Perception or Reality: Auditor Independence And Objectivity
Rocky J. Dwyer, PhD, FCPA, CPA, FCMA, CMA
Independence is considered by many to be of paramount importance to the effectiveness of the audit function and increasingly, the public, media critics and regulatory agencies have questioned if auditors are sufficiently independent of their clients in fact and appearance. While the private and public sectors acknowledge the importance of auditor independence, there is a division over how independence should be implemented and measured. Audit professionals argue that independence should be measured by actual independence, while regulators argue that independence must be gauged in terms of appearances. Like Caesar’s wife, organizations must not only be virtuous but also be seen to be so!
Independence and Objectivity – the concept
While the joint provision of management advisory and audit services research provided no conclusive evidence that independence was impaired, in fact or appearance. The research results on other factors although diverse, suggested that certain client pressures, compensation schemes, auditor employment with clients, share ownership of clients, GAAP subjectivity, and the client’s financial position had the potential to affect independence. Industry sources report that in the early 00s traditional audit firms earned approximately 20 percent of their revenues from management consulting services. Today, the percentage is nearly 70 percent, while audit services revenues have dropped to about a third of total revenues.
Contrary to the profession’s stance, regulators argue that auditors must be held to a standard that goes beyond independence in fact, and that the public’s perception of the profession is a critical aspect of independence. Implementation and enforcement of independence must be based on independence in appearance. Accordingly, it is no longer sufficient that audit quality is maintained and the numbers are right. It is also necessary that financial report users perceive the information as correct.
Private vs Public – the Appointment and Anointment Stage
Standards on independence are different in public sector audits than those in the private sector according to the International Organization of Supreme Audit Institutions and this notion of difference is supported by the literature. Specifically, private sector auditors are accountable to the corporation that they audit – in principle to the shareholders. Additionally, they are professionally accountable for adherence to professional association standards; and may be held accountable through the courts for their compliance with relevant statutes. In this context they may be accountable in a wider sense to those who rely on their reports and opinions. Whereas the essential role of the AG is to improve the economy, efficiency, administrative effectiveness and accountability of Canadian public sector institutions through auditing and audit report findings.
In stark contrast to the private sector, the public sector auditee does not choose an auditor nor determine the scope of enquiries and is expected to assist the AG. In the private sector, if the auditee does not assist the auditor, the auditor can withdraw. This is not an option available to the AG, in audits of statutory authorities – the AG and the auditee are stuck with each other.
Common standards exist for private and public sector auditors to ensure independence. For example: audit personnel are not members of management committees nor do they participate in the management or operations of an auditee body in any way that could prejudice an objective approach to an audit. Auditors are not involved in instructing personnel of auditee bodies. Any audit personnel known to have close affiliations with the management of an auditee body, such as social, kinship or other relationships conducive to a lessening of objectivity, would not be assigned to audit that body.
The independence of both private and public sector auditors appear to be somewhat compromised by expectations guiding their appointments. For example, the Canadian Business Corporation Act requires an auditor to be independent; however, it also permits an exemption from the requirement to be independent via the courts. More recently, the global accounting and auditing scandals have called into question the idea of auditors as being automatically trusted, independent advisors. Hence, the parameters of a new concept of independence continue unfolding, but there appears to be a consensus of independence that emphasizes a greater degree of separation between external auditors and client management. Private and public sector interests have called for additional research regarding independence to contribute to the ongoing dialogue and creation of a framework to further enhance independence in fact and perception.
Mandatory Audit Firm Rotation
The case for mandatory audit firm rotation may seem by many to be the industry cure-all. However, like all hypothetical solutions there are disadvantages and advantages. Disadvantages include:
- Loss of ‘corporate memory’ of a client reduces audit effectiveness.
Effective audits require a comprehensive understanding of both the industry environment and the client. Given the level of complexity in most businesses, it can take new auditors several years to fully understand the business. Industry studies have determined that business failures occurred almost three times as often when the auditor was performing the audit for the first or second year.
- Increased costs of doing business.
New auditors need to review audit proposal processes regularly, which distracts senior client time and audit resources away from the real task of their business. Audit staffs are continually being trained in the complexities of the business systems and non-financial procedures.
- Impact of rotation on the audit profession.
The competitive nature of audit appointments with mandatory rotation has resulted in fee reductions of about 40%. While this appears to be a positive development, potentially this may reduce audit quality.
- Rotation may conceal auditor issues.
Prior to legislative changes, an auditor concerned about a client would resign or not seek reappointment. Industry sees this as a strong signal to the market. Compulsory rotation allows the relationship to terminate naturally and may conceal real concerns.
- Global concerns regarding the practicalities of rotation.
