Auditors Independence
Contents:
1. Legal and social stigma
2. Sarbanes- Oxley Act of 2002
3. Advocacy culture and independence culture
4. Self discipline
5. Conclusion
6. References
1. Legal and social stigma
The comment that auditors are not independent is not unfounded. In recent past independence of auditors have faced the wrath of various governing and other regulatory authorities. The professional independence of auditors has been held responsible for many major corporate collapses and financial debacles very recently. Auditors faced such legal and social stigma that it rocked the accounting profession world over. Accounting profession is facing the real challenge to save its independence image. Auditors are independent when their functioning is not affected by the vested interests of parties, other than shareholders, in the financial statements. Management is one of such party that can directly influence the independence of auditors especially when auditors are advocating causes than auditing. Whether an auditor is actually independent when he appears to be independent is a matter that only the auditor knows. In fact it is necessary for auditors to not only act independently but be seen to be independent. This is because independence in appearance reduces the opportunity for an auditor to act otherwise than independently. The atmosphere is so polluted that comments like ‘the concept of auditor independence should be scrapped’ are not uncommon. An all round cleansing effort is required to save the independence of auditors, otherwise those tarnishing the image of independence will be the worst sufferers themselves.
The Term Paper on Maintaining Auditor Independence
Maintaining Auditor Independence AbstractIn this paper, we resolve the auditor independence problem that arises in the model studied in Antle (1982, 1984). We argue that the owner-manager-auditor relationship exhibits a "separability" that facilitates the use of a particularly simple mechanism that prevents collusion. The mechanism prevents collusion as long as the agents do not play strictly ...
2. Sarbanes- Oxley Act 0f 2002
Sarbanes-Oxley Act of 20021 in US (followed by similar legislations in other countries) is an effort in this direction. The Act establishes a five member Public Company Accounting Oversight Board with general oversight by SEC basically to
a) oversee the audit of public companies, b) establish audit standards and rules; and c) to inspect, investigate and enforce compliance on the part of registered public accounting firms and those associated with the firm.
Remunerative non-audit services are the root cause that sometime deprives the independence from the auditor. The Panel on Audit Effectiveness2 (established by Public Oversight Board in US) has recommended that non- audit services that exceed a threshold amount need to be approved by audit committees considering the under mentioned guidelines in respect to auditor’s independence:
whether the service is being performed principally for audit committee,
the effect of service on audit effectiveness on the quality and timeliness of entity’s financial reporting process,
whether the service would be provided by specialists who ordinary also provide recurring audit support,
whether the service would be performed by audit personnel, and if so, whether it will enhance their knowledge of entity’s business and operations,
whether the role of those performing the service would be inconsistent with the auditor’s role,
Whether audit firm personnel would be assuming a management role or creating a mutual or conflicting interest with management.
whether auditors, in effect, would be ‘auditing their own numbers’,
whether the project must be started and completely very quickly,
whether the audit firm has unique expertise in the service, and
The size of the fee(s) for non-audit service(s).
3. Advocacy culture and independence culture
Stephen Taub in his article with CFO.com3 noted ‘when it comes to choosing auditors, the size of the firm doesn’t seem to matter as much as it did in the past’
The Term Paper on Audit Firm Size And Going-Concern Reporting Accuracy
This study examines the association between measures of going-concern reporting accuracy and audit firm size of the companies listed in Tehran Stock Exchange. Prior works have examined the association between auditor size and audit quality, using various proxies for audit quality. Recent work has hypothesized that going- concern reporting accuracy can also measure audit quality. Furthermore, Prior ...
He has further stated “among the reason for the trend towards favoring small auditors are that the Big Four have aggressively hiked their fees; they’re less interested in taking on financially risky companies as audit clients; and they’re more selective in their clientele because they already have more work than they can do” It is true that smaller accounting firms are now getting more auditing opportunities; but this is also a matter of concern. Will the smaller firms be able to maintain independence when offered financially lucrative non-audit assignments alongside?
