Introduction and Background to Auditor Independence
Audits are examinations of financial or non-financial information for the purpose of evaluating its reliability, intended for users of information who are either internal or external to the organization. The objective of external auditing is to increase the confidence of shareholders regarding the quality of the financial information produced by organizations.
Audit independence refers to the ability of the external auditor to act with integrity and impartiality during his auditing functions (Akpom and Dimkpah, 2013). The concept of independence comprises two elements: independence in fact and independence in appearance. Independence in fact is the mental state that allows an auditor to perform his or her own duties with integrity and objectivity, without being influenced by factors that could compromise his or her professional judgment. Independence in appearance refers to public perception of “the absence of circumstances” that would cause a third party to conclude that an auditor’s integrity, objectivity, or professional judgment had been compromised (Blann, 2012).
The Importance of Auditor Independence
Independence is one of the most important requirements for audit firms. Audit independence is a key factor in the auditing discipline, as investors rely on audited financial reports to make economic decisions hence, an honest and unbiased opinion on the truthfulness of a firm’s financial statements is fundamental to build trust in reported numbers (Lopez & Bonilla 2018, p. 2).
Audit review is a mandatory requirement for public-listed firms by financial regulators in most countries. However, there is an economic relationship between the auditor and its client because of the way in which audit fees – and potentially other fees – are paid by the client, that relationship constitutes a direct threat to said independence (Lopez & Bonilla 2018, p. 2).
The importance of audit independence was underpinned after the infamous corporate scandal that saw the collapse of Enron in 2001 and the eventual dissolution of public accounting firm Arthur Andersen that had negatively influenced public perception of the audit function.
Threats to Auditor Independence
A threat to auditor independence is defined as any circumstance that could impair an auditor’s professional judgment. The audit profession has recognized the following six threats to auditor independence:
1. Self-interest threat
Self-interest threat may occur as a result of financial or other interests of an audit firm, a member of the audit team, or of an immediate or close family member. For example, an auditor’s objectivity may be impaired, or may be perceived to be impaired, if he had an investment in the client’s firm, the value of which would be affected by the outcome of the audit engagement and report. Such threats may also arise where an auditor depends on the management of the company to secure its re-appointment as auditor.
2. Self-review threat
Self-review threat may occur when a previous engagement needs to be reviewed by an audit firm or a member of the audit team that was responsible for that engagement. For example, the auditor’s objectivity in forming a view on the carrying value of an asset may be, or may be perceived to be, impaired if he or another partner of the firm had assisted the client in valuing the asset for financial reporting purposes.
3. Management threat
The management threat may arise when the auditor assumes the role of management and takes part in decision-making which are the responsibility of the client. In the case where an audit firm is involved in the selection and implementation of the accounting system for the client, the auditor may become closely aligned with the views and interests of the management, resulting in the impairment, or perceived impairment, of the auditor’s objectivity and independence.
4. Advocacy threat
Advocacy threat may occur when an audit firm or a member of the audit engagement team promotes a position or opinion of a client to the point that subsequent audit objectivity may be compromised. For example, the auditor’s objectivity in forming a view on the carrying value of a potential liability may be, or perceived to be, compromised if he or another audit partner of the firm were assisting the client in the related litigation against a third party, or in advocating a client’s position publicly may be seen as too closely associated with management’s interests.
5. Familiarity threat
Familiarity threat may occur when, because of a close relationship, an audit firm or an audit team member becomes too sympathetic to the interest of the client, thereby impairing his objectivity. For example, an auditor’s objectivity may be compromised in forming a view on the truth and fairness of a client’s financial statements if he or she develops too close a personal relationship with a member of client’s management.
6. Intimidation threat
Intimidation threat may occur when an audit firm or a member of the audit engagement team may be deterred or prevented from acting objectively by threats, actual or perceived. For example, an auditor may be deterred from giving an objective audit report if he or the firm were overly reliant on the client in terms of fees and there was a threat from the management that the firm would be asked to resign if the audit opinion was unfavorable. Such a threat could arise if the auditor were subject to the demands of an over-domineering or powerful client.
Ernst & Young – the Case of Gregory Bednar
To the assignment question on Ernst & Young’s former senior audit partner Gregory Bednar, he was tasked with mending a client relationship and got too close with the client’s chief financial officer. This is a form of familiarity threat that would have compromised his objectivity in forming an unbiased view on the truth and fairness of the client’s financial statements. Moreover, Bednar had spent more than $100,000 in entertainment expenses for the client. He had succumbed to the self-interest threat and impaired his objectivity in auditor’s independence as Ernst & Young had a financial interest and was dependent on the client for audit fees.
Ernst & Young – the Case of Pamela Hartford
In the separate case involving another Ernst & Young’s former audit partner Pamela Hartford, she had been ‘romantically involved’ with Robert Brehl, Ventas’s former Chief Accounting Officer and Controller between 2013 and 2014, while auditing the firm. Due to the nature of ‘romantic relationship’ between the audit partner and the client’s management team member, the familiarity threat would have caused her to align with the client’s interest and compromised her objectivity required in auditor’s independence.
The Enron Scandal
Audit firms sometimes set audit fees at less than market rate and make up for the deficit by providing non-audit services, such as tax advisory and management consultancy. As a result, some audit firms have commercial interest to protect too. This raises concerns that the auditor’s interests to protect the shareholders of the client and his own commercial interests may conflict with each other (Corplaw 2014).
