Examining whether audit firms should provide professional audit services to clients


Since 1980s, more and more companies requested their audit firms to provide professional services in order to gain a competitive advantage in the market. The volume of this business enjoyed an explosive growth in the end of the last century and reached its peak in 2000. Later the collapse of Enron and Anderson caused critical arguments around whether the provision of non-audit services would threat the independence of audit. Since then, regulations and principles were introduced to improve the regime and restrict the non-audit services.

In chapter 1, I will represent the developments in the non-audit issues and analysis the strength and weakness of the arguments. In chapter 3, two companies, Barclays Bank Plc and its external audit firm PricewaterhouseCoopers LLP are chosen as examples of banking sectors and professional firms to test the influence of NAS changes to them.


There are completely different opinions towards whether or not audit firms should provide non-audit services (NAS) to audit clients. Much of the research are based on the past reports and review.

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The case study is based on the companies' annual report. When testing the influence of the regulation and code to the organizations, fees disclosed in the accounts are used as evidence.

1.3 Main findings

(1) UK is widely influenced by US events and trends in external audit issues.

(2) UK takes voluntary approach to regulate the NAS provision in the past ten years

(3) Banks and audit firms respond swiftly to the economic and regulation changes.

(4) Provision of NAS by audit firms has more benefit to shareholders than threats.

Chapter 2 Literature review

2.1 Background

External auditors have the capability to provide non-audit services (NAS) because of their experience and independence position. As auditors have a well understanding of business, they help clients' to work smarter and reduce the cost. NAS mainly include three categories:

Legislation: e.g. regulatory, legal requirements

Compliance: e.g. taxation,

Consultancy: e.g. human resource, transaction, management strategy

2.2 Key stages and changes towards NAS issues

2.2.1 US and EU environments

It was widely reported that in the Enron scandal, Anderson was paid $25m towards audit while $27 for NAS. Many commentators and shareholders suspected that the audit independence would be threatened if audit firms are over-reliance on NAS. The US passed Sarbanes-Oxley Act 2002 to prohibit a series of NAS provided to audit clients (Appendix 1). In the following year, the US rules required NAS to be pre-approved by audit committee and fully disclosure to shareholders. In 2002, European Commission published a principle-based model to restrict auditors providing certain audit services (EC Recommendation 2002). It implemented a "threats and safeguards approach" which emphasized on the identification of threats and reducing them to an acceptable level. All the threats were also category into self-review, self-interest, advocacy and the safeguards. Auditors must compliance to mitigate these threats (Statutory Audit Directive Article 22).

2.2.2 Development in UK 2002-2004

In 2002, the UK government set up the "Co-ordination Group on Audit and Accounting Issues" (CGAA) to review UK's audit arrangements. CGAA recommended principle-based rules with "tougher and clearer safeguards to ensure that the joint provision of audit and non-audit services would not undermine auditor independence in fact or appearance".

In 2003, the Combined Code on Corporate Governance added new provisions for audit committees to review independence and develop policies on engagement of NAS towards external auditors. Later the Smith Report was published (FRC 2003) in detail guidance for audit committee.

In purpose of maintaining auditors' objectivity, integrity and independence, a fundamental principle -APB Ethical Standards 5 (ES 5) was introduced by the Auditing Practices Aboard in 2004. ES 5 developed a general acceptable procedure for auditors to consider before accept to provide NAS to audited entities plus emphasized on communication with audit committee about the independence issues. The key steps required by Ethical Standards including consider a third party's perception towards the objectivity of the NAS; identify any material threats to the independence; assess safeguards to eliminate or reduce threats to a desirable level. If not satisfied, the audit firm should not undertake or accept the engagement (Appendix 2). A larger prohibition under certain circumstance was also provided for listed companies, including corporate finance, IT services, internal auditing and taxation (Appendix 3). This guidance offered a flexible solution to variety of conditions.

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Based on the EC Recommendation 2002, APB identifies the threats in four categories: self-interest, management, self-review and advocacy threat, which carefully deal with ethical and human nature.

2.2.3 Development after 2004

In 2005, Companies Regulations required listed companies to disclose details of value and nature of the NAS provided by external auditors in financial statements as well as set up standards for governing NAS. We can see a significant change in the Barclays' Annual Report in 2005. The amount of fees on categories of non-audit services are disclosed in detail and well explained. APB also revised the Ethical Standard in 2006 and 2007, towards issues on reporting accounts and consultations.

