Audit Independence: Modern Audit with Japan

2785 words (11 pages) Essay

8th Feb 2020 Accounting Reference this

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Quoting Power (1994), “What are we to make of this explosion of audits?” In the current economy, audit is a necessary process for the benefit of shareholders and that the auditors are appointed to provide an independent report to the shareholders on the truth and fairness of the financial statements. (ICAEW, 2006) The appointed auditors have to possess a certain level of credibility when they issue their reports to gain assurance from all stakeholders and users of interest. With reference to Gray et al. (2015), the implication for credibility is that the auditors must ensure that they are seen to be competent, independent and behaving with integrity and in an ethical way. With independence being a key component to user credibility, in this essay we are going to analyse how relevant audit independence is to modern day audit based on one of Flint’s (1988) auditing postulate: “Essential distinguishing characteristics of audit are the independence of its status and its freedom from investigatory and reporting constraints” with links to Japan’s accounting & auditing scandal over the years.

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Flint’s (1988) postulates can be considered as one of the base principles/assumptions for audit to be viable and reliable. Building on Gray et al’s (2015) suggestion that auditors have to be credible, audit independence is defined by Mautz and Sharaf (1961) as the formation of judgement, concluded through the state of an unbiased mind. In a situational example, the auditor has to be free from any relationships with the company, its management and its user groups that would threaten the credibility of the auditor’s report. Ideally, the situation has to be free from any conflict of interest between the corporate auditor and corporate management. Taking into account the structure of the auditing profession, an auditors’ job scope sometimes covers more than simply verifying the validity of clients’ financial statements. Auditors are allowed freedom in their search for evidence and the way they report and independence in that entices not being influenced by the client or any third party when assessing evidences. As mentioned by Lee (1993), “the corporate auditor has to be in a suitable independent position, both mentally and physically, to verify and attest with sufficient objectivity the quality of the reported financial statements to shareholders and other interested users.” 

To criticize Gray et al.’s (2015) statement on how auditors must ensure they are seen to be independent, this is a matter of auditor’s personal accountability. It may be much simpler to be seen as independent as compared to actually taking action to perform independently. However, to ensure auditors are not only autonomous in mind but also independent in appearance, they have to be in no involvement with any situations or relationships that have the possibility of their objectivity and credibility being questioned. Firstly, we can analyse their relationship with all groups of possible stakeholders – public, managerial, professional, personnel and political. (ibid.) In terms of independence from the public, the auditors are to keep information about their client confidential such that they cannot use audit information for the gain of members of the public. To add on, auditors are also expected to refrain from discussing and obtaining opinion from people outside work. As for individual and professional independence, auditors have to live out their books of values whether it is personal or of professional standards of an accounting body in doing what is morally right. The stakeholder groups that are most susceptible to the interference of independence is managerial independence and political independence. Auditors are typically subordinates that are held to account by not only their client but also their superiors. Politically, auditors have accountability to the shareholders and directors who elected them. This relates to the pressure imposed on the auditors and its effect on audit independence which I will discuss using the Japanese scandals as examples.

In the 1980s, Japan’s economy was looked upon as a model for innovation. Despite their introduction of several well-known business strategies, the Japanese economy is experiencing stagnant growth. Some see this as a consequence of the string of corporate scandals in Japan over the past decade. According to a research by (Ajao et al, 2016), the biggest evolvement of auditing was observed in the 1960s to 1990s mainly due to the increase in growth in size of companies. As a result, auditors in this period had placed much higher reliance on companies’ internal control in their audit procedures. (Lee & Azham, 2008) The 2011 Olympus Scandal exhibited the consequences of the reliance on internal controls on audit independence when it was uncovered that the major Japanese manufacturer has been concealing losses of over ¥100bn over 13 years. Considered as one of the biggest financial scandals in the history of corporate Japan, many questioned the role of Olympus’ auditors over the years – KPMG and EY in this fraud. The two Big 4 firms have since been cleared of any responsibility for the scandal whereas 5 former and current statutory auditors were apprehended instead. Woodford (2013) revealed that the close relationship between Olympus and KPMG over many years had reduced the likelihood of fraud coming to light. This relationship suggests that the external auditor has a lack of independence from the client because KPMG decided to sign off Olympus’ accounts a few times despite finding problems that turned out to be a channel that was related to the fraud.

