The ethical standards

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This essay aims to examine the issues of auditor independence in relations to current provision of other services.

After the bankruptcy of Enron when huge accounting fraud was exposed, Auditing

Practices Board (APB) decided to set standards for auditor independence. The Ethical Standards (ESs) was published by the APB in 2004, which auditors have to conform with and introduce new requirements, especially in relation to the provision of non-audit services. A revised standard of the ESs was published in 2008 and then a consultation paper in 2009 to gather reviews. This was done in response to the Treasury Select committee which published a report on 'Banking Crisis: reforming corporate governance and pay in the City', calling for the appropriateness of the provision of non audit services by auditors. And stated "We strongly believe 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 reviews brought attention to research that proposed, the developments to decrease the threats to auditor independence, particularly in relation to the provision of non-audit services.

The main objective of an audit of the financial statements is that the auditor has to provide independent assurance to the shareholders and express an opinion as to whether or not the financial statements give a true and fair view.

Regulators and critics of argue that the provision of these services threatens auditor independence. Interviews and focus groups show an increase in pressure on the objectivity and independence of and are described as "somewhat worrisome" (Earnscliffe Research & Communications 1999, 9). Especially in the kpmg case.

In contrast, the Public Oversight Board (2000) asserts that non audit services do not compromise auditor independence.

Independence is related to and underpins objectivity. However, whereas objectivity is a personal behavioural characteristic concerning the auditor's state of mind, independence relates to the circumstances surrounding the audit, including the financial, employment, business and personal relationships between the auditor and the audited entity.

There is greater competition among public accounting firms and small part of the revenue comes from auditing. Therefore auditing firms find alternatives ways to increase revenue by providing non audit services i.e. internal audit, risk management, and consulting services.

The government proposed that listed companies need to compulsory rotate the audit firms every seven years.

Neil Lerner, UK head of risk management at KPMG stated that audit firm rotation was not a good idea. (ref)

Moreover David Illingworth president of ICAEW said 'evidence suggests that audit firm rotation is detrimental to audit quality.' (ref)

Alternatively Nick Land, the chairman of Ernst & Young, asserts that countries such as Italy and Spain that have endeavour rotation of auditors have not seen positive results. (Independent)

Most of the public confidence depends on the credibility of the auditors' opinions and reports on the financial statements. Such credibility depends on beliefs concerning the integrity, objectivity and independence of the auditor and the quality of audit work performed mentioned in the IFAC code of ethics, which have a principle based approach to ethical matters. Auditing Practices Board (APB) establishes quality control, auditing and ethical standards to provide a framework for audit practice.

According to (ref1) asserts that 'firms with higher ratios of NAS are more likely to make optimistically biased and inaccurate forecasts.'

Whether or not the purchase of non-audit services (NAS) impairs audit independence is the focus of a growing body of accounting research. This question is of critical importance because of the ongoing debate about the appropriate structure of the accounting profession and the appropriateness of providing NAS by accounting firms (Larcker and Richardson, 2004). Prior studies have examined whether non-audit services impair independence.

Frankel et al. (2002) find that non-audit services are positively related to companies beating analysts' forecasts as well as the magnitude of discretionary accruals. However, subsequent research has failed to find evidence that non-audit services impair auditor independence (Ashbaugh et al., 2003; DeFond et al., 2002; Geiger and Rama, 2003).1

Many people have raised concerns about the KPMG audit deal with Rentokil. KPMG have agreed to perform the internal and external audit of Rentokil and by doing so it cut audit cost of up to 30% which caused concerns. The internal-external audit mix also known as 'extended assurance', in use for FTSC 100 is under scrutiny by Financial Reporting Council (FRC) and will investigate if it is in line with the ethical standards. According to the ethical standard published by APB, KPMG could be in self-review and management threat.

'A self-review threat which arises where, as a result of the audit firm having provided the non-audit service, the auditor may be reluctant to evaluate objectively the non-audit work that has been undertaken even though the auditor relies upon it in order to reach an opinion on the financial statements during the statutory audit.' (APB)

However if the external audit i.e. financial statement is not heavily relied on the internal audit, the audit firm can establish effective safeguards to address the threats to objectivity.

management threat arises when, the internal auditor starts to make decisions and assumes the role of management.

Investor may believe that the auditor is not being independent and not applying a proper degree of professionalism in reviewing matters, regarding the financial statements and being subjective on the decisions they take.

Oliver Tant, head of audit of KPMG said, 'We are comfortable that this is perfectly feasible to do in the spirit and letter of the law.'

Furthermore both ACCA and IFAC's principles require auditors to identify and evaluate circumstances and relationships that create threats to independence and take appropriate action to either eliminate or reduce the threats to an acceptable level by the application of safeguards. If the auditor cannot eliminate or reduce the threat to an acceptable level then the auditor should not undertake the assurance assignment.

Therefore auditors are not allowed to take o jobs that pose a threat to its independence and from being involved in management decisions in their client firm. it is also emphasizes that audit fees should be reasonable and not influenced by the provisions of non audit services.

Moreover stated by Mario Christodoulou 'More surprising, the structure was being promoted by the international auditcompanywhich knew full well that the arrangement would be illegal in the US and possibly in France where independence criteria is much more strict.'

An American Senator Paul Sarbane proposed a Sarbanes Oxley Act 2002, also called the "Business Revolution Act", which issue standards on independence. It states that CPA cannot provide both audit and non audit services as determined by the Public Company Accounting Oversight Board (AOB).

Merging these two important functions has the potential to cause serious conflicts of interest and reduce the effectiveness of internal controls and the management of risk.'

IIA, the executive Dr Ian Peters said that merging both of these function will cause 'serious conflict of interest' and the effectiveness of internal controls and the management of risk will be reduced.

Also David Ellis, investment group Pirc's UK corporate governance manager supports this argument and further states "We firmly believe other commercial interests can compromise auditors in their ability to confront directors on difficult issues. Ideally therefore we would favour a prohibition on non-audit services being provided."

Others in the same profession draw attention on internal audit committees, believing greater transparency over why firms are selected might aid to expose the practice.

The international ethics standards board for accountant issued a revised code of ethics for professional accountants and one of the requirements is to issue a review of the total fees from an public audit client that exceed 15% of the total fees of the audit firm for two consecutive years.

Richard Fleck, chairman of APB said there have been a, '...greater transparency on the fees paid for non-audit services...',