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Due to the rapid growth in global economy, the world has become a place with no boundaries. With the increase of foreign investment, joint venture activities, the separation of ownership from the management and the limited liability of members become the main features of the corporate bodies nowadays. Therefore, the governance of these organizations must be maintained. The rapid development in the size of companies and their complexity structures had really challenged the traditional perspective of a company seen as a self-regulatory body which primarily accountable to the market and its members. That is why the term and concept of corporate governance has become a hot discussion almost in every country.
Corporate governance simply means the implementation of the best corporate practices to enhance shareholders value as well as protecting the interest of the other stakeholders at the same time. However, high-profile corporate scandals such as Satyam Computers have gained the attention from the public of how management attempts to deceive the public by manipulating the figures and earnings in the financial statements. Since then, public confidence towards the corporate governance structures and the capabilities of corporate board of directors in regulating themselves has been decreased to a very low level. Then, who should be in charge in ensuring good corporate governance in the organizations?
As the famous saying "there will be no waves without winds", the present thrust is being widely circulated due to audit failures in various giant companies. We all realize that the main objective of an audit process is to make sure that the daily operation of a company are being carried out in good faith by the top management without using the resources allocated to serve their self-interest. An auditor is expected to provide his/her opinion in good faith. However, recently, audit has failed in providing the right judgment and opinions on the operations carried out by the management. The main reason for the failure of effectiveness of audit is because of the absence of auditor independence. With only one factor, it has already paved their way for good corporate governance.
What is this auditor independence and what role does it play in ensuring good corporate governance? Elliott and Jacobson (1998) said that the immediate role of audit independence is to serve the audit, and the objective of the audit is to improve the reliability of information used for investment and credit decisions. Ultimately, the purpose of audit independence is to improve the cost-effectiveness of the capital markets.
2.0 Concept and Transformation of Auditor Independence
Auditor independence actually means that auditors should be performing their audit work with honesty and sincerity. An auditor should also be fair and should not let prejudice to override his/her objectivity. Moizier viewed auditor independence in an economic sense. According to him, auditors are given expectation to perform audit works that will decreased the chances of a company being sued to an acceptable level to the auditor. (Moizier, 1991, as cited in Mahdi Salehi, 2008)
Independent auditing is actually a vital feature of efficient capital markets. As we all know, in the auditing profession the main objective of independent audits is to provide and deliver expert opinion regarding the fairness of the financial statements. Independence is actually the base of the public accounting profession. A high independence level will ensure a good quality accounting practice.
Mahdi Salehi (2008) said that the concept of auditor independence had actually existed since 150 years ago. Auditor independence actually has a relationship to the business environment for different period of time. However, there was no clear transition or transformation from a concept relating auditor independence to another. The initial concept of auditor independence actually begins during the nineteenth century from the British. During that time, the primary duty of an auditor and professional accountant was to perform oversight to the absentee investments in existing colonies of British Empire. During this period, the British investors strongly prohibit the auditors from having financial stakes or working in business that they are currently auditing. Also, so long as the auditors retained their loyalty to the investors in British, they were already considered as conducting professional accounting services.
The initial concept regarding auditor independence transformed in between the late nineteenth and the early twentieth century. This is due to the economic shift of capital from the foreign sources to the capital that are derived from local sources. From then, the management-auditor relationship is usually viewed base on the objectivity and independence of the auditors. The relatively new concept of auditor independence needs auditors to not being advocates with their clients, and that management must not be able to affect the scope of audit as well as the audit fees. Without this transition, the auditor independence standards will be only something on the surface that will not provide enough assurance that an auditor is independent from the client management. Therefore, the best protection for the auditors to prove that their pockets are empty is to detect fraudulent reporting on financial statements disregarding the materiality level on the financial statements with independent view!
Auditor independence is essentially important because the separation in ownership from the management really need a professional whom they can believe for the reliability to safe guard their interest. A professional watch on management is needed as they will be the one who will be preparing and presenting the financial statements. There is an argument that auditor independence will enhance the credibility of financial statements in two aspects. Firstly, independent auditors will enhance the possibility of financial statements prepared are in accordance with the accepted accounting principles (GAAP). Secondly, investors will certainly more likely to have strong reliance on financial statements that are audited by an independent auditor. Base on these arguments we can say that auditor independence really plays an important role in enhancing the value and credibility of the financial statements. Therefore, anything that will affect an auditor independence will certainly has uninvited effects to the capital markets.
