Auditors’ Independence: Threats and Concerns

Introduction

The value of auditing rests on two crucial requirements. First, the attestation needs to be competent. It needs to be undertaken by those with appropriate expertise and may involve the necessity of having a competent audit structure, technologies, and processes to undertake the audit. Second, it must be undertaken independent of management. The judgment exercised by the auditor needs to test the assertions made by the management and not simply concur with them.

The independence of auditors has long been a subject of great debate. With the globalization of large multi-disciplinary companies and recent happenings with respect to large accounting firms, the matter has once again taken the prime spot in the accounting sector. Fresh guidance and measures issued by The International Federation of Accountants (IFAC), the Security Exchange Commission (SEC), Independent Standard Board (ISB), European Commission (EC), FEE, and many other accounting bodies world over have encouraged a wider consideration of the issue.

Public confidence in statutory auditors performing their audit work independently would considerably increase when factual independence is displayed by auditors for all concerned to observe it happening. ‘Independence in appearance’ has gained prominence to ensure that auditors in fact possess the independence.

The auditors should seriously view the threats to their independence that may arise in practicing the profession; and take necessary available safeguards to eliminate those threats or reduce them to an acceptable level. Threats emerging out of performances of ‘non- audit services’ for audit clients are real challenges for auditors and authorities. Rotation of auditor order by authorities may provide a temporary respite, but the damage caused by rotation of deterioration of technical experiences gained through the regularity of audits would definitely affect the audit efficiency. Auditors’ concern for independence contains many other issues that endanger the very concept of audit independence. These matters of concern to the auditors are studied in-depth in this paper to display the exact prevailing scenario.

Statutory auditors’ independence is of considerable interest to stock markets, banking and insurance industry, investors, and many other interesting sectors. But for the accounting profession auditors’ independence is one of the main means of demonstrating that statutory auditors and audit firms perform their task at a level that meets established ethical principles, particularly those of integrity and objectivity.

Literature Review

‘The profession’s authoritative literature on audit independence does not contain an unmistakably clear concept of establishing independence rules. By an unmistakable clear concept, we mean one of that consistently defines what is included and what is excluded from the category audit independence. There are, of course, many rules designed to judge independence in specific situations, but these kinds of rules are too rooted in the specific situations to be able to applicable to all other situations.’20

An auditor is not independent with respect to an audit client if the auditor is impaired in the auditor’s exercise of objective and impartial judgment on all matters arising out of the auditor’s engagement. Auditor independence is one of the most important issues in accounting practice these days. Independence increases the efficiency of the audit by providing assurance that the auditor will plan and execute the audit objectively. High quality audit enhance the reliability of the financial statements among the users of such statements.

For long auditing profession is considered as pious profession from the point of view of its reputation and ability to be independent in providing opinion on financial statements. The immediate objective of auditing of financial statements is to improve the reliability of financial information. Recently this reputation of being ‘independent’ faced open public criticism in view Enron and other scams. These happenings focused the issue on accounting and auditing practices. The independence of auditors became the major concern as auditor independence is fundamental to public confidence in the audit process and reliability of financial statements. In fact is that audit adds to the value of financial statements that become basis of numerous transactions in the field of trade and commerce in the world. In case of investors in stock markets, audit is not just a benefit to investors, but it reduces the cost of information for both buyer and seller.

After recent happenings, auditing profession, with its back on the wall, is trying hard to appear and function to reinstate its ‘independent ’image. The conceptual framework of financial reporting developed by FASB lays the emphases on enhancing the confidence of the users of financial statements. Statement of Financial Accounting Concepts (SFAC) 1 states “financial statements are often audited by independent accountants for the purpose of enhancing creditability in their reliability”. It further observes that both users and providers of information “view an independent auditor’s opinion as enhancing the reliability or creditability of the information”.

Definition of Auditors’ Independence

Auditors’ independence implies that auditors have to remain independent from parties, other than shareholders, while executing their professional assignments as those parties have an interest in financial statements of the entity being audited by the auditors. So much so, the auditors have to be independent of the management from whom they claim their professional remuneration.

Basically independence is freedom from pressure and other factors encountered during execution of work assignments. These pressures or factors affecting independence may be indicated by certain activities or relationship emerging during work or job execution. These activities or relationship may impair or perceived to impair the willingness of auditors to exercise appropriate personal attributes, including objectivity and integrity, when performing audit functions.

The official definition of audit independence exists in AU section 220 of the AICPA’s codification of auditing standards. As per second general standard the auditor “must be without bias with respect to client since otherwise he (or she) would lack that impartiality necessary for the dependability of his (or her) findings, however excellent his (or her) technical proficiency may be”. The section further states independence requires “intellectual honesty” and a “judicial impartiality that recognizes an obligation not only to management and owners of a business but also to creditors and those who may otherwise rely (in part, at least) upon the independent auditor’s report, as in the case of prospective owners or creditors”.

‘The definition of independence does not require the auditor to be completely free of all the factors that affect the ability to make unbiased audit decisions, but only free from those that rise to the level of compromising that ability. For example, the audit client pays the auditor’s fee, so complete independence is impossible and not necessary to meet the framework’s definition.”6

In 2002, ‘The Chartered Institute of management Accountants’ (CIMA) conducted a study on independence of auditors. The study reviewed the following three definitions of term ‘Independence’ in the context of auditors before making recommendations in this respect. IFAC, EC, and SEC have pronounced the three definitions on independence of auditors reproduced hereunder respectively:

International Federation of Accountants (IFAC) defines independence as:

  • “Independence of mind: state of mind that permits the provisions 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.
  • Independence in appearance: avoidance of fact and circumstances that are so significant that a reasonable and informed third party , having knowledge of all relevant information, would reasonably conclude a firm’s, or a member of the assurance team’s integrity, objectivity, or professional skepticism had been compromised.” 1

With regard to auditor’s independence, European Commission (EC) states that:

“When carrying out a statutory audit, a statutory auditor must be independent from his audit client, both in mind and in appearance. A statutory auditor should not carry out a statutory audit if there are any financial, business, employment, or other relationships between the statutory auditor and his client (including certain non- audit services provide to the audit client) that a reasonable and informed third party would conclude compromise the statutory auditor’s independence.”2

European commission stresses that objectivity and professional integrity of the auditor should be demonstrated to the public as an act being conducted independently.

