Provision of non-audit services by auditors: a theoretical and empirical analysis in a corporate governance context

Chapter 1 – Introduction
Background
Experian reports that the the incidence of organizational insolvencies has gone up by 11% in 2005. This has been accounted for by bankrupcies of companies which have bot been able to cope up with the dynamism of the business playing arena in the United Kingdom. Organisations have explained that this was caused by a gradual decrease in the spending of customers, increased energy expense and bureacracy. Specifically, the company asserts that there have been over eighteen thousand such losses in that year, which has been a record high since 3 years ago. The players which were most badly hit were those from non-food reatil, business services and media. Moreover, it projects that these numbers will increase all the more in the immediate future, probably within the next two years (online, BBC).

It is widely acknowledged that changes in the demands of customers may have a very strong impact in the earnings of an organization, and yet this is nothing compared to the impact of accounting controversies within such firms. The management of these organizations are being blamed for the bankruptcy of the companies under their management helm. One other repercussion of such is the massive reengineering of the organization which usually follows. A concrete example is Enron (Dewing & Russell, 2003).
In the latter part of the ninety’s and two thousand, this particular company had a leverage in the trading floor. The organzation has began a gas company and ultimately was able to broaden its reach to other sectors. There has been a period where the company seemed to have prospered in every business venture it has delved into. The organization has been successful at getting the right people on the bus, initially those sourced from the energy industry and others who came from Wall Street. However, these human resource assets were futile in preventing the eventual demise of the Enron phenomenon (Dewing & Russell, 2003).
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The well documented controversial scandal relayed the specific details that had to do with how accounting has been manipulated by Enron to its advantage. In effect, from a status of being among the cream of the crop among American industries, it became a menace and an epitome of dishonesty. It became an example of what not to do to ensure that one complies with ethics and corporate social responsibility standards. There were numerous individuals who were hard hit by Enron’s downfall. Because of bankruptcy, there were a lot of employees who needed to be terminated involuntarily and with little separation pay. The organization has convinced its former employees to allot their pension assets towards firm stock, and these people have lost substantial amounts in the form of pension, as well as long term employment. Thus, after thorough investigation, its top managers Skilling and Lay have been found guilty on cases of conspiracy and fraud (Dewing & Russell, 2003).
With this much talked about controversy, various stakeholders, including prospective investors, law making entities and members of management have realized hat there are clear factors that influence the exercise of ethics and governance of the firm. These factors are crucial and determine sustainability in the long haul. Governance of the organization emphasizes areas which arise from the distinction of ownership and control. Among these issues is the prioritization of shareholder value through the promotion of honesty in accounting practices. This implies that a firm’s accounting documentation need to be valid and straightforward. This is one among the many lessons that may be gleaned from the Enron experience. And yet, it is worthy to mention that corporate governance does not merely indicate the assocation between stakeholders and management, but instead encompasses more relevant areas that are related to the firm’s manner of arriving at critical decisions – such as issues that have to do with the environment, ethics, and graft (Dewing & Russell, 2003).
Corporate governance has taken greater importance in the realm of ethics and has evolved such that management needs to draft strategies that are aligned towards this thrust. In addition, it has managed to appeal to the general public causing much clamor for focus on governance practices to ensure the long-term sustainability and profitability of contemporary firms. The Organisations for Economic Co-operation and Development (OECD) presents the following definition of the construct: “Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance.” (OECD 2004). The top honcho of the World Bank has also given his own version of the concept as something keenly related to fairness, honesty, and responsibility.
Problem Statement
Spelling out an effectual corporate governance policy is one which is effective at advocating transparency and accountability among the organization’s managers, the board ought to depict an objective and profound evaluationof the organization’s status which covers the interim and other reports that are of interest to its stakeholders. This documentation must also address statutory requisites. In addition, the board must sustain a fine system of controls to protect the investment of its stakeholders as well as its own. Another accountability is to finalize official and honest transactions for the exercise of financial reporting and such internal control. There should be a healthy association developed with the firm’s auditors (Financial Reporting Council 2006).
Further, the Financial Reporting Council (FRC) has presented a straightforward definition on what the audit team has to accomplish towards the thrusts of transparent financial reporting to the public in general. Among its roles for a firm, the FRC has defined its primary responsibility of detecting oversight, evaluation, and assessment of a specific role or undertaking. In addition, it adds that it is not the accountability of such teams to undertake functions that are not within the scope of its jurisdiction, including the drafting of financial statements. Instead, audit teams are to guarantee a stable and reliable structure of financial control.However, it must not carry out the tracking function on its own because if they do, they are taking off accountability from auditors and managers (Financial Reporting Council 2006).
The Financial Reporting Council (2003) expounds on the role and accountabilities of the audit committee. These are outlined below:
1)      To track the objectivity of financial statements of the organization and any official releases associated with the firm’s financial performance, assessing important and substantive financial interpretations that are presented in these reports;
2)      To assess the firm’s internal financial control system, and if not explicitly defined by a distinct risk team consisting of autonomous directors of by the board, the firm’s internal control and risk management systems;
3)      To track and revisit the efficacy of the organization’s internal audit role;
4)      To draft measures for the board which the latter will present to stakeholders for concurrence in an assembly, that are related to the designation of external auditors, including the manner of involving them as well as their compensation;
5)      To track and review the external auditor’s autonomy and honesty and the efficacy of the process the latter undertakes, with the view of British regulatory requisites;
6)      To deploy and apply policy in contracting external auditors for rendering non-audit services, with proper consideration of ethics in undertaking non-audit services by this external audit arm;
7)      To inform the board issues that may enhance audit systems as necessary and to put forth action steps which may be carried out to address such issues.
Th FRC has established the accountabilities of the audit committee in the organization’s board as an entity that protects the oversight function, external auditors’ autonomy and transparency. However, there is strong contention on these issues of independence and maintenance of transparency in the audit exercise.
There are numerous regulators and recipients of financial information that are keen on the fact that auditors give up such autonomy by permitting customers to influence objectivity in exchange for attractive professional fees. With the Enron debacle came issues about the provision of non-audit services by auditors anchored on the principle that auditors may succumb to lucrative fees over the exercise of integrity in auditing (Ashbaugh, LaFond, Mayhew 2003).
De Angelo (1981) asserts that there is an economic relationship between the auditing entity and the customer. As this bond strengthens, there is a noted increase in the reliance of the auditor to the custoemr and this is reinforced by an increase in their non-audit fees. The latter clearly sends a message of an increased proportion of profit that is yielded from that customer (Simunic 1984; Becker et al. 1998). Non-audit fees can serve as a threat to autonomy when the customer maneuvers them to be dependent on the fees paid to the auditor. Magee and Tseng (1990) assert that these fees have been specifically noted as threats by audit standards, and customers can cause such fees the obstructing non-audit services that do not yield much profit when the auditor does not permit the customer to leeway in presenting its earnings report. Furthermore, the advisory characteristic of many non-audit services creates a fear on the auditor’s independence for regulators such as Securities and Exchange Commission. The advisor nature of these non-audit services places auditors in a managerial roles which could create conflict of interests and impair their neutrality in the transactions they audit (SEC 2000).
In contrast, auditors contest this assumption. Ashbaugh, LaFond, & Mayhew (2003) presents their case that this assumption does not take into account the likelihood of regulatory penalties and loss of good standing to its customers when auditors unethically deal with a few important customers. Thus, the stiff regulatory penalties and possible loss of good standing may provide a strong motivation for auditors to preserve their independence. The likelihood of loss of good standing can be seen with the case of Arthur Andersen’s case with Enron collapse. BusinessWeek describes as “the Enron meltdown gives present and prospective clients an excuse to flee. They may want to avoid the heightened attention an Andersen audit might get in shareholder litigation or fear their financial reports could draw more scrutiny from regulators if they’re handled by Andersen.” Therefore, following these arguments, the market provides a strong reason for auditors to preserve their independence (Reynolds & Francis 2000; Antle et al. 1997; Palmrose 1986).
Organization for Economic Co-Operation and Development and the Financial Reporting Council presents the significance of auditor’s role as an “oversight” in the true financial condition of a firm in presenting itself to the investing public. OECD and FRC maintains that auditor should always uphold their autonomy in the audit process. Because the notion of autonomy and neutrality is a vital gauge in the quality of audit services, how can we assess if there is a decrease auditor’s autonomy in exchange for increased non-audit work? Furthermore, do the regulatory bodies offer stiff penalties on proven occurrences of collusion between auditors and management? How does the investing public ensure that the offer of non-audit service does not result to conflict of interest with audit work? The purpose of this study is to examine and answer the following research questions:
What are the market-based and regulatory incentives for auditors to remain independent?
What is the relationship between the non-audit services to the quality of audit work?
Hypotheses
The researcher’s goal is to develop the appropriate concept and information in understanding and assessing auditor’s autonomy for this study. The researchers list a number of aspects that may have a direct effect on the auditor’s autonomy and neutrality in the audit process.
Watts and Zimmerman (1983) defines auditor’s independence as “the probability that an auditor will report a discovered breach in the financial reports.” Following Watts and Zimmerman’s definition, the researchers therefore emphasize that auditor’s independence is the same as the auditor’s impartiality and the capacity to resist client pressure to go along with substandard reporting.
Frankel, Johnson, & Nelson (2002) methodology utilized the connection between audit fees and predisposed financial reporting, which uses the firm’s discretionary accruals and the chances of meeting or exceeding analyst’s earning forecasts. They apply these measures to draw inferences on auditor’s autonomy. They hypothesized that in an effort to take advantage non-audit service, auditors may give in to client pressures. Frankel, Johnson, & Nelson (2002) chose the discretionary accruals and the chances of meeting or exceeding analyst’s forecast as proof of auditor’s impartiality based on three assumptions: (1) standard audit process requires management to present financial reports objectively, (2) discretionary accruals represents the degree of prejudice inserted in the reports by management and permitted by the auditor; and (3) the presentation to only meet or exceed analyst’s forecast are not considered to be random and suggest management’s bias to meet forecasts and performance measure. Thus, an auditor is considered to be autonomous if he does not succumb to the pressure to allow discretionary accruals to meet analyst’s forecast despite increased economic bond between auditor-client relationship.
Considering the essentiality of the relationship of the auditor’s fees and auditor’s independence, the following hypothesis was formed as follows:
Hypothesis 1: There is a significant relationship between the provisions of non-audit services and auditor`s independence.
A number of individuals and committees raised the belief that mandatory auditor rotation can improve auditor’s impartiality. The committees include the Cadbury Committee, the Irish Review Group on Auditing, and the AICPA. As the groups analyzed the cost/benefit of legislating a mandatory auditor rotation, the committees deduced that the disadvantages of rotation outweigh its advantages.
