The implication of the auditor in non-audit services and the impact on its independence : evidence from Romania

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The implication of the auditor in non-audit services and the

impact on its independence: Evidence from Romania

Program: MSc Accountancy & Control – Accountancy Track Student: Elena-Raluca Dragoman

Student number: 10828745

First supervisor: A.Th.A. Koet RA

Second supervisor: Dr. J.J.F (Jeroen) van Raak Date: 22nd of June, 2015

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Page 2 Statement of Originality

This document is written by student Elena Dragoman, who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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Page 3 Abstract

Purpose

This paper gives a view regarding the implication of the auditor when non-audit services and audit services are conducted simultaneously for one client, and particularly how this will impact its independence. In the United States it is forbidden to provide non-audit services and audit services (assurance services) as it is in most European countries.

The thesis depicts the case of Romanian audit firms and its clients, analyzed from the audit partner‟s point of view and from the audit staff‟s point of view. It will describe the manner in which the implication of the auditor in non-audit services for the client firm impacts its independence, when he also performs audit services.

Design/methodology/approach

For the purpose of this study a qualitative approach has been used, conducting interviews with audit partners and audit personnel.

Findings

The paper documents the fact that in a country still affected by communism influences, the profession of auditor is a development quite new in order to consolidate the steps needed to be made towards democracy. That so, there are a lot of concerns regarding his implication in consultancy services (one of the non-audit services) for the client firm and how this will impact the independence of an auditor who also does the audit of the annual report of the firm.

Research limitations

In spite of its facilitative role, the study is based on qualitative research method, bearing the difficulty of generalizing the findings of one specific country in a specific contextual setting to the practices in other countries.

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Page 4 Originality/Value

Besides being placed in an under-researched country, namely Romania, the study presents the case of audit firms in which communism reminiscent still pertain. The researched topic of the auditor‟s independence is studied in this specific context. The research also aims to fill a research gap, by conducting it in an emergency country, from which prior evidence could not be found.

Key words

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1. Introduction and motivation

Change is a notion that invariably characterizes every individual and company. Be it a transformation, an alteration or a substitution, change occurs in order to adapt to a continuously evolving environment. So, this is the case of Romania, when the country became a member of the European Union in 2007, a lot of regulations were imposed in the financial sector and through this master thesis I want to discuss the differences in the audit profession in Romania before the country was a member of the European Union and Romania after it became a member within the European Union.

Given the diversification of companies‟ activities and the expanded global concerns regarding fraudulent reporting, a new concept had to be created in Romania in order to ensure the investors and the regulators that what is annually reported represents the true fair view of the company and the role of the financial audit with regard to that aspect. One of the topics is an auditor who is in charge of an audit also conducts non-audit services.

This paper investigates the definition of the audit, the non-audit services, the role of the auditor and its independence.

In order to be able to answer the research question I take the following steps:



Find standards for audit definitions and non-audit services.



Search for, review and discuss relevant literature and documents on audit and non-audit services.



Find standards for the role of the auditor, in general and with regard to non-audit services.



Search for, review and discuss relevant literature on the independence of the auditor.



Set up interview questions to address the concluding remarks on the definitions of audit, non-audit services and independence.

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Determine the interviewee list in particular with regards to the implication of the auditor in non-audit services.



Collect and analyze the results of the interviews and draw conclusions.

The audit firms that make the object of this study add a glimpse of novelty to the paper, because of its setting. Being located in Romania, an under-researched Eastern European country, the companies also have the particularity of existing since the communist era. This had a major impact on the mentality of older employees, for whom the changes in legislation do not fundamentally challenge their attitude and behavioural habits. Furthermore, the cultural practices have a different meaning in this setting, which still contains influences from an era characterized by default, constrains and limitations.

In order to contribute to the prior literature mainly conducted in the US and to give a glimpse of novelty, shading light on the practices used in a developing country, the following research question has been formulated:

“Does the engagement of the external auditor in non-audit services impact its independence when he performs an audit of the financial statements for the same client?”

I assess the results by collecting and analyzing the outcomes of the interviews. Furthermore I will review existing literature. Elaboration on the methodology and details can be found in Chapter 2.

The thesis is structured as follows: after this introductory chapter, section 2 will depict the methodology used. Chapter 3 will follow with the relevant concepts regarding the key topics of the paper: auditor, non-audit services and independence. The subsequent section, that is Chapter 4, will provide a detailed description of the legislation in Romania and the United States. In Chapter 5, I will present the relevant literature that has been used in order to conduct the research. In chapter 6 the findings will be presented in line with the frameworks introduced before in chapters 3 and 5. The conclusion and subsequent research recommendation will be presented in Chapter 7.

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2. Method of research and hypothesis

In this chapter, I explain the research method I use in order to perform this study. Furthermore, I underpin the validation of the method and explain the development of the interview questions.

2.1. Research design

This research is designed to capture the quintessence of the audit independence on the audit mission. To do so, I will use interviews with audit partners and also audit staff. This research is considered appropriate because it facilitates a comprehensive and detailed view of the major questions raised in this study and will also gain insight and understanding of people‟s experiences, perceptions, opinions, feelings and knowledge. In the beginning, I have started with a critical analysis of the existing literature on the subject. With the study of the literature I had a number of goals, which are:

 Prevent copying the work done by other researchers

 Get insight in methods which could be helpful for my research  Develop the research question and goals for the research  Possible future recommendations.

Even though the relation between providing non-audit services and how this can impact auditor‟s independence has been widely researched, this has been done in a quantitative way. What I am really seeking through the qualitative approach is to get a glimpse of the perceptions of the auditors in this matter.

Qualitative research methods are being used increasingly and such methods involve the use of unstructured, semi-structured or structured interviews. In most of the cases, the interview process is straightforward enough and the difficulty often arises with the question of how to analyze the transcripts once the interviews have been completed (Burnard, 1991).

