CHAPTER ONE: INTRODUCTION

This chapter gives a brief background of the study area, the research problem and the main purpose of the research that summarizes what the research project wants to achieve. In addition, it covers the significance, limitation and delimitation of the study, the definition of some relevant concepts and the methodology of the study, which is the approach that has been chosen for the study.

1.1. Background of the study

One of the distinguishing marks of a profession is that its members in recognition of their responsibility to the public and others impose on themselves codes of professional ethics and are careful to establish means for observance of ethical rules. (Thomas and Henke, 1983) Larsen (1977) identifies characteristics of professions which includes; a body of knowledge and techniques which professionals apply in their work, training to master knowledge, service orientation, distinctive ethics which justifies the self regulation granted by society and autonomy and prestige. Generally, a profession can safely be characterized by the following elements; specialized body of knowledge, standard of qualification for admission, standard of conduct of behavior, level of status recognition and acceptance of social responsibility and legal liability. (Johannes and Engida, 2009) Supporting this, Meigs et al. (1989) say, all recognized professions have developed codes of professional ethics. The fundamental purpose of such codes is to provide members with guidelines for maintaining a professional attitude and conducting themselves in a manner that will enhance the professional stature of the discipline. (Meigs, Whittington, Pany and Meigs, 1989) Hall and Singleton (2005) have defined ethics as it pertains to the principles of conduct that individuals use in making choices and guiding their behavior in situations that involve the concepts of right and wrong. Ethics are rules designed to maintain a profession on a dignified level, to guide members in their relations with each other and to assure the public that the profession will maintain a

high level of performance. Ethics are derived from fundamental values, many of which are held in common by all professions. (Carmichael and Willingham, 1989) The increased interest for ethics in businesses today is highly dependent on the corporate scandals. Ethics deals with issues such as what individuals are confronted with in their decision- making (Collste, 1996). Ethics is also the study of morality in order to explain specific rules and principles that determine right and wrong for any given situation. Morality is more concerned with norms, values and beliefs that are part of a social process, which define right and wrong. Morality in a sense precedes ethics and both individuals and organizations possess morality to a certain point (Crane & Matten, 2004). According to Harris et.al (2005) professional ethics is the set of standards adopted by professionals insofar as they see themselves acting as professionals. The purpose of these ethical standards is to ensure adherence to moral behavior by the members of the profession to the benefit of the clients and the society which they serve. Accountants and auditors who are members of accountancy bodies are generally subject to a code of ethics, which is enforced by the professional body of which they are members. Members of the public rely on accounting professionals for sound financial reporting and advice and on auditing professionals to enhance the credibility of financial information. It is in the best interest of the accounting and auditing professions that those to whom they provide services trust that these services are executed at the highest level of performance and according to the ethical requirements described in the code of professional ethics that strive to ensure such performance. (Rossouw et al, 2009)

1.2 Statement of the problem

Ethical conduct by members of professions is highly valued in most society. Codes of conduct, codes of ethics and canons of law provide ample evidence of these values, even without such codes and canons professionals should feel a strong obligation to act ethically because it is in the best interests of both themselves and society. However, many observers of the contemporary scene (event) are disturbed by what is seen as an increasing trend toward unethical behavior in society or at the least a pronounced increase in the impact that unethical behavior has on daily living. (Taylor and Glezen, 1994) There is a great reliance of public trust on audited financial statements and accounting reports as they constitute the bedrock of the financial markets. This means that the auditors at all times must be objective in performing their duties. The independence of an auditor demonstrates objectivity and builds the trust of those who depend on their services. Since independence is of great relevance to the auditing profession, the rules related to it must remain relevant, effective and fair in any business environment (Eilifsen et al., 2006, p.577). The most recent financial scandals and audit failures of Enron and WorldCom just to mention a few, has left the business community skeptical about the auditor independence. These scandals have brought up a lot of attention in media. These scandals have indicated the lack of ethics at the executive levels. Audit failure has meant that the accounting profession is confronted with the crisis of confidence and credibility. Criticism of the profession is widespread and harsh in the changing economic, social and regulatory climate in which the profession at present functions. (Hemraj, 1990) Audit failure range from allegations of technical incompetence(often due to cost cutting and inadequately trained staff) and lack of diligence in getting beyond the paper figures to the underlying economic realities, to charges of illegality and deception that amount to gross immorality, in particular where the failure to conduct a proper audit is attributed to a conflict of interest. Auditors do their job in a way that secures their personal careers, their continuing contracts as auditors or promotes the other business interests of their firm rather than a way that fulfills their legal and moral professional obligation to shareholders and other stakeholders.

The fundamental ethical issue in auditing is that there is a business interest on the part of auditors to collude with the auditee who is the source of the fees from which they derive their income. (Campbell, 2005) An auditor who receives payment for non-audit services from his client raises a potential for conflict. Performing other professional services in addition to audit, or entering into business relationships with clients might jeopardize auditors independence. John Spence (2005) articulated that, firms may be taken to another ethical dilemma that is said to be endemic in auditing. This arises when pressure is brought to bear on the auditor not to draw attention to irregularities or problems that have emerged in the course of the audit, pressure that is often related to a real or perceived threat to the future commercial relationship between the auditee and the auditor. This is a manifestation of what is a straight conflict of interest at the core of the standard auditee/auditor relationship that the auditor is financially dependent on the auditee. Another ethical problem which is affirmed by Meigs et al. is the nature of auditors work makes it necessary for them to have access to their clients most confidential information. Of course, the client would be financially injured, as well as embarrassed, if the auditor were to leak (divulge) such information. (Meigs, Whittington, Pany and Meigs, 1989) Several other studies have been conducted within the field of ethical behavior of auditors in general and the auditors independence in particular. Nevertheless, there are few studies undertaken in this area in an Ethiopian context. Hence, This research attempted to fill the gap and proposes to investigate and analyze the ethical behavior of audit firms with a special emphasis on their independence in relation to compatibility and non-compatibility of services provided by them and the tenure which they have with their client.

1.3 Purpose and Objective of the study

The general intent of the study was to investigate the ethical behavior of audit firms in some selected places in Ethiopia, particularly those working in Addis Ababa. The specific objectives of this study were: To identify the audit firms ethical behavior that impairs their professional independence in relation to the compatibility and non- compatibility of services. To identify audit firms behavior of independence in relation the tenure which the audit firms have with their clients.

Hence, having the above objective(s) this project paper was designed to answer the following basic questions: o To what extent the provision of incompatible services affect audit firms independence? o To what extent the provision of incompatible services affect other audit firms independence? o What are the ethical dilemmas in relation to non-audit services? o To what extent long association of audit firm with its client affect their independence? o Is there a cutoff date for long association between the audit firm and its clients?

1.4. Scope and Limitation of the study

This study was confined within the realm of identifying the major ethical behavior of audit firms in relation to their independence in Ethiopia particularly, those audit firms working in the metropolis, Addis Ababa.

According to Lemma and Assefa, in Ethiopia, although it is believed that external audits are carried out on the basis of Generally Accepted Auditing Standards, there is no nationally promulgated standard to be followed by all auditors in the country and in all sectors. (Lemma and Assefa, 1994) Therefore, the study was depend on those auditing standards promulgated by American Institute of Certified Public Accountant (AICPA) namely, Generally Accepted Auditing Standards (GAAS), International Federation of Accountants (IFRS) code of ethics and International Standards of Auditing (ISA) which is issued by IFAC through the International Auditing and Assurance Standards Board (IAASB). There are many factors that affect audit firms independence from their client. They include: Financial interest in the audit client Close business relationship with audit client Family and personal relationship with senior management of audit client A partner in the audit firm serves as a director on the board of client Loans and guarantees provided to or obtained from the audit client Non- audit services Tenure etc. Due to shortage of time, resource and vastness of each factor the study was limited to assessing two factors which affect audit firms independence i.e. compatibility and non-compatibility of services and tenure. Moreover, this study was conducted to assess the effect of non audit services and audit tenure on the independence of audit firms from the audit firms perspective. The research project couldnt see it from audit clients viewpoint and I hope this will be another research area for those who are willing to do.

Some of the challenges that the researcher faced to conduct the study was thoroughly lack of time and shortage of resources. Difficulties in gathering data happened due to confidentiality and generally unwillingness of the target auditors to provide the necessary data.

1.5. Significance of the study

Users of financial statements of an entity mostly depend on audited financial statements. During conducting an audit auditors should behave in an ethical manner, and should follow auditing standards formulated by international organization as well as local government regulations. Hence, the study tried to explain the ethical behavior of audit firms with special reference of independence in relation to the compatibility and non- compatibility of services and the tenure which the audit firms have with their clients in Ethiopia. Consequently, this study was significant for the following major reasons; the findings of the study may create awareness on audit firms ethical behavior when they engage in audit work among stakeholders, since they are both influenced by and have the ability to affect businesses, it may help all concerned bodies in addressing some of the problems related to ethical conducts of the audit firms; and the findings of the study may help as a basis of future reference for further research and discussions.

1.6. Theoretical framework

Various theories have been established with regard to the audit firms independence in relation to incompatible services and audit tenure. Theories in relation to audit firms independence were presented first followed by theories concerning non audit services and audit tenure.

1.6.1 Auditors independence

The development of auditing as a profession is closely tied with the importance of independence in audit. Independence is the cornerstone to professional audit. (Johannes and Engida, 2009)

The above idea is strengthened by John Carey as, independence is fundamental to the reliability of auditors reports. Those reports would not be credible, and investors and creditors would have little confidence in them, if auditors were not independent both in fact and appearance. (Carey, 1970) Burger considers independence to be a crucial concept that sets auditors a part from the accountancy profession, as their core mission is to certify the public reports that describe companies financial status- an exclusive function performed by auditors for society. (Burger, 1990) Auditors independence could be impaired by having direct or material indirect financial interest in the client. (Taylor and Glezen, 1994) In so far as the role of auditor is potentially in conflict with the role of financial adviser when the same person performs both roles for a client, there is a conflict of interest. Thus, we have conflicts of interest in accounting firms that perform audits for the companies for which they also provide lucrative financial consultancy and other financial management services. Here the latter role has a tendency to curtail or diminish the auditors independence, and can thus potentially interfere with the proper exercise of an auditors fiduciary duty of ensuring that a companys financial statements present a true and fair view of the companys operations.(Spence,2005) The potential influence of non-audit services sometimes called management advisory services (MAS) on auditor objectivity has long been an area of concern. That concern has been compounded in recent years by significant increases in the scope and amounts of non-audit services provided by audit firms. These services may cause an auditor consciously or subconsciously to subordinate his or her judgment to a clients desires. Also, as non-audit services have grown, concern has been expressed that management of audit firms may have tended to focus more on them than on auditing. The other factor which may affect independence is rotation of auditors. According to Hemraj rotation is favored because of the belief that it will avoid the auditors becoming, or to be perceived to have become stale or to be suffering from some other incapacity affecting independence. (Hemraj, 2002)

The justification for rotation is that involvement with the same client over a long period of time could result in a lack of objectivity and detraction from the regular and robust consideration of issues connected with the audit. Rotation of audit partner gives the client a fresh, objective scrutiny and new ideas without losing the benefit the knowledge of the business that the firm has already acquired. Therefore, the theory suggests that non-audit services and rotation of auditors have an effect on the auditors independence in their audit work.

