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EFFECTS OF AUDITORS’ INDEPENDENCE ANALYSIS AND RECOMMENDATIONThe purpose of this research is twofold. First, it is devoted to explain auditors’ independence, which is the corner of auditing profession. Emphasis has been given to possible factors that are considered to impair auditors’ independence in the performance of their duties. Secondly, it specifically treated the effects of non audit services and fees on auditor independence
EFFECTS OF AUDITORS’ INDEPENDENCE ANALYSIS AND RECOMMENDATIONThe purpose of this research is twofold. First, it is devoted to explain auditors’ independence, which is the corner of auditing profession. Emphasis has been given to possible factors that are considered to impair auditors’ independence in the performance of their duties. Secondly, it specifically treated the effects of non audit services and fees on auditor independence
2009
Fekadu BelaynehStrayer University
June 2009
Effects of Auditors’ Independence 2
EFFECTS OF AUDITORS’ INDEPENDENCE
Effects of Auditors’ independence on Public Accounting Profession
A research paper prepared in partial fulfillment for the degree of
Masters of Science in Accounting
Fekadu Belayneh
Strayer University
June 5, 2009
Effects of Auditors’ Independence 3
Running Head: Effects of Auditor Independence
Effects of Auditors’ Independence 4
Abstract
The purpose of this research is two fold. First it is devoted to explain auditor independence,
which is the corner of auditing profession. Emphasis has been given to possible factors that are
considered to impair auditor independence in the performance of their duties.
Secondly, it specifically treated the effects of non audit services and fees on auditor
independence.
The coming into being of Sarbanes- Oxley act of 2002 has been critical to bring about check
and balance in audit engagement process.
The SEC requirement about disclosure of non-audit fees has to larger extent affected auditor
independence. As auditor independence is critical to gauge and subjective to evaluate, it is
probably helpful to focus on factors that causes impairment of independence and look for means
and ways to improve independence which is otherwise called corner stone of auditing profession.
Key words: Independence
Securities and Exchange Commission
Audit fees
Non-audit services
Public Company Accounting Oversight Board
Effects of Auditors’ Independence 5
Acknowledgment
First of all, I would like to express my heart-felt feelings for the almighty Lord who helped
me accomplish the research from beginning to end.
I am also indebted to all members of Strayer University LRC for providing me with the
necessary materials to conduct the research.
I would also like to thank my Professor, Bill Makkawi, who has been very crucial in
providing me with the necessary direction and invaluable comments during the course of the
research.
Last but not least, I would like to extend my special thanks to my wife, Kidest Tadesse and
my three beautiful kids (Nate, Beza and Ruth) for their patience and love that enabled me to
complete the research paper.
Effects of Auditors’ Independence 6
Table of contents
Title Page
Chapter one: Context of the Problem ……………………………………… 7
1.2 Statement of the Problem…………………………………… 10
1.3 Research Question…………………………………………… 11
1.4 Significance of the Study………………………………………. 12
1.5 Research design and Methodology…………………………… 14
1.6 Organization of the Study……………………………………… 15
Chapter Two: Literature Review……………………………………………… 16
Chapter Three: The rationale of Auditor Independence…………………...... 22
Chapter Four: Factors Affecting Auditor Independence…………………… 27
4.1 Provision of Non audit services……………………………..... 28
4.2 Client-size…………………………………………………… 36
4.3 Audit firm tenure……………………………………………….37
4.4 Alumni affiliation………………………………………………37
4.5 Disclosure of Non-audit fees………………………………….. 39
4.6 Training of Auditors…………………………………………. 41
Effects of Auditors’ Independence 7
Title Page
4.7 Audit Committee……………………………………………… 41
4.8 Culture of the Audit firm……………………………………… 42
4.9 Auditors’ ethical and moral characteristics…………………… 43
Chapter Five: Audit and Non-audit fees- Conflict of Interest……………….... 44
Chapter Six: Conclusion and Recommendation……………………………… 47
References…………………………………………………………….. 52
Effects of Auditors’ Independence 8
Chapter one
Context of the problem
The public accounting profession passed through several difficulties over the past few years.
Being a prominent discipline since long time, it provided the public with a professional service to
affirm its commitment to providing assurance about financial information.
The role of accounting in the current global economy has been of paramount importance.
More specifically, auditors find themselves in a situation where they are all required to abide by
set of rules and regulations- independence being the cornerstone of their day- to-day activity.
According to AICPA “ Independence is the state of mind that permits the performance of an
attest service without being affected by influences that compromise professional judgment,
thereby allowing an individual to act with integrity and exercise objectivity and professional
skepticism”. (“Independence”, 2004, para.4)
This requirement has been a challenge for many auditors for it is the basis by which their
relationship with clients is to be evaluated. From this it follows that auditors should exercise
independence in the performance of their duties and responsibilities.
In the recent past we have witnessed facts where the auditor’s lack of independence resulted
in the closure of the biggest firms. Cases in point are the Enron and WorldCom fiascoes that
focused the attention of the investing public.
The issue of independence is described as a “corner stone of auditing profession that helps to
ensure quality audits and contributes to financial statements.” (Lindberg and Beek2004, para.3)
Effects of Auditors’ Independence 9
As mentioned above, the cardinal principle of auditing which is independence has been
challenged by two major issues- Non audit services and auditor-client relationship. This is
related with the high audit fee that the audit firm expects from its client that brings about a
conflict of interest thereby affecting the independent performance of auditors in attesting the
financial statement of the client. In an attempt to relate Auditors’ independence with non audit
service SEC (2000b) expressed its concern in the following way:
“the rapid rise in the growth of non-audit services has increased
the economic incentives for the auditor to preserve a relationship
with the audit client, thereby increasing the risk the auditor will be
less inclined to be objective…”
AICPA has also been consistently focusing on the issue of independence and its impacts on
the overall operations of various firms. Accordingly, it explains the issue in the following way:
“Independence shall be considered impaired by an auditor when he makes management
decisions on variety of factors. Generally, CPAs are not independent if they are in a position to
influence, provide certain accounting services, or have financial interests in an entity. A CPA is
required to document any possible situations that might impair his or her independence on an
engagement, inform his or her CPA firm, and inform the potential client if any such situations
may exist.” (“Independence”2006, para.4)
For the most part, independence is explained by the conflict of interest arising as a result of
the nature of relationship that audit firms establish with their clients. This means that some of the
audit firms might provide the public with misleading financial statements because of their
ulterior motive.
