The Threat To Auditors Independance And Impartiality

This research is basically to access and analyse the threat to auditor independence and impartiality. This is crucial because the position of an auditor when auditing a financial statement will determine if he or she will be independent and impartial when drawing a conclusion on a financial report. This is why this research is very important. What this research wants to assess is to find out if auditor’s independence and impartiality can be threatened through offering non-audit services to their clients.

Financial report is very important to stakeholders of an organisation. It is also important to prospective investors interested in an organisation. It is also important to the general public as a whole. Therefore, for this reason, the authenticity of a financial report is very crucial and important.

This validation is authenticated by a set of people called auditors.

Stakeholder, investors and the general public will rely on this authenticated report for making decision. However, there is a fact that this report may be misleading and this calls for concern. This is because auditor often offer further services to their clients other than auditing called non-auditing services which may make them impartial when auditing such company’s financial report because of money been realised from non-audit services. This is when Auditor independence and impartiality could be threatened.

This research will be based on this topic, finding whether the provision of these non-audit services can impair the independence and impartiality of auditors.

1.1 BACKGROUND

History reveals that audit is a Latin word meaning “he hears”. Auditing originated in those years when individuals entrusted with public funds were required to give an oral account of their handling of those funds. Porter (1997)

An opinion of an independent chartered accountant is needed to give the public rest of mind that the sets of accounts presented were true and fair and also conform to lay down standards.

Independence is the cornerstone of auditing; Stewart (1977) quoted by Porter. In carrying out the audit assignment, the auditors must be independent i.e. the sense of being self reliant and his/her professional judgement not being subordinated by the opinion of others. (Porter, 1997, p.65)

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It is very important for the auditors to be independent otherwise the audit report will be undermined and lose its value. In order to make the users of information to have faith and rely on the audited account, they must be sure that the audited accounts are independent of entity, its management and other interested party.

This is reflected in the fundamental principles of external auditing- objectivity and independence which state that auditors are objective and they express opinion independently of the entity and its directors. As the guide to professional ethics statement (GPES) 1:201: integrity objectivity and independence explains, objectivity is essential for any professional person exercising professional judgement. Objectivity is sometimes described as independence of mind (Dunlea, A. & Maclochlainn, N. p.19).

However, it is possible to identify some threats to auditors’ independence. The provision of non-audit services by auditors to their client is referred to as a self-review threat to auditors’ independence. This is so because once an auditor of a company starts to provide non-audit services to its client e.g. computation of corporation tax matters and other financial services the auditor and the directors tend to develop a relationship and this may jeopardise the objectivity of the auditor (Woolf, E. 1997, p.11-14).

The provision of non-audit service by auditors to their client is still a topical issue. The New Standards on Ethics issued in October, 2004 by Auditing Practices Board (APB), gave some exemptions to small companies on the provision of non-audit services.

CHAPTER TWO

LITERATURE REVIEW

2.1 INTRODUCTION

Since the introduction of the auditing standard on independence, which requires auditors to be independent of the clients being audited, the maintenance of independence has become a critical issue for the accounting profession. Bartlett, R. W (1993, Online)

The author sees independence in auditing as able to maintain an unbiased mental attitude in making decisions about audit work that one is to report upon.

Bartlett, R. W. (1993) defined independence in auditing to be the auditor’s ability to resist client pressure or and the auditor’s ability to act with integrity and objectivity.

Dunn, J. (1991, p.19) also described independence and impartiality as an attitude of mind characterised by integrity and an objective approach to professional work.

Whittington and Pany, (1998, p.34) sees independence as the ability to maintain an objective and impaired mental attitude throughout the audit assignment or engagement.

There is a general consensus that independence is an attitude of mind, which does not allow the viewpoints or conclusion of the corporate auditor to become reliant on or subordinate to the influence of pressures of conflicting interests; Lee (1993, p.98) quoted by Sherer, M. and Turley, S. (1997).

For the purpose of this research, independence and impartiality will be separated into two related concepts of independence, which are:

Independence and impartiality in fact

Independence and impartiality in appearance.

Independence and impartiality in fact occurs when an auditor displays independence in mental attitude when carrying out his statutory audit assignment while independence and impartiality in appearance simply means that the auditor should be seen as been independent and impartial in the publics’ view (shareholders, Potential investors).

Public confidence would be impaired by evidence that independence was lacking, and/or when there is the existence of circumstances, which the public might believe, is likely to influence independence and impartiality.

The relationship that exists between the auditor and their client should be such that it appears independent to the third party, Bartlett, R. W (1993).

Whittington and Pany (1998, p.35) added that the requirement by the third party from the auditor is to give credibility to the audited financial statement.

