Auditor independence approach
Auditor independence issues are complex. Set out below is an overview of the issues, followed by a list of key documents that consider them in more detail, including links to articles and research documents.
Company financial reporting is key to the efficient and effective operation of capital markets. A critical element is the quality of the audit, and auditor independence is one of a number of important blocks on which that quality is built.
ICAEW believes that:
- The most effective way to ensure the reality of independence is to provide guidance centred around a framework of principles rather than a detailed set of rules that can be complied with to the letter but circumvented in substance.
- A blanket prohibition on the provision of non-audit services to audit clients can be inefficient for the client and is neither necessary to ensure independence, nor helpful in contributing to the knowledge necessary to ensure the quality of the audit.
We advocate a framework approach that:
- Sets out fundamental ethical principles;
- Provides a reasoned analysis of the possible threats to these principles; and
- Gives guidance on the safeguards which may be necessary to mitigate these threats.
In short, it represents a more rigorous means of ensuring auditor independence than the rules based approach favoured by many commentators and regulators, particularly in the US.
Under a framework approach:
- Fundamental principles are set out which must always be observed by a professional accountant. In the case of audit, the relevant fundamental principles are integrity and, particularly, objectivity, which necessarily requires the auditor to be independent.
- The accountant must conscientiously consider, before taking on a piece of work, whether it involves threats which would impede the observance of the fundamental principles.
- The threats are that independence will be compromised by self-interest, self-review, being in an advocacy position, over-familiarity, or intimidation. Actual threats need to be considered, and so do situations that might be perceived as threats by a reasonable and informed observer.
- Where such threats exist, the auditor must put in place safeguards that eliminate them or reduce them to clearly insignificant levels. Safeguards apply at three levels: safeguards in the work environment, safeguards that increase the risk of detection, and specific safeguards to deal with particular cases. If he is unable to implement fully adequate safeguards, the auditor must not carry out the work.
- Ethical guidance based on this framework includes examples of threats that might arise and appropriate safeguards to deal with them. But these are illustrative and not comprehensive. The auditor must be able to demonstrate that, in the particular circumstances under consideration, the fundamental principles had in fact been observed - a far more rigorous test of compliance.
The framework approach is considered the most appropriate to adopt as:
- The aim of good guidance should be proactive: ie, to require the auditor to identify and address risks, not merely passively to obey the letter of the code.
- A set of principles supported by reasoned guidance avoids the argument that any course of conduct that is not specifically prohibited is permissible, encouraging a search for ways around the rules.
- The approach recognises the reality that the auditor is not wholly independent of his client, but that the threats to independence must be managed to clearly insignificant levels.
- Although the basic principles of auditor independence are straightforward they may need to be applied to an almost infinite number of circumstances. The detailed rules-based approach will have to be incomprehensibly complex to cope with all possible circumstances, or will be a blunt instrument, sometimes imposing inappropriate solutions or completely missing the problem.
- The business environment and structure of audit firms and their clients are continually evolving particularly in an international context. A framework based on the application of principle can deal with this.
- Clients and shareholders are generally allowed to choose the auditors to perform other work if they believe it is most efficient for them to do so, where adequate safeguards can be put in place. Nonetheless, where adequate safeguards cannot be put in place, the guidance does include specific prohibitions.
When a large company fails, the quality of the audit is often called into question. Typically, the accusation is made that the auditors have allowed inappropriate accounting treatments because their independence has been compromised by the non-audit fees payable to them.
We believe this sets an artificial distinction between the value of income from different sources. Ultimately, as long as audit appointments and fees are determined by the company being audited, the auditor can never truly be economically independent of the client. That is why there are broader codes of conduct which govern the relationship between both parties. Thus, rather than impose an artificial restriction on the types of income an auditor is allowed to generate from a client, ethical guidance in the UK stipulates that income from any one client, for whatever service, is kept to no more than a certain proportion of that firm's overall practice income. That way, dependence on the client cannot be reduced to levels at which the auditor's decision could be influenced by financial considerations.
The guidance also details the kinds of threats to independence which may arise during an audit and the corresponding safeguards which should be adopted to avert them. Both should be explicitly considered and documented where an audit client has offered non-audit work. Moreover in some instances, for example the promotion of the shares of an audit client, insurmountable conflicts of interest arise. In such cases the activity is prohibited.
Responsibility for ensuring auditor independence does not rest exclusively with the auditor however. The Combined Code on corporate governance requires audit committees, as representative of the shareholders, to oversee the relationship with the auditors and, inter-alia, keep the nature and extent of non-audit services under review. Their task is assisted by a UK Auditing Standard on quality control, which requires that with listed companies, the partner responsible for the audit in any given case must confirm the audit firm's independence in writing to the audit committee, including arrangements for ensuring this independence remains in place when non-audit work is undertaken.
In addition, shareholders themselves are able to assess the extent of non-audit services provided by auditors. The Companies Acts have for some year required the total amount on non-audit fees paid to auditors to be disclosed.
We believe that unnecessarily restricting the provision of non-audit services would have an unintended, adverse effect on the underlying quality of the audit through restrictions in knowledge and skills. Read further discussion of this issue.
Thus, in summary, 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. The mechanisms are in place to allow this to happen.