In recent years, auditor's independence has always been a significant issue in accounting perspective. Audit fees, non-audit services, qualified reports have been related with auditor's independence. However, there are still many factors that will influence the independence of an auditor. It is accepted as true that auditor independence and credibility are an important issue and will have significant impact on the development of auditing practices and standards. The question is, what will actually affect an auditor's independence and how could this issue be prevented? This will be discussed at the following sections.
3.0 Real Life Issue in India - Satyam Computers
Satyam Computers was the fourth largest Information Technology firm in India. However, its legacy and business was struck and stranded when the then Chairman of Satyam Computers, confessed to the public that the financial statements were being overstated for a number of years. The announcement of scandal had caused Satyam Computer to be removed from the Nifty 50 and Sensex. Besides, the clients of the company pulled off from them before they no longer put any faith in the company. In fact, the overstatement was a significantly material amount of $1.04 billion!
How could this scandal even happen when the company financial statements were under the safe guards of one of the Big Four Accounting Firm in the world - PricewaterhouseCoopers? Who should be in blame for this scandal? In this case, it is the auditor's independence that should be questioned upon.
Obviously, the purpose of audit is to independently serve and look after the interests of shareholders. Therefore, they have the authority to access the information that they need in their audit. Their main objective is to serve the shareholders' interest, but it is the management that hires and fires the auditors. So, the issue here is, can auditors be truly independent given that the management has the authority to employ and fire them? Should they fulfill their responsibility towards the shareholders or the management?
The difference between India and the United States is that there is a restriction on the size of audit firm and maximum number of clients that a partner can serve in India. Therefore, the small amount of clients will lead to a great reliance of audit firms to the fees. In contrast, the largest individual client's account was merely half a percent of audit firm's total billing in the United States. This will certainly lead to greater possibility for audit firms in India to affect their independent point of view because of fear in losing their customers. Furthermore, there were 1,000 audit firms in India. Each of them only has roughly one stock-exchange-listed customer each. With this extent of total dependence on one client for an audit firm's livelihood, could we expect the auditors to be independence?
Other than that, the laws and regulations in India were not strict enough to create fear among the auditors to perform their audit work in dignity. Like many other countries, audit firms in India regulate themselves through the Institute of Chartered Accountants of India (ICAI). However, they did not impose the law that strict disciplinary penalties to those who did not perform their jobs independently. In this case for instance, if the partners of PricewaterhouseCoopers, Messrs Gopalakrishnan and Talluri are held to have only been negligent rather than guilty of criminal conduct, there will only be a cancellation of the license of practice and a find of Rs. 5 lakhs. No further sanctions and penalties could be made against the audit firm - PricewaterhouseCoopers! With huge benefit and not-so-strict penalty, auditors will be providing unqualified opinions to their clients against their independent point of view without fearing that they will face severe legal sanctions!
In this case, it is clear that the factors that affect auditor independence are the dependence of the audit firm to the client's fees and the regulations that are not strict enough to impose sanctions to them. We personally feel that, a country should develop or come out with a rule that will ensure auditors will perform their job with dignity. Furthermore, an active audit committee should be set up to perform oversight activities in ensuring external auditors perform their practices in accordance to the legal requirements and professional ethics. Auditors should no longer be given the authority to regulate their auditing activities. These will further discussed and elaborated at the following section.
4.0 Factors That Affect an Auditor's Independence (Perspective from China)
In our research, we had chosen China as a country representing Asia as China is one of the developing countries in Asia. Therefore, the factors below were actually being referred from the studies by experts regarding the auditing services in China. (Wan Hua L. et al., 2010)
1. Non-audit services
Nowadays, audit firm has already expanded their services into non-audit service by offering management advisory or financial consultation such as internal control implementation in order to sustain in the competitive environment. Although non-audit services are a value - added services to the audit client, these services will somehow affect the audit independence. An audit firm is prohibited to perform auditing and consulting services at the same time. This is because auditor who serves a consultancy role might possess financial stake in the company's performance and therefore, the audit independent is definitely questionable.
An auditor will tend to have greater tendency to compromise with clients when there are economic incentives provided throughout the non-audit services process, hence it will decrease audit independence. An audit firm that provided non-audit services and audit services at the same time actually will have a conflict of interest of whether to serve the best interest of the shareholders as a safe guarder or to serve the interest of the management as a consultant.
For a nation like China, they are a country facing rapid development. Therefore, they have been oriented towards a private ownership model. Despite the swift development of the separate role of ownership and management concept, Chinese CPA firms, still do not provide substantial non-audit services. Therefore, we can say that there are fewer inducements for the audit firms in China to give up their independence as compared to those countries where audit firms perform substantial non-audit services for their clients. However, non-audit services are an important factor that will affect auditor independence in other nations.
