Threat To Auditor Independence

Published Date: 02 Nov 2017

In almost all countries auditing, as a profession, is becoming very demanding. Auditor independence has long been regarded as a cornerstone of the auditing profession (AICPA 1999; SEC 2000). The government of Mauritius often requests for a Report on Observance of Standards and Codes, Accounting and Auditing Review (ROSC A&A) which focuses on the institutional framework underpinning the accounting and auditing practices in the country. It evaluates the statutory framework supporting the accountancy profession; education and training of accountants; professional accountancy organizations and ethics; accounting and auditing standards; and monitoring, enforcement, and oversight of the profession. The link between auditor independence and audit risk is closely linked. Audit independence as well as audit risk, both has a significant effect on audit quality and audit credibility and the economy as a whole and is also related to sustainable success. Safeguards are identified and classified by the Financial Reporting Council, the Mauritius Institute of Professional Accountants and the National Committee on Corporate Governance to strengthen auditor independence. Auditors play an important role in the capital markets. Financial markets crisis since 2007 has unfolded many issues regarding the supervision of financial institutions, financial reporting and auditing as of core importance to many regulatory bodies in order to ensure proper-functioning framework in the internal market, more specifically, this has brought issues of long-standing debate (Brown, 2005; Young, 2005; Reinstein and McMillan, 2004; Dewing and Russell, 2003) including: audit and accounting regulation; auditor independence; earning management; and audit and audit firm quality controls. This issue results in a lack of confidence on part of the public. Ethics have been observed to play a key part in the work of auditors. The accountancy profession claims to be both moral and ethical (Francis, 1990).

1.2 Research problems

In Mauritius, scarce literature is available on the perception of the threats that impair auditor independence and safeguarding it. People are taught the professional behavior; integrity, objectivity and independence. But have regulatory framework and education been able to instill complete independent (both in fact and in appearance) in the work of auditor? The aim of this study is to provide data viewed from a local perspective by taking into account the Mauritian’s framework, as well as institutions, which provides the training to equip people with the required professional and ethical conducts required as an auditor, so as to safeguard auditor independence. But in one way or the other auditor independence is threatened. It is argued that poor outcomes arise where the safeguards are insufficient defence against the threats thus increasing independence risk and also incentives also influence an auditor. Stakeholders and regulators due to their concerns for the audit quality have criticized the auditing profession. Auditors have the main aim to assure the trust of the public. Concerns are shown towards both the competence (discovering a problem or making a correct judgment) and the independence (disclosure of the problem by the auditor) of the accounting firm (Duff, 2004). In addition the audit process is seen to be unobservable to third parties, while audit risk is fundamental to the audit process as auditors cannot and do not attempt to check all transactions. Another problem is that the behavior of the auditor is not only determined by the professional conducts, but also ethical cognition and moral of the auditor also influence the work of the auditor. This research enables us to investigate the relationship between independence and audit risk as well as ethical cognition and auditor independence and the role of the regulatory framework in influencing individual auditors as well as safeguard the trust of the public.

1.3 Objectives of the research

This assignment has two overall objective:

Part 1: This assignment examines whether an appropriate accounting framework and ethical code of professional conduct effectively enhances auditor independence.

Part 2: The impact of both auditor independence and audit risk on the main elements related to an audit work; audit quality, audit failure, earning management and the audit process, to ensure confidence for the public interest.

Specific objectives:

-To highlight the importance of auditor independence and how it is fundamental to public confidence in the audit process.

-To determine the factors associated with the decision-making process of an auditor; ethical, moral and independence in judgment-base decisions.

-To determine the extent to which Mauritius framework protect auditors’ independence.

-To reflect how risk and independence are linked.

-To analyse the impacts that auditor independence and audit risk have on audit work and hence public confidence.

