An overseas audit deal between Rentokil Initial and KPMG has raised eyebrows in the United States, prompting the Institute of Internal Auditors to remind capital markets of the significance of auditor independence.

Rentokil Initial is a British-based company that asked its external audit firm, PricewaterhouseCoopers, and KPMG to provide proposals for “a more integrated financial assurance process extending external audit coverage to some work undertaken by internal audit,” according to the company’s most recent interim report. The company’s board of directors decided to hire KPMG for its 2009 audit, reducing internal and external audit costs by about 30 percent. PwC will continue providing “significant specialist assurance and non-audit services.”

A United Kingdom audit official for KPMG said performing internal audit work isn’t a conflict conceptually, “only if you get involved in the wider aspects such as management, which we are not,” according to a press report. “Companies are aware today of the importance of good assurance yet at the same time, they’ve got to look at costs. There are ways you can do it more efficiently and effectively.”

In the United States, auditors are subject to independence rules under both the Securities and Exchange Commission and the Public Company Accounting Oversight Board that forbid external auditors from performing internal audit work and certain other tax and consulting services for their clients. The idea is to keep external auditors at arm’s length from their audit clients so they can perform an objective audit.

The Institute of Internal Auditors published a statement to emphasize that the blending of internal and external audit services under one firm is a bad idea. “We have expressed this numerous times over the past two decades and we feel it’s important to re-emphasize this at a time in which the practice is potentially being reconsidered,” said Richard Chambers, IIA president and CEO. Even if it’s permitted in other countries, Chambers said it creates a “perceived impairment” of independence and chips away at public trust in the audit process.

“It’s not really useful for anyone for the external auditor to provide internal audit services for a client,” Chambers told Compliance Week. Acknowledging the present-day demands on internal auditors, he said it’s not uncommon for global companies to hire an outside firm to help with internal audit work, but it shouldn’t be the same firm that performs the external audit.

The Center for Audit Quality is touting the role of auditors in capital markets with a consumer-focused guide to investors explaining what auditors do.

The “Guide to Public Company Auditing” is a broad, basic overview of the auditor’s role in providing assurance that a company’s financial statements are fairly stated. It explains the relationship between company management, the audit committee, and the auditors, and it describes how an audit is performed.

The guide also explains some of the touchy issues around auditing, such as the auditor’s role and limitations in finding fraud and auditors’ requirement to maintain independence from management.

The CAQ said it published the guide with hopes it will help investors and others with roles in public policy to better understand how auditing is done. The guide “is in line with the CAQ’s mission to foster confidence in the audit process and to aid investors and the capital markets,” said Cindy Fornelli, executive director of the CAQ. “By giving market participants the information they need to make informed decisions, public company auditors are responsible for an increasingly invaluable function.”

Auditors have long worked against what has become known as the “expectation gap,” or the perception that investors assume the audit is supposed to provide a guarantee against misstatements or errors in the financial statements. The guide points out that audits provide “reasonable assurance” but not absolute assurance. “Because auditors do not examine every transaction and event, there is no guarantee that all material misstatements, whether caused by error or fraud, will be detected,” the guide says.

The guide also explains that auditors are hired by and report to the audit committee of the board of directors, not management, to assure greater independence from management, which brings more professional skepticism to the audit.

The proportion of audit vs. non-audit fees paid by public companies to their audit firms held steady in 2007 after the dramatic shift that occurred with Sarbanes-Oxley.

According to the latest data from Audit Analytics, fees for audit work paid by public companies to audit firms accounted for 79 percent of the total amounts those companies paid to audit firms in 2007. The remaining 21 percent paid to audit firms represents consulting services that are not directly tied to the audit work for financial statements or internal control over financial reporting.

Non-audit fees as a portion of total fees paid to audit firms plunged in 2002, 2003, and 2004 with implementation of Sarbanes-Oxley, which brought in new requirements for auditors to establish more independence from their clients. The split between audit and non-audit fees has remained relatively stable from 2005 to 2007, according to Audit Analytics.

Don Whalen, director of research for the firm, says it tracks audit vs. non-audit fees as a way of helping monitor auditor independence. “The Securities and Exchange Commission and other agencies are concerned if the principal auditor earns too much on the non-audit fee side of things, they inadvertently become biased when performing the independent audit,” he says. “It’s critical to keep a finger on the pulse of audit fees and non-audit fees.”

Whalen said it might be unrealistic to expect any further spread between audit and non-audit fees. “Some regulations require the auditor to help registrants prepare for regulations,” he says. “I think 20 percent is a good figure. If 80 percent of the money is coming from the independent audit, then the independent audit isn’t going to be influenced by the other one-fifth.”