1.6.2 Auditing standards

Standards are authoritative rules for measuring the quality of performance. (Meigs, Whittington, Pany and Meigs, 1989) The standards of a profession, such as the auditing profession, include both technical standards of competence and ethical standards. Ethical standards are often presented in a code of professional ethics that are aimed for both self-regulation and also the professions commitment to the public. A code of ethics is not an option for a professional; rather it is required by the profession (Boatright, 1999). It is stated that a code of ethics is a crucial element in forming a profession and truly ethical professionals will keep their behavior well above the minimum requirements. Moreover, no code of conduct will be effective if members of a profession are personally of low character and lack integrity (Smith et al., 2005) The existence of generally accepted auditing standards is evidence that auditors are much concerned with the maintenance of a uniformly high quality of audit work by all independent public accountants. If every certified public accountant has adequate technical training and performs audits with skill care and professional judgment, the prestige of the profession will rise, and the public will attribute more and significance to the auditors opinion attached to financial statements. (Meigs, Whittington, Pany and Meigs, 1989) The ten standards set forth by the American Institute of Certified Public Accountant(AICPA) include training and proficiency, independence, due professional care, adequate planning and supervision, sufficient understanding of internal control, sufficient competent evidential matter, conformity with

GAAP, consistency in the application of GAAP, adequate informative disclosure and the auditors opinion as a whole. Most professional bodies in the field of accounting and auditing are members of the International Federation of Accountants (IFAC). The professional bodies therefore typically use IFACs code of ethics as the point of departure in determining their own codes of professional ethics, and then added additional sections to deal with local matters affecting the particular members of the professional bodies and, if considered necessary, to amplify certain sections of the IFAC code of ethics. In order to achieve the objectives of the accounting profession, the following fundamental principles are identified in the IFAC code of ethics; integrity, objectivity, professional competence and due care, confidentiality and professional behavior.

1.7. Research Methodology

Research Design The study employed both qualitative and quantitative methods. Qualitative method occurs in natural settings where human behavior and events occur. The idea behind it is to purposefully select participants or sites that will best help the researcher to understand the problem and research question. A discussion about participants and site might include four aspects identified by Miles and Huberman: the setting (where the research will take place), the actors (who will be observed or interviewed), the events (what the actors will be observed or interviewed doing), and the process (the evolving nature of events undertaken by the actors within the setting). (Miles and Huberman, 1994) Various theories supported that the provision of incompatible services will affect the independence of audit firms. Moreover, some theories asserted that, long association of audit firms with their client has a negative effect on the audit firms professional independence Hence, the study tried to identify audit firms independence in relation to non- audit services and tenure in Addis Ababa in terms of the percentage of audit and non-audit fees as compared to the total income earned by the audit firms; and for how long the audit firms have been conducted audit services on one audit client.

The most common quantitative method for collecting data is the survey method. The rationale for using this method is to generalize from a sample to a population so that inferences can be made about the behavior of this population. The survey method is selected as a preferred type of data collection procedure because of the economy of the design and the rapid turnaround in data collection. The survey was cross-sectional approach, with data collected at one point in time during the study period.

Data Collection It is obvious that the method of data collection is tremendously dependent on the character, type and nature of the problem. Thus, data were collected using self-administered questionnaire, which the respondents complete the questions themselves. Face to face Interviews were conducted with some audit firm managers. Interview is selected as a tool for data collection because the interviewees can provide historical information relating to the problem and it allows the researcher control over the line of questioning. These interviews was structured and generally open ended questions intended to elicit views and opinions from the audit firms about the effect of non audit services and audit tenure on audit firms independence. The data collection, either through questionnaire or interview, focused on the percentage of audit and non-audit fees, which are charged by the audit firms from their clients and for how long the audit firms have been conducted audit services on one audit client. Secondary materials, which are internet and written documents prepared on the area of the problem, have been consulted.

Sampling Method The population that the study focused on is audit firms, which work in Addis Ababa. At present, there are 62 licensed audit firms and 500 authorized accountants in Ethiopia. (Johannes and Engida, 2009) The sampling design for this population was single stage sampling in which the researcher can sample the audit firms directly. Random sampling, in which each audit firms in the population has equal

probability of being selected, was employed as a selection process for the study. I have taken 13 audit firms from the population of the licensed audit firms working in Addis Ababa.

Data Analysis Data, which were collected in relation to ethics in the auditing profession in Ethiopia in general and the independence of audit firms with respect to compatibility of services and audit tenure in particular using questionnaires and interviews, were analyzed using descriptive method of analysis. To support and strengthen the analysis tables and percentages were part of the study.

1.8. Definition of Key Terms

Audit firm: a sole practitioner or partnership of professional accountants; an entity that control such parties; and an entity controlled by such parties. (OFAG, 2009) External auditor: A professional accountant conducting auditing and related services to the entity but not employed by the entity or by its manager and is independent of the persons who manage the entity. (OFAG, 2009) Audit client (auditee): an entity in respect of which a professional accountant conducts an audit engagement Ethics: is the study of standards of conduct and moral judgment. Independence: implies impartiality and freedom from or rejection of improper influences in conducting the work and in reaching judgments and conclusions. (OFAG, 2009) Audit tenure: the length of time which the audit firm has been filing the audit needs of a given client.

Non audit services: are services other than audit work like consultation and advice on various matters.

1.9. Organization of the Paper

The research paper has four chapters. Chapter one presents the introduction part containing statements of the problem, purpose, significance, scope and limitations of the study as well as research methodology. Chapter two presents a critical review of the related literature with various arguments made by previous researchers. Chapter four contains the data analysis and presentation. The paper ends with summaries, conclusion that summarizes the main results of the study and gives some recommendations in the fourth chapter.

CHAPTER TWO: REVIEW OF RELATED LITERATURE

This chapter dwells on previous or existing literature related to the area under study and tries to relate these existing literatures to this study. The main essence of this chapter is to enable us get a grasp of what is already known within our area of study such that we can maintain the originality of this study. It is focused mainly on the researches and arguments made on the compatibility and non-compatibility of services given by audit firms and the number of consecutive years that the audit firm has audited the client on their effect on the audit firms independence. It constitutes ethics in the auditing profession in general, auditors independence, prior studies on the research area, and finally auditors independence in Ethiopia.

2.1. Ethics in the auditing profession

Ethics is the study of standards of conduct and moral judgment. General ethics comprises a code of principles (written and unwritten) about what is right and what is wrong, which is aimed at clarifying the kind of conduct necessary to promote human welfare (Powers and Vogel, 1980). As occupational groups aspire to professional status, they have historically made the development of a code of ethics one of their foremost concerns, testifying to the public that their obligation to the society transcends economic self-interest (Smith and Brain, 1990) Professional ethics is also concerned with moral behavior, but is more restrictive in the sense that it encompasses the expected ethical pattern unique to a certain profession. Furthermore, as the circumstances of professional practice change, the specific responsibilities of the practitioner change as well. As a result, some principles take on a new meaning or importance whereas some others decline in importance. However, the purpose of a profession remains unchanged and it acts as a normative filter. (Powers and Vogel, 1980) The adoption of a code of ethics is an important milestone in the professionalization of any occupation. To obtain professional recognition, many occupations quickly adopt some type of formal code of ethics. The mere adoption of such a code is not enough, however. The individuals involved in the practice of the profession must actually guide their actions by both the prescriptions and proscriptions (prohibitions) of such a code. By embracing and living by their code, they enhance the respect that others hold both for them and for their profession. Professions generally are granted a great deal of autonomy. With such autonomy, professions are expected to regulate themselves. Failure of a profession to regulate and discipline its members may result in that profession losing some or all of its autonomy. At the heart of professional selfdiscipline is a code of ethics. The code defines acceptable and unacceptable professional behavior. Additionally, the code enhances the image of a profession in the eyes of a society by attracting the confidence of the public it seeks to serve. (Hermanson et al, 1989) Ethics in auditing is a subclass of a professional ethics which is also normative in nature. It can be defined as the study of those decisions of auditors, which involve moral values, and actions, which might differentially affect various parties such as clients, competitors, colleagues, members of the community or the broader society. (Gandz and Hayes, 1988)

2.2. Auditors independence

There is no precise definition for the term "auditor independence" (Antle, 1984). It has been viewed as a personal trait encompassing objectivity and impartiality. As such, it is neither directly observable nor readily assessable. Another view focuses on appearances, i.e., observable actions, events, and structures that are presumed to be related to objectivity and impartiality. These observable phenomena can arise ex ante or ex post to the audit process. Ex ante, they suggest a causal relation between the observation and the independence state that ensues; ex post, they imply an evidence relation between the observation and independent state that occurred. (Parkash and Venable, 1993) Independence is traditionally regarded as being one of the fundamental principles underlying the auditor's work. It is held that if an auditor is not truly independent then his opinion on a company's financial statements will be of no value. This, in turn, will mean that users will have less confidence in financial statements. (Firth, 1980) Auditor independence is often defined as the probability that the auditor will report a discovered breach in the financial reports (Watts and Zimmerman [1983, 1986]).This suggests that auditor independence is synonymous with auditor objectivity and the ability to withstand client pressure to acquiesce to substandard reporting. Generally, independence can be of two forms, independence of mind and independence in appearance. The former, requires the auditor to have a state of mind that permits the provision of an opinion without being affected by influences that compromise professional judgment allowing an individual to act with integrity and exercise objectivity and professional skepticism (Hayes et al., 2004, p.85). While independence in appearance requires the auditor to avoid situations that will cause others to conclude that they are not maintaining an unbiased objective attitude of mind (Porter et al., 2003 cited in Nasser et al., 2006, p.724). Therefore, the auditor is charged with the responsibility of carrying out a personal assessment to verify if independence risk can be accepted or not. It is only after the auditor must have identified, analyzed, evaluated and then apply appropriate safeguards to ensure that independence risk is brought to a minimal level before a job

can be accepted. If such a task is not performed, then independence is at risk so too is objectivity, thus, the assurance engagement must be terminated. The threats to independence are often very significant and thus undermine the auditors effectiveness in rendering the auditing services. It becomes even more challenging when the auditor over-stays with a client, these threats may sneak in very gradually over time which in turn, can affect independence. Auditor independence has been the subject of considerable debate for some time, and it has been examined from the perspectives of both non-audit fees and auditor tenure. The existing studies on the association between non-audit fees and auditor independence have evaluated whether higher non-audit fees create an economic bond between the auditor and the client, which enables the client firm to exert influence over the auditors decisions and make auditors less independent as non-audit fees increase. (Gul et al., 2007)

2.3. Prior research on auditors independence and non- audit services

The provision of non audit services (NAS) by auditors especially when they are incumbents has been a hotly debated issue among policy makers, practitioners, academics and researchers (Beattie et al., 1999, p.71). It has been a common practice for auditors to perform NAS to their clients. As the audit tenure extends, the auditors stand a greater chance of earning more NAS because of increased knowledge of the clients business operations which eventually result to knowledge spillover (Beattie et al., 1999, p.71). The issue that comes to mind is whether there is or are there threats to auditor independence when they perform these services. Some proponents dispute the claim that auditor independence can be subconsciously impaired when they provide NAS as a result of a conflict of interest as most of the NAS are management related. Since most of these NAS are management related, the management will feel more comfortable letting an extended tenured auditor to undertake the tasks rather than are short tenured auditor. This is because they think they now know the auditors better and can trust them to come to their aid when they need them.

