Auditor independence
Encyclopedia
Auditor independence refers to the independence
of the internal auditor or of the external auditor from parties that may have a financial interest in the business being audited.
Independence requires integrity
and an objective approach
to the audit process. The concept requires the auditor to carry out his or her work freely and in an objective manner.
Independence of the internal auditor means independence from parties whose interests might be harmed by the results of an audit. Specific internal management issues are inadequate risk management
, inadequate internal control
s, and poor governance
. The Charter of Audit and the reporting to an Audit Committee
generally provides independence from management
, the code of ethics of the company (and of the Internal Audit profession) helps give guidance on independence form suppliers, clients, third parties...
Independence of the external auditor means independence from parties that have an interest in the results published in financial statements
of an entity. The support from and relation to the Audit Committee
of the client company, the contract and the contractual reference to public accounting standards/codes generally provides independence from management
, the code of ethics of the Public Accountant profession) helps give guidance on independence form suppliers, clients, third parties...
Internal and external concerns are convoluted when nominally independent divisions of a firm provide auditing and consulting services . The Sarbanes-Oxley Act
of 2002 is a legal reaction to such problems.
This article mostly deals with the independence
of the statutory auditor
(commonly called external auditor). For the independence of the Internal Audit, see Chief audit executive
, articles "Independent attitude" and "organisational independence", or organizational independence analysed by the IIA.
The purpose of an audit is to enhance the credibility of financial statements
by providing written reasonable assurance from an independent source that they present a true and fair view in accordance with an accounting standard. This objective will not be met if users of the audit report believe that the auditor may have been influenced by other parties, more specifically company managers/directors
or by conflicting interests (e.g. if the auditor owns shares in the company to be audited). In addition to technical competence, auditor independence is the most important factor in establishing the credibility of the audit opinion.
Auditor independence is commonly referred to as the cornerstone of the auditing profession since it is the foundation of the public’s trust in the accounting profession. Since 2000, a wave of high profile accounting scandals
have cast the profession into the limelight, negatively affecting the public perception of auditor independence.
Programming independence essentially protects the auditor’s ability to select the most appropriate strategy when conducting an audit. Auditors must be free to approach a piece of work in whatever manner they consider best. As a client company grows and conducts new activities, the auditor’s approach will likely have to adapt to account for these. In addition, the auditing profession is a dynamic one, with new techniques constantly being developed and upgraded which the auditor may decide to use. The strategy/proposed methods which the auditors intends to implement cannot be inhibited in any way.
While programming independence protects auditors’ ability to select appropriate strategies, investigative independence protects the auditor’s ability to implement the strategies in whatever manner they consider necessary. Basically, auditors must have unlimited access to all company information. Any queries regarding a company’s business and accounting treatment must be answered by the company. The collection of audit evidence is an essential process, and cannot be restricted in any way by the client company.
Reporting independence protects the auditors’ ability to choose to reveal to the public any information they believe should be disclosed. If company directors have been misleading shareholders by falsifying accounting information, they will strive to prevent the auditors from reporting this. It is in situations like this when auditor independence is most likely to be compromised.
an auditor is in, and how the auditor acts in/deals with a specific situation. An auditor who is independent 'in fact' has the ability to make independent decisions even if there is a perceived lack of independence present, or if the auditor is placed in a compromising position by company directors. Many difficulties lie in determining whether an auditor is truly independent, since it is impossible to observe and measure a person’s mental attitude and personal integrity. Similarly, an auditor’s objectivity must be beyond question, but how can this be guaranteed and measured? This is why perceived independence is of such importance.
It is essential that the auditor not only acts independently, but appears independent too. If an auditor is in fact independent, but one or more factors suggest otherwise, this could potentially lead to the public concluding that the audit report does not represent a true and fair view. Independence in appearances also reduces the opportunity for an auditor to act otherwise than independently, which subsequently adds credibility to the audit report.
leaving them with the power in the relationship. There in lies the dilemma, how can the audit team please the directors without losing any of their independence but keep the directors happy to ensure repeat business?
The problems regarding independence stem from two main sources the auditors’ relationship with the company and the nature of the accountancy profession.
In most cases it is the directors that negotiate an audit contract with the auditors. This may cause problems. Audit firms on occasions quote low prices to directors to ensure repeat business, or to get new clients. By doing so the firm may not be able to perform the audit fully as they do not have enough income to pay for a thorough investigation. Cutting corners could mean the audit team would be reporting without all the evidence required which will affect the quality of the report. This would bring into question their independence.
Under what conditions an auditor is dependent on the client is an open question.
It is common for the audit firm of a company to provide extra services as well as performing the audit. Helping a company reduce its tax charges or acting as a consultant for the implementation of a new computer system, are common examples. Having this additional working relationship with the client would result in questions being asked of the independence of the audit firm. If non-audit fees are substantial in retaliation to audit fees suspicions will arise that auditing standards may be compromised. The firm would no longer be unbiased, as it would want the company to perform well so it can continue to earn the addition fee for their consultancy. This would mean the audit firm would be dependent on the directors and they would no longer be working with independence.