Security Exchange Commission (SEC), the regulators of US security market states that “independence is generally understood to refer to a mental state of objectivity and lack of bias.”3 It also observes that objectivity is a state of mind and that, except in unusual circumstances, a state of mind is not subject to direct proof. Usually, it is demonstrated by reference to circumstantial evidence.

According to SEC, “Independent auditors have an important public trust. Investors must be able to rely on issuers’ financial statements. It is the auditor’s opinion that furnishes investors with critical assurance that the financial statements have been subjected to a rigorous examination by an object, impartial, and skilled professional, and that investors, therefore, can rely on them. If investors do not believe that an auditor is independent of a company, they will derive little confidence from the auditor’s opinion and will far less likely to invest in that public company’s securities.”4

CIMA Audit Review Working Committee (ARWP) reviewed the above definitions and concluded that:

  • The approaches of IFAC, the EC, and the SEC towards independence are similar, albeit the SEC is more prescriptive.
  • The IFAC definitions are sound.
  • The perception, as well as the reality, of independence is fundamental in supporting investor confidence in the integrity and credibility of audited financial statements.”8

On the basis of above, conclusions CIMA recommended IFAC definition of independence. Therefore, auditors’ independence has two aspects, namely, independence in fact (or mind) and independence in appearance

Independence ‘in fact’

‘Independence in fact’ denotes that auditors are factually independent It is concerned with the sate of mind of the auditor. As stated earlier, the SEC definition of independence particularly dealt with this aspect of independence of the auditors. As per SEC, “The first prong of the standard is direct evidence of the auditor’s mental state: independence “in fact”. The second prong recognizes that generally mental state can be assessed only through observation of external facts; it thus provides that an auditor is not independent if a reasonable investor, with knowledge of all relevant facts and circumstances, would conclude that the auditor is not capable of exercising objective and impartial judgement.’5

Further in this regard, it is important to refer to Sec. 290.8 of IFAC ‘Code of Ethics for Professional Accountants’ that reads,

‘Independence requires:

Independence of Mind

The state of mind that permits the expression of a conclusion without being affected by influences that compromise professional judgment, allowing an individual to act with integrity, and exercise objectivity and professional skepticism.’9

APB of The institute of Chartered Accountants in England and Wales has recommended ‘When undertaking audit engagement, members should comply with the requirements of section 290 of the International Federation of Accountants (IFAC) Code of Ethics.’10

Basically, the ‘Independence in fact’ stratum is concerned with state of mind of the auditor, and how the auditor reacts to a particular situation. In some cases or situations, it is difficult to determine whether the auditor has acted independently, while in many situations it may not be possible to determine at all. How it is possible to judge what is going on in the mind of an auditor.

Independence in appearance

This stratum of auditor’s independence denotes how third parties view the independence exhibited by the auditor. It is necessary for auditors to not only act independently, but also be seen as independent. Independence in appearance, perhaps, reduces the possibilities for an auditor to act otherwise than independently. This is one of reasons exhibition of independence by an auditor lends creditability to auditors’ reporting of entity’s financial statement behavior.

“Independence in appearance is entirely based on perceptions. Consider the case of a partner who is not involved in an audit but whose child is given a share of stock in one of firm’s audit client- a client served by a firm office located halfway across the country. It is unlikely that anyone would view this indirect ownership interest-a child’s single share of stock-as impairing the firm’s objectivity and integrity. The question is at what point could the public perceive this as problematic.”7

Independence in appearance of auditors may be addressed by:

  • Prohibiting proprietors, partners, and employees of accounting firms from holding shares in, lending to, or otherwise having a beneficial interest , either directly or indirectly, in audit clients.
  • Prohibiting audit firm’s owners and their staff from receiving any benefits from client organizations, other than audit fee. These prohibitive benefits may take the shape borrowings, commissions, or discounts.
  • Prohibiting audit firm’s owners and their staff from holding any office, including the office of directorship, in client organizations.

In this regard, it is important to mention certain provisions of Sarbanes Act, 2002 those have tried to strengthen the dwindling role of auditors as independent auditors in fact and in appearance. ‘Sarbanes Oxley Act contains significant provisions for SEC issuers designed to strengthen both the fact and the perception of auditor independence. These include:

  • Direct reporting responsibility between independent auditor and audit committee , not management, of the company under audit.
  • Pre- approval by the audit committee of all services provide by the independent auditor.
  • Limits on the types on non- audit services that the accounting firms may provide to companies under audit.
  • More clearly defined disclosures of the fees paid to the auditors for all services.
  • Restrictions on the employment of audit engagement team members by companies under audit.
  • More frequent rotation of lead audit partner, concurring review partner, and other audit partners.’16

Following the above provisions of Sarbans Oxley the auditor and the management still be working together, but the independent nature of their working relationship will be strengthened through greater involvement of audit committees. Sarbans Oxley act has tried to establish the ‘Independence in appearance’ attribute of independence of auditors more prominently.

Vivien Beattie and Stella Fernley11 have, in their study ‘Auditor Independence and Non- Audit Services: A Literature Review, very rightly stated that ‘Independence is seen as a risk continuum rather than an absolute, and judgments about seriousness of the threat to independence are balanced against the effectiveness of the safeguard available. Five threats are identified: self-interest, self-review, advocacy, familiarity or trust, and intimidation.’ They have further recognized that ‘there are four main sources of safe guards: the regulatory framework, the audit firm’s internal quality controls, the client company’s corporate governance, and refusal to act.’

As far as audit firm’s internal quality controls are concerned, the audit firm must add the following two controls to ensure more independence in appearance:

  • The audit firm should circulate a list of its audit clients among its owners and staff so that they become aware about all the clients of audit firm, and may not indulge into prohibitive activities that tarnish the audit firm’s independence in appearance.
  • The owner and staff of audit firm are compulsorily asked to sign an undertaking stating that they are familiar with firm’s independence policy and they hold no prohibitive investments and/ or relationships with audit clients of the audit firm.