Mautz and Sharaf (1961, p.277) propose that small firms should be prohibited from providing NAS on the assumption that fees gained from these services constitute a major source of revenue for the small firms and are more than the audit fee. This will now require that each small firm choose whether to perform NAS or carry out only an audit. Having specialized teams within the audit firm of the auditors that provide various services could be a welcome relief to independence but it may be very challenging to the independence of an audit firm that has an extended tenure. It is thought that there is a tendency for the specialized teams for NAS and those for auditing services at some point in time to collude as they both are employees of the same auditor. This collusion puts the independence of the auditors with extended audit tenures into question. To further strengthen the above literatures, the International Federation of Accountants (IFAC) Code outlines some non-audit services that auditors cannot provide to their clients. These services include: Management level decision making functions that may involve authorizing or exercising authority on behalf of the assurance client, determining which recommendations should be considered and reporting in a management role to those charged with governance. Bookkeeping services which include preparation of financial statements, payroll services, and entries recording services in the books of accounts. Corporate financial and other similar service like underwriting of a clients shares, consummate a transaction on behalf of the client, promoting or dealing in a clients share and committing a client to the terms of a transaction. Litigation support services. That is at no point should the auditor act as an advocate for the client as this will deeply jeopardize their independence.

Given the shift in revenue streams of public accounting firms, it is important to discuss the services that audit firms provide. An accountant becomes a Certified Public Accountant (CPA) to engage in attestation services, that is, conduct audits. Only a licensed CPA can sign the audit report. Being a

CPA is also associated with providing tax services although a tax preparer, unlike an auditor, does not have to hold a permit to practice public accounting. As the demand for business expert services grew over the late 20th century, public accounting firms expanded the scope of their services to include corporate and individual tax planning, internal audit outsourcing, and consulting related to mergers and acquisitions, information systems, and human resources. Over the last decade the proportion of revenue of large public accounting firms derived from providing non-audit services grew from 12% to 32% (Public Oversight Board, 2000), suggesting that the economic bond between auditors and their clients strengthened over this time as auditors delivered more consulting-oriented services to their audit clients. Over the last 40 plus years, numerous committees, boards, and professional bodies have studied and commented on the risks associated with auditors providing non-audit services to their audit clients. For example, in 1961, Mautz and Sharaf issued a study titled The Philosophy of Auditing (American Accounting Association, 1961) that claimed that the provision of consulting and tax services impaired the appearance of auditor independence. The first wave of academic research on the effect of non-audit services on auditor independence began in 1978, when non-audit fee data became publicly available due to a change in SEC (Security and Exchange Commission) reporting requirements. In 1978, the SEC required publicly traded firms to disclosure in their annual proxy statements the fees for all non-audit services as a percentage of total fees paid to the auditor and whether the audit committee or board had approved the services and considered the possible effects on independence (Securities and Exchange Commission, 1978). Evidences and arguments opposing the provision of MAS (Management Advisory Services) to audit clients are more common. Schulte [1965, p. 593] lists four arguments which are representative. First, CPAs providing consulting services may become advocates of the client, making it difficult to remain truly independent. Second, the audit firm may develop a stake in the client, for its prestige as a successful adviser depends upon the client's success. Third, consultants may, in effect, become decision makers, thus placing the audit firm in the position of auditing its own decisions. Finally, CPAs may develop too close a relationship with management during an MAS engagement. In addition, Hartley and Ross suggest that an audit firm's financial dependence on a client may increase as the size of the MAS fee increases [1972, p. 44]. Research findings

supporting such negative relations between MAS and independence have been reported by Schulte [1965, p. 590], Briloff [1966, p. 492], Titard [1971, p. 51], and Hartley and Ross [1972, p. 44]. Beck et al. (1988) investigate the independence issue by investigating the audit firm tenure distribution for engagements in which recurring versus nonrecurring non-audit services are performed. They report that audit tenure for companies with high recurring non-audit services is greater on average, and with smaller variance, than the audit tenure of companies with low recurring non-audit services. Thus, the results of the Beck et al. (1988) study suggest that the provision of non-audit services does increase the economic bond between auditors and their clients. Other research also suggests that the joint provision of audit and non-audit services gives rise to economic rents, which create incentives for audit firms to compromise their objectivity, e.g., waive audit adjustments, to retain audit clients (Palmrose 1986) The effect of the joint provision of audit and other services on returns to auditors has been modeled analytically by Simunic (1984) and Beck et al. (1988a). An important implication of their models is the potential for increased efficiency and lower client fees resulting from knowledge spillovers associated with the joint provision of audit and other services. Simunic interprets the impact of this on auditor independence in the following way: . . . while efficiencies from joint production may exist, this does not imply that joint performance of MAS and auditing is necessarily desirable. Efficiencies can be partially appropriated as rents to the CPA firm supplier, and hence can themselves create a threat to independence. The degree of competition among CPA firms is therefore a critical factor in the problem. (Simunic, 1984)

In contrast, Davis, et al. (1993), was studying audit data from one large public accounting firm, report that firms purchasing non-audit services pay higher audit fees than firms not purchasing non-audit services from their auditors. Nevertheless, they also report that the higher fees are associated with a proportional increase in audit effort, suggesting that the performance of non-audit services for audit clients does not result in incentives for auditors to compromise their objectivity.

Parkash and Venable (1993) and Firth (1997) study firms' incentives to limit the purchase of nonaudit services from their auditors. Overall, the results of this study suggest that auditees recognize the potential for perceptions of independence impairment and voluntarily manage the amount of recurring nonaudit services that are purchased from their auditor. These results also support the implications of knowledge spillover from the Beck et al. (1988a) model of the market for joint audit and nonaudit services. Firth (1997), using public disclosures of UK firms' auditor related fees, also reports significant associations between UK companies' director shareholdings, large shareholders, financial distress measures and the relative non-audit services provided by the UK companies' auditor. The second wave of academic research investigating whether the provision of non-audit services is associated with auditor independence violations commenced in 2001 when audit and non-audit fee disclosures became available as a result of the SEC requiring publicly traded firms to disclose in their annual proxy statements the fees paid to auditors (Security and Exchange Commission (SEC), 2000). One of the first papers that used the new fee disclosures was Frankel, et al. (2002). Frankel et al. (2002) use the association between audit firm fees and two measures of biased financial reporting -firms' discretionary accruals and the likelihood of firms meeting earnings benchmarks to draw inferences on auditor independence. They suggest that their results provide evidence that firms that pay high non audit fees relative to total fees engage in biased financial reporting and thus, auditor independence is compromised when clients purchase a large proportion of non-audit services from their auditors. In contrast, the results of Ashbaugh et al. (2003) indicate that the Frankel et al. (2002) results are sensitive to research design choices, and find no systematic evidence supporting the claim that auditors violate their independence as a result of clients purchasing relatively more non-audit services. The conclusions drawn by Ashbaugh et al. (2003) are further supported by evidence presented in Chung and Kallapur (2003), who report no statistically significant association between abnormal accruals, i.e., their measure of biased financial reporting, and the ratio of client fees to total audit firm fees, which proxies for client importance. In general, the working papers circulating in academic circles which address the association between biased financial reporting and the provision of non-audit services (e.g., Larcker and Richardson, 2003) support the

conclusions drawn by Ashbaugh et al. (2003) and Chung and Kallapur (2003) that the provision of non-audit services does not impair auditor independence. The recent studies noted above specifically looked to measures of biased financial reporting as evidence of auditor independence violations. There are other studies that use the frequency of modified audit opinions (e.g., DeFond et al. 2002) or the frequency of financial restatements (e.g., Raghunandan, et al., 2003) to investigate whether the provision of non audit services impair auditor independence. In general, the results of these studies also find no evidence that the provision of non-audit services impair auditor independence. As providing non-audit services (NAS) could greatly affect independence since it is a source for threats to independence, the audit tenure could also be as controversial as NAS. It is probable that auditors with an extended tenure will provide more NAS than auditors with a short tenure because of the knowledge about the clients business operations they are able to accumulate over time with their extended tenures. Therefore, it is imperative to shade some light on what is thought about audit tenure.

2.4. Auditors Tenure

An audit firms tenure, the length of time it has been filing the audit needs of a given client has been cited as having an impact on the risk of a loss of independence:
Long association between a corporation and an accounting firm may lead to such close identification of the accounting firm with the interests of its client's management that truly independent action by the accounting firm becomes difficult [U.S. Senate, 1976, p. 211. In a great many ... cases, however, the greatest threat to [the auditor's] independence is a slow, gradual, almost casual erosion of his "honest disinterestedness" [Mautz & Sharaf, 1961, p. 208].

Extended audit tenures have received much criticism from regulatory bodies, congressional bodies, academics and the press (Gul et al., 2007, p.120). This is because most proponents against long (extended in our case) tenure like the regulatory bodies believe that the auditor independence will be impaired and hence the audit quality. They are of the opinion that when the auditors have

extended audit tenures, there is the tendency for the auditors to gradually align themselves with the wishes of the management and hence cease to be independent (Geiger & Raghunandan, 2002, p.67). Mautz and Sharaf (1961, p.208) also acknowledge that extended associations with the same client can lead to problems with independence though such associations in themselves are not detrimental. Simply put, not all extended associations with a client can impair independence so long as the auditor remain as an advising arm to management and not join them to perform their tasks. Another aspect been denounced is that the work of the auditor becomes increasingly routine when they have an extended audit tenure (Arruada & Paz-Ares, 1997, p.45). Extended audit tenures make the audit work to become routine which affects the competence of the auditor. This is because working with the same client for a long period will increase the auditor reliance on previous years work thereby resulting to a repetition of the previous years audits without any fresh perspectives. But in a case where the auditors are required to be rotated, implying an elimination of extended audit tenures and thus shorter tenures, the auditors bring fresh views requiring an in-depth review of the previous years audit work (Arruada & Paz-Ares, 1997, p.46). Complacency, lack of innovation, less rigorous audit procedures, and a learned confidence in the client may arise after long association with a client. The Metcalf subcommittee's staff considered this danger serious enough to recommend mandatory rotation of auditors as a possible remedy [U.S. Senate, 1976, p. 211.] Mandatory rotation implies that an explicit limit is placed on the time during which a specific audit firm may be the auditor of record for a specific client company. The maximum time limit for the rotation process has not been indicated. A system of mandatory audit firm rotation would require companies to rotate their independent auditor periodically. On the other hand, extended audit tenures in themselves, are not detrimental as most results from research (e.g. Knechel & Vanstraelen 2007; Carcello & Nagy 2004; Myers et al., 2003; Geiger & Raghunandan 2002; and Johnson et al., 2002) have shown. Those who support long associations are of the opinion that extended audit tenures could be beneficial to the audit firms or auditors as they garner firm specific knowledge. Though the auditor may have the auditing expertise and the industry knowledge, they may lack the adequate client/firm specific knowledge to ensure an

effective and quality audit (Myers et al., 2003, p.780; Geiger & Raghunandan, 2002, p.70; and Barton 1991). This client knowledge comes with extended audit tenures because in the early stages of the audit, the auditor may fall short of this knowledge and the quality of the audit may suffer. As evident in Myers et al. (2003, p.780), another view by proponents for extended audit tenures also suggest that start-up audit costs will be higher at the initial years of the audit. They argue that short audit tenures will increase audit start-up costs and increase the risk of audit failures as there will be increasing reliance by the auditors on the clients estimates and representation in the initial years of the audit (Myers et al., 2003, p.780).

