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Journal of Governance and Regulation / Volume 5, Issue 3, 2016
90
AUDITING VERSUS CONSULTANCY:
A CRITIQUE OF THE EU LAW REFORMS
ON THE NEW FORM OF AUDITING
H. Kubra Kandemir *
* Izmir Katip Celebi University, Faculty of Economics and Administrative Sciences, Turkey
Abstract
Auditors used to serve the interest of the shareholders only. However, there have been
significant changes in terms of auditors’ role and their function. Auditors are now expected to
verify financial statements, but at the same time give an assurance regarding the financial
sustainability of the entity. Regarding the latter role, audit firms provide consulting services,
including risk assessment and management services. However, the law does not assign the latter
role to external auditors. This situation results in an expectations gap in relation to both the role
of the auditors and the scope of the external auditing. In addition, the growing economic
importance of consulting and the long years of auditor tenure is likely to impair auditor
independence. This paper submits that the new form of auditing is not problematic but creates
issues. First, the expectations between the users of the financial reports and auditors are wider.
Second, auditors’ independence is damaged due to the long years of auditor tenure and
dependence of non-audit fees generated from consultancy services that not related to audit. The
recent law reforms issued by the European Commission has brought some important provisions
in terms of filling the expectations gap, reinforcing auditor independence and reducing the
familiarity threat. EU’s relatively strict rules on provision of non-audit services and audit firm
rotation are expected to have an important impact in the audit market. A critical analysis of the
new EU law is submitted with some policy recommendations.
Keywords: Auduting, Consultancy, Reforms, EU Law
1. NTRODUCTION
Since the 1200s, and the early development of firms,
auditing has existed (Watts and Zimmerman, 1983).
External auditing was first used to check on
managers on behalf of shareholders, in the manner
of detectives (Shapiro, 2004). As a result, auditors
used to serve the interest of the shareholders only.
However, there have been significant changes in
terms of auditors’ role and their function. Users of
audited reports have been extended beyond
shareholders. Today, external auditing is necessarily
important for investors, but also depositors,
regulators, suppliers, creditors, and anybody who is
likely to use audited financial reports, thus assigning
a public role to auditors as gatekeepers of sorts
(Shapiro, 2004; Coffee, 2006).
External auditing refers to the relationship
where corporate management hires an independent
external auditor to review and approve annual
financial statements. Annual financial statements
include the balance sheet and the related statement
of income, retained earnings and cash flow for the
completed fiscal year (Ronen, 2010). Financial audit
is the process of checking the accuracy of these
annual financial statements and compliance with the
related accounting standards (Ronen, 2010).
In the EU, it is a legal requirement that listed
companies’ financial statements should be audited
by an independent external auditor (Directive
2006/43/EC - as amended). Member States’
competent authorities approve statutory auditors
(natural persons) or audit firms (legal persons) to
perform statutory audits at the national level (UK,
Companies Act. 2006, section 489). For instance, in
the UK, only statutory auditors recognized by
supervisory bodies, such as the Institute of
Chartered Accountants of England and Wales
(ICAEW), are allowed to perform statutory audits of
public companies (UK, Companies Act. 2006,
section 1212). In general, the statutory audits of PIEs
are provided by the audit firms rather than
individual statutory auditors. Auditors have to apply
certain standards, e.g. IFRS, ISAs, auditors’ code of
ethics (IFAC, 2010), when they perform audits of
publicly listed companies. In addition, they are
subject to regulatory supervision of public oversight
authorities, e.g. PCAOB in the US and FRC’s Audit
Quality Review (the former Audit Inspection Unit) in
the UK.
The audit process is constituted of three main
stages. In the first stage, the auditor gains
understanding of the audited company and its
activities through assessment of accounting system
and internal control mechanism (Porter, Simon, and
Hatherly, 2003, p. 149). This stage involves
evaluation of internal controls in detail, as to
whether the transactions and account balances are
parallel to company records and whether there are
any material misstatements. If the auditor is
satisfied with the accuracy of internal control
records from the evidence gathered from stage one,
Journal of Governance and Regulation / Volume 5, Issue 3, 2016
91
he (or she) continues with the second and final
stage, to issue the audit report. However, if the
auditor finds additional risk factors, such as
asymmetric records with the transactions and
internal control reports, then the scope of the audit
is reset (Ronen, 2010, p. 191). In the third and final
stage, the auditor issues an audit report to provide
information to shareholders and other third parties.