One of the biggest factors leading to the emergence of fraudulent accounting practices in Japan is its traditional corporate culture of how much they tolerate a disinclination to challenge authority and lack of accountability among senior executives. This culture of “respect” towards superiors is broadly applicable in many parts of Asia and has impacted audit independence where obedience towards superiors are emphasized. In Japan, statutory auditors are essentially the “puppet” of shareholders, whereby they hold a position in the board and overlook the audit process done by external auditors. Olympus’ statutory auditors demonstrated shortcomings in terms of managerial independence when they succumbed to superiority and failed to be autonomous. Similar to Olympus’ auditors, the 2015 Toshiba scandalof a £780m profit overstatement was a result of pressure. The fact that managers were cornered into manipulating numbers to meet targets demonstrates that they seemingly put more significance in satisfying directors. The internal auditors also lack the independence to make decisions for the sake of the shareholders and users of interest when they decided to let errors in financial reports pass. However, some may argue that internal auditors need not be as independent as external auditors because they are only reporting to the management. This can be a very misleading assumption that contradicts Flint’s (1988) postulate despite independence in internal audit being as important as in external audit.

Though there are so many different definitions, audit independence of status to me is essentially when auditors have completely no relation to their client so that they can form a fair opinion on the client’s financial reports for the sake of accountability towards shareholders that elected them. Noting Flint’s (1988) postulate of accountability, the directors owe a duty of an acceptable accountability to the shareholders for the interest of the company. Therefore, audits are necessary for a healthy relationship between the directors and shareholders by aligning their views on the direction of the company. However, many have debated about auditors’ roles in helping achieve all classes of accountability on top of proving the validity of the financial statements. With the example of the Toshiba scandal, PwC’s refusal to approve the company’s fiscal 2016 financial results render Toshiba to consider hiring a different auditor. With that, we observe that accountability and independence can sometimes be contradicting such that auditors lose an accountable relationship with the management of Toshiba if they form independent opinions for the benefit of the shareholders and users of interests.

One common aspect in most Japanese scandals is that the law has rendered auditors helpless. Lee (1993) asserted that there are no unreasonable legal or other regulatory restrictions placed upon corporate auditors which hinder their verifying and attesting the quality or the reported financial statements to shareholders and other interested users. However, Japan’s auditors have insufficient legal powers to detect accounting irregularities due to the relatively weak position they hold in their relationship with clients which explains how many are unable to uncover clients falsifying financial statements. Perria (2011) stated that auditors cannot detect errors because they do not have any legal power like the tax collector. On top of their pressurizing corporate culture, Japanese audit firms are typically paid a fraction of what UK auditors receive (ibid.). In Japan, the audit fee is too small and balance of regulations on auditor’s breadth is too light for them to be fully independent. Small audit fee means auditors are more risk averse when it comes to standing their ground against clients as they fear they will lose clientele.

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With regards to losing business, we can briefly incorporate Flint’s (1988) postulate of audit producing social and economic benefits with audit independence. Being a credible auditor is essential for auditor reputation as good reputation results in good returns therefore the reputation of KPMG, PwC, EY & Deloitte has significantly increased after obtaining the label of the Big4. Despite that, KPMG & EY took a big hit in reputation after failing to expose Olympus’ coverup of funds. Another example would be the cosmetic group Kanebo’s Scandal in 2005 where the concealed net worth of ¥200billion tarnished the auditors’ reputation to the extent where PwC ChuoAoyama had to be shut down and rebuilt from scratch. (The Japan Times, 2005) Therefore, the independence postulate has a positive relationship with the benefits postulate such that being independent positively impacts auditor reputation and returns. This is supported by an extraction from Watts and Zimmerman (1986), “The probability of auditor reporting matters of concern is likely to be high because of adverse effects on reputation if their failure to report comes to light.”