In addition, mandatory auditor rotation would not be a viable solution to the problem of “Chinese Wall” in the audit firms. With increasing provisions of non-audit services, the statistics suggest the increasing pervasiveness of consultancy work for large audit client. The problematic aspect of this is that big accounting firms which does the consultancy may also provide audit services to the client. This may create a conflict of interest as suggested by the “Chinese wall” problem where the auditor is on one side and the consultant on the other. As a result, the researchers cannot find conclusive link between auditor’s independence.
Nevertheless, it would be important to look into the relationship of auditor’s tenure and auditor’s independence. The following hypothesis was formed as follows:
Hypothesis 2: There is a significant relationship between the rotation of auditors doing audit works for the same client and the independence of auditor.
As the audit committee manages audit services and can have a significant impact on the auditor’s autonomy. The association of public accounts defined the importance of audit committees function as “the achieving and maintaining balance in the relationship between the independent auditor and management” (AICPA 1978). Occasionally, disputes arise from clients and auditors and audit committees are unable to proactively intervene, allowing overzealous managers to exert undue pressures on auditors (Knapp 1987).
Hence, we look also into the relationship of audit committee’s support in enhancing the auditor’s independence in technical disputes with client management. The following hypothesis was formed as follows:
Hypothesis 3: There is a significant relationship between the support of audit committee and auditors` objectivity.
Watt and Zimmerman defined audit quality as “the ability of auditor to carry out a thorough examination of the accounts and detect possible errors or anomalies (technical competence) and his willingness to provide an objective opinion on them (his independence).” In particular, technical competence can be hindered and independence trivialized if auditors are not allowed to exercise their professional judgment. Moreover, autonomy does not only include the client and auditor but other clients such as financial analysts and banks as well.
In effect, legislations can have an effect on the usefulness of information of auditing service to third parties. The following hypothesis was formed as follows:
Hypothesis 4: There is a significant relationship between the accountancy profession`s regulations and auditors` independence.
Limitation and Delimitation
        The findings of this study will be affected by the following limitations:
Since this study’s subjects are in the auditing industry, not emphasizing on a particular sub-industry group, the selected group of UK audit companies may not be evenly correspond to the different sub-industry groups in the entire audit industry. The research focuses on publicly traded companies listed in the UK stock exchange, and its findings cannot be deemed to be representative of UK audit companies in other countries. However, in the matter of fact, the main purpose of this study was to investigate the quality of auditing services.
Significance of the Study
In recognition of the importance of market-driven competition within the audit industry, the researchers acknowledge the benefits such as innovation and development of the quality within the industry. If it does not offer these benefits, then it might be more reasonable to have state-owned audit agency that have monopoly of audit service.
Since the recent Enron, Worldcom, and Xerox fiasco, re-establishing auditor independence has become the focus of attention. The three big debacle points when major accounting firms considered offering greater consulting work to its client companies. As a result, audit services became a relationship, which was exploited to sell an ever growing range of consulting services. Because of the relatively large portion of revenues from non-audit services, the big-business advisory attitude has become deeply rooted within the sales process of major accounting firms and driving it out and restoring the primacy of auditor professionalism proves to be a challenge. Dewing & Russell (2003) however, suggests that if regulators can create an effective division of auditing and advisory services, it would surely play a part in improving effective competition of public company audits within the context of corporate governance.
McGrath et al. (2001) defined auditor independence as “freedom from those factors that compromise, or can reasonably be expected to compromise, an auditor’s ability to make unbiased audit decisions.” Further, auditor independence “does not require the auditor to be completely free of all the factors that affect the ability to make unbiased audit decisions, but only free from those that rise to the level of compromising that ability” (McGrath et al. 2001).
Thus, it became more imperative to establish auditor independence in order “to support user reliance on financial reporting process and to enhance capital market efficiency.”
The Overview of the Study
            Chapter 2, Literature Review will describe the concept and the rationale behind the principles of corporate governance as our guiding principles in the audit process. We will also look into the important legislation in the UK audit industry highlighting on the provisions for reporting non-audit services and its effect on earnings  report to ensure auditor’s autonomy and impartiality as oversight in financial reporting. Related researches on the factors that affect auditors’ independence will also be discussed.
            Chapter 3, Methodology, will describe the research design of this study. The research design of this study is empirical research method using secondary data for quantitative analysis. Sample group was chosen from UK publicly traded companies. Secondary data was also taken from research subject’s annual reports from 1996 to 2005.  The databases are London Stock Exchange Annual Report Service. Statistical methods, such as descriptive and correlation statistics was also utilized to assess the relationship and distinction between auditor’s independence and non-audit service provisions, auditor rotation, audit committee support, and professional regulations.
            Chapter 4, Results will demonstrate the results of this study.  At first, the descriptive statistical data such as maximum, minimum and mean, as well as the selected indicators that affect the quality of audit services that were employed in the analysis will be tabulated and correlation statistical outcome will examine the relationship among variables. The findings will then be generated from these analyses will be presented and interpreted.
Chapter 5, Summary, Conclusion and Recommendations, the “Summary” section will first provide a comprehensive summary of the major findings of this study.  The “Conclusion” section will highlight the implications of the research findings.  Finally, “Recommendations” will be proposed to help companies safeguard the auditor’s independence and improve the quality of the audit service.  In next chapter, related researches in corporate governance, provisions of non-audit services, and the quality of auditing will be reviewed and measurement approaches will be introduced.
CHAPTER 2
LITERATURE REVIEW
First, in this chapter, we look into the concept and significance of corporate governance as the context in understanding the importance of auditor’s independence in financial reporting. We will look into the principles of corporate governance to understand economic context of audit service in financial reporting. We will then review the audit committee and external auditor guidelines set forth by Financial Reporting Council and discuss the different threats and safeguards in ensuring the quality of audit.
Principles of Corporate Governance
In 1998, the Organisation for Economic Co-Operation and Development (OECD) convened with republics, pertinent entities and the private sector to develop a set of corporate governance standards and guidelines. As the principles of corporate governance had been agreed in 1999, it has evolved into a firm reference for corporate governance efforts. This applies to both OECD and non-OECD nations alike. In addition, these guidelines have been take as among the Twelve Key Standards for Sound Financial Systems in the Financial Stability Forum. In addition, the World Bank and International Monetary Fund have also considered these guidelines in their documentation fof the Observance of Standards and Codes (ROSC) (OECD 2004).
The development of the Principles of Corporate Governance were intended “to assist OECD and non-OECD governments in their efforts to evaluate and improve the legal, institutional, and regulatory framework for corporate governance in their countries and to provide guidance and suggestions for stock exchanges, investors, corporations, and other parties that have a role in the process of developing good corporate governance.” Corporate governance within publicly listed companies are the focal point in the development of the Principles. The aim is to progress accountability and transparency in both financial and non-financial reporting of executives, shareholders, and managers alike. Furthermore, these Principles are not mutually exclusive and may offer as a practical tool for private corporations as well. The underlying reason for the progress of these Principles is to supply a common basis and essential tools for OECD member countries towards the creation of good governance practices (OECD 2004).
In recognition of the synergy between macroeconomic and structural policies in achieving policy goals, OECD and its member governments has developed these Principles. The rationale is because institutions and corporate alike recognize that effective corporate governance is an essential element to further economic efficiency and growth and boost investor sentiment in the country. Corporate governance related to the elaborate relationships between the different stakeholders within the company such as its management, its board, its shareholders, and others. In addition, OECD (2004) highlights the advantages of an effective corporate governance system within an individual company and across an economy. The benefits are as follows:
–       presents a structure or framework through which its management can set goals, develop strategies to achieve these objectives, and monitor performance
–       offers the appropriate motivation for the board and management to follow opportunities that are in the interest of the shareholders and to aid in monitoring progress
–       provide a degree of confidence on the veracity and integrity of corporation which is vital for the proper functioning of a market economy
–       lowers the cost of capital and encourages firms to use resources more efficiently, thereby underpinning growth.
In the midst of the important benefits such as a sound structural policy within an individual company, corporate governance also plays a vital role in the larger economic context. The corporate governance framework takes into consider the macroeconomic policies, degree of competition in product and factor markets, as well as the legal, regulatory, and institutional environment. More importantly, governance also accounts for factors such as business ethics and corporate awareness of the environmental and societal interests of communities in which a company operates can also have an impact on its reputation and long-term success. Understanding the political, economic and social impact of an effective corporate governance system can encourage managers, shareholders, and its board in implementing a strategic corporate governance system (OECD 2004).
OECD (2004) highlights that “given the multiplicity of factors affecting the governance and decision making processes of firms, and are important to their long-term success, the Principles focus on governance problems that result from the separation of ownership and control.” Nonetheless, while the conflicting interests of between shareholders and management has become a central element in addressing this issue, it is important to look at it in a more broader perspectives. In other countries, the issue can arise between shareholders. Examples would be the exertion of undue influence of controlling shareholders over minority shareholders or the important legal rights of employees to the corporation irrespective of their ownership rights and some other issues relevant to a company’s decision-making processes include anti-corruption, environmental concerns or ethical concerns. These are all taken into account in corporate governance.
Therefore, corporate governance is affected by the relationships among participants in the governance system. Participants include controlling shareholders, institutional investors, individual shareholders, creditors, employees and other stakeholders, and government. Controlling shareholders, which could be individuals, family holdings, bloc alliances, or another holding firm, can assert significant influence over the corporate behavior. Because of the amount of capital invested in corporations, institutional investors are seeking greater voice in corporate governance. Individual investors are less likely to exercise governance rights but are highly apprehensive on acquiring a fair treatment from controlling shareholders and management. Creditors, while they do not wish to be involved in the internal affairs often acts as a monitor over corporate performance. Employees also play a critical role in delivering performance and ultimately driving the success of the company. Lastly, government provide the overall institutional and legal framework for corporate governance to operate. The role of each of these participants and their interactions vary widely in different countries and markets; more importantly, these relationships are subject, in part, to law and regulation and, in part, to voluntary adaptation and, most importantly, to market forces (OECD 2004).
As investment has progressively become international in nature, the degree to which corporations adopt the principles of corporate governance has become an important criteria for investment decisions. The international characteristic of investments allows corporations to access a larger pool of investors. If countries are to reap the full benefits of the global capital market, and in order to attract long-term “patient” capital, corporate governance system must transparent and trustworthy, well understood across borders and adhere to internationally accepted principles. Nonetheless, even though corporations do not seek capital from international investors, a good corporate governance system can improve the sentiment of domestic investor, thereby reducing the cost of capital, further develop capital markets and ultimately encourage more stable sources of financing (OECD 2004).
OECD (2004) highlights that the Principles are non-binding and do aim at detailed prescription for national legislation. Rather, setting broad objectives and identifying strategies is the goal in the creation of the Principles. Their purpose is to serve as a baseline and as a reference point. They can be used by policy makers as they examine and develop the legal and regulatory frameworks for corporate governance that reflect their own economic, social, legal, and cultural circumstances, and by market participants as they develop their own practices.
