Why do accountants need to be independent?

An independent auditor is a certified public accountant (CPA) or chartered accountant (CA) who examines the financial records and business transactions of a company with which they are not affiliated. An independent auditor is typically used to avoid conflicts of interest and to ensure the integrity of performing an audit.

Independent auditors are often used—or even mandated—to protect shareholders and potential investors from the occasional fraudulent or unrepresentative financial claims made by public companies. The use of independent auditors became more critical after the implosion of the dotcom bubble and the passage of the Sarbanes-Oxley Act (SOX) in 2002.

An auditor may perform various auditing, tax, and consulting services for individuals, corporations, nonprofit organizations, or government entities.

An independent auditor either works for a public accounting firm or is self-employed. An auditor examines financial statements and related data, analyzes business operations and processes, and provides recommendations on achieving greater efficiency. They evaluate company assets for impairment and proper valuation and determine tax liability, ensuring compliance with tax code and laws.

The auditor develops an opinion asserting the reliability and fairness of clients' financial statements, then communicates the information to investors, creditors, and government organizations. Also, an auditor may perform other auditing, tax, and consulting services for individuals, corporations, nonprofit organizations, or government entities.

An independent auditor asks questions of management and staff for a better understanding of the business, its operations, financial reporting, internal control system, and known fraud or error. They may perform analytical procedures on expected and unexpected variances in account balances or transaction classes, then test documentation supporting those variances. The auditor also observes the company’s physical inventory count and confirms accounts receivable (AR) and other third-party accounts.

The Sarbanes-Oxley Act of 2002 was passed after Enron, WorldCom, and several other technology companies collapsed due to accounting improprieties. The goal of SOX was to improve corporate governance and restore the faith of companies' investors. However, many in the business world are against SOX, seeing it as a politically motivated move leading to a loss of risk-taking and competitiveness.

Of concern to many is the mandate requiring that public companies obtain an independent audit of their internal control practices. The cost of the requirement is felt most acutely by companies with a market capitalization of $75 million or greater. The audit standards were modified in 2007, reducing costs for many firms by 25% or more annually.

  • Independent auditors are certified public or chartered accountants who examine the financial records of companies and are not affiliated with the companies being audited.
  • Independent auditors have a mandate to protect shareholders and potential investors from a public company’s possible fraud and accounting improprieties.
  • Company managers can use the results of an independent audit to improve company processes.
  • Independent audits provide a clear picture of a company's worth, which helps investors make an informed decision when considering whether to purchase a company’s shares.

Despite the high initial costs of the internal control mandate, companies can experience many benefits from the independent audit process. Managers can use the information to continually improve internal processes. Companies frequently find that over time the internal control testing becomes more cost-effective.

Additionally, markets use the information from the audit to assess businesses more effectively. Audits provide a clear picture of a company's worth, which helps investors make an informed decision when considering whether to purchase shares in a company. Financial analysts and brokerage companies also rely on an audit's results when making investment recommendations to their clients.

Accountants in public practice should be independent in fact and appearance when providing auditing and other attestation services. If you provide attestation or assurance services to clients, a conflict of interest may prevent you from also providing investment advisory services.

AICPA rules state that an accountant’s independence will be impaired if the accountant:

  • makes investment decisions on behalf of audit clients or otherwise has discretionary authority over an audit client’s investments.
  • executes a transaction to buy or sell an audit client’s investment.
  • has custody of assets of the audit client, such as taking temporary possession of securities purchased by the audit client.

Accountants may provide certain advisory services to audit clients without impairing independence. Accountants can:

  • recommend the allocation of funds that an audit client should invest in various asset classes, based on the client’s risk tolerance and other factors.
  • provide a comparative analysis of the audit client’s investments to third-party benchmarks.
  • review the manner in which the audit client’s portfolio is being managed by investment managers.
  • transmit an audit client's investment selection to a broker-dealer, provided the client has made the investment decision and has authorized the broker-dealer to execute the transaction.

By Josephine Haste

Let me take you back to your time at university. Do you remember when you would diligently attend your audit lectures and madly scribble notes on every word the lecturer said? No?

Recent observations from CPA Australia’s quality review program suggest that many of us skipped the lecture (and forgot to collect the notes!) on the fundamental importance of actual and perceived independence.