Effects of Auditors’ Independence 10
Although we are not focusing on the Enron debacle, it would be beneficial to raise the issues
of independence of the audit firm, Arthur Anderson, who provided unqualified audit report for
consecutive years while Enron’s financial statements were in complete mess. According to
David (2003), “Arthur Andersen's audits of Enron's financial statements during each years
resulted in unqualified reports. In other words, Andersen expressed its opinion that Enron's
financial statements fairly presented, in all material respects, Enron's financial position in
accordance with Generally Accepted Accounting Principles.” (p. 5)
One may ask as to what is the motive behind such misrepresentation of financial statements
while the reality is just the opposite. As stated above, independence of auditors could be
primarily affected by their relation with the clients. It is evident that clients have an upper hand
in their relation with audit firms. With respect to the relationship between Anderson (the audit
firm) and Enron, it appeared that the former excessively intervene in the internal operations of
the latter. This situation resulted in loss of confidence on the audit firm for the simple reason that
it compromised its independence and integrity.
The issue of independence has been the focal point especially after the collapse of Enron.
Several firms were forced to shut down their business as a result of Auditors report that did not
reveal the actual financial standing of the firms.
In order for auditors to live up to the public expectation, they should qualify for the minimum
standards of professionalism- their independence. Their integrity should well be restored. The
accounting educators are expected “to help restore the credibility of the critically important, if
long underappreciated, independent audit function”. (Knapp, 2006.p1).
Effects of Auditors’ Independence 11
Among some of the factors affecting auditor independence is the non- audit service that the
audit firm provides to the clients. There has been regulation on how to break down and disclose
those fees in an attempt to protect the principle of independence.
The focus of the auditor independence standard is to better serve the public interest and to
maintain a high degree of integrity, objectivity, and independence for audits of government
entities. The standard includes a principle-based approach to addressing this issue, supplemented
with certain safeguards. The independence standard for non-audit services is based on two
overarching principles:
1. Auditors should not perform management functions or make management decisions.
2. Auditors should not audit their own work or provide non-audit services in situations
where the amounts or services involved are significant or material to the subject matter of
the audit. (“Independence”, 2006)
When we raise the issue of independence, the effects of the provision of non- audit services
come into the picture. There is a wide spread perception that the provision of non-audit services
undermine auditor independence (Islam,Karim & Van Zijl, 2005).
Generally speaking, the purpose of this paper will be mainly analyzing those factors affecting
the independent performance of an auditor.
1.2 Statement of the Problem
Independence is one of the core elements of Auditing profession. Auditors are always
expected to be objective in their attitude and performance of duties during their engagement
with their clients. However, the independence functions of Auditors are affected by such factors
Effects of Auditors’ Independence 12
as audit fees, non-audit fees, size of the firm and so on. Lack of independence resulted in loss of
public confidence towards audit professionals.
1.3 Research Questions
It is evident that the general public attaches great importance to the functions performed by
Auditors. Auditors need to provide the general public with unbiased and objective audit findings.
The ultimate objective is to provide third parties or the public with their findings on the accuracy
of financial statements. Regarding this fact, (Hopwood, Leiner & Young, 2008) stated that the
Auditors’ objective is to determine whether the financial statements are free of material
misstatement, whether from error or fraud. From this it follows that such an objective could be
attained if independence of auditors is not impaired by factors described in this research paper.
Therefore the purpose of this research is to analyze and determine how the independent
functioning of Auditors serves as a core element in audit engagement process and what major
factors affect independence of Auditors? In order to effectively answer this question, the
following sub-question will be touched upon.
1. What does Auditor independence entail in general?
2. What specific factors are considered to have influence on independent functioning of
an Auditor?
3. Why audit and non-audit fees are the main causes of conflict of interest of Auditors?
Effects of Auditors’ Independence 13
1.4 Significance of the study
It has become critically important to look into the independence related problems associated
with audit firms in their engagement with their clients. Over the past few years, we have
witnessed the collapse of many companies due to problems linked with the lack of independence
in their audit firms.
As it is clearly stated in Generally Accepted Auditing Standards, auditors are expected to
be independent in mental attitude in all matters related to their assignment (AICPA, 2005).
Despite this accepted principle, many audit firms violate this core principle primarily because of
the large sum of audit and non-audit fees they receive from their clients.
In an attempt to cite a realistic example of the lack of independence associated with Arthur
Andersen, an accounting firm that audited Enron’s financial statements, David ( 2003) explains
the fact that conflict of interest simply overwhelmed prudential consideration and millions of
dollars were at stake- not only audit fees but also consulting revenues.
This implies the fact that the core element on which the auditing profession is built is
always in danger in so far as the client has an upper hand in providing the audit fee. It is also
important to clearly limit the type of activities that an audit firm is expected to perform for its
clients.
Many problems arose when audit firms excessively interfere in their clients’ internal
operation by compromising their independence. Because of this, when they issue their opinion, it
could be hard to be impartial.
Effects of Auditors’ Independence 14
To maintain overall revenues and firm profitability, accounting firms began to place more
emphasis on non-audit services. The relative reduction in audit fee revenue and relative increase
in reliance on revenues from non-audit services may have placed increased pressure on auditor
independence (The CPA Journal, 2005)
In light of the above issues mentioned, this research will try to address basic factors
contributing to the lack of independence of Auditors. It will also try to reveal some of the
conflicting interests of audit firms in the performance of their duties to their clients. As we
discussed in the background of this research, there are so many factors to be considered in
dealing with independence issues.
In dealing with independence “Financial relationships and interests as well as the safeguards
regarding non-audit financial services offered by audit firms are among the issues of continuing
concern…” (Auditor Independence, 2005, para.3)
Generally speaking, the investing public expects the audit firms and the CPAs to act
responsibly and without bias when they issue their audit opinion. For the last many years, audit
firms have been accountable to their clients rather than to the public. The public require each
audit firm to issue its qualified or unqualified audit opinion of companies by employing the basic
auditing standards of independence. Regardless of this fact, this process has been deeply
challenged over the past years. And that is why this research is significant in revealing those
factors apart from the audit fees that are affecting the independent functioning of Auditors
recommendations.
Effects of Auditors’ Independence 15
1.5 Research Design and Methodology
Basically, it is the researcher’s plan to make use of qualitative research methodology to
gather, analyze and interpret data concerning the independence of Auditors. Quantitative method
will also be used to a certain extent.
In an attempt to make the best use of a qualitative research, the actual research will employ
content analysis whereby it is possible to systematically examine the varying concepts Auditor
independence and some of the factors therein.
This procedure applies to the research due to the fact that it is suitable for analyzing issues
surrounding independent functioning of Auditors.
The specific data gathering method to be applied to the research consists of secondary data
(Journals, web-resources, conference papers, text books, etc) to be collected from libraries and
internet resources.
The research basically addresses all accounting professionals who are trying to improve the
standards of the discipline and who may be helpful in providing information on the subject.
It is believed that this research is directly relevant to the current study of Accounting the
researcher is engaged in.
Any research is not free from bias. Due to the qualitative nature of data gathering, the
researcher is concerned not to be biased in limiting himself with those data written on problems
associated with independence of Auditors disregarding some of the positive elements in it.
