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This report discusses whether or not a restriction in the provision of non-audit services adversely affects the quality of the external audit by considering the effects on auditor independence, benefits and disadvantages from such a restriction.
What are non-audit services?
The Auditing Practices Board (2008) states that 'non-audit services' encompasses any professional services that an audit firm provides to an audit client other than the audit of financial statements. The Sarbanes-Oxley Act (2002) regards the following as non-audit services:
Book-keeping and other services related to the accounting records or financial statements
Internal audit outsourcing
Legal and expert services unrelated to audit
Arguments for a restriction in the provision of non-audit services
The main question that arises when auditors provide both audit and non-audit services is whether the auditors are able to conduct their audit impartially, without being concerned about losing or failing to gain additional non-audit services (Salehi 2009). In other words, does the provision of non-audit services negatively affect the auditor's independence hence, the quality of the external audit?
The quality of an external audit is determined by the ability of the auditor to carry out the audit independently so that an unbiased opinion may be given regarding an entity's financial statements. Auditor independence is the cornerstone of auditing as it provides stakeholders assurance as to the reliability and credibility of the financial statements (Salehi 2009).
The ISB (2000 cited Salehi 2009 p.138) defines auditor independence as "freedom from pressures and other factors that impair, or are perceived to impair, an auditor's willingness to exercise objectivity and integrity when performing an audit." Independence is associated with both integrity (honesty) and objectivity (making unbiased judgements).
There are two aspects of independence (Salehi 2009):
Independence in fact (actual) - this relates to the auditor's state of mind and the ability to maintain a correct attitude when conducting the audit. It is not directly observable although it is necessary to enhance the reliability of financial statements.
Independence in appearance (perceived) - an informed third party should not doubt the auditor's independence. It is observable by indicators and is necessary to promote public confidence.
The main argument for a restriction in the provision of non-audit services is due to the fact that these services are perceived to pose a threat to auditor independence and ultimately affect the quality of the external audit. Sanderson (2010) reported that the House of Commons Treasury Committee expressed the belief that "investor confidence and trust in audit would be enhanced by a prohibition on audit firms conducting non-audit work for the same company".
The APB (ES5) identifies four threats to independence most commonly associated with non-audit services:
The threat arises when the auditor has a financial interest in the client. In relation to non-audit services, the main threat concerns fees and economic dependence (APB ES5). Over the last decade, the proportion of revenue of large public accounting firms derived from non-audit services grew from 12% to 32%, suggesting that the economic bond between auditors and their clients strengthened over this time (Salehi 2009).
Ojo (2009) claims that auditors do not violate their independence as a result of clients purchasing non-audit services; independence is compromised when clients pay high non-audit fees relative to total fees. This was the case with WorldCom where its auditors, Arthur Anderson, received $4.4m in audit fees and $12.4m for non-audit services in 2001.
The APB (ES4) states that an audit firm must receive less than 15% of its gross practice income from unlisted company clients and less than 10% from listed company clients to avoid undue economic dependence.
Economic dependence as a result of high fees received from a client may prevent the auditor from providing a qualified audit opinion (if the client deserves one) for fear of losing the client (Bloomfield, Shackman 2008).
Independence is also compromised when non-audit service fees are calculated on a contingent basis (APB ES5) e.g. auditors will receive their non-audit service fees only if they issue an unqualified opinion.
This threat arises when auditors review their own work or the work of the members of the same audit firm (APB ES5). The auditor cannot provide an unbiased opinion as it is highly unlikely that they will criticise their own work.
Auditors may face a self-review threat if they prepare accounting records or financial statements because when they undertake the audit, they will have to review financial statements that they themselves have prepared. Auditors are prohibited by law from providing such services to their audit client that is a listed entity, except in emergency situations (CIMA s.390.171). The audit firm may provide these services to an unlisted entity, provided that any self-interest threat is reduced to an acceptable level (CIMA s.390.170).
However, the provision of technical assistance regarding matters such as accounting principles, financial statements disclosure, appropriateness of controls etc do not generally threaten the auditor's independence since it promotes the fair presentation of the financial statements (CIMA s.390.168).
This threat arises where the audit firm acts as an advocate of an audit client. Providing taxation services may pose an advocacy threat where the audit firm represents the audited entity in any negotiations or proceedings involving the tax authorities e.g. representing the audit client before a tax tribunal (APB ES5).
However, if the audit firm simply provides information to the tax authorities, this will not be regarded as an advocacy threat since the audit firm is not representing the audit client (APB ES5)
This threat arises where auditors take executive decisions on behalf of the management of the audit client. The auditor may become closely aligned with the views of management hence, may not apply a proper degree of professional scepticism (APB ES5).
The management threat is unacceptably high where the audit firm provides internal audit services that involve audit firm staff taking decisions or making judgements which are the responsibility of management e.g. taking decision regarding the design and implementations of internal controls (APB ES5).
