The Various Threats to Auditor Independence
There are a number of threats to auditor independence. In my discussion of these threats I make reference not only to several professional and regulatory pronouncements, but also more broadly to points raised by various commentators and academics. It should also be noted that different professional and regulatory organizations have a somewhat different view of the potency of such threats. This is the case because different countries have different legal and commercial systems that are embedded in broader cultural and societal contexts. As a matter of convenience, however, I will refer mainly to the ethical framework adopted recently by the United Kingdom’s Auditing Practices Board (APB).6 The threats listed below and discussed in the following sections may, thus, not be exhaustive.
The appointment and termination processes.
Familiarity and complacency.
Management and employment.
The Appointment and Termination Processes
Although the external auditor is employed for the benefit of shareholders, the appointment and dismissal processes are quite removed from shareholders. Management is responsible for suggesting the external auditor and rarely offers a choice to shareholders. As a rotation of audit firms is relatively infrequent—a periodic rotation is currently not required by law in most countries—the typical scenario is that the renewal of the incumbent auditor’s term is brought to the annual general meeting (AGM) for approval by shareholders. In practice there is little that shareholders can do except vote against a nomination or renewal. In other words, the nomination and appointment mechanism does not allow for competing proposals to be brought directly before shareholders. The result is that the incumbent auditor is at the mercy of the client’s managers as to the renewal process. Moreover, there are no direct channels between auditors and shareholders through which competing auditors can make a case for appointment. Thus, the special auditor–client relationship is off to a problematic start: the nominated auditor “owes it” to the client’s managers and is under threat of dismissal by managers.
Occasionally auditors are rotated, on a voluntary basis. Academic evidence suggests that many voluntary rotations take place because the incumbent auditor is too independent for managers’ taste (see, for example, DeFond and Subramanyam, 1998; and Lennox, 2000). The new auditor is likely selected by the client’s management in an opportunistic fashion in that the new auditor is more likely to accommodate clients’ wishes than the incumbent auditor. Since managers have almost exclusive control of this process, shareholders seem unable to influence the decision in a way that would ensure auditor independence. The result can be the nomination of a new and less-independent auditor.
The presence of financial interest of the auditor in the audited firm can impair objectiveness, and hence independence. Consider an auditor who is also a shareholder. The (independent) auditor’s duty is to ensure that financial performance is accurately reported, even if this implies reporting poor performance. However, as a shareholder, the auditor may prefer that bad news is withheld, at least until the auditor-shareholder can sell his/her position. Similar arguments hold for an auditor-lender (for example, through the holding of corporate bonds).7
As a second example of a self-interest threat to independence, consider the case where the external auditor carries out some nonaudit work for the client. This is quite a common situation. The auditor therefore may need to scrutinize and evaluate the nonaudit work carried out by colleagues in the audit firm. Many auditors may be quite reluctant to confront their colleagues and would have the self-interest to minimize any exposure that could risk his audit firm’s reputation.
Familiarity and Complacency
Familiarity can blunt the skepticism that is expected of the auditor. This may be because the auditor develops a degree of overconfidence in his or her knowledge of the client firm. It may be that the repetitive nature of a long-term engagement between the auditor and his/her client leads to complacency and, consequently, to the underweighting of warning signs. Some commentators speak of the need for “fresh” eyes and mind that lead to a better scrutiny of the client.
Yet familiarity also has a positive aspect as it implies a better understanding of the client and helps the auditor to perform better. Research on auditor tenure suggests that, as the audit–client relationship lengthens, audit quality improves.
Long-term audit engagements bring the external auditor and members of the client firm’s management team closely together. It is not unusual for friendships to form in the workplace. Moreover, to the extent that a client’s managers nominate auditors from their own circle of friends, the likelihood of objectivity on the part of the auditor decreases. This “self-serving” bias is grounded in psychology theory and arises when, as a consequence of close relationships, one cannot separate one’s own interests from those of others.
It is not entirely clear, however, how powerful this threat is. Auditors need to follow certain professional and ethical norms, and they are bound by social norms. Moreover, concerns about reputation may be quite powerful and sufficient to rein in such a threat, even if only at the subconscious level.
The Economic Bond
Auditors’ livelihoods depend on the fees they generate from audit and nonaudit services. Auditors thus have an inherent incentive to keep the client—that is, the audited firm’s managers—“happy.” Failure to do so can cost them the client and the loss of a long stream of future income. This economic bond is regarded by many as perhaps the greatest threat to auditor independence.
