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It seems that the term auditor independence is a sensitive topic between different public sectors in recent years since a number of people concerned that whether auditors can be truly independent if their revenues come from offering non-audit services as well as traditional audits. There is strong evidence that the role of audit firms play an important part on companies and external investors since all company information that audited by the accounting firms should be disclosed in public with unbiased, impartial views. If auditor is independent, investors can be protected due to the fact that they probably make investment decision based on the financial statements of the company. However, a phenomenon shows that in some situations, some factors such as non-audit services, close relationship between clients and auditors or economic incentives seem threaten the independence of auditors because these factors may affect the auditors' opinions and judgement when they doing audit works.
Therefore, in this essay, it will initially give the definition of independence and explain why the independence of auditor is important for both company and investors. Then it will identify and assess the threats to the objectivity and independence of auditor. Thereafter, it will explain how accounting firms can be independent when they provide joint provisions of audit and non-audit services. Finally, it will discuss how audit firm could be compromised due to offering audit and non-audit services.
Definition and importance of independence
One the one hand, according to Flint (1988, cited in Gray and Manson 2011, p. 64), independence refers to be 'completely objective, unprejudiced by previous involvement in the subject of audit, uncompromised by vested interest in the outcome or its consequences'. However, there are two types of independence. Firstly, independence in mind states that it not only allows audit firm to be straightforward, honest and unbiased, but also need to exercise professional scepticism. For instance, when auditors express a conclusion, the conclusion should not be affected by influences such as compromise professional judgement. Secondly, independence in appearance indicates that accounting firm should obey the main principles including integrity, objectivity and professional scepticism due to the fact that a third party may evaluate all the detailed facts or circumstances (IFAC 2012, P. 46). In other words, when auditors auditing the financial statements, it is important that auditor not only should not be affected by conflicts of interest or other factors, but also they should act individually. On the other hand, according to Companies Act 2006 (p. 242-243), the responsibility of auditor is to investigate and record adequate accounting information of the company and review the individual accounts of the company to examine whether it is in agreement with the accounting records and returns and so on. The information audit firms record will give an important effect on the view of the report which they state due to the fact that if auditors are lack of independence, it may has great negative impact on audit quality.
On the other hand, auditor independence is important as they assist to protect the interests of shareholders. Recent research on BBC (2013) has showed that there is a tendency for auditors to concentrate on management satisfactory rather than meet the interests of shareholders as a result of close relationship between auditors and company management. In addition, one main reason why professional accountants focus on satisfying management is that the senior managers are the people who make key decisions in the company. Therefore, if auditors can meet the needs of management, they may continue to serve this company, otherwise, they may lose this client (competition commission, 2013). It seems that accounting firms cannot be independent as their opinions may be affected by meeting the needs of management and the thought of retaining the clients. Furthermore, the independence of audit firms may increase the reliability and credibility of financial statements of the company and outside investors. Hence, it gives advantage on protecting investors through avoiding facing high level of risks when they invest in company projects. Moreover, if auditors fail to be independent when auditing the annual report, it not only damages the reputations of themselves and the audited entity, but also governments may censure the auditors and impose a fine.
Identification and assessment threats to auditor independence
It would appear that when auditor auditing its clients, there are some threats that threaten the objectivity and independence of accounting firm, which include self-interest threat, intimidation threat, familiarity threat, self-review threat, the threat of advocacy and management threat (APB ES1 2011, P. 15-16). Nevertheless, there are some specific conditions that may create threats to impair auditor independence, such as financial interest, loans and guarantees, close business relationships between auditors and audited entity, family and personal relationships, employment with an audit client, temporary staff assignments, recent service with an audit client, non-audit services or the audit or non-audit services that conducted on the basic of contingent fee (IFAC 2012, P56-63). If professional accountants do not pay attention on those factors when provide audit and non-audit services to their clients, it may easy to cause themselves involve in independence impairment.