Effects of Auditors’ Independence 16
1.6 Organization of the study
The first chapter of the research paper devotes itself to providing background information
related to the research topic of interest – Auditor independence within the context of the
statement of the problem mentioned therein. The main research question is also given with four
related sub-questions and an overview of the significance of the study. The second chapter
presents the review of literatures written in the areas of public accounting profession, challenges
of Auditor independence and factors affecting independence. An analysis of the role of
independence of Auditors in Audit firms’ financial statement has been briefly touched upon.
Chapter 3 provides basic understanding as to what is meant by auditor independence in general.
Chapter 4 deals with explaining major factors considered to have influenced independent
functioning of an Auditor. The role of audit and non-audit fees will be described in depth.
Chapter 5 presents the main reasons and significance of audit and non audit services and outline
some of the regulatory framework within which audit firms implement their services. The last
chapter concludes the paper by summarizing and providing recommendations.
Effects of Auditors’ Independence 17
Chapter Two
Literature Review
The concept of auditor independence has been special area of concern since the collapse of
the big accounting firms in the last decade. Knapp (2006) underscores that a series of high
profile scandals and the collapse of Enron and World com “focused the attention of the investing
public, business journalists, wall street and eventually the U.S. congress on our profession” (p.
xvii). The main problems of the scandals were associated with the lack of integrity by the then
famous accounting firms in the performance of their duties. Knapp (2006) continues to
emphasize that a renewed dedication on the part of the accounting firms will have “a far reaching
implications for the independent audit function in coming years” (p. xvii).
The issue of independence has been exhaustively argued to have been looked at in two
different perspective- independence “in fact” and independence “in appearance”.
The CPA journal (2004) states that an auditor who is independent in fact has the ability to make
independent audit decisions regardless of whether there is a perceived lack of independence.
Regarding the public outlook on auditor being independent “ in fact”, the journal continue to
state that even though the auditor is independent “in fact”, the public believe that there are some
factors that lead the public to believe that the auditor does not appear independent.
It went on emphasizing the fact that “since auditor independence in fact is a mental state,
investors and other users of financial statements can not accurately assess actual auditor
objectivity; thus even when an auditor acts independently in fact and issues an unbiased audit
Effects of Auditors’ Independence 18
opinion, investor confidence is eroded if investors and other users of the financial statement
information do not perceive that the auditor was independent in appearance”.
On the same subject of independence, it has been noted that auditors should comply with
generally accepted auditing standards that require that auditors perform the engagement with due
care and an objective state of mind. (“Auditor’s responsibilities,”2000, para.8). The article also
stresses on how auditors remain independent by taking into account the context in which they
practice, the risk to independence and the safeguards available to them. (p. 7).
It is true that the investing public attach much more importance with the way the auditors are
operating. In view of this expectation, it is firmly stated that “the fact and appearance of
independence is the independent auditor’s most fundamental distinguishing professional
characteristics given their primary role to serve as unbiased competent witnesses of management
prepared financial statements. They must thus avoid situations that may lead to outsiders to
doubt their independence” (Auditor Independence, 2001, para.1).
This refers to the fact that providing auditing services to clients should be performed
independently to meet the public demand. Nevertheless, this expectation has not been realized
and still remains to be a problem.
In an attempt to give emphasis to the problems associated with independence it has been
stated that “Independence derives the accounting profession which survives on the public’s faith
in the integrity and objectivity of its opinion. However, the increasing size and number of CPA
firms’ non-audit engagement has raised concerns of potential conflicts of interest that could
compromise independent audit services” (Auditor Independence, 2001, para.2).
Effects of Auditors’ Independence 19
Though it seems hard to evaluate, auditors are required to adhere to the principles of
independence to perform their duties without being prejudiced by such factors as the size of the
audit fees they receive from their clients and non-audit service fees. It is argued whether auditors
independence is a function of non audit fee ration (ratio of non-audit to total fees from a client)
or client importance (the ratio of fees from a given client to total revenue (Ghosh, Kallapur and
Moon, 2006).
Regarding clients financial power over the auditor, it is noted that “many clients who perceive
that audit service do not add value also aggressively negotiate for lower audit fees”(Auditor
Independence, 2001, para.4). In such a situation, auditor independence will be in jeopardy.
McGrath (2001) also pointed out possible threats to independent performance as self interest, self
review, advocacy, familiarity (or trust) and intimidation. Apart from financial interest, these
factors are also considered to affect independence.
AICPA, in its practice alert 99-1, elaborates the above mentioned risks in the following way:
Self interest risk- a threat that arises from an auditor acting in his or her own
interest
Self review risk- a threat that arises from an auditor reviewing his or her own work
by others in the auditor’s firm
Advocacy risk- a threat that arises from an auditor acting as an advocate for or
against an auditee’s or opinion rather than as an unbiased attester
Effects of Auditors’ Independence 20
Familiarity or trust risk- a threat that arises from an auditor being influenced by a
close relationship with an auditee.
Intimidation risk- a threat that arises from an auditor being in appropriately pressured
by an auditee or by another interested party.
Capitalizing on the factors to be considered on independence, the Canadian Institute of
Chartered Accountants (CICA) on its on-line publication stated the following:
“The significance of a threat depends on factors such as its force,
the stature of the persons involved, the nature of the matter causing
the threat and the strength of the auditor’s integrity….. A threat can
be considered significant if, considering all of its quantitative and qualitative
aspects, it increases the level of independence risk to an unacceptably high
level.”
Apart from the general view that auditor’s independence can be impaired due to factors
described previously, many attribute this issue to specific monetary benefits derived from the
audit engagement process, be it the regular audit fee or the peripheral services such as non-audit
fees.
Effects of Auditors’ Independence 21
Flaming (2001) also indicated the provision of non-audit services reduces investors’
judgments of auditor independence, audit quality and the attractiveness of the firm as an
investment.
Over the last decade, many companies were forced to collapse as a result of independence
related issues. Miller (2001) points out that “Anderson appears to have failed miserably in its
responsibility as Enron’s auditor” (p.5). In order to alleviate the problems an audit firm may have
with regard to independence, the Securities and Exchange Commission (SEC) promulgated
several guidelines. (Palm rose and Saul, 2001) mentions the new rules that “prohibits accounting
firms from providing certain non-audit “consulting” services to their audit clients”.
Emphasizing on the issue of independence (Beck and Lindberg, 2004) stated that the Enron
bankruptcy had great impact on the public attitude towards what is expected of auditors. The
service rendered by any incumbent audit firm to a client is highly restricted by Sarbanes-Oxley
act of 2002. This act was necessitated to minimize any possible interference of the audit firm into
internal operation of any potential client.
