Auditor independence: an update
| by Peter Byrne
06 Jan 2001
|Auditor independence continues to be an important topic on both the Paper 6 and Paper 10 syllabi and Examiners have indicated that they expect a clear understanding of the rationale underpinning the Rules of Professional Conduct covering this area. The objective of this article is to remind students of the key issues and provide an update on recent developments.
DefinitionObjectivity or “independence of mind” is essential for the exercise of professional judgement. It is a state of mind which only has regard to considerations relevant to the task in hand and ignores other factors. It is quite possible that an auditor could be objective when auditing a company owned by a close relative but he would not be “seen to be independent”.
RulesThe Companies Act 1985 and the ACCA Rules of Professional Conduct provide detailed guidelines to ensure that auditors are not only independent but are also “seen to be independent”. The Companies Act requirements for auditor independence have been developed by successive acts of legislation and cover the rules on appointment, removal, resignation and the rights of auditors.
The Rules of Professional Conduct are more detailed and provide guidance on specific threats to independence e.g., “undue dependence on an audit client” which limits the proportion of gross earned income from one client to 15% (or 10% in the case of public interest companies). The detailed requirements of both the Companies Act and the Rules of Professional Conduct are provided in all auditing texts/ manuals and students should ensure they are familiar with them. Care needs to be taken in ensuring a clear distinction between the two!
ProblemsDespite the comprehensive rules referred to above a number of practices persist which have a detrimental effect on the perceived independence of auditors.
(a) Negotiation of the audit fee
(b) Provision of other services
AccountancyAssistance with the preparation of the company’s financial statements and accounting records of a listed or public interest company is prohibited by the Rules of Professional Conduct “save in an emergency”. Such assistance is rarely required by large companies but at the other end of the spectrum auditors will almost always prepare the accounts of small companies prior to performing an audit. The threat here is principally that of self-review and audit firms often guard against this by employing different staff to prepare the accounts and audit them (although this is not specifically required by the Rules of Professional Conduct).
It can be argued that by preparing accounts an auditor obtains a more detailed understanding of the client’s business and this outweighs the potential threat to independence. It is feasible that the “auditor” could miss errors in accruals, etc. that he/she had calculated whilst preparing the accounts but in my view audit work can still be performed objectively and the results of an after date cash review, for example, would probably be considered before the bad debt provision was finalised.
TaxationThis will normally involve preparation of the corporation tax computation and personal tax assessments/P11Ds of the directors. The former is not normally a problem area but assisting client directors with their personal tax affairs raises the threat of the auditor becoming too closely involved with the interests of the directors, especially if problems arise with the Inland Revenue.It could be argued that this threat is mitigated if different personnel are involved in performing the personal tax work.
ConsultancyThis can include a range of services such as assistance with raising finance, management consultancy, design/implementation of new accounting and computer-based systems, employee recruitment and training, etc.
It has been suggested that the larger firms may tender for audits by quoting a low audit fee with a view to attracting the more lucrative consultancy work that may also be required, so called ‘lowballing’. Although firms would never admit to this practice comparisons of the audit fees of similar size companies often reveal significant differences that surely cannot entirely be due to differences in audit approach or complexity of the client’s business. Annual reviews of the respective size of audit and consultancy fees of listed companies also tend to increase such speculation. These reviews have been possible following the introduction of Statutory Instrument (1991/2128) issued in 1991 which requires large companies (per the Companies Act criteria) to disclose non-audit fees in their financial statements. Another aspect to this problem is that many of the larger firms now advertise their audit services as “adding value” to clients’ businesses. This seems to imply that the audit performs a consultancy function which conflicts somewhat with the idea of auditor independence. The section in the Rules of Professional Conduct which requires auditors to ensure they do not perform management functions or make management decisions is relevant here.
Expert servicesThis work comprises reports, opinions, valuations or statements which directly affects amounts and disclosures in the financial statements. An expert for this purpose possesses skill, knowledge and experience in a particular field other than auditing such as specialist valuations, litigation support and arbitration.
Probably the most infamous case of a conflict of interest arising from such services is the brand valuation of the Mirror Group newspaper titles in 1991 by Coopers & Lybrand who also performed the audit. Subsequently a Joint Disciplinary Tribunal fined them £1.2m in 1999 and the firm admitted 57 complaints relating to the quality of their audit work. However, it would be wrong to suggest that the provision of these expert services were the primary cause of the lack of objectivity on Coopers & Lybrand’s part, the most likely factors being the threat posed by Maxwell’s dominant personality and over-familiarity as the audit was performed by Coopers & Lybrand for 20 years.