The concept of appearance of independence has been primarily concerned with identifying those situations in which a qualified Chartered Accountant might not be perceived to be independent. The mere perception that an auditor is not independent renders his report useless to the shareholders who wish to rely on it for decision-making purpose.

Beattie, V. et al. (1999) stated that,

The reality and perception of auditor independence and impartiality is fundamental to public confidence in financial reporting.

This work will identify and assess the key threat to auditor’s independence and impartiality and concentrate on the provision of non-audit services. This will examine the controversies that exist on the provision of non-audit services and establish the opinions of the public and auditors on such provisions. Later in the course of this research, conclusion will be drawn on the extent to which provision of non-audit service does and is perceived to weaken the auditors’ independence and impartiality.

2.1 ANALYSIS OF THE PRESENT AUDIT SYSTEM

Various factors could be identified in textbooks, articles, journals, auditing standards and the public’s view, which can affect auditors’ independence and impartiality.

Hussey, R. and Lan, G. (2001), identified some of the factors such as: the nature of the auditor-client relationship (Goldman and Barley, 1974), lack of strict auditing regulations, and competitive pressures leading to what has been termed predatory pricing or lowballing and the provision of non-audit services. Beattie and Fearnley, (1994), quoted by Hussey, R. and Lan, G. (2001), (Online).

The auditing practice board (n.d) (Online) categories these threat as follows: Self interest threat, self review threat, management threat, advocacy threat, familiarity threat, and intimidation threat.

Woolf, E. (1997, p.13), lists examples of “threat to Auditors’ independence” as follows:

Undue dependence on a single audit client, overdue fees, litigation, external pressure or influence, family and other personal relationship, beneficial interest in shares (other investment) and trust, trustee investment in audit clients, voting on audit appointment, loans to and from client, receipt of hospitality or goods and services on preferential terms, and provision of non audit services to audit clients etc.

Beattie, V. et al. (1999) stated the principal threat factors to independence relate to economic dependence and non-audit service provision. I have chosen to concentrate on how the provision of non-audit poses a threat to auditors’ independence, (Online).

According to the Auditing standards guidelines (online, n.d.), “non audit services” comprises:

Any engagement in which an audit firm provides professional services to an audit client other than pursuant to:

the audit of financial statements; and

those other roles which legislation or regulation specify can be performed by the auditors of the entity.

An online source (n.d.) defined, non-audit service as those services that are permissible under applicable legislation and that are routine and recurring, that do not impair the independence and impartiality of the auditor, and are consistent with APB rules on external auditor independence.

Other services that are rendered by auditors apart from auditing are: bookkeeping or other services related to the accounting records or financial statement, financial information systems design and implementation, actuarial services, internal audit outsourcing services, management functions, human resources, broker-dealer, investment adviser, legal services just to mention a few. (Online)

The Authors’ research as indicated that over the years, there as been a growing dissatisfaction among investors and other users of financial statements about auditors’ provision of non-audit service. These services are perceived to weaken auditors’ independence when both audit work and non audit work are performed by the same audit firm to the same audit client.

Barkess and Simnett, (1994), disagreed with the view that the provision of non-audit service does impair auditors’ independence and impartiality. They argued that there is no relationship between the level of other services and the type of audit report issued; hence they concluded that, the provision of other services by the external auditors to their clients does not compromise the independence of the external auditors.

The accounting profession also disagreed about whether non-audit services impaired the performance of the audit and financial reporting process. Several auditors are of the opinion that when they understand the factors that influence and improve the entity’s performance, then they will be able to focus their audit on those critical issues.

Others view provision of non audit service, as an impediment to independence because, in some cases, the fees from the provision of non-audit services are more than that of audit fees. If the income earned from provision of non audit service, is more than that of audit service, auditors have naturally tendencies to lose their independence, considering the cost of losing a client can be considerably more than simply the audit fees.

From an online source from wiley.com, it was established that the Securities Exchange Commission, in the United States of America, carried out a research in 1999 and discovered that:

4.6% of Big Five SEC audit client paid consulting fees in excess of audit fees. The SEC is concerned that the more the auditor has at stake in its dealing with the audit client, the greater the cost to the auditor should he or she displease the client, particularly when the non-audit service relationship has potential to generate significant revenue on top of the audit management.

The SEC concluded that issue that impairs auditor’s objectivity are subtle and that certain non-audit services, when provided by the auditor do create inherent conflicts, (Online). http://www.wiley.com

In a situation where an auditor assists an audit client with their bookkeeping services, this places the auditor in the position of later having to audit his or her own work. It is rather unprofessional for the person who prepared the account to also audit the account. When such happen it is practically impossible to expect the auditor to be able to audit those same records with an objective eye.