Self-regulatory measures provide foolproof system to demonstrate the independence of auditors. Audit firm collect documentary evidences, as stated above, from its owners and staff members. Nevertheless, important thing to display is professional morality and not just documentary evidences. Are the auditors ready to bind themselves in self disciplinary framework of internal controls?. Vivien Beattie and Stella Fernley11 in their study have pointed out that ‘Experimental studies of actual auditor independence in settings where joint provisions occurs have tended to show that auditors, if anything, have more independently. They become more critical when faced with self review threat and increase their effort generally.’ This disclosure about the attitude of auditors is encouraging. Auditors intend to put breaks to criticism of post Enron era. Auditors are ready to bring internal controlling systems to vehemently display the independence in appearance.

Independence in appearance has also been addressed through various statutes in different countries, professional standards issued by professional bodies, and the policies of the audit firm. However, even after bounding themselves with various professional and statutory restrictions, it is seen that some actions of professional auditor harm to their reputation of independence. There is an increasing concern that these strategies do not fully address the problem of independence of auditors. Some argue that knowledge gained through by undertaking the consulting work; whereby audit firm earns additional monetary gains, enable the auditor to perform audit assignments in a more effective manner. As such, consultancies provided to its clients by audit firm’s owners and staff should not be considered as breach of independence in appearances.

Potential Threats to Independence of Auditors

Threats to auditors’ independence represent pressures or other factors impairing an auditor’s objectivity. In fact, threats to auditors’ impartiality are the sources of potential bias that may compromise an auditor’s ability to make an independent observation. These threats find way through various types of activities, relationships and other circumstances. It is useful and necessary to analyze threats to auditors’ independence based on their nature and significance of their effect on, or potential effect, the independence of auditors. There are, as per CFAI, five types of potential threats to the independence of auditors as discussed hereinafter.

Self interest threats

These threats emerge out when auditor’s activities are influenced by auditor’s own emotional, financial, and other personal self interests. Auditors may favor, consciously or subconsciously those self interest over the interest of performing a professional assignment. Auditor’s relationship with client creates a financial self interest as the client pays the auditor fees. Auditors also have a financial self-interest if the auditor owns shares in an auditee. Similarly, an emotional or financial self-interest is created if an employment relationship exists between someone from auditor’s family and auditee.

Regulators, financial statement users, and researchers are concerned that auditors compromise their independence by allowing high fee clients more financial statement discretion relative to low fee clients. Audit fee or for that matter total financial earnings from a client play a serious role to infringe the impartial audit functioning. Self- interest threat that got considerable attention in Enron case was the auditor’ fee creating threat to the auditor independence. Ashbaugh, Hollies and others in a paper titled ‘Do non audit services compromise auditor independence? Further Evidence15 have researched on issue “whether the degree of client auditor bonding is associated with evidence that financial statements reflect a biased view of the client’s financial condition.” The results were revealing when the paper states “ We both use the magnitude of discretionary accruals and earning benchmarks as evidence of biased financial statements.

Discretionary accruals and earning benchmarks can be viewed as an evidence of auditor independence violation on three assumptions. The first assumption is that an independent auditor requires his/ her client to file objective (i.e. unbiased) financial statements. The Second, discretionary accrual provide a measure of the degree of biased inserted into the financial statements by the management and allowed by the auditor. Third, just meeting or beating earnings benchmark such as prior years’ earnings or a current analyst forecast is not random, suggesting that managers bias financial statements to meet earning targets.”15 The result of the investigation reflects that financial earnings are real self- interest threat to independence. The audit firm plays a role in emergence of self interest threats. Many a times, self-interest from a large fee is very effective in disturbing the impartiality of the auditor. The audit firm under such circumstances should take up the matter with audit committee of the auditee and bring out normalcy in the entire affair.

Self review threats

A self-review threat may arise when auditors review judgments and decisions they, or other in their organizations have made. These threats arise from auditors reviewing the work done by the auditors themselves or by their colleagues. No body will like to find out his/ her own deficiencies in the work, and per chance some one is positioned to assess or review one’s own performance bias are going to emerge during such assessment or review at the cost of independence. That is why it is advocated vehemently that the same auditor should not conduct external as well as external audit of a client.

It may be more difficult to evaluate without bias the work of one’s own organization than the work conducted by some one else or some other organization. Various authorities have always put restrictions on activities of auditors so that situation of self- review does no creep up. Like, SEC has always prohibited auditors from bookkeeping. In fact, Sarbans- Oxley statute has made it even legal. But there are threats from other quarters. ‘Many services are routinely provided to audit clients as part of audit (i.e., that are not non- audit services) that arguably involve reviewing one’s own work and that are not explicitly covered by any law or rule. For example auditors frequently:-

  • Propose adjustment entries to the client’s financial statements;
  • Prepare, or heavily involved in the preparation of , federal and state income tax provisions, as well as the provisions of income taxes in many foreign subsidiaries;
  • Calculate LIFO provisions; and
  • Determine allowances for doubtful accounts and notes receivables, inventory obsolescence, warrantee obligations, and legal matters.’13

Self-review threats may arise in certain circumstances where an audit firm provides internal audit services to an audit client. This would arise, for example, where there is no clear separation between the management and control of internal audit and internal audit activities themselves determines the nature of subsequent audit procedures.

Advocacy threats

Advocacy threats arise when an auditor or someone from auditor’s organization acting in support of, or in opposition to, an existing or past auditee in the resolving a dispute or a litigation. Imagine a situation when an auditor defending the financial statements of his audit client in a tax court of law. Auditor can never remain independent when he seeks clearing his own qualified statements before say tax authorities. Few examples of circumstances that may create such threat are as under:

  • Audit team member dealing in, or being a promoter of, shares or other securities in an audit client; and
  • When a member of audit team appears for the audit client in a court of law to defend the client in resolving disputes with third parties.

Familiarity (Trust) threats

Auditor’s independence gets affected when auditee is relative or friend of the auditor. These types of threats to auditors’ independence arise when auditors are influenced by a close relationship with auditee. Such threats exist if auditors are not sufficiently skeptical of auditee assertions and, as a result, too readily accept an auditee point of view because of auditee’s familiarity with the auditor.

