Defining Auditor Independence
Nowadays auditor independence is one of the most important topic as world has witnessed so many cases of accounting fraud in many big companies around the world. The auditor’s independence is the integral part of the audit process and in general it means independence of external auditor. In simple terms it can be said that auditor is independent when the auditing is carried in a freely and in an objective manner. The independence of auditor has been measured through evaluating the honesty of Auditor in reporting material misstatements in its audit report that were found during the audit process. Independence of auditor can be maintained through not having conflict of interest with the client (Managers of Company). As external auditor does what has been written in audit engagement and no other liabilities arises other than mentioned in auditor engagement. It is important that auditor must maintain its independence in the sight of investors to the extent the audit fees cover the cost of complete audit process.
The main purpose of this report is to evaluate the various literatures on auditor’s independence in order to understand the major audit risks and threats in the whole audit process. In addition to this the failure of Worldcom, Enron, and Lehman Bros has been discussed in detailed in order to evaluate causes of failure and lessons learned from these cases.
There have been so many literatures that discusses about the concern of audit risk at various level of audit process. According to Fearnley, Beattie & Brandt (2005), audit risk has been defined in Auditing Standard 312 and as per this standard it is responsibility of auditor to consider audit risk and materiality when making the planning for conducting the audit of financial statements. Typically audit risk has three key components: detection risk, control risk and inherent risk. The detection risk arises when the substantive procedure applied by the auditor are not sufficient to detect the material misstatement that are left in the audit process of financial statements. Control risks on the other hand can be defined as risks that are material in nature but they cannot be prevented, detected and corrected by the internal control system and accounting process on timely manner. Lastly inherent audit risks refer to the errors of various account balances or class of transactions that are material in nature and they cannot be determined through applying the internal control procedures. The level of audit risk is completely dependent upon the substantive testing carried by the auditor. The main concern is the detection risks as auditor is completely responsible for the detection risks and his liability lies to the level of efforts he has put for identification of risks that are material in nature (Fearnley, Beattie & Brandt, 2005).
In the view of Adelopo (2016) audit risks have been replaced by the business risks which is defined as risks that does allow the audited entity to fulfill the objectives. The auditors are now more concerned to the business risk assessment in order to focus on the risks of material misstatements of financial statements. In this way auditors can improve the auditor independence and reduce the level of threats in the audit practices (Adelopo, 2016).
As per Austin & Herath (2014), auditor must be independent to his or her client in order to have true and fair audit opinion and not to be influenced by the relationship between them. It is technically expected from the auditors by the investors of the company to provide unbiased and honest audit opinion on the financial statements so that they can wise decision on their financial investment (Austin & Herath, 2014). There are multiple threats that affect the auditor’s opinions and thus impact the auditor’s independence. The six threats that worst affect the auditor’s independency are as follows:
- Self-Interest Threats: As per this audit threat external auditor is financial dependent on the client or where someone closely related to auditor has some financial or other interest with the audit client. As an external auditor, it is critically thinking of every auditor to secure its re-appoint in the auditor firm that creates a sense of dependency on the management.
- Threat of familiarity: As the relationship of auditor and client become familiar due to long relation that make auditor involved in the process of management and make him advise on various matter that defines the management role (Gray and Manson, 2007).
- Self Review Threat: As an external auditor it is the responsibility of auditor to have a check on the previous year work as it will use to make financial report of current year. So external auditor either has to re-evaluate or challenge the previous auditor work in case if it is not performed previously by the same auditor.
- Threat of trust: It is nature of auditor that they become too trustworthy for management and directors that make them or allow them to perform proper testing of information provided by the management and other representation given by them.
- The intimidation threat: The auditor frequently faces pressure from the client and other parties that is the main reason of intimidation threat.
- The advocacy threat: It has been seen in many cases that auditors start taking active interest in defending and promoting the interest of client (Adelopo, 2016).
According to Dodo (2017), there have been fundamental changes in the role of the auditor influenced by the critical economic events such as corporate failures that occurred due to accounting scandals in Enron, Worldcom and Lehman Bros that are discussed as follows:
This accounting scandal has highlighted the importance of auditors to make unbiased audit decisions for protecting the trust and confidence of the external stakeholders of a business entity. This is because the accounting scandal have known to occur due to inability of auditor to act independently and making their judgments under pressure and other factors. The corporate scandals of Enron, a US based energy, commodities and services company that eventually leads to bankruptcy after attaining the dramatic heights of profitability. The company is known to have manipulated the financial statements and thus presenting a false view of its financial position to the end-users (Dodo, 2017).
As per the views of Abodia (2018), the scandal have highlighted the role of accountants in developing and disclosing the financial statements to depict the true and fair view of the company. The auditor of Enron, Arthur Andersen, was held responsible for presenting a false view of the company financial position. The auditors properly shredded many documents of the company and was proved to be guilty of intentionally reflecting the manipulated financial information to the end-users. It has been claimed that Enron has maintained a long-term relation with its auditors for about 10 years and some of the partners of Andersen has been hired by the company as financial officers. Thus, it may have contributed to influence the independence view of the auditors in relation to Enron financial statements and thus hiding materialistic facts about its financial position from the investors (Abodia, 2018).
