Striving for Absolute Independence – Will the Prohibition of Non-Audit Services Result in Better Audits?

Hardld RINGVice President,Institut der WirtschaftspruferGermany

Harald RingHarald RingPresident of the Institut der President of the Institut der

Wirtschaftspruefer, GermanyWirtschaftspruefer, Germany

Harald RingHarald RingPresident of the Institut der President of the Institut der

Wirtschaftspruefer, GermanyWirtschaftspruefer, Germany

Striving for Absolute Independence Will the Prohibition of Non-audit Services Result in Better

Audits?

Striving for Absolute Independence Will the Prohibition of Non-audit Services Result in Better

Audits?

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Introduction (1)Introduction (1)

Accountants: a profession that is bound to very strict ethical standards Responsibility not limited to satisfy the client’s

needs Rather, acceptance of a particular responsibility

to the public Particularly, when accountants act as auditors

Today: new debate about auditor independence Intensified by the Enron collapse and other

accounting scandals One key issue: Scope of services the auditor may

provide to his audit client

Accountants: a profession that is bound to very strict ethical standards Responsibility not limited to satisfy the client’s

needs Rather, acceptance of a particular responsibility

to the public Particularly, when accountants act as auditors

Today: new debate about auditor independence Intensified by the Enron collapse and other

accounting scandals One key issue: Scope of services the auditor may

provide to his audit client

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Introduction (2)Introduction (2)

Opposing views as to the scope of permitted services Far going prohibition of non-audit services (“audit-

only approach”) No general prohibition of non-audit services Both approaches can be found in current rule sets

Opposing views as to the scope of permitted services Far going prohibition of non-audit services (“audit-

only approach”) No general prohibition of non-audit services Both approaches can be found in current rule sets

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Overview over the different rule sets (1)

Overview over the different rule sets (1)

IFAC Code of Ethics/EU Commission’s Recommendation on Auditor Independence Principles-based approach

Catalogue of possible independence risks and safeguards to mitigate the risks

Individual evaluation of each audit engagement is needed

Amended by “specific circumstances” (examples how to apply the principles-based approach in frequently occurring situations where independence may be compromised)

IFAC Code of Ethics/EU Commission’s Recommendation on Auditor Independence Principles-based approach

Catalogue of possible independence risks and safeguards to mitigate the risks

Individual evaluation of each audit engagement is needed

Amended by “specific circumstances” (examples how to apply the principles-based approach in frequently occurring situations where independence may be compromised)

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Overview over the different rule sets (2)

Overview over the different rule sets (2)

Provision of non-audit services Permitted if general safeguards (independent of

the specific service) and specific safeguards (dependent of the specific service) exist

Application illustrated for different kinds of services (e.g., preparation of accounts and financial statements, design and implementation of financial information systems, valuation services, …)

Prohibition of the service only as an ultimate safeguard

Provision of non-audit services Permitted if general safeguards (independent of

the specific service) and specific safeguards (dependent of the specific service) exist

Application illustrated for different kinds of services (e.g., preparation of accounts and financial statements, design and implementation of financial information systems, valuation services, …)

Prohibition of the service only as an ultimate safeguard

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Overview over the different rule sets (3)

Overview over the different rule sets (3)

Sarbanes-Oxley-Act in the U.S. Eliminated the exceptions and conditions of Rule

2-01 of Regulation S-X which could result in the admissibility of a non-audit service

Uniformly prohibits the following services Bookkeeping or other services related to the

accounting records or financial statements of the audit client

Financial Information systems design and implementation

Actuarial services

Sarbanes-Oxley-Act in the U.S. Eliminated the exceptions and conditions of Rule

2-01 of Regulation S-X which could result in the admissibility of a non-audit service

Uniformly prohibits the following services Bookkeeping or other services related to the

accounting records or financial statements of the audit client

Financial Information systems design and implementation

Actuarial services

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Overview over the different rule sets (4)

Overview over the different rule sets (4)

Appraisal or valuation services, fairness opinions or contribution-in-kind reports

Internal audit out-sourcing services Management functions or human resources

services Broker or dealer, investment adviser, or

Investment banking services Legal services and expert services unrelated to

the audit Any other service that the PCAOB determines

impermissible Shift towards an “audit-only approach“

Appraisal or valuation services, fairness opinions or contribution-in-kind reports

Internal audit out-sourcing services Management functions or human resources

services Broker or dealer, investment adviser, or

Investment banking services Legal services and expert services unrelated to

the audit Any other service that the PCAOB determines

impermissible Shift towards an “audit-only approach“

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Deficiencies of an “Audit-only Approach” (1)

Deficiencies of an “Audit-only Approach” (1)

Absolute versus relative independence Legislators’ view: absolute independence as the

ideal state that should be strived for However, auditor independence as a concept of

relative independence Insufficient consideration of client-specific

knowledge as the basis of today’s audit Improving independence is not automatically

equivalent to improving audit quality Increasingly complex and rapidly changing

business environment

Absolute versus relative independence Legislators’ view: absolute independence as the

ideal state that should be strived for However, auditor independence as a concept of

relative independence Insufficient consideration of client-specific

knowledge as the basis of today’s audit Improving independence is not automatically

equivalent to improving audit quality Increasingly complex and rapidly changing

business environment

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Deficiencies of an “Audit-only Approach” (2)

Deficiencies of an “Audit-only Approach” (2)

Non-audit services assist the auditor in obtaining the knowledge required for high-quality audits

Negative impacts on auditor quality and recruiting Audit quality depends on auditor quality Non-audit services assist the auditor in recruiting

“high potentials” Inseparability of audit and certain non-audit

services Lack of empirical evidence as to negative trade-offs

between non-audit services and audit quality

Non-audit services assist the auditor in obtaining the knowledge required for high-quality audits

Negative impacts on auditor quality and recruiting Audit quality depends on auditor quality Non-audit services assist the auditor in recruiting

“high potentials” Inseparability of audit and certain non-audit

services Lack of empirical evidence as to negative trade-offs

between non-audit services and audit quality

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ConclusionConclusion

Non-audit services have the potential of impairing auditor independence and these risks must be eliminated

However, a general ban on a wide range of non-audit services is not an appropriate solution Independence risks primarily depend on the

circumstances of the individual case Thus, an “audit-only approach” may remove “non-existent”

independence risks, thereby encumbering audit quality Rather, a flexible concept like the one pursued by

the IFAC Code or the EU Recommendation is needed

Non-audit services have the potential of impairing auditor independence and these risks must be eliminated

However, a general ban on a wide range of non-audit services is not an appropriate solution Independence risks primarily depend on the

circumstances of the individual case Thus, an “audit-only approach” may remove “non-existent”

independence risks, thereby encumbering audit quality Rather, a flexible concept like the one pursued by

the IFAC Code or the EU Recommendation is needed