The Issue Of Auditor Independence Accounting Essay


The issue of auditor independence is a crucial element and very important for the audit profession. This concept has been discussed widely and many definitions have been presented in literature. Independence refers to the auditor's ability to present his opinion about the reliability of financial statements honestly and impartially away from his interest or the pressure of clients [1] (Ahmad, 2009; 1985). Accountants [2] have long recognized that independence is critical to the viability of auditing as a profession. Few among auditors, preparers, financial statement users, or their legal advisors would seriously dispute the value of independent assurance on a company's financial statements. Thus auditors should express his conclusions honestly and impartial.

Literature has contemplated two standards for assessing auditor independence. Mautz & sharaf(1961), who are among the pioneers in the study on auditors independence have developed a concept of independence with two components: practitioner-independence(independence in fact) and profession- independence(independence in appearance). The Public Oversight Board emphasized that the members that the members of Certified Public Accountant firms should protect the profession by being independence both 'in fact' and in 'appearance' (Lowe et al, 1999). Independence in fact refers to the mental attitude of the auditor characterized by the integrity and the objective approach to the audit process. Also, the practitioner independence requires the auditor to be free from personal interest, susceptibility to excessive pressure [3] ( Moizer & Sutton, 1997). However, since this mental process is unobservable and auditors also have incentives to violate their independence through satisfying their clients so as to maintain the economic bonding to the client [4] (DeAngelo, 1981), there is a need for the auditors to be perceived as independent(named independence in appearance) from the management team who prepares the financial statements. Orren (1997) states that independence in fact refers to the actual, objective relationship between auditing firms and their clients whereas independence in appearance is the subjective stated of that relationship as perceived by the clients and the third parties. Church and Zhang, (2002) argue that independence in fact is necessary to enhance the reliability of financial statements. On other hand, independence in appearance is necessary to promote public confidence such that users will rely on audited financial statements.

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Securities and Exchange Commission, 1979 asserts:

"The [auditor independence] issue is both one of appearance and of fact; if public confidence in the integrity of financial reporting is to be maintained, it is of the utmost importance that public confidence in the objectivity of independent auditors be similarly maintained".

American Institute of Certified Public Accountants (Public Oversight Board, 1979):

"While it is, of course, essential that an auditor preserve his objectivity and integrity from his own viewpoint, commonly called "independence in fact," it is also important that the auditor appear independent to all users of the financial information he provides. This latter concept is a key ingredient to the value of the audit function, since users of audit reports must be able to rely on the independent auditor. If they perceive that there is a lack of independence, whether or not such a deficiency exists, much of that value is lost".

The need for Auditor's independence

Independence is an important auditing standard because the auditor adds justification and credibility to financial statement even when there are no material misstatements or omissions in the financial statements prepared by management (okolie 2007). Teoh (1992) states "the audit of financial information adds significant assurance that the information is reliable and thereby enhances its credibility." The author Gupta (1999) is of opinion that is auditor is not independent of management; his opinion would mean nothing to shareholders, prospective investors, bankers, government agencies, and others who are concerned with the financial statements of a company.

The author Ezeipe(2004) describes the concept of auditor's independence in three dimensions [5] :

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Programme independence: Sometimes client manager have the intention to restrict or modify the procedures that the auditor want to perform. Thus auditors should always remain free from interference of client managers.

Reporting Independence: The auditor should never let any feelings of loyalty towards the client to affect his work. He must fully and fairly disclose his obligations. Management are never allowed to pressurize the auditor.

Investigative Independence: The auditor should have access to all necessary materials required on the content of an audit. For example, the auditor must have access to books and records; also active co-operation from management personnel during audit examination is required (salehi 2009).

In theory, there are many factors that affect independence of an auditor and these factors which have been studied can be:

The effects of gifts (pany and Reckers, 1980)

The purchase of discounts arrangement(pany and Reckers, 1980)

The audit firm size(Shockley, 1981)

The provision of management advisory services by the audit firm(Knapp, 1985)

The client financial condition((Knapp, 1985)

The nature of conflict issue()

The audit firm's tenure

The degree of completion in the audit services market

The size of the audit fees

The audit committee

Practising non-audit services by auditors

In this study, only factors such as the provision of non audit services, the audit firm size, the audit firm's tenure, the degree of competition in the audit services market, the size of audit fees and the audit committee will be analysed and whether these factors will impair or enhance auditor's independence.

