A Framework for Auditor Independence

The ISB lays a foundation for future guidance.

BY SUSAN MCGRATH, ARTHUR SIEGEL, THOMAS W. DUNFEE, ALAN S. GLAZER AND HENRY R. JAENICKE
January 1, 2001

EXECUTIVE SUMMARY
  • THE INDEPENDENCE STANDARDS BOARD issued an exposure draft for a conceptual framework for auditor independence containing the concepts and basic principles that will guide the board in its future standard setting.
  • THE NEED FOR A FRAMEWORK AROSE FROM the jumble of confusing independence rules and regulations that applied to public companies and their auditors, many in the form of interpretations issued in response to specific independence questions.
  • THE FRAMEWORK DEFINES AUDITOR INDEPENDENCE and identifies its goals. The ISB’s model for standard setters involves three steps: (1) identify threats to the auditor’s independence and consider their significance; (2) evaluate the effectiveness of potential safeguards, including restrictions; and (3) determine an acceptable level of independence risk.
  • UNDER THE FRAMEWORK, THE GOAL OF INDEPENDENCE is “to support user reliance on the financial reporting process and to enhance capital market efficiency.” The goal looks beyond the immediate benefit of the auditor’s independence—unbiased audit decisions—to the broader targets of user reliance on the financial reporting process and enhanced capital market efficiency.
  • ONE OF THE MOST CONTROVERSIAL ASPECTS of the auditor independence debate is the role that “appearance” should play in setting standards. The ED, in its discussion of the definition and goal of independence, specifies that the board and other standard setters should consider the perceptions of investors and other users of financial information.
Susan McGrath, CPA, is a director at the ISB and ARTHUR SIEGEL, CPA, serves as the board’s executive director. Their e-mail addresses are smcgrath@cpaindependence.org and asiegel@cpaindependence.org . Thomas W. Dunfee, the Joseph Kolodny Professor of Social Responsibility and vice-dean for the undergraduate division of the Wharton School of the University of Pennsylvania, advises the ISB on ethical matters. His e-mail address is dunfeet@wharton.upenn.edu . Alan S. Glazer, CPA, professor of business administration, Franklin & Marshall College, is associate director of the conceptual framework project. His e-mail address is a_glazer@acad.fandm.edu . Henry R. Jaenicke, CPA, the C.D. Clarkson Professor of Accounting at Drexel University, is project director of the conceptual framework. His e-mail address is jaenickh@drexel.edu .

n November the Independence Standards Board (ISB) issued an exposure draft (ED) of a conceptual framework for auditor independence containing the concepts and basic principles that will guide the board in its standard setting. The framework defines auditor independence as “freedom from those factors that compromise, or can reasonably be expected to compromise, an auditor’s ability to make unbiased audit decisions.”

It will help practitioners, investors, regulators and other standard setters understand the significance of auditor independence and provide a common language so that those involved in the ongoing independence debate can contribute to the development of ISB standards. The framework does not provide easy answers to specific independence questions but it supplies a structure and methodology for analyzing issues. This article describes the framework and some of the reasoning behind it.

A HODGEPODGE OF REGULATIONS

The need for a framework arose from the jumble of confusing independence rules and regulations—many in the form of interpretations issued in response to specific independence questions—that applied to public companies and their auditors. The guidance in those interpretations, issued over the years and under changing circumstances, sometimes conflicted and lacked theoretical consistency. Auditors also faced challenges in applying such guidance if the facts and circumstances of an auditor’s relationship with his or her audit client did not match those in the interpretation. While the independence regulations helped to ensure quality audits and contributed to the high level of financial reporting we enjoy in the United States, in today’s increasingly complex business environment the ISB believes that some revisions are in order. The recent SEC rule on auditor independence (see “SEC Approves Rules on Auditor Independence” ) updates many of the independence rules and regulations, but numerous issues remain.

