Answer 5 discussion questions

Discussion Questions

1.What pressure does an auditor face that can challenge their and their firm’s integrity in the course of conducting an audit? How should the auditor handle such pressure?

2.What is the purpose of the audit function and what is required in order for accountants to successfully complete this task?

3.Who is the auditor ultimately responsible to and how does this impact the auditor/client relationship?

4.Discuss the auditor’s basic responsibilities and potential problems that can arise when carrying out these responsibilities.

5.Discuss the various threats to independence and how a firm should mitigate the risk involved with the threats.

These are chapter 7 discussion question. Attached will be a portion of chapter 7 that you can use as guidance. Please let me know if you need more information.

Chapter Seven
The Auditing Function
“It’s Enron and Arthur Andersen all over again. In the end, the firm [KPMG] acquiesced to what
were just flat-out errors in the financial statements.” Former Securities and Exchange
Commission Chief Accountant Lynn Turner.1
“This is really the embryo of the credit crisis. … The theme of the report is how easily the loans
were originated, how exceptions were made, how they used bad appraisals. There were no
appropriate internal controls, and KPMG failed to look at these things skeptically.” Michael
Missal, Court Examiner.2
In January 2007, “KPMG and New Century’s own accountants stunned the company’s board by
revealing that the lender had incorrectly calculated the reserves for troubled home loans. That
mistake was likely to cost New Century $300 million, wiping out profits from the second half of
2006.”3 A week later, New Century announced it would restate financials from the first three
quarters of 2006. The market reaction to New Century’s announcement was swift, and its stock
price dropped significantly at the news. Shares dropped further when the company announced
on March 2, 2007, that it would not file its 2006 annual report on time. This declaration placed
additional financial pressure on the beleaguered mortgage lender, and on March 8, New
Century stated that it had stopped accepting new loan applications. A few days later, the New
York Stock Exchange delisted New Century Financial Corporation, and on April 2, only two
months after the restatement announcement, New Century filed for bankruptcy protection.4
The March 2008 report submitted by the court-appointed bankruptcy examiner chronicles the
catastrophic failure of the company, once the second largest distributor of subprime
mortgages. New Century originated, retained, sold, and serviced home mortgage loans
designed for subprime borrowers. In 1996, the company originated more than $350 million in
loans, and by 2005, subprime loan originations and purchases had grown to an astounding $56
billion. New Century’s growth trajectory mirrored the growth of the subprime loan industry in
the United States. Between 2001 and 2003, subprime loans accounted for only 8 percent of all
residential mortgage originations, but by 2005, they had grown to 20 percent.
New Century retained KPMG as the company’s auditor from its inception in 1995 until April
2007 when KPMG resigned. KPMG had several different engagement partners, with varying
degrees of experience in the mortgage industry, heading the New Century account over the
years. The examiner’s report lists seven types of improper accounting practices not in
conformity with GAAP. The practice that has garnered the most attention concerns the
mistakes in calculating the repurchase reserve. New Century sold mortgages in loan pools to
investors, primarily major financial intermediaries such as Goldman Sachs and JPMorgan Chase.
New Century’s loan purchase agreement required them to repurchase the loans if (i) they
suffered an early payment default, (ii) it was found that New Century had misrepresented their
loans, or (iii) if there was borrower fraud.5 The problem, according to the examiner’s report,
was that New Century calculated the repurchase reserve incorrectly. Essentially, New Century
used historical data about the rate of repurchases, which was inaccurate, and based its model
on the incorrect assumption that all repurchases would be made within 90 days.6
The error was exacerbated by New Century’s lack of reliable data on the numbers of repurchase
claims it received, because repurchase claims were handled by different departments within
the company. This led to a backlog of repurchase claims worth $188 million, which were
unresolved in 2005. By 2006, the backlog had skyrocketed to $421 million as many borrowers
became delinquent within only a few months of taking out a loan.7 New Century’s reserves
were seriously inadequate, as it had only $13.9 million set aside for repayment, which would
cover a mere 3.5 percent of the repurchase claims.
Did KPMG fail? According to one report:
New Century’s accounting methods let it prop up profits, charming investors and allowing the
company to tap a rich vein of Wall Street cash that it used to underwrite more mortgages.