Audit independence is so emphasized as it does not only impact shareholders but also the audit firm itself, the client reputation and all users of interest of the financial statement. Recently, Deloitte Japan has been hit by a $2m penalty due to breach over independence rules after it was discovered that dozens of employees are holding sizeable bank accounts at a company it audited. (Marriage and Shubber, 2019) Deloitte auditors were then perceived to be “in the pocket” of company management, causing stakeholders to be sceptical towards the professionalism and objectivity of the auditors. This is mainly due to the violation of audit independence rule of holding a limited value in bank accounts with clients whereby Deloitte’s auditors exceeded. Flint’s postulate was “created” in 1988 and much has changed since then. The auditing industry have observed so much growth since the 19th century in Japan, where it was common for auditors to be shareholders of the company they were auditing. The historical method would not be feasible now as it gives auditors the opportunity to act immorally for personal gain. If an auditor is seen as biased, it is expected that in the long term they would lose credibility and consequently closing down their business. What makes modern day audit different is then again, the emphasis on audit independence.

In this era of auditing and information technology, there are Computer Assisted Audit Techniques (CAAT) to assist in audit processes. The roles of auditors are intertwined with the evolution of the auditing theory itself. The possibility in being biased in the process of investigating and reporting are minimized if CAATs are utilized. To add on, many modern auditors are placing trust in their clients and adopt the business risk approach to auditing which involves participation between auditor and management. Audit independence is still present in such cases but not as strongly as business risk auditing heavily weighs client-auditor relationship.

Overall, Flint’s (1988) postulate was a helpful starting point for people to recognize that independence is a vital element audit reporting and is necessary even in modern day audit to gain the trust of the stakeholders. With the increase in number of obstacles threating credibility and objectivity nowadays, we can only expect the significance of auditor independence to strengthen in the near future. However, there will be cases such as business risk auditing that gives independence less attention compared to other postulates. As for Japan, much work still has to be done for auditors to be able to achieve the independence they desire in terms of legal and culture restrictions. Other than that, the postulate can be considered a universal, timeless requirement of auditing.

Quoting Power (1994), “What are we to make of this explosion of audits?” In the current economy, audit is a necessary process for the benefit of shareholders and that the auditors are appointed to provide an independent report to the shareholders on the truth and fairness of the financial statements. (ICAEW, 2006) The appointed auditors have to possess a certain level of credibility when they issue their reports to gain assurance from all stakeholders and users of interest. With reference to Gray et al. (2015), the implication for credibility is that the auditors must ensure that they are seen to be competent, independent and behaving with integrity and in an ethical way. With independence being a key component to user credibility, in this essay we are going to analyse how relevant audit independence is to modern day audit based on one of Flint’s (1988) auditing postulate: “Essential distinguishing characteristics of audit are the independence of its status and its freedom from investigatory and reporting constraints” with links to Japan’s accounting & auditing scandal over the years.

Flint’s (1988) postulates can be considered as one of the base principles/assumptions for audit to be viable and reliable. Building on Gray et al’s (2015) suggestion that auditors have to be credible, audit independence is defined by Mautz and Sharaf (1961) as the formation of judgement, concluded through the state of an unbiased mind. In a situational example, the auditor has to be free from any relationships with the company, its management and its user groups that would threaten the credibility of the auditor’s report. Ideally, the situation has to be free from any conflict of interest between the corporate auditor and corporate management. Taking into account the structure of the auditing profession, an auditors’ job scope sometimes covers more than simply verifying the validity of clients’ financial statements. Auditors are allowed freedom in their search for evidence and the way they report and independence in that entices not being influenced by the client or any third party when assessing evidences. As mentioned by Lee (1993), “the corporate auditor has to be in a suitable independent position, both mentally and physically, to verify and attest with sufficient objectivity the quality of the reported financial statements to shareholders and other interested users.” 