There is a general consensus in the fact that auditors may act favorably towards their client
from whom they receive a large sum of non-audit fees. The Sarbanes-Oxley act of 2002 restricts
a registered public accounting firm from providing non-audit service to its clients. Some of such
services are outlined below (Sarbanes-Oxley, 2002).
Bookkeeping or other records related to the financial statements of the audit client
Financial information system design and implementation
Appraisal and valuation services
Effects of Auditors’ Independence 22
Internal audit outsourcing services
Management functions and human resources.
In general, it is very important to recognize the type of audit service that would affect
independence of auditors.
Effects of Auditors’ Independence 23
Chapter Three
The rational of Auditor Independence
As has been explained in the previous chapter, auditor independence is the corner stone of
auditing profession. Auditors need to show their integrity to the general public and be abiding by
set of rules and regulations.
The Securities and Exchange Commission has stipulated major requirements of auditor’s
independence in its final rule of 2001 and adopted certain amendments. Auditor independence
has been explained in the executive summary of this amendment as follows:
“Independent auditors have an important public trust.
Investors must be able to rely on issuers' financial statements.
It is the auditor's opinion that furnishes investors with critical assurance
that the financial statements have been subjected to a rigorous
examination by an objective, impartial, and skilled professional, and that
investors, therefore, can rely on them. If investors do not believe
that an auditor is independent of a company, they will derive little confidence
from the auditor's opinion and will be far less likely to invest in that public company”
It is also argued that the investor’s attitude towards the day to day performance of an auditor
impacts to a great extent how the auditor can accomplish the task objectively. With respect to the
investor attitude ( SEC 2000 ) states the fact that an auditor may not be operating independently
Effects of Auditors’ Independence 24
if a reasonable investor with knowledge of all relevant facts and circumstances concludes that
the auditor is not capable of exercising objective and impartial judgment ( p.3)
One should always analyze the importance of independence to perform tasks without any bias
and hidden benefit. According to SEC’s independence standard, independence generally is
understood to refer to a mental state of objectivity and lack of bias. The amendments retain this
understanding of independence and provide a standard for ascertaining whether the auditor has
the requisite state of mind.
The role of the audit committee is of paramount importance in reinforcing the independence
of auditors. Therefore, audit committee should be able to bridge the gap that may exist between
the board of directors and external auditors. It is indicated that “by probing the relationship
between management and the auditor, the audit committee helps to promote the independence of
the auditor and ensures higher quality financial reporting”(CISA Publication, 2000, p.9).
AICPA Standards Document establishes the need for independence in its Code of conduct in
a very clear way. According to Section 100 of the code, Independence, Integrity, and Objectivity
of an auditor are inseparable elements of the audit process. The code of ethics:
a. Sets independence standards that CPAs must adhere to in regards to the type of
work performed.
b. Applies to CPAs in all situations involving an attest client.
c. Attest: Services requiring independence and assurances from the CPA such as
audits, reviews, and agreed-upon procedures.
Effects of Auditors’ Independence 25
Moreover, Government Accountability Office (GAO) emphasizes on independence
whereby it:
d. Sets independence standards for federal entities and those organizations receiving
federal funds. Various laws require compliance with the comptroller general’s
auditing standards in connection with audits of federal entities and funds.
Furthermore, many states, local governments, and other entities, both
domestically and internationally, have voluntarily adopted these standards.
e. Underscores the fact that GAO rules are generally more restrictive than those of
the AICPA pertaining to independence of auditors.
Even though different institution sets their own standards on auditor independence, there
seems to be a general consensus on the basic requirement of the subject. Many argue that
auditors must fulfill obligation even in a situation where it might adversely affect their
employers. From this we could appreciate how this principle is important in the auditing sphere.
When we discuss the “what” of independence, it is primarily necessary to understand the
threats associated to it. Mcgrath(2001) clearly mentioned the following three steps that the
Independence Standard Board put forward as a conceptual framework for auditor independence .
The three steps are:
i. Identifying threats to auditor independence and analyze their significance
ii. Evaluate the effectiveness of potential safeguards including restrictions
iii. Determine an acceptable level of independence risk.
Effects of Auditors’ Independence 26
In order to address the issue of auditor independence, one needs to recognize the threats to the
independence. Auditors operate in an open system where their profession is being challenged
critically. However, the investing public always expects a reliable financial reporting in which
the objectivity of auditors is reflected.
Regarding the relationship between conflict of interest and independence, Brenkert( 2004)
made it clear that “ auditor independence involves conflict of interest”. It went on explaining
conflict of interest arise when the auditor owes a duty the performance of which could well be
influenced by his/her interest.
This argument is related with the notion that self interest could be the main deriving force for
auditors to compromise their independence. As we will see in the next chapter, the primary
reason of conflict of interest causes the independence issue to be questionable.
The question of independence has vastly been addressed by AICPA from the very beginning.
Accordingly, AICPA (2005) mentions that the maintenance of objectivity and independence
requires a continuing assessment of client relationship and public responsibly. It is also described
that a member who provides auditing and other attestation services should be independent in fact
and appearance.
The Public Company Accounting Oversight Board (PCAOB) also supports the fact that
auditors should maintain independence standards as promulgated in AICPA code of conduct.
The PCAOB which was established under the 2002 Act of Sarbanes- Oxley is believed to
provide assurance to investors by looking into auditors’ engagement with their clients.
According to PCAOB web site, the mission of the organization is stated as follows:
Effects of Auditors’ Independence 27
“The PCAOB is a private sector, non-profit corporation, created by
the Sarbanes-Oxley Act of 2002, to oversee the auditors of public
companies in order to protect the interests of investors and further
the public interest in the preparation of informative, fair and independent
audit report.”
It is also stated in the PCAOB web site that a registered firm is not independent of an audit
client if the firm provides tax services during the audit and professional engagement period.
The CPA Journal (2004) emphasized that most audit failure arise as a result of the failure by
the auditor to understand the wider business dimension rather than lack of independence.
However, this assertion seems to ignore the recent issues that caused such big firms as Enron and
WorldCom to collapse once and for all.
Effects of Auditors’ Independence 28
Chapter Four
Factors affecting auditor independence
As explained in the background of the paper, auditor independence can be seen in terms of
two pronged approach: independence “in fact “and independence “in appearance’’. The former is
a state of mind of the auditor which in most cases is considered to be a semblance of
independence in appearance to influence investors’ judgment.
It is evident the goal of independence boils down to “support user reliance on financial
reporting process and to enhance capital market efficiency’’. To arrive at unbiased audit decision
independence is not only requirement but also a mandatory element of audit engagement process.
Nonetheless, the desire to bring about a change in independent performance of auditors has
never existed without problem. This is because of multitude of factors affecting auditor
independence and considered to be a threat to independent performance of audit duties.
