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Auditor independence: an international perspective

Rocco R. Vanasco Director, Centre for Internal Auditing Studies, National-Louis University, Chicago, Illinois, USA
Examines the role of professional associations, governmental agencies, and international accounting and auditing bodies in promulgating standards to foster auditor independence domestically and abroad. Focuses specically on the role played by the American Institute of Certied Public Accountants, the Institute of Internal Auditors (IIA), the Securities and Exchange Commission and the US Government Accounting Office. Also looks at other professional associations in banking, industry, and manufacturing sectors dealing with sensitive issues of auditors' involvement in such matters as management advisory services, operating responsibilities, outsourcing, opinion shopping, auditor rotation, and other conicts of interest which may impair auditor independence.

Introduction
No person is an island unto himself and that independence is always a relative term. That is greater or less, but never absolute[1].

Managerial Auditing Journal 11/9 [1996] 448 MCB University Press [ISSN 0268-6902]

The American Institute of Certied Public Accountants (AICPA), The Institute of Internal Auditors (IIA), the American Accounting Association (AAA), the Securities and Exchange Commission (SEC) and several professional associations nationally and abroad have emphasized that auditor independence is both an ethical and a professional issue crucial to auditors. Independence has been viewed as a deeply felt professional credo. It is believed that part of the solution in solving ethical dilemmas regarding potential and perceived threats to auditor independence is to place more emphasis on professional ethics[2]. The Ethics Committee of the International Federation of Accountants (IFAC) has also emphasized the concept of independence as an ethical issue in its guidelines on auditor independence. Several authors have come with philosophical, sociological, behavioral, and legal denitions of independence and what leads to its impairment. Elijah Watts Sells[3] emphasized the importance of the auditors independence vis--vis the auditee: The position of the public accountant with respect to corporations and their management is always an independent one. Unlike attorneys, accountants are not expected to make out a case. The character of the service they render is impersonal. Early in 1928, an editorial in the Journal of Accountancy highlighted the existence of a conict of interest when an auditor is a stockholder, officer, or director of the organization. It stated: The accountant should be utterly divorced from nancial or other participation in the success or failure of an undertaking under audit that no one could ever point an accusing nger, however unjustly, and allege the possibility of bias[4]. Mautz and Sharaf[5], in their Philosophy of Auditing, advocated recognition of three dimensions of auditor independence which can minimize or eliminate potential threats to the auditors objectivity:

1 Programming independence includes: freedom from managerial interference with the audit programme; freedom from any interference with audit procedures; and freedom from any requirement for the review of the audit work other than that which normally accompanies the audit process. 2 Investigative independence encompasses: free access to all records, procedures, and personnel relevant to the audit; active co-operation from management personnel during the audit examination; freedom from any management attempt to specify activities to be examined or to establish the acceptability of evidential matter; and freedom from personal interests on the part of the auditor leading to exclusions from or limitations on the audit examination. 3 Reporting independence includes: freedom from any feeling of obligation to modify the impact or signicance of reported facts; freedom from pressure to exclude signicant matters from internal audit reports; avoidance of intentional or unintentional use of ambiguous language in the statement of facts, opinions, and recommendations and in their interpretations; and freedom from any attempt to overrule the auditors judgement as to either facts or opinions in the internal audit report. Carey and Doherty[6] came up with three meanings of auditor independence:
First, in the sense of not being subordinate, it means honesty, integrity, objectivity and responsibility Second, in the narrow sense . in which it is used in connection with auditing and expression of opinions on nancial statements, independence means avoidance of any relationship which would be likely, even subconsciously, to impair the CPAs objectivity as auditor. Third, it means avoidance of relationships which to a reasonable observer would suggest a conict of interest.

Michael Barrett[7] indicated that the audit professions ethical notion of apparent independence can be dened in a sociological role

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Rocco R. Vanasco Auditor independence: an international perspective Managerial Auditing Journal 11/9 [1996] 448

construct, whereas its conception of real independence can be dened as a personality construct. Professional audit independence, according to Barrett, has two constructs: 1 Interpersonal independence describes functional situations which promote or dysfunctional situations which impair the professions auditor image as perceived by reasonable observers, and 2 Intrapersonal independence is the second order factor containing three operational content variables. It is assumed that auditors who are eld analytical rather than global eld types, who evidence a low social approval need rather than being approval motivated, and who prefer to describe themselves in terms of independent rather than intermediate or dependent personality typologies tend to possess a high degree of intrapersonal independence as characterized by their behavior in test and non-test situations. Shockley[8] examined the effects of competition in the audit profession, management advisory services (MAS), and size of the audit rm in third-party perceptions of the external auditor independence. His results show that all the variables signicantly affected third-party perceptions of auditor independence. Knapp[9] also examined the effects of a number of variables that could affect thirdparty perceptions of the auditors ability to resist management pressure in an audit conict situation. His results indicate that the nature of the conict, the nancial condition of the client, and competition, affected the perceptions of the auditors ability to resist management pressure. Lawrence Sawyer[10] speaks of two kinds of independence for internal auditors: 1 Practitioner independence: when the internal auditor, by reason of a sufficiently high reporting status in the organization, can maintain an objective attitude in forming opinions and preparing reports. 2 Professional independence: the image that internal auditors bring to minds of people, a feeling of trust that evidence has been gathered without bias, and opinions have been expressed freely . Pasewark and Wilkerson[11] suggested that auditors examine the following factors when considering independence: whether the auditor and the client have certain nancial relationships, and whether the auditor can be considered part of the management or an employee under management control.

They mention ve sources of power that have the potential to inuence the auditors independence: 1 authoritative power; 2 expertise power; 3 control over rewards; 4 coercive power; and 5 personal power. When evaluating a specic client or potential client, the auditor should consider the clients potential to inuence auditor independence. As an aid in performing such an evaluation, they recommended the following: Consider the client in terms of the ve sources of power. Assess the probability that the client might exercise the power possessed. Consider how the probability of the use of the power might inuence auditor independence. Accept or reject the engagement on the basis of the evaluation. Bartlett[12] suggests that the extensive body of literature and research concerning auditor independence has centred mainly on alleged threats to perceived independence or threats to actual independence. Whenever the independence concept in accounting is questioned, there is a tendency to be defensive by citing a kind of semi-spiritual incantation such as: No instance can be found in which an auditors independence is lacking. Surveys indicate that the CPA profession is held in the highest regard by those who know what CPAs do. If more constraints are placed on the professions activities, it will not be able to serve clients properly, leading to signicant costs to the public. Independence is a mental state for professional accountants and not subject to empirical observation or quantication. Bartlett believes that these semi-spiritual incantations serve as a poor justication for the actual existence of independence. If the mission of the profession is public welfare, and if the members of the profession are convinced that independence actually exists, then it is time to revise and restate a concept of independence that can be observed. The auditing profession has come under constant scrutiny regarding the auditors perceived independence. Forbes[13] published an editorial questioning auditor independence by raising the following: Since auditors are selected and paid by management, are they truly independent? and the Wall Street Journal[14] published another editorial in which a shareholder criticized a $1.6

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Rocco R. Vanasco Auditor independence: an international perspective Managerial Auditing Journal 11/9 [1996] 448

million loan by the bank to the companys auditors on the ground that such loan constituted a conict of interest and jeopardized the auditors independence. The harsh criticism by the public and private sectors on auditors apparent and perceived independence has led the AICPA, the IIA, the SEC and international accounting bodies to formulate rules regarding independence and adopt procedures to enforce them.

RESOLVED, that no member or associate shall certify the nancial statements of any enterprise nanced in whole or in part by public distribution of securities if he is himself the actual or benecial owner of a substantial nancial interest in the enterprise or if he is committed to acquire such an interest[17].

In 1940, the nancial independence rule became part of the Code of Professional Ethics. The AIA adopted the following rule on auditor independence:
A member or associate shall not express his opinion on nancial statements of any enterprise nanced in whole or in part by public distribution of securities, if he himself is the actual or benecial owner of a substantial nancial interest in the enterprise or if he is committed to acquire such an interest; nor shall a member or an associate express his opinion on nancial statements which are used as a basis of credit, if he is himself the actual or benecial owner of a substantial interest in the enterprise or if he is committed to acquire such interest, unless he discloses his nancial interest in his report[18].

Part I Professional assocations, government, and management


The role of the AICPA
Because it is an attitude or state of mind, independence is difficult to assess objectively; only an auditors actions can be used by observers to evaluate independence[15].

CPAs perform the attest function on communication of economic data by one party to another. The attest function adds credibility to the communication only if CPAs are independent and competent. The AICPA has dealt with the delicate issue of auditor independence on several occasions. The following chronology details the evolution of this concept of CPA independence and affirms the high priority given it by the AICPA. Independence has become the cornerstone of the auditing profession. The AICPAs predecessor, the American Association of Public Accountants (AAPA), established in 1887, did not recognize independence in its constitution and by-laws. In 1907, its bye-laws were amended expressing the desirability of avoiding incompatible functions. In 1916, the AAPA was renamed as the American Institute of Accountants (AIA). Both the AAPA and AIA did not appear to be actively concerned with auditor independence until 1930. In 1931, the AIA recognized the importance of the auditors independence when CPAs assumed the dual roles of both director and auditor for a company To pre. vent such incompatible functions, the AIA introduced the following:
RESOLVED, that the maintenance of a dual relationship, as director or officer of a corporation, while acting as auditor of that corporation is against the best interests of the public and the profession and tends to destroy that independence of action considered essential in the relationship between client and auditor[16].

In 1942, the AIA amplied this rule and aligned itself with the 1937 SEC position taken in the ASR # 2. The AIA added the following clause specifying that the auditors independence is impaired:
if he (auditor) owns or is committed to acquire a nancial interest in the enterprise which is substantial either in relation to its capital or to his own personal fortune[19].

In 1947, the AIAs Committee on Auditing Procedures published a special report titled Tentative Statement of Auditing Standards. Their Generally Accepted Signicance and Scope in which independence in fact is described as:
Independence in the last analysis bespeaks an honest disinterest on the part of the auditor in the formulation and expression of his opinion, which means unbiased judgment and objective consideration of facts as determinants of that opinion. It implies not the attitude of a prosecutor, but the judicial impartiality that recognizes an obligation on his part for fair presentation of facts which he owes not only to the management and the owners of a business but also to the creditors of a business, and to those who may otherwise have a right to rely upon the auditors report as in the case of prospective owners or creditors[20].

The AIAs Council also recognized that a conict of interest may arise when CPAs certify nancial statements of companies in which they have a substantial interest. To prevent such situations, the following was adopted at the 1934 AIA annual meeting:

The 1948 Statement on Auditing Procedures (SAP) No.23 describes the ten generallyaccepted auditing standards (GAAS). The second general standard required that in all matters relating to the assignment, an independence in mental attitude is to be

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Rocco R. Vanasco Auditor independence: an international perspective Managerial Auditing Journal 11/9 [1996] 448

maintained by the auditor[15]. In 1950, the AICPA published Audits by Certied Public Accountants: Their Nature and Signicance emphasizing that Independence, both historically and philosophically, is the foundation of the public accountant[21]. In January 1962, the AICPA adopted the following rule on independence as part of the Code of Professional Ethics:
Article 1: Relations with Clients and the Public: 1.01 Neither a member or associate, nor a rm of which he is a partner, shall express an opinion on nancial statements of any enterprise unless he and his rm are in fact independent with respect to such enterprise. Independence is not susceptible to precise denition, but is an expression of the professional integrity of the individual. A member or associate, before expressing his opinion on nancial statements, has the responsibility of assessing his relationships with an enterprise to determine whether, in the circumstances, he might expect his opinion to be considered independent, objective and unbiased by one who had knowledge of all the facts. A member or associate will not be considered independent, for example, with respect to any enterprise if he, or one of his partners, (a) during the period of his professional engagement or at the time of expressing his opinion, had, or was committed to acquire, any direct nancial interest or material nancial interest in the enterprise, or (b) during the period of his professional engagement, at the time of expressing his opinion or during the period covered by the nancial statements, was connected with the enterprise as a promoter, underwriter, voting trustee, director, officer, or key employee.

In the 1980s, several critics of the profession charged that the AICPA Code of Professional Ethics did not serve the public interest. In response to these charges the AICPA formed the Anderson Committee in 1983 to review the Code. This resulted in 1988 in the establishment of a new Code of Professional Conduct. The following issues were reviewed: limited liability; client condentiality and whistleblowing; and auditor independence. Collins and Schultz[25] argue that a number of issues still remain unresolved or confounded by the new Code and that, in each area, the AICPA promoted a position that is potentially harmful to the public good. SAS #58, Reports on Audited Financial Statements attempted to close the expectations gap by revising the auditors standard report which explicitly labels the report as the Independent Auditors Report to emphasize the auditors independence. The expectations gap refers to the signicant difference that existed between the level of condence perceived by nancial statements users and the level of condence provided by the auditor[26]. SAS# 65, Considering the Internal Audit Function in an Independent Audit of Financial Statements states that when external auditors use internal audit information to reduce their own work, they are obligated to investigate the internal auditors independence by learning about their organizational status and lines of communication in the company . SAS #65 was based on the theory that independence is enhanced when internal auditors report to the highest level of management and the audit committee. Research results indicate that the Big Eight auditors, non-Big Eight CPAs, bank loan officers, and certied nancial analysts differed signicantly in the extent of their support for the policies discussed in the Cohen Commission Report as a means to enhance auditor independence[27]. On many occasions auditor independence has been questioned by the SEC and the media which led the AICPA to conduct seminars and publish its views on auditor independence. In March 1993, the AICPA Public Oversight Board (POB) published a report, In the Public Interest: Issues Confronting the Accounting Profession, expressing concern about the independence and objectivity of the accounting profession. The POB appointed an advisory panel to look into this matter. The advisory panel, after interviewing 77 professional accountants, business executives, attorneys, academics, and others, concluded there are

In March 1962, the AICPA moved to prohibit the direct nancial interest or material indirect nancial interest in an enterprise under audit by a member[22]. In 1972, the AICPA, in its Restatement of the Code of Professional Ethics, stated that independence has always been a concept fundamental to the accounting profession, the cornerstone of its philosophical structure and adopted new rules of conduct regarding auditor independence[23]. In November 1972, the AICPA Committee on Auditing Procedures issued Statement on Auditing Standards (SAS) No. 1 which emphasizes auditor independence both in fact and appearance and states:
To be independent the auditor must be intellectually honest; to be recognized as independent, he must be free from any obligation to or interest in the client, its management, or its owners[24].

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Rocco R. Vanasco Auditor independence: an international perspective Managerial Auditing Journal 11/9 [1996] 448

important steps that should be taken to better assure the integrity and objectivity of auditors judgement[28]. In June 1993, the AICPAs board of directors issued a statement entitled, Meeting the Financial Reporting Needs of the Future: a Commitment from the Public Accounting Profession[29]. The AICPA endorsed all the recommendations of the Public Oversight Board and proposed several accounting reforms in order to: improve fraud detection; strengthen auditor independence; enhance the usefulness of nancial reports; and discourage unwarranted litigations through congressional tort reform[30]. In 1993, the AICPA issued Ethics Ruling 97 stating that external auditors: cannot perform management functions or make management decisions; cannot be part of the clients approval process; or cannot be part of the internal control system without impairing their independence[31]. In 1994, the AICPAs Professional Ethics Division published a proposed interpretation of the professions Code of Professional Conduct to sharpen the distinction between client advocacy and client service. Firms and individual CPAs should exercise professional independence before committing to client positions on accounting or nancial reporting issues. The AICPA Statement on Auditing Standards and the Code of Professional Ethics both emphasize independence as a precondition in expressing an opinion on nancial statements. The General Standards of SIAS No. 1 state that In all matters relating to the assignment, an independence in mental attitude is to be maintained by the auditor or auditors. Rule 101 of the Code deals with auditor independence and states that: A member in public practice shall be independent in the performance of professional service as required by the standards promulgated by bodies designated by Council. Interpretation of Rule 101 provides examples of situations that would impair an auditors independence:
Independence shall be considered to be impaired if, for example, a member had any of the following transactions, interests, or relationships: A During the period of a professional engagement or at the time of expressing an opinion, a member or a members rm:

had or was committed to acquire any direct or material indirect nancial interest in the enterprise; was a trustee or executor or administrator of any estate if such trust or estate had or was committed to acquire any direct or material indirect nancial interest in the enterprise; had any joint, closely held business investment with the enterprise or with any officer, director, or principal stockholders thereof that was material in relation to the members net worth or to the net worth of the members rm; and had any loan to or from the enterprise or any officer, director, or principal stockholder of the enterprise. This proscription does not apply to the following loans from a nancial institution when made under that institutions normal lending procedures, terms, and requirements: Loans obtained by a member or a members rms that are not material in relation to the net worth of such borrower; Home mortgages; and Other secured loans, except loans guaranteed by a member or by a members rm which are otherwise secured.

B During the period covered by the nancial statements, during the period of the professional engagement, or at the time of expressing an opinion, a member or a members rm: was connected with the enterprise as a promoter, underwriter, or voting trustee, a director or officer or in any capacity equivalent to that of a member of management or of an employee; or was a trustee for any pension or protsharing trust of the enterprise.

The AICPA Code of Professional Ethics states that a CPA shall not express an opinion on nancial statements of an enterprise unless he and his rm are independent with respect to such enterprise. An opinion on the fairness of presentation of nancial statements should be issued only if he or she is independent of the client both in fact and appearance. In other words, independence must be perceived by third parties. In February 1994, the POB and the SEC Practice Section (SECPS) appointed a threemember advisory panel on auditor independence. The panels charge was to determine whether the SECPS, the accounting profession or the SEC should take steps to better assure the independence of auditors and the integrity and objectivity of their judgements on the appropriate application of generallyaccepted accounting principles to nancial statements.