Threats to Auditor Independence
Alabede (2012) have stated that the corporate scandal of Worldcom, one of the largest telecommunication company across the world, that went bankrupt in the year 2008 for representing false financial information by disclosing the inflated value of assets by about $11 billion. Andersen was the auditor of the Worldcom too and has come under scrutiny for hiding the information in relation to accounting irregularities within the financial statements of the company. However, Andersen has claimed that the company has concealed significant materialistic information such as line-costs transfer and neither did consult with the auditors about the accounting treatment and policies adopted. The role of auditor in protecting the trust and faith of the stakeholders so that they cannot get deceived by the false financial information has also been highlighted by this corporate scandal (Alabede, 2012).
In addition to this, Norris (2011) stated that the corporate failure of Lehman Brothers, a global services firm, has also highlighted the importance of auditing profession in protecting the interests of the investors. The scandal has also known to believe to occurred due to failure of its auditors Ernst &Young to present true and fair view of the financial position of the company. The auditor of the company is accused to hide its financial problems and communicating the pertinent financial issues to the audit committee of the Board of Director’s. It has been identified that the company has adopted the use of Repo 105 for making its financial results better. It has been claimed that the auditors were aware of its use and thus have not fulfilled its responsibility and adopted the use of fraudulent behavior towards the stakeholders (Norris, 2011).
As per the information from Public Company Accounting Oversight Board (2017), the occurrence of these corporate scandals has highlighted the significance of auditors to carry out their responsibility independently and fairly to protect the interest of the investors. As such, the audit rules and regulations have been amended and the Public Company Accounting Oversight Board (PCAOB) have been established for inspecting the deficiencies in the work of the auditors. PCAOB have been established that large public accounting companies need to audit their financial reports on an annual basis and smaller firms need to audit it at least once in every three years. The scandals have also emphasized on the need for adopting the rotation of auditor for ensuring that they provide their independent view about a company’s financial position. The European Union have called the need for listed companies to change their auditors in every tend years. The auditors are directed to report the company specific issues as Part I findings and the company wide related issues under Part 2 Findings. The auditors are held responsible for ensuring that firms have adopted adequate internal controls for reporting financial truncations and are stated to provide their opinion free from nay pressure with reasonable assurance and free from any error (Public Company Accounting Oversight Board, 2017).
Lessons from Enron, Worldcom, and Lehman Bros
It can be stated from analysis of the causes of corporate failures of these big firms that the most important role of the accounting professionals in present contemporary world is to develop and disclose quality financial information to investors, creditors, lenders and other end-users. In this context, the role of auditors can be regarded as extremely important for companies in preventing the occurrence of fraud by reviewing effectively the internal controls and other accounting irregularities in the financial reporting of businesses. The role of auditors is extremely important for independent examination of the financial statements to increase the value and credibility of financial information. The audit of the company is essential for increasing the confidence of the users and thereby reducing their investment risk and maximizing the value developed for stakeholders (Scandals and regulation lead to an auditing merry-go-round, 2015).
Conclusion
It can be stated from the overall discussion held in the report that auditor’s independency is critically dependent upon the threat and risks that are integral in the auditing process. Thus, it is recommended to the auditors to perform substantial audit so that material misstatement can be avoided. The occurrence of corporate scandals has emphasized on the need for developing relevant auditing standards for ensuring that they provide their view in an independent and fair manner. It is the key responsibility of auditors to protect the interest of investors by providing them an honest and assured view of the financial position of a company.
References
Abodia, D. (2018). Audit Regulations Meant to Curb Accounting Scandals Are Working, Mostly. Retrieved 4 September, 2017, from edu/article/audit-regulations-meant-to-curb-accounting-scandals-are-working-mostly”>https://insight.kellogg.northwestern.edu/article/audit-regulations-meant-to-curb-accounting-scandals-are-working-mostly
Adelopo, I. (2016). Auditor Independence: Auditing, Corporate Governance and Market Confidence. Routledge.
Alabede, J. (2012). The Role, Compromise and Problems of the External Auditor in Corporate Governance. Research Journal of Finance and Accounting 3(9), pp. 114-126.
Austin, E. & Herath, S.K. (2014). Auditor independence: a review of literature. International journal Economics and Accounting 5(1), pp. 1-14.
Dodo, A. (2017). Corporate Collapse and the Role of Audit Committees: A Case Study of Lehman Brothers. World Journal of Social Sciences 7(1), pp. 19-29.
Fearnley, S., Beattie, V. & Brandt, R. (2005). Auditor independence and audit risk: a reconceptualisation. Journal of International Accounting Research 4(1):pp. 39-71.
Gray, I. and Manson, S. (2007). The Audit Process: Principles, Practice and Cases. Cengage Learning EMEA.
Norris, F. (2011). Lehman Case Hints at Need to Stiffen Audit Rules. Retrieved 4 September, 2017, from com/2011/07/29/business/in-lehman-case-a-hint-that-audit-rules-are-lacking-floyd-norris.html”>https://www.nytimes.com/2011/07/29/business/in-lehman-case-a-hint-that-audit-rules-are-lacking-floyd-norris.html
Public Company Accounting Oversight Board. (2017). Retrieved September 4, 2017, from https://pcaobus.org/Standards/Auditing/Documents/PCAOB_Auditing_Standards_as_of_December_15_2017.pdf
Scandals and regulation lead to an auditing merry-go-round. (2015.) Retrieved 4 September, 2017, from com/scandals-and-regulation-lead-to-an-auditing-merry-go-round-41904“>https://theconversation.com/scandals-and-regulation-lead-to-an-auditing-merry-go-round-41904
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