The External Auditor Has Long Played An Important Role Accounting Essay

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Independence is fundamental to the reliability of auditor's reports. Those reports would not be credible, and investors and creditors would have little confidence in them, if auditors were not independent in both fact and appearance. Independence is the guiding principle of the audit profession. Independence, both historically and philosophically, is the foundation of the public accounting profession and upon its maintenance depends the profession's strength and stature. [1] John L. Carey described independence as a state of mind and a matter of character. [2] It is an attitude of the mind characterized by integrity and an objective approach to professional works. In general, independence means an auditor's opinion must be based on objective (without bias) and disinterested assessment of whether the financial statements are presented fairly in conformity with Generally Accepted Accounting Principles (GAAP). The value of audit derives entirely from its independence.

The external auditor has long played an important role in the corporate governance function. They are public accounting firm employees brought in under contract to review the accounting and financial books of the company (audit client). Jill Solomon regards external audit function as one of the cornerstones of corporate governance. [3] It represents one of the most indispensable corporate governance checks and balances that help to monitor company management's activities, thereby increasing transparency. The role is to provide an unbiased and independent evaluation of all the financial records.

The external auditor's responsibility is to provide assurance to the general public regarding the truth of the information presented in the financial statements. This information provided is relied upon by the public at large; thus it is imperative that the firms are independent, objective and free from influence.


The importance of accounting is best seen from the status of the "profession" that is given to the job of auditing rather than terming it as an employment or service. [4] Audit is a process of assuring fairness of the financial statements and their conformity with the legal requirements in accordance with the generally accepted principles. Audit, can thus be defined as, 'an independent examination of statements, prepared by another qualified accountant by means and to the extent determined by the auditor of a company's financial statements for the purpose of his rendering an opinion on them'. [5] Thus, what emerges as the most important characteristic, which may also be termed as the fundamental qualification of an auditor is his independence.

The Cadbury Report emphasized that the annual audit is one of the cornerstones of corporate governance. The audit provides an external and objective check on the way in which the financial statements have been prepared and presented. [6] According to Association of Chartered Certified Accountants (ACCA) Code of Ethics objectivity or independence is essential for the exercise of professional judgement. The appointment of quality auditors serves as an assurance to the investors that the companies' financial disclosures would be accurate and truthful. The assurance is credible because the auditors, with their reputation at stake, will closely scrutinize their client's books and truthfully disclose their findings. [7] The audit function is one of the most vulnerable areas, recommending urgent attention to improve the effectiveness (Solomon, 2009). This function helps the shareholders in their monitoring and control of the company management. The failure would result in the downfall of the company.

According to the Cadbury Report, it is important to bear in mind that the auditor's role is not to prepare the financial statements, nor to provide a guarantee that the company will continue as a going concern, but the auditors have to state in the annual report that the financial statements show 'a' true and fair view rather than 'the' true and fair view. [8] The main reason for the auditor independence being compromised is close relationships between the auditors and company managers. Such relationships with the clients may affect the financial statements they are auditing. A balance has to be attained. This is a difficult path to tread and one that is clearly bedecked with obstacles.

External auditors are independent service providers whose impact can influence the organization that is being audited. As outsiders, they play an important role in developing internal control. They comment on the weaknesses in the accounting records, systems and controls that they review. They provide a statistical clarity and effectiveness of the accounting policies. Their main role is to advice the company management through recommendations in their audit notes or discussions. Each of these opinions is vital for an organization.

There are two main issues in auditor independence.


A problem raised in the Cadbury Report is regarding the independence and effectiveness of the audit function that involves multiple services offered by auditors to their clients. It is controversial whether the provision of non-audit services (NAS) by auditors impairs auditor independence, or is instead economically efficient (because of benefits from knowledge spillovers, reduction of search costs, or mitigation of contracting frictions). [9] The scope of non-audit services has been a subject of intense policy debates. The main argument is that the provision of (NAS) could threaten auditor independence because it creates economic incentives for the auditor to preserve the auditor-client relationship (Simunic, 1984; Beck et al., 1988). The Smith Report (2003) stated that: "…we do not believe it would be right to seek to impose specific instructions on the auditor's supply of non-audit services through the vehicle of Code guidance. We are sceptical of a prescriptive approach, since we believe that there are no clear-cut, universal answers…there may be genuine benefits to efficiency and effectiveness from auditors doing non-audit work". [10] The Smith recommendations seem to pass the buck on to the audit committee.

