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Table of Contents

• Introduction

• Independence of internal auditor

• Independence of external auditor

• Types of independence

• Real independence and Perceived independence

• Restrictions on independence

• Relationship with the client

• The structure of the accountancy profession

• Independence regulations

• Possible future developments

• Law, regulations and the conceptual framework

of accounting

INTRODUCTION
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Auditors independence Refers to the independence of

the internal auditor or of the external auditor. It is essentially
an attitude of mind characterized by integrity and an
objective approach to the audit process. The concept
requires the auditor to carry out his work freely and in an
objective manner.

The purpose of an audit is to enhance the credibility of

financial statements by providing written reasonable
assurance from an independent source that they present a
true and fair view in accordance with an accounting
standard. This objective will not be met if users of the audit
report believe that the auditor may have been influenced by
other parties, more specifically company managers/directors
or by conflicting interests (e.g. if the auditor owns shares in
the company to be audited). In addition to technical
competence, auditor independence is the most important
factor in establishing the credibility of the audit opinion.

Auditor independence is commonly referred to as the

cornerstone of the auditing profession since it is the
foundation of the public’s trust in the accounting profession.
Since 2000, a wave of high profile accounting scandals have
cast the profession into the limelight, negatively affecting
the public perception of auditor independence

Independence of internal auditor

Independence of internal auditor means independence
from parties whose interests might not be totally aligned
with an effective risk management, an effective internal
control, and an optimal governance.The Charter of audit and
the reporting to an Audit Committee generally provides
independence from management, the code of ethics of the
company (and of the Internal Audit profession) helps give
guidance on independence form suppliers, clients, third
parties.
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Independence of external auditor

Independence of the external auditor means
independence from parties, that have an interest in the
financial statements of an entity. The support from and
relation to the Audit Committee of the client company, the
contract and the contractual reference to public accounting
standards/codes generally provides independence from
management, the code of ethics of the Public Accountant
profession) helps give guidance on independence form
suppliers, clients, third parties.

Types of independence
There are three main ways in which the auditor’s
independence can manifest itself. Mautz, R.K. & Sharaf, H.A.
(1961) ‘The Philosophy of Auditing’, American Accounting
Association. & Dunn, J., 1996. Auditing Theory and Practice.
2nd ed. Prentice Hall.

• Programming independence
• Investigative independence
• Reporting independence

Programming independence
Programming independence essentially protects the
auditor’s ability to select the most appropriate strategy
when conducting an audit. Auditors must be free to
approach a piece of work in whatever manner they consider
best. As a client company grows and conducts new activities,
the auditor’s approach will likely have to adapt to account
for these. In addition, the auditing profession is a dynamic
one, with new techniques constantly being developed and
upgraded which the auditor may decide to use. The
strategy/proposed methods which the auditors intends to
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implement cannot be inhibited in any way.While

programming independence protects auditors’ ability to
select appropriate strategies,

Investigative independence
Investigative independence protects the auditor’s
ability to implement the strategies in whatever manner they
consider necessary. Basically, auditors must have unlimited
access to all company information. Any queries regarding a
company’s business and accounting treatment must be
answered by the company. The collection of audit evidence
is an essential process, and cannot be restricted in any way
by the client company.

Reporting independence
Reporting independence protects the auditors’ ability to
choose to reveal to the public any information they believe
should be disclosed. If company directors have been
misleading shareholders by falsifying accounting
information, they will strive to prevent the auditors from
reporting this. It is in situations like this when auditor
independence is most likely to be compromised.

Real independence and Perceived

independence
There are two important aspects to independence
which must be distinguished from each other: independence
in fact (real independence) and independence in appearance
(perceived independence). Together, both forms are
essential to achieve the goals of independence. Real
independence refers to the actual independence of the
auditor, also known as independence of mind. More
specifically, real independence concerns the state of mind an
auditor is in, and how the auditor acts in/deals with a specific
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situation. An auditor who is independent 'in fact' has the

ability to make independent decisions even if there is a
perceived lack of independence present, or if the auditor is
placed in a compromising position by company directors.
Many difficulties lie in determining whether an auditor is
truly independent, since it is impossible to observe and
measure a person’s mental attitude and personal integrity.
Similarly, an auditor’s objectivity must be beyond question,
but how can this be guaranteed and measured? This is why
perceived independence is of such importance.

It is essential that the auditor not only acts

independently, but appears independent too. If an auditor is
in fact independent, but one or more factors suggest
otherwise, this could potentially lead to the public concluding
that the audit report does not represent a true and fair view.
Independence in appearances also reduces the opportunity
for an auditor to act otherwise than independently, which
subsequently adds credibility to the audit report.

Restrictions on independence
When auditors of a company are in conflict with the
directors it is important this conflict can be resolved without
the auditors losing any of their independence. This can prove
to be difficult as an auditor earns a fee from providing a
service, which is how he earns a living. This fee is paid by
the board of directors leaving them with the power in the
relationship. There in lies the dilemma, how can the audit
team please the directors without losing any of their
independence but keep the directors happy to ensure
maintain repeat business?

