May 1999 Issue

A blueprint that builds on the old

In Search of Concepts of Auditor Independence

By Douglas R. Carmichael

In Brief

Keeping What Works

Several articles on the subject of audit independence have appeared in The CPA Journal. In the December 1998 issue, Robert K. Elliott and Peter D. Jacobson presented their versions of the objective, definition, and principles of audit independence. The author presents contrary views on the following points raised by Elliott and Jacobson:

* The objective of an audit,

* The effect of appearance of independence on information risk,

* The appropriateness of regulating the appearance of independence, and

* The wisdom of viewing integrity, objectivity, and independence as mutually exclusive qualities.

At the close of "Audit Independence Concepts" (The CPA Journal, December 1998), Robert K. Elliott and Peter D. Jacobson throw out a challenge to those unwilling to engage in wholesale abandonment of existing concepts of audit independence. They state:

It is unlikely that a conceptual framework worthy of the profession's heritage will emerge without a frank admission that past independence concepts--to the extent they existed at all--left much to be desired. Those who revere the profession's history may find the admission difficult, but it would be in the best traditions of independence.

While reexamination of historically held views on any topic is usually necessary for progress, it is important to make sure those views are understood before considering discarding them. To that end, I accept Elliott and Jacobson's challenge on behalf of all those who do revere the profession's history.

There Is a Definition of Independence

Elliott and Jacobson assert that there has never been an official definition of the term independence and that there has never been a conceptual framework for audit independence.

There has been an official definition of audit independence since Generally Accepted Auditing Standards were first proposed in 1947 (Tentative Statement of Auditing Standards--Their Generally Accepted Significance and Scope). Essentially the same definition exists today in AU section 220 of the AICPA's codification of auditing standards. The second general standard on independence requires that the auditor "must be without bias with respect to the client since otherwise he [or she] would lack that impartiality necessary for the dependability of his [or her] findings, however excellent his [or her] technical proficiency may be." AU section 220 also states that independence requires "intellectual honesty" and a "judicial impartiality that recognizes an obligation for fairness not only to management and owners of a business but also to creditors and those who may otherwise rely (in part, at least) upon the independent auditor's report, as in the case of prospective owners or creditors."

The official definition of audit independence equates the term with an attitude and approach of objectivity (being unbiased, fair, and impartial) and integrity (being intellectually honest). There has also been an excellent foundation, at least for a conceptual framework, for several decades. This is discussed later in relation to the appearance of independence.

The Audit Should Enhance Credibility of Financial Information

Elliott and Jacobson assert that the immediate objective of the audit is to improve the reliability of information. They make passing mention of credibility, but relegate it to the periphery (not the core contribution). A key distinction between credibility and reliability is whether the focus is on the financial information or the user of that information. Financial information is made more reliable by preventing, or detecting and correcting, material misstatements or omissions in it. Financial information is made more credible by increasing users' confidence that the information is reliable.

FASB, in developing a conceptual framework of financial reporting [Statement of Financial Accounting Concepts (SFAC)], puts the emphasis on enhancing users' confidence. SFAC 1 states that "financial statements are often audited by independent accountants for the purpose of enhancing confidence in their reliability," and observes that both users and providers of information "view an independent auditor's opinion as enhancing the reliability or credibility of the information."

Shortly after the AICPA membership officially adopted the 10 generally accepted auditing standards, including the general standard on independence, The CPA Handbook, published by the AICPA, explained the independence standard as follows:

Independence is an essential auditing standard because the opinion of the independent accountant is furnished for the purpose of adding justified credibility to financial statements, which are primarily the representations of management.

The auditor can add justified credibility to financial statements even when no material misstatements or omissions are detected by validating their absence. Reliability is a characteristic of the financial information. The audit of the financial information adds significant assurance that the information is reliable and thereby enhances its credibility.

Why does the distinction between improving reliability and adding credibility (enhancing confidence in reliability) matter at all? No matter which view is taken, the audit objective is to improve the quality of the information. The answer is found in the implication concerning the importance attached to the appearance of independence. If the objective of an audit is merely to improve reliability, then the perceptions of users about the independence of auditors can be regarded as irrelevant, or at least insignificant, within a conceptual framework and principles of independence. Viewing the auditor's role as adding credibility increases the legitimacy of treating the appearance of independence as a separate, self-sufficient cause for regulation.

Appearance of Independence Does Affect Perceived Information Risk

Elliott and Jacobson assert that "appearance of independence does not, at least in any way that has been identified, affect ... information risk." This assertion is very important to the concepts of independence that they propose because they acknowledge that "the information risk perceived by investors and creditors is reflected in the cost of capital to the corporation," and they propose that "the purpose of audit independence is to improve the cost-effectiveness of the capital markets." The link between audit independence and the effectiveness of the capital markets is at the heart of their analysis.

The relationship between the appearance of independence and the effectiveness of capital markets is not at all difficult to identify. In very simple terms, if investors and creditors believe that auditors are advocates for their clients and lacking in objectivity and integrity, then the information risk perceived by investors and creditors will increase and negatively impact the cost of capital. The cost of capital will increase for corporations generally and for new and relatively unknown companies especially. This would undermine the effectiveness of capital markets and, at the least, seriously diminish the value of the audit function.

