External auditors’ independence is very important for the audit profession as it is characterised by integrity and an objective approach. Auditors are appointed to carry out audit work on behalf of the audited company’s shareholders. To fulfil their duty properly, it is fundamentally required the external auditors to be independent of the audited firm’s managers. Livne (20xx) reviews that Auditing standards require independence both in mind and in appearance. Independence implies the ability and willingness of the auditor to express an independent opinion as to whether the financial statements prepared by management comply with accepted standards and fairly present the financial condition and past performance of the firm. According to Antle (1984), the lack of independence arises when the auditor may ensure the manager by not truthfully reporting as the shareholders expect.
In practice, the external auditors’ various interactions with the audited firm are conducted through and with the client’s top management. This gives rise to a “special” relationship between managers of the audited firm and the auditor. During the audit process, management is responsible for providing answers to the auditor concerning matters about which it knows more and so auditors must rely on managers. In addition, the fees are paid to the auditors by the audited firm, not directly by shareholders. According to Mayhew and Pike (2004), the auditor’s financial dependence on the client depends heavily on the client’s ability to hire and fire the auditor. As a result, the control over hiring and firing the auditor serves as the central motivation for auditors to maintain or compromise their independence. Therefore quite sensible to think that in this kind of relationship if auditor independence can be maintained that would be good.
The consideration of external auditors’ independence is controversial. There are many factors that affect independence of an auditor. The factors such as the provision of non audit services, the audit firm size, the audit firm’s tenure and the degree of competition in the audit services market impair or enhance auditor’s independence. (The Factors Affecting Auditor Independence Accounting Essay, 2013)
Provision of Non Audit Services:
The factor that affect independence of auditors most is the Provision of Non Audit Services. According to Gray and Manson (2011), the greater Non Audit services provide by auditors, the greater auditor depend on their client because of the value of the fees. Simunic (1984) suggests that auditing firm acting as both auditor and consultant may be motivated not to report consulting deficiencies observed during the audit. In general, any situation which increases the probability that an auditor will not truthfully report the results of his/her audit investigation can be viewed as a threat to independence. To support the idea, Brandon, Crabtree and Maher (2004) investigates the effects that Non Audit services performed by external auditors have on perceive auditor independence in the bond market. The results of their research indicate that the amount of Non Audit services provided by external auditors is negatively associated with bond rating. In Addition, the research of Schneider, Church and Ely (2006) focus on whether providing Non Audit Services impairs the auditor’s independence – in fact or appearance by taken the perspective of financial statement users, auditors or managers. For users, the primary issue is whether Non Audit Services affects auditor independence in appearance while for the other two groups is in fact. The result indicates that Non Audit services can impair independence in appearance but doesn’t seem to impair independence in fact. However, within the research on independence in appearance, there are conflicting results as to when Non Audit services impairs independence as different groups may be affected differently by the auditor provision of non-audit services.
Due to the great extent of Non Audit services, investors do not consider external auditors independent from their firm managers. Krishnan, Sami and Zhang (2005) examines whether investors perceive auditor independence as being impaired when auditors supply non auditor services. The results indicate that investors did observe non audit services as impairing auditor independence. The reason for investors not considering external auditors are independent because of relationship between auditors and managers. Quick and Warming-Rasmussen (2005) indicates that the provision of consulting services to audit clients can affect auditor independence as it 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.
Overall, the findings suggest that the provision of non-audit services negatively affect perceived auditor’s independence. In my opinion, if an auditor provides both audit and non-audit services to the same client then non-audit services may threaten the independence of auditor. The reason for this is that non-audit services fees make auditors financially dependent on their clients. Also less willing to stand up to management pressure for fear of losing their business. It is not necessarily that the provision of non audit services by audit firms does affect auditor independence. However, where the fees generated from non audit services are relatively high, this creates a situation whereby the auditor’s independence is likely to be compromised. I also believe that the provision of non audit services by auditors to their audit clients will impair independence more severely for smaller auditors than for longer auditors. So, it can be concluded that the extent to which non audit services impair auditor independence will vary negatively with auditor size.
Tenure:
Long auditor tenure is beneficial as auditors gain expertise in the field they audit and may reduce the auditor’s ability to detect irregularities or material misstatements. However, a long association between a company and an accounting firm is likely to result a close identification of the firm with the interests of its clients. It may lead to a cozy relationship between the client and the auditor which will lead to impairment of auditor independence due to a decrease in the auditor’s due diligence.
The findings of Gul, Jaggi and Krishnan (2007) research suggests that Nonaudit fees may impair auditor independence when auditor tenure is short and not when auditor tenure is long. Furthermore, suggests that high Nonaudit fees have a negative impact on auditor independence when auditor tenure is short and client firm size is small. Gul et al. (2007) argue that auditors who have had a long relationship with their clients are likely to be more concerned about auditor reputation protection and are less likely to be influenced by Nonaudit fees. In other words, results show that the relation between Nonaudit fees and auditor independence is conditional on auditor tenure. While Catanach and Walker (1999) commented that longer auditor tenure leads to audit quality decline. To support Catanach and Walker (1999), Shockley (1981) also believes that long tenure are having an impact on the risk of a loss of independence.
In my opinion, it is quite clear that independence is impair if an auditing firm is charging higher audit fees for a short period of tenure. In the case of long tenure, the concern about tenure arises because a company and an auditing firm have been in close association for a long time which may lead to auditors identifying with their client’s management with a consequent detrimental effect on independence. On the other hand, Auditors of large firms are more likely to remain independent even in a long tenure relationship because of client visibility and reputation protection. Therefore, it depends on auditors who are in a long tenure relationship with clients to decide if they want to impair or enhance their independence.