In the same vein, when an auditor performs certain valuation services for the audit client, can such auditor raise questions in line with valuation of assets at the end when auditing that same audit client? An auditor who has appraised an important client asset at a period during the year is less likely to question his or her own work at year-end.

Various examples can be used to see how the provision of non-audit service will impair audit independence.

An auditor who provides services in a way that is tantamount to accepting an appointment as an officer or employee of the audit client cannot be expected to be independent in auditing the financial consequences of management’s decisions. An auditor who has also helped an audit client to negotiate the terms of employment for a new chief financial officer is less likely to bring quickly to the audit committee questions about the new CFO’s performance.

Considering the following examples of non audit services rendered by auditors to their audit client, it would be seen that such services not only impair auditors’ independence but also shows that the accounting profession is not prepared to provide the reasonable assurance that the public expects.

Graeme, W. (1994), carried out a further investigation on whether there is the potential for an appearance of auditor independence impairment when higher levels of non-audit services are provided to audit clients. He investigated this, by analyzing the audit reports for a sample of publicly listed companies over a 10 years period. The results of his analysis revealed that the auditors of companies not receiving an audit qualification of any type over the period derived a significantly higher proportion of their remuneration from non-audit services fees than the auditors of companies receiving at least one audit qualification, (Online)

The result of his findings could suggest that auditors are less likely to qualify a given company’s financial statements when higher levels of non-audit services fees are derived.

Firth M. (1997) in his write up concluded that, the provision of non-audit services to audit clients does increase the economic bond between the auditor and client. This bond, he said, is perceived as impaired auditor independence (Beck, Frecka, and Solomon 1988b; DeBerg, Kaplan, and Pany 1991; Pany and Reckers 1983, 1984), quoted by Firth, M.

Firth, M. further affirms this by given two reasons to believe that such service impair independence:

The audit firm is unwilling to ‘criticize’ the work done by its consultancy division, and secondly, the audit firm does not want to lose lucrative consultancy services provided to the audit client and is, therefore, more reluctant to disagree with management’s interpretations of accounting matters.

He concluded that, auditors disagreements with management could lead to a change of auditor, a move which implies not only a loss of audit fees but, in all probability, a loss of consultancy fees as well. (Online)

On one hand, many practitioners (auditors) are adamant that their auditing firms are able to wear both the hats of auditor and consultant without reducing the effectiveness of either service (Burton, 1980; Carey and Doherty, 1966; Klion, 1978; Mednick, 1990) quoted by Bartlett, R. W. (1993).

The supporters of the opinion that non-audit service does not impair auditors’ independence argue that independence is a quality of auditor professionalism which can have a range of values:

…like all attributes of professionalism, independence is a matter of degree. Those arguing that independence is impaired by combining consulting and auditing have assumed that independence must be absolute, while their opponents have recognized that independence is a matter of degree and have decided that the auditor can achieve the necessary degree of independence and act in the dual capacity of auditor and consultant. Carmichael and Swieringa (1968) quoted by Bartlett, R. W. (1993).

Auditing Practice Board under the Accounting Standard Board maintained its stand that the provision of non-audit services to audit clients does reduce the public confidence in the independence of the auditor, Bartlett, R. W (1993).

However, consideration was given to small entities. A small entity is defined for the purposes of ES-PASE as;

“As a company which is not a UK listed company or an affiliate thereof that meets two out of the following three criteria: turnover below £5.6 million, balance sheet total below £2.8 million and employees below 50.

ES-PASE:

Provides auditors of Small Entities with procedures as an alternative to the safeguards described in Ethical Standards 1- 5, in relation to threats to independence created when the auditors have a degree of economic dependence or where they provide non-audit services to their audit clients;

Makes available exemptions to the auditors of Small Entities in relation to:

The prohibition on auditors representing their clients at tax tribunals;

The prohibition on auditors providing non-audit services, including tax and accountancy services, unless management is sufficiently ‘informed’ to make independent judgements and decisions in relation to them. (APB, 2010 Online)

2.2 AUDIT STRATEGY CONCEPT

In the USA, the General Accounting Officer (G.A.O.) did a graphical representation of both the permitted and prohibited audit work to audit client:

The standard for non-audit services was said to employs two major principles:

Audit organizations should not provide non-audit services that will involve performing management functions or making management decision.

Audit organizations should not audit their own work or provide non-audit services in situations where the non-audit services are significant to the subject matter of the audits.

Please, note: an APPENDICE 2.2.1 has been inserted for table of permitted & prohibited non- audit service TABLE before References page.