The auditor’s opinion on the financial statements is
meant to provide a reasonable assurance on whether
financial statements are free from material
misstatement caused by fraud or error, and whether
they are in accordance with the related accounting
standards and laws (ISA 700, para. 10). The auditor’s
opinion should also note any circumstances that
may affect the financial stability of the audited
entity.
If the auditor is satisfied with the audit
evidence, and that the financial statements give a
true and fair view, and they are prepared in
compliance with the relevant accounting standards
and legislation, she issues an unqualified audit
report (ISA 700, para 16). If unqualified, this audit
report is a ‘clean’ audit report. The auditor may also
decide to issue a qualified audit report due to
misstatements in the financial statements or
because she was unable to obtain sufficient evidence
about the accuracy of the financial statements.
Before issuing a qualified audit report, the auditor
needs to modify the opinion in the report (ISA 700,
para. 17). There are three types of modified
opinions: a qualified opinion, an adverse opinion,
and a disclaimer of opinion (ISA 705, para. 2). If
there are material misstatements, but there is
nothing pervasive to the financial statements, the
auditor issues a ‘qualified opinion’ (ISA 705, para. 7).
This is still a clean opinion. If the misstatements are
material and pervasive to the financial statements,
the auditor expresses an ‘adverse opinion’ (ISA 705,
para. 8). This is an unclean audit opinion. Lastly, the
auditor may issue a disclaimer of opinion when she
is unable to obtain sufficient appropriate audit
evidence regarding the accuracy of financial
statements (ISA 705, para. 9). The auditor disclaims
the audit opinion because of the risk that
undetected misstatements could have a material and
pervasive effect on the financial statements.
2. DUAL ROLE OF AUDITORS
The history of auditing dates back to the early
development of joint stock companies.
111
In the UK,
this occurred with the enactment of the first
Companies Act (Joint Stock Companies Act) of 1844,
which recognized audit for English companies on a
voluntary basis (Watts and Zimmerman, 1983, p.
628). The Companies Act of 1900 required audit for
the first time; however, it did not define any rules to
determine an auditor as qualified to perform audits
(Porter, Simon, and Hatherly, 2003, p. 22).
Thereafter, auditing did not develop as a profession
in the UK until 1948 (Cosserat 2000, p. 5). Before
then, directors or officers appointed by shareholders
111
As it was translated from the original Medieval Latin text,
in 1200, a constitution of English merchant guild (an early
example of association of traders) at Ipswich had a provision
for annual audit. See Charles Gross, The Gild Merchant 4
(1890) in Watts and Zimmerman, 1983, p. 616.
performed the audits of early joint stock companies
(Watts and Zimmerman, 1983, p. 624). In line with
its development, the objective of auditing has
evolved over time.
2.1 Auditors as Detectives (Public Watchdogs)
During the late 1890s, in the early days of auditing,
the objective of an audit was to check the
consistency of internal records (book-keeping of
company transactions) of the company (Cosserat,
2000, p. 6). This role mainly involves the detection
of fraud and material errors in the accounts
(Dicksee, 1892). As a result, auditors were only
responsible to the company that they audited
(Shapiro, 2004, p. 1034). The role of the detective-
auditor was mainly to serve the owners of the
company by confirming the consistency of internal
records with the company transactions and to make
sure that the treasurer was not cheating the owners.
The fraud detection role of auditors was also
acknowledged in case law in the UK. The two cases
of London and General Bank (Re London and General
Bank (No.2) 1895) and Kingston Cotton Mill Co Ltd.
(Re Kingston Cotton Mill Co. (No.2) 1896) re-stated
an audit’s objectives of detecting fraud and error.
These cases also stated that auditors could not be
expected to detect every fraud and error (Re London
and General Bank (No.2) 1895) since they are
watchdogs but not detectives or bloodhounds; they
do have to show reasonable skill and care in their
work, however (Re Kingston Cotton Mill Co. (No.2)
1896).
2.2 Auditors as Certifiers (Gatekeepers)
In the 1970s, by the time of the development of the
securities markets, small investors needed more
information regarding the fairness of financial
information included in companies’ statements.
Auditors were asked to approve information to be
disclosed to a third party, namely to shareholders,
investors or in general, to the public.