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Page 9 Having a structured list of procedures and a strategy to consistently draw the most relevant information out of candidates is crucial to developing a working interview protocol. Even though the initially proposed questionnaires could end up changing, it is normal to evolve the model in relationship to the exact purpose of the problem. As data is collected, quick adjustments will offset fundamental mistakes to an otherwise static questionnaire system, and therefore constantly checking against the cost and trade-off of losing initial data versus having a good model at the end should always be kept in mind.

As documented by Saunders, Lewis and Thornhill (2006), the definition of an interview is: “a conversation between two or more persons aimed at a specific goal. With the help of interviews, it is possible to collect valid and reliable data, which could be important for the research questions and research goals.” (2006, p. 255)

Bryman, 2008, states that the interview is probably the most widely employed method in qualitative research, due to its flexibility which makes it so attractive. Interviewing, the transcription of interviews and the analysis of the transcriptions are very time consuming, but they can provide more insight on the subject than quantitative research.

In qualitative research, the approach tends to be much less structured, because the emphasis is on the formulation of the initial research ideas and on interviewees‟ perspectives. There is much greater interest in the interviewees‟ point of view because it gives insight into what the interviewee sees as relevant and important. Also, in qualitative research, interviewers can depart significantly from any schedule or guide that is being used. They can ask new questions that follow up interviewees‟ replies and can vary the order and even the wording of questioning. As a result, qualitative interviewing tends to be more flexible, responding to the direction in which interviewees take the interview and perhaps adjusting the emphasis in the research as a result of significant issues that emerge in the course of interviews. Moreover, the interviewer wants rich, detailed answers.

However, qualitative interviewing varies a great deal in the approach taken by the interviewer and there are two main types:

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Page 10  Unstructured interview: there may be just a single question that the interviewer asks and the interviewee is then allowed to respond freely. It tends to be very similar in character to a conversation.

 Semi-structured interview: the researcher has a list of questions or fairly specific topics to be covered, often referred to as an interview guide, but the interviewee has the opportunity of replying freely. Questions may not follow on exactly in the way outlined on the schedule, also questions that are not included in the guide may be asked. 1

The main steps in qualitative research are:

1. General research question

2. Selection of relevant site and subject 3. Collection of relevant data

4. Interpretation of data

5. Conceptual and theoretical work 6. Writing up findings/ conclusions.

My choice of using interviews is based on the aforementioned arguments and for the main reason I refer to Sykes (1991, p.8): “The most important reason for the potential superiority of qualitative methods for getting information is that the flexible and responsive interaction between the interviewer and interviewee makes it possible that opinions are further investigated, that subjects are viewed through different perspectives and the questions are being explained to the interviewees.”

The research conducted was based on 7 interviews, from which 5 were audit partners and 2 were audit staff, more precisely audit managers.

In the following table I will provide the name of the interviewees and the audit firms who made the subject of this study.

1

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Name Organization Type

Ana Morariu, PhD SC As Audit Co SRL Small audit firm

Camelia Anton General Audit SRL Small audit firm

Alina Gheorghe Ernst & Young Romania Big audit firm

Adina Bocanu Vulpoi & Toader Management Big audit firm

Alina Angelescu, FCCA TPA Horwath Big audit firm

Luisa Dragoman SC DralContexpert SRL Small audit firm

Alina Mirea, FCCA Deloitte Romania Big audit firm

Table 1. Interviewee and organization list 2.2. Development of the hypothesis

As documented by Iyer et al. (2003), there was an increased concern about the independency of the auditors in the US because of the provision of non-audit services by public accounting firms to their audit clients, especially after the collapse of Enron Corporation. In the past, non-audit service fees have increased while non-audit fees have remained at the same level or even, in some cases, have decreased. The Security and Exchange Commission (SEC) commented that “the dramatic expansion of non-audit services may fundamentally alter the relationship between auditors and their audit clients in two principal ways. First, as auditing becomes a smaller portion of a firm‟s business with its audit clients, auditors become increasingly vulnerable to economic pressures from audit clients. Second, certain non-audit services, by their very nature, raise independence issues.” My investigation will be based on the concerns raised by the Romanian regulators regarding the implication of the auditor in non-audit services.

H1: In Romania, the auditors are engaged in non-audit services for their audit client which might trigger independence loss.

The hypothesis of the research conducted is referring to the implication of the auditors in non-audit services for their audit client, which can lead to impaired independence. Because, doing so the auditor might develop a personal relationship with the client and will lose its

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Page 12 motivation and objective to issue an audit report which will reflect the true financial position of the firm.

3. Concepts

3.1. The concept of audit

In the first paragraph of this subchapter, I describe the background of the role of the audit and of the auditor in general. Furthermore, I give an overview of earlier literature. Afterwards, I will explain the notion of non-audit services, independence, ethics and professional skepticism in order to have an input for my survey.

The major objectives of the audit have undergone significant changes (Waymire, 1978) since the extensive audits of British firms prior to the 1850s. Early audits were elaborate reviews of all the bookkeeping entries made by the employees of the firm in an effort to discover any employee defalcations. These reviews could be made because businesses were much smaller and less complex than they are today. In the latter half of the nineteenth century, the audit objective began to undergo a change. As businesses grew larger, a need developed to identify material clerical errors in the audit as well as fraud. During this period, audit sampling procedures were introduced as a means of assessing the accuracy of the accounting records. For approximately the first thirty years of the twentieth century the discovery of fraud still dominated the thoughts of the auditor. However, a new notion appeared on the scene: that auditors should determine if the financial statements "fairly present" the firm's financial condition and results of operations. With the rise of the corporation and public stock issuances, public disclosure of accounting information was a reality. From 1930 to the present, the objectives of the audit have reflected the tremendous surge in economic growth. Statistical sampling has become a prevalent method of determining the fairness of financial presentation. The detection of fraud is no longer the driving influence in the audit that it was fifty years earlier. This specific point was clarified in September 1960, when the American Institute of Certified Public Accountants (AICPA) issued Statement on Auditing Standards No. 30. Briefly, it states that the auditor should rely on the integrity of the

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Page 13 company's information system unless something arouses his suspicion about the possibility of fraud. If that occurs, the auditor should perform all tests he deems necessary to satisfy his doubts.