2.4.1. Arguments in Favor of Mandatory Auditor Rotation

Individuals who support mandatory audit firm rotation contend that pressures faced by the incumbent audit firm to retain the client company could adversely affect the auditors actions to appropriately deal with financial reporting issues that materially affect the companys financial statements. The fewer adjustments that need to be made to the financials and the more quickly (thus, less expensively) the audit can be performed, the more satisfied the client company is with its chosen audit firm (and individual employee auditors), the more likely it is that the auditing firm will retain the client and the individual auditors will have continued future employment, and the stronger the auditor-auditing firm-audit client relationship becomes. In other words, auditors have strong business reasons to remain in clients good graces and are thus highly motivated to approve their clients accounts (Bazerman, Loewenstein, & Moore, 2002). According to Hoyle, a client may be a significant source of revenue for an auditor, and the auditor may be reluctant to jeopardize this revenue stream. A second argument in favor of mandatory audit firm rotation is that it would increase the publics perception of auditor independence in other words, the element of independence in appearance would be raised. Such a positive perception was a conclusion of the Bocconi University Report from Italy, which has a mandatory auditor rotation requirement (Arel, Brady, & Pany, 2005)..

A third reason in favor of mandatory rotation is that it would allow audit firms to be more vocal about disagreeing with questionable client practices. Knowing that a client company would only belong to the audit firm for a limited period of time, the firm would not be risking a perpetual revenue stream by agreeing to overly aggressive practices, deterring questionable judgments, or taking compromise positions on recording business transactions (Conference Board, 2003, p. 34). A fourth reason in favor of mandatory rotation is that it would, to a limited extent, help level the playing field for audit firms. Essentially forcing firm rotation among smaller firms provides a distinct advantage to the larger public accounting firms that have the partnership personnel available for rotations into engagements. Thus, mandatory rotation puts all audit firms on some degree of level footing and could encourage smaller firms to grow and develop niche specializations that would allow greater competition with the others. Fifth, some individuals believe that the costs associated with mandatory rotation would be less than the costs associated with audit failures. For example, Morgan Stanley estimates that the increased cost of mandatory rotation would be approximately $1.2 billion per year, versus the $460 billion loss in market capitalization caused by the failures of Computer Associates, Enron, Quest, Tyco, and WorldCom (Healey, 2004). The increase was calculated using $10 billion of audit fees in 2000 for the (then) Big Five, a 30 percent increase in audit fees for the first two years, and a rotation period of every five years. Finally, knowing that another audit firm would, at some specific future time, be reviewing the financial statement judgments made by the current audit firm would simultaneously create some internal pressure to be less amenable to potential client manipulations. The successor audit firm would bring fresh eyes and limited relationship baggage to the engagement new brooms to sweep away any financial statement fictions that may have been overlooked, ignored, encouraged, or acquiesced to by a predecessor audit firm. Awareness that the successor auditor might readily identify the lapses of a predecessor auditor could reduce the possibility of overlooking accounting irregularities or signing off on controversial accounting procedures; obviously, a continuing

auditor would be less likely than a new auditor to reverse an accounting position taken in a prior year on a clients accounting transactions. Despite the increased start-up costs which are involved with introducing a new auditor, supporters of audit firm rotation propose that the costs of corporate collapses, which may not have occurred had audit quality been higher, outweigh the increase in audit costs involved when introducing a new auditor. From this perspective, a new auditor brings in more objectivity as they are not familiar with the client, potentially improving the quality of the audit. The arguments in favor of mandatory audit firm rotation are summarized in Exhibit 1.

EXHIBIT 1

Arguments for Mandatory Rotation of Auditing Firms

 Decreases the development of friendships and coziness between audit firm and client employees Decreases the potential for auditors to succumb to management pressure to use questionable accounting techniques or accept compromised accounting procedures Increases public perception of auditor independence Increases the potential for audit firms to be more vocal about disagreeing with questionable client practices Potentially increases the supply of audit firms that are of the size and have developed the specialized industry expertise to audit the larger publicly held companies in niche sectors Increases the level of competition among audit firms for clients, which could possibly reduce audit fees Increases audit quality by providing a fresh look at client reporting practices Increases audit quality because the current audit firm would be aware that a successor auditor would be more likely to detect and disclose predecessor auditor errors or inefficiencies Increases the possibility that audited firms might reexamine their audit needs and negotiate for more experienced auditors on the engagement

2.4.2. Arguments against Mandatory Auditor Rotation

It is no wonder that terms such as client entrenchment, vested interests, and fraternization have proliferated through the recent corporate audit scandals: the Government Accountability Office of USA (GAO) survey (2003) indicated that the average auditor tenure at Fortune 1000 public companies was 22 years. The accounting profession and many others abhor the concept of mandatory auditing firm rotation for a variety of reasons. First, those in opposition contend that the new auditors lack of knowledge of the companys operations, information systems that support the financial statements and financial reporting practices will dramatically reduce audit quality. According to PricewaterhouseCoopers (2002), audit quality depends on numerous factors, ordinarily including the experience, integrity, and training of the auditors and the firm with which they are associated; their independence and

objectivity; their knowledge of professional standards; and their knowledge and understanding of the company being audited and the industry in which it operates. The issue of audit quality was specifically addressed in an AICPA Statement of Position (1992), which discussed the substantial learning curve that is needed for auditors to become not simply acquainted or conversant with, but accomplished in the corporations operating environment, risks, and technical accounting policies and procedures. It is estimated that two to three years on an engagement are necessary for an auditor to understand fully the business, procedures, and nuances of a complex client (Terry, 2002). This factor is especially important when the company being audited had numerous domestic and/or foreign locations. A logical extension of the 2001 Report of the Review Group on Auditing in Ireland comment that audit quality would be detrimentally affected by the removal of experienced personnel from the audit team is that audit quality would be even more greatly affected by a change in the entire audit team that would occur through mandatory rotation (Institute of Chartered Accountants in England & Wales [ICAEW], 2002). One study of business failures between 1996 and 2001 concluded that a companys risk of audit failure increased with each change in auditing firm and that there was a reduction in audit quality when a new auditor was unfamiliar with the clients business or operations (George, 2004). However, a different study concluded that increased audit tenure does not lead to reduced audit and earning quality (Myers, Myers, & Omer, 2003, p. 798). The learning curve issue is a primary causal factor in the second reason against mandatory rotation: an increase in costs within the audit firm so that personnel can get up to speed on engagement issues and a corresponding increase in audit fees for the client company to compensate for the additional audit staff time. In the past, an audit firm might have set the first-year audit fee at an average level, in anticipation of the long-term revenue stream from the client, rather than attempting to cover true costs of the new engagement. Costs of familiarizing audit personnel with the new client and its practices will now be spread out over the shortened rotation period (rather than the average 22-year tenure) and would, therefore, have to cause an increase in billed audit fees.

Third, the learning curve is also cited as a crucial source of increased risk of audit failure in the initial years of an audit engagement, during that time needed to acquire the knowledge of financial reporting issues that could materially affect the client companys financial statements. This audit risk potential, in and of itself, creates an extremely negative cost/benefit relationship in the eyes of both audit firms and client companies. In addition to the accounting matters that create audit risk, there are also risk factors created by the organizational change that has occurred. Regardless of the fact that audit personnel are not an internal part of the client company, relationships have been established between individuals. The client employees must attempt to form new personal linkages with members of the incoming audit firm and establish the same level of trust that existed with staff of the predecessor audit firm. In all instances of relationship change, there is a high potential for misunderstanding, uncertainty, and ambiguityall of which could have critical impacts on the level of audit risk. In study made by Arel et al, audit failures are generally higher in the first years of audit-client relationships as the new auditor becomes familiar with the clients operations. (Arel et al., 2005) Audit costs would also rise due to the additional work needed by the new audit firm. A fourth reason against mandatory rotation relates to the number of audit firms that have the quantity of personnel, depth and breadth of industry expertise, or merely the name recognition to satisfy large domestic and international client companies. Fifth, those opposed to mandatory rotation point to the fact that the new Sarbanes-Oxley independence and partner rotation requirements have not had a reasonable amount of time to be fully implemented. Until the full effects of such implementation can be assessed, it would be premature to impose mandatory audit firm rotation at this time (GAO, 2003). Sixth, even without compulsory rotation, new hires and the normal attrition of personnel within a given auditing firm will cause the audit team on an engagement to change over time. These factors, combined with partner rotation, should help provide the periodic fresh perspective on an audit engagement that is desired by the investing public.

Seventh, the potential shifting of auditors from one client to another is a reason against mandatory rotation. Many audit firm respondents to the GAO survey indicated that they would shift their most knowledgeable and experienced audit personnel from a current engagement to another audit as the end of the rotation period nearedeven though they believed that reassigning these individuals would increase the risk of an audit failure (GAO, 2003). Several other justifications have been made against enforced rotation. Mandatory rotation might minimize attempts at continuous improvement efforts because the audit firms would be aware that client retention would soon end, thus minimizing or negating any investment effect. Mandatory auditor rotation might result in opinion shopping among the audit firms. Moreover, mandatory rotation might create, in the minds of the public, a negative perception or red flag toward the company engaged in the change. This reason, however, does not appear to hold much credibility. Although such a perception is fairly common when firms change auditors in the current business environment, most of the Fortune 1000 company respondents to the GAO survey did not believe this perception would be continued if the rotation process were made mandatory. Finally, there is the issue of global credibility. At present, mandatory audit firm rotation for public companies is required only in Italy and Brazil; Singapore requires audit rotation for banking engagements. Italys requirement was introduced in 1975 and Brazils in 1999. Canada, Spain, Austria, and Greece previously had mandatory rotation requirements for auditors, but these countries have revoked such laws, citing an increase in audit cost and a lack of cost effectiveness, as well as achieving a stated objective of increasing audit service competition. The Italian experience has provided evidence that mandatory rotation increases costs to businesses, creates problems with audit quality in the period immediately after the change of audit firms, and leads to further consolidation of audit work amongst the largest audit firms (Wyman, 2005).The arguments against mandatory audit firm rotation are summarized in Exhibit 2.

