May 2012
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Promoting Auditor Independence
In March 2012, the Public Company Accounting Oversight Board (PCAOB) held a public meeting to discuss ways to improve auditor independence, objectivity, and professional skepticism. It also extended the comment deadline for its Concept Release on Auditor Independence and Audit Firm Rotation (PCAOB Rulemaking Docket Matter 037) until April 22. The time and effort devoted to this process underscores the importance of the underlying issue involved—maintaining investor confidence in the global capital markets—and the role of the auditing profession in achieving that goal.
Auditor independence is fundamental to the integrity of the audit. As PCAOB member Jeanette Franzel noted in her remarks at the public meeting, “Without auditor independence, an engagement is not an audit but, rather, a consulting engagement conducted on behalf of management.”
The AICPA's Code of Professional Conduct defines independence in two ways, and both are needed for an auditor to be considered truly independent:
Independence of mind—The state of mind that permits the performance of an attest service without being affected by influences that compromise professional judgment, thereby allowing an individual to act with integrity and exercise objectivity and professional skepticism.
Independence in appearance—The avoidance of circumstances that would cause a reasonable and informed third party, having knowledge of all relevant information, including safeguards applied, to reasonably conclude that the integrity, objectivity, or professional skepticism of a firm or a member of the attest engagement team had been compromised (ET section 100-1.06).
Acknowledging that auditors are, after all, human and subject to certain human frailties, research has documented that self-interest impairs our ability to be impartial. In other words, despite our integrity and honesty, our desires color our interpretation of information. When faced with incentives to be rehired by a company to conduct future audit engagements, auditors' self-interest impairs their independence.
Choices
Audit firm rotation is not the only option available to promote auditor independence; it is simply the latest proposal put forth to address the challenge of eliminating—or at least reducing—conflicts of interest for individual auditors and audit firms. The concept of audit firm rotation received support from a variety of stakeholders; however, there was resistance from others, including the NYSSCPA, the Government Accountability Office, and, at the meeting, by the Center for Audit Quality (CAQ), an organization that has representatives from the largest accounting firms and the AICPA on its governing board.
Audit firm rotation is not the only option available to promote auditor independence.
High-profile audit failures jeopardize the relevancy of the audit function in protecting the public interest. But a resolution to this ongoing problem has eluded the profession.
The GAO stated in a December 2011 letter to the PCAOB that it is not convinced that audit quality issues are caused by a lack of auditor independence or professional objectivity, and the CAQ has asked for “evidence that mandatory firm rotation would result in direct and measurable improvement in audit quality” (Cindy Fornelli, March 2012, http://pcaobus.org/Rules/Rulemaking/Docket037/ps_Fornelli.pdf), but empirical data on the costs and benefits of auditor independence— or the lack thereof—are virtually impossible to measure. How do you measure the benefits of improved objectivity, free from the bias of self-interest? Furthermore, the CAQ believes that “such a mandate would have far-reaching, costly, and unintended consequences, not only for auditors and audit firms, but also for public companies, audit committees, and investors” (Fornelli 2012). But where is the evidence to support this belief? On the other hand, we have witnessed the costs that result when auditors don't conduct independent audits—unnecessary investor losses.
Mandatory firm rotation is just one option available to mitigate conflicts of interest—whether perceived or real—for the audit profession. Other alternatives that were raised by meeting participants could include allowing audit committees access to PCAOB inspection reports, placing limitations on an audit firm's ability to pay for entertainment costs with companies it audits, and establishing a third-party payer system to break the connection between companies and their auditors.
Reasonable parties can disagree about which option to choose to address the inherent independence-impairing conditions that exist between auditors and the companies they audit, but ethical standards demand that the auditing profession delivers what it claims to provide—independent audits.
As always, I welcome your comments.
The opinions expressed here are my own and do not reflect those of the NYSSCPA, its management, or its staff.