Farsighted Approaches to Auditor Independence: Responding to Global Challenges

The revised standards address pivotal issues – limits, conditions and prohibitions on the provision of non-assurance services (NAS) to audit clients; principles for the transparency and the distinct separation of fees charged for audit and non-audit services; and restrictions directed to limitation or elimination of fee dependency of the auditor on a single client. All this is viewed by the new standards through the lens of their positive impact upon “independence in fact” and “independence in appearance”, to use the language of the Code.

These new provisions are path-breaking in several ways. Their greatest advantage is that they are future-focused as explained below.

Project Initiation

Concerns among stakeholders, especially from the regulatory and investor communities, have been lingering for quite some time about the impact of the provision of NAS to audit clients on auditor independence.

The extant Code includes prohibitions on the provision of NAS, in many cases subject to a materiality threshold. It also requires the use of a “reasonable and informed third party” test implying that outsiders’ perceptions about independence have to be considered in auditor judgments.

The occurrence of corporate failures and the pressures of persistent crises led many around the world to question whether independence could be maintained when NAS were becoming both a significant source of revenue to audit firms. The deeper issue has been one of possible distortion of incentives, or, in the language of the Code, emergence of serious threats to independence: Can a firm conduct an independent audit when the provision of NAS to the audit client is becoming a serious business relationship that can influence auditor judgments and objectivity? Are there not situations when safeguards do not suffice and prohibitions must be put in place?

Confronted with such questions, the IESBA conducted outreach on the basis of a paper issued in May 2018 and titled “Non-assurance Services: Exploring Issues to Determine a Way Forward”. We also commissioned a review of academic literature on impact of fees on market perceptions about auditor independence.

Further, we studied the steps that some advanced jurisdictions took to reinforce independence. “Black lists” of prohibited NAS or “white lists” of allowed NAS to be provided to audit clients have surfaced in national regulations. Fee disclosures and caps on types of fees have also been established in some jurisdictions as a constraint to NAS provision to audit clients. These initiatives furnished a guidepost to the deliberations of the Ethics Board as to the direction of travel. Audit firms themselves, sensitive to perceptions and regulatory pressure, had also been taking steps to reduce in fact and appearance the mixing of audit and non-audit services by instituting various forms of separating walls among various business lines. Thus, both regulatory evidence and wide perceptions pointed to the need for the global standard-setter to step in; and so we did with simultaneous projects on NAS and on fees.

The Objectives

The overarching objective of the projects has been to strengthen the International Independence Standards (IIS), addressing public interest concerns about independence when firms provide NAS to their audit clients and in certain fee-related situations.

An important supplementary objective, common to all Code provisions, is that the standards have to be applicable and operable globally, not being fashioned for a few select jurisdictions. By and large, this “applicability” objective implies the advancement of principles-based provisions with some flexibility to meet local needs.

More specifically, the work, consultations and deliberations of IESBA looked for conditions, limits, and targeted prohibitions of the provision of NAS to audit clients; they also viewed mandating transparency of related fees paid by the audit client for both audit services and NAS, and to possible threats to independence that fee correlation between the two categories of services or fee dependency may create.

It was clear in the specification of project objectives that the new independence provisions would be differentiated, depending on whether the client entity is a public interest entity (PIE) or not. This distinction rests on the premise that, by definition, independence requirements need to be more stringent for PIEs, as their financial condition is more relevant to a broad set of stakeholders with higher impact on the public interest. The critical distinction between PIEs and non-PIEs already exists in the Code and provides an important and socially meaningful canon for scalability of provisions. It would be disproportionate if SMEs and SMPs were, for example, subjected to strictures as burdensome as for large and more complex entities.

IESBA Solution – NAS: Key Features

The “IESBA Solution” responds to all these queries and concerns. Here, the focus will be on key provisions, discussing their broad significance. Those who would like to see the complete provisions for NAS and fees, can visit our webpage (ethicsboard.org) for full details, including responses to consultation and justification of IESBA’s choices of standard content and architecture.

The structural elements on which the Code is premised are the list of five fundamental principles and a conceptual framework that specifies threats to compliance and how to address them. The five threats are worth repeating here: self-interest, self-review, advocacy, familiarity, and intimidation. All these threats may affect independence. And all, or most, become entwined with the provision of NAS and the payment by the audit client of fees to the audit firm for these services.

Examining the black lists in jurisdictions that have regulated this matter, we find a common – and powerful – denominator in the prohibited NAS: the distinct possibility that their provision creates a self-review threat (SRT). Self-review means reviewing your own previous work in the course of an audit; and this is the most evident and most damaging circumstance to both the substance and the appearance of independence. Reflecting about it, review of own work cancels the critical perspective or scepticism – it undermines, or even leads to disappearance of independence. Of all threats, SRT is the most damaging to independence, both in fact and in perception.

It is important to emphasise here that the new standard prohibiting the risk of SRT is efficient, stringent and objective:

• It is efficient because with one principles-based prohibition, it, in fact, prevents the provision of a whole set of NAS to audit clients.
• It is stringent because it eliminates not simply all NAS that give rise to a SRT but all NAS that might give rise to a SRT, i.e. not just the fact but even the mere possibility of a SRT occurring.
• It is objective because the prohibition does not depend on a materiality threshold. So it is not a matter of judgment whether the prohibition will bite or not. It will bite for PIEs.

