Dr Anthony Tyen Co ACCA Council Member International

Dr. Anthony Tyen & Co. ACCA Council Member

International Federation of Accountants Beijing 28 October 2009

SMPs Adapting to The Economic Turbulence and Laying Foundations For Sustainable Growth

Is Offering Non-Assurance Service to SMEs the Solution for SMPs?

SMPS SERVING THE MARKET • An SMP since 1985 • Presenting the views from both as an SMP as well as a “half”academic • SMPs are no different from any other businesses that serves to meet the needs of the market and their customers, but perhaps without all the necessary resources they wish to have • “Where is my competitive edge over my competitors for sustainable growth within the professional constraints? ”

PROVISION OF NAS TO SMEs • Resorted to literature on SMPs trying to draw ideas but the volume of literature on big firms in those days outnumbered considerably those on SMPs • Made enquiries and did surveys with SME audit clients, “What ELSE do you need from me? ” • Started to provide non-assurance (or non-audit) service (NAS) • Careful not to infringe professional code of ethics, providing non-recurring services (Parkash and Venable, 1993), and more transaction oriented (less decision-oriented) NAS (Cassar and Ittner, 2008)

SME NEEDS • My SMP focuses on SMEs. MNEs would not engage my SMP, and in any case, globally, SMEs account for 99% of business numbers and 40% to 50% of GDP • Trust is built between SMEs and SMPs through professional engagements • The needs of SMEs vary widely, but in economic turbulence, SME would be in more pressing need of trusted advisors, because small businesses are less likely to survive because their narrow resource base does not allow them to adapt its products or services

SMEs IN ECONOMIC TURBULENCE • Holmes et al (1991), for example, conjecture that small companies seek external support when a ‘crisis point’ is reached. The external accountant is a potential source of critical competencies for survival and development (Hillman and Dalziel, 2003; Westphal, 1999) • Carey and Tanewski (2009) argue that SMEs might engage their external accountant to provide advice which directly assists performance (e. g. , strategic advice on growing revenue)

AUDITOR INDEPENDENCE • However, SMEs, which typically do not have sufficient resources in-house and the required knowledge to operate and compete successfully, and benchmark their business performance with their rivals, are forced to engage other outside advisors, and may not be able to capitalise on the specific firm / client knowledge as rents accrued to the relationship and trusts already built with their auditor, merely because of independence issue, since that is THE concern of professional bodies and regulators in auditors providing NAS.

A CLOSER LOOK AT INDEPENDENCE (1) • Concern about independence issues – but is that an issue? • Literature review on independence • Impairment in the perception of independence is consistently found in the joint provision of audit and NAS with varying degrees depending on nature of NAS and audit team involvement, where non-auditors are more skeptical, and investors place less trust when more NAS was provided by auditor • BUT…

A CLOSER LOOK AT INDEPENDENCE (2) • There is no consistent conclusive evidence of any generalised link between NAS and quality of financial information (Ruddock et al, 2006, Kinney, 2004, Chung and Kallapur, 2003, Defond et al, 2002) • In some studies, investors were found to believe audits are better if auditors know more about a company when they provide NAS and audit quality might suffer when auditors are less knowledgeable about the client’s business (Penn, Schoen and Berland Associates, 2000) • The evolution of audit firms into consulting fields was logical and the provision of most consulting services are not likely to create real problem of independence (Kornish and Levine, 2000)

A CLOSER LOOK AT INDEPENDENCE (3) • Some found that the joint provision of audit and NAS has a positive effect on investors’ perceptions of auditor independence (Jenkins and Krawczyk, 2000) • In studies in New Zealand (Gul, 1991; 1989) and Malaysia (Gul and Yap, 1984), bankers and shareholders’ confidence increased with provision of NAS by auditors • Cultural differences were cited as explanation to different perceptions of auditor independence with auditor providing NAS (Agacer and Doupnik, 1991) • Experimental studies of actual independence show auditors behave more, not less, independently where joint provision of audit and NAS occur (e. g. Emby and Davidson, 1997)

A CLOSER LOOK AT INDEPENDENCE (4) • No effect was found of the auditor providing NAS on his/her propensity to issue (or not issue) a going-concern audit opinion for a financially distressed client (Geiger and Rama, 2003) • Audit effectiveness was found to actually improve via better risk assessments when an auditor provides both audit and NAS (Joe and Vandervelde, 2007) • NAS fee levels and restatement of financial statements, calling for the question of the audit quality of the original one, were found to be unrelated (Kinney et al, 2004; Raghunandan et al, 2003)

A CLOSER LOOK AT INDEPENDENCE (5) • What inference can be drawn from these studies? Brendon and Mueller (2009) sum it up nicely: • “The only apparent consistent effect of auditors providing (NAS) services is on perception, not reality” • “For private companies, it is ultimately the decision of the business and the auditor to enter into a relationship beyond the external audit function” • “Because the research clearly shows that the issue is of interest to key stakeholders of public companies, private companies should at least consider disclosing auditor-provided non-audit services to major stakeholders” • Independence is more a perception issue and may not be a real one

