Question

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.

Answer 1

Threats to Independence of Auditor

1 Nature ofThreats to Auditor Independence

The “nature” as applied to threats to auditor independence includes the scope and the peculiarities of threats to auditor independence. It signifies how auditor independence is likely to be affected by a variety of threats relevant to audit engagement1. The term “threat” means: “indication of something undesirable coming”; and “person or thing regarded as dangerous”. Threat is alternately termed as risk, hazard, danger, menace, and presage. The AICPA Code states that “Threats to independence are circumstances that could impair independence” (ET Section 100-1, AICPA, 2011). There is a general agreement on possible threats to auditor independence. The notion of threat to auditor independence is not new. The US SEC issued Accounting Series Release (ASR) 2 in 1937 and took the position that an auditor’s significant investment in the company audited would impair independence (SEC, 1937). In an article, Morgenson (2000) caught the threats to auditor independence and states eloquently

The extant literature discusses primarily two facets of auditor independence viz., “independence in fact” and “independence in appearance” which can amplify the idea of threats to independence. Since independence of mind is an attitude of mind, it is difficult to observe and evaluate. This is why most studies have emphasised on perceived independence, as perceptions are fundamental to public confidence in financial reporting (Carmichael, 2004). DeAngelo (1981) opines that auditor independence may be impaired when auditors earn clientspecific fees, which provide an incentive not to report the discovered breach to retain the client. However, different threat / risk factors can undermine independence of auditor which leads to different stakeholders indecisions, in particular to the rational investment decisions. Beattie and Feamley (2003) maintain that independence risk is considered to be the likelihood that an auditor’s objectivity would be compromised or would appear to be compromised to well investors or others. Therefore, an auditor shall not knowingly engage in any pursuit and relationship that may impair integrity and objectivity.

2 Significance of Threats to Auditor Independence

Significance of threats to auditor independence is discussed from two standpoints -the reasons of threats and the evaluation of threats to independence. Several studies heavily lean upon to identify factors that potentially impinge on auditor independence. But the real problem of auditor independence stems from two principal sources. First, auditor’s relationship with the company he audits; second, the price competition. An auditor earns his livelihood revenue from the audit and lucrative NAS fees. This is paid by the board-management (the de facto authority to hire and fire auditors) of a company. If an auditor feels that the fee from his client is so indicative he may not perform an objective and independent audit because ofthis reliance and economic dependency. Dunn (1996) argues that an auditor earns a living from the fee he is paid; it is therefore automatic that he does not want to do anything to jeopardize this income. Similarly, price competition is an important factor in auditor independence (Baker, 2005). Prior to the 1970s audit firms were not allowed to advertise and take part in bidding competition for contracts. Today, competition between the audit firms has greatly put pressure on the audit firms to reduce audit fees. Competitive bidding for contracts induces the reductions of auditor’s engagement hours (Baker, 2005). When an audit firm is threatened by the audit market the compelling influence to reduce audit costs might potentially undermine the quality of audit and impair auditor independence. Therefore, threats to auditor independence are affected by livelihood of auditors (includes audit and non-audit fees), authority to hire and fire auditors, fixing up the audit and non-audit fees by the appointing authority, and audit market and price competition (includes competitive bidding). As far as the evaluation of threats to independence is concerned the responsibility of a professional accountant2 is not confined to satisfying the needs of an individual audit client3 or employer; he has also responsibility to act for the public interest. In doing so an auditor has an obligation to evaluate any threat or presage to comply with the fundamental principles of accountancy profession - the integrity and objectivity when he knows or could reasonably be expected to know offacts or relationships that may bargain fundamental principles. In fact, the significance of threats to auditor independence is determined by a broad range of factors and relationships between auditors and their clients. Significance of threats is to be evaluated for severity to employ the appropriate actions. The IESBA Code requires “...a professional accountant to identify, evaluate, and address threats to compliance with the fundamental principles” (Para. 100.6, IFAC, 2010). The AICPA (1988b) states: “For a member in public practice, the maintenance of objectivity and independence requires a continuing assessment of client relationships and public responsibility...”(ET 55-Article IV). The IOSCO (2002) states standards of auditor independence should require the auditor to identify and evaluate all significant or potentially significant threats to independence. So, evaluating threats to independence is crucial as it abets auditor and decision-makers involved in the audit process.