Correspondingly, the objective of auditing moved
from fraud detection towards ensuring the
credibility of financial statements (Carmichael,
1974). From that time, providing assurance services
was recognized as the primary role of auditors,
while detection and prevention of fraud were
assigned to the internal control mechanism
designated by the management (Porter, Simon, and
Hatherly, 2003, p. 27).
By the 1990s, the business risk approach was
adopted in auditing (Porter, Simon, and Hatherly,
2003, p. 32). The business risk approach holds that
audit failures
112
are not generated because of
undetected fraud or error, but because of the
uncontrolled operational risks in a company (Porter,
Simon, and Hatherly, 2003, p. 33). Accordingly, in
order to reduce the business risk, auditors started to
focus on the provision of consultancy services and
they acknowledged their responsibility to provide an
opinion as gatekeepers regarding a firm’s ability to
continue as a going concern.
112
Audit failure refers to issue a clean audit opinion on
financial statements that are materially misstated.
Journal of Governance and Regulation / Volume 5, Issue 3, 2016
92
3. MODERN AUDITING PROFESSION
Today, auditors are seen as gatekeepers (or
certifiers), rather than detectives. From a
gatekeeper’s perspective, the objectives of modern
auditing can be considered to be the provision of a
review of the company’s accounts, to examine
financial statements to ensure they are free from
material misstatements, omissions and misleading
information, and to express an audit opinion
including any concerns regarding a firm’s ability to
continue as a going concern.
Public companies are required to disclose
financial information to the public once shares are
offered, and for as long as they are traded on stock
exchanges (Directive 2004/109/EC – as amended,
Articles 4 and 6). Auditors then review and certify
the financial information disclosed to third parties.
There are a number of users of this verified financial
information: namely, the existing company
shareholders, potential shareholders (investors),
regulatory agencies, and any third party that might
be involved in the operations of the company.
Investors use the audited financial information to
decide whether to make an investment in the
company. Regulatory agencies seek the efficiency of
financial markets through accessible reliable and
sound financial information. All of this has the aim
that stock prices reflect companies’ present reliable
information and that the market determine the
correct prices of securities (Shapiro, 2004, p. 1041).
However, this dual role of auditors might cause
conflicts of interest. On the one hand, auditors have
to perform an auditor-as-detective role to the
company owners (existing shareholders). On the
other hand, certifier auditors verify disclosed
financial information and approve financial stability
- whether it is financially sound to invest in the
company. Though detective-auditing has a public
watchdog role, certifying auditing may give auditors
an incentive to please the client instead of
protecting the interest of the public.
In certification auditing, public companies hire
auditors to verify the disclosed financial information
so that they can induce the potential investors to
make investments in their companies. Here, there is
a risk that the auditor might favor the company,
even though the user of this information is a third
party (potential investors). There is a risk that the
auditor might become an advocate of the company,
instead of acting like an impartial detective, and
serving their public watchdog role (Jenkins and
Lowe, 1999). This conflict of interest arises naturally
because of the auditor-client relationship, i.e.
auditors are hired and paid by the audited company
(the client), and they have an incentive to please
their clients.
113
Furthermore, auditing is now extremely
focused on adding value to the audit (Jeppesen,
1998). Value-added services include detecting,
understanding, and analyzing the business risks that
the audited firm is involved in, and building a
113
In a study, a group of business students were assigned to
be the auditors of a fictional company A. The other group
assigned as auditors of another fictional company B that
wants to take over the A. The figures of the sellers’ auditors
show higher value than the figures of the buyers’ auditors.
See (Shapiro, 1984, p. 1041).
strategy to manage and control those risks
(Jeppesen, 1998, pp. 522-525). Value-added auditing
is delivered in the form of consulting. Consulting
includes strategic management planning, internal
audit outsourcing services, risk assessment business
performance, and e-commerce to name but a few.
Today, it is common that audit firms provide
advisory services in addition to the traditional form
of audit (i.e. the verification of financial statements).
In fact, it has now become the case that, because the
fees generated from the audit are lower, auditors are
seeking to provide non-audit services to the same
client or to non-audit clients (Max Planck Institute,
2012, p. 5) . This situation is called ‘lowballing’. Via
lowballing, auditors seek to compensate for low
audit fees through the provision of consultancy
services for higher fees. Revenues generated from
advisory services form an important part of the
revenues of the Big Four audit firms. To give an
example, as of 2015, 37.47 % of the global total
revenue (US$ 45.455 billion out of US$ 121.3 billion)
of the Big Four is generated by advisory services.
