EVALUATING THE NEW ICANZ CODE FO ETHICS IN TERMS OF AUDITOR INDEPENDENCE: LOW-BALLING

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EVALUATING THE NEW ICANZ CODE FO ETHICS IN TERMS OF AUDITOR INDEPENDENCE LOW-BALLING

An audit is done to confirm that the financial statements are a true and fair view. The auditor is asked to use their best judgement and to state an opinion as to whether the financial statements reflect a true and fair view of the financial health of the entity. The audit is not just a statutory regulation. It also confirms that management is taking due care with stakeholders monies and confirms that accountability is taking place.

There is a lot of emphasis placed upon the audit. It must show a high level of assurance to the opinion stated. The more effort and funds that go into the audit, the greater the assurance (Pratt and Van Peuresm 1). This is what enhances the value of the opinion.

The new Code of Ethics (00) has been developed and reviewed to help increase the level of confidence in the auditor¡¦s opinion. It is also in the Public Interest. The Code of Ethics (00) identifies five fundamental principles - integrity, objectivity and independence, competence, quality performance and professional behaviour. Messier (00) points out that if the profession cannot show clearly that the audit was performed with integrity, objectivity and independence then the profession as a whole losses value in the assurance they provide.

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Independence is viewed as the most essential element of audited financial statements in safeguarding the interest of several parties (Vanasco et al., 17). It discourages bias when auditors are making judgements and coming to an informed opinion. Lee and Zhaoyang (18) define independence as the absence of collusion between the auditor and the client firm.

The Code of Ethics (00) have defined the requirements of independence under paragraph 5 as;

Independence requires

(a)Independence of mind - The state of mind that permits the provision of

an opinion without being affected by influences that compromise professional judgement, allowing an individual to act with integrity, and exercise objectivity and professional scepticism and

(b)Independence in appearance - The avoidance of facts and circumstances that are so significant that a reasonable and informed third party, having knowledge of all relevant information, including safeguards applied, would reasonably conclude a firm¡¦s, or a member of the assurance team¡¦s, integrity, objectivity or professional scepticism had been compromised.

Whatever the definition, independence is there to encourage and enhance objectivity.

The practice of low-balling consists of auditors setting their fees below total current costs in order to be hired by the client (Schatzberg 10). The auditor anticipates that they can hold on to the client and recoup costs later. In essence low-balling is a marketing strategy akin to ¡¥low introductory pricing¡¦ (Lee and Zhaoyang 18).

Research shows that low-balling is not only practiced but also wide spread. Singleton-Green (10) points out that the major British firms practice low-balling when bidding for engagements. Simon and Francis (188) have undertaken research and found evidence of low-balling. The research identified the average fee discount was about 4% for the first year and persisting for two more years at a lower level.

Regulatory authorities disagree with accounting research in regards to low-balling and independence. American Institute of Certified Public Accountants (AICPA) makes a comparison between low-balling and unpaid audit fees (Neidermeyer et al., 18). This suggests that the auditor has a financial stake in the client and therefore lacks independence. This financial interest is indirect rather than direct. This would give the auditor incentive to ensure that the client stays in business so that the auditor receives payment. They become committed to retaining the client and this reduces independence.

Messier (00) writes that low-balling can cause the auditor to decrease both the time allocated to the audit and the extent of audit procedures. This could well form a bias in the auditors mind and effect their objectivity and independence in relation to the client.

The Exposure Draft of the Code of Ethics Independence in Assurance Engagements (00) states

{When a firm obtains an assurance engagement at a significantly lower fee level than that charged by the predecessor firm, or quoted by other firms, the self-interest threat created will not be reduced to an acceptable level (Paragraph .105)

{¡§Self-interest Threat¡¨ occurs when a firm or a member of the assurance team could benefit from a financial interest in, or other self-interest conflict with, an assurance client (Paragraph .105)

What the ED is saying is that lower fees create the impression of self-interest on the auditors behalf and both the ED and Code identify self-interest as a threat to independence. Under the COE (00) paragraph 145, low-balling is seen as violating the independence in appearance clause. The argument is that there is a perception that the quality of work could be impaired.