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Rocco R. Vanasco Auditor independence: an international perspective Managerial Auditing Journal 11/9 [1996] 448

One month later, on 16 March, 1994, the POB announced the formation of a special panel to inquire into matters relating to auditor objectivity and independence. This was in response to the criticism made by Walter P. Schuetze, chief accountant of the SEC[32]. The panel recommended appropriate steps to bolster the professionalism of the independent auditor, and to assess the working relationships among the profession, the SEC, and the FASB[33]. On 13 September, 1994, the POBs advisory panel on auditor independence issued its report entitled Strengthening the Professionalism of the Independent Auditor[34]. The panel made the following recommendations: The independence of boards of directors must be enhanced to protect the interests of corporate investors. The auditor must consider the board of directors to be its audit client. There should be more timely, more frequent, more open, and more candid communication between the auditor and the board. These recommendations were aimed at improving auditor independence and strengthening corporate governance. The advisory panel also published its suggestions and recommendations on such matters as: the need for additional rules on auditor independence; the role of auditing in public accounting rms; strengthening the relationship between the board of directors and the independent auditor; and the relationship among auditors, standard setters, and the SEC[34]. In the report, the panel urged the accounting profession to look to the board of directors as the audit client, not management. It called for a direct interface between the board and the auditor at least annually, and an expanded interface with the audit committee[35]. Donald J. Kirk, chair of the advisory panel on auditor independence, stressed that the auditors role is not a seller of other services, by putting to work the skills and judgements gained in dealing with control systems and complex accounting issues to promote added value. Auditor independence is enhanced when the auditing professional steps into the role of commenting on the quality of reporting practices[36].

opinion and to report matters as they are rather than as some executives would like to see them[10].

The Institute of Internal Auditors (IIA) was founded in 1941. On 15 July, 1947, The IIA issued its rst Statement of Responsibilities of the Internal Auditor[37] which dened internal auditing as an independent appraisal activity within the organization for the review of the accounting, nancial, and other operations as a basis for protective and constructive service to management. It deals primarily with accounting and nancial matters but it may also properly deal with matters of an operational nature. Ernest Meyers[38] reported that early in the 1950s the internal auditors role of inuence and independence was limited because of four majors factors: 1 Internal auditors did not have access throughout the corporation and could not question higher management decisions. 2 The majority of internal audit departments lacked trained professional accountants. 3 Most internal audit departments were allowed to concern themselves only with matters of accounting and nancial nature. 4 The majority of internal audit departments reported to lower-level management. Gupta[39] observed that management soon started to realize that the reason why their internal audit staff were not able to make larger contributions to the entity was due to their lack of stature in the organization. By allowing internal auditors to report to the highest echelon of the organization, management enhanced internal auditors independence as well as their stature. Sawyer[40] believes that the enhanced internal auditor independence is not only attributed to the managements recognition of the major contributions internal auditors bring to the organization, but also to the IIAs posture in expanding considerably the role of the internal auditor by: departing from the traditional image of an internal auditor as an accounting clerk; extending the role of the internal auditor to operational activities; and having the internal auditor report to the highest echelon of management to enhance auditor independence. To professionalize the discipline of internal auditing and recognize its expanded independence, the IIA amended and rened the Statement of Responsibilities of Internal Auditors in 1957[41]. The new denition of internal

The role of the Institute of Internal Auditors


The professional internal auditor must have independence to full a professional obligation, to render a free, unbiased, unrestricted

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Rocco R. Vanasco Auditor independence: an international perspective Managerial Auditing Journal 11/9 [1996] 448

auditing elevates internal auditors to a partnership with management. Internal auditing is dened as an independent appraisal activity within an organization for the review of nancial accounting and other operations as a basis for service to management. It is a managerial control, which functions by measuring and evaluating the effectiveness of other controls. The Statement was further rened in 1971, 1974, and 1981 to reect signicant changes in the internal auditing profession. In the 1970s, the board of directors of major corporations and professional associations such as the AICPA, the American Accounting Association (AAA), the Financial Executives Institute (FEI), the National Association of Accountants (NAA), and the International Federation of Accountants (IFAC) recognized the changing role of internal auditors, the relevance of the internal auditing function, and the professionalism of internal auditors. Internal auditors were reporting to the audit committee and independent auditors were coordinating their audit efforts with internal auditors[42]. In 1978, the IIA issued the Standards for the Professional Practice of Internal Auditing (SPPIA)[43] thus broadening its scope and reaffirming internal auditor independence as the most important aspect of the internal auditing profession. Bradford Cadmus[44] eloquently stressed that independence is essential to the effectiveness of an internal auditing programme. The reason why independence is so important is that it permits internal auditors to render impartial and unbiased judgements. Independence for internal auditors differs from that for external auditors. Internal auditors, as employees of the entity, do not have the nancial independence of an external auditor[45]. The SPPIA[43] requires that internal auditors be independent of the activities they audit. Two important factors contribute to independence: 1 The organizational status (110.01) of the internal auditing department should be sufficient to permit the accomplishment of its audit responsibilities. Internal auditors should have the support of top management and the board of directors so that they can gain the co-operation of auditees and perform their work free from interference. Internal auditors should not report to divisional management, line managers, or other persons with a stake on the outcome of their ndings. Independence is thus enhanced when auditors do not audit their bosses. Independence is enhanced when the director of the internal auditing department is responsible to an individual

in the organization with sufficient authority to promote independence and to ensure broad audit coverage, adequate consideration of audit reports, and appropriate action on audit recommendations. 2 Objectivity is an independent mental attitude which internal auditors should maintain on performing audits (120.01). Objectivity requires internal auditors to perform audit in such a manner that they have an honest belief in their work product and that no signicant quality compromises are made (120.02). Thus internal auditors should be excluded from line operations and involvement in the decision-making process. Objectivity is questioned when internal auditors report to divisional management, line managers, or other persons with a stake in the outcome of their ndings. The SPPIA underscores the importance of independence by stating: Independence permits internal auditors to perform their work freely and objectively Without indepen. dence, the desired results of internal auditing cannot be realized. The SPPIA also describes several means of meeting its standards. The guidelines for the independence standards are: The director of the internal auditing department should be responsible to an individual in the organization with sufficient authority to promote independence and to ensure broad audit coverage, adequate consideration of audit reports, and appropriate action on audit recommendations. The board of directors should concur in the appointment or removal of the director of the internal auditing department. The purpose, authority, and responsibility of the internal auditing department should be dened in a formal written document (charter). The director should seek approval of the charter by management as well as acceptance by the board. The charter should: establish the departments position within the organization; authorize access to records, personnel, and physical properties relevant to the performance of audits; and dene the scope of internal auditing activities [43]. Independence is so relevant to internal auditors that the IIA issued eight interpretations in its Professional Standards Bulletins (PSBs). PSB 85-6, Independence of Internal Auditors vs External Auditors[46] notes that the greatest single issue concerning the

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Rocco R. Vanasco Auditor independence: an international perspective Managerial Auditing Journal 11/9 [1996] 448

independence of internal auditors is that they are inside looking in. All auditors, when in compliance with their standards, are equally independent; therefore, all internal and external auditing organizations strive to maximize managements knowledge and understanding of, and agreement with, standards governing their efforts. In this way, practical independence is enhanced. PBS 85-6 emphasizes that as long as the internal auditors subscribe and adhere to the standards and do not have responsibility or accountability for operations subject to review, they may be as independent as any other entity providing appraisal services to an organization. PSB 88-4, Steps to Foster Independence, stresses that the organizational independence of the internal audit department has the greatest impact on both actual and perceived independence. To foster independence PSB 88-4 suggests that the following additional criteria be considered by the director of the internal audit department: an audit charter, outlining the departments responsibilities signed by the audit committee which precludes outside interferences or reprisals; periodic meetings between the audit director and the audit committee with immediate access in time of special need; balanced audit scope and plan approved by the audit committee; adequate budgetary resources; strong staff qualications, experience, and continuing educational requirements; rotation of staff members assigned to audits; and the level and organizational position of management responsible for the performance appraisal and compensation of the director. The evolution of internal auditing in the last 50 years has been in tandem with the expanded concept of internal auditor independence. The new role assumed by internal auditors requires an unrestricted independence in order to perform a variety of duties within the organization they serve. The interface with the audit committee and other constituencies conrm that auditor independence is paramount in the internal auditing profession.

independence. Over the years the SEC has issued several pronouncements related to auditor independence. It was the SECs insistence on strict observance of specic rules dening independence that led to the independence clause in the AICPA Code of Professional Ethics. On 6 July, 1933, the SEC adopted the following resolution:
The Commission will not recognize any such certied accountant or public accountant as independent if such accountant is not in fact independent. Unless the Commission otherwise directs, such accountant will not be considered independent with respect to any person in whom he has any interest, directly or indirectly, or with whom he is connected as an officer, agent, employee, promoter, underwriter, trustee, partner, director, or person performing similar functions[48].

The Securities Exchange Act 1934, Section 78(1), requires SEC-registered companies to include audited nancial statements in their annual reports to shareholders and to provide other nancial information in an annual ling to the SEC. In 1936, the SEC amended this rule with respect to independence and adopted the AICPAs position prohibiting any substantial interest[49]. On 6 May, 1937, the SEC issued Accounting Series Release (ASR) #2[50] and took the position that an auditors signicant investment in the company audited would impair independence:
The Commission has taken the position that an accountant cannot be deemed to be independent if he is, or has been during the period under review, an officer or director of the registrant or if he holds an interest in the registrant that is signicant with respect to its total capital or his own personal fortune.

In 1937, the Commission refused to hold an auditor as independent because of his substantial investment in the company:
In a recent case involving a rm of public accountants, one member of which owned stock in a corporation contemplating registration, the Commission refused that the rm could be considered independent for the purpose of certifying the nancial statements of such corporation and based its refusal upon the fact that the value of such holding was substantial and constituted more than 1 percent of the partners personal fortune.

The role of the SEC


If investors were to view the auditor as an advocate for the corporate client, the value of the audit might well be lost[47].

The Securities and Exchange Commission (SEC) has tried to dene independence in a series of rules and regulations which has played a prominent role in fostering auditor

In 1939, In the Matter of Interstate Hosier Inc., , 4 SEC 706, 717, the SEC found that a staff member of a CPA rm had been maintaining client accounting records. Further, the nancial statements had been falsied by the staff member. Clearly, this dual role of the internal

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Rocco R. Vanasco Auditor independence: an international perspective Managerial Auditing Journal 11/9 [1996] 448

accountant and independent auditor resulted in defeating the purpose of the audit[51]. On 14 March, 1941, the SEC issued ASR #22[52] prohibiting any immunity from liability provided to the auditor by the audited company William W. Wernts, SEC chief . accountant, commented thus:
When an accountant and his client, directly or through an affiliate, have entered into an agreement of indemnity which seeks to assure to the accountant immunity from liability for his own negligent acts, whether of omission or commission, it is my opinion that one of the major stimuli to objective and unbiased consideration of the problems encountered in a particular engagement is removed or greatly weakened. Such condition must frequently induce a departure from the standards of objectivity and impartiality which the concept of independence implies.

cases in which independent auditors were not independent. In 1962, the SEC decided that a CPA rm was not independent because one of its partners also acted as the clients legal counsel[56]. On 21 May, 1963, the SEC issued ASR #97[57] and discussed the situation about a CPA who lacked independence since he was one of the three stockholders and was an officer of the company . On 26 June, 1972, the SEC issued Regulation S-X. On the issue of auditor independence, Rule 2-01 of S-X states:
The Commission will not recognize any certied public accountant or public accountant as independent who is not in fact independent. For example, an accountant will be considered not independent with respect to any person or any of its parents, its subsidiaries, or other affiliates (1) in which, during the period of the professional engagement to examine the nancial statements being reported on or at the date of his report, he or his rm or a member thereof had or was committed to acquire, any direct nancial interest or any material indirect nancial interest, or (2) with which, during the period of his professional engagement to examine the nancial statements, he or his rm or a member thereof was connected as a promoter, underwriter, voting trustee, director, officer, or employee, except that a rm will not be deemed independent in regard to a particular person of a former officer or employee if such person is employed by the rm and such individual has completely disassociated himself from the person and its affiliates, and does not participate in auditing nancial statements of the person or its affiliates covering any period of his employment by the person. For the purposes of Rule 2-01 the term member means all partners in the rm and all professional employees participating in the audit or located in an office of the rm participating in a signicant portion of the audit.

On 7 November, 1942, the SEC issued ASR #37[53] and pointed out that in determining auditor independence due consideration is given, not only to the relationships but also to the practices involved in rendering such services to the corporation by the independent auditor. On 25 January, 1944, the SEC issued ASR #47[54] and provided some scenarios which impair independence:
Both an accountant and a business associate made loans to the registrant. Further, a son of the accountant was an officer of the registrant. The accountant advanced funds to the registrant for nancing a new department. The registrant was unable to pay the accountants fee and the registrant pledged shares of its own stock to assure that such fee would be paid. In addition, it had given the accountant an option to purchase the pledged security at market price at the option date. The accountant was the treasurer and a shareholder of a company which sold some of the registrants products. The son of a partner was serving as assistant treasurer and chief accountant of a registrant. The son resided with his father. The accountant audited cash reports prepared by the clients staff, entered them in a summary record, posted such data to the general ledger, and made adjusting entries each month.

The SEC has moreover emphasized an important facet of factual independence stating:
Perhaps the most critical test of actuality on an accountants independence is the strength of his insistence upon full disclosure of transactions between the company and members of its management as individuals; accession to the wishes of management in such cases most inevitably raises a serious question of whether the accountant is, in fact, independent.

In 1950 the SEC revised its rule on independence by deleting the word substantial from the clause substantial interest thus reaffirming its original position taken in 1933 in which there was a prohibition against the accountant having any direct nancial interest in his client. On 11 December, 1958, the SEC issued ASR #81[55] and highlighted 34

On 5 July, 1972, the SEC issued ASR #126[58] and provided some guidelines for accountants in determining the existence or lack of independence. It stated: The concept of independence, as it relates to the accountant, is fundamental to this purpose because it implies an objective analysis of the situation

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by a disinterested third party. ASR #126 provides samples of situations in which the auditors independence could be impaired. As to bookkeeping and EDP services, the ASR stated: Systems design is a proper function of the qualied public accountant. Computer programming is an aspect of systems design and does not constitute a bookkeeping service. However, where source data is provided by the client and the accountants work is limited to processing and production of listings and reports, independence will be adversely affected if the listings and reports become part of the basic accounting records on which, at least in part, the accountant would base his opinion[58]. The release also lists the following as an example of a situation that impairs auditor independence:
A client prepared and forwarded to the CPA tapes to be read on an optical scanner. The CPA merely sent those tapes to a service bureau and forwarded print-outs of the nancial statements and general ledgers back to the client. Due to the appearance that the service bureau was acting as the CPAs agent, independence is impaired. If instead, the client dealt directly with the service bureau, no such impairment would result.

literature or, at worst, directly contrary to existing accounting pronouncements[32]. In March 1994, the Office of the Chief Accountant (OCA) of the Securities and Exchange Commission published a comprehensive Staff Report on Auditor Independence. The report concludes: The OCA believes that the combination of the extensive systems of independence requirements issued by the Commission and the AICPA, coupled with the Commissions active enforcement program, provides to investors reasonable safeguards against loss to the audits by accountants that lack independence from their audit clients[59]. Further differences between the SEC and AICPA on auditor independence are included in the section of cases dealing with outsourcing, MAS, and other auditing issues.

The role of the US General Accounting Office


There is a global tendency for the government audit function to transcend the traditional parameters of nancial attestation and legislative compliance in order to espouse broader notions relating to auditor independence, auditing accountability, and audit mandate[60].

In contrast the AICPA sees no impairment of independence in offering bookkeeping or data processing services. Attempts to align the differences between the SECs views and the AICPAs rules in this area have been unsuccessful. The SEC has developed a number of independence rules, including the preclusion against the auditors owning stock in a client. On 23 May, 1973, the SEC issued ASR #144 and determined that the independence of a large rm has been impaired because partners and employees of the branch office received payments from the general partners of the client company in the guise of prots from participation in the purchase and sale of hot issues. In December of 1977, the SEC issued ASR # 234 and set forth the guidelines for resolving independence questions. The SEC had taken a more restrictive view of independence until the July 1972 change in S-X reporting guidelines for public companies. In January 1994, Walter P. Schuetze, chief accountant of the Securities and Exchange Commission, made a presentation titled A mountain or a molehill? at the AICPAs National Conference. He questioned the independence and objectivity of external auditors who are not standing up to their clients in nancial accounting and reporting issues when their clients take a position that is, at best, not supported in the accounting

Since its inception in 1921, the US General Accounting Office (GAO), an independent auditing agency of the federal government, has been charged to perform comprehensive auditing of the federal government agencies. In the 1930s and 1940s, the federal government mandated that accounting be used not merely as a bookkeeping function but also as an instrument of management control. Audits were conducted to assess whether governmental agencies properly spent and controlled their appropriation and complied with appropriate laws and regulations. In the 1950s, the US Congress began requesting information on the efficiency of performance by management at the various federal agencies. The purpose was to determine whether management was using personnel, property, funds and other resources in an economical and efficient manner. In the 1960s and the early 1970s, the GAO expanded its scope and began evaluating the effectiveness of a total program. Such evaluations needed independent nonadvocate auditors. In 1972, the GAO issued Standards for Audits of Governmental Organizations, Programs, Activities, and Functions which set forth audit standards for auditors in all levels of government. Such comprehensive government auditing includes three categories: 1 Financial and compliance auditing to assess whether the entity has complied with laws and regulations of the legislative

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body and whether nancial statements fairly present the nancial position and the results of operations in accordance with the generally accepted accounting principles (GAAP); 2 Economy and efficiency auditing to assess whether the entity is managing and utilizing the resources economically and efficiently and to determine the causes of inefficiencies; and 3 Program results auditing to assess whether the desired results or benets established in the legislating body have been achieved and whether the agency has considered alternatives that might yield desired results at a lower cost[61]. The 1972 GAO standards were revised in 1988, and again in 1994. There have been substantive changes over the years regarding independence. Studies conducted by the GAO indicate substantial deciencies in the quality of audits in the public sector. The GAO has urged some 100,000 public entities receiving federal assistance to organize and use audit committees to enhance auditor independence and to move forward in pursuit of quality audits[62]. The role of the government auditor and the related independence issue have evolved in the last 50 years owing to the GAOs changing mission. The General Standards of the GAO Standards for Audits[61] require that government auditors be independent:
In all matters relating to audit work, the audit organization and the individual auditors, whether government or public, should be free from personal and external impairments to independence, should be organizationally independent, and should maintain an independent attitude and appearance.