EXHIBIT 2

Arguments against Mandatory Rotation of Auditing Firms

Increases audit risk and potential for audit failure because the new audit firm is less familiar with client practices Increases audit costs because the new audit firm must become familiar with client practices; such costs would be passed along to the client company through increased audit fees Increases selection and support costs to the client company; such costs would reduce company profitability and shareholder value Decreases the level of open communications between the audit firm and client employees who are not familiar with one another Limited number of available audit firms of the size or with the industry expertise necessary to perform client engagements; the lack of competition could create higher audit fees for the client company Limited number of available audit firms that are not performing restricted non-audit services for the client Increase in the possibility that the new audit firm may be overly aggressive in challenging the predecessor auditors judgments because the new firm is less familiar with client operations; such challenges could, in turn, increase the tension between the new audit firm and the client Possibility that the audit firm may rotate its most qualified audit staff off the client engagement in years close to the mandatory rotation date and place those staff members on new client engagements Possibility that the audit firm might begin focusing on marketing non-audit services to the client in years close to the mandatory rotation date rather than concentrating on providing the highestquality audit services Difficulty in resolving issues such as the maximum number of years prior to mandatory rotation, the number of years before a firm could recompete for an audit client after mandatory rotation, whether mandatory rotation would be applied uniformly to all publicly held companies, and how the mandatory rotation process would be implemented for the companies Excessive overreliance of successor auditors on the work of predecessor auditors

2.5. Auditors Independence in Ethiopia

The degree of the development of accounting in Ethiopia is something to be studied. This degree of development has a great bearing on the independence of auditors in Ethiopia. But we can safely say that the auditing profession exists in Ethiopia. In view of the reliance by third parties on the work of auditors engaged in performing the attest function, it is understandable that there would be concern for the professional qualification of the public accountants who do this work. Anyone who wishes may not assume the designation certified or qualified public accountant. The requirements vary from country to country or from place to place. But in most places including Ethiopia, one has to be certified (or chartered) Public Accountant (CPA) to acquire audit license. In turn, to be a CPA, an accountant needs to pass a professional examination administered by accounting professional organizations. In addition, it is necessary to have a college accounting education and some number of years of audit experience. In Ethiopia, it is the Auditor General that has the authority and responsibility to license accountants to perform audit work. (Belete, 1992) Nowadays, auditors in Ethiopia can be classified as governmental auditors like Auditor General and Audit Service Corporation and about 62 private audit firms as well as over 500 authorized accountants (Johannes and Engida, 2009) which are conducting audit services on their own. Lemma and Assefa on their article stated that audit practice in Ethiopia has been facing a number of problems both in its development and practice. The most important of these problems can be discussed under the category of adverse national environment, institutional vacuum, absence of accountability, weakness in the implementation of audit results, shortage of qualified manpower, the absence of nationally promulgated audit standards, duplication of audit efforts and inappropriate use of the available manpower. They affirmed that there are debilitating problems, which have been considered as limiting factors to the success of the public sector audit in Ethiopia. The literature of audit practice by Supreme Audit Institutions has been devoting much attention to the independence of Supreme Audit Institutions for a long time now. In Ethiopia the enabling legislation gives protection to the

independence of the Office of Auditor General as far as reporting requirements are concerned, but in actual practice the Offices independence is seriously curtailed by the imposition of manpower and budgetary controls effected by audit institutions. (Lemma and Assefa, 1994) It has been stated in the Ethiopian Government Auditing Standards that Auditors have an obligation to refrain from becoming involved in all matters in which they have a vested interest. Auditors should avoid any possible conflict of interest by refusing gifts and gratuities, which could influence or be perceived as influencing their independence and integrity. Auditors should not use their official position for private purposes and should avoid relationships which involve the risk of corruption or which may raise doubts about their objectivity and independence. It is also stated that auditors must not only be independent in their attitudes and beliefs but be seen to be so otherwise the authority of their opinion and its value to those who seek to place reliance on it could be eroded. Individual auditors must perform their audit without any financial influences that might compromise their offices' independence. They should also be sufficiently removed from political pressures to ensure that they can audit and report their findings and conclusions objectively without fear of political repercussion. Personal Impairments In Ethiopia, there are circumstances under which auditors may not be impartial, or may not be perceived as impartial. The audit organization is responsible for having policies and procedures in place to help determine if auditors have any personal impairment. Managers and supervisors need to be alert for personal impairments of their staff members. Auditors are responsible for notifying the appropriate official within their audit organization if they have any personal impairment. If a personal impairment affects the auditor's ability to do the work and report findings impartially, the auditor should decline to perform the audit. These impairments apply to individual auditors, but they may also apply to the audit offices. Personal impairments may include, but are not limited to, the following:

Official, professional, personal, or financial relationships that might cause an auditor to limit the extent of the inquiry, to limit disclosure, or to weaken or slant audit findings in any way;

Preconceived ideas toward individuals, groups, organizations, or objectives of a particular program that could bias the audit; Previous responsibility for decision-making or managing an entity that would affect current operations of the entity or program being audited; Biases, including those induced by political or social convictions, that result from employment in, or loyalty to, a particular group, organization, or level of government; Financial interest that is direct, or is substantial though indirect, in the audited entity or program; Relationship, particularly with the staff of audited body, which might cause the auditor to fail to carry out his duties to the full.

External Impairments Factors external to the audit offices may restrict the audit offices or interfere with the auditor's ability to form independent and objective opinions and conclusions. For example, under the following conditions, audits may be adversely affected and the auditor may not have complete freedom to make an independent and objective judgment: External interference or influence that improperly or imprudently limits or modifies the scope of an audit; External interference with the selection or application of audit procedures or in the selection of transactions to be examined; Unreasonable restrictions on the time allowed to complete an audit; Interference external to the audit offices in the assignment, appointment, and promotion of audit personnel; Restrictions on funds or other resources provided to the audit offices that would adversely affect the audit offices' ability to carry out their responsibilities;

Authority to overrule or to influence the auditor's judgment as to the appropriate content of an audit report; Influences that jeopardize the auditors continued employment for reasons other than competency or the need for audit services.

In 1994, a survey of audit reports in Ethiopia had taken by Johannes, which covers 227 audit reports of 140 organizations (enterprises) which are audited by 14 different auditors or auditing firms covering a period of 24 years from December 1967-1990. The auditees included were service rendering, manufacturing, agricultural, construction, and mining enterprises. The majority that is 44% is in manufacturing and 33% is in the service industry. With regard to the timeliness of audit reports, he has analyzed that the time elapsed between the fiscal period under audit and the date of audit report issued shows 52% of them were issued two years or more past the fiscal period. This indicates that there are many reports, produced several years later after the fiscal period under audit, which render audit reports useless for taking timely corrective actions. The longer the time that elapsed between the fiscal period and audit engagement, the more difficult it becomes to gather audit evidence, and makes the usefulness of audit report for timely decision doubtful. The cause for this gap may neither be the auditor nor the time taken to perform the audit. But, rather due to the time taken to close the books of accounts to be ready for audit. Here the question of the responsibility of the auditor in assisting clients in closing of books becomes an issue to contend with vis--vis compatibility of performing audit related services and their implication on the independence of the auditor. With respect to the audit opinion, his survey showed that 64% of audit reports were qualified opinion, 14% disclaimer of opinion and 22% unqualified. It is significant to note that the majority had qualified opinions, and overall, this indicates 78% of audit reports are of doubtful credibility. The increasing number of qualified audit opinions must reflect a deficiency on the part of preparers where this is repeatedly done year by year in the same auditee by the same auditor. These qualifications should also reflect the financial reporting practices, and be of concern to all

stakeholders unless the stakeholders are negligent, indifferent, or ignorant of the usefulness and relevance of financial reports and audit reports are never seriously used for any significant decision making. Another aspect of this is that if so many audit reports systems are qualified, could this reflect poor accounting skill on part of clients, or absence of enforceable standards, or lack of integrity on the part of the auditors? He cited from Puro and Haring , there is a tradition that auditors are captives of their clients, especially large clients and therefore, either lobby for their clients or protect the clients from exposure in order not to jeopardize their engagement. In todays accounting and auditing literature this has come to be known as agency theory. (Puro 1984, and Haring 1979). Then he said auditors are thus identified as agents of the firm (auditee), representing the clients with regulatory agencies. Is this part of audit services extend too much to be a threat to professional ethical standards? In his examination of several audit reports of an organization in general and the auditors tenure in particular, Johannes continues, what is interesting to observe is the continuation of audit engagements for a period of 10 years without influencing a change in the exceptions indicated. Could this point out anything on the ethical and professional responsibility of the auditor; or suggest something about the auditor becoming the agent of the client? Could the auditor be motivated more by the interest of keeping his engagements? If an auditor is engaged for ten years in one enterprise, what about the auditor becoming captive and ensuing quality of his work? In this respect, could the phenomena reflect auditors popular preference and proneness to issuing qualified audit opinion as they are the least harmful to the client /auditor relation? Whether the repeated qualifications would warrant issuance of negative opinion is subject to argument. He has only found one negative opinion in more than 200 audit reports he had examined. (Johannes, 1994) According to Belete, who conducted his study based on the above survey, in the preliminary summary of 227 audit reports, 143 or 63% of them were performed by audit service Corporation. From these reports, 4 or 2.8% had reports with unqualified opinions, 116 or 81.12% qualified opinions, and 23 or 16.08% disclaimer of opinions. On the other hand, one private audit firm

conducted the audits of 23 or 10.13% of the 227 reports. 15 or 65.13% of them had unqualified opinion, 6 or 26.09% qualified, and 2 or 8.7% disclaimer. On the bases of these preliminary summaries, he would question the independence of our auditors, though extensive detail study may prove otherwise. What would explain the reason that made the private auditors to make 56% of their reports "unqualified", while Audit Service Corporation unqualified only 2.8% of its reports? One may raise the issue that when statements are unqualified, it does not necessarily imply that the auditors lack independence. He agrees with this idea, as a general principle. But, he doubts "independence of the audits on the ground that given more or less the same political, social, and economic environment, the results of the audits to vary to the extent of 2.8% to 56 %. 1992) As stated on the article of Tesfaye Mengasha (2003), on capital weekly news letter," bidding/tendering may sometimes result in saving in audit fees. Should this be the primary concern of the government? Audit fee levels were recovered to be the lowest even by African standards, before the tendering/bidding systems came about. What if such reductions in fees are achieved at the expense of the quality/effectiveness of the independent audit, which is the "raison-d'etre" of the entire exercise? When the tax collection role of the government is considered, the quality of the audit, as a reliable source of information, becomes even more important, relative to the required audit fees. Having said this, one must be wary of the limitations of an audit with the possibility of expectation gaps being created. Financial statement audits are sample based. Clear distinction should be made between tax evasion, an illegal practice, and tax avoidance scheme, which should be regarded as quite legitimate. Not everyone is an angel in as much as not everyone Satan. Any audit has its own start up costs to the auditor concerned. Far too frequent changes in auditors, following the mechanical bidding/tendering system, also break continuity and familiarity with the assignment. As a result, the auditors' independence could be impaired". (Capital: 2003) (Belete,

Moreover, Muluneh Beyene (2007), in his research project on

auditors professional

responsibilities and legal liability with regard to private auditors in Ethiopia, concluded, from the survey results of audit clients regarding the independence of private auditors, that although it is

said that private auditors were independent in their audit work there could an occasion where private auditors by force or interest can violate the principle of auditors independence from their clients in conducting an audit work. Moreover, it is wise to conclude from the above mentioned article (from the article of Tesfaye) that as a result of tendering/bidding nature the auditors' independence could be compromised.

