Debate on Auditor Independence

Abstract

Recently of corporate collapse in the US, Australia, and elsewhere, regulatory attention has been drawn to the published of auditor provided non-audit services (NAS) and audit client relationship. This assignment aims to debate on auditor independence by providing evidence regarding the relationship between non audit services and provide consulting services at a lower cost for their audit clients.

In tracking the development and identify the key stages and the changes that took place in approaches to external auditing. The two listed companies selected for arguments are Enron Corporation versus Chartered Semiconductor Manufacturing Ltd.

Enron Corporation (former NYSE ticker symbol ENE) was an American energy company based in Huston, Texas. It was one of the world’s leading electricity, nature gas, paper and communications companies.1

Chartered Semiconductor Manufacturing Ltd (Chartered) is one of the world’s top dedicated semiconductor foundries in Singapore. It provides comprehensive wafer fabrication services and technologies to semiconductor supplier and system companies.

They are taken a reference for the arguments that influenced by the changes which have reported and analyses the effect. Research on non audit service provision impairs auditor independence, differential incentives drive auditor behavior.

Introduction

Auditor independence is a cornerstone of the auditing profession, a crucial element in the statutory corporate reporting process and a key prerequisite for the adding of value to an audited financial statement (Mautz and Sharaf, 1961). However, recent account scandals, involving corporations such as Enron in the US, HIH Insurance in Australia have cast doubt over the independence of auditors and overall value of auditing.

These legislative interventions however have occurred despite limited and mixed empirical evidence of these proposed threats to auditor independence. Furthermore, some basic questions underlying this debate remain unresolved. For example, “ What factors influence a company’s decision to purchase NAS from its incumbent auditor?’2

The provision of NAS reduces investors’ judgments of auditor independence, audit quality and the attractiveness of the firm investment but not their auditor knowledge or financial statement reliability judgment. This assignment have consider two areas of literature which relating the theories and model of auditor independence. It also relevance on NAS found in current professional, regulatory frameworks, reviewed and summarized original theoretical and empirical studies but have excluded commentaries and opinion.

The Big Five audit firms (Ernst & Young, Arthur Anderson, Deloitte & Touche, PricewaterhouseCoppers and KPMG) charger higher audit fees for initial engagement. It has prediction that where audit fees are disclosed publicly. The audit firms lower their audit fees to accept new clients when they also provide more lucrative non audit services. It is no actual loss of audit independence despite the loss of perceived independence of the Big 5 firms.

The provision of NAS by audit firms for their audit clients are popular in the current market and continuous debate over auditor independence. NAS may include consulting service such as systems design, compliance-related service, taxation, book-keeping or other services relating to the accounting records or financial statement of the audit client; financial information systems design and implementation; actuarial service; internal audit outsourcing service; management functions or human resources; dealer and investment advisor

The emerged from the Enron collapse has been the extent to which audit firms are providing NAS to their audit clients. The fees generated by NAS have been rising more rapidly than audit fees. This has led to widespread beliefs that provision of NAS can cause the auditors to compromise their independence. There are two main concerns which auditors may not stand up to management because they wish to retain the additional income from NAS which is in management’s gift. Second provision of service to management may lead the auditor to indentify too closely with management and lose skepticism.

The remainder of the paper is organized as follows:  Contains the background and literature review  Develops the hypotheses and research questions,  Contains the conclusions.

Background and Literature Review

Auditor must maintain independence in mental attitude in all matter relating to the assignment which stated by Generally Accepted Auditing Standards (GAAS). Independence auditors furnish critical assurance that the financial statement have been examined by “an objective, impartial and skilled professional� (SEC 2000,p.2). It look as a risk continue rather than an absolute and judgment about the seriousness of the threat to independence are balance against the effectiveness of the safeguards available.

Independence maintained through external constraints (e.g, legislation and regulation) or through the profession itself which maintain the independence to preserve its market value (Kinney 1999). It appears uncertain of auditor ability to accept client pressure and emphasizing the effect of the economic interest. Its calls that consulting services as “the tail that wags the dog� in the accounting industry (Investment New Article, Nov 20, 2000).

The SEC announce the new rule that the auditor independence required to disclosure the audit fee in their proxy statement, the total fees billed for services rendered by the principal accountant (the external audit firm) disaggregated into three categories as audit services, information technology services and all other services. It reveals that nearly all firm purchase non audit services from their audit firm to their audit client.