Internal auditing in the federal government is done by the Offices of the Inspectors General[65], which were established by the Inspectors General Act 1978. Anthony Carrollo, Inspector General of the Environmental Protection Agency (EPA), brought to our attention that the independence of government auditors is more in line with the publics perception of what auditor independence is or should be, rather than the actual independence of CPAs or CIAs (Memo addressed to R. Vanasco, 11 March, 1996). The AICPA has acknowledged that state governmental auditors, although government employees, were sufficiently independent to express audit opinions that were acceptable by the federal government in meeting mandatory audit requirements for the purpose of qualifying for revenue sharing funds. From time to time, the GAOs independence has been questioned. An editorial wrote: GAO has been functioning lately not as Congresss watchdog but as its lapdog[64]. Several countries are establishing governmental auditing offices similar to the US Government Accounting Office and are issuing auditing standards to safeguard their state auditors independence. In 1988, Egypt established the Central Auditing Organization (CAO) as an independent body that helps parliament to oversee public funds. CAO laws require that state auditors maintain an independent perspective. To protect their independence, CAO laws have incorporated the following safeguards: senior auditors have immunity privilege, and they can be relieved from their positions by a presidential decree requiring the approval of the majority of members of the Peoples Assembly[66]. In January 1995, the Estonian parliament established the State Audit Office (SAO). The legislation authorizes the SAO to order independent audits to be performed by authorized independent state auditors. The law addresses state auditors independence by allowing them unlimited access to documents and les[64].

The interpretation of this standard is that government auditors shall be certain their attitudes and beliefs allow them to be completely objective and there is nothing that would lead others to doubt their independence[63]. Government auditors, like external and internal auditors, hold independence as a goal. Auditors of governmental units are presumed independent when they are: free from sources of personal impairment; free from sources of external impairment; organizationally independent; independent under the AICPA Code of Professional Conduct; elected or appointed reporting to a legislative body of government; or auditing in a level or branch of government rather than the one to which they are normally assigned[64].

The role of the audit committee


Regular communication with the board assures independence and provides a means for the board and the director to keep each other informed on matters of mutual interest[43].

The New York Stock Exchange (NYSE), the SEC, and the AICPA have led a concerted effort to persuade corporations to establish audit committees comprising independent members of the board of directors to enhance

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audit independence. The argument is that outside directors can preserve a higher degree of independence from management inuence. To emphasize independence from management, many corporations follow the practice of having internal auditors report to the audit committee. In addition, the external auditors are appointed by the committee and elected by the stockholders[68]. More than 80 per cent of publicly-traded companies in the USA now maintain audit committees. The Treadway Commission stressed their importance, and many rms are working to revise and expand their audit committee charters. Fraudulent nancial reporting is more likely if issues related to accountant independence and preservation of internal auditor independence have been omitted from the charter[69]. Independence, however, is enhanced when the board concurs in the appointment or removal of the director of the internal auditing department[43, 100.3]. In 1987, Knapp examined several factors affecting audit committees perception on auditor independence. His results show that audit committee members background (corporate managers or non-audit managers), audit rm size class (Big Eight and non-Big Eight), objectivity of professional standards, and the nancial condition of the auditee signicantly affected the extent to which committee members were willing to support external auditors[70]. Internal audit independence and objectivity depend greatly on the internal auditors reporting relationship with the organization. A survey of chief internal auditors shows that a strong majority of internal auditors indicate that vesting the hiring-ring authority with the audit committee would enhance internal auditor independence, improve oversight by the audit committee, and improve the ability of the internal auditor to get action on audit ndings [71]. In 1993, a comprehensive study, Improving Audit Committee Performance: What Works Best, prepared by Price Waterhouse for the IIA, stressed that the credibility of nancial reporting has been increasingly questioned and urged all parties involved in the nancial reporting by providing, on behalf of the board of directors, oversight of the nancial reporting process as well as internal controls[72]. In 1994, the AICPA advisory panel on auditor independence recommended that instead of legislating audit committees functions, the panel should place responsibility on the independent auditor to be more forthcoming in communicating with the audit committee and the board of directors. Stronger, more accountable boards will strengthen the professionalism of the auditor, enhance the value

of the audit, and serve the investing public [73]. Some practices that lead to independence include: the frequency of audit committee meetings with the internal audit executives; the length of the audit committee member terms of office; and the appraisal of internal audit executive performance by the audit committee. Although these situations may constitute an ideal situation, it must, however, strike a balance between total independence from management and the risk of alienating management and isolating the internal auditing department[74]. The interchange between audit committees and internal auditors is more frequent in the USA, the UK and Canada than in Japan. A recent survey shows that US rms audit committees meet with internal auditors four or more times a year, whereas Japanese audit committees meet with auditors twice a year[75]. The Canadian Institute of Chartered Accountants study group on audit committees reported that corporate audit committees enhance auditors perceived independence, making it easier for them to be objective and not be subject to undue inuence by management. A recent survey conducted by Arthur Andersen LLP shows that about 56 per cent of companies around the world have no audit committees. The analysis reveals large disparities between traditions in Canada, the USA and the UK and those in other countries. Many audit committees around the world have no resemblance to American, Canadian, or British audit committees[76].

The role of management


True audit independence is still elusive. Too often we have to temper our opinions because of political issues[77].

Management can do much to establish an attitude of independence by allowing auditors ample freedom in selecting the operations for study and by informing those responsible for the operations under study that the investigation is fully sanctioned. One of the dangers for the internal auditing function is the loss of top management support. Should management or the board unduly interfere with the auditor or fail to support the audit function, there is a danger that the auditors will lose the necessary independence to perform their duties[63]. The internal and external auditors must remain independent of operations and the decision-making process of the organization, and should remain independent of undue inuence by management. Audit objectivity

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could be jeopardized by any perceived or real intimidation by management personnel who might be affected by audit ndings[78]. A research project sponsored by the Iowa Chapter of the Institute of Internal Auditors shows that although independence is a necessity for the internal auditor, absolute independence may not be achievable. The respondents apparent concerns in this area may reect some discomfort with the political aspect of the internal auditors position and the ethical dilemmas that result[77]. Chadwick[74] reported that at an IIA conference, 12 chief internal audit executives of major publicly-held companies were asked the following three questions: 1 What if the chief executive officer (CEO) asked you not to audit certain manufacturing operations even though the audit engagement had already been specied in the plan approved by the audit committee? 2 What if the CEO asked you not to discuss with the audit committee a highly embarrassing nancial exposure related to hazardous waste dumping identied during an audit of a subsidiary? and 3 What if your vice president of sales restricted auditor access to his or her travel and expense reports? What would you do? None dared to report the above situations to the audit committee because they would be red and would probably never nd another job as senior internal audit official. This situation led Chadwick to suggest eliminating the joint reporting relationship of internal audit departments to both senior management and audit committees. To prevent management inuence and create a truly independent relationship, the director of internal auditing should report solely to the audit committee[74]. John J. Mickevice, director of internal audit of the American Bar Association and former president of the IIA Chicago Chapter, commented on Chadwicks ndings:
Chadwicks comments are of great interest. This does not bode well for the internal audit profession. I did not realize the chief executives are so weak-willed!! No wonder many of their peers have been outsourced! What is the relationship of these chiefs to their Audit Committee? If the chiefs feel it is unwise to tactfully report these impairments on their scope, how can an effective relationship be established with their respective Audit Committee? This is a signicant area of internal auditor independence. If the chiefs are too afraid to address these items, what is their long-term value to their organization? (Memo addressed to R. Vanasco, 15 March, 1996).

Whittington et al.[79] shows that there is every reason to believe that auditors do not carry out their work with complete independence from management. This arises from the anecdotal evidence of directors putting pressure on audit partners, and audit partners applying pressure to technical partners, to secure their approval for schemes that take creative accounting to, and sometimes beyond, the limits permitted by accounting standards. Some degree of auditor liability is essential in the absence of complete auditor independence. Hosseini and Rezaee[80] elaborate on the partnership concept, the shifting from the traditional role of the internal auditing as one of policing the various units to the organization to the collaborative approach by providing a broad range of assistance to management, including proactive decision-making and problem-solving functions. The key argument against the partnership concept is that it may impair internal auditors independence if not properly implemented. This sort of participative auditing was previously discussed by Sawyer[10]. This approach to auditing brings the auditee into the audit process as part of a co-operative venture. He warns, however, that participative audits must be dealt with very carefully since they may impinge upon auditor independence.

Part II The industry sector


The banking sector
Independence is perhaps the single most important attribute that the CPA brings to the client-CPA relationship. Independence and the appearance of independence must be preserved at all costs[81].

Third parties often rely on the work of internal auditors, so their professional objectivity is an important issue. A study was undertaken to determine whether a rms management can inuence the professional objectivity of the rms internal auditors. A sample of 58 internal auditors from three banks participated in a decision-making exercise involving internal control systems. The results indicate that management did have the ability to inuence the internal control system evaluations reached by internal auditors. IIA membership is an important determinant of internal auditorss professional objectivity[82]. In Switzerland, all companies or branches in the banking sector are subject to the supplementary auditing requirements of the Swiss banking law which entails a detailed audit by a rm of specialized independent bank auditors recognized by the Swiss Federal Banking Commission[83].

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The healthcare sector


Professional competence is largely acquired through the study of technical literature, but the information available that may permit an auditor to be unequivocally assured of independence is much more uncertain[84].

Krishnamoorthy and Spruill[85] conducted a study on the material departments of various hospitals and concluded that operational audits are particularly benecial to the hospital material department because this department represents one of the major cost centres in the hospital. Such audits have the potential to increase efficiency and lead to signicant cost savings. It can be done by an internal auditor or by external consultants. Auditor independence is an important consideration in either event. The internal auditors independence can be ensured if the auditor has no direct connection to the material or any user department. Dame[86] believes that operational audits of material transportation activities can help to reduce freight costs by identifying inefficiencies or ineffective practices. Any improvements of transportation operations can result in a reduction of the cost to purchase material and substantial savings for the organization.

activities ranked highest by administrators involved: (a) facilitating the audit and (b) helping to maintain auditor independence. The need for a committee to act in a watchdog capacity is not necessary in a municipal setting; rather, the driving issue seems to be that of achieving efficiency and effectiveness in city government[89].

The insurance sector


Although independence is a necessity for the internal auditor, absolute independence may not be achievable[77].

Auditor independence is called for when a special industry sector undergoes crisis in credibility The number of insolvencies in the . insurance sector has risen to a level that demands serious analysis. Given the tremendous investment in insurance company liabilities by employee benet plans, independent credit evaluation sources and auditor independence need to be re-evaluated[88].

Part II the international arena


The statement that professional accountants in practice should be "independent in fact and appearance will be a puzzle in a collective culture in which relationships and group membership are the cornerstone of the organization of society[90].

The municipal sector


Auditors must appear independent to auditee managers if they are to be effective and efficient[87].

The Institute of Internal Auditors, in the introduction to the SPPIA, states:


throughout the world internal auditing is performed in diverse environments and within organizations which vary in purpose, size, and structures. In addition, the laws and customs within various countries differ from one to another. These differences may affect the practice of internal auditing in each environment. The implementation of these Standards, therefore, will be governed by the environment in which the internal audit department carries its assigned responsibilities.

A study was undertaken to examine municipal internal auditors and the environment in which they function. The results of the study indicate that internal auditors are independent to perform the task to the best of their ability A potential weakness to this conclu. sion was that most of the respondents did not follow the guidelines of the Institute of Internal Auditors. They were in violation of the SPPIA (110.01):
the director of the internal audit department should be responsible to an individual in the organization with sufficient authority to promote independence and to ensure board audit coverage, adequate consideration of audit reports, and appropriate action on audit recommendations.

Failure to meet this guideline impairs auditor independence and poses potential conict in that the internal auditor reports to those who made the appointment[88]. The audit committee is believed to be the most logical avenue for local governments to enhance auditor independence and satisfy the growing demands for services with limited resources. A survey of municipal officers of 164 cities revealed that the audit committee

Thus, cultural differences may limit the effectiveness of auditor independence. They are important to our understanding of differences in the perception of auditor independence and their values because they identify generally-held beliefs and norms of appropriate behavior in a country [91]. The concept of independence in China and Japan is tied up to their collectivist culture. Individualism is considered selsh and therefore evil. The individuals self-interest is best guaranteed by maintaining the group wellbeing. In oriental cultures, individuals are driven not by their personal needs, but rather the need not to lose face. One loses face by failing to

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meet the social requirements deemed appropriate to the social position one occupies[92]. Stamp and Moonitz[93] have identied professional independence as one of two key areas of difficulty encountered in the international auditing eld. It is their contention that the implementation of professional independence in the multinational context is difficult to implement. They believe that the steps taken are likely to be those that will preserve the outward form of independence, objectivity and integrity without necessarily preserving its essence. To assess auditor independence worldwide, a representative group of international accounting associations and several countries in the various continents have been taken as a sample to determine whether or not: governments and/or professional associations require that nancial statements be audited; statutes describe factors that impair auditor independence; and professional associations or societies of accountants have promulgated auditing standards that dene the concepts of integrity, objectivity, and independence. The government often takes the lead in developing auditing standards in countries that do not have a well-developed auditing profession, as well as in some industrial countries that are very legalistic and prescriptive.

guidance to the external auditors when the internal auditing function is considered in determining the nature, timing, and extent of the audit procedures in nancial audited statements[97].

The role of the European Union (EU)


Above all, we clearly uphold our independence and objectivit[98].

International Federation of Accountants


Auditor independence in developing countries is important since the auditor by providing credibility to nancial statements facilitates the allocation of scarce capital resources in nancial and capital markets. Auditor independence is also necessary for formulating international harmonization of auditing standards[94].

The EU Fourth Directive requires companies, whose annual accounts are required to be audited, to appoint an auditor to examine the accounts and express an opinion about whether they present a true and fair view[99]. The Eighth Directive, adopted in 1989 and implemented on January 1, 1990, deals with the qualications of statutory auditors, reciprocity, and independence[100]. Independence is one of the areas of strong disagreement in the draft of the Directive. Some countries felt that statutory auditors should do nothing but audit nancial statements, whereas other countries felt that tax and advisory services could be performed by auditing rms without impairing independence. Since no agreement was reached on independence, the Eighth Directive decided to allow the individual member countries to determine the condition for independence. The Commission may introduce a specic directive on the independence of auditors[101]. Many problems identied in the current debate about possible EU legislation on auditor independence could be remedied if the profession were given at least some self-regulatory responsibilities. A single Institute of Accountants in Europe is not the answer. Rather, the solution lies somewhere between a single institute and the present situation[102].

The role of the IASC


Auditors independence and objectivity may be compromised in a collective culture where auditors have extended family ties[103].

Founded in 1977, the International Federation of Accountants (IFAC) is a federation of national professional accounting bodies. Its objective is the development and enhancement of a co-ordinated world-wide accountancy and auditing profession and the harmonization of accounting principles and auditing standards[95]. In 1977, IFAC issued the International Audit Guidelines (IAG)[96]. One of the guidelines denes independence as the ability of the accountants to be and appear to be free of any interest that might be regarded as being incompatible with integrity and objectivity . In 1994, IFACs International Auditing Practice Committee (IAPC) issued International Auditing Standard (IAS) No. 10 entitled Using the Work of an Internal Auditor which gives

The role of the International Accounting Standard Committee (IASC), which was founded in 1973, was to contribute toward the development and adoption of accounting principles and auditing standards that were relevant and comparable internationally The . IASC developed standards that allowed a substantial degree of choice, presenting two or more alternative accounting approaches with respect to a transaction[104]. By the end of 1999, the IASC and the International Organization of Securities Commissions (IOSCO) plan to have in place a core set of international accounting and auditing standards that will reduce reliance on national standards[105].

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Asian countries The Chinese perspective


If culture inuences a societys norms and values, if it affects the behavior of group interactions, then audit independence in China should have a considerably different mien from that found in the West[106].

independence of the internal auditors is enhanced when they report to an audit committee[112].

The Japanese perspective


The history of some business failures in Japan illustrates the lack of t of the AngloAmerican focus on independence within the Japanese collective culture[113].