A long-standing personal and professional relationship between auditor and auditee often create such threats. That is the reason rotation of auditors is recommended repeatedly.

The Sarbanes Oxley Act of 2002 in the United States makes it unlawful for a firm to provide audit services to a publicly traded company if the lead audit partner having primary responsibility for the audit or audit partner responsible for reviewing the audit has performed audit services for the entity in each of the five previous fiscal years. Familiarity of any type of auditor with his client mars the performance in any field of professional and non- professional assignments. It takes its first toll on the attribute of impartiality. Some examples of this type of threat are as under:

  • A member of audit team having relations with director or senior or other important employee of audit client is in a position to exert direct and significant influence over audit proceedings.
  • A former partner of audit firm being a director or other important employee of audit client can certainly influence the auditors using his/ her earlier clout over them.
  • Long association of members of audit team with audit client.
  • When members of audit team accept gifts or hospitality, unless those are of insignificant value, a definite situation emerges to exert familiarity threat over audit happenings and thereby professional independence of auditor is challenged.

Intimidation

When audit client is in a position to influence auditor by using coerce actions or threats to challenge the independence of auditor.. Intimidation threats arise from being, or believing that they are being, openly or secretly coerced by auditees, or by other interested parties. This occurs when member of an audit team may be deterred from acting objectively and exercising professional skepticism by threats, actual or perceived from directors, officer of employees of audit client. Few examples of circumstances that may create threat of intimidations are:

  • Threat of replacement over an issue of disagreement with any of the interested parties.
  • Pressure to compromise with professional performance in view of quantum of professional fee involved.
  • Some dominate personality with audit client unnecessarily disturbing audit proceedings so that auditing remain below standards.

Key Issues Inviting Threats

The above discussion indicates that following are three key issues are major causes for threats to independence of auditors:

    1. Employment relationships
    2. Financial relations, and
    3. Provision of non- audit services.

Employment relationships

Employment relations of auditors with audit clients normally arise as an effect of following happenings:

  • When auditor firm’s current and/ or former member or professional staff happen to be present or past employees of auditee.
  • When close relatives of members or employees of audit firm are present or past employee of firm’s audit clients.
  • When auditor become director or member of senior management of auditee company.

Financial Relations

The financial relationships of the auditors and their clients may take the following ways to get established:

  • Direct or indirect investments of the auditor into the business of auditee, its subsidiary, or holding company, or wherein auditee has substantial financial interests.
  • Other financial interests of auditors with the auditee like loans, guarantees, saving and/or cheque accounts, and insurance products.
  • Any member of the audit engagement team, or any of his or her immediate family members may make direct or indirect investments.

As regards loans audit firm is not independent when any of its members or staff or their immediate family

  • accepts a loan from the client; or
  • makes a loan to a client; or
  • has a loan guaranteed by the client; or
  • guarantees a client’s loan

unless the loan is made in normal course of client’s business under normal lending procedure, terms and conditions as are with other business clients of auditee.

Financial relations are often termed as business relations and these business relations of auditors are definitely give rise to ensuing threats challenging the independence of auditor. On this business relationship count, it can be said that an auditor is not independent when:

  • any member of audit engagement team has business relationship with the client or any of its officer and that relationship are significant to both members of audit engagement teams and audit client or its officer;
  • the audit firm has business relationship with client or its officer and those business relations are significant from the point of both audit firm and its audit client or its officer.

Such business relations certainly do not include professional relations as auditors. Independence may also be threatened by an apparently insignificant indirect financial interest in an audit client. The level of threat will be higher, and likely to be unacceptable, if such financial interest is acquired or held on normal commercial terms or negotiated on an arms’ length basis.

Non- Audit Services

Providing non- audit services to an audit client significantly reduce perceived independence of auditors. When an audit firm provides non-audit services to a client along with audit services, the audit firm in fact is serving two different set of clients. These are ‘Management’ for non- audit services and ‘Audit Committee, shareholders and all those relying on financial statements’ for audit engagement. Serving two different sets of clients is bound to create conflicting interests and thus can become cause to give rise to threats to the independence of auditors.

Non- audit services to management are not generally consistent with professional demands on an auditor to be persistently skeptical, cautious, and questioning about management’s financial regulations, and thereby creating a tension counter productive to audit excellence.

Certain categories of non- audit services are considered potential threats ( particularly advocacy threats) to auditors’ independence when the auditors have to defend them at some platform or the other. These non-audit services are:

  1. Performance of management functions,
  2. Accounting and other bookkeeping services,
  3. Actuarial services,
  4. Valuation services,
  5. Legal services,
  6. Staff recruiting services,
  7. Internal audit services, and
  8. Computer programming services, like development of software etc.

The threats posed by non- audit services arise under the following circumstances:

  1. When audit firm is over depending on professional earnings of non- audit services from an audit client.
  2. When owners or staff of audit firm develops close relationship with the management of audit client because of provision on non- audit services to that audit client.
  3. When audit firm is involved in setting up management information systems.
  4. Audit firm is involved in such non- audit activities that influence the judgment of management or the amounts at which assets and liabilities may be stated in the balance sheet.
  5. When audit services are undertaken based on fee from non-audit services.

Ensuring Independence via Safeguards

It is very necessary to realize that absolute independence is not possible in view of the fact that auditors are paid by the auditee for their professional services. To attain normal required independence certain safeguard against ensuing danger from threats are necessary. The purpose of safeguards is to reduce the impacts of threat to independence to a level that auditors form an absolute neutral opinion on the financial statements.

The importance of auditors’ independence is well-recognized prerequisite for an honest opinion on financial statements. Accordingly accounting profession itself has established certain ethical guidelines relating to performance of audit and non- audit services provided by accountants and auditors to support and demonstrate independence.