Robert H. Colson, PhD, CPA and Editor-in-chief in his editorial with January 2005 issue of ‘The CPA Journal’4 raised the issue vehemently stating “can the advocacy culture and the independence culture exist simultaneously for the same client? Can an accounting firm be convincingly independent in its audit responsibilities and also convincing advocates in its tax practice? It is easier for most observers to conclude from appearances that advocacy will trump independence in a business relationship. In the past, when CPA firms received most of their revenues from accounting and auditing services, it was natural for them to develop a firm culture that exercised advocacy with restraint. Now that many firms generate far more revenues from tax preparation and advice, additional steps may be needed to safeguard the independence culture necessary for auditing”.
The function of auditing cannot exist without its independent culture. Robert Colson is right when he suggests that additional steps are required to safeguard the independence culture necessary for auditing. Code of ethics for professional accountants existed all along. But there was lack of self discipline. ISA 2205 of IFAC has already encoded professional ethical procedures to be adopted on identification of conflicts of interest. ISA 220 inter-alias prescribes the following:
1. A professional accountant in public practice should take reasonable steps to identify circumstances that could pose a conflict of interest. ( sec.220.1)
2. A professional accountant in public practice should evaluate the significance of any such threats. Evaluation includes considering, before accepting a client relationship or specific arrangement, whether professional accountant in public practice has any business interest or relationship with the client or a third party that could give rise to threats. (Sec. 220.2)
The Essay on Safeguard of Auditor Independence
... from non-audit services add to the auditing firm’s dependence on client. When facing the risk of losing services of a client, an auditor is less ... an auditing firm to provide both audit services and non-audit services simultaneously (www. sarbanes-oxley. com). We support the recommendation because it creates independence ...
4. Self discipline
Despite these pronouncements like ISA 220 the independent image of auditors got tarnished in the recent past because of lack of self discipline on part of auditors. It is seen that statutory restrictions and prohibitions are enacted only after happening of some misdeed affecting the community at large. Legal precautionary measures are rarely framed in advance. Sarbanes-Oxley occurred only when the corporate sector was jolted by large scale scams. Accounting community has to take initiative. The onus is on them to maintain the independent culture. At present the prestige of accounting profession is at stake. Concrete self disciplinary measures are required to be taken by the members of accounting profession to safeguard the independent image and interest of the accounting profession. This can be achieved with few self disciplinary corrective measures described hereunder:
Avoid receiving any benefit, other than audit fee, from client organisations. This includes borrowing money from the audit client, accepting commissions for new business by the audit firm to its audit clients; and accepting discounts given to audit staff members normally only available to the client’s staff.
Audit firm should not accept the audit assignments in which audit fee is more than five per cent (or other mutually decided ceiling limit) of the total income of the audit firm.
Owners and staff of auditing firm should restrain from holding shares, lending to, or otherwise having a beneficial interests in audit clients.
Audit firm members or their staff needs to avoid holding any office, including the office of director, in client organisation.
Restrain from undertaking any consulting assignment, such as taxation and corporate advisory work, for existing audit clients.
Annual signing by the owners and staff members of audit firm of an independence statement stating that they are familiar of independence policy of the firm, and that they hold no prohibitive investment or relationships.
Audit staff needs to be rotated at least once in five years. The basic idea is to guard against the possibility of auditor and his/her staff becoming too close to senior management and thus a consequent impairment of the auditor’s independence.
The Essay on Recommendation Brief for an Internal Auditor
... the activities of and communicating information among the board, external and internal auditors and management”. (theiia.org, 2013) In addition the IIA states under the ... years experience in auditing. Also, she has a Bachelor’s and Master’s in Accounting. She has been an instructor college level accounting course. Ms. ...
Occasionally the audit work of the engagement partner needs to be reviewed by other qualified and experienced member of the audit firm. This is a sort of peers review of the work performed.
Audit firm should not accept the audit assignments of the entities in which its partners (or former partners) of the auditor are members of the governing body of the client.
5. Conclusion
Audit function cannot be performed without its independent character. No doubt auditing profession has been jolted by the misdeeds of some of its elite fraternity members. In order to restore its nobility and reverence, the accounting profession has to follow self disciplinary measures. Only then the virtue of independence of the auditor will regain its glory.