To criticize Gray et al.’s (2015) statement on how auditors must ensure they are seen to be independent, this is a matter of auditor’s personal accountability. It may be much simpler to be seen as independent as compared to actually taking action to perform independently. However, to ensure auditors are not only autonomous in mind but also independent in appearance, they have to be in no involvement with any situations or relationships that have the possibility of their objectivity and credibility being questioned. Firstly, we can analyse their relationship with all groups of possible stakeholders – public, managerial, professional, personnel and political. (ibid.) In terms of independence from the public, the auditors are to keep information about their client confidential such that they cannot use audit information for the gain of members of the public. To add on, auditors are also expected to refrain from discussing and obtaining opinion from people outside work. As for individual and professional independence, auditors have to live out their books of values whether it is personal or of professional standards of an accounting body in doing what is morally right. The stakeholder groups that are most susceptible to the interference of independence is managerial independence and political independence. Auditors are typically subordinates that are held to account by not only their client but also their superiors. Politically, auditors have accountability to the shareholders and directors who elected them. This relates to the pressure imposed on the auditors and its effect on audit independence which I will discuss using the Japanese scandals as examples.

In the 1980s, Japan’s economy was looked upon as a model for innovation. Despite their introduction of several well-known business strategies, the Japanese economy is experiencing stagnant growth. Some see this as a consequence of the string of corporate scandals in Japan over the past decade. According to a research by (Ajao et al, 2016), the biggest evolvement of auditing was observed in the 1960s to 1990s mainly due to the increase in growth in size of companies. As a result, auditors in this period had placed much higher reliance on companies’ internal control in their audit procedures. (Lee & Azham, 2008) The 2011 Olympus Scandal exhibited the consequences of the reliance on internal controls on audit independence when it was uncovered that the major Japanese manufacturer has been concealing losses of over ¥100bn over 13 years. Considered as one of the biggest financial scandals in the history of corporate Japan, many questioned the role of Olympus’ auditors over the years – KPMG and EY in this fraud. The two Big 4 firms have since been cleared of any responsibility for the scandal whereas 5 former and current statutory auditors were apprehended instead. Woodford (2013) revealed that the close relationship between Olympus and KPMG over many years had reduced the likelihood of fraud coming to light. This relationship suggests that the external auditor has a lack of independence from the client because KPMG decided to sign off Olympus’ accounts a few times despite finding problems that turned out to be a channel that was related to the fraud.

One of the biggest factors leading to the emergence of fraudulent accounting practices in Japan is its traditional corporate culture of how much they tolerate a disinclination to challenge authority and lack of accountability among senior executives. This culture of “respect” towards superiors is broadly applicable in many parts of Asia and has impacted audit independence where obedience towards superiors are emphasized. In Japan, statutory auditors are essentially the “puppet” of shareholders, whereby they hold a position in the board and overlook the audit process done by external auditors. Olympus’ statutory auditors demonstrated shortcomings in terms of managerial independence when they succumbed to superiority and failed to be autonomous. Similar to Olympus’ auditors, the 2015 Toshiba scandalof a £780m profit overstatement was a result of pressure. The fact that managers were cornered into manipulating numbers to meet targets demonstrates that they seemingly put more significance in satisfying directors. The internal auditors also lack the independence to make decisions for the sake of the shareholders and users of interest when they decided to let errors in financial reports pass. However, some may argue that internal auditors need not be as independent as external auditors because they are only reporting to the management. This can be a very misleading assumption that contradicts Flint’s (1988) postulate despite independence in internal audit being as important as in external audit.

