Audit: Threats And Safeguards
This essay will discuss in depth, whether external auditors can be independent given their reliance on the fee income from the company being audited. It will explore the threats and safeguards in relation to one of the threats being the company under audit paying the audit fee. Independence is crucial to the audit and auditors. The FRC describes independence as “Freedom from conditions and relationships which, in the context of an engagement, would compromise the integrity or objectivity of the firm or covered persons.” (Financial Reporting Council 2019). Independence is considered to be compromised if it is likely than an objective unreasonable third party would conclude that a threat impairs integrity or objectivity to the extent that it would be inappropriate for the firm to continue the audit unless threats were eliminated or safeguards were implemented. Auditors are expected to provide an unbiased opinion on work they have performed.
The main threat being explores is a self-interest threat, which could possibly happen consequently due to the financial or other interests of a professional accountant under audit. For example, this could be fee dependence, the firm having fee dependence on total fees from a client therefore would they impact their independence to keep the clients. The other threats which may impact an auditors independence have been listed next. Self-review threats, the auditor has maintained the financial accounts and then audits them. Advocacy threats, this threat arises where you support your client’s views, for example the auditor acts on behalf of the client at a court case. Familiarity threats, which may occur when, because of a close relationship which has developed over several years the auditor becomes too understanding to the interests of others. Intimidation threats, when the directors have overbearing personalities which then the auditor feels obliged to act in a certain way and can prove difficult to work with. (Code of Ethics, IFAC 2005). Each member of the audit team should ensure safeguards should be developed to reduce the threat to an acceptable level.
In theory, there are many factors that affect independence of an auditor and these factors and these could be the audit firm size, size of audit fees, the effects of gifts and many more that could impact the auditors independence. So if the company under audit was paying the audit fee then this could be a threat to the auditors independence. The auditor may have motivation to not report certain errors or may act favourable towards the client as they are relying on the fee income. A safeguard the FRC put in place for a long serving client listed on an exchange market that if the audit fee exceeds 10% of the total annual fee income then the auditor should resign or withdraw from the reappointment. They could also be threatened with litigation or be pressured to reduce fees in order to reduce the workload of the audit according to the auditor. When total fees paid to a client subsides 15%, safeguards should be put in place to ensure that auditors are giving an objective high-level audit. No matter what the fee is, whether it be less than the 15% or 10%, threats should still cautiously be reviewed. From Gray, Manson and Crawford, safeguards could include conducting a second review by an independant third party member. However smaller firms may reach out to other firms for expert guidance. A study conducted by Craswell, Stokes and Laughton was in the interest of financial interests of auditors in their clients and how it affects their independence at different levels. The results showed that due audit firms putting safeguards in place such as using review partners and peer reviews to safeguard the auditor’s independence. This highlights the company’s importance of having a valued and trustworthy reputation. From Blay and Geiger (2012) a study was conducted and uses a declaration from DeAngelo 1981. The results show that auditors independence may become weakened when the auditor in general becomes too focused on the fee income.
Another main threat is familiarity, when the client has been involved with the auditor for several years. It is debatable as to whether a partner should audit a client for more than ten years and this could question an auditor’s independence. However, on listed companies there are limitations on how long partners can audit a company for. An engagement partner can only be involved for a maximum of five years, for key partners it is 7 years and for senior staff it is also 7 years. Audit firms should carry on revising possible threats to their auditor’s independence and put safeguards in place to reduce any threats that become apparent. Although for senior staff this can be extended if there is a validated reason to do so (Ben Goldie RGU Lecture 2020). Auditors may form well known relationships with their clients and gain a large sum of income from them. From Gray, Manson and Crawford it states that a possible safeguard that can be put in place to reduce the question of independence would be to rotate the audit team as well as the engagement partner. If rotation were to become mandatory by the FRC it would essentially avoid the well established relationships between the client and the auditor, the firm would also potentially increase the quality of work produced as a new firm would be conducting the audit after them.
Audit firms have great experience and can provide excellent opinions on non-audit services. Non-audit services can have greater fee income overall which can even be more significant than auditing fees charges. However this can question an auditors capability of remaining independent. The firm should take great consideration in deciding whether to carry out the non-audit work or to withdraw completely from the audit to protect the auditors independence. DeFond et all (2002) found that there was no significant link connecting non audit services with the auditors opinion along with Craswell (1999). So in particular Defond (2002) concluded that non auditing services are in no definite way of damaging the auditors independency. On the other hand Sharma and Sidhu (2001) agreed that it may have a damaging effect as their results found that auditors opinions would be compromised by carrying out non audit services, meaning auditors independence would be questioned. This is due to the fact that the non-audit fees that are involved are allowing the auditors to provide a lower quality examination and an overall poorer analysis compromising an auditors ability to remain independent and objective. From the BBC website, accountancy firm KPMG have decided not to continue to do consultancy work for companies alongside auditing them. The firm. The chairman stated that they were hoping to “remove even the perception of a possible conflict of interest”. So essentially KPMG are trying to regain trust which may have broken down over the past few years and build up a positive image and auditor independency. A study from Stanford Graduate School of Business has showed that non auditing services does weaken an auditors external independence to ensure that they are giving an objective high level audit. The study found that companies who contribute more non-auditing fees compared to audit fees have a lower earning standards. It was also found that companies who have a lower share value on the stock market if they are paying more towards non-audit fees than auditors.
From the discussion on whether external auditors can be independent given their reliance on fee income from the company being audited there is a range of factors which can question an auditors independence. There can be a great threat and question of auditor independence due to fee dependence, however applicable safeguards set out by accounting standards have been put in place in order to reduce the threat of independence. One main issue is that auditors can create well relationships with clients and sometimes maybe too close, again an increasing threat of independence. Finally it is not possible to say whether external auditors are completely independent given their reliance on fee income from the company being audited.