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Auditor independence 3


Auditor Independence

Audit failure is a prevalent problem in today’s financial world. It is a situation whereby an audit is wrongly stated in a company’s account claiming they are correct when for a fact they are false. It is not until the failure is investigated that the financial statements can be deemed valid. The primary objective on an audit is to ensure credibility of financial statements according to the accounting standards. For an audit report to be considered objective and of integrity, most businesses being audited usually seek the services of an external auditor who is independent (Swanger & Chewning Jr 2001).

Auditor independence is usually a fundamental factor when it comes to the auditing profession as it is used as a principle that determines the reputation of the profession. (Craswell, Francis and Taylor 1995). This is because the public judge the auditors based on this principle. This essay intends to look into the Enron Corporation- Arthur Andersen case whereby the former collapsed due to bankruptcy, analyze the audit failures that Arthur Andersen committed in its audit work as well as critically discuss how auditor independence plays a role in audit failure where it will look into the situations that create a threat on auditor independence and how to remedy them as well as future developments with respect to auditor independence.

In October 2001, a scandal that proved to be too big of an ‘iceberg’ to sink a ‘wall street titanic’. The Enron scandal, as it is referred, led to the bankruptcy of an energy company called Enron Corporation. In addition, it led to the dissolution of Author Andersen, an audit firm which was Enron’s auditor. It was the biggest bankruptcy and audit failure problem of that time. Enron started crumbling down when Jeffrey Skilling, its Chief Executive Officer reorganized executives who used accounting loopholes, special projects and poor financial planning to hide the company’s debt in form of billions of dollars, all through failed projects and deals (Sherman 2002). The chief financial officer at the time was able to mislead directors and the audit committee on accounting practices which were of high risk. In addition, the auditors, Andersen were coerced to ignore the issues. It was later when the company’s market value declined as a result of share price fall from a $90.75 in the mid 2000s to less than $1 by the end of November 2001 when the shareholders decided to file for a lawsuit. (Thomas 2002) The oversight body tasked with ensuring best practices of the industry, the Securities and Exchange Commission, began an investigation and on December 2001, bankruptcy was filed by Enron.

Arthur Andersen, Enron’s auditor, was found guilty of illegally destroying documents which would be important especially in the SEC investigation. The license to audit public companies was revoked and hence it closed down. The auditor appealed in the United States Supreme court where they had the ruling overturned but by then, the company had already ceased operating and lost its clients. Eventually the shareholders and employees salvaged limited returns after lawsuits against Enron Corporation.

Arthur Andersen was Enron’s auditor for 16 years and the collapse of its client signified what can be attributed as audit failure (Francis 2004). There are a number of audit failures that Arthur Andersen carried out. In what began as an informal investigation by the Securities and Exchange Commission, the engagement partner for Enron was briefed on the policy of document handling. The policy supported the shredding of any secondary document that did not support the audit opinion in case of an occurrence of a lawsuit. A secondary document was created by the firm a year and half before. The auditor kept destroying crucial documents despite being requested by the Securities and Exchange Commission (Kelly 2006). This ceased after the corporation was issued with a subpoena. The indictment of the auditor was validated since it was a show of obstruction of proceedings. Vividly, the shredding of the documents has had traumatic effects in the audit profession. In the Enron case however, the auditor was aware of the Securities and Exchange Commissions investigation and therefore they decided to shred crucial documents which was against the law hence showing an audit failure.

Secondly, Arthur Andersen compromised on the high standards of integrity and independence. This is contrary to what an auditor needs to be I.e. objective (he is to offer opinions without prejudice, and compromise), and independent both in mind and appearance. Soon after Arthur Andersen was formed, it purposely declined to sign of incorrect accounts of a large rail company despite the possibility of losing the client. The pressure of retaining clients as the auditor expanded as well as maintaining the revenue led to the shift of objectives. This created an environment where the client was able to dictate their demands to the auditor since they knew they were dependent on them. At Arthur Andersen, the firm had audit failure when they succumbed to pressure of having revenue of Enron Corporation’s management be the ultimate performance measure.

Arthur Andersen had audit failure in the way its business culture was being conducted. Its value statement leaned on integrity as to how the founder wanted. During its collapse, it had a change of culture on how it operated. (Squires and Squires 2003) They hired graduates who would conform to the rules rather than those who would challenge the status quo. Training was done to ensure everyone was in agreement with the same approach instead of personal and professional development. It was tragic since everyone knew that what they were doing was okay in light of shareholders who were to be protected by them.