We all are well-aware that how strict regulations work in ensuring people to behave. "Auditor firms in nations with stronger incentives to protect the shareholders and high quality legal systems are more likely to report negative news regarding qualified reports." (Bushman and Piotroski, 2006, as cited in Wan Hua L. et al., 2010) In contrast, in countries with weaker protections and judicial system, auditor firms will less likely report bad news or issue qualified reports. Other than that, the state involvements in the national economy also affect the independence of the auditor firm. For countries with higher state attachment, the audit firms tend to speed up the recognition of positive news and delay the recognition of negative news in reported earnings. Therefore, we can say that the force of politic towards a country could be above the power of the regulations and thus will affect an auditor's independence.
In China, the legal sanctions for non-compliance with the auditing standards are severe. Rule-breaking auditors could have their practice licenses being pulled back and even face imprisonment. However, "The level of law enforcement of China is below average as compared to other countries." (Allen et al., 2005, as cited in Wan Hua L. et al., 2010) This is due to the ineffectively enforcement of the laws. Besides, there was a conflict of interest between the monopolizing power of one and only ruling political party and the practice of law. Therefore, there is a possibility that auditors will collude with the government and affect their independence when the government officials and their affiliates are involved in the practice. So, according to this, China is regarded or can be said as one of the worst in shareholders protection and possesses a weak judicial system. Thus, we can say that audit firms in China will tend to go against the rules and regulations as there are "holes" between the laws.
The reputation or brand name of an auditing firm is very important for investors to rely on. This is because investors make their decision mainly based on audit opinions. The reputation of an auditing firm is essentially important as the investors do not know how to judge the quality of the auditors. They often consider the reputation as an indicator of quality.
In China, auditor reputation depends mostly on their guanxi relationships. (guanxi means relationship in Mandarin) This type of guanxi code of conduct is a lot more predominant than being recognized as a firm that has good audit practice. Therefore, an auditing firm in China that has a closer relationship with the government will tend to indirectly have a "better reputation" as compared to those which do not have relationship with the government. This will in turns affect the independence of those firms that have so called "better reputation". They will tend to collude with their clients or the government against their independent point of view just because of this recognition. Investors that relied on the opinions might be misleaded if the auditors did not provide an independent view.
It is undeniable that competition is one of the factors that will affect auditor independence. In order to regain or sustain their customers, audit firms will sometimes use unethical methods, for instance, by accepting clients' opinion and intervention to report the modified opinions.
Despite of the increasing number of foreign audit firms that enters into China, the auditing environment of China still remained as not so competitive. This is because the foreign auditing firms have to get proper authorization in order for them to audit Chinese stock companies listed on the exchange. Other than that, foreign auditing firms are not allowed to conduct external audit for most of the unlisted and local-state-owned companies. These restrictions in place are to protect the China auditing firm as they might not have the ability to compete with large multinational audit firms. Therefore, competition is not the reason why China auditors reduce their independence level to sustain their clients.
5. Low-balling and price-cutting
Low-balling or price-cutting means that an auditor firm will eventually decrease the professional fees of their services to gain additional market shares. This cannot be an excuse for the auditing firms in China as there is a reduced competition audit practice in China. Other than that, the lack of Chinese CPAs' firms' brand name as compared with the Big 4 also prevent them from gaining an additional market share with low-balling practices. Therefore, low-balling is not a factor that will affect auditor's independence in China.
6. Audit firms size
Zulkarnain Muhamad Sori et al. (2006) said that the size of audit firm has been used as a surrogate for audit quality, that is large audit firms have a reputation to safeguard and therefore will ensure an independent quality audit service. So, audit firms size is also one of the factors that will influence an auditor's independence. In general, bigger auditing firms will surely perform better in resisting clients' pressure than the smaller practices. This will lead to a better quality of service by the bigger audit firms. "Bigger auditing firms can resist clients' pressure better than smaller auditing firms in China." (Lia et al., 2004, as cited in Wan Hua L. et al. 2010) So, auditors in smaller audit firms might lose their independent point of view because they were unable to resist and overcome the pressure of their clients.
To conclude regarding the auditing environment in China, we can say that the regulations of the country, the reputation of the auditing firms, and the size of the audit firms will directly influence and affect the independent point of view of an auditor. However, these factors defer depend on the auditing environment of every countries. In addition to the factors above, there are still a few factors that will affect an auditor's independence.