The quality review program continues to find members who have failed to comply with this most critical accounting principle. Perhaps even more concerning is that when a breach of independence is reported, many members don’t fully understand that it may be illegal not to satisfy the requirements of actual and perceived independence.

So what is independence and why is it at the cornerstone of every audit that is conducted? The purpose of an audit is to express an opinion that is objective, impartial in judgement and reliable for those who are using an audit opinion to make decisions about investment or for regulatory purposes.

For an audit report to be worth its salt, the auditor who prepared it must be seen to be free of any undue influence. In financial terms, this means that the auditor should not have any dependency on the client by either personal affiliation or financial reliance. An auditor who fulfills these criteria is regarded as independent.

Actual independence is quite straightforward for an accountant who is across the requirements. If, however, there is a significant financial connection, other than through the reasonable fees paid for the auditing services, or a connection via a personal relationship, actual independence may be impeded.

This could be a problem to the point where it is unlikely that any safeguards would ensure that the audit opinion is seen as objective, even if an independent auditor would have drawn the same conclusions from an examination of the entity.

"Perhaps it is the time for your practice to take an independence health check."
— Josephine Haste

Perceived independence is where shades of grey creep in to the normally black-and-white world of audit. Looking at the relationship between the auditor and the client, every individual may perceive an arrangement differently, and this is where professional judgement comes to the fore.

As a guiding principle, perceived independence is when a third party looking into the arrangement would consider the auditor independent from the client. When faced with a perceived independence issue, an appropriate consideration is materiality. APES 110 Code of Ethics for Professional Accountants suggests that “When assessing materiality, a member in public practice or a firm shall consider both the qualitative and quantitative aspects of the matter which might have, or be seen to have, an adverse effect on the objectivity of the member or the firm.” 

What is key in this quote are the words “or be seen to have”, which suggest that the accountant should adopt a wider viewpoint when assessing perceived independence.
In Australia, there is an abundance of literature on auditor independence. To compile a risk assessment on the topic, the place to start is the principles enshrined in law. These are the legal requirements that impose the greatest risk to an accounting practice.

The independence requirements applying to auditors are legally enforceable and are located within the following legislation and standards:
  • Divisions 3, 4 and 5 of Part 2M.4 and section 307C of the Corporations Act 2001
  • APES 110 Code of Ethics for Professional Accountants, sections 290 and 291 – applicable to all members of professional accounting bodies
  • Auditing standard ASQC 1 Quality Control for Firms that Perform Audits and Reviews of Financial Reports and Other Financial Information, and Other Assurance Engagements
  • Auditing Standard ASA 220 Quality Control for an Audit of a Financial Report and Other Historical Financial Information

To help members better understand the independence requirements and fully digest this information, the Joint Accounting Bodies issued the fourth edition of the Independence Guide in February 2013. This provides practical, case-based scenarios to help practitioners assess issues of independence that they may encounter.

So let’s now take the mid-semester test on independence. For each example given below, state whether you think the accountant is independent or non-independent and, if the accountant is non-independent, whether that non-independence is actual or perceived.

  1. The accountant has their domestic partner, who is also an accountant, sign off on their trust account audit.
  2. A sole practitioner employs a staff member who holds a public practice certificate. The sole practitioner prepares the accounts and the staff member signs off on the audit of a superannuation fund.
  3. A practitioner who is not a qualified Registered Company Auditor (RCA) employs an RCA to sign off on an audit engagement that requires an RCA sign-off. The RCA engaged has no public practice certificate or public liability insurance.
  4. A firm with three partners has one partner responsible for the compilation of accounts and another partner responsible for signing off the audit.
  5. A sole practitioner completes the audit for an entity who engages the practitioner’s wife for bookkeeping services.
  6. A small firm accepts a large audit engagement where the fees associated with the audit will comprise 85 per cent of the total fee revenue for the firm.

You may consider these examples to be great works of fiction, but in fact they are taken from case findings from the quality review program.

All of these examples are real concerns for auditors. How did you score on the test? Perhaps it is time for your practice to take an independence health check. Here’s a prescription for some resources which may help you assess your own independence, both actual and perceived:

Josephine Haste is CPA Australia’s manager for quality review education.