The increased competition between the larger firms means that company image is very important. No audit firm wants to have to explain to the press the loss of a big client. This gives the directors of the large company a commanding position over its audit firm and they may look to take advantage of it. The audit team would feel pressured to satisfy the needs of the directors and in doing so would lose their independence.
and the Companies Act 1989 although the matter is also covered by the professional accounting bodies’ rules of professional conduct and the Auditing Practices Board
. It is also of note that regulations (i.e. International Accounting Standards or International Financial Reporting Standards
) relating to the preparation of financial statements are also relevant.
The Companies Act 1985
dictates that it is the responsibility of shareholders (rather than directors) to appoint the auditor at the annual general meeting
(AGM) – section 384 of the act refers. The theory behind this is that directors cannot intimidate auditors with the threat of replacement or bribe them by offering reappointment. In practice the existing auditors of a company are generally reappointed for another term at the AGM but the shareholders are free to choose another auditor if they wish to. Directors can only appoint auditors in exceptional circumstances (perhaps to fill a casual vacancy
during the year). However, such appointments by directors will expire at AGMs. The Companies Act 1985 (section 386) allows shareholders to eliminate the need to reappoint an auditor each year. If they elect to do so then it is automatically assumed that the existing auditor will be reappointed each year without the matter arising at the AGM. In such circumstances it would take an extraordinary general meeting
(EGM) in order to remove the auditor.
The Companies Act 1989 (part II) goes further to protect the independence of the auditor in various ways. One of the key ways is that auditors must belong to a recognised supervisory body (RSB) before they can undertake such work. Within the United Kingdom ICAEW, ICAS
, ICAI
and ACCA
have been granted this status. Schedules 11 and 12 of the Companies Act 1989 specify the duties of the RSBs and the strict entry requirements for their members that they must impose. It is intended to ensure that all auditors have the required knowledge and skills in order to carry out their role to an acceptable standard.
Section 33 of the Companies Act 1989 allows for professional accountants who have gained their qualification in another country to practice within the United Kingdom although it is necessary for such persons to undertake extra education in British law and accounting practices. In the past this would tend be exploited by members of the Commonwealth
but due to there being an EU directive
on mutual recognition of professional qualifications it is now possible for professional accountants within Europe to come and work in the United Kingdom. The safeguards put in place by section 33 (that any foreign professional accountants must have an adequate knowledge of British law and accounting practices) should protect the quality of audits.
The Companies Act 1989 also has provisions to prevent employees of firms from becoming auditors of their own companies and subsequently either any subsidiary
of their employers or parent companies (section 27 refers). This is intended to prevent the appointment of an auditor with vested interest
s in a company.
It is also a requirement that any person barred from acting as an auditor should refuse any such offers of appointment and resign immediately if for whatever reason they become ineligible during their appointment. If for whatever reason an ineligible person carries out an audit then the Secretary of State (under section 29 of the Companies Act 1989) has the power to require a company to appoint a second auditor and bear the brunt of the cost as a result. However, companies are allowed to recover additional fees from the original ineligible auditor.
Further to regulations regarding the appointment of auditors the various Companies Acts also contain rules regarding the rights of auditors. The most fundamental of these regulations is section 389A of the Companies Act 1985. This section states that auditors have a right of access at all times to accounting related information from companies and further have the right to demand explanations from companies regarding any accounting related enquiry they may have. Section 389A also covers other matters such as making it illegal for employees of a company to make misleading, false or deceptive statements to auditors regarding any accounting related queries they may have. Subsidiaries of British companies also must provide any accounting related information to the auditor of the parent company
should they request it although in general it is usually the same auditor who undertakes the audit of both the parent company and its subsidiaries. Section 389A finally goes on to state that companies must take all reasonable steps to obtain accounting related information for auditors from any overseas subsidiaries it may have. Auditors also have the right to communicate directly with shareholders as dictated in section 390 in the Companies Act 1985.
Whilst this legislation prevents directors of companies from limiting the information available to auditors it does not prevent directors from setting tight deadlines for auditors where it may prove difficult to obtain all the necessary information they feel they require for audit. Directors could also attempt to negotiate a fee that would not be enough to cover the costs of a proper audit thereby forcing the auditor to perhaps undercut corners in order to reduce costs. Shareholders are not likely to be sympathetic to auditors in such circumstances either as they may be likely to see auditors as unnecessarily overcharging for their service.
