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The Various Threats to Auditor Independence

There are a number of threats to auditor independence. In my discussion of these


threats I make reference not only to several professional and regulatory
pronouncements, but also more broadly to points raised by various commentators
and academics. It should also be noted that different professional and regulatory
organizations have a somewhat different view of the potency of such threats. This is
the case because different countries have different legal and commercial systems
that are embedded in broader cultural and societal contexts. As a matter of
convenience, however, I will refer mainly to the ethical framework adopted recently
by the United Kingdoms Auditing Practices Board (APB). The threats listed below
and discussed in the following sections may, thus, not be exhaustive.
The Appointment and Termination Processes
Although the external auditor is employed for the benefit of shareholders, the
appointment and dismissal processes are quite removed from shareholders.
Management is responsible for suggesting the external auditor and rarely offers a
choice to shareholders. As a rotation of audit firms is relatively infrequenta
periodic rotation is currently not required by law in most countriesthe typical
scenario is that the renewal of the incumbent auditors term is brought to the
annual general meeting (AGM) for approval by shareholders. In practice there is
little that shareholders can do except vote against a nomination or renewal. In other
words, the nomination and appointment mechanism does not allow for competing
proposals to be brought directly before shareholders. The result is that the
incumbent auditor is at the mercy of the clients managers as to the renewal
process. Moreover, there are no direct channels between auditors and shareholders
through which competing auditors can make a case for appointment. Thus, the
special auditorclient relationship is off to a problematic start: the nominated
auditor owes it to the clients managers and is under threat of dismissal by
managers.
Occasionally auditors are rotated, on a voluntary basis. Academic evidence
suggests that many voluntary rotations take place because the incumbent auditor is
too independent for managers taste (see, for example, DeFond and Subramanyam,
1998; and Lennox, 2000). The new auditor is likely selected by the clients
management in an opportunistic fashion in that the new auditor is more likely to
accommodate clients wishes than the incumbent auditor. Since managers have
almost exclusive control of this process, shareholders seem unable to influence the
decision in a way that would ensure auditor independence. The result can be the
nomination of a new and less-independent auditor.

Self-Interest
The presence of financial interest of the auditor in the audited firm can impair
objectiveness, and hence independence. Consider an auditor who is also a
shareholder. The (independent) auditors duty is to ensure that financial
performance is accurately reported, even if this implies reporting poor performance.
However, as a shareholder, the auditor may prefer that bad news is withheld, at
least until the auditor-shareholder can sell his/her position. Similar arguments hold
for an auditor-lender (for example, through the holding of corporate bonds).
As a second example of a self-interest threat to independence, consider the case
where the external auditor carries out some non-audit work for the client. This is
quite a common situation. The auditor therefore may need to scrutinize and
evaluate the non-audit work carried out by colleagues in the audit firm. Many
auditors may be quite reluctant to confront their colleagues and would have the
self-interest to minimize any exposure that could risk his audit firms reputation.
Familiarity and Complacency
Familiarity can blunt the skepticism that is expected of the auditor. This may be
because the auditor develops a degree of overconfidence in his or her knowledge of
the client firm. It may be that the repetitive nature of a long-term engagement
between the auditor and his/her client leads to complacency and, consequently, to
the underweighting of warning signs. Some commentators speak of the need for
fresh eyes and mind that lead to a better scrutiny of the client.
Yet familiarity also has a positive aspect as it implies a better understanding of the
client and helps the auditor to perform better. Research on auditor tenure suggests
that, as the auditclient relationship lengthens, audit quality improves.
Social Bonding
Long-term audit engagements bring the external auditor and members of the client
firms management team closely together. It is not unusual for friendships to form in
the workplace. Moreover, to the extent that a clients managers nominate auditors
from their own circle of friends, the likelihood of objectivity on the part of the
auditor decreases. This self-serving bias is grounded in psychology theory and
arises when, as a consequence of close relationships, one cannot separate ones
own interests from those of others.
It is not entirely clear, however, how powerful this threat is. Auditors need to follow
certain professional and ethical norms, and they are bound by social norms.
Moreover, concerns about reputation may be quite powerful and sufficient to rein in
such a threat, even if only at the subconscious level.

