1. EFFECTS OF AUDITORS INDEPENDENCE ANALYSIS AND RECOMMENDATION The purpose of this research is twofold. First, it is devoted to explain auditors independence, which is the corner of auditing profession. Emphasis has been given to possible factors that are considered to impair auditors independence in the performance of their duties. Secondly, it specifically treated the effects of non audit services and fees on auditor independence EFFECTS OF AUDITORS INDEPENDENCE ANALYSIS AND RECOMMENDATION The purpose of this research is twofold. First, it is devoted to explain auditors independence, which is the corner of auditing profession. Emphasis has been given to possible factors that are considered to impair auditors independence in the performance of their duties. Secondly, it specifically treated the effects of non audit services and fees on auditor independence 2009 Fekadu Belayneh Strayer University June 2009
2. Effects of Auditors Independence 2 EFFECTS OF AUDITORS INDEPENDENCE Effects of Auditors independence on Public Accounting Profession A research paper prepared in partial fulfillment for the degree of Masters of Science in Accounting Fekadu Belayneh Strayer University June 5, 2009
3. Effects of Auditors Independence 3 Running Head: Effects of Auditor Independence
4. Effects of Auditors Independence 4 Abstract The purpose of this research is two fold. First it is devoted to explain auditor independence, which is the corner of auditing profession. Emphasis has been given to possible factors that are considered to impair auditor independence in the performance of their duties. Secondly, it specifically treated the effects of non audit services and fees on auditor independence. The coming into being of Sarbanes- Oxley act of 2002 has been critical to bring about check and balance in audit engagement process. The SEC requirement about disclosure of non-audit fees has to larger extent affected auditor independence. As auditor independence is critical to gauge and subjective to evaluate, it is probably helpful to focus on factors that causes impairment of independence and look for means and ways to improve independence which is otherwise called corner stone of auditing profession. Key words: Independence Securities and Exchange Commission Audit fees Non-audit services Public Company Accounting Oversight Board
5. Effects of Auditors Independence 5 Acknowledgment First of all, I would like to express my heart-felt feelings for the almighty Lord who helped me accomplish the research from beginning to end. I am also indebted to all members of Strayer University LRC for providing me with the necessary materials to conduct the research. I would also like to thank my Professor, Bill Makkawi, who has been very crucial in providing me with the necessary direction and invaluable comments during the course of the research. Last but not least, I would like to extend my special thanks to my wife, Kidest Tadesse and my three beautiful kids (Nate, Beza and Ruth) for their patience and love that enabled me to complete the research paper.
6. Effects of Auditors Independence 6 Table of contents Title Page Chapter one: Context of the Problem 7 1.2 Statement of the Problem 10 1.3 Research Question 11 1.4 Significance of the Study. 12 1.5 Research design and Methodology 14 1.6 Organization of the Study 15 Chapter Two: Literature Review 16 Chapter Three: The rationale of Auditor Independence...... 22 Chapter Four: Factors Affecting Auditor Independence 27 4.1 Provision of Non audit services..... 28 4.2 Client-size 36 4.3 Audit firm tenure.37 4.4 Alumni affiliation37 4.5 Disclosure of Non-audit fees.. 39 4.6 Training of Auditors. 41
7. Effects of Auditors Independence 7 Title Page 4.7 Audit Committee 41 4.8 Culture of the Audit firm 42 4.9 Auditors ethical and moral characteristics 43 Chapter Five: Audit and Non-audit fees- Conflict of Interest.... 44 Chapter Six: Conclusion and Recommendation 47 References.. 52
8. Effects of Auditors Independence 8 Chapter one Context of the problem The public accounting profession passed through several difficulties over the past few years. Being a prominent discipline since long time, it provided the public with a professional service to affirm its commitment to providing assurance about financial information. The role of accounting in the current global economy has been of paramount importance. More specifically, auditors find themselves in a situation where they are all required to abide by set of rules and regulations- independence being the cornerstone of their day- to-day activity. According to AICPA Independence is the state of mind that permits the performance of an attest service without being affected by influences that compromise professional judgment, thereby allowing an individual to act with integrity and exercise objectivity and professional skepticism. (Independence, 2004, para.4) This requirement has been a challenge for many auditors for it is the basis by which their relationship with clients is to be evaluated. From this it follows that auditors should exercise independence in the performance of their duties and responsibilities. In the recent past we have witnessed facts where the auditors lack of independence resulted in the closure of the biggest firms. Cases in point are the Enron and WorldCom fiascoes that focused the attention of the investing public. The issue of independence is described as a corner stone of auditing profession that helps to ensure quality audits and contributes to financial statements. (Lindberg and Beek2004, para.3)
9. Effects of Auditors Independence 9 As mentioned above, the cardinal principle of auditing which is independence has been challenged by two major issues- Non audit services and auditor-client relationship. This is related with the high audit fee that the audit firm expects from its client that brings about a conflict of interest thereby affecting the independent performance of auditors in attesting the financial statement of the client. In an attempt to relate Auditors independence with non audit service SEC (2000b) expressed its concern in the following way: the rapid rise in the growth of non-audit services has increased the economic incentives for the auditor to preserve a relationship with the audit client, thereby increasing the risk the auditor will be less inclined to be objective AICPA has also been consistently focusing on the issue of independence and its impacts on the overall operations of various firms. Accordingly, it explains the issue in the following way: Independence shall be considered impaired by an auditor when he makes management decisions on variety of factors. Generally, CPAs are not independent if they are in a position to influence, provide certain accounting services, or have financial interests in an entity. A CPA is required to document any possible situations that might impair his or her independence on an engagement, inform his or her CPA firm, and inform the potential client if any such situations may exist. (Independence2006, para.4) For the most part, independence is explained by the conflict of interest arising as a result of the nature of relationship that audit firms establish with their clients. This means that some of the audit firms might provide the public with misleading financial statements because of their ulterior motive.
10. Effects of Auditors Independence 10 Although we are not focusing on the Enron debacle, it would be beneficial to raise the issues of independence of the audit firm, Arthur Anderson, who provided unqualified audit report for consecutive years while Enrons financial statements were in complete mess. According to David (2003), Arthur Andersen's audits of Enron's financial statements during each years resulted in unqualified reports. In other words, Andersen expressed its opinion that Enron's financial statements fairly presented, in all material respects, Enron's financial position in accordance with Generally Accepted Accounting Principles. (p. 5) One may ask as to what is the motive behind such misrepresentation of financial statements while the reality is just the opposite. As stated above, independence of auditors could be primarily affected by their relation with the clients. It is evident that clients have an upper hand in their relation with audit firms. With respect to the relationship between Anderson (the audit firm) and Enron, it appeared that the former excessively intervene in the internal operations of the latter. This situation resulted in loss of confidence on the audit firm for the simple reason that it compromised its independence and integrity. The issue of independence has been the focal point especially after the collapse of Enron. Several firms were forced to shut down their business as a result of Auditors report that did not reveal the actual financial standing of the firms. In order for auditors to live up to the public expectation, they should qualify for the minimum standards of professionalism- their independence. Their integrity should well be restored. The accounting educators are expected to help restore the credibility of the critically important, if long underappreciated, independent audit function. (Knapp, 2006.p1).
11. Effects of Auditors Independence 11 Among some of the factors affecting auditor independence is the non- audit service that the audit firm provides to the clients. There has been regulation on how to break down and disclose those fees in an attempt to protect the principle of independence. The focus of the auditor independence standard is to better serve the public interest and to maintain a high degree of integrity, objectivity, and independence for audits of government entities. The standard includes a principle-based approach to addressing this issue, supplemented with certain safeguar