The primary purpose of the statement is to dispel some of the myths concerning the auditor's role as a fraud detector. The auditor must still be aware of the possibility of fraudulent activities; however, the focus of the audit is now on a review of the internal control systems that operate to decrease the probability of loss due to fraud. (Waymire, 1978)

In Romania, according to the OUG 75/1999, article 2, the financial audit is defined as: “the work performed by auditors in order to express an opinion on the financial statements or on their components, exercise other assurance and professional services according to the International Standards on Auditing and other regulations adopted by the Chamber of Financial Auditors of Romania”.

According to the article 3, financial auditor is defined as: “the person or legal entity that acquires this capacity under this ordinance”.

The auditor shall issue a report to the members of the society on the accounts examined by the audit team. The auditor in performing his duties is expected to exercise all care, diligence and skills as is reasonably necessary in each particular circumstance (Adeyemi et al, 2011). As Adeyemi et.al (2011) states: audit report is the way through which the auditor expresses his opinion on the financial statement examined by him. Due to familiarity, threat of replacement of an auditor, provision of book-keeping services by the auditor and many other factors, the auditor may want to issue an unqualified audit report even when the situation on ground proved otherwise. This situation raises doubt about the independence of an auditor.

Types of audit opinions:

 Unqualified - “statements present fairly” Versus

 Reservation of opinion (three types):

o Qualified auditor‟s report – “Except for one or more exceptions, statements present fairly”

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Page 14 o Denial / Disclaimer – “No opinion”.

Three Types of Auditor’s Reports

Unqualified Standard Unqualified Report Modified Unqualified Report Reservation Qualified Report Disclaimer Qualified Report Adverse Based on Materiality And Pervasiveness Scope Limitations Violations of Accounting Standards

Table 2. Types of auditor‟s opinion, source: Assurance lecture 2, ppt. 30;

In order to understand the necessity and the importance of the audit, it is necessary to explain what the outcomes are and who the beneficiaries of the audit report are. An article wrote by Monica Bizon, which is very helpful to guide the research states, that financial audit, among concepts like corporate governance must represent one of the key factors to contribute to financial stability through guarantying a fair view of the financial statements made by the company. The direct beneficiaries of the increased credibility in the financial statements would not be only the investors and the creditors, but also audited companies, their employees and also the public in general.

According to OECD, the definition for corporate governance is: “a set of relationships between a company‟s board, its shareholders and other stakeholders. It also provides the structure through which the objectives of the company are set, and the means of attaining those objectives, and monitoring performance, are determined.”, on the other hand, Tirole, 2001 states

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Page 15 that the standard definition for corporate governance among economists and legal scholars refers to the defense of shareholder‟s interests.

3.1.1. Summary

The studied literature focuses on the evolvement of the role of the audit in organizations. There seems to be a common understanding that the role has changed from the start of contemporary audit in the 1850s until nowadays. Audit profession has started as a way of reviewing bookkeeping entries done by the employees and it has evolved into reviewing of the internal control systems that are put in place in order to decrease the probability of loss due to fraud, as explained by Waymire.

3.2. Independence, ethics and professional skepticism

The opening story illustrates the importance of the independence (to add more), the ethics and the professional skepticism of the auditor in order to have a clear picture of the qualities needed by the auditor when conducting an audit mission. My research is based on the provision of non-audit services by the auditor to the audit in situations where he also performs the financial audit of the financial statements and why this can have an impact on his independence.

Krishnan et al. (2005) conducted a study regarding the examining of auditor independence in appearance. They have divided the independence in fact and in appearance. Independence in fact means that the auditor needs to have an objective state of mind while conducting the audit mission, while independence in appearance means that the auditor needs to be perceived by outside parties as objective. Their conclusion was that the investors see non-audit services as impairing auditor independence.

The auditor must have an independent mental attitude. The competence of the auditor in performing the audit is of little value if they are biased in the accumulation and evaluation of evidence. Auditors strive to maintain a high level of independence to keep the confidence of users relying on their reports. Auditors reporting on company financial statements are often

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Page 16 called independent auditors. Although external auditors are being paid by the client, it is assumed that they should be independent (in appearance and in mind).

Independence is the key of the audit quality. Without it, the stakeholders would perceive the audit report as untrustworthy. It is assumed that auditors that do the financial audit and non-audit services at the same time cannot be independent, because of the implication of the auditor in non-audit services, which will make the report biased; this is because auditors become too familiar with the company by rending other services than audit services. Considering such facts, it was necessary for the standard setters to impose regulations upon the auditors, so that they cannot be involved in non-audit services and then to review their own work, because as said before there is the possibility of developing a personal relationship with the company. Through such regulations the audit quality should increase because the independence of the auditor is assured.

The challenge of being perceived and acting as an independent auditor may arise from the fact that corporate management hires, fires, and pays their external auditors. Auditors, therefore, develop good relationships with management to keep the job of the client. They may not, therefore, be independent of the corporate management. In the United States of America, the Sarbanes - Oxley Act (2002) prevents auditors from providing non - audit services to their clients (Adeyemi et al, 2011).

In the following paragraphs I will describe the qualities that an auditor needs to have in order to be compliant with the demands of the standard setters and also required by the users of the audit report.

Ethics can be defined broadly as a set of moral principles or values. Each of us has such a set

of values, although we may or may not have considered them explicitly. Examples of prescribed sets of moral principles or values include laws or regulations, church doctrine, codes of business ethics for professional groups such as CPAs, and codes of conduct within organizations.2

Our society has attached a special meaning to the term professional. Professionals are expected to conduct themselves at a higher level than most other members of society.

2

Arens A.A., Elder R.J., Beasley M.S., 2014, Auditing and assurance services: An integrated approach, Fifteenth edition, Pearson, United States of America, pg.125

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Page 17 The term professional means a responsibility for conduct (not really scientific, add reference) that extends beyond satisfying individual responsibilities and beyond the requirements of our society‟s laws and regulations. A CPA, as a professional, recognizes a responsibility to the public, to the client, and to fellow practitioners, including honorable behavior, even if that means personal sacrifice.