The emergence of professional service firms in recent years has resulted from a growing demand from businesses for specialist advice to help them achieve business advantage in an increasingly competitive market place. Much of this advice is requested from audit firms, because auditors are trained to understand the dynamics of a business from an external perspective and also because independent view point can often shed light on problems that may appear intractable from within an organization. The Institute of Chartered Accountants in England and Wales (ICAEW) states that when a company fails, the quality of audit is often called into question. The Institute's Code of ethics forbids auditors to provide non-audit services to audit clients if that would present a threat to independence for which no adequate safeguards are available. The provisions of the (Combined Code 1998) stress on review of the nature and extent of non-audit services. Here the audit committee should act as the representative of the shareholders and must satisfy itself that the independence and objectivity of the auditor are not compromised. The shareholders should be able to assess the extent of non-audit services provided. The Companies Act, 2006 has time and again required the total amount on non-audit fees paid to the auditor to be disclosed.

The U.S. Securities and Exchange Commission (SEC) has progressively tightened regulations related to the non-audit services that, if provided to an audit client, would impair an accounting firm's independence. [11] The Sarbanes-Oxley Act, 2002 says that to be considered independent, a registered public accounting firm that audits a public company's financial statements would not be permitted to provide, contemporaneously with the audit, any of the non-audit services listed in Section 201 or any other service the Oversight Board determines by regulation to be impermissible. Some examples of these prohibited services include financial information systems design and implementation; actuarial services; legal services and expert services unrelated to the audit; management functions or human resources; internal audit outsourcing services.

But on the other hand nowadays auditing companies offer consultancy services and IT services to the companies that they audit. Assuming no undue overall economic independence results from the auditor-client relationship and adequate safeguards can be implemented the companies themselves should determine whether they use auditors for non-audit services, in consultation with the professional guidelines.


Whether there should be a system of rotation of auditors in companies is being debated in various quarters in view of the recent developments resulting in corporate failures due to deficiencies in reporting by some audit firms. The Cadbury Report (1992) discussed the possibility of having compulsory rotation of auditors, as it could be a means of avoiding cosy auditor-client relationships. However, the report concluded that the costs of such an initiative would outweigh the benefits, as it would result in a loss of confidence and trust between the auditor and their client company. [12] 

The ultimate question is that whether rotation of auditors would enhance audit quality, and if so, at what cost. It may lead to more-independent auditors performing better audits by either detecting or reporting material misstatements in the financial statements or constant rotation would result in inferior audit performance. There are three related conditions which affect issues of audit quality and audit firm rotation, they are closeness to client management, lack of attention to detail due to staleness and redundancy and eagerness to please the client. [13] 

Closeness to Management

More than 40 years ago, in The Philosophy of Auditing, authors Robert K. Mautz and Hussein A. Sharaf warned auditors: [T]he greatest threat to his independence is a slow, gradual, almost casual erosion of this honest disinterestedness­---the auditor in charge must constantly remind his assistants of the importance and operational meaning of independence. The nature of auditing requires auditors to interact extensively with their clients. This long-term relationship between the two would result in a troublesome degree of closeness between the company management and the auditing firm. This may create a conflict of interest for the auditor and it can affect the entire auditing process to a very large extent. There is also a possibility that the company management would take advantage of this closeness by making a personal appeal for compassion and support. The graphic example here would be Enron and Arthur Andersen. Familiarity rarely breeds contempt between companies and their auditors. More often than not, it results in a level of comfort that weakens auditor independence and reduces audit quality. The price of that closeness is borne by the non-promoter shareholders, investors, employees and other stakeholders in the company. Sometimes, it threatens the survival of the company.

The auditors must interact with the company management on a daily basis during the audit; such relationships are bound to occur regardless of the length of the relationship between the two. It should be more of a comfortable relationship, where the client can discuss his problems and share information pertaining to the audit. While auditors must maintain a level of professional skepticism, this auditor-client relationship is a function of mutual understanding and experience. An auditor must be able to gauge, when the client is not willing to provide sufficient information. The main problem here is that by rotation, the new firm is faced with the "getting to know each other" stage. This closeness contributes to knowledge sharing and is very critical to the entire audit process.

Staleness and Redundancy

Most of the auditors view the audit, as a simple repetition of prior undertakings. They fail to highlight the important changes occurring. This leads to staleness, whereby the originality and effectiveness of the audit function is lost. Many prior used schedules and work papers are relied upon to plan the audit, set the budget and provide valuable information needed. Thus reliance is a significant problem. It affects the auditor's response to the company management on various subjective issues. An example would be whether a management estimate is in accordance with Generally Accepted Accounting Principles (GAAP).