The provision of non audit services by auditors

Audit failures reported in the past have affected the profession of auditor worldwide because the interests of shareholders and stockholders have not been safeguarded. This problem has arisen as a result of the provision of non-audit services (Salehi and Moradi 2010).

Non- audit services can be any services other than audit that an auditor provides to an audit client. Over the late 20th century, demand for business expert services has increased, wattington and Pany (2001) identified the different range of services which are offered by auditors to private and public sectors and these non-audit services include: training, services for payroll, risk management advice, mergers and acquisition, taxation, public offering, portfolio monitoring, recruitment and human resources and corporate governance. Prior research suggests that the impact of non-audit services on auditor's independence is uncertain. An auditor needs to pay much attention when both audit and non-audit services are provided to the same client, because these non-audit services may threaten the independence of auditor.

As far as globalization in accounting profession is concerned , assurance service has created the multidisciplinary nature of large audit firms (Brierley and Gwilliam, 2003). These multidisciplinary firms offer audit and non-audit services to audit clients and this have become one of the major concerns regarding the potential auditor independence dilemma (Quick and Rasmussen, 2005)

Although there are market-based incentives for auditors to remain independent, there are also forces that potentially threaten auditor independence. Specifically, regulators are concerned about two effects of non-audit services. One is a fear that non-audit service fees make auditors financially dependent on their clients, and hence less willing to stand up to management pressure for fear of losing their business

The other is that the consulting nature of many non-audit services put auditors in managerial role (Defond et al 2002). These concerns are summarized in the following quote from the SEC regulations mandating fee disclosures (SEC, 2000). Auditor's services relationship raises two types ofindependence concerns. First, the more the auditor has at stake in its dealing with the audit client, particularly when the non-audit services relationship has the potential to generate significant revenues on top of the audit relationship. Second, certain types of non-audit services, when provided by the auditor, create inherent conflicts that are incompatible with objectivity.

In the United States, the Sarbanes Oxley Act of 2002 implemented a ban on nine non-audit services which include:

1. Bookkeeping and other services related to the audit client's accounting records or financial statements

2. Financial information systems design and implementation

3. Appraisal or valuation services and fairness opinions

4. Actuarial services

5. Internal audit services

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6. Management functions

7. Human resources

8. Broker-dealer services

9. Legal services

According to Ojo(2009), the provision of non- audit services by audit firms does not necessarily affect auditor independence. Nevertheless, where the fees generated from such non-audit services are considerably high(in proportion to the audit fees earned by such accounting firms) and insufficient safeguards operates to protect the auditor's independence, this creates a situation whereby the auditors independence is likely to be compromised since the auditor may be denied profitable contracts [6] where he decides to give a qualified opinion on the financial statement being audited.

Proponents of the provision of audit services argue that synergies of knowledge spillover and audit efficiency arise from providing both audit and non- audit services. While the opponents contend that providing non-audit services increases the auditor's financial reliance on the client and therefore may impair auditor's independence.

Audit committee

An audit committee consists of a selected number of members of a company's board of directors whose main duties are to help auditors remain independent of management (Arens at al, 1999), that is, committee should support the auditor instead of management in different audit disputes. The members who participate in the audit committee can be corporate managers, academicians and retired partners of CPA firms (Knapp, 1987). Beattie et al. (1999) reported that audit partners, finance directors and financial journalists believed that audit committee helps to enhance auditor independence [7] (Beattie et al 1999).

SEC requires Audit Committees to evaluate the independence of the company's external auditor when deciding whether or not to hire the auditor for providing non-audit services. In so doing, Audit Committees also are encouraged to consider how the auditor provided non-audit services may improve audit quality and affect auditor independence

Size of audit firm [8] 

The size of audit firm is an essential characteristic that reflects auditor independence. A number of studies have proven that auditor reputation is directly associated with audit quality. Large audit firms will make sure to provide an independent quality audit service as the larger audit firms tend to have better research facilities and efficient financial resources, more advanced technology and more skilled employees who will be able to undertake large company audits compare to smaller audit firms. Large audit firms have larger client portfolios which enable them to resist management pressures whereas small firms provide personalised services as their client portfolios are limited and they have to succumb to management requirements (Lys and Watts, 1994).