The reason for an expectation of a high level of professional conduct by any profession is the need for public confidence in the quality of service by the profession, regardless of the individual providing it. For the CPA, it is essential that the client and external financial statement users have confidence in the quality of the audits and other services, because otherwise the value of CPA‟s firms audit and other attestation reports is reduced and the demand for these services will thereby also be reduced.3

Professional skepticism defined by ISA 200 is: “an attitude that includes a questioning

mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence”. According to Lee et al., 2013, some believe that the definition requires auditors to have a neutral attitude when evaluating audit evidence and this belief is in line with the auditing standards, which state that auditors should not take for granted that the management is honest. This also implies that an auditor should have a mental perspective of presumptive doubt when the circumstances suggest fraud risk, for example, when there is potential for overstated or understated revenue, or when there is conflicting or missing audit evidence.

3.3. The provision of non-audit services and auditor’s independence

“The performance of non-audit and auditing for the same client by the same accountant is a combination of incompatible services.” (Mautz and Sharaf, 1961)

3

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Page 18 As researched by Craswell, the provision of management advisory and other services by auditors to their audit clients has long been regarded, by regulators in the US, UK, Australia and other countries as a threat to auditor independence.

Craswell has conducted a study in 1999 focused on whether the provision of non-audit services influence auditors in issuing modified opinions less frequently, using publicly available information for Australian listed companies. The tests the author used were carried out over several years from which he concluded that auditor‟s decisions to qualify their opinions are being unaffected by the provision of non-audit services.

In the United States of America, the Metcalf Committee Staff Study (Metcalf Committee, 1976) suggested that the provision of non-audit services to the audit client may lead to a conflict of interests because in this way the auditors would have an additional economic incentive to retain the clients and they would not jeopardize to lose them due to disagreeing with the management. But an opposite view was taken by the Cohen Commission [1978, p.97] which emphasized that there may be benefits in associated with the supply of the two services, such as when non-audit services provided by the auditor to the audited firm, the client‟s search costs for a credible consultant and other transaction costs can be reduced. According to this we have a cost/benefit trade-off: certain non-audit services may threaten the auditor‟s independence, but this joint is likely to be efficient for both the auditor and the client. (Simunic, 1984)

The approach adopted by Craswell (1999) is based on prior research conducted by Barkess and Simnett (1994) and Wines (1994), based on publicly available data from the annual reports of the listed companies in Australia in 1984, 1987 and 1994. In these articles, the authors based their research on the association between the provision of non-audit services and auditor‟s reporting decisions, using publicly listed companies in Australia from 1986 to 1990. However, the results are conflicting, meaning that Wines found a relation between the provision of non-audit services and non-auditor‟s reporting decision under conditions of higher non-audit and non-non-audit services fees, while Barkess and Simnett were unable to find the relation.

Due to increasing concerns in US, UK, Europe and Australia especially because of the downfall of Enron and the wrong practice provided by Arthur Andersen, The Independence Standards Board in US adopted Independence Standard No. 1, Independence Discussions with

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Page 19 should communicate in writing, with the audit committee, matters which are likely to influence audit independence. One of the major concerns was the provision of non-audit services and this is why the standards require disclosing the amount of audit fees and nature and the level of non-audit fees derived from the client.

The author, Sharma, analyzed the provision of non-audit services and their potential threat to the auditor‟s independence from two perspectives: the early literature and the late literature. While the early literature took a behavioral approach, meaning that auditor‟s and third parties perceptions were surveyed resulting that auditors perceive little threat or no threat while third parties were concerned about the conflict between the provision on non-audit services and auditor‟s independence. The late literature adopted an archival approach, meaning that the author used the application of bankruptcy prediction models and it led to the conclusion that these models were more objective than the auditors. She based her research on a sample of bankrupt Australian companies using reported non-audit services fees proportionate to total fees as a measure of economic incentives.

The interesting choice of bankrupt companies was because the studies in the US found that approximately up to 50% of bankrupt companies did not receive a going concern report prior to their bankruptcy, implying that this was due to the fact that either the auditors were incompetent in identifying the problems or they may have had their independence impaired.

The result of the research was that auditors may be tempted to lose independence when their audit clients generate higher proportions of non-audit services fees to total fees, implying that audit independence may be impaired for economic reasons.

To be able to test the conclusions of the literature review, I propose the following questions to the interviewees:

 What are in your opinion the non-audit services the auditor can provide for their clients?

 Do you believe that auditors should engage in non-audit services for their clients?  If yes, what do you believe that there are drawbacks in providing non-audit services

for clients?

 If the audit firm has provided non-audit services for the client firm have you considered all the risks and threats that can impact the independence?

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Page 20  If yes, what were those risks and threats?

 Do you believe that providing non-audit services to an audit client gives the auditor more experience of the client‟s industry and more access to the client‟s accounting system? And what are the benefits?

 In your opinion, is providing non-audit services to the audit client of benefit, meaning that the auditor can issue a better quality report?

 What do you perceive to be the biggest advantage and disadvantage when providing non-audit services for an audit client?

4. The situation in Romania

4.1. Introduction

The integration into the European Union has imposed on Romania to find ways to grow the efficiency and effectiveness of the economic activity and to remove inconsistencies discovered in firm‟s business processes, in the private sector as well as in the public sector. Therefore, a method by ensuring those qualities was the conducting of the audit mission on organizations such as economic agents and public institutions.

Also of particular importance in the audit rules contained in the package which needed to be implemented was the type of organizations which needed to be annually audited, because not every company needed to be subject to an audit mission, but only listed companies and companies of public interest. However, for reasons of correlation and consistency in understanding common notions the definition of public interest entities was clarified by listing the exact type of entities which are of interest: listed entities, credit institutions, insurance, payment institutions, institutions issuing electronic money and investment companies.