Since different jurisdictions have adopted various time-frame rotation practices, this may compromise audit quality and other practicalities, including scope of service conflicts of interest.
- Rotation restricts freedom of choice.
Audit firms may fall into a routine where they are less inclined to invest in their clients, knowing they will be relinquishing these investments.
One must also consider rotation benefits. Proponents of firm rotation argue the perceived closeness of the relationship between auditor and client management. The commercial pressure to retain long-term relationships may impede auditor independence and impact the perception of independence. Compulsory rotation would likely overcome these issues.
Compulsory firm rotation increases systemic risk in the market place due to compromised audit effectiveness. Against this is the increased cost of doing business for auditors and clients who may be regularly in the proposal, learning and orientation phase.
There is no strong evidence from Italy or Spain that mandatory audit rotation positively impacts audit quality. Research (SDA Universita Bocconi, 2002) concluded rotation carries significant threats to audit quality from competitive pressures and suggested that other approaches such as effective regulatory oversight might be preferable.
The joint provision of audit and non-audit services poses a significant problem for auditor independence. Auditors, building on their existing relationships, provide a wide range of services to their long-term clients including corporate finance, tax compliance, planning services, IT, legal services and management services. Prawitt for example, noted the ratio of non-audit services supplied to clients has increased rapidly in recent years to around 50 percent. This trend has caused concern in the marketplace with some proponents suggesting a ban on the provision of non-audit services to clients by audit firms.
Proponent’s arguments for auditors to provide non-audit services to their audit clients include:
- Research by a number of bodies, including the SEC in the United States, failed to demonstrate that non-audit services delivered in accordance with the profession’s independence guidelines impair independence. There has been no direct cause-and-effect relationship established between an increasing level of non-audit services and audit failures.
- Providing non-audit services strengthens an auditor’s economic bond with the client and investors value this effect.
- The effect of prohibiting accounting firms from providing certain non-audit services to clients would inhibit their ability to innovate types of service and grow them in a way that makes the economy more efficient. In addition, audit-dominated accounting firms may be unable to attract and retain the specialists necessary to assist and support the audit function of the firm.
- Non-audit services i.e. tax, are so closely linked to the audit that only the auditor can provide them. Thus, if there is a separation of services, audit quality may diminish in the near future and not improve.
- The Audit Committee is responsible to consider providing non-audit services by the external audit firm and the possible effect on their independence.
Arguments against auditors providing non-audit services:
- Auditor objectivity could be comprised when faced with a potential conflict between statutory responsibilities to shareholders, and the commercial pressures resulting from growth of business through the supply non-audit services.
- Clients may try to prevent an auditor from reporting accounting problems by threatening to end the auditor – client relationship.
- Potential for negative stock-market reactions exists when clients pay their auditors unusually high non-audit fees.
- There is a fundamental conflict of interest in providing audit and non-audit services to clients and reporting to shareholders and others who rely on the audited financial statements
- Prospective revenues from the provision of non-audit services, extending into the future, create a financial stake producing a conflict of interest capable of impairing audit independence.
- The incentive to compete on price will be sharply reduced. Charges for auditing may not be adequate to attract and hold the quality professionals necessary to perform quality audits.
Auditor independence is considered the hallmark of the auditing professional and is viewed as the most essential element in safeguarding the interests of several parties – management, investors, creditors, government, taxpayers and the general public.
Around the corner or around the world, jurisdictions in both private and public sectors, recognize the importance of auditor independence, and have taken steps to enhance auditor independence by promulgating professional standards and regulations and detailing situations that constitute impairment of auditor independence.
The path to independence is wide open. Clearly, the choices available to organizations and regulators are diverse. This short journey through the auditor independence concept has given but a glimpse of its complexity and diversity. It is evident that there are many avenues for future exploration.
Rocky J. Dwyer, PhD, FCPA, CPA, FCMA CMA is a Professor at Walden University’s College of Management & Technology. He is an award winning writer, editor and educator, who has consulted and undertaken research for private, not-for profit, and public sector organizations to examine and validate strategic organizational capacity, and performance management. His research has been published and presented at conferences and symposiums in Canada, the United States, South America, Germany, the Russian Federation, and the People’s Republic of China. He can be contacted at: firstname.lastname@example.org.
 Examples include: Enron, Nortel, WorldCom, Arthur Anderson
 Examples include: Nortel, Arthur Anderson, Public Works & Government Services Canada
 Examples include: Pricewaterhouse Coopers
 Examples include: Canada Firearms Centre
 Examples include: Nortel
 Italian statutes requires mandatory audit firm rotation every nine years
 Spanish statutes removed mandatory audit rotation in 1995