The issue of maintaining auditor independence is more crucial for smaller firms than larger firms. Pearson (1980) found the larger size of audit firms will enhance auditor's independence, because, smaller firms would experience more difficulty in resisting client pressures in situations of conflict. As a result, the information content of audit reports certified by large firms are considered to be more and reliable than those of smaller audit firms [9] (Titman and Trueman, 1986).

However, as pointed out by Goldman & Barlev (1974), it cannot be concluded that large CPA firms are more resistant to pressures from their clients. This is so because the few court cases which challenge the assumption that CPA firms acted independently indicate that there is no guarantee that large CPA firm has the ability to resist pressures from clients, as happened with Arthur Andersen and Enron [10] .

Level of competition in audit service industry

Competition [11] has been identified as an external factor affecting auditor independence (Shockley 1981). Many firms which operate in an intensely competitive environment may have difficulty remaining independent as the client can easily acquire services of another auditor. The [12] AICP Cohen Commission (1978) in its report affirms that there are excessive competitions among public accounting firms. This excessive competition among different firms has become a problem to the auditing profession today.

Thus, extensive competition within the audit market has been consistently identified as a factor threatening auditor independence [13] (Farmer et al., 1987). The audit firms which operate in an environment characterized by a high level of competition for audit clients usually have a greater risk of decreasing their audit independence compare to those audit firms which operate in a low-competition environment.

Shockley (1981) had found that audit firms operating in an environment characterized by a high level of competition for audit clients would have a greater risk of decreasing their audit independence than where audit firms operated in a low-competition environment.

Auditor tenure

An audit firm's tenure refers to the length of time required to fill the audit needs of a given client. A long association between a company and an accounting firm is likely to result a close identification of the firm with the interests of its clients, thus an independent action by the accounting firm (U.S. Senate, 1976). The author Mautz & Sharaf (1961) added that after a long association, less rigorous audit procedures, complacency and a learned confidence in the client may arise. However, long auditor tenure may lead to a cozy relationship between the client and the auditor ad this may impair auditor independence due to a decrease in the auditor's due-diligence and also becomes more prepared to "turn a blind eye" to inappropriate managerial actions. On the other hand, long auditor tenure is beneficial as auditors gain expertise in the field they audit and may may reduce the auditor's ability to detect irregularities or material misstatements (Gul et al., 2009)

Size of audit and non audit fees

The IFAC's Code of Ethics for Professional Accountants (1996, para 8.7) propose that client size which is measured from size of fees could raise doubts as to independence. The EFAA (October, 1998, p.4) clearly states that," the (total) fee from one client should not exceed a certain percentage of the total turnover of the audit firm". In cases of accounting scandals (for example Enron and WorldCom), the audit firm appeared to be in collusion with the management in hiding fraudulent activities. The major factor behind such reservation was the amount that the auditors received as non-audit fees from these clients. Anderson, the auditor for Enron, received US dollar 27 million as non audit fees in addition to US dollar 23 million as audit fees. The fact that the accounting firm received more than half of its Enron revenue from NAS gives an appearance of a lack of independence in the audit (Flaming 2002).

In addition, the fees for non-audit services has also increased substantially and are more profitable than fees from audit services, thus strengthening the economic bond and substantially lead to impairment of AI . The regulatory bodies in the U.S. like the SEC, the POB and the AICPA emphasized that significant high non audit fees can negatively affect auditor independence and also impair auditor decision-making, when those decisions involve a substantial amount of professional judgment.

In Malaysia the MIA By-Law (Section B-1.98 on Professional Independence) has emphasized that "if the total fees (arising from assurance and non-assurance services) generated by one assurance client or its related entities exceed 15% of the firm's total fees in each year over two consecutive financial periods, financial dependency shall be considered to exist, in which case, a self-interest threat to independence is created. In such event, the only course of action is to refuse to perform or withdraw from the assurance engagement". This 15% criterion has also been the level generally used by the ICAEW and Australia at which auditors have to consider their independent position.

Empirical Evidence

There have been a large number of studies on perceptions of auditor's independence. Some examples can be Dykxhoorn & Sinning (1981) in German, Gul (1989) in New Zealand, Gul & Tsui (1992) and Lau & Ng; (1994) in Hong Kong, and Alleyne et al. (2006) in Barbados to name a few. There are only some published studies focussing mainly on the factors affecting auditor's independence (i.e Gul & Teoh, 1984; Teoh & Lim 1996; Abu Bakar et al. 2005, 2009).The study Gul and Teoh(1984) analyses the main effects of combined audit and management consulting services provided by public accounting firms and the population sample taken comprised of bankers, public accountants, mangers and shareholders. The result obtained was that the expansion by audit firms into non audit services reduced their confidence in the auditor's independence.

