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HOW INDEPENDENT

The auditor’s r eal and per ceived independence and


autonomy in the per for mance of the attest function seems
universally accepted as a desirable attribute.

CAN AN
EXTERNAL AUDITOR
REALLY BE?
J OA N A . C E Z A I R

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H
eadline-grabbing litigation from perfect independence and objec-
cases involv ing Cer tified tivity and potentially result in undesir-
Public Accounting (CPA) able conduct even if they comply w ith
firms have left the public professional standards. 1
questioning the integrit y Independence rules are contained in
of external auditors w ith regard to pub- the American Institute of Certified Pub-
l i s h e d , au d i te d f i n a n c i a l s t at e m e nt s . lic Accountants (AICPA) Rules of Conduct.2
Many question the effectiveness of exter- The need for these Rules of Conduct is occa-
nal auditors in the attestation function. sioned by the barrage of criticism of the
Educators and researchers theorize that accounting profession and includes rules
poor auditor judgment is to blame; while governing such issues as auditor inde-
others theorize that time pressures have pendence, integrity and objectivity, com-
negative impacts on audit qualit y. This petency and technical standards. Under
ar ticle explores the arguments for and the conceptual f ramework for auditor
against outside auditors and evaluates independence issued by the AICPA’s Inde-
their effectiveness in fulfilling their attes- pendence Standards Board (ISB), audi-
tation function. tor independence is defined as “freedom
from those factors that compromise, or can
reasonably be expected to compromise
Is an “independent” auditor a myth? an auditor’s ability to make unbiased audit
Independence and objectivity are hallmarks decisions.”
of the auditing profession. However, audi- The definition of independence has
tors are subject to economic incentives to been explained as follows: the auditor
please clients that could lead them away is not required to be completely free of
all the factors that affect the abilit y to
DR . JOAN A. CEZ AIR i s a n a ssi sta nt professor of account-
i n g i n t h e D e pa r t me nt of Accou nt i n g i n t h e S ch ool of
make unbiased audit decisions, but only
B u si n ess a n d E con omi cs a t Fa yet t e v i l l e S t a t e Uni ve r si t y free from those that rise to the level of
i n Nor t h Ca rol i n a . D r. Cez a i r hol ds a P h . D. i n Accou nt -
i ng f rom Ar gosy Uni ve r si t y a t S a ra sot a . S he i s a l so a n
compromising that abilit y. 3 The defini-
a lumna of Howa rd Universit y a nd the Universit y of Ma r y- tion compels the auditor to make a per-
la nd where she ea r ned her Ba chelor’s a nd Ma ster’s degrees,
consecut ively, i n Account i ng. Dr. Cez a i r cur rent ly tea ches
sonal assessment of his or her objectivity
cou r ses i n F i n a n ci a l a n d Ma n a ge r i a l Accou nt i ng a t t he to determine if pressures and other fac-
u n d e r g r a d u a t e l e v e l . He r r e s e a r c h i n t e r e s t s i n c l u d e
a ccou n t i n g e du ca t i on , ge n d e r a n d di v e r s i t y i s s u e s i n
tor s comprom i s e t h e abi l i t y to m a ke
a ccou nt i ng a n d a u di t i ng. unbiased audit decisions. The f r ame-

