The Varying Concept of Auditor Independence
Shifting with the Prevailing Environment

By C. Richard Baker

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AUGUST 2005 - As CPA Journal Editor-in-Chief Robert Colson observed in his March 2004 column, “Auditor Independence Redux,” the concept of auditor independence has varied over the last 150 years. In a general sense, auditor independence has borne a relationship to the prevailing commercial environment in different time periods. There has not, however, been a clear transition from one concept of auditor independence to another. Frequently, more than one idea of auditor independence has been present in the discussion about independence between professional accountants and auditors, regulators, and the general public.

The initial concept of auditor independence, which arose during the 19th century, was based on the premise, primarily British in origin, that a principal duty of professional accountants and auditors was the oversight of absentee investments in the existing and former colonies of the British Empire. During this period, a relatively small number of accounting firms could perform audits for a relatively large number of entities. Professional accountants and auditors could render reports on the financial performance of different entities and could work for different investor groups.

The concept of auditor independence during this era did not conceive of auditors as advocates for audited entities; British investors explicitly forbade auditors from investing or working in the businesses that they audited. At the same time, as long as auditors maintained their primary loyalty to the investors back home, the scope of professional accounting services could be reasonably broad. For example, auditors were permitted to keep the books and prepare the financial statements for the entities they audited.

This initial concept of auditor independence changed during the late 19th and early 20th centuries. During this time, there was an economic shift from capital coming primarily from foreign sources to capital deriving primarily from domestic sources. This change was associated with the emergence of large American corporations in industries such as mining, railroads, energy, and telegraph and telephone. The emergence of large American corporations was accompanied by a change in the understanding of the purpose and nature of the business corporation. In the 1930s, noted economists Adolf Bearle and Gardiner Means articulated this change by advancing the proposition that large corporations were based on the separation of ownership from management and that an important role for accounting and auditing was to properly value the proprietary interest of the corporation. Periodic balance sheets were needed to determine the portion of retained profit that could be validly distributed to the proprietary interest. In the context of this new idea of the corporation, the auditor’s primary duty was to serve the needs of the collective proprietary interest rather than a specific absentee-ownership interest. This collective proprietary interest essentially comprised domestic shareholders, that were often large banks or wealthy investors, but increasingly the general public has become involved in stock ownership.

The passage of the federal securities acts during the New Deal era, and the creation of the SEC, led to another transition in the concept of auditor independence. The SEC’s most important effect on auditor independence derived from its efforts to establish standards for financial reporting and auditing. Because of these efforts, public accountants and auditors no longer accepted that their primary responsibility was to a specific absentee owner, or to a collective proprietary interest, but rather to a set of professional standards established for the preparation and audit of financial statements. The concept of auditor independence shifted in favor of objectivity and neutrality in the reporting of the financial position and the results of operations, rather than loyalty to a particular party. This view was articulated academically and intellectually by Professor W.A. Paton, who stressed the entity view of corporate financial reporting. In particular, section 13 of the Securities Exchange Act of 1934 established the following requirements (U.S. Code, Title I, section 13, 48 statute 894):

Every issuer of a security registered pursuant to section 12 shall file with the Commission, in accordance with such rules and regulations as the Commission may prescribe as necessary or appropriate for the proper protection of investors and to insure fair dealing in the security—

1. such information and documents (and such copies thereof) as the Commission shall require to keep reasonably current the information and documents required to be included in or filed with an application or registration statement filed pursuant to section 12, except that the Commission may not require the filing of any material contract wholly executed before July 1, 1962.
2. such annual reports (and such copies thereof), certified if required by the rules and regulations of the Commission by independent public accountants and such quarterly reports (and such copies thereof), as the Commission may prescribe. [Emphasis added.]

The objective and neutral concept of auditor independence prevailed until the 1970s, when FASB was established as the authoritative independent accounting standards setter. From approximately that time, public accounting firms began to modify their objective and neutral focus and started advocating for their audit clients with regard to accounting and auditing matters. Simultaneously, the rapid growth of business enterprises on a worldwide basis provided large public accounting firms with an opportunity to become the preferred providers of a wide spectrum of business services, the revenues from which quickly outpaced the fees from traditional auditing services. While the standards issued by the Auditing Standards Board (ASB) of the AICPA continued to stress independence from clients, the increasingly competitive marketplace for audit services, along with the complexity of international business practices, led some auditors to reduce their focus on objective and neutral interpretation of accounting standards in favor of becoming a trusted advisor for clients.