Although the big 5 auditing firm continue to maintain their independence is not impaired by these services , recently problems at Enron, WorldCom and other public firm brought accounting and auditing concerns to the attention of Congress and the public. Newly passed legislation prohibits NAS, including financial information services and internal auditing services (Sarbanes-Oxley Act 2002).

Non audit services (NAS) are defined as all services provided by an auditor that are not considered as an audit. The Sarbanes Oxley Act (SOX) reduce the number of non audit services that an auditor are required pre-approval by the audit committee of such extended engagement (Rouse, 2005).

Most banned services related to consulting or advisory services that might create conflict of interests for independent auditors (Banham, 2003). The banned non audit services include:

1. Book-keeping or other services related to the accounting records or financial statements of the audit client. The auditor is considered not independent when he provides book-keeping services for audit client. It involves with an inherent conflict of interest, and auditor should examine accounting records or financial statements prepared appropriate.

2. Internal audit outsourcing services – under generally accepted auditing standards, the auditor is required to evaluate the effectiveness of internal control system over financial reporting, to create another example of conflict of interest. For example, Arthur Anderson provided the internal control function for Enron, before it was banned by 2000 SEC rule, and was blamed for not improving Enron’s ineffective control system.

3. Expert services unrelated to audit – providing an expert opinion or other expert service for audit client to advocating an audit client’ interests in litigation, regulatory, administrative proceeding and investigation.

4. Design and implementation of accounting information systems – its creating inherent conflict of interest as an auditor is required to evaluate the effectiveness of accounting system in designed or implemented. Installing a computerized accounting system for client was immensely popular consulting services in many big accounting firms.

5. Management functions acting – temporarily or permanently, as director, officer, employee of an audit client in performing any decision making, supervisory or ongoing monitoring function for audit client.

These services can provide by the incumbent audit firm or external audit firm. This research on auditor independence under these conditions identifies the following issues. The provision NAS likely lead to a lack of actual independence and therefore lead to audit failure.

Hypotheses and Research

One of the major public concerns which emerged from the Enron collapse has been the extent to which audit firms are providing non audit services (NAS) to their audit clients.

In 1997, Enron engaged Arthur Andersen as its External Auditor. Subsequently, Enron appointed Arthur Anderson as consultant also. Enron paid Andersen $52 million in 2000 in both auditing and consulting services including development of computerized financial system for conducting Enron’s internal audit, but majority for consulting services. There have been many criticize about the potential conflict of interest faced by audit firms who received large consultancy fees from their audit client (e.g. Financial time 2001a). Its expressed about how auditor with a statutory responsibility to company shareholders can handle a commercial relationship with the company’s management and remain impartial (e.g. financial Times, 2001b).

Andersen leaders responded by pushing partners to become salesman, it’s to upsetting the delicate balancing act any auditor must perform between a client and looking out for the public investor. Peoples have forgotten their significant responsibility not only to clients but also to investor, creditors and the public, etc.

These issues by attacking the “specific symptoms of the audit breakdown that occurred in the Enron Caseâ€? (Gavious, 2007,pg458), Arthur Anderson whose Enron client found to have encouraged clients to use accounting techniques to mislead and deceive the market (Gavious,2007). Enron select to use a method of fair value accounting that misleading, overstated profits in the current period. These accounting techniques were employed by Enron on the advice of Arthur Anderson and it was the employment of these techniques that ultimately led to the organisation’s collapse (Benston, 2006) . Due to IT and other frauds which investors lost confidence in market (Crasewell, 1999).

Its beliefs that provision of NAS cause the auditors to compromise their independence. Andersen has been severely criticised for significant economic and its independence has been questioned form two point of view – significant economic dependence on Enron due to the party designing accounting and tax structures, and therefore it could not express an objective view on Enron’s results.

The two main concerns are auditor may not stand up to management because they wish to retain the additional income from NAS which is in management gift, and second the provision of a range of services to management may lead the auditor to identify too closely with management and lose skepticism. Thus, auditor independence is fundamental to public confidence in the audit process and reliability of auditor report.

However, the problem facing the auditing profession is not a lack of actual independence and objectivity rather it is the lack of confidence in financial statements. Public confidence in a company’s financial statements will only be achieved by companies remaining completely separate to their audit firms (Ronen and Cherny,2002). Thereby increasing the auditor’s perceived independence.