MARCH/APRIL 2010 INTERNAL AUDITING 3


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work also identifies five t y pes of threats mission (SEC) accused Arthur Andersen
to the auditor’s independence that are: of “knowingly or recklessly” issuing false
• Self- interest: The threat that arises and misleading audit reports. According
when an auditor acts in his or her to the press release, the SEC said it found
ow n emotional, financial or other financial statements that were issued as
personal self-interest. “clean” opinions by Andersen that over-
• Self-rev iew : The threat of bias aris- stated Waste Management’s pre-tax income
ing when an auditor audits his or by more than $1 billion for the years 1993
her ow n work or the work of a col- to 1996. 8 As a consequence, Arthur Ander-
league. sen agreed to pay 7 million to settle the
• Advocacy : The threat that arises case. 9
WHAT DOES IT when an auditor acts as an advocate As Richard H. Walker, the SEC’s then
MEAN TO
for or against an audit client’s posi- Director of Enforcement, said in a state-
“APPEAR”
INDEPENDENT? tion or opinion rather than as an ment: “Arthur Andersen and its partners
unbiased attester. failed to stand up to company manage-
• Familiarit y (or trust): The threat ment and thereby bet rayed their ult i-
that arises when an auditor is being mate allegiance to Waste Management’s
influenced by a close relationship shareholders and the investing public.” 1 0
w ith an audit client. Another scandal at Just for Feet chain
• Intimidation: The threat that arises of shoe stores illustrates an example of
when an auditor is being, or believes the impact of the threat of self-interest, one
that he or she is being, overtly or of the threats to auditor independence
covertly coerced by an audit client or listed in the auditor’s independence frame-
by another interested part y. 4 work. A shareholder class action suit filed
Auditors have to not only be independent against the company in 1999 claimed the
in fact, but also independent in appear- shoe chain inflated its profits and under-
ance. But what does it mean to “appear” stated expenses for three fiscal years stretch-
independent? In assessing appearance, ing from 1997 to 1999. The suit further al-
the existing literature directs the auditor leged that the company’s auditors, Deloitte
to consider whether a “reasonable investor, & Touche, helped pad the financials while
knowing all the facts and circumstances, pursuing a consulting contract from the
would believe a particular relationship auditee. The Just for Feet managers then
or activity with an audit client might affect alleged that they told the auditors that
the auditor’s independence.” 5 their associates had breached the com-
In 2001, researchers performed a study puterized accounting systems but, rather
t hat ex a m i ne d t he i ndep endence a nd than report that problem promptly to the
obj e c t iv it y of auditors . 6 T he a na lys is company’s audit committee, Deloitte sought
showe d t hat if t he auditor conclude d to profit from Just For Feet’s inadequate sys-
there was a misstatement in the financial tems by successfully bidding on a con-
statements but the client knew or believed sulting project to cure the many deficiencies
that there was none, then the client would in those systems. 11
encourage the auditor to do more work One group of researchers believe audit
so that it was possible to render an unqual- failures rarely result from the deliberate
ified opinion. In addition, the research c o l lu s i o n o f au d i t o r s w i t h c l i e nt s . 1 2
also showed that risks of misstatements Instead, they theorize that auditors may
persisted even when investors diversi- f i nd it p s ycholo g ic a l ly i mp o s s ible to
fied portfolios because the misstatements re m a i n i mp a r t i a l a n d o bj e c t i ve . T h e
were all likely to be in favor of the client researchers believe that bias t y pically
overstating the company’s value—mak- enters unconsciously and unintention-
ing the overall misstatement in the port- ally at the stage of making judgments, not
folios potentially ver y large. 7 when repor ting them. When people are
An example of just this ty pe of action called on to make impar tial judgments,
is exemplified in Arthur Andersen’s audit- those judgments are likely to be uncon-
ing of Waste Management Inc. On June 19, sciously and powerfully biased in a man-
2001, the Securities and Exchange Com- ner that is commensurate with the judge’s