6. References:
1 Sarbanes- Oxley Act of 2002 http://fl1.findlaw.com/news.findlaw.com/hdocs/docs/gwbush/sarbanesoxley072302.pdf
2 The Panel on Audit Effectiveness Report and Recommendation, August 31, 2000, page 4 http://www.iasplus.com/resource/pobaudit.pdf
3 Stephen Taub’s article ‘More Companies Pick Smaller Audit Firms’ at www.cfo.com/article.cfm/3171613/c
4 ‘Advocacy and Independence’ by Robert H. Colson in ‘The CPA Journal’
http://www.nysscpa.org/printversions/cpaj/2005/105/p80.htm
5 Handbook of International Auditing, Assurance and Ethics Pronouncements, Page
42, issued by IFAC http://www.ifac.org/Members/DownLoads/2007_IAASB_Handbook.pdf
Answer to question 2
internal audit and External audit
Audit is audit. It does not matter whether it is done by external auditor or internal auditor. The same kind of professionalism is required. The issue of external versus internal audit has nothing to with the methodology; it has every thing to do with different roles. The external auditor gives assurance to the shareholders- the owners of the organisation- that managers are managing in the best interests of the owners. And the internal auditors give assurance to senior management that they can rely on the management controls that are in place and that the risks are being managed as they relate to financial control, regularity and performance. But both serve good accountability1.
The Essay on Nature of Auditing and the Public Accounting Profession
1. Auditing neither creates goods nor adds utility to existing goods and therefore does not add value to business. Auditing exists only because it has been legally mandated. Auditing exists because it is needed by the company. It is beneficial to users who need assurance if their financial statements reflect economic conditions that occurred in a period. Without reliable information, companies ...
Contents
1. Scope, purposes and weaknesses of Internal Audit
2. Scope, purposes and limitations of External Audit
3. External Vs. Internal Audit
4. Utility of Internal Audit during business growth
5. References
1. Scope, purposes and weaknesses of Internal audit
Internal auditing is conducted by auditors employed by the management. The role of internal auditor is broader and is defined by the kinds of assurances management wants from internal auditor. Usually internal auditor examines the efficiency and efficacy of processes, departments, projects or internal controls. The management is the main beneficiary of internal audit. Internal auditing provides an appraisal for the review of operations as a service to the management. It is a managerial control which functions by measuring and evaluating the effectiveness of other controls. Basically management uses Internal Audit function to:
1. Review the reliability and integrity of management, financial and operating information.
2. Review the system established to ensure compliance with policies, regulation procedures and laws.
3. Determine the adequacy, efficiency and effectiveness of the internal control structure.
4. Review the procedures of safeguarding the assets of the organisation.
5. Make an appraisal of efficiency, efficacy and economy with which the resources at disposal of the entity are employed.
6. Evaluate whether results are consistent with established objectives and goals.
7. Provide advisory and training services to ensure fiscal and administrative integrity.
Internal Auditing is intended to provide operating management a reasonable, but not absolute, assurance regarding the adequacy of internal controls. The overall object of internal audit is to evaluate internal controls over assets, revenues and expenditures.
The Research paper on Internal QMS auditor training assessment booklet
Case Study 1: Pre-Audit Preparation Instructions: 1. Each participant should individually study the background of the company including the background of organisation, organisation chart and process flow chart provided: • Managing Customer Service: Front Office VVG-FO-B-7.5.1 (D) • Managing Customer Service: Food and Beverage VVG-FB-B-7.5.1 (D) • Managing Property: Engineering VVG-EN-B-7.5.1 (D) • ...
Weaknesses
a) The internal auditors have no direct authority over, or responsibility for, any of the activities examined.
b) Internal auditors are not substitutes or relieve the responsibilities of other persons of assigned responsibilities.
c) Internal auditing is not independent as internal auditors have to perform strictly as per management directions.
2. Scope, purposes and limitations of External Audit
An external audit programme encompasses an independent auditor to perform full fledged financial statement audit. Basically this is a balance sheet only audit or other agreed upon external audit procedures settled in terms of appointment of the auditor. If external audit is a statutory audit (when performed to fulfil the requirements of provision of any statute) then the specific requirements of statute under which it is being performed are taken care of.
The main objective of external audit function is to express an opinion on financial statements (that include balance sheet, profit and loss account and cash flow statement) dealt with under the audit function. External auditor reports to the shareholders or other stakeholders of the entity.