Nonaudit services have attracted the harshest criticism. These include consulting services such as corporate finance advisory, investment advisory or management, valuation services, and IT consulting and implementation services. Typically, fees for nonaudit services represent a very lucrative source of income. Some commentators have raised concern that in order to be awarded nonaudit service contracts, auditors may compromise their audit work.
Even in the absence of nonaudit services, the fundamental problem remains. While in the past audit work was relatively limited in scope, following SOX external auditors now need to audit internal control systems. As a result, there has been a sharp increase in audit fees. At the same time, SOX and similar regulations in many other countries have restricted the ability of external auditors to provide nonaudit services.8
These facts are also reflected in the data. Table 1 shows that average total fees (audit and nonaudit) have increased steadily since 2003, when many of the SOX requirements came into effect. Moreover, while nonaudit fees have declined sharply, audit fees have significantly increased. Importantly, these trends appear for both large and small auditors. Hence, an economic bond can still arise in the post-SOX era, though more so with respect to audit fees.
|Number of observations||5,648||7,784||13,343||15,284||14,180||14,014||13,892||13,548||12,804||11,815|
|Big Four auditors†|
|Number of observations||4,442||6,044||9,308||10,140||8,985||8,349||7,801||7,287||6,874||6,503|
|Non-Big Four auditors|
|Number of observations||1,206||1,840||4,035||5,144||5,195||5,665||6,091||6,261||5,930||5,312|
* I thank Angela Pettinicchio for helping me to compile this table.
† Deloitte & Touche, Ernst & Young, KPMG, PricewaterhouseCoopers (PwC), and, prior to 2002, Arthur Andersen.
Management and Employment
The auditor and the audited firm must be different entities, as an effective and objective audit clearly requires such a separation. For this reason, US regulation explicitly prohibits the provision of nonaudit services that involve activities which otherwise should be performed by the client’s management and personnel (i.e. management roles).
Matters become somewhat more complex when a previous auditor is hired by the client firm to perform a management role. One concern is that the members of the audit team will be reluctant to criticize a former colleague, perhaps because of social bonding. A second concern is that the ex-auditor, having acquired knowledge of the audit process and its weaknesses, may be able to take advantage and “game” the new auditor to the benefit of the client (and now the new employer). In the United States, therefore, there is a requirement of a one-year cooling-off period. In the United Kingdom, APB Ethical Standard 2 requires a two-year cooling-off period.
Sometimes disputes between client and auditor end up in legal action or, short of that, a threat to take matters to the courts. In such a case auditor independence is perceived to be impaired.
The ability of the auditor to judge matters on an objective basis irrespective of allegations of deficiencies in the audit procedures and conclusions comes under threat in these circumstances. By the same token, when the auditor sues the client, the natural presumption is that objectivity is lost. The US ethical rules require the audit firm to assess whether independence is impaired. In the United Kingdom ethical standards are stricter and require the auditor to resign.
Litigation by shareholders, for example through “class action,” typically targets not only the client and its management, but all too often the external auditor. The threat to the client–auditor relationship is less clear here. It is possible that the auditor would take a more “aggressive” approach to the audit to reduce potential damages that might be awarded by a court. To the extent that this creates bias in judgment, independence is impaired.
It is also interesting to note differences in legal systems. In the United States, civil litigation as well as criminal litigation is possible and there is no cap on the amount of damages that can be awarded. In the United Kingdom the legal environment changed with the new Companies Act 2006. Criminal charges can be brought against auditors, although in these cases the penalties do not include prison sentences. Perhaps more importantly, auditors and clients can for the first time enter into a “liability-limitation agreement” that caps the amount an auditor would need to pay in compensation. On one hand, this should encourage auditors to avoid a box-ticking mentality and rely more on their professional judgment as the fear of financial losses recedes. On the other hand, with the lowered threat of litigation, auditors may feel that the penalty for “collaboration” with clients is less costly. If the latter holds, auditor independence is likely to suffer.
Occasionally, the audit firm helps a client to defend itself against a legal dispute or with respect to regulatory inquiry or investigation. ASB Ethical Standard 1 (revised) calls this an “advocacy threat” because the auditor needs to defend the client. The standard states that, as a result, the audit firm effectively assumes a role very similar to a management role. This, in turn, threatens the auditor’s objectivity and independence.