There are five categories of safeguards:

  • Safeguards created by profession, legislature, or regulations,
  • Safeguards recommended or demanded by audit client,
  • Safeguards created by audit firm’s own system and procedures,
  • Ethical safeguards.
  • Governance safeguards

Professional, legislature, or regulatory safeguards

Professional, legislative, and regulatory safeguards entail the following measures:

  1. Accounting professional institutes around the world have started compulsory or optional continuing educational programmes. These programmes train members about and provide them current information to face threats so that independence is maintained.
  2. Professional institutes take strict entry examination only to provide membership to determined persons and responsible persons so that inducing effects of threats does not influence them.
  3. Setting up of standards to follow to maintain neutrality.
  4. Monitoring the professional performances of members of the profession and taking disciplinary actions when members compromise their independence below the standards fixed to maintain them.
  5. External review of audit firm’s quality control system, and
  6. Passing legislations to govern the auditors independence.; and
  7. Formalizing peer review programs.

With regard to safeguard against the threats emerging out of non-audit assignments being conducted by statutory independent auditors, in the case of publicly traded companies, Sarbanes Oxley Act has made it compulsory, with effect from June 2003, to get approval of such assignments from the audit committee of the company. ‘Pre approval requirements are applicable to services provided by the principal auditor to an SEC issuer audit client and its subsidiaries and to a registered management investment company. The audit committee should establish pre- approval policies and procedures, and it may consult outside advisors to do so. The pre- approval process may be accomplished by any of the following three methods:

  1. The audit committee may establish a framework of engagements that are approved on a periodic basis, such as annually.
  2. The audit committee may approve individual engagements on an as- needed basis prior to engaging the independent auditor.
  3. The audit committee may use combinations of methods A and B.’16

It is not out of place to mention here the restrictions on hiring of members or staff of auditors put by Sarbans- Oxley and subsequent regulations issued by SEC through the mandate of a one-year cooling off period before the audited company may hire any member or staff member of auditors. The basic idea behind such regulation is to help remove the potential appearance of a lack of independence on the part of ongoing audit engagement team with respect to their former colleague.

Safeguards recommended by the clients

  1. Audit firm will not force the appointment of a managerial person unless appointee is technically sound and appointment is as per laid company’s down rules
  2. Senior qualified and experienced auditors should take up the audit proceedings.
  3. Audit policies and procedures should emphasize the audit client’s commitment to fair financial reporting.
  4. Installation of internal procedures that ensures objective choices in commissioning non-audit engagements.
  5. Competent audit committee to provide appropriate oversight and communication regarding the audit firm’s services.

Safeguards created by audit firm

Audit firm needs to develop such policies and procedures within the audit firm itself that act as safeguard against the possible threats to the independence. Such policies and procedures should ensure the followings:

  • Audit engagements are carried out adopting adequate quality control procedures.
  • Annual confirmation of independence by partners and senior staff members are strictly adhered to.
  • Staff members who are not members of a particular audit party should not interfere into the working of that audit party so that there is no excretion of undue influence over the audit findings.
  • Existence of a system to ensure physical and virtual separation of staff involved in conflicting transactions.
  • Operation of a disciplinary mechanism to promote compliance with policies and procedures.
  • Staff members should instantly communicate the urgent matters concerning independence of the audit to senior members or partners of the firm.
  • Arrangements to ensure that partner remuneration is not linked to selling of non-audit services.
  • A list of restricted entities need be maintained so that their assignments are not accepted inadvertently.

The audit firm may put some additional safeguard into operation beside the above stated general safeguards in respect of specific audit assignments. These safeguards are:

  • Additional accountants may be involved to review the work already executed by the audit team.
  • Rotation of senior members of audit team.
  • Independence issues should be discussed with the audit committee at appropriate opportunity.
  • Formulation of policies and procedures to ensure that members of audit team do not make, or assume responsibilities for, management decisions for the audit client.
  • Involving other professional firm to perform or re-perform, in full or in part, the audit engagement.
  • Professionals other than regular employees of audit firm conduct non- audit services occasionally.
  • Removal of member of audit party who got involved in financial or other arrangements threatening the independence of audit.

An audit firm may develop safeguards as per prevalent circumstances of specific assignments. Senior members of audit party are always well placed to assess the situation, so that corrective measures are taken whenever there is possibility of threats of any kind. Practical instant solutions sometime prove more useful than laid down procedures. Rotation of staff play a very important role in curbing the threat on its emergence, as experience gained during one assignment is always handy for the other engagement.

Ethical safeguards

Professional ethical prohibits an auditor from:

  • Maintaining close family, personal, or business relationship with an audit client;
  • Accepting loan from or giving loan to a audit client.
  • Accepting goods, services, or hospitality from a client.
  • Avoiding holding an investment with a client company.

Professional bodies must take care of situations where audit partner or senior staff joins the audit client as an employee. Such person earlier remained in charge for or somehow responsible for audit activities conducted during audit proceedings in respect of that particular client. Knowledge about the nuances of audit procedures followed earlier create threats to independence and those can only be curbed by pursuing some ethical safeguards.

‘The key requirements of ethical guidance is that safeguard be put in place to guard against the self- interest and self – review threats to independence arising from the employment of former audit partner or senior audit staff. Such safeguards can include:

  1. Notification of intention to join the client, coupled with immediate removal from the engagements and a review of significant audit judgments previously made by that person.
  2. Any person joining the client should no longer derive retirement or other benefits from audit firm except in accordance with pre-determined arrangements.; and
  3. No person joining the client should take part, or appear to take part, in further business or professional activities for the audit firm.’14

Governance Safeguards

Governing structure of an entity plays an important role in safeguarding the independence of auditors. Normally ‘audit committee’ oversees all matters relating to external auditors, as it is not possible for auditors to have a direct relationship with shareholders whom they report. To mitigate the effects of threats to independence of auditors, the audit committee should undertake following steps:

  • The audit committee should evaluate whether audit fee charged by the auditor appear adequate in relation to work required to support an independent opinion of the auditors on financial statements.
  • The audit committee should arrange meetings with auditors without the presence of management representatives to discuss the contentious issues that have arisen with management during the audit proceedings. Further the audit committee must ensure that those issues have been solved to the satisfaction of auditors.
  • The audit committee should consider all matters of relationships between auditor and management that might affect the auditor’s ability to perform objectively. Audit committee should review all such relationships in discussion with auditors and seek their understanding as how they would guard against any identified threats.
  • The committee must obtain information about the policies and procedures of audit firm to maintain their professional independence; and monitor the compliance with relevant requirements.
  • The committee should discuss with audit firm’s systems and processes for maintaining independence.
  • The audit committee should seek a written statement from auditors confirming that they are, and have been throughout the conduct of audit engagement, independent in accordance with the terms and all relevant regulatory professional requirements. This statement from the auditors should also carry the information about significant services provided by auditors to the entity and its affiliates with the amount of fee charged by them. The auditor must distinguish between audit and non- audit service while providing such information to the committee.

