How independent are auditor’s really?

Critically assess the role of the auditor and the requirement for an independent opinion in 2015. Identify two factors that impact on the perceived independence of auditors and critically evaluate the extent to which they have been resolved within the current UK regulatory framework.


 

Introduction

The role and responsibilities of auditors are developing as rapidly as the scope of the audit report. However, increasing responsibilities means increasing expectations, posing a greater risk to the perception of independence, indicated by the amount of research evidence suggesting auditor independence is not at the level it should be (Forbes, 2001). In light of major corporate and audit firm scandals in the last two decades (Toshiba, 2015; Arthur Andersen, 2002), there has never been such focus on auditor independence. This essay will critically assess the role of the auditor by today’s standards, the relevance of an independent audit opinion in 2015, focussing on auditor independence and the threats therein, and the extent to which these threats have been resolved under the current UK regulatory framework. The proposed changes to the current framework will also be addressed, highlighting key areas for potential future research.

Independence

There have been a number of definitions for independence proposed in research (Bakar, Rahman & Rashid, 2005), however, the Auditing Practices Board (a branch of the Financial Reporting Council [FRC]) issued five Ethical Standards (ES) prior to its dissolution in 2012, providing the most reliable definition of independence in ES 1 as “freedom from situations and relationships which make it probable that a reasonable and informed third party would conclude that objectivity is impaired or could be” (para.13, p.6). Mautz and Sharaf (1961) developed a concept of independence consisting of two components, which has since been widely accepted amongst academics and the profession. The International Federation of Accountants (IFAC) now recognises two types of independence: practitioner-independence (of mind) and professional-independence (in appearance) (Campa & Donnelly, 2015). The main problem surrounding auditor independence arises largely from the latter of these two components. Lindberg and Beck (2004) conducted a survey of 1,500 Chartered Public Accountants pre and post-Enron, finding that due to auditor independence being a mental state, stakeholders could only assess an auditor’s independence in appearance. They concluded that various threats including non-audit services (NAS) affected auditors perceived independence more detrimentally than actual independence. They also discussed the idea that regardless of whether the auditor is independent in fact or not, if the public does not believe them to be truly independent, they may feel they cannot rely on financial statements. It may therefore be argued that perceived independence is perhaps more important than actual independence. Beattie and Fearnley (2002) highlight the significance of perceived independence through a literary review of existing research, concluding that the value of audit is lost if auditors are not seen to act independently of management.

In continuation, Beattie and Fearnley (2002) also concluded that there is a difficulty in all studies posing to investigate the effects of certain factors on auditor independence. This difficulty being that independence in fact is unobservable and thus proxy measures are used, of which some, such as discretionary accruals, are questionable. This has a wide reaching impact, suggesting it is important to note how each study measures independence, demonstrating the importance of perceived independence.

The Purpose of Audit

The main purpose of audit is to provide an independent, professional and unbiased opinion on the accounts of the company being audited. Traditionally, auditors gave a binary ‘yes/no’ opinion as to whether the financial statements were ‘true and fair’. In a speech given by Martin Bauman (2014), chief auditor of the Public Company Accounting Oversight Board, he identifies the current issue that investors only check reports to see who the auditor is and if the opinion given is clean, inferring that the independent opinion is in fact the most valuable content of the report, also expressed by PwC (2011). The significance of this statement is that it demonstrates the recognition of the weaknesses of the audit report by regulatory bodies as a whole, which has spurred the recent developments in the adoption of the new audit report and reforms within the profession. This new report also emphasises the importance of the opinion and its usefulness to users by bringing it to the forefront of the report.

Agency theory suggests that the need for audit arises as a result of the separation between principals (shareholders) and agents of the principals (directors). It was proposed, therefore, with reference to the ‘remoteness gap’ (appendix 1), that the role of auditors is to bridge this gap by acting as intermediaries between management and shareholders (Porter et al., 2003 [cited in Adelpo, 2012]; Lee, 1986). Undoubtedly, conflict arises as the primary source of information on which shareholders may assess managements stewardship is the financial statements, which are prepared by management. This highlights the relevance of Mautz and Sharaf’s (1961) postulate that audit exists as a result of the need to prove that the statements by management are valid, providing a solid basis for further research.

In reality, auditors test samples of transaction classifications, however, the current public understanding is that auditors check all transactions and accounts, and are thus heavily criticised in the media when a scandal occurs, as was seen after the financial collapses in 2000-2002 (Fargher & Jiang, 2008). This difference in understanding between what auditors are expected to do, and actually do is termed the ‘expectations gap’ (appendix 2) and the “perceptions of auditor independence are a fundamental part of this” (Beattie, Brandt & Fearnley, 1998, p.159). The substantial impact of research into the expectations gap is such that reforms within the profession are designed in an attempt to reduce the gap in order to increase perceived independence (Beattie et al., 1998; Ruhnke & Shmidt, 2014).