There is another argument against low-balling, which states that it is anticompetitive, and an abuse of market position (Accountancy, 15). This does not concern independence; rather it concerns the principle of Professional Behaviour and conduct.

There is no reliable research available to support the argument that low-balling decreases the independence between auditor and client (Accountancy, 15 and Neidermeyer et al., 18), except under quite restricted situations. Magee and Tseng (10) suggest, ¡§ A disagreement between potential auditors judgement over an audit situation must prevail in order to have an impairment of the auditors independence¡¨. Schatzberg (14) states ¡§Independence is impaired only when the cost of the litigation is less than continuing the audit¡¨. This is because the profession equates the external auditor solely as an agent of the manager and ignores the auditor¡¦s legal liability to the shareholders.

The research does not support the argument that low-balling can impair independence in fact it suggests that low-balling may serve a public interest (which is why we have the Code of Ethics). An astute business manager can see how it would create market competition. This is not a bad thing as it encourages efficiency in the work place and higher standards. Lee and Zhaoyang (18) think that the market exclusion of auditing firms unable to give initial discounts may even be healthy. Cash strapped auditors will leave the market. They use a three-pronged model to explain how a combination of low-balling and the auditor¡¦s legal liability maintains auditor independence. The model is dependent on who has the right to hire or fire the auditor. The shareholders should engage the auditor rather than the manager as the auditor has a legal liability to shareholders.

Neidermeyer et al. (18) found that there was an acceptance of low-balling by professional auditors. In fact, the further up the management hierarchy, the more low-balling was accepted as a valid business tool. It was found that senior management and partners believed that low-balling was an acceptable practice that does not violate the Principals of Professional Behaviour. If this is the dominant attitude and culture at the top of hierarchy then the likelihood of it spreading, especially when promotions are given, is high. If individuals don¡¦t conform to the existing culture then they are likely to leave Public Accounting.

In conclusion, does discouraging low-balling because of perceived lack of independence serve the public interest? To be blunt, no. It suppresses industry competition and pushes up the cost for the client, which is unfair to smaller clients. The only thing low-balling is guilty of is giving a discount at the beginning of the relationship rather than a few years later.

After evaluating the information I have come to the conclusion that it is not necessary to discourage low-balling as it serves a public interest. Perhaps the Code review committee is trying to inflate the value of the auditor¡¦s opinion.

Word Count 1,51

Accountancy. 15. Low-balling? No barrier to quality. Vol. 116. Iss. 18. p. 8.

Lee, C.J. and Zhaoyang, G. 18. Low-balling, legal liability and auditor independence. Accounting Review. Vol. 7. Iss. 4. pp 5 ¡V 556.

Magee, R. and Tseng, M. 10. Audit Pricing and Independence. Accounting Review. Vol. 55. pp. 15 ¡V 6.

Messier, N.T. 00. rd Edition. Auditing and Assurance Services a systematic approach. McGraw-Hill Irwin New York.

Neidermeyer, P., Tuten, T. and Neidermeyer, A. 18. Hierarchical differences in auditors¡¦ perceptions of low-balling A study of current attitudes. Journal of Applied Business Research. Laramie. Vol. 14. Iss. . pp. -10

Pratt and Van Peuresm. 1. Auditing Theory and practice in New Zealand (rd Edition). Auckland. Addison Wesley Long-man.

Schatzberg, J. 10. A Laboratory Market Investigation of low-balling audit. The Accounting Review. Vol. 65. Iss. . pp. 7 -6

Schatzberg, J. 14. A new Examination of Auditor ¡§Low-ball¡¨ Pricing Theoretical Model and Experimental Evidence. Auditing A Journal of Practice and Theory. Vol. 1. pp. ¡V 55.

Simon, D. T., and J. R. Francis. 188. The effects of auditor change on audit fees Tests of price-cutting and price recovery. The Accounting Review (April) 55-6

Singleton-Green, B. 10. Auditor Independence ¡V dodging Mr Davies. Accountancy. Vol. 106. Iss. 1168. p. .

The Exposure Draft of the Code of Ethics Independence in Assurance Engagements (00)

Vanasco, R., Skousen, C. and Santagato, R. 17. Auditor Independence an International Perspective. Managerial Auditing Journal. Bradford. Vol. 1. Iss. . pp. 48 - 505

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