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Audit Independence

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A paper on the independence of auditors in the business context.

A paper on the independence of auditors in the business context.

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  • 1. Jason Cates Audit Independence0Auditor IndependenceThe Way ForwardWritten byJason Cates
  • 2. Jason Cates Audit Independence1© Jason Cates, 2013Reproduction for the following uses is authorised provided the source is acknowledged inline with the Copyright, Designs and Patents Act 1988;Private and research study purposes, performance, copies or lending for educationalpurposes, criticism and news reporting, incidental inclusion and copies and lending bylibrarians. Further details of authorised use under the above Act is available from the UKCopyright Service.This publication may be made available online at SlideShare.net/AdrJasonCates for publicuse no earlier than 09:00hrs (GMT) on 18 April 2013 as deemed appropriate by theacknowledged source.This paper has referenced appropriate sources in line with Harvard Referencing.Any queries regarding this publication should be sent to:AdrJasonCates@GoogleMail.com orLinkedIn.com/in/AdrJasonCatesTo be delivered to the University of Hertfordshire on or by4 March 2013Ordered by Jason Cates to be printed4 March 2013Printed in the United Kingdom
  • 3. Jason Cates Audit Independence2‘Just like beauty, quality and independence are in the eye of the beholder, thereforeperception of audit quality and of auditor independence is paramount’Michel Barnier, European Internal Market and Services CommissionerRequired: Critically evaluate the safeguards in place to enhance auditor independence andthe extent to which any proposed measures may enhance auditor independence in thefuture.Word count: 1200
  • 4. Jason Cates Audit Independence3Table of ContentsBackground ....................................................................................................................................... 4ISA 200 .......................................................................................................................................... 4Framework.................................................................................................................................... 4Ethical Standards 1 and 5 (Integrity and Non-audit Services).......................................................... 5Ethical Standards 2 and 3 and ISA 220 (Relationships and Long Association) .................................. 5Ethical Standard 4 (Fee Dependence) ............................................................................................ 6Proposed Safeguards......................................................................................................................... 7Audit Firm Rotation ....................................................................................................................... 7Mandatory Audit Tendering........................................................................................................... 7Limit on Non-Audit Services........................................................................................................... 7Conclusions....................................................................................................................................... 8Signatories ........................................................................................................................................ 9Harvard Referencing........................................................................................................................ 10
  • 5. Jason Cates Audit Independence4BackgroundThis report will evaluate the current safeguards in place to ensure audit independence with a focuson the ethical standards. Furthermore, it will evaluate how proposals set forth by the EuropeanCommission will address any current issues concerning such independence.ISA 200Ethical requirement remain at the heart of auditor independence as set out in ISA 200. Thisincludes auditors retaining “professional scepticism and judgement” when carrying out the audit.(IFAC, 2009) These attributes are required to critically evaluate the evidence available and to makeappropriate judgements regarding issues such as materiality. Furthermore, these attributes areessential when deciding upon appropriate interpretations and implementation of the standards. Thisis particularly the case when standards of specific jurisdictions differ from those of the ISA’s. This cancreate inconsistently across different jurisdictions in which clients and auditors may operate.(ICAEW, 2013)(FRC, 2011a)Another area requiring “professional judgement” is evidence requirements. Where there isconsidered to be a high level of audit risk, greater levels of evidence may be required. This opens upthe evidence requirements to interpretation and differences depending on the audit firm used.(Millichamp & Taylor, 2012)FrameworkThe current ethical framework takes that of a principles-based approach. This includes fivefundamental principles; integrity, objectivity, confidentiality, competence and professionalbehaviour. This is compared to a rules-based approach as seen in the USA which, by its nature,cannot deal with every eventuality. Thus, having a principles-based approach places theresponsibility on auditors to ensure the standards are upheld. (Millichamp & Taylor, 2012)