Summary
Ethics is the study of standards of conduct and moral judgment. When it is concerned with moral behavior, it is more restrictive in the sense that it encompasses the expected ethical pattern unique to a certain profession, it becomes professional ethics. Auditing is one of the professions that have its own code of ethics. Among them, independence is traditionally regarded as being one of the fundamental principles underlying the auditor's work. Auditor independence has been the subject of considerable debate for some time, and it has been examined from the perspectives of both nonaudit services and auditor tenure. Regarding the non-audit services some researchers believe that economic bond between auditors and their client is strengthened as a result of delivering more consulting-oriented services. That is, auditors independence will be undermined. On the other hand, some researchers results of studies find no evidence that the provision of nonaudit services impair auditor independence. Therefore, I am convinced by the first researchers argument, which asserted that the provision of non-audit services will compromise auditors independence. I believe that these services may cause an auditor consciously or subconsciously to subordinate his or her judgment to a clients desires. Besides, as non-audit services have grown, concern has been expressed that management of audit firms may have tended to focus more on them than on auditing. Hence, I have tried to identify whether non-audit services impair audit firms independence in some selected audit firms in Addis Ababa.

With respect to audit tenure, some says that auditors should be rotated because involvement with the same client over a long period of time could result in a lack of objectivity and detraction from the regular and robust consideration of issues connected with the audit. In contrast, those who are against auditor rotation affirm that new auditors lack of knowledge of the companys operations, information systems that support the financial statements and financial reporting practices will dramatically reduce audit quality. In my view, I am influenced by the idea that as the auditors spent long time with their client; this may lead to such close identification of the audit firm with the interests of its client's management. In addition, it may also degrade public perception about the audit firms independence. Consequently, audit firms who have been auditing their clients over three consecutive years will jeopardize their independence. Like the non-audit services, it has been examined how long association of audit firms with their clients affect audit firms independence or not.

CHAPTER THREE: DATA ANALYSIS AND PRESENTATION

This chapter presents the findings of the research project with survey methods i.e. questionnaires and interviews. The results the questionnaires were presented using tables and percentages whereas the interview results are presented in a descriptive manner. 3

3.1 Background and respondents information

In this part, the research project has tried to assess whether the provision of incompatible services and extended audit tenure with the client can lead to the emergence of threats to audit firms independence. The effect of non-audit service to the audit firms independence is analyzed using the proportion of non-audit service fees as compared to the total income earned by the selected audit firms. On the other hand, audit tenure is analyzed for how long an audit firm performs audit service for one client successively. To accomplish this, with respect to questionnaire, sampled audit firms and individual auditors were asked a total of 25 questions. Interviews were structured and constitute 12 questions. Among the 25 questions which were included in the questionnaire part, 6 questions were in relation to the demographic aspects of individual auditors who are working in those selected private audit firms. The other 10 questions were asked concerning audit firms independence in relation to non-audit services, whereas, the remaining 9 questions in relation to tenure of audit firms. Underneath, data which are collected through survey methods i.e. through questionnaires and interviews are analyzed and interpreted. The research paper took a sample of thirteen (13) private audit firms, from around 62 audit firms, which are working in Addis Ababa. Questions were distributed to these audit firms, using questionnaires, to be filled by audit firm managers and individual auditors about the independence of audit firms in relation to compatibility of services and tenure of audit firms. Moreover, I have also tried to interview some of the managers and individual auditors of selected audit firms. From the distributed questionnaire 70% were collected from the respondents. The remaining 30% of the data could not be collected because of the time in which I was conducting my study was high period of audit activity for most of the audit firms. Based on the survey on the selected private audit firms, the data obtained were analyzed using tables and percentages.

3.1.1 Findings on the survey

In the following table, selected audit firms were asked about the number of years worked as a licensed audit firm. The response was summarized below: Table 3.1: Years of experience of the audit firms Number of years worked as a licensed audit Responses in percentage firm 0-4 5-9 10-19 28.57% 28.57% 42.86%

Based on the above table, 28.57% of them had worked up to four years and 28.57 from five to nine years whereas the majority i.e. 42.86% of them worked from ten to nineteen years. On aggregate, the audit firms who have worked up to 9 years constitute 57.14% indicating that most audit firms are established recently for auditing the clients financial statements. Table 3.2: Number of qualified auditors who are working in the audit firms Number of qualified auditors 1-5 Above 5 Responses in percentage 83.33% 16.67%

With respect to number of qualified auditors who are working in the audit firms, 83.33% of them have qualified auditors up to five whereas 16.67% of them have above five. This indicates that most audit firms have few experienced staff members who undertake audit services to the clients and they have filled by individuals who are recent graduates. Table 3.3: Gender of qualified auditors who are working in the audit firms Gender of qualified auditors Male Responses in percentage 80%

Female

20%

Most qualified auditors who are working in the audit firms, constituting 80%, are male and 20% of them are female. All (100%) of the audit firms have individual auditors having Ethiopian nationalities. The educational qualifications of individual auditors who are working in those selected audit firms were reviewed through questionnaires and it is summarized below.

Table 3.4: Educational qualifications of the respondents Educational qualifications Responses in percentage

Diploma BA/BSc MA/MSc

22.22% 66.67% 11.11%

Regarding educational qualifications of individual auditors who are working in those selected audit firms, 22.22% of them are diploma holders, 66.67% BA/BSc holders and 11.11% of the are MA/MSc holders. This confirms that the majority of individual auditors who are working in these private audit firms are bachelor degree holders. However, the research project didnt identify their field of studies for those BA/BSc degree holders, whether they are accounting, other businesses or other natural sciences graduates.

3.2. Audit firms independence

Independence, both historically and philosophically, constitutes the foundation of the auditing profession and upon it, depend the professions strength and stature (Carey, 1970). There is a great

reliance of public trust on audited financial statements and accounting reports as they constitute the bedrock of the financial markets. This means that the auditors at all times must be objective in performing their duties. The independence of an auditor demonstrates objectivity and builds the trust of those who depend on their services. Since independence is of great relevance to the auditing profession, the rules related to it must remain relevant, effective and fair in any business environment (Eilifsen et al., 2006). The most recent financial scandals and audit failures of Enron and WorldCom just to mention a few, has left the business community skeptical about the auditor independence. Independence is considered the most complicated and controversial, yet the cornerstone aspect of the auditing profession because it strengthens the professions commitment to objectivity. The reason for its complication and controversial nature is as a result of the difficulty to measure the professionals conduct of behavior. Table 3.5: Audit firms responses on the essentiality of audit firms independence Yes Do you think that audit firms independence is essential in Ethiopian auditing practice? 100% 0% 100% No Total

All (100%) of the respondents agree that audit firms independence is essential in Ethiopian auditing practice. They stated that it is not only essential in Ethiopian auditing practice but also internationally because there is no need for audit practice without an independence of audit firms. They believe that independence is fundamental to the reliability of audit firms reports. Those reports would not be credible in the eyes of the users if audit firms were not independent. In addition, independence is the foundation of the auditing profession since the value of the auditing services depends upon the fundamental assumption that audit firms are independent of their clients. It is essential for promoting public confidence in the audit process, and must be monitored continuously.

Regarding the assurance of independence of audit firms in Ethiopia, some interviewees say that the very essence of external audit is to give unbiased opinion on the financial statements of companies and organizations. This opinion should emanate from independent professionals who are free from any direct or indirect impositions so as to get credibility from users of the financial statements such as banks, tax authorities etc. In Ethiopia, due to the absence of an organized strong national professional association there is no comprehensive set of ethical standards to govern the behaviors of professional accountants. In the case of authorized auditors, it is assumed that they adhere to the code of ethics set by the professional bodies to which they are members. Because many of these institutions are foreign based, they have remote access to follow the conducts of their members practicing in Ethiopia. (OFAG, 2009) The absence of such strong national associations presupposes the existence of one regulatory organ to lay down ethical rules and follow their enforcement. It is based on this assumption that Office of the Federal Auditor General (OFAG) mandated to act upon taking the issue as one of the key objectives in its establishment legislation stated as: "make efforts, in co-operation with concerned organs, to promote and strengthen accounting and audit professions." In order to achieve this objective, from time to time, the Office needs to evaluate the prevailing condition and ensure that all authorized auditors and accountants have uniform ethical standard in place and respect in discharging their duties to the public.

The Office of Federal Auditor General (OFAG) has adopted standards to be followed by authorized audit firms and accountants. Under chapter two of general standards it is stated that: In all matters related to their audit work, audit offices and individual auditors must have independence from the legislature, executive and the management of the audit entities. Moreover, the standards set forth by OFAG also affirm that: audit offices and auditors must be objective in their audit of entities. They should use sound judgments in determining the scope, audit objectives, selecting the methodology and procedures for the audit. Their opinions, conclusions, judjementa and recommendations should be impartial and should be viewed as

impartial by knowledgeable third parties. They should also gather information on the views of the auditee organization and other parties. However, their own conclusions should not be affected by such views. They should be fair in their evaluations and in reporting on the outcome of audits. Audit firms have an obligation to refrain from becoming involved in all matters in which they have a vested interest. Auditors should avoid any possible conflict of interest by refusing gifts and gratuities which could influence or be perceived as influencing their independence and integrity. Auditors should not use their official position for private purposes and should avoid relationships which involve the risk of corruption or which may raise doubts about their objectivity and independence. Practically, as I have established through questionnaires, audit firms independence will be ensured through investigations and assessments made by the Office of Federal Auditor General (OFAG) on the auditors working papers and by interviewing some external auditors randomly when they are on duty at their clients offices. Moreover, some respondents asserted that audit firms themselves, having professional responsibilities, should assure their independence by doing their audit work with objectivity and integrity. Moreover, audit clients and other stakeholders also must share the responsibility of ensuring independence of the audit firms.

3.3. Non- audit services

The first and foremost focus of this paper is to identify the effect of non-audit services on the independence of audit firms. So far, in the literature part, it has been stated that the provision of incompatible services to clients has positive and negative effect on the independence of audit firms. According to the survey the results regarding the non audit services which are provided by audit firms are presented below. The sampled audit firms were asked whether they are providing non-audit services or not. The response is summarized below: Table 3.6: Audit firms responses on non-audit services

Yes Does your audit firm renders services services? other than audit 63%

No

Total

37%

100%

With respect to the provision of non-audit services, 63% of the respondents/audit firms are rendering non-audit services to their clients whereas, 37% of them do not render non-audit services. Hence, based on my sample most of audit firms are providing services other than audit services. Among the 63% of audit firms all (100%) of them are rendering tax related services to their clients whereas 75% of them provide accounting system design services and advise on internal audit and internal control system. Audit firms which provide incompatible services render management consulting and financial system design services which constitutes 25% each.