Compared with UK's "principle-based" approach, the US rules are relative restrictive, in particular the direct prohibit of certain NAS and pre-approval of audit committees. However, the APB Ethical Standards allows variety situations and appropriate enforcement.

2.3 Arguments about NAS threat independence.

The collapses of some US and Australia companies have called a wide suspicion of non-audit services qualities. Before that, the total non-audit fees paid by FTSE 100 reach 680 million and remain a similar level in 2001.

After the Enron event, many companies started to rethink of their relationship with audit firm. More researches were taken at that time to investigate whether provision of NAS would have potential threats on audit independence and opinions on going concern. Some studies, e.g. Dopuch et al (2003), Krishnan et al (2005), were based on survey and experimental settings, which proved that NAS have a high threat to independence. Other studies tested the NAS influence on audit opinion and quality of financial information to show NAS has no impact on audit independence. For example, in DeFond et al 2002, it argued auditors have market-based incentives to remain independent and they would outweigh their temptation to lose independence for economic reasons. Similarly, Reynolds and Francis 2001 claimed that auditors are more likely to be conservative for their cost of reputation.

In contrast, some studies showed that higher NAS fees would impair the auditors' going concern opinions ( Sharma and Sidhu 2001). Kornish and Levine (2000) found it was more likely for auditors to issue favorable audit report if they also provide NAS to client. Furthermore, studies found more evidence on management control over audit firms when large NAS was purchased (Larcker and Richardson 2004).

2.4 Analysis of changes in NAS purchasing behavior

There was a significant decrease in purchase of NAS among FTSE 100 companies from the early 2002 to before UK regulatory changes (Appendix 4). A number of factors may contribute to this voluntary reduction. Response 1: Some firms reduced the NAS purchase simply because they want to stay away from the shareholders' arguments about potential threat to financial reporting and audit independence. This represented a protective response in the changing climate. Response 2: Some companies choosed to disclose more information about NAS purchase in annual report to help shareholders evaluate the threat to objective. Any conflict of interest in the audit relationship would be shown during the disclosure. As a result, companies may voluntary drop part of the NAS and audit firm may also refuse to accept some NAS purchase to remain independence. Response 3: It was also possible for companies to outweigh the non-audit services more than audit services. They may choose to change a new audit firm and remain the previous audit firm to provide NAS. In this circumstance, the fees of audit assurance and NAS may change as they are provided by different audit firm.

Since the Ethical Standards issued in 2004, regulations prohibited certain non-audit services provision to audit entities. There was also more attention on the audit committee's involvement in the auditors' independence evaluation and perception. As a consequence, the percentage of non-audit fees as of audit fees decrease from 191% in 2002 to 100% in 2004 to 71% in 2008.

Prior to 2005, Company Act 2005 required the fees paid to audit firms be separated into audit and non-audit services. Later, CGAA recommended a breakdown of types of NAS by regulation. While in 2005, a legislative approach towards the disclosure of associate purchases and services in detail. Company Regulations 2005 requires disclosure in 9 types of categories (Appendix 5).

2.5 Strength and weakness of general prohibition

The NAS once again become a bone of contention in the credit crunch in 2008. The Treasury Select Committee strongly recommended a general prohibition of audit firms conduct NAS to its audit clients. The advantages of prohibition can be foreseen. First, the audit committees don't have to judge and test the threat to objectivity of auditor. Second, audit firms will not compromise under the strong incentives as for fear of lose non-audit services. No suspicions will remain for NAS purchase issues.

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However, APB advocated a voluntary judgment by client's audit committee rather than an entirely ban of NAS purchase. Arguments against the prohibition concentrated on the quality and effectiveness of audit services. Firstly, the knowledge and skills accumulated from business and management services would reduce due to the prohibition. Without the understanding of business, auditors may have lower ability to provide assurance to the financial statements, which in return harm the shareholders' interest. Secondly, the prohibition would make the audit firm over-reliance on the client. This may threat the independence if the audit fee becomes a larger part of total income. Thirdly, the separation of audit and non-audit service would cause an increase in costs, which would be too expensive for SMEs to bear. As a lot of services are sub-product by audit process, so it is efficient for auditors to do some non-audit work that derived from the accounts.

Chapter 3

Case study

3.1 Analysis of Barclays

Changes in the NAS purchase and disclosure

Audit committee

The Barclays Bank Plc purchases non-audit services from its audit firm PricewaterhouseCoopers LLP including legislation, taxation, corporate finance and compliance.

