 (Integrity and Non-audit Services)
Integrity and objectivity are two key principles of the framework and the Auditing Practices
Boards Ethical Standard one. (FRC, 2011a) These require auditors to avoid situations where conflicts
of interest may arise. However, this focuses on auditors on an individual basis rather than on an
organisational level. A number of auditing failures have put into question the strength of these
standards. One of the issues highlighted by recent collapses has been the level of non-audit work
carried out by the “Big Four” accounting firms for clients in which they were auditing. Issues such as
these can create “conflicts of interest” for auditors and impede the audits independence. Thus,
where non-audit services are provided, auditors must ensure adequate safeguards are in place to
maintain auditor objectivity. (FRC, 2011b)
Ethical Standards 2 and 3 and ISA 220 (Relationships and Long Association)
Ethical Standard two covers personal relationships which include all family, financial,
business and employments relationships. This aims to maintain auditor independence on an
individual basis and requires audit partners to identify possibly “threats” to their objectivity.
Therefore, auditor objectivity and professional judgement form a key part to this standards long-
term viability. It also requires adequate controls be in place as to ensure this objectivity is
maintained. For example, ISA 220 requires auditors to carry out annual “reviews” of their
relationships with clients to ensure this objectivity is maintained. (FRC, 2010a)
Ethical Standard three places the onus on auditors to implement the standards using their
professional judgement. This lack of precision in the standard allows for interpretations of the
standards to be made. This can become an issue of concern when there is insufficient competition in
the audit to drive up standards regarding independence. A lack of competition among auditors
discourages clients to change auditor and has resulted in audit firms retaining specific clients
unchallenged. This may lead to relationships forming between the management of both client and
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auditor and impede the auditor’s objectivity. An increase in competition will increase the auditor’s
accountability to client shareholders with the focus on independence and audit quality. (FRC, 2009)
Ethical Standard 4 (Fee Dependence)
As set out by Ethical Standard four, total fees for the provision of both audit and non-audit
services from an individual listed company should not exceed 10% of the audit firm’s total income. In
cases where total fees do exceed 10% of income, the auditing firm is expected to step back from the
role of auditor. Ensuring non-reliance on specific clients helps to ensure professional judgement is
maintained with the only considerations being those relevant to the audit. Thus, this standard helps
to ensure auditor independence is maintained on an organisational level. (FRC, 2010b)(Craswell,
Stokes & Laughton, 2001)
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Proposed Safeguards
Audit Firm Rotation
The first proposal set out by European Commission was that of a “mandatory audit firm
rotation”. This would require auditor appointments to serve at least two-year terms, but with a
maximum term of six years. Once this maximum term has been served, the audit firm would not be
permitted to serve as auditor for at least four years. This safeguard will help prevent relationships
from forming between the audit team and the management of the audit client. This deals with the
issue of “management familiarity” which may impede on the auditor’s ability to maintain objectivity
and utilise professional judgement. (Deloitte, 2012)
Mandatory Audit Tendering
Mandatory audit tendering would require a more “competitive” and “transparent”
tendering process when appointing a new auditor. Practically, this would require companies to
consider at least one audit firm from outside the “big four” accounting firms as auditor.
Shareholders would then choice between at least two of these audit firms alongside the
recommendations of the audit committee. This will require client management to justify their choice
of auditor with the focus being on auditor independence and competence. This will place the onus
on shareholders to ensure auditor independence is maintained. (Deloitte, 2012)
Limit on Non-Audit Services
The third key proposal places a limit on the level of non-audit work a company’s auditor will
be allowed to provide. The proposal would allow “very few non-audit services” to be provided to a
client by its auditor. This would include the provision of “expert services unrelated to the audit”
being considered a “conflict of interest” and thus, would not by permitted these proposals these
expert services will include, but not exclusively, tax consulting and bookkeeping. This will further
strengthen auditor objectivity and independence. (Deloitte, 2012)
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Conclusions In conclusion, the current safeguards protect independence on an individual level, but fail to
protect independence on an interfirm level. The measures proposed by the European Commission
aim to address this issue.
