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Home > Auditing Best Practice > Threats to Auditor Independence and Possible Remedies

Auditing Best Practice

Threats to Auditor Independence and Possible Remedies

by Gilad Livne

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.

  • Self-interest.

  • Familiarity and complacency.

  • Social bonding.

  • Economic bonds.

  • Management and employment.

  • Litigation.

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.

Self-Interest

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.

Social Bonding

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.

Table 1. Average audit and nonaudit fees (US dollars) earned by Big Four and non-Big Four auditors in the United States during 2000–09.* (Source: Audit Analytics)

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Overall
Total fees 1,330,292 1,240,280 894,348 842,561 1,181,108 1,226,629 1,309,223 1,327,210 1,378,652 1,351,729
Audit fees 414,876 405,472 442,310 511,669 853,722 949,328 1,043,746 1,046,198 1,104,626 1,082,009
Nonaudit fees 915,416 834,808 452,009 330,892 327,387 277,301 265,477 281,012 274,026 269,721
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†
Total fees 1,658,027 1,582,697 1,245,717 1,228,660 1,796,259 1,950,704 2,191,428 2,309,410 2,407,913 2,307,484
Audit fees 506,958 507,378 608,674 740,242 1,293,586 1,504,478 1,738,797 1,808,029 1,918,416 1,837,057
Nonaudit fees 1,151,070 1,075,320 637,044 488,418 502,674 446,225 452,631 501,381 489,497 470,427
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
Total fees 123,162 115,513 83,706 81,471 117,174 159,497 179,347 184,056 185,543 181,685
Audit fees 75,716 70,734 58,540 61,099 92,955 131,154 153,565 159,525 161,290 157,671
Nonaudit fees 47,447 44,780 25,167 20,373 24,219 28,342 25,782 24,530 24,253 24,014
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.

Litigation

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.

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Further reading

Book:

  • Carey, J. L. “The new pressures on the CPA.” In Symposium for Educators. Washington, DC: Ernst & Ernst, 1967; pp. 11–22.

Articles:

  • Amir, Eli, Yanling Guan, and Gilad Livne. “Auditor independence and the cost of capital before and after Sarbanes–Oxley: The case of newly issued public debt.” European Accounting Review 19:4 (2010): 633–664. Online at: dx.doi.org/10.1080/09638180903503986
  • Ashbaugh, Hollis, Ryan LaFond, and Brian W. Mayhew. “Do non-audit services compromise auditor independence? Further evidence.” Accounting Review 78:3 (July 2003): 611–639. Online at: dx.doi.org/10.2308/accr.2003.78.3.611
  • Brandon, Duane M., Aaron D. Crabtree, and John J. Maher. “Non-audit fees, auditor independence, and bond ratings.” Auditing: A Journal of Practice and Theory 23:2 (September 2004): 89–103. Online at: dx.doi.org/10.2308/aud.2004.23.2.89
  • Chung, Hyeesoo, and Sanjay Kallapur. “Client importance, non-audit services and abnormal accruals.” Accounting Review 78:4 (October 2003): 931–955. Online at: dx.doi.org/10.2308/accr.2003.78.4.931
  • DeFond, Mark L. “How should the auditors be audited? Comparing the PCAOB Inspections with the AICPA Peer Reviews.” Journal of Accounting and Economics 49:1–2 (February 2010): 104–108. Online at: dx.doi.org/10.1016/j.jacceco.2009.04.003
  • DeFond, Mark L., and K. R. Subramanyam. “Auditor changes and discretionary accruals.” Journal of Accounting and Economics 25:1 (February 26, 1998): 35–67. Online at: dx.doi.org/10.1016/S0165-4101(98)00018-4
  • Dhaliwal, Dan S., Cristi A. Gleason, Shane Heitzman, and Kevin D. Melendrez. “Auditor fees and cost of debt.” Journal of Accounting, Auditing and Finance 23:1 (January 2008): 1–22. Online at: dx.doi.org/10.1177/0148558X0802300103
  • Europa. “Fourth Directive: Annual accounts of companies with limited liability.” Fourth Council Directive 78/660/EEC. July 25, 1978. Online at: tinyurl.com/896ky8x
  • Europa. “Seventh Directive: Consolidated accounts of companies with limited liability.” Seventh Council Directive 83/349/EEC. June 13, 1983. Online at: tinyurl.com/7a2twu6
  • Khurana, Inder K., and K. K. Raman. “Do investors care about the auditor’s economic dependence on the client?” Contemporary Accounting Research 23:4 (Winter 2006): 977–1016. Online at: dx.doi.org/10.1506/D171-8534-4458-K037
  • Kim, Jeon-Bon, and Cheong H. Yi. “Does auditor designation by the regulatory authority improve audit quality? Evidence from Korea.” Journal of Accounting and Public Policy 28:3 (May–June 2009): 207–230. Online at: dx.doi.org/10.1016/j.jaccpubpol.2009.04.006
  • Larcker, David F., and Scott A. Richardson. “Fees paid to audit firms, accrual choices, and corporate governance.” Journal of Accounting Research 42:3 (June 2004): 625–658. Online at: dx.doi.org/10.1111/j.1475-679X.2004.t01-1-00143.x
  • Lennox, Clive. “Do companies successfully engage in opinion shopping? Evidence from the UK.” Journal of Accounting and Economics 29:3 (June 2000): 321–337. Online at: dx.doi.org/10.1016/S0165-4101(00)00025-2
  • Lennox, Clive, and Jeffrey Pittman. “Auditing the auditors: Evidence on the recent reforms to the external monitoring of audit firms.” Journal of Accounting and Economics 49:1–2 (February 2010): 84–103. Online at: dx.doi.org/10.1016/j.jacceco.2009.04.002
  • Mayhew, Brian W., and Joel E. Pike. “Does investor selection of auditors enhance auditor independence?” Accounting Review 79:3 (July 2004): 797–822. Online at: dx.doi.org/10.2308/accr.2004.79.3.797
  • Myers, James N., Linda A. Myers, and Thomas C. Omer. “Exploring the term of the auditor–client relationship and the quality of earnings: A case for mandatory auditor rotation?” Accounting Review 78:3 (July 2003): 779–800. Online at: dx.doi.org/10.2308/accr.2003.78.3.779
  • Ruddock, Caitlin, Sarah J. Taylor, and Stephen L. Taylor. “Non-audit services and earnings conservatism: Is auditor independence impaired?” Contemporary Accounting Research 23:3 (Fall 2006): 701–746. Online at: dx.doi.org/10.1506/6AE8-75YW-8NVW-V8GK
  • Zeff, Stephen A. “How the U.S. accounting profession got where it is today: Part I.” Accounting Horizons 17:3 (September 2003): 189–205. Online at: dx.doi.org/10.2308/acch.2003.17.3.189

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