Independence of Auditor

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Table of Contents

Introduction

Independence of internal auditor

Independence of external auditor

Types of independence

Real independence and Perceived independence

Restrictions on independence

Relationship with the client

The structure of the accountancy profession

Independence regulations

Possible future developments

Law, regulations and the conceptual frameworkof accounting

INTRODUCTION


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Auditors independenceRefers to the independence ofthe internal auditor or of the external auditor. It is essentiallyan attitude of mind characterized by integrity and objective approach to the audit process. The concep

requires the auditor to carry out his work freely and in anobjective manner.

The purpose of an audit is to enhance the credibility offinancial statements by providing written reasonableassurance from an independent source that they present atrue and fair viewin accordance with an accountingstandard. This objective will not be met if users of the auditreport believe that the auditor may have been influenced byother parties, more specifically company managers/directors

or by conflicting interests (e.g. if the auditor owns shares inthe company to be audited). In addition to technicompetence, auditor independence is the most importantfactor in establishing the credibility of the audit opinion.

Auditor independence is commonly referred to as thecornerstone of theauditing profession since it is thefoundation of the publics trust in the accounting profession.Since 2000, a wave of high profile accounting scandals havecast the profession into the limelight, negatively affectingthe public perception of auditor independence

Independence of internal auditor

Independence of internal auditor means independencefrom parties whose interests might not be totally alignedwith an effective risk management, an effective internal

control, and an optimal governance.The Charter of audit andthe reporting to an Audit Committee generally providesindependence from management, the code of ethics of thecompany (and of the Internal Audit profession) helps giveguidance on independence form suppliers, clients, thirdparties.
http://en.wikipedia.org/wiki/Financial_statementshttp://en.wikipedia.org/w/index.php?title=True_and_fair_view&action=edit&redlink=1http://en.wikipedia.org/wiki/Managershttp://en.wikipedia.org/wiki/Executive_directorhttp://en.wikipedia.org/wiki/Auditinghttp://en.wikipedia.org/wiki/Accountinghttp://en.wikipedia.org/wiki/Accounting_scandalshttp://en.wikipedia.org/wiki/Managementhttp://en.wikipedia.org/wiki/Code_of_ethicshttp://en.wikipedia.org/wiki/Financial_statementshttp://en.wikipedia.org/w/index.php?title=True_and_fair_view&action=edit&redlink=1http://en.wikipedia.org/wiki/Managershttp://en.wikipedia.org/wiki/Executive_directorhttp://en.wikipedia.org/wiki/Auditinghttp://en.wikipedia.org/wiki/Accountinghttp://en.wikipedia.org/wiki/Accounting_scandalshttp://en.wikipedia.org/wiki/Managementhttp://en.wikipedia.org/wiki/Code_of_ethics


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Independence of external auditor

Independence of the external auditor meansindependence from parties, that have an interest in thefinancial statements of an entity. The support from andrelation to the Audit Committee of the client company, thecontract and the contractual reference to public accountingstandards/codes generally provides independence frommanagement, the code of ethics of the Public Accountantprofession) helps give guidance on independence formsuppliers, clients, third parties.

Types of independence

There are three main ways in which the auditoindependence can manifest itself. Mautz, R.K. & Sharaf, H.A.(1961) The Philosophy of Auditing, American AccountingAssociation. & Dunn, J., 1996. Auditing Theory and Practice.2nd ed. Prentice Hall.

Programming independence Investigative independence Reporting independence

Programming independence

Programming independence essentially protects theauditors ability to select the most appropriate strategywhen conducting an audit. Auditors must be free

approach a piece of work in whatever manner they considerbest. As a client company grows and conducts new activities,the auditors approach will likely have to adapt to accountfor these. In addition, the auditing profession is a dynamicone, with new techniques constantly being developed andupgraded which the auditor may decide to use. Tstrategy/proposed methods which the auditors intends to
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implement cannot be inhibited in any way.Whileprogramming independence protects auditors ability toselect appropriate strategies,

Investigative independence

Investigative independence protects the auditorsability to implement the strategies in whatever manner theyconsider necessary. Basically, auditors must have unlimitedaccess to all company information. Any queries regarding acompanys business and accounting treatment must beanswered by the company. The collection of audit evidence

is an essential process, and cannot be restricted in any wayby the client company.