Because directors can impose tight deadlines, negotiate low audit fees or perhaps threaten to nominate another auditor to shareholders it could be argued that auditors are not truly independent within the United Kingdom. Whilst there may be some truth to this it would not be fair to say the rules are entirely ineffective as auditors have to consider that if they fail to carry out an audit effectively they will face stiff penalties, they could potentially have to compensate any damages as a result of their failure, they could potentially lose a lot of business and ultimately their credibility would be shattered. Therefore in reality it is thought that British auditors are only influenced in minor ways and normally over matters of opinion given that an auditor would put retaining its business before the loss of one single client.
arising from audit companies having a high percentage of total revenue staked in the contract of one client. To date this has not been made a requirement. Both auditors and their clients have argued that the knowledge acquired during the audit process can allow other services to be provided less expensively.
alism and independence at all times. Such a system has not been accepted by UK auditors; however, it is expected that many large firms already have peer reviews in place which are conducted by audit teams from offices in other parts of the country.
was first made in the Cadbury Report
(1992). A group of three to five non-executive directors from within the company are chosen to provide what is supposed to be a truly objective view on all aspects of the audit: from evaluation of internal control systems to recommendations on audit fee. Since the Cadbury Report
, this practice has been implemented yet many still remain unconvinced of the neutrality of non-executive directors.
However, proposals for a maximum client servicing period of five years have since been dismissed after lobbying by accounting firms and their clients, again stressing that it is vitally important that auditors familiarise themselves with client operations in order to conduct a successful audit.
The International Federation of Accountants
requires partner rotation but not rotation of firms. The IFAC states in its International Standard on Quality Control (ISQC1 of 15/12/09) that "The IESBA Code (International Ethics Standards Board for Accountants
) recognizes that the familiarity threat is particularly relevant in the context of financial statement audits of listed entities. For these audits, the IESBA Code requires the rotation of the key audit partner after a pre-defined period, normally no more than seven years, and provides related standards and guidance. National requirements may establish shorter rotation periods"
In the area of Government Auditing, in its ISSAI 1000 standard (art.66) the INTOSAI also recommends partner rotation: "ISQC 1 requires engagement partner rotation for listed entities after a predefined period. In the public sector, this requirement may be applied to significant public interest entities. However, legislation establishing the appointments and terms of office of the Auditor General may make rotation impractical. Supreme Audit Institutions may establish policies and procedures to promote compliance with the spirit of this requirement".
In the USA, audit partner rotation is recommended in Title II Section 201 (Auditor Independence) of the Sarbanes–Oxley Act.
The European Commission
has issued on 16/5/02 a recommendation: "Statutory Auditor
s’ Independence in the EU, A Set of Fundamental Principles". The recommendation only requires partner rotation on listed clients after seven years. It differs in some respects from most national/international requirements, namely:• it allows a return after two years • it applies to ‘public interest clients’, not just listed clients • in a group context, extends to key audit partners other than the audit engagement partner. No countries within the EU, with the exception of Italy, currently have a system of mandatory audit firm rotation.
In the United Kingdom
, the Auditing Practices Board
(FRC) has issued a revised Ethical Standard 3: Long Association with the Audit Engagement (applies on 15 December 2009). It can be summarised as follows: Audit engagement partner - maximum rotation period remains at five years, with a minimum of five years not involved in the audit afterwards. However, flexibility of up to an additional two years is permitted.
, rather than legislation. They feel a set of agreed definitions on matters which are not encompassed by formal standards would benefit the auditor and, ultimately, remove any doubts over real and apparent independence.
Independence
Independence is a condition of a nation, country, or state in which its residents and population, or some portion thereof, exercise self-government, and usually sovereignty, over its territory....
of the internal auditor or of the external auditor from parties that may have a financial interest in the business being audited.
Independence requires integrity
Integrity
Integrity is a concept of consistency of actions, values, methods, measures, principles, expectations, and outcomes. In ethics, integrity is regarded as the honesty and truthfulness or accuracy of one's actions...
and an objective approach
Objective approach
Taking an objective approach to an issue means having due regard for the known valid evidence pertaining to that issue. If relevant valid evidence is denied or falsified, an objective approach is impossible...
to the audit process. The concept requires the auditor to carry out his or her work freely and in an objective manner.
Independence of the internal auditor means independence from parties whose interests might be harmed by the results of an audit. Specific internal management issues are inadequate risk management
Risk management
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
, inadequate internal control
Internal control
In accounting and auditing, internal control is defined as a process effected by an organization's structure, work and authority flows, people and management information systems, designed to help the organization accomplish specific goals or objectives. It is a means by which an organization's...
s, and poor governance
Governance
Governance is the act of governing. It relates to decisions that define expectations, grant power, or verify performance. It consists of either a separate process or part of management or leadership processes...
. The Charter of Audit and the reporting to an Audit Committee
Audit committee
In a U.S. publicly-traded company, an audit committee is an operating committee of the Board of Directors charged with oversight of financial reporting and disclosure. Committee members are drawn from members of the company's board of directors, with a Chairperson selected from among the committee...
generally provides independence from management
Management
Management in all business and organizational activities is the act of getting people together to accomplish desired goals and objectives using available resources efficiently and effectively...