It is expected for the Principles to evolve over time. More importantly, the Principles should be reviewed in light of significant changes in the political, economic, and social environment. To remain competitive in a changing world, corporation must always innovate and improve. Furthermore, corporate governance must evolve to adapt to the changing market environment and pursue new opportunities. On the same note, governments have the responsibility to provide the necessary support such as shaping an effective regulatory framework that provides sufficient flexibility to allow markets to function effectively. It is up to governments and market participants to decide how to apply these Principles in developing their own frameworks for corporate governance, taking into account the costs and benefits of regulation (OECD 2004).
The Organization for Economic Co-Operation and Development (2004) has set forth six guiding principles for the development of corporate governance framework. The principles are as follows:
Principle #1: The corporate governance framework should promote transparent and efficient markets, be consistent with the rule of law and clearly articulate the division of responsibilities among different supervisory, regulatory and enforcement authorities.
In order to create an effective corporate governance framework, governments must enact and create appropriate and effective legal, regulatory, and institutional foundations for market participants to rely on establishing their private contractual relations. In general, government takes into account the country’s specific culture, tradition, and history in enacting legislation and regulation as necessary tools in creating the corporate governance framework. More importantly, the content and structure of the framework must evolve as new experiences are acquired and the market change (OECD 2004).
It is important for government to maintain oversight and monitor their corporate governance framework, including regulatory and listing requirements of businesses. The objective is to maintain and strengthen the company’s contribution to the trustworthiness within the market and further economic performance. On this note, the interactions and checks and balances between different stakeholders in the corporate governance framework must be taken into account. More importantly, their ability to offer ethical, responsible, and transparent corporate governance practices is the key element. Such analysis should be viewed as an important tool in the process of developing an effective corporate governance framework. To this end, effective and continuous consultation with the public, industry leaders, and academe is an essential element that is widely regarded as good practice. Moreover, in developing a corporate governance framework in each jurisdiction, national legislators and regulators should duly consider the need for, and the results from, effective international dialogue and cooperation. If these conditions are met, the governance system is more likely to avoid over-regulation, support the exercise of entrepreneurship and limit the risks of damaging conflicts of interest in both the private sector and in public institutions. This in principle will lead to a more transparent and efficient market governed by the rule of law (OECD 2004).
Principle #2: The corporate governance framework should protect and facilitate the exercise of shareholders’ rights.
Equity investors have certain property rights. For example, an equity share in a publicly traded company can be bought, sold, or transferred. OECD defines an equity share as “an entitlement for the investor to participate in the profits of the corporation, with liability limited to the amount of the investment”. In addition, ownership of an equity share provides a right to information about the corporation and a right to influence the corporation, primarily by participation in general shareholder meetings and by voting (OECD 2004).
As a practical matter, however, the corporation cannot be managed by shareholder referendum. This is because the shareholding body is made up of individuals and institutions. Each may have different interests, goals, investment horizons and capabilities. Moreover, the corporation’s management must be able to take business decisions rapidly. In light of these realities and the complexity of managing the corporation’s affairs in fast moving and ever changing markets, shareholders are not expected to assume responsibility for managing corporate activities. Thus, in principle, the responsibility of visioning and operations is typically placed in the hands of the board and a management that is selected, motivated and, when necessary, replaced by the board (OECD 2004).
Shareholders’ rights to influence the corporation centre on certain fundamental issues, such as the election of board members, or other means of influencing the composition of the board, amendments to the company’s organic documents, approval of extraordinary transactions, and other basic issues as specified in company law and internal company statutes. This Section can be seen as a statement of the most basic rights of shareholders, which are recognised by law in virtually all OECD countries. Additional rights such as the approval or election of auditors, direct nomination of board members, the ability to pledge shares, the approval of distributions of profits, etc., can be found in various jurisdictions (OECD 2004).
Principle #3: The corporate governance framework should ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights.
OECD highlights that investors’ confidence that the capital they provide will be protected from misuse or misappropriation by corporate managers, board members or controlling shareholders is an important factor in the capital markets. Corporate boards, managers and controlling shareholders may have the opportunity to engage in activities that may advance their own interests at the expense of non-controlling shareholders. Hence, in order to providing protection to investors, a distinction can usefully be made between ex-ante and ex-post shareholder rights. Ex-ante rights are, for example, pre-emptive rights and qualified majorities for certain decisions. Ex-post rights allow the seeking of redress once rights have been violated. In jurisdictions where the enforcement of the legal and regulatory framework is weak, some countries have found it desirable to strengthen the ex-ante rights of shareholders such as by low share ownership thresholds for placing items on the agenda of the shareholders meeting or by requiring a supermajority of shareholders for certain important decisions. The Principles support equal treatment for foreign and domestic shareholders in corporate governance. They do not address government policies to regulate foreign direct investment (OECD 2004).
One of the means in which stakeholders can uphold rights is to summon both the law and administrative action. This may be carried out agains both members of the board and of management. Anecdotal evidence indicates that a critical factor in the protection of their rights is the presence of effectual methods in resolving grievances in a cost-effective and timely manner. There is a premium placed on the protection of minority stakeholders, with the latter’s confidence being increased as the legal system provides measures for legal action within reasonable circumstances. Making such measures avaiable is the accountability of those who regulate these systems and those who legislate related policy (OECD 2004).
There is some risk that a legal system, which enables any investor to challenge corporate activity in the courts, can become prone to excessive litigation. Thus, numerous legal systems have featured clauses that intend to protect the members of the board as well as management against litigation abuse. This is in the form of tests for the adequacy of stakeholder issues, and safe harbors for information disclosure. Ultimately, there must be a healthy balance between permitting investors to find palliatives for the violation of ownership rights and evading unecessary legal action. Many countries have found that alternative adjudication procedures are an efficient method for dispute settlement, at least at the first instance level (OECD 2004).
Principle #4: The corporate governance framework ought to acknowledge shareholders’ rights as defined by the lawy through symbiotic agreements and to promote co-operation between corporations and stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.
An important facet of corporate governance deals with assuring that the flow of external capital to organizations (in both credit and equity). It also delves into seeking means of convincing the different shareholders in the organization to carry out economically beneficial investment levels of organization-specific human and physical capital. The competitiveness and ultimate success of a corporation is the result of teamwork that embodies contributions from a range of different resource providers including investors, employees, creditors, and suppliers. Organizations must acknowledge that stakeholders’s contribution compose an important asset for establishing sustainable and profitable organizations. It is, therefore, in the long-term interest of corporations to foster wealth-creating cooperation among stakeholders. The governance framework should recognise that the interests of the corporation are served by recognising the interests of stakeholders and their contribution to the long-term success of the corporation (OECD 2004).
Principle #5: The corporate governance framework ought to guarantee that prompt and precise disclosure is done on all material aspects of the firm, including the financial situation, performance, ownership, and governance of the company.
In most OECD member countries a large amount of information, both mandatory and voluntary, is gathered in public trade and big unlisted companies, and then distributed to a wide array of users. Public disclosure is typically required, at a minimum, on an annual basis though some countries require periodic disclosure on a semi-annual or quarterly basis, or more frequently. One such case is when there are important changes that are influencing the firm. Companies often make voluntary disclosure that goes beyond minimum disclosure requirements in response to market demand (OECD 2004).
An impactful disclosure era advocates authentic objectivity as a crucial characteristic of market-based tracking of organizations and is core to stakeholders’ ability to exercise their ownership rights on an informed basis. Anecdotal evidence from several nations indicate that amongst sizable and active equity markets, disclosure can be a potent instrument for directing the behavior of firms towards the protection of its stakeholders. A strong disclosure regime can help to attract capital and maintain confidence in the capital markets. By contrast, weak disclosure and non-transparent exercises may influence unethical practice and contribute to reduction in the integrity of the market at substantial cost – that is, not just to the firm but to stakeholders and the economy in general. Shareholders and potential investors require access to regular, valid and testable data in adequate detail to enable them to evaluate the efficacy of management, and make informed decisions about the valuation, ownership and voting of shares. Inadequate or ambiguous data may serve as an obstacle for the effective functioning of markets, increase the cost of capital and result in a poor allocation of resources (OECD 2004).
Disclosure also helps improve public understanding of the structure and activities of enterprises, corporate policies and performance with respect to environmental and ethical standards, and companies’ relationships with the communities in which they operate (OECD 2004).
Disclosure requirements are not expected to place unreasonable administrative or cost burdens on enterprises. Nor are companies expected to disclose information that may endanger their competitive position unless disclosure is necessary to fully inform the investment decision and to avoid misleading the investor. In order to determine what information should be disclosed at a minimum, several nations deploy the idea of materiality. Such information is depicted as that whose neglect or misrepresentation may have an effect on the economic decisions of the recipients of such data (OECD 2004).
The Principles support timely disclosure of all material developments that arise between regular reports. They also support simultaneous reporting of information to all shareholders in order to ensure their equitable treatment. In maintaining close relations with investors and market participants, companies must be careful not to violate this fundamental principle of equitable treatment (OECD 2004).
Principle #6: The corporate governance framework ought to guarantee the strategic direction of the firm and the effectual tracking of board management, and the board’s accountability to the company and the shareholders.
Board structures and procedures vary both within and among OECD member countries. Some countries have two-tier boards that distinguish the supervisory role and that of the managerial role into separate entities. Such systems typically have a “supervisory board” composed of non-executive board members and a “management board” composed entirely of executives. Other countries have “unitary” boards, which allow the convergence of those who hold executive and non-executive roles. In certain nations, there are dedicated statutory entities for the audit function. The principles are intended to be sufficiently general to apply to whatever board structure is charged with the functions of governing the enterprise and monitoring management (OECD 2004).
Together with guiding corporate strategy, the board is primarily accountable for tracking the performance of managers and in attaining sufficient return for shareholders. Simultaneously, they are to evade conflicts of interest and maintain a healthy equilibrium among the conflicting demands of the firm. In order for boards to effectively fulfill their responsibilities they must be able to exercise objective and independent judgement. Another important board responsibility is to oversee systems designed to ensure that the corporation obeys applicable laws. In some countries, companies have found it useful to explicitly articulate the responsibilities that the board assumes and those for which management is accountable (OECD 2004).
The board is not only accountable to the company and its shareholders but also has a duty to act in their best interests. In addition, boards are expected to take due regard of, and transact honestly with other shareholder interests encompassing those of employees, creditors, customers, suppliers and local communities. Compliance to principles that promote environmental and social responsibility are important in such a setting (OECD 2004).
Guidance on Audit Committee
As the OECD has developed the six Principles in developing the corporate governance framework, OECD member countries have integrated these principles as guide in further improving structural policies in financial reporting and enacting legislations to support these. As one of the important principles is the establishment of transparent and efficient market consistent with the rule of law, the OECD suggests the creation of an audit committee and an external auditor as an oversight function in corporate governance. The creation of guidelines for Audit committees suggests the applicability of such statute for all UK publicly listed companies (FRC 2003).