In Romania, the Body which supervises the organization and the functioning of the financial audit is The Chamber of Financial Auditors in Romania (CFAR). Chapter V, article 61 of the Finance Minister‟s Order specifies that one of the conditions of incompatibility in which the

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Page 21 auditor can find himself is “if develops accounting activities, consultancy or other similar activities” for the same client for whom they are doing auditing.

My contribution through this research paper will be to fill the literature gap which exists regarding the commitment of the auditor in non-audit services in Romania and how this can influence the independence of the auditor. Furthermore, the study can provide significant insight regarding the perceptions of Romanian auditors on the auditor‟s independence. This came to my mind, because of my affinity for the audit sector. Moreover, I have found that conducting this research in Romania would be of a great interest not only for regulators, but also for other interested parties, which can gain a broader view of this practice in this specific country.

In this chapter, I want to provide an overview of the situation in Romania and how it came to implement the financial audit activity as a primary basis for certifying the financial statements.

4.2. Romania in the communist era

In Romania, December 1989, before the falling of the dictator Nicolae Ceausescu, there was the State Planning Committee (SPC), which was the central organ of the state administration. It ensured uniform administration of the communist party and the state‟s policy in the field of economic and social planning. SPC was coordinating the planning of the national economy, providing the necessary proportions between different branches and sub-branches of the economy and the material balance, financial, currency and monetary of the state‟s plan.

One of the principal attributions was to draw up proposals for the single national plan of economic and social developments. The plan was based on its own studies and proposals of plan holders, ensuring implementation of party‟s policy in order to raise the efficiency of the entire economic activity. This in turn, would allow to continuously increase the national income by increasing productivity and reducing costs of production and circulation, by a better management of the labour workforce and improvement of their training.

In Romania, before 1989, during the centralized economic model, known as the communist regime, special attention was paid to the financial control measures for verifying how the companies were managing the resources of the state, as the sole owner. (Laptes et al, 2014)

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4.3. The steps to a more modern Romania

In the late 90s, from the need to enhance the credibility of accounting information published in the financial statements and by recourse to international practice, the concept of audit was implemented in the Romanian regulations. In this country, until 1999, the chartered accountant, through the censor institution, was responsible of expressing independent opinions as to whether the financial statements give a fair, clear and full view of the firm‟s assets and liabilities and the outcome of the economic entity, as it was documented by Laptes et al., 2014, but this was a concept that needed to be changed so that the country can become a part of the European Union.

Before 2007, the year in which Romania became a part of the European Union family, the country had to accept the communitarian acquis.

The concept of communitarian acquis means includes all the legal norms which regulate the activity of EU institutions, EU policies and actions, which consist of:

 The content, principals and political objectives contained in the original and subsequent Treaties of the European Communities;

 The legislation adopted by the European Union‟s institution for the implementation of the treaties (regulations, directives, decisions, opinions and recommendations);  The law of the European Court of Justice;

 The declarations and resolutions adopted within the European Union;

 Joint actions, joint positions, conventions signed, resolutions, statements and other acts adopted under the Common Foreign and Security Policy and cooperation in the field of Justice and Foreign Affairs and;

 International agreements to which the Community is part of (but not the European Union, because it doesn‟t have legal personality) and agreements between Member States of the European Union with regard to its work.

Romania has accepted the communitarian acquis in the field of financial control by Chapter 28 of the Accession Agreement – “Financial control” –which had to be effectively implemented by the date of adherence. After the adherence, Romania must ensure a rigorous financial

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Page 23 management, transparency and control of the utilization of European funds as well as protection of financial interest of the European Union as being guiding principles.

So, in this aspect a lot of demands had to be implemented such as: public internal audit, internal control, financial control and financial audits done by an independent auditor of the company.

4.4. Adoption of the International Standards on Auditing (ISA)

A research conducted by Ioana Pop shows us that in the countries members of the European Community, all the audits have to be conducted according to the International Standards on Auditing (ISA). The Directive 2006/43/EC through article 26, impose on the member states that: “statutory audits and audit firms conduct the legal audits under the International Standards on Auditing adopted by the European Commission”. Furthermore, “the member states may apply a National Standard of Auditing as long as the Commission doesn‟t adopt an International Standard on Auditing which refers to the same problem” and the member states “can impose procedures or additional requirements or eliminate some parts, but only if come from specific internal requirements”.

In Romania, this legislation was transposed through Chapter V, article 28 of OUG 90/2008 where it is mentioned that the International Standards on Auditing (ISA) will be implemented when conduction an audit mission.

4.5. Regulations in Romania

In Romania, according to the Order no. 1802/2014, Accounting regulations harmonized with

EU directives, every company which fulfills at least two of three quality criteria, the public

companies and companies which are listed on the stock exchange are required to appoint an external auditor. The three criteria which need to be fulfilled are:

1. Total assets: 3,650,000 Euros and; 2. Net turnover: 7,300,000 Euros and;

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Page 24 3. The average number of employees during the financial year: 50.

As said before, in Romania, the body which has the legal competence to issue rules and regulations is the The Chamber of Financial Auditors. It also has the power to judge disciplinary offenses consisting of acts or omissions committed by the members of CFAR, rules of professional conduct in violation of the Rules of the Organization and functioning of the Code of Ethics and the decisions of the governing bodies of CFAR to the extent that these deviations affect ethical behaviour and professional prestige and the credibility of the financial auditor profession.

CFAR sanctions the members, the financial auditors for offenses that attract a prohibition on exercising the profession of financial auditor. The disciplinary action may be brought within one year from the date of the deed and within three months from the date of the final judgement through which a member of the CFAR has been convicted of offenses that attract the prohibition of the right to practice.

In accordance with the article 94 of the rules of organization and operation of CFAR auditors, they can be sanctioned for misconduct with:

a. Warning; b. Reproach;

c. The suspension of membership of the CFAR for a period of 6 months to a year and; d. Exclusion from CFAR.

This is important to know because in the following paragraph I want to present an overview of the regulations in the United States.

