Independence is the primary justification of the existence, and thus the hallmark of the auditing profession. It is recognized as the primary attribute to be maintained by auditors in all circumstances.
Independence has been described as "avoidance of situations which would tend to impair objectivity or permit personal bias to influence delicate judgment" (Carey et al., 1966). Auditor independence, in particular, implies "absence of influence or control in the matter of the auditor's conduct, action and opinion" (AAA, 1973). It simply refers to the auditor's ability to express his conclusions honestly and impartially. In discussing the foundation of the concept of auditor independence, Pany & Reckers (1983) emphasize that the concept of auditor independence is closely originated from the reason for the existence of auditing itself. According to them, the rationale for the external auditor's work (i.e. independent audit) - indeed a primary justification for the existence of the public accounting profession - arises from the need for reliable financial information
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This paper shall discuss the concept of auditor independence in relation to the failure of the HIH case. This will present arguments in relation to the involvement of the auditors in the fallout of HIH as well as on the views of global harmonization of auditor independence standards. Finally, this paper shall compare and contrast the issue of auditor independence on both HIH and Enron issues.
II. Background of the HIH Collapse
The HIH collapse is not 'a case where wholesale fraud or embezzlement abounded. Instead, it is a rather pathetic tale in which, to the great cost of thousands of ordinary Australians, the unwary followed the inept further and further toward predictable demise. By the time the group was wound-up on 27 August 2001; its deficiency was estimated at between $3.6 billion and $5.3 billion. Only two days later, a Royal Commission of Inquiry was established to investigate the cause.
That this saga was allowed to unfold is as much a testament to poor corporate governance as it is to any default on the part of the auditor, Arthur Andersen. Yet recent legislative reforms, although in name targeting both 'corporate disclosure' and 'audit reform', have weighed-in very heavily on the audit reform side of the ledger - particularly in the area of auditor independence.
Corporate regulation in Australia in the late 1990s and into the present decade was replete with mechanisms designed to detect danger signs and promote the financial health and longevity of commercial entities. The law imposes duties and responsibilities on corporate officers and others such as auditors to ensure that problems that may adversely affect the solvency of a commercial entity are detected at an early stage. When problems of this nature are detected, corporate officers have a responsibility to take action. In the case of a company such as HIH, the corporate officers must inform the regulators and the public of the company's true financial position. The law also confers on regulators significant powers to act on the information that is provided and to obtain other information to protect the public interest.
Despite these mechanisms, the corporate officers, auditors and regulators of HIH failed to see, remedy or report what should have been obvious. And some of those who were in or close to the management of the group ignored or, worse, concealed the true state of the group's steadily deteriorating financial position.
III. Failures of the Auditors
Unquestionably, the HIH story is also one of auditor failure. Although the extent to which Andersen's failures were ultimately causative of the group's collapse is necessarily speculative, it is informative to note that between 1998 and 2001 the firm had employed a client-risk assessment mechanism (dubbed 'SMART') that had consistently assessed HIH as a maximum-risk client. Its internal operations manual accordingly required the firm to employ expanded risk management procedures and to formulate a formal risk management plan in this respect. Given the extremely high materiality of any potential misstatement in relation to the provision for future claims, Andersen's own policies required that the reports of the consulting actuary be subject to rigorous review. Remarkably, however, the firm 'generally relied on extracts from six monthly reports that Slee [the principal consulting actuary] preparedâ€¦ which were received before the finalisation of the year-end accounts' and which 'generally speaking â€¦ provided scant detail as to Slee's methodology and assumptions'. Moreover, the firm did not engage any expert assistance in considering these extracts.
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Whilst Andersen's unquestioning acceptance of the actuary's reports was arguably the firm's principal failure, it formed merely an aspect of an overall lack of inquisitive rigour. In particular, Andersen relied extensively upon HIH's internal business audit processes. Indeed, the firm relied on those processes without conducting any evaluation or testing of the operations, policies and procedures of internal audit function,- even though the audit team had identified deficiencies in the internal audit division and even though Andersen's own operations manual mandated such evaluation and testing.
The firm also failed to deal with a number of accounting anomalies. These were identified by the Royal Commission as falling into four main categories, namely: accounting for future income-tax benefits, deferred acquisition costs, deferred information technology costs and goodwill.
In the case of future income-tax benefits, the relevant accounting standard makes plain that, where a company incurs a tax loss, significant doubts must arise about the company's ability to realise the related future income-tax benefits in subsequent periods. Although a 'virtual certainty' test is posited, Andersen's engagement partner testified that he applied the far less exacting test of whether there were 'reasonable grounds to believe that HIH would continue to operate profitably in the future'. In the Commission's view, the auditor failed to obtain sufficient appropriate evidence under AUS 502 and should have issued a qualified opinion.