The problems regarding independence stem from two

main sources the auditors’ relationship with the company
and the nature of the accountancy profession.

Relationship with the client

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An auditor earns a living from the fee he is paid it is

therefore automatic that he does not want to do anything to
jeopardize this income. This reliance on clients’ fees may
affect the independence of an auditor. If the auditor feels
this client income is more important than their
responsibilities to shareholders he may not perform the audit
with the shareholder’s interests in mind. The larger the fee
income the more likely the auditor is to shirk his
responsibilities and perform the audit without independence.
This could lead to the manipulation of figures and
exploitation of accounting standards. By performing the
audit without independence the shareholders’ may get
misled, as the auditor is now reliant on the directors. To
encourage auditors to maintain their independence they
must be protected from the director’s board. If they were
able to challenge statements and figures without the risk of
losing their job they would be more likely to work with
complete independence. Ultimately, as long as the client
determines audit appointments and fees an auditor will
never be able to have complete economic independence.

In most cases it is the directors that negotiate an audit

contract with the auditors. This may cause problems. Audit
firms on occasions quote low prices to directors to ensure
repeat business, or to get new clients. By doing so the firm
may not be able to perform the audit fully as they do not
have enough income to pay for a thorough investigation.
Cutting corners could mean the audit team would be
reporting without all the evidence required which will affect
the quality of the report. This would bring into question their
independence.

It is common for the audit firm of a company to provide

extra services as well as performing the audit. Helping a
company reduce its tax charges or acting as a consultant for
the implementation of a new computer system, are common
examples. Having this additional working relationship with
the client would result in questions being asked of the
independence of the audit firm. If non-audit fees are
substantial in retaliation to audit fees suspicions will arise
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that auditing standards may be compromised. The firm

would no longer be unbiased, as it would want the company
to perform well so it can continue to earn the addition fee for
their consultancy. This would mean the audit firm would be
dependent on the directors and they would no longer be
working with independence.

The structure of the accountancy

profession
Price competition is a major factor in auditor
independence. Prior to the 1970’s audit firms were not
allowed to advertise their services and take part in bidding
competitions for contracts. Competition between the
accountancy firms greatly increased when these restrictions
were abolished, putting pressure on the audit firms to
reduce audit fees. Competitive bidding for contracts has also
encouraged the reduction of auditor engagement hours. The
pressure to reduce costs may compromise the quality of an
audit. If a firm feels threatened by competition they may be
tempted to further reduce costs to keep a client. This risks
lowering the standard of the audit performed and therefore
mislead shareholders.

The increased competition between the larger firms

means that company image is very important. No audit firm
wants to have to explain to the press the loss of a big client.
This gives the directors of the large company a commanding
position over its audit firm and they may look to take
advantage of it. The audit team would feel pressured to
satisfy the needs of the directors and in doing so would lose
their independence.

Independence regulations
There are various regulations in force regarding auditor
independence. The main enforcement of auditor
independence is through the Companies Act 1984 and the
Companies Act 1984 although the matter is also covered by
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the professional accounting bodies’ rules of professional

conduct and the Auditing Practices Board. It is also of note
that regulations (i.e. International Accounting Standards or
International Financial Reporting Standards) relating to the
preparation of financial statements are also relevant.

The companies Act 1984 dictates that it is the

responsibility of shareholders (rather than directors) to
appoint the auditor at the annual general meeting(AGM) –
section 384 of the act refers. The theory behind this is that
directors cannot intimidate auditors with the threat of
replacement or bribe them by offering reappointment. In
practice the existing auditors of a company are generally
reappointed for another term at the AGM but the
shareholders are free to choose another auditor if they wish
to. Directors can only appoint auditors in exceptional
circumstances (perhaps to fill a casual vacancy during the
year). However, such appointments by directors will expire
at AGMs. The Companies Act 1984 (section 386) allows
shareholders to eliminate the need to reappoint an auditor
each year. If they elect to do so then it is automatically
assumed that the existing auditor will be reappointed each
year without the matter arising at the AGM. In such
circumstances it would take an extraordinary general
meetings (EGM) in order to remove the auditor.

The Companies Act 1984 (part II) goes further to

protect the independence of the auditor in various ways. One
of the key ways is that auditors must belong to a recognised
supervisory body (RSB) before they can undertake such
work. Schedules 11 and 12 of the Companies Act 1984
specify the duties of the RSBs and the strict entry
requirements for their members that they must impose. It is
intended to ensure that all auditors have the required
knowledge and skills in order to carry out their role to an
acceptable standard.

Section 33 of the Companies Act 1984 allows for

professional accountants who have gained their qualification
in another country to practice within the United Kingdom
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although it is necessary for such persons to undertake extra

education in British law and accounting practices. In the past
this would tend be exploited by members of the
commonwealth but due to there being an EU directiveon
mutual recognition of professional qualifications it is now
possible for professional accountants within Europe to come
and work in the United Kingdom. The safeguards put in place
by section 33 (that any foreign professional accountants
must have an adequate knowledge of British law and
accounting practices) should protect the quality of audits.