Besides being efficient, stringent and objective, the SRT prohibition has another more powerful advantage: it covers possible future services, embedding new technologies that may present new forms and opportunities for the SRT to surface. In a world of technology-driven innovation, this is a clear advantage as compared to lists of presently defined and known NAS that may well change: The SRT prohibition is farsighted and future-proof.

The centerpiece prohibition of services that might give rise to a SRT is complemented by a series of other provisions that enhance independence. For one, the new standards elevate very significantly the role of Those Charged with Governance (TCWG) within the client entity. They have to concur to the provision of any NAS not otherwise prohibited and they approve the fees, as well. Communication of the auditor with those charged with governance (TCWG) is an important feature because it empowers these parties to play a very significant role in the process, to express an opinion on the question of independence and to act on this opinion. This too is a significant novelty.

By virtue of the Code’s “related entity” provision, the SRT prohibition of NAS extends to cover related entities of the PIE client. For a listed client in particular, this will include related entities under direct or indirect control of the listed entity, its parent entity as well as its sister entities. A noteworthy supplement to the standard is that the provision of NAS, not otherwise subject to the SRT prohibition, to certain members of the PIE’s corporate family, especially the parent entity, must also be disclosed to TCWG of the PIE by the audit firm. These will be taken into account when assessing independence and concurring with (or rejecting) the provision of the NAS.

Core provisions prohibiting the SRT apply to PIEs, as already explained. In the case of non-PIEs, the provisions are scaled down but still involve a strengthening of evaluation and review of the SRT and the application of appropriate safeguards by the auditor.

So, on the whole, the new standard represents a general strengthening and clarification of independence requirements with respect to the SRT. This does not mean that other threats are disregarded or omitted. There is ample consideration, requirements or application material for the management and reduction of other threats. Singling out IESBA’s focus on the advocacy threat can also seriously undermine independence. The new standard places limitations on provision of NAS such as legal services or tax-planning services, for example, precisely in order to prevent the erosion of confidence in the auditor’s skepticism and independent judgement.

The IESBA Solution – Fees: Key Features

The Board and the extant Code recognize the wide acceptance of the audit client payer model. Yet, the payment of fees on the basis of that model may give rise to threats to independence, especially the self-interest threat and the intimidation threat. A clear project objective is to raise the awareness of audit firms about these threats and to make provisions addressing those threats.

Approaching the question of fees, the Board stayed away from any attempt to determine what the proper level of fees should be, as this is a business decision and depends on a variety of real-life factors. However, the new provisions flag important elements of principle:

Audit committees of PIEs must be fully informed on the determination of fees and services involved on the basis of requirements of the Code. The new provisions go further: for PIEs, they mandate public disclosure of fees paid by the client to the audit firm and network firms separately and distinctly for the audit and the non-audit services. Thus, market participants will be able to make comparisons and draw their own conclusions about the trustworthiness of audits.

A last important provision relates to “fee dependency”. Already described in the Code, this relates to situations of an audit firm receiving substantial revenue from a single client. This is a situation where “self-interest” and “intimidation” threats come to play. The new provisions banish fee dependency by flagging that, in the case of PIEs, the appearance of revenue concentration of more than 15 percent from a single client must be corrected:

In the case of non-PIEs, the Code now prescribes a less stringent but still robust use of safeguards.

Complementary Projects

Two ongoing projects have a bearing on how the NAS and Fees provisions are applied around the world: the revision of the definition of PIE and the work on technology and ethics.

The current definition of PIE includes “listed entities” and accepts additional entities that local laws and regulations may specify. This extant specification leads to significant variety across jurisdictions. IESBA is now specifying steering indications of what features PIEs should have so that local definitions are more globally consistent. We are considering consultation results at this point. The project is closely coordinated with the IAASB so that we can work towards a common definition.

Our technology initiatives are looking at the impact of innovations on ethical behaviour. A comprehensive review of the Code’s fundamental principles, taking into account current technological inroads, has shown the Code’s fundamental principles to be solid, comprehensive and clear in their coverage of new configurations of technologically-supported human judgment and practice. Nevertheless, we are actively studying potential enhancements to the Code that would enable professional accountants to appropriately respond to threats to ethical behaviour when they are involved in the development, implementation or use of technology. Additionally, in the case of NAS, we plan to offer additional guidance to the implementation of the new NAS provisions, in the context of dense technological applications.

Conclusions

A principle-based Code with clear guidance for application continues to be the best option for globally consistent practice of ethical precepts and requirements.

Code pronouncements must be comprehensive and remain relevant not only in the context of new technologies but also in another context: the pressing needs for more informative and more standardised non-financial reporting, which will require an extension of the system of external examination in the form of audits, reviews and assurance.

Lastly, advancements in ethical codes – analogous to the IESBA’s International Code – across the entire eco-system of corporate professions, both within and around corporate organisations should be promoted by the accounting profession, corporate organisations and policy makers. I remain a very strong proponent of a generalised elevation of ethical cultures and behaviours across the actors who move and energise our economies. The International Code of Ethics for professional accountants furnishes an excellent prototype.