Reporting independence

Reporting independence protects the auditors ability tochoose to reveal to the public any information they believeshould be disclosed. If company directors have beemisleading shareholders by falsifying accountinginformation, they will strive to prevent the auditors fromreporting this. It is in situations like this when auditorindependence is most likely to be compromised.

Real independence and Perceivedindependence

There are two important aspects to independencewhich must be distinguished from each other: independencein fact (real independence) and independence in appearance(perceived independence). Together, both forms areessential to achieve the goals of independence. Reindependence refers to the actual independence of theauditor, also known as independence of mind. Morspecifically, real independence concerns the state of mind anauditor is in, and how the auditor acts in/deals with a specific
http://en.wikipedia.org/wiki/Mental_healthhttp://en.wikipedia.org/wiki/Mental_health


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situation. An auditor who is independent 'in fact' has theability to make independent decisions even if there is aperceived lack of independence present, or if the auditor isplaced in a compromising position by company directors.

Many difficulties lie in determining whether an auditor istruly independent, since it is impossible to observe andmeasure a persons mental attitude and personal integrity.Similarly, an auditors objectivity must be beyond question,but how can this be guaranteed and measured? This is whyperceived independence is of such importance.

It is essential that the auditor not only aindependently, but appears independent too. If an auditor isin fact independent, but one or more factors sugg

otherwise, this could potentially lead to the public concludingthat the audit report does not represent a true and fair view.Independence in appearances also reduces the opportunityfor an auditor to act otherwise than independently, whichsubsequently adds credibility to the audit report.

Restrictions on independence

When auditors of a company are in conflict with the

directors it is important this conflict can be resolved withoutthe auditors losing any of their independence. This can proveto be difficult as an auditor earns a fee from providing aservice, which is how he earns a living. This fee is paid bythe board of directors leaving them with the power in therelationship. There in lies the dilemma, how can the auditteam please the directors without losing any of thindependence but keep the directors happy to ensurmaintain repeat business?

The problems regarding independence stem from twomain sources the auditors relationship with the companyand the nature of the accountancy profession.

Relationship with the client
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An auditor earns a living from the fee he is paid it istherefore automatic that he does not want to do anything tojeopardize this income. This reliance on clients fees mayaffect the independence of an auditor. If the auditor feels

this client income is more important than theresponsibilities to shareholders he may not perform the auditwith the shareholders interests in mind. The larger the feeincome the more likely the auditor is to shirk responsibilities and perform the audit without independence.This could lead to the manipulation of figures aexploitation ofaccounting standards. By performing theaudit without independence the shareholders may getmisled, as the auditor is now reliant on the directors. Toencourage auditors to maintain their independence they

must be protected from the directors board. If they wereable to challenge statements and figures without the risk oflosing their job they would be more likely to work withcomplete independence. Ultimately, as long as the clientdetermines audit appointments and fees an auditor willnever be able to have complete economic independence.

In most cases it is the directors that negotiate an auditcontract with the auditors. This may cause problems. Audit

firms on occasions quote low prices to directors to ensurerepeat business, or to get new clients. By doing so the firmmay not be able to perform the audit fully as they do nothave enough income to pay for a thorough investigation.Cutting corners could mean the audit team would reporting without all the evidence required which will affectthe quality of the report. This would bring into question theirindependence.

It is common for the audit firm of a company to provide

extra services as well as performing the audit. Helping acompany reduce its tax charges or acting as a consultant forthe implementation of a new computer system, are commonexamples. Having this additional working relationship withthe client would result in questions being asked of theindependence of the audit firm. If non-audit fees substantial in retaliation to audit fees suspicions will arise
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that auditing standards may be compromised. The firmwould no longer be unbiased, as it would want the companyto perform well so it can continue to earn the addition fee fortheir consultancy. This would mean the audit firm would be

dependent on the directors and they would no longer beworking with independence.