Highlighting Andersen's close personal relationships to HIH and its unquestioning acceptance of the results of both the company's internal audit processes and the work of its consulting actuary, counsel assisting the Commission mounted an extremely cogent argument to the effect that Andersen was not, in fact, independent in its conduct of the 1999 and 2000 audits. The point was also made that Andersen's partners were under considerable pressure to maximise profits through the provision of non-audit services. Indeed, one of the Andersen partners stated in evidence before the Commission that, if he was called upon to exercise independent and professional scepticism by resisting management proposals, it would have adversely affected his ability to promote the supply of non-audit services to HIH. Notwithstanding the considerable probity of the counsel's submissions, the Commission found a lack of independence only in appearance, not in fact.
IV. Recommendation of the Royal Commissioner
Prior to recent reforms, the Corporations Act dealt with the issue of auditor independence by focusing on specific indicia of objectivity, such as indebtedness and employment relationships between the company and its auditor. Now, however, the Act enshrines 'Professional Statement F1', an independence standard developed and adopted by the profession itself. The standard requires auditors to identify specific threats to independence and to apply safeguards reducing them to an acceptable level: it is now an offence under the Corporations Act for auditors aware of a conflict of interest situation to fail to 'take all reasonable steps to ensure that [the situation] ceases to exist'. Auditors unaware of a conflict situation will still be caught if they failed to operate 'a quality control system reasonably capable of making the individual auditor or audit company aware of the existence of [the situation]'. Similar liability attaches to directors of audited companies. Indeed, it is an offence for even an employee of an audit firm, whether associated with the engagement or not, to fail to notify ASIC within seven days of a known conflict. Auditors must now also provide written declarations that there have been no contraventions of the auditor independence requirements of the Corporations Act or of 'any applicable code of professional conduct'- failure to do so constitutes a strict liability offence. The independence requirements are extremely convoluted, even including 'maximum hours tests' (that vary depending upon the level of audit involvement) for the provision of non-audit services. Directors' statements on annual reports must detail any non-audit services provided by an external auditor, including fees paid for such services, and provide an explanation as to why the audit committee is satisfied that the provision of the services does not compromise independence.
Further independence requirements impose restrictions on the composition of the audit team. The audit partner and other personnel who 'play a significant role' in the audit of listed companies must be rotated every five years. Once rolled off, such personnel cannot return to an engagement for at least two years. Further restrictions bolster these requirements. No more than one former ex-partner of an external auditor can be appointed to the directorship or senior management of a former audit client. Moreover, audit and review partners are unable to accept such appointments for a period of two years following resignation.
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V. Background of Enron Collapse
Only months before Enron Corp.'s bankruptcy filing in December 2001, the firm was widely regarded as one of the most innovative, fastest growing, and best managed businesses in the United States. With the swift collapse, shareholders, including thousands of Enron workers who held company stock in their 401(k) retirement accounts, lost tens of billions of dollars. Investigations of wrongdoing may take years to conclude, but Enron's failure already raises financial oversight issues with wider applications.
Federal securities law requires that the accounting statements of publicly traded corporations be certified by an independent auditor. Enron's outside audits have received much attention. Outside investors, including financial institutions may have been misled about the corporation's net income (which was subsequently restated) and its losses and liabilities (which were far larger than reported). The auditor, Arthur Andersen, has been indicted on criminal obstruction of justice charges, related to destruction of documents.
VI. Comparison and Contrast of Enron and HIH in terms of Anderson
One issue is whether Andersen's extensive consulting work for Enron may have compromised its independence and its judgment in determining the nature, timing, and extent of audit procedures and in asking that revisions be made to financial statements, which are the responsibility of Enron's management. Oversight of auditors has primarily rested with the American Institute of Certified Public Accountants (a nongovernmental trade group) and state boards of accountancy.
Another auditor issue is the provision of non-audit services to audit clients. Some believe that provision of such services is a conflict of interest that tends to undermine the arm's-length, watchdog posture expected of the outside auditor. Several bills before the 107th Congress would limit the provision of non-audit services by auditors to their clients, including H.R. 3617, H.R. 3693, H.R. 3736, H.R. 3763, H.R. 3818, H.R. 3795, H.R. 3970, S. 1896, S. 1921, and S. 2004. The Big Five accounting firms have agreed to impose (or support) a prohibition on provision of internal audit and information technology services to their audit clients. A crucial issue will be whether tax services, a major component of accounting firms' revenues, are included in the services deemed to compromise independence.
VII. Harmonisation of Auditor Independence Standards
The issue of auditor independence revolves around the premise that publicly traded companies may "cook" their books in order to provide favorable financial statements to the investing public - sometimes referred to as "earnings management." Thus, an independent third party should review these statements, along with the company's books, to assess the accuracy of the statements. Accountants are in an optimum position to provide this function. They have traditionally provided a similar function to business owners and base their reputation on scrupulous objectivity and integrity. Accordingly, the Securities Act of 19338 and the Securities Exchange Act of 19349 (together, the "Securities Laws") established requirements that companies which offer to sell their securities to the general public must have their financial statements certified by an independent public accountant upon the original offering of the securities and annually thereafter.10 This independent verification of the financial statements is the "statutory audit."
