The Impact On Audit Independence And The Threats Thereto Accounting Essay

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1.0 INTRODUCTION

Quality of Audit Report and Independence of Auditors has recently been an issue in the corporate world. "Non Audit Service" (NAS) is a much talked topic in the world. Some recent issues have triggered this up more. Especially it is being said that Non Audit Services affect the independence of auditor.

This paper serves to analysis the impact on audit independence and the threats thereto, with the support of current corporate issues from credible sources and laws. It is also influenced by the recent state of the institutions of charted accountants in England and Wales that a restriction in the provision of non audit service may have an adverse effect on the underlying quality of the external Audit.

2.0 BACKGROUND INFORMATION

2.1 AUDIT DEFINITION

The term auditing is used to describe a broad range of activities in the corporate world. Audit is a form of assurance. It is an inspection of the accounting procedures and records performed by a professional charted accountant or Charted Public Accountant (Emile Woolf 1990).

The ''Report of committee on Basic Auditing Concepts of the American accounting association '' (accounting review, vol 4.7) define audit as a systematic process of objectively obtaining and evaluating evidence and events to assertion the degree of correspondence between those assertions and established criteria and communicating the results to interested users.(William C Boynton, Raymond N Johnson and Walter G kell 2001)

Attributes of auditing contained in the definition merits special comments:

Communicating the results is achieved through a written report that indicates the degree of correspondence between the assertions and established criteria. The communication of the results enhances or weakens the credibility of the presentations made by another party.

Audit is also referred to as an independent examination by way of sampling of and expressing an opinion on the financial statements of an entity by jury appointed auditor in pursuit of that appointment. It is noteworthy to highlight the independence part as it is essential and underlies the value of an auditing and opinion means another auditor can view the same financial statements and give a different opinion (David Coderre 2009).

3.0 AUDITOR INDEPENDENCE

Independence is the foundation of the auditing profession. It means that the auditor is neutral about the entity and therefore objective. The stakeholders can place faith in the audit functions because an auditor is impartial and recongnise an obligation for fairness.(Michael J.Pratt 2002)

Audit independence can also be defined as the probability that the auditor will report a discoved breach in the financial report. This stated probability is often under threat.(Watts and Zimmerman 1983, 1986)

Some auditors are sad not to be taking due care of the ethical standard because they are engaged in 'non audit service' from the same audit client contrary to statutory audit service (Chee-Yeow Lim & Hun Tong Tan 2007 ).

There is some evidence that provision of non audit service impairs independence in appearance but has either weak or no effect on independence (Levitt 2000 ).

In the wake of the Enron bankruptcy, a concern about audit independence has triggered the USA congress to enact legislations that prohibit most auditor providing Non audit Service (Reinstein, A. &Weirich, T.R. 2002).Regulators concerns about Non audit service are based on the assumption that auditors are willing to sacrifice their independence In exchange for retaining client that pay large non audit fees.

The auditor function is simply being used as a catalyst to more lucrative consulting service. The issue has come into focus following the collapse of WorldCom, Enron and Anther Anderson (Frankel, Johnson, and Nelson 2002).

3.1 Independence in Mental Attitude

Competence alone is not sufficient. The auditor must also be free of client influence in performing the audit and in reporting the findings. The auditor must also meet the independent requirement in the AICPA'S code of professional conduct.(Boynton, Johnson and kell 2001)

3.2 ANALYIST PESPECTIVE ON NAS AND INDEPENDENCE

Expect give different view point Frankl, Johnson & Neson report some evidence consistent with a significant and positive association between the ratio of NAS fees to total fees and surrogates for lower financial reporting quality. A number studies have observed that the relationship between auditors and Board of Directors is potential threat to independence. (Whisenant, K Raghunandan and S Sankaraguruswamy 2002)

It is argued that auditors consider companies as presented by their directors as their client rather than shareholders (Kinney Jr., W.R., Palmrose, Z-V. &Scholz, S. 2004)

Non audit services also create pressure to auditors to allow the management for appropriation. Simunic (1984), Beck et al. (1988) and Beeler and Hunton (2001) says that the provision of non audit services can strengthen the auditor's economic bond with the client, thereby increasing the auditor's incentive to acquiesce to client pressure, including pressure to allow earnings management.

Other sources indicate that the provision of NAS creates economic bond that weakens Auditor independence and therefore reduces audit quality. The regulatory bodies worldwide became cautious about how to protect this and prevent the malpractices. In response the US congress passed Sarbanes-Oxley Act ("SOA") in November 2002.

4.0 SARBANES-OXLEY ACT ("SOA) 2002

The SOA attempts to eradicate specified likely conflicts of interest arising out of "non-audit services" and gives further power to the Audit Committee. The committee exists under the provisions of the Combined Code of corporate governance. The SOA explicitly prohibits large scale, big fee financial information systems design and implementation or information technology work. This was a very high profit area for the non-audit arms of the large accounting firms. The SOA also bars internal audit outsourcing and "expert" services.