Competition in the Auditing Profession:
Competition in the auditing profession is identified as an external factor affecting auditor independence. Firms which operate in a competitive environment may have difficulty remaining independent as the client can easily acquire services of another auditor. Shockley (1981) suggests that Competition effect on the extent and quality of audit services provided. However, an audit firm which allows competition, and implicitly its fee, to affect the nature of its audit may also be dangerously close to non independence. As competition for audit clients increases, clients' opportunities and incentives to replace incumbent auditors also increase. The reason for the change may range from minimization of audit fees to a search for a more compliant auditor. Nevertheless, auditors' dependence on their clients may increase if they believe that other auditing firms would be happy to accept the engagement should a client become displeased.
On the other hand, DeAngelo (1981) supports the idea that when auditors start providing low prices for their services in the competitive environment, then this will may lead to poor audit quality but do not affect independence. DeAngelo (1981) indicates that “low balling” does not impair independence; rather it is a competitive response to the expectation of future quasi-rents to incumbent auditors. “Low Balling” is the process by which auditors compete for these advantages. The SEC has also expressed concern that ‘low balling’, i.e., price competition among auditors may lead to an overproduction of dishonest reporting. In actual, the SEC concerned that situations where the auditor agrees to be fee significantly less than is normal in order to obtain the client may constitute a lessening of independence. Regulators and Profession have claimed that ‘low balling’ impairs auditor independence by itself by creating a future economic interest in clients. But DeAngelo (1981) demonstrates that ‘low balling’ is a competitive response to the expectation of future quasi-rents and doesn’t itself impair independence.
I believe that there is a possible negative effect of competition on the perceived independence within the profession. But, it depends on the size of the auditing firm. For larger firms like BIG 4, it doesn’t make a great difference if they lose any clients (as long as not one of the large client). In the case of Non BIG 4, every client matters. According to me, the more chances of impair independence is in the case of smaller firms not large ones. In my opinion, competition for audit clients increases audit dependency on the client only when increased competition makes it more likely that an auditor will be replaced by one prepared to agree with management.
The Size of the Audit Firm:
The size of the audit firm is an essential characteristic that reflects auditor independence. Auditor reputation is directly associated with audit quality. Wines (1994) suggests that Auditors providing non audit services are normally expressed in terms of economic dependency and mutuality of interest. To create a demand for audit services, auditors have to convince the market of their independence. An auditor’s reputation, once established, increases the demand for his/her services and fees. Hence, the auditor’s reputation serves as a collateral bond for independence, in that the reputation of an auditor found to be less independent than expected will be damaged and the present value of his/her audit services will be reduced.
To support the idea, Ghosh, Kallapur and Moon (2009) found that there is no evidence of a relation between perceived auditor independence and the Nonaudit fee ratio. However, perceived auditor independence is negatively associated with client importance. Because auditors are likely to be especially concerned about the loss of reputation from a perception that independence is impaired for large clients, and because auditors are less economically dependent on small clients, investors are less concerned about loss of independence for engagements with large and small clients. Like Ghosh et al. (2009), Shockley (1981) also commented that larger audit firms are often considered less subject to a loss of independence than are smaller firms. First, a large audit firm tends to be less small firm because the associated fees usually constitute a smaller proportion of the audit firm's total resources.
In my opinion, large audit firms will make sure to provide an independent quality audit service as they are better technologies and facilities compare to smaller audit firms. Large auditing firms would wish to avoid loss of reputation from adverse publicity of poor auditing, perceived to arise from lack of independence. The larger audit firms will enhance auditor’s independence. Therefore, the issue of maintaining auditor independence is more crucial for smaller firms than larger firms. I believe that reason for this is that the impact of losing a client and its non audit services revenue would not be as great for a large firm as for a smaller firm. Also, large auditing firms usually have separate non audit service departments. Separation of auditors and consultants would act to reduce any negative effect on audit independence. In small firms, however, the auditor and the consultant are often the same person due to smaller firms keeping costs down be one person doing both auditor and consultant job.
Auditors cannot be consider independent as they are fully dependent on the management of the firm for gathering information as well as for audit fees. This give rise to a special relationship between managers and auditors which is proved as a threat for auditors’ independence. Even, investors believe that Auditors are not fully independent. That is the reason, it is hard to fully rely on the work of auditors.
The result of Shockley (1981) research indicates that audit firms operating in highly competitive environments, firms providing greater non audit services, smaller audit firms and long tenure are perceived as having a higher risk of losing independence. This study indicates that each variable has a definite potential impact on the credibility of the independence assumption, and that the direction of impact can be predicted. The article written by Hussey and Lan (2001) recommend that an audit can only be effective if the auditor is independent and is believed to be likely to report breaches of the contract between principals and agents. A number of factors have been identified which may detract from auditor independence. The finance directors seems to agree that by excluding non-audit work and prescribing the rotation of auditors, their independence in the perceptions of 3rd parties would be enhanced. In my opinion, those who do enjoy good relationship with their auditors are aware of the perceptions which may arise in the mind of 3rd parties and are, therefore, more likely to agree with the implementation of mechanisms which make independence more clear.
It can be concluded that External Auditors cannot be consider independent as they are dependent on the client to pay the audit fee. In addition to fee pressure, they have been their auditors for a long time or because they also do non audit work for them. Moreover, if auditors were really independent, they would not need an extensive list of rules to hide behind when clients try to use strange accounting methods to produce misleading financial statements. To enhance the independence of external auditors, there are few changes to make. First of all, the power of hiring and firing auditors should transfer to shareholders from managers. Additionally, the external auditors should be restricted to provide only a certain amount of non audit services. Except from this, audit rotation should be mandatory not voluntarily. This changes will help strengthening independence and reducing the incidence of audit failure.