The inherent problem that has existed and continues to exist is what is described in the
AICPA rules of professional conduct as “conflict of interest”. The code in section 102-2
mentioned the fact that “a conflict of interest may occur if a member performs a professional
service for a client or employer and the member or his or her firm has a relationship with another
person, entity, product, or service that could, in the member's professional judgment, be viewed
by the client, employer, or other appropriate parties as impairing the member's objectivity”.
Effects of Auditors’ Independence 29
This conflict of interest arises, among other things, due to the following factors.
4.1 Provision of non-audit services
As the name entails, non-audit services (NAS) constitute all those services rendered by the
auditor except the regular audit jobs acquired as a result of the audit engagement.
According to Sarbanes- Oxley act of 2002, nine major non-audit services have been specified.
The act indicated the fact that if the following nine non-audit services are provided by an
accounting firm, it is highly likely that auditor independence is impaired. The prohibited services
are mentioned as follows:
Bookkeeping or other services related to the accounting records or financial statements of
the audit client
The rules will prohibit an accountant from auditing the bookkeeping work performed by
his or her accounting firm.
Financial information systems design and implementation
These rules will prohibit the accounting firm from providing any service related to the
audit client's information system, unless it is reasonable to conclude that the results of
these services will not be subject to audit procedures during an audit of the audit client's
financial statements. These rules will not preclude an accounting firm from working on
hardware or software systems that are unrelated to the audit client's financial statements
or accounting records as long as those services are pre-approved by the audit committee.
Effects of Auditors’ Independence 30
Appraisal or valuation services, fairness opinions, or contribution-in-kind reports
Appraisal and valuation services include any process of valuing assets both tangible and
intangible, or liabilities. Fairness opinions and contribution-in-kind reports are opinions
and reports in which the firm provides its opinion on the adequacy of consideration in a
transaction. These rules will prohibit the accountant from providing such services unless
it is reasonable to conclude that the results of these services will not be subject to audit
procedures during an audit of the audit client's financial statements.
Actuarial services
These rules will prohibit an accountant from providing to an audit client any actuarially
oriented advisory service involving the determination of amounts recorded in the
financial statements and related accounts for the audit client unless it is reasonable to
conclude that the results of these services will not be subject to audit procedures during
an audit of the audit client's financial statements. The accountant, however, may assist a
client in understanding the methods, models, assumptions and inputs used in computing
an amount.
Internal audit outsourcing services
These rules will prohibit the accountant from providing any internal audit service that has
been outsourced by the audit client that relates to the audit client's internal accounting
controls, financial systems or financial statements unless it is reasonable to conclude that
the results of these services will not be subject to audit procedures during an audit of the
audit client's financial statements.
During the conduct of the audit or when providing attest services related to internal
controls, the auditor evaluates the company's internal controls and, as a result, may make
Effects of Auditors’ Independence 31
recommendations to the audit client for improvements to the controls. Doing so is a part
of the accountant's responsibilities under GAAS or applicable attestation standards and,
therefore, is not a prohibited service.
Management functions or human resources
Consistent with our proposal, the final rules will prohibit the accountant from acting,
temporarily or permanently, as a director, officer or employee of an audit client, or
performing any decision-making, supervisory, or ongoing monitoring function for the
audit client.
These rules also will provide that an accountant's independence is impaired with respect
to an audit client when the accountant seeks out prospective candidates for managerial,
executive or director positions; acts as negotiator on the audit client's behalf; or
undertakes reference checks of prospective candidates. Under the rule, an accountant's
independence also will be impaired when the accountant engages in psychological testing
or other formal testing or evaluation programs, or recommends or advises the audit client
to hire a specific candidate for a specific job.
Broker or dealer, investment adviser, or investment banking services
Acting as a broker-dealer (registered or unregistered), promoter or underwriter on behalf
of an audit client and similar activities will make the accountant an advocate for the audit
client and will impair the accountant's independence.
Legal services
An accountant will be prohibited from providing to an audit client any service that, under
circumstances in which the service is provided, could be provided only by someone
licensed, admitted, or otherwise qualified to practice law in the jurisdiction in which the
Effects of Auditors’ Independence 32
service is provided.
Expert services unrelated to the audit
These rules will prohibit an accountant from providing expert opinions or other expert
services to an audit client, or a legal representative of an audit client, for the purpose of
advocating that audit client's interests in litigation or in a regulatory or administrative
proceeding or investigation. An accountant's independence will not be impaired,
however, by an accountant providing factual accounts or testimony or explaining the
positions taken or conclusions reached during the performance of any service by the
accountant.
The Act which was designed to establish a mechanism by which the inherent problems
associated with independence of auditors is believed to serve the investing public.
SEC had also designed a system by which independent audit firms categorize and
disclose any fee received by providing non-audit service. Knapp (2006) stated that “the
continuing controversy over the magnitude and nature of non-audit fees paid by large
companies to their independent auditors caused SEC to revise its audit fee disclosure”
Accordingly, SEC has established a mechanism that requires its registrants to classify
professional fees paid to their auditors into the following four categories:
Audit fees
Audit related fees
Tax fees
All other fees (Knapp, 2006 p.368).
Effects of Auditors’ Independence 33
The rational behind this regulation serves one and only one purpose- verifications of
auditor independence.
Some proponents of this regulation described that auditors should provide any service to their
audit client (Peterson, 2008). They insist on mentioning that providing NAS does not affect
independence but rather helps the auditing firm understand its client and undertake the audit
efficiently. He continued to advocate that “audit firms should be free to provide their clients with
any services within their skills…
However, the researcher has come to realize the fact that most audit failure that occurred over
the last decade was the results of lack of independence by providing what is known as non-audit
service to audit clients. Because of the financial interest, many audit firms refrain from
disclosing the real financial situation of their client thereby providing unqualified audit report to
the investing public.
This problem necessitated the enactment of the new rule of independence by Securities and
Exchange Commission. ( Palm rose and Saul, 2001) stressed that the adoption by the Securities
and Exchange Commission of the rule helps to avoid the basic conflict of interest that existed in
providing both auditing and consulting services to a client (p.18).
In general, the basic conflict lies in providing consulting services to a client who will be
audited by the same firm that provided consulting business.
There is also a wide spread concern that provision of non-audit service severely affect
independence. Wooten (2003) indicated that providing other services to audit clients may
influence pricing. He also continued to emphasize that when a firm provides both auditing and
Effects of Auditors’ Independence 34
consulting services, some type of fee savings is given to the client. The firm can lose its
independence if it becomes economically bonded to the client through the receipt of large fees,
unrelated to the audit (The CPA Journal, 2003).
One also may appreciate the significance of non-audit service in terms of financial
contribution in relationship the regular audit service from the following table.