Most of the attention concerning auditor independence focuses on non-audit consulting services. Thus, the spin offs and restructurings of Big 5 consulting divisions may seem to moot independence concerns. But a large number of non-audit advisory and consulting services remain within the accounting, audit, and tax divisions of these firms, e.g., Andersen Business Consulting. Given the profitability and panache of consulting services it may be hard for the Big 5 to stay away from them. The Big 5 assert that they need consulting expertise just to perform statutory audits on their large multinational audit clients and that provision of non-audit services to these clients enables them to perform a better audit through a deeper understanding of the client's operations. But as Former SEC Chairman Levitt has pointed out, the Big 5 currently only perform substantial non-audit services for 25% of their audit clients, so this must mean that the audits performed on the remaining 75% are somehow subpar, an assertion the Big 5 are not likely to agree to.463 A stronger rebuttal may be that the Big 5 argument proves too much - under its logic auditors should be allowed to perform any services for audit clients that would increase the auditor's knowledge of its client. Should we then allow auditors to provide the clearly independence impairing services of bookkeeping and management functions to their clients?
Consequently, "independence" has arisen as a proxy for objectivity integrity because we feel that any auditor who is completely devoid of business, personal, or other interested relationships with a statutory audit client will have no real motive to act other than with integrity and objectivity for the company creditors' and the investing public's interest. This does not mean that the interests of company creditors and the investing public are necessarily at odds with those of shareholders, but rather that they may be at odds under certain non-trivial circumstances. Hence, it is difficult to speak of these interests as unitary. Assuming they are not, then even the laudable efforts of the corporate governance movement to insist on company board audit committees comprised of at least some disinterested directors does not protect the interests of the investing public because directors' fiduciary duties only run to other board members, shareholders, and the corporation itself.
Accordingly, there may be no quick fix for independence issues. Independence related problems and scandals have been increasing in frequency and severity since the 1970s, yet each time a crisis comes to a head some temporary resolution is reached that puts off a real solution of the underlying problems. Most recently, the SEC "modernized" its rules, while the Big 5 made various attempts to distance their consulting practices from the rest of the firm -perhaps in an effort to ward off more draconian solutions by the SEC or Congress. At the same time, reports by the ISB, Panel on Audit Effectiveness and POB indicate that independence is a growing problem. The profession argues that independence violations have yet to be positively linked to an audit failure. Yet, this may be because it is difficult to prove the connection, not that there is no connection.
In fact, there was little discussion of independence from the profession, the SEC, or elsewhere through the 1950s. The SEC did begin to note the rise in non-audit services being offered by accounting firms, but it was not until the 1970s when independence issues gained public attention. The accounting profession was consolidating and offering more non-audit services that were increasingly important to firm revenues. Public corporations were becoming the dominant form of business organization and many had grown so large and complex that statutory audits required a small army of individuals with varying expertise. This began limiting such audits to the largest firms, which led to further growth and consolidation. Presently, the world is very different from when the Securities Laws were enacted. Only the Big 5 can effectively perform statutory audits on the major Fortune 500 companies who also represent the prime business targets of the firms' non-audit services. The Big 5 themselves are extremely large, multinational organizations employing thousands of people in many countries. Finally, the evolution of professionals from those pursuing public service to business people pursuing a healthy bottom line means that there must be sound personal economic incentives for the auditor to prioritize independence over big fees. Consequently, it is not the provision of non-audit services alone that threatens independence, but rather the entire business environment in which auditors operate.
But the Enron crisis may have changed all of this. In the wake of the company's collapse, discussions of auditor independence have finally raised the prospect of a fundamental reconsideration of the basic independence framework and statutory audit system. Prior to this, fundamental restructurings such as bringing the statutory audit system into a government agency were deemed off limits because "no one has seriously considered this in seven decades." But, such arguments are always circular non-starters as a logical matter. In fact, Congress not only considered alternatives to the present system when it enacted the Securities Laws, but it also reconsidered them during the last few decades. We must not allow the auditor independence issue to once again receive a temporary fix, but should instead encourage Congress and regulators to make the kind of fundamental inquiry that could establish a solid conceptual framework for the validation of financial statements - the heart of our successful capital markets, economy, and standard of living - for the Twenty-First Century.
There are likely other alternatives than those sketched here, and all need further investigation. But this paper will have succeeded if it brings discussion back to an open-minded and free ranging consideration of all the options available to achieve the goal of protecting investors in public companies. This was the promise of Professor Allen's opening salvo at the outset of the ISB, which remained, unfortunately, unfulfilled. Rather than stay mired down in a status quo established before the advent of computers, and even television, we should inquire into the first principles of securities regulation and the role of audits therein. We should not accept a temporary solution once again for a recurring problem. Instead, we must fashion a long term solution that will reinforce our capital markets and economy, prevent another Enron-type crisis, and place us well on the way to a successful Twenty-First Century.