Objectivity and Independence in the Auditing Profession

The reliability of financial information is a foundation of a stable economy, allowing confident decision-making. The principles of objectivity and independence in the auditing profession are central to this reliability, ensuring that auditors are free from biases that could color their judgment. Public trust in financial reporting is directly linked to the performance of independent auditors.

This trust allows capital markets to function, as investors and creditors rely on audited financial statements to allocate resources. By upholding these principles, auditors provide a check on the information companies present to the public, supporting the transparency of the financial system.

Foundational Concepts of Auditor Integrity

Objectivity is a state of mind representing an auditor’s commitment to intellectual honesty and impartiality. It requires them to perform duties without bias, basing judgments on factual evidence rather than personal feelings or external pressures.

Independence is the condition that protects objectivity. It is freedom from relationships that a reasonable observer might conclude would compromise an auditor’s judgment. Independence has two components: independence in fact and independence in appearance, both of which are necessary for a credible audit.

Independence in fact is the auditor’s actual ability to remain unbiased. It is a private state of mind, free from connections to the client that could impair judgment. This aspect of independence cannot be directly observed by outsiders.

Independence in appearance relates to how an auditor’s situation is perceived by others. It requires avoiding circumstances that would cause a third party to question the auditor’s impartiality. For example, a close family relationship between an auditor and a client’s CFO would damage the appearance of independence. Auditors must be independent in their own minds and in the eyes of the public to maintain trust.

The Significance for Capital Markets and Stakeholders

Auditor objectivity and independence are the foundation of confidence in capital markets. Investors rely on credible financial statements to make informed decisions about securities. Without the assurance of an independent audit, investors would be unable to trust a company’s financial information, leading to uncertainty.

Creditors and lenders also rely on audited financial statements when assessing the risk of extending credit. A reliable audit report provides insight into a company’s financial health and its ability to meet debt obligations. This verification allows lenders to make more accurate risk assessments.

These principles address information asymmetry, the imbalance between a company’s management and outside stakeholders. Management has complete access to company information, while investors do not. The independent auditor bridges this gap by scrutinizing financial information on behalf of the public and providing an opinion on its fairness.

Government bodies and regulators depend on independent audits to ensure companies comply with laws and regulations, contributing to market fairness. The public’s confidence in the financial system is bolstered by the work of independent auditors. This trust encourages participation in capital markets and facilitates economic growth.

Identifying Threats to Professional Judgment

Self-Interest Threat

A self-interest threat arises when an auditor has a financial interest that could improperly influence their judgment. For example, if an auditor owns stock in a company they are auditing, their financial well-being is tied to the company’s performance. This creates an incentive to overlook issues that might negatively impact the stock price.

Another example is when an audit firm is excessively dependent on fees from a single client. The firm may be hesitant to issue a critical finding for fear of losing that revenue. A loan to or from a client, or a joint business venture, can also create a self-interest threat.

Self-Review Threat

A self-review threat occurs when an auditor reviews their own work or their firm’s work. This situation compromises objectivity because it is difficult to maintain professional skepticism when evaluating prior judgments. It is similar to a student grading their own exam.

An example is when a firm audits internal control systems it previously designed and implemented. In this case, the auditors would be evaluating their own work, creating a conflict. Another instance is if an audit firm provides bookkeeping services and then audits those same financial records.

Advocacy Threat

An advocacy threat emerges when an auditor promotes a client’s interests to the point that objectivity is compromised. In these situations, the auditor acts as a proponent for the client rather than an impartial assessor. This can happen when an auditor represents a client in a legal dispute or promotes the client’s securities.

For instance, providing expert testimony in court on behalf of a client means advocating for that client’s position. This role is at odds with the neutral stance required of an auditor. The public’s perception of independence is damaged if an auditor is seen championing a client’s cause.

Familiarity Threat

A familiarity threat arises from a long or close relationship between an auditor and a client. Over time, an auditor can become too sympathetic to the client’s interests or too accepting of their work. This diminishes the professional skepticism applied during the audit.

An example is when a lead audit partner has been assigned to the same client for many years. The long-term relationship with management could dull the auditor’s critical perspective. Another example is when an audit team member has a close family member in a key financial role at the client.

Intimidation Threat

An intimidation threat occurs when an auditor is deterred from acting objectively by actual or perceived threats. This coercion can come from a dominant client, pressure to reduce audit fees, or the risk of losing the engagement. Such pressure can prevent an auditor from challenging a client’s questionable accounting practices.

An example is when a client’s management threatens to dismiss the audit firm if it issues an unfavorable opinion on the financial statements. The pressure to keep a client can be immense, especially if it is a significant source of revenue. An intimidation threat also exists if a client pressures the firm to reduce the scope of its work to cut costs.

The System of Safeguards and Oversight

Safeguards Created by the Profession, Legislation, and Regulation

A framework of safeguards has been established by professional organizations and government regulators to counter threats to independence. The Sarbanes-Oxley Act of 2002 (SOX) created the Public Company Accounting Oversight Board (PCAOB). The PCAOB oversees and disciplines accounting firms that audit public companies, setting standards for auditing and independence.

SOX introduced several safeguards, including the mandatory rotation of the lead audit partner every five years to mitigate familiarity threats. It also prohibits audit firms from providing certain non-audit services to their audit clients to prevent self-review threats. The Securities and Exchange Commission (SEC) also sets and enforces independence rules for auditors of public companies.

Safeguards Implemented by the Client

The client company plays a part in maintaining auditor independence. A safeguard at the client level is an independent audit committee, which is a subcommittee of the board of directors. Under SOX, the audit committee is responsible for the appointment, compensation, and oversight of the external auditor, creating a buffer between the auditor and management.

This structure ensures the auditor reports to a body whose interests are aligned with shareholders, not executives. An effective audit committee provides a forum for auditors to discuss concerns without fear of reprisal. A client’s commitment to strong internal controls can also reduce risk and ease pressure on the audit.

Safeguards Implemented by the Firm

Audit firms implement internal safeguards to protect their independence. These include firm-wide policies, such as restrictions on owning financial interests in audit clients. Firms also provide mandatory annual training on independence requirements for all staff.

Firms have procedures for accepting client relationships, which involve evaluating threats to independence beforehand. They also use internal consultation processes for complex accounting issues. A final review is often provided by an engagement quality review partner, who is independent of the engagement team and provides a second look before the report is issued.