Essay: Auditor Independence & Impact On Audit Quality.

For many decades, practitioners and academics have struggled to find definitions for independence in the audit context. Perhaps the best known definition in the academic literature is that of De Angelo (1981, 186) ‘the conditional probability of reporting a discovered breach’. Others include: ‘the ability to resist client pressure’ (Knapp 1985); ‘an attitude/state of mind’ (Schuetze 1994); ‘a function of character with the integrity and trustworthiness being key’ (Magill and Previts 1991). More recent definitions contained in pronouncements from various representative bodies of the profession world-wide extend the definition of a state of mind, for example, ‘freedom from those pressures and other factors that compromise, or can reasonably be expected to compromise, an auditors’ ability to make unbiased audit decisions’ (Independence Standards Board (ISB) 2000).

In the text -  Behind Closed Doors: What Company Audit is Really About (Beattie, Fernley and Brandt 2001)  provides an analysis of six company case studies which show how accounting issues which arise during the audit process are resolved between audit engagement partners  and finance directors From these cases, audit quality is shown to be an holistic activity in which issues of competence, independence in fact and audit risk are inextricably linked.

The restatement of the Enron accounts and the collapse of Andersen following the obstruction of justice finding against the firm (SEC 2002) shows the devastating effect of loss of confidence in the integrity of an audit firm. Despite the lack of knowledge about independence in fact, Enron  severely compromised independence in appearance.

• From a search of the academic literature, discuss risk and independence with a view to understanding where  key audit risks, and threats to auditor independence really lie.  What is it exactly that undermines auditor independence.
• Review the literature on the failure of Enron, Worldcom and Lehman Bros and what lessons have been learnt by the accounting profession from these collapses.

Important:  You must develop your viewpoint and not plagiarise  another author’s language.  The learning skills advisor at your library can assist you to develop your writing skills.

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Definitions of Independence in the Audit Context

Any kind of threat that is imposed on an auditor, set a limit on his work does affect the professionalism of the job. There are many authors who have described the threats that may affect the professionalism of auditing as overdue salary, actions or threatened litigations, personal relationship with the firm or partners, beneficial interesting shares and other Investments in the business, interesting interests and loans, acceptance of services and goods as gifts or hospitality as a bribe and provision to other services to audit clients. It is important to note that auditor independence is one of the pivotal factors that help in getting a clear view of the state of affairs (Hoffelder, 2012). Moreover, the results are not influenced with any external factors.

The direct incentive which can is provided to an auditor can involve an actual or potential monetary benefit in which the interests of the auditor underlying with the management in turn which will lead to the possibility of corruption of data and exploitation of the elders and investors (Lapsley, 2012). The fees that are provided to an auditor by the client main result in the development of personal interests within the auditor which will merge with the management’s preferences and hence become untruthful in nature. There are also many financial dependence strategies which include different incentives which will affect the ability of an auditor to be free from any management pressure and work in a conceptual manner (Kaplan, 2011).

There are indirect incentives that can be gained by an auditor under the circumstances that a make it difficult to maintain the objectivity. This type of corruption of data occurs when the auditor is having any personal or family relationship with the client. Hence, it is imperative that the auditor should not develop any relation with the client that will impact the smooth flow of the decision (Kaplan, 2011). Also, this kind of position may arise at the time if the statements have been made by the auditor himself and all the recommendations for the financial statements have been researched and developed by him and not outsourced by any other external audit service. This interpersonal relationship between the organization and the auditor may cause to affect the ability of an auditor to exercise auditing and professional level and without any kind of scepticism (Gay & Simnet, 2015).

The judgment of an auditor is usually dependent on the incentive and motivation. There have been many resources which state that the incentives player a very vital role in the decision that is displayed by the auditor and can further affect the organization in a positive or negative manner (Manoharan, 2011). The auditor may also make certain decisions that are not appropriate and the valuation of that judgment is very important. In the situations when there is no judgment order later judgment is required, it will be observed that the audio quality has been reduced (Sharp, 2006). There also exist many other disturbing factors which may cause an auditor to practice and fair means while conducting the auditing process. In general, it has been stated that the use of incentives will affect the outcome that may we reached at the time of auditing (Fazal, 2013).