Though there are so many different definitions, audit independence of status to me is essentially when auditors have completely no relation to their client so that they can form a fair opinion on the client’s financial reports for the sake of accountability towards shareholders that elected them. Noting Flint’s (1988) postulate of accountability, the directors owe a duty of an acceptable accountability to the shareholders for the interest of the company. Therefore, audits are necessary for a healthy relationship between the directors and shareholders by aligning their views on the direction of the company. However, many have debated about auditors’ roles in helping achieve all classes of accountability on top of proving the validity of the financial statements. With the example of the Toshiba scandal, PwC’s refusal to approve the company’s fiscal 2016 financial results render Toshiba to consider hiring a different auditor. With that, we observe that accountability and independence can sometimes be contradicting such that auditors lose an accountable relationship with the management of Toshiba if they form independent opinions for the benefit of the shareholders and users of interests.

One common aspect in most Japanese scandals is that the law has rendered auditors helpless. Lee (1993) asserted that there are no unreasonable legal or other regulatory restrictions placed upon corporate auditors which hinder their verifying and attesting the quality or the reported financial statements to shareholders and other interested users. However, Japan’s auditors have insufficient legal powers to detect accounting irregularities due to the relatively weak position they hold in their relationship with clients which explains how many are unable to uncover clients falsifying financial statements. Perria (2011) stated that auditors cannot detect errors because they do not have any legal power like the tax collector. On top of their pressurizing corporate culture, Japanese audit firms are typically paid a fraction of what UK auditors receive (ibid.). In Japan, the audit fee is too small and balance of regulations on auditor’s breadth is too light for them to be fully independent. Small audit fee means auditors are more risk averse when it comes to standing their ground against clients as they fear they will lose clientele.

With regards to losing business, we can briefly incorporate Flint’s (1988) postulate of audit producing social and economic benefits with audit independence. Being a credible auditor is essential for auditor reputation as good reputation results in good returns therefore the reputation of KPMG, PwC, EY & Deloitte has significantly increased after obtaining the label of the Big4. Despite that, KPMG & EY took a big hit in reputation after failing to expose Olympus’ coverup of funds. Another example would be the cosmetic group Kanebo’s Scandal in 2005 where the concealed net worth of ¥200billion tarnished the auditors’ reputation to the extent where PwC ChuoAoyama had to be shut down and rebuilt from scratch. (The Japan Times, 2005) Therefore, the independence postulate has a positive relationship with the benefits postulate such that being independent positively impacts auditor reputation and returns. This is supported by an extraction from Watts and Zimmerman (1986), “The probability of auditor reporting matters of concern is likely to be high because of adverse effects on reputation if their failure to report comes to light.”

Audit independence is so emphasized as it does not only impact shareholders but also the audit firm itself, the client reputation and all users of interest of the financial statement. Recently, Deloitte Japan has been hit by a $2m penalty due to breach over independence rules after it was discovered that dozens of employees are holding sizeable bank accounts at a company it audited. (Marriage and Shubber, 2019) Deloitte auditors were then perceived to be “in the pocket” of company management, causing stakeholders to be sceptical towards the professionalism and objectivity of the auditors. This is mainly due to the violation of audit independence rule of holding a limited value in bank accounts with clients whereby Deloitte’s auditors exceeded. Flint’s postulate was “created” in 1988 and much has changed since then. The auditing industry have observed so much growth since the 19th century in Japan, where it was common for auditors to be shareholders of the company they were auditing. The historical method would not be feasible now as it gives auditors the opportunity to act immorally for personal gain. If an auditor is seen as biased, it is expected that in the long term they would lose credibility and consequently closing down their business. What makes modern day audit different is then again, the emphasis on audit independence.