Without the appearance of a strong bottom line, New Century’s financial lifeline could have
been cut even earlier than it was.8
The examiner’s report did not find sufficient evidence to conclude that New Century had
engaged in earnings management or manipulation, or that KPMG had engaged in intentional
wrongdoing. The report did conclude, however, that KPMG failed to conduct its audits in
accordance with professional standards:
Had KPMG conducted its audits and reviews prudently and in accordance with professional
standards, the misstatements included in New Century’s financial statements would have been
detected long before February 2007. The 2005 (KPMG) engagement team, in particular, was not
staffed with auditors with sufficient experience in the client’s industry and/or relating to the
particular tasks to which they were assigned. … The team also consisted of auditors who were
relatively inexperienced in the mortgage banking industry. The engagement team’s lack of
experience was compounded by the fact that New Century’s accounting function was weak and
led by a domineering and difficult controller.9
Lawsuits filed against KPMG in the matter of New Century allege that the engagement team
dismissed the claims made by experts from KPMG’s Structured Finance Group when they tried
to call attention to the problems at New Century:
When a KPMG specialist continued to raise questions about an incorrect accounting practice on
the eve of the Company’s 2005 Form 10-K filing, the lead KPMG audit partner told him: “I am
very disappointed we are still discussing this. As far as I am concerned we are done. The client
thinks we are done. All we are going to do is piss everybody off.”10
Although KPMG may not have created New Century’s problems, many claim that it turned a
blind eye to what could be considered reckless and irresponsible business practices. More
egregiously, KPMG continued to do so even when its own experts challenged New Century’s
accounting practices. The lawsuit alleges that KPMG’s failings were motivated by a desire to
appease a demanding client and to maintain a profitable relationship.
Not everyone, however, is convinced that KPMG should be held responsible for what is
ultimately the failure of a risky and poorly conceived business strategy. David Aboody, an
accounting professor at UCLA argued as follows:
I think it’s a stretch to blame everything on the accounting profession. … What does the SEC
want? Does it want an auditor who tries to predict the future? Or does it want an auditor to
record what is clearly going on at the time?11
Professor Aboody raises an interesting question: What does the public expect of independent
auditors in a situation like New Century? If a company is engaged in risky and unsound business
practices, it seems that the public expects the audit report to reflect this. This leads to another
question: If auditors cannot provide the investing public with this information, if they cannot or
will not sound the alarm about companies operating like New Century, then is the independent
auditor of any use to the average – or even the sophisticated – investor?
The case of KPMG and New Century is only one example of the serious ethical pressures in the
accounting profession today – risks and dangers to the integrity of the accounting practice
created by conflicts of interest and the necessity to survive in a competitive market. To
maintain profitable relationships with valued clients, the auditor can feel intimidated into
approving inappropriately aggressive accounting treatments that can lead to financial
statements that misrepresent the firm’s economic substance.
It appears unlikely that an auditor will be able to maintain a client relationship if that client is
given an unfavorable audit. The client might then shop for an audit firm that will provide a
more lenient reading of the books. If the audit is inadequate, however, and people suffer from
misinformation that the accountants should have uncovered, the accounting firm might be
sued, because auditors are expected to look out for the public interest before looking out for
the client’s interest. This responsibility reinforces the critical importance of the role the auditor
plays in financial services.
As a result of the way financial markets and the economic system have developed, society has
carved out a role for the independent auditor, which is absolutely essential for the effective
functioning of the economic system. If accounting is the language of business, it is the auditor’s
job to ensure that the language is used properly to communicate relevant information
accurately, “to see whether the company’s estimates are based on formulas that seem
reasonable in the light of whatever evidence is available and that formulas chosen are applied
consistently from year to year.”12 The lawsuits filed against KPMG in the matter of New
Century Financial allege that the audit team failed to fulfill this obligation.
The Ethics of Public Accounting
Usually, when people talk about the ethics of public accounting, they are discussing the
responsibilities of the independent auditor. Auditing the financial statements of publicly-owned
companies is not the only role of an accountant, but in the current economic system, it is
certainly one of the most important.