In China, issues of national importance include promoting independent nancial audits of state enterprises. The national regulatory authority for Chinas CPA profession is the Ministry of Finance. The Chinese Institute of Certied Public Accountants (CICPA), which was established in late 1988, is the organization that actually regulates the profession. China does not have a private professional standard board to set national audit regulations. Regulations are set by the government and contained in the Audit Regulations of the Peoples Republic of China 1989. The new audit regulations aim at improving and strengthening the independence of auditors[107]. Audits are required under the income tax laws and audited nancial statements are therefore prepared for tax reporting purposes. The audit requirements for foreign investment enterprises are contained in the Accounting Regulations of the Peoples Republic of China for Enterprises with Foreign Investments promulgated in July 1992[108]. Article 3 of the Audit Regulations of the Peoples Republic of China states: The auditing organizations execute their auditing work independent of any interference from other government administrative organizations, other social groups or individuals[109]. The audit bureaux are permitted by the new regulations to establish an internal audit department to perform internal audits.

The Hong Kong perspective


The advocacy of weak and unsupported client accounting positions speak loudly about independence in fact. It is hoped that through self-restraint independence issues will be reexamined[110].

In Hong Kong, companies are incorporated under the Companies Ordinance and are required to appoint an auditor to audit their nancial statements. The Hong Kong Society of Accountants has set forth guidance on professional ethics and independence that are similar to those of the USA. The code of ethics warns auditors to exercise due care, objectivity, and integrity They must avoid . situations that may impair their independence[111]. Managing directors share a consensus perception of the audit function as an independent appraisal of the companys internal control system. More than 50 per cent of top management believe that

The construct of auditor independence is central to the Anglo-American auditing tradition. The notion of an independent function runs counter to the Japanese belief in the centrality of the group and its resulting desire for privacy[113]. CPAs and audit corporations are required to be independent of their clients under both the CPA law and the securities and exchange law. CPAs or audit corporations may not render continuous tax services for a fee to audit clients. Tax return preparation services are instead provided by certied tax advisers (CTAs). The by-laws of the Japanese Institute of Certied Public Accountants (JICPA) include rules of professional ethics and independence. Audit standards are provided under the Auditing Standards, Audit Procedures Rules and Audit Reporting Rules issued by the Enterprise Accounting Deliberation Council of the Ministry of Finance[114]. The Japanese business law requires the presence of a statutory auditor to look after stockholder interests, the relationship between the statutory auditor and the corporation is typically of independence between management and auditor. In reality the nancial and mental independence necessary for the objective performance of the statutory auditors review and supervisory duties remain absent[115]. Owing to the collective nature of Japanese culture, auditors have little success in obtaining the specic documents necessary to independently assess the nancial position of the entity audited. Internal auditors within the Japanese rms appear much less independent. They report to high-level management and do not have an audience with the board of directors[72].

The Malaysian pespective


Since ones usefulness as an auditor is impaired by any feeling on the part of third parties that he is likely to lack independence, he has the responsibility of not only maintaining independence in fact but also of avoiding any appearance of lacking independence[116].

In Malaysia, the accounts of all companies incorporated under the Companies Act 1965 must be audited by an independent auditor. In order to qualify as auditor, a person must be approved by the Ministry of Finance. The Companies Act requires auditors to report to

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the Registrar of Companies any breach or nonobservance of any of the provisions of the Companies Act[117].

The Dutch perspective


The concept of independence is at the center of the audit function. The accounting profession has long recognized the need for auditor independence in both fact and appearance[121].

The Singapore perspective


Clearly, if the internal auditors are going to fulll the role of providing reassurances to boards of directors on the relevance and reliability of a companys internal control system, it is important that the internal auditors are as independent as possible from the executive management[118].

Singapore requires that all registered companies under the Companies Act have their nancial statements audited. The Singapore Auditing Guideline (SAG) #4, Basic Principles Governing an Audit, requires auditors to be independent, honest, and sincere. They must not allow prejudice or bias to override their objectivity Independence is impaired when: . members of the auditors immediate family hold a signicant benecial interest in the company audited; the auditor was an officer or employee of the company audited; and the auditor has direct or indirect interest in the company audited[117].

The nancial statements of Dutch companies are audited to meet statutory and stock exchange requirements. In 1984, the Dutch adopted the EU Fourth Directive which requires that the annual accounts be audited. The Dutch audit philosophy and practice is similar to the US practice. The Code of Ethics has a legislative status and gives guidance to its members on matters dealing with auditor independence, due care, and professional conduct. The requirement of objectivity and independence is detailed in Article 20 of the Code. Auditors engaged in practice may not perform a service for a person, corporation, or institution if they have a vested interest that may affect their objectivity[122].

The French perspective


Internal audit departments cannot be independent of senior management because they depend on them for the same operational needs as any other department in the organization[71].

European countries The Danish perspective


Growing reliance on nonaudit services has the potential to compromise the objectivity or independence of the auditor by diverting some leadership away from the public responsibility associated with the independent audit function[34].

All limited liability companies are required to be audited in Denmark by certied auditors licensed by the Ministry of Industry To . the Danes, the following constitutes an impairment to independence: CPAs are not allowed to render an opinion on the nancial statements of a company that has any kind of economic inuence in the form in which the auditor is an employer. Auditors are not allowed to receive loans or guarantees from a company that they audit. The following persons are precluded from acting as auditors: members of the board of directors of a company; persons who are employed by the company; and persons who are related by marriage, adoption, or family relation to the directors or management of the company . However, rendering consulting service does not prohibit an individual from acting as an independent auditor[120].

The accounting profession in France is divided into two main bodies. The Ordre des Experts Comptables et des Contable Agres includes all qualied independent accountants. The Institute of Statutory Auditors (Compagnie Nationale des Commissaires aux Comptes) is the professional body of official statutory auditors. Statutory auditors are required to be independent of their clients. Any remuneration from the client company other than that for the audit is prohibited. The auditing standards are similar to those of the USA[123]. In January 1996, the Federation of European Accounting Experts released The Role, Position and Liability of the Statutory Auditor in the European Union which prohibits the simultaneous provision of all non-audit services by statutory auditors.

The Spanish perspective


To optimize the image of independence in practice, an auditor must remain free of any obligation or interest that would damage independence in appearance[124].

In 1988, the Spanish government approved a law requiring annual nancial statements for all entities except small companies. A stock exchange regulation provides that companies quoted on the stock exchange must appoint independent auditors. The Instituto de Contabilidad y Auditoria de Cuentos published the auditing standards in its Gazette. The auditing standards are similar to those of the

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USA and include guidelines on auditors independence, integrity, and objectivity[125].

issued ethical rules dealing with auditors independence and objectivity[83].

The Swedish perspective


The internal auditor is provided with the independence and objectivity to look at the various operational activities in the light of total company welfare, and without the bias of specic interests[1].

Anglo-Saxon countries The Australian perspective


Without independence, the value of any auditors work to the client or to the investing public is questionable. And neither internal or external auditors can claim to be independent unless they have the ability to determine and control the scope of their audit tests[129].

In Sweden, the Institute of Authorized Public Accountants has developed rules of professional ethics similar to those of the US certied public accountants that include guidelines on auditor independence, condentiality, and professional conduct. The Companies Act prohibits the engagement of an auditor who is not personally, professionally, and nancially independent from the company . Both the Companies Act and the Institute of Authorized Public Accountants consider independence in fact and appearance to be a requirement for any audit engagements[126]. Recently, a Swedish law has required that internal auditing of public authorities be performed in accordance with the IIA Code of Professional Ethics and the generally accepted internal auditing principles as outlined in the IIA Standards for the Professional Practice of Internal Auditing (SPPIA). This initiative proposed by the Swedish National Audit Bureau will not only enhance internal auditor independence but will also recognize internal auditing as an international profession. Previously, the Swedish internal auditing had taken three forms: 1 The internal audit department served mainly as a support unit for external auditors performing nancial audit. 2 The internal audit department performed operational audit and had no responsibility for nancial audits. 3 There was no internal audit service at all[127]. Internal auditors are required to provide audit coverage and report the ndings to management.

The Swiss perspective


The concept of independence is not absolute; no auditors can claim complete independence of a client. Rather, independence is relative a matter of degree[128].

Under Australian corporate law, the auditor of a company is required to report to the shareholders on every balance sheet and prot and loss account (income statement) submitted to shareholders of the company . The auditor has the right to access at all times the accounting and other records of the company and the right to obtain from officers of the company such information and explanations as are required for the audit. Australian auditing standards (AUS) are comparable with those applicable in the USA[130]. AUS #1 requires that auditors be independent, honest, and sincere. They shall maintain an impartial attitude and be free of any interest that might be regarded as being incompatible with their integrity and objectivity Auditors are prohibited from: . being beneciary owners of shares in an audit client; acting as trustees of a trust or as directors of a corporate trustee company; accepting, making, or guaranteeing loans from or to an audit client; accepting from audit clients goods or services on terms more favorable than those generally available to others; accepting or retaining a directorship of a company that exerts signicant inuence overanother company that is an audit client; acting in an executive decision-making role when providing management consulting services to an audit client; participating in the preparation of the book of account of a public company being audited[131].

The Canadian perspective


Independence is the keystone of the audit profession; without independence, the users of nancial statements would not be able to rely on the auditors report[132].

In Switzerland, corporations are required to have one or more auditors who must be independent of the board of directors and shareholders. They must also be independent of companies belonging to the same group of companies. Independent auditors report on compliance with legal requirements and provide support to business management on nancial matters. The Swiss Institute of Certied Accounts and Tax Consultants

In Canada, an auditor must be independent, must be licensed by the province in which he practices, and must comply with the rules of ethics of the organization to which he belongs. The auditor has a statute-protected right of access to all books, records, information, and explanations that he requests[133].

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The Canadian Business Corporation Act requires an auditor to be independent. However, the Act permits an interested person to apply to the court for an order exempting the auditor from the requirement to be independent. The Act still requires the audit to be conducted with generally accepted auditing standards and the nancial statements to be prepared in accordance with generally accepted accounting principles[134].

The New Zealand perspective


The Internal Auditing Standards Board of the Institute of Institute of Internal Auditors has been diligent in its efforts to ensure internationalization of the IIA Standards[135].

Companies incorporated under the New Zealand Companies Act 1955 are required to have their nancial statements audited. All foreign-owned subsidiary companies must also be audited by a New Zealand chartered accountant. The Code of Ethics of the New Zealand Society of Accountants is similar in many respects to those of the USA, Australia, Canada, and the UK[136]. The Office of the Auditor Generals Guidelines on Integrity, Objectivity, and Independence preclude statutory auditors who certify nancial statements of a company from serving as internal auditors of the company .

The UK perspective
Arguments about what is needed to safeguard the auditor independence are perennial. Whatever rules are introduced, the debate on independence will no doubt be as lively as it has been this time around[137].

The British have emphasized auditor independence for almost two centuries. The provision against auditors serving as officers or employees of their auditees has been a landmark of the British system. A concern for the auditors independence in the UK appeared in the Companies Clauses Act 1845, section 102, which prohibited auditors from serving as officers of the company:
Where no other qualication shall be prescribed by the special Act, every Auditor shall have at least one share in the undertaking; and he shall not hold any office in the company, nor be in any other manner interested in its concern, except as a shareholder[138].

The requirement of shareholding, however, has not been retained in the UK as an auditor qualication as evidenced by the Companies Act 1862, which permitted but did not require shareholding[138]. The Companies Act 1948, Section 161, provided that no person who is an officer or servant of the company is qualied for appointment as auditor of such company .

The standards of independence in the UK are similar to those in the USA, although one major difference is that, in the UK, independent auditors are allowed to perform certain bookkeeping functions for private companies. The Companies Act 1985 requires companies to issue audited nancial statements. Auditors have the right of access to books, records, and other pertinent information as needed to carry out their statutory duties. The rst statement on ethical matters requires a member in public practice to be and to be seen to be independent[139]. The UK amended the Companies Act 1985 to implement the European Unions Eighth Directive. It lays down minimum approval requirements for company auditors, including their education and training. It obliges member states to ensure that company audits are performed with integrity and that there are appropriate safeguards to protect auditor independence[140]. For over 100 years, the accountancy profession in the UK has built its reputation on the foundation of objectivity, integrity, and competence which include all that is required for auditor independence. Darbyshire[141] contends that investigations into corporate crashes that have occurred over the past two decades show that, in the relatively few cases where the auditors role has been challenged, in virtually no case has lack of independence been demonstrated or even alleged. It has been suggested that, after a number of years, auditors become too cosy with their clients. Although the evidence presented is limited, it shows that audit failure is three times as likely to occur in the rst two years after a change in auditor than in subsequent years. He believes that there is substantial evidence that auditors should be separate from their clients management, although the US and Canadian commissions have concluded that there is no reason to suppose that auditor independence is affected by the provision of non-audit services. A questionnaire survey has revealed a wealth of detail as to how auditors and some of the main participants in the UK company nancial report process differ in their views regarding the nature of auditing and the work that auditors do. The survey conrms the extent of the auditors responsibilities to third parties, the nature of balance sheet valuation, the strength of, and continuing threats to, auditor independence. The results of the factor analysis of activity constructs provide evidence of the prevalence of independence-related attributes in assessments of the contribution and quality of auditing[142]. Owen Green[143] has called for a greater auditor independence and an in-depth review

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of the auditing profession in the UK. He argues that such a system would restore the auditor as watchdog and release nonexecutive directors to a more constructive role.

permit an auditor to be unequivocally assured of independence is much more uncertain[84].

African countries The Africa perspective


As the eyes and ears of the audit committee, it is essential that internal auditors be truly independent[71].

Auditing has always been seen as an alien phenomenon in most parts of the Third World, especially in Africa. This is because of Africas history, culture, and collective way of life . The Charter, as dened by the Institute of Internal Auditors, does not really seem to give that unrestricted scope to Third World auditors. If auditing is a reection of culture, applying the IIA standards of independence and objectivity poses a serious dilemma to Third World auditors[103].

The Israeli legislature, the Knesset, passed the Internal Auditing Act 1992 on 16 March, 1992. The new law makes the State of Israel one of the few to award such explicit statutory status and governmental recognition to the internal audit function and the role of the internal auditor. It requires public institutions to establish the internal auditing function in their organization. The legislation has safeguards for auditor independence. The Israeli Securities and Exchange Commission Act 1968 and guidelines published on 24 July, 1989, by the Israeli Institute of Certied Public Accountants preclude statutory auditors who certify nancial statements of a company from serving as internal auditors.

The Russian Federation perspective


As long as internal auditing staffs are highly skilled, efficient and responsive to management, organizations are best served by keeping the internal audit function internal[146].

The Nigerian perspective


In the Third World countries, an objective auditor is not always accepted by management as loyal. The auditor is made to feel helpless and totally dependent on management[100].

Ahmed Opetubo[144], in his Masters thesis on Perceptions of Nigerian auditor independence, showed that public accountants and users of certied statements disagree about the role that the auditors independence plays in the audit environment. This discrepancy reects the cultural and political bias in Nigerian society .

Auditing in the Russian Federation is in its infancy In December 1993, the Presidential . Commission on Auditing Activity started to issue licences to auditing rms to carry out auditing activities. The Commission plans to co-ordinate auditing practices and issues guidelines dealing with auditors objectivity, integrity, and independence[147].

South American countries The Argentine perspective


Rules on independence are stated, usually in general terms, but are appropriately developed and dened by the technical institutions[145].

Part IV Cases impairing auditor independence


Although independence is a necessity for internal auditors, the respondents in this area reect some discomfort with the political aspect of the internal auditors position and the ethical dilemmas that result[74].

In Argentina, annual nancial statements of all companies must be audited by an independent public accountant. The auditors report, issued after an examination made in accordance with dened auditing standards, must be led with regulatory authorities. Auditing standards are similar to those of the USA and are embodied in Technical Pronouncement No. 7 of the Argentine Federation of Professional Councils of Economic Sciences. Auditing standards include guidelines dealing with auditor independence, integrity, and objectivity[145].

The Middle East The Israeli perspective


Professional competence is largely acquired through the study of technical literature, but the information available that may

Several situations may impair the auditors independence, such as contingent fee arrangements, gifts, auditors overfamiliarity with personnel or operations, management advisory services (MAS), outsourcing, opinion shopping, reporting relationships, and others. The line of what constitutes impairment to the auditors independence may be debatable and subject to cultural, economic, environmental, legal, and political biases. Even in the USA, we witness that despite the many similarities between the SEC rules on independence in Rule 2-01(b) of Regulation S-X and the AICPA Interpretation of Rule 101 of the Rules of Conduct, there are substantive differences in the way the two regulatory bodies interpret conict of interests, family relations, nancial interests, former

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partners, outsourcing, MAS, and other matters related to auditor independence. Thus divergent views may arise from the AICPAs advocacy posture in the expanding role of the external audit work and in the SECs position in protecting investors, creditors, and the public.

Conict of interest
Independence means that an auditor should be objective and unbiased. An auditor does not subordinate his judgement to pressures from others and avoids relations that would appear to others to create a conict of interest[148].