Audit firm rotation and mandatory audit tendering will help to address the “perceived” lack
of independence in the eyes of key stakeholders. However, in order to be effective, audit firms must
ensure they have the required skills to audit the variety of companies in which this proposal will
apply. This is to avoid, companies appointing audit firms without the required competence to carry
the audit, purely to comply with these proposals.
Limits of the levels of non-audit may reduce the attractiveness of offering an audit service as
compared to offering other financial disciplines deemed to be more “profitable”. (Deloitte, 2012)
However, this may be overcome by audit firms maintaining diverse client portfolios. This will allow
them to offer a broad range of financial services without contradicting this proposal.
These policies are likely to be disruptive in the short-term, met with resistance and will
require long-term structural reform of the audit industry. However, they will contribute to the
safeguarding of audit “objectivity” and “independence” on an industry wide basis.
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Signatories I commend this paper to the University of Hertfordshire to be delivered on or by 4 March 2012.
Jason Cates
___________
Mail: [email protected]
Portfolio: SlideShare.net/AdrJasonCates
LinkedIn: LinkedIn.com/in/AdrJasonCates
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Harvard Referencing Craswell, A., Stokes, D, J. & Laughton, J. (2002) “Auditor independence and fee dependence.” Journal
of Accounting and Economics 33: 253-275.
Deloitte (2012) Deloitte Audit Reform Briefing: Unprecedented reform proposed for the EU audit
market. [Online] Available at:
http://www.deloitte.com/view/en_GX/global/services/Audit/cff7925771678310VgnVCM100000195
6f00aRCRD.htm [Accessed: 7th February 2013]
IFAC (2009) Overall objectives of the independent auditor and the conduct of an audit in accordance
with international standards on auditing. [Online] Available at:
http://www.ifac.org/sites/default/files/downloads/a008-2010-iaasb-handbook-isa-200.pdf
[Accessed: 7th February 2013]
FRC (2009) APB Ethical Standard 3 (Revised) - Long Association with the Audit Engagement. [Online]
Available at: http://www.frc.org.uk/Our-Work/Publications/APB/ES-3-(Revised)-Long-Association-
with-the-Audit-Eng.aspx [Accessed: 19th February 2013]
FRC (2010a) APB Ethical Standard 2 (Revised) - Financial, business, employment and personal
relationships. [Online] Available at: http://www.frc.org.uk/Our-Work/Publications/APB/ES-2-
(Revised)-Financial,-business,-employment-and.aspx [Accessed: 12th February 2013]
FRC (2010b) APB Ethical Standard 4 (Revised) – Fees, remuneration and evaluation policies, litigation,
gifts and hospitality. [Online] Available at: http://www.frc.org.uk/Our-Work/Publications/APB/ES-4-
(Revised)-Fees,-remuneration-and-evaluation-p.aspx [Accessed: 12th February 2013]
FRC (2011a) APB Ethical Standard 1 (Revised) - Integrity, objectivity and independence. [Online]
Available at: http://www.frc.org.uk/Our-Work/Publications/APB/ES-1-(Revised)-Integrity,-
objectivity-and-independ.aspx [Accessed: 12th February 2013]
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FRC (2011b) APB Ethical Standard 5 (Revised) - Non-audit services provided to audited entities.
[Online] Available at: http://www.frc.org.uk/Our-Work/Publications/APB/ES-5-(Revised)-Non-audit-
services-provided-to-audi.aspx [Accessed: 12th February 2013]
ICAEW (2013) ICAEW input to APB review of their Ethical Standards. Available at:
http://www.icaew.com/en/technical/ethics/auditor-independence/icaew-input-to-apb-review-of-
their-ethical-standards [Accessed: 15th February 2013]
Millichamp, A. and Taylor, J. (2012) Auditing. 10th edn. Hampshire: Cengage Learning.