Factors Affecting Auditor Independence

There are numerous factors appearing to impact auditor independence, most of which are strongly interlinked and are summarised in Shockley’s (1982 [cited in Gray, Manson & Crawford, 2015]) conceptual model of perceived independence (appendix 3). These factors, identified from existing research through causal analysis, include; non-audit service fees, competition, tenure, audit firm size, accounting flexibility, professional sanctions, auditors legal liability, and the fear of losing clientele or reputation. Given that Shockley’s model is now over 30 years old, a more recent and perhaps appropriate model to use is established by Tepalagul and Lin (2015) confirming only three of these threats; client importance, NAS, tenure, and introducing the new threat of client affiliation with audit firms (appendix 4). However, both studies rely on existing research to form models, which rest on the assumptions and limitations of previous research. It may therefore be suggested that a new model based on current data collected personally by the researcher would be more credible. Similarly, Beattie, Brandt and Fearnley (2005) identified that these factors are not included in the current audit risk model, suggesting a need for model restructuring. Each factor has its relative strengths and weaknesses, nonetheless, for the purposes of this essay I will focus on two factors I consider to be most important: NAS and tenure.

Non-Audit Services

One of the concerns for auditor independence is based on the increasing demand for auditors to provide NAS. Research by Canning and Gwilliam (1999) may be used to explain this growth, as they discovered users of financial statements were accepting of a small impairment of auditor independence as a consequence of NAS, provided they resulted in a better quality audit. It has been alleged that UK major audit firms use audits as loss leaders to win contracts, hoping that clients will purchase additional services (Mitchel et al., 1993 [cited in Canning & Gwilliam, 1999). It is in this respect some critics stipulate that auditors compromise their independence simply by providing NAS to clients (Simunic, 1984; Parkash & Venable, 1993; Firth, 1997; Canning & Gwilliam, 1999). Campa & Donnelly (2015), whilst agreeing with this premise, used a moderating variable derived from abnormal NAS fees to measure independence, finding that both practitioner and professional-independence became compromised by the size of NAS fees. The significance of this research is that it draws a distinction between NAS and NAS fees, allowing for further research to be conducted to better understand how separate these two factors truly are. Similarly, although representing views from Malaysia, a survey of accountants conducted by Bakar and Ahmad (2009) found that currently the size of NAS fees poses the greatest threat to auditor independence (appendix 5). However, there are still arguments that NAS and their associated fees do not negatively impact auditor independence (Ashbaugh, LaFond & Mayhew, 2003; Barkess & Simnett, 1994; DeFond, Raghunandan & Subramanyam, 2002). For now, there seems to be little consensus as to whether independence is impaired by the provision of NAS. If so, by which particular services, as investor perceptions of independence are thought to vary with the type of NAS (Mishra, Raghunandan & Rama, 2005 [cited in Dart, 2011]; Quick & Warming-Rasmussen, 2015), which may be as a result of a number of threats: familiarity, self-review, advocacy, self-interest and others. Rather, it may be due to the dependency of audit firms on the income generated from these services.

The current legal restrictions in the UK on the provision of NAS are minimal, with regulations coming predominantly from professional bodies, standard-setting bodies and other regulators (Gwilliam, Teng & Marnet, 2014). The main regulations for NAS are provided in the APB’s ES4 and ES5, which prohibit audit firms from acting as auditors of a company who’s fees exceed 10% (listed) or 15% (non-listed) of the firm’s total income. These standards require in such cases for the auditor to resign or not stand for reappointment. One safeguard improvement could be to prohibit all NAS, however, a study published by an ICAS working group concluded there would be no benefit to the complete prohibition of NAS (ICAS, 2010 [cited in Gray et al., 2015). Another proposition would be for NAS to be provided by a function separate from audit. This is supported by Canning & Gwilliam (1999), who used questionnaires and interviews to gather detailed information from academics, investment managers, corporate lenders and financial analysts, concluding that perceptions of independence were reduced as a result of audit team personnel providing the NAS. It is now expected that major changes are to occur in mid-2016, as a cap on billable NAS fees and a list of prohibited NAS are scheduled for adoption from the EU Audit Directive 2014 (PwC, 2014). This aims to reduce the notable problems within this threat, improving auditor independence and stakeholder confidence.