Steps that firms should take to mitigate the threatsThe Rules of Professional Conduct require auditors to take appropriate measures to negate or reduce potential threats to independence which may include:
Recommendations for improving auditor independence – recent developmentsMany of the recommendations for improving auditor independence have been re-issued in slightly different guises over the years.The objective of this section is to identify recent developments in the auditing environment which directly affect the issue of auditor independence.
Prohibition of other servicesIt has been suggested that auditors should be prohibited from performing any other work for client companies. Consequently this would remove the self-interest threat of losing lucrative work if the auditors displease the directors. The involvement of another firm would obviously have cost implications especially for smaller companies. However, the potential problems will be considerably diminished when the turnover threshold for a statutory audit is raised in July 2000 to £1m and eventually to £4.8m. Although raising the threshold represents a potential loss of income to smaller practices it can also give them the opportunity to get more actively involved in client affairs without any attendant independence problems.
However, in the case of listed companies, practically all of whom are audited by the big accountancy practices, the case in favour of the prohibition of other services seems to have even greater substance given the spate of audit failures in the last 10 years (e.g., BCCI, Polly Peck, and Maxwell). The firms would argue that objectivity is not impaired as the work is performed by separate consultancy practices. However, this has not prevented the Securities and Exchange Commission in the U.S.A. from pressing the “Big Five” audit firms to devolve their consultancy practices and Ernst & Young and PricewaterhouseCoopers are in the process of doing exactly that.
Rotation of auditorsIt is argued that auditors will not become too familiar or trusting of directors if the audit firm is changed periodically say every five to seven years. It could also be argued that auditors would be less concerned about losing an audit that will be rotated in the near future anyway. This would also have cost implications as first audits are more time consuming and the recommendation has not surprisingly proved unpopular with clients as well as audit firms. However, no doubt in an attempt to be seen to address this issue, the Rules of Professional Conduct now state “in relation to the audit of listed companies no engagement partner remains in charge of such an audit for a period exceeding seven consecutive years. An audit engagement partner who has ceased under the above provision should not return to that audit until a minimum of five years passed but is not precluded from other involvement with the client”.
Peer reviewThis suggestion would involve an independent review of the audit files of one firm by another and has been a requirement in the USA for a number of years. It has proved an unpopular suggestion in the UK and it could now be argued that the role of the ACCA and Joint Monitoring Units, whose visits include a review of a sample of audit files and the quality control and independence procedures operated by registered audit firms, has rendered this suggestion redundant.
Audit committeesListed companies in the UK were first required to set up an audit committee of non-executive directors by the Cadbury Code (1992) which is now enshrined in the Stock Exchange listing agreement. The rationale is to place auditors at arm’s length from the executive directors. The Hampel Committee (1998) replaced Cadbury and requires audit committees to review the scope, results, cost-effectiveness, independence and objectivity of external audit. An earlier discussion document by the APB, The Audit Agenda in 1994, had suggested shareholder representation on audit committees but this somewhat radical suggestion was not adopted.
However, audit committees will only be effective if the non-executive directors are impartial and a paper by Collier 1997 raises doubts on this point.
Company law reformIt has often been suggested that many of the requirements of the Rules of Professional Conduct such as shareholdings in client companies could be prohibited by law. Earlier this year the Company Law Review Steering Group issued a consultation document Modern Company law for a Competitive Economy: Developing a Framework. The document makes a large number of recommendations re auditors’ duty of care and liability and the abolition of the audit of small companies referred to above. However, it makes no specific recommendations re auditor independence.
ConclusionAuditor independence has been the subject of a considerable number of research papers and discussion documents which have produced many recommendations for improvement. Although the ethical guidelines of the professional bodies are updated periodically there have been no radical changes and with the exception of audit committees few of the above recommendations have been implemented.
However, it is important that students are familiar with the principles underlying the independence debate and can make reference to recent developments. Hopefully this article will have provided some assistance.
Unable to open a PDF document? To open a PDF you need Adobe Acrobat Reader, which can be downloaded for free from the Adobe website.