External auditors execute their duties in accordance with generally accepted audit standards (GAAS).
They have also to keep in view generally accepted accounting principles (GAAP), or International Financial Reporting Standards (IFRS), or International Accounting Standards (IAS), as the case may be, while assessing accounting principles being followed by the entity. GAAP inter- alia include accounting pronouncements and standards framed by accounting bodies and also local accounting conventions. Accounting bodies world over are eager to bring uniformity in adoption of accounting standards at least in case of accounting for registered companies. Like from 2005 onwards European companies have to compulsorily follow International Accounting Standards. Accounting bodies of different countries have developed their own GAAP (generally accepted accounting principles).
External auditor has to access that accounting principles being followed by the entity are in conformity with GAAP (or other applicable accounting standards) before formulating an opinion on financial statements being audited.
Limitations:
a) The legislation requires external auditor to give a ‘true and fair view’ of financial statements; but what is true and fair is not defined neither by any legislation or any body of accountants.
b) Further, the external auditors are required to provide a reasonable assurance that financial statements are free from ‘material’ misstatements. The term ‘material’ is a relative issue and has often been abused by auditors.
3. External vs. Internal auditing
The driver for external auditing is the external regulatory requirements for an independent certification that the financial information provided to the shareholders and the financial community is reasonable and accurate. On the other hand, internal auditing is primarily driven by management’s desire to have an internal resource that focuses attention on organisational processes and ensures accuracy, efficiency and effectiveness of operations4.
External audit provides reasonable assurance that financial statements and other records are free from material misstatements. This audit also certifies that these financial statements are in accordance with relevant legislation and also they adhere to applicable accounting standards. They improve operations and help ensure transparency and accountability through evaluation of programmes, activities and functions.
Internal auditors are different to external auditors because they do not focus only on financial statements or financial risks; much of their work is looking at reputational, operational or strategic risks. They also give an independent opinion on whether internal controls- such as policies and procedures- put in place to manage these risks are actually working as intended5.
Internal auditors assist in maintaining an effective system of internal control. Internal auditor functions provide strategic, operational and tactical value to organisation’s operations. Internal auditing is:
a) resource to the management to ensure that the entity has the resources, systems and processes for operating an effective and efficient business.
b) an assurance tool with the management to oversee the entity’s operations and ensuring its continuous improvement and success.
c) an independent validation resource that entity’s efforts are proactive and effective against current and emerging threats.
Internal auditor identifies and qualifies key business risks and makes appropriate recommendations as a result of the risk assessment. Whereas, external auditor identifies key transactions and exposures for financial statements.
4. Utility of Internal Auditing during business growth
Resources and controls are more taxed during growth period and it is during this period of rapid growth internal auditing plays the vital role of a crusader of success. If internal controls are unplanned or unchecked, growth becomes counter productive because of internal weaknesses and defects of the systems. The role of Internal auditing at such a stage assumes extra importance in order to sustain the growth.
Unfortunately the business community has not yet fully appreciated such an important aspect of internal auditing. The fact is that even today the internal audit is underutilized and unappreciated function. Many companies see little or no value in internal audit functioning
According to a study by PricewaterhouseCoopers, half of the US companies surveyed are now using “continuous auditing” techniques, which typically leverage technology to accelerate the internal audit cycle and improve risk and control assurance, an increase from 35% in 2005. Of those that do not yet have continuous auditing technique in place, 31 percent have implemented plans to do so2.
The above finding of PricewaterhouseCoopers indicates that a sizeable portion of companies are still unaware of the value of internal audit function either because they do not have an internal control system; or the internal audit system exits only to appease an audit committee or regulators.
The internal audit process has to be integrated with basic strategic objectives and goals of the entity. Unless internal audit functioning is involved with objective to be pursued it is not possible to reap full benefits of this function. Risk assessment is one process of business planning where the role of internal audit is crucial and advantageous in achieving the ultimate goals. Without involving the internal auditing function with strategic planning it is not possible to realise its worth.