- To determine the actions taken in Mauritius to ensure confidence in auditors’ work to the public by manipulating audit quality, audit failure, earning management, the audit process as a whole

Part 1

Auditor Independence

2.1 Definitions of an audit, auditor and auditor independence

An audit is basically an examination of a set of records, both financial and non financial, to ensure that they can be relied upon in terms of accuracy and completeness. An auditor is a qualified person who carries out the audit assignment and reports on the ‘true and fair view’ of the client entity’s financial statements so that the users of financial statements can rely on the reliability and credibility of the financial statements. The objective of auditing has been given by International Standards of Auditing (ISA) 200; Overall Objectives of the Independent Auditor and the Conduct of an Audit in accordance with International Standards on Auditing. ISA 200 deals with the independent auditor’s overall responsibilities when conducting an audit of financial statements in accordance with ISAs. Specifically, it sets out the overall objectives of the independent auditor, and explains the nature and scope of an audit designed to enable the independent auditor to meet those objectives.

The Mauritius Financial Reporting Act 2004 states: "independence" means independence of mind and independence in appearance. Independence Standards Board (ISB) 2000 states that auditor independence is the ‘freedom from those pressures and other factors that compromise, or can reasonably be expected to compromise, an auditors’ ability to make unbiased audit decisions’. According to Okolie (2007), "audit independence equates the term with an attitude and approach of objectivity (being unbiased, fair and impartial) and integrity (being intellectually honest". Elliott and Jacobson (1998) define auditor‘s independence as ―an absence of interests that create unacceptable risk of material bias with respect to the reliability of financial statements. Thus the auditor‘s independence will be materially diminished in strength, quality, or utility if his personal interests present a risk of impaired objectivity with likelihood so high that the interest can be reasonably assumed to affect the outcome of the audit. According to Mcgrath,Siegel, Dunfee, Glazer and Jaenicke (2001) however, the definition of independence does not require the auditor to be completely free of all the factors that affect the ability to make unbiased audit decisions, but only free from those that rise to the level of compromising that ability.

Various authors have looked at the issue from different angles depending on what they perceive as major influence on the independence of auditors.

2.2 Independence of mind and independence in appearance

Independence "in fact" (or actual independence) and "in appearance" (or perceived independence) is two types of auditor independence.

Mauritius Financial Reporting Act 2004 states:

independence of mind :

"independence of mind" means the state of mind that permits the provision of an opinion without being affected by influences that compromise professional judgment, allowing an individual to act with integrity, and exercise objectivity and professional skepticism;

independence in appearance :

"independence in appearance" means the avoidance of facts and circumstances that are so significant that a reasonable and informed third party, having knowledge of all relevant information, including any safeguards applied, will reasonably conclude that the integrity, objectivity or professional skepticism of a firm or a member of the audit team had been compromised

2.3 Importance of auditors’ independence

Independence is a key concept-a characteristic that is essential for ensuring the credibility of audit work. If users of financial statements are to believe and rely on the auditor’s opinion, it is essential that the auditor is, and is perceived to be, independent of the entity and its management. This is reflected in the fundamental principle of auditing- Objectivity and Independence- which states: "Auditors are objective. They express opinions independently of the entity and its directors. (APB, 1996)

The importance of auditors’ independence – to both investors and the wider economy was succinctly conveyed by Turner (2001), former Chief Accountant of the Securities and Exchange Commission (SEC) in the USA, when he stated:

"The enduring confidence of the investing public in the integrity of our capital markets is vital…. [The capital they invest] is providing the fuel for our economic engine, funding for the growth of new businesses . . . and job opportunities for tens of millions of workers. . . .[But] the willingness of investors to continue to invest … cannot be taken for granted. . . . Public trust begins, and ends, with the integrity of the numbers the public uses to form the basis for making their investment decisions. . . . It is the report of the independent auditor that provides investors with the critical assurance that the numbers in the financial statements have been subjected to an impartial, unbiased and rigorous examination by a skilled professional. But in order for that report to have credibility with investors, to add value to the process and investors, it must be issued by a person or firm that the investor perceives is free of all conflict- conflicts that may or will in part weight on or impair the auditor’s judgments about the accuracy of the numbers" (pp. 1-2)"

As expressed by Bartlett, (1993) audit independence refers to an unbiased mental attitude in making decisions throughout the audit and financial reporting that without independence, audit has no value (Power, 1997), as the result, auditor should maintain independent and exists to professional ethics, but current audit environment changing very rapidly, increased many force on the audit independence.

