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Home > Auditing Best Practice > Threats to Auditor Independence and Possible Remedies

Auditing Best Practice

Threats to Auditor Independence and Possible Remedies

by Gilad Livne

This Chapter Covers

  • A description of the nature of the client–auditor relationship, together with a brief historical perspective.

  • How impaired auditor independence can cause significant losses to various parties, such as shareholders and lenders.

  • The potential benefits when auditor independence is strong.

  • A discussion of some of the main threats to independence, followed by the possible remedies and their limitations.

Introduction

The external auditor is nominated to carry out audit work on behalf of the audited company’s shareholders. Being a proxy for the shareholders fundamentally requires the external auditor to be independent of the audited firm’s managers. Auditing standards require independence both in mind and in appearance. Independence implies the ability and willingness of the auditor to identify a range of deficiencies during the audit process and then to challenge the audited firm on these findings. Such deficiencies include matters regarding internal control, the accounting policies adopted, and absent or misleading reporting.

In practice, the external auditor’s various interactions with the audited firm are conducted through and with the client’s top management. Inevitably, this gives rise to a “special” relationship between managers of the audited firm and the auditor. This special relationship typically starts with the nomination process—often the client’s management suggests that a particular audit firm should be nominated1—and continues along several dimensions: fees are paid to the auditor by the audited firm, not directly by shareholders. During the audit process, management is responsible for providing answers to the auditor concerning matters about which it knows more, and so auditor must rely on (often self-serving) managers. In preparing the annual report, accounting and reporting issues are effectively jointly decided by management and the auditor, even though, strictly speaking, the preparation of the accounts is the responsibility of the managers. It is therefore quite sensible to ask if auditor independence, both in mind and appearance, can be maintained given this nature of the relationship. In other words, it is important to identify the threats to auditor independence in light of this special relationship.

This is not an abstract exercise. The recent financial crisis has brought the question of auditor independence to the fore. It has put auditors under a public magnifying glass, with some commentators questioning the integrity of external auditors and their complicity in producing what may be misleading reports (for example, in the case of Lehman Brothers’ reporting of transactions in certain loans, known as Repo 105). Before this crisis, the accounting scandals of the early 2000s, including Enron, WorldCom, and Parmalat, led to a comprehensive rethink of matters relating to auditor independence in the United States and indeed around the world. Legislation followed—most prominently in the United States, with the Sarbanes–Oxley Act (henceforth SOX) of 2002 imposing various restrictions on the external auditors.

It is worth remembering that blaming compromised auditor independence for accounting scandals is not a recent phenomenon.2 An early example, from 1938, is the case of McKesson & Robbins, where the firm Price, Waterhouse & Co. failed to verify the existence of inventory. The bankruptcy of Westec in 1965 raised concerns, many years before Enron, that the provision of nonaudit services compromised auditor independence. Not surprisingly, some commentators have suggested that auditors do not serve as the protectors of shareholders’ and lenders’ interests (e.g. Carey, 1967). These and other failures have prompted a wave of litigation against auditors, with large sums awarded to plaintiffs and paid by auditors.

These auditing failures and the large losses inflicted on shareholders, lenders, and employees demonstrate that impaired auditor independence can lead to grave consequences. However, it is not sufficient to focus on the adverse effects of compromised independence. It is also important to highlight the possible advantages of maintaining a high degree of auditor independence. This is the subject of the next section.

Independence of Mind vs Independence in Appearance

It is common to speak of these two types of auditor independence, but what is the difference? A clear distinction may be hard to make, as the two overlap and interact. Nevertheless, independence of mind is a desirable psychological–behavioral trait in an auditor. He or she should be objective and free from bias. He/she should be willing to challenge clients and maintain a good degree of skepticism coupled with an inquisitive mind-set. Being knowledgeable also increases the auditor’s ability to challenge managers on their reporting decisions. This highlights the important role education and training can play.

Independence in appearance is about avoiding relationships or circumstances that can threaten, or may be seen to threaten, the willingness or ability to scrutinize and criticize managers. For example, having a managerial or advisory role in the client firm can impair the auditor’s objectivity and hence his or her ability to carry out an effective audit on behalf of shareholders. Having connections through family ties is another example.

It should be made clear, however, that appearing to be independent is not sufficient. What truly is required is the independence of mind.

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Further reading

Book:

  • Carey, J. L. “The new pressures on the CPA.” In Symposium for Educators. Washington, DC: Ernst & Ernst, 1967; pp. 11–22.