In Australia, auditors have both professional and legal obligations to communicate in writing regarding their independence and are required to comply with both the spirit and letter of the law.

  • The audit committee should oversee the establishment of entity’s policies with regard to non- audit service that can be performed by auditors and ensure that such policies do no endanger the attribute of objectivity of auditors in order to avoid emergence of any threat to their independence.
  • The audit committee must get formulated a policy that allotment major non- audit assignments to auditors must have prior approval of the audit committee.
  • The audit committee should get establish policies relating to the hiring of audit firm’s senior employees for the entity so that they may be assigned jobs that do not mingle with the normal functioning of auditors.
  • Above all, the audit committee should report to shareholders on the actions it has taken to safeguard the independence of the auditors, including satisfying itself that auditor is independent in accordance with applicable standards.

Evaluation of impact of threats

The auditor should assess the extent of damage from a possible threat to the; so that immediate corrective measures are taken to mitigate the impacts of threat. The ICRA in a paper titled ‘Third party auditor impartiality and conflict of interest’12 has suggested to express the level of risk to impartiality as point on a continuum that ranges from ‘no risk’ to ‘maximum risk’. The paper also suggests the following segments of the impartiality risk continuum that fall between these ends. Putting the risk in these segments will certainly help auditor to assess the extent of level of risk involved and help the auditor to take a decision about continuity of the particular audit assignment, or the extent of compromise auditor has to undergo in completing those assignments:

Table distinguishing among impartiality risks:

No Risk Remote Risk Some Risk High Risk Maximum Risk
Compromised objectivity is virtually impossible Compromised objectivity is very unlikely Compromised objectivity is possible Compromised objectivity is probable Compromised objectivity is virtually certain

The paper suggests ‘CRBs should determine whether the level of impartiality risk at an acceptable position on the impartiality risk continuum. CRBS should evaluate the acceptability of the level of impartiality risk that arises from specific activities, relationships, and other circumstances. That evaluation requires them to judge whether safeguard eliminates or adequately mitigate threats to auditor impartiality posed by those activities, relationships, or other circumstances. If they do not, CRBs should decide which additional safeguard (including prohibition) or combination of safeguards would reduce the risk, and the corresponding likelihood of compromised objectivity, to an acceptable low level.’12

Some people suggest that safeguard against threats to independence can be strengthen when there are regulations or legislation in respect of matters of independence or threat to independence. They argue that a regulatory body, if setup to review auditor independence, will inevitably examine only independence issues. But, independence threats typically involve instances of subtle threats, which are not easily measured and therefore not susceptible to an effective legalistic or regulatory intervention. These are the ethical measures that remain always effective solutions to ever increasing threats to independence of auditors.

Auditors’ concerns relating independence

‘Independence’ has become an emotive word, a banner standing for objectivity, integrity, freedom, and all that is good. Professional independence is a concept fundamental to the accounting profession. It is essentially an attitude of mind characterized by integrity and objective approach to professional work. Independence is desirable in case of auditors because they cannot give an unbiased opinion unless auditors are independent of all the parties involved. Moreover, that objectivity can only be assured if the auditor is, and is seen to be independent. The matter of audit independence is of great concern in respect of following issues:

Independent Appearance

Independence to auditors from interested parties helps to produce quality reports and thus gaining the confidence and reliance of financial statement users. But an auditor is concerned to seek both ‘independence in fact’ and ‘independence in appearance’ as mere independence in fact may send wrong signals to users of audited information, and thereby harming the audit client’s prospectus just by misconception.

“Auditors’ independence has for long been couched in term of Independence ‘in fact’ and ‘independence in appearance’. An auditor who is independent in fact has the ability to make independent audit decisions even if there is a perceived lack of independence, or if the auditor is placed in a potentially compromising position. Nonetheless, even when the auditor is in fact independent, one or more factor may lead the public to believe that auditor does not appear independent. This may cause users of financial statements to believe that they cannot rely on financial statements.”17

Thus appearance in independence is as important to an auditor, particularly in post Enron era, as the independence in fact.

Independence and non-audit services

For auditors the most important issue concerning independence is the issue of provision of non-audit services (NAS) to audit clients. Critics argue that NAS affects auditors’ independence in fact. But the provision of NAS is not without potential benefits. NAS enhances the auditors’ knowledge of clients, leading to more effective and efficient audit. This can be argued that restricting NAS can inhibit the auditor’s acquisition of knowledge about audit client, thereby reducing auditor’s capabilities and lower audit quality.

NAS is also a good economic source for the auditor. For audit services to have a high value, users must perceive that NAS fee do not color the auditor’s judgment. The auditors are definitely concern with NAS fee aspect as it is assumed that wherever auditor receives huge fee for NAS, chances of dilution of independence get enhanced. A myriad of studies have examined the issue in depth but the findings are difficult to summaries due to differences in users group, time period, and the specific type of NAS examined.

Over the years regulators have taken actions in response to concerns over the auditors’ provision of NAS. These prohibitions include internal audit outsourcing as well as financial information system design and implementation services. SEC even require the disclosure of fees for audit services, audit related services, tax services, and all other NAS services. Not surprisingly, auditor’s provision of NAS continues to be a topic of discussion and debate, and auditors are very rightly concerned for NAS’s effect on independence of audit functions.

The auditors are rightly concerned about non- audit services when those are evaluated with independence issue of auditing. Many non- audit services have their roots in auditing. These days special skills are required to pursue audit proceedings in the wake of increasing business complexities emerging from all round developments. Today, effective audit depend more than ever on specialists. Audit activities require the consultancies of specialists like

  1. Technology and system specialist,
  2. Actuaries to evaluate risk management control, insurance companies reserves etc.,
  3. Treasury specialist to evaluate control over cash management,
  4. Tax specialists, and
  5. Valuation specialist for assets valuations for various audit functions.