114
The provision of non-audit services to an audit
client, namely advisory services, builds an economic
relationship with the client (Jeppesen, 1998, p. 525).
When the auditor gives advice on the business of the
client, the auditor gains an interest in the financial
success of the client (Mautz and Sharraf, 1961, pp.
268-269). There is therefore an economic interest for
auditors in the provision of consulting services. As a
result of the growing importance of advisory
services, auditors became less dependent on
reputations for high-quality auditing (Coffee, 2002)
and more dependent on their relationships with the
client for the sake of consulting services (Briloff,
1990).
The growing economic importance of
consultancy services converts auditing into a new
form of doing business. This new form of auditing
builds a mutual economic interest between auditor
and client. As results, auditors primarily consider
the business demands of the clients, and consider
less the interests of the users of financial statements
(Jeppesen, 1998, p. 525). This new form of auditing
might result in independence issues. Auditor
independence requires the absence of economic
interests that could cause a conflict between auditor
and client. Economic interest in an audited company
makes it difficult for auditors to perform
independent auditing: there is a risk of ‘self-serving’.
4. PROBLEMS WITH THE NEW FORM OF EXTERNAL
AUDITING
4.1 Does the public expect too much from auditors?:
the expectations gap
Auditors are not only asked to perform a detective-
auditor role, but they are also called to consider the
business risks which includes the assessment of
whether an entity will fail to achieve its objectives
(Tatum and Stuart, 2000). There is a general
perception among stakeholders that financial
statements with unqualified audit reports guarantee
the financial health of the entity (Valukas, 2010).
However, audit opinion does not have to give such
114
Data extracted from the global annual review reports of
2015 of the Big Four audit firms.
Journal of Governance and Regulation / Volume 5, Issue 3, 2016
93
assurance regarding the future sustainability of the
entity.
The number of collapses and major fraud
incidents called for increased accountability and
hence, changes in perceptions of auditors’ role (e.g.
the Arthur Andersen’s financial chicanery in Enron
case). Nevertheless, auditors are not primarily
responsible for the prevention and detection of
fraud; instead, this role falls to the management (ISA
240). Auditors are required to show reasonable skill
and care to detect and report fraud (Re Kingston
Cotton Mill Co. Ltd. (No.2) 1896). The term
‘reasonable’ causes ambiguity, however, and
therefore results in an expectations gap regarding
the stakeholders’ understanding of the duties of
auditors.
As UK case law has recognized, it cannot be
expected of auditors to detect every fraud and error
in financial statements (Re Kingston Cotton Mill Co.
Ltd. (No.2) 1896). It is likely there would be
undetected material misstatements in the financial
statements even if the auditor showed reasonable
skill and care. Moreover, capital markets become
more sophisticated and complex every day. It is true
that neither regulators nor auditors fully understand
today’s complex financial markets (Leeson, 2007). It
gets more difficult for auditors to audit effectively
and provide an assurance in such complex markets
(Sikka, 2007).
4.2 Dependence on non-audit fees: impaired auditor
independence
In capital markets, investors use a company’s
financial statements in determining their
investments, so as to make the highest return on
their investment with the lowest risk (Healy and
Krishna, 2001). There is a possibility that managers
will accidently - or deliberately - misrepresent
financial statements. Thus, external auditors as are
needed as independent outsiders to assure investors
that financial statements prepared by the
management are presented accurately. Investors
consider external auditing as an assurance regarding
the reliability of financial statements only because
external auditors have professional qualifications
and knowledge and they are independent of the
management. If auditor independence were
impaired, their financial statements will no longer be
trusted.
The professional qualification of an auditor is
important for detection misstatements and errors in
the financial statements, so that the accuracy of the
financial statements is ensured. DeAngelo defines
audit quality as the auditor’s ability both in
discovering corruption in financial statements, and
in reporting it (DeAngelo, 1981, p. 186). An auditor
is only able to detect fraud if she has the
professional qualification(s), knowledge, and
experience to perform an audit (Flint, 1988, p. 48).