Appearance of Independence Is an Appropriate Subject of Regulation

Elliott and Jacobson suggest that the appearance of independence, apart from the fact of independence, is not a separate, self-sufficient cause for regulation. They argued in an earlier article (The CPA Journal, April 1998) that investors do not suffer damages from a specific engagement when there is an appearance of lacking independence. Investors in this circumstance simply do not rely upon the auditor. If the auditor is not independent in both appearance and fact, then lack of reliance is the proper response. If the auditor is actually independent in fact, but not appearance, then the auditor suffers, but the investor does not. Thus, regulation of the appearance of independence is not justifiable, they argue, because only the person pursuing the activity is harmed.

This position runs head-on into the official description of the importance of the appearance of independence stated as follows in AU section 220.03:

It is of utmost importance to the profession that the general public maintain confidence in the independence of independent auditors. Public confidence would be impaired by evidence that independence was actually lacking, and it might also be impaired by the existence of circumstances which reasonable people might believe likely to influence independence. To be independent, the auditor must be intellectually honest; to be recognized as independent, he [or she] must be free from any obligation to or interest in the client, its management, or its owners. [Emphasis in original.]

This rationale for the importance of the appearance of independence has been part of the official description of audit independence since at least 1963, when Statements on Auditing Procedure were codified with auditing standards. However, in the spirit of Elliott and Jacobson's challenge to look afresh at even historically revered notions, let's examine this description more closely. Does the concept of appearance of independence belong in a conceptual framework of auditing and audit independence?

A highly regarded previous attempt to develop a conceptual framework for auditing is found in R.K. Mautz and H.A. Sharaf's The Philosophy of Auditing. Mautz and Sharaf develop a concept of independence with two components: practitioner-independence and profession-independence. Practitioner-independence is a state of mind and equates to the notion of the integrity and objectivity of the individual auditor. Profession-independence is the apparent independence of auditors, as a professional group, to the public.

The appearance of independence can be evaluated at two levels--the user's perception of the individual auditor's ability to be independent in particular unique circumstances and the general public's view toward public accountants as a professional group. Both levels exist in the authoritative auditing literature, but auditing standards attach the greatest significance to profession-independence. "It is of utmost importance to the profession that the general public maintain confidence in the independence of independent auditors" (AU section 220.03). This reference is clearly to auditors as a professional group.

The logic of Elliott and Jacobson works only at the individual auditor level. If users are aware of all of an auditor's relationships and interests with respect to an audit client and believe there is something that creates an appearance of lack of independence, the situation can be avoided. They can "walk away," as financial analysts generally say they do, at any sign of an independence problem.

The same logic does not work at the profession level. If investors and creditors begin to view auditors as a professional group as lacking in independence, if they are viewed as client advocates, then as the U.S. Supreme Court concluded (in United States v. Arthur Young), "The value of the audit function itself might well be lost."

For this reason, the appearance of independence is an appropriate subject for regulation. Appearance of independence can, as described earlier, affect perceived information risk and thereby reduce the cost-effectiveness of the capital markets.

Integrity, Objectivity, and Independence Are Not Mutually Exclusive

Elliott and Jacobson put forward a view of integrity, objectivity, and independence that makes them distinct, mutually exclusive concepts rather than interdependent qualities. In their formulation, the only requirements for a quality audit are for the auditor to be competent and objective. As they state the relationships, "Objectivity can result from perfect integrity (despite impaired independence), perfect independence (despite impaired integrity), or some adequate combination of reasonable independence and integrity."

As explained earlier, the current official definition of independence at the individual auditor level equates independence in fact with integrity and objectivity. At the individual level, no significant purpose is served by trying to parse integrity, objectivity, and independence. If the auditor knowingly gives an unqualified opinion on financial statements that are materially and intentionally misstated, whether the cause is intellectual dishonesty, bias favoring the client's management, or some other cause of lack of impartiality is unimportant and usually not determinable with any degree of certainty.

The historical reason for the prohibitions against a direct financial interest in the client and against serving the client in the capacity of management or employee has been a quest for external signs by which a lack of independence might be recognized. Because members not in public practice could not meet these stringent requirements, a separate rule on integrity and objectivity was adopted and made applicable to all AICPA members. This occurred in the 1973 code. However, the existence of two rules in the code does not mean that the qualities of integrity and objectivity should be viewed separately from the quality of independence at the individual public auditor level.

The Independence of Auditors as a Profession Must Be Preserved

The interests, relationships, and transactions that create a presumption of lack of independence were adopted into existing requirements because of value judgments made about their potential effect at both the practitioner and profession level. The longevity of those requirements should not deter a searching reexamination of the underlying value judgments. However, any conceptual framework worthy of the profession's heritage cannot ignore the importance of the public's perception of auditors as a professional group. To do so would risk far more than reverence for that heritage. *

Douglas R. Carmichael, PhD, CFE, CPA, is the Wollman Distinguished Professor of Accountancy in the Stan Ross Department of Accountancy of the Zicklin School of Business, Baruch College, City University of New York. He is currently a consultant to CPA firms, attorneys, public corporations, and state and Federal government agencies. He has been an editor of The CPA Journal.

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