The core function of the audit committee defined by the FRC is to act as an oversight of a particular function. While it is not the duty of the audit committee that properly belong to others such as conducting of audits, the audit committee must intervene if there are signs that something may be seriously amiss. For example, if the audit committee is uneasy about the explanations of management and auditors about a particular financial reporting policy decision, there may be no alternative but to grapple with the detail and perhaps to seek independent advice (FRC 2003).
Under this guidance, audit committees have wide-ranging, time consuming and sometimes intensive work to do. Therefore, support and cooperation of companies have to be ensured. This means that companies need to make the necessary resources available. This includes suitable remuneration for the members of audit committees themselves. They – and particularly the audit committee chairman – bear a significant responsibility and they need to commit a significant extra amount of time to the job (FRC 2003).
In particular, the management is under an obligation to ensure the audit committee is kept properly informed, and should take the initiative in supplying information rather than waiting to be asked. Moreover, because cooperation is a must, all company directors are required to provide the audit committee any information it requires (FRC 2003).
The FRC (2003) sets the scope of responsibility of the audit committee in the hands of the board. The board decides to which extent the audit committee undertakes tasks on behalf of the board, the results should be reported to, and considered by, the board. In doing so it should identify any matters in respect of which it considers that action or improvement is needed, and make recommendations as to the steps to be taken.
FRC (2003) defines the roles and responsibility of an audit committee in 4 functions: (1) financial reporting, (2) Internal Control and Risk Management Systems, (3) Internal Audit process, and (4) External Audit Process. It is also important to note that the audit committee is responsible for reviewing arrangements by which staff of the company may, in confidence, raise concerns about possible improprieties in matters of financial reporting or other matters. The audit committee’s objective is to ensure that arrangements are in place for the proportionate and independent investigation of such matters and for appropriate follow-up action.
Financial Reporting. The audit committee should review the significant financial reporting issues and judgments made in connection with the preparation of the company’s financial statements, interim reports, preliminary announcements and related formal statements.
While it is management’s responsibility to prepare the complete and accurate company’s financial statement in accordance with the financial reporting standards and applicable rules and regulations, it is the audit committee’s responsibility to review and assess whether the financial statements have been prepared in accordance to the general financial reporting standards. The audit committee also considers significant accounting policies, any changes to them and any significant estimates and judgments. As a policy, management should inform the audit committee of the methods used to account for significant or unusual transactions where the accounting treatment is open to different approaches. Taking into account the external auditor’s view, the audit committee assess whether the company has adopted appropriate accounting policies and, where necessary, made appropriate estimates and judgments. The audit committee lastly reviews the clarity and completeness of disclosures in the financial statements and checks whether the disclosures made are set properly in context (FRC 2003).
Where, following its review, the audit committee is not satisfied with any aspect of the proposed financial reporting by the company, it is the committee’s responsibility to report its views to the board (FRC 2003).
In addition to the examination of the accounts, audit committees also review the veracity of related information presented with the financial statements, including the operating and financial review, and corporate governance statements relating to the audit and risk management. The committee also reviews other statements containing financial information where information can affect the stock price or significant financial returns to regulators (FRC 2003).
Internal Controls and Risk Management Systems. The audit committee is responsible for the review of company’s financial controls and risk management systems. In certain companies, the board may opt to create a separate board risk committee comprised of independent directors or the board itself. Nonetheless unless the board has expressly identified and created a separate risk committee, the audit committee shall be responsible for the review of this function.
These financial controls and risk management systems pertain to the systems established to identify, assess, manage and monitor financial risks. It is the company management’s responsibility to identify, assess, manage, and monitor risk and to develop, operate, and monitor the system of internal as well. Further, it is the responsibility of the management to assure the board of the financial controls and risk management are in place and monitored. Usually, the audit committee receives reports from management on the effectiveness of the systems they have established and the conclusions of any testing carried out by internal and external auditors (FRC 2003).
The committee also reviews and approves the statements included in the annual report in relation to internal control and the management of risks (FRC 2003).
Internal audit process. If an internal audit function exists within the organisation, the audit committee monitors and reviews the effectiveness of such function. However, if the company opts not to develop an internal audit function, the audit committee should annually assess whether there is a need for an internal audit function and make the recommendation to the board. The absence of such function and accompanying reasons is to be explained in the relevant section of the annual report.
The creation for an internal audit function will depend on the recommendation of the audit committee. In general, the committee assesses the need depending on the company specific factors such as scale, diversity, and complexity of the company’s activities and the number of employees as well as cost/benefit considerations.  Senior management and the board may desire objective assurance and advice on risk and control. An adequately resourced internal audit function (or its equivalent where, for example, a third party is contracted to perform some or all of the work concerned) may provide such assurance and advice. There may be other functions within the company that also provide assurance and advice covering specialist areas such as health and safety, regulatory and legal compliance and environmental issues (FRC 2003).
External audit process. The audit committee is the body responsible for overseeing the company’s relations with the external auditor.
The committee is responsible for making a recommendation on the appointment, reappointment, and removal of the external auditors. If the board does not accept the audit committee’s recommendation, the note should be include it in the annual report. Further, the note should indicate any papers recommending appointment or reappointment, a statement from the audit committee explaining its recommendation and should detail the reasons why the board has taken a different position (FRC 2003).
The audit committee also approves the terms of engagement and the remuneration to be paid to the external auditor in respect of audit services provided (FRC 2003).
In addition, the audit committee is responsible for the creation of procedures to ensure the independence and objectivity of the external auditor, taking into account the relevant UK professional and regulatory requirements. This assessment should involve a consideration of all relationships between the company and the audit firm (including the provision of non-audit services). The audit committee should consider whether, taken as a whole and having regard to the views, as appropriate, of the external auditor, management and internal audit, those relationships appear to impair the auditor’s judgment or independence (FRC 2003).
To ensure no conflict of interest exist with external auditors, audit committee seeks reassurance that the auditors and their staff have no family, financial, employment, investment, or business relationship with the company other than in the normal course of business. In addition, external audit firms are asked for information about policies and processes for maintaining independence and monitoring compliance with relevant requirements, including rotation of audit partners and staff (FRC 2003).
The audit committee also sets and applies formal policies specifying the type of non-audit work as follows: (1) from which the external auditors are excluded; (2) for which the external auditors can be engaged without referral to the audit committee; and (3) for which a case-by-case definition is necessary (FRC 2003).
Lastly, non-audit services by external auditors should be explained to shareholders in the annual report. As such, the audit committee must highlight how auditor objectivity and independence is safeguarded in the audit process (FRC 2003).
Corporate Failures and Non-audit Fees
The provisions on the non-audit services have garner much attention and debate. While the Guideline for Audit Committee presented by Smith has detailed the requirements for the proper reporting of non-audit services in the annual reports, a number of researchers argue that extent external auditors compromises their objectivity and independence in assuming greater non-audit fees. The assumption sees auditors are willing to sacrifice their independence in exchange for retaining clients that pay large non-audit fees. In with this are prior research supporting the economic theory of auditor independence (DeAngelo 1981; Watts Zimmerman 1981). DeAngelo (1981) suggests that auditor’s incentives to compromise their independence are related to client importance, and the quasi-rents generated from this close customer relationship, thereby effectively increasing the reliance of the auditor on the client. Further, the assumption has led to the belief that corporate failures are due to the increasing non-audit fees of external auditors.
The Investor Responsibility Research Center (IRRC) has released its second annual report on the fees public companies pay to their auditors. Audit versus Non-Audit Fees: What U.S. and U.K. Companies Pay Their Auditors indicates that increasing audit failures and corporate scandals had some, but not much, impact on how and how much companies paid their auditors in 2001 and early 2002.
In the U.K., a surprising 67% of the total fees paid to company auditors also related to non-audit services. Consulting fees paid by U.K. companies to their auditors appear to have increased dramatically in the last several years. According to a 1994 IRRC survey, only 33% of 141 large U.K. companies paid non-audit fees equal to or greater than the amount paid for their audit. By contrast, 58% of the U.K. companies studied this year paid more in non-audit fees than they did for their audits.
The top non-audit fees paid by U.K. companies were Unilever with $67.7 million of $81.9 million paid to Price Waterhouse Coopers, BP-$59 million of $83 million paid to Ernst ; Young, GlaxoSmithKline-$51.9 million of $62.4 million paid to Price Waterhouse Coopers, and  Barclays-$39.3 million of $46.5 million paid to Price Waterhouse Coopers.
U.S. and U.K. companies pay about the same, on average, for audit services. The mean audit fee reported by the U.S. companies was $1.3 million, compared with a mean of $1.1 million among the U.K. companies examined. The top fee paid for audit services by U.S. and U.K. companies was also about the same: Citigroup paid $24.7 million in audit fees to KPMG, while U.K.-based HSBC Holdings paid $24.3 million, also to KPMG.
“Increasing investor concern about potential conflicts of interest when accountants earn the majority of their revenue by consulting to the companies whose books they audit did apparently have some impact on company behavior,” notes study author Allie Monaco of IRRC’s Governance Research Service. While the percentage of total fees related to non-audit work remained at 72 percent among the U.S. companies overall, it represented only 66 percent in the subset of companies whose fiscal years ended after Dec. 31, 2001, in the wake of Enron’s meltdown and rising suspicions about the integrity of other corporate financial reports.
Prior research of Frankel, Johnson, ; Nelson (2002) finds that the provisions of non-audit services, as measured by the ratio of non-audit fees to total fees, has potentially detrimental aspects in terms of auditor’s independence. Frankel, Johnson, ; Nelson (2002) argues that the provisions of non-audit services is associated with: (1) the likelihood of reporting earnings that meet or slightly exceed analyst expectation, and (2) the magnitude of the absolute value of abnormal accruals. The results of their study show that there is a strong evidence that the provision of non-audit services reduces auditor independence and lowers the quality of financial information.
Subsequent research, however, questions the appropriateness of the conclusions in Frankel, Johnson, ; Nelson’s study. Ashbaugh, LaFond, ; Mayhew (2003) find that after controlling for firm performance there is no longer a positive relation between the provision of non-audit services and measures of unexpected or abnormal accruals. Chung ; Kallapur (2003), on the hand, fail to find any evidence of a relation between measures of unexpected accruals and measures of auditor independence. Ashbaugh, LaFond, and Mayhew find no correlation between firms meeting analyst forecasts and auditor fees; however, Francis ; Ke (2003) clarifies in their study that association between firms meeting analyst forecast and auditor fees exists but is sensitive to the choice of comparison group.
Larker, ; Richardson (2004) also examined the fees paid to auditors for audit and non-audit services and the choice of accrual measures for a large sample of firms. The goal is to determine of their study is to determine whether there is a significant relationship between the fees paid to audit firms for audit and non-audit services and the behavior of accounting accruals. Similar to some prior research, we find little evidence of a positive relation between the fees paid to auditors and measures of accruals for a large pooled sample of firms.
