Auditor independence the issues ASIC

Monday, 01 October 2001

Ian Mackintosh photo
Ian Mackintosh

    ASIC chief accountant Ian Mackintosh discusses the hot topic of auditor independence.

    The concept of independence is fundamental to auditing. The auditor's independent opinion enhances the credibility of a company's financial reports. The idea that the auditor can carry out the audit, to the greatest possible extent, free of externally imposed constraints, and free from bias, personal interest, or susceptibility to undue influence, is key to this credibility. In most countries, standards for auditor independence are set by professional accounting bodies with maybe a few ad hoc requirements in law. I want to focus here on two approaches to auditor independence.

    IFAC's conceptual approach

    The International Federation of Accountants (IFAC) issued an exposure draft on audit independence and is due to issue a final standard in November this year. IFAC states that as it is seldom possible or reasonable to be totally independent – you need to evaluate the significance of economic and financial relationships in light of what "a reasonable and informed third party, knowing all relevant information, would reasonably conclude to be acceptable". Under IFAC's conceptual approach, it's up to the audit/assurance firms and team members themselves, to:

    • identify and evaluate circumstances and relationships that create threats to independence, and

    • eliminate the threats or to reduce them to an acceptable level, by applying safeguards.

    While IFAC believes it's impossible to define every threat and appropriate safeguard, their exposure draft does outline:

    • five types of threats to independence: self interest, self-review, advocacy, familiarity and intimidation

    • three categories of safeguards:

    - those created by the profession, legislation or regulation

    - those within the client

    - those within the audit firm's own systems and procedures. IFAC also gives examples of threats and appropriate suggested safeguards.

    US SEC's independence requirements By contrast, the US Securities and Exchange Commission sets and amends numerous rules for auditor independence, in addition to those of the professional body. The US SEC states four principles of independence, similar to IFAC's conceptual approach. They are: whether the relationship or the provision of service: 1. creates a mutual or conflicting interest between the accountant and the audit client 2. places the accountant in the position of auditing his or her own work 3. results in the accountant acting as management or employee of the audit client 4. places the accountant in a position of being an advocate of the audit client. They recently issued changes to rules including:

    • narrowing the application of rules on financial and employment relationships to apply only to those persons who can influence the audit, instead of all partners in an accounting firm

    • listing non-audit services that affect independence which include:

    - bookkeeping

    - financial information systems design

    - appraisal or valuation services and fairness opinions

    - actuarial, human resources or legal services.

    IFAC believes that its conceptual framework is more in the public interest than complying with a set of rules such as the US SEC's, which may be arbitrary. The US SEC, in contrast, does not believe you can rely on the audit firms to self-review and self-analyse. It says that the audit firms' culture does not support this approach and that experience has shown that firms will not do it. It believes that consistent, uniform and enforceable rules are required in this situation.

    Another view

    It seems to me there's not a lot of difference between IFAC's concepts and the US SEC's four principles. The key bones of contention seem to be:

    • how many situations should be explicitly covered, and

    • whether the situations should be regarded as just guidance or rules to be followed

    I suggest that Australia adopt the IFAC concepts and examples in the first instance with an ongoing program to add to, and expand on the examples, so that over a period of time, they become quasi rules or precedents. I also agree somewhat with US SEC's contention that "the fox may be guarding the henhouse" if it is left entirely up to the firms' management to decide when a threat exists and what safeguards are adequate. The profession needs to set up a mechanism to ensure the spirit of the independence concepts is being followed. Perhaps this could be part of the review of audit firms that is already being carried out, or via an annual declaration by the firms of their independence to a relevant body. A need may also exist for a board or panel that members can go to for advice and where complaints can be heard. This panel could also be responsible for keeping the "examples" up to date.

    Appointment of auditors

    Auditors are, in theory, appointed by the shareholders. But, unfortunately, the auditors are in reality, appointed by the management and the board, which leads to the view that auditors are not independent of the board and management. Many suggestions have been made over a number of years (and particularly recently) to rectify this situation. They have included:

    • appointment of auditors by ASIC (our chairman was quick to disagree)

    • a greater role for the audit committee

    • a democratically-elected corporate governance board to make appointments

    • a committee of shareholders, not related to management, to make appointments

    • an independent regulatory agency to oversee appointments.

    Consideration should be given to a strengthened audit committee appointing and removing auditors, setting audit fees and calling for audit tenders. The "strengthening" would be achieved by adding one or two shareholder-elected members, who would only deal with the above-mentioned matters and report to shareholders.

    Whatever solution is felt to be best, I think the creation of a satisfactory appointment process for auditors would also go a long way to improving public perception of the independence of auditors.


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