The study Teoh & Lim (1996) investigate the effects of five selected factors of AI of Malaysian public and nonpublic accountants. They make use of a repeated measures experimental design. The results conclude that a large audit fee received from a single client is the most essential factor leading to the risk of losing AI, followed by the provision of management consultancy services. The non-rotation of audit firms is not considered to be a dominant factor but the formation of audit committees is found to have a strong positive impact on improving auditor independence, while the positive impact of disclosure of non-audit fees is considerably less.

Some studies can be those of Abu Bakar(2005) who analyses the factors influencing auditor's independence from the perceptions of Malaysian loan officers. The study examines the opinions of commercial loan officers who were relatively financial statement users who would understand the importance of audit report and the issues related to auditor independence. A total of 86 officers responded to the self administered questionnaire. The results indicate that audit firms operating in a higher level of competitive environment, larger size of audit fees, audit firm serving a client over longer duration, audit firm providing managerial advisory services and non-existence of an audit committee are perceived as having the risk of losing auditor's independence. The most important factor affecting AI is given by Audit firm size, followed by tenure, competition, audit committee, MAS and size of audit fee. Another study by Abu Bakar (2009), attempts to explore the main determinants of auditor independence as perceived by Malaysian accountants. A self administered mail survey was used and a total of 72 completed questionnaires were received producing usable replies of 14.4%. From the survey, it is evidenced that, larger size of audit fees is the most important factor that is perceived as having risk of losing auditor independence followed by other factors [14] . Additionally, the study also provides a basis for the profession to establish policies relating to auditor independence.

Review of literature in terms of the different factors

In reality there are many factors which impair auditor independence and some studies concentrated on only one factor. For example, Salehi(2009) examined non audit services and audit independence. The result of this study strongly agrees that providing NAS to external auditors to the same client impair auditor independence. Several prior studies concluded that NAS has negative effects on auditor practices and auditor independence. A Survey carried out by Wines (1994) suggests that auditors receiving NAS fees are less likely to qualify their opinion than auditors that don't receive such fees, based on his empirical analysis of audit report issued between 1980 and 1989 by 76 companies publicity listed on Australian stock exchange. He found that auditors of companies with clean opinions received higher proportion of non audit fees than did auditors of companies with at least one qualification.

According to Beeler and Hunton (2002) contingent economic rents such as potential non-audit revenue, increase unintentional bias in the judgments of auditors. They found experimentally that audit partner participants searched more supportively, weighted confirmatory evidence more heavily, and made more elaborate arguments in the presence of low balling and potential non-audit revenue than provision of audit, and NAS claimed that auditors would not perform their audit service objectively and that joint provision would impair perceived independence (Glezen and Miller, 1985 [15] ;). Mitchel et al. (1993) believed that the joint provision of audit and NAS to audit clients would cause unfair competition due to the use of audit services to the same client and thus would impair AI.

Several prior studies also suggest that NAS has positive effects on auditor practices and auditor independence. Gul (1989) who studied the perceptions of bankers in New Zealand found that the effect of provision of NAS was significantly and positively associated with auditor independence. Hussey (1999) reported that the majority of the UK finance directors that participated in his study suggested that joint provision of audit and NAS to audit clients should continue to be allowed. In Malaysia Gul and Yap (1984) reported that NAS provision increased their confidence in auditor independence. Arruanda (1999, p. 165) pointed out that joint provision of audit and NAS would reduce overall cost, raises the technical quality of auditing, enhance competition. This would ultimately increase auditor independence. Kinney et al (2004) denoted knowledge of a client's information system and tax accounting could spill over to the audit, improve the information available to the auditor and thus improve audit quality which in turn would increase the probability that problems are discovered.

