Auditor Financial Independence: An Exploratory Examination with Implications for Audit Risk Management

• In Event: Continental Breakfast and Research & Education Forum
  In Paper Session: Table 5: Audit Risk II

Abstract

Financial independence is critical to the success of auditing. When financial statement fraud is uncovered, the first and most aggressive line of inquiry delves into the financial relationship between the auditor and the client. Theoretical concerns about the auditor-client financial relationship have led to considerations regarding different contracting models, though no proof of a systematic failure of independence exists.

Hence, the purpose of this paper is twofold. First, the paper provides a brief history of audit regulations regarding financial dependency in the U.S. and Europe and sets forth four propositions about the relationship between audit and total client fees and (a) auditee revenue, (b) audit firm global revenue, (c) audit firm average global office revenue, and (d) audit firm average local office revenue. Second, the paper compares audit-related financial metrics of seventeen notable audit failures since 1997 to similar metrics from publicly available data of the 100 largest companies in the U.S. in 2013. From this comparison, the paper reports three key findings.

First, audit and total client fees as a percentage of client revenue are unusually high in the vast majority of cases of financial fraud. The result may indicate that the auditor recognized the higher risk of the engagement (and the costs of the additional audit steps required). Alternatively, the higher fee may reflect an erosion of auditor independence. More importantly, going forward, audit firms now have access to audit and non-audit fee data which will enable them to identify fee structures that are out of alignment with market norms and enable firm leadership to drive discussions with local offices regarding audit risk management expectations.

The second key finding is that audit and total fee revenue from larger audit clients tend to be a significant percentage of average office revenue of the auditor. It is not uncommon for audit fees for a larger client to exceed 20% of the auditor firm’s average global or local office revenue. Consequently, future discussions about regulating the fees an audit firm can receive from a single client should incorporate this information into their discussion.

Thirdly, the paper finds that audit fees or total clients fees as a percentage of global or local office revenue are not typically higher than industry norms in cases of fraud. This suggests that examinations of fee structures in relationship to auditor revenue may not be an effective means to identify potential erosions of financial independence.

Author

• Richard J Palmer, Southeast Missouri State University