The Importance of Audit Independence
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Published: Wed, 25 Apr 2018
As the development of the modern business, audit is playing a more and more important role to insure the trueness of the financial report and help report users to make proper decisions. Consequently, it is very important for auditors to remain independence in body and mind when conducting an audit based on a public limited company. To expound this topic clearly, the essay is divided into the following parts: Firstly, it makes a literature review of audit independence and concluded the viewpoint into four categories; secondly, it introduces the definition of audit independence in body and mind and stated the important of both of them separately; Finally, it analyzes why it is important to remain audit independence from many angles such as shareholders, creditors, government, operators and other stakeholders.
2. Literature review
When it comes to the audit independence, many scholars have conducted systematic research in this topic. Some scholars pointed out that auditor has two kinds of independence- body and mind, lack of the former one may shake the public’s confidence on independence and lead to interest conflicts, and lack of the latter one means auditors lose their professional ethics and this is very dangerous (Carmichael & Swieringa, 1968). Salehi have emphasized that the cornerstone for the auditing profession is audit independence. The auditor’s opinion is suspect without independence and the third parties think that there is no need for external auditors without independence (Salehi, 2009).
Due to highly publicized audit failures, the topic of auditor independence has gained increasing attention from academics, regulators, and practitioners around the world in recent years (Hope & Langli, 2008). Under the background of many high profile companies fraud cases exposure such as Enron, Adelphia, WorldCom, the importance of audit independence to improve corporate governance is getting more and more attention (Rezaee. 2003).
As the no-audit services has become a more and more important lucrative business for CFA firms, audit independence is somewhat influenced, which make it even more crucial to maintain audit independence for auditors (Gul, Tsui & Dhaliwal, 2006).
Besides, Bou-Raad G. emphasized the significance of audit importance from the value -added prospect. Internal auditors are not just a traditional audit for supervision but also a valuable access to assisting managers to execute the objectives of the organization. In other words, corporate management benefits from audit quality (Bou-Raad. 2000).
From the literature above, the importance of audit independence can be categorized into four reasons: Firstly, audit independence can hold the public confidence and avoid interest conflicts; Secondly, audit independence can help auditors to provide high quality financial report and avoid scandals like ‘Enron bomb’; Thirdly, the development of no-audit services make it more difficult but more important to maintain audit independence; Lastly, audit independence can improve the quality of audit and it can assist managers to make strategy formulations.
3. The introduction of audit independence in body and mind
When it comes to remaining independence in body, it can be also called physical independence, external independence or surface independence. Auditors should take the role of independence auditors on front of the third parties. And it is the direct evidence for the public judging the independence of auditors. Once report users think that auditors have some current or potential relationship that damages the independence with the consigner such as employment, business partner, family or relatives and so on, it will definitely decrease the audit function as they probably do not depend on those reports so much (Law, 2010). Auditors should have no specific relationships with entity, and they mustn’t hold equity stakes of the entity and should not be on the senior position of it. In order to avoid misunderstanding and enhance the trust, auditor must avoid or diminish this threat to a level which is acceptable. Independence in mind is hard to improve and the public can only infer the independence of auditors from the body like relationships with the entity and other stakeholders. Actually, even if auditors maintain independence in mind, as long as the public think they take sides with the entity or any other parties, no matter how precise the audit result is it is useless.
As for remaining independence in mind, it demands that there is no stake between auditor and the consigner intrinsically. In the whole auditing process, auditor should keep an unbiased attitude that makes a professional decision and never succumbs to any external pressure. It comes up with higher requirement for auditors’ mindset. They are required to be neutral, objective and fact-based.
Actually, those two concepts are different but integrative. They reflect both external and internal sides. Only remaining independence in body and mind can make sure the auditing result persuasive. Also, the function and value of conducting audit can be realized.
4. The importance of remaining audit independence
Stakeholders make economy decisions by taking advantage of reports. Whether those reports are related and reliable are questions. Audit can help to solve this problem. However, auditor fails to fulfill the duty if they cannot remain independence in the conducting process. On one hand, report users will doubt this kind of dependence if they thought auditor and consigner belong to the same party. On the other hand, when auditor cannot keep an unbiased mindset, the auditing opinion probably gets wrong. For example, auditor fails to find out the information is cooked and issues unqualified opinion. This result is easy to mislead related report users for decision making. They may bear loss because of depending on this audit opinion. As the situation varies from Stakeholder to Stakeholder, the following analysis in the importance to remain independence in body and mind is based on different Stakeholders.
4.1 The importance of audit independence for the shareholders
Shareholders are the direct beneficiary of companies and they will get more bonuses if the companies operate successfully. Consequently, shareholders have high demand for audit independence. Actually, when the company is in poor operation, controlling shareholders are not willing to public the truth, and then hurt the interest of minority shareholders. Controlling shareholders don’t have the incentive to employ high independence auditors, and this phenomenon is called Entrenchment Effect (Fan & Wong, 2002).