, the code of ethics of the company (and of the Internal Audit profession) helps give guidance on independence form suppliers, clients, third parties...
Independence of the external auditor means independence from parties that have an interest in the results published in financial statements
Financial statements
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
of an entity. The support from and relation to the Audit Committee
Audit committee
In a U.S. publicly-traded company, an audit committee is an operating committee of the Board of Directors charged with oversight of financial reporting and disclosure. Committee members are drawn from members of the company's board of directors, with a Chairperson selected from among the committee...
of the client company, the contract and the contractual reference to public accounting standards/codes generally provides independence from management
Management
Management in all business and organizational activities is the act of getting people together to accomplish desired goals and objectives using available resources efficiently and effectively...
, the code of ethics of the Public Accountant profession) helps give guidance on independence form suppliers, clients, third parties...
Internal and external concerns are convoluted when nominally independent divisions of a firm provide auditing and consulting services . The Sarbanes-Oxley Act
Sarbanes-Oxley Act
The Sarbanes–Oxley Act of 2002 , also known as the 'Public Company Accounting Reform and Investor Protection Act' and 'Corporate and Auditing Accountability and Responsibility Act' and commonly called Sarbanes–Oxley, Sarbox or SOX, is a United States federal law enacted on July 30, 2002, which...
of 2002 is a legal reaction to such problems.
This article mostly deals with the independence
Independence
Independence is a condition of a nation, country, or state in which its residents and population, or some portion thereof, exercise self-government, and usually sovereignty, over its territory....
of the statutory auditor
Statutory auditor
A is an official found in Japanese kabushiki kaisha .Statutory auditors are elected by shareholders and hold a position in the hierarchy alongside the board of directors. A kabushiki kaisha must have at least one statutory auditor, unless the transfer of shares is restricted in the articles of...
(commonly called external auditor). For the independence of the Internal Audit, see Chief audit executive
Chief Audit Executive
The Chief Audit Executive , Director of Audit, Director of Internal Audit, Auditor General, or Controller General is a high level independent corporate executive with overall responsibility for the Internal audit....
, articles "Independent attitude" and "organisational independence", or organizational independence analysed by the IIA.
The purpose of an audit is to enhance the credibility of financial statements
Financial statements
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
by providing written reasonable assurance from an independent source that they present a true and fair view in accordance with an accounting standard. This objective will not be met if users of the audit report believe that the auditor may have been influenced by other parties, more specifically company managers/directors
Executive director
Executive director is a term sometimes applied to the chief executive officer or managing director of an organization, company, or corporation. It is widely used in North American non-profit organizations, though in recent decades many U.S. nonprofits have adopted the title "President/CEO"...
or by conflicting interests (e.g. if the auditor owns shares in the company to be audited). In addition to technical competence, auditor independence is the most important factor in establishing the credibility of the audit opinion.
Auditor independence is commonly referred to as the cornerstone of the auditing profession since it is the foundation of the public’s trust in the accounting profession. Since 2000, a wave of high profile accounting scandals
Accounting scandals
Accounting scandals, or corporate accounting scandals, are political and business scandals which arise with the disclosure of misdeeds by trusted executives of large public corporations...
have cast the profession into the limelight, negatively affecting the public perception of auditor independence.
Types of independence
There are three main ways in which the auditor’s independence can manifest itself. and- Programming independence
- Investigative independence
- Reporting independence
Programming independence essentially protects the auditor’s ability to select the most appropriate strategy when conducting an audit. Auditors must be free to approach a piece of work in whatever manner they consider best. As a client company grows and conducts new activities, the auditor’s approach will likely have to adapt to account for these. In addition, the auditing profession is a dynamic one, with new techniques constantly being developed and upgraded which the auditor may decide to use. The strategy/proposed methods which the auditors intends to implement cannot be inhibited in any way.
While programming independence protects auditors’ ability to select appropriate strategies, investigative independence protects the auditor’s ability to implement the strategies in whatever manner they consider necessary. Basically, auditors must have unlimited access to all company information. Any queries regarding a company’s business and accounting treatment must be answered by the company. The collection of audit evidence is an essential process, and cannot be restricted in any way by the client company.
Reporting independence protects the auditors’ ability to choose to reveal to the public any information they believe should be disclosed. If company directors have been misleading shareholders by falsifying accounting information, they will strive to prevent the auditors from reporting this. It is in situations like this when auditor independence is most likely to be compromised.