Analysis of fee income of the Big Five firms in the US: 1990 and 1999
Service
Category
% of total fee income
Service 1990% of total fee income 1999
All clients SEC auditClient
All clients SEC auditClient
Accounting &
Audit
53 71 34 48
Tax 27 17 22 20
Consulting 20 12 44 32
Total 100 100 100 100
Source: Beattie, V. and Fernley, S. (2003)
Reported in Auditor Independence and NAS by Islam, Karim and Van Zijl (p.4)
The above table reflects how much of the auditing firm income derived from provision of
different services as accounting, tax and consulting. From this it follows that the prohibited
nine activities mentioned in this chapter would not only help to achieve independence but also
Effects of Auditors’ Independence 35
reduces the income derived out of non-audit service as the firm is required to report any income
derived from SEC registrants.
From the table, it is also evident to refer to the fact that the sum of non-audit fees, such as tax
and consulting services may impair the firm’s independence to report reliable financial
statements to the users. SOX (2002) stipulated that “a registered public accounting firm may
engage in any non-audit service, including tax services, only if the activity is approved in
advance by the audit committee of the issuer”.
There is no denying the fact that many audit firms have been counting on revenues derived
from audit related services thereby compromising their being objective in the opinion they
establish to the general public. According to Citron (2001) there has been a sharp increase in
audit firms’ total fee revenues and in the proportion of those fees earned from consulting and
related services. The combined UK fees of KPMG, Ernst & Young and Deloitte & Touche, the
three Big Five firms providing full data over this period, totaled £1.27 billion in 1994/95,
representing a 40% increase over their 1989/90 level. By 2001/2002 their fees had grown by a
further 130% to £2.92 billion. While audit and tax accounted for 75% of these firms’ fees in
1989/90, the share of these activities fell to 64% by 1994/95 and further to 58% by 2001/2002.
Thus consulting, corporate finance, corporate recovery and other activities contributed
42% of total fees in 2001/2002 (p.11).
The increasing dependence on audit related fees by providing peripheral services made the
accounting firms to rely on that revenue to a greater extent. However, post Sarbanes-Oxley
period brought about a relatively declining trend in revenue derived out of non-audit service
activities. We can also appreciate how the Act served the investing public by helping audit firms
Effects of Auditors’ Independence 36
achieve certain level of independence. This is to say that the measure taken to diferatiate audit
duties from non-audit duties would help the auditing firm exercise an objective judgment during
the course of its engagement with its client. Cheffers (2008) substantiated the declining trend of
non-audit revenues this in the following way:
As shown in the graph, while audit fees rise as percentage of total fees, non-audit fees
Continued to fall down.
Audit Fees & Non-Audit Fees as a % of Total Fees
100%80% A 70%60%50%40%30%20%
10%Non %
0%
2002
2002 2002 2003 2004 2005 2006
Source: Mark Cheffers ( Non-Audit fees- A five yearTrend- March 2008)
Effects of Auditors’ Independence 37
According to Cheffers (2008) we clearly understand that “from 2002 to 2006, non-audit
fees have consistently dropped as a percentage of the total fees paid by accelerated filers. During
calendar year 2002, non-audit fees represented 50.44% of the total fees paid to independent
auditors by the3, 667 accelerated filers. In 2003, the percentage dropped to 40.17% and
continued to drop the following years. In 2004, non-audit fees equaled 27.21% of total fees and
in 2005 they equaled 21.67%.Another drop occurred in 2006, with non audit fees representing
only 19.65% of total audit fees paid”. (Audit Analytics, 2008, p.1).
4.2 Client size
Among the common factors that affect perceived auditor independence is the size of the
client that the firm depends to generate revenue from. In other words, it is logical to assume that
the number of customers affect how much income an auditing firm derives.
The auditor expects a large payment of audit fee upon completion of the audit to the client.
Practically, we can assume that the auditor is dependent on the client in regards to audit fee. The
regular audit fee that the client pays could be the only source to the auditor or supplemental to
the auditor. In a situation where an auditor has very few clients, it is recognized that the
independence of the auditor is severely affected. This is because of the fact that the auditor does
not want to loose its client; rather compromise its independence. It is exemplified as “if an
auditor has 100 clients all of equal size, it may not matter much if the auditor loses one of the
clients. However, if the auditor only has 2 clients of equal size, it is obvious that the
consequences of losing a client will be serious to the auditor, in this case it would be hard to
Effects of Auditors’ Independence 38
argue that the auditor is not biased in favor of the client” ( Auditor independence- An Impossible
dream, p.2).
4.3 Audit firm tenure
The auditor-client relationship over a period of time establishes an environment whereby the
audit firm is fully aware of the goals and operation of the client. The longer the period of
relationship, the more will be the possibilities not to switch to other audit firms. This will also
bring about a potential benefit to both the audit firm and its client.
Regarding the relationship, Ye (2006) explained that the continuity of interaction makes the
audit firm more knowledgeable as to the needs of the client that enables the former to customize
some of its services. It is also stated that the lengthy audit firm tenure is critical to audit process.
Wooten (2003) associated audit tenure not only with independence but also with audit qualities
where he indicated that many audit failures are likely to happen as a result of short and long audit
tenure. (The CPA Journal, 2003). By the same token, it is also argued that long tenure would
provide the firm with the opportunity to understand its client and make possible adjustment
during the course of the engagement. However, the conventional wisdom is the fact that long
tenure severely affects the objectivity of auditors. Wooten continued to put this fact in the
following way:
“Long tenure with the client has been associated with low
audit quality. Long associations have the potential to breed
complacency, less rigorous audit procedures and too much
dependence on management representations. The auditor can
Effects of Auditors’ Independence 39
become too comfortable with the client and not adjust audit procedures
to reflect the changing business and associated risks.”
It is argued that the absence of rotation may give rise to making both client and audit firm
dependent on each other which in turn deprive the audit firm of the core element of
independence expected of it. In contrast, its correlation with audit failure is just the opposite.
There is an inverse relationship between auditor tenure and audit reporting failures. (American
Accounting Association, 2002).
It appears that there is a general consensus regarding the effects of audit tenure on
independent functioning of auditors. A CPA journal that was published in January 2005
indicated that the average auditor tenure for Fortune 1000 companies is 22 years. “Also, 10% of
the companies in the study were found to have had the same auditor for 50 years, with the
average tenure of this group being 75 years” ( The CPA journal, January 2005).
At this point it is essential to recognize one of the breakthroughs brought about by the
Sarbanes-Oxley act of 2002 to reduce the impact of long tenure ship where it required periodic
rotation of audit engagement partners.
4.4 Alumni affiliation
The good will that is created as a result of the clients director being former alumni of the audit
firm should also be considered in dealing with how independently the audit firm performs its
functions. It is also natural to predict that the alumni prefer to get non audit services from its
former employer. In this respect Ye (2006) continue to emphasize that when the alumni directors
Effects of Auditors’ Independence 40
make decision on NAS suppliers, they may naturally consider their previous firm for they have a
better knowledge of the range of services offered by their former firms.