The framework is the product of an open process. A task force of academics, lawyers, audit committee members, regulators, auditors and others helped identify the issues and reviewed drafts for clarity and completeness. The group included representatives from international standard setters so board standards could be harmonized where possible with those used in other countries. A board oversight task force provided direction. In addition, many individuals and groups provided comments on the discussion memorandum, which the ISB issued earlier to alert them to a possible ED and to solicit opinions. The board hopes the ED will receive the same level of participation.

THREE STEPS

The framework defines, and identifies the goal of, auditor independence. The model for standard setters is based on three key steps:

Identify threats to the auditor’s independence and analyze their significance.

Evaluate the effectiveness of potential safeguards, including restrictions.

Determine an acceptable level of independence risk—the risk that the auditor’s independence will be compromised.

Under the model, the ISB and other standard setters are to analyze the costs and benefits of regulations and consider the views of investors, other users of financial information and additional interested parties.

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. For example, the audit client pays the auditor’s fee, so complete independence is impossible and not necessary to meet the framework’s definition. The framework doesn’t spell out specific examples of what would constitute “rising to the level of compromising” an auditor’s independence, but it does offer a structure that will allow an auditor to analyze whether undue bias exists in a particular situation.

Further, independence is defined as more than just compliance with the independence rules. The proposed definition compels the auditor to make a personal assessment of his or her objectivity—to determine if pressures and other factors compromise the ability to make unbiased audit decisions. While this “introspective” evaluation is critical, the definition also calls for an assessment of how activities and relationships with the audit client would appear to others; the guidance explains that the auditor should consider the “rationally based expectations of well-informed investors and other users.”

This inclusion of perceptions in the definition reflects the ISB’s belief that

The idea that independence is entirely a personal matter, which varies from auditor to auditor in a given set of circumstances, is not useful in setting standards for all auditors.

The ability to be objective does not well serve the auditor or the client if no one believes that the auditor can be objective in a given set of circumstances.

The goal of independence is “to support user reliance on the financial reporting process and to enhance capital market efficiency.” With this aim, the ISB looks beyond the immediate benefit of the auditor’s independence—unbiased audit decisions—to these broader targets. If standards reduce independence risk slightly but carry unintended consequences that harm the quality of financial reporting or capital market efficiency, they do not serve the public interest.

THREATS AND SAFEGUARDS

The framework, in identifying five types of threats to the auditor’s independence, follows the approach of European standard-setters. These classifications are illustrations only; it is not necessary, under the model, for an auditor to place identified threats into one of these categories:

Self-interest. The threat that arises when an auditor acts in his or her own emotional, financial or other personal self-interest.

Self-review. The threat of bias arising when an auditor audits his or her own work or the work of a colleague.

Advocacy. The threat that arises when an auditor acts as an advocate for or against an audit client’s position or opinion rather than as an unbiased attestor.

Familiarity (or trust). The threat that arises when an auditor is being influenced by a close relationship with an audit client.

Intimidation. The threat that arises when an auditor is being, or believes that he or she is being, overtly or covertly coerced by an audit client or by another interested party.

Some of these categories may overlap. In addition, although some involve conscious acts by an auditor in his or her own self interest, others may result from subconscious biases.

Once an auditor identifies such threats and evaluates their significance, he or she should analyze potential safeguards. These include procedures firms can perform to protect auditor independence, such as review by a second partner, consultation with designated professionals in the firm or disclosure to the audit committee. Safeguards also include restrictions on an auditor’s relationships with an audit client, such as prohibitions on owning the stock of an audit client or on assigning to an audit client firm professionals whose family members are employed in certain positions at the client. Standard setters must analyze the significance of threats and the effectiveness of potential safeguards to ensure that their standards sufficiently reduce independence risk.

THE APPEARANCE OF INDEPENDENCE

The ED, and the discussion memorandum that preceded it, raise some significant issues. For example, one of the most controversial aspects of the auditor independence debate is the role that “appearance” should play in setting standards. The “appearance” concept—though not well defined—is ingrained in the existing independence literature. Indeed, everyone who has taken an introductory auditing course knows that auditors must be independent in both fact and appearance. But what does it mean to “appear” independent? Whose perceptions count?

