Importance of Auditor Independence - Case Study Example

Audit Framework Audit Framework Introduction Certainly, the global business community will not be hit with such a case as the Enron Scandal again, given the impact of such issues on the global economic climate. Eichenwald (2005) however lamented that even after the Enron scandal there continue to be cases of audit failures among some UK companies. Auditing plays a very important role in the financial and corporate management of organisations as through auditing, the financial health of the company is clearly known. This is given the fact that auditing aids to undertake a systematic and independent examination of data, records and operations of a company, based on which the financial and non-financial performance of the company is known for a given purpose. In the definition of auditing given, it would be noted that independence is a major issue in auditing. Bradshaw et al. (2010) actually noted that in most cases of auditing failures within the UK, the most common cause can be attributed to interference in the main auditing process. It is therefore not surprising that in the 2014 publication of the Financial Reporting Council (FRC), it came out that most interest groups are more concerned about issues of independence in ensuring effective and quality auditing. This paper therefore seeks to take a critical overview of the importance of independence to the auditing profession and how independence can be achieved in the auditing practice in the UK. This will be done with specific emphasis on examples of cases in the UK that make the recommendation for independence either a possibility or threatened. Importance of auditor independence in ensuring high quality audit reporting Graham and Harvey (2011) noted that in every organisation there are internal and external stakeholders, each of who have their own needs that they expect the organisation to serve. In most cases, the needs of the stakeholders are rounded up to be the growth of the organisation. Meanwhile for the organisation to growth both financially and at the corporate level, it is important that strategic growth decisions will be made by management and other leaders responsible for the day to day running of the organisation (Toffler & Reingold, 2004). This is where auditing comes in as an important factor to ensure growth. This is because auditing helps the company to have a very objective and fair overview of its statements, records, operations and performances, based on which it will know whether it is growing or falling (Collins, 2006). In effect, effective and quality auditing plays a part in the growth of the company and thus goes a long way to ensure that the needs of stakeholders are met. Having said this, it is important to speculate on what happens when the outcome of audit reporting based on which growth decisions are made is not credible or accurate. Certainly, an inaccurate audit reporting will mean that decisions to be made about the company cannot be regarded as right or tailored towards the real state of the company (Eichenwald, 2005). It is against this backdrop that auditor independence can be linked to the achievement of the needs of stakeholder groups in the organisation and in UK as a whole. This is because Sharpe (2004) found auditor independence to be a major factor in ensuring accuracy with audit reports. In the UK, stakeholders concerned with ensuring that statutory audit is a high quality product can be grouped into internal stakeholders and external stakeholders. In the same way, auditor independence comes in two forms which are independence of the internal auditor and independence of the external auditor. Independence of the internal auditor is enforced when the internal auditor is given independence from parties or people whose interest may be harmed by the outcome of the audit report (Bradshaw & Franc, 2010). Likewise, independence of the external auditor is said to be enforced when the external auditor is kept independent from parities or people who may have an interest in the published statements of the company (Rubinstein, 2006). Graham and Harvey (2011) however debated that for the needs of stakeholders, whether they are internal or external stakeholders to be achieved, it is important that independence of the internal auditor and independence of the external auditor will both be promoted in the same way. This is because internal audit reports have direct influence on management decision making, which also has a direct influence on what external stakeholders, particularly shareholders get from the company (Roll, 2012). In a like manner, external audit reports have direct influence on shareholder decision making, which also has a direct influence on what goes on with internal stakeholders such as employees (Toffler & Reingold, 2004). This means that independence of the internal audit is not only necessary to meet the needs of internal stakeholders but external stakeholders as well. In a like manner, the independence of the external auditor is not only necessary to meet the needs of external stakeholders but internal stakeholders as well. Writing on how independence of auditors influence effectiveness and quality of audit reports, Bradshaw and Franca (2010) indicated that of the numerous stakeholders of the company such as employees, board of directors, suppliers, shareholders, regulatory agencies, pressure groups, and the general public, each of them would want that any interest they hold which might be harmed be protected. To achieve this, they may want to influence the auditing process so as to ensure that their interests are kept intact. Keeping such people or parties independent from the auditor therefore means that the auditor will have the means to undertake professional duty in such a way that benefits the collective interest of the company rather than the interest of a selected few. As the FRC’s 2014 report