Auditor independence is usually affected by a number of threats that eventually lead to audit failure. By fact, different organizations have different view of the potential of such threats. Though not exhaustive, the threats listed below will shed light on what are inhibiting genuine auditing.

The appointment and dismissal process that the independent auditor has gone through is a threat. It is wholly beneficial to the shareholders when an external auditor is employed. However, the provision of dismissal of the independent auditor is not usually in the hands of the shareholder (Acemoglu and Gietzmann 1997). It’s only the management that is mandated to carry out termination of the independent auditor. The shareholders are hence left out on suggesting the best choice of an independent auditor. The nomination or renewal of the incumbent is brought for approval by the shareholders at the Annual General Meeting hence no competing proposals are directly brought before them. This results to the incumbent auditor being at the mercy of the management with regards to the renewal process. The independent auditor is therefore under threat of manipulation since he owes the management of any audit malpractice should there be one that may arise. The remedy to this situation may be modification of the selection process whereby the shareholders are allowed to directly nominate and appoint the auditor. The organization may also form audit committees, who are sufficiently independent, whose responsibility is to oversee the nomination process.

The independent auditor also faces the threat of self interest. Whenever financial interest of an independent auditor arises, it blinds him to an extent that he is not objective. In a case whereby the auditor is also the shareholder, he may misreport the financial performance. (Bazerman, Morgan and Loewenstein 1997).This is unalike an independent auditor who would report a loss when the financial performance is bad. Self interest is also a threat to independence when the auditor carries non audit work in the client organization and fails to expose information that may risk the reputation of his audit firm. To thwart this, the auditor has to be limited on carrying out non audit services.

Another threat to independence is complacency by the auditor. Complacency seems to blunt the doubts that the auditor may expect (Shockley, 1981). This complacency is brought about by the long-term engagement between client and auditor whereby the auditing process is the same since he is familiar to solve this threat to independence; it is prudent for the audit firm to change its leading partner after a certain length of time. This is because the new leading partner will bring in new ways hence tackling the problem of complacency.

Social bonding between the auditors and the client is also a threat to independence. It is obvious that the long-term auditing engagement between the auditor and the client brings about friendships hence professional ethics is compromised (Choi, et al, 2012). Objectivity is not achieved since the clients can go to the extent of picking up friends to carry out the audit work for them. To solve this, the managers and the auditors need to form boundaries when it comes to their relationship especially in the workplace.

Since auditors depend on audit fees for their wellbeing, the economic bonding between them and the client can be a threat to independence. It is therefore intrinsic for the auditors to always keep the managers happy since failure to do so can make them lose the client and hence the audit fees which is an important source of income. It is widely seen that audit firms provide other services such as financial advisory, investment advisory et al. According to (Firth 1997) Non audit services is usually a plum source of income, which makes an auditor compromise their audit in order to be given such a contract. the past decade has witnessed an increase in the audit fees. This just shows that even if the non audit services are not provided, the core problem of economic bonding still remains. To curb this threat, it is prudent for the countries to have a policy that discloses the fees that are paid to the auditor. This is important to shareholders since the extent of economic dependence is established.

Lack of clarity of separation between the auditor and the client as different entities can be a threat. It may be more complex if the client firm hires a previous auditor to perform a manager’s role. the ex auditor is able to take advantage and hoax an incumbent auditor since he has the knowledge of the audit processes. To curb this, the firm has to adopt corporate governance structures that can increase the auditor’s independence.

Disputes between auditor and the client may at times lead to lawsuits which ultimately jeopardize the independence of the auditor. Despite the auditor judging matters objectively during an audit work, he may come under allegations of not being able to follow the right procedures hence his conclusion comes under jeopardy. (Arnold, Bernardi & Neidermeyer 1999). With respect to the flawed audit report, if the auditor files for litigation against the client, objectivity is endangered. In some instances, an audit firm may assist a client especially during the defense of a lawsuit whereby a breach of standards, investigation or a regulatory inquiry is involved. Here an advocacy threat is faced. Since the audit firm assumes the management role, independence and objectivity of the auditor is threatened. To protect against this threat, it is prudent for audit firms to have a regulatory body that will increase independence by threatening for an enforcement action if the law is broken. Audit fees can also be made contingent partially even if published accounts are corrected. This will show the interconnection between quality and compensation and subsequently litigation cost will be reduced.