When an audit firm will employ various specialist and professionals, it also require certain non- audit assignment at least to reduce the costs of such specialists and professionals. If remunerative NAS are taken away in the name of maintaining independence of audits, auditors are going to face tuff time; and that will result into deterioration of audit service qualitatively.

Auditors’ Rotation

In audit practice people generally believe that long term auditor- client relationship could impair auditor independence. In fact, many clients select their external auditors in accordance with personal friendship between responsible staff and auditor, or partner of audit firm. Even if not so, the auditor may be familiar with client inevitably after many years, and then establish close relationship, even become the benefit community. Therefore, when the auditor is employed by one client to offer audit services, the longer the service term is, the worse the audit independence is. So, theoretically rotation regularity is advantageous not only to maintain audit independence, but also to provide the chance to later auditor to find the problem that the former auditor had not discovered.

But from auditors’ point of view on relating the issue of rotation with independence the matter becomes more complicated and needs a thorough analysis in order to arrive at a conclusion.

Independent audit issue concerns the auditors on rotation matters in following ways:

  1. Compulsory firm rotation
  2. Audit Personnel rotation

‘The arguments for and against mandatory audit firm rotation concern whether the independence of a public accounting firm auditing a company’s financial statements is adversely affected by a firm’s long term relationship with the client and the desire to retain the client. Concerns about the potential effects of mandatory audit firm rotation include whether its intended benefits would outweigh the costs and loss of company specific knowledge gained by an audit firm through years of experience auditing the client. In addition question exit about whether the Sarbanes Oxley Act requirements for reform will accomplish the intended benefits of mandatory audit firm rotation.”19

Compulsory rotation of auditors’ looks very simple when considered superficially but it creates a number of problems when implemented practically as discussed hereunder:

  • Rotation of auditors clearly means that incumbent has to start afresh. No auditor can acquire proficiency in audit performance in the very first year of audit. Till the time that proficiency is acquired and the auditor gets rotated the entire process of learning has to be done again by the incumbent. The result is the loss of ‘corporate memory’ of a client and the resultant reduction in audit effectiveness.
  • Auditors are seriously concerned about the training costs of senior staff that goes waste when audit is not performed continuously and interrupted because of rotation requirements. Similarly, when auditors have to start as incumbent in the rotation process additional cost of training irks as unwanted overheads.
  • With compulsory rotations, the relationship terminates and this may conceal many auditing issues.
  • Auditor greatly looses the right of choice

Auditors who favor rotation are concerned with the other side of the picture. According to those auditors persisting closeness with client mars the independent quality of the audit to a great extent, and therefore rotation in a way strengthen the attributes of independence in the auditor.

Appointment of auditors and Independence

Independence for a professional is a state of mind. No specific restrictions or requirements can achieve independence. However, some specifications can contribute towards the maintenance of independence of mind. In practice, independence has three main elements:

  1. Adequate remuneration, so that professional stick to a job for a longer period,
  2. Security of tenure to ensure professional a sense of protection, and
  3. Freedom from undue pressures in making important professional decisions.

The initial appointment of an auditor after the incorporation of the company is made either by directors or by the company in its general meeting. Such auditor holds office till next annual general meeting, at which time the company must appoint an auditor who eill hold office until death, retirement or removal. Casual vacancies are also filled in similar way.

It would seem that directors of a company have the ability to control or influence the majority of voting shares and thus they can ensure passing of any resolution the might be placed before annual general meeting. It can be argued by professionals and members of business community that despite such influences of directors, auditors remain independent of directors in majority of the cases. On the other hand some accountants and representatives of small investors and shareholders group believe that the lack of independence is a significant problem and that auditor is, in practice, responsible to management or the directors.

Accordingly, issue of independence with regard to appointment of directors is actually of concern particularly in cases of small and medium companies. The directors are bound to exert their clout and bring in their favorites as auditors. Under such situations the independence will always be at danger as auditor’s reappointment will be at the mercy of directors holding or controlling majority of voting rights.

The issue of appointment of auditors is of grave concern and need to be addressed at appropriate forums.

Audit Engagement Letters may affect auditor independence

This is completely an unusual issue but it revelation has certainly aroused the auditor’s concern about independence. These issues are so important that auditors are going to face serious legal and other problems if those are not taken care at the time of executions of engagement letters.

An engagement letter is a written contract between the auditor and audit client that serves to minimize misunderstanding between auditor and the audit client. In case of statutory audits, where the objectivity and scope of the engagement and auditor’s obligations are laid down in the applicable statute or regulations, audit engagement letters provide general clarifications and auditing assurances. In case of voluntary audits, i.e, audit engagements where the objective and scope of the engagement and auditor’s obligations are not laid down in any statute or regulations, audit engagements letter plays an important role in defining the objective and scope of the engagement, obligations of auditor audit client, as well as the terms governing the relation between auditor and the audit client.

There are certain provisions in the standard clauses of engagement letters issued by publicly traded companies to its auditors that impair the independence of auditor. These clauses and consequents concerns of auditors along with remedies are discussed as under:

Often audit engagement letters expressly contain such clauses “ in which the audit client agrees to compensate the auditor for any losses resulting from litigation arising out of the engagement, including losses to third parties such as investors. Other limitations on liability may protect the auditor only from liability to the audit client, or only against certain kind of damages. For example, an engagement letter might cap the auditor’s liability to the client at the amount of audit fee that the client paid.’18

In this respect attention is drawn to the meeting of ‘Standing Advisory Group’ of PCAOB (Public Company Accounting Oversight Board) held on Feb. 9, 2006 that held that present legislation was ineffective to deal with these type of agreements and it was declared by the meeting that such agreements certainly impair the independence of auditors.