Tenure

Before discussing tenure, it is first important to note the impact of competition on tenure and independence. The audit market is stifled by the ‘Big Four’ (Chambers, 2011), and it is this lack of choice of firms with the capability to audit multinationals that drives companies to maintain long tenure periods with audit partners (ACCA, 2014). This signifies that long tenure periods are not always by choice, but perhaps necessity, reinforcing the calls for increased competition. Auditors may have their independence tested when directors use their powers to pressurise and manipulate auditor behaviour by threatening replacement (intimidation threat) (Allen & Siegel, 2002). However, this threat affects auditor’s actual independence more than perceived independence, and is less likely to occur as relationships grow with tenure. Therefore, in my view, the main threat posed to perceived independence by tenure is the familiarity threat. When companies fail, the common accusation is that auditors have compromised their independence by becoming too close to the company. This accusation is based on the assumption that long tenure periods facilitate the growth of relations between auditors and clients, with auditors assuming more managerial responsibilities (QFinance, n/a). Research has repeatedly shown that long tenure periods lead to the reduced inclination to issue a qualified report, using this as a measure of independence (Geiger & Raghunandan, 2002; Barkess & Simnett, 1994; DeFond et al., 2002). This research therefore brings into question the validity and reliability of the audit report itself, and consequently the audit opinion. There is, however, a positive element to familiarity in that the auditors detailed knowledge of the client allows them to provide better, tailored services, which are likely to improve audit quality, and arguably allow auditors to “become more independent of management” (Solomon et al., 1999 [cited in Ghosh & Moon, 2005, p.588]).

As a means of addressing these threats, the current rules in the UK require FTSE 350 companies to put their audits out to tender every 10 years. The reasoning behind this is to try and increase competition and confidence in the industry, to reduce complacency and to encourage innovation (Gray et al., 2015), which were all said to be lacking in firms with long tenure periods (Shockley, 1981). The new reforms, as previously mentioned, will require companies to change auditors every 10 years, and it is assumed the UK will adopt the tenure extension options. This gives prominence for future research to investigate the effects of different lengths of tenure on auditor independence for potential reforms to promote the positive element of tenure, whilst minimising the threats.

In addition to these specific safeguards, there are a number of more generic safeguards aimed at reducing risks to auditor independence, classified by IFAC into three main categories, “those created by the profession… by legislation or regulations… and those involving third parties” (Beattie et al., 2005). Safeguards created by the profession, legislation and regulations include measures such as certification and training with Recognised Qualifying Bodies and Recognised Supervisory Bodies, continuing professional development, ethical standards set by regulatory bodies, as well as the many professional standards, legislation and corporate governance regulations. These efforts all aim to maintain professionalism, integrity, and to increase the public perception of auditor independence.

Conclusion

In conclusion, after examining empirical evidence and looking at an array of studies using different data collection methods, it is clear from the varying conclusions that there is much confusion as to which factors pose the greatest threat to auditor independence. However, the answer to the question regarding the relevance of the audit opinion in 2015 is unequivocally yes, the opinion is still valued. It provides confidence in capital markets which fuel the economy, and is the confirmation to shareholders and other users that the auditors have complied with relevant legislation and standards, vicariously affirming their independence. Similarly, as demonstrated in this essay, research has shown that the most valuable content of the audit report is the independent opinion. Independence, like scepticism, is primarily a state of mind, and thus unobservable. This makes it hard to draw conclusions on the extent to which particular factors compromise auditors’ independence. However, it is my personal view that the biggest threats facing audit today are those to perceived independence as opposed to practical independence. The current and future reforms should therefore be designed with the aim of reducing the expectations gap that exists between stakeholders and the profession, and restoring independence (perceived and practical), and confidence where they are much needed. The timing of these new reforms is imperative, as the profession not only needs change, but regulators must also be seen to be actively improving the profession following numerous corporate failures, to prevent any further detriment to the public perception of auditor independence.

 

LIST OF APPENDICES

Appendix 1. – The role of audit in terms of the ‘remoteness gap’

Appendix 1
Image cited from Gray, Manson and Crawford (2015, p.71)

Appendix 2. – Structure of the audit ‘expectations gap’

Appendix 2
Image cited from Porter (1993, p.50)

 Appendix 3. – Shockley’s (1982) conceptual model of perceived independence

Appendix 3
Image cited from Gray, Manson and Crawford (2015, p.78)

Appendix 4. – Ranking of factors influencing auditor independence

Table II. The importance of factors in influencing AI (1-Most important; 6-Least important): The mean and rank of factors

Appendix 4
Adapted from Bakar and Ahmad (2009, p.139)

 

Reference List

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List Of Statutes And Standards

APB. (2010). Ethical Standard 4 (Revised): Fees, remuneration and evaluation policies, litigation, gifts and hospitality. Retrieved from https://www.frc.org.uk/Our-Work/Publications/APB/ES-4-(Revised)-Fees,-remuneration-and-evaluation-p.pdf.

APB. (2011). Ethical Standard 1 (Revised): Integrity, objectivity and independence. Retrieved from https://www.frc.org.uk/Our-Work/Publications/APB/ES-1-(Revised)-Integrity,-objectivity-and-independ.pdf.

APB. (2011). Ethical Standard 5 (Revised): Non-audit services provided to audited entities. Retrieved from https://www.frc.org.uk/Our-Work/Publications/APB/ES-5-(Revised)-Non-audit-services-provided-to-audi.pdf.

Featured image courtesy of http://intheblack.com/~/media/intheblack/allimages/magazine-2015/11-inpractice/goldfish-bowl.jpg

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