Other researchers looked into the effect of audit qualifications in financial reporting on the market price of a publicly traded companies. Choi ; Jetter (1992) studied the market responsiveness to earning’s announcement declines significantly after the issuance of qualified audit reports for a sample of ‘subject to’ qualifications and consistency qualifications. Accordingly, Choi ; Jetter (1992) that audit qualifications reduce the market’s responsiveness to earnings announcements by altering the market’s perception of earnings noise or the persistence of earnings, or both.
Caitlin, Taylor, ; Taylor (2006) examine whether the provision of non-audit services by incumbent auditors is associated with a reduction in the extent to which earnings reflect bad news on a timely basis (that is, news-based conservatism). They argue that reduced conservatism is expected to occur if relatively high levels of non-audit services result in reduced auditor independence and ultimately, lower-quality auditing. Because client-specific demand for non-audit service is expected to vary, our proxy for the auditor-client economic bond is the extent to which non-audit service purchases (relative to audit fees) are greater or less than expected. The result consistently showed that higher than expected levels of non-audit service are not associated with reduced conservatism. Further, they argue that auditors are unlikely to risk their objectivity citing that the results are consistent with factors such as market-based incentives, the threat of litigation, and alternative governance mechanisms offsetting any expected benefits to the audit firm from reducing its independence. However, they claim that recent legislative intervention aimed at restricting the supply of non-audit service is unlikely to result in increased independence (Caitlin, Taylor, ; Taylor 2006).
Larcker and Richardson (2006) cites three economic or econometric explanation for the conflicting results in the prior literature. First, Larcker and Richardson (2006) explains that the role of corporate governance is largely ignored in the research. The auditor is only one of many potential monitoring mechanism designed to mitigate the inherent agency problems in a publicly traded firm. They argue that examining the auditor in isolation of alternate governance mechanism provides an incomplete analysis of the determinants of earnings quality. Second, there are many ways to measure the financial connection between the auditor and the client. Prior research only tends to focus on the provision of non-audit services (e.g. ratio of non-audit fees to total fees). Nonetheless, Larcker and Richardson (2006) highlights that the provision of non-audit is an equally plausible measure for the dependence of the auditor on the client. Finally, different models are likely to describe the relation between audit fees and earnings quality across a large sample of firms. Larcker and Richardson (2006) highlights the importance of the monitoring role served by the auditor, for example, should vary depending on the strength of the client’s governance structure. Hence, using a single (pooled) regression model across a sample that is composed of different models is unlikely to provide assessment of the relation between fees paid to the auditor (both audit and non-audit) and accrual choices.
Audit Turnover and Audit Quality
Aside from the provisions of non-audit services of audit firms as a cause for concern for regulators and the public in ensuring transparency and objectivity on financial reporting, a number of debates also arose surrounding the auditor’s tenure and its effect on audit quality. The concept of mandatory auditor rotation is that a company’s auditors should provide services for a defined period only, after which they should be replaced by a different firm of auditors.
Recent studies provide valuable insights into the debate surrounding auditor tenure by examining the relationship of audit tenure and (1) accounting accruals, (2) analysts’ forecast errors, and (3) the cost of debt. Myers, Myers, ; Omer (2003) argues that longer auditor tenure constrains managerial discretion with accounting accruals, which suggests high audit quality. Johnson, Khurana, ; Reynolds (2002) also find that accruals are larger and less persistent for firms with short auditor tenure relative to those with medium and long tenure. Mansi, Maxwell, ; Miller (2004) used credit spreads between bond yields and matched Treasury yields as a benchmark for cost debt. In relation to the audit quality, Mansi, Maxwell, ; Miller (2004) argues that the cost of debt declines with longer tenure, which suggests bondholders perceive audit quality as improving with extended tenure. On the other hand, Davis, Soo, ; Trompeter (2002) argues that audit quality declines with extended tenure because, as tenure increases, client firms have greater reporting flexibility and earnings forecast errors decline.
In the US, regulators express concerns that pressure to retain client firms and the ‘‘comfort level’’ created between auditors and management over time impair auditor independence, which adversely affects audit quality, and thereby enacted a law to require a mandatory rotation of audit firms (U.S. Government Accounting Office [GAO] 2003).
On the other hand, there is no regulatory requirement for UK listed companies to change auditors after a number of years in office. However, if the same audit engagement partner acts for an audit client for a prolonged period, a familiarity threat is recognised as arising. As a result, the UK regulatory requirements are that, for listed companies, the audit engagement partner cannot act for more than seven years and cannot return to that role for a further five years.
Irish Review and Ramsay Report carried out, the report highlights the arguments for and against mandatory rotation. The perceived benefits of mandatory rotation can be summarized as follows: (1) an improvement in audit quality due to the avoidance of over-familiarity with the client and its management and the opportunity for a fresh approach to the audit; (2) a better perception of auditor independence; and (3) the benefits of competition. On the other hand, it is generally recognised that there are (1) additional start-up costs affecting both the auditor and client, (2) adverse effects on the quality of the audit due to a lack of familiarity in the first and early years of the audit, (3) a lack of incentive if the audit is about to change hands and (4) the signals that may be given out currently when there is a change of auditor will be lost.
Looking further at Myers, Myers, ; Omer research, we also looked into the effect of Earnings Quality with Auditor Rotation. The concerns on managers misrepresenting their financial conditions in collusion with auditors because of the long-term auditor-client relationship seem to be a valid alarm for both investors and regulators. However, as reported by Myers, Myers, ; Omer (2003), the audit quality increases with auditors tenure as familiarity on the business and industry practices increases. Thus, the results disprove the concerns on collusion due to provisions of non-audit services to increase earnings report to improve the stock price performance in the short term. This suggests that despite the provisions of non-audit services long-term auditor-client relationship can in fact improve on audit quality. More importantly, the rotation of auditors does not guarantee the increase of audit quality.
Although the evidence reviewed has not shown that rotation improves independence, the perception of independence is arguably just as important. In addition, a further impact on audit quality related to the introduction of mandatory rotation is purported to be the potential reduction in incentive for audit firms to invest in the development of the audit process, effectiveness and efficiencies. This is expected to arise due to the lack of long-term commitment (Arrunada and Paz-Ares 1997). Numerous studies have concluded that the costs related to the regular switching of auditors are unacceptably high and outweigh the potential benefits of mandatory rotation. The increase in cost is due to the fact that the incoming auditor has to start the audit from scratch and gain the necessary experience of the client’s business, operations and systems. Any efficiencies developed by the previous auditor are also lost (Arrunada and Paz-Ares 1997).
The accounting profession, on the other hand, claims that the likelihood of audit failures is greater during the initial period of an auditor-client relationship because of lack of information about client-specific risks (PricewaterhouseCoopers 2002).
Audit Committee and External auditor independence
Knapp (1987) showed that audit committee members tend to support auditors rather than management when audit disputes occur. While the claim that audit committee is reluctant to in intercede on auditor’s behalf in case of client disputes, the findings does not support such claim. However, Knapp (1987) identifies factors that may compromise audit committee member’s support for auditors.
Knapp (1987) identified two contextual variables, neither of which is directly controllable by auditees, that tend to diminish the support of audit committee members for auditors involved in audit disputes. Audit committee members in this study were less likely to support the auditor when the focal issue of a dispute was not the subject of objective technical standards. More objective specification of technical standards by accounting and auditing standards would likely encourage audit committees to more readily support positions maintained by auditors in disputes with management. In addition, Knapp (1987) argues that audit committee members to be less supportive of the auditor when the auditee is in strong financial condition and more critical when the audited firm is in financial distress. While Knapp (1987) did not state that the results gathered on the relationship of financial condition of the audited firm and the support of audit committee to external auditor in cases of disputes are not conclusive, he nonetheless, emphasized the fiduciary obligations and regulatory authorities perception of the importance of those obligations. This responsibility alone may increase support for auditors irrespective of the audited firm’s financial condition.
Auditors and Transparency in Audit Disclosures
As the financial press discusses the various perceived ills of financial reporting in the post Enron era, transparency in financial reporting has been of particular importance and interest. It has been used in discussions of defalcations, fraudulent financial reporting, earnings management, accounting method choice, inadequate disclosure, and disclosure overload, to name a few. The variety of contexts in which the term is used is indicative of its popularity with financial statement users as well as its lack of precision as a financial reporting concept.  Mensah, Nguyen, ; Prattipati (2006) argues that the concept could be harnessed to improve communication between financial statement preparers and regulating bodies on the one hand and users of financial statements on the other hand. They further propose a framework in a multi-level model of transparent financial reporting and demonstrate that comparing the transparency model to the FASB conceptual framework provides clearer picture and greater relevance to financial statement user or analyst.
Citron, David ; Taffler, Richard J (2004) also argues that the concerns on the transparency issues in financial reporting are due to the expectation gap concerns on Auditors and financial statement users. McEnroe ; Martens (2001) defines expectation gap as “to the difference between what the public and other financial statement users perceive auditors’ responsibilities to be and what auditors believe their responsibilities entail.” Citron, David & Taffler (2004) argues that the notion of this divergence receives much attention in the accounting literature that prompted regulatory bodies to issue SAS No. 600 Auditors’ Reports on Financial Statements and SAS No. 58 Reports on Audited Financial Statements to reduce the expectation gap between users and auditors. As such, Citron, David, ; Taffler (2004) concludes that if the objective of a new auditing standard is to enhance the quality of audit report disclosures, then it is necessary to ensure that such a standard addresses the mode of communication and does not solely rely on unobservable audit procedures. Form and presentation issues cannot be separated from substance in such potentially confrontational areas as reporting of going-concern uncertainties.
In addition it is important to note that various studies (Nair and Rittenberg 1987; Lowe and Pany 1995; McEnroe ; Martens 2001) have looked into and have compared audit partners’ and investors’ perceptions of auditors’ responsibilities involving various dimensions of the attest function. The studies were conducted to determine if an expectation gap currently exists and they found that it does; investors have higher expectations for various facets and/or assurances of the audit than do auditors. McEnroe & Martens (2001) findings serve as evidence that the accounting profession should engage in appropriate measures to reduce this expectation gap. Nonetheless, in the context of corporate governance, it is important to note that it is the directors or managers who are responsible for the integrity and veracity of the financials reports. It is nonetheless, the auditor’s responsibility to see whether the generally accepted methodology and process were used in the preparation of financial reports.
CHAPTER 3
METHODOLOGY
The target population of this study are the publicly listed firms in the London Stock Exchange, where the practice of financial reporting is highly regulated.
The study provides a convenient avenue for exploring the linkage in managing the audit-client relations in the various industries. The framework of this study examines the relationship between audit quality (independence) and non-audit provisions, audit rotation, audit committee support, and auditing regulations with regard to veracity of financial information.