  • 6. Jason Cates Audit Independence5Ethical Standards 1 and 5 (Integrity and Non-audit Services)Integrity and objectivity are two key principles of the framework and the Auditing PracticesBoards Ethical Standard one. (FRC, 2011a) These require auditors to avoid situations where conflictsof interest may arise. However, this focuses on auditors on an individual basis rather than on anorganisational level. A number of auditing failures have put into question the strength of thesestandards. One of the issues highlighted by recent collapses has been the level of non-audit workcarried out by the “Big Four” accounting firms for clients in which they were auditing. Issues such asthese can create “conflicts of interest” for auditors and impede the audits independence. Thus,where non-audit services are provided, auditors must ensure adequate safeguards are in place tomaintain auditor objectivity. (FRC, 2011b)Ethical Standards 2 and 3 and ISA 220 (Relationships and Long Association)Ethical Standard two covers personal relationships which include all family, financial,business and employments relationships. This aims to maintain auditor independence on anindividual basis and requires audit partners to identify possibly “threats” to their objectivity.Therefore, auditor objectivity and professional judgement form a key part to this standards long-term viability. It also requires adequate controls be in place as to ensure this objectivity ismaintained. For example, ISA 220 requires auditors to carry out annual “reviews” of theirrelationships with clients to ensure this objectivity is maintained. (FRC, 2010a)Ethical Standard three places the onus on auditors to implement the standards using theirprofessional judgement. This lack of precision in the standard allows for interpretations of thestandards to be made. This can become an issue of concern when there is insufficient competition inthe audit to drive up standards regarding independence. A lack of competition among auditorsdiscourages clients to change auditor and has resulted in audit firms retaining specific clientsunchallenged. This may lead to relationships forming between the management of both client and
  • 7. Jason Cates Audit Independence6auditor and impede the auditor’s objectivity. An increase in competition will increase the auditor’saccountability to client shareholders with the focus on independence and audit quality. (FRC, 2009)Ethical Standard 4 (Fee Dependence)As set out by Ethical Standard four, total fees for the provision of both audit and non-auditservices from an individual listed company should not exceed 10% of the audit firm’s total income. Incases where total fees do exceed 10% of income, the auditing firm is expected to step back from therole of auditor. Ensuring non-reliance on specific clients helps to ensure professional judgement ismaintained with the only considerations being those relevant to the audit. Thus, this standard helpsto ensure auditor independence is maintained on an organisational level. (FRC, 2010b)(Craswell,Stokes & Laughton, 2001)
  • 8. Jason Cates Audit Independence7Proposed SafeguardsAudit Firm RotationThe first proposal set out by European Commission was that of a “mandatory audit firmrotation”. This would require auditor appointments to serve at least two-year terms, but with amaximum term of six years. Once this maximum term has been served, the audit firm would not bepermitted to serve as auditor for at least four years. This safeguard will help prevent relationshipsfrom forming between the audit team and the management of the audit client. This deals with theissue of “management familiarity” which may impede on the auditor’s ability to maintain objectivityand utilise professional judgement. (Deloitte, 2012)Mandatory Audit TenderingMandatory audit tendering would require a more “competitive” and “transparent”tendering process when appointing a new auditor. Practically, this would require companies toconsider at least one audit firm from outside the “big four” accounting firms as auditor.Shareholders would then choice between at least two of these audit firms alongside therecommendations of the audit committee. This will require client management to justify their choiceof auditor with the focus being on auditor independence and competence. This will place the onuson shareholders to ensure auditor independence is maintained. (Deloitte, 2012)Limit on Non-Audit ServicesThe third key proposal places a limit on the level of non-audit work a company’s auditor willbe allowed to provide. The proposal would allow “very few non-audit services” to be provided to aclient by its auditor. This would include the provision of “expert services unrelated to the audit”being considered a “conflict of interest” and thus, would not by permitted these proposals theseexpert services will include, but not exclusively, tax consulting and bookkeeping. This will furtherstrengthen auditor objectivity and independence. (Deloitte, 2012)
  • 9. Jason Cates Audit Independence8ConclusionsIn conclusion, the current safeguards protect independence on an individual level, but fail toprotect independence on an interfirm level. The measures proposed by the European Commissionaim to address this issue.Audit firm rotation and mandatory audit tendering will help to address the “perceived” lackof independence in the eyes of key stakeholders. However, in order to be effective, audit firms mustensure they have the required skills to audit the variety of companies in which this proposal willapply. This is to avoid, companies appointing audit firms without the required competence to carrythe audit, purely to comply with these proposals.Limits of the levels of non-audit may reduce the attractiveness of offering an audit service ascompared to offering other financial disciplines deemed to be more “profitable”. (Deloitte, 2012)However, this may be overcome by audit firms maintaining diverse client portfolios. This will allowthem to offer a broad range of financial services without contradicting this proposal.These policies are likely to be disruptive in the short-term, met with resistance and willrequire long-term structural reform of the audit industry. However, they will contribute to thesafeguarding of audit “objectivity” and “independence” on an industry wide basis.