has exposed high level of dissatisfaction with the effectiveness and quality of audit reports among stakeholders, it is only expected that independence of auditors both at the internal and external levels will be used to address the concerns of stakeholders. Graham and Harvey (2011) noted that if no one is influencing the auditor and the auditor is working in absolute independence, the only way or reason for which there may be questions of effectiveness and quality is when the auditor has any personal interest to sabotage the organisation. But knowing that auditors have their own professional regulations and standards based on which the outcome of their works are judged, this latter possibility is very limited. It is therefore important that auditor independence will be allowed to help bring out essential management and stakeholder issues such as risk management, corporate governance and control. How auditor independence is regulated to enhance audit quality Due to how important independence is in ensuring effective and quality statutory auditing, there are specific regulations in the UK that are aimed at enforcing the principles of independent auditing. Like the scope of this paper, the focus of most of these regulations is on statutory auditing or independence of the external auditor. It will be observed that as far as independence regulations in the UK are concerned, there are three major avenues or sources of regulations. These are the Auditing Practices Board (APB), Companies Act 1985 and Companies Act 1989, and international standards. As far as the APB is concerned, it serves as the official regulator and mouthpiece of the professional accounting bodies in the UK which set rules of professional conduct for auditors and accountants. The APB is also known to be part of the former structure of the larger FRC (International Accounting Standards Board, 2007). Established as far back as 1990, the APB has been responsible for setting auditing standards for practitioners in Ireland and the UK. APB’s operations have mainly been influenced by the need to ensuring that boosting public confidence in the audit process, given the fact that the extent of public confidence in the audit process directly affects the level of relevance that the public attaches to audit reports as working documents (Sharpe, 2004). Since 2002, the APB’s mandate has been more consolidated as it was brought under the auspices of the Accountancy Foundation. This is because since the period, the APB’s objectives have become more structured around the need to promote auditor integrity, objectivity and independence (Roll, 2012). The Companies Act 1985 and the Companies Act 1989 are two other sources for defining, ensuring and regulating auditor independence. Dunn (1996) explained that the major means by which the Acts regulate auditor independence is by clearly dictating the responsibilities of shareholders and directors when it comes to the appointment and relations with auditors. More specifically, section 384 of the Companies Act 1985 provides that it should be shareholders and not directors who must appoint auditors for the company. This is a provision that many have seen as an ideal means of promoting independence. This is because previous experiences show that directors rather than shareholders have often had issues and interests to protect with the final outcomes of audit reports (International Accounting Standards Board, 2007). A clear example of this is the case involving JPMorgan Chase and the UK arm of PwC, where the audit company, PwC was eventually fined £1.4m for audit failure (Jones, 2014). What is more, the provision of the Companies Act has also been noted to promoted auditor independence because as part of the principles of corporate governance, shareholders are recognised as the right owners of the company. What this means is that issues and decisions concerning the financial and non-financial data, statements, records, and operations of the company must best be undertaken when shareholders are in control. Indeed the Companies Act 1989 also gives additional provisions for the protection of auditor independence under its part II. An example of this is the provision that auditors must be part of supervisory bodies where the actions and outcomes of the auditor’s work can be monitored (Rubinstein, 2006). Apart from the above discussed sources of regulation, there are international auditing bodies whose regulations and principles are also very important for the promotion of auditing independence in the UK. One such international body is the International Accounting Standards (IAS) or International Financial Reporting Standards (IFRS). As far as these international bodies are concerned, their major scope of regulation as far as the independence regulations in the UK is concerned have to do with the issuance of regulations and standards that have to do with the preparation of financial statements (Collins, 2006). The IFRS for example has qualitative characteristics that it gives for the preparation of financial statements. To engage in effective and auditing that qualifies under the qualitative characteristics of financial statements, auditors are expected to exhibit high level of independence that is free of all forms of interferences (Collins, 2006). By following the practices of qualitative characteristics of financial statements are which are relevance and faithful representation, auditors are expected to work in the best forms of independence that can guarantee that the outcomes of audit reports are the result of their own professional applications (Dunn, 1996). Again, Toffler and Reingold (2004) noted that when auditing firms in the UK are made to follow the principles and regulations of the IFRS, they are afforded the opportunity of conforming their practice and actions to a common global language that is considered acceptable for business and company accounting. Meeting