In 2001, there was only a simply category of audit related service and non-audit services. All the regulatory and assurance services were regarded as audit related services. In 2002, Barclays started to disclose the fees paid to PWC for consulting and management consultancy service.

The total auditor's remuneration paid to PWC has a slightly decrease in 2002-2004. This is a caused by a voluntary decrease of purchasing regulatory and compliance services by response to Enron Scandal.

In 2003, due to the publication of Smith Report and Combine Code, the company categoried the services by audit related, further assurance services, taxation services and other services. The detail of each kind of service was also disclosed, e.g. further assurance includes internal audit review, consultation on financial accounting and reporting standards. In 2004, to compliance with US reporting, the further assurance services once again be treated as audit related services.

From 2005 to 2009, there was a significant increase in total auditor's remuneration paid to PWC, from 29million to 52 million in 2009. The non-audit services total fees only has slightly fluctuation in the past ten years time, this does not compliance with the FTSE 100 companies which have significant decrease in NAS purchase. However, there is a marked growth in the audit-related fees, especially the fees payable to services and other services associated with legislation. Barclays started to purchase a lot of regulatory and legislation services since 2006. This was because of increasing fees paid towards preparation of reporting under US Sarbanes-Oxley Act and additional advisory.

In 2005, as the Company Regulation required all listed companies to disclose the detail of non-audit services in nine categories. We can immediately see the change in the notes of annual report 2005, Barclays has five kinds of services out of nine. All detail services in each kind is also well explained in the notes. From 2006-2009, there are no changes in the format of disclosure of NAS.

3.2 Analysis of PWC LLP

Changes in the NAS disclosure and provision of NAS services

PWC mainly provides assurance, tax and advisory services to its clients. The audit independence is maintained by compliance with regulation, ethical standards, company policy and personal independence confirmation. PWC jointly work with clients' audit committee to avoid conflict of interest and loss of objectivity. All the services are pre-approved and assessed before accepting to supply NAS.

Influenced by US scandals, PWC as a professional firm experienced a hard time from 2001 to 2003. The volume of sales decreased in the weak economic environment (Exhibition 3). The speed of merger and acquisition slowed down for the uncertainty in policies and regulation. PWC clients were more careful towards NAS purchase and paid more attention to cost control. The US regulation change also impacted the company's performance in UK market. A number of clients' audit committee reduced the NAS purchase for audit independence and disclosure requirement.

The APB Ethical Standards required audit firms to provide NAS under certain circumstance, in order to avoid the threat to independence. As the result, the PWC Consulting was sold in 2003 as it is prohibited to provide IT designing to listed clients. This caused a loss of volume in revenue but PWC remained providing other advisory services. In the same year, PWC acquired part of Andersen and its clients.

From 2004 to 2007, PWC enjoyed a growth of steadily growth every year, mainly form increasing services to non-audit clients. Many companies chose to hence the independence of auditor by changing firms to supply NAS. SOX s404 and IFRS required audit firms to improve internal auditing and legislation compliance. As a result, in 2007, non-audit services form more than 72% of turnover.

However, the revenue from NAS provision to audit clients continued to drop due to SOX and changing nature of the environment.

During the economic downturn in 2008, the company's NAS remained growing. Under the requirement of "Guidance on Audit Committee 2008", audit committee was responsible for monitoring the external auditor's independence and safeguards of assurance. PWC started to publish transparency reports, which further disclose the detail of supply of NAS to its clients.

In 2009, PWC faces a great challenge in the financial crisis, clients remain conservative in NAS purchase. The collapse of Lehman Brothers once again calls attention on prohibition for Audit firms providing NAS to clients.

Chapter 4


Although there may exist potential threats that may influence the objectivity of auditor's independence, there is no direct evidence to prove that NAS cause the audit failure. From the case study we can see that both Barclays and PWC regarded NAS vital to their business. Many services towards legislation and taxation are widely welcomed by clients, as they are beneficial to companies' development. It is suggested that there should be no general ban for auditors supply NAS to audit clients.

However, to improve the governance framework, more changes may be taken. First, APB may call for more disclosure for non-audit work done by audit firms. Second, FRC may set restriction on proportion of non-audit purchases from auditors. Third, more requirements will appear for audit committee to take more responsibility to monitor the safeguard of approach. More efforts would be taken for audit firms to provide transparent, independent audit and non-audit services under the UK ethical standards.