Audit committee

The author Sori (2009) made the study of audit Committee and Auditor Independence through the Bankers' Perception. The questionnaire and the interview survey reveal that the majority of the respondents agreed that auditor independence would be safeguarded by the presence of an active and independent audit committee. The audit committee is responsible for approving and reviewing audit fees as the majority of audit committee members are independent and non-executive directors. Teoh & Lim (1996) in their study find that the formation of audit committees has a strong positive impact on enhancing auditor independence. Similarly, Patten & Nuckols (1970), Knapp (1985) and Lau & Ng (1994) find that the existence of an audit committee increases the likelihood of bankers' approving a loan, which is a reflection of an increased confidence in the auditor. On the contrary, Gul (1989) suggests that audit committees did not significantly affect the perceptions of auditor independence.


Many empirical studies have proven that the high level of competition in the audit firm has resulted in less auditor independence (e.g. Shockley, 1981 [16] ;). However, Gul (1989) [17] who obtains the opposite, in explaining this, he argued that the existence of competition caused auditors to be more independent and create a favourable image in order to maintain their clientele. In a UK study (Beattie et al 1999) competition was the factor influencing auditor AI. The sample comprised of audit partners and the author argued that the factors affecting the perceptions of AI are likely to change over time owing to changes in the local economic, political, cultural and regulatory environment.

Size of audit firm and auditor tenure

Almost all empirical studies that attempted to find relationship between larger audit firm size and AI concluded that there is a positive relation between them [18] (De Angelo 1981). The author DR Zulkarnain (2006) analyses the size of audit firm and perceived auditor independence in his study. Questionnaires and interview survey were used to seek the perceptions of senior managers of audit firms, banks and public listed companies. The result concluded that the Big Four firms were perceived to be superior and more efficient compared to the non-big four firms in all aspects relating to independence from their clients. The respondents indicated that big four auditors are better able to resist management pressure in situations of conflicts and are more effective at detecting activities that will affect clients' company continuity. The non-big four firms are more risk averse with regard to litigation arising from fraud and irregularities compare to non-big four firms.

Most writers [19] , who discuss the relationship between tenure and AI, support that audit firms serving a given client over a longer duration has the risk of losing an auditor's independence. However, in studies conducted by Shockley(1981) and Teoh & Lim(1996) tenure was not found to have a significant impact on perceptions of AI.

Audit and non audit fees

Most empirical studies conducted on size of audit fees do not look at that factor itself; instead the studies are inter-related with other factors. For example, Shockley (1982) in his study suggests that the negative effects of MAS, the size of the audit firm and competition on a third party's PAI actually arise because of the linkage of these variables to audit fees.

However, there is a study that proves otherwise. For example, Gul (1991) who analyses banker's perceptions of AI proves that each independence-related variable such as the audit firm size, affects bankers' PAI in its own right. He also found size of audit fees to be essential factor of bankers' PAI. Another study related to the size of audit fees was by Pany & Reckers (1983).They noted that the large size of the client's audit fee (measured as a percentage of office revenues to the audit firm),though do not show any significant impacts on PAI, have influenced respondents to feel less confidence in the auditor's independence.

Additionally, where non-audit fees are concerned, several prior papers have studied the interests and importance of non-audit fees in terms of auditor independence. Unfortunately, the research stream which evaluates the association between non-audit services and auditor independence, by examining the effect of non-audit fees on the auditor's propensity to issue a going concern modified opinion (hereafter GC), has produced rather mixed results [20] . Researchers in the U.S. suggest that there is no relationship (DeFond et al., 2002; Geiger and Rama, 2003)1. Thus, despite the concerns of the regulators and the financial press, there is no clear evidence that higher non-audit fees negatively affect auditor independence.

Research on audit fees has also documented that client size is an important determinant of audit fees (Simunic, 1980; Francis, 1984), while other research indicates that the relative magnitude of non-audit fees is also higher for larger clients (Abbott et al., 2002). Further, the provision of non-audit services by the incumbent auditor leads to better understanding of the client and knowledge spillovers (Simunic, 1984; Francis, 1984), and thus to a better informed audit reporting decisions. Together, these results suggest that audit opinions may be influenced by the magnitude of non-audit (and audit) fees received from clients. Some prior research base on the effect of non-audit fees on auditor independence is also inconclusive [21] (for example, Wines 1994)

In most empirical studies audit independence is proxied by the relative magnitude of the audit fee as against the NAF received from a particular audit client. Hoitash (2007) hypothesise that the fees paid to auditors can affect audit quality in two principal ways. First, large fees paid to auditors may increase the effort exerted by auditors and thereby increase audit quality. Alternatively, large fees paid to auditors, particularly those that are related to NAS, make auditors more economically dependent on their clients.