Real independence and perceived independence
There are two important aspects to independence which must be distinguished from each other: independence in fact (real independence) and independence in appearance (perceived independence). Together, both forms are essential to achieve the goals of independence. Real independence refers to the actual independence of the auditor, also known as independence of mind. More specifically, real independence concerns the state of mindMental health
Mental health describes either a level of cognitive or emotional well-being or an absence of a mental disorder. From perspectives of the discipline of positive psychology or holism mental health may include an individual's ability to enjoy life and procure a balance between life activities and...
an auditor is in, and how the auditor acts in/deals with a specific situation. An auditor who is independent 'in fact' has the ability to make independent decisions even if there is a perceived lack of independence present, or if the auditor is placed in a compromising position by company directors. Many difficulties lie in determining whether an auditor is truly independent, since it is impossible to observe and measure a person’s mental attitude and personal integrity. Similarly, an auditor’s objectivity must be beyond question, but how can this be guaranteed and measured? This is why perceived independence is of such importance.
It is essential that the auditor not only acts independently, but appears independent too. If an auditor is in fact independent, but one or more factors suggest otherwise, this could potentially lead to the public concluding that the audit report does not represent a true and fair view. Independence in appearances also reduces the opportunity for an auditor to act otherwise than independently, which subsequently adds credibility to the audit report.
Restrictions on independence
When auditors of a company are in conflict with the directors it is important this conflict can be resolved without the auditors losing any of their independence. This can prove to be difficult as an auditor earns a fee from providing a service, which is how he earns a living. This fee is paid by the board of directorsBoard of directors
A board of directors is a body of elected or appointed members who jointly oversee the activities of a company or organization. Other names include board of governors, board of managers, board of regents, board of trustees, and board of visitors...
leaving them with the power in the relationship. There in lies the dilemma, how can the audit team please the directors without losing any of their independence but keep the directors happy to ensure repeat business?
The problems regarding independence stem from two main sources the auditors’ relationship with the company and the nature of the accountancy profession.
Relationship with the client
An auditor earns a living from the fee he is paid it is therefore automatic that he does not want to do anything to jeopardize this income. This reliance on clients’ fees may affect the independence of an auditor. If the auditor feels this client income is more important than their responsibilities to shareholders he may not perform the audit with the shareholder’s interests in mind. The larger the fee income the more likely the auditor is to shirk his responsibilities and perform the audit without independence. This could lead to the manipulation of figures and exploitation of accounting standards. By performing the audit without independence the shareholders’ may get misled, as the auditor is now reliant on the directors. To encourage auditors to maintain their independence they must be protected from the director’s board. If they were able to challenge statements and figures without the risk of losing their job they would be more likely to work with complete independence. Ultimately, as long as the client determines audit appointments and fees an auditor will never be able to have complete economic independence.In most cases it is the directors that negotiate an audit contract with the auditors. This may cause problems. Audit firms on occasions quote low prices to directors to ensure repeat business, or to get new clients. By doing so the firm may not be able to perform the audit fully as they do not have enough income to pay for a thorough investigation. Cutting corners could mean the audit team would be reporting without all the evidence required which will affect the quality of the report. This would bring into question their independence.
Under what conditions an auditor is dependent on the client is an open question.
It is common for the audit firm of a company to provide extra services as well as performing the audit. Helping a company reduce its tax charges or acting as a consultant for the implementation of a new computer system, are common examples. Having this additional working relationship with the client would result in questions being asked of the independence of the audit firm. If non-audit fees are substantial in retaliation to audit fees suspicions will arise that auditing standards may be compromised. The firm would no longer be unbiased, as it would want the company to perform well so it can continue to earn the addition fee for their consultancy. This would mean the audit firm would be dependent on the directors and they would no longer be working with independence.
The structure of the accountancy profession
Price competition is a major factor in auditor independence. Prior to the 1970s audit firms were not allowed to advertise their services and take part in bidding competitions for contracts. Competition between the accountancy firms greatly increased when these restrictions were abolished, putting pressure on the audit firms to reduce audit fees. Competitive bidding for contracts has also encouraged the reduction of auditor engagement hours. The pressure to reduce costs may compromise the quality of an audit. If a firm feels threatened by competition they may be tempted to further reduce costs to keep a client. This risks lowering the standard of the audit performed and therefore mislead shareholders.The increased competition between the larger firms means that company image is very important. No audit firm wants to have to explain to the press the loss of a big client. This gives the directors of the large company a commanding position over its audit firm and they may look to take advantage of it. The audit team would feel pressured to satisfy the needs of the directors and in doing so would lose their independence.
Independence regulations in the United Kingdom
Within the United Kingdom there are various regulations in force regarding auditor independence. The main enforcement of auditor independence is through the Companies Act 1985Companies Act 1985
The Companies Act 1985 is an Act of the Parliament of the United Kingdom of Great Britain and Northern Ireland, enacted in 1985, which enabled companies to be formed by registration, and set out the responsibilities of companies, their directors and secretaries.The Act was a consolidation of...
and the Companies Act 1989 although the matter is also covered by the professional accounting bodies’ rules of professional conduct and the Auditing Practices Board
Auditing Practices Board
The Auditing Practices Board Limited was originally established in 1991 as a committee of the Consultative Committee of Accountancy Bodies, to take responsibility within the United Kingdom and Republic of Ireland for setting standards of auditing with the objective of enhancing public confidence...