5.0 Additional Factors that will Affect Auditor's Independence
1. Huge amount of audit fees
According to the MIA By-Law, the amount of audit fees collected from the clients should not exceed 15% of the firm's total fees in each of every two consecutive financial periods. Auditing firms should refuse to perform the engagement if that so. This is because the larger amount of audit fees being paid over the total audit revenue, it will be very likely that audit independence will be impaired. This can be shown when an audit firm is serving a big client, the auditors will have the tendency to please them by feeling reluctant to express an qualified opinion.
2. Self interest of auditors
When an auditor has self interest like financial stakes towards an audited company, an auditor might feel reluctant to provide sound negative opinion that would affect the financial performance of the company. In addition, they might have the tendency to maximize their own personal interest by intruding the unauthorized information of the company audited by them. On the other hand, the independent point of view of an auditor might also be affected if he/she has a family member in the company that being audited. In these kinds of situation, the auditor would be more likely to express an unqualified opinion rather than qualified opinion.
3. Same audit client for a long duration (Audit Tenure)
When an auditor is engaged with the same audit client for a long period of time, the situation is called audit tenure. In this period of time, auditor might have already developed a personal relationship with the client. Hence, it will develop the bond of loyalty relationships between the auditor and the client and will unconsciously affect the auditor independence. If auditors are too close with their clients, they will tend to decrease the thorough and precise steps in conducting their audit. Usually, the longer the duration of the audit tenure, the higher will be the tendency of an auditor to issue an unqualified opinion regarding their clients audited financial statements. The bonding between audit clients and audit firm would definitely influence the independence of the auditors in evaluating the internal control system of their clients.
6.0 Critical Analysis and Opinions
Based on our research and references from researches done by various experts, we personally felt that in order to enhance auditor independence, the following issues must be taken into consideration. It is undeniable that there are still many other precaution steps that can be taken in order to ensure that auditors perform their duty with integrity and credibility. However, in our opinion, we think that the following are few main steps that should be taken in enhancing auditor independence.
1. Forming an independent audit committee
Members of audit committee
An audit committee is a community that is formed by the directors or the top management of a company. The main task of an audit committee is to act as oversight committee in ensuring the company's financial statements are being presented in good faith and support the role of the auditors. An audit committee should consist of independent non-executive directors that do not have interest in the companies. This will further enhance the oversight duty of the committee through an independent point of view. Furthermore, we all know that non-executive directors do not report directly to CEO. Besides, they are also not being involved in the daily operations of the company's business. Therefore, it is most likely that they will bring new perspective for the other point of view in supporting the management to obey the law and to comply with the industry best practices.
Moreover, the audit committee should consist of members from different background and adequate knowledge of the operation of the company, for instance, people who know about the accounting standards and also the regulation with regarding to the listing requirements. In addition, the audit committee should also gain support from the chief audit accountant in the company. This is because the internal auditor will be the one who provide relevant information to the audit committee. In addition, an audit committee should have some sort of regulations to protect their oversight role in order to ensure the independence point of view. During certain occasions, the executive directors will be influencing the judgment view of the audit committee and use their power to terminate the audit committee in order to gain self interest. Therefore, company should set up a regulatory authority in order to protect the audit committee. This will certainly enhance the independence quality of an audit committee.
Active and responsible Audit Committee
Zulkarnain Muhamad Sori et al. (2009) found out that the frequency of audit committee meetings would be a sign of the amount of effort by members of audit committee in delivering their responsibilities. So, to be effective in ensuring company's operation are being carried out in good faith, an audit committee should be active and responsible. The audit committee should spend more time in performing their duties. Due the changing dynamic business environment, audit committees should also always keep themselves updated so that they can perform their job well and efficiently. Furthermore, they should spend more time in discussing issues relating to the auditors tasks and also the financial reporting of a company. If they are active enough, it should not be a problem for them to understand the issues and detect any misstatement being reported. Therefore, they should conduct a few meetings a year to keep everything updated. Owing to the role of audit committee that is formed to monitor the financial reporting and operation of a company, they must first understand the nature and how the company conducts their daily operations.
In this sense, regular meetings will definitely enhance their understanding towards the nature and conducts of the daily operations of a company. Not to miss out, the audit committee should co-operate well with external auditors. This is to make sure that they will provide information that are reliable and has credibility. In short, an audit committee should understand the code of conduct of a business in order to enhance their ability to perform their jobs.
The report of the audit committee
As we know, the stakeholders are unaware of information generated from audit committee activities. This is due to the private and confidential classification of their minutes of meetings. However, we think that the report of audit committee should be publicized. With that, it will increase the independence of the auditors as well as benefit to those in need for the information. Every company should include audit committee report in their annual reports. Other than that, they should make sure that the audit committee reports are reported in good faith and with independence. Moreover, the reports should cover action that they have taken to sustain the best practices in the operation of the company as well as their opinion towards the audit performance of the external auditor.