stakeholder expectations of auditor independence in the UK Regardless of the availability of regulations in the UK as has been discussed above, there are many who still doubt if these regulations are strong enough to ensure that stakeholders achieve the much desired goal of auditor independence. What makes such critics very worried are examples of cases of auditing failures in the UK, most of which can clearly be attributed to the absence of auditor independence. For example in 2013, KPMG was engaged in audit issues over HBOS failure. This is because back in 2008, Aldrick and Kirkup (2013) report that KPMG cleared the company’s management decisions to set aside only £370m in provisions but when the final divisional losses were made, it turned out that the actual loss was £25bn. What is worse, in 2013, KPMG gave the company a clean bill of health when in actual fact the company was carrying £47bn of losses when it was rescued by the taxpayer (Aldrick and Kirkup, 2013). To many critics therefore, the possibility that some management members may be in bed with shareholders who are responsible for the selection of auditors is possible. When this happens, the probability that the auditors will work independently to uncover parities whose interests might be harmed with the true results of audit is very low. Clearly when there are such reports involving big auditing firms like KPMG, one becomes suspicious if the regulations are comprehensive in making stakeholders attain their ambitions. It is however strongly believed that there are recommendations which can be put in place to improve auditor independence confidence. In the first place, it is important that the regulatory bodies in the UK such as FRC and all other agencies and boards that come under it such as Accounting Standards Board (ASB), Financial Reporting Review Panel (FRRP), Accountancy & Actuarial Discipline Board (AADB), Professional Oversight Board (POB), Auditing Practices Board (APB), and Board for Actuarial Standards (BAS) be given more powers to be involved in the selection of auditors, especially for bigger multinational companies. This is because the possibility that independence can be trusted at the shareholder level can hardly be depended on, given the fact that some directors may have their own connections among the top shareholders. Should the FRC and its agencies be given the mandate of appoint what may even be anonymous auditors for the firms there can be that third party neutrality in the selection process. What is more, until the extent of punishment given to defaulting auditing firms and those seen to be compromising with interferences is made deterrent enough, the practice may continue. The case of PwC where the company was fined £1.4 as what is now the highest fine for auditing failure must be made to continue (Jones, 2012). Conclusion The paper has been very useful in outlining the important role that auditing plays in the global business environment. As stakeholders take decisions on companies by the day, evidence and facts from audit reports serve as important avenues through which their decisions can be validated. Core challenge is however identified if auditing reports cannot be considered credible. This is because in such cases of lack of credibility with audits, the eventual implication is that any decisions that are made by stakeholders based on the audit will also suffer credibility and accuracy. Meanwhile, the extent to which auditors are able to work in independence has been found to be an important determinant in promoting credibility and quality with auditing. Indeed independence in auditing has been known to be relevant for both external and internal stakeholders of companies. As stakeholders have their own needs, it is important that auditing will be done in such a way that directly addresses the needs of all stakeholders in a fair, unbiased and non-discriminatory manner. Meanwhile, when a few people are made to manipulate the auditing process, such levels of fairness and equality in serving the interests and needs of all stakeholders becomes hampered. But before independence in auditing can be institutionalised in the UK, it is important that the level of autonomy and anonymity given to auditors be improved. Until this is done, it will be very difficult for realise the ambition of ensuring effectiveness and quality with auditing through the promotion of independence of auditors. References Aldrick, P. & Kirkup, J. (2013, April 4). KPMG faces possible audit inquiry over HBOS failure. Retrieved from http://www.telegraph.co.uk/finance/economics/9979995/KPMG-faces-possible-audit-inquiry-over-HBOS-failure.html Bradshaw, M. & Franca, T. (2010). Response to the SECs Proposed Rule- Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards (IFRS) by U.S. Issuers, Accounting Horizons 24(1), 45-53. Collins, D. (2006). Behaving Badly: Ethical Lessons from Enron. Texas: Dog Ear Publishing. Dunn, J. (1996). Auditing Theory and Practice. New York: Prentice Hall. Eichenwald, K. (2005). Conspiracy of Fools: A True Story. Monaco: Broadway. Graham, J. & Harvey, C. (2011). The Theory And Practice Of Corporate Finance: Evidence From The Field, Journal Of Financial Economics 60, 187-243 International Accounting Standards Board (2007). International Financial Reporting Standards, London: LexisNexis Jones, A. (2012, April 15). PwC fined £1.4m for audit failure. Retrieved from http://www.ft.com/intl/cms/s/0/b2b4332e-36d7-11e1-b741-00144feabdc0.html#axzz3KTPS1lKM Roll, R. (2012). A Critique of the Asset Pricing Theory Test, Journal of Financial Economics, 4, 129-176 Rubinstein, M. (2006). A History of the Theory of Investments. Hoboken: John Wiley & Sons, Inc Sharpe, W. F. (2004). Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk, Journal of Finance 19, 425-442 Toffler, B.L. & Reingold J. (2004). Final Accounting: Ambition, Greed and the Fall of Arthur Andersen. Monaco: Broadway Business Read More