What is Auditor Independence?

Auditors are expected to provide an unbiased and professional opinion on the work that they audit. An auditor who
lacks independence virtually renders their accompanying auditor report useless to those who rely on them.

For example, consider yourself a potential investor in ABC Company. If you know that the auditor for ABC Company
keeps a close, personal relationship with the CEO of the company, how much would you trust that the audited work is a
fair representation of the company’s financial standing? How can you be certain that the auditor and CEO did not
collude to issue a favorable audit report?

The fact is that auditors who lack independence compromise the integrity of financial markets and the reliability of
information. Investors would not be willing to extend capital to companies, knowing that the audited information was
performed by an auditor who is not independent. Furthermore, banks would not be willing to issue a loan for fear that
the auditor might’ve provided a biased audit report. 

Five Threats to Auditor Independence

The following are the five things that can potentially compromise the independence of auditors:

1. Self-Interest Threat

A self-interest threat exists if the auditor holds a direct or indirect financial interest in the company or depends on the
client for a major fee that is outstanding.

Example

The audit team is preparing to conduct its 2020 audit for ABC Company. However, the audit team has not received its
audit fees from ABC Company for its 2019 audit.

Issue

The audit team might be tempted to issue a favorable report so that the company is able to secure a loan to settle the
fees outstanding for their 2019 audit.

2. Self-Review Threat

A self-review threat exists if the auditor is auditing his own work or work that is done by others in the same firm.

Example

The auditor prepares the financial statements for ABC Company while also serving as the auditor for ABC Company.

Issue

By having the auditor review his or her own work, the auditor cannot be expected to form an unbiased opinion on the
financial statements.

3. Advocacy Threat

An advocacy threat exists if the auditor is involved in promoting the client, to the point where their objectivity is
potentially compromised. 
Example

The auditor is assisting in selling ABC Company while also serving as the auditor for the company.

Issue

The auditor may issue a favorable report to increase the sale price of ABC Company.

4. Familiarity Threat

A familiarity threat exists if the auditor is too personally close to or familiar with employees, officers, or directors of the
client company.

Example

ABC Company has been audited by the same auditor for over 10 years and the auditor regularly plays golf with the CEO
and CFO of ABC Company.

Issue

The auditor may have become too familiar with the client and, thus, lack objectivity in their work.

5. Intimidation Threat

An intimidation threat exists if the auditor is intimidated by management or its directors to the point that they are
deterred from acting objectively. 

Example

ABC Company is unhappy with the conclusion of the audit report and threatens to switch auditors next year. ABC
Company is the biggest client of the auditor.

Issue

The auditor’s independence may be compromised, as ABC Company is their biggest client and they, quite naturally, do
not want to lose such a client. Therefore, the auditor may issue a report that appeases ABC Company.

What is Accounting Ethics?

Accounting ethics is an important topic because, as accountants, we are the key personnel who access the financial
information of individuals and entities. Such power also involves the potential and possibilities for abuse of
information or manipulation of numbers to enhance company perceptions or enforce earnings management. Ethics is
also absolutely required in the course of an audit. Without meeting the requirements of auditing and accounting
ethics, an audit must instantly be paused.

 
Ethics and the Code of the Conduct

Ethics and ethical behavior refer more to general principles such as honesty, integrity, and morals. The code of
professional conduct, however, is a specific set of rules set by the governing bodies of  chartered accountants. Although
the rules set out by different bodies around the world are unique, some rules are universal. Let’s take a closer look at
some of these important rules.

Rules and Guidance

One of the key rules set out by professional accounting bodies in North America is the idea of independence. This is the
idea that, as an auditor, you must be totally objective and must be without ties to or relationships with the client since
that could potentially impair your judgment and impair the overall course of the audit work.

There are two forms of independence:

 Independent in fact
 Independent in appearance

Independence in fact refers to any factual information such as whether you, as an auditor, own any shares or other
investments in the client firm. These facts are usually easy to determine.

Independence in appearance, however, is more subjective. Let’s say, for example, that as an auditor you were invited to
a year-end party at the client firm. The party turns out to be extremely luxurious and you also receive a nice watch as a
gift. In appearance, would the auditor, who was invited to the party and who also received a gift, be able to maintain
independence in the audit? In order to solve a potential conflict of interest, a reasonable observer’s test is used  – i.e.,
what would a reasonable observer say about the situation? 