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self-interest. Psychologists call this the balling is a marketing strateg y akin to
“self-ser v ing bias.” “low introductor y pricing.” 16 The SEC is
When presented w ith identical infor- ver y suspicious of the practice because
mation, the researchers point out that it may impair auditor independence. The
individual perceptions of a situation dif- “Cohen Report” issued by the Commis-
fer dramatically depending on one’s role sion on Auditor Responsibilities to exam-
in the situation. 13 Self-serving biases exist ine the issue of auditor independence
because humans are imperfect informa- took a dist inc tly negat ive v iew of the
tion processors. One of the most impor- practice of low-balling. The report argued
tant non-objective influences on infor- that low-balling may impair auditor inde-
mation processing is self-interest. People pendence by creating the equivalent of a
tend to confuse what is personally ben- bai l b ond held by the manager of the
eficial w ith what is fair or moral. In sum, audited firm who could then threaten its
the research confirms that auditors’ judg- u su r p at ion shou ld t he aud itor re ve a l
ments are likely to be biased in favor of information harmful to the manager. The
their own and their clients’ interests. 14 auditor, by offering to “low ball”, signals
Rob er t K . E l l iot t , C ha i r m a n of t he to the manager her readiness to be pliant. 1 7
Board of Directors of the AICPA for 1999-
2000, noted in a sy mposium held by the
New York State Society of Certified Pub- Have changes in the structure of CPA
lic Accountants that audits are not free. firms impaired their independence?
“If audits were free, we could demand The Big Four accounting firms have devel-
that auditors be completely and absolutely oped on a worldw ide scale into what has
independent. But audits are not free. There become known as Multidisciplinary Prac-
are degrees of independence: the greater tices (MDPs). The 1990s saw the consult-
the independence, the greater the cost.” ing practices of large CPA firms become
Some advocates favor the rotation of audi- the largest segments of their business.
tors to improve auditor independence. CPA consulting ser vices have become an
However, Elliott further noted that audit increasing ly impor t ant component of
failures often occur in the first year or two public practice. Critics argue that exces-
of a relationship and that the audit firm sive involvement in consulting engagements
that must replace its entire portfolio every w ith attest clients can imp air auditor
three, five, or even seven years, may seek independence, which is a distinctive char-
to be known as a more compliant player, acteristic of the profession and a basic
in order to attract clients, thus impact- element of the relationship with the client.
ing the quality of audits under this ty pe In a case involving Oxford Health Plans,
of rotation system. a h e a lt h m a i nte n a n ce org a n i z at i on
Independence has been characterized (HMO), $4.5 billion of their $6.8 billion
as perhaps the sing le most impor t ant market valuation was erased when it came
attribute that the CPA brings to the rela- out that Oxford’s sof tware system was
t i o n s h i p w i t h h i s o r h e r c l i e nt . 1 5 To vastly overstating revenues and under-
emphasize, former SEC Chairman Levitt stating expenses. Plaintiff lawyers claimed
has stated that “more than any thing else, in this case that CPA firm KPMG, outside AUDITORS’
it is the independent auditor who stands auditor for Oxford, would have been more JUDGMENTS
ARE LIKELY TO
guard in defense of the public interest. motivated to uncover the deception if it BE BIASED IN
It is his dut y and his unique franchise to had not been so preoccupied w ith sell- FAVOR OF THEIR
protect and honor that interest.” ing tax, appraisal and actuarial ser vices OWN AND THEIR
to Oxford. 18 CLIENTS’
In another famous case involv ing the INTERESTS.
Does the practice of low-balling impair now defunct Ar thur Andersen over the
auditor independence? collapse of the DeLorean Motor Co. in
Low-balling refers to the deep initial dis- 1982, according to sealed cour t docu-
count granted by an external auditor when ments, Andersen’s auditors put together
they enter a potentially long-term audit the DeLorean Company’s profit figures
engagement with a client firm. Thus, low- a n d t h e n au d ite d t h e i r ow n wor k . In