2.4 AUDIT CONCEPTUAL FRAME WORK

The contention on the provision of non-audit service has been critically analysed. Different views of all stakeholders concerned with the provision of non-audit services to audit client have been examined. A logical conclusion has been drawn, as to the extent to which provision of non-audit service does and is perceived to weaken the auditors’ independence. The accounting profession has also reviewed the statement of Auditing Standard on auditors’ independence, knowing fully well that, without value in the auditor opinion, there would be no demand for audit service.

Various proposals have been propounded for protecting auditors from the undue influence of directors and regarding the provision of non audit services. There have been many similarities with the proposals of Institute of Chartered Accountants of Scotland and the Board for Chartered Accountants in Business, in considering possible mechanisms to remedy the perceived weaknesses of regulations, practises on other audit services.

They concern is to whether there should be a prohibition on firms undertaking work other than audit for their audit clients or whether there should be compulsory rotation of audit firms, after a fixed period of say anything between 5 and 12 years or whether the responsibility for the development of auditing standards and guidelines be distanced from the Institute of Chartered Accountants in England and Wales?

The conclusions it reached were that to prohibit additional work or require compulsory rotation of audit firms would increase clients’ costs, reduce efficiency and place restrictions on the freedom of the client to make decisions on the services they desired. The Board was also opposed to the establishment of another body to control auditing practices. It argued that this would lead to a bureaucratic, inflexible framework without the advantage of the accumulated experience of the accounting profession.

They came out with these conclusions as regards non-audit service that;

Auditors should no more be allowed to undertake work other than audit work for the same client. They recommended that there should be compulsory rotation of audit firm after a fixed number of years. This will break any relation that might exist between auditor and company management and would also make the auditor to perform his job without been biased knowing that other auditor (firm) will come in after him (them).

“An audit can only be effective if the auditor is independent and is believed to be likely to report breaches of the contract between principals (shareholders and lenders) and agents (managers)”

(Fearnley & Page, (1994), quoted by Hussey, R. and Lan, G. (2001)

CHAPTER THREE

RESEARCH OBJECTIVES

To carry out a critical literature review to identify and assess the key threats to auditors’ Independence and impartiality.

To examine the controversies on the provision of non-audit service.

To carry out empirical research to establish the opinions of auditors on the provision of non-audit service, to know whether it can pose a threat to auditors’ independence and objectivity.

To come to a conclusion on the extent to which the provision of non-audit service does and is perceived to weaken the independence and impartiality of auditors.

3.2 RESEARCH OBJECTIVES

After carrying out a literature review to collate data on the views of different authors on issue of provision of non audit services to audit client and how this is viewed to threaten auditor’s independence and impartiality, a set of questions will be prepared. This is necessary so as to be able to have a wide range of auditors and entrepreneurs view on the subject matter.

In order to obtain relevant information needed to achieve the objectives stated below, questionnaires will be sent and delivered to some twenty five auditing firms and fifteen small business entities for the following reasons:

To examine the controversies on the provision of non-audit service.

To analyse and establish the opinions of auditors on the provision of non-audit service, to know whether it can pose a threat to auditors’ independence, impartiality and objectivity.

To draw a conclusion on the extent to which the provision of non-audit service does and is perceived to weaken the independence and impartiality of auditors.

3.3 RESEARCH APPROACH

3.3.1 RESEARCH PHILOSOPHY

Blaikie, N. (2003) defined positivism as the research that assumes that social reality is external to people involved and only the aspect that can be measured are regarded as relevant to research.

Jackson, W. (1995) stated that research just like positivism relies on experiments, survey and secondary data, therefore my research philosophy is positivism based. The author will be using questionnaire which comes under the Survey category.

3.4 RESEARCH STRATEGY

The deductive approach or research strategy will be used for this research because, sufficient materials like journals, articles and periodicals are available to carry out a test on how the provision of non-audit service does and is perceived to weaken the independence of auditors.

This research approach will involve different researches strategies ranging from Experiment, Survey, Case Study, Ethnography and action Research but the Survey strategy will be used for this research.

Survey strategy and questionnaire option are chosen under this category leaving behind the structured interview and observation.

Kumar, R (1999, p.104) stated that sometimes information required to carry out a research are readily available but needed to be gathered or collected from different sources to get the clue to what one is trying to find out or achieve.

To achieve the objective of this research as earlier stated above, questions will be tailored to answer the Research Objectives.

Questionnaire was chosen because it allows the collection of data from a sizeable population i.e. auditing firms and small business entities as stated in the literature review.