  • 10. Jason Cates Audit Independence9SignatoriesI commend this paper to the University of Hertfordshire to be delivered on or by 4 March 2012.Jason Cates___________Mail: AdrJasonCates@GoogleMail.comPortfolio: SlideShare.net/AdrJasonCatesLinkedIn: LinkedIn.com/in/AdrJasonCates
  • 11. Jason Cates Audit Independence10Harvard ReferencingCraswell, A., Stokes, D, J. & Laughton, J. (2002) “Auditor independence and fee dependence.” Journalof Accounting and Economics 33: 253-275.Deloitte (2012) Deloitte Audit Reform Briefing: Unprecedented reform proposed for the EU auditmarket. [Online] Available at:http://www.deloitte.com/view/en_GX/global/services/Audit/cff7925771678310VgnVCM1000001956f00aRCRD.htm [Accessed: 7thFebruary 2013]IFAC (2009) Overall objectives of the independent auditor and the conduct of an audit in accordancewith international standards on auditing. [Online] Available at:http://www.ifac.org/sites/default/files/downloads/a008-2010-iaasb-handbook-isa-200.pdf[Accessed: 7thFebruary 2013]FRC (2009) APB Ethical Standard 3 (Revised) - Long Association with the Audit Engagement. [Online]Available at: http://www.frc.org.uk/Our-Work/Publications/APB/ES-3-(Revised)-Long-Association-with-the-Audit-Eng.aspx [Accessed: 19thFebruary 2013]FRC (2010a) APB Ethical Standard 2 (Revised) - Financial, business, employment and personalrelationships. [Online] Available at: http://www.frc.org.uk/Our-Work/Publications/APB/ES-2-(Revised)-Financial,-business,-employment-and.aspx [Accessed: 12thFebruary 2013]FRC (2010b) APB Ethical Standard 4 (Revised) – Fees, remuneration and evaluation policies, litigation,gifts and hospitality. [Online] Available at: http://www.frc.org.uk/Our-Work/Publications/APB/ES-4-(Revised)-Fees,-remuneration-and-evaluation-p.aspx [Accessed: 12thFebruary 2013]FRC (2011a) APB Ethical Standard 1 (Revised) - Integrity, objectivity and independence. [Online]Available at: http://www.frc.org.uk/Our-Work/Publications/APB/ES-1-(Revised)-Integrity,-objectivity-and-independ.aspx [Accessed: 12thFebruary 2013]
  • 12. Jason Cates Audit Independence11FRC (2011b) APB Ethical Standard 5 (Revised) - Non-audit services provided to audited entities.[Online] Available at: http://www.frc.org.uk/Our-Work/Publications/APB/ES-5-(Revised)-Non-audit-services-provided-to-audi.aspx [Accessed: 12thFebruary 2013]ICAEW (2013) ICAEW input to APB review of their Ethical Standards. Available at:http://www.icaew.com/en/technical/ethics/auditor-independence/icaew-input-to-apb-review-of-their-ethical-standards [Accessed: 15thFebruary 2013]Millichamp, A. and Taylor, J. (2012) Auditing. 10thedn. Hampshire: Cengage Learning.

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