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In: Accounting

Question 2: (20 marks) A series of financial scandals revealed a key weakness in American business...

Question 2:

A series of financial scandals revealed a key weakness in American business model. The failure of the U.S. auditing system delivers to true independence. Audit independence is important so that auditor’s opinion can be unbiased, free from undue influence or conflicts of interest to override the professional judgement.

Required: Explain the concept of independence and discuss the broad categories of threats to independence with examples.

Solutions

Expert Solution

Auditor independence refers to the independence of the internal auditor or of the external auditor from parties that may have a financial interest in the business being audited. ... The concept requires the auditor to carry out his or her work freely and in an objective manner.

1. Self-Interest Threat

A self-interest threat exists if the auditor holds a direct or indirect financial interest in the company or depends on the client for a major fee that is outstanding.

Example

The audit team is preparing to conduct its 2019 audit for XYZ Company. However, the audit team has not received its audit fees from XYZ Company for its 2018 audit.

Issue

The audit team might be tempted to issue a favorable report so that the company is able to secure a loan to settle the fees outstanding for their 2018 audit.

2. Self-Review Threat

A self-review threat exists if the auditor is auditing his own work or work that is done by others in the same firm.

Example

The auditor prepares the financial statements for XYZ Company while also serving as the auditor for XYZ Company.

Issue

as auditor review his or her own work, the auditor cannot be expected to form an unbiased opinion on the financial statements.

3. Advocacy Threat

An advocacy threat exists if the auditor is involved in promoting the client, to the point where their objectivity is potentially compromised.

Example

The auditor is assisting in selling XYZ Company while also serving as the auditor for the company.

Issue

The auditor may issue a favorable report to increase the sale price of XYZ Company.

4. Familiarity Threat

A familiarity threat exists if the auditor is very close to or too familiar with employees, officers, or directors of the client company.

Example

XYZ Company has been audited by the same auditor for over 10 years and the auditor regularly plays chess with the CEO and CFO of XYZ Company.

Issue

The auditor may have become too familiar with the client and, thus, lack objectivity in their work.

5. Intimidation Threat

An intimidation threat exists if the auditor is intimidated by management or its directors to the point that they are deterred from acting objectively.

Example

XYZ Company is unhappy with the conclusion of the audit report and threatens to switch auditors next year. XYZ Company is the biggest client of the auditor.

Issue

The auditor’s independence may be compromised, as XYZ Company is their biggest client and they, quite naturally, do not want to lose such a client. Therefore, the auditor may issue a report that appeases XYZ Company.

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