How independent are the auditors?

The majority of auditors, audit clients and institutional shareholders consider the independence and impartiality of audits to be currently impaired – at least to some degree – by concerns about losing an audit assignment, the desire to gain more lucrative non-audit services and the development of cosy relationships with the directors of their audit clients, a MORI survey conducted for the Accountancy Foundation Review Board suggests.

It is apparent, even before publication of Derek Higgs’ report on the role and effectiveness of non-executive directors, that the audit committee will have an enhanced role in corporate life. Already it is clear, according to a MORI survey, that there is limited support for alternatives to the audit committee, such as shareholder or stakeholder panels or setting up an independent body to appoint auditors as in the public sector.

Many have suggested the audit committee should be closely involved in appointing auditors, reviewing the appointments process, the remuneration of the auditor, decisions on the acceptability and disclosure of non-audit services, and the independence and effectiveness of the audit.

One important condition that was apparent from the Review Board’s attitudinal research is that the audit committee should not undermine the unitary board of directors, with executive and non-executive directors working together as equals. This was preferred to the approach adopted in some European countries where the board of directors is accountable to a supervisory board made up of non-executive directors.

One possible scenario, already adopted by many companies, would be for the executive directors of the company to present their recommendations on, say, the choice of the auditor to the audit committee, who would assess the appropriateness of these recommendations and the context in which they were made. If satisfied, the audit committee would make its recommendations to the board of directors for subsequent approval by the shareholders.

The role and powers of the audit committee will affect the choice of other regulatory solutions. For instance, if the audit committee makes decisions on the acceptability of non-audit services, do we need to ban auditors from undertaking all or certain non-audit services?

Some believe all non-audit services should be banned and a case made for exempting certain services. There is a danger that such a ban could cause the Big Four to focus on this area in the future, bearing in mind that their income from non-audit fees was more than three times greater than their audit fees in 2001.

This would undoubtedly cause instability in the audit market, especially for the larger companies. By contrast, the current approach to non-audit services is based on a spectrum of acceptability. Some non-audit services, such as tax compliance, are not a threat to independence while some, such as preparing the accounts and implementing financial IT systems, should clearly be banned.

If one looks at the ethical codes for auditors adopted internationally it is clear that some countries, including the UK, adopt a principles-based approach by identifying the threats to independence, such as auditing one’s own work or taking decisions on behalf of management, and considering safeguards, such as compliance reviews within the audit firms, to minimise these threats.

In the context of a modern global economy it would be useful to obtain consistency between countries.

A number of commentators believe that establishing long-term relationships between auditors and audit clients can impair auditors’ objectivity and solutions such as mandatory audit firm rotation would help to reduce this possibility.

International experience suggests that some governments, such as the Republic of Ireland and Australia, have rejected the concept of mandatory audit firm rotation whilst others such as Spain, Greece and Slovakia have tried and subsequently dispensed with the requirement. Italy is the only country which currently requires audit firms to rotate (every nine years) – but are these lessons applicable to the UK, whose industrial and accounting structure is different?

Some empirical studies to date suggest there might well be advantages to mandatory audit firm rotation by the new audit firm adopting a fresh innovative approach to the audit from a new perspective; an interesting observation when one considers that most of the current FTSE-100 companies have had the same auditors for the past ten years.

This might have implications for the recent suggestion of a ‘back stop’ by Sir Howard Davies regarding audit firm rotation after a period of, say, 20 years.

But there are suggestions that the potential advantages of greater independence are overstated since there is regular and natural turnover among key individuals, both in the audit firm and the audit client. Similarly, the suggested benefits of rotation encouraging competition are unlikely if a ‘musical chairs’ scenario is adopted among the Big Four regarding the audit of large companies.

Other analyses suggest there is an increase in costs due to the incoming auditor having to undertake the audit with no knowledge or experience of the client’s business and even more importantly that the quality of the audit suffers in the early years, and in the final year when the auditors are automatically replaced.

The preceding paragraphs have considered a variety of, but by no means all, potential regulatory solutions to strengthen auditor independence and minimise the possibility of an Enron or WorldCom situation occurring in the UK. No single solution is a panacea. Yet the government’s co-ordinating group on audit and accounting issues has only until the end of the year to come up with the required solutions.

• Colin Reeves is director of the Accountancy Foundation Review Board and a member of the Co-ordinating Group on Audit and Accounting Issues.