A high-profile example would be the relationship between US energy giant Enron and its auditor, Arthur Andersen. In 2000, Andersen received from EnronUS$27m for non-audit services, compared with US$25m for audit services, which accounted for over 25% of the fee revenue generated by the firm. In the aftermath of Enron’s bankruptcy, Andersen was accused of not acting independently and that they had aligned with Enron’s interest in order to retain their work (Corplaw 2014). This was a classic case of self-interest threat and self-review threat that seriously impaired auditor independence.
Measures to Safeguard and Strengthen Auditor Independence
Considerable emphasis must be placed on the need for the auditors to recognize the effects of the inherent conflicts of interests that arise as a result of the audit firm being paid by the client, as well as to deal with other ethical dilemmas as they arise. There are rules, regulations and guidelines set by governments and international agencies to help reduce threats to auditor independence, to safeguard and to strengthen auditor’s independence.
1. United States – Sarbanes-Oxley Act (SOX) 2002
Following a series of financial scandals in Enron, WorldCom and others, public concern for auditor independence became heightened and the 2002 Sarbanes-Oxley Act (SOX hereafter) was passed by the US Securities and Exchange Commission (SEC) to protect shareholders’ interest.
The SOX contains prescriptive rules in preventing conflicts of interest and undue influences by company management in the works of auditors. Non-audit services, partner rotation, audit committee, etc. It also requires fully independent audit committees to be directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm. This statutory requirement is a regulatory attempt to eliminate management influence over the external auditor and align auditor incentives with those of the board and shareholders (Dhaliwal, Lamoreaux, Lennox & Mauler 2018).
2. United Kingdom – Companies Act 2006
In the UK, the Companies Act 2006 contains provisions related to company audit and auditors, provide rules for independence and the effect of lack of independence, and regulate auditor’s appointment, removal, resignation and remuneration, as well as disclosure of fees and expenses paid to auditors for non-audit services.
3. The International Federation of Accountants (IFAC)
International accounting bodies such as The International Federation of Accountants (IFAC) provides a framework of principles that auditors should use to identify threats to independence, evaluate the significance of those threats, and if they are present, identify and apply safeguards to eliminate the threats or reduce them to an acceptable level, such that the independence in fact and independence in appearance are not compromised.
The International Standard on Auditing (ISA) UK 200 sets out the ethical requirements pertaining to auditor independence. In the UK, auditors are subject to ethical requirements from two sources: the Financial Reporting Council’s Ethical Standard concerning the integrity, objectivity and independence of the auditor, and the ethical pronouncements established by the auditor’s relevant professional body (Financial Reporting Council 2016).
4. The Auditing Practices Board (APB)
The Auditing Practices Board’s (APB) ethical standards relating to integrity, objectivity and independence of auditors provide general environmental safeguards for auditors and specific safeguards for identified situations of risk (Gray, Manson & Crawford 2017, pp. 129-130).
5. Audit Firms’ In-house Policy
Public accounting firms typically require their auditors to comply with its code of conduct or in-house guide to independence requirements. Such in-house policies serve to safeguard auditors on how to conduct their business and personal affairs so as to avoid the impairment, or the appearance of impairment, of the objectivity of the firm’s professional work (PriceWaterhouseCoopers 2016).
Peer Review Programme is another measure to strengthen auditor independence, which is the review of the outcome of an audit engagement by a concurring audit partner. It is essentially a quality control procedure designed to ensure that audit quality is maintained throughout the profession.
Mandatory rotation of auditor can enhance the confidence of investors and provide better quality audit. The new audit firm may bring different perspective to the company and make constructive suggestions for improving audit process. Lack of auditor rotation could conceivably compromise independence in some organizations.
6. The Role of Audit Committee
An audit committee is an operating committee of a company’s board of directors in charge of overseeing financial reporting and disclosure (Choi, Han & Lee 2014). The committee typically involves the oversight of financial reporting, monitoring of accounting policies, oversight of external auditors, regulatory compliance, risk management, and special investigations in cases of suspicious or problematic accounting practices (Chien, Mayer & Sennetti 2010).
Post SOX, countries like Singapore, Malaysia, Hong Kong, and Korea also mandated the audit committee system for public-listed companies to strengthen auditor independence and to protect shareholders’ interest (Choi, Han & Lee 2014).
Conclusion
Most of the times, stakeholders and the public consider an auditor’s report to be a clean bill of health (Salehi 2016). There may be expectation gaps between what the society perceives to be the nature of assurance that results from the audit and the actual purpose of the audit. However, it is not the objective of the auditor to attempt to resolve these differing expectations beyond clarifying the purpose and impact of the audit (Institute of Chartered Accountants in England & Wales 2006). Accordingly, the UK Companies Act 1985/2006 does not prescribe that auditors have a duty to detect fraud, hence any duty that auditors have for detecting fraud relates to their duties to form a true and fair view opinion of the financial statements.
Auditors’ responsibility for fraud detection and their liability to third parties have been of major concern in recent years. Due to many recent financial scandals and their subsequent impact on the audit profession, there is more pressure on auditors to take responsibility for fraud detection. Society also has a general expectation that auditors will help to fulfill the need to detect fraud. However, it is difficult to establish auditors’ liability to third parties because there is no contractual relationship, as the only contractual relationship is between the company and the audit firm.
Nevertheless, auditors owe a duty of care to the company and can be sued for negligent by the company under contract law when they failed to detect a material fraud in the company (Gray, Manson & Crawford 2017, p. 814). Liability is one of the few threats that keep auditors up to the mark (The Economist 1992).
Reference List
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