On auditors’ independence, self-review and twisted knickers

In July 2009, Rentokil Initial Plc walked into the middle of a storm when they announced:

“The Company invited its existing auditors PricewaterhouseCoopers LLP as well as KPMG Audit Plc to submit proposals for a more integrated financial assurance process extending external audit coverage to some work undertaken by internal audit. The board has decided to proceed with KPMG, who will be appointed to undertake the 2009 audit. Combined internal and external audit costs will reduce by approximately 30%.”

Within a week, under the headline Cut-price Rentokil-KPMG deal raises ethical questions for auditors Accountancy Age reported that:

“The arrangement has led some to re-examine audit’s ethical code which highlights two main risks when external auditors also provide internal audit services.  The first threat, known as the self-review threat, warns against the external auditor relying heavily on its own internal audit work. The second threat, known as the management threat, warns against the internal auditors assuming the role of management.”

Two years later, the Financial Reporting Council’s Audit Inspection Unit (“the AIU”) (now the Audit Quality Review Team) reported:

“In the light of the prior year publicity surrounding the provision of “extended assurance” services, we reviewed the audit of two entities where such services had been provided. We did not identify any relevant requirements of the Ethical Standards applicable at the time that had not been met or any adverse impact on audit quality.”

Confused yet?  Had KPMG engaged to be both external and internal auditors at Rentokil?  If they had, why wasn’t this an ethical problem for them and their regulator?

In 2009, when KPMG proposed for the Rentokil audit, they were working within the boundaries set by the Auditing Practices Board (“the APB”) Ethical Standard 5 (“ES 5”) 2008 Non-audit services provided to audited entities.  This included a prohibition on an  audit firm providing internal audit services to an audit client “where it is reasonably foreseeable that:

a)      for the purposes of the audit of the financial statements, the auditor would place significant reliance on the internal audit work performed by the audit firm; or

b)     for the purposes of the internal audit services, the audit firm would undertake part of the role of management” (APB ES5: 44)

APB ES5 (2008) went on to give an example of a scenario where the self-review threat would be considered “unacceptably high” noting that the auditor of a large bank should conclude that it is unacceptable to provide internal audit services, too, to that bank since the external audit team is likely to place significant reliance on the work performed by the internal audit team in relation to the bank’s internal financial controls (APB ES5 (2008): 44-45).

Wait! Run that by me again please: does it say that the auditor may not test the internal financial controls of its audit client? No – the external auditor is not only permitted but expected to test internal financial controls.  But what if the internal auditors have already tested them? Where that is the case, the external auditor has a decision to make: can the testing carried out by internal audit be relied upon or should the external auditor retest the controls?

APB International Standard on Auditing (United Kingdom and Ireland) 610 reminds the external auditor that he “has sole responsibility for the audit opinion expressed, and that responsibility is not reduced by the external auditor’s use of the work of the internal auditors” (APB ISA (UK&I) 610: 4)  Inevitably, therefore, the external auditor will reperform some testing; the question is how much?

Provided the external auditor can establish to his satisfaction that the work of internal auditors is reliable, he may reduce considerably his own controls testing.  This remains an option if the internal audit services are contracted out to a professional services provider, but, according to APB ES5 (2008), not if that professional services provider is the same firm as the external auditor. Why? Because then the external auditor would be reviewing his own firm’s work, which constitutes self-review, creating exactly the scenario identified in the 2008 standard as constituting an “unacceptably high” threat to the external auditor’s independence.

The flaw in this reasoning can be exposed thus.  Supposing the external audit team does not plan to use the work of internal audit, but rather re-perform all of the controls testing themselves.  This could conceivably result in a scenario where each sampled instance of any one control is tested twice: once to provide comfort to those charged with governance, acting as a proxy for the shareholders, by the internal auditors and once to provide comfort to exactly the same ultimate party, by the external auditors.  This actually seems a dangerous outcome because those charged with governance may wrongly conclude that they are getting twice as much comfort, whereas in fact they are being supplied with the same result twice by different teams. 

Where the effective operation of a control is an objective binary outcome – it either operated effectively or it failed – no matter how many times any one historical instance of that control is tested, assuming no negligence on the part of the testers, the result of the test will be the same.  The same is true for a substantive test with an objective, binary outcome.  Does it matter whether such tests are performed once, by one team, who then report the result directly to those charged with governance (previously the role of the internal auditor) but then go on to use that result as evidence in forming the external audit opinion? 

