It is the objective of public audit to improve the true and fair representation of financial reports by providing reasonable assurance from an independent source. However, if public auditors are influenced by parties with related interests, users of the audit report will not believe the credibility of financial statements be met that the auditor may have been influenced by other parties. Therefore, whether the external auditors of listed companies are sufficiently independent to serve the public interest is considered as a most important issue of public audit. Since 2000, the current international regulatory environment for the auditing profession was focused on by the public because of the loss of trust in public audit from a wave of accounting scandals (Lindberg & Beckï¼Œ2004).
Concept framework of Audit Independence
Because financial reports have important economic consequences for the users, how to represent financial position and operational performance is crucial to different parties. If there is no audit independence, the interests of the public audit can be impaired by some parties for improper purposes. Therefore, all regulatory organizations all make great efforts to revise the concept of audit independence to improve regulatory environment.
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How to define independence is different in current audit standards. In APB Ethical Standard 1 revised in 2008, independence is freedom from situations and relationships which make it probable that a reasonable and informed third party would conclude that objectivity either is impaired or could be impaired (APB Ethical Standard 1, 2008). In Code of Ethics for Professional Accountants revised by IFAC in 2009, independence is classified in independence of mind and independence in appearance. Independence of mind is the state of mind that permits the expression of a conclusion without being affected by influences (Code of Ethics for Professional Accountants, 2009). Independence in appearance is the avoidance of facts and circumstances that are so significant that a reasonable and informed third party would be likely to conclude that objectivity or professional scepticism has been compromised (Code of Ethics for Professional Accountants, 2009). Mautz, R.K. & Sharaf, H.A. (1961) classified independence into programming independence, investigative independence and reporting independence.
Obviously, there are no significant differences in the above definitions, since their emphasis all are placed on the freedom of public audit from the influence of related parties. But the definition by IFAC has more operability. It provides auditors with aids in how to protect and enhance their independence.
International Regulation of Non-Audit Services
In practice, auditors provide clients with not only audit service but also non-audit service. Non-audit service can produce benefit to both clients and auditors (Verrecchia, 2001). Based on audit proof and audit conclusion, the non-audit service by auditors can be more efficient and effective than other business consultants. However, non-audit service also will impair the objectivity and independence of auditors.
Fear of loss of non-audit service from the entities audited, auditors will conduct improper audit process and prepare unreasonable audit report under the press of the entities audited. For example, in the accounting scandal of Enron, audit company Arthur Andersen had to provide false audit report so as to benefit from non-audit service for Enron. When there are lots of non-audit services, it is possible for auditors not to hold reasonable independence and caution. And the public will lose the trust in the credibility of audit report in light of the close relationship between auditors and entities audited (Palmrose, 1986).
Therefore, how to safeguard auditor independence from non-audit service is critical to auditors. Otherwise, the credibility of independent audit and the public interests will be destroyed by non-audit service.
In professional ethical codes, the related issues are discussed. According to Ethical Standard 5 revised in 2008, auditors with non-audit service for entities audited should identification and assessment of threats for audit independence and establish operable safeguards. And they should communicate the above events with those charged with governance. All these behaviour and documents should be recorded for important proof. In Ethical Standard 5, non-audit services comprise any engagement other than the audit of financial statements and the pursuant to those other roles which legislation or regulation specify can be performed by the auditor of the entity. Non-audit service usually includes Internal audit services, information technology services, valuation services, actuarial valuation services, tax services, litigation support services, legal services, recruitment and remuneration services, corporate finance services, transaction related services and so on.
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Although the independence from non-audit service isn't discussed in Code of Ethics for Professional Accountants revised by IFAC, the conceptual framework approach to independence can be applied to protect independence impairment from non-audit service. For example, identify threats to independence, evaluate the significance of the threats identified and apply safeguards when necessary.
The main four accounting firm in USA have always stated that non-audit services do harm to the auditor independence. After the Enron scandal and Xerox finance cheating happeningï¼ŒSOX 2002 requires that they would never provide their clients with information techniques consulting and internal control services. In addition, SOX 2002 established the Public Company Accounting Oversight Board (PCAOB), appointed & overseen by the Securities Exchange Commission (SEC). The PCAOB now has the responsibility for oversight of the auditors of public companies in the USA including establishing auditing and quality control standards and performing inspections of quality controls at audit firms.
International Regulation of Mandatory Auditors Rotation
Except for the supervision over non-audit service, almost regulatory organizations focus on mandatory auditor rotation. In other word, audit tenure should be limited.
Proponents of mandatory rotation of auditors argue that it helps improve the due independence of auditors. Mautz and Sharaf (1961) suggest that longer auditor tenure can result into a higher probability of establishing close relationship with the client so that the audit independence can be impaired. Davis et alï¼Ž(2002) reveal that the auditor tenure is positively related with the absolute value of discretionary accruals. Chi and Huang (2005) use discretionary accruals to measure audit quality and consider the tenure of both audit firms and their partners. They find that in Taiwanï¼Œas auditor tenure increasesï¼Œauditors become more familiar with the clients' businessï¼ŽHowever, excessive familiarity may 1ead to a decline of audit quality.
After the financial scandals of Enron and WorldCom, the US promulgated the Sarbanes-0xley Act of 2002 (known as SOX). Section 203ï¼ŒChapter 2 of SOX requires the mandatory rotation of auditors. In Australia, the basic rule is that the lead and review auditors must rotate after five successive years and also may not audit a particular audit client for more than five out of seven successive financial years. Canada, the UK and the SEC Rules require rotation after five successive years. The EU Recommendation requires rotation after seven years. However, the requirements in Australia, Canada, the UK and the SEC only apply to listed companies. There is a debate over whether the auditor engaging a firm can be forced to replace on a regular basis.
International Regulation of Audit fee
When an auditor obtains a high proportion of revenue from a particular client, this creates economic bonds between the auditor and client, and makes the auditor be financially reliant on the client. this can cause the auditor to lose objectivity (DeAngelo 1981). Some research suggests the same outcome but the mechanism by which the auditor loses objectivity with fee dependence is said to be unconscious (Kunda, 1990). When fee dependence is low, as auditor tenure increases, audit quality increases with auditors' tenure but is more likely. When fee dependence is high, as auditor tenure increases, audit quality decreases with auditors' tenure.
AICPA point out it necessary that in disagreeing with management, auditors would no longer be risking a stream of revenues that they believed would continue in 'perpetuity,' since the audit engagement would no longer be perceived as permanent" (Commission on Public Trust and Private Enterprise 2005, p. 39). Although other international regulatory organizations ignore the issue, audit fee, which is related with audit independence, will be placed more emphasis in the future.
To make auditors act for the public interests, international regulatory organizations make great efforts to improve audit independence. In current international regulatory environment, international regulatory rules, such as the SOA, state that some non-audit service for audited entities, which are easy to lead to independence are explicitly prohibited when auditors performing an independent audit of a public company. Audit firms are encouraged to divide their business units into the consulting units and the audit units. Audit units provide assurance service. And consulting units are independent of audit units and provide non-audit service. The mandatory rotation of auditors is adopted by many regulatory organizations to improve audit quality. Additions, some organizations, such as AICPA, even focus on the regulation of audit fee.
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The findings provide useful insights to the international regulatory environment. However, whether the current international regulatory environment for the auditing profession is robust enough to ensure audit quality has to be tested by lots empirical investigations.