Financial reporting is one of the legal requirements in accounting since it enables the effective creation of information for the general public. In addition to financial reporting, auditing enhances the reliability and credibility of the financial information by various parties such as investors, creditors and other relevant stakeholders. Auditors form a principal external element in checking the integrity of all the financial statements. This means that they play a significant role in adding value on financial statements and improve on the reliability of the information. Considering the fact that there is an agency relationship which exists between the shareholders and the management, auditing plays a significant role in enhancing the role of corporate governance. This serves to ensure that there is no conflict of interest between the management and the shareholders (Shockley, 1982, p.26). In addition, financial auditing ensures that the management team is accountable to the shareholders in their stewardship role. In their operation, auditors have a commercial interest.
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In their operation, shareholders rely on external auditors in an effort to enhance on the reliability of their financial information. In their supervisory role, external auditors are required to maintain certain standards. This ensures that possible conflict between the shareholders and the auditors are eliminated. Some of these standards relate to integrity, independence and objectivity.
According to Shockley (1982, p. 119), accounting standards relate to the expected level of performance that the auditors are required to comply with in their operation. Lack of complying with these standards would culminate into failure of the audit work and hence its reliability. Integrity is one of the requirements for all individuals acting in the interest of others to integrate. In line with this, it is important for auditors to conduct their tasks with integrity by considering other qualities such as candor, intellectual honesty, fairness and confidentiality. Through objectivity, auditors are able to eliminate biasness, compromise and prejudice in their reporting. Objectivity ensures that conflict of interest between the auditor and shareholders do not have an influence on the auditor’s judgment. In addition, incorporating objectivity ensures that the auditors are prepared to disagree with the judgments of the directors when necessary. The importance of objectivity arises from the fact that most issues in financial reporting are based on judgment rather than facts. According to corporation law, auditors are required to form an opinion in relation to whether the information presented in a firms financial statements are true and fair. In addition, auditors are required to provide the credibility of the information regarding the firm’s financial position, whether the firm complies with the stipulate financial accounting standards in reporting and its financial performance. As a result, auditors have a legal obligation to present an independent report. Shockley (1982, p.26) defines auditors independence as the independence an auditor has from other parties who have interest in financial statements apart from the shareholders. According to Shockley (1982, p. 127), independence of auditing arises from the fact that there is limited access of sufficient financial information by most users of the information. This means that the third party users of the financial information cannot be able to determine the objectivity of the auditor’s reports. The discussion of this paper involves an analysis on auditor’s independence. Various elements are considered in the analysis. These include the importance of independence in auditing in relation to independence in fact and appearance. There are a number of safeguards which can be incorporated in an organization to enhance an auditor’s independence. The safeguards are designed with the objective of either eliminating or mitigating the effects of the threats.
Importance of independence in auditing
Acts as the basis public accounting profession
Independence in auditing acts as the foundation of the entire public accounting profession both philosophically and historically. Audited financial reports are important to the regulators in assessing the company’s performance. The external auditing in a firm which is conducted by and independent party ensures that the shareholders and other interested parties are comfortable with integrity of the financial reports. In addition, independence in auditing ensures that the concept of objectivity is incorporated in the process of developing financial reports.
Enhancing audit reports and their credibility
Over the past decades, there has been an increment in the rate of globalization which has affected various organizations. This has culminated into increased recognition and desirability of attaining a high level of uniformity and harmonization in relation to auditing, reporting and also other ethical requirements of accounting. The primary objective of auditing is to verify the financial statements of a given firm. As a result, professional independence is a key element in auditing considering the fact that it is the auditors goal to enhance credibility of the financial information reported. By integrating the concept of independence, the auditors are able to conduct their duties free from any form of external pressure and imposed constraints. Auditing enables effective reduction of the cost involved in exchanging information between various parities within an organization such as the management and the shareholders. In addition, auditing also acts affective signaling mechanism.
Independence in auditing ensures that auditors provide an independent verification to the financial statements. This means that through an auditor’s independence, credibility of financial information is enhanced. This contributes towards minimizing the probability of business failing through inappropriate reporting culminating into a negative public image. For example, there would be minimal confidence in creditors and the investors if auditors are not independent in fact and appearance. Auditor’s independence results into an increase in the level of reliability of the financial reports amongst the interested parties. This is achieved through detection and correction of misstatements and omissions in the statements.
