The primary purpose of an audit is to provide company shareholders with an expert, independent opinion as to whether the annual accounts of the company reflect a true and fair view of the financial position of the company and whether they can be relied on. Independence is the main means by which an auditor demonstrates that he can perform his task in an objective manner.
The Need For Auditor Independence
The auditor should be independent from the client company, so that the audit opinion will not be influenced by any relationship between them. The auditors are expected to give an unbiased and honest professional opinion on the financial statements to the shareholders.
Doubts are sometimes expressed regarding the independence of external auditors. It can be argued that unless suitable corporate governance measures are in place, a firm of auditors may reach audit opinions and judgments that are heavily influenced by the wish to maintain good relations with the a client company. If this happens, the auditors can no longer be said to be independent and the shareholders cannot rely on their opinion.
Accounting firms sometimes engage set audit fees at less than the market rate and make up for the deficit by providing non-audit services, such as management consultancy and tax advice. As a result, some audit firms have commercial interests to protect too. This raises concerns that the auditor's interests to protect shareholders of a company and his commercial interests may conflict with each other.
A high profile example would be the relationship between Enron and their auditors, Arthur Andersen. In 2000, Andersen received $27m for non-audit services, compared with $25m for audit services, meaning Enron accounted for over 25% of the fees generated by the firm’s Houston office. In the aftermath of Enron’s demise, the accounting firm was accused of not acting independently and suggestions were made that they had gone along with the accounting practices in Enron in order to retain their work.
Threats To Auditor Independence
The audit profession has recognised the following threats to auditor independence, many of which are linked to the provision of non-audit services:
Self-interest threat: Where an auditor is financially dependent on the audit client or where an auditor or someone closely associated with him has a financial or other interest in the audit client. The auditor also depends on the management of the company to secure its re-appointment as auditor.
Familiarity threat: The relationship between the auditor and client is long-standing or otherwise is so familiar that the auditor becomes involved in advising the client or acting in a management role.
Self-review threat: A judgment is required of the auditor which demands that previous work of the firm (whether audit or non-audit) be challenged or re-evaluated.
The trust threat: The auditor becomes too trusting of directors and management, thereby preventing a proper testing of management information and representations.
The intimidation threat: The auditor is intimidated by actual or potential pressures from the client or other party.
The advocacy threat: The auditor becomes involved in actively promoting or defending the client’s interests.
Reliance On The Audit
The need for independence arises because in many cases users of financial statements and other third parties do not have sufficient information or knowledge to understand what is contained in a company’s annual accounts. Thus, they rely on the auditor’s independent assessment. Public confidence in financial markets and the conduct of public interest entities relies partly on the credibility of the opinions and reports given by auditors in relation with financial audits.