Providing audit and non-audit services may not violate auditor independence
It is apparent that although accounting firms received a considerable audit and non-audit fees, however, it may not impair the independence of auditors. For instance, it is illustrated from the annual report of First group (2012) that it paid its auditor Deloitte 1.5 million pounds audit fees and 0.4 million pounds non-audit fees. In addition, Deloitte (2012) reported that its total revenue in fiscal 2012 was 2,329 million pounds. According to ES4 (2010), the audit and non-audit fees received from a listed audited entity and its subsidiaries audited by the accounting firm cannot regularly exceed 10 per cent of the total revenue of the auditor. Otherwise, it may violate the independence standards. However, it can be calculated that the total fees for First Group in 2012 were 1.9 million, which only accounted for approximately 0.08 per cent of the total revenues of Deloitte. Thus, on the evidence of the findings, it would be seen that Deloitte did not violate the independence in terms of the standards of fees. It seems that although auditors charge higher audit fee, it does not mean that they will violate the independence when conducting audit and non-audit services. From Firth's (1997, p. 512) opinion, there are a number of factors determine the audit fees. For instance, the company size may be one of main factors to deciding the audit fees because if the firm has a lot assets and sales revenues, auditors may need to spend more time on checking. Furthermore, the complexity of the audit and the riskiness of the client may also affect the amount of audit work that professional accountant do. Hence, higher audit fees may not violate auditor independence. On the other hand, despite offering non-audit services to audited entity, the accounting firm still can be independent when auditing the financial statements. It has been examined by Salehi (2009, p. 146) that it is beneficial to enhancing auditors independence if they providing audit and non-audit services to their clients at the same time. The reasons are that it not only can reduce the overall costs such as agency costs, but also helps to improve the auditing quality because audited entity which has higher non-audit fees seems can limit the choices of abnormal accruals. Additionally, because of the costly litigation costs and loss of reputation of auditors, audit firms can remain independent when providing audit and non-audit services at the same time (DeFond, Raghunandan and Subramanyam, 2002, p. 1251). It seems that there is no evidence that providing provisions of audit and non-audit services can impair their independence and Hussey (1999, cited in Salehi 2009, p. 146) also suggested that it should not prohibit professional accountants to offer joint provision of audit and non-audit services to audited entity.
Auditor independence may be impaired if audit firm received considerable total fees
In contrast, it has been argued that audit and non-audit fees would be a significant factor that affecting the auditor independence because total fees may become an economic incentive that affect the total income of auditor. In order to avoiding losing the significant clients, the audit firm may not behave independence. On the evidence of the findings, it is possible that audit services provided by audit firms may lead to auditor be lack of independence. Taking Enron as an example, Barrett's (2005) article demonstrates that Enron's auditor Arthur Andersen received the total fees of 52 million dollars, included 25 million dollars of audit fees and 27 million dollars of non-audit fees during 2000. Firstly, it can be seen that the fees for non-audit services are much higher than the audit fees. It seems that Andersen focused on the non-audit work of Enron and that could be influenced the audit work because the financial statements of Enron could be affected by the non-audit services and Andersen also cannot give an unbiased opinion and judgement. In according with APB ES5 (2004, P.9), it is probably that auditors seem to be loss of independence if non-audit fees are significant greater than audit fees. In such a case, a self-interest threat might be created to Andersen's independence because the amount of non-audit fees was significant to his total income. Additionally, it is reported by Abdullah (n.d.) that during 2000, the non-audit fees paid to Andersen accounted for approximately two-third of the total income of accounting firm. Regarding to the APB ES4 (2010, P. 10) that the auditor cannot charged total fees for both audit services and non-audit services of non-listed audited company over 15 per cent (listed audited company-10 per cent) of the total income of auditor. Therefore, it can be concluded that financial incentive is a significant factor that lead to accounting firm violate the independence.