Accordingly, the issue of independence has even concerned the auditors at stages when they appointed by their audit clients. In this respect, auditors may seek assistance from conclusions of the said meeting wherein SAG clarified whether certain clauses of engagement letters impair the auditor’s independence. The meeting’s conclusions and suggestions are reproduced in the following table:

Type of Clause AICPA Proposed Interpretation FFIC Proposed Advisory
Auditor indemnified against claims based on auditor’s negligence Impairs independence Unsafe and unsound practice
Auditor indemnified against claims based on knowing misrepresentation by audit client’s management. Does not impair independence Unsafe and unsound practice

It is important to note that both above types of clauses of indemnification to auditor in engagement letters is held by FFIC (The Federal Financial Institutions Examination Council) as ‘unsafe and unsound practice’. That means third parties can lodge protests against such indemnities stating auditors were not independent while conducting audit. Therefore, auditors must be careful and concerned while executing their approval on engagement letters.

Independence adds value to financial statements

Auditors should remain concerned to keep their independent status alive during their entire audit conduct as this not only adds values to the results, but to the impartial status of the audit firm. A few examples of auditors’ independence adding value to financial statements are as under:

  • Independent audit adds value to a company and have the potential to affect stock prices. Financial reports are management assertions. These assertions are guided by accounting standards, GAAP, and conventional business practices. However, these financial statements do not extend a critical professional independent review until those are audited by competent and independent auditors. Only when these statements are annexed with a report of audit conducted by a competent auditor, who is independent of management, it adds to the market’s perception that financial reports are both valid and reliable. Financial information that is perceived to be valid and more reliable means that the information provide lesser risk. Financial reports that have attached to them a competent and independent audit have lower information risk in the market. Lower information risk results in higher stock price.
  • Take the case of two companies identical in all respects to the extent that the financial statements of each one of them presents similar financial results but with only difference. There is huge difference in stock prices of each of the company. One company has an audit provided by an audit firm that has a reputation for providing an adequate and independent audit, and the financial statements of other companies have not been audited. Stock price difference between these two companies would not be as large as that existing for companies with a competent, independent audit and no audit at all, but there would still be a price difference in stock prices traded by the two companies, other things being equal. One can say that differing audit quality levels have differential value adding effects. The difference of independent audit has resulted into a price differential in shares of the companies. Similarly, those that trade in debt of companies will attach a higher risk premium for companies that are audited by auditors who are competent and independent of management as compared to those companies whose auditors are not independent.

Independent audit aims at building transparency and enhance accountability of key officials and decision makers within the organization being audited. Positive findings of an independent audit can go a long way in building public trust, while a negative can serve to catalyze change.

Conclusion

The underlying rule of auditors’ independence is that in all matters relating of the conduct of audit, the audit firm or the individual auditor should be free both in fact and in appearance from personal, external, and organizational impairments of audits.

Independence of audit have been described and defined by many authorities administering the profession, but the definition provided by IFAC is a complete description of auditors’ independence.

Independence of mind provide necessary input to make decisions independent of management, but practically speaking such independence does not exist from the point of view of those interested in financial statements unless independence is displayed. In other words ‘independence in appearance’ carries more weight than the ‘independence in fact’ over those strata of public who are interested in financial statement for making certain important decisions.

Threats to independents are real barriers to freedom for the conduct of audit with dedicated professional approach. Auditors have to put impediments on self interests in order to provide a cleaner audit environment. Non- audit services to audit clients are real dangerous source creating threats to independence. That is why, and wisely so, authorities have purged the entire spectrum of non- audit services in order to come out with a list of such services those in fact assist in maintaining independence rather endangering it. Still the aspect of threats to auditors’ independence needs fresh inspection in view of changing business scenarios keeping pace with unprecedented technical advancement.

Matters of concerns to auditors emerging out the issue of auditors’ independence like independence in appearance, appointment of auditors, auditors’ indemnification terms in standardized engagement letters, non- audit services to audit clients, rotation of auditors and many others need fresh considerations as far as possible. These matters, when not handled properly, become the real source of threats to independence of auditors. However, auditors need to take decisions as per prevailing conditions so that their independence is not put on stake affecting the economic and other decisions of parties depending upon audited financial statements.

References

IFAC Code of Ethics for Professional Accountants, page 95, Web.

EC recommendations Statutory Auditors’ independence in the EC: A set of Fundamental Principles, Web.

US Securities and Exchange Commission, Final Rule: Revision of the Commission’s Auditor’s Independence Requirements 2001, Web.

ibid.

ibid.

A Framework for Auditor Independence; Susan McGrath, Arthur Siegel and others, Web.

Independence and Public Perception: Why We Need to Care, Ann Morales Olazable and Elizabeth Dreike Almer, Web.

An independent view on the independence of auditors: CIMA Review of Auditor Independence, page 18, Web.

Code of Ethics for Professional Accountants, International Federation of Accountants’ Ethics Committee, page 36, Web.

APB ethical standards on auditor independence: overview of status and issues, Web.

Auditor Independence and Non- Audit Services: A Literature Review, Vivien Beattie and Stella Fearnley, page 11, Web.

‘ Third party auditor impartiality and conflict of interest’, ISO/IAF Auditing Practices Group Papers, 2005, page 3-4, Web.

Arthur Siegel and Susan McGrath, ‘Recognizing an addressing conflict of interest’, 2003, The CPA Journal, Web.

Reviewing Audit Independence, November 2003, ICAEW, page 25, Web.

Do non audit services compromise auditor independence? Further evidence., Ashbaugh, Hollies, and others, Web.

The Sarbanes- Oxley Act of 2002: Understanding the Independent Auditor Role in Building Public Trust, Pricewaterhouse Coopers, Business Credit Magazine, Web.

‘Before and After Enron: CPAs’ views on Auditor Independence’, Deborah L.Lindberg and Frank D. Beck, The CPA Journal, 2004, Web.

‘The Effects On Independence of Indemnification, Limitation of Liabilities, and Other Litigation- Related Clauses in Engagement Letter” 2006, SAG Group Meeting, PCAOB, Web.

 Public Accounting Firms: Required Study on the Potential Effects of Mandatory Audit Firm Rotation, GAO –04-216, 2003, Web.

 Audit Independence: Concept and application, Jacobson, Peter D., The CPA Journal Online, 1992, Web.