«Auditor Independence and Non-Audit Services: A Literature Review Vivien Beattie University of Stirling and Stella Fearnley University of Portsmouth ...»
Auditor Independence and Non-Audit Services:
A Literature Review
University of Stirling
University of Portsmouth
TABLE OF CONTENTS
List of tables and list of figures v
About the authors vi
List of abbreviations vii Executive summary ix Part 1 Auditor independence 1 Introduction 1
1.1 The role of audit in regulating capital markets 1
1.2 The ‘problem’ of non-audit services (NAS) 1
1.3 The current UK regulatory and professional environment 2
1.4 Motivation for this study 3
1.5 Structure of report 3 2 Auditor independence 4
2.1 Introduction 4
2.2 Definitions of auditor independence 4
2.3 Economic models of auditor independence not including NAS 5
2.4 Models of auditor pricing and independence in the presence of NAS 5
2.5 Economic power models of auditor independence 8
2.6 Moral psychology, ethical reasoning and independence 8
2.7 Broader based studies into auditor decision making 9
2.8 Summary and comments 11 Part 2 Current regulatory frameworks Auditor independence and NAS: analysis of current regulatory frameworks
3.1 Introduction 13
3.2 Regulation of auditor independence 13
3.3 Independence in professional and legal regulatory frameworks 13
3.4 Independence and NAS 19
3.5 Overall economic dependence 22
3.6 Small companies 22
3.7 Summary and comments 23 Part 3 Empirical studies of NAS 4 Methods 25
4.1 Literature search procedures
Vivien Beattie, MA CA PhD is Professor of Accounting at the University of Stirling, Scotland. A graduate of St Andrews University, she qualified as a Chartered Accountant in 1983. She has worked in the higher education sector for 18 years.
During this time, she has held research grants from the ICAEW, the ICAS, the ACCA, and HM Treasury. From 1991 to 1997 Vivien was an Academic Fellow of the ICAEW. Since 1997 she has held the part-time post of Director of Research at The Institute of Chartered Accountants of Scotland. Publications include over 30 articles in refereed academic journals, nine published research reports and books and numerous articles in professional journals and the financial press. Her main research interests are business reporting and the external audit market. She is currently a member of the Academic Panel of the Accounting Standards Board and was a member of the ASB Working Party undertaking the recent review of the OFR Statement.
Stella Fearnley, BA FCA is a Reader in Accounting at Portsmouth Business School.
She is an elected member of the Council of The Institute of Chartered Accountants in England and Wales. She is also Vice-Chair of the Management Board of the ICAEW Centre for Business Performance (formerly the Research Board), and a member of the Audit and Assurance Faculty Committee. She was President of the Southern Society of Chartered Accountants in 1991-92. Stella trained with Price Waterhouse and was a senior technical manager in Grant Thornton before becoming an academic. Her main research interests are audit and the regulation of financial reporting. She has published widely on these subjects in professional and academic journals and in national newspapers.
We would like to thank Richard Brandt, our Research Fellow, for his careful reading and detailed comments on drafts of this report.
Vivien Beattie Department of Accounting, Finance and Law, University of Stirling, Stirling FK9 4LA. Tel. 01786 467306 Email V.A.Beattie@stirling.ac.uk Stella Fearnley Department of Accounting and Management Science, Portsmouth Business School, Locksway Road, Milton, Southsea, Hants, PO4 8JF, Tel. 01705 844234 Email Stella.Fearnley@port.ac.uk
ACCA Association of Chartered Certified Accountants AICPA American Institute of Certified Public Accountants APB Auditing Practices Board ARS Accounting Series Release ASB Accounting Standards Board CIMA Chartered Institute of Management Accountants EC European Commission ESB Ethics Standards Board ICAEW Institute of Chartered Accountants in England and Wales ICAI Institute of Chartered Accountants in Ireland ICAS The Institute of Chartered Accountants of Scotland IFAC International Federation of Accountants ISB Independence Standards Board JMU Joint Monitoring Unit NAO National Audit Office NAS Non-audit services POB Public Oversight Board RSA Royal Society for the Encouragement of the Arts, Manufacturers and Commerce SEC Securities and Exchange Commission
1. INTRODUCTION This executive summary is divided into three sections. This section sets out the motivation and scope of the study. Section 2 summarises the key findings and section 3 offers conclusions
1.1 Motivation for this study One of the major public concerns which has emerged from the Enron collapse has been the extent to which audit firms are providing non-audit services (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. First, auditors may not stand up to management because they wish to retain the additional income from NAS which is in management’s gift and, second, the provision of a range of services to management may lead the auditor to identify too closely with management and lose scepticism. NAS may include consulting services such as systems design, compliance-related services, such as taxation and accounting advice, and assurancerelated services, such as due diligence.
Because of public concerns about possible links between the provision of NAS and auditor independence, the Institute of Chartered Accountants in England and Wales (ICAEW) asked us, as independent academics, to conduct a review of ‘available research, professional and academic, on the provision of non-audit services by audit firms to audit clients’.
1.2 The scope of this study We have conducted a comprehensive search of recognised databases both for published and recently written unpublished studies into NAS. We have reviewed and summarised original theoretical and empirical studies but we have excluded commentaries and opinion pieces. In order to set this review in context, we have also considered two areas of literature relating to auditor independence, being theories and models of auditor independence which have relevance to NAS, and the provisions relating to independence and NAS found in current professional and regulatory frameworks.