The Economic Bond


Auditors livelihoods depend on the fees they generate from audit and non-audit
services. Auditors thus have an inherent incentive to keep the clientthat is, the
audited firms managershappy. Failure to do so can cost them the client and the
loss of a long stream of future income. This economic bond is regarded by many as
perhaps the greatest threat to auditor independence.
Non-audit services have attracted the harshest criticism. These include consulting
services such as corporate finance advisory, investment advisory or management,
valuation services, and IT consulting and implementation services. Typically, fees for
non-audit services represent a very lucrative source of income. Some commentators
have raised concern that in order to be awarded non-audit service contracts,
auditors may compromise their audit work.
Even in the absence of non-audit services, the fundamental problem remains. While
in the past audit work was relatively limited in scope, following SOX external
auditors now need to audit internal control systems. As a result, there has been a
sharp increase in audit fees. At the same time, SOX and similar regulations in many
other countries have restricted the ability of external auditors to provide non-audit
services.
These facts are also reflected in the data. Table 1 shows that average total fees
(audit and non-audit) have increased steadily since 2003, when many of the SOX
requirements came into effect. Moreover, while non-audit fees have declined
sharply, audit fees have significantly increased. Importantly, these trends appear for
both large and small auditors. Hence, an economic bond can still arise in the postSOX era, though more so with respect to audit fees.
Management and Employment
The auditor and the audited firm must be different entities, as an effective and
objective audit clearly requires such a separation. For this reason, US regulation
explicitly prohibits the provision of non-audit services that involve activities which
otherwise should be performed by the clients management and personnel (i.e.
management roles).
Matters become somewhat more complex when a previous auditor is hired by the
client firm to perform a management role. One concern is that the members of the
audit team will be reluctant to criticize a former colleague, perhaps because of
social bonding. A second concern is that the ex-auditor, having acquired knowledge
of the audit process and its weaknesses, may be able to take advantage and
game the new auditor to the benefit of the client (and now the new employer). In
the United States, therefore, there is a requirement of a one-year cooling-off period.

In the United Kingdom, APB Ethical Standard 2 requires a two-year cooling-off


period.
Self-review threat
These occur when the auditor has also prepared some of the accounting for the
fund.
Ghandar says the vast majority of independence breaches are related to self-review
threats. In large firms, this threat can be addressed by separating the accounting
and auditing work between two distinct teams or partners that operate
independently
of
each
other.
However, Ghandar says it is very difficult for such distinctions to be made in a small
firm because of the close relationship between staff and partners. Importantly, he
says it is impossible for a sole practitioner to achieve independence.
Self-interest threat
This threat emerges when, for example, an auditor has only one client or one client
represents a significant proportion of their business.
"Their independence is threatened because they'll be less likely to want to issue a
qualified audit opinion or something that will cause an issue for the client because
they're worried about losing the client," says Ghandar.
Multiple referrals threat
This arises when an auditor receives a large number of referrals from the one client,
which can also be characterised as a self-interest threat.
"Issuing a qualified report could impact on that referral relationship and in turn
impact on their business."
Ex-staff and partners threat
This happens when a staff member or partner leaves to start their own business and
performs audits for their former employer. "Just having those roles accounting and
audit in separate practices doesn't necessarily mean it's independent, notes
Ghandar. You still have to look at all the other aspects of independence,
particularly including the familiarity between the people in the accounting firm and
the audit firm."
Advising threat
This threat occurs when an SMSF auditor also provides financial advice for the
client. "Our position is that it's very difficult to have an independent audit if the firm
is also providing financial advice, so we recommend to stay well clear of that."
Relationships threat

Relationship threats are broad and generally cover anything that involves the
auditor knowing the SMSF trustees, members, or accountant on a personal level. "If
you have a close family or business relationship with a trustee or member of the
SMSF, you can't achieve independence in auditing that SMSF," says Ghandar. Due to
the family nature of SMSFs, it is an issue the ATO pays particularly close attention
to.
How to deal with threats
If any of these threats occur, it doesn't necessarily mean an auditor can't complete
the audit. Rather, safeguards must be put in place to eliminate the threat and these
safeguards must be documented in the audit report. When doing so, it is important
to note that a single circumstance may give rise to more than one threat and each
threat must be addressed.
"One of the issues we come across a lot is that people have considered
independence and they probably could achieve independence according to the
code, but they just haven't documented their thought process around it," says
Ghandar.

Ghandar adds that auditors should use the framework provided in the APES 110
Code of Ethics for Professional Accountants as a template for documenting
independence threats. That is:
1. Identify the threat
2. Evaluate the significance of that threat
3. Consider safeguards you can put in place to address the threat.
Safeguards
Auditors can use safeguards to eliminate threats. In the case of a multiple referrals
threat, for example, Ghandar says the auditor can have an external reviewer look at
certain files within the SMSF.
An external review may also make it possible for ex-staff and partners to safely
work with former employees.
"It can be a real positive because they will know the business and have a good
working relationship, but it is also making sure that independence has been fully
considered and that the appropriate safeguards are in place," says Ghandar.
However, as each situation is unique, the code says auditors must use their
professional judgement to determine if the safeguard is appropriate.
In some cases, the nature of the threat may be so significant that even a safeguard

may be called into question by regulators.


"If after you've determined the significance of the threat and come up with the
safeguards, if the answer is that you really can't achieve independence with the
safeguards, you're not comfortable, then you would need to decline or resign from
the engagement," says Ghandar.

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