As the shareholders right separates from the management right, owners do not involve into the daily management to the company. They employ staff to operate their company and enjoy the profits. Usually, shareholders care much about the profitability, efficiency, going concern, and solvency and so on. Those indexes reflect how well manager operates the company. Also, shareholders can assess managers’ performance according to the information. Generally speaking, they obtain the information from the reports prepared by managers. However, the report may involve fraudulence because it is manager who makes those reports. It has the possibility that managers cook the report so as to cover up their mistakes, bad performance and other situation where they fail to fulfill their responsibility. At this time, auditor’s work helps answer the question that how much report users can depend on the report information. But if auditor is unable to keep independence, it probably arouses the doubt to audit opinion from report users. Obviously, audit loses the value under this condition. Without unbiased and objective audit opinion, report users are unable to acquire useful information to know the company’s condition and assess managers’ performance. Once shareholders lose control to the company, this business mechanism will definitely go disorder as managers probably make their own benefits by taking advantage of shareholders’ resource and power and regardless of the limitation from regulation and law (Agbejule, 2009). In the end, the company probably goes to liquidation or bankruptcy.
4.2 The importance of audit independence for creditor
Nowadays, debtor-creditor relationshipÂ is very common and necessary. Debtors want to loan in order to expend production or develop new market, and creditors want to obtain interest using their spare money. And what the creditors concern most is the debtor’s ability to pay for the debt. The debtor’s financial reports can offer some information such as some ratios which can reveal the debt paying ability. And if the company has a bad financial result, creditors can consider calling in a loan ahead of the expiry day to insure their money is safe. However, those reports are made by the debtor. Therefore, creditors may raise the doubt whether there exists the possibility that debtor offer false information to diddle money or conceal the fact that they have no ability to pay that money back. At this time, auditor’s work can eliminate or alleviate this doubt. However, audit can’t work out if auditor were unable to remain independence when conducting the audit. Creditors are likely to make a wrong decision due to the failed audit opinion. When creditor lends money to unqualified debtor, it probably bears a lot of bad accounts and toxic asset as consequence (Siddiqui, 2002). Consequently, audit independence which can help to provide true financial reports is very crucial to creditors.
4.3 The importance of audit independence to government
As a company operates within one country, it uses the infrastructure construction and investment environment offered by the government. It should take on tax responsibility. The financial statement provided by companies is the evidence for government to decide whether levy or not and how many to levy. For example, business tax is based on the gross income of the company which can be found on the income statement. And the income tax is based on the profit also from income statement. If company cooks the financial reports in order to save tax cost, the government will be suffered directly. Therefore, government will conduct audit in case of tax evasion.
Moreover, lacking of audit independence would influence government indirectly. If auditors provided fake financial reports, the pubic will be suffered. They will have less confidence on the trueness of the operation of the company, and the stakeholders will feel betrayed. If their interests are impaired, conflicts would emerge, and it is bad for the stability of the society. That is why the government published the 2002 Sarbanes-Oxley Act after the “Enron Bomb”.
4.4 The importance of audit independence for operator
Many people may misunderstand that auditor is enemy to operator referring to manager in this essay and the existence of audit is a stone in the way. This idea is partial and shallow. The role of audit plays is to increase the dependence to the information and check whether the whole business activities are in accordance with the regulation. To some degree, it serves to obtain superior management (Shih, 2006). Sometimes, auditors will come up with solutions to the existing management problems. For example, the internal control has leak which may incur situation where damages the whole benefits of company. Going details, the design of regulation may give a chance for embezzlement. Or auditor finds out some staff goes against regulation. Cases like that should call managers’ attention for better management. If auditor cannot keep independence when conducting audit, it will pose the threat to the company such as damage the company benefits. For example, the auditor is a brother to the cashier. When this auditor conducts audit to cash, he can’t remain independence or his independence has been affected. He may conceal the fact if the cashier had some guilt and issues unqualified opinion (Fadzil, 2005). Because of this opinion, managers can’t notice this threat. It may have a bad effect on their working performance and company development.
4.5 The importance of audit independence for the other stakeholders
The existence of a company has to bear many responsibilities. Therefore, the stakeholders can never be limited to the above mention. When a company becomes a listed company namely a public limited company, it has to fulfill more duties to the society and accept more supervision from the public. It raises fund by stock shares. Its public investors sell or buy the shares in the stock exchange, and their decision usually relies in the financial reports. However, those reports perhaps cannot reflect the financial position and income condition. Audit opinion is very important in their decision making process. If auditor could not remain independence, the audit opinion will mislead the users. Investors will lose money if they invested a loss company. For example, the collapse of Enron results from the accounting firm Andersen failed to remain independence. In the end, the share price cannot reflect the value of the company (Abbott, 2000). Stock market will go wrong and the economy will fall apart.
The most important responsibility for auditors is to provide high quality financial report which can help report users to make right decisions. The authenticity and reliability of the financial report is very crucial because it directly decides the strategies of stakeholders. The trueness of financial report which is also the quality of audit is decided by two factors: professional competence of auditors and audit independence, and the latter is more important. Audit failures caused by lack of audit independence have led to many companies fraud cases. Audit independence is also the need of shareholders, creditors, government, operators and other stakeholders. All in all, it is really important for auditors to remain independence in body and mind when conducting an audit.
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