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addition, Andersen effectively became response to major audit failures in the 1990s,
a par t of DeLorean’s management, seek- most famously the collapse of Enron Cor-
ing investment capital and negotiating poration. SOX was initially intended to
contracts on the company’s behalf. Mean- raise the bar for integrit y and compe-
while, Andersen’s consultants won a con- te nce for publ icly t r ade d comp a n ie s ,
tract to design and install a computerized although its effect has been to promote
accounting system. greater accountability within the private
THE ENACTMENT A common focus of research relating sector as well.
OF SOX to the auditor’s prov ision of non-audit One requirement of SOX addresses
CERTAINLY services (NAS) is whether providing NAS auditor independence in that public com-
DOES NOT MAKE
impairs the auditor’s independence–in fact pany audit committees must now consist
THE ISSUE OF
AUDITOR or appearance. Researchers have noted solely of independent directors and at least
INDEPENDENCE that overall, evidence from both pre-and one financial exper t. More impor tantly,
GO AWAY. post-Enron periods suggests that per- the audit committee must be given the
ceptions of independence may depend responsibility for, and complete control,
upon the size of the NAS relationship over the hiring, compensating, and retain-
w ith concerns mitigated when separate ing of the company’s independent audi-
personnel perform audit and NAS. 19 The tors and for overseeing the work of the
value of NAS by auditors depends upon auditor in preparing or issuing any audit
the cost/benefit tradeoff, w ith compro- repor t. 21 It is clear by this requirement,
mises in auditor independence as one of that the government recognizes that com-
the most critical potential costs. promising of auditor independence con-
Some analysts, however, believe that the tr ibuted to the collapse of these large
size of today’s CPA firms render many inde- cor porations, most specifically, Enron
pendence rules irrelevant since the size C or p or at ion a nd t he once g i a nt C PA
of these larger fir ms reduces the per- firm, Ar thur Andersen, LLP.
centage of individual partners’ interests Part of SOX regulation was the estab-
in the overall business of a firm and thus lishment and organization of the Public
has eliminated financial dependence on Company Accounting Oversight Board
a ny one cl ient . O t hers arg ue t hat t he (PCAOB or the Board). The PCAOB was
“appearance” test for independence should given power, among other things, to reg-
be abandoned because it is a worthwhile ister and discipline accounting firms that
but unattainable ideal. Still others con- audit public companies. Public account-
tend t hat NAS en hances t he auditor’s ing firms are now required to register
knowledge of the client, leading to a more with the Board and the Board has discretion
efficient and effective audit. 20 to reject applications.
The Big Four have heeded the calls to In keeping with the idea of maintaining
divest their consulting ser v ices in light auditor independence, SOX has shortened
of these scandals. Ernst & Young sold its the list of consulting ser vices that CPA
consulting business to France’s Capgem- firms can provide to publicly held audit
ini, a worldw ide consulting firm; KPMG clients. The Act lists specific types of con-
sold a fifth of its consulting arm to Cisco sulting services that are now unlawful when
Systems for $1 billion and account ing provided to publicly held audit clients:
par tners have divested their remaining • Bookkeeping;
stake in the consulting firm; and Price- • Information systems design and
WaterhouseCoopers (PWC) separated implementation;
the management consult ing unit f rom • Appraisals or valuations ser v ices;
its accounting and auditing business. • Actuarial ser v ices;
• Internal audits;
• Management and human resources
Does the Sarbanes-Oxley Act improve ser v ices;
auditor independence? • Broker/dealer and investment bank-
The implement at ion of the Sar banes- ing ser v ices;
Oxley Act of 2002 (SOX or The Act) came • Legal or exper t ser v ices related to
as a direct result of the U.S. government’s audit ser v ices; plus

6 INTERNAL AUDITING MARCH/APRIL 2010 EXTERNAL AUDITOR INDEPENDENCE


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• A “catch-all” categor y authorizing dence go away. In 2003, the SEC charged
the Board to prohibit any ser v ices it HealthSouth Corp. w ith faking $1.4 bil-
w ishes for auditors of publicly held lion in profits since 1999. Outside experts
companies. 22 claim sur prise that the firm’s indepen-
According to a 2004 ar ticle examining dent auditors, Ernst & Young, could have
SOX and audit failure, the root causes of missed a misstatement this big. Critics
audit fai lure are (1) auditor blunders point to the revolv ing do ors b etween
caused by unintentional human error; (2) audit firm and client that existed between
auditor fraud; (3) undue influence caused HealthSouth and then-CEO Richard M.
by financial interests; and (4) undue influ- S c r u s hy, w h o h a d h i re d a nu mb e r of
ence caused by personal auditor-client senior auditors f rom Er nst & Young’s
relationships. 23 The key provisions of SOX Birmingham (Ala.) office. 24
that have the potential to reduce the like- What is expected to be the major focus
lihood of audit failure can be summa- of the Board w ill be the inspection pro-
rized as follows: gram to assess the degree of compliance
• activ ities of the PCAOB; of each registered public accounting firm
• new rules for audit committees; w ith SOX. 25 This is indeed a major shift
• new criminal penalties and protec- i n t h e p ol i c i ng of i n de p e n de nt C PAs
tion for whistle-blowers; since, for years CPAS were allowed to
• limits on auditor consulting; and regulate themselves through the “peer
• new financial repor ting and audit- re v iew” pro ces s w hich C PA f ir ms are
ing procedures. required to conduc t to sat isf y AICPA
The enac t ment of SOX cer tainly does m e m b e r s h i p. Pe e r r e v i e w s a r e s t i l l
not make the issue of auditor indepen- required for membership in the AICPA