Table 1 shows the variables that were used in the study. The ratio of non-audit fees and total audit fees will be measurable variable of auditor’s independence. It can be inferred that audit quality are likely to decrease with increase provisions of non-audit service. The cost of management time in gathering client-specific information in auditor will be the measurable variable of auditor’s quality in providing lower cost. It can be inferred that audit quality are likely to decrease with increase with the introduction of mandatory rotation of audit firms within a specific period. The provisions for audit committee support to external auditors in case of disputes with clients on technical issues will be the measurable variable of auditor’s independence. The provisions of auditing regulations affect the extent of the auditor’s are willing to offer their expert opinion.
Table 1. Research Variables
Area
Construct
Variable
Auditor’s independence and objectivity with increasing provisions of non-audit service
Audit Quality (independence)
Provisions for non-audit services
Auditor’s client-specific information and the impact of the cost of management time
Audit Quality (cost)
Provisions for rotation of audit firms
Audit committee support for auditors in cases of disputes with clients on technical issues
Audit Quality
Provisions for audit committee support
Effect auditing regulations and legislations on the expert opinions of auditor
Audit Quality (expert opinion)
Auditing regulations
To emphasize the importance of different factors that affects the audit quality, the selection of the survey instrument was geared toward a specific area, such as provisions for non-audit services.
An initial list of publicly listed companies in the London Stock Exchange was obtained from FSTE website (http://www.londonstockexchange.com/en-gb/). The listing includes a total of 3208 publicly list companies categorized according to industry. We looked at the ratio of total audit fees and non-audit fees of 30 companies that failed and 30 companies that did not fail.
The purpose of the survey was to collect data on effect of different factors on audit quality and analyze their relationship on the quality of audit delivery.
The following hypotheses have been tested in the current study through a self-constructed tool (see Appendix A).
Hypothesis 1: There is a significant relationship between the provisions of non-audit services and auditor`s independence.
Hypothesis 2: There is a significant relationship between the rotation of auditors doing audit works for the same client and the independence of auditor.
Hypothesis 3: There is a significant relationship between the support of audit committee and auditors` objectivity.
Hypothesis 4: There is a significant relationship between the accountancy profession`s regulations and auditors` independence.
The Pearson correlation coefficient was used to determine whether significant bi-variate relationships exist between the following variables. For Hypothesis 1, ratio of non-audit services and total audit service affect the auditor’s independence. For Hypothesis 2, cost of management time and learning curve affect the quality of audit. For Hypothesis 3, likelihood of audit committee will support the external auditor in case of dispute with clients on technical issues. For Hypothesis 4, the likelihood the external auditor will provide soft information or expert opinion in the context of accountancy profession’s regulations.
CHAPTER 4
RESULTS
Descriptive Statistics
Before testing the correlation of the audit quality with the different factors affecting auditor’s independence and objectivity, we looked into the published reports of audit fees of 60 sample companies both listed in FSTE250 and FSTE100.  The non-audit as percentage of audit fee is shown below in Table 1.
Table 1. Sample of Audit and non-audit fees for a sample of 60 publicly listed companies in the London Stock Exchange. The audit fees are from the financial reports of various companies for period ending Dec. 31, 2005. (Figures is in £ millions).
Company
Auditor
Audit Fee
Non-audit Fee
Total Audit Fee
Non-audit as % of audit fee
1
3i
E&Y
£1.000
£0.400
£1.400
40%
2
Amvescap
E&Y
£2.196
£1.797
£3.993
82%
3
Assoc Brit Foods
KPMG
£3.200
£3.400
£6.600
106%
4
BAA
PwC
£0.700
£0.800
£1.500
114%
5
Barclays
PwC
£7.000
£15.000
£22.000
214%
6
BOC
PwC
£2.500
£3.100
£5.600
124%
7
BP
E&Y
£23.497
£20.219
£43.716
86%
8
Centrica
PwC
£2.500
£5.300
£7.800
212%
9
Diageo
KPMG
£4.300
£3.000
£7.300
70%
10
DSG Int’l
D;T
£0.800
£0.800
£1.600
100%
11
Enterprise Inns
E;Y
£0.300
£0.900
£1.200
300%
12
Friends Provident
KPMG
£1.200
£4.400
£5.600
367%
13
GlaxoSmithKline
PwC
£7.200
£7.300
£14.500
101%
14
GUS
PwC
£3.000
£4.000
£7.000
133%
15
Hammerson
D;T
£0.579
£0.311
£0.890
54%
16
HBOS
KPMG
£4.800
£6.800
£11.600
142%
17
Hilton Group
E;Y
£2.200
£1.300
£3.500
59%
18
Imperial Tabacco
PwC
£1.900
£2.100
£4.000
111%
19
International Power
KPMG
£1.800
£1.900
£3.700
106%
20
Johnson Matthey
KPMG
£1.000
£0.700
£1.700
70%
21
Kelda Group
E;Y
£0.400
£0.200
£0.600
50%
22
Legal ; General
PwC
£1.500
£1.700
£3.200
113%
23
Liberty Int’l
PwC
£0.443
£0.134
£0.577
30%
24
Man Group
PwC
£1.622
£2.162
£3.784
133%
25
Marks and Spencer
PwC
£1.200
£1.400
£2.600
117%
26
Morrison (Wm)
KPMG
£0.700
£3.200
£3.900
457%
27
National Grid
PwC
£5.000
£3.000
£8.000
60%
28
O2
PwC
£1.035
£1.848
£2.883
179%
29
Party gaming
BDO
£0.219
£0.109
£0.328
50%
30
Tesco
PwC
£1.700
£2.400
£4.100
141%
31
Unilever
PwC
£8.827
£7.469
£16.296
85%
32
ARM Holdings
PwC
£0.314
£0.700
£1.014
223%
33
Avis Europe
PwC
£0.900
£0.800
£1.700
89%
34
AWG
PwC
£0.600
£6.600
£7.200
1100%
35
BBA Group
PwC
£0.700
£0.179
£0.879
26%
36
Bellway
KPMG
£0.140
£0.126
£0.266
90%
37
Benfield Group
PwC
£0.860
£2.322
£3.182
270%
38
BSS Group
PwC
£0.200
£0.039
£0.239
20%
39
Bunzl
KPMG
£1.900
£2.600
£4.500
137%
40
Burren Energy
D&T
£0.150
£0.650
£0.800
433%
41
Cambridge Antibody Tech
D&T
£0.039
£0.045
£0.084
115%
42
Capital & Regional
D&T
£0.190
£0.172
£0.362
91%
43
Catlin
PwC
£0.926
£1.607
£2.533
174%
44
Cattles
PwC
£0.336
£1.151
£1.487
343%
45
Colt Telecom
PwC
£0.906
£1.056
£1.962
117%
46
Corus Group
KPMG
£3.140
£2.565
£5.705
82%
47
Countrywide
KPMG
£0.551
£1.755
£2.306
319%
48
intertek Group
KPMG
£0.900
£0.300
£1.200
33%
49
Investec
E&Y
£3.843
£2.670
£6.513
69%
50
JJB Sports
D&T
£0.091
£0.081
£0.172
89%
51
John Laing
D&T
£0.400
£0.300
£0.700
75%
52
LogicaCMG
PwC
£1.200
£1.800
£3.000
150%
53
Lonmin
KPMG
£0.390
£0.278
£0.668
71%
54
Marconi Corporation
E&Y
£1.800
£1.000
£2.800
56%
55
MFI Furniture
D&T
£0.400
£0.800
£1.200
200%
56
Minerva
PwC
£0.100
£0.214
£0.314
214%
57
Misys
PwC
£1.000
£0.900
£1.900
90%
58
Northgate
D&T
£0.228
£0.166
£0.394
73%
59
Pennon Group
D&T
£0.308
£0.444
£0.752
144%
60
Rank Group
PwC
£1.400
£3.600
£5.000
257%
Source: The Annual Audit Fees survey for 2005. Financial Director, (January 2006). [Online] Available: http://www.financialdirector.co.uk/accountancyage/specials/2148078/full-2005-audit-fees-survey
Table 2 presents the minimum, maximum, mean and standard deviation for the audit fee, non-audit fee, and total audit fee. The findings for UK audit fees survey is summarized as follows (Figures is in £ millions except for standard deviation):
Audit Fee
Non-audit Fee
Total Audit Fee
Mean
£1.971
£2.368
£4.338
Mediam
£0.963
£1.350
£2.567
Minimum
£0.039
£0.039
£0.084
Maximum
£23.497
£20.219
£43.716
Range
£23.458
£20.180
£43.632
Std. Deviation
£3.372
£3.441
£6.616
The mean audit fee for the sample is £1.971 millions while mean non-audit fee accounts for £2.368 millions. The ratio of the mean non-audit fee as percentage of audit fee is 120.14%. This suggests that non-audit fees account for more a greater revenue share in the revenues of audit firms. While the non-audit fees are considerably greater in the sampled publicly corporations, the survey conducted by ICC notes that the historical trend of non-audit fees have declined in recent years. ICC notes that four years ago, the auditors-cum-consultants earned more than three times as much in non-audit fees as audit fees.
The following hypotheses have been tested in the current study through a self-constructed tool (see Appendix A).
Hypothesis 1: There is a significant relationship between the provisions of non-audit services and auditor`s independence.
Hypothesis 2: There is a significant relationship between the rotation of auditors doing audit works for the same client and the independence of auditor.
Hypothesis 3: There is a significant relationship between the support of audit committee and auditors` objectivity.
Hypothesis 4: There is a significant relationship between the accountancy profession`s regulations and auditors` independence.
The Pearson correlation coefficient was used to determine whether significant bi-variate relationships exist between the following variables For Hypothesis 1, ratio of non-audit services and total audit service affect the auditor’s independence. For Hypothesis 2, cost of management time and learning curve affect the quality of audit. For Hypothesis 3, likelihood of audit committee will support the external auditor in case of dispute with clients on technical issues. For Hypothesis 4, the likelihood the external auditor will provide soft information or expert opinion in the context of accountancy profession’s regulations.
Results
The following table of correlation coefficients has been used to interpret the results of the statistical analysis:
Degrees of Freedom
Probability, p
0.05
0.01
0.001
1
0.997
1
1
2
0.95
0.99
0.999
3
0.878
0.959
0.991
4
0.811
0.917
0.974
5
0.755
0.875
0.951
6
0.707
0.834
0.925
7
0.666
0.798
0.898
8
0.632
0.765
0.872
9
0.602
0.735
0.847
10
0.576
0.708
0.823
11
0.553
0.684
0.801
12
0.532
0.661
0.78
13
0.514
0.641
0.76
14
0.497
0.623
0.742
15
0.482
0.606
0.725
16
0.468
0.59
0.708
17
0.456
0.575
0.693
18
0.444
0.561
0.679
19
0.433
0.549
0.665
20
0.423
0.457
0.652
25
0.381
0.487
0.597
30
0.349
0.449
0.554
35
0.325
0.418
0.519
40
0.304
0.393
0.49
45
0.288
0.372
0.465
50
0.273
0.354
0.443
60
0.25
0.325
0.408
70
0.232
0.302
0.38
80
0.217
0.283
0.357
90
0.205
0.267
0.338
100
0.195
0.254
0.321
Hypothesis 1.