Determining the level of audit fees
Lately, there are a lot of threats and pressure faced by the auditors during the negotiation process of amount of audit fees. Due to the fierce competition in the auditing environment, auditors might feel threatened and compromise with the company in producing non-independent view on the financial reporting. In our opinion, we think that this problem could be solved if the audit committee were to borne the responsibility of approving the appropriate audit fees. An independent party approving the audit fees will surely better than an executive director who might have personal stake in the company.
If the audit fees is properly negotiated and there were no pressure by the management using audit fees as leverage, the auditors will definitely be able to voice up their views without the fear of service termination. Other than that, it is more appropriate for the audit committee to approve the audit fees because they have a better understanding regarding the audit processes and the resources that needed by an auditor. However, the majority number of members in an audit committee should consist of the board of directors to avoid conflict to emerge. For instance, there will less likely to be a dispute over the audit fees if the audit committee is consists of a large number of board of directors as this indirectly indicates that the decision is actually come from the board of directors.
2. Turnover of auditing firm (Audit tenure)
Audit tenure, or in other words, the turnover of auditing firms is necessary after a few years of engagement to ensure that auditors still perform their job with independent point of view. This is because the auditors might have a strong bond of relationship with the company if the engagement has been carried on for many years, for instance, 10 years. They will somehow be hesitating to issue negative opinion regarding their client. This will go against the practice that auditors should be independent in auditing the financial reporting of their clients. Besides, auditors might tend to neglect the essential steps in performing their auditing activities as they feel that they already gain full understand of the company. Furthermore, there is more likely for collusion between the management and the auditors in auditing the company. Therefore, the need of auditing firms' turnover should be emphasized to decrease the likelihood of auditing firms to compromise with the management because of strong bond of relationship.
3. Non-audit services
Non-audit services are other services except external audit that an audit firm will provide to their clients, for instance the design of internal control system. Auditing firms are prohibited to perform non-audit services to clients that they are auditing. This is because it will create a conflict of interest. Imagine that you need to provide evaluation on the tasks that you had performed, will you give bad comments or judgments towards them? The likelihood scenario is that an auditor will be in a situation of evaluating their own designed internal control system. They might have a self-reviewing interest and provide opinions that are not from an independent point of view. Therefore, rules and regulations should be strict and emphasize on the importance on not having external and non-audit services at the same time.
4. Regulations and standard of practices
We all know that strict laws will create lawful society. In most of the countries, rules and regulations might not be strict enough to create fear among auditors in ensuring them to carry out their duties with good faith. They might have the feeling that the maximum penalty they will face is not severe enough. Therefore, it indirectly creates a tendency for them go against their independent point of view and provide unsound opinions. This is because they feel that the huge benefit they received by going against their independent point of view outweighs the maximum sanctions they might face. Therefore, it is a must for countries to revise the laws and regulations and impose much stricter laws in order to enhance the independence of the auditors.
Of course, we can't deny that there are still many other steps that could be taken to ensure auditor independence. However, in our point of view, we felt that the 4 issues above if taken proper action, will really enhance the independence of auditors.
7.0 Conclusion and Recommandations
Tanlu et al. (2003) mentioned that despite the hard works of many different parties over the past decades to come up with solutions to regulate the auditing profession, auditor independence remains an illusion, and current regulations are unable to make it a reality unless there is an a radical reorganization in the auditing industry. And this will allow the term of "auditor independence" to be used to perfectly in describing auditors.
In order to maintain good corporate governance, auditors must provide true and fair view to preserve the interest of various stakeholders. However, are auditors independent enough to take care of the interest of all the stakeholders? In our research, we found out that there are a lot of factors that will influence auditor independence. For example, the amount of audit fees and the competitive environment of auditing. Given these kinds of temptation, how would auditors ensure that they are performing their job with integrity and ethics? Therefore, everyone related to this issue should take full responsibilities by playing their roles in preserving auditor independence.
Audit committee, especially, could significantly ensure auditor independence if all of the members are dedicated, independent and knowledgeable in improving good corporate governance regardless of fear and favor. Auditors and audit firms themselves should also always remember their main objective while performing audit work - to safeguard the asset of the absent shareholders. Therefore, they should perform their duties with full independence and good faith to serve the best interest of the shareholders.
To conclude, independent auditing will surely ensure good corporate governance. Good corporate governance will surely prevent corporate scandals to happen and create a healthy corporate environment.