John Bogle, founder of The Vanguard Group, articulates it skillfully:
The integrity of financial markets – markets that are active, liquid, and honest, with participants
who are fully and fairly informed – is absolutely central to the sound functioning of any system
of democratic capitalism worth its salt. It is only through such markets that literally trillions
upon trillions of dollars – the well-spring of today’s powerful American economy – could have
been raised in the past decade that became capital for the plant and equipment of our Old
Economy and the capital for the technology and innovation of our New Economy. Only the
complete confidence of investors in the integrity of the financial information they received
allowed these investment needs to be met at the lowest possible cost of capital.
Sound securities markets require sound financial information. It is as simple as that. Investors
require – and have a right to require – complete information about each and every security,
information that fairly and honestly represents every significant fact and figure that might be
needed to evaluate the worth of a corporation. Not only is accuracy required but also, more
than that, a broad sweep of information that provides every appropriate figure that a prudent,
probing, sophisticated professional investor might require in the effort to decide whether a
security should be purchased, held, or sold. Those are the watchwords of the financial system
that has contributed so much to our nation’s growth, progress, and prosperity.
It is unarguable, I think, that the independent oversight of financial figures is central to that
disclosure system. Indeed independence is at integrity’s very core. And, for more than a
century, the responsibility for the independent oversight of corporate financial statements has
fallen to America’s public accounting profession. It is the auditor’s stamp on a financial
statement that gives it its validity, its respect, and its acceptability by investors. And only if the
auditor’s work is comprehensive, skeptical, inquisitive, and rigorous, can we have confidence
that financial statements speak the truth.13
As Bogle notes, a free market economy needs to base transactions and decisions on truthful
and accurate information. In market transactions, a company’s financial status is vital
information on which a decision to purchase is based. The role of the auditor is to attest to the
accuracy of the company’s financial picture presented to whatever the user needs to make a
decision on the basis of that picture.
This function and responsibility is not new. It has recently come to the public’s attention,
however, with the eruption of the numerous accounting scandals that shocked investors,
regulators, and politicians in 2002. Justice Warren E. Burger made this statement about the
auditor’s function and responsibility in the 1984 landmark Arthur Young case:
Corporate financial statements are one of the primary sources of information available to guide
the decisions of the investing public. In an effort to control the accuracy of the financial data
available to investors in the securities markets, various provisions of the federal securities laws
require publicly held companies to file their financial statements with the Securities and
Exchange Commission. Commission regulations stipulate that these financial reports must be
audited by an independent CPA in accordance with generally accepted auditing standards. By
examining the corporation’s books and records, the independent auditor determines whether
the financial reports of the corporation have been prepared in accordance with generally
accepted accounting principles. The auditor then issues an opinion as to whether the financial
statements, taken as a whole, fairly present the financial position and operations of the
corporation for the relevant period. (Italics added.)14
Burger states the responsibility of the auditor clearly: to issue an opinion about whether the
financial statement fairly presents the financial position of the corporation. Performance of this
role, attesting that the corporation’s financial positions and operations are fairly presented,
requires that an auditor have integrity and honesty. Further, to ensure that an accurate picture
has been presented, it is essential that the auditor’s integrity and honesty is not jeopardized by
the presence of undue influence. To bolster integrity and honesty, the auditor must have as
much independence as possible. Those who need to make decisions about a company based on
true and accurate information must be able to trust the accountant’s pictures if the market is to
function efficiently. Trust is eroded if there is even an appearance of a conflict of interest.
Trust
We can understand why if we apply Immanuel Kant’s first categorical imperative, the
universalizability principle: “Act so you can will the maxim of your action to be a universal law.”
As we saw earlier (see Chapter 3 for a detailed discussion of Kant’s ethical theories), to
universalize an action, we must consider what would occur if everyone acted the same way for
the same reason. As we learned in Chapter 3, an individual generally gives a false picture to
cause another party to act in a way other than the party would act if given full and truthful
information. Suppose a CFO misrepresents his company’s profits to obtain a bank loan, thinking
that no loan would be forthcoming if the bank had the true picture. What would happen if this
behavior were universalized – that is, if all individuals misrepresented the financial health of
their companies when it was to their advantage to lie?