However, Peter Wyman ("Is Auditor Independence Really the Solution?," April 2004) makes an important contribution to this discussion, about being full independent by emphasizing that auditor independence is an enabler of good auditing, and that to view it as an end in itself could have severe adverse consequences. He states that attracting and retaining high-quality people to the auditing profession is vital. Incompetent but totally independent auditors are not a solution.

2.4 Threats to auditor independence

2.4.1 Threat to auditor independence

Threat to auditor independence is the risk that set limits on the auditor preventing him from acting fully with professional behavior. Pany and Whittinton (1997), Gupta(1999), ICAN (1999), ISB (2000), (Myring and Bloom, 2003), Aquaisua (2004) and Okolie (2007) identify some of these threats which include undue dependence on a client; overdue fees; actions or threatened litigations; family or other personal relationships; beneficial interesting shares and other investments; beneficial interests in trusts, loans, voting on audit appointments; acceptance of goods and services as gifts or hospitality; and provision of other services to audit clients.

UK, European Commission, Australia, IFAC as well as Mauritius framework identify five threats by the approach of "threats and safeguards" approach. According to this threats and safeguards approach, the frameworks identify five basic categories of threats to auditor independence:

self-interest threat: the threat to auditors’ independence resulting from a financial or other self-interest conflict

self-review threat: the difficulty of maintaining objectivity in situations where a judgment of a previous audit, or non-audit, assignment needs to be challenged or re-evaluated in reaching audit conclusions

advocacy for client threat: the threat to auditors’ objectivity resulting from auditors becoming advocates for (or against) their client’s position in any adversarial proceedings or situations

intimidation by clients threat: the possibility that auditors may be intimidated by threat, by a dominating personality, or by other pressures, by a director or manager of their client or by some other party

trust or familiarity threats: this arises from auditors becoming over-influenced by the personality and qualities of their clients’ directors and/or senior managers and consequently too sympathetic to their interest. Alternatively, auditors may become too trusting of management representations and, thus, insufficiently rigorous in their audit testing.

The relative importance of each of these threats varies based on the details of the individual audit firm-client relationship, but most of the threats exist in every auditor-client arrangement.

2.4.1.1 Meaning of an urgency threat

This can arise when issues emerge at a late stage, either as a result of audit procedures or from events within the company. Auditors find themselves under greater pressure when issues come up at last minute and that there is no time to research matter properly. (Fearnley, S.and Beattie, V.and Brandt, R.(2005) Auditor independence and audit risk: a reconceptualisation.)

2.4.1.2 Meaning of loss of face threat

This is the threat arising from dismissal. The threat of dismissal is the fundamental self-interest threat for an auditor as it leads to loss of face for the firm and very probably for the partner as well. Here there is the risk of losing the client. (Fearnley, S.and Beattie, V.and Brandt, R.(2005) Auditor independence and audit risk: a re-conceptualisation.)

2.4.1.3 Independence risk with judgment-base decisions

2.4.1.3.1 Definition of independence risk

According to Johnstone (2001) independence risk is defined as the risk that an auditor's independence may be compromised or may be perceived to be compromised. Some actual or perceived incentive to the auditor is necessary for independence risk to exist as well as judgment-based decision situations are necessary for independence risk to adversely affect actual or perceived audit quality.

2.4.1.3.2 Direct and indirect incentives decisions

2.4.1.3.2.1 Definition of direct incentives

Direct incentives involve actual or potential monetary benefit, for examples investments in the client might cause an auditor's financial interests to align with the interests of management, possibly to the detriment of the interests of other investors or creditors. Client's fees to auditors that are contingent upon specific opinions can, if allowed to occur, result in the auditor's financial interests becoming dependent upon whether audit judgments coincide with management's preferences. Financial dependence introduces incentives that threaten the auditor's ability to resist management pressure, out of concern that a financial relationship will be terminated (Johnstone, K.M., M.H. Sutton and T.D. Warfield. 2001. Antecedents and consequences of independence risk: framework for analysis).