Table 1. Correlation between ratio of non-audit fees and total audit fees on auditor’s independence.
Variables
Pearson r
P
Ratio of Non-audit fees and total audit fees
0.13
<.01
Auditor’s independence
*significant at .05 level
**significant at .01 level
Table 1 shows that there is a weak correlation between the ratio of non-audit fees on audit fees as an indicator of decreasing level of auditor’s independence (r=0.13, p<.01). This suggests that as the increased in the level of non-audit services does not translate to lower audit quality which is also consistent with the studies conducted by Ashbaugh, LaFond, & Mayhew (2003).
Hypothesis 2
Table 2. Correlation between the cost of management time and learning curve and audit quality.
Variables
Pearson r
P
Cost of management time and learning curve
0.87
<.01
Audit Quality
*significant at .05 level
**significant at .01 level
For Hypothesis 2, Table 2 shows that there is a positive, significant correlation between increased audit process cycle due to rotation of audit firms and the level of audit  (r=.87, p<.01). This connotes that the mandatory rotation of audit firms would result for audit firms to need more time to gather client-specific requirements and thereby effectively increasing the cost of management time and learning curve in order to provide the same level of audit quality.
Table 3. Correlation between the quality of earning report and rotation of auditors.
Variables
Pearson r
P
Quality of Earnings Report
0.09
<.01
Rotation of Auditors
*significant at .05 level
**significant at .01 level
For Hypothesis 2, Table 3 shows that there is weak correlation between rotation of audit firms and the quality of earnings report  (r=.09, p<.01). This connotes that the mandatory rotation of audit firms would not necessarily result to improve conservatism in earnings report for audit firms.
Hypothesis 3
Table 4. Correlation between likelihood of audit committee will support the external auditor and auditor’s objectivity.
Variables
Pearson r
P
Likelihood of audit committee will support the external auditor
0.64
<.01
Auditor’s Objectivity
*significant at .05 level
**significant at .01 level
For Hypothesis 3, Table 4 shows that there is a positive, significant correlation between the likelihood of audit committee to act as intermediary in case of disputes with client for technical issues (r=.64, p<.01). This connotes that as audit committee is more likely to act as intermediary in resolving technical issues between client and auditor for technical disputes.
Hypothesis 4
Table 5. Correlation between the likelihood the external auditor will provide soft information or expert opinion in the context of accountancy profession regulations.
Variables
Pearson r
P
likelihood the external auditor will provide soft information or expert opinion
0.18
<.01
Audit Quality
*significant at .05 level
**significant at .01 level
For Hypothesis 2, Table 5 shows that there is a weak correlation between the auditor’s likelihood of providing insights or soft information outside the professional regulations (r=.18, p<.01). This connotes that auditors are more likely to publish their expert judgment conservatively and not provide additional information other than what is required from the regulating commission.
CHAPTER 5
SUMMARY, CONCLUSION AND RECOMMENDATIONS
Summary
Over the years, the quality of financial reporting has varied widely. Some of the companies did the bare minimum to meet accounting standards, while others were more cautious. Most of the recent corporate scandals that rocked the US companies such as Enron, WorldCom and Xerox were a result of accounting problems and board oversights. In the case of Enron, the board bore significant responsibility for the company’s collapse; as Enron’s high-risk investments and accounting maneuvers were hidden from the public and regulators. WorldCom was reclassifying expenses as capital spending in order to boost operating cash flow margin, which led to $3.9 billion fraud at the US telecommunication company. Xerox, a US photo-copier company, had overstated its operating earnings by $1.4 billion by using accounting practice to inflate its profits. In a nutshell, the accounting scandals at Enron, WorldCom, and Xerox have all come in different forms and disguises. The question therefore is how to protect the investing public and regain its trust after a series of accounting scandals.
The common misconception relates to the public perception that the primary role of employing an auditor is to detect fraud (Dunn 1989). Fraud are deliberate steps by one or more individuals to deceive or mislead with the objective of misappropriating assets of a business, distorting an organization’s apparent financial performance or strength, or otherwise, obtaining an unfair advantage. As the Enron debacle has unveil, management and its director can have an undue influence in the presentation of financial statement in order to either increase the stock price or to meet and exceed shareholder’s expectations. Moreover, in the context of corporate governance, it is the management (directors), rather than auditors, who is responsible in ensuring that proper accounting records and statements are prepared and maintained. In practice, the auditor is normally concerned with a suspected rather than proven fraud or irregularity. Nevertheless, the auditor should be able to detect all material fraud. The notion of public interest requires an auditor to report to management, shareholders, and third parties on their finding whether the financial statements were prepared in accordance with the Generally Accepted Accounting Principles. Thus, auditors are there to give credibility to financial statements.
Auditor’s independence is therefore of particular importance in the ensuring the transparency in financial reporting of publicly listed companies and debates have emerged on the provisions of non-audit services provided to clients. A number of studies have been conducted to support or to refute the assumption that non-audit provisions places the auditor’s independence at risk (or lowers) in the auditor-client relationships.
On one hand, regulators, financial statement users, and researchers are concerned that auditors compromise their independence by allowing high fee client more discretion or leeway in the presentation of financial statements relative to low fee clients. This assumption alarms regulators that auditors may be willing to compromise their independence by allowing greater “latitude” in financial reporting in exchange for greater share of a more profitable and more revenue-generating non-audit services of the company. DeAngelo (1981) economic model theory is of particular importance to this assumption as it explains the economic bond between audit and firms. The theory of economic bond explains that relationship of the between the audit fees and auditor’s dependence is proportionate, which means that as the economic bond increases auditor’s dependence on the firm also increases. It can then be argued that non-audit fees further increases the audit-client bond following the economic theory, thereby effectively influencing auditor’s independence. The theory of economic bond extends further on the client importance or the lifetime value of a client. DeAngleo (1981) argues that the auditors are likely to provide greater leeway to bigger clients in order to build closer customer relationships and maintain the quasi-rents generated from this. Following this assumption, DeAngelo (1981) therefore argues that auditor’s incentives to compromise their independence are related to client importance, thereby effectively increasing the reliance of the auditor on the client. In addition, the consulting nature of the non-audit provisions is a point contention and a potential source of conflict of interest for auditors. This puts auditors in managerial roles, which may influence their objectivity in the transactions that they audit. More importantly, the assumption has led to the belief that corporate failures are due to the increasing non-audit fees of external auditors.
We looked into this assumption by comparing the audit fees and non-audit fees of Big-Four audit firms for 2005. Based on the published report of 60 sample companies both listed in FSTE250 and FSTE100, we found that the mean audit fee for the sample is £1.971 millions while mean non-audit fee accounts for £2.368 millions. The ratio of the mean non-audit fee as percentage of audit fee is 120.14%. This suggests that non-audit fees account for more a greater revenue share in the revenues of audit firms. While the non-audit fees are considerably greater in the sampled publicly corporations, the survey conducted by ICC notes that the historical trend of non-audit fees have declined in recent years. ICC notes that four years ago, the auditors-cum-consultants earned more than three times as much in non-audit fees as audit fees. Thus, the alarming trend has caused regulators and investors to have a serious look on the ability of auditor to remain independent in the face of increasing economic bond between auditor-client relationships.
The research of Frankel, Johnson, & Nelson (2002) concludes the provision of non-audit services has a detrimental effect in the practice of auditor’s independence. They associate that the level of compromise may take the form of (1) granting more latitude in accounting for earnings report to meet or slightly exceed financial analyst’s expectation, thereby boosting stock market price, and (2) giving consent in the provisions of reporting abnormal accruals in financial reports, thereby creating a misrepresentation of true financial condition of the company. The results of their study show that there is a strong evidence that the provision of non-audit services reduces auditor independence and lowers the quality of financial information.
A number of researchers, on the other hand, contest this assumption arguing that it ignores the auditor’s expected costs of compromising their independence. Ashbaugh, LaFond, & Mayhew (2003) argues that while the increase in non-audit provision in the course can increase the revenues of the audit firms, the risk of loss of reputation and litigation costs may outweigh these benefits. Moreover, the risk of losing auditor’s reputation and the associated litigation costs are likely to provide strong incentives for auditors to maintain their independence. Studies (Ashbaugh, LaFond, & Mayhew 2003; Chung & Kallapur 2003; Francis & Ke 2003) questions the appropriateness of the conclusions in Frankel, Johnson & Nelson’s report. They argue that the results of their studies cannot categorically claim a positive relationship between the provision of non-audit services and the measures of unexpected or abnormal accruals. The findings of Ashbaugh, LaFond, and Mayhew does not find any conclusive evidence to relate auditor fees with the meeting financial analyst’s forecast; however, in a similar study, Francis & Ke (2003) notes that this association may exist in only on the choice of comparison groups.
Similarly, following the varying measures used by Frankel, Johnson, & Nelson and the subsequent researches, Larker & Richardson (2004) also followed up on the study in examining the fees paid to auditors for audit and non-audit services and the choice of accrual measures for a large sample of firms. Their aim is to find any pattern in the behavior of accounting accruals in relation of audit fees. Their study also concludes that they found very little evidence of a positive relation between audit fees and the measures of accruals for a large pooled sample of firms.
As while several studies have shown the relationship of auditor’s independence and the provisions of non-audit fees, Caitlin, Taylor, & Taylor (2006) was interested on the effect on the provisions of non-audit services with a reduction in the extent to which earnings reflect bad news on a timely basis (that is, news-based conservatism). They argue that reduced conservatism is expected to occur if relatively high levels of non-audit services result in reduced auditor independence and ultimately, lower-quality auditing.
Taking into account the varying provisions of non-audit services in practice, they used a similar model in identifying the economic bond between auditors and client as a proxy. The results consistently showed that higher than expected levels of non-audit service are not associated with reduced conservatism. Further, taking into account the regulatory requirements and associated risks, they argue that auditors are unlikely to risk their objectivity citing that the results are consistent with factors such as market-based incentives, the threat of litigation, and alternative governance mechanisms offsetting any expected benefits to the audit firm from reducing its independence. However, they claim that recent legislative intervention aimed at restricting the supply of non-audit service is unlikely to result in increased independence (Caitlin, Taylor, & Taylor 2006).