Two things would happen. First, trust in business dealings that require information about
financial status would be eroded. Chaos would ensue, because financial markets cannot
operate without trust. Cooperation is vital, and trust is a precondition of cooperation. We
engage in hundreds of transactions daily that demand trusting other people with our money
and our lives. If misrepresentation became a universal practice, trust and, consequently,
cooperation would be impossible.
Second, universalizing misrepresentation, besides leading to mistrust, chaos, and inefficiencies
in the market, would make the act of misrepresentation impossible. Why? Because no one
would trust another’s word, and misrepresentation can occur only if the person lied to trusts
the person lying. Prudent people do not trust known liars. Thus, if everyone lied, no one would
trust another, and it would be impossible to lie. Universalized lying, therefore, makes lying
impossible. Do we trust the defendant in a murder case to tell the truth? Do we trust young
children who are concerned about being punished to tell the truth? Of course not. Once we
recognize that certain people are unreliable or untrustworthy, it becomes impossible for them
to misrepresent things to us, because we don’t believe a word they’re saying. Hence the
anomaly: If misrepresentation became universalized in certain situations, it would be
impossible to misrepresent in those situations, because no one would trust what was being
represented. This makes the universalizing of lying irrational or self-contradictory.
The contradiction here, according to Kant, is a will contradiction, and the irrationality lies in
simultaneously willing the possibility and the impossibility of misrepresentation, by willing out
of existence the conditions (trust) necessary to perform the act. Face it, people who lie don’t
want lying universalized. Liars are free riders. Liars want an unfair advantage. They don’t want
others to lie – to act like the liars are acting. They want others to tell the truth and be trusting
so that the liars can lie to those trusting people. Liars want the world to work one way for them
and differently for all others. In short, liars want a double standard. They want to have their
cake and eat it, too. Such a selfish, self-serving attitude is the antithesis of ethical.
If misrepresentation of an organization’s financial situation were universal, auditing would
become a useless function. Rick Telberg, in Accounting Today15, claims this may have already
happened. “CPA firms long ago became more like insurance companies—complete with their
focus on assurances and risk-managed audits—than attesters,” he says. The attitude precludes
telling the public what a company’s financial condition really is. Firms with this attitude just
guarantee that the presentation won’t be subject to charges of illegal behavior. These firms
serve the client and not the public.
This points to another important aspect of trust. Only a fool trusts someone who gives all the
appearances of being a liar. Only a fool trusts people who put themselves in positions where it
is likely that their integrity will be compromised. These are the reasons why individuals take
precautions against getting involved with anyone who gives even the appearance of being
caught in a conflict of interest. Because trust is essential, even the appearance of an
accountant’s honesty and integrity is important. The auditor, therefore, must not only be
trustworthy, but he or she must also appear trustworthy.
The Auditor’s Responsibility to the Public
The auditor’s duty to attest to the fairness of financial statements imbues the accountant with
special responsibilities to the public. As we saw in Chapter 4, these responsibilities give the
accountant a different relationship to the client than those relationships in other professions.
Justice Burger refers to this relationship this in his classic statement of auditor responsibility:
The auditor does not have the same relationship to his client that a private attorney who has a
role as … a confidential advisor and advocate, a loyal representative whose duty it is to present
the client’s case in the most favorable possible light. An independent CPA performs a different
role. By certifying the public reports that collectively depict a corporation’s financial status, the
independent auditor assumes a public responsibility transcending any employment relationship
with the client. The independent public accountant performing this special function owes
ultimate allegiance to the corporation’s creditors and stockholders, as well as to the investing
public. This “public watchdog” function demands that the accountant maintain total
independence from the client at all times and requires complete fidelity to the public trust. To
insulate from disclosure a CPA’s interpretations of the client’s financial statements would be to
ignore the significance of the accountant’s role as a disinterested analyst charged with public
obligations. (Italics added.)16
Given the sometimes opposing interests between the public and clients, it is clear that auditors
face conflicting loyalties. To whom are they primarily responsible – the public or the client who
pays the bill? Accountants are professionals and thus should behave as professionals. Like most
other professionals, they offer services to their clients. But the public accounting profession,
because it includes operating as an independent auditor, has another function. The
independent auditor acts not only as a recorder, but also as an evaluator of other accountants’
records. The auditor fulfills what Justice Burger calls “a public watchdog function.”