It cannot be denied that, prior year audit often produces substantial benefits which result in increased audit effectiveness. The auditor is familiar with the matter at hand. He has a better understanding of the issues and better appreciation for changes taking place from time to time. Due to complexity in many of the companies, it is very difficult for an auditor to understand the working of the company management within a very short period of time. The auditor is not starting from scratch, the management is familiar with what the auditor would ask for, and there is less interruption to the normal business of the company. Auditors take up a great deal of a client's time, creating both a financial and time-saving motivation to have a smooth and efficient audit.

Eagerness to please the client

The existence of a long-term "annuity" of possible future audit fees may result in a situation in which the obvious "business decision" is to please the client so as to retain the client. With no long-term connection to the client, the auditor does not face a conflict of interest and can act more freely. It addresses the unconscious desire of the auditor to please the client. Psychological research has demonstrated that even when people attempt or try to remain objective and impartial, often they are unconsciously and unintentionally unable to remain impartial, due to a "self-serving bias" that causes them to reach decisions that favour their own interests. [14] With the rotation of auditors, the interest of the auditor does not have to match with that of the client.

There is always a temptation to be in the good books of the client. If a difference occurs, there is a potential of losing the client prematurely. An auditing firm may be less motivated to serve the client during the final year of the audit. He may treat the client as a "lame-duck". Rotation of auditors requires companies to choose a new auditing firm, which in itself may lead to an opinion-shopping in deciding which firm to hire.

The idea of enhancing auditor independence through rotation appeals superficially to many, yet the net effects are far from certain. Various safeguards are in place to address the key issues of concern relating to independence and objectivity of the audit firms. In addition, company management are taking a more active role in oversight of the system, to prevent abuse.

There are differences in perceptions of independence when the company followed a rotation policy versus when there was no rotation. [15] In addition to this, different countries have different safeguards and policies with regard to rotation of auditors.


The year 2002 saw the end of an era of skyrocketing stock prices and booming businesses. Things that had seemed to be too good to be true were just that. Companies that were previously thought of as unstoppable didn't have the earnings they claimed to have. [16] This chapter examines the impact of weaknesses and failures of corporate governance on companies and on society. In this chapter, we examine the Enron saga in order to highlight the consequences that arise from the failure of corporate governance mechanisms. We also examine the downfall of Enron, looking at the main reasons for collapse and commenting on the corporate governance problems within the company. The reason for picking Enron is to explain why this case encouraged corporate governance reform worldwide, especially in the auditing process.


Enron was formed in July 1985 when Houston Natural Gas merged with Omaha-based Inter-North. The company was founded by entrepreneur, Kenneth Lay. As the energy markets, and in particular the electrical power markets were deregulated, Enron's business expanded into brokering and trading electricity and other energy commodities. In a period of 16 years the company transformed from a small entity, to the world's largest energy trading company (The Economist, 28 November 2002). Deregulation had a far reaching impact on all the energy providers. In this newly deregulated and innovative forum, Enron embraced a culture that rewarded "cleverness". Deregulation opened up the industry up to experimentation and the culture at Enron was one that pushed the employees to explore this new playing field to the utmost. [17] This led to enormous success for the company.

From the start of the 1990's until year-end 1998, Enron's stock rose by 311 percent, only modestly higher than the rate of growth in the Standard & Poor's 500. But then the stock soared. It increased by 56 percent in 1999 and a further 87 percent in 2000, compared to a 20 percent increase and a 10 percent decline for the index during the same years. By December 31, 2000, Enron's stock was priced at $83.13, and its market capitalization exceeded $60 billion, 70 times earnings and six times book value, an indication of the stock market's high expectations about its future prospects. [18] 

Enron's success was phenomenal. It was rated as the most innovative large company in America in Fortune magazine's survey of the Most Admired Companies. It built up its glittering reputation and success before crashing down in such a monumental fashion. Ironically the company's commercial which ended with the reverberating phrase, "Ask why, why, why?" Questions such as what happened, why did it collapse, why were there no backup plans, why did the world's leading energy company fail, bring us to the problems arising within the company before the filing for bankruptcy in 2001.

The word "Enron" has become synonymous with corruption on a colossal scale - a company where a handful of executives were able to pocket millions of dollars while carelessly eroding the life-savings of thousands of employees. The individual and collective greed of the executives built an atmosphere of market euphoria and corporate arrogance. Arrogance and aggressiveness of the company management had pushed the law too far and this led to a heap of bad debts and ignominy.