A change of time presents a different way of doing things. This explains why also auditors need to change the way the way they carry out their audit work if they are to maintain their reputation of being objective and independent. It is argued that in order for an auditor to be independent, the number of non audit services offered by the auditor need to be limited. In future, this is supposed to ensure that auditors who gain a high percentage of income from one client do not encounter any conflict of interest. (DeFond, Raghunandan and Subramanyam 2002) Proponents of non audit services however believe that providing services assists in building a deeper understanding of the client and hence enhance quality of the audit through insight and professional skepticism. To date, no policy has been made to ensure that auditors don’t provide non audit services.

In some countries, peer reviews by another firm are to be conducted to ensure utmost accuracy and independence is achieved is achieved. This is usually carried after a certain length of time. Another possible future development in auditor independence is the formation of audit committees within organizations. (Kalbers and Fogarty 1993) The Cadbury report of 1992 was the first recommendation of an audit committee. They ensure that the quality of the audit report is achieved. Confidence is integrity of the reports can only be achieved when the audit committees are effective. It is also the audit committees role o ensure that a favorable environment for transparency between the clients and the auditors is achieved. Having the main role of overseeing the auditors, auditors need to understand the audit strategy and be satisfied with the risks that may come up. In addition, auditors should be asked what they do to maintain consistency by the committees in order to achieve professional skepticism.

Lastly, a possible future development is the introduction of rotating external auditors. Here, it is either the audit firm or the engagement partners who is going to be affected. It is believed that an incumbent auditor is less likely to enter into collusion with the client even if the contract is expiring in the foreseeable future(Daniels and Booker 2011).The auditor is also unlikely to forge friendships with the client’s management. Furthermore, if the current management is aware of possible replacements, they are likely to prepare reports of high standards and quality which are independent since they are wary of being exposed by the new audit team.

List of References

Acemoglu, D. and Gietzmann, M.B. (1997), Auditor independence, incomplete contracts and the role of legal liability. European Accounting Review, 6(3), pp.355-375.

Arnold Sr, D.F., Bernardi, R.A. and Neidermeyer, P.E., 1999. ‘The effect of independence on decisions concerning additional audit work: A European perspective.’ Auditing: A Journal of Practice & Theory, 18(s-1), pp.45-67.

Bazerman, M.H., Morgan, K.P. and Loewenstein, G.F., 1997. ‘The impossibility of auditor independence’. MIT Sloan Management Review, 38(4), p.89.

Choi, J.H., Kim, J.B., Qiu, A.A. and Zang, Y., 2012. ‘Geographic proximity between auditor and client: How does it impact audit quality?’, Auditing: A Journal of Practice & Theory, 31(2), pp.43-72.

Craswell, A.T., Francis, J.R. and Taylor, S.L., 1995. ‘Auditor brand name reputations and industry specializations’. Journal of accounting and economics, 20(3), pp.297-322.

Daniels, B.W. and Booker, Q., 2011. ‘The effects of audit firm rotation on perceived auditor independence and audit quality’. Research in Accounting Regulation, 23(1), pp.78-82.

DeFond, M.L., Raghunandan, K. and Subramanyam, K.R., 2002. ‘Do non–audit service fees impair auditor independence?’, Evidence from going concern audit opinions. Journal of accounting research, 40(4), pp.1247-1274.

Firth, M., 1997. ‘The provision of non-audit services by accounting firms to their audit clients’. Contemporary Accounting Research, 14(2), pp.1-21.

Francis, J.R., 2004. ‘What do we know about audit quality?’, The British accounting review, 36(4), pp.345-368.

Kalbers, L.P. and Fogarty, T.J., 1993. ‘Audit committee effectiveness: An empirical investigation of the contribution of power’. Auditing,12(1), p.24.

Kelly, J., 2006. ‘Power of an Indictment and the Demise of Arthur Andersen’,The. S. Tex. l. rev., 48, p.509.

Sherman, S., 2002. Enron: uncovering the uncovered story. Columbia Journalism Review, 40(6), p.22.

Shockley, R.A., 1981. ‘Perceptions of auditors’ independence: An empirical analysis’. Accounting Review, pp.785-800.

Swanger, S.L. and Chewning Jr, E.G., 2001. ‘The effect of internal audit outsourcing on financial analysts’ perceptions of external auditor independence’. Auditing: A Journal of Practice & Theory, 20(2), pp.115-129.

Thomas, C.W., 2002. ‘The rise and fall of Enron’. Journal of Accountancy, 193(4), p.41.

Squires, S.E. and Squires, S., 2003. Inside Arthur Andersen: shifting values, unexpected consequences. FT Press.