Auditors’ ability to report a breach or
misrepresentation in financial statements depends
on her independence (Citron and Taffler, 1992, p.
344). If the auditor is not independent, she will have
no incentive to express their competence to detect
fraud.
Nevertheless, independence is an ambiguous
concept; it is not easy to ensure. In the existing
literature, auditor independence is analysed
according to two concepts: independence ‘in fact’
and independence ‘in appearance’ (Dopuch, King and
Schwartz, 2003). The former concept refers to the
attitude of being impartial and objective, while the
latter refers to the perception of independence by
users of financial statements, namely shareholders
and investors (Dopuch, King and Schwartz, 2003, p.
84). Auditor independence can be ensured in a
number of ways. First, auditors, as certified public
accountants, are subject to professional discipline
and the oversight of national public bodies (e.g. the
Conduct Committee,
115
part of the Financial
Reporting Council (FRC) in the UK). Second, auditors
are required by law to be independent meaning that
there may not be any close ties to, or financial self-
interests in the audited company (Directive
2006/43/EC – as amended, Article 22(2)).
The audit contract is signed between the
auditors and the managers of the audited company
who actually pay the auditors with the financial
resources of the company. Audit firms are
inherently commercialised institutions that seek to
increase their profits and market share and
therefore, they might forget their actual clients and
become capitalist institutions simply trying to
maximize their profits. As a result, there is a risk
that they are not able to deliver independent audits
when they are dependent upon company directors
for their fees and have an incentive to please the
company management, in order to secure their non-
audit fees.
116
This situation might suggest that
auditors would avoid disputes in order to be
reappointed (or not to be dismissed).
Even if the auditor is independent ‘in fact’, they
have to show this independence to the public. Being
independent ‘in fact’ is an ambiguous concept and
difficult to interpret in practice, because it depends
upon auditors’ mentality in their audit work
(Richard, 2006, p. 156). Even though it might not be
possible to prove mental independence to the public
(i.e. objectivity), there are a number of ways to
evaluate the degree of independence ‘in appearance’.
These are: auditors’ dependence on non-audit fees,
the length of auditor tenure, and the competitive
environment, i.e. the choice of auditor (Arnold,
Bernardi and Neidermeyer, 1999). The provision of
consultancy services and dependence on non-audit
fees may impair independence ‘in appearance’.
4.3 Long years of auditor tenure: the familiarity
threat
The ‘familiarity threat’
117
is explained as where the
auditors have been involved for many years in audit
engagements. The long years of auditor tenure could
make auditors less skeptical because of an ongoing
relationship with the client and this may cause
auditors failing to spot misrepresentation in
financial statements because she would be looking
115
The duties of the Professional Oversight Board are
assigned to the Conduct Committee.
116
Ronen indicated a saying to highlight the independence
issue of auditors; ‘whose bread I eat his song I sing” (Ronen,
2010, p. 189).
117
Familiarity threat may occur due to a long or close
relationship with a client where in professional accountant
becomes too sympathetic to the interests of the client (IFAC
Code of Ethics 2010; para. 100.12).
Journal of Governance and Regulation / Volume 5, Issue 3, 2016
94
from the perspective of their client (Arnold, Bernardi
and Neidermeyer, 1999, p. 50; Klimentchenko, 2009).
The Directive 2006/43/EC required the key
audit partner to be rotated every seven years
(Directive 2006/43/EC – as amended, Article 42),
however it did not state any rotation rules for audit
firms. Hence, it is common across EU listed
companies to have the same audit firm for many
years. For example, according to a survey, it is
common in the EU (except in Italy)
118
to have the
same audit firm for more than 7 years (London
Economics, 2006, p. 73). Having the same audit
partner for many years is also evident in the UK
financial markets where the average tenure rate for
FTSE 100 companies is 48 years on average (House
of Lords, 2011, p. 13).
The trend to have the same audit firm for many
years is hazardous for auditor independence in a
number of ways. First, this situation might impose
pressure on auditors not to lose the client, say in the
UK market, for another 48 years on average. Because
of this pressure, it would be difficult for auditors to
carry out statutory audits with a questioning mind
(i.e. professional scepticism), which involves critical
evaluation and questioning existing information in
the financial statements provided by the
management. Therefore, they would be reluctant to
detect and report errors in the financial
statements.