Table 3.7: Audit firms responses on types of non-audit services Types non-audit services Percentages of services given to clients by selected audit firms Tax related services Accounting system design services and advise on internal audit and internal control system Management consulting and financial system design services 25% 75% 100%

On the same case, all (100%) of the audit firms offer their services to manufacturing, merchandising and service companies and 50% of them renders to mining, transportation and financial institutions and 25% to real estate companies.

There has been an explosive growth in non-audit services in recent years, to the point where many large firms revenues from these services exceed their audit revenues. Regarding the proportion of audit and non-audit fees from the total income, 25% of the audit firms get 85% and 15% of audit and non-audit fees respectively. Others identified that the non-audit fee which they earn is below 15% from their total income. Hence, this shows that fees which are charged by most audit firms for non-audit services are insignificant as compared to the total income generated by them. As it is stated in the literature part, the research results of Ashbaugh et al. (2003), DeFond et al. (2002) , Raghunandan, et al., 2003), Larcker and Richardson ( 2003), as well as Chung and Kallapur (2003) find no evidence that the provision of non-audit services impair auditor independence. Therefore, based on my sample, I can also conclude that the provision of non-audit services may not pose a threat to the audit firms independence. So long as auditors provide non-audit services to audit clients, there will be at least an issue with respect to the appearance of independence. Non-audit services may impair audit firms independence depending upon the type and extent of the service, according to some respondents. They said that they take care of the issue and do not involve in the types of services that may adversely affect their independence. However, most respondents do not agree that their independence can be impaired by providing incompatible services though they believe strongly in the absolute need for audit firms independence, objectivity and integrity. Their argument is based on the following reasons: Those audit teams who provide non-audit services and those who provide audit services are different. The works of both audit and non-audit service teams are reviewed by an independent senior audit manager. Based on the above two reasons they think that the provision of incompatible services do not impair their independence from their clients. They also believe that audit firms can provide both audit and non-audit services to the same audit client and maintain independence, objectivity and integrity. They have confidence that management and audit firms are fully capable of exercising their responsibilities and making rational, appropriate judgments.

Audit firms were also asked whether they believe that the provision of non-audit services affect the independence of other audit firms which are involved in auditing clients financial statements. The responses are summarized below: Table 3.8: Audit firms responses on the effect of non-audit services Yes Do you think that the provision of non-audit services affect the independence of other audit firms? 63% 37% 100% No Total

As it is depicted above, 63% of the respondents think that delivering incompatible services affect other firms independence whereas 37% of them believe that the provision of incompatible services could not affect other audit firms independence. The former respondents (those who say it may affect their independence) explain their argument in two ways: The audit firms may lose their independence when they do not try to take apart the teams who are performing audit and non-audit services. If the work of the audit team is not reviewed by an independent senior audit managers. Independence of the senior audit manager is decisive to review the audit and the non audit work. They also asserted that firms independence with small number of staff members may be jeopardized since the staff members /individual auditors can be engaged for both assignments. These firms will also be forced to assign the same team for both assignments in order not to lose the income earned from the non-audit services. The following ethical problems in relation to non-audit services and audit firms independence were stated by some respondents on the free response part of the questionnaire:

Self review threat- when the auditor directly or indirectly through others in the firm

or affiliates, ought not to be put in the position of reviewing its own work. This is when there is a difficulty to evaluate without bias the auditors work or that of their firm. This may emanate from the auditor or a member of the audit team having a direct or indirect influence on the subject matter of the audit. That is, for example, a member on the engagement team was an employee of the client (in particular director or officer) in a position to exert significant influence over the subject matter of the assurance engagement.

Self interest threat- This occurs when the auditors favor or is perceived to favor their own self-interest over the interest to perform an unbiased audit. This may arise from auditors financial, emotional or other personal interests in the clients. For Example, Direct financial interest or indirect material financial interest in the client company.

Conflict of interest- A conflict of interest may occur if a professional accountant performs a professional service for a client or employer and the professional accountant or his or her firm has a relationship with another person, entity, product, or service that could, in the his/her professional judgment, be viewed by the client, employer, or other appropriate parties as impairing the professional accountant's objectivity.

Moreover, some respondents stated, while I am conducting interview, that the demand of auditing in Ethiopia is not worth mentioning since the profession is in its growing stage. The audit fee which the clients are paying is slightly low as a result of fee competition between the audit firms. This may discourage the audit firms to provide only the audit services rather than rushing to render incompatible services together with the audit one. So far in this chapter, I have occluded that most selected audit firms are rendering incompatible services to their clients and the above argument of some audit firms may strengthen the conclusion. In line with this issue, the following article has been written. As stated on the article of Tesfaye Mengasha (2003), on capital weekly news letter," bidding/tendering may sometimes result in saving in audit fees. Should this be the primary concern

of the government? Audit fee levels were recovered to be the lowest even by African standards, before the tendering/bidding systems came about. What if such reductions in fees are achieved at the expense of the quality/effectiveness of the independent audit, which is the "raison-d'etre" of the entire exercise? When the tax collection role of the government is considered, the quality of the audit, as a reliable source of information, becomes even more important, relative to the required audit fees. Having said this, one must be wary of the limitations of an audit with the possibility of expectation gaps being created. Financial statement audits are sample based. Clear distinction should be made between tax evasion, an illegal practice, and tax avoidance scheme, which should be regarded as quite legitimate. Not everyone is an angel in as much as not everyone Satan. Any audit has its own start up costs to the auditor concerned. Far too frequent changes in auditors, following the mechanical bidding/tendering system, also break continuity and familiarity with the assignment. As a result, the auditors' independence could be impaired". (Capital: 2003)

3.4. Audit tenure

Audit tenure has received extensive attention from regulators and researchers alike. The responsibility of setting how long an audit tenure should be, rest on the regulators, whom in most cases work in tandem with the government. With respect to audit tenure the article of Johnson et al. (2002, p.640) wherein they examine the correlation of audit tenure and audit quality; they considered a long (an extended) audit tenure to be a relationship between the auditors and their clients that have lasted for more than 9 years, while a short tenure represents a relationship with any client type that has lasted for less than 3 years. As generally thought, independence is lost when the auditors have a personal relationship with clients of any size, which often arises when the tenure is long. There is a likelihood that the mental strength of the auditors will be at stake such that the objectivity of their opinion may not be enough to ensure all assertions made by management represent a true and fair view of the state of affairs. It is in this regard that 9(nine) specific questions were asked on the survey in relation to tenure of audit firms. Therefore, Selected audit firms were asked for how long have they been auditing their clients. Their response is summarized in the following table.

Table 3.9: Audit firms responses on the duration of the audit for clients 1-3 years Few of their clients Some of their clients Most of their clients 62.5% 80% 44.44% 4-10 years 37.5% 20% 55.56% 100% 100% 100%

According to the above table, of the sampled audit firms 62.5% of them perform their audit work to few of their audit clients for the period one to three consecutive years whereas 37.5% of them from 4-10 years. They also audit 80% of some of their audit clients between one to three years whereas 20% for the period four to ten years. They were also asked for how long they audit most of their clients. Accordingly, they engage in audit of 44.44% of most of their clients from the period of one to three years and 55.56% of most of their clients for the period between four to ten years. This shows that greater percentage i.e. 55.56% of their audit clients have been audited for more than three years. In my hypothesis so far, audit firms who stay with their audit clients for more than three years may lose their independence. A scheme of compulsory audit firm rotation within short period of time prevents them from becoming too aligned with clients, having positive impact on their independence. A client may be a significant source of revenue for an audit firm, and the audit firm may not want to lose this revenue stream by quitting their relationship. Arel, et.al (2005), Bazerman, et.al (2002), Geiger et.al (2002). Mautz and Sharaf (1961) have stated that when the audit firms have extended audit tenures, there is the tendency for them to gradually align themselves with the wishes of the management and hence cease to be independent. According to Johannes (1994), in his examination of several audit reports of an organization in general and the auditors tenure in particular, says what is interesting to observe is the continuation of audit engagements for a period of 10 years without influencing a change in the exceptions

indicated. Could this point out anything on the ethical and professional responsibility of the auditor; or suggest something about the auditor becoming the agent of the client? Could the auditor be motivated more by the interest of keeping his engagements? If an auditor is engaged for ten years in one enterprise, what about the auditor becoming captive and effect on ensuing quality of his work? In this respect, could the phenomena reflect auditors popular preference and proneness to issuing qualified audit opinion as they are the least harmful to the client /auditor relation? Whether the repeated qualifications would warrant issuance of negative opinion is subject to argument. Johannes has only found one negative opinion in more than 200 audit reports he had examined. (Johannes, 1994) Moreover, the research project results of Muluneh Beyene (2007) also affirmed the possibility of the loss of audit firms independence from their clients. After analyzing the situation he concluded that although it is said that private auditors were independent in their audit work there could be an occasion where private auditors by force or interest can violate the principle of auditors independence from their clients in conducting an audit work. Moreover, it is wise to conclude from the above mentioned article (from the article written by Tesfaye Mengesha on audit bidding/tendering) that as a result of tendering/bidding nature the auditors' independence could be compromised. My study also shows that the selected audit firms may lose their independence from their clients since most of them (55.56%) have been auditing their clients for more than three uninterrupted years.

3.5. Long association between audit firms and clients

Long association between the audit firms and audit clients is also an important issue with respect to audit firms independence. Some literatures stand in favor of long association and others against it as it is presented in the review of related literature part of this paper under chapter two. Respondents were asked their opinion of whether long association between audit firms and clients affect audit firms independence. This question was asked in order to discern of what they think what ought to be versus what is in practice.

Table 3.10: Audit firms responses on effect long association between an audit firm and a client Yes Do you think long association between audit firms and clients affect audit firms independence? 60% 40% 100% No Total

Amongst the chosen audit firms, the majority i.e. 60% of them think long association between audit firms and clients can affect audit firms independence whereas 40% of them do not think long association affects their independence. Those respondents who said it may affect their independence positively reason out the following: The new audit firm will be less familiar with client practices such as companys operations, information systems that support the financial statements and financial reporting practices. As a result of these the audit risk and the potential for audit failure will increase. This argument is consistent with research indicating that a greater proportion of audit failures occur on newly acquired clients (Berton 1991; Petty and Cuganesan 1996) and that auditors' litigation risk is greater in the early years of an engagement (Palmrose 1986b, 1991). Promoting new audit firm will increase audit transaction costs because the new audit firm must become familiar with the client practices, such costs would be passed along to the client company through increased audit fees.

Economy of scale in the work due to experience. Cooperation will takes place between an audit firm and audit clients. Opponents of mandatory audit firm rotation stress that not all extended associations with a client can impair independence so long as the auditor remain as an advising arm to management and not join them to perform their tasks.