The structure of the accountancyprofession

Price competition is a major factor in auditoindependence. Prior to the 1970s audit firms were notallowed to advertise their services and take part in biddingcompetitions for contracts. Competition between theaccountancy firms greatly increased when these restrictionswere abolished, putting pressure on the audit firms toreduce audit fees. Competitive bidding for contracts has alsoencouraged the reduction of auditor engagement hours. Thepressure to reduce costs may compromise the quality of anaudit. If a firm feels threatened by competition they may betempted to further reduce costs to keep a client. This riskslowering the standard of the audit performed and thereforemislead shareholders.

The increased competition between the larger firmsmeans that company image is very important. No audit firmwants to have to explain to the press the loss of a big client.This gives the directors of the large company a commandingposition over its audit firm and they may look to takeadvantage of it. The audit team would feel pressured tosatisfy the needs of the directors and in doing so would losetheir independence.

Independence regulations

There are various regulations in force regarding auditorindependence. The main enforcement of auditorindependence is through the Companies Act 1984 and theCompanies Act 1984 although the matter is also covered by
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the professional accounting bodies rules of professionalconduct and the Auditing Practices Board. It is also of notethat regulations (i.e. International Accounting Standards orInternational Financial Reporting Standards) relating to the

preparation of financial statements are also relevant.

The companies Act 1984 dictates that it is tresponsibility of shareholders (rather than directors) toappoint the auditor at the annual general meeting(AGM) section 384 of the act refers. The theory behind this is thatdirectors cannot intimidate auditors with the threat oreplacement or bribe them by offering reappointment. Inpractice the existing auditors of a company are generallyreappointed for another term at the AGM but t

shareholders are free to choose another auditor if they wishto. Directors can only appoint auditors in exceptioncircumstances (perhaps to fill a casual vacancy during theyear). However, such appointments by directors will expireat AGMs. The Companies Act 1984 (section 386) allowsshareholders to eliminate the need to reappoint an auditoreach year. If they elect to do so then it is automaticallyassumed that the existing auditor will be reappointed eachyear without the matter arising at the AGM. In s

circumstances it would take an extraordinary generameetings (EGM) in order to remove the auditor.

The Companies Act 1984 (part II) goes further toprotect the independence of the auditor in various ways. Oneof the key ways is that auditors must belong to a recognisedsupervisory body (RSB) before they can undertake suchwork. Schedules 11 and 12 of the Companies Act 1984specify the duties of the RSBs and the strict erequirements for their members that they must impose. It is

intended to ensure that all auditors have the requiredknowledge and skills in order to carry out their role to anacceptable standard.

Section 33 of the Companies Act 1984 allows forprofessional accountants who have gained their qualificationin another country to practice within the United Kingdom
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although it is necessary for such persons to undertake extraeducation in British law and accounting practices. In the pastthis would tend be exploited by members of tcommonwealth but due to there being an EU directiveon

mutual recognition of professional qualifications it is nowpossible for professional accountants within Europe to comeand work in the United Kingdom. The safeguards put in placeby section 33 (that any foreign professional accountantsmust have an adequate knowledge of British law aaccounting practices) should protect the quality of audits.

The Companies Act 1984 also has provisions to preventemployees of firms from becoming auditors of their owncompanies and subsequently either any subsidiary of their

employers or parent companies (section 27 refers). This isintended to prevent the appointment of an auditor withvested interests in a company.

It is also a requirement that any person barred fromacting as an auditor should refuse any such offers ofappointment and resign immediately if for whatever reasonthey become ineligible during their appointment. If fowhatever reason an ineligible person carries out an auditthen the Secretary of State (under section 29 of Companies Act 1984) has the power to require a company toappoint a second auditor and bear the brunt of the cost as aresult. However, companies are allowed to recover additionalfees from the original ineligible auditor.

Further to regulations regarding the appointment ofauditors the various Companies Acts also contain rulesregarding the rights of auditors. The most fundamental ofthese regulations is section 389A of the Companies Act

1984. This section states that auditors have a right of accessat all times to accounting related information frocompanies and further have the right to demanexplanations from companies regarding any accountingrelated enquiry they may have. Section 389A also coversother matters such as making it illegal for employees of acompany to make misleading, false or deceptive statements


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to auditors regarding any accounting related queries theymay have. Subsidiaries of British companies also mustprovide any accounting related information to the auditor ofthe parent company should they request it although in

general it is usually the same auditor who undertakes theaudit of both the parent company and its subsidiaries.Section 389A finally goes on to state that companies musttake all reasonable steps to obtain accounting relateinformation for auditors from any overseas subsidiaries itmay have. Auditors also have the right to communicatedirectly with shareholders as dictated in section 390 in theCompanies Act 1984.

