Keeping the current auditor and future pool totally independent

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here has been a noticeable increase recently in audit quality shortfalls reported in the press, and of course this is of major concern and needs to be addressed for confidence to be improved in the audit process; however, the independence of the auditor is equally critical in ensuring public trust.

The accusation is often made that the auditor’s independence has been compromised, either because they have become too close to the company or because their objectivity is challenged by over-reliance on income, from a single source.

There are very few audit firms that do not also offer clients a range of advisory services from structuring, tax, management consultancy and even personal tax for key members of the client – and this is equally the case in mid-tier firms as it is in the Big 4.

We cannot lose sight of the fact that non-audit services are often far more lucrative than the audit fees and this will naturally have an impact on the type of work firms want to engage all clients with.

This, in addition to legislation and competitive market forces encouraging audit firms to be rotated, creates a perfect storm of factors that lead to a significant threat to the independence of the auditors.

The independence of the auditor is both a factual issue and importantly one of perception - audit firms will set in place strict protocols for the approval of non-audit services, implement adequate safeguards to independence, restrict some types of services completely as will the clients and their audit committees do all to maintain independence, however the perception of independence often cannot be managed through limits and these steps alone.

Additionally, the movement of senior audit firm staff or partners to an audit client – even from the audit team itself – will also often cast doubt on independence.

The limitation of non-audit services to audit clients must be further limited and strictly regulated by the regulators of the audit profession as well as the audit clients themselves; however, this will still lead to questions over ‘perceived’ independence.

The only way of ensuring that actual and perceived independence of the auditor is maintained is for the audit firm not to provide any non-audit services to that audit client. Advocates against this will argue that they believe that unnecessarily restricting the non-audit services would have an unintended, adverse effect on the underlying quality of the audit through restrictions in knowledge and skills gained from performing non-audit services.

Although prohibiting any non-audit services would help address the independence issue, there is also another important aspect that needs to be considered: the audit operates on relatively thin margins compared to premium advisory work and often the economics of the audit function within a firm is supported by the delivery of non-audit services.

Therefore, these firms will still want to provide non-audit services to make their firms economical, but will need to do this by expanding their work by engaging with a greater number of non-audit clients.

The impact of this could be significant in that when a company looks to change its auditors, their ‘pool’ of potential future auditors may already be restricted if some of those potential audit firms have already provided non-audit services to them and hence are not seen to be independent.

This can be a bit of a ‘catch 22’ scenario, restricting firms from providing non-audit services to their audit clients means those firms will increase such business to more current non-audit clients which in turn will potentially reduce the firm’s availability to be selected by those current non-audit clients as their future auditor.

Interestingly, the proposals for shared audits will further exacerbate the reduction in firms able to provide sizeable non-audit services to companies, while maintaining independence.

Having said this though, this does bring an opportunity for mid-tier firms to capitalise on the market opening-up to provide non-audit services to large audit clients of Big 4 firms and indeed visa-versa to be the auditor of large non-audit clients of Big 4 firms (where the Big 4 firm have decided on the route of non-audit services to those clients).

There are a limited number of specialist advisory firms – such as Theta – with deep technical expertise who offer a solution to clients needing to engage firms for non-audit services while protecting auditor independence.

Such niche advisory firms do not undertake audit work at all; companies that use the services of such ‘audit-independent’ firms benefit both from maintaining their current auditor independence and not tainting or limiting the pool of future potential auditors to choose from.