Independence is critical in the auditing profession and goes hand in hand with objectivity. Independence is "freedom from situations and relationships which make it probable that a reasonable and informed third party would conclude that objectivity either is impaired or could be impaired" and objectivity is "a state of mind that excludes bias, prejudice and compromise and that gives fair and impartial consideration to all matters that are relevant to the task in hand, disregarding those that are not" (Accounting Practices Board, 2010).
However, one may wonder why independence is so critical in the auditing profession and whether there are methods which could be used to enhance it. There are in fact already various requirements which attempt to maintain auditor independence; however it could be questioned whether these are sufficient enough. For example, ES5 (Ethical Standard 5 of the Accounting Practices Board) explains the threats to auditor independence and states that when these threats cannot be reduced to an acceptable level, the firm either must not undertake the non-audit service engagement or must not accept/withdraw from the audit engagement (Accounting Practices Board, 2010). However, at what level is a threat deemed to be acceptable?
The importance for auditors to be independent
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The requirement for auditors to be independent exists because of the reports produced by them. Auditors' reports are used by firms to prove to stakeholders that their financial statements truly and fairly reflect their financial position and that everything that should be disclosed, is in fact disclosed. One may assume that it is just the shareholders who would benefit from an auditor's report however this is just one group of many stakeholders who benefit. Often creditors, such as banks and other loan/investment institutions, require the firm to provide an audited set of financial statements before any money is transferred. Trade consumers of a firm would also benefit from knowing that the firm's financial statements have been audited, assuring them of a secure supply. Together with this, employees benefit from audited financial statements because it would assure them that the firm has not been deceptive in disclosing its financial position and this would provide the employees with information on the security of their employment.
If auditors were not to be independent of audit clients then the auditor's report would be misleading to stakeholders, as the opinion formed in the report would be biased and would reflect what management wants it to reflect as opposed to reflecting the professional opinion of the auditor. Consequently, the role of the auditor would become a pointless role as it would not fulfil society's expectations and it would not bring any benefits to the stakeholders.
How the independence of auditors could be enhanced
Although there are already legal requirements which attempt to maintain auditor independence, there are other methods which could be used to enhance the independence of auditors.
One such method could be the requirement to rotate audit firms. This requirement would mean that firms would have to change audit firms every so often, for example every year or every 5 years. Auditor independence would be enhanced because it would prevent auditors from being affected by the familiarity threat. Familiarity threat arises when the auditor fails to sufficiently question the audit client's point of view and therefore lacks the professional scepticism that an auditor should have because the auditor has developed a close relationship with the audit client through long association with them (Porter et al., 2008). By changing the audit firm every so often, the chance for a close relationship to develop between the auditor and the audit client would reduce.
Looking at the collapse of Enron and its auditor Arthur Anderson, the problems occurred because there was such a close relationship between the two firms. If the requirement to rotate audit firms was put in place then perhaps this scandal would never have happened.
Not only would audit firm rotation increase the actual independence of the auditor but it would also increase society's perception of auditors' independence and the relationship between the auditor and the audit client would be a distant one.
Having said this, it can be argued that audit firm rotation reduces the quality of the audit because over time an audit firm would develop increased knowledge of the audit client and its operations and so it would be able to use the accumulated knowledge to better audit the client in future years. If the client must rotate the audit firms, then this knowledge cannot be gained by the auditor and information may be overlooked.
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Another method could be for audit firms to be either state owned or appointed by the state. Audit firms, in theory, should be appointed by the shareholders of the potential audit client however in reality they are often appointed by the directors or the audit committee of the audit client. Whilst this is the case, auditors can never be truly independent because the management of the audit client has influential powers over the appointment of the auditor and their remuneration. By having the auditor appointed by the state or by having a state owned auditor appointed, the connection between the auditor and the audited firm is truly broken and so independence would be dramatically enhanced.
However, the problem with having a state owned auditor is that there may be a burden to perform an audit with a political view in mind. If this is the case, then auditor independence and objectivity would be impaired and this method would not have enhanced independence at all.
A third method could be for a panel of shareholders to be elected, as opposed to an audit committee. This would be favourable because it would return the appointment and remuneration decisions back from the audit committee (consisting of non-executive directors) to the shareholders. The shareholder panel would consist of no directors and so this would eliminate any motives that directors may have when determining which audit firm to appoint and remunerate. Consequently, the relationship between management and the auditor would be more distant and so auditor independence would be enhanced.
However, as Porter mentions, in time the panel could develop into a stakeholder panel and reflect a wider group of interests. This could result in an accountability issue, as the directors would be accountable to the shareholders but the auditors would be accountable to the stakeholder panel (Porter et al., 2008).
Yet another method would be to disallow audit firms from providing non-audit services to their audit clients.
Whilst there are many potential solutions to the question of whether independence can be enhanced, these all come with arguments in favour of and against the proposals. Perhaps the most important point to consider is whether the negative points of the potential solutions are outweighed by the cost of the scandals which they would prevent. Morgan Stanley estimated that the loss in market capitalisation resulting from the failures of WorldCom, Tyco, Qwest, Enron and Computer Associates was approximately $460 billion (Ariff and Ratnatunga, 2004). Any measure which would have prevented these failures should, without doubt, be implemented. Moreover, if these proposals enhance auditor independence as well as enhance auditors' perceived independence then it would be difficult to argue against their introduction.
Nevertheless, the introduction of any proposal requires public debate and views from both sides of the argument to be expressed. Only then can regulatory bodies fully determine whether it is beneficial to introduce new measures to enhance auditor independence.