According to the CPA journal of 2005, close auditor-management relation affects the audit
process affecting the audit process. It has also resulted in many auditors being hired by former
clients. Regarding Enron’s case, “it was revealed that many Enron employees had previously
worked for Arthur Andersen. Company personnel may be the auditors from the past, and current
auditors may be auditioning for future employment”.(The CPA Journal, 2005)
When we view same practice from the point of view of independence, it is also hard to
imagine the audit firm will not be biased on its client as a result of prior relation and the benefit
derived out of the sale of NAS to its client.
Having evaluated the adverse effects of the relationship, the Sarbanes-Oxley act of 2002
prohibited accounting firms from auditing companies that have hired a former auditor for a key
accounting position during the prior twelve months.
4.5 Disclosure of non audit fees
The requirement by SEC on all its registrants to disclose the non audit fees has affected
independence to a greater degree. If the proportion of non audit fees as a percentage of total fees
is high, then it may be possible to assume that the firm’s independence is in jeopardy.
Knapp (2006) points out that the SEC’s new audit fee disclosures re-ignited the contentious
debate whether auditors were truly independent of their major clients. To quell this controversy,
many corporate executives began insisting that the “other services” provided by accounting firms
Effects of Auditors’ Independence 41
were typically “audit related”…. Many companies encouraged by their auditors have tried to
allay such independence concerns by voluntarily disclosing how much of their fees for “other
services are “audit related”.
Several companies were urged to disclose the non audit fee as it is an indication of the
existence of independence or not. A case in point on the disclosure issue is described as follows:
General
During fiscal 2000, the company paid KPMG LLP fees in the aggregate amount of approximately $ 4,517,800. Of this amount, approximately $ 991,400 was fees for the fiscal 2000 audit and other audit services.
Financial Information Systems Design and Implementation
KMPG did not render any services related to financial information systems design and implementation during fiscal 2000.
All other Fees
KPMG rendered other services consisting primarily of tax consulting, due diligence assistance, environmental consulting, litigation support, and audit of the company’s employee benefit plans and other entities within the consolidated group for statutory filing purposes. Aggregate fees bills for all other services were $ 3,526,400
The Home Depot Fiscal 2000 Audit Fee Disclosure
Source: Knapp (Contemporary Auditing, 2006) P. 366
Effects of Auditors’ Independence 42
The merits of requiring public companies to disclose the fees associated with the auditing and
non auditing tasks has contributed to evaluate the pattern of audit expenses thereby urging audit
firms to comply with the independence rule.
4.6 Training of auditors
Human resources development plays a key role in implementing the independence rule. Apart
from their day-to-day endeavor to live up to the public expectation, auditors should consistently
acquire relevant information on the rule and procedure governing their profession. In this
respect, when laws are enacted auditors must be familiar with their implementation to be able to
perform.
Training pertains to enabling auditors to understand basic issues surrounding the audit
profession- independence being the primary issue. From this it follows that there is a direct
relationship between independence and proper awareness of rules governing auditor
independence.
4.7 Audit committees
The role of audit committees in the overall process of financial reporting has changed from
the traditional role of passive action to a proactive endeavor due to the challenges of the auditing
profession. Though a lot can be done by an audit committee, it should make sure that the proper
organizational culture is first in place in order to be able to positively influence management to
adhere to audit rules and procedures.
Effects of Auditors’ Independence 43
In order to discharge its responsibility, the committees should also be aware of the scope of
services provided by the audit firm.
A strong audit committee in an indispensable to the healthy functioning of the audit firms for
it strives to attain a check and balance in the organization.
Regarding the new role expected of any strong audit committee, Brodsky (2003) stressed that
audit committee should stand at the intersection of management, independent auditors, internal
auditors, and the board of directors. He continued to emphasize that “the role of the audit
committee has been to oversee, monitor, and advise company management and outside auditors
in conducting audits and preparing financial statements, subject to the ultimate authority of the
board of directors”.
Finally the author concludes by underscoring the fact that “audit committees therefore need to
ensure accountability on the part of management and internal and external auditors; make certain
all groups involved in the financial reporting and internal controls process understand their roles;
gain input from the internal auditors, external auditors, and outside experts when needed; and
safeguard the overall objectivity of the financial reporting and internal controls process”.
4.8 Culture of the audit firm
Independence is also a function of how the audit firm is originally structured. The belief to
promote responsible behavior is essential for audit firms to perform their duties independently.
Their track record in auditing other clients should well be evaluated in order to arrive at certain
judgment as to their objective opinion on financial statements.
Effects of Auditors’ Independence 44
4.9 Auditor’s ethical and moral characteristics
Ethical responsibilities of auditors are also a key element in an attempt to bring about
independent audit engagement with clients. It is evident that the lack of this core principle
resulted in many problems in the past.
It is stated under section 102 of the AICPA code of professional conduct that “in the
performance of any professional service, a member shall maintain objectivity and integrity, shall
be free of conflicts of interest, and shall not knowingly misrepresent facts or subordinate his or
her judgment to others”
Effects of Auditors’ Independence 45
Chapter Five
Audit and Non-audit fees - Conflict of interest
The primary relation that existed between an audit firm and its client during an audit
engagement process is that of providing an audit service to come up with an audit opinion based
on the realities reflected on financial statements of the latter.
As explained in the previous chapter, the magnitude of audit revenues is certainly affecting
audit firms. Many argue that audit firms will find it difficult to pick out their own mistake in
advising their clients while they perform the regular audit function. This will impair the degree
of independence and even create a conflict of interest on non-audit and audit functions.
Flaming (2002) is of the opinion that New SEC proxy disclosure requirement reveal an
average of non-audit service fee to audit fee ratio of over 200 percent (p.2). This figure is self
explanatory to arrive at certain judgment about the level of independence and audit firm may
have in performing the regular audit duties.
Results indicated that post SOX period has proved a declining non-audit revenues as some of
the activities are prohibited or needed prior approval of the audit committee. Iyengar and
Zampelli(2007) argue that “ Today, for most auditors, audit fees are but a small proportion of
their total income.” The authors tried to capitalize on the contribution of other services (non-
audit and audit related fees) apart from the regular means of income.
The conflict of interest that exists while undertaking both audit and non-audit services is well described in the SEC (2000a) rule proposal as follows:
Effects of Auditors’ Independence 46
“... as auditors become involved in a broad array of business
arrangements with their clients, they come to be seen by themselves,
their firms, their clients, and investors less as exacting, skeptical professionals
who must be satisfied before signing off on the financial statements,
and more like any other service vendor who must satisfy the client to make the
sale”.
SEC(2000b) went on underscoring that fact that “ the rapid rise in the growth of non audit
services has increased the economic incentives for the auditor to preserve a relationship with the
audit client, thereby increasing the risk that the auditor will be less inclined to be objective”.