There was some confusion over what type of NAS the outside accountants could perform for public corporation. In fact, some of the major accounting firms sold their consulting units in recent years in order to avoid possible conflict of interest.(Securities and Exchange Commission, 2000; Sarbanes-Oxley Act, 2002).

5.0 ROLE OF CORPORATE GOVERNANCE REGARDING NAS

Under the requirements of the Combined Code of corporate governance, the audit committee, as envoy of the shareholders, is required to oversee the relationship with the auditors and keep the nature and extent of non-audit services under review. Carcello and Neal, 2000, 2003).

This important task is underpinned by United Kingdom Auditing Standards, which specifically require that, for listed UK companies, audit engagement partners in the firm who are responsible for a company's audit must:

Disclose in writing to the audit committee all relationships between the audit firm and the client that may reasonably be thought to bear on the firm's independence and the objectivity of the audit engagement partner and staff (including arrangements for ensuring that independence remains when non-audit services are commissioned) and the related safeguards that are in place.(Vafeas, 1999; Xie et al., 2003).

Confirm that, in their professional judgment, the firm is independent and the objectivity of the audit engagement partner and audit staff is not impaired. (Hermalin and Weisbach, 2003)

5.1 THE PROVISION OF NAS IMPAIRING AUDITOR INDEPENDENCE

The SOA set forth below nine Non Audit Service prohibiting registered accounting firms performing to public companies which can impair audit independence (SOA section 201).

1. Bookkeeping

Or other services related to the audit client's accounting records or financial statements. Currently, an auditor's independence is impaired if the auditor provides bookkeeping services for an audit client. (Ashbaugh et al., 2003; Chung and Kallapur, 2003; Larcker and Richardson, 2004; Reynolds et al., 2004)

2. Financial information systems design and implementation

The accountant is not independent if the accountant designs or implements a system that is or will be used to generate information that is significant to the audit client's financial statements taken as a whole.

3. Appraisal or valuation services, fairness opinions, or contribution-in-kind reports.

The impairment of independence is when such services lead to the reasonable likelihood that the results will be audited by the auditor.

4. Actuarial services

Actuarial services are such services that impairer independence of auditors, unless the audit client uses its own actuaries or third-party actuaries to provide management with the primary actuarial capabilities.

5. Internal audit outsourcing

An auditor is not independent when the auditor performs certain internal audit services for an audit client or an affiliate. However, nonrecurring evaluations of discrete items or programs that are not in substance the outsourcing of the internal audit function or operational internal audits unrelated to internal accounting controls, financial systems, or financial statements are not included as the limitations related to this item.( Beeler JD, Hunton JE 2001)

6. Management functions

The current rule that prohibits serving temporarily or permanently as a director, officer, or employee of the audit client or an affiliate or performing any decision-making, supervisory, or ongoing monitory functions (Zeff 2006).

7. Human resources

Use of Audit for Non-Audit Services. Independence is impaired with respect to an audit client when the auditor recruits, hires, or designs compensation packages for officers, directors, or managers of the audit client or its affiliate (F Gul, B Jaggi and G Krishnan 2007). Independence is also impaired when the auditor advises an audit client about its or its affiliate's management or organizational structure, when the auditor develops employee evaluation programs, or when the auditor conducts psychological or other formal testing of employees (Levitt, A. 2000).

8. Broker-dealer, investment adviser or investment banking services

An accountant is not independent if the acts as a securities professional for an audit client or an affiliate of the audit client (Beeler, J. D., and J. E. Hunton 2002)

9. Legal services

Legal services are deemed to be incompatible with auditor independence and any other service that the accounting board determines, by regulation, is impermissible.

The SOA also provides that a registered public accounting firm may engage in NAS including TAX SERVICE, which is not described in the foregoing nine activities, but only if the activity is approved in adherence by the audit committee (SOA section 202).

6.0 RULES OF CONDUCT UNDER SECTION 101

A member in public practice shall be independent in performance of professional service as required by standards promulgated by bodies designed by council.

The rule incorporates into the code, by reference, the influence requirements in technical standards issued by the AICPA; the bodies which have issue standards by including a requirement that the CPA be independent are Auditing Standard Board And the Accounting & Review Service Committee e.g. a member must be independent in performing attest service such as financial statements of a non public entity. A member is required to be independent in rendering Non Audit Service such as accounting, tax and management consulting service (Boynton Johnson Kell 2001).

6.1 INSTITUTION'S ETHICAL VIEW TO NON AUDIT SERVICE

The Institute's ethical code forbids auditors to provide non-audit services to audit clients if that would present a threat to independence for which no adequate safeguards are available. In such circumstances, the firm must either resign as auditor or refuse to supply the Non-Audit Services (cf. Norris 2000).