The SEC considers independence impaired in most cases when a spouse, dependent person or someone else in the members household has a direct or material indirect nancial interest, or when non-dependent close relatives have material direct nancial interests in or management relationship with an audit client. The AICPA, however, makes allowance for the audit sensitivity of a relatives employment, letting independence be considered intact if the position is not sensitive. Overall, the AICPA position appears to be very exible and permits assessment of the circumstances in each case[64)] The SEC considers the rms independence impaired if: a former partner becomes a member of the board of directors of the auditee within two years after his resignation or retirement; a former partner who was prominent in his rm becomes a director of a client of the accounting rm within ve years; and a former partner becomes an executive of a client of the accounting rm without a total separation, including settlement of retirement benets from the rms. Although the AICPA rules are similar, they do not contain the specic time limits[63]. The performance of duties that conict with the internal audit role constitutes a potential impairment to internal audit objectivity The underlying philosophy of a policy . dealing with conict of interest is to ensure all concerned employees avoid situations which might be interpreted as a conict between their personal interests and those of the organization (PSB 84-7). The IIA Standards for the Professional Practice of Internal Auditing suggest that internal auditors should report to the director of internal auditing any situation in which a conict or bias is present or may be reasonably inferred. In such circumstances, the director should reassign the internal auditors (120.02.2). Article IV of the IIA Code of Professional Ethics addresses independence by prohibiting internal auditors from entering into activities

which may be in conict with the interest of their organization or which would prejudice their ability to carry out objectively their duties and responsibilities. Violation of the IIA Code of Professional Ethics is subject to forfeiture of membership in the institute and the certied internal auditor designation. Fifty-four audit partners participated in a study by completing hypothetical audit cases designed to allow varying ranges of acceptable accounting alternatives. This investigation revealed that the degree to which rms emphasized local office performance in determining individual partner compensation was a discriminating feature of compensation schemes. This represents an audit-client conict in audit judgements[149]. In the UK, the Guidance for Internal Auditors states that the internal auditor, notwithstanding his employment, should be free from any conict of interest arising either from performance or personal relationships or from pecuniary or other interests in an organization or activity which is subject to audit[150]. The 1991 Ethics, Interpretations and Rulings of the Joint Ethics Committee of the Institutes of Chartered Accountants in England and Wales (ICAEW), Scotland (ICAS) and Northern Ireland (ICANI)[151] give examples of cases in which independence may be deemed to be impaired. For instance, independence would be considered to be impaired with respect to a client for whom the member or the client has guaranteed a loan for the other party If the guarantee exists during the . period of the professional engagement or at least at the time of expressing an opinion, independence would be considered impaired. Another case of impaired independence arises when an individual participating in an engagement, who is offered employment by, or seeks employment with, that client during the conduct of the engagement must consider whether or not his or her ability to act with integrity and objectivity has been impaired. When the engagement requires independence, the individual must remove himself or herself from the engagement until the employment offer is rejected or employment is no longer sought, in order to prevent any appearance that integrity and objectivity have been impaired[152].

Contingent fees
Contingent fee agreements may tempt a practitioner to issue the wrong opinion[148].

Contingent fee is a fee established for the performance of any service pursuant to an arrangement in which no fee will be charged unless a specied nding or result is attained, or in which the amount of the fee is

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otherwise dependent upon the nding or result of such service. Rule 302 of the AICPA Code of Professional Conduct prohibits contingent fees in attest engagements where users of nancial information may be relying on the CPAs work. Acceptance of contingent fee arrangements is considered an impairment of independence. There are, however, exceptions in tax matters as described in Rule 302-1. As of January 1990, state laws and board of accountancy rules in 48 states prohibit contingent fees. Some professional liabilities insurance policies exclude contingency-fee arrangements from their malpractice[153]. Report-contingent audit contracts may appear inherently undesirable because they seem to compromise auditor independence. An analysis conducted shows that a single auditor with a single client may seek to employ a contingent contract, even though auditors collectively would prefer to ban contingent fees. In addition, it is possible to identify certain conditions under which expanding auditors contracting opportunities may reduce competition[154].

earnings, and cash ows for the year then ended were not audited by us and accordingly, we do not express an opinion on them.

In Japan, if the auditors disclaim an opinion, the fact and reasons thereof, including nonapplication of important audit procedures, must be indicated[114].

Disclosure of sensitive information


Although the appearance of independence does not guarantee independence in fact, such appearance is essential in maintaining public condence[63].

Rule 301 of the AICPA Code of Professional Conduct denes condential information that information which should not be disclosed to outside parties unless demanded by a court or an administrative body having subpoena power. The Code specically provides that the condential relationship must not infringe upon auditor independence and obligation to fully and fairly report on audited nancial statements. In the US v. Arthur & Young, the US Supreme Court stated:
The independent public accountant performing the audit function owes ultimate allegiance to the corporations creditors and stockholders, as well as to the investing public... If the auditor were convinced that the scope of the audit had been limited by managements reluctance to disclose matters relating to tax accruals, the auditor would be unable to issue an unqualied opinion on the corporations nancial statement.

Disclaimer of opinion
The independent public accountant must be without bias with respect to the client; otherwise, he would lack that impartiality necessary for the dependability of his ndings[155].

Another reason for a departure from the standard report is when the auditor is not independent. SAS No. 26 states:
When an accountant is not independent, any procedures he might perform would not be in accordance with generally accepted auditing standards, and he would be precluded from expressing an opinion on such statements. Accordingly, he should disclaim an opinion with respect to the nancial statements and should state specically that he is not independent[155].

In his disclaimer, the auditor: should not mention any reasons for not being independent because the reader might erroneously interpret them as unimportant; should make no mention of any audit procedures applied because readers might erroneously conclude that they were sufficient; and should label each page of the nancial statement as being unaudited. The disclaimer of opinion should read as follows:
We are not independent with respect to XYZ company, and the accompanying balance sheet as of December 31, 199X and the related statements of income, retained

Information is not considered condential if disclosure of it is necessary to make nancial statement not misleading. Disclosure of sensitive information may impair objectivity and internal auditor independence. An experiment was conducted to determine the prediction-task judgement of 54 internal auditors from the public and private sector. The results of this experiment suggest that internal auditors believe that disclosure of sensitive information such as fraud is unlikely, especially when disclosure would result in job termination. Disclosure is inuenced by the channel the internal auditor uses to communicate information and is not affected by the position of the internal auditing department within the organization[156].

Gifts
Independence is a cornerstone of the accounting profession, but it is difficult to prove and easy to challenge[2].

Gifts and discounts received by the auditors constitute the most frequent conict of interest concerning auditor independence. The IIAs professional standards state that

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internal auditors should be objective in performing an audit. Accepting a fee or gift may imply that the auditors objectivity has been impaired. The IIA Code of Professional Ethics also prohibits internal auditors from accepting a fee or gift from an employee, a client, a customer, or a business associate of their employer without the knowledge of senior management. No consideration should be given to the audit status as justication for receiving fees or gifts. In Japan, small gift exchanges should be viewed as a part of the cultural etiquette rather than as a compromising of audit integrity[115].

Trompeter[149] examined the impact of audit partner compensation schemes and generally accepted accounting principles (GAAP) on audit judgements involving auditor-client conict. These factors are important because of their potential impact on auditor independence and objectivity . Fifty-four audit partners participated in a study by completing hypothetical audit cases designed to allow varying ranges of acceptable accounting alternatives. This investigation revealed that determining individual partner compensation was a discriminating feature of compensation schemes and had a potential impact on auditor independence.

Incentive plans
As long as the auditing department is a part of the enterprise and receives its life support from the enterprise, it must relinquish some independence[10].

Management advisory services and co-contracting


CPAs shall be aware of others views of their role and shall not permit themselves to be put in a position that would endanger their objectivity and independence[159, No. 3].

The IIAs Professional Standards Bulletin PSB 83-26 discusses the impact of bonus/incentive plans on the internal auditors independence. PSB 83-20 states that bonus/incentive compensation programmes, which are an integral part of the organizations compensation programme and administered by the board or its salary administration committee, would not impair audit objectivity However, if such programmes are based . on operating results, it may impair audit objectivity PSB 87-8 points to the possibility . that an audit manager may fail to report the results of the audit work completely or release the results of the audit work with timing favourable to the bonus/incentive compensation[157]. The PSB warns that extra care needs to be taken in designing a bonus/incentive plan for auditors due to the unique reporting responsibilities they have in the organization. Numerous businesses are, however, including auditors in incentive/results sharing types of programmes. These can have positive impacts in that they sharpen the identication of auditors with improving operating results. There is also a concern that the auditors expected economic benet from keeping a client (the value of incumbency) may affect auditor independence towards that client. Magee and Tseng[158] demonstrated that, when all auditors agree as to whether a reporting decision is consistent with generally accepted accounting principles (GAAP), a positive value of incumbency should not lead to a compromise of independence when auditors disagree about the proper treatment of an item. These conclusions are based on the assumption that an enforceable ban on contingent contracts exists between auditor and client.

Management advisory services (MAS) consist of advice and assistance to a client to improve capabilities and resources and achieve stated objectives. The accountant may conduct studies and counsel management in such matters as business organization, planning, controls, systems operations, personnel and nances[159, No. 1]. Management engagements require an investigation and analysis of the clients operations to determine the enterprises objectives, the nature of the problem, and feasible solutions. They also include the evaluation of alternative solutions, formulation and recommended action, and suggestions for and assistance in the implementation process. MAS could also require the review of the nancial statements for a client. All these professional services may pose a threat to the auditors independence. Auditors must, therefore, exercise due care to preserve their status of independence. In 1966, the AICPA appointed an ad hoc committee investigating the propriety of CPAs rendering management services. The Committee report did not nd instances in which independence had been impaired. Some researches have, however, shown that management advisory services can actually enhance an audit rms independence[160,161]. In the 1970s and early 1980s, the issue on non-audit services was once again debated. Some critics argued that independence is improved when a rm realizes signicant non-audit fees from an audit client. In 1972, the SEC issued ASR # 126 Financial Reporting[57], which states that auditors are not considered independent and cannot full the role of outsider critic for clients for whom they also perform bookkeeping and write-up

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services. The SEC dened independence as an objective analysis of a situation by a disinterested third party and stated:
It is the Commissions position that an accounting rm cannot be deemed independent with regard to auditing nancial statements of a client if it has participated closely, either manually or through its computer services, in the maintenance of the basic accounting records and preparation of the nancial statements, or if the rm performs other accounting services through which it participates with management in operational decisions.

The basic consideration is whether, to a third party, the client appears to be totally dependent on the accountants skill and judgement in its nancial operations or to be reliant only to the extent of the customary type of consultation or advice. In 1977, the Metcalf Subcommittee claimed that non-audit services impair independence. In 1978, the Cohen Commission on Auditors Responsibilities considered management advisory services for audit clients and concluded that there is little question that the provision of some other services to audit clients poses an obvious potential threat to the auditors independence. In 1977, the AICPA issued Rule of Conduct 102, MAS Engagement to Evaluate Service Bureaus. CPAs, who are asked to evaluate service bureaux for processing the clients accounting records, should not accept the engagement if they have a nancial interest in one of the service bureaux under consideration. The clients nancial interests can constrain the rms ability to perform certain MAS engagements[162]. In 1978, the SEC responded to the nonaudit services issues with Accounting Release Series (ARS) # 250, which required disclosure in Form 10-K of the nature of all non-audit services and the percentage of audit fees. In 1981, the SEC rescinded ARS # 250, and as a result, public disclosure of non-audit services is no longer mandatory Some research in the . 1980s suggests that both sophisticated nancial information users, such as nancial analysts, and educated but inexperienced readers, have relatively high condence in auditor independence, even in cases involving non-audit services[163]. In June of 1979, the SEC issued ASR # 264 implying that engaging an auditor for management advisory services might impair independence. AICPA rules do not emphasize this point. Jack Robertson[64] feels that the SEC view casts a cloud of suspicion over the practice of negotiating with the client the nature and amount of nancial statement adjustments proposed by the auditors.

In 1979, at the request of the AICPAs Executive Committee of the SEC Practice Section, the Public Oversight Board (POB) examined the question of management services and auditor independence. The POB report concluded that mandatory limitations on scope of services should be predicated only in the determination that certain services, or the role of the rm performing certain services, will impair a members independence in rendering an opinion on the fairness of a clients nancial statements or present a strong likelihood of doing so[164]. In 1986, the POB of the AICPA commissioned Audits & Survey Inc. to conduct a survey on the public perception of management advisory services on auditor independence. The ndings indicate that the following MAS engagements could impair independence: Negotiating mergers, acquisitions and divestitures; Performing actuarial services that directly affect amounts involved on the balance sheet; Implementing a strategic plan; Valuing assets in business combination; Executive search for senior management; Renegotiations or redetermining price under a procurement contract; Developing a strategic plan; and Developing an executive compensation plan[165]. In January 1991, the Big Six accounting rms published a report titled The Public Accounting Profession: Meeting the Needs of a Changing World suggesting a new framework for dening independence. It stated: Business relationships between public accountants and audit clients do not impair independence so long as they result from the ordinary course of business and are not material to either party. The proposed framework, which was rejected by the Securities and Exchange Commission, downplayed concerns about the appearance of conicts of interest with audit clients. In 1993, the AICPA, in order to assist CPAs in identifying what functions make up consulting services, issued the rst Statement on Standards for Consulting Services (SSCS), Denition and Standards. The new statement discusses auditor independence and the performing of consulting services for attest clients. The SSCS states that the AICPAs independence standards relate exclusively to performance of attestation services and that consulting for an attest client does not, in and of itself, impair independence[81]. In March 1994, the Securities and Exchange Commission issued its Staff Report on Auditor

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Independence and discussed whether or not the performance of management advisory services by auditors has an impact on auditor independence. The SEC stated that the lack of an apparent, dramatic increase in MAS provided to SEC audit clients suggests that a fundamental change in the Commissions regulation is not necessary at this time[59]. As the size and the complexity of the client information systems needs have risen, CPA rms have found it necessary to co-contract with non-CPA rms as a means of efficiently providing services to clients. The SEC has taken the position that co-contracting with audit clients is unacceptable because it impairs auditor independence. The Big Six CPA rms have proposed certain safeguards in an effort to satisfy the SECs concerns but the SEC has not yet developed workable standards on co-contracting with audit clients[166]. In providing management advisory services including training programmes, supervision, review of engagements and co-contracting, those in charge should emphasize the signicance of independence in mental attitude[63]. The history of providing MAS to audit clients has been a thorny issue in the auditing profession. In providing MAS engagements, CPAs must be independent in fact; independence in appearance is encouraged[45]. CPAs must be careful that the combination of accounting, tax, and management services does not create conict of interest or the appearance of such. In summary, research on management advisory services impacting on auditor independence shows contrasting views. Some claim that MAS can actually enhance audit rms independence. Others believe that MAS threatens auditor independence. CPAs who provide them may: become the clients advocate; develop a stake in their clients success; make decisions that they are later required to audit; and become too close to management[45]. In the USA there is no prohibition against auditors performing management advisory services for their clients as long as they do not get involved in making management decisions. In Germany, auditors do a lot of tax and management-consulting work with their client companies whereas in The Netherlands auditors do not perform any tax services, management services work, or any other form of consulting activity for their audit clients. In the UK, independent auditors are allowed to perform certain bookkeeping functions for private companies.

In Australia, non-audit service has become a very important if not the most important source of revenue for accounting rms. A questionnaire regarding attitudes toward accounting independence was mailed to Australian CPAs. The respondents did not think that accounting rms rendering non-audit services to their clients were at a greater risk of losing their independence than accounting rms not rendering such services[167]. Wines[168] investigated the question of whether there is the potential for an appearance of auditor independence impairment when higher levels of non-audit services are provided to audit clients. This question was investigated by analysing the audit reports for a sample of publicly listed companies over the period 1980 to 1989. The ndings suggest that auditors are less likely to qualify a given companys nancial statements when higher levels of non-audit services fees are derived. Barkess and Simnett[169] also conducted a research study to: identify the extent and level of other services provided by incumbent auditors in the Australian business environment; examine pricing issues and audit fees; and address the question of independence by: identifying whether the incidence of audit qualication is related to the level of other services purchases; and investigating whether there is a relationship between audit tenure and the level of services, size, and audit qualications. The study provides evidence that an increasing number of clients are purchasing other services from their auditors.

Operating responsibilities
Since complete objectivity is essential to the audit function, internal auditors should not develop and install procedures, prepare records, or engage in any other activity which they normally would be expected to review and appraise[44].

The Standards for the Professional Practice of Internal Auditing (SPPIA) specically prohibit internal auditors from assuming operating responsibilities since it would impair objectivity But if on occasion management . directs internal auditors to perform nonaudit work, it shall be understood that they are not functioning as internal auditors. Moreover, objectivity is presumed to be impaired when internal auditors audit any activity for which they had authority or responsibility This impairment should be . considered when reporting audit results (120.02.4). The Standards also state that: Designing, installing, and operating systems are not

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audit functions. Performing such activities is presumed to impair audit objectivity(120.03). A study was conducted to determine whether internal auditor involvement in systems design affects decisions about subsequent audit work. The participants in the study consisted of 51 internal auditors who worked for 21 different organizations located in a large US city The results of the study indicate . that the internal auditors maintained their objectivity despite previous involvement in the design of a particular system. These ndings support the view that internal auditors are true to the ideals of objectivity[166]. PSB 81-1, Independence Bank Reconciliations, cautions that the director of internal auditing should avoid preparing bank reconciliations as an operating responsibility If . management requires the internal auditing department to perform bank reconciliations, the director of internal auditing should inform management and the companys public accountant that this activity is not an internal audit activity; and therefore, auditrelated conclusions should not be drawn. PSB 81-3, Independence Operating Responsibilities, suggests that the assignment of personnel to audit the activities for which they previously had authority or responsibility should be delayed until their successors have had the time and opportunity to inuence the system of control for the activity Even though . objectivity could be preserved by carefully scheduling steps in the audit programme, PSB 81-3 suggests that the director of internal auditing must consider whether those members of the organization who read the report will accept the results if the auditor previously had operating responsibility or authority within the audit area. When a CPA rm is asked to help an audit client to implement an information and control system, the rm must be careful to avoid direct supervision of operations or undue involvement in management function. Under Rule of Conduct 101, the CPA rms independence would not be impaired if: management made all of the decisions related to both hiring and system implementation; and supervisory activities were restricted to initial instruction and training[171]. In the UK, the Ethics, Interpretations and Rulings of the joint Institutes of Chartered Accountants state that an independent auditor should not participate in the preparation of the accounting records of public company audit clients except in exceptional circumstances[135].