Though it is extremely difficult to gauge auditor independence, it is not impossible to detect
some likely factors that cause impairment of independence. One such factor is analysis of the
client’s expenses in audit areas. In so doing, one can get a clue as to the existence of a healthy
relation between the audit firm and its client.
The other consideration is analysis of risk factors as described along the continuum in the
publication of CICA as shown below: RISK OF IMPAIRED INDPENDENCE
NO RISK REMOTE RISK SOME RISK PROBABLE
RISK
CERTIANITY
Auditor clearly
Independent
Impaired
independence
very unlikely
Independence
might be
impaired
Impaired
independence
very likely
Auditor clearly
not independent
Source: CICA Publication “Guidance for Audit committee” ( P. 9)
Effects of Auditors’ Independence 47
One needs to look into what causes this impaired independence. The view that the financial
dependency resulted in lack of objectivity is predominantly reflected in most audit related
researches. This is even stretched to influence the competition among audit firms to get a new
audit client by providing “Low Balling” to clients to step into the business. Providing below
market price to audit clients is also an indication of the hidden desire to undertake non-audit
services and compensate the revenue.
. When we analyze audit fee to affect independence, we basically measure the audit revenue
as percentage of the total revenue an auditor collects. Miller (2001) raises practical questions as
to why Andersen, a firm that audited Enron’s financial statements assisted Enron in its financial
shell games and replied, as “It appears that conflict of interest simply overwhelmed prudential
consideration Millions of dollars were at stake not only audit fees but also consulting fees (p.5).
In a nutshell, the researcher has come to realize that the conflict of inertest between audit and
non-audit fees exists as long as there is an audit engagement.
Effects of Auditors’ Independence 48
Chapter Six
Conclusion and Recommendation
As explained in the previous chapter, independence is a core element of auditing.
Nonetheless, this principle has been affected by the following factors:
Audit fees
Impartial mental attitude is a state of mind that lends itself to performing tasks without
external influence. The auditor expects a large payment of audit fee upon completion of the audit
to the client. Practically, we can assume that the auditor is dependent on the client in regards to
audit fee. The regular audit fee that the client pays could be the only source to the auditor or
supplemental to the auditor. In a situation where an auditor has very few clients, it is recognized
that the independence of the auditor is severely affected. This is because of the fact that the
auditor does not want to loose its client; rather compromise its independence. It is exemplified as
“if an auditor has 100 clients all of equal size, it may not matter much if the auditor loses one of
the clients. However, if the auditor only has 2 clients of equal size, it is obvious that the
consequences of losing a client will be serious to the auditor, in this case it would be hard to
argue that the auditor is not biased in favor of the client” ( Auditor independence- An Impossible
dream, p.2).
This suggests that if total fee received from a client is minimal, then the auditor may perform
his duties independently. When we analyze audit fee to affect independence, we basically
measure the audit revenue as percentage of the total revenue an auditor collects. Miller (2001)
raises practical questions as to why Andersen, a firm that audited Enron’s financial statements
Effects of Auditors’ Independence 49
assisted Enron in its financial shell games and replied as “It appears that conflict of interest
simply overwhelmed prudential consideration. Millions of dollars were at stake not only audit
fees but also consulting fees (p.5).
From this it follows that the audit fee impacts auditor independence. Jennings, Lander and
Reinstan (2001) clearly explained that the public interest is best served when auditors perform
reasonable tasks to genuinely reflect the real financial structure of the firm (p.4)
If auditor is not committed to achieving objectivity, then they are promoting their own
economic self interest. That is why the type and size of audit fee is directly related to auditor
independence.
Non-audit service fee
Non-audit services are considered to be all those services primarily of consulting services
rendered to the client.
The audit firms used to provide consulting services to its client until it was prohibited by
Sarbanes-Oxley act of 2002. The rational is that it is hard to be independent while providing
consulting services to a potential client.
Self-Interest
This is a factor affecting independence that arise out of an emotional, financial or personal
motive.
Effects of Auditors’ Independence 50
Self- Review
Self-review may adversely affect auditor independence as it requires an auditor to perform
auditing of his/her own work.
Familiarity
This is also a situation where the auditor may be influenced by a close friend.
Intimidation
If an auditor is threatened by a third party upon the performance of a auditing, then it is highly
likely that independence is in jeopardy.
This suggests that auditors might be affected by factors other than those having monetary
implications.
Finally the researcher has come to realize that though it is difficult to measure in concrete
terms, it is possible to determine the impairment of independence in perspective. This means that
there should be checks and balances in the process of audit engagement.
What we witnessed over the past decade was a complete lack of independence due to the
inherent weaknesses of the process of audit engagement. It is also possible to draw a lesson from
the collapse of too many big companies as a result of lack of independence of their audit firm.
The large sum of audit and non-audit fees has been the main concern for impairment of
independence.
Effects of Auditors’ Independence 51
The researcher has also arrived at a conclusion whereby the power imbalance between the
auditors and the client is a phenomenon that has existed and will continue to exist. However, the
new independence rule serves the public interest in its quest for getting unbiased audit opinion
from the audit firms.
The fact that an accounting firm is limited to providing specific tasks to the client by being
denied of consulting services would assure reasonable public confidence as it may help auditors
be independent.
The SEC requirement of disclosure of audit, non-audit and information technology fee of
audit firms helps to get information on the relative dependency of an audit firm. If the ratio of
non-audit fee to audit fee is too high, it is possible to conclude that the auditors’ independence
might have been impaired.
This suggests that the audit firm will be biased to arrive at an objective conclusion of the
clients’ financial statements.
The other aspect of power imbalance is when the audit firm has too few clients on whose
revenue the firm is dependent. In such a situation, it is hardly possible for the audit firm to arrive
at a qualified audit opinion. This also suggests that independence is impaired. However, it may
not hold true for big audit firms who have a large number of clients and alternative sources of
revenue.
In order to build public confidence in the accounting profession, a need arose to formulate
new rules of independence. The Sarbanes-Oxley act of 2002 was one step to assure the integrity
of auditors in the performance of their tasks. As an attempt was made in the previous chapters to
Effects of Auditors’ Independence 52
explain issues of independence, it is also the researcher’s belief to stress the fact that the
measures taken to improve standards of auditor independence have positively influenced
independence.
In conclusion, the researcher points out the following on the issue of independence:
1. Checks and balances could be achieved if auditors are in compliance with the new
independence rule.
2. As ethics and independence are highly interrelated, audit professionals must take ethical
standard training on regular basis.
3. The implementation of Sarbanes-Oxley act of 2002 must be re-assured by enforcing the
nine restricted services mentioned above.
4. There should be a need to follow-up how the independence rule is being implemented.
Effects of Auditors’ Independence 53
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