Auditor’ independence means freedom of internal or external auditor from individuals who many have financial interests in the company being audited (Auditor Independence 2010). The concept of independence requires an auditor to undertake his/her audit work, without any interference by any other party, and with an aim of verifying if, the financial statements of a business reflect the true and fair view of the business (Auditor Independence 2010). Moreover, auditor’s independence requires an objective and honest approach to the audit process. To external auditors, the concept of auditor independence is very important. This is because; many stakeholders such as investors, creditors, the government, and employees, use audit reports, to make important economic decisions.
Independence of external auditor means autonomy from individuals, who may have substantial interests in the published financial reports of a business/company (Auditor Independence 2010). In many cases, independence of external auditors from such individuals is ensured by the audit committee of the given client company. Moreover, external auditors source their support for autonomy from the contractual and contract references of the public accounting standards, which provide that external auditors should be independent from the management (including the directors) of their client companies/businesses (Auditor Independence 2010).
The International Auditing Standards (IASs) also requires external auditors to observe independence in various areas. For instance, external auditors are required to report only to the audit committee of the client company/business (Auditor Independence 2010). These include, reporting matters related to revision of audit fee and approval of certain types of non-audit services. In fact, the International Auditing Standards prohibit external auditors from providing non-audit services such as internal audit outsourcing services, bookkeeping, asset valuation, and designing of client’s financial system. Moreover, external auditors are prohibited from having direct equity ownerships in their clients’ companies/businesses. In addition, external audits should not engage in activities, which are closely related to management functions. Other requirements related to the independence of external auditor include being solely involved in determining the scope and extent of their work, conducting frequent rotations of certain audit personnel during the engagement, and not acting as an advocate for an audit client or any of its directors/managers (Auditor Independence 2010).
External auditors are required to confirm their independency in writing, once they agree to undertake the audit engagement, to the audit committee of the client company/business. In cases where an external auditor fails to adherence to the independence requirements, the respective professional body, the government, through the court of law, or the client company/business can take a corrective action. This may include cancellation of practicing certificate, suspension from engagement, imprisonment, or cash fines (Auditor Independence 2010).
Theoretically, external auditors play important roles in safeguarding the interests of the shareholders of client companies. In addition, external auditors’ role in auditing financial reports plays a significant role in corporate governance whereby, they ensure that managers are accountable to the shareholders in all business aspects related to the company (Ojo 2006). Despite the importance of the external audit function to the shareholders, and the requirement that an external auditor should not have direct personal interests in the client’s company/business, they have been seen to develop commercial and personal interests while undertaking audit engagements in their clients’ companies/businesses (Ojo 2006).
Over the past few decades, many questions concerning external auditors’ independence have evolved. According to Hunton and Rose, one of the major sources of interference of external auditors’ independence is the directors (2008). Hunton and Rose observe that directors of many companies/businesses usually act as directors in more than two companies/businesses. Therefore, they only have less time to concentrate on monitoring the performance of their companies. Mostly, they concentrate on the reputation they achieve from the public (investors, business owners, shareholders, and creditors), concerning their success in managing numerous entities. Therefore, in order to maintain their reputation, they usually try to make sure that the financial reports of the entities where they are directors always represent positive performance, even when such performance is not achieved. Directors achieve this is by influencing the work of external auditors.
Directors interested in maintaining their reputations interfere with external auditors’ independence in different ways. One of these ways is to limit the scope of external auditors during audit engagement (Huston and Rose 2008). For instance, the directors may be involved in determining the scope of auditors’ work during the engagement, by identifying the specific areas where the auditors should conduct their investigations, and the areas, where they should not conduct investigation. Such areas include directors’ fees, use of business assets, such as motor vehicles, by the directors for personal reasons, and directors’ allowances among others. Many directors usually prohibit auditors from conducting investigation is such areas because; they do not usually present a true and fair view of the entities’ financial position (Huston & Rose 2008). It is common to see directors receive huge allowances for meetings, which never attend. In other cases, directors use entities’ motor vehicles to conduct their personal businesses.
All these activities amount to violation of directors’ code of conduct, as well as illegal use of entities’ resources for personal gain. If auditors were allowed to conduct audit engagement without interference of their independence by the directors, they would definitely discover these activities, and consequently report them during their audit reports to the shareholders. Publication of such reports can potentially ruin directors’ reputations, hence resulting into fewer opportunities to hold directorial positions in other entities, or dismissal from the boards of entities where he/she holds directorial positions. This would mean that such a director would lose his/her sources of income.
Moreover, the negative reputation would prevent him/her from seeking directorial positions in other entities in future. In order to prevent this from happening, directors ensure that the scope of external auditor is limited. In return, they may get into mutual agreements with the auditors. In many occasional, external auditors tend to take the offers presented to them by the directors as a way of protecting their commercial interests (earning more income). According to Huston and Rose, common offers made to external auditors include increased audit fee and continued audit engagement in the entity (2008). Even though the audit committee, in many cases, mainly determines audit fee, the directors and the audit committee members work in liaison to protect their reputation among the stakeholders. Therefore, the directors can easily influence the auditors’ pay. Similarly, directors can ensure continuous engagement of the current audits by ensuring that their reputation among the shareholders is positive.