Furthermore, familiarity threat to Andersen independence has been created as result of long duration and close relationship with Enron. For instance, Enron employed Andersen as its external auditor since 1985, which the duration would be approximately 20 years (Abdullah , n.d.). However, an audit engagement partner shall not work for the same clients for more than five years and if an audit engagement partner held for the role for a continuous period of ten years, they should be rotated (APB ES3, 2009, P. 5-6). Moreover, It is apparent that the long association between Andersen and Enron became a public interest entity which not only led to Andersen failed to fairly report the revenues of Enron as Andersen sympathized to the interests of Enron so that he insufficiently questioned the materials, but also a self-interest threat might be created because if Andersen could meet the interests of Enron's management, he might received gifts or hospitability as reward (IFAC 2011, P. 72). In addition, as Thomas (2002) stated that a number of internal accountants, CFOs and controllers of Enron were previous executives of Andersen. According to APB ES2 (2010, p. 16), a person cannot be employed by an accounting firm to conduct audit work if he/ she is also employed by the audited entity. It seems that those people might be familiar with the audit work, therefore, their behaviours or opinions had significant impact on the audit report of Enron, which led to Andersen cannot comply with its professional competence, overstated the material and data and had unconscious bias on the audit work.
On the other hand, it is claimed that auditors providing non-audit services may also lead to them cannot be truly independent. Recent research from the economist (2012) illustrated that large proportions of revenues of accounting firms come from offering non-audit services to audited entity in recent years. Moreover, the development of consultant services offered by accounting firms increase rapidly. Moreover, the revenue of Deloitte increased in fiscal 2012 due to the fact that approximately 14 per cent of consulting and 15 per cent of financial advisory ascended. For instance, the Enron case showed that its audit firm has been offered tax services and internal audit services which violated the independence rules (Barrett, 2005). Firstly, offering tax services to client may be possible to create threats to the independence of auditor. For instance, for IFAC (2011, p.81-82), a self-review threat might be created if Andersen provided tax advisory services or promoted tax structure to Enron, an accounting treatment might be adopted in order to make proposed arrangements and Andersen audited the annual report for Enron but at the same time he also provided non-audit services to Enron, in that case it had significant impact on the judgement and opinion on the financial statement. Furthermore, providing tax services may create advocacy threat to the independence of Andersen if Andersen acted as an advocate role to help Enron resolve a tax matter before a court and affect the amounts that are material to the financial statements (IFAC, 2011, P. 83-84). Additionally, it might create management threat to Andersen's independence because Andersen might act a management role for Enron and involved in making decisions or engaging in the management when proving tax services, eventually, it is possible that Andersen also became coordinate and meet the interests of management of Enron (APB ES5, 2011, P. 32-34). Another possible threat to Andersen's independence might be the self-interest threat. The reason is that 3.5 million dollars accounted by tax services among the non-audit fees of 27 million dollars. It was a significant fee to the total income of Andersen. Thus, it might be possible that Andersen in order to continue to offer tax services to Enron, it tried to take some actions that violate its professionals (APB ES5, 2011, P. 32-34).
Apart from the tax services to Enron, Andersen also offered internal audit services to Enron (Barrette, 2005). Since Andersen was the external auditor of Enron, it seems that self-review threat and management threat might be created to the independence of Andersen (APB ES5, 2011, P. 23). Firstly, if the internal audit services offered by Andersen that involved in helping Enron to improve its internal audit activities, or purposed to improve the effectiveness and efficiency of operating activities such as risk management, control and governance processes. Moreover, Andersen might not professionally evaluated the results of internal audit service so that it may influence the true and fair views of financial statement, that circumstances have been led Andersen to violate the independence standards. In addition, Andersen might act a management role to take management responsibilities such as setting internal audit policies or making recommendations or decisions on the internal audit activities, helping the company to design internal controls or implement changes. In terms of that condition, management threat might be created which impaired the independence of Andersen (IFAC 2012, P. 84-86). Hence, offering tax services and internal audit services to audited entity may impair auditor independence and have a significant impact on the creditability and reliability of financial statements of audit firm.