. It is also of note that regulations (i.e. International Accounting Standards or International Financial Reporting Standards
International Financial Reporting Standards
International Financial Reporting Standards are principles-based standards, interpretations and the framework adopted by the International Accounting Standards Board ....
) relating to the preparation of financial statements are also relevant.
The Companies Act 1985
Companies Act 1985
The Companies Act 1985 is an Act of the Parliament of the United Kingdom of Great Britain and Northern Ireland, enacted in 1985, which enabled companies to be formed by registration, and set out the responsibilities of companies, their directors and secretaries.The Act was a consolidation of...
dictates that it is the responsibility of shareholders (rather than directors) to appoint the auditor at the annual general meeting
Annual general meeting
An annual general meeting is a meeting that official bodies, and associations involving the public , are often required by law to hold...
(AGM) – section 384 of the act refers. The theory behind this is that directors cannot intimidate auditors with the threat of replacement or bribe them by offering reappointment. In practice the existing auditors of a company are generally reappointed for another term at the AGM but the shareholders are free to choose another auditor if they wish to. Directors can only appoint auditors in exceptional circumstances (perhaps to fill a casual vacancy
Casual vacancy
In the Parliament of Australia, a casual vacancy is caused when a member of either house :* dies* resigns mid-term * is expelled from Parliament and their seat is declared vacant, or...
during the year). However, such appointments by directors will expire at AGMs. The Companies Act 1985 (section 386) allows shareholders to eliminate the need to reappoint an auditor each year. If they elect to do so then it is automatically assumed that the existing auditor will be reappointed each year without the matter arising at the AGM. In such circumstances it would take an extraordinary general meeting
Extraordinary General Meeting
An extraordinary general meeting, commonly abbreviated as EGM, is a meeting of members of an organisation, shareholders of a company, or employees of an official body, which occurs at an irregular time. The term is usually used where the group would ordinarily hold an annual general meeting , but...
(EGM) in order to remove the auditor.
The Companies Act 1989 (part II) goes further to protect the independence of the auditor in various ways. One of the key ways is that auditors must belong to a recognised supervisory body (RSB) before they can undertake such work. Within the United Kingdom ICAEW, ICAS
Institute of Chartered Accountants of Scotland
The Institute of Chartered Accountants of Scotland is the Scottish professional body of Chartered Accountants . It is a regulator, educator and influencer.ICAS act as a thought leader and voice of the professional business community...
, ICAI
Institute of Chartered Accountants in Ireland
Members of the Institute use the designatory letters ACA. Senior members may be elected Fellows and use the designatory letters FCA....
and ACCA
Association of Chartered Certified Accountants
Founded in 1904, the Association of Chartered Certified Accountants is the global body for professional accountants offering the Chartered Certified Accountant qualification . it is one of the largest and fastest-growing global accountancy bodies with 147,000 members and 424,000 students in 170...
have been granted this status. Schedules 11 and 12 of the Companies Act 1989 specify the duties of the RSBs and the strict entry requirements for their members that they must impose. It is intended to ensure that all auditors have the required knowledge and skills in order to carry out their role to an acceptable standard.
Section 33 of the Companies Act 1989 allows for professional accountants who have gained their qualification in another country to practice within the United Kingdom although it is necessary for such persons to undertake extra education in British law and accounting practices. In the past this would tend be exploited by members of the Commonwealth
Commonwealth
Commonwealth is a traditional English term for a political community founded for the common good. Historically, it has sometimes been synonymous with "republic."More recently it has been used for fraternal associations of some sovereign nations...
but due to there being an EU directive
European Union directive
A directive is a legislative act of the European Union, which requires member states to achieve a particular result without dictating the means of achieving that result. It can be distinguished from regulations which are self-executing and do not require any implementing measures. Directives...
on mutual recognition of professional qualifications it is now possible for professional accountants within Europe to come and work in the United Kingdom. The safeguards put in place by section 33 (that any foreign professional accountants must have an adequate knowledge of British law and accounting practices) should protect the quality of audits.
The Companies Act 1989 also has provisions to prevent employees of firms from becoming auditors of their own companies and subsequently either any subsidiary
Subsidiary
A subsidiary company, subsidiary, or daughter company is a company that is completely or partly owned and wholly controlled by another company that owns more than half of the subsidiary's stock. The subsidiary can be a company, corporation, or limited liability company. In some cases it is a...
of their employers or parent companies (section 27 refers). This is intended to prevent the appointment of an auditor with vested interest
Vested interest
Vested interest is a communication theory that seeks to explain how influences impact behaviors. As defined by William Crano, vested interest refers to the amount that an attitude object is deemed hedonically relevant by the attitude holder...
s in a company.