The Companies Act 1984 also has provisions to prevent

employees of firms from becoming auditors of their own
companies and subsequently either any subsidiary of their
employers or parent companies (section 27 refers). This is
intended to prevent the appointment of an auditor with
vested interests in a company.

It is also a requirement that any person barred from

acting as an auditor should refuse any such offers of
appointment and resign immediately if for whatever reason
they become ineligible during their appointment. If for
whatever reason an ineligible person carries out an audit
then the Secretary of State (under section 29 of the
Companies Act 1984) has the power to require a company to
appoint a second auditor and bear the brunt of the cost as a
result. However, companies are allowed to recover additional
fees from the original ineligible auditor.

Further to regulations regarding the appointment of

auditors the various Companies Acts also contain rules
regarding the rights of auditors. The most fundamental of
these regulations is section 389A of the Companies Act
1984. This section states that auditors have a right of access
at all times to accounting related information from
companies and further have the right to demand
explanations from companies regarding any accounting
related enquiry they may have. Section 389A also covers
other matters such as making it illegal for employees of a
company to make misleading, false or deceptive statements
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to auditors regarding any accounting related queries they

may have. Subsidiaries of British companies also must
provide any accounting related information to the auditor of
the parent company should they request it although in
general it is usually the same auditor who undertakes the
audit of both the parent company and its subsidiaries.
Section 389A finally goes on to state that companies must
take all reasonable steps to obtain accounting related
information for auditors from any overseas subsidiaries it
may have. Auditors also have the right to communicate
directly with shareholders as dictated in section 390 in the
Companies Act 1984.

Whilst this legislation prevents directors of companies

from limiting the information available to auditors it does not
prevent directors from setting tight deadlines for auditors
where it may prove difficult to obtain all the necessary
information they feel they require for audit. Directors could
also attempt to negotiate a fee that would not be enough to
cover the costs of a proper audit thereby forcing the auditor
to perhaps undercut corners in order to reduce costs.
Shareholders are not likely to be sympathetic to auditors in
such circumstances either as they may be likely to see
auditors as unnecessarily overcharging for their service.

Due to the fact that directors can impose tight

deadlines, negotiate low audit fees or perhaps threaten to
nominate another auditor to shareholders it could be argued
that auditors are not truly independent within the United
Kingdom. Whilst there may be some truth to this it would not
be fair to say the rules are entirely ineffective as auditors
have to consider that if they fail to carry out an audit
effectively they will face stiff penalties, they could potentially
have to compensate any damages as a result of their failure,
they could potentially lose a lot of business and ultimately
their credibility would be shattered. Therefore in reality it is
thought that British auditors are only influenced in minor
ways and normally over matters of opinion given that an
auditor would put retaining its business before the loss of
one single client.
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Possible future developments

Service limitations
Many have advocated that in order for an auditor to
remain strictly independent they should not be allowed to
provide audit clients with any other advisory services. This
idea was detailed in the EC’s Eighth Directive and was
designed to remove conflicts of interest arising from audit
companies having a high percentage of total revenue staked
in the contract of one client. To date this has not been made
a requirement. Both auditors and their clients have argued
that the knowledge acquired during the audit process can
allow other services to be provided less expensively.

Peer assessment
A review of audit control procedures by another firm is
a requirement in the US that must be satisfied once every
three years. This has been implemented to ensure external
audits are carried out with the utmost professionalism and
independence at all times. Such a system has not been
accepted by UK auditors; however, it is expected that many
large firms already have peer reviews in place which are
conducted by audit teams from offices in other parts of the
country.

Audit committees
The recommendation for companies to form an audit
committee was first made in the Cadbury Report (1992). A
group of three to five non-executive directors from within the
company are chosen to provide what is supposed to be a
truly objective view on all aspects of the audit: from
evaluation of internal control systems to recommendations
on audit fee. Since the cadbury Report, this practice has
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been implemented yet many still remain unconvinced of the

neutrality of non-executive directors.

Rotating external auditors

It is widely believed that a mandatory rotation of audit
firm could improve auditor independence. Firstly, current
auditors will have no incentive to work in cahoots with their
client if the contract is due to expire in the foreseeable
future.] Similarly, auditors will be less likely to forge
relationships with directors and staff, thus will be less
concerned about upsetting them through an unfavourable
audit report. And because current auditors will know they are
soon to be replaced, they will be inclined to produce audit
reports which demonstrate high standards and are an
exemplar of true independence, as to avoid having any
shortcomings exposed by the new audit team.

However, proposals for a maximum client servicing

period of five years have since been dismissed after lobbying
by accounting firms and their clients, again stressing that it
is vitally important that auditors familiarise themselves with
client operations in order to conduct a successful audit.

Law, regulations and the conceptual

framework of accounting
In the future, issues regarding conflicts of interest may
be tackled through legislation which bans audit firms holding
shares in client companies. Some financial commentators
believe that it is the subjective nature of modern day
accounting which is the main contributor to the ambiguity of
auditor independence and suggest this could be clarified
through the introduction of a conceptual framework, rather
than legislation. They feel a set of agreed definitions on
matters which are not encompassed by formal standards
would benefit the auditor and, ultimately, remove any
doubts over real and apparent independence.
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