How much are we willing to pay to ensure auditor independence?
A perpetual ethical problem for auditors is the conflict of interests that exists with a client and client management who are responsible for selecting the auditor, paying the audit fee, and making decisions about auditor retention. Can we reasonably expect auditors to be independent of the client when their ability to service that client depends on the client’s view of matters other than the performance of the auditor?
Independence issues abound for auditors. Restrictions exist in the Sarbanes-Oxley Act (SOX) that limits the non-audit services which can be provided to the audit client. Auditors must avoid a variety of threats to independence such as self-review threats, when they audit their own work that might have been performed through internal audit outsourcing. An auditor lacks independence, in appearance if not fact, when auditing work they have initially prepared or reviewed on behalf of the audit client.
Other threats to independence include a familiarity threat when an auditor becomes involved in a business relationship with the client or client management. A financial self-interest threat exists when the auditor, or a member of his/her immediate family, owns stock in the audit client. Other rules exist limiting the ability of close relatives to engage in financial relationships when they have a financial reporting oversight role with the client entity.
The issues I address in this blog deal with the possible adverse interest threat to independence that may exist when an auditor expects a client to report financial statements items in a manner different from the original reporting by the client. The auditor may have identified a series of problems that are lumped into “materially misstated” financial statement items. If independence is to be applied fairly, then the mere threat in such situations, and perception that independence could be impaired, would seemingly create a threat to independence that cannot be breached by any safeguards that can be instituted. After all, independence is all about perceptions, not necessarily reality.
Is it possible that conflicts of interests due to the fee-payment system compromise the objectivity of auditors and the quality of audits? If so, are they due, at least in part, to the current system? The problem is severe, I believe. In 2014, the Public Company Accounting Oversight Board (PCAOB) found deficiencies in 23 of the KPMG LLP audits they evaluated in their latest annual inspection of the Big Four accounting firm’s work.
The 23 deficient audits the PCAOB found in its 2013 inspection of the firm were out of 50 audits or partial audits conducted by KPMG that the PCAOB evaluated—a deficiency rate of 46%. In the previous year’s inspection, the PCAOB found deficiencies in 17 of 50 KPMG audits inspected, or 34%. I imagine the results would be similar for the other Big-4 firms.
If, in fact, the purpose of the audit profession is to serve the public interest, then shouldn’t the question be how best to accomplish the goal? I believe this means changing the auditor-fee-payment system to reflect the changing culture in the profession and scope of professional services. At least let’s start a dialogue on this important issue.
In the interests of preventing this blog from being solely an academic exercise, I will briefly discuss a New York Times editorial that supports the government-administered hiring, retention and auditor payment system, and an insightful opposing-view opinion piece written by Jim Petersen, who writes a blog called Re:Balance.
On August 15, 2014, the NY Times wrote an editorial about “a revamped system in which audits are paid for not by company management, but by fees that companies pay to a public entity for the purpose of financing audits”. Some critics have dismissed the Times suggestions as reflecting “either breath-taking naïveté or an incomprehensible and unworthy lack of understanding of the audit services market – one that has operated exclusively on the ‘client pays’ model since privately-provided assurance was invented in the 1850’s in England and Scotland."
I have to disagree. Just because the auditor assignment and payment system has been the same for many years, it does not mean it should always be that way. The nature and scope of professional services performed for audit clients have exploded during the past twenty years thereby creating all sorts of conflicts of interest that cannot be explained away by rationalizing that the system will never change.
As with most issues, the devil is in the details and Jim Peterson makes some great points about the practical difficulties of moving toward a government assignment and payment system. Jim identifies some of the problems in his August 20, 2014, posting. Here is a sampling of the concerns he raises.
- What single-country government agency could evaluate and compare the global competence, resources and freedom from conflicts of auditor candidates in every one of the several dozen countries where a global-scale company operates and would require audit services?
- What costs and disruptions would the audit networks have to incur, to tender their credentials and proposals to such a government body?
- Because government agencies are by their very DNA unable to resist political pressures, what would be the impact of the inevitable lobbying on behalf of small and minority firms, lower-tier accounting school graduates, and population groups under-represented in the profession?
- Would auditors bid for appointments? And if so, what pricing mechanism could be functional to provide transparency and integrity?
- How would the constraints of government-dictated budgets and liability exposures be reconcilable with the need for engagement cost changes in light of judgmental decisions to modify or expand audit scope?
- In light of these and a host of other questions, how could a government-run process of auditor proposal, selection and monitoring possibly function on a schedule that would enable the delivery of audit reports both timely and informative to the community of interested users?
These are great points! What’s needed now is to open a dialogue about changes to the auditor assignment and fee payment system. What I envision is an independent body to make such decisions, not a government entity. The PCAOB could be such a body. This quasi-governmental entity has, in my opinion, done good work with respect to the inspections of audits of registered public accounting firms. Isn’t it possible to add to their plate a responsibility to make decisions about which firm should do the auditing and what is a reasonable fee?
Blog posted by Dr. Steven Mintz, aka Ethics Sage, on May 26, 2015. Professor Mintz is on the faculty of the Orfalea College of Business at Cal Poly San Luis Obispo. He also blogs at: www.workplaceethicsadvice.com.