2.4.1.3.2.2 Definition of indirect incentives

Indirect incentives arise from other circumstances that could make it difficult for the auditor to maintain objectivity. Theses occur when the auditor possesses a personal, family, or professional relationship with the client. These incentives also arise when auditors audit their own work, including financial statements they prepared, valuations they recommended for financial statement items such as in-process research and development, outsourced internal audit services they did, and management decisions they advised on. Interpersonal relationships might cause the auditor to favor personal over professional objectives and also might affect the auditor's ability to exercise an appropriate level of professional skepticism (Johnstone, K.M., M.H. Sutton and T.D. Warfield. 2001. Antecedents and consequences of independence risk: framework for analysis).

2.4.1.3.2.3 Independence risk as a function of incentives in judgment-based decisions

Incentives and motivation play a vital part in auditor judgments. Experimental research has documented that auditor judgments can be impacted by incentives which, in turn, can negatively or positively influence the quality of the audit process. Judgment-based decisions are those in which there is uncertainty regarding the appropriate decision or valuation judgment that an auditor should make. For example, settings in which there might be a high degree of judgment include deciding on the appropriateness of a client’s revenue recognition policy or judging the adequacy of a client’s allowance for doubtful accounts. Where little or no judgment is required in certain circumstances is unlikely that incentives to compromise independence will result in reduced audit quality. The quality of auditor judgments has been found to be adversely impacted by the perceived risk of client loss (e.g., Farmer et al. 1987; Blay 2005); fee pressure (e.g., Houston 1999; Gramling 1999), client retention incentives (e.g., Lord 1992; Trompeter 1994; Chang and Hwang 2003), economic benefits contingent on specific actions (e.g., Schatzberg and Sevcik 1994; Beeler and Hunton 2002), and other client-related and engagement pressures (e.g., Hackenbrack and Nelson 1996; Haynes et al. 1998; Jenkins and Haynes 2003; Kadous et al. 2003; Blay 2005). However, there are several countervailing incentives in place, such as concerns for regulatory enforcement, potential litigation costs, and potential reputation losses, promoting high audit quality (e.g., Nelson 2009). In general, it is believed that incentives lead to preferences for a desired outcome which unintentionally influence one’s decisions, in a self-serving manner (e.g., Kunda 1990; Russo et al. 2000).

However, the quality of an auditor’s judgment is also influenced by pressures emanating from the firm itself. These pressures can arise from immediate supervisors on the audit team or the overall evaluation process used by the firm. For example, audit managers held accountable to a partner who aggressively tries to grow the firm’s business are more likely to support bidding on a client who engages in aggressive accounting practices (Cohen and Trompeter 1998). Likewise, audit managers who perceive audit partners to value efficiency as compared to effectiveness may rely on questionable work by an internal auditor to a greater extent (Gramling 1999) and engage in less skeptical behaviors during audit testing (Brown et al. 1999). Finally, research also finds auditors’ perceived goals of the audit (Sweeney and McGarry 2011) and perceptions of how the audit firm values them (Herrbach 2001) influences auditors’ judgments.

2.5 Safeguard to auditor independence

The issue of auditor’s independence has always been an important public concern and a matter of many debates, especially because of the fiduciary role played by the auditors in modern society. "At the heart of the audit profession is a belief about human nature. Human being will speak the truth unless there is sufficient to be gained by being dishonest’. Many would disagree and argue that it is a partial view of human nature. However, if all the auditors were truly independent the subject would not find such a prominent place in the code of conduct of every professional institute of the world. The very fact that it attracts so much attention would indicate that auditors, independence is difficult to maintain.

Safeguarding independence is a key component requirement of the regulatory framework which supports capital markets. This independence can be maintained through external constraints (i.e., legislation and regulation) or through the profession itself, which will maintain independence to preserve its market value (Kinney 1999). According to the UK, European Commission, Australia, IFAC as well as Mauritius framework there are four safeguards against these threats are identified (Vivien Beattie and Stella Fearnley, September 2002, "Auditor Independence and Non-Audit Services):

regulatory safeguards and sanctions either emanating from legal or professional requirements e.g. auditing standards, prohibitions, disclosure requirements, ethical guidelines, oversight and enforcement, etc;

safeguards within the firm which can be firm-wide or engagement specific, e.g. quality control and documentation, identification of threats, availability of consultation procedures, internal reviews by independent partners, division of responsibilities, training, staff development, ethical standards, etc.

governance procedures in the company, particularly the audit committee;

where the safeguards are not considered sufficient the auditor can refuse to act.

