Does client 'importance' affect audit partner independence?

Recognising the potential threat to auditor independence posed by important clients is crucial for maintaining public trust in financial reporting

Over the years, several high-profile incidents of independence breaches have drawn regulators' attention, raising important questions about audit quality. Most recently, PwC has come under fire after it was revealed that it profited from privileged information. The issue has sparked debate (and a police investigation) into conflicts of interest between auditors, accountants and consultants.

Auditor independence is a crucial foundation of ethical financial reporting, but how impartial are the consultancy firms working for some of the world's biggest companies?

Dr Jeff Coulton and Dr Sarowar Hossain, two Senior Lecturers in the School of Accounting, Auditing, and Taxation at the UNSW Business School, alongside their co-author Jenny Wang, a Senior Lecturer in the School of Business at the University of Wollongong, examine these concerns and the potential impact of 'important clients' on the independence of audit partners in their latest study. The paper, Client Importance and Audit Quality at the Individual Audit Partner, Office, and Firm Levels, explores the correlation between a client's importance and audit quality using audit fees and consulting fees paid as a proxy for the economic bond between client and auditor.

What is the role of an audit partner?

All Australian Stock Exchange (ASX) listed companies must provide audited financial statements. Auditors (consultancy companies like KPMG) assure users of the financial statements that the companies have followed accounting rules. However, the client companies pay the auditors, and, as Dr Coulton explains, there is a concern that if an auditor gets a lot of money from a client, they will allow 'worse' accounting by that client. An audit partner – a full partner at an accounting firm with a financial stake – plays a crucial role in the audit process. And while previous research has explored the impact of client importance on audit quality at the office and firm levels, little attention has been given to partner-level data.

Dr Coulton's and Dr Hossain’s study examines the concerns about independence. By focusing on the audit signing partner, the research provides unique insights for audit firms, stakeholders, and regulators. The signing partner holds the greatest responsibility for audit quality within the audit firm and is most susceptible to potential pressures that may compromise independence.

Dr Coulton explains: “This is an important contribution as the audit partner signing the audit report is the most responsible for the audit quality (from the audit firm end) and most susceptible to pressure to 'go easy' on the client firm's accounting decisions or choices.”

Unlike most prior research, the study also offers unique insights because it examines the actual audit fees the clients paid, which uses indirect measures like client firm size or revenues. “We focus on audit fees since the audit partner cannot undertake any non-audit work performed by the audit firm for that client and cannot be directly compensated for such non-audit work," says Dr Coulton.

And unlike in other countries – where the audit report contains only the audit firm's name and not the audit partner – in Australia, audit partners must sign off on financial reports. This unique feature can measure “client importance” at the audit partner level, the city audit office, and the national audit office levels. In most other countries, the audit firm's name is only on the audit report, not the audit partner.

Read more: Three ways data analytics will change the future of accounting

Does a client’s ‘importance’ influence an audit?

The study analyses financial statement and audit fee data from 2939 ASX-listed firms over the duration of 2003-2017 (totaling 29,000 observations, where each observation is a given client firm each year).

On average, the study doesn't find much proof that richer clients who pay more money for audits receive less strict audits. The researchers found that there were fewer signs of 'bad auditing' when dealing with these important clients. The worry was that auditors might take it easy on them, but the study didn't show higher levels of 'bad auditing' in those cases.

So according to the findings, audit quality actually increases with client importance, as measured by the proportion of audit fees compared to total audit fees received by the audit partner from all their clients, and higher non-audit service fees from a client do not compromise auditor independence.

“Our findings provide evidence to regulators, audit clients, and stakeholders that audit partners do not succumb to pressure from economically more important clients, as audit quality has a positive association with client importance," says Dr Coulton, who adds this is good news for all users of financial statements, investors, lenders, managers, regulators, and others. Such findings have important implications for practice, suggesting that disclosing engagement partners and non-audit service fees can help assess auditor-client economic bonds and their impact on financial reporting outcomes.

Ethics and integrity: the bedrock of accurate financial reporting

According to Dr Coulton, the results are consistent with what audit firms often claim, which is they spend a lot of time and money educating their staff on auditor independence and professional ethics issues. However, Dr Coulton acknowledges that measuring firms' audit or accounting quality is difficult; the study itself uses fairly 'noisy' measures of audit quality. This means that the study has some limitations, such as the potential for overstating client importance due to the lack of identification of private clients and the assumption of lower litigation risk in Australia compared to the US. 

To address this, Dr Coulton suggests future research could look at the audit team's actual working procedures and decision-making, but says this also requires access to data that is often very difficult to obtain.

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Overall, he says audit firms can take comfort from the study in that it shows audit partners are typically able to maintain professional independence even when a client is important to them in terms of the audit (and non-audit) fees paid. 

“This suggests that the ongoing training and professional education within audit firms is not completely misplaced,” he explains. “Audit clients can take comfort that users of their financial statements can have confidence that the auditors typically do a professional job, even though the client firms are the ones paying the auditors. The integrity of the financial reporting system is important.”