It is also a requirement that any person barred from acting as an auditor should refuse any such offers of appointment and resign immediately if for whatever reason they become ineligible during their appointment. If for whatever reason an ineligible person carries out an audit then the Secretary of State (under section 29 of the Companies Act 1989) has the power to require a company to appoint a second auditor and bear the brunt of the cost as a result. However, companies are allowed to recover additional fees from the original ineligible auditor.
Further to regulations regarding the appointment of auditors the various Companies Acts also contain rules regarding the rights of auditors. The most fundamental of these regulations is section 389A of the Companies Act 1985. This section states that auditors have a right of access at all times to accounting related information from companies and further have the right to demand explanations from companies regarding any accounting related enquiry they may have. Section 389A also covers other matters such as making it illegal for employees of a company to make misleading, false or deceptive statements to auditors regarding any accounting related queries they may have. Subsidiaries of British companies also must provide any accounting related information to the auditor of the parent company
Parent company
A parent company is a company that owns enough voting stock in another firm to control management and operations by influencing or electing its board of directors; the second company being deemed as a subsidiary of the parent company...
should they request it although in general it is usually the same auditor who undertakes the audit of both the parent company and its subsidiaries. Section 389A finally goes on to state that companies must take all reasonable steps to obtain accounting related information for auditors from any overseas subsidiaries it may have. Auditors also have the right to communicate directly with shareholders as dictated in section 390 in the Companies Act 1985.
Whilst this legislation prevents directors of companies from limiting the information available to auditors it does not prevent directors from setting tight deadlines for auditors where it may prove difficult to obtain all the necessary information they feel they require for audit. Directors could also attempt to negotiate a fee that would not be enough to cover the costs of a proper audit thereby forcing the auditor to perhaps undercut corners in order to reduce costs. Shareholders are not likely to be sympathetic to auditors in such circumstances either as they may be likely to see auditors as unnecessarily overcharging for their service.
Because directors can impose tight deadlines, negotiate low audit fees or perhaps threaten to nominate another auditor to shareholders it could be argued that auditors are not truly independent within the United Kingdom. Whilst there may be some truth to this it would not be fair to say the rules are entirely ineffective as auditors have to consider that if they fail to carry out an audit effectively they will face stiff penalties, they could potentially have to compensate any damages as a result of their failure, they could potentially lose a lot of business and ultimately their credibility would be shattered. Therefore in reality it is thought that British auditors are only influenced in minor ways and normally over matters of opinion given that an auditor would put retaining its business before the loss of one single client.
Independence regulations in the United States
Issues of audit have been delegated by the U.S. Congress to the Securities and Exchange Commission (SEC). As part of the Sarbanes-Oxley act the SEC has issued Requirements Regarding Auditor Independence. Recently the SEC has followed up on cases where auditor independence is questionableService limitations
Many have advocated that in order for an auditor to remain strictly independent they should not be allowed to provide audit clients with any other advisory services. This idea was detailed in the EC’s Eighth Directive and was designed to remove conflicts of interestConflict of interest
A conflict of interest occurs when an individual or organization is involved in multiple interests, one of which could possibly corrupt the motivation for an act in the other....
arising from audit companies having a high percentage of total revenue staked in the contract of one client. To date this has not been made a requirement. Both auditors and their clients have argued that the knowledge acquired during the audit process can allow other services to be provided less expensively.
Peer assessment
A review of audit control procedures by another firm is a requirement in the US that must be satisfied once every three years. This has been implemented to ensure external audits are carried out with the utmost professionProfession
A profession is a vocation founded upon specialized educational training, the purpose of which is to supply disinterested counsel and service to others, for a direct and definite compensation, wholly apart from expectation of other business gain....
alism and independence at all times. Such a system has not been accepted by UK auditors; however, it is expected that many large firms already have peer reviews in place which are conducted by audit teams from offices in other parts of the country.
Audit committees
The recommendation for companies to form an audit committeeAudit committee
In a U.S. publicly-traded company, an audit committee is an operating committee of the Board of Directors charged with oversight of financial reporting and disclosure. Committee members are drawn from members of the company's board of directors, with a Chairperson selected from among the committee...
was first made in the Cadbury Report
Cadbury Report
The Cadbury Report, titled Financial Aspects of Corporate Governance, is a report of a committee chaired by Adrian Cadbury that sets out recommendations on the arrangement of company boards and accounting systems to mitigate corporate governance risks and failures. The report was published in 1992...
(1992). A group of three to five non-executive directors from within the company are chosen to provide what is supposed to be a truly objective view on all aspects of the audit: from evaluation of internal control systems to recommendations on audit fee. Since the Cadbury Report
Cadbury Report
The Cadbury Report, titled Financial Aspects of Corporate Governance, is a report of a committee chaired by Adrian Cadbury that sets out recommendations on the arrangement of company boards and accounting systems to mitigate corporate governance risks and failures. The report was published in 1992...