Threats to Auditor Independence and its Impact on Audit Quality

The frameworks on auditor independence lay down that there are major five threats which can harm the objectivity of an auditor. These include Self-interest threats, self-review threats, and advocacy, familiarity, and Intimidation threats. The self-interest threats include various ranges of personal threats such as emotional, financial and other threats. The auditor may sub-consciously choose self-interest over the interest of performing and providing quality services (Cappelleto, 2010). The most common example of this is the relationship between the auditor and the people who appoint them; it leads to financial self-interest. The auditor may also be affected if they hold any kind of interest in the client's company, or if any of his friend or family may benefit from such a relationship (Livne, 2012). The second threat is a self-review threat. When an auditor has to check his own work, he may become biased. If he is to check work done by his colleague or anyone else in the firm then he may become judgemental. Therefore, when it comes to checking and rive of the work is already done, there always lies a self-review threat. The third threat is advocacy threat. This threat arises when an auditor or any other person involved in the audit work advocates or promotes any position of the client, which is based on some personal opinion and not on the actual facts (Livne, 20120. For example, if any of the persons involved in the audit is also a promoter of the client company, then they would promote or advocate on behalf of the client making their opinion biased. The fourth type of threat is familiarity threat. This type of threat is most commonly witnessed when the auditor fails to apply professional scepticism in his work. Due to the lack of personal opinion, the auditor depends too much on the explanation provided by the client and tends to develop the same viewpoint as the client, even if it is wrong. For example, when the auditor develops a close relationship with those in the management of the company to be audited then he tends to overlook the depth of the nature of the transactions (Baldwin, 2010). Lastly, there are intimidation threats. This type of threat arises when the auditor involved is intimated because of any reason which makes his opinion biased. The most common example of intimidation threat is when the auditor fears of being replaced by any other auditor. Under such circumstances, even if the auditor is sure of his opinion on the financials, then he is intimidated and tends to make a wrong decision (Niemi & Sundgren, 2012). Therefore, the auditor should always be professional in his work. He should carry out his work with professionalism and should always be sceptical about making his decision.

Importance of Auditor Independence in Ensuring Unbiased Audit Decisions

Both auditing and accounting play a significant part in enhancing and developing the international works and economical companies. Depending upon the opinion of auditors about the truthfulness of financial lists, the primary objective of reviewing is to add confidence and trust on the financial information prevalent in the statements. However, owing to the failure of WorldCom, Lehman Bros, and Enron, the entire accounting profession has been negatively affected that offers many important lessons for the future.

The behaviour of Enron has clearly confirmed that in few areas, significantly the treatment of off-balance sheet items dodges, thereby shedding light on the fact that American standards of accounting are too lax in nature (Matthew, 2015). Besides, while in other cases, they are so prescriptive that broader principles have become highly discarded. Further, past attempts on the part of FASB (financial accounting standards board) to enhance standards have also been stymied through vociferous lobbying. Hence, it is due time when the Securities Exchange Commission imposed strict standards but the same must be introduced through effective and sound principles that includes paying lesser attention to single figures for earnings instead of overly described rules. In addition, implementation of internationally agreed standards can also assist in advocating the accounting profession in future. Another significant lesson from the collapse of Enron is that accountants and auditors must ask a relevant question before proceeding with their respective jobs and the questions are what are the kinds of company’s activity, etc. The main ideology behind this lesson can be attributed to the fact that the auditors of Arthur Anderson failed to understand the financial lists for such problematic and complicated company and therefore, they continued the auditing procedure even after the company became a major merchant of speculation and financial bonds in the market. Furthermore, another moral lesson in the case of Enron would be to take obligations for accounting profession from the private accounting firms altogether and thereafter, offer it, stock, lock, and barrel the same to the government. Nevertheless, such an alteration may become compulsory considering the complications in the recent scenario. However, it would also run the risk in relation of auditors’ quality and therefore, it is not mandatory that a government agency can manage to get rid of the complications to which the private firms have usually fallen prey (Matthew, 2015). Therefore, as an intermediate step, the most vital and simple advice in relation to Enron would be to take the duty of choosing auditors away from the senior management of the company.

