Accounting Bits

Provision of the Client Audit and Consulting Services

The statutory auditor evaluates the correctness of financial statements. The audit report is only beneficial if it contains reliable information. If addressees do not believe that an auditor is independent of a company, they will have little confidence in the auditor’s opinion.

The IFAC distinguishes between independence in mind and independence in appearance. Independence in mind is defined as the state of mind that permits the provision of an opinion without being affected by influences that compromise professional judgment, allowing an individual to act with integrity, and exercise objectivity and professional scepticism and independence in appearance as the avoidance of facts and circumstances that are so significant that a reasonable and informed third party … would reasonably conclude a firm’s … integrity, objectivity or professional scepticism had been compromised. The requirement that a statutory auditor should be independent addresses both.

The European Commission as well as IFAC identify five threats or risks which can compromise the statutory auditors independence: self-interest threat, self-review threat, advocacy threat, familiarity or trust threat and intimidation threat. Specific circumstances in which threats to independence can arise include financial interests, business relationships, employment with the audit client, managerial or supervisory role with the audit client, personal relationships and the provision of non-audit services.

Previous literature has discussed the compatibility of the provision of audit and non-audit services to the audit client. The provision of consulting services to audit clients can affect auditor independence. Consulting is based on a special bond of trust between consultant and client’s management. This may result in excessive trust in the client and insufficient objective testing of the accounting data. If the auditor provided consulting services to the client, the auditor would have to review facts which were influenced by his or her recommendations. In such a situation, the auditor is failing to maintain an objective distance and is not focusing on the audit task at hand. During the audit, the auditor may ignore errors which are related to advisory services or conceal consulting errors detected by audit work. The greater the degree of non-audit services provided, the higher the risk that the auditor identifies with the client’s interest (advocacy threat). Furthermore, the provision of advisory services to the audit client could result in financial dependence on the client (self-interest threat) because the total fee from one client increases.

Numerous arguments have been raised for the provision of non-audit services to audit clients. Such services can lead to information advantages and cost reductions. As a consultant the statutory auditor obtains additional insights into the enterprise which may increase audit efficiency. In addition, the audit findings are available for the advisory service and knowledge spillovers not only enhance efficiency but also the quality of audit and consulting services.

The provision of non-audit services to audit clients reduces clients’ consulting risk. Not only is the auditor highly qualified and required to meet strict ethical rules, but also the client knows the capability of the statutory auditor from the audit services. In addition, the client’s transaction costs are reduced. Furthermore, consulting services level out seasonal variations in the demand for audit services. Supporters of the provision of MAS argue that it is difficult to differentiate between auditing and consulting, that the provision of non-audit services increases the trust of the audit client, that advisory services are usually provided by a separate department of the audit firm and that the provision of consulting services increases the attractiveness of the audit profession for graduates (Jacobs, 1975, p. 2239). It has also been suggested that a prohibition of the provision of non-audit services to audit clients could be eluded and that it would be difficult to control such a prohibition. Finally, it can be argued that the provision of consulting services strengthens the position of the statutory auditor because the client is interested in a long-term relationship because of efficiency reasons.

Recently, dramatic changes in the accounting profession, the types of services that auditors are providing to their audit clients as well as increases in the absolute and relative size of the fees charged for non-audit services have exacerbated concerns about independence. The problems associated with independence have also increasingly come into the public arena and particularly into media reports since the collapse of the Enron Corp. Through ‘creative bookkeeping’ Enron succeeded in showing profits which reached approximately $600,000,000 above the correct level. However during this time, the audit firm Arthur Andersen failed to notice the anomaly. Meanwhile, Arthur Andersen was also providing consulting services to Enron. In fact in 2001, Arthur Andersen provided $27,000,000 worth of consulting services to Enron which was two million more than for auditing services. The case of the Enron collapse is just one example of how auditing activities failed to notice certain discrepancies in the bookkeeping practices of particular powerful companies. This has, without a doubt, increased worldwide calls for greater independence.

Thus, the main purpose of this paper is to analyze whether restrictions on the provision of consulting services would increase interest groups’ confidence in auditors’ independence. The remainder of the paper is organized as follows: First, an overview of international and Danish regulation is provided. Then theoretical models, which explain why the provision of non-audit services impairs auditors’ independence, are introduced. In addition, prior empirical research related to the above mentioned problem are summarized and analyzed. Theories as well as prior research results are used to formulate hypotheses. Afterwards, the results of an empirical study performed in Denmark are presented and discussed. The final section draws conclusions and refers to limitations.

Art. 24 of the eighth EC-Directive requires the independence of the statutory auditor, but leaves it to the member states to issue concrete rules. As a consequence, member states’ national rules regarding statutory auditors’ independence currently differ in several aspects. Thus, it is difficult for investors and other stakeholders to assess whether audit services are provided equally independently in different member states. This issue was addressed by the Commission’s Green Paper. The Green Paper states that the statutory auditor should not take part in decision-making processes of the audit client. Furthermore, the statutory auditor should not provide the following services: preparation of financial statements, valuation of assets and liabilities, litigation support services and recruiting of senior management.

In May 2002, the European Commission issued a recommendation on statutory auditors’ independence in the EU. It is a principle-based approach that provides the flexibility to react promptly and efficiently to new developments. The recommendation consists of two sections. Section A (framework) sets out the overarching independence requirements for statutory auditors. Different types of safeguards have to be established in order to eliminate threats to auditors’ independence. Section B (specific requirements) reviews a range of specific circumstances in which threats to independence could arise and provides guidance on the measures a statutory auditor should take to mitigate such threats in relation to a particular statutory audit. The provision of non-audit services is a focus of Section B. Statutory auditors should neither make any decisions nor take part in any decision-making on behalf of the audit client. Specific situations are highlighted which can compromise a statutory auditor’s independence: preparation of accounting records and financial statements, design and implementation of financial information technology systems, valuation services, participation in the audit client’s internal audit, acting for the client in the resolution of litigation and recruiting senior management.

Tags: audit services