Over time, the evaluation of another accountant’s records has become a necessary component
of capitalist societies, particularly the part of society that deals in money markets and offers
publicly traded stocks and securities. In such a system, it is imperative for potential purchasers
of financial products to have an accurate representation of the companies in which they wish to
invest, to whom they are willing to loan money, or with whom they wish to merge. There must
be a procedure to verify the truthfulness of a company’s financial status. The role of verifier
falls to the public accountant – the auditor.17
In their article, “Regulating the Public Accounting Profession: An International Perspective,”
Baker and Hayes reiterate the accountant’s distinctive role:
Other professionals, such as physicians and lawyers, are expected to perform their services at
the maximum possible level of professional competence for the benefit of their clients. Public
accountants may at times be expected by their clients to perform their professional services in
a manner that differs from the interests of third parties who are the beneficiaries of the
contractual arrangements between the public accountant and their clients. This unusual
arrangement poses an ethical dilemma for public accountants.18
Although auditors’ clients are the ones who pay the fees for the auditor’s services, the auditor’s
primary responsibility is to safeguard the interest of a third party – the public. Because the
auditor is charged with public obligations, he or she should be a disinterested analyst. The
auditor’s obligations are to certify that public reports depicting a corporation’s financial status
fairly present the corporation’s financial position and operations. In short, the auditor’s
fiduciary responsibility is to the public trust, and “independence” from the client is fundamental
in order for that trust to be honored.
As Justice Burger notes, the auditor’s role requires “transcending any employment relationship
with the client.” Thus, dilemmas arising from conflicts of responsibility occur. We’ll now
examine the auditor’s specific responsibilities.
The Auditor’s Basic Responsibilities
We have seen that the auditor’s first responsibility is to certify or attest to the truth of financial
statements. But an auditor also has other responsibilities. A document known as the Cohen
Report contains a comprehensive statement of an independent auditor’s responsibilities. They
are the same today as when the report was issued. We turn now to that report.
In 1974, the AICPA’s Commission on Auditor’s Responsibilities (the Cohen Commission) was
established to develop conclusions and recommendations regarding the appropriate
responsibilities of independent auditors. Another of the commission’s tasks was to evaluate the
public’s expectations and needs and the realistic capabilities of the accountant. If disparities
existed, the commission was to determine how to resolve them.
As we might expect, the report defined the independent auditor’s main role as an intermediary
between the client’s financial statements and the users of those statements, to whom the
auditor is accountable. Hence, the Cohen Commission made it clear that the auditor’s primary
responsibility is to the public, not to the client.
The commission also examined what auditors, given the restraints of time and business
pressures can reasonably be expected to accomplish. The report pointed out some areas that
are not the responsibility of the independent auditor.
For example, some people erroneously assume that auditors are responsible for the actual
preparation of the financial statements. Others wrongly believe that an audit report indicates
that the business being audited is sound. Auditors, however, are not responsible for attesting to
the soundness of the business. Recall that Professor Aboody made this point in reference to the
KPMG/New Century Financial case earlier in this chapter. In most cases, management
accountants prepare the financial statements, and it is management – not the auditor – who is
responsible for them. (We will examine the management accountant’s role in Chapter 8.)
Auditors are responsible for forming an opinion on whether the financial statements are
presented in accord with appropriately utilized accounting principles. The traditional attest
statement affirms that the financial statements were “presented fairly in accordance with
generally accepted accounting principles.” This is a controversial subject in the accounting
ethics literature. In the 1960s, a committee of the AICPA raised the following questions about
the fairness claim:
In the standard report of the auditor, he generally says that financial statements “present
fairly” in conformity with generally accepted accounting principles – and so on. What does the
auditor mean by the quoted words? Is he saying: (1) that the statements are fair and in
accordance with GAAP; or (2) that they are fair because they are in accordance with GAAP; or
(3) that they are fair only to the extent that GAAP are fair; or (4) that whatever GAAP may be,
the presentation of them is fair?19
The Cohen Report recognizes that “fair” is an ambiguous word; hence, it is imprudent to hold
auditors accountable for the fairness of the financial statements, if that means the accuracy of
material facts. Rather, the responsibility of the auditors is to determine whether the judgments
of managers in the selection and application of accounting principles was appropriate in the
particular circumstance. Note that this differs from Justice Burger’s opinion that the auditor
attests to the “fairness” of the picture.