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EXTERNAL AUDITOR INDEPENDENCE MARCH/APRIL 2010 INTERNAL AUDITING 7


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5
but registered firms are also subject to McGrath, Siegel, Dunfee, Glazer, and Jaenicke, op.
cit. at note 3.
a peer rev iew administered by the Cen- 6
Boritz and Zhang , op. cit. at note 1.
ter for Public Audit Firms (CPCAF) com- 7
Ibid.
mittee under the CPCAF Peer Rev iew 8
SEC Press Release 20 01-62.
9
Program. 10
Ibid.
Ibid.
11
E. MacDonald, “Was that Auditor ’s Opinion really
I n d e p e n d e n t ? ” Fo r b e s 16 7, n o . 7 ( M a r ch 2 0 01 ) :
Conclusion 10 9 – 111 ( a c c e s s e d Ja n u a r y 2 010 f r o m B u s i n e s s
Source Premier dat abase).
The auditor’s real and perceived inde- 12
M. Bazerman, K. Morgan and G. Loewenstein, “The
pendence and autonomy in the perfor- impossibilit y of auditor independence,” Sloan Man-
agement Review 38, no. 4 (Summer 1997): 89–94
m a n c e o f t h e at t e s t f u n c t i o n s e e m s (accessed Januar y 2010 from Academic Search Pre-
universally accepted as a desirable at- mier dat abase).
13
tribute. The enactment of SOX was an Ibid.
14
Ibid.
attempt to restore public confidence in 15
W. Read, “Consulting ser vices and CPA firms,” The
this function. However, regulatory actions CPA Journal (Februar y 1993).
16
which only affect the appearance of inde- J. Chi-Wen and & Zhaoyang Gu, “Low Balling , Legal
L i a b i l i t y a n d Au d i t o r I n d e p e n d e n c e ,” Ac c o u n t i n g
pendence (as opposed to changing actual Review 73, no. 4 (October 1998): 533 (accessed Jan-
independence) will never reduce the like- 17
uar y 2010 from Business Source Premier database).
Ibid.
lihood of audit failure. 26 The post-Enron 18
MacDonald, op. cit. at note 11.
era has put external auditors, their work 19
A. Schneider, B. Church, and K. Ely, “Non-Audit Ser-
and their independence under a micro- vices and Auditor Independence: A Review of the
L i t e r a tu r e ,” Jo u r n a l o f Ac c o u n t i n g L i t e r a tu r e 2 5
scope. Cor porate governance and audi- (20 06): 169–211 (accessed Januar y 2010 from Busi-
tor independence are in vogue again. I ness Source Premier dat abase).
20
Ibid.
21
G . L a n d e r, W h a t i s S a r b a n e s - O x l e y ? N e w Yo r k :
NOTES McGraw-Hill (20 04): 54–58.
1 22
E. Boritz and P. Zhang , “The Auditor ’s Objectivit y C. Latshaw, “Fraudulent Financial Reporting: The Gov-
vis-à-vis Material Misstatements,” Journal of Accoun- ernment and Accounting Profession React,” Review
t ancy 191, no. 4 (April 20 01): 93 (accessed Janu- of Business 24, no. 2 (Spring 2003): 13–18 (accessed
ar y 2010 from Academic Search Premier dat abase). Januar y 2010 from Academic Search Premier dat a-
2 base).
These rules of conduct are available online at http://
23
www.aicpa.org/about/code/sec10 0.htm. J. Tackett, F. Wolf, and G. Claypool, “Sarbanes-Oxley
3 and audit failure–A critical examination,” Manage-
S. McGrath, A. Siegel, T. Dunfee, A. Glazer, and H.
Jaenicke, “A Framework for Auditor Independence,“ rial Auditing Journal 19, no. 3 (20 04): 340–350 (ac-
Journal of Account ancy 191, no. 1 (Januar y 20 01): cessed Januar y 2010 from Business Source Premier
39–42 (accessed Januar y 2010 from Business Source dat abase).
24
Premier dat abase). D. Foust, “Missing the Red Flags,” Business Week
4
H. Jaenicke, “A framework for auditor independence,” no. 3828 (April 14, 20 03): 72 (accessed Januar y
T h e Fr e e L i b r a r y ( J a n u a r y 2 0 01 ) , a v a i l a b l e o n - 2010 from Academic Search Premier dat abase).
25
line at http://www.thefreelibrar y.com/A+framework+ G . L a n d e r, W h a t i s S a r b a n e s - O x l e y ? N e w Yo r k :
for+auditor+independence.-a069372738 (accessed McGraw-Hill (20 04): 85–89.
26
Januar y 2010). Tackett, Wolf, and Claypool, op. cit. at note 23.

8 INTERNAL AUDITING MARCH/APRIL 2010 EXTERNAL AUDITOR INDEPENDENCE