Additionally, the example of Britvic (2012) indicated that professional accountant provides the provision of non-audit services to audited entity may lead to auditor be lack of independence. For instance, the annual report of Britvic in fiscal 2012 shows that Enrst and Young charged Britvic total fees 3.3 million pounds, included auditor fees are 0.6 million pounds and total non-audit fees are 2.7 million pounds which is much higher than the annual audit fees. However, without doubt the amount of non-audit services is significantly greater than audit-fees. While according to APB ES5 (2011, P.27), if non-audit service fees are greater than the annual audit fees, it is possible that auditor may be lack of independence. Furthermore, it can be seen that the total fees are significant to the total income of audit firm so that Enrst and Young might agree to the wishes Britvic to do some adverse audit work in order to retain its clients. Therefore, in such circumstance, a self-interest threat was created to Enrst and Young's independence as result of the financial interests.
In addition, the non-audit services that offered by Enrst and Young to Britvic included taxation advisory services, corporate finance services and other non-audit services which might be possible to create threats to the independence of auditor (Britvic, 2012). For instance, for APB ES5 (2011, p. 32-33), a self-review threat might be created when Enrst and Young provided tax advisory services to Britvic because tax planning, tax advices and compliance work that conducted by auditor might influence the material on the financial statements. Furthermore, providing tax services may create advocacy threat to the independence of Enrst and Young because it is possible that Britvic's auditor acted as an advocate role to help resolving a matter such as involvement in the negotiation with tax authorities. Additionally, management threat might be existed because Enrst and Young might act a management role for Britvic and involved in making decisions or engaging in the initiating transactions when proving tax services. Another possible threat to the independence of Enrst and Young might be the self-interest threat. The reason is that 0.2 million pounds accounted by tax advisory services among the non-audit fees of 2.7 million pounds (Britvic, 2012). It was a significant fee to the total income of Enrst and Young. Thus, it might be possible that the professional accountant in order to continue to offer tax advisory services to Britvic, it tried to take some actions that violate its professionals (APB ES5, 2011, P. 34-36).
Moreover, it might create threats to the independence of Enrst and Young when providing the provision of corporate finance services to Britvic. On the one hand, if Enrst and Young should not provide corporate finance services such as handling, underwriting, promoting shares, advices that might have significant impact on the amounts in the financial statements included structuring a corporate finance transaction, funding issues to Britvic, otherwise, it might create a self-review threat and advocacy threat to Enrst and Young's independence (IFAC 2011, p. 90-92). On the other hand, self-interest might be possible to create if the corporate finance services are provided on the basic of contingent fee. In addition, other non-audit services provided to Britvic might contain internal audit services, information technology services, litigation support services, legal services and so on. Those services might also create some different main threats such as management threat, advocacy threat, self-review and self-interest threat to the independence of Enrst and Young (APB ES5, 2011, p.1 & 41). Therefore, it can be seen that in certain circumstances, accounting firm can be lack of independence when providing a provision of non-audit services to audited clients.
In conclusion, it is apparent that the independence of professional accountant is significant since auditor independence not only can increase the confidence of investors when making decision on investments, but also it improves a financial reporting process so that it gives confidence to shareholders of companies. Moreover, violating independence standards not only lead to the reputation of auditors damage and cost them large amount of litigation, but also it causes investors lose confidence in the capital market. Although some people stated that the provision of audit and non-audit services provided by accounting firm cannot impair the independence rules and it has advantages for auditor to audit the financial statements of audit clients, such as enhancing audit quality and competition as well as reducing agency costs. However, it is argued that auditor cannot be truly independent when they received a considerable amount of audit and non-audit fees to provide audit and non-audit services to audited entity because there are some factors such as economic incentives that create threats to threaten the independence of audit firm. Additionally, providing non-audit services not only create conflict of interests between auditor and audit clients, but also may lead them to act a management or advocacy role in its clients, so it has negative effect on the independence of auditor. To sum up, auditor should be independent to give an impartial view on the financial statement. Furthermore, either the government or accounting firm should make policies to prevent auditor to be lack of independence and enhance their conscious and perceptions of independence.
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