The Cohen Report would likely find Burger’s viewpoint too rigid for three reasons: (i) In some
situations, there may be no detailed principles that are applicable, (ii) in others, alternative
accounting principles may be applicable, and (iii) at times, the cumulative effects of the use of a
principle must be evaluated. The report calls for more guidance for auditors in these three
areas. Still, the idea prevails that “fairly” presented means that the report being audited will
give a reasonable person an accurate picture of an entity’s financial status. GAAP principles,
however, can be used by artful dodgers to hide the real health or sickness of a company.
Indeed, one accountant has suggested that accounting is an art, and a truly proficient artist can,
by the skillful use of GAAP, make the same company look to be a dizzying success or a
miserable failure. We will consider the “fairness” debate in Chapter 10 of this book. For now,
let’s return to the Cohen Report and its enumeration of auditors’ responsibilities.
The Evaluation of Internal Auditing Control
The Cohen Report also discussed corporate accountability and the law, and it examined the
auditor’s duties regarding internal accounting control. Not only is the auditor responsible for
attesting to the appropriateness of the financial statements, the commission said, but he or she
is also responsible for determining whether the internal auditing system and controls are
adequate. This necessarily leads to the conclusion that auditors have an obligation to examine
the internal workings of the company’s accounting procedures and safeguards. The issue of the
appropriateness of internal controls at New Century Financial and KPMG’s failure to challenge
what it knew were faulty assumptions and inadequate policies were criticized in the examiner’s
report and cited as grounds for the lawsuit against KPMG.
But what specifically is an internal auditor to do? Briefly, the auditor is responsible for
evaluating whether the management accountant is fulfilling his or her obligations, and for
ascertaining the adequacy of and adherence to internal auditing controls. This subject is
covered fully in Chapter 8.
Responsibility to Detect and Report Errors and Irregularities
Another auditor responsibility, according to the Cohen Report, is to convey any significant
uncertainties detected in the financial statements. Further, the report clarified the auditor’s
responsibility for the detection of fraud, errors, and irregularities. Consider the following
situation, which is strikingly similar to the New Century/KPMG case:
Lawyers for the Allegheny health system’s creditors have sued Allegheny’s longtime auditors,
PricewaterhouseCoopers, asserting that the accounting firm “ignored the sure signs” of the
system’s collapse and failed to prevent its demise.
The suit called PricewaterhouseCoopers “the one independent entity that was in a position to
detect and expose” Allegheny’s “financial manipulations.” Yet the system’s financial statements
audited by the firm “consistently depicted a business conglomerate in sound financial
condition,” even after Allegheny’s senior officials were fired in 1998.
A spokesman for PricewaterhouseCoopers, Steven Silber, said, “We believe this lawsuit to be
totally without merit. We intend to defend ourselves vigorously and we’re fully confident that
we will prevail. Accounting firms are considered to be deep pockets and lawsuits happen to
auditors with great frequency.”20
What was Pricewaterhouse Coopers’ responsibility to detect and expose Allegheny’s financial
manipulations? How much time, effort, and money must be expended to identify the signs of a
system’s collapse? Does the public have a right to expect an audit to identify such matters? The
responsibility to report errors and regularities is one of the most serious – and confusing – to an
auditor. In the first place, it seems to run counter to the accountant’s responsibility of
confidentiality that we examined in Chapter 6.21
John E. Beach in an article, “Code of Ethics: The Professional Catch 22,” gives two examples of
how the accountant’s responsibility to the public can lead to a lawsuit if it conflicts with the
responsibility to keep the client’s affairs confidential:
In October of 1981, a jury in Ohio found an accountant guilty of negligence and breach of
contract for violating the obligation of confidentiality mandated in the accountant’s code of
ethics, and awarded the plaintiffs approximately $1,000,000. At approximately the same time, a
jury in New York awarded a plaintiff in excess of $80,000,000 based in part on the failure of an
accountant to disclose confidential information.22
Without wrestling with this complex issue, which involves deciding when it is permissible for
auditors to report certain of their client’s inappropriate activities, suffice it to say that there is
legal opinion that the duty of confidentiality is not absolute, and “overriding public interests
may exist to which confidentiality must yield.”23
Now we turn to the auditor’s most important obligation – the obligation to maintain
independence.