3 Forms of Threats to Auditor Independence

Threats to independence have evolved over time. The FEE (1998) and the ISB (2000) (now defunct) identified five categories of threats - self-interest threat, self-review threat, advocacy threat, familiarity threat, and intimidation threat. The IESBA Code concedes these five categories ofthreats (Para. 100.12) and provides examples ofthreats (Para. 200.4 to 200.8) (IFAC, 2010). The UK’s APB (2008a & 2008c) in its Ethical Standard (ES) 1 & 5 concede these five categories of threats and identified a six threat the “management threat.” The AICPA states that seven broad categories of threats should always be evaluated when threats to independence are being identified and assessed. They are self-review, advocacy, adverse interest, familiarity, undue influence, financial self-interest, and management participation threats (ET Section 100-1, AICPA, 2011). The AICPA Code defines these threats and provides some examples of threats which are as follows: Self-review threat—members reviewing as part of an attest engagement evidence that results from their own, or their firm's, non-attest work such as, preparing source documents used to generate the client's financial statements (ET Section 100-1.13); Advocacy threat—actions promoting an attest client's interests or position (examples among others, include promoting the client's securities as part of an initial public offering) (ET Section 100-1.14); Adverse interest threat—actions or interests between the member and the client that are in opposition, such as, commencing, or the expressed intention to commence litigation by either the client or the member against the other (ET Section 100-1.15); Familiarity threat—members having a close or longstanding relationship with an attest client or knowing individuals or entities (including by reputation) who performed non-attest services for the client (examples among others, include a member of the firm having recently been a director or officer of the client) (ET Section 100-1.16); Undue influence threat— attempts by an attest client's management or other interested parties to coerce the member or exercise excessive influence over the member (examples among others, include pressure from the client to reduce necessary audit procedures for the purpose of reducing audit fees) (ET Section 100-1.17); Financial self-interest threat—potential benefit to a member from a financial interest in, or from some other financial relationship with, an attest client (examples among others, include having a direct financial interest or material indirect financial interest in the client) (ET Section 100-1.18); and Management participation threat—taking on the role of client management or otherwise performing management functions on behalf of an attest client (examples among others, include serving as an officer or director of the client) (ET Section 100-1.19) (AICPA Code, AICPA, 2011).

4 Factors Undermining Auditor Independence

There are several circumstances and relationships that cause threats to auditor independence. The AICPA Code states that many different circumstances (or combinations of circumstances) can create threats to independence. It is impossible to identify every situation that creates a threat (ET Section 100-1, AICPA, 2011). Shockley (1981) identifies areas of significance to independence, selecting four conditions pertaining to an auditing firm that could impact the outcome of their audit services competence, non-audit services, audit firm size, and audit tenure. These factors were found to affect auditor independence even though these are not the only factors. There will be other conditions where, depending upon the facts, an auditor may lack his independence. However, to protect independence authoritative bodies worldwide identify factors that potentially impinge on auditor independence. This section discusses the threats to auditor independence identified by the IFAC; core components that undermine auditor independence; and demonstrate some other issues that affect auditor independence. The discussion begins with core circumstances identified by the IFAC.

5.Employment Relationships

Employment relationships cover three broad areas of involvement between an accounting firm and its audit client: employment of an accounting firm’s current and former members and professional staff by an audit client; employment of close relatives of an accounting firm’s members and staff by an audit client; and employment of directors and senior management of a company by its auditor (Ramsay, 2001). The UK’s APB (2008b) maintains employment relationships as: management role with an audited entity (includes loan staff assignment, partners and engagement team members joining an audited entity, and family members employed by an audited entity); governance role with an audited entity; and employment with audit firm (Para. 36-58, ES 2). But we discuss family and personal relationships separately. However, employment relationships between an audit firm and an audit client can give an impression that an auditor is not independent of the client as it creates self-interest threat, self-review threat, familiarity threat, advocacy threat, and intimidation threat. The SEC explains the rationale ofimposing restrictions on such relationships as:

“Independence requirements related to employment relationships between accountants or their family members and audit clients are based on the premise that when an accountant is employed by an audit client, or has a close relative or former colleague employed in certain positions at an audit client, there is a significant risk that the accountant would not be capable of exercising the objective and impartialjudgment that is the hall mark ofindependence”

Therefore, regulators and professional accounting bodies worldwide impose restrictions on certain types of employment relationships

6. Business Relationships

The UK’s APB (2008b) states that business relationship between the audit firm or a person who is in a position to influence the conduct and outcome of the audit, or an immediate family member of such a person, and the audited entity or its affiliates, or its management involves the two parties having a common commercial interest (Para. 27, ES 2). The Treasury of Australia defines business relationships as

“A business relationship between an audit firm or a member of the audit engagement team and the audit client or the management of the audit client involves a common commercial or financial interest and may create self-interest, advocacy or intimidation threats to the auditor’s objectivity and a perceived loss ofindependence”

The IESBA Code provides that a close business relationship between a firm, or a member of the audit team, or a member of that individual’s immediate family, and the audit client or its management, arises from a commercial relationship or common financial interest and may create self-interest or intimidation threats (Para. 290.124, EFAC, 2010). It may also create advocacy threat. So, regulators and professional bodies worldwide suggest rules restricting business relationships with audit client.