4.6. Regulations in the United States

Certified public accounting firms are responsible for auditing the published historical financial statements of publicly traded companies. The title certified public accounting firm

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Page 25 reflects the fact that auditors who express audit opinions on financial statements must be licensed as CPAs.4

Additional services commonly provided by CPA firms include accounting and bookkeeping services, tax services, and management consulting services – the so called non-audit services.

CPA firms vary in the nature and range of services offered, which affects the organization and structure of the firms. Three main factors influence the organizational structure of all firms:

1. The need for independence from clients. Independence permits auditors to remain unbiased in drawing conclusions about the financial statements.

2. The importance of a structure to encourage competence. Competence permits auditors to conduct audits and perform other services efficiently and effectively. 3. The increased litigation risk faced by auditors. Audit firms continue to experience

increases in litigation related costs.

CPAs are licensed by the state in which they practice, but a significant influence on CPAs is exerted by their national professional organization, the American Institute of Certified Public Accountants (AICPA), which sets professional requirements for CPAs, conducts research, and publishes materials on many different subjects related to accounting, auditing, attestation and assurance services, management consulting services, and taxes. 5

CPAs must meet continuing education requirements to maintain their licenses to practice and to stay current on the extensive and ever changing body of knowledge in accounting, auditing, attestation and assurance services.

For a CPA firm, quality control comprises the methods used to ensure that the firm meets its professional responsibilities to clients and others. These methods include the organizational structure of the CPA firm and the procedures the firm establishes. Practice monitoring, also known as peer review, is the review, by CPAs, of another CPA firm‟s compliance with its

4_{Arens A.A., Elder R.J., Beasley M.S., 2014, Auditing and assurance services: An integrated approach, Fifteenth}

edition, Pearson, United States of America, pg.35

5_{Arens A.A., Elder R.J., Beasley M.S., 2014, Auditing and assurance services: An integrated approach, Fifteenth}

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Page 26 quality control system. The purpose of a peer review is to determine and to report whether the CPA firm being reviewed has developed adequate quality control policies and procedures and follows them into practice. Unless a firm has peer review, all members of the CPA firm lose their eligibility for AICPA membership.6

In the United States, due to accounting and auditing scandals, the reputation of CPA firms was dramatically affected (Carmichael, 2014). This lead to the creation of the PCAOB (Public Company Accounting Oversight Board), which is a “unique, quasi-public organization to oversee and regulate auditors of public companies.” Section 102 of Sarbanes – Oxley Act charged the PCAOB with the establishment of auditing rules and related attestation standards, quality control standards, and ethics standards, including specifically independence standards and rules which CPAs must follow.

For me, the reviewed regulations raised the following questions, which I proposed in the interviews:

 In Romania CFAR is the body which oversees the auditors. Do you believe that the regulations are well established?

 CFAR adopted ISA (International Standards on Auditing) for the audit mission. Do you believe that this is appropriate or more national rules would be more appropriate?

4.7. Summary

Based on the research done on the background of Romania, I conclude that after the falling of the communist regime, the country has taken important steps in developing its economy and also on becoming a democratic country. In this regard, the country has accepted the communitarian acquis in order to become a member state of the European Union and had also implemented the regulations imposed by the European Commission through Directives.

6

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5. Literature review

In this chapter I describe the results of other researchers regarding the implication of the auditor in non-audit services for the same firm for which he provides assurance services and how this can impact its independence.

There have been previous studies in the past concerning the connection between providing non-audit services and audit independence, especially conducted in the United States.

The essential key of efficient capital market is the independent auditing, as stated by DeFond et al (2002). In that matter, standard setters have been long concerned with possible threats that may arise and affect the independence. DeFond documented that in the era of Enron bankruptcy, those concerns have made the Congress of the United States to issue legislation which ban auditors, that conduct an audit of the financial statements, in providing non-audit services to their clients. Those concerns were based on the assumption that auditors are willing to lose their independence in favour of retaining clients which pay large non-audit fees. DeFond argues that there is a problem with the assumption: that loss of reputation and litigation costs may provide strong incentives to make auditors not lose their independence, but contrary to regulator‟s concerns, he was not able to find any connection between the non-audit service fees and loss of independence.

A study conducted by Frankel et al. (2002) shows that the concerns regarding the provision of non-audit services and their impact upon the financial statements of the audited company was the primary trigger for Security and Exchange Commission to issue revised auditor independence rules in November 2000, by defining independence as “a mental state of objectivity and lack of bias”. Those rules require that firms disclose the amounts of all audit fees and non-audit fees paid to the auditor of their financial statements filed on or after February 5, 2001. This was imposed so that investors would acknowledge whether non-audit fees have impaired the auditor‟s independence. The disclosure can inform investors about financial reporting quality, because if investors believe that the provision of non-audit services compromises auditor‟s objectivity they will bid down the share values of firms which disclose unexpected high non-audit fees. However, the author did not find any association between the disclosure of non-non-audit

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Page 28 fees and share values, meaning that the general belief of investors is that providing non-audit services for the same audited client would not impair auditor‟s objectivity.

While the value of auditing services is based on the assumption that certified public accountants are independent of their clients, experience has shown that independence in fact is insufficient to support the credibility of this assumption and this is why the US regulators have struggled to ban management advisory services by auditor to the audit client. (Shockley, 1981) The arguments opposing the provision of management advisory services are more common to affect the independence, for example: first, CPAs may become advocates of the client, making it difficult to remain independent; second, the audit firm may become linked to the client because of their success as advisors upon the client‟s success; third, consultants may find themselves in the position of decision makers, thus auditing their own decisions and finally CPAs may develop a close relationship with the management during management advisory services engagement. Based on these arguments, Shockley tried to find a relationship between the provision of management advisory services and the loss of independence, concluding that this kind of practice bears high risk of impairment of independence.