Whilst this legislation prevents directors of companies

from limiting the information available to auditors it does notprevent directors from setting tight deadlines for auditorswhere it may prove difficult to obtain all the necessaryinformation they feel they require for audit. Directors couldalso attempt to negotiate a fee that would not be enough tocover the costs of a proper audit thereby forcing the auditorto perhaps undercut corners in order to reduce cosShareholders are not likely to be sympathetic to auditors insuch circumstances either as they may be likely to see

auditors as unnecessarily overcharging for their service.

Due to the fact that directors can impose tigdeadlines, negotiate low audit fees or perhaps threaten tonominate another auditor to shareholders it could be arguedthat auditors are not truly independent within the UnitedKingdom. Whilst there may be some truth to this it would notbe fair to say the rules are entirely ineffective as auditorshave to consider that if they fail to carry out an auditeffectively they will face stiff penalties, they could potentially

have to compensate any damages as a result of their failure,they could potentially lose a lot of business and ultimatelytheir credibility would be shattered. Therefore in reality it isthought that British auditors are only influenced in minorways and normally over matters of opinion given that anauditor would put retaining its business before the loss ofone single client.


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Possible future developments

Service limitations

Many have advocated that in order for an auditor toremain strictly independent they should not be allowed toprovide audit clients with any other advisory services. Thisidea was detailed in the ECs Eighth Directive and wasdesigned to remove conflicts of interest arising from auditcompanies having a high percentage of total revenue stakedin the contract of one client. To date this has not been made

a requirement. Both auditors and their clients have arguedthat the knowledge acquired during the audit process canallow other services to be provided less expensively.

Peer assessment

A review of audit control procedures by another firm isa requirement in the US that must be satisfied once everythree years. This has been implemented to ensure externalaudits are carried out with the utmost professionalism andindependence at all times. Such a system has not beenaccepted by UK auditors; however, it is expected that manylarge firms already have peer reviews in place which areconducted by audit teams from offices in other parts of thecountry.

Audit committees

The recommendation for companies to form an audit

committee was first made in the Cadbury Report (1992). Agroup of three to five non-executive directors from within thecompany are chosen to provide what is supposed to be atruly objective view on all aspects of the audit: fevaluation of internal control systems to recommendationson audit fee. Since the cadbury Report, this practice has


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been implemented yet many still remain unconvinced of theneutrality of non-executive directors.

Rotating external auditors

It is widely believed that a mandatory rotation of auditfirm could improve auditor independence. Firstly, currentauditors will have no incentive to work in cahoots with theirclient if the contract is due to expire in the foreseeablefuture.] Similarly, auditors will be less likely to forgrelationships with directors and staff, thus will be lessconcerned about upsetting them through an unfavourableaudit report. And because current auditors will know they aresoon to be replaced, they will be inclined to produce audit

reports which demonstrate high standards and are aexemplar of true independence, as to avoid having anyshortcomings exposed by the new audit team.

However, proposals for a maximum client servicingperiod of five years have since been dismissed after lobbyingby accounting firms and their clients, again stressing that itis vitally important that auditors familiarise themselves withclient operations in order to conduct a successful audit.

Law, regulations and the conceptualframework of accounting

In the future, issues regarding conflicts of interest maybe tackled through legislation which bans audit firms holdingshares in client companies. Some financial commentatorsbelieve that it is the subjective nature of modern dayaccounting which is the main contributor to the ambiguity of

auditor independence and suggest this could be clarifiedthrough the introduction of a conceptual framework, ratherthan legislation. They feel a set of agreed definitions onmatters which are not encompassed by formal standardswould benefit the auditor and, ultimately, remove andoubts over real and apparent independence.
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Documents

Independence of Auditor