While Chartered engagement of KPMG as its external auditor to perform non audit services which management must consider the actual, perceived and potential impact upon the independence of external audit prior to engaging external audit to undertake any non audit services.

Chartered have established the Audit Committee of the Supervisory Board (Audit Committee.) to oversight of Company’s financial position. It’s responsible to supervising the operation of the internal risk management and control system, codes of conduct, compliance with recommendation and observation of internal and external auditor.

In contrast, audit committee of Chartered have to consider whether the provision of such non audit services is compatible with maintaining the external auditors’ independence, by obtaining assurance and confirmation that the additional services provided by external auditor are not in conflict with the audit process.

The audit committee has authority in independent audit are to be-approved with information sufficient to enable Audit Committee to know as follows: – the precisely what services it is being asked to pre-approved, – know that any non audit service to be performed is a permissible non audit service – made a well-reasoned assessment of the impact of the proposed service on the auditor independence.

The external auditors are prohibited from providing specified non audit service contemporaneously with providing audit services to Chartered Semiconductor Manufacturing, including:-

– bookkeeping or services related to accounting records or financial statements – financial information system design and implementation – internal audit outsourcing services – legal services an expert service unrelated to the audit

Audit committee has clarified and added further prohibited activities for the external auditor. By focus of the importance of Audit Committee in control and supervise the activities of the external auditors. This section, Audit Committee is the plans to strengthen the independence accountants are truly independence thus and will give greater credibility to audits.

In this research, Enron should have formed an audit committee to oversight the company and prevent any fraud which collapse to bankruptcy which compare with Chartered, although the audit firm provide non audit services, but they have a stronger and capability audit committee to oversight the company financial position.

Conclusion

In the debate on auditor independence, the first matter that is usually raised is the provision of non audit services to audit client.

To be able to perform their task of providing independence and objective assurance to shareholders, auditor must act independently. It is argued that by providing non-audit services to the audit client, the auditor’s independence and objectivity is impaired.

In term of codes of ethics all over the world, it is not only necessary for auditors to be independence, but there is also a need for auditors to be seen to be independent, and even a perception of a conflict can compromise his or her position. It behooves the auditor therefore never to get into such a situation.

If one examines the research, there is little empirical evidence that proves that the provision of non audit services actually impairs independence, but one must concede that it is difficult to prove. Recent corporate failures have brought this issue very much under the spotlight again. As a profession, we should not underestimate the public feeling and the strong view held by governments on this issue.

The rule of fundamentally change the way auditing profession does its business as following:

Fundamental shift in regulating accounting industry – from the primarily self-regulated environment to public regulation approach.

A new set of independence rules and regulations affects the accounting profession directly in performing audit engagement.

A new independent public oversight board now has the direct authority to police audit process, auditing standards, and disciplinary measure on auditors, including

• registering public accounting firms that issue audit report for publicly(trade companies),
• establishing auditing, quality control, ethics, independence, and other standards relating to the preparation of audit reports
• conducting inspections of registered public accounting firms
• conducting investigations and disciplinary proceeding and imposing appropriate sanctions on audit firms and auditors.

An independent oversight board (IOB) set up by Andersen in the US , after the Enron problems emerged but before the firm collapsed, recommended that some consulting services provided by the firm should be separated into partnerships managed independently form audit partners and without financial independence to audit clients. Recommendation was strengthen of internal quality control over auditing thought out the firm.

Beside this it’s create an independent regulatory oversight agency for accounting industry. Now no truly independent agency with the authority, power or will to enforce penalties against illegal. While the Public Oversight Board was a nominally independent private body that set standards for the industry’s self-regulatory schemes, it was never truly independent. The finding comes from the America Institute of Certified Public Accountants.

Thus, in summary I conclude that since such evidence as there is indicates that there is no correlation between levels of non-audit fee and audit failure, comprehensive safeguards are already applied, and rigorous separation of non-audit services seems likely to increase the cost and reduce the quality of the audit, the suggestion should not be pursued. Assuming no undue overall economic dependence results from the auditor/client relationship and adequate safeguards can be implemented, we believe that companies themselves should determine whether they use auditors for non audit services, in consultation with the profession’s guidelines.

References

1. Enron profile Available at : http://en.wikipedia.org/wiki/Enron

2. Ashbaugh, H.,R.LaFond,and B.Mayhew.2003. Do non-auidt services compromise auditor independence? Further evidence. The Accounting Review 78: 611-639.