Of a great similarity, a research was conducted in a developing environment, namely Jordan, by Nidal Sabri. The research was aimed to investigate the situation of the non-audit services offered by the CPAs to audit clients. As documented by the researcher, in Jordan, there is nothing stated in the laws to regulate or to prohibit non-audit services to audited clients, being the primary trigger for this investigation. CPAs firms working in developing countries are smaller than in the US for example and due to this, research findings have shown that smaller firms are exposed to a greater risk of losing independence when performing non-audit services. Secondly, most business firms in developing countries are small or middle-size which probably has no qualified personnel in the accounting industry and thus, more in need of non-audit services. The above characteristics are found in Jordan and the methodology of the research aimed to gain insight into two groups of participants: CPAs and the management of the client firm. The results indicated that the majority of the attestation engagements included accounting services performed by the auditors and that CPAs perceived that this situation is not conflicted with their independence.

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Page 29 The promotion of the audit independence through prohibiting or restricting their ability to provide advisory services to their clients has been the solution for improving financial reporting (Jamal, 2011). The central belief is that the users of certification services should attain confidence by the certification report from someone who has the aim to provide quality service or at least who does not have a conflict of interest that may interfere and keep him from providing a report which validates the true and fair view of the financial statements.

A study conducted by DeAngelo (1981) and Watts and Zimmerman (1986) define auditor independence in terms of the probability of auditors reporting errors conditional upon an error being discovered. In essence, independent auditors differ from other auditors in two respects: (i) they design and execute audit programs with the aim of detecting errors; and

(ii) when errors are discovered, they disclose the nature of the errors in their reports.

However, apart from the implication of the auditor in non-audit services, the literature has identified a few determinants which can compromise the independence of the auditor, such as: the audit firm size, level of competition in the audit services market, tenure of the audit firms serving the need of an audit client, size of audit fees received by the audit firm, provision of managerial consultancy services provided by the audit firm to the audit client and the existence of the audit committee. (Adeyemi et al, 2011).

“The audit function is simply being used as a springboard to more lucrative consulting services” (Levitt, 2000). The study conducted by Kinney, Palmrose and Scholz (2004) investigates whether from 1995 through 2000 the fees for non-audit services provided by an audit firm are associated with restatements of previously issued financial statements. The motivation comes from the long debate in the US if an audit firm should be allowed to provide both audit services and non-audit services to the same publicly held company. As support for the concerns regarding the independence of the auditor, SEC emphasized the increased number of restatements of previously issued audited financial statements during the latter half of the 1990s, a period in which the fees for non-audit services have dramatically increased in the US compared to audit fees. The methodology used for the research is comprised of data before the SEC rule and the passage of SOX, meaning from 1995 to 2000. The three main findings are:

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Page 30 1. No positive association between fees for financial information system design and

implementation or internal audit services and restatements;

2. Significant positive association between audit fees, audit related fees and unspecified non-audit services fees and restatements;

3. Tax services fees are typically negatively associated with restatements and that the association is statistically significant.

6. Research in Romania

6.1. General

In this chapter, I summarize and analyze the outcomes of the research on the engagement of the auditor in non-audit services. Furthermore, I give an overall picture of the reactions of the interviewees and give notable quotes on the topic. I analyze the reactions and the most important findings are comprised in Chapter 7. The questions for the interviews, which are described in Appendix A, are based on the concepts presented in Chapter 3.

6.2. Summary of interviews

In the following table I will provide a summary of what interviewees responded to the questions regarding the investigation in Romania.

Questions Interview ee 1 Interview ee 2 Interview ee 3 Interview ee 4 Interviewee 5 Interview ee 6 Interview ee 7 What is your function in the company ? Audit partner Audit partner Audit manager Audit manager Audit partner Audit partner Audit partner How long have you For 10 years For 13 years For 8 years For 9 years For 10 years For 12 years For 6 years

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Page 31 been working in the company ? When having a new audit client what are the steps taken in order accept the client? The most important is the independ ence check, not having any kind of relationsh ip with the client First of all the ethic code is respected and the auditors are very careful to have independ ence Verificati ons in order to accept the client: to see if the auditors are connecte d with the client. The auditor sends a prelimina ry questionn aire to the audit client and always research about the client. The auditor tries to document the industry in which the client activates and then it verifies if there are no threats to independen ce. The auditor document s everythin g about the client‟s business and then it sends the letter of engagem ents In the beginnin g auditors have to know the client: the industry in which it operates. Who is responsib le in assuring that there is no conflict of interest between the audit client and the audit firm? The personnel do everythin g to ensure that there are no conflicts of interest. The audit partner is responsib le for accepting of declining the client. The audit manager and the audit partner. The audit personnel and then acceptanc e by the audit partner. The audit partner. The auditor itself has to document all the risks that may come up when accepting a new audit client. The audit manager and audit partner verify if there are no independ ence issues. What are the circumsta nces that have potential threats to auditor‟s independ ence when accepting If the personnel who is in the audit team has any connectio n with the client, like shares in the client Financial dependen cy like the percentag e of the fees from the audit client in the total fees of the audit Independ ence, if the audit firm has a financial interest in the client or a relationsh ip between the If someone from the audit team has a familiar relationsh ip with the client or any financial interests. If other department s in the audit firm are having service contracts with the audit client, which can influence the If there is financial dependen cy or a personal relationsh ip with the client. The most important would be if other departme nts are offering non-audit services to the client.