Outsourcing
Because external auditors must be independent, in fact and in appearance, of the company being audited, external auditors attempting to attend to both responsibilities of the external auditor and the responsibilities performed by the internal auditor function must exercise great care[110]. The independence issue arises when the same rm that provides an independent opinion of an organizations nancial statement also performs an internal auditing engagement upon which management bases its opinion[172].

Reasons for outsourcing


The recent phenomenon of outsourcing is viewed by the Institute of Internal Auditors, the Securities and Exchange Commission and internal auditors as a potential threat to auditor independence. Courtemanche[173] believes that the major reason for outsourcing the internal audit function is that CPA rms can provide better services with better qualied staff, lower overall costs, continuity of internal audit operations, and better planning. To prevent outsourcing, he believes that internal auditors must provide added value to their organizations since outside rms claim that they have: more qualied staff; better planning; greater emphasis on internal control; discount pricing and lower overall costs; and continuity of operations. Peter Block[174], in his book Stewardship, maintains that consistency and control have been the way we rationalize the need for policing and auditing and admonishes that when given a choice, and it is coming, the line organization will not continue to buy policing, inspection, and care-taking services. Instead, they will ask: What value have you added to the process of delivering our product or service to our customers? Blocks idea is that staff functions, including internal auditing, need to begin building competency in the organization they serve. He stated: Instead or maintaining consistency and control, their contribution is that of building capability Auditings deeper pur. pose is to support stewardship responsibilities at every level[175]. Gary Stern[176] suggests 15 ways of adding value to the company; these include auditors: becoming catalysts of change; sharing technology; and concentrating on business risks. Lampe[177], James[178], and others share the same view that audit departments that fail to

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bring added value to the company may run the risk of being outsourced. The outsourcing of the internal audit functions proves, according to Tongren[179], that internal auditors are not independent of those who control their resources. Internal auditors cannot perform objective audits of the overall internal control system when they are an integral part of it. He questions the basic doctrine of internal audit as of an independent appraisal function that aims to assist members of the organization in the effective discharge of their responsibilities and suggests to replace the concept of independent internal auditor with the synergy of the work group, the judgemental appraisal of an outsider internal auditor with team self-realization. Richard Anderson[129] believes that if auditors are not successful in enhancing services and perceived value to clients and shareholders, future examples of entrenched, inwardly focused, and defunct organizations may include us. Downsizing, rightsizing, re-engineering, and outsourcing are not limited to the internal auditing departments. The trend suggests that companies are moving away from a hierarchical organization structure to a horizontal or at organization structure to increase communication among various departments and gain a better control of their organization. But the outsourcing of the internal audit function may pose more problems than companies had bargained for. Management may unconsciously outsource internal auditing departments, not because of its lack of added value to the organization, but rather for other suspicious motives such as: meeting stockholders expected higher returns; and eliminating those basic controls which may impair management fraud. Outsourcing is often undertaken by companies without understanding the full spectrum of the advantages and disadvantages in eliminating the internal auditing function. The Treadway Commission and a recent study on audit committees sponsored by the Institute of Internal Auditors suggest that auditors must be proactive in advising both management and audit committees on internal auditing matters. A well-informed audit committee can be a strong ally in preventing outsourcing[68]. A survey of 72 Big Six audit partners reveals that outsourcing is a real threat to auditor independence. The partners who have been involved in outsourcing reported that 86 per cent of their engagements were with current clients[178]. Outsourcing eliminates the common checks and balances that

exist between internal and external auditors since the Big Six rms would have a monopoly on an organizations operational audit processes[180]. This limitation would exist when the same rm was performing both functions.

The SEC position on outsourcing


The 1984 SECs interpretative decision on Rule 2-01(b) of Regulation S-X views outsourcing an impairment to auditor independence:
It also appears that the Internal Audit Type Duties... would impair the appearance of the Firms independence. The internal auditor relationship seems to be one which would be close in nature to that of an employee. An auditor may assist a client in the establishment of a system of internal control which will be administered by the clients personnel. An internal audit function generally would be part of the system of internal controls administered by employees of the client.

On 4 November, 1994, during the AICPAs Nineteenth Annual Conference on Banking, Walter D. Schuetze, the past chief accountant of the US Securities and Exchange Commission, questioned the independence of outsourcing practices whereby external auditors perform both the external and internal audit functions. He stated:
I understand that there are many different alternatives available to a company that wishes to outsource its internal audit function. One alternative being considered by some is for a company to completely replace its internal audit function with an expanded external audit function. As a result, the external auditor would perform both the external audit functions and the functions previously performed by the internal audit department. That is, the external auditor would be responsible for: performing audit procedures and issuing an opinion on whether the nancial statements were prepared in conformity with GAAP, issuing another opinion on managements assertions regarding the effectiveness of the companys internal controls, and designing and executing audit procedures that traditionally were performed by the internal auditors.

Because external auditors must be independent, both in fact and in appearance, of the company being audited, external auditors attempting to attend to both the responsibilities of the external auditors and the responsibilities traditionally performed by the internal audit function must exercise great care[181]. At the 1995 AICPAs National Conference on Banking, Michael H. Sutton, SEC chief

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accountant, expressed his frustration over the lack of clear, ethical guidance in the area of auditor independence[182]. The SEC official called for clarication as to whether or not an independent auditor who accepts outsourced internal audit functions from a client has assumed management or employee responsibilities:
Im getting impatient with the AICPA; Im getting impatient with the process of clarifying the standards. I want to emphasize that it is not the staff s goal to preclude auditors from providing internal audit outsourcing. Rather, if auditors provide those services to the audit clients, we believe that the impact of those arrangements on auditors independence should be carefully considered in each situation[183].

participation of the internal audit function in all facets of the company is vital to prevent the issuance of fraudulent nancial statements.

The AICPA position on outsourcing


In 1993, the AICPA, aware of the potential impact of outsourcing on the external auditors independence, issued Ethics Ruling 97, Performance of Certain Extended Audit Services[31], which states that the external auditor: cannot perform management functions or make management decisions; cannot be part of the clients approval process; and cannot be part of the internal control system without impairing their independence. In its response to the proposed interpretation of the AICPA Ethics Ruling 97, the AICPAs Public Oversight Board (POB) declared its support of the performance of extended audit services by the external auditor as long as the auditor does not assume managements operational or decision-making responsibilities. However, the SEC staff advised auditors that it would question independence, consistent with Ethics Ruling 97, when external auditors perform procedures that are management functions. Practitioners are, therefore, advised to give careful consideration to the implications that attend such outsourcing arrangements and the resulting effect on the accountants independence[182]. Jerry Sullivan, executive director of the Public Oversight Board, observed that the POBs position is based on the premiss that the monitoring of the internal control system over and above that required by the generally accepted audit standards, when performed by the external auditor, is not part of the internal control structure as dened by the COSO Report. In his letter to the AICPAs director of professional ethics, Sullivan stated:
COSO recognizes and states that parties external to the organization, such as regulators, the independent auditor, customers, and others transacting business with the enterprise, are not part of the entitys internal control system but do assist management in fullling its responsibility to monitor internal control. Thus, monitoring activities conducted by the independent auditor to replace the internal audit function are not internal to the organization and are not part of the monitoring component of the internal control structure[184].

At the 14 December, 1995 meeting of the Committee of Sponsoring Organizations (COSO) of the Treadway Commission, Sutton discussed the situation in which the external auditor has both the attest function and the internal auditing engagement. He expressed the SECs concern regarding the external auditors independence in providing extended audit services. He emphasized the following points: There should be a responsible and competent manager for internal auditing within the company with a clear separation of management and external auditor functions. The guidelines covering extended audit services should clearly delineate ongoing monitoring activities so as to identify those that could impair the independence of external auditors. In attestation situations such as FDICIA, the external auditors should obtain assurances from management that it did not rely heavily on the external auditor to form the basis for managements assertion on the effectiveness of internal controls. There should be a clear separation of managements and auditors responsibilities and that their individual roles should be claried (Bishops letter to Finkston, Appendix 1). Spectacular business failures have been attributed to the absence of a sound internal control system. The SEC enforced the Foreign Corrupt Practices Act and required that all companies devise an internal control system to prevent unethical and illegal actions perpetrated by management. Simply, outsourcing means weakening the apparatus of the internal control system for which the SEC had worked assiduously for many years. It also runs counter to the Treadway Commissions recommendation that active

Sullivans interpretation refers to the following passage of the COSO Report:


Everyone in the organization has some responsibility for internal control. Management, however, is responsible for an entitys internal control system. The chief executive

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officer is ultimately responsible and should assume ownership of the control system. Financial and accounting officers are central in the way management exercises control, though all management play important roles and are accountable for controlling their units activities. Similarly, internal auditors contribute to the ongoing effectiveness of the internal control system, but they do not have primary responsibility for establishing and maintaining it. The board of directors and its audit committee provide important oversight to the internal control system. A number of external parties, such as external auditors, often contribute to the achievement of the entitys objectives and provide information useful in effecting internal control. However, they are not responsible for the effectiveness of, nor are they a part of, the entitys internal control system.

operational or decision-making responsibilities. He further stated: We have heard informally from representatives of the Institute of Internal Auditors and certain regulators a contrary view, i.e., that such extended monitoring is part of the internal control structure as dened in the COSO Report, and therefore, the performance of the service by the external auditors might impair independence under certain circumstance. He urged that the Ethics Ruling 97 dealing with this issue be re-examined[186]. In September 1995, the Public Oversight Board (POB) report entitled Directors, Management, and Auditors Allies in Protecting Shareholders Interests stated that under the responsibilities of the independent auditor:
The board of directors, as the representative of the shareholders, should be the client, not corporate management. Corporate boards and audit committees should make this clear to the auditors[187].

But the COSO reports indicates that: Internal control is effected by people within the entity . Internal auditing is part of the entitys internal control system a Management responsibility . External auditors are not part of the internal control system. At the session on Outsourcing the audit function sponsored by the IIA, some panellists expressed their concerns about CPA rms performing the internal audit function for their clients. Richard Anderson, national director of internal audit services for Ernst & Young, expressed concern for independence and urged that care be taken in such situations. He stated:
Such an engagement has to be very carefully structured to protect our independence and the independence of the company We have . very specic policies how those types of engagements have to be structured[185].

On 5 April, 1995, key representatives of the AICPAs Public Oversight Committee (POB), visited IIA headquarters seeking input on the issue of auditor independence. POB executive director Jerry D. Sullivan and representative Donald J. Kirk discussed with IIA representatives the independence of external auditors who perform both the internal and external auditing functions for the same organization. The IIA presented the argument that an external auditors independence is impaired when performing both nancial and internal auditing for an organization[35]. In June 1995, A.A. Sommer Jr, chairman of the POB, wrote a letter to the AICPA Ethics Division stating that the POB is supportive of the performance of the extended audit services by the external auditor as long as the auditor does not assume managements

At the 19 January, 1996 meeting of the AICPA Professional Ethics Executive Committee held in Fort Lauderdale, Florida, there was recognition that independence could become an issue when the attest function auditor and internal auditor are the same. The Committee commented that services can be divided into components: management of the internal auditing function; and performance of extended audit procedure. The view of the Committee is that performance of procedures can be performed by the external auditor without impairment of independence. The IIA recognized that extended audit services can effectively supplement an organizations internal auditing function, although The IIA believes that total management of the internal auditing function must consist of organization employees[188]. On 28 February, 1996, the Professional Ethics Executive Committee issued an Exposure Draft of proposed interpretation 101-13 Extended Audit Services and related rulings under Rule 101, Independence, which was mailed for a six-day comment period to 10,000 AICPA members. William J. Inlanfeldt, president of the Institute of Management Accountants (IMA), in response to the Exposure Draft, wrote:
Generally, the IMA Ethics Committee does not support the AICPAs proposed interpretations and rulings as outlined in the Exposure Draft, and the committee urges the AICPA not to proceed based upon the proposed provisions. The principal reason for the committees position is that the performance of the extended audit services such as internal auditing by the same form which conducts the external audit would, at a minimum, impair the appearance of independence under any circumstances.

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Inlanfeldt felt that:


the exposure drafts attempt to dene circumstances that would maintain independence for the external auditor to perform such services will create a serious public perception problem if the rulings and interpretations are implemented. It would appear to us that the solution to this problem is straightforward. Any public accounting rm can perform the internal audit function for any client for which it does not perform the attest function[189].

a denition of the role and services that the internal auditing function must provide; strong communication skills; enhanced organizational and staff development[190]. The IIA has discouraged outsourcing and provided useful advice to help members to develop a positive professional strategy with regard to outsourcing. The IIAs position on outsourcing is based on the following rationale: When the internal auditor and the external auditor are one and the same, it will jeopardize the external auditors independence. An organization cannot delegate its total responsibility for monitoring the effectiveness and efficiency of its internal control structure to an external party, especially to its external auditors. One-time extended services or activities can, however, be performed under the supervision of the internal auditing director, such as: reviewing controls in new applications development; providing auditors to support audit tests in remote areas; providing language skills on international audits; analysing controls of re-engineered processes; and investigating frauds. The IIAs posture on outsourcing is a grave concern for the auditing profession. The IIA believes that outsourcing: violates the IIAs Standards for the Professional Practice of Internal Auditing (SPPIA) which states: The internal auditing department is an integral part of the organization and functions under the policies established by senior management and the board; does not comply with the Committee of Sponsoring Organizations (COSO) Guidelines on internal control which state that: internal control be effected by people within the entity; internal auditing is part of the entitys control system a management responsibility; external auditors are not part of the internal control system. The pamphlet has had a great impact in dissuading some corporations from outsourcing internal audit departments[191]. The stature, the maturity, and the professionalism of the auditing profession, as evidenced in the last 20 years, supports the IIA position on outsourcing. On 26 September, 1995, William G. Bishop III, president of the Institute of Internal

By advocating outsourcing, directly or indirectly, the AICPA has aroused the IMAs and the IIA s suspicion, and justiably so, that the concept of independence of CPAs does not reect the ethical posture on independence espoused by its predecessor the American Institute of Accountants which stated that: Independence in the last analysis bespeaks an honest disinterest on the part of the auditor. Some internal auditors may interpret that the AICPA is reneging on its original posture on auditor independence.

The IIA position on outsourcing


The IIA position, in its white paper entitled Perspective on Outsourcing Internal Auditing: a Professional Brieng for Chief Audit Executives[146], is that a competent internal audit department that is properly organized with trained staff can perform the internal audit function more efficiently and effectively than a contracted service since internal auditors are better acquainted with the organization, policies, procedures, operating practices, and personnel. The IIA recommends that internal auditors: evaluate their mission and strategies on an ongoing basis, and they should ensure that management is aware of the unique and critical contributions of the internal auditing department; prepare and implement a vision statement which is based on and linked to the overall organizational vision and is implemented through a strategic plan. An internal auditing department with vision is: proactive, innovative, focused, integrated, and motivated. Other key indicators for strong auditing departments include: a clear image of who are the most important internal auditing customers; an enhanced planning process; an enhanced methodology that provides selective risk coverage and increased management involvement in the audit process;

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Auditors, in his letter addressed to Michael H. Sutton, the SECs chief accountant, reiterated the IIAs long-standing position on outsourcing which considers outsourcing of material segments of internal auditing work to an external auditor to be inappropriate and a threat to independence. Bishop makes a forcible argument on the incompatibility of the so-called extended services on the part of the external auditors (Appendix 2). On 5 December, 1995, IIA president Bishop, in a press release titled Accountants May Impair Independence by Accepting Internal Audits, termed the move by public accountants into total outsourcing internal auditing functions a threat to the objectivity and independence of the auditing process[192]. Bishop believes that the control environment of the organization is adversely impacted by the disruption of the roles of internal and external auditing. On 15 January, 1996, IIA president Bishop sent a letter to Herbert Finkston, director of the AICPA Professional Ethics Division, in which he wrote that the development and interpretations on the independence of the external auditors when performing the internal auditing function for a client, should give consideration to the IIA Standards and other pronouncements which provide a basic structure to frame the three factors impacting the independence of the external auditor: 1 the scope of internal auditing; 2 the structuring of internal auditing as part of management; and 3 the demand for total independence of the external auditor. Bishop made the following three recommendations: that the Ethics Executive Committee specifically dene extended audit services so as to identify those services that would impair the independence of the external auditor; that language be included that would require a dedicated, competent professional appropriately resourced to be able to carry out the full authority and responsibility required to comply with the IIA Standards; that the Code of Professional Ethics guidelines should focus on the need for total independence of the external auditor. Guidelines should encompass the breadth of internal auditor and management responsibilities, including planning, staffing, organizing, controlling, reporting, follow-up, etc. Further, the guidelines should include requirements to document fully the scope and conditions of the engagement, including an understanding of the extent of managements reliance upon

the external auditor for an assessment of the system of internal control (Appendix 1). Bishop believes that the extended audit services provided by the external auditor are not clearly dened, and it is unclear whether these services encompass the full range of internal auditing activities. On 31 January, 1996, IIA president Bishop met with representatives of the Big Six accounting rms to discuss the outsourcing of the internal auditing function. The IIA articulated its view on outsourcing into eight statements: 1 Internal auditing must be performed in accordance with the IIAs Standards. 2 The internal auditing function is best performed by a fully resourced and professionally competent staff that is integrated to the management of an organization. 3 Independence is an issue when total internal audit function is performed by the organizations external auditor. 4 Some situations warrant outsourcing to achieve organizational goals and objectives more economically . 5 Outsourcing could be a remedy to substandard internal auditing activities. 6 Outsourcing can be preferable to having no internal auditing. 7 The IIAs role in guiding internal auditors to improve the quality of the internal auditing services. 8 The IIA posture to co-operate with public accounting rms in all aspects of the profession[193]. On 26 April, 1996, the Institute of Internal Auditors made its official response to the AICPA Professional Ethics Division regarding the Exposure Draft, Omnibus Proposal of Professional Ethics Division Interpretations and Rulings, dated 28 February, 1996. In its response, the IIA recommended that the Exposure Draft: include greater denition of the management responsibilities that the external auditor cannot assume without impairment of independence; more clearly dene the types of extended audit services (internal auditing) which, if performed, would impair the external auditors independence; delineate ongoing monitoring activities and identify those that impair the external auditors independence. The IIA also made the following suggestions: With respect to the responsibilities of the client for managing the internal auditing function, the IIA recommends that the nal interpretations and rulings include a reference to the IIAs Standards, and/or incorporate explicit statements individually

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describing those director of internal audit responsibilities prescribed in the IIAs Standards. The Exposure Draft should amplify the management functions of the internal auditing department that must remain within the company to protect the independence of the external auditor from impairment and should require the company to retain a qualied director of internal audit capable of performing those management functions. Management should not rely to a material degree on the work of the external auditor when performing their assessment of the system of internal control. In executing their responsibilities to the clients shareholders, the external auditor should test managements representations without being involved in supplying information used to formulate the assessment. The Exposure Draft should delineate the types of extended audit services and specify those that impair independence. The ruling should preclude performance of operational audits during which the member evaluates business activities and processes to the point of formulating recommendations for procedures which are managements responsibility[189]. The IIA believes that the adoption of the Exposure Draft, in its present form, would result in independence standards in the US being less stringent than in other countries.