119
5. AN OVERVIEW OF THE EU LAW REFORMS IN
TERMS OF THE PREVAILING PROBLEMS IN THE
AUDIT MARKET
The global financial crisis of 2008 witnessed not
only the failure of banks and financial institutions
but also the failure of auditors (Sikka, 2009). This
has damaged the reliability of financial statements
and statutory auditors. As a response, in October
2010, the European Commission issued a Green
Paper entitled ‘Audit Policy: Lessons from the Crisis’
that emphasised the role of the auditors in financial
markets and their relation to the financial crisis
(European Commission Green Paper, 2010).
Following the Audit Green Paper, in November 2011,
the European Commission issued two law proposals:
a Directive to enhance the single market for
statutory audits (Directive 2014/56/EU - amending
Directive 2006/43/EC) and a Regulation to increase
the quality of audits of financial statements of
Public Interest Entities (PIEs) (Regulation No.
537/2014). Both law proposals came into affect on
May 2014.
PIEs often involve cross-border activities across
the EU. Audit practices and regulation in Member
States, however, are not homogenous, but have
different auditing standards and different
approval/registration rules for auditors and audit
firms. This situation creates a high administrative
burden on the audit of PIEs. Therefore, regarding the
audit of PIEs, a separate legal requirement was
118
In Italy, there is a regulatory requirement for mandatory
rotation for audit firms every 9 years. See (European
Commission Impact Assessment, 2011, p.170).
119
Also, auditors who have long-tenure tend to be reluctant to
make adjustments regarding errors in the prior audit periods
because this would mean admitting past mistakes (Bazerman,
Loewenstein, and Moore, 2002).
suggested (European Commission Impact
Assessment, 2011, p. 9). Although the general
requirements for a statutory audit of PIEs (i.e. the
requirements for the registration/approval of
auditors) dealt with the existing Directive
2006/43/EC (as amended by Directive
2014/56/EU),
120
the specific additional requirements
regarding the conduct of statutory audits of PIEs
were set by this Regulation. Hence, the revised
Directive and the Regulation must be read together.
5.1 Filling the expectations gap
It has long been the subject of a number of
discussions as to what sort of information auditors
should be providing to stakeholders.
121
It is
highlighted that users cannot find what they are
looking for in auditor reports since the most
common audit opinion is a “template”, (European
Commission Impact Assessment, 2011, p. 13)
providing a standard content.
Previously the law did not refer explicitly the
content of the audit reports however, both the
Directive 2014/56/EU (amending Directive
2006/43/EC) and the Regulation No. 537/2014 now
govern what needs to be included in the audit
report. Accordingly, audit reports shall indicate that
the statutory audit was conducted in accordance
with ISA (Directive 2006/43/EC – as amended,
Article 28(1)), identify key areas of risk of material
misstatements in the financial statements
(Regulation No. 537/2014, Article 10(2)/c-i), explain
to what extent the statutory audit was designed to
detect irregularities, i.e the fraud (Regulation No.
537/2014, Article 10(2)/d), declare the prohibited
non-audit provisions were not provided (Regulation
No. 537/2014, Article 5(1)) and that the statutory
auditor(s) or the audit firm(s) remained completely
independent (Regulation No. 537/2014, Article
10(2)/f). Also, in a separate audit report, auditors
shall provide a statement on the situation of the
entity especially on the assessment of the entity’s
ability to stay as a going concern (Regulation No.
537/2014, Article 11(2)/i).
5.2 Reinforcing auditor independence
Auditor independence is one of the key elements
reflecting the reliability of financial statements. An
auditor’s ability to reflect her professional
judgement freely on the audit report is also
necessary for audit quality. However, some auditors
might be involved in certain situations where
independence is impaired due to a conflict of
interest. The provision of certain types of non-audit
services, such as bookkeeping and tax consultancy
for example, could impair auditor independence
because there is a risk in this situation that auditors
become more dependent on non-audit fees (Briloff,
1990).
There is no homogeny regarding the provision
of non-audit services to the audit client in the EU,
since Article 22 of previous Audit Directive
120
Articles 39 to 44 and 22 (2) of the Directive 2006/43/EC will
be deleted to be integrated to the Regulation on specific
requirements for the statutory audits of PIEs.
121
For a brief history of the last 100 years of the expectations
gap, see Humphrey, Moizer, and Turley,1992.