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Page 32 audit engageme nt? or personal relationsh ip firm auditors and the client manageme nt‟s decisions. In Romania CAFR is the body which oversees the auditors. Do you believe that the regulation s are well establishe d? The interview ee is also the Vice-president of CAFR. The regulatio ns are well establishe d. The rules are very well establishe d The rules are in accordan ce with the internatio nal practices. The rules are in place and well establishe d. CAFR has tried to do everything to regulate as good as possible the audit field. CAFR has always assured the quality of the audit field in Romania. There rules are applicabl e and in place. CAFR has tried to do everythin g possible to ensure that the rules are in place and that the auditors are following them. CAFR adopted ISA (Internati onal Standard of Audit) for the audit mission. Do you believe that this is appropria te or more national rules would be more appropria te? ISA is more appropria te because in this way a comparis on between countries can be made. ISA is effective, because transpare ncy can be assured. It is much better to have ISA than a national code, because in this way you can assure transpare ncy. The auditor said that it is better to have ISA than national regulatio ns CAFR has adopted ISA. There are no national rules. What they did was good for the auditors. ISA is much more appropria te than a national regulatio n regarding the auditor‟s activity. ISA is more appropria te. In this case you can compare the audit among countries. If you don‟t comply The audit firm receives They check you on You are sanctione d and you The audit firm gets a fine and They verify you and if you don‟t The auditor can lose The auditors are

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Page 33 with the rules regarding the auditor‟s independ ence what are the sanctions ? a mark. If the mark is not A or B you get a fine and if you don‟t improve you can be disqualifi ed the quality of the audit engagem ent and if you broke the law they punish you according ly can even be disqualifi ed if there are major breeches. a bad mark and if it doesn‟t improve you can lose the quality of being an auditor. meet the criterion you get a fine. its professio n if rules are not followed. sanctione d by receiving a bad mark and they also receive a fine. What are in your opinion the non-audit services the auditor can provide for their clients? Do you believe that auditors should engage in non-audit services for their clients? Tax consultan cy, financial analyzes. The auditor should not engage in non-audit services. Consulta ncy or IFRS restateme nt. The auditors should not be engaged in non-audit services. Tax consultan cy, advisory consultan cy, legal advice. But always have to be sure that other departme nts are providing them, not the audit team. The audit firm can help them with advices regarding tax declaratio n. The auditor should not mix assurance services with non-audit services. For example compliance and agreed procedures. The auditors directly should not be engaged in non-audit services. You can offer the audit client tax advices, advisory advices, but never to take the decisions instead of the managem ent. It is better if auditors don‟t offer other types of services to the audit client. For instance tax consultan cy, advisory consultan cy, legal advice or even human resource advice. The audit firm offers non-audit services, but through other departme nts. If yes, what do you believe that are the drawback s in providing - - There are no drawback s, because you don‟t get to review the work - Depends how affected independen ce is. If the auditor gives a recommend ation, this - No drawback s, because they are completel y separate.

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Page 34 non-audit services for clients? done by your colleague s from other departme nts. can be done in the audit engagemen t. Independen ce is not threatened as long as you don‟t take decisions instead of them. If the audit firm has provided non-audit services for the client firm have you considere d all the risks and threats that can impact the independ ence? The audit firm is not providing non-audit services The firm has not provided non-audit services, but if they were to provide, they were very concerne d about not losing independ ence. The threats were mostly regarding the independ ence, but since other people were providing them, there was no threat of self-review. The audit firm has not provided non-audit services for audit clients. Yes, independen ce was always in mind when the audit firm has provided non-audit services. The firm has not provided non-audit services. The most important was that the auditor should not be in the position of self-review. The auditor has always checked with the colleague s from other departme nts that these services are separated . If yes, what were those risks and threats? - - Risks of ending to review a treatment that has been - The risk would be to try and influence the manageme - Risk of reviewin g a treatment recomme nded by

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Page 35 suggested by the colleague s from other departme nts nt‟s decisions, but as long as other department s are offering the services for us would be no risks. the auditor‟s colleague s. Do you believe that providing non-audit services to an audit client gives the auditor more experienc e of the client‟s industry and more access to the client‟s accountin g system? And what are the benefits? What is best is that every time audit engagem ents should be separated from other services with an audit client. There should be no mix. The auditor has to do his job professio naly. The fact that the firm offers non-audit services is not a criterion; on the contrary it would make the auditor feel too familiar with the client. This is not possible since the auditors are not offering the non-audit services. The benefits would be that the auditor would be comforta ble having other services done by their colleague s In the auditor‟s opinion, you have to do the audit mission according ly; non-audit services shouldn‟t help you have more informati on about the client. The benefit would be that you can see in detail every transactio n Yes, the auditor would know more about the client‟s business and how it operates and it can help the auditor see in detail. In general yes, but this should not be the case, because you have to do your work as an auditor and know the client‟s business. This is the case if the auditor does non-audit services, but in the audit firm other departme nts are providing them. The benefit would be that you are more confident in the work done by your colleague than any other firm. In your opinion, is providing non-audit services to the The auditor should know everythin g about the client One of the targets the auditor is following is to The auditor doesn‟t see this as a benefit. The This should not be the case; the auditor should not be No, auditors should have their work well documente d in order Probably not, because you need to be very professio All things considere d, the auditor thinks that the

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Page 36 audit client of benefit, meaning that the auditor can issue a better quality report? from the audit, not from non-audit services know very well the client. Having non-audit services would not have to improve the quality of the auditor‟s work auditor should do its work correctly. influence d by these factors when issuing an audit opinion. to give an appropriate audit opinion. nal when issuing an audit opinion, otherwise you can lose your license to practice. quality of the audit opinion would be improved by having other services, apart from audit. What do you perceive to be the biggest advantage and disadvant age when providing non-audit services for an audit client? Advantag e: more connecte d to the client‟s business Disadvan tage: the ethics can be put under question. Advantag e: much higher fee Disadvan tage: You have to be very careful to respect your independ ence. Advantag e: feeling confident in the work of the colleague s Disadvan tage: the possibilit y of losing an audit client in favor of other departme nt. Advantag e: the auditor would connect very well to the client‟s business Disadvan tage: the auditor would connect too well and probably will lose skepticis m. Advantage: any type of service can help the auditor know the client‟s business better. Disadvanta ge: it can be time-consuming and if the auditor doesn‟t know that area, it shouldn‟t provide non-audit services. Advantag e: higher fees for the audit company Disadvan tage: developm ent of an inappropr iate relationsh ip with the client. Advantag e: you connect much well with the client‟s industry. Disadvan tage: you may be lost in the details and fail to see the significan t things. Do you take into considera tion providing non-audit services for audit clients? No No The audit firm has non-audit services for audit clients. No The audit firm has non-audit services. No The audit firm has also non-audit services.

The implication of the auditor in non-audit services and the impact on its independence : evidence from Romania