However, evaluating the design and operating effectiveness of internal controls and commenting on weaknesses is a by-product of the audit service and will not be regarded as a non-audit service (APB ES5).
It is evident that certain non-audit services pose threats to independence. Without independence, investors and the public lack confidence as to the reliability and credibility of the financial statements thus, adversely affecting the quality of the external audit. Therefore, restricting non-audit services may ensure that audit independence is not prejudiced.
The provision of non-audit services also gives rise to a conflict of interest. Theoretically, the audit firm is serving two different set of clients; when providing non-audit services it is serving the management and when providing audit it is serving the shareholders as a body. How, then, can an auditor with a statutory responsibility to company shareholders handle a commercial relationship with the company's management and remain impartial? In this context, the provision of non-audit services is perceived to threaten auditor independence (Salehi 2009).
Arguments against a restriction in the provision of non-audit services
The reason why audit firms provide both audit and non-audit services are due to the economies of scope involved i.e. cost savings obtained when both types of services are provided by the same person or firm. Productive economies (knowledge spillovers) usually arise from the fact that both types of service utilise the same set of information e.g. the information required to evaluate an internal control system is largely identical to the one needed to improve it. By restricting the prohibition of non-audit services, such economies of scope are lost with the result of making the audit inefficient (ArruÅ„ada 1999).
KPMG ran into controversy over a deal with Rentokil Initial to provide more internal audit services alongside its external audit work. Oliver Tant, head of audit at KPMG, said "It's not about us taking over internal audit and never has been. It results in clients obtaining more assurance and getting more work done as well as providing a chance for them to make savings." (Hughes 2009)
The provision of non-audit services enables auditors to gain a better understanding of the audited entity and acquire valuable information that is rarely reflected in the accounts e.g. business reputation and management capabilities. This enhances the technical competence of auditors in a wide variety of area thus, reducing the chances of undetected misstatements. Therefore, non-audit services are an important source of information for professional judgement resulting in a better quality audit being performed. (Collis, Jarvis 2005).
While a restriction of non-audit services will normally reduce/eliminate most threats it will, however, create an intimidation threat. Non-audit services restriction would eventually result in smaller audit firms since its specialist departments will shut down thus, audit clients will be bigger than the audit firm and also form a larger part of the firm's income (Anon 2010).
It may seem obvious that auditors are willing to compromise their independence in return for high non-audit service fees but this is not the case. The entire auditing profession is based on reputation; integrity and independence are among the most important economic assets of audit firms. If auditors tarnish their reputation, they not only will lose their current clients but future clients as well and face the threat of litigation.
Therefore, it is unlikely that they will willingly compromise their independence for any short-term financial gain (Lennox 1999). Since auditors have little incentive to compromise their independence, it is irrational to restrict non-audit services to protect their independence.
Many researchers argue that a restriction of non-audit services is necessary to maintain auditor independence because of the existence of other threats besides high fees. One of the recommendations of the Co-ordinating Group on Audit and Accounting issues (CGAA) was to have "tougher and closer safeguards to ensure that joint provision of audit and non-audit services does not undermine auditor independence in fact or appearance." (Brown et al 2010). The application of appropriate safeguards makes it unnecessary to restrict non-audit services.
There is a perception that, in relation to Enron, the level of involvement of the audit firms in non-audit services compromised the quality of the audit. In this context, academics believe that a restriction of non-audit services will enhance public confidence. However, greater transparency and appropriate disclosure in the annual reports of entities with regard to non-audit services will assist stakeholders' understanding and should remove some of the negative perceptions that currently exist (Brown et al 2010). Allister Wilson, a senior audit partner at Ernst & Young, said, "I think a lot of heat would be taken out of the debate if there were more clarity and disclosure around what the services provided actually are." (Hughes 2009)
In summation, the simultaneous provision of audit and non-audit services is for efficiency reasons rather than to maximise revenues for the auditors. Restricting the amount of non-audit services may result in inefficiencies which will have an adverse effect on the quality of the audit (Patel et al 2010).
The provision of non-audit services enhances the quality of the external audit in terms of knowledge spillovers, and better professional judgements are made. Restricting non-audit services may create inefficiencies due to the economies of scope lost thus, lowering the quality of the audit.
Concerning the negative public perception regarding non-audit services, appropriate disclosures can be made in the annual reports to enhance public confidence. Where there is a fear that the provision of such services will threaten auditor independence and hence, lower the quality of the audit, appropriate safeguards can be applied to eliminate or reduce the threat to an acceptable level without the necessity to restrict such services. Only those non-audit services must be restricted for which there is no appropriate safeguard to reduce the threat. Otherwise, an unnecessary restriction in the provision of non-audit services may have an adverse effect on the underlying quality of the external audit.