Journal of Governance and Regulation / Volume 5, Issue 3, 2016
95
2006/43/EC has been interpreted differently by
Member States. Directive 2006/43/EC states that the
auditor shall not carry out a statutory audit if there
is any direct or indirect financial, business,
employment or any other relationship between the
auditor (or audit firm) and the audited company
(Directive 2006/43/EC – as amended, Article 22(2)).
Directive 2006/43/EC granted Member States
discretionary powers to take necessary steps to
ensure the appropriate safeguard on the auditors’
independence. As a result, Member States take
different approaches in terms of the provision of
non-audit services. For instance, the French Code of
Ethics banned the provision of non-audit services
(French Code of Ethics, Articles 10, 23, and 24; ESCP
Europe, 2011, p. 154), while the UK’s approach is
less restrictive since there is no such ban with
respect to the provision of non-audit services to the
audit client.
122
Therefore, it is common in the UK that
audit firms, including the Big Four, offer consultancy
services to their audit clients,
123
and listed
companies disclose fees paid to auditors for those
services (UK, Companies Regulation, 2008 No. 489).
Although certain types of non-audit services
not related to the audit work can impair auditor
independence, it is claimed that provision of non-
audit services can improve auditors’ skills and
knowledge, and this may enhance their audit quality
in general (Lennox, 1999). It could be suggested that
auditors should not be forbidden to provide all
consultancy services to the audit clients. However, it
might be necessary to divide non-audit services into
categories with respect to their degree of threat to
auditor independence.
The first category is the type of non-audit
services that have a direct impact on the accounts,
these services are consultancy services that are not
related to audit and will have a direct impact on
auditor independence. In the recent law reforms, the
European Commission strictly banned the provision
of this type of non-audit services. These services are
outlined in Article 5(1) of the Regulation No.
537/2014: bookkeeping, payroll services, legal
services, services related to the audited entity’s
internal audit function, and human resources
services.
The second type of non-audit services can be
necessary for auditors to perform the audit work
more effectively, e.g. tax services and valuation
services (Regulation No. 537/2014, Article 5(1)/a/i,
a/iv to a/vii and f). The provision of this type of
services can be allowed by the Member States if
these services have no direct effect on the audited
financial statements and the independence of the
audit firm and the auditor are secured (Regulation
No. 537/2014, Article 5(3)/a/c).
The third category includes services that are
termed audit-related financial services,
encompassing services required by legislation or
122
Auditing Practices Board (APB) Ethical Standards state
that audit firms should consider any possible threat to
independence when accepting a proposed engagement with
non-audit services (APB Ethical Standard 5 (Revised), para.
14).
123
For instance in 2006, PwC received £700.000 fees not
related to audit from Northern Rock (House of Lords, 2010,
24).
contract to be undertaken by auditors.
124
The
provision of non-audit services is necessarily
problematic when non-audit fees are higher than
audit fees. This situation can increase auditor
dependency on non-audit fees and hence, mitigate
independence.
125
Therefore, the total fees for non-
audit services other than those referred in Article
5(1) of the Regulation No. 537/2014 shall be limited.
Accordingly, the total fees for such services shall not
exceed 70 % of the average fees paid in the last three
consecutive financial years (Regulation No.
537/2014, Article 4(2)). Furthermore, when a
substantial part of an audit firms’ revenues (i.e. 15
%) originate from a single audited entity the auditor
shall disclose the fact with the audit committee and
consider the treats to their independence
(Regulation No. 537/2014, Article 4(3)).
5.3 Reducing the threat of familiarity
Long and close auditor engagements with the same
audit firm are likely to jeopardize auditor
independence because there is a risk of getting
overfamiliar with the audited company. Key audit
partner rotation by itself is not enough to reinforce
auditor independence. In order to reduce the threat
of familiarity, two types of auditor rotation might be
suggested: internal and external rotation. While
internal rotation allows a different audit partner
from the same audit firm to engage in the audit for
the next period (tendering), external rotation
requires a change of audit firm (rotation).
In addition to tendering (rotation of the key
audit partners every 7 years – with a three year
cooling period), the Regulation No. 537/2014 has
brought a mandatory rotation policy for audit firms
(Regulation No. 537/2014, Articles (7) and (4)/b). In
this respect, audit firms would no longer be
appointed for many years, but the maximum
duration will be 10 years (or 24 years in case of joint
audits), including the renewed engagements
(Regulation No. 537/2014, Article 17(1)). In addition,
there shall be a four years gap (cooling period) if the
same audit firm were to be appointed after the
maximum period of ten years (Regulation No.