7.Financial Relationships

Financial relationships cover three broad categories of relationships viz., investment in audit clients, loans and guarantees to and from audit clients and other creditor / debtor relationships between an audit firm and audit client. Ramsay (2001) opines financial relationships cover two broad categories of transactions between an audit firm and an audit client: (a) investments in, or other business relationships with, audit clients, and (b) other financial interests in audit clients including loans, savings and cheque accounts and insurance products. But business relationships have traditionally been addressed separately from other financial relationships. The UK’s APB (2008b) defines a financial interest as an equity or other security, debenture, loan or other debt instrument of an entity, including rights and obligations to acquire such an interest and derivatives directly related to such an interest

“... [A] member would not be considered independent with respect to any enterprise if he or any of his partners during the period of the professional engagement or at any time of expressing his opinion had, or was committed to acquire, any direct financial interest or material indirect financial interest in the enterprise or was connected with the enterprise as a promoter, underwriter, voting trustee, director, officer or key employee”

The existence of financial relationships between the audit firm and audit client can give an impression that an auditor is not independent of his / her audit client Such an interest in an audit client creates self-interest or familiarity or intimidation threats to independence. Thus, regulators and professional bodies of accounting worldwide suggest safeguards for the financial relationships.

General Statement / Standard ofAuditor Independence

There is a consensus that the concept of auditor independence involves: independence of mind and independence in appearance (IFAC, 2010; IOSCO, 2002; EC, 2002; FEE, 1998). A general statement / standard of auditor independence (henceforth “a Standard”), is a cornerstone for auditor independence safeguards. A Standard incorporates both “independence ofmind” or “independence in fact” (for “subjective test”) and “independence in appearance” or “perceptive independence” (for “objective test”). In determining whether an auditor is independent, all relevant circumstances and relationships should be taken into consideration between the auditor and the audit client. The inclusion of a Standard in the audit rules serves the purpose of ensuring that auditor independence is a comprehensive and continuing audit requirement in the sense that it applies to all circumstances with regard to an audit and assurance engagement. Some countries have included a general standard in their audit rules namely, the USA and Australia.  

Independent Public Oversight Audit Regulator / Body

Independent oversight mechanism has emerged in the developed countries in the postEnron era. This new regulatory mechanism has influenced the accounting profession to change the way in which it performs its professional audit services. Humphrey et al. (1993) offer three suggestions expanding auditor’s responsibilities and enhancement of auditor independence. One of the suggestions is setting up of an independent office for auditing to enhance auditor independence by overseeing the appointment of auditors of larger companies and to regulate audit fees. The IOSCO (2010) maintains that auditors should be subject to adequate levels of oversight (Principle 19). The EU Directive advocates the system of public oversight (Article 32). Currently, the EC (2010) proposes for public oversight systems. There is no denting the fact that self-regulation has been the long standing tradition in the domain of accounting profession. Government direct intrusion is rare except in few e.g., the USA. Self-regulation of accounting industry increasingly came in fore a serious criticism in 2001 onwards after a series of corporate scams worldwide. Earlier the AICPA and its self-regulatory agency, the Public Oversight Board (POB) was to oversee the public accountants’ activities in the US. But the POB had no authority to sanction auditors for their lack of professional competencies and negligence. Self-regulation by the accounting profession was not successful in the US and hence, the POB was dissolved in 2002. In response to the failure of Enron and others the US Congress enacted the SOX Act and created the PCAOB, an independent audit regulator. The PCAOB was a radical departure from the past long-standing self-regulatory practice in the US. Several other jurisdictions have independent audit regulators and have memberships of the IFAIR including: the UK, Australia, Brazil, Canada, Frannce, Germany, Italy, Japan, Spain, and Switzerland (IFAIR, 2010).

Good Corporate Governance and Establishment ofAudit Committee

Good corporate governance is about ethical conduct in modem business. Corporate governance is “the system by which companies is directed and controlled” (Cadbury, 1992). It stems from the organization’s culture and mind set of management which can not be regulated by legislation only. There are several international studies on corporate governance practice including the study conducted by Aijoon (2005); the Organisation for Economic Cooperation o and Development (OECD) . According to Arjoon (2005) the failure in corporate governance is a real threat to the failure of every corporation. He opines that ethics is truly an essential ingredient for business success and it will continue to serve as the blueprint for success in the 21st century. However, the Corporate governance practices include a subcommittee of the board of Directors called, “audit committee” (AC), which is charged with oversight ofthe audit process of company. The US SEC and the NYSE first recommended the institutions of AC in 1940. Since then, many international works endorsed the uses of AC including Treadway Commission (1987), Cadbury Committee (1992), Blue Ribbon Committee (1999), IOSCO (2002). Several audit regimes require public company must have AC or an equivalent body. AC is a subcommittee of the BoD, a majority of whose members are non-executives officers. The UK’s FRC states the BoD should establish an AC of at least three, or in the case ofsmaller companies, two, independent non-executive directors. The board should satisfy itself that at least one member of the AC has recent and relevant financial experience (FRCUK, 2008). The AC has primary responsibility for making recommendation on the appointment, reappointment and removal of auditors. An AC can enhance, if not assure, the credibility and integrity of corporate financial reporting (Williams, 1977). Treadway Commission (1987) asserts: “An audit committee consisting of independent directors is the primary vehicle that the board of directors uses to discharge its responsibility with respect to the company’s financial reporting.” But the effectiveness of AC would depend upon the independence of non-executive directors. To be effective, an AC must maintain a degree of autonomy from the BoD; as with choice of auditor the BoD, in fact, chooses the members ofthe AC (Abdel-kahlik, 2002)