Cases of outsourcing
The following cases show that outsourcing of the internal auditing function can be detrimental to companies: An outside auditor, who was doing the Landmark Bancorps internal audit work, failed to detect a $2.1 million fraud. The bank officer was stealing from unused credit lines of six customers and using an outside address to receive the customers billing statement. Landmark discontinued the outsourcing and hired its own internal auditors[194]. In 1993, most of the internal audit department of Morrison Knudsen Corporation in Boise, Idaho, was laid off and Deloitte & Touche was charged with performing Morrisons external and internal audit. A Morrisons spokesman defended Deloittes double duty arguing that there was no conict of interest because the accounting rm has a Chinese wall and so, in essence, it does two audits. In early 1995, the board ousted William Agee as chief executive officer because the construction company reported huge losses[194,195].

Some corporations have adopted the single integrated approach. In 1993, Chicagos Continental Bank outsourced the bulk of its internal auditing function by expanding its relationship with Price Waterhouse, its external auditor since 1985. Under this unusual arrangement, internal and external auditing work have been integrated[196]. The Continental Bank researched the possibility of outsourcing the internal function completely but rejected it. Instead the Continental Bank adopted a single integrated audit programme which combines the previously separate internal and external audit programs into a single whole under the joint management of Continentals Audit Department and Price Waterhouse[125]. Some companies and banking institutions have rejected outsourcing: In New York, the audit committee of a large multinational bank rejected the idea of outsourcing the internal audit function after a presentation on the topic by the general auditor. The presentation, which relied heavily on the material from the IIAs pamphlet on outsourcing, pointed out the advantages of a professional internal function and outlined the SECs position on outsourcing[197]. On 9 February, 1995, the Norwegian Banking, Insurance, and Securities Commission sent a circular to the boards of directors of all commercial and savings banks, and insurance companies stating that internal audit work cannot be performed by the nancial institutions external auditors[198]. The US Governments FDIC Improvement Act 1991, the Office of the Comptroller of the Currency, the Federal Reserve Board, and the Office of Thrift Supervisions Draft, Interagency Policy Statement on Audit Outsourcing, have raised the external auditors independence issues and questioned the practice of outsourcing[198]. Some companies may prefer outsourcing the auditing function. The cost savings provided by outsourcing may be worth the risk. In 1993, McDermott International, the big marine-construction company based in New Orleans, gave Ernst & Young, its external auditor, the internal auditing job. The move was made to save several million dollars annually[194].

Reactions to outsourcing
The specic functions attributed to the internal auditors and external auditors are viewed by professional and governmental bodies as separate and independent in the checks and balances of the internal control systems. The necessity of the internal audit function in the

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corporate and governmental settings has been recognized worldwide. The Research Committee of the Institute of Chartered Accountants of Scotland (ICAS) in a discussion document entitled Auditing into the twenty-rst century emphasizes such a need:
To provide a board of directors with reassurance that its management information systems and internal control systems are sufficiently reliable and relevant, we believe each company should establish and maintain a strong internal audit function under the direction of a Chief Internal Auditor. As the internal auditors will be carrying out their work on a continuous basis they should have a sound understanding of the range of activities in which a company is involved. The Chief Internal Auditor should be in a strong position to provide a board of directors with reassurances regarding the reliability and relevance of the systems being operated within that company .

simultaneous provision of all non-audit services by the statutory auditor. The Italian agency which oversees the public companies quoted in the stock exchange has released regulations which forbid companies from hiring management consulting rms which are directly or indirectly associated with the rms who certify their nancial statements. The Indian Companies Act 1956 precludes statutory auditors, who certify nancial statements, from serving as internal auditors of the company[189].

Opinion shopping and lowballing


The value of the accountants attestation is due to their neutrality and judicial impartiality[63].

The ICAS Research Committee also recognized that the need for constant monitoring of the system of internal control is a role for the internal auditors rather than the external auditors. McInnes and Stevenson[118] believe that the present work of the external auditors does not provide boards of directors with the reassurance on internal controls. Prior to the POBs statement on outsourcing, the IIA presented its view that, because of the auditors dual role in the control process, the performance of internal audits by the external auditor may jeopardize the auditor independence and thereby contribute to the organizational risk. Carman Young, the auditor for the Bank of Canada and IIA past chairman, voiced the IIAs concern when the same external auditor responsible for attesting to the fairness of an organizationals nancial statement performs the internal audit[186]. According to the Institute of Internal Auditors survey on outsourcing, several countries and organizations preclude statutory auditors who certify nancial statements of a company from serving as the internal auditors: The European Confederation of Institutes of Internal Auditing stated in their 1995 Position Paper that the knowledge and understanding of internal auditing can best be achieved by entrusting internal auditing to personnel employed within the enterprise. The Federation of European Accounting Experts, in their The Role, Position and Liability of the Statutory Auditor in the European Union (January 1996), stated that two countries, France and Italy, prohibit the

The SEC has dened opinion shopping as the practice of seeking an auditor willing to support a proposed accounting treatment designed to help a company to achieve its reporting objectives even though doing so might frustrate reliable reporting. Auditor independence, the credibility, role, and status of the accounting profession, and the reliability of nancial statements can be substantially affected by opinion shopping[199]. In 1977, the Commission on Auditors Responsibilities, known as the Cohen Commission, cited possible excessive competition for opinion shopping. Such a practice affects the quality of services[200]. To enhance auditor independence and deter opinion shopping, the SEC requires that registrant companies provide an explanation as to why the auditor was red. ASR # 165 explicitly states that whenever the companies dismiss the auditor they must give the following information in ling Form 8-K on whether:
there were any disagreements with the former accountant on any matter of accounting principles or practice, nancial statement disclosure or auditing scope or practice, which disagreements if not resolved to the satisfaction of the former accountants would have caused him to make reference in connection with his report on the subject matter of the disagreement[201].

Form 8-K requires the following disclosures: Were former accountants dismissed or did they resign? Did the board of directors or audit committee discuss disagreements with former accountants? and Did registrant company limit discussion between new and former accountants?[202]. A study found that after the change of auditor, the companys reported earnings and auditors opinions were more favourable[203]. In

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the UK, the need to take into account the publics perception of auditors and their independence led the Joint Ethics Committee of the Institutes of Chartered Accountants in England and Wales (ICAEW), Scotland (ICAS) and Northern Ireland (ICANI) to limit the circumstances in which audit rms may give second opinions, and to ban specialist valuations. It was felt that the danger in providing a second opinion is that the rm might not be aware of particular circumstances[204]. Regulatory bodies have also expressed concern about the common practice of pricing initial audit signicantly below cost (lowballing). They fear that lowballing could weaken auditor independence and reduce audit quality[205]. The SEC also criticized the practice of lower initial fees, suggesting that it could affect the auditor independence in a manner analogous to uncollected fees[206].

In 1978, the AICPA established a Quality Review Division for CPA rms and issued a Peer Review Manual to emphasize CPA rms independence and integrity in their work[210]. Policies and procedures should be established to provide the rm with reasonable assurance that rms at all organizational levels maintain independence to the extent required by the: rules of conduct; regulations; interpretations; rulings of the AICPA, state CPA society, state board of accountancy; and, if applicable, accounting series releases of the Securities and Exchange Commission[124]. In 1984, the Institute of Internal Auditors followed other professional organizations as a means of objectively reviewing internal auditing functions and issued a Quality Assurance Manual for Internal Auditing[211]. Later, the IIA amended the SPPIA and issued SIAS No. 4, Quality Assurance[212]. In 1987, the suit over the fraud of E.S.L. Government Securities Inc. not only received the professions attention as a threat to the entire professions reputation, but also encouraged improved emphasis on quality control, auditors independence, the maintenance of an ethical environment within CPA rms and clearer communication. Integrity is foremost in tandem with technical effectiveness[45].

Quality control
The evaluators must be independent of the organization and without a real or apparent conict of interest[10].

Competence alone is not sufficient; auditors must also be free of client inuence in performing the audit and in reporting the ndings. To emphasize independence from their clients, members of professional associations embraced self-regulation to emphasize their independence toward their clients. They wanted to assure the public, investors, and creditors that their services were not only of high quality but were also done with impartiality As a consequence, the AICPA, the IIA, . the SEC, the GAO and other professional bodies developed policies to ensure quality control among them by subjecting themselves to self-regulation and independent reviews and appraisal of performance. In 1976, the US General Accounting Office (GAO) issued Audit Standards Supplement No. 9, Self-Evaluation Guide for Governmental Audit Organizations[207]. In 1977, the Comptroller General of the USA issued a Comptrollers Handbook for National Bank Examiners containing instructions for the review of a banks internal audit function[208]. In 1977, the AICPA issued its Statement of Quality Control Statement No. 1, System of Quality Control for CPA Firms which mandates CPA rms to have a system of quality control. The rst element of quality control is independence and pertains to the performance of attest services only It states: .
All professionals should be independent of clients when performing attest services. An investigation is made to determine the rms independence before accepting a new audit client[209].

Rotation of auditors
The lack of auditor rotation could conceivably compromise independence in some organizations[213].

The SEC prohibits anyone who performs write-up services for a company from also serving as an auditor for that company To . prevent close relationships between the client and the auditor that might impair the appearance of independence, accounting rms that belong to the SEC Practice of the AICPA are required to rotate every ve years the partner in charge of a client. In March 1992, the SEC Practice Section of the AICPA issued a report entitled Statement of Position Regarding Mandatory Rotation of Audit Firms of Publicly Held Companies making a case in opposition to mandatory rotation[214]. To enhance auditor independence, directors of internal audit departments rotate their audit staff especially in small rms. In a survey of internal audit directors of small groups (staff sizes two to eight), it was felt that monitoring independence and handling peer review can present thorny problems for

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small audit staff. Directors must be sensitive to situations that might impair independence, and they should intervene personally as needed. Directors feel that simply being aware of the potential problem and keeping close watch mitigates the independence issue[213]. The IIAs PSB 82-5, Independence Objectivity, cautions that auditing the same area several times might result in personal relations with the auditee that could impair objectivity Internal auditors may not con. tinue to use professional scepticism in reviewing areas with which they are familiar. Accordingly, it is a prudent policy to rotate auditors periodically from assignment to assignment. PSB 82-5 also recommends that an internal audit departments professional development program for staff should include proper job rotation that will allow professional growth and will assure that audits are performed objectively . In 1992, the Chartered Accountants Joint Ethics Committee in the UK proposed the rotation of audit partners, not only because it would help avoid situations that could lead outsiders to question the auditors objectivity, but also because it would give the client the benet of a fresh and objective scrutiny of the nancial statements[204].

independence, issued several accounting series releases, and provided several examples of situations that could impair auditor independence. Unfortunately, many countries do not have a governmental body like the US Securities and Exchange Commission to enforce auditor independence in audited nancial statements. The survey of the countries examined shows that they have taken steps to enhance auditor independence by: establishing codes of ethics; promulgating professional auditing standards; and detailing situations that may constitute impairment of auditor independence. The UK recognized the relevance of auditor independence as early as 1845. Most countries have followed the UK footsteps in requiring that nancial statements be audited by independent auditors. Most countries view auditor independence not just as a legal tenet but also an ethical matter to reckon with. Most codes of ethics prohibit conicts of interest by not: allowing the auditor to serve as director or employee of the company audited; acting as a corporate trustee of the company audited; accepting, making, or guaranteeing loans from or to an audit client; having a direct or indirect material interest in the company audited; assuming operating responsibilities; having family relationship with the audit client;and being in situations in which auditor independence is presumed to be impaired. In several countries, the implementation of auditor independence and the compliance with professional audit standards are carried out by their governments and, in many occasions, sanctioned by professional associations. Independent auditors may be censured and even expelled from their respective professional associations if they are found in violation of their codes of ethics. The survey also shows that cross-cultural differences may limit the effectiveness of auditor independence even within a relatively homogeneous profession such as auditing. First, they create a lack of consensus within a profession as to what constitutes auditor independence; and, second, they cause a diversity of interpretations. The statement that auditors should be independent in fact and appearance will be a puzzle in a collective culture in which relationships and group memberships are the cornerstones of society[92]. Jensen and Yiu[106] indicated that the Western concept of auditor

Conclusion
We must be fully aware of the truth that complete independence can never be achieved. This is true because there are always conditions that to some extent limit independence[1].

Auditor independence is considered the hallmark of the auditing and accounting profession. Independence is viewed as the most essential element of the audited nancial statements in safeguarding the interests of several parties management, investors, creditors, and the government. Professional associations such as the American Institute of Certied Public Accountants, the Institute of Internal Auditors, the Canadian Institute of Chartered Accountants (CICA), the Cadbury Committee in the UK, and many others have recognized the importance of auditor independence as both a professional and ethical matter and codied it in their professional codes of ethics. The US Securities and Exchange Commission, the US General Accounting Office, foreign governments, and stock markets have played an important role in requiring that nancial statements be audited by independent accountants. The SEC, since its inception, has played an active role in enhancing auditor

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independence runs counter to the cultural values of the Asian communal society Even . Confuciuss admonishments discourage auditor independence since The man who is learned and discerning risks his life, for he exposes others faults (Lau Tses Admonishment to Confucius). China, Japan, Malaysia, and Singapore may adopt international auditing Standards for their multinational corporations, still their cultural values are inconsistent with the independent relationships of the Asian society, their belief in the centrality of the group, and its resulting desire for privacy[113]. Since the admission of the UK into what was then the European Common Market, later became the EEC and is now the European Union, and the enactment of the Eighth Directive on Company Law on auditors qualications, the European countries are familiarizing themselves with the American concept of auditor independence. Some critics believe, however, that cultural differences among European countries make the concept of auditor independence into a sort of window dressing. This may be the reason that led the International Audit Committee of the International Federation of Accounting (IFAC) to let the local governments deal with matters of auditor independence and other related matters. Auditing in Africa, in Russia, and in some Middle Eastern countries is still in its infancy It is premature to predict how audit . independence will evolve. Audit independence in the Anglo-Saxon countries (Australia, Canada, UK, USA, and New Zealand) has reached a high level of sophistication owing to the inuence of powerful accounting and auditing bodies. The Institute of Internal Auditors has played a major role in fostering the internal auditor independence and placed it at the top of its agenda. To dispel the notion that internal auditors, as part of management, may be viewed as less independent than their counterpart the external auditors, the SPPIA required that internal auditors report to the highest echelon of the management hierarchy and that an audit committee be made of external directors. The Institute of Internal Auditors, as an international auditing association, will face some dilemmas in the area of auditor independence on whether the SPPIA ought to be modied to meet the cultural values of its diverse international membership, or let the local institutes develop their own standards in consonance to their cultural values. The US Securities and Exchange Commission has recognized the unique role of internal auditors and has required that

corporations devise an internal control system and establish an internal audit function to monitor the internal control system in compliance with the Foreign Corrupt Practices Act. Internal auditor independence is a well-accepted notion worldwide that even the AICPA has recently created a new internal auditing post of the director of internal audit and quality control. According to AICPA president, Barry Melancon, the creation of the post indicates that internal auditing is something that goes beyond the nancials, it includes your organizations processes and ability to meet its goals[181]. Certied public accountants (CPAs) are not limiting themselves to the traditional attest function of nancial statements but have expanded their services by providing companies with management advisory services (MAS) and absorbing the functions of the internal auditors. This has caused a serious concern on the part of the Institute of Internal Auditors and the Securities and Exchange Commission. Historically the AICPA and the SEC have been at the crossroads on matters of auditor independence, conict of interest, ination accounting, the Foreign Corrupt Practices Act and now outsourcing. Unfortunately, attempts to align the differences between the SECs views and the AICPAs rules in the areas of auditor independence have been unsuccessful. The latest surveys and research studies conducted in Australia show an inverse correlation between the expansion of services provided by the CPA rms and the number of qualications issued. The larger the services provided the fewer the audit qualications. This conrms the SECs long standing position that extended services to companies being audited may impair audit independence. The Institute of Internal Auditors has articulated its views about the new wave of outsourcing that is endangering the internal auditing profession and casting a doubt on CPA rms that are assuming the dual role of external and internal auditors. The reasoning that the internal audit function and the attestation function of nancial statements are done by two different and separate departments within the same CPA rm does not seem a convincing argument that auditor independence will be preserved. In the past, the SEC brought examples in which the CPA rm played the dual role by helping the company in preparing the nancial statement and, at the same time, auditing them. There are no assurances that this will not happen again thus creating a new wave of scandals. The legislation on auditor independence is very clear in demanding from external