Subsequent to the accounting and auditing scandals of the early 2000s, and the passage of the Sarbanes-Oxley Act of 2002 (SOA), the idea of auditors as trusted advisors appears to have become increasingly unsustainable. The parameters of a potentially new concept of auditor independence are still unfolding, but the Public Companies Accounting Oversight Board (PCAOB) seems to be stressing a concept of auditor independence that emphasizes a greater degree of separation between registered auditors and client management.

Prior Debates About Auditor Independence

The second half of the 20th century saw various debates in both the academic and the professional literatures about auditor independence. One argument pertaining to auditor independence developed from idealized views of professionalism that emerged historically in both the British and the American accounting professions. For example, Thomas A. Lee, in Company Auditing, 3rd ed. (Van Nostrand Reinhold, 1986, page 89), suggested the following:

An honest auditor will behave like someone who is independent, using independence to mean an attitude of mind which does not allow the viewpoints and conclusions of its possessor to become reliant on or subordinate to the influence and pressures of conflicting interests.

Unfortunately, this admirable expression about auditor independence does not acknowledge that an auditor’s state of mind is not determinable, and, therefore, to conclude whether an auditor is independent pursuant to Lee’s definition is impossible.

P. Moizier, in “Independence” (in Current Issues in Auditing, edited by M. Sherer and S. Turley, Paul Chapman Publishing Ltd., 1991), argued for an economic rationale for auditor independence, which was summarized as follows:

There is an expectation that the auditor will have performed an audit that will have reduced the chances of a successful negligence lawsuit to a level acceptable to the auditor. In the language of economics, the auditor will perform audit work until the cost of undertaking more work is equal to the benefit the auditor derives in terms of the reduction in the risk of a successful lawsuit being possible. This then represents the minimum amount of work that the reader can expect the auditor to perform. However, all auditors are individuals with different attitudes to risk and return and so one auditor’s minimum standard of audit work will not necessarily be that of a colleague.

This economic argument, while logical, would be unsustainable if certain auditors took advantage of the general presumption regarding auditor independence in order to obtain increased market share. In other words, for the economic argument to be effective, complete compliance with the principle of auditor independence would be required.

In contrast to the professional and economic arguments for auditor independence, R.W. Bartlett, in “A Heretical Challenge to the Incantations of Audit Independence” (Accounting Horizons, vol. 5, No. 1, 1991), suggested that auditing is a sort of ceremony involving incantations about independence. Bartlett argued that there have been four kinds of “incantations” regarding auditor independence:

  • The “smoking gun.” This is the argument that only in a few documented instances has auditor independence been found to be implicated in audit failures, at least if one accepts the evidence provided by lawsuits and prosecutions of auditors for securities fraud. Most lawsuits and prosecutions of auditors have been based on assertions of incompetence or lack of due diligence in the application of auditing standards, rather than lack of independence. An inability to obtain access to detailed records of lawsuits and other evidence about audit failures, however, makes this incantation difficult to prove.
  • “We are doing pretty good.” Based on public opinion surveys, the public accounting profession has generally been held in high regard. Public opinion polls assessing the esteem of the profession often address issues like objectivity, reliability, and honesty, rather than independence per se. While objectivity, reliability, honesty, and independence may overlap, what “independence” actually means to the general public is unclear. Often, the public is not well informed about what auditors do.
  • The “public good.” This incantation suggests that if too many constraints are placed on the public accounting profession’s scope of services, accounting firms will be unable to serve clients properly, thereby imposing significant costs on the public. Some public accounting firms have argued that providing nonauditing services allows them to perform better audits because they can obtain a better understanding of the client’s systems. R. David Plumlee, in “The Standard of Objectivity for Internal Auditors: Memory and Bias Effects” (Journal of Accounting Research, vol. 23, No. 2, 1985), has asserted that while this argument seems reasonable, it is difficult to accept that, even with independence of mind, auditors can objectively opine on the proper functioning of systems that they have designed.
  • “Trust us.” Independence is often said to be a mental state possessed by professional accountants and therefore not subject to empirical observation or quantification. This incantation is based on the idea of auditor economic self-interest; that is, auditors are assumed to maintain independence and objectivity so as not to harm their longer-term economic interests. This assumes that auditors continually evaluate the costs and benefits associated with ethical behavior and always resolve conflicts in favor of behaving ethically because doing so produces the greatest long-term economic benefit. While these assumptions may be argued, it can also be observed that the individual economic calculus of a particular auditor may weigh in favor of retaining an important client rather than being objective and independent, thus undermining the “trust us” argument.