In view of the conflicting results of prior literature, Larker and Richardson (2006) explains that economic and econometric reasons for this phenomenon. First, they explain that the prior researches do not take into account the role of corporate governance in the audit process. In the context of corporate governance, the auditor is only one of many potential monitoring mechanism designed to mitigate the inherent agency problems in a publicly traded firm. Examining the auditor in isolation of alternate governance mechanism provides an incomplete analysis of the determinants of earnings quality. Second, there are many ways to measure the financial connection between the auditor and the client. Prior research only tends to focus on the provision of non-audit services. Larcker and Richardson (2006) however clarifies that the provision of non-audits as a measure of auditor dependence is a plausible means of determining the auditor’s dependence. While the economic bond is a good measure, a number of different models are also likely to describe the relation between audit fees and earnings quality across a large sample of firms. Larcker and Richardson (2006) highlights the importance of the monitoring role served by the auditor, for example, should vary depending on the strength of the client’s governance structure. Hence, the methodology of using a single pooled regression model does not provide an assessment of the relationship between the audits fees and accrual choices.
Other researchers looked into the effect of audit qualifications in financial reporting on the market price of a publicly traded companies. In a of the market responsiveness to earnings announcements, Choi & Jetter (1992) concludes that audit qualifications reduces market responsiveness after the issuance of qualified audit reports (i.e. ‘subject to’ qualification and consistency qualification) in the financial statement. Accordingly, Choi & Jetter (1992) notes that audit qualifications can alter the market’s perception of earnings noise or the persistence of earnings, or both. This only describes the importance of corporate governance to investors which is firmly associated with the auditor’s expert opinion and judgment in financial reporting.
Nonetheless, Organizations for Economic Co-Operation and Development and Financial Reporting Council emphasized the importance of auditor’s independence in its role as an oversight in the veracity and integrity to a company’s financial reporting. Since the concept of independence and objectivity is a critical measure in the quality of audit services, how can we measure the whether auditors do compromise the quality of audit services in return for non-audit services? How tough are regulations on the breach of trust or conduct unbecoming for auditors who compromise the quality of audit work?
Hence, in order to obtain the appropriate concept and information for evaluating the auditor’s independence for this study, we identified different factors that may affect the auditor’s independence and objectivity in auditing. We looked into the provisions of non-audit services, rotation of audit firms, audit committee’s support, and audit rules and regulation as affecting the level of audit quality.
Our results show that there is a weak correlation on the provisions of non-audit services in reducing the level of audit quality. This suggests that as the increased in the level of non-audit services does not translate to lower audit quality.
Second, our results show significant correlation between the level of audit quality and the cost of management time and learning if a mandatory rotation of audit firms were enacted. This connotes that the mandatory rotation of audit firms would result for audit firms to need more time to gather client-specific requirements and thereby effectively increasing the cost of management time and learning curve in order to provide the same level of audit quality.
Similarly, because of the importance of a good understanding of client-specific risks, the accounting profession claims that the likelihood of audit failures is greater during the initial period of an auditor-client relationship because of lack of information (PricewaterhouseCoopers 2002).
While debates arose surrounding the auditor’s tenure and its effect on audit quality, the concept of mandatory auditor rotation requires company’s auditor to render services for a defined period only, after which they should be replaced by a different firm of auditors. The assumption and rationale of this proposed policy is to reduce the “comfort level” created between auditors and management over time, which could adversely affect the audit quality. Studies have examined the effect of audit tenure on various factors namely (1) accounting accruals, analysts’ forecast errors, and (3) cost of debt. Myers, Myers, ; Omer (2003) argues that longer auditor tenure allows auditors to learn more about the business and the industry. This information constrains managerial discretion with accounting accruals, which suggests high audit quality. Johnson, Khurana, ; Reynolds (2002) also find that shorter auditor tenure may lead to larger and less persistent accounting accruals for firms. Mansi, Maxwell, ; Miller (2004) used credit spreads between bond yields and matched Treasury yields as a benchmark for cost debt. In relation to the audit quality, Mansi, Maxwell, ; Miller (2004) argues that with the perception of greater audit quality, investors and bondholders are likely to ask for a premium on the cost of capital thereby effectively reducing the cost of debt. On the other hand, Davis, Soo, ; Trompeter (2002) argues that audit quality declines with extended tenure because, as tenure increases, client firms have greater reporting flexibility and earnings forecast errors decline.
Such while have been advocated in the US had not been adopted in United Kingdom for the reason that the costs of mandatory rotations does not justify its benefits. The perceived benefits of mandatory rotation can be summarized as follows: (1) an improvement in audit quality due to the avoidance of over-familiarity with the client and its management and the opportunity for a fresh approach to the audit; (2) a better perception of auditor independence; and (3) the benefits of competition. On the other hand, it is generally recognized that there are (1) additional start-up costs affecting both the auditor and client, (2) adverse effects on the quality of the audit due to a lack of familiarity in the first and early years of the audit, (3) a lack of incentive if the audit is about to change hands and (4) the signals that may be given out currently when there is a change of auditor will be lost.
Although the evidence reviewed has not shown that rotation improves independence, the perception of independence is arguably just as important. In addition, a further impact on audit quality related to the introduction of mandatory rotation is assumed to reduce the likelihood for audit firms to invest in the development of effective and efficient audit process. The lack of long-term commitment of audit firms to customers can be the contributing factor to this effect (Arrunada and Paz-Ares 1997). Numerous studies have concluded that the costs related to the regular switching of auditors are unacceptably high and outweigh the potential benefits of mandatory rotation. The increase in cost is due to the fact that the incoming auditor has to start the audit from scratch and gain the necessary experience of the client’s business, operations and systems; thus, any efficiencies developed by the previous auditor are lost (Arrunada and Paz-Ares 1995).
Third, shows that there is a positive, significant correlation between the likelihood of audit committee to act as intermediary in case of disputes with client for technical issues. This connotes that as audit committee is more likely to act as intermediary in resolving technical issues between client and auditor for technical disputes. The result is also consistent with similar studies (Knapp 1987).
Knapp (1987) concludes that audit committees are more likely to support external auditors with their duties and maintain auditor independence because of the fiduciary obligations and regulatory authorities’ perception of the importance of those obligations. He further notes that more objective specification of technical standards by accounting and auditing standards would likely encourage audit committees to more readily support positions maintained by auditors in disputes with management.
Lastly, our results show that there is a weak correlation on the likelihood that auditor will provide additional insights or soft information outside the professional body’s regulations. This connotes that auditors are more likely to publish their expert judgment conservatively and not provide additional information other than what is required from the regulating commission.
We note that these results are only consistent with the role of auditor and the expectation gap that exist between the financial statement users and auditors. Citron, David ; Taffler (2004) discusses that the concerns on the transparency issues in financial reporting are due to the expectation gap concerns on Auditors and financial statement users. As defined by McEnroe ; Martens (2001), expectation gap is “to the difference between what the public and other financial statement users perceive auditors’ responsibilities to be and what auditors believe their responsibilities entail.”
In addition it is also important to note that related researches (Nair and Rittenberg 1987; Lowe and Pany 1995; McEnroe & Martens 2001) have looked into and have compared audit partners’ and investors’ perceptions of auditors’ responsibilities involving various dimensions of the attest function. The studies were conducted to determine if an expectation gap currently exists and they found that it does; investors have higher expectations for various facets and/or assurances of the audit than do auditors. Nonetheless, in the context of corporate governance, it is important to note that it is the directors or managers who are responsible for the integrity and veracity of the financials reports. It is nonetheless, the auditor’s responsibility to see whether the generally accepted methodology and process were used in the preparation of financial reports.
Appendix A – Questionnaire
Dear Respondent,
I am a researcher undertaking a study on the effect of provisions of non-audit services, mandatory rotation of auditors, audit committee’s support for external auditors, and audit disclosures  on audit quality. You are invited to participate in the study by expressing your opinion on the statements below. Rest assured that all information shall be used strictly for academic research purposes only.
With kind regards,
Demographic Information
Working as:
? Auditor
? Director
? Audit Committee
? External Financial Statement User. Please specify: ____________
Tenure:
? ;1 years           ? 1-;3 year       ? 3-;5 years         ? 5-;10 years
? 10-;15 years   ? 15-;20 years  ? 20-;25 years     ? ;25 years
Opinions to Audit Quality
FOR AUDITORS.
We would like to know more of your opinion on the mandatory auditor rotation. Kindly answer the following with this case in mind.
1.)    How long is the estimated period to complete the audit process for new clients?
____ days
2.)    How long is the average processing period to complete the audit process for old clients?___ days
3.)    There is increased probability of missing important client-specific risk factors on new clients.
? Strongly Agree      ? Agree           ? Neutral           ? Disagree        ? Strongly Disagree
FOR AUDIT COMMITTEE.
We would like to know more of your opinion on the likelihood you will support an external auditor on following issues. Kindly answer the following with this case in mind.
4.)    At the end of the 1989 audit in early March of 1990, a customer-vendor defaulted on a large receivable. The customer financial problem resulted from extensive damage to its production facilities caused by a fire in early January 1985. Technical accounting standards are quite explicit in recording for such situation. The standards support the audit firm’s contention that the material loss on the receivable should be disclosed in the footnotes of the 1989 financial statements. Nevertheless, management disagrees with the standards and its audit firm and asserts that since the event occurred after year-end, the loss should not have to be disclosed in any manner.
Given the above information, how likely is it that you would support the auditors rather than management in this dispute?
? Strongly Support      ? Support           ? Neutral           ? Disagree        ? Strongly Disagree
FOR EXTERNAL USERS/AUDITORS
We would like to know more of your opinion on your expectations on following issues.
5.)    Auditors are responsible for the integrity and veracity of financial reports.
? Strongly Agree      ? Agree           ? Neutral           ? Disagree        ? Strongly Disagree
6.)    Auditors must not only certify the compliance to standard accounting practices of the company, but must also provide on their expert opinion on the true condition of the company.
? Strongly Agree      ? Agree           ? Neutral           ? Disagree        ? Strongly Disagree
***END OF SURVEY. THANK YOU FOR YOUR TIME.***
REFERENCES
American Institute of Certified Public Accountants. “The Commission on Auditors Responsibilities: Report, Conclusions, and Recommendations.” New York, AICPA, 1978.
Antle, R., P. A. Griffen, D. J. Teece, and O. E. Williamson. (1997). An economic analysis of auditor independence for a multi-client, multi-service public accounting firm. Report prepared for the AICPA by The Law ; Economics Consulting Group, Inc.
Arrunada ; Paz-Ares, (1997). Mandatory Rotation of Auditors: A Critical Examination. International Review of Law and Economics 17: 31-61.
Ashbaugh, H., R. LaFond, and B. Mayhew (2003). Do nonaudit services compromise auditor independence? Further evidence. The Accounting Review 78 (July): 611–639.
Becker, C.; M. Defond; J. Jiambalvo; AND K. Subramanyam (1998). “The Effect of Audit Quality on Earnings Management.” Contemporary Accounting Research 15: 1–24.
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