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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). The threats listed below
and discussed in the following sections may, thus, not be exhaustive.
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
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.

through the holding of corporate bonds). This is quite a common situation. Moreover. consider the case where the external auditor carries out some non-audit work for the client. Research on auditor tenure suggests that. It is not unusual for friendships to form in the workplace. This “self-serving” bias is grounded in psychology theory and arises when. to the underweighting of warning signs. and hence independence. The auditor therefore may need to scrutinize and evaluate the non-audit work carried out by colleagues in the audit firm. consequently. The (independent) auditor’s duty is to ensure that financial performance is accurately reported. as the audit–client relationship lengthens. 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. as a consequence of close relationships. However. the auditor may prefer that bad news is withheld. how powerful this threat is. It is not entirely clear. even if this implies reporting poor performance. concerns about reputation may be quite powerful and sufficient to rein in such a threat. however. at least until the auditor-shareholder can sell his/her position. Yet familiarity also has a positive aspect as it implies a better understanding of the client and helps the auditor to perform better. the likelihood of objectivity on the part of the auditor decreases.Self-Interest The presence of financial interest of the auditor in the audited firm can impair objectiveness. Consider an auditor who is also a shareholder. Familiarity and Complacency Familiarity can blunt the skepticism that is expected of the auditor. to the extent that a client’s managers nominate auditors from their own circle of friends. . Social Bonding Long-term audit engagements bring the external auditor and members of the client firm’s management team closely together. Auditors need to follow certain professional and ethical norms. As a second example of a self-interest threat to independence. even if only at the subconscious level. This may be because the auditor develops a degree of overconfidence in his or her knowledge of the client firm. Similar arguments hold for an auditor-lender (for example. as a shareholder. and they are bound by social norms. Moreover. Some commentators speak of the need for “fresh” eyes and mind that lead to a better scrutiny of the client. audit quality improves. It may be that the repetitive nature of a long-term engagement between the auditor and his/her client leads to complacency and. one cannot separate one’s own interests from those of others.

following SOX external auditors now need to audit internal control systems. Moreover. US regulation explicitly prohibits the provision of non-audit services that involve activities which otherwise should be performed by the client’s management and personnel (i. For this reason. fees for non-audit services represent a very lucrative source of income. may be able to take advantage and “game” the new auditor to the benefit of the client (and now the new employer). These facts are also reflected in the data. the fundamental problem remains.” Failure to do so can cost them the client and the loss of a long stream of future income. . Matters become somewhat more complex when a previous auditor is hired by the client firm to perform a management role. Non-audit services have attracted the harshest criticism. valuation services. This economic bond is regarded by many as perhaps the greatest threat to auditor independence. and IT consulting and implementation services. At the same time.The Economic Bond Auditors’ livelihoods depend on the fees they generate from audit and non-audit services. While in the past audit work was relatively limited in scope. Table 1 shows that average total fees (audit and non-audit) have increased steadily since 2003. when many of the SOX requirements came into effect. while non-audit fees have declined sharply. management roles). These include consulting services such as corporate finance advisory. One concern is that the members of the audit team will be reluctant to criticize a former colleague. SOX and similar regulations in many other countries have restricted the ability of external auditors to provide non-audit services. perhaps because of social bonding. the audited firm’s managers—“happy. there is a requirement of a one-year cooling-off period. these trends appear for both large and small auditors. In the United States.e. an economic bond can still arise in the postSOX era. having acquired knowledge of the audit process and its weaknesses. Even in the absence of non-audit services. Hence. audit fees have significantly increased. Importantly. investment advisory or management. Management and Employment The auditor and the audited firm must be different entities. Auditors thus have an inherent incentive to keep the client—that is. as an effective and objective audit clearly requires such a separation. auditors may compromise their audit work. As a result. A second concern is that the ex-auditor. therefore. there has been a sharp increase in audit fees. Some commentators have raised concern that in order to be awarded non-audit service contracts. Typically. though more so with respect to audit fees.

Ghandar says it is very difficult for such distinctions to be made in a small firm because of the close relationship between staff and partners. this threat can be addressed by separating the accounting and auditing work between two distinct teams or partners that operate independently of each other. Self-review threat These occur when the auditor has also prepared some of the accounting for the fund." Advising threat This threat occurs when an SMSF auditor also provides financial advice for the client. an auditor has only one client or one client represents a significant proportion of their business." Ex-staff and partners threat This happens when a staff member or partner leaves to start their own business and performs audits for their former employer. "Our position is that it's very difficult to have an independent audit if the firm is also providing financial advice. "Issuing a qualified report could impact on that referral relationship and in turn impact on their business. which can also be characterised as a self-interest threat. APB Ethical Standard 2 requires a two-year cooling-off period.In the United Kingdom. "Their independence is threatened because they'll be less likely to want to issue a qualified audit opinion or something that will cause an issue for the client because they're worried about losing the client." Relationships threat . Multiple referrals threat This arises when an auditor receives a large number of referrals from the one client.” notes Ghandar. "Just having those roles   accounting and audit   in separate practices doesn't necessarily mean it's independent. Self-interest threat This threat emerges when. he says it is impossible for a sole practitioner to achieve independence. for example. “You still have to look at all the other aspects of independence. Importantly. However. so we recommend to stay well clear of that. Ghandar says the vast majority of independence breaches are related to self-review threats. particularly including the familiarity between the people in the accounting firm and the audit firm." says Ghandar. In large firms.

or accountant on a personal level." says Ghandar. Safeguards Auditors can use safeguards to eliminate threats. you can't achieve independence in auditing that SMSF. "If you have a close family or business relationship with a trustee or member of the SMSF. it doesn't necessarily mean an auditor can't complete the audit. it is an issue the ATO pays particularly close attention to. When doing so. In the case of a multiple referrals threat. That is: 1. the code says auditors must use their professional judgement to determine if the safeguard is appropriate." says Ghandar. but they just haven't documented their thought process around it. but it is also making sure that independence has been fully considered and that the appropriate safeguards are in place. the nature of the threat may be so significant that even a safeguard . Ghandar adds that auditors should use the framework provided in the APES 110 Code of Ethics for Professional Accountants as a template for documenting independence threats. "It can be a real positive because they will know the business and have a good working relationship. However. for example." says Ghandar. An external review may also make it possible for ex-staff and partners to safely work with former employees. Rather. Identify the threat 2. members. safeguards must be put in place to eliminate the threat and these safeguards must be documented in the audit report. "One of the issues we come across a lot is that people have considered independence and they probably could achieve independence according to the code. In some cases. Consider safeguards you can put in place to address the threat. Due to the family nature of SMSFs. Ghandar says the auditor can have an external reviewer look at certain files within the SMSF. as each situation is unique. it is important to note that a single circumstance may give rise to more than one threat and each threat must be addressed. How to deal with threats If any of these threats occur.Relationship threats are broad and generally cover anything that involves the auditor knowing the SMSF trustees. Evaluate the significance of that threat 3.

" says Ghandar. "If after you've determined the significance of the threat and come up with the safeguards. . if the answer is that you really can't achieve independence with the safeguards. then you would need to decline or resign from the engagement.may be called into question by regulators. you're not comfortable.