Fletch Homer and Lorilynn Holdren in their article” Breaking the Internal Audit Paradigm”3 have made following recommendation in order to change the wrong perception about Internal audit function:
“Recommendation 1: Involve a cross section of management, including top executive, in the development of the internal audit platform and annual internal audit plan.
Recommendation 2: Leverage people and technology to provide information to manage risk and improve performance.
Recommendation 3: Consider outsourcing resources or specialised skills that are too costly to maintain inside the company”.
By following the third recommendation advance technology can be employed with the internal audit functioning. This will greatly enhance the effectiveness of internal audit in order to manage the organisation more efficiently.
5.References
1 “Interaction between the External Auditor and Internal Auditors: The Canadian Experience” By David Rattray, page9, http://www.parlcent.ca/easterneurope/docs/Speech%20on%20External%20Versus%20Internal%20Audit.pdf
2 PricewaterhouseCoopers 2006 State of Internal Audit Profession study…, June 26, 2006 http://www.pwc.com/extweb/ncpressrelease.nsf/docid/FBA8D81E3195663E85257199004BA8B9
3 “Breaking the Internal Audit Paradigm: Improving the Effectiveness of Inter Audit Function” by Fletch Homer and Lorilynn Holdren
http://www.pwc.com/images/gx/eng/fs/re/internalaudit.pdf
4 ‘Common misconceptions’ in the journal ‘Tone at the Top’ March 2005 issue, published by The Institute of Internal Auditors
5 What is an Internal Audit? At ‘The Institute of Internal Auditors UK and Ireland online’ http://www.iia.org.uk/about/internalaudit/
Answer to question 3
Joint Audit Engagements
The dominance of the Big Four is hurting competition in the audit market. It is also keeping small and mid sized rivals from gaining a foothold with blue- chip clients. Concentration in audit market has increased over time. The general perception is that by taking non Big Four as auditors, the companies are taking a risk. Such fears or barriers are required to be removed for a more level playing field… The concept of joint audit is refreshing in face of competition and existence of high level of concentration in the audit market by ‘Big Four’. Not only joint auditing provides non Big Firms a real opportunity to audit blue-chip clients but allows the entities to optimise the resources of more than one audit firm. If individual firm’s goals and objectives are predefined, the joint auditors work more effectively on shared responsibilities; be it case of internal audit or external audit.
Contents
1. The Auditing Oligopoly
2. Joint Audit the real solution
3. Impact of Joint Audit on quality and cost
4. Conclusion
5. References
1. The Auditing Oligopoly
With the collapse of the Arthur Anderson the number of big international accounting firms has reduced to four. These ‘Big four’ in audit world are Ernst & Young, Deloitte & Touche, KPMG and PricewaterhouseCoopers. Concentration of big four can be gauged from the fact that ‘Big Four’ audit more than 78% of US public companies, representing 99% of the public company sales. This was the analysis of Robit Bloom and Davit C. Schirm of the report of GAO (Government Accountability Office) 1. The problem of concentration is so acute that practically Big Four has left no scope of professional growth for auditors outside the ring of Big Four. This study further states that, ‘Because each of the Big Four is dominant in particular field of specialization, many companies have, for practical purposes, only one or two from which to select. For example, PricewaterhouseCoopers dominates the petroleum and coal industry, while KPMG covers financial institutions.’ Robit Bloom and Davit C. Schirm also mentioned in the analysis that ‘ The report points out that market for audit services to large companies has become a ‘tight oligopoly’ defined as a market structure in which the top four providers control at least 60% of the market and other entities face significant barrier to entry into the market1.’
There is feeling among multinationals that only big auditing firms have the resources, global reach and expertise to satisfy the assurances and their consultancy needs. The decrease in number of big audit firms (after merger of Anderson) and the desire of engaging reputed audit firm have increased the concentration further. The problem can be aggravated if any of big firm voluntarily or involuntarily leaves the market. The audit concentration level will increase further. That means there is an urgent need of a solution to maintain a healthy competition among audit firms.
