SEPARATIoN oF INDEPENDENT AUDITS AND CoNSULTATIoN

Through the so-called “low-balling” ⁸¹ which refers to a practice whereby 81 This model was first described in the chapter on auditing by Linda de Angelo (cf. De Angelo, 1981, p. 113-127).

the fee of the prevailing auditor is undercut by the offer of another auditor, many auditing firms were put in a position where the costs of the independent auditing process were no longer covered. This harmful type of competition results from the special structure of the auditing sector. In contrast to other professions, it is near to impossible to manage the business through the reputation of an auditor. Baetge and Matena demonstrate the difficulty of the sector with an illustrative example:

A patient being treated by a doctor can ascertain the performance of the doctor by whether his health has improved. The actual customer of the independent au- ditor is the owner of the corporation and not the company’s management as is often falsely presumed. The shareholder, however, can often not make a statement about the quality of the work the auditor performed as the shareholder has not got the possibility to directly view and control the work of the independent audi- tor. Mostly a lack of quality of the independent auditor’s work only comes to the shareholders’ attention if the independent auditor makes a false attestation over the formal and tangible correctness of the published annual financial statement.

This then comes to light when a company files for insolvency in the following year despite of having received an unconditional audit certificate (cf. Baetge/Matena in Wollmert et al, 2003, p. 185).

Through the enormous price competition in the sector of annual financial statement audits, there has been a vast extension of the services offered to compa- nies audited by a financial auditor. The costs of the auditing services which cannot be covered are subsidized by other services (cf. Baetge/Matena in Wollmert et al, 2003, p. 185). however, between 2001 and 2005 due to the worldwide high num- ber of cases of accounting fraud detected, many auditing firms either listed their consulting firms on the stock exchange or sold them off. The reason for this was the fear that the Securities and Exchange Commission could force them to rigor- ously differentiate their auditing from their consultancy business. kPMG listed its consulting company on the stock exchange, Ernst & Young sold its consulting com- pany to Capgemini for 11.5 billion euros, and pwc sold its consulting department to IBM for 3.5 billion dollars. But after the legislator then did not enforce a strict distinction between auditing and consulting after all, the auditing firms attempted to enter this lucrative market again. Due to the high profit margins that can be achieved in the consulting sector, this process of re-entering the market was not done gradually but as fast as possible (cf. Fink, 2005, p. k01). This is why nowadays many auditing companies are once again consulting conglomerates with multiple

service offerings. There is still a cross-subsidization of auditing services as the margins that can be attained through consulting services are much higher than the margins that can be attained through auditing. Therefore the danger exists, that by providing auditing services as well as audit related consultation to the same company, the auditor loses his independency and becomes a servant of two masters. on the one hand, he has to pursue the role of independent auditor in rep- resenting the interests of the shareholders and creditors and, on the other hand, due to his offered consultation services he has to fulfill the wishes of the com- pany’s management. As the consultation services offer higher profit margins, it can lead to a situation where the auditor is not orientated towards the expectations of the investors and shareholders but rather towards the demands and provisions of the company’s management. Baetge and Matena call this web of relationships of independent auditors, the shareholders and the company’s management a con- structional flaw. The auditors, on the one hand, must scrutinize the actions of the company’s management whilst, on the other hand, for the consultation services the auditor must be the provider and the company’s management is the customer and the so-called customer is king. Baetge and Martena see two possibilities of correct- ing this constructional flaw. one must clearly separate the auditing from simulta- neous consulting services. If this does not happen, then an external auditor rota- tion and an official scale of fees for services by auditors could at least substantially reduce the issue of dependency (cf. Baetge/Matena in Wollmert et al, 2003, p. 185 f).

A further advocate of a distinct separation between independent auditors and simultaneous consulting within the same company is Riecke. In his view the criminal acts of some auditors point to a cultural decline. The era of computers has dramatically changed the way in which the auditing sector works. The in- come of the hourly paid auditors has come under increasing pressure. The au- diting firms have reacted to this by increasing their portfolio of services offered.

By taking over consulting activities relating to tax, organizational and strategic questions, they have doubled their income over the last ten years. As overly-strict bookkeeping could endanger their lucrative consulting orders, the auditors have become dependent on companies. This conflict is made worse due to the fact that the companies’ management is under extreme pressure to achieve growing share prices and therefore try to get the most out of their numbers. Riecke brings up the Enron-Andersen scandal to demonstrate this. here the auditing firm Andersen was evidently also, at the same time, an accomplice to accounting fraud. In his

assessment Riecker also refers to the former boss of the US central bank volcker who is a strong advocate for a fundamental change of this sector. The auditors must separate themselves from providing consultation services in order to avoid any conflict of interest. In addition, volcker requests that companies should be obliged to change their auditor after five years at the latest. only by doing this could the trust of investors in auditors be re-built (cf. Riecke, 2002, p. 9 f).

A strict opponent of the request to separate the services of auditing and con- sultation is Ring. he views the general problem as being such that the auditors per se – meaning independently of whether they provide other services – are facing growing competition. This has resulted in the situation that independent audits are sometimes offered at a fee that can hardly cover costs if the audit is performed according to the regulations that apply. Ring sees as the logical consequence that the effort made in the audit – with corresponding consequences for the quality of the independent audit – orientates itself to the fees that are paid. he also doubts that consultation orders really have a significant impact on the quality of the inde- pendent audit or that through low balling the auditing fees can be “bought”. Such tendencies are contrary to market mechanisms and economic incentives. his view is that a separation of consulting and auditing would damage the quality of the independent audit. When completing their audit, the auditor must have a high cer- tainty of judgment. To be able to do this an in-depth background knowledge of the customer in question is needed that includes detailed knowledge about the char- acteristics of the business activity, the economic and legal environment in which the company and the sector operates which the auditor can only have if they also do consultation work for the company. According to Rings, it is more important to work on appropriate and targeted measures that avoid negative repercussions on the quality of the audit. only by doing this, can one avoid an inevitable iteration of the crisis of confidence (cf. Ring, 2002, p. 1348 f).