In this era of auditing and information technology, there are Computer Assisted Audit Techniques (CAAT) to assist in audit processes. The roles of auditors are intertwined with the evolution of the auditing theory itself. The possibility in being biased in the process of investigating and reporting are minimized if CAATs are utilized. To add on, many modern auditors are placing trust in their clients and adopt the business risk approach to auditing which involves participation between auditor and management. Audit independence is still present in such cases but not as strongly as business risk auditing heavily weighs client-auditor relationship.

Overall, Flint’s (1988) postulate was a helpful starting point for people to recognize that independence is a vital element audit reporting and is necessary even in modern day audit to gain the trust of the stakeholders. With the increase in number of obstacles threating credibility and objectivity nowadays, we can only expect the significance of auditor independence to strengthen in the near future. However, there will be cases such as business risk auditing that gives independence less attention compared to other postulates. As for Japan, much work still has to be done for auditors to be able to achieve the independence they desire in terms of legal and culture restrictions. Other than that, the postulate can be considered a universal, timeless requirement of auditing.

References

  • Ajao, O., Olamide, J. and Temitope, A. (2016). Evolution and Development of Auditing.
  • Dutta, S. and Lawson, R. (2018). Accounting Fraud at Japanese Companies. [online] Strategic Finance. Available at: https://sfmagazine.com/post-entry/november-2018-accounting-fraud-at-japanese-companies/ [Accessed 30 Apr. 2019].
  • Flint, D. (1988). Philosophy and Principles of Auditing: An Introduction. Basingstoke: Macmillan Education.
  • Gray, I., Manson, S. and Crawford, L. (2015). The Audit Process: Principles, Practice and Cases. 6th ed. Andover, Hampshire, U.K.: Cengage Learning.
  • ICAEW (2006). Audit Quality: Fundamentals – Audit Purpose. In: Audit Quality Forum. [online] ICAEW. Available at: https://www.icaew.com/-/media/corporate/files/technical/audit-and-assurance/audit-quality/audit-quality-forum-fundamentals/fundamentals-audit-purpose.ashx [Accessed 30 Apr. 2019].
  • Lee, T. (1993). Corporate Audit Theory. London: Chapman & Hall.
  • Lee, T. and Azham, M. (2008). The evolution of auditing: An analysis of the historical development. Journal of Modern Accounting and Auditing, 4(12).
  • Marriage, M. and Shubber, K. (2019). Deloitte Japan fined $2m for auditing rule breaches. [online] Financial Times. Available at: https://www.ft.com/content/409ba95c-2fb3-11e9-ba00-0251022932c8 [Accessed 1 May 2019].
  • Mautz, R. and Sharaf, H. (1961). The philosophy of auditing. Sarasota, FL: American Accounting Assoc.
  • Millichamp, A. and Taylor, J. (2018). Auditing. Andover, Hampshire: Cengage Learning.
  • Nakamoto, M. (2011). Prosecutors raid Olympus Tokyo offices. [online] Financial Times. Available at: https://www.ft.com/content/b922f88a-2b88-11e1-9fd0-00144feabdc0 [Accessed 1 May 2019].
  • Perria, S. (2011). Olympus scandal: Japanese auditors lack ‘power’ to detect fraud. [online] International Accounting Bulletin. Available at: http://www.internationalaccountingbulletin.com/news/olympus-scandal-japanese-auditors-lack-power-to-detect-fraud [Accessed 30 Apr. 2019].
  • Power, M. (1994). The Audit Explosion. Demos.
  • The Japan Times. (2005). Kanebo committed 200 billion yen accounting fraud. [online] Available at: https://www.japantimes.co.jp/news/2005/04/14/national/kanebo-committed-200-billion-yen-accounting-fraud/#.XMXab5NKjOQ [Accessed 1 May 2019].
  • Watts, R. and Zimmerman, J. (1986). Positive Accounting Theory. Englewood Cliffs, NJ: Prentice Hall.
  • Woodford, M. (2013). Exposure: From President to Whistleblower at Olympus. London: Penguin Books.

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