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auditors complete independence from the company audited. In the United States v. Arthur Young & Co., the Supreme Court of the USA upheld that the independent public accountant owes ultimate allegiance to the corporations creditors and stockholders, as well as to the investing public. The public watchdog function demands that the accountant maintain total independence from the client at all times and requires complete delity to the public trust. This is also the view upheld by the Securities and Exchange Commission. This reinforces the concern of the Institute of Internal Auditors regarding the new wave of internal audit services provided by external auditors which creates an imbalance in the internal control process. Since the CPA rms are assuming the dual role of the internal auditor and the external auditor, there is no need, therefore, for the external auditor to investigate the internal auditor independence in accordance to SAS # 65, Considering the Internal Audit Function. It is dubious when a section of the CPA rm that is charged with the attestation of the nancial statements has to assess the independence of another section of the same rm charged with the internal auditing function. Some critics have argued, and forcibly so, that when checks and balances between external auditors and internal auditors are broken, who is going to safeguard the organization against the issuance of potential fraudulent nancial statements? But the AICPA is still arguing that CPA rms may provide internal auditing services and are operating within the COSO framework. Outsourcing the internal audit departments translates into billion dollars of added revenues for the expanding CPA rms that are fast incorporating internal auditing in their practice. There is a potential risk that the slowing down of the internal auditing function performed traditionally by the internal auditors may further increase the likelihood of management fraud, the proliferation of fraudulent nancial statements which may result in the collapse of corporations in the long run. Historically, the US government has been slow in preventing business failures and has intervened only after congressional committees have been formed to investigate their causes and recommended courses of actions to remedy the disastrous situations. The IIA wants outsourcing stopped entirely and warned the SEC that the extended audit services or double duty trend can lead to major problems. These extended services provided by external auditors are inconsistent with the checks and balances built into the internal control system, are in violation of the Foreign Corrupt Practices Act which

requires the establishment of an internal control system to be monitored internally, and threaten the very existence of the Institute of Internal Auditors, an international association that provides counseling worldwide on internal controls. The IIA views internal auditing as a key management function that conicts with the public accountants responsibilities to be independent of management (Appendix 1). The main body of literature and research concerning auditor independence shows contrasting views. It has centred mainly on alleged threats to perceived and actual independence. Schleifer and Shockley[27] investigated the differences in the way in which auditors and nancial statement users react to policies designed to enhance auditor independence. They used multidimensional scaling techniques to measure the similarities and dissimilarities of four separate groups: 1 Big Eight CPA rms; 2 non-Big Eight CPA rms; 3 bank loan officers; and 4 certied nancial analysts. The results indicate that the four groups differed signicantly in the extent of their support for the 14 policies discussed in the Cohen Commission Report as a means to enhance auditor independence. The only perception gap on auditor independence that could potentially affect the accounting and auditing profession is the one regarding the auditors restrictions in providing services such as MAS and outsourcing. Internationally, there is no consensus on other auditing services provided by the external auditors. This has led the International Auditing Standard Committee of the International Federation of Accountants (IFAC) to defer this matter to the local governments. Despite the controversy about CPAs providing other accounting and auditing services, it must, however, be acknowledged that auditor independence is unparalleled in the USA. This is mostly due to the relentless efforts of the US Securities and Exchange Commission, the Institute of Certied Public Accountants, and the Institute of Internal Auditors.

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127 Chapman, C., Swedish public authorities to follow IIA standards, Internal Auditor, December 1995, p. 8. 128 Whittington, R.O. and Pany, K., Principles of Auditing, Irwin, Chicago, IL, 1995. 129 Anderson, R., The truly integrated audit, The Internal Auditor, December 1994, p. 65. 130 Price Waterhouse, Doing Business in Australia, Price Waterhouse, Chicago, IL, 1993. 131 Forster, K.P., The Accounting Profession in Australia, AICPA, New York, NY, 1994. 132 Evans, T.G., Taylor, M.G. and Holzmann, O.J., International Accounting & Reporting, South-Western, Cincinnati, OH, 1994. 133 AICPA, The Accounting Profession in Canada, AICPA, New York, NY, 1987. 134 Price Waterhouse, Doing Business in Canada, Price Waterhouse, Chicago, IL, 1994. 135 Taylor, W.L., Opening doors, Internal Auditor, October, 1995, p. 23. 136 Price Waterhouse, Doing Business in New Zealand, Price Waterhouse, Chicago, IL, 1993. 137 Auditors, outsiders and independence, Accountancy, Vol. 104, September 1989, p. 1. 138 Berryman, G.R., Auditor independence: its historical development and some proposals for research, Contemporary Auditing Problems, University of Kansas, Lawrence, KS, 1974. 139 AICPA, The Accounting Profession in the United Kingdom, AICPA, New York, NY, 1987. 140 Anderson, J. and Keenan, D., The Companies Act 1989: auditing aspects, Accountancy, Vol. 105, March 1990, pp. 98-106. 141 Darbyshire, D., Cutting auditors noses off to spite clients faces, Accountancy, Vol. 110, December 1992, p. 101. 142 Humphrey, C., Mozier, P. and Turley, S., The audit expectations gap in Britain: an empirical investigation, Accounting & Business Research, Vol. 23, 1993, pp. 395-440. 143 Green, O., Auditing review urged, Accountancy, Vol. 113, April 1994, p. 14. 144 Opetubo, A., Perceptions of a Nigerian auditor on independence, Masters thesis, New School for Social Research, New York, NY, 1985. 145 Price Waterhouse, Doing Business in Argentina, Price Waterhouse, Chicago, IL, 1992. 146 IIA, Perspective on Outsourcing Internal Auditing: a Professional Brieng for Chief Audit Executives, The Institute of Internal Auditors, Altamonte Springs, FL, 1995. 147 Price Waterhouse, Doing Business in the Russian Federation, Price Waterhouse, Chicago, IL, 1991. 148 Bollom, W.J. Ethics and self-regulation for CPAs in the USA, Journal of Business Ethics,Vol. 7, 1988, pp. 55-61.

149 Trompeter, G., The effect of partner compensation schemes and generally accepted accounting principles on audit partner judgement, Auditing: A Journal of Practice & Theory, Vol. 13, Fall 1994, pp. 54-68. 150 Audit guideline: guidance for internal auditors, Accountancy, Vol. 106, September 1990, pp. 141-4. 151 Ethics, Interpretations and Rulings, Journal of Accountancy, Vol. 171, February 1991, pp. 110-14. 152 Arens, A.A. and Loebbecke, J.K., Auditing, Prentice-Hall, Englewood Cliffs, NJ, 1994. 153 Allen, P.W., Changing standards for commissions and contingent fees, CPA Journal, January 1990, pp. 12-18. 154 Dye, R.A., Balachandran, B.V and Magee, . R.B., Contingent fees for audit rms, Journal of Accounting Research, Vol. 28, Autumn 1990, pp. 239-66. 155 AICPA, Codication of Auditing Standards, AICPA, New York, NY, 1993. 156 Ponemon, L.A., Internal auditor objectivity and disclosure of sensitive issues, Internal Auditing, Vol. 7, Summer 1991, pp. 36-43. 157 PSB 87-8: Independence Conict Arising from Incentive Compensation, The Internal Auditor, Vol. 44, October 1987, p. 22. 158 Magee, R.P. and Tseng, M.-C., Audit pricing and independence, Accounting Review, Vol. 65, April 1990, pp. 315-36. 159 AICPA, Statement on Standards for Management Advisory Services (MAS), Various numbers. 160 Hartley, R.H. and Ross, T.L., MAS and audit independence: an image problem, Journal of Accountancy, November 1972, pp. 42-52. 161 Schulte, A., Compatibility of management counseling and auditing, Accounting Review, July 1965, pp. 587-95. 162 Rule of conduct 102: MAS engagement to evaluate service bureaus, Journal of Accountancy, January 1977, p. 98. 163 Reckers, P.M. and Stagliano, A.J., Non-audit services and perceived independence: some new evidence, Journal of Practice & Theory, Summer, 1981, pp. 23-47. 164 AICPA, Public Oversight Board Report: Scope of Services by CPA Firms, AICPA: SEC Practice Section, 1979. 165 AICPA, Public Perceptions of Management Advisory Services Performed by CPA Firms for Audit Clients: A Research Report, AICPA, New York, NY, October 1986. 166 Lowe, J.D. and Pany, K., Auditor independence: the performance of consulting engagement with audit clients, Journal of Applied Business Research, Vol. 10, Winter 1994, pp. 6-3. 167 Wong, T., Yau,O. and Johnson, R., The accountants perceptions on auditors independence: an Australian experience, Proceedings of the Second Asian-Pacic Conference on International Accounting Issues, California State University, Fresno, CA, 1990.

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168 Wines, G., Auditor independence, audit qualications and the provision of non-audit services, Accounting & Finance, Vol. 24, May 1994, pp. 75-86. 169 Barkess, L. and Simnett, R., The provision of other services by auditors: independence and pricing issues, Accounting& Business Research, Vol. 24, Spring 1994, pp. 99-108. 170 Church, B.K. and Schneider, A., Maintaining objectivity despite conict duties, Internal Auditing, Vol. 7, Fall 1991, pp. 11-17. 171 Rule of Conduct 101: Independence during MAS Systems Implementation, Journal of Accountancy, January 1977, p. 98. 172 Bishop, W.G. III, Bishop shares IIAs view on auditor independence with new SEC chief accountant, IIA Today, December, 1995. 173 Courtemanche, G., Outsourcing the audit function, Internal Auditor, August 1991, pp. 34-39. 174 Block, P., Stewardship, Berrett-Koehler, San Francisco, CA, 1993. 175 Gibbs, J., Control and audit in an age of empowerment, Internal Auditor, December 1995, p. 14. 176 Stern, G.M., Ways internal auditing departments are adding value, Internal Auditor, April 1994, p. 30. 177 Lampe, H.C., Using internal audit outsourcing to meet the challenges of the 1990s, Internal Auditing, Summer 1993, pp. 3-12. 178 James, M.L., Outsourcing from the public accountants perspective, Internal Auditing, Summer 1994, pp. 55-8. 179 Tongren, J., Reality check, Internal Auditor, December 1994, p. 71. 180 Acciani, N., Outlaw outsourcing, Internal Auditor, February 1995, pp. 50-51. 181 IIA, Schuetze raises questions regarding independence, IIA Today, February 1995, p. 5. 182 IIA, SEC chief accountant expresses frustration over lack of guidance in the area of auditor independence, IIA Today, January/ February 1996, p. 4. 183 Rankin, K., CPA chided on outsourcing, Accounting Today, 11 December, 1995, p. 3. 184 IIA, The independence question, Internal Auditor, October 1995, p. 10. 185 IIA, AAA panel discusses outsourcing, Internal Auditor, October, 1995, p. 10. 186 IIA, Changes at the AICPA, Internal Auditor, December 1995, p. 8. 187 AICPA, Directors, Management, and Auditors Allies in Protecting Shareholders Interests, AICPA, New York, NY, September 1995. 188 IIA, IIA executives discuss independence issue with AICPA professional ethics executive committee, IIA Today, March/April 1996, p. 5. 189 IIA, IMA Nixes AICPA exposure draft, IIA Today, May/June 1996, p. 5. 190 IIA, To remain internal you must remain integral, IIA pamphlet suggests how, IIA Today, March/April 1996, p. 4.

191 IIA, Outsourcing loses ground in banking industry, Internal Auditor, April 1995, p. 8. 192 Bishop, W.G. III, Accountants may impair independence by accepting internal audits, IIA News, 5 December 1995. 193 IIA, IIA hosts meeting with Big Six, IIA Today, March/April 1996, p. 2. 194 Berton, L., Who is going to audit the auditors?, The Wall Street Journal, 5 March, 1996, p. B1. 195 Chapman, C., Financial turmoil does not dissuade company from outsourcing, Internal Auditor, 1995, p. 9. 196 Verschoor, C.C., Continental bank outsources IA, Internal Auditor, June 1993, p. 10. 197 Chapman, C., Outsourcing loses ground on banking industry, Internal Auditor, 1995, p. 8. 198 IIA, Perspective on Outsourcing Internal Auditing: A Professional Brieng for Chief Executives, The Institute of Internal Auditors, Altamonte Springs, FL, 1995. 199 Hendrickson, H. and Espahbodi, R., Second opinion, opinion shopping and independence, CPA Journal, Vol. 61, March 1991, pp. 26-9. 200 Cohen Commission on Auditors Responsibilities, Report of Tentative Conclusions, AICPA, New York, NY, 1977. 201 Securities and Exchange Commission (SEC), Accounting Series Release, #165, 12(b) of Form 8-K, 1987. 202 Smith, D.B., An investigation of securities and exchange commission regulation of auditor change disclosure: the case of accounting series release No. 165, Journal of Accounting Research, Spring 1988, pp. 134-45. 203 Mangold, N.R., The Effect of Auditor Changes on Earnings, Auditors Opinions, and Stock Prices, Working Paper, California State University, Hayward, CA, 1988. 204 Accountancy, Ethics rules to be tightened, Accountancy, Vol. 110, July 1992, p. 13. 205 Kanodia, C. and Mukheriji, A., Audit pricing, lowballing and audit turnover: a dynamic analysis, Accounting Review, Vol. 69, Oct 1994, pp. 593-615. 206 AICPA, The Commission on Auditors Responsibilities: Report, Conclusions, and Recommendations, AICPA, New York, NY, 1978. 207 General Accounting Office (GAO), Audit Standards Supplement No. 9, Self-Evaluation Guide for Governmental Audit Organizations, Comptroller General of the United States, Washington, DC, 1976. 208 Comptroller of the Currency, Comptrollers Handbook for National Bank Examiners, Office of the Comptroller of the Currency, Washington, DC, 1977. 209 AICPA, Statement of Quality Control No.1 System of Quality Control for CPA Firms, AICPA, New York, NY, 1977. 210 AICPA, Peer Review Manual, AICPA, New York, NY, 1978.

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211 IIA, Quality Assurance Manual for Internal Auditing a Self-Assessment Handbook, The Institute of Internal Auditors, Altamonte Spring, FL, 1984. 212 IIA, SIAS No. 4 Quality Assurance, The Internal Auditor, December 1986. 213 Cuzzetto, C.E., Lean, mean, auditing machines, The Internal Auditor, Vol. 51, December 1994, pp. 26-30. 214 AICPA, Statement of Position Regarding Mandatory Rotation of Audit Firms of Publicly Held Companies, AICPAs SEC Practice Section, New York, NY, 1992.

1. There should be a responsible and competent manager for internal auditing within the company, with a clear separation of management and external auditor functions. 2. The guidelines covering Extended Audit Services should clearly delineate ongoing monitoring activities so as to identify those that could impair the independence of external auditors. 3. In attestation situations such as FDICIA, the external auditors should obtain assurances from management that it did not rely heavily on the external auditor to form the basis for managements assertion on the effectiveness of internal controls. The IIA has similar concerns as SEC officials have expressed. The IIA is opposed to the total outsourcing of the internal auditing function to a companys public accountant because it impairs the external auditors independence. Internal auditing is a key management function that conicts with the public accountants responsibilities to be independent of management. Also, The IIA believes that total management of the internal auditing function must consist of company employees. This would allow the company to meet The IIA Standards for the Professional Practice of Internal Auditing (Standards) and still outsource parts of the internal auditing work. The IIA, however, objects to the appointment of a gurehead member of management in an attempt to shield the public accountants from a management role. Finally, The IIA acknowledges that the internal auditing function could be outsourced to third party providers other than the companys public accountants if The IIA Standards were followed. We commend the Ethics Executive Committee for the difficult work being performed to develop interpretations on the independence of the external auditor when performing the internal auditing function for a client. The IIA believes that consideration of pertinent IIA Standards and other pronouncements provides a basic structure to frame the three factors impacting the independence of the external auditor: (1) the scope of internal auditing; (2) the structuring of internal auditing as a part of management; and (3) the demand for total independence of the external auditor. First, Extended Audit Services are not clearly dened, and it is unclear whether these services encompass the full range of internal auditing activities. The IIA Standard 300, Scope of Work, states that The scope of internal auditing should encompass the examination and evaluation of the adequacy and effectiveness of the organizations system of internal control and the quality of performance in carrying out assigned responsibilities. This would include:

Appendix 1: Bishops letter to Finkston


William G. Bishop III, CIA President The Institute of Internal Auditors 249 Maitland Avenua Altamonte Springs, Florida 32701-4201 (407) 830-7600 Ext. 288 FAX (407) 831-5171 January 15, 1996 Herbert A. Finkston Director, Professional Ethics Division AICPA, Harborside Financial Center 201 Plaza Three Jersey City, NJ 07122-3881 Dear Mr. Finkston: The