Articles:

  • Amir, Eli, Yanling Guan, and Gilad Livne. “Auditor independence and the cost of capital before and after Sarbanes–Oxley: The case of newly issued public debt.” European Accounting Review 19:4 (2010): 633–664. Online at: dx.doi.org/10.1080/09638180903503986
  • Ashbaugh, Hollis, Ryan LaFond, and Brian W. Mayhew. “Do non-audit services compromise auditor independence? Further evidence.” Accounting Review 78:3 (July 2003): 611–639. Online at: dx.doi.org/10.2308/accr.2003.78.3.611
  • Brandon, Duane M., Aaron D. Crabtree, and John J. Maher. “Non-audit fees, auditor independence, and bond ratings.” Auditing: A Journal of Practice and Theory 23:2 (September 2004): 89–103. Online at: dx.doi.org/10.2308/aud.2004.23.2.89
  • Chung, Hyeesoo, and Sanjay Kallapur. “Client importance, non-audit services and abnormal accruals.” Accounting Review 78:4 (October 2003): 931–955. Online at: dx.doi.org/10.2308/accr.2003.78.4.931
  • DeFond, Mark L. “How should the auditors be audited? Comparing the PCAOB Inspections with the AICPA Peer Reviews.” Journal of Accounting and Economics 49:1–2 (February 2010): 104–108. Online at: dx.doi.org/10.1016/j.jacceco.2009.04.003
  • DeFond, Mark L., and K. R. Subramanyam. “Auditor changes and discretionary accruals.” Journal of Accounting and Economics 25:1 (February 26, 1998): 35–67. Online at: dx.doi.org/10.1016/S0165-4101(98)00018-4
  • Dhaliwal, Dan S., Cristi A. Gleason, Shane Heitzman, and Kevin D. Melendrez. “Auditor fees and cost of debt.” Journal of Accounting, Auditing and Finance 23:1 (January 2008): 1–22. Online at: dx.doi.org/10.1177/0148558X0802300103
  • Europa. “Fourth Directive: Annual accounts of companies with limited liability.” Fourth Council Directive 78/660/EEC. July 25, 1978. Online at: tinyurl.com/896ky8x
  • Europa. “Seventh Directive: Consolidated accounts of companies with limited liability.” Seventh Council Directive 83/349/EEC. June 13, 1983. Online at: tinyurl.com/7a2twu6
  • Khurana, Inder K., and K. K. Raman. “Do investors care about the auditor’s economic dependence on the client?” Contemporary Accounting Research 23:4 (Winter 2006): 977–1016. Online at: dx.doi.org/10.1506/D171-8534-4458-K037
  • Kim, Jeon-Bon, and Cheong H. Yi. “Does auditor designation by the regulatory authority improve audit quality? Evidence from Korea.” Journal of Accounting and Public Policy 28:3 (May–June 2009): 207–230. Online at: dx.doi.org/10.1016/j.jaccpubpol.2009.04.006
  • Larcker, David F., and Scott A. Richardson. “Fees paid to audit firms, accrual choices, and corporate governance.” Journal of Accounting Research 42:3 (June 2004): 625–658. Online at: dx.doi.org/10.1111/j.1475-679X.2004.t01-1-00143.x
  • Lennox, Clive. “Do companies successfully engage in opinion shopping? Evidence from the UK.” Journal of Accounting and Economics 29:3 (June 2000): 321–337. Online at: dx.doi.org/10.1016/S0165-4101(00)00025-2
  • Lennox, Clive, and Jeffrey Pittman. “Auditing the auditors: Evidence on the recent reforms to the external monitoring of audit firms.” Journal of Accounting and Economics 49:1–2 (February 2010): 84–103. Online at: dx.doi.org/10.1016/j.jacceco.2009.04.002
  • Mayhew, Brian W., and Joel E. Pike. “Does investor selection of auditors enhance auditor independence?” Accounting Review 79:3 (July 2004): 797–822. Online at: dx.doi.org/10.2308/accr.2004.79.3.797
  • Myers, James N., Linda A. Myers, and Thomas C. Omer. “Exploring the term of the auditor–client relationship and the quality of earnings: A case for mandatory auditor rotation?” Accounting Review 78:3 (July 2003): 779–800. Online at: dx.doi.org/10.2308/accr.2003.78.3.779
  • Ruddock, Caitlin, Sarah J. Taylor, and Stephen L. Taylor. “Non-audit services and earnings conservatism: Is auditor independence impaired?” Contemporary Accounting Research 23:3 (Fall 2006): 701–746. Online at: dx.doi.org/10.1506/6AE8-75YW-8NVW-V8GK
  • Zeff, Stephen A. “How the U.S. accounting profession got where it is today: Part I.” Accounting Horizons 17:3 (September 2003): 189–205. Online at: dx.doi.org/10.2308/acch.2003.17.3.189

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