Independence
Thus far, we have discussed the responsibilities of the auditor. To meet those responsibilities, it
is imperative that the auditor maintain independence. Let’s look at Justice Burger’s statement
again:
… The independent public accountant performing this special function owes ultimate allegiance
to the corporation’s creditors and stockholders, as well as to the investing public. This “public
watchdog” function demands that the accountant maintain total independence from the client
at all times and requires complete fidelity to the public trust. …24
“Total independence” is the term that Burger uses. Obviously, an external auditor should be
independent from the client. But must independence be total, as Justice Burger says? If so,
what does total independence require? What does “complete fidelity to the public trust”
require? We need to examine whether total independence is a possibility or even a necessity.
How much independence should an auditor maintain, and how should the auditor determine
that?
The AICPA Code of Professional Conduct recognizes two kinds of independence: independence
in fact and independence in appearance. Independence in fact is applicable to all accountants.
If the accountant’s function is to render accurate financial pictures, conflicts of interest that
cause incorrect pictures do a disservice to whoever is entitled to and in need of the accurate
picture. Whether independence in appearance must apply to all accountants or only to
independent auditors is an open question. Some contend that independence in appearance is
applicable only to independent auditors.25
The Independence Standards Board (ISB) published “A Statement of Independence Concepts: A
Conceptual Framework for Auditor Independence,” one of the most thorough documents on
independence ever prepared. The ISB was established in 1997 by Securities and Exchange
Commission Chairman Arthur Levitt in concert with the AICPA. “The ISB was given the
responsibility of establishing independence standards applicable to the audits of public entities,
in order to serve the public interest and to protect and promote investors’ confidence in the
securities markets.”26 It acknowledged that “[t]he various securities laws enacted by Congress
and administered by the SEC recognize that the integrity and credibility of the financial
reporting process for public companies depends, in large part, on auditors remaining
independent from their audit clients.”27
The ISB originated from discussions between the AIPCA, other representatives of the
accounting profession, and the SEC. However, as a result of the pressure that large accounting
firms were exerting on the AICPA – for which independence might mean surrendering their
lucrative consulting contracts with firms they audited – the ISB was dissolved in August 2001.
Nevertheless, its findings are among the best resources for ethical responsibilities.
Shortly after the dissolution of the ISB, the fallout from the Enron/Andersen debacle occurred,
and in the winter of 2002, the Big Five (now the Big Four since Andersen’s fall) began separating
their auditing and consulting functions. This separation was ultimately mandated, as we have
discussed, by provisions of the Sarbanes–Oxley Act. Recent history has taught us that this
independence is necessary.
John Bogle explains why eloquently:
Our government, our regulators, our corporations, and our accountants have … properly placed
the auditor’s independence from his client at the keystone of our financial reporting system.
And auditor independence has come to mean an absence of any and all relationships that could
seriously jeopardize – either in fact or in appearance – the validity of the audit, and, therefore,
of the client’s financial statements. The auditor, in short, is the guardian of financial integrity.
On the need to maintain, above all, this principle of independence, I hear not a single voice of
dissent – not from the corporations, not from the profession, not from the regulators, not from
the bar, not from the brokers and bankers – the financial market intermediaries – and not from
the institutional investors who, as trustees, hold and manage the securities portfolios of their
clients.28
What did the proposed conceptual framework of the now-defunct ISB say about
independence? The ISB board defined auditor independence as
Discussion Questions
What pressure does an auditor face that can challenge their and their firm’s integrity in the
course of conducting an audit? How should the auditor handle such pressure?
What is the purpose of the audit function and what is required in order for accountants to
successfully complete this task?
Who is the auditor ultimately responsible to and how does this impact the auditor/client
relationship?
Discuss the auditor’s basic responsibilities and potential problems that can arise when carrying
out these responsibilities.
Discuss the various threats to independence and how a firm should mitigate the risk involved
with the threats.