On the other hand, some respondents believe that long association between an audit firm and a client may have a negative effect on their independence by stating the following arguments: Long association may lead to close identification of the audit firm with the client management which could adversely affect the audit firms actions to appropriately deal with financial reporting issues that materially affect the companys financial statements. When the audit firm stays for a long time with clients the publics perceptions of their independence will be diminished. In other words, the element of their independence in appearance would be questionable. Mandatory rotation proponents argue that limiting auditor tenure reduces concerns about deteriorating independence and audit quality It will increase the potential for audit firms to fail to resist the management pressure to use questionable accounting techniques or accept compromised accounting procedures. Long association with clients leads to the advocacy of the audit firm, being on the side of the client. Sampled audit firms were also asked for how long should an audit firm carries out an audit work. The responses were presented below:

Table 3.11: Audit firms responses on effect long association between an audit firm and a client

3 years For how long should an audit firm conduct audit service for one client? 50%

Other than 3 years

Total

50%

100%

Different opinions have given by respondents regarding the duration of an audit work for one client. From the selected audit firms 50% of them expresses that three consecutive years is sufficient time for conducting an audit for one client. Others believe that the duration may depend upon the type of the client i.e. there are some regulations which dictate the number of years an audit firm should audit a client. For example, there are some regulations which dictate nongovernmental and governmental organizations to be audited only up to three uninterrupted years. For private limited companies (PLC) and sole proprietorships no limit has been set as to the length of audit work that can be conducted by an audit firm. There is no regulation which confines these audit clients when they wish to continue with that particular audit firm to accomplish audit activity. We can take examples of audit law with respect to the duration of an audit firm with its clients. The Spanish Audit law of 1988 had a provision that required mandatory rotation of auditors after every 9 years (Carrera et al., 2007, p.672). This was to ensure that no one auditor stays more than 9 years with a single client, hence setting the length of audit tenures at 9 years. Though this policy was suppose to be fully implemented in 1997, it did not stand the test of time as it was formally abolished in 1995 because it did not work and neither did it achieve its objectives as public policy (Carrera et al., 2007, p.672). Despite the failure in Spain to fully implement lengths for tenures, currently, listed companies in both Brazil and Italy are required by law to rotate their independent auditors after every 5 and 9 years respectively; therefore, setting lengths of audit tenures to 5 and 9 years in Brazil and Italy respectively (Jackson et al., 2008, p.421). In the US, lengths for audit tenures are set at 5 years only for audit partners according to a provision in the SOX Act enacted after the collapse of Enron (Healey & Kim, 2003, p.10).

Some respondents, while interviews are carried out, asserted that independence is related to the integrity of the professionals involved. They do not think that specific years of association with

clients do not show the presence of audit firms independence. They added that it is too subjective to define the exact year/s in which the audit firms independence will be damaged. Moreover, they added that, an audit firm could act contrary to the principles and standards of their professional ethics in the first year of audit of a client while the other may perform ethically in the period of fifty years. Respondents were also asked to identify their optimum number of years in which the audit firms should conduct an audit to their clients. Their response was summarized below: Table 3.12: Audit firms responses on the optimum years of audit for clients 1-5 years 6-10 years 11-15 years Above 16 years 70% 10% _ _ There is no optimum year/s 20%

As it is illustrated in table 3.11, the majority of respondents i.e. 70% of them believe that the optimum number of years in which an audit firm should conducts an audit service to its clients is from one to five years. Some of the respondents constituting 20% think that there is no optimum year/s of audit service in which an audit firm spent its time with its clients. They said that, we cannot objectively state this type of year/s of service is optimum and any other year/s is not. However, there is a regulation, as it is mentioned earlier, which prohibits audit firms from auditing nongovernmental and governmental institutions for more than three years. In addition, they believe that long association will not matter if the audit team and audit partner who reviews the assignment not the audit firm is changed or rotated. The remaining 10% of the respondents consider that it is an optimum period to audit a client from 6 to 10 years. It can be concluded that most audit firms believe that the audit firms should audit a client for a maximum of 5 years otherwise their independence can be jeopardized.

3.6. Cutoff date for long association

Mandatory rotation of audit firms implies that an explicit limit should be placed on the time during which a specific audit firm may be the auditor of a specific client company. The maximum time limit for the rotation process has been indicated in some countries audit laws as it is indicated earlier. Whereas, some countries did not specify the time limit with which the audit firms stay with their clients. In Ethiopia, despite the regulation with respect to governmental and nongovernmental organizations to be audited only for three successive years according to the survey results, there is no limit which states the number of years an audit firm should conduct its audit activity for a client.

Table 3.13: Audit firms responses on the cutoff date for long association between an audit firm and a client Yes Is there a cutoff date for long association between an audit firm and its client? 14% 86% 100% No Total

In line with the above question, selected audit firms were also asked whether there is a cutoff date for long association between an audit firm and its client. The majority of the respondents i.e. 86% of audit firms agree that it is difficult to put a cutoff date/year for long association between the audit firm and client despite some laws concerning NGOs and governmental organizations. They also added that the term cutoff date for long association by itself is subjective and ambiguous that one cannot specify accurately. The remaining 14% of the respondents identified that, they may call it long association when one audit team of a firm undertakes audit work for the client in a period more than five years. Hence, these respondents specify five years as a cutoff date for long association.

3.7. Ethical problems in relation to audit tenure and audit firms independence
Some respondents stated the following ethical problems concerning long association of audit firms with their client and their independence on the free space provided in the last part of the questionnaire. When there is long association with clients, the firm may develop a fear of losing the client, so it may stand in favor of the client. Most of the time the client is a major source of revenue for a firm. In this case, the audit firm can be an advocate of a client. Since there is a shortage of staff members for most audit firms, the same audit team is going to conduct an audit to a client for more than two years. Long association usually creates intimate friendship and personal relationships which adversely affects the independence of audit firms. The absence of specified year/s for the duration of audit firm with clients by itself can create an ethical problem.

CHAPTER FOUR SUMMARY, CONCLUSIONS & RECOMMENDATIONS

The aim of this chapter is to give a general summary of the analysis through discussions and make broad conclusions drawn from the findings of the results. Moreover, the research paper will make possible recommendations; depict grey areas that could be interesting for future research as well as highlight some limitations of this research project.

4.1. Summary and conclusions

Most audit firms, based on the sample, have worked for less than ten years as licensed audit firm indicating that most audit firms are established recently for auditing the clients financial statements. They have staff members up to five qualified individual auditors. This indicates that most private audit firms have a shortage of experienced auditors. Moreover, most individual auditors who are working in the audit firms are male and all are Ethiopians. The majority of individual auditors who are working in these private audit firms are bachelor degree holders. Audit firms independence is indispensable in Ethiopian auditing practice. It is not only essential in Ethiopian auditing practice but also internationally because there is no need for audit practice without an independence of audit firms. Independence is a crucial concept that gives auditors a core mission to certify the public reports that describe companys financial status which is an exclusive function performed by audit firms for the society. In Ethiopia, the Office of Federal Auditor General (OFAG) has adopted standards to be followed by authorized audit firms and accountants. Standards vis--vis independence has been identified together with other forms of standards under chapter two of the general standards. Practically, audit firms independence are ensured, according to the survey results, through investigations and

assessments made by the Office of Federal Auditor General (OFAG) on the auditors working papers and by interviewing some external auditors randomly when they are on duty at their clients offices. Most audit firms are rendering non-audit services to their clients. All of them are providing tax related services and most of them are giving accounting system design services and advise on internal audit and internal control system. Few of the audit firms are giving management consulting and financial system design services to their clients. All of them offer their services to manufacturing, merchandising and service companies and half of them to mining, transportation and financial institutions and few of them to real estate companies. With respect to the proportion of audit and non audit services, I can conclude that non audit services may not impair audit firms independence. This is because, the percentage of non audit service fees are 15% or below from the total income earned by the audit firms. Most respondents do not agree that their independence can be impaired by providing incompatible services though they believe strongly in the absolute need for audit firms independence, objectivity and integrity. However, they believe that delivering incompatible services may affect other firms independence. The majority of audit firms are providing audit work for more than three consecutive years to their audit clients. It can be concluded that, those audit firms who stay with their audit clients for more than three years may lose their independence since they may become too aligned with clients. Nearly everyone of the selected audit firms agree that long association between audit firms and clients can affect audit firms independence. Half of the audit firms express that three consecutive years is enough time for conducting an audit for one client. Others believe that the duration may depend upon the type of the client. In the case of non- governmental and governmental organizations, there is a regulation which prohibits audit firms from conducting an audit above three years. For private limited companies (PLC) and sole proprietorships no limit has been set as to the length of audit work that can be conducted by an audit firm.

The majority of the respondents believe that the optimum number of years in which an audit firm performs an audit service to its clients is from one to five years. Few of them think that there is on optimum year/s of audit service in which an audit firm spent its time with its clients. The majority of the respondents/ audit firms are in agreement that it is difficult to put a cutoff date/year for long association between the audit firm and client despite some laws concerning NGOs and governmental organizations. They also added that the term cutoff date for long association by itself is subjective and ambiguous that one cannot specify accurately. To sum up, the findings of this study reveals that though most of the sampled audit firms which are working in Addis Ababa are rendering non-audit services to their clients, the proportion of nonaudit service fees from the total income becomes insignificant. Therefore, it can be inferred that the provision of incompatible services to clients may not impair audit firms independence. On the other hand, with respect to long association of audit firms with their clients, the major finding of this study was most of the audit firms (55.56%) have been auditing their clients for more than three uninterrupted years. From this finding, it can be concluded that extended audit tenure between audit firms and their clients may have a negative effect on their professional independence. This research project tried to identify some ethical problems in relation to independence of audit firms which are working in Addis Ababa with respect to compatibility and non-compatibility of services and audit tenure. It has tried to cover the gap with regard to the above components of independence. However, audit firms independence will be impaired by other factors which are beyond the scope of this paper. Hence, the potential researchers can conduct their study on the remaining factors which affects independence of audit firms. Moreover, this research paper has identified some ethical problems of audit firms from the view point of selected private audit firms in Addis Ababa. It will contribute a lot when other prospective researchers accomplish their studies from the audit clients perspective in Addis Ababa or outside.

4.2. Recommendations
The following possible recommendations can be used to help audit firms keep their professional independence in relation to the compatibility of services and audit tenure which they have with their clients.

Authorized audit firms and accountants have an important role in society. Investors, creditors, employers and other sectors of the business community, as well as the government and the public at large rely on professional accountants for sound financial accounting and reporting, effective financial management and competent advice on a variety of business and taxation matters. Therefore, audit firms should discharge their professional responsibilities and accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate commitment to professionalism.
When the number of staff members of the selected audit firms was reviewed, most of them

had a shortage of certified and experienced auditors who carry out audit services to their clients. Hence, it is appropriate to employ additional auditors who are certified with ACCA
(Association of Chartered Certified Accountant) to effectively conduct audit services.

With respect to incompatible services provided by the audit firms, most of them are rendering to their clients. However, in determining the appropriateness of a particular service, one guiding principle, which I support, should be whether the service facilitates the performance of the audit, improves the clients financial reporting process, or is otherwise in the public interest.

 Audit firms should give an opinion based on the findings during an examination of financial statements not based on the wish of their clients since they have professional responsibility to present what has been found. The Office of Federal Auditor General (OFAG) should establish regulation which limits years of association of audit firms with their clients especially for private organizations like the one which dictate non-governmental and governmental organizations to be audited only up to three uninterrupted years.

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