7.0 THE ARGUMENT AGAINST GENERAL PROHIBITION

When the audited company liquidates the quality of the auditor is often scrutinized and called answer. The accusation is made that the auditors have allowed inappropriate accounting treatments because their independence has been compromised either because they have become too close to the client. Familiarity treats will occur because their objectivity is challenged by overreliance on income from single source (Gulati, Ranjay. 1995).

Due to this point some believe that the only solution is for auditors to be prohibited from providing any service other than audit to a client.

Some believe that unnecessarily restricting the provision of Non-Audit Services would have an unintended, adverse effect on the underlying quality of the audit through restrictions in knowledge (Kotabe, M., Xavier Martin, and H. Domoto. 2003) and skills. The quality of recruits will reduce due to lack of specialization by accountant. Dependence on client will create intimidation threat. Quality of business' own systems will deteriorate, while the costs will increase in provision of service as two jobs will be done by different firms. The Speed of reporting will decrease due to bureaucracy (Sharma, D.S. & Sidhu, J. 2001).

7.0 CONCLUSION

It is the rights of member that they should be provide Non Audit Service to audit client other services beyond performing an audit. Auditors are not obliged to perform executive functions or make executive decisions. Those are the duties of management. It is important that auditors should be aware in providing such services because they can drift into a situation as they will be stepping across the border line, of what is proper. Because it will end up their independence being jeopardized and the value of audit reduced.

8.0 BIBILOGRAPY

BOOKS

A model of the market for MAS and audit services: knowledge spillovers and auditor-audited bonding. J Account Lit 17:50-64 Beeler JD, Hunton JE (2001)

Emile Woolf 1990 Auditing Today 4th edition, published by john Wiley & sons. Inc.

David Coderre 2009 Internal Audit- efficiency through Automation published by john Wiley & sons. Inc. page 30001 published by john Wiley & sons. Inc

Morden Auditing 7th edition .William C Boynton, Raymond N Johnson and Walter G kell 2 page 53

JOURNAL

Ashbaugh, Hollis, Ryan LaFond, and Brian W. Mayhew. 2003. Do Nonaudit Services

A Journal of Practice & Theory, Vol.3, no.2, pp. 89-97 Reinstein, A. &Weirich, T.R. 2002, 'Accounting Issues at Enron'

F Gul, B Jaggi and G Krishnan, "Auditor independence: evidence on the joint effects of auditor tenure and non-audit fees",Auditing: A Journal of Practice & Theory, Vol 26, No 2, 2007.

R Frankel, M Johnson and K Nelson, "The relation between auditors' fees for non-audit services and earnings management",

The Accounting Review, Vol 71, 2002.

Improvement in the U.S. And Japanese Automotive Industries. Strategic Management Journal 24 (4): 293-316.

Compromise Auditor Independence? Further Evidence. The Accounting Review Journal 78 (3): 611-39.

Kotabe, M., Xavier Martin, and H. Domoto. 2003. Gaining From Vertical Partnerships: Knowledge Transfer, Relationship Duration, and Supplier Performance

Non-Audit Services, and Restatements: Was the U.S. Government Right?, Journal of Accounting Research, vol.42, no.3, pp. 561-588 Levitt, A. 2000

Journal of Accounting Research 22(2): 679-702. Sharma, D.S. &Sidhu, J. 2001, 'Professionalism vs Commercialism.

Journal of Accounting Research ,Vol 47.N1.March 2009 editors: Ray Ball ,Phili G, Merle Erickson, Richard Leftwich, Douglas J Skinner and Abbie Smith page 12

Norris, F. Three Big Accounting Firms Assail SEC's Proposed Restrictions. The New York Times (July 27): C9.

Gulati, Ranjay. 1995. Does Familiarity Breed Trust? the Implications of Repeated Tiesfor Contractual Choice in Alliances. Academy of Management Journal 38 (1): 85-112.

3 S Whisenant, K Raghunandan and S Sankaraguruswamy, "Evidence on the joint determination of audit and non-audit fees", Journal of Accounting Research, Vol 41, No 4, 2003.

How the U.S. Accounting Profession Got where It Is Today: Part II', Accounting Horizons, vol.17.no.4.pp.267-286, Zeff2006

The CPA Journal, Vol. 73, No. 1, pp 48-51. Beeler, J. D., and J. E. Hunton 2002

Journal of Business Finance & Accountancy, vol, 29, no.5 &6, pp. 661-693 Kinney Jr., W.R., Palmrose, Z-V. &Scholz, S. 2004, 'Auditor Independence, Non-Audit Services, and Restatements: Was the U.S. Government Right?,

University of South Carolina CheeYeow Lim & Hun-Tong Tan June 2007, Non-Audit Service Fees and Audit Quality

INTERNET

107th Congress. 2002. Sarbanes Oxley Act of 2002. Available at: http://frwebgate.access.gpo.gov/cgibin/getdoc.cgi?dbname=107_cong_public_laws&docid=f:publ204.07 (accessed on 10/06/2010 ) and http://www.sarbanes-oxley.com (accessed on 10/05/2010)

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