, this practice has been implemented yet many still remain unconvinced of the neutrality of non-executive directors.
Rotating external auditors
It is widely believed that a mandatory rotation of audit firm could improve auditor independence. Firstly, current auditors will have no incentive to work in cahoots with their client if the contract is due to expire in the foreseeable future. Similarly, auditors will be less likely to forge relationships with directors and staff, thus will be less concerned about upsetting them through an unfavourable audit report. And because current auditors will know they are soon to be replaced, they will be inclined to produce audit reports which demonstrate high standards and are an exemplar of true independence, and avoid having any shortcomings exposed by the new audit team.However, proposals for a maximum client servicing period of five years have since been dismissed after lobbying by accounting firms and their clients, again stressing that it is vitally important that auditors familiarise themselves with client operations in order to conduct a successful audit.
The International Federation of Accountants
International Federation of Accountants
International Federation of Accountants is the global organization for the accountancy profession. IFAC has 164 member and associates in 124 countries and jurisdictions, representing more than 2.5 million accountants employed in public practice, industry and commerce, government, and academe...
requires partner rotation but not rotation of firms. The IFAC states in its International Standard on Quality Control (ISQC1 of 15/12/09) that "The IESBA Code (International Ethics Standards Board for Accountants
International Ethics Standards Board for Accountants
The International Ethics Standards Board for Accountants develops and promotes ethical standards and guidance for professional accountants...
) recognizes that the familiarity threat is particularly relevant in the context of financial statement audits of listed entities. For these audits, the IESBA Code requires the rotation of the key audit partner after a pre-defined period, normally no more than seven years, and provides related standards and guidance. National requirements may establish shorter rotation periods"
In the area of Government Auditing, in its ISSAI 1000 standard (art.66) the INTOSAI also recommends partner rotation: "ISQC 1 requires engagement partner rotation for listed entities after a predefined period. In the public sector, this requirement may be applied to significant public interest entities. However, legislation establishing the appointments and terms of office of the Auditor General may make rotation impractical. Supreme Audit Institutions may establish policies and procedures to promote compliance with the spirit of this requirement".
In the USA, audit partner rotation is recommended in Title II Section 201 (Auditor Independence) of the Sarbanes–Oxley Act.
The European Commission
European Commission
The European Commission is the executive body of the European Union. The body is responsible for proposing legislation, implementing decisions, upholding the Union's treaties and the general day-to-day running of the Union....
has issued on 16/5/02 a recommendation: "Statutory Auditor
Statutory auditor
A is an official found in Japanese kabushiki kaisha .Statutory auditors are elected by shareholders and hold a position in the hierarchy alongside the board of directors. A kabushiki kaisha must have at least one statutory auditor, unless the transfer of shares is restricted in the articles of...
s’ Independence in the EU, A Set of Fundamental Principles". The recommendation only requires partner rotation on listed clients after seven years. It differs in some respects from most national/international requirements, namely:• it allows a return after two years • it applies to ‘public interest clients’, not just listed clients • in a group context, extends to key audit partners other than the audit engagement partner. No countries within the EU, with the exception of Italy, currently have a system of mandatory audit firm rotation.
In the United Kingdom
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
, the Auditing Practices Board
Auditing Practices Board
The Auditing Practices Board Limited was originally established in 1991 as a committee of the Consultative Committee of Accountancy Bodies, to take responsibility within the United Kingdom and Republic of Ireland for setting standards of auditing with the objective of enhancing public confidence...
(FRC) has issued a revised Ethical Standard 3: Long Association with the Audit Engagement (applies on 15 December 2009). It can be summarised as follows: Audit engagement partner - maximum rotation period remains at five years, with a minimum of five years not involved in the audit afterwards. However, flexibility of up to an additional two years is permitted.
Law, regulations and the conceptual framework of accounting
In the future, issues regarding conflicts of interest may be tackled through legislation which bans audit firms holding shares in client companies. Some financial commentators believe that it is the subjective nature of modern day accounting which is the main contributor to the ambiguity of auditor independence and suggest this could be clarified through the introduction of a conceptual frameworkConceptual framework
A conceptual framework is used in research to outline possible courses of action or to present a preferred approach to an idea or thought. For example, the philosopher Isaiah Berlin used the "hedgehogs" versus "foxes" approach; a "hedgehog" might approach the world in terms of a single organizing...
, rather than legislation. They feel a set of agreed definitions on matters which are not encompassed by formal standards would benefit the auditor and, ultimately, remove any doubts over real and apparent independence.
See also
- Kearney & CompanyKearney & CompanyKearney & Company is a CPA firm established in 1985. It is headquartered in Alexandria, Virginia. It exclusively serves the Federal Government of the United States...
- US Department of State Auditor which exclusively serves the Federal Government of the United States