Maintaining Trust in the Integrity of an Audit Firm

In relation to the collapse of Lehman Brothers, the entire accounting profession suffered negatively too. Therefore, the lessons achievable from such collapse are that policy makers like the SEC, International Financial Reporting Standards (IFRS), etc must introduce tough and stricter policies so that Lehman failure can be prevented in future. Further, the firm was said to have enhanced its Repo 105 transactions some days prior to the period of reporting and thereafter, borrowed to purchase back immediately after such period of reporting. This gives rise to the fact that a critical and enhanced audit of the firm’s quarterly financials may have assisted in depicting the illegal treatments of such repo 105 transactions together with the quality of the mortgage portfolio adopted by the firm. Besides, the reason behind such lesson can be attributed to the fact that auditing profession failed to highlight or trace such issue that also sheds light on the incapability of regulatory bodies (Roach, 2010). Therefore, when it comes to the collapse of Lehman Bros, analysis and preparation of financial statements together with auditing can allow regulators to identify wrong doings on the part of financial institutions. Besides, one significant lesson is that more focus must be exerted on the affairs of big financial conglomerates in terms of monitoring and supervision because the effect of their failures can be very harmful to the entire financial system. Lastly, if standards like ASA 701 was prevalent at the time of such collapse, all the figures and facts of the firm would have been easily come into highlight. Nevertheless, the non-existence of such standard allowed the auditors in hiding significant facts and follow non-communication of material facts about the firm.

When it comes to the collapse of WorldCom, the lessons to accounting profession are that the internal auditors must always take control of supervising and monitoring the affairs specially when the company appears to be performing well within the external environment that is very bleak in nature. In addition to this lesson, it is the primary duty of external auditors to come in with a goal, unbiased state of mind, and audit the company with honesty, integrity, and independence. Furthermore, the transfer of obvious costs into capital expenditures in WorldCom was totally fraudulent and there is no excuse for such contravention. This is because everyone can agree that if service charge is paid to lease local lines, it is a clear-cut expense (Roach, 2010). Hence, the accounting profession must clearly take account of the fact that such expenses must be immediately identified as and when they are incurred, and unlike expenses that can be legally capitalized as assets and depreciated over their useful lives. Nevertheless, when WorldCom misrepresented these expenses, the same resulted in an artificial exaggeration of their EBITA and net income. Furthermore, another major lesson to the accounting profession is that there must be some strict and effective changes to the Generally Accepted Accounting Principles because after the collapse of WorldCom, it was ascertained that the complications and length of accounting policies may have enticed the company to try to get around these. Lastly, after determination of scope of audit in WorldCom, the major lesson and requirement was to include outside auditors in the process so that they could have concentrated on various broad areas whilst dealing with a company like it. Initiating with an analytical review of the draft financial reports that includes comparison of the financial data of the client to that of other company in the same segment will ensure that there are no striking discrepancies. Nevertheless, this will also include proper study of the company’s information to seek internal inconsistencies.

References

Baldwin, S. (2010). Doing a content audit or inventory. Pearson Press.

Cappelleto, G. (2010) Challenges Facing Accounting Education in Australia. AFAANZ, Melbourne

Fazal, H. (2013, May 13). What is Intimidation threat in auditing?.Retrieved from: https://pakaccountants.com/what-is-intimidation-threat-in-auditing/

Gay, G., and Simnet, R. (2015). Auditing and Assurance Services. McGraw Hill

Hoffelder, K. (2012). New Audit Standard Encourages More Talking. Harvard Press.

Kaplan, R.S. (2011). Accounting scholarship that advances professional knowledge and practice. The Accounting Review, 86(2), 367–383. https://doi.org/10.2308/accr.00000031

Lapsley, I. (2012). Commentary: Financial Accountability & Management. Qualitative Research in Accounting & Management, 9(3), pp. 291-292. https://doi.org/10.1111/1468-0408.00081

Livne, G. (2015, May 12). Threats to Auditor Independence and Possible Remedies. Retrieved from: https://www.financepractitioner.com/auditing-best-practice/threats-to-auditor-independence-and-possible-remedies?full

Manoharan, T.N. (2011). Financial Statement Fraud and Corporate Governance. The George Washington University.

Matthew, S. E. (2015). Does Internal Audit Function Quality Deter Management Misconduct?. The Accounting Review, 90(2), 495-527. https://doi.org/10.2308/accr-50871

Niemi, L., and Sundgren, S. (2012). Are modified audit opinions related to the availability of credit? Evidence from Finnish SMEs. European Accounting Review, 21(4), 767-796. https://doi.org/10.1080/09638180.2012.671465

Roach, L. (2010). Auditor Liability: Liability Limitation Agreements. Pearson.

Sharp, D.J. (2006).  Cases in Business Ethics. Thousand Oaks, CA: SAGE