Threats to Independence

There are always threats and situations that can reduce the level of independence. Let’s take a look at some of these
threats:

Other Important Rules

Some other rules outlined by professional accounting bodies include the following:
  Contingent fees are not allowed – For example, audit fees that are based on a percentage of the net income
figure or a percentage of a bank loan received
 Integrity and due care – Audit work must be done thoroughly, diligently, and in a timely manner.
 Professional competence – Auditors must be competent, which means he/she must have both the necessary
academic knowledge and experience in the relevant industry.
 Duty to report a breach of rules – This rule is commonly referred to as the whistleblower rule. If a CPA observes
a fellow CPA violating any of these rules, he/she has a responsibility to report it.
 Confidentiality – Auditors must not disclose any information regarding the client to outsiders.

What is Audit Fraud?

In addition to their primary role, an auditor is required to consider the potential for audit fraud, in accordance with the
respective auditing standards of different countries around the world.

The primary responsibility for the prevention and detection of fraud rests with those charged with the governance of the
entity (i.e., the Board of Directors) and management (the client). It is mainly management’s role to place a strong
emphasis on fraud prevention, which can severely reduce opportunities for corporate misdeeds. 

An auditor’s role is to conduct an audit in such a manner as to obtain reasonable assurance that the  financial
statements, taken as a whole, are free from material misstatements, whether due to fraud or error. The distinction
between fraud and error is a matter of intent. Intentional errors are considered fraud and unintentional errors are
simply errors.

Two Types of Audit Fraud

Fraudulent Financial Reporting Misappropriation of Assets

Usually perpetrated by senior Usually perpetrated by lower

management (CEO, CFO, COO) level employees

Committed by the organization Committed against the

organization

Benefits the organization/company Benefits the

individual/employee

Auditor are highly concerned about Rarely material and less of a

this concern for an auditor

The Audit Fraud Triangle

The fraud triangle refers to conditions that are generally present when material misstatements due to fraud occur.
 

Incentives/Pressures

Generally, refers to companies undergoing excessive pressure to meet analysts’ or investors’ expectations

Stock options and bonuses based on net income are also examples of such incentives and/or pressures

Opportunities for Fraud

Ineffective governance – for example, the Board of Directors is not committed to ethical policies and morals

Significant subjective judgment calls or estimates are involved in accounting

Potential Problems arising from Attitudes/Rationalization

Management is very aggressive, has a risk-taking mentality, and makes highly unrealistic forecasts that need to be met

The ethical tone at the top is poor, which allows perpetrators to rationalize their actions

The Auditor’s Role

When the auditor is considering the potential for fraud in an audit, they will focus on risk assessment procedures in the
planning stage. Remember that auditors must maintain an attitude of professional skepticism. One of the auditor’s
responsibilities includes asking management and the audit committee if they know of any unusual situation or any
employee who is acting strangely, because the prevention and detection of fraud is ultimately their responsibility.

Fraud isn’t just about catching unusual transactions and relationships in the numbers in the books but also about
examining the general behavioral patterns of employees and any hardships, financial or otherwise, that they may be
suffering at the time.

In addition, the auditor will consider the fraud triangle and look for any fraud risk factors ( red flags) that indicate an
incentive/pressure to commit fraud. Finally, in the planning stage, auditors will also carry out ratio and trend analyses to
look for any unusual patterns or unexpected results in relation to previous year/industry data. 

The Auditor’s Responses to Audit Fraud Risks

An auditor’s action in response to potential fraud can be divided into an overall (i.e., financial statement level) and then
a more specific (specific line item/assertion level) response.

In dealing with significant fraud risks at the overall level, the accounting firm will assign more experienced audit staff to
the engagement and increase the level of supervision of lower level staff. The auditor will also thoroughly consider the
client’s accounting choices and policies to determine acceptability. Finally, auditors may choose to implement
unpredictable, surprise procedures to verify the values on the financial statements – such as unexpectedly showing up at
the client’s inventory count unannounced.

On a more specific level, auditors will make an effort to gain more reliable evidence by relying more on documentary
evidence as opposed to oral or visual evidence. In addition, they may also try to obtain more evidence from third parties
instead of just from the client. They may also change the extent of their procedures by increasing their sample size to
substantiate values, as well as by performing procedures closer to year end (varying the timing of the audit procedure).

We can see why the planning stage of an audit is very important. Depending on the client, the client’s inherent risk level,
and the audit risk level that auditors are willing to tolerate, the scope of audit work can differ substantially. With
effective planning, proper implementation, and a skeptical attitude, auditors should be able to uncover most frauds that
take place.