2. Joint audit the real solution.
A number of suggestions are flouting to mitigate the dominance of big four. Some suggest merger of big firm with medium sized accounting firms. Others suggest that government should introduce some sort of taxation on big firms. There are also talks of providing incentives to mid-sized and small firms to reduce the gap and create a healthy competition. But the fact is that gap between big four and fifth accountancy firm is so large that these suggestions will prove futile when brought to action. There is another idea of ‘joint audit’ which offers an attractive and viable alternative to Big Four firms. Non- Big Four firms can work as joint auditors with Big-Four firms to mitigate the concentration problem to great extent.
Nicolas Veron2 responding to the ‘Financial Reporting Council’s Discussion Paper on Choice in UK audit market’ has remarked ‘that “Joint audit” system, by which large companies have required to have their financial statements audited by two separate firms (as the case in France) has allowed a number of non-Big Four firms to be involved in the audit of large companies but apparently not to the extent that they could compete with Big Four firms for the full extent of their services. This is evidenced by the fact while the numbers of large French companies have a non-Big Four firm as joint auditors alongside a Big Four firm; very few (even fewer) have two non Big Four firms as joint auditors. Furthermore, I know of no comprehensive assessment of the positive or negative impact of the joint audit system on audit quality’
This comment of Nicolas Veron brings forth the real scenario that will emerge on introduction of joint-audit system. The situation not discouraging as even otherwise there can not be any healthy competition between Big Four firms and non- Big Four firms. At least non-Big Four firms will be provided an opportunity to work on qualitative professional assignments which have been completely corned by Big Four. A different type of healthy competition will emerge. Non-Big Four firms will try to prove their worth and Big-Four firms will have their reputation at stake when in joint venture with non-Big Four firms. Ultimately healthy competition will emerge as a success.
3. Impact of Joint Audit on quality and cost
Emergence of oligopoly type of market has the effect of concentration on prices with limited consumer choice. Oxra report acknowledged it stating ‘that higher concentration has led to higher audit fees (in line with economic theory and with several other recent empirical studies).
While there is a degree of price sensitivity among companies, and some bargaining on fees takes place during the annual audit firm reappointment process, in general the focus of audit committee chairs is more on quality (and reputation) than on price. Separately from the impact of concentration, audit fees seem to have risen in recent years as a result of cost increases, caused by factors such as changes in regulation3.’ Oxra report pointed that concentration was, among others, the reason for rise in price for audit. In fact determination of prices should be the result of interaction of market forces in healthy competitive market.
Not only cost of audit but quality of audit also suffered because of oligopoly created by Big Four. Quality Forum of Institute of Chartered Accountants, England and Wales rightly emphasised that ‘Competition and choice is necessary to ensure that audit quality is maintained and enhanced, but any proposal for intervention in the audit market to stimulate such competition and choice, needs to take into account, what impact, if any, the policy might have on overall quality4.’ The proposal joint audit definitely brings in qualitative audit process into action. Non-Big Four will have to prove themselves that they are parallel to Big Four quality wise, and Big Four will impress upon that do not compromise quality while sharing responsibilities in joint audits.
4. Conclusion
Introduction of joint audit is a concrete step to remove oligopoly. Joint Audit place every player on equal footing, be they are Big Fours or non-Big Fours. In fact the term Big Four needs a decent farewell for the sake of healthy competition to bring out quality in auditing. Let the price of auditing be remaining an interaction of market forces.
References
1‘Consolidation and Competition in Public Accounting- an Analysis of the GAO Report’ by Robert Bloom and David C. Schirm in ‘The CPA Journal’- June 2005 issue. http://www.nysscpa.org/cpajournal/2005/605/infocus/p22.htm
2 ‘Choice in the UK Market’ Response by Nicolas Veron to the Financial Reporting Council’s Discussion Paper on Choice in the UK Audit Market. http://www.bruegel.org/Public/publication.php?ID=22&PHPSESSID=86de8e77fbf03ce40bb8a44a4e52ebe0
3 ‘Competition and Choice in the UK market’ Prepared for Department of Trade and Industry and Financial Reporting Council in April 2006 http://www.oxera.com/cmsDocuments/Reports/DTI%20Auditors%20executive%20summary.pdf
4 ‘Shareholder involvement- Competition and choice’, Interim Report on Audit Quality forum, Audit and Assurance Faculty of The Institute of Chartered Accountants in England and Wales page 6 http://www4.icaew.co.uk/index.cfm?route=115499