The delivery and collection questionnaire method is considered appropriate for this research. The questionnaire will be delivered in person to selected auditing firms and small business entities, asking them of a possible date of collection. This is chosen to be the best form of questionnaire method necessary to achieve the aim of the research, Saunders et al (2001)

The author considered interview as another option to this research, but realised that time may be a limiting factor. It may be impossible to interview Twenty five auditing firms and fifteen small business entities due to time frame.

The author also considered the convenience of answering the structured interview as respondents may be busy with other business matters on the day of interview. This may cause lack of concentration or simply not getting the best from the person interviewed.

If time permits, additional information through interview would be gathered. This will be done by carefully selecting respondents from the questionnaire who are willing to supply more information on the subject matter and are ready to be interviewed, to assist in achieving the objective of the research.

A question will be in the questionnaire asking whether respondent are willing to give further information to help achieve the research objective (Interview).

Other research strategy or methods are considered in appropriate for this kind of research.

ADVANTAGES OF QUESTIONNAIRE

Questionnaires are generally seen as been cheaper to administer compared to interviews. Researchers and authors believe that questionnaire saves time, human and financial resources.

Bryman, A. (2004, p. 133) added that, the reduction in cost of carrying out a research is an advantage considering a sample that is geographically widely dispersed.

Questionnaires are also quicker to administer as they can be sent out through the post, distributed in an office, school or working place etc.

It also offer greater anonymity as some questions are sensitive and are best asked without face to face interaction, Kumar R. added.

This allows the respondent to freely express his/her opinion on the topic of research.

According to Bryman, A. (2004), it has been argued that the characteristics of the interviewers (and respondents) do affect the answers that people give. It was discovered that characteristics like ethnicity, gender, social background of the interviewer may combine to bias the answers that the respondent provides.

This is also part of the reason why questionnaire was chosen to be the most appropriate method of data collection.

DISADVANTAGES OF QUESTIONNAIRE

Despite all these advantages, questionnaire also has its own disadvantages and these are discussed below:

Questionnaire can only be applied to a population that can read and write. This does not provide opportunity for the population sector that is part of the research that is illiterate, very young or old, or handicapped, Kumar R. stated.

A low response rate or low feedback from the distributed questionnaire is a major disadvantage of the use of questionnaire. Some of the distributed questionnaires are thrown in the waste bin, some are forgotten where they are kept by the respondent; these do not make the researcher to get a perfect picture on the subject matter and conclusion may be drawn from few respondent who returned the questionnaire.

Kumar, R. (1999), stated factors that can contribute to low response of the questionnaire as follows:

The interest of the sample population on the topic of study; the layout and length of the questionnaire; the methodology used to deliver the questionnaire.

In tackling these factors for the purpose of this research, I have carefully selected auditing firms that are directly involved in provision of non audit services. I have also considered the small business entities that desire the use of auditors for both auditing purposes and non audit services.

Gill, J. and Johnson, P. (1997, p.89), stated that all questions in the questionnaire should be really relevant to the research question, therefore I have handled the issue of relevance, layout and length of question with care.

I have also made up my mind to deliver the questionnaires in person to the sample of population selected and asking a convenient day and time for collection of the questionnaire. This approach will assist to reduce the problem of low response rate experienced using questionnaires.

Another disadvantage of questionnaire is that respondent does not have the opportunity to ask for clarification on issues. This does affect the quality of information supplied by respondent. The may also cause collation problem for the researcher, if different respondent interpret same question differently. In handling this, the questions in the questionnaire will be set in a simple and unambiguous manner. The questions will be stated in clear terms for all to understand.

Questionnaire cannot probe, stated Bryman, A. (2004). The researcher cannot probe further on an issue apart from that which is in the questionnaire.

The only way that questionnaire can be made to probe is by asking an open-ended question.

In Open- ended questions possible responses are not given to the respondent. The respondent write down the answers in his/her words, Kumar, R. (1999, p.116)

The disadvantage of open ended questions is that it may be difficult for the research to summarise his find as opinion of respondent may be far apart/ different from each other making it difficult for researcher to summarise and conclude.

Kumar, R. (1999), gave another disadvantage of questionnaire as its inability to be supplemented with other information like interview which can be supplemented with observation.

To handle this, if time permit as earlier stated an interview will be conducted to supplement (additional information) the information gathered through questionnaire.

CHAPTER FOUR

RESEARCH METHODOLOGY

1. Conduct a review of literature on auditing in relation to auditors

Independence and threat to auditors’ independence in order to develop research question.

2. A questionnaire will be developed with question based on the background and objective of the research.

The questions in the questionnaire will seek to test the research question; does the provision of non-audit service, pose a threat to auditors’ independence?

The questionnaire will be distributed to a sample of 20 auditi