537/2014, Article 17(3)).
6. CONCLUSIONS AND RECOMMENDATIONS
It is true that financial scandals and crises give
lawmakers opportunities to regulate the market.
While crisis time regulations were seen as lifesavers
during the crisis time, there is a risk that they have
become an over-reaction to corporate scandals and
not be effective, but represent only symbolic actions
(Tomasic and Akinbami, 2011, p. 272-273). As for
the European Commission’s law reforms, it is
important that they provide a practical response to
the issues, rather than following a regulatory routine
(Kandemir, 2013). Although time will tell as to when
124
Audit related services include services such as reporting
required by law or regulation to be provided by the auditor,
reviews of interim financial information, and reporting on
regulatory returns (APB Ethical Standard 5 (Revised), para.
54).
125
To give an example, Enron’s auditor Arthur Andersen
received US$ 25 million for audit fees and US$ 27 million for
non-audit fees in 2000. (Benston and Hartgraves, 2002).
Journal of Governance and Regulation / Volume 5, Issue 3, 2016
96
we might see the actual results of these reforms in
the EU audit market, possible effects of these
reforms could be estimated in bold outline.
To begin with, it is acknowledged that the
European Commission aimed to reduce the
expectations gap by improving audit reports to
provide more information to stakeholders and to the
public. Expanding audit reports that include more
information may indeed be helpful to the users of
the audit reports in understanding the work of the
auditor and the business of the audited entity.
Hence, the expectations gap is likely to be reduced
by the expanded content of public audit reports.
Nevertheless, the long list of additional information
to be included in audit reports (almost 38 provisions
with nine clauses) create an extra regulatory burden
on auditors and audit firms.
Secondly, the European Commission’s proposal
on the prohibition of provision of non-audit services
has its remits because auditor dependency on non-
audit fees is likely to impair auditor independence.
However, the Commission’s proposal for large audit
firms to limit the provision of related non-audit
services to the audit client is rather restrictive.
These services are closely related to audit work and
therefore are less likely to have a negative impact on
independence. It is clear that the business of the
large audit firms is likely to be affected by this
restriction.
Thirdly, the policy options presented by the
European Commission for the mandatory rotation of
audit firms is expected to create a healthy
competition environment. This policy will also
increase the choice of auditors in the market, as
mandatory rotation is likely to break up the barriers
to mid-tier firms (European Commission Impact
Assessment, 2011, p. 57).
Nevertheless, mandatory audit rotation is not
unproblematic. Mandatory audit firm rotation
results in significant costs because of a substantial
amount of specific assets is destroyed and has to be
rebuilt every time a rotation takes place.
126
For
example, auditors have to have knowledge of the
audited company’s accounting system and internal
control; the audited client must in turn make
resources available for the audit (Arrunada and Paz-
Ares, 1997, p. 34). The auditor as well as the audited
client must rebuild these audit routines every time a
rotation takes place, which is costly for both sides of
the engagement.
127
It can be concluded that there is no proof of a
negative correlation between auditor continuity and
the degree of auditor failure. However, there is also
no empirical evidence that suggests that audit firm
rotation will enhance competition in the market, but
it is likely to increase audit costs. Thus, until now,
regulators have focused on the rotation of key audit
partners instead of audit firm rotation (Directive
2006/43/EC – as amended, Article 42). The
mandatory rotation of audit firms may not be the
best remedy for increasing competition, but it can be
considered an effective tool in terms of preventing
126
It is estimated by PwC that switching costs for the audited company
could be up to £1 million, while Office of Fair Trading (OFT) found the
average of FTSE 100 audit fees was £5.2 million (OFT, 2011, para. 516).
127
Also, it should be taken into account that many of these assets may
not be rebuilt immediately, such as the trust that builds between two
parties over the past successful audits (Arrunada and Paz-Ares, 1997,
p. 45).
auditors from becoming overfamiliar with the
audited company. Alternatively, voluntary rotation
might be suggested. However, if the auditor resigns
voluntarily, investors might consider this resignation
a warning sign for the company and this would
therefore not be a perfect alternative to mandatory
rotation.
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