Changes in the Market That Affected Auditor Independence

Jonathan Weil, in “Behind Ways of Corporate Fraud: A Change in How Auditors Work” (The Wall Street Journal, March 25, 2004), suggests that during the 1970s and 1980s the market for audit services and the way in which audits were conducted changed, contributing to a decline in auditor independence. The first component of change was price competition. Prior to the 1970s, the AICPA Code of Conduct prohibited auditors from publicly advertising their services, from making uninvited solicitations to rival firms’ clients, and from participating in competitive bidding for audits. Under threats of antitrust action by the federal government, the AICPA was compelled to remove these prohibitions against competitive practices. As a result, competitive bidding in auditing became commonplace and created pressure to reduce audit engagement hours. Audits were said to have turned into a commodity product. To maintain overall revenues and firm profitability, accounting firms began to place more emphasis on nonaudit services. The relative reduction in audit fee revenues and relative increase in reliance on revenues from nonaudit services may
have placed increased pressure on auditor independence.

The second change in how audits were conducted was an increased emphasis on “risk-based auditing.” Risk-based auditing is reasonable in that the largest amount of audit effort is placed on the greatest areas of audit risk. This logical idea assumes, however, that auditors are experts in determining the riskiest areas of a company’s operations. Unfortunately, as Enron and other business failures have demonstrated, some auditors are not sufficiently able to determine which areas of a company’s operations are subject to the greatest risks. In addition, auditors using a risk-based approach might not detect fraudulent activities. The movement to risk-based auditing was based in part on pressures to reduce engagement hours. Consequently, some auditors shifted their concept of auditor independence away from being an objective and neutral arbiter of accounting standards to becoming a trusted advisor to the client’s management. While this new concept of auditor independence may be appropriate for an auditor in certain circumstances, too often an auditor’s efforts to aid management resulted in misleading accounting numbers that concealed true economic performance. During the 1990s, it appeared that some auditors neglected their most immediate responsibility to act on behalf of third-party investors or, at a minimum, to be an objective and neutral interpreter of accounting standards.

Pre–Sarbanes-Oxley Proposals to Enhance Auditor Independence

P. Moizier, in “The Image of Auditors” (Auditing and the Future, Institutes of Chartered Accountants in Scotland and England and Wales, 1991), summarized several ways to increase auditor independence:

  • Legal prohibition of financial interests in client companies. A legal prohibition against an auditor possessing a financial interest in a client has been the cornerstone of auditor independence rules in the United States since the 1930s. Until the 1990s, this was not necessarily true in the United Kingdom and some other countries, even though prohibitions against holding financial interests were generally observed in practice because of the standards of the accounting institutes and common law.

Currently, a prohibition against auditors possessing financial interests in clients is virtually a universal principle. Both the SEC and the public accounting profession have focused most of their attention regarding auditor independence on defining and enforcing prohibitions against financial interests. Elaborate rules and reporting structures have been formulated for the purpose of revealing any type of financial interest on the part of professional employees of accounting firms, their spouses, their parents, or their children. The PCAOB has adopted most of these rules, with a degree of relaxation in areas where the rules seemed unreasonable.

  • Rotation of audit appointments. In several countries (e.g., Italy) auditors are permitted to audit a client for only a specified number of years. This type of regulation has never been seriously considered in the U.S. or the U.K., although Sarbanes-Oxley requires that individual auditors rotate off a client on a periodic basis. In France, the concept of auditor rotation is reversed: Auditors are appointed for a fixed period of time, during which time they cannot be replaced. This rule was intended to increase auditor independence, because the auditor has less fear of being fired by the client.

Many auditors object to rotation rules, arguing that the high start-up cost associated with the initial years of an audit would be lost if there were regular rotation of auditors. This argument is difficult to assess. Just as likely, the benefits of regular audit rotation to the investing public would outweigh the added initial start-up costs.

  • Peer review. The basic idea of having another auditor review the work of an audit firm is appealing. Peer review has been commonplace in the American auditing profession for years, and it has become increasingly common in other countries as well.

The challenges of peer review became evident, however, during the time when the AICPA’s peer review system was under the supervision of the Public Oversight Board (POB), which disbanded in 2001. During its last years, the POB’s budgets and scope of operations were reported to have been constrained, thereby causing it to be less effective. Sarbanes-Oxley provided for the funding of the PCAOB in a manner independent from the auditing profession and the issuers of financial statements.

The PCAOB has now assumed responsibility for inspecting the auditing firms that audit public companies. As a result, PCAOB inspections can be expected to more or less replace peer review for the public company practices of registered auditors. Peer review continues to be important for audits of non-SEC registrants.