1.3 Academic research into auditor independence and NAS The audit process (i.e. the means by which an audit opinion is reached) is not publicly observable and access by researchers to real-life situations on a significant scale is not possible. Researchers, therefore, have adopted other methods of investigation. These include: theory development; mathematical models;
questionnaire studies; case studies; experiments with groups of participants using artificially created datasets; and statistical analyses of data from publicly available sources, mainly published financial information.
ix All research methods have strengths and limitations and this should be borne in mind when evaluating the results of studies. Formal economic models focus attention on key issues which are drawn from logical theory. Their limitation lies in simplifying assumptions which are made, such that they do not adequately reflect the complexities of real-life situations. Statistical analyses of data can be limited by the use of sometimes questionable proxy measures for the key variables of interest. Case studies represent real-life situations and are valuable for theory development but by definition are small in number and cannot be assumed to be representative of the entire population. Questionnaires elicit a wide range of views but low response rates may produce non-response bias (i.e. an unrepresentative overall view) and declared responses may only partially reflect the real views of the respondents. A similar risk lies in experimental studies in that the subjects’ responses may not truly reflect their real-life behaviour. However, experiments are valuable in eliciting behaviour patterns from different groups. Where different research methods lead to the same answers, our confidence is the answers is thereby considerably increased.
Much of the research into NAS has been carried out in the USA. Readers should be aware that research findings in different regulatory environments do not necessarily translate satisfactorily into others.
2. KEY FINDINGS Key findings under each chapter heading are set out below, followed by a summary and conclusion.
2.1 Models of Auditor Independence: chapter 2 Formal models of auditor independence assume economic rationality and generally ignore behavioural issues on the part of market participants. These studies on the whole show that the joint provision of audit and NAS by incumbent auditors does not adversely affect auditor independence. This is a significant finding, in that it allows us to see that economic incentives generally produce independent behaviour.
Other studies recognise behavioural factors, drawing upon concepts in moral psychology. Experimental studies have found that the individual auditor’s level of ethical cognition has a significant impact on audit decisions. The influence of the audit firm’s culture is beginning to be explored and is already emerging as an important influence.
There are also recently developed broader-based frameworks of auditor decision making which are not formal models, but which encompass a more comprehensive set of influences on auditor behaviour, encompassing economic, behavioural, regulatory and contextual influences. One of these frameworks has been developed from recent UK case studies of real-life audit conflict situations. These frameworks confirm the important influence on decision making of the individual’s level of ethical cognition and the culture of the audit firm.
2.2 Current regulatory frameworks: chapter 3 Six auditor independence frameworks are reviewed, those for the UK, the US (SEC), Australia, EC, IFAC and Ontario. Apart from the US framework, which is predominantly rule-based, with a set of prohibitions, a principles-based approach is taken. (The SEC framework sets out principles but these are outside the actual rules.) Independence is seen as a risk continuum, rather than an absolute, and judgments about the seriousness of the threat to independence are balanced against the effectiveness of the safeguards available. Five threats are identified: self-interest, selfreview, advocacy, familiarity or trust, and intimidation. There are four main sources of safeguards: the regulatory framework, the audit firm’s internal quality controls, the client company’s corporate governance and refusal to act. Where no safeguard could be deemed adequate (such as an auditor taking management decisions) the frameworks contain a prohibition. In relation to the provision of NAS the threats are seen as wide-ranging. Only intimidation does not appear as a relevant threat. There is less convergence among the frameworks about the level of threat which arises from internal audit and the installation of financial information systems than exists for the other threats. With the exception of the UK framework, where the recommended upper level of economic dependence for a firm is defined (10% of total firm income, including NAS from one listed company client), the frameworks are generally imprecise about an acceptable level of economic dependence for a firm, a specific office of a firm or an individual partner.
With the exception of SEC which is directed only at listed companies, the frameworks recognise that flexibility is needed in applying the principles to the auditors of small entities.
The frameworks all identify the importance of both independence in fact (i.e.
independent behaviour) and independence in appearance (i.e. the belief that auditors are independent). The current benchmark for measuring independence in appearance is what a well-informed investor or third party would believe. The threats and safeguards do not distinguish between the defence of independence in appearance and independence in fact.
2.3 Descriptive studies of the amount and type of NAS: chapter 5 In some jurisdictions and time periods, there has been no requirement for companies to disclose the total amount of NAS purchased from their auditor. Even where this is a requirement, there is generally no breakdown of the total by service type (e.g. UK). In these circumstances, evidence is collected via company surveys. This generates less reliable data, due to the risk of response bias. In the UK, the ratio of non-audit to audit fees paid to the incumbent auditor has risen to 300% for the FTSE 100 companies (up from 98% in 1996). There is some evidence that taxation services predominate and that the overall ratio of NAS to audit fees is higher in the UK than in the US.
2.4 Determinants of the purchase decision: chapter 6 Researchers have investigated three aspects of the NAS purchase decision: the choice between the incumbent auditor or another provider; the types of service purchased;
and the absolute and relative amounts of NAS. A major argument is that those xi companies with higher agency costs (i.e. companies where there is perceived to be a higher risk that the directors will not act in the best interests of the shareholders) have greater need of the audit as a monitoring device. The value of the audit is reduced if there are independence concerns and so companies with high agency costs are predicted to purchase less NAS from their auditor.
Studies show that companies with higher agency costs, more effective audit committees and a lower proportion of performance-based management compensation have lower NAS fee ratios. The overall explanatory power of these models is, however, low, since the amount of variation being explained is in the region of only 10-20%. It may be that factors that are systematically related to the purchase decision have been omitted and/or the decision has inherently random elements.