IFAC CODE OF ETHICS (1) • IFAC Code of Ethics for Professional Accountants (“the IFAC Code”, revised July 2009) provides a conceptual framework that requires a professional accountant to identify, evaluate and address threats to compliance with fundamental principles in providing NAS, which are independence oriented • Safeguards include, inter alia, using a partner or senior staff member with appropriate expertise who is not a member of the audit team • However, providing NAS to audit clients that are not public interest entities, or SMEs, could still be difficult for sole or “extra small” practitioners, since they do not have the privilege of such partner or senior staff member

IFAC CODE OF ETHICS (2) • Paragraph 100. 7 of the IFAC Code “Conceptual framework approach” provides that “In making that determination (whether appropriate safeguards are available and can be applied to eliminate threats or reduce them to an acceptable level), the professional accountant shall exercise professional judgment and take into account whether a reasonable and informed third party … would be likely to conclude that the threats would be eliminated or reduced to an acceptable level by the application of the safeguards such that compliance with the fundamental principles is not compromised” • However, it seems there is no proper communication platform within the IFAC Code for the professional accountant to “inform” the third party

ETHICAL STANDARD, APB • Ethical Standard (ES) Provisions Available for Small Entities (PASE) issued by the Auditing Practices Board (APB) in the United Kingdom offer such a platform • It provides exemptions where the audit firm is not required to adhere to the prohibitions in APB ES 5 (which discusses independence issues with those charged with governance, confirming management accepts related responsibilities; and discloses this fact and the type of NAS) • Where the audit firm is taking advantage of such exemption, the audit engagement partner shall “ensure that the auditors’ report discloses this fact, and … discloses the type of non-audit services provided to the audited entity” (paragraph 22) • Communication through the audit report to mitigate the issue of perception of independence

NAS IN IFAC CODE OF ETHICS • List of NAS as discussed in the IFAC Code • Preparing Accounting Records and Financial Statements • Valuation Services • Taxation Services • Internal Audit Services • IT Systems Services • Litigation Support Services • Legal Services • Recruiting Services • Corporate Finance Services • The Comfort Zone

CHALLENGE FOR THE SMP ARE WE PREPARED TO GO BEYOND THE COMFORT ZONE?

HOW TO ENHANCE COMPETENCE? • In times of economic turbulence, SMEs may demand auditors of their competencies for survival and development and strategic advice on growing revenue, which may not be within their comfort zone • Expectation gap is a main area identified in SMPs providing services to clients (e. g. Ciccotosto et al, 2008; Kirby et al, 1998; Kirby and King, 1997) • How should auditors enhance their competence beyond the comfort zone in providing NAS to meet the expectation of SMEs?

BEYOND THE TECHNICAL CPD • Being a professional accountant does not necessarily make one proficient in serving the needs of SMEs • Anecdotal evidence seems to suggest the following: • Consulting skills • General management knowledge • Economics • Marketing • Psychology • Professional accountants should broaden their knowledge base beyond the technical CPD for accountants

SO, IS OFFERING NAS TO SMEs A SOLUTION? • There is a genuine demand for NAS by SMEs of SMPs through the trust built in the professional engagement • While an audit is an audit, it should be acknowledged that independence is more a perception issue rather than a real issue • Offering NAS to SMEs could be a solution if those requirements that the sole or “extra small” practitioners might not be able to meet are relaxed, provided that the auditor is allowed to communicate with stakeholders through the audit report that would serve to mitigate the issue of perception of independence • Small and medium practices shall have to enhance their competencies by going beyond their comfort zone in fulfilling the expectation and needs of SMEs

SUSTAINABILITY OF THE PROFESSION • In December 2007 IFAC published a report called “Regulation of the Accountancy Profession”: “… the sustainability of the accountancy profession depends upon the quality of the services provided by its members and on the profession’s capacity to respond effectively and efficiently to the demands of the economy and society”

THE IFAC SMP COMMITTEE • More specifically for SMPs, “The SMP Committee considers that SMPs, through their provision of a range of high quality professional services, play a key role in the health and prosperity of SMEs. The committee believes this role needs to be publicly promoted and, furthermore, that its activities should increasingly focus on raising awareness as to how SMPs can better support SMEs. ” IFAC SMP committee meeting in Berlin, January 2009 • BUT…

THE STRINGENT RESTRICTIONS… “In earlier books I chronicled how I managed to build a profitable and quality practice that provided excellent service and counsel to many smaller business clients. Perhaps my success was due in great part to my lack of a certified public accountant (CPA) certificate. I had opted to forgo the examination despite possessing all of the prerequisite educational course requirements. The stringent restrictions placed on the profession … would have prevented me from serving the small and medium-sized market niches in the way I had chosen I knew to be most effective. ” Jack Fox “Building a Profitable Online Accounting Practice” John Wiley & Sons, 2001

FLEXIBLE AND OPEN TO INNOVATION “I firmly believe that the future of our profession depends on all of us being flexible and open to innovation” Fermin del Valle (now ex-President) in his message in the 2008 annual report