  • An independent auditor-appointing and fee-setting body. The intent behind this proposal is to reduce the ability of client management to determine the scope of the audit and the remuneration of auditors, thereby increasing an auditor’s ability to exercise independent judgment and action.

While this proposal has received little support in a general sense, Sarbanes-Oxley requires auditors to be engaged by, and the audit fee determined by, the audit committee of the board of directors of the client. Whether this requirement is being observed in practice, or whether management continues to exert influence on the amount of the audit fee and the scope of the audit, is unclear. Nevertheless, the determination of the audit fee and the scope of the audit is central to auditor independence, and the control of these determinations will impact independence in fact.

Auditor Independence After Sarbanes-Oxley

The Sarbanes-Oxley Act created the PCAOB as the regulator of all accounting firms that perform audits of SEC registrants, whether U.S.-based or foreign. Auditors of SEC registrants must register with the PCAOB and agree to have their audit practices inspected on a regular basis by PCAOB inspectors. While the PCAOB is not a U.S. government agency, it operates under the SEC’s oversight. In addition to registering and inspecting audit firms, the PCAOB has also taken over responsibility for establishing auditing standards, ethical standards, and independence standards.

Title II of SOA concerns auditor independence. Section 201 specifies a list of services that registered auditors are prohibited from providing to audit clients. The list includes primarily nonaudit services like bookkeeping, financial information systems design and implementation, and valuation services. Even though the nonaudit fees at Enron and other scandal-ridden companies were often disproportionate in relationship to audit fees—thereby supporting the argument that nonaudit fees negatively impact auditor independence—it is unclear whether auditor independence will be enhanced by prohibiting certain specific nonaudit services. The concept of auditor independence is more complex than a simple division between audit and nonaudit services.

With regard to independence standards, the PCAOB has adopted interim rule 3600T as part of its bylaws and rules. Rule 3600T reads as follows:

In connection with the preparation or issuance of any audit report, a registered public accounting firm, and its associated persons, shall comply with independence standards—

(a) as described in the AICPA’s Code of Professional Conduct Rule 101, and interpretations and rulings thereunder, as in existence on April 16, 2003 [AICPA Professional Standards, ET sections 101 and 191 (AICPA 2002)], to the extent not superseded or amended by the Board; and
(b) Standards Nos. 1, 2, and 3, and Interpretations 99-1, 00-1, and 00-2, of the Independence Standards Board, to the extent not superseded or amended by the Board.

Note: The Board’s Interim Independence Standards do not supersede the Commission’s auditor independence rules. See Rule 2-01 of Reg. S-X, 17 C.F.R. 240.2-01. Therefore, to the extent that a provision of the Commission’s rule is more restrictive—or less restrictive—than the Board’s Interim Independence Standards, a registered public accounting firm must comply with the more restrictive rule.

Essentially, the PCAOB has recognized the independence standards previously developed by the AICPA and the SEC through the Independence Standards Board. The question is whether these rules are sufficient to meet the public’s expectations regarding auditor independence under SOA.

Reconsidering Auditor Independence

What is needed now is a complete reconsideration of the concept of auditor independence. Such reconsideration might lead to a new concept in which auditor independence would be based on reasserting the accounting profession’s former ethic of being an objective and neutral interpreter of accounting standards, rather than an advocate for client positions. Given the recent and ongoing accounting and auditing scandals, it seems obvious that independent auditors should not be advocates for client positions. Neither SOA nor the PCAOB independence standards specifically address this issue.

A second issue pertaining to auditor independence that may not have been adequately addressed by SOA and the PCAOB rules is the extent to which client management may still be able to influence the audit fee and the scope of the audit engagement. SOA section 301 specifies the following:

The audit committee of each issuer, in its capacity as a committee of the board of directors, shall be directly responsible for the appointment, compensation, and oversight of the work of any registered public accounting firm employed by that issuer (including resolution of disagreements between management and the auditor regarding financial reporting) for the purpose of preparing or issuing an audit report or related work, and each such registered public accounting firm shall report directly to the audit committee.

Despite this clear provision in SOA, no specific enforcement mechanism ensures that management does not become involved, directly or indirectly, in selecting the auditor or determining the audit fee and the scope of the audit. The PCAOB inspection process should focus to a greater extent on this issue.

A new concept of auditor independence is required that specifically incorporates the propositions that 1) auditors should not be advocates for their clients, and 2) management should not be able to influence the audit fee and the scope of the audit. Without a transition to this concept, auditor independence standards will most likely be primarily cosmetic and will not provide sufficient assurance that auditors are in fact independent from client management.


C. Richard Baker, PhD, is a professor of accounting at the school of business of Adelphi University, Garden City, N.Y.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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