A number of proposals have been put forward to safeguard auditors’ independence and empower them to withstand pressures to compromise. Some of the suggested safeguards have already been implemented in many countries including Mauritius, such as restriction on other services, rotation of auditors and user education.

According to Myring and Bloom (2003), these safeguards are the controls, which mitigate against the effects of threats, and provide greater incentives to the auditors to make appropriate independent decisions.

2.5.1 Establishing real auditor independence

Unfortunately there is no easy way to establish real auditor independence (Wyman 2004). But a more drastic step would be to require rotation of audit firms at regular intervals (say every five years). Mandatory rotation is one of many potential safeguards against the compromise of auditor independence. It is relatively attractive as a mechanism as it is a very visible indication of independence. Its popularity as a 'solution' has risen in recent years due in part to its perceived value in addressing audit market concentration. Gupta (1999) and Okolie (2007) also agree that one of the most effective safeguards is the rotation of auditors.  However, that mandatory rotation is primarily a safeguard of the appearance of independence.

The existence of these frameworks does not mean that these above safeguards are always effectively applied. It must be noted that even thought we make a distinction between the two types of auditor independence (in fact and in appearance), when considering the threats and safeguards to auditor independence these two components are not considered separately.

2.6 Ethical cognition and auditor independence

2.6.1 Definition of ethical cognition

Experimental studies have found that the individual auditor’s level of ethical cognition has a significant impact on audit decisions. Based on individual’s ethical development which influences judgment and work, Kohlberg (1958) defined ethical development as the ‘Cognitive Moral Development’ (CMD) of the individual, governing the thought and knowledge processes involved in deciding about what is right or wrong. Kohlberg’s CMD implies that higher levels of ethical development should result in more ethical behavior. Kohlberg’s CMD model distinguishes three part of an individual’s ethical development to examine an auditor’s implicit reasoning in the resolution of an independence conflict, which he described as

– the pre-conventional level: an individual’s ethical decisions are shaped by external authorities, self interest, and the rewards and punishment associated with various choice outcomes. This stage reflects the lowest level of cognitive moral or ethical development

– conventional level: an individual’s ethical decision is shaped by considerations of the law and social norms.

– post-conventional level: an individual’s ethical decision-making is influenced by universal principles of fairness, conscience and justice. This stage reflect the highest order of ethical development.

James Rest (1982) built on Kohlberg’s work by developing a four-component model of the ethical decision-making process which describes the cognitive processes individuals (as cited in Bebeau 2002). Bebeau (2002) has summarized Rest’s (1982) the four-component model as starting with ethical sensitivity: the individual must be able to identify a moral dilemma through to his/her intention and finally courage to behave ethically, moving to an ethical judgment whereby the individual forms a judgment on the ideal solution to the moral dilemma, moving to the ethical intention which is the individual’s intention to comply or not comply with the ideal solution is formed and finally ethical behavior. Here the individual develops the courage to follow through with his/her moral action.

Ethical decisions are affected by the decision maker’s level of moral development, awareness of relevant professional standards, and contextuality, defined as the interaction between issue characteristics and person characteristics (Wright, Cullinan, & Bline, 1997). Kohlberg (1969) believed that ethical decision making is largely a function of one’s level of moral development, and he formulated a six-stage model of moral development that was further classified into three levels: pre-conventional, conventional, and post-conventional.

2.6.2 Auditors’ moral in the cognitive process underlying ethical reasoning:

2.6.2.1 Independence judgments are significantly influenced by factors relating to penalty and less sensitive to affiliation factors

Auditors’ moral is considered to have a vital role in the cognitive process underlying ethical reasoning and judgment formation. Moizer (1997) identifies two types of ethical reasoning:

consequentialism, whereby actions are judged in terms of their consequences (to self or others); and

deontology, whereby some actions are deemed morally obligatory regardless of their actions.