According to Bauer the question, whether simultaneous audit and consultancy services endanger the independency of the auditor could not be proven as having a negative inter-dependency either on a scientifically empirical nor a scientifically theoretical basis (cf. Bauer, 2004, p. 184). quick comes to a similar result. he found that most empirical studies cannot prove that there is a negative impact of consulting services on the actual independency of the auditor (cf. quick, 2006, p. 56).

In Bauer’s view, a statutory requirement to disclose the auditing and

consulting fees would be sufficient to solve the issue. By doing this, the interested public has the necessary transparency and could form its own view on whether potential conflicts of interest exist. Bauer thinks that this way the balance can be made between the positive economic effects through the simultaneous demand of consulting services with the auditing firm and the negative effects under certain circumstances, of a possible limited independency of the auditing firm on a trans- parent open market (cf. Bauer, 2004, p. 184).

Furthermore, Bauer states the auditor is consulted by third parties when ful- filling auditing as well as consulting orders. here the regulatory body of a compa- ny, for example, the supervisory board as contracting authority of the audit, needs to ensure that they obligate an independent auditor. If certain consultancy services are not compatible with simultaneous audit activities, then the auditor should be kept away from such assignments (cf. Bauer, 2004, p. 184).

one must note, in contrast to Bauer’s opinion, that the supervisory board has a high interest in attaining the most favourable audit result possible. This is not just because the remuneration of the board but also of the supervisory board is closely tied to the results and the success of a company. In addition, studies by Loebbecke / Eining / Willingham⁸² (1989) and Terlinde (2005) underline that also the supervisory board is, in a not insignificant number of cases, involved as pri- marily responsible offender. ⁸³

The German regulations regarding the compatibility of simultaneous audit- ing and consulting services provided by the independent auditor make the fol- lowing provisions after the German Accounting Reform Act and the German Act to Modernize Accounting Law (BilMoG) came into effect: Pursuant to § 319 (3), number 3 a “financial auditor or chartered accountant is especially not eligible as an independent auditor if he or a person he is working with has provided in addi- tion to the auditing services with or for the company to be audited in the year of the audit taking place or up to the point in time when the audit certificate is issued:

a) has provided support with the bookkeeping or services related to the annual financial statement,

b) has taken part in a responsible position in the administrative audit of the client, 82 10 per cent of offenders were members of the Supervisory Board or according to the US system part of the Board of Directors.

83 See point 2.3.3 of this paper.

c) has provided management services or financial services to the client or

d) has provided actuarial or assessment services that have a significant impact on the annual financial statement to be audited,

provided these activities are of no minor nature”⁸⁴ (translated in context by the author).

In addition, there are further special reasons for exclusion for companies of special public interest. In relation to this point, pursuant to § 319a (1), number 2 and number 3 of the German Commercial Code “a financial auditor is in addition to the points mentioned in § 319 (2) and (3) also to be excluded from the financial audit of a company which is capital market orientated within the meaning of § 264 d if he 2. has provided, in the financial year to be audited, in addition to auditing

services, legal or tax services which go beyond simply pointing out alternative arrangements and which directly and not insignificantly influence the depiction of the situation of assets, finances and earnings in the year the annual financial statement is to be audited,

3. during the financial year under review has been involved, in addition to his auditing services, in the development, installation and introduction of financial reporting information systems, providing these activities are not of secondary

84 „Wirtschaftsprüfer oder vereidigter Buchprüfer insbesondere von der Abschlussprüfung ausgeschlossen, wenn er oder eine Person, mit der er seinen Beruf ausübt, über die Prüfungstätigkeit hinaus bei der zu prüfenden oder für die zu prüfende kapitalgesellschaft in dem zu prüfenden Geschäftsjahr oder bis zur Erteilung des Bestätigungsvermerks

a) bei der Führung der Bücher oder der Aufstellung des zu prüfenden Jahresabschlusses mitgewirkt hat,

b) bei der Durchführung der internen Revision in verantwortlicher Position mitgewirkt hat,

c) Unternehmensleistungs- oder Finanzdienstleistungen erbracht hat oder

d) eigenständige versicherungsmathematische oder Bewertungsleistungen erbracht hat, die sich auf den zu prüfenden Jahresabschluss nicht nur unwesentlich auswirken,

sofern diese Tätigkeiten nicht von untergeordneter Bedeutung sind.“

importance….”⁸⁵ (translated in context by the author)

The regulations made by the German legislation are a step in the right di- rection as the regulations affecting commerce were considerably reinforced in re- gard to the separation of simultaneous auditing and consulting. however, many of these regulations are extremely imprecisely and vaguely formulated so that they provide companies with a wide creative leeway. For example, in § 319a (1), number 2 it is stated: “… which directly and not insignificantly influence the depiction of the situation of assets, finances and earnings in the year of the annual financial statement to be audited.” however, what a direct and not insignificant effect ex- actly depicts is not explained in more detail. The same applies to point 3 in the same paragraph: “…providing these activities are not of secondary importance”.

When are services rendered of secondary importance? Also in this case the ques- tion remains unanswered by the law.