It affects the cost to the shareholders of the overall level of assurance achieved, with it clearly being preferable to pay for each test only once.  And it affects the effectiveness of assurance activities, because the elimination of duplicate testing provides resource for other controls (generally operational controls) to be brought into the scope of testing for the first time.  Moreover, as noted above, the very existence of separate internal and external audit teams can create a false sense of security for stakeholders, if, in reality, both teams largely duplicate each other’s work.

The APB recognised the rationale behind the extended audit model and, following an open consultation with interested parties, revised APB ES5 accordingly.  This now recognises that some extended audit work is effectively a part of the external audit and, subject to some conditions, presumed not to be a threat to the auditor’s independence.

The conditions imposed by the APB on allowing such extended audit work to be considered part of the audit are that it relates to financial information and/or financial controls, is authorised by those charged with governance, is integrated with the work performed in the audit and is on the same principal terms and conditions as the audit. (APB ES5: 68-69).

So are auditors and those charged with governance of cash-strapped audited entities now living happily ever after?  Not quite, for it is relatively easy for some testing which the audited entity wishes to commission to fall without the four conditions set out above, for example, testing of operational rather than financial controls.

Where this is the case, the additional testing is not prohibited, but the auditor is forced to consider the threats to independence, principally management and self-review!  However, as explained above, where the outcome of any testing is an objective, binary result, it cannot make any difference to the finding whether the test is performed once, twice or many times.  Duplicate testing to avoid self-review is an expensive, redundant safeguard.  So we are left asking why APB ES5, in this specific regard, positively requires the auditor to consider a threat to independence – self-review – that cannot, in fact, have any effect on the auditor’s independence. 

The investigation into the extended audit model significantly failed to justify the historical concern over the external auditor doing too much testing.  The resulting amendment to APB ES5, by leaving in place the requirement to consider the self-review threat in a broad range of circumstances where the four extended audit criteria will not be met, has created a lasting legacy of concern that for the external auditor to go beyond the bare minimum of testing needed to form the audit opinion is, somehow, unethical.  As a result, there has been a relatively low take-up of the opportunity to extend the scope of the external audit, and reduce any duplication of internal audit test work.  This should be a matter of concern to all stakeholders.

Even if we attribute the hysterical response of the financial press on the occasion of the Rentokil announcement to their concern for institutional investors, who are said to regard the independence threats of the external auditor performing internal audit work as some of the most significant of any non-audit service, we get no nearer to understanding why those investors are so vexed. 

An outsider may conclude that one of the greatest threats to the quality of the external audit is for there to be any co-ordination or even combination of internal and external audit in the interests of efficiency and cost savings.  But if that is the case, why haven’t we seen the FRC mandate a minimum level of internal audit testing to be carried out by listed companies?  Indeed, a number of listed companies have no internal audit function at all.

It remains necessary, critical even, that for internal audit services which do not meet the four conditions to be considered an extension of the external audit work, the effect of the management threat to independence be fully assessed by the auditor and either safeguards put in place, or, where no safeguards are adequate, the opportunity declined.  And it is right that the auditor must consider the self-review threat to independence where the non-audit service being offered is one in which the professional forms subjective opinions, such as valuation services.  Here, the auditor’s objectivity must be safeguarded from the inevitable bias that arises when a colleague from the same firm has already formed a view.

But it is high time that the auditing profession and its regulators re-opened the discussion about self-review.  If the auditor can’t be trusted to review anything he or a colleague has done without bias creeping in, where is the value in the many review processes mandated by auditing standards as an essential part of the external audit?  And how can the auditor ever be satisfied with his own work on the previous year’s figures, a genuine instance of self-review that is far more likely to require objective professional judgment than just evaluating the results of internal audit work over financial or non-financial controls? 

In the current environment, the onus is on auditors to deliver to stakeholders the maximum breadth and depth of independent assurance for the fee. This commitment to delivering value is, in itself, an ethical purpose, one that must follow naturally from compliance with applicable ethical standards, if those standards are to achieve their intended result.  It’s vital, therefore, that the auditing profession investigates and addresses the residual concern remaining that extending the scope of the external audit and eliminating duplication from the work performed by internal and external auditors is – somehow, for some reasons, we can’t quite explain why – unethical.

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