An article in The Economist (26 February 1998) raised certain doubts over the permanency of Enron's success. There were three causes of concern. Firstly, deregulation was occurring in differing speeds in the different states of America and therefore the ability to achieve free competition. Secondly, Enron did not have enough resources to deal with small customers that they were taking on. And lastly the company's management team were arrogant and overambitious.


Transparency is an essential ingredient for a sound system of corporate governance. The company's lack of transparency in reporting its financial affairs, followed by financial statements disclosing billion of dollars of omitted liabilities and losses, contributed to its demise. The whole affair happened under the eye of Arthur Andersen LLP, which kept a floor of auditors assigned at Enron year-round. [19] 

Kenneth Lay hired Jeffrey Skilling to assist him in developing Enron's business strategy. Skilling began to change the corporate culture at Enron to match the company's transformed image as a trading business. As Enron's reputation with the outside world grew, the internal culture apparently began to take a darker tone. Skilling was responsible for the constitution of the Performance Review Committee (PRC) which was also known as the "360-degree review". It was the harshest employee ranking system. This encouraged the employees to work longer and post earnings for the company. Thus there prevailed fierce internal competition. Enron's corporate leadership was in the hands of Lay and Skilling who travelled across the country to sell their concepts to other power companies and energy regulators. The company then gained the reputation of being a major political player in the United States, lobbying for deregulation of electric utilities.

By the end of 1998 Enron had eight divisions and its revenue grew from $2 billion to $7 billion. Thus the company was flying high with double digit growth (at least on paper) with every venture. The main reason for these figures was the mark to market accounting rule. Under these rules, whenever companies have outstanding energy related or other derivative contracts (either assets or liabilities) on their balance sheets at the end of a particular quarter, they must adjust them to fair market value, booking unrealized gains of losses to the income statement of the period. [20] A difficulty with the application of these rules is that commodities such as gas have no quoted prices to have base valuations thus companies are free to develop their own methods and assumptions. The Financial Accounting Standards Board's (FASB) stated that Enron had valuation estimates which overstated the earnings of the company.

Arthur Andersen LLP was widely considered the firm of choice for auditing businesses in the oil and gas industry, auditing 70 percent of Houston's oil and gas companies. [21] It was logical for Enron, one of the world's leading energy companies to choose Andersen to perform its financial statement audits. Thus Andersen was the professional gatekeeper [22] . They are reputational intermediaries who provide verification and certification services. The relationship began in 1985 when Andersen began auditing Enron, but soon became much closer. It performed the role of an external as well as an internal auditor. Enron frequently hired many of Andersen's auditors to the strategic positions of the CFO (Chief Financial Officer) and Chief Accountant. Because of these cosy relationships with Enron, Andersen's audit independence was called into question. It raised serious doubts about the credibility of the audit process.

Both the audit function and the accounting function in Enron were fraudulent and opaque. Enron's accounting was anything but transparent. The company recorded profits, for example, from a joint venture with Blockbuster Video that never materialized (The Economist, 7 February 2002). Enron manipulated the accounting numbers to inflate the earnings figure. They removed substantial amounts of debt from their accounts by setting up a number of off-balance sheet entities. Off-balance sheet entities are used to artificially inflate profits and make firms look more financially secure than they actually are. Enron would build an asset such as a power plant and immediately claim the projected profit on its books even though it hadn't made one dime from it. This was done with the help of Andersen, in order to hide the company's liability from the balance sheet. In order to satisfy Moody's and Standard & Poor's credit rating agencies, Enron made sure that the leverage ratios were within acceptable ranges. Andrew Stuart Fastow, the former CFO of Enron continuously lobbied around these agencies with the intention of influencing their decisions and raising Enron's credit rating. This entire process resulted in a cumulative profit reduction of $591 million and a rise in debt of $628 million for the financial statements from 1997 to 2000. [23] This triggered an investigation by the Securities and Exchange Commission (SEC) into the auditing work of Andersen.

As mentioned earlier, Andersen had a very cosy relationship with Enron which resulted in conflicts of interest. Conflicts of interest are a frequent problem in the audit profession. Independent appointment of the company's auditors by the company's shareholders is frequently replaced by subjective appointment by company bosses, where the auditor is all too often beholden to the company's senior management. Further, there are conflicts of interest arising from interwoven functions of audit and consultancy. [24] These special cosy relationships between the company management and the auditors compromise independent judgement and cloud the auditing function. The Enron implosions called into question not only the adequacy of disclosure practices in USA but also the integrity of the independent audit process.