Emerging academic research suggests companies may be better off having one audit firm assist with both the internal and external audit, punching holes in the Sarbanes-Oxley tenet that external auditors aren’t adequately independent if they assist with internal audits.

Three accounting professors looked at the outsourcing of the internal audit function and the risk of misleading or fraudulent financial reporting. The professors wondered if companies that outsourced their internal audit function to their external auditor before Sarbanes-Oxley prohibited such ties had a higher risk of misleading or fraudulent financial reporting. Their preliminary findings suggest the Sarbanes-Oxley assumptions may have been wrong.

“We looked at accounting risk as an indicator of future problems, like restatement or enforcement actions,” said Douglas Prawitt, accounting professor at Brigham Young University. “We found the accounting risk is lower for companies that outsource internal audit to their external auditor. If the external auditor does both the external and the internal audit, the accounting risk is actually lower.”

Prawitt said there are two competing factors at play. On the one hand, Sarbanes-Oxley reasoned that the external auditor is too economically bonded to the client company if it also performs internal audit work, likely skewing the external auditor’s judgment or ability to be skeptical.

“The flip side of that coin is the knowledge gain,” said Prawitt. “When you do more for the client, you learn more about the client, so you possibly do a better job of both. The explanation we offer is if you do both the external and the internal audit, you’re a better auditor all around, so the financial statements come out with less accounting risk.”

That doesn’t mean, however, that the researchers would advocate for policy change, said David Wood, accounting professor at Brigham Young University and co-author of the study. “Within the current regime, it increases the importance of communication between the different governance players,” he said. “There needs to be more working together to achieve good governance.”

Nathan Sharp, another co-author and a professor at Texas A&M University, said Sarbanes-Oxley’s prohibition of a link between internal and external audit likely still serves an important purpose in investor confidence. “Lawmakers are dealing with a problem with the public’s perception of auditor independence,” he said. “Even if the data go in an opposite direction, they’re not only worried about independence in fact, but they’re also worried about independence in appearance.”

Auditors need to get more skeptical and supervisors need to get more engaged when it comes to crucial, high-risk financial reporting areas, according to a recent report from audit regulators.

The Public Company Accounting Oversight Board said audit deficiencies persist in many cases because auditors aren’t skeptical enough, especially at the highest levels in the auditing reporting chain. Certain deficiencies led the PCAOB to have doubts about the sufficiency, rigor, and effectiveness of audit supervision, especially from engagement managers, engagement partners and concurring partners. The board raised concerns about the level of professional skepticism and objectivity, even in some of the larger audits that have been inspected.

The PCAOB published the report to summarize four years worth of observations inspecting the eight largest audit firms, which are inspected annually. It found there are still shortfalls in key audit areas such as revenue recognition, fair value, management’s estimates, determination of materiality, and audit scope.

PCAOB Chairman Mark Olson told an audience of accountants and auditors at a conference of the American Institute of Certified Public Accountants that inspectors found some recurring themes as they reviewed audits of all shapes and sizes. Most notably, auditors fail too often to look for terms in sales contracts or test estimated total costs to complete long-term contracts to verify revenue recognition. Inspectors also frequently flagged problems in planning audits and evaluating audit results, he said.

“In some cases, the deficiencies appear to have been caused at least in part by the failure to apply the right degree of professional skepticism, which is always critical to the conduct of a quality audit,” Olson said. “In fact, some of the deficiencies occurred in some of the larger audits, where one may assume that the depth of experience and expertise of the audit team should not be an issue.”

The summary report says inspectors pulled personnel files for partners that had racked up significant negative inspection results and developed concerns about how partners were evaluated and compensated, finding little to suggest audit quality was a factor. Inspectors found “concurring review partners or internal inspectors were not held accountable for failing to identify significant deficiencies in audits they reviewed and where partners’ quality ratings were affected significantly by the results of client satisfaction surveys or the profitability of their audits and their ability to increase revenues,” the report says.

Inspectors also found technical personnel too often reported through folks in charge of growing audit practices, raising concerns about objectivity. Olson said firms have responded to those criticisms, aligning audit partner compensation with audit quality and changing reporting structures to minimize the likelihood that economic considerations would impact audit considerations. The board also has a standard in development that would address the engagement quality review.

The report notes some audit areas have shown marked improvement since the beginning of the inspection process, especially the confirmation of accounts receivable and the auditing of income tax accounts. The board also notes while there are still concerns about auditors’ use of analytical procedures, the concerns have narrowed to only a handful of issues rather than the overall failure to apply governing standards discovered at the outset of the inspection process four years ago.

“You can be assured that PCAOB inspectors will continue to focus on the significant areas where they have encountered deficiencies, as well as new areas that emerge as economic conditions and accounting and auditing guidance continue to evolve,” Olson said.