By conducting their duty without any form of coercion or pressure, the financial information becomes more credible culminating into an increment in the user’s level of confidence. For the reports by the auditors to be relied upon, it is important that the auditor’s opinion be objective. In addition, assessment of the financial statement by the auditors must be free from any interest by the auditor. According to Shockley (1982, p.27), the auditor must also ensure that the assessment is in conformity with all the accounting principles. Therefore independence forms one of the key elements of auditing standards. This is due to the fact that the opinion of an independent accountant is supplied thus justifying the financial statements. An auditor’s opinion can greatly contribute towards an increase the credibility of the financial statements even if there were no omissions and misstatements. This is through validation of the absence of such errors.
Independence in fact and appearance
In relation to auditor’s independence, there are two crucial aspects that the auditors must consider to achieve their independence goals. These relate to independence of fact and appearance. According to Shockley (126, p.27), these elements are paramount in ensuring that there is integrity and objectivity in the process of certifying the financial statements. Independence in facts is also referred to as actual or real independence while independence in appearance is also referred to as perceived independence (Guide for audit committee, 2003, p. 4). This means that it more emphasis is given to how the auditors deal with a certain situation. Incorporating the concept of independence of fact enables the auditor to make decisions independently despite the perception that there is lack of independence. In addition, independence in fact ensures that the auditor does not compromise to pressures by the auditors who might who might influence his or her decision in reporting. This makes the auditors quality of opinion to be key in maintaining a high level of confidence in reporting.
According to Shockley (1982, p. 129), there should be no any element of bias in the auditors opinion. To achieve this, auditors must incorporate the concept of objectivity which requires independence from the company being audited. However in some situations, it is not possible for independence in fact to be seen resulting into bias in the process of reporting. Owning of shares by an auditor may result into compromise of accounting principles. For instance, the auditors can involve themselves in aggressive accounting with the goal that increase in the level of earning will result into an increase in the firm’s share price. This represents an infringement of the auditors to independence in fact. This would result into a destruction of the auditing function. Also, infringement of independence of fact would reduce the value of auditing o the users of financial statements.
Violation of independence in fact in auditing have both long term and short term implication to the auditing firm and the auditor. For instance, such violations of independence of facts would culminate into sanctions being placed by the auditing regulatory organizations. The effect is that the firm would incur certain legal liabilities. The auditing firm can also be affected through loss of revenue and opportunities to sell other non audit services. In addition, this can also result into both the firm and the auditor losing their reputation in the auditing field. Douglas (1999, Para. 6) asserts that lack of effective auditing would result into poor investment decisions. This is due to the fact that financial reports form act as a source of information for some investors in the process of making investment decision. If there is a low degree of reliability in the information provided, providers of capital demand higher proceeds so as to compensate for possible risks.
In the long term, lack of independence in fact in relation to auditing have a negative impact to the financial markets through an increment in the cost of capital. According to Campbell and Keith (2002. p. 229), it is difficult to determine the degree of independence in fact in an auditor in the process of executing their duty. This is due to the fact that determining an auditor’s independence in fact will involve knowing exactly what happened in the mind of the auditor.
Independence in appearance
Auditors are not only supposed to act independently but should be seen to operate independently. This is due to the fact that independence in appearance results into a reduction of an auditor’s opportunity to act in different manner rather than independently.
Considering the fact that independence in fact in auditing cannot be measured, it is paramount that independence in appearance be integrated in auditing. Independence in appearance is only a matter of perception. This means that independence in appearance relates to how the pubic interprets the auditors independence in the execution of his or her tasks. Alternatively, independence in appearance can also be defined as how a different and reasonable individual with relevant information views another auditor’s independence in his or her financial reporting. It is paramount that accounting as a profession to maintain a high level of public confidence by ensuring independence of the auditors. There is a high probability of public confidence being impaired if there is existence of certain circumstances which might be perceived to impair independence. The auditor must be recognized to independent and free from any form of interests and obligations from his client (Campbell &Keith, 2002, p.228).
There are various ways through which independence in appearance can be infringed. For example, an auditor who is not directly involved in audit but his or her child is a part owner of the firms represents an infringement to integrity and objectivity elements of auditor’s independence. This is due to the fact that the auditor has indirect ownership interests. Considering a case where 10,000 shares are owned by staff accountants or partners parents but are not personally part of the engagement, the public may have a perception that the auditors are not independent. This public perception may have damaging repercussions to the firm similarly to actual independence violation.
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There are various ways through which auditor’s independence in relation to independence in appearance can be addressed. These relate to set professional standards, policies and statutory law. The following are some o f the statutes, standards and audit firm policies which address independence. The statutes may restrict staff of an accounting firm from becoming owners of the client firm through shareholding. Alternatively, the statutes may restrict any form of beneficial interest such as lending to the firm. The staffs of audit firm are prohibited from holding receiving other forms of benefits apart from the audit fee.