Mautz and Sharaf (1961, pp. 204-231) and Berryman (1974, p. 1) say that since independent auditors occupy a position of trust between the management of the reporting entity and users of its financial statements, they must be perceived to be operating independently on the basis of sound auditing standards and strong ethical principles.

Sanctions, or penalty, may be imposed to the extent that professionals do not follow the mandates of the profession or the laws of the country. The effectiveness of penalties depends on both the individual and the situation. An individual’s attitude toward sanctions, which varies across individuals, may affect judgments when sanctions are present. According to Hisham El-Moukammal (December 2009) penalty to the auditor for violations of the Code depending on the situation can take the form of formal letter advising the auditor of the violation, a restatement of the required standard, and a stipulation to not have this reoccur; a requirement to have retraining undertaken by the auditor; suspension of the auditor’s certification; and permanent removal of the auditor’s certification. A research conducted by Haim Falk, Bernadette Lynn, Stuart mestelman and Mohamed Shehata (1999)(Auditor independence, self-interested behavior and ethics) indicates that independence judgments are significantly influenced by factors relating to penalty. The results show that:

1. As the probability of losing a client by disagreeing with the client’s decision increases, the frequency of independence violations increases. This result is independent of whether the independent auditors’ behavior is monitored.

2. Monitoring and penalizing independent auditors behavior reduce the frequency of independence violations when the probability of losing a client is small, but the frequency of violations is not reduced when the probability of the loss of a client is high.

3. On average, subjects with low moral development scores violate independence more frequently than those who have higher scores.

These results suggest that while external review and potential penalties (litigation costs, loss of reputation, directness or license suspension) may reduce violations of auditor independence somewhat, the positive reinforcement of the attribute may come from increasing independent auditors’ awareness of the ethical dimensions of their decisions.

Codes of ethics are normally designed to motivate members of professional organisations to operate in an ethical manner. Prior studies suggest, however, that the underlying psychology that governs professional behavior is more complicated than simply hoping that professionals adhere to the organization’s code of conduct. The existence of a penalty is more likely to affect the decision to increase the likelihood to behave ethically than unethically (whether the choice is ‘ideal’ or ‘actual’). According to the Australasian Accounting Business & Finance Journal, Loh & Wong: Matching the ‘Knowing What to do’ and the ‘Doing What you Know’ in Ethical Decision Making (October 2009), a study was carried out and this indicates that the existence of a penalty for unethical behavior does seem to increase the likelihood for ethical behavior, with the numbers showing more percentage of accountant moving from an unethical choice to the ethical choice in their actual course of action.

According to Terri L. Herron and David L. Gilbertson (June 2003: Ethical Principles vs. Ethical Rules), one’s level of moral development is measured by the Defining Issues Test (DIT) with the P score measuring one’s propensity to reason at the post-conventional stage. Accountants’ Moral Reasoning Though research into accountants’ moral development is still growing (Gaa, 1992). Research addressing accountants’ ethical judgments consistently finds that accountants reason at conventional levels, focusing heavily on maintaining norms and following rules. Sweeney & Roberts (1997) found that auditors at lower levels of moral development were more likely to comply absolutely with independence standards, while auditors at higher levels of moral development were less likely to resolve an independence dilemma by referring solely to technical standards. Ponemon & Gabhart (1990) found that the independence judgments of auditors with low DIT P scores were significantly influenced by penalty factors, such as the threat of legal liability, whereas auditors with high P scores ranked this as the least important consideration. Other authors Sweeney and Roberts’ (1997) research show the same result as Ponemon and Gabhart. The higher the moral development of a person the less likely their judgments will be affected by potential sanctions. This suggests that an auditor at pre-conventional and conventional level will display a lower propensity of not complying with standards when it is likely that violation will be detected and the sanctions will be imposed. That is the individual places self-interest well above the common interests of society and is sensitive to penalty attributes. While auditor at post-conventional level judgment will not be affected by nature or severity of sanction. Auditors with a higher level of moral reasoning are more likely to reveal audit finding which management does not wish to be revealed regardless of reprisal. (Arnold and Ponemon, 1991).