In assessing appearances, the existing literature directs the auditor to consider whether a “reasonable investor knowing all the facts and circumstances” would believe a particular relationship or activity with an audit client might affect the auditor’s independence. Implicit in this guidance is the notion that independence lends credibility to the audit process and to the client’s financial reporting process. Some of those who commented on the discussion memorandum, while acknowledging the importance of credibility, point out the difficulties involved in identifying and assessing appearances, the probable lack of consensus about the circumstances and relationships likely to affect the auditor’s independence and the resulting difficulty in determining whose views are “reasonable.” Others ask why standard setters should worry about perceptions. Rules that promote actual auditor independence theoretically should lead to a public perception of the independence of the profession. Standards that promote the appearance of independence without an actual enhancement would be misleading.

We suspect that the requirement to consider appearances arose with the recognition that “independence in mind”—actual auditor independence—is impossible for investors and others to assess. In determining whether to avoid a particular activity or relationship, therefore, the auditor should be guided not solely by the effect the activity or relationship would have on his or her objectivity, but by the effect it would be expected to have on most auditors’ objectivity. The literature directs the auditor to consider how investors and others would view the activity or relationship in question. Similarly, a standard setter, charged with working to protect the independence of auditors generally, cannot set standards based on an individual auditor’s state of mind but on situations or relationships that would likely threaten the independence of most auditors.

How should the ISB consider appearances in its standard setting today? The discussion memorandum suggested that appearances could be incorporated into the standard-setting process in one of three ways if the board concludes that enhancing financial statement credibility—in addition to financial statement reliability—is an appropriate goal of auditor independence. One method is to solicit the views of all interested parties and develop independence standards that reflect them. If the views of all stakeholders are weighted evenly, this could result in standards “by majority rule.”

Another option is to solicit the views that reflect the likely perceptions of a hypothetical group—“reasonable, fully informed users of financial information.” The difficulty with this approach, of course, for the ISB is that it must infer the views of the hypothetical group.

A third approach, and the one the board favors, is to solicit the views of all interested parties, but to develop independence standards based on the board’s judgment about how best to meet the goal of auditor independence. The board would neither ignore appearances nor base its decisions solely on the perceptions of interested parties. After all, board members were selected for their judgment, experience and knowledge. They have spent a great deal of time over the past three years educating themselves on the issues and are uniquely positioned to be “fully informed” of both the threats to auditor independence and the systems in place to protect it. As long as the standards are effective (and penalties for noncompliance swift and firm), audit failures related to independence impairments should be minimal, and investors’ belief in the independence of the auditors should reflect that reality.
It is noteworthy that the ED, in its discussion of the definition and goal of independence, stresses that the ISB and other standard setters should consider the perceptions of investors and other users of financial information. While the board’s policies require, and the framework principles endorse, the board’s consideration of the views of all interested parties in auditor independence, the ED emphasizes that independence is designed to promote the reliability and credibility of financial information for investors and other users.

THE RIGHT BALANCE

Perhaps the framework’s most significant contribution will be its formal recognition that auditor independence is merely a means to an end—not the ultimate goal. Quality audits and reliable and credible information that contribute to efficient capital markets are the objectives. In other words, the ISB and other standard setters must look at the big picture and at the possible consequences of their regulations. For example, a standard that enhances auditor independence slightly but discourages qualified people from entering the profession may, in the long run, harm audit quality. This thinking is reflected in ISB Standard no. 3, the board’s pronouncement on employment with audit clients. In it, the board concluded that prohibiting former firm partners and other professionals from accepting jobs with audit clients could significantly reduce the profession’s appeal and harm clients seeking to improve their financial management. Mandating safeguards, the board concluded, would achieve the same independence benefits without the adverse consequences. The framework is designed to be the foundation for broad and nuanced independence standards that reflect the complexities of the issues they address.

For more information…

To obtain a copy of the ISB exposure draft (ED 00-2, A Conceptual Framework for Auditor Independence ), go to the board’s Web site at www.cpaindependence.org or call the ISB at 212-596-6133. The comment period ends February 28, 2001.

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