In the their study, Hunton and Rose also observed that in other occasions, directors allow the auditors to provide non-audit services, inclusive of those that are prohibited by the International Auditing Standards, to enable them earn extra income from the entities (2008). This usually happens when the directors require the auditors not to disclose all the relevant information to the shareholders, or when the directors require the auditors to present an unqualified audit report even when the audit evidence indicates that the report should be qualified. Another area where Huston and Rose observed significant interference of auditors’ independence by the directors is in restatement of earnings (2008). Sometimes, the auditors may require restatement of previous financial statements, after they discover significant omission of the Generally Accepted Accounting Principles (GAAPs) or a significant loophole in the internal control systems.
Since restatement of financial statements has adverse effects on the value of shares, directors tend to object restatement of previous financial statements (Huston & Rose 2008). Moreover, since restatement of financial statements indicate weakness in corporate governance (lack of competence among the audit committee members), audit committees also interfere with the independence of external auditors during such situations. The audit committee may face dismissal, or even legal actions in case of restatement of financial statements. Likewise, the directors may lose their current and future board seats. For these reasons, both the directors and the audit committee interfere with the independence of external auditors in bid to secure their positions in various entities.
Studies indicate that, the recent cases of fallen firms were due to interference of external auditors’ independency by the board of directors, and the audit committees (Lindberg & Beck 2002). In many cases, the directors and the audit committee members tend to protect the interests of the shareholders insufficiently, through interfering with the auditors’ independency. A very good illustration of such a firm is Enron. Enron was declared bankrupt in December 2001 (Lindberg & Beck 2002). According to Lindberg and Beck, Enron collapse was because of direct actions of the directors, audit committee, and the external auditors (2002). During the previous years, Enron had been recording negative earnings (Lindberg & Beck 2002). The firm’s financial statements also indicated that the firm had been substantially violating the accounting principle of materiality. Large volume of transactions would be omitted from the financial records, and hence in the final financial statements. Studies also indicate that, Enron had violated other accounting standards concerned with accounting for business combinations and revenue recognition (Lindberg & Beck 2002).
During the external audit, the directors in liaison with the audit committee would lure the firm’s auditors with high audit fee and non-audit services. In fact, Lindberg and Beck point that the accounting firm that was providing external audit services to Enron was earning more fees from provision of non-audit services, than it was earning from audit services (2002). In return, the auditors could provide unqualified audit reports. This trend continued for quite a long time until when the irregularities were finally discovered. Unfortunately, by the time of the discovery, all the firm’s financial resources had been drained It was then declared bankrupt. Enron is an example of other numerous cases of big multinational and local companies, which have collapsed due to interference of auditors’ independence by the directors and the audit committees.
Some individuals argue that directors interfere with the independence of external auditors in order to protect the interests of the shareholders. For instance, in Enron’s case, the directors feared that if they allowed the auditors to present qualified audit reports during the annual general meetings, the shareholders would lose faith in the company, and would opt to withdraw their investments from the firm. This could have been a great disappointment especially to the firm’s biggest shareholders. However, Zawada argues that interference of auditors’ independence in the name of protecting shareholders’ interests is not a justified (n.d.). Instead, directors and audit committee members should allow the external auditors to undertake their work independently, so that they would be able to unveil areas within a firm/business entity, where corrective actions need to be taken as soon as possible before the problems become dire. If auditors are allowed to work independently, most of the major causes of business collapse can be controlled during their development stages.
Accordingly, Zawada states that lack of interference with auditors’ independence is the best way of protecting shareholders’ interests (n.d.). However, since many directors and audit committee members would rather safeguard their reputations among the stakeholders, than to allow the auditors present a true and fair view of the financial position to the shareholders, then it is clear the interference of auditors’ independency will not cease in the near future. In the same way, due to their commercial interests, the accounting firms will continue to allow interference of their independence during audit engagement by the directors and audit committee members. It is therefore clear that the shareholders will continue to lose, as the directors and the external auditors continue to fulfill their personal and commercial interest.
According to Ojo, external audit processes are costing the shareholders a lot of money, yet they are of no importance to them (2006). In fact, Ojo points out that, external audit processes leave the shareholders worse off, than they would be if, external audits were not conducted. This is because; auditors tend to manipulate the financial statements and reports in favor of the directors and the audit committee members. In the end, shareholders use the published and audited financial statements and/or reports, to make important economic decisions. For instance, an unqualified audit report, which ought to be qualified, may indicate good financial performance of a given business entity. As a result, a shareholder makes a decision to invest substantial amounts of money in the entity’s stocks, hoping to reap huge in terms of dividends and capital gains. In the long run, the shareholders does not earn any dividends, neither does he/she earns capital gains from sale of the stock, since in most cases, negative performance affects the price of an entity’s stocks in the market.
Therefore, from a personal perspective, the external audit function serves no important purpose to the shareholders. Since they usually serve their own interests and those of the directors, at the expense of the shareholders, their roles in public owned and limited liability entities should be removed. Instead, shareholders can invest the money used to pay external shareholders, in the internal audit departments, since so far, the internal departments have proofed to make significant contributions to the shareholders’ interests.