In addition, there are also standards which prohibit the owners of audit firms and the staff from seeking finances from their audit client or accepting commissions for recommendations on new business ventures to their audit client. In addition, there are also stipulations which prohibit the auditors from undertaking various non-auditing services. These services relate to corporate advisory activities and taxation for their clients.
Threats to independence in auditing
The objective of certification of financial statements by third parties is to increase the level of confidence in all the parties that rely on the financial statements. Auditor’s independence is one of the principles that are integrated in instilling this confidence. However, there are a number of potential threats that the auditors face in their effort to enhance the concept of independence. These threats influence the auditor’s tasks in a number of ways. According to Shockley (1982, p. 128), the auditors ability to determine a certain situation fairly is compromised.
In appropriate hiring of audit staff
Some threats to independence in auditing relate to hiring or appointment of staff. For instance, hiring of the audit staff may consist of former audit staffs to the audit committee or the board of directors. In addition, the hiring process may integrate close relatives of the firms audit partners to the audit committee (Campbell & Keith, 2002, p. 226). According to Campbell and Keith (2002, p. 226), this hinders the independence of the auditors in their reporting activities. This is due to the fact that there is a high probability of their reporting process being skewed towards one side. The effect is that the information provided through the financial statements will not be effective due to lack of reliability.
Threats of intimidation
Campbell and Keith also assert that, independence in auditing is affected by the threats issued by the auditee in relation to termination of his or her engagement with the auditor. Threat of intimidation results into a perception that the auditor is being pressurized by the auditee or other interested parties. The coercion to the auditors may either be secretly or openly conducted (Shockley, 1982, p. 128). For example, the auditor may be threatened with termination of his or her contract due to disagreement with the auditee’s demands of specific requirements in the auditing report. This may occur upon the auditor applying certain accounting principles in his or her reporting. Intimidation threat may also arise from increased pressure by the client to reduce inappropriately the magnitude of work performed so as to minimize the fee paid to the auditor. In addition, intimidation may result from the presence of a dominant individual holding a senior position in the audit client and with the capacity to control the activities of the auditor (Guidance for audit committee, 2003, p.). Intimidation results into deterrence of the auditor from conducting their duties objectively. In addition, their capacity to exercise professional skepticism is also deterred by the threat of intimidation. This results into destruction of the relationship between the management and the auditors thus impairing the auditor’s level of independence in their duties.
Threat of Self interest
Self interest poses a threat to auditor’s independence. Self interest refers to threats that result from conflict of interest between the auditor and the management. This means that auditors are more concerned with attaining their own interests and not that of the client.
According to Campbell and Keith, (2002, p. 236), self interest may relate to the auditors financial or emotional interests. For instance, an auditor may either subconsciously or consciously favor self interests at the expense acting in the interest of the management system. For instance, a part ownership between the auditing firm and its clients through shares represents financial self interest. In addition, financial self interest may also be present if the auditor owns shares in his or her client firm. Self interest may also result due to existence of employment relationship.
Self interest may also be evident if the auditor perceives potential employment in his clients.
Threat of self review
This occurs in the event that the judgments or products of previous assurance by an auditor require re-evaluation. Self review threatens an auditors independence if one of the members of the auditing team was an officer, employee or a director of the firm who had the capacity to influence the subject matter in relation to auditing. This means that they will be reviewing their own works or that done by their colleagues. Other circumstances in which an auditor’s circumstance may be influenced include performing the services of an audit client which have a direct effect on subject matter of either subsequent or current audit engagement. In addition, threat of review may also arise from the original data that is used to generate the financial statements. In such an event, it would be difficult for the auditors to review the work without bias. This means that the auditor’s independence in their duties is compromised.
Threat of advocacy arises when an audit firm or an audit team member is perceived to or promotes the position or opinion of the audit client to the degree where the concept of objectivity is being or perceived to be compromised. There are various circumstances which may result into threat of advocacy. These include dealing with, promoting shares and other financial securities to an audit client. Shockley (1982, p. 137) asserts that advocacy threat may also occur when the auditor acts in an advocate capacity on behalf of the audit client in the process of dispute settlement. By acting as an advocate, an auditor’s independence is affected since he or she does not act in an unbiased manner in his or her role as an attestor of the financial statements (Guide for audit committee, 2003, p. 8).
Threat of familiarity
According to guide for audit committee (Anon., 2003), threat of familiarity arises from existence of a close relationship between parties involved in auditing. These may either be employees, directors or officers of the audit firm or client firm. It may also occur if the audit team members become compassionate with the clients interests. A number of circumstances may result into threat of advocacy thus affecting the auditor’s independence. For example, there might be a relationship between the audit team and the client either on family or professional basis. This relationship may have the capacity to influence the subject matter in auditing thus posing a threat to auditor’s independence.
Due to the trust developed between the parties involved, the degree of skepticism in the auditors in relation to assertion by the auditees is not sufficient. This makes them too ready to heed the auditees’ viewpoints.
Safeguards against threats
Upon the identification and evaluation of significance of potential threats to auditor’s independence, it is necessary that potential safeguards be implemented. According to Campbell and Keith (2002, p. 229), safeguards refer to the various restrictions that formulated to guide the relationship between an auditor and the client. Alternatively, safeguards can be defined as the control mechanisms that are put in place to eliminate or mitigate threat that impair an auditor’s independence. There are a number of factors that determine the safeguards which are to be adopted by the organization. Some of these relate to size of the firm and the type of company, that is, either private or public.
According to Campbell and Keith (2002, p.30) , the formulated safeguards should have the capacity to eliminate the probability of the threat impairing auditors independence up to a certain acceptable level for them to be effective. In addition, the safeguards should at least address all the threats in relation to self review, advocacy, intimidation, familiarity and self interest. However, their appropriateness depends on facts and circumstances in which they are applied. According to guidance for audit committee (Anon. , 2003), it is important that consideration be given to conclusion of the third parties in relation to what is they consider as being reasonable and what is unacceptable. However, these considerations will be influenced by other issues such as the importance of the threats, structure of the firm and the target users of the audited financial reports. Safeguards are classified into three main categories. These include the following:
- Safeguards created through legislation, regulation and by the accounting profession
- Safeguards formulated within the audit client
- Safeguards formulated by the audit firm
Safeguards created through legislation, regulation or the accounting profession
According to guidance for audit committee (Anon., 2003), these safeguards relates to key requirements in relation to joining the accounting profession. These may include disciplinary processes, educational requirements, reviewing the firm’s quality control system externally and other legislations relating to independence requirements of an organization. Education requirement may demand that auditor continue with education in regarding auditing ethical requirements and independence. Alternatively, the safeguards may relate to the expected degree of experience and competency for one to be granted an auditing license.
Safeguards implemented by the audit client
These safeguards relate to measure implemented to guide the operation of the entire organization. These may relate to the procedures and systems that a firm has adopted. For example, the management team of an auditing firm may emphasize on the benefits of auditing independence through documentation of various independence procedures and policies. For example, according to guidance for audit committee (Anon. , 2003), the management team may emphasize on the firms dedication to fair reporting. In addition, the management team may stipulate various procedures to enable effective monitoring to ensure compliance of with the set policies and engagement safeguards. In an effort to determine compliance with the set policies and procedures, the management may consider reviewing of an auditor tasks. In addition, the management may consider removing a member of the assurance team if his or her interests conflict with that of his clients. Removal of the member may also be considered if his or her relationship with the client threatens the concept of independence (Shockley, 1982, p. 135).
The management of the audit firm can also enhance safeguard to threats of an auditor’s independence through formation of an effective corporate governance structure. This will enable the firm to integrate the concept of audit governance. According to audit governance position paper (Anon. , 2002), audit governance is defined as the vigilance through which shareholders analyze the performance of the management with regard to auditing. For instance, the structure may integrate an audit committee. The committee will provide the necessary communication and oversight to in relation to the audit firms services.
Safeguards implemented by the audit firm
These safeguards also relate to procedures and policies which are implemented to enhance an auditor’s independence. According to Guidance for audit committees (Anon. , 2003), some of the procedures may relate to quality control of the audit engagement and an annual confirmation of an auditors independence. The safeguards may also involve identification of threats to auditor’s independence such as dependence on revenue from a particular client and provision of other non-audit services to their audit client. In addition, the safeguards may also entail listing the restricted entities and ensuring that remuneration of the partners is not linked to providing non audit services. There may also be restrictions prohibiting individuals from who is not part of the audit team from affecting the results of the auditor’s engagement. The policies and procedure stipulated may also entail both virtual and physical separation of the individuals who are engaged in conflicting transactions. There should also be a mechanism ensuring effective communication between management team and the lower level staff on issues related to objectivity and independence (Shockley, 1982, p. 135).
The audit firm may also incorporate additional accountants whose task is to review the audit work done by other parties and provide the necessary advice. The safeguards may also involve, disclosure of the type of services provided and the fee charged to audit committee and discussing on independence issues. The firm may also involve a different firm to either perform or re-perform a certain part of the firms audit engagement (Shockley, 1982, p.34).
Other safeguards may entail formulation of policies aimed at deterring violation of the already existing safeguards. For example, a firm may formulate a zero tolerance strategy enabling the suspension of the auditors services by auditing accreditation bodies. According to audit governance position paper (Anon. , 2002), there should also be safeguards restricting relationships and activities that are a threat to auditors independence. For instance, the safeguard may prohibit provision of consultancy services by the auditors to their clients.
It is important for auditors to implement the relevant safeguards for there to be independence in reporting. This means that t he auditor should conduct a comprehensive assessment of the intended safeguards before their implementation. This will contribute towards ensuring that the safeguards implemented are effective in enhancing auditor’s independence.
There are various legal stipulations requiring both private and public entities to disclose their financial statements to the public. The importance of these legal requirements is to ensure that the general public accesses information which they can use to make their investment decision. This makes credibility of the financial information to be paramount. The accounting professional ensures that the information is reliable through auditing. The auditors role is to verify the information provided in the firms financial statements which serves to increase the credibility of the information. Auditors are required to integrate the concept of independence in the process of executing their duties.
All professional accountants must consider fundamental principles in accounting. In relation to auditing, these principles include integrity and objectivity. To fulfill these principles, an auditor is required to be independent. Therefore, independence in auditing forms the basis of the entire accounting profession. Audited financial statements are important to firms regulator and the capital market. Therefore it is important that the information provided be reliable.
By being independent, the auditors are able to conduct a free and fair reporting. This is due to the fact that they are not influenced by external forces such as coercion from the management and other interested parties. In addition, they are able to ensure that all the accounting principles and standards are incorporated in the reporting. An auditor is required to be independent in relation to fact and appearance. Independence of fact is mainly concerned with the auditor’s state of mind. This means that the auditor has to be independent in the process of making decisions concerning a particular situation.
This means that the auditor is able to exercise his or her duty with a high degree of professional skepticism and integrity (Douglas, 1999, Para. 4).
On the other hand, independence of appearance refers to the perception of the public by the public. Through independence of fact and appearance, the auditors are able to improve on the degree of confidence in the investors, creditors and the shareholders in relation to the financial information provided. This means that they can be able to make optimal investment decision. This has a long term effect to the firm’s investment. This is due to the fact that there will be an increment in investors’ confidence in relation to the firm.
There are various threats which can impair an auditor’s independence. These threats could culminate into reduction of credibility of financial reports and hence impairing their reliability. Some of these threats include threat of self interest, self review, advocacy, familiarity, and threat of intimidation. Threat of self interest arises from conflict of interests between the management and the external auditor. The interest could either be financial or emotional. This can either be through an auditor being part owner of the firm through shareholding. Threat of intimidation may occur if the management team threats to replace the auditing team for not acting to their personal demands. This damages the relationship between the auditor and the management. On the other hand self review occurs if the members of the assurance team are reviewing their own work. This arises if he or she was a former employee, director or an officer to the organization. The effect is that there is a high probability of the review being biased.
Familiarity also poses a threat to auditor’s independence. This is due to the fact that the trust relationship established between the management and the auditor limits the element of skepticism in the auditors. The relationship can either be based on profession or close family relationship. The effect is that the auditors cannot be able to challenge the management’s viewpoints in their duty. This means that they accept the view points even if they are not in accordance with accounting principles and standards. Advocacy threat arises from the auditor supporting the opinion of the auditor compromising the element of objectivity.
To either mitigate or eliminate the threats to auditor’s independence, the management team should consider implementing various safeguards. These safeguards relate to various policies and procedure restricting the relationship between the auditor and the client. The safeguards can either be implemented by the audit firm or the audit client. In addition, safeguards can be implemented through legislation or policies and regulations stipulated by the accounting profession. The safeguards should be evaluated before their implementation to determine whether they will result to the desired auditor independence.
Campbell, T & Keith, C. 2002. Ethics and auditing. (E-Book). New York: Pricewaterhouse coopers. Web.
Douglas, R. 1999. In search of concept of auditors independence. (On-line). New York: New York State Society of CPAs. Web.
Susan, S, Arthur, S, Thomas, D, Alan, G. & Henry, R. 2001. A framework for auditors independence. (On-line). Journal of accountancy. Web.
AFrameworkForAuditorIndependence.htm  Shockley, R. A. 1982. Perceptions of Auditors Independence: a Conceptual Model. (online). Journal of Accounting, Auditing and Finance. Vol.6, issue no. pp.26- 143.
The Institute Chartered Accountancy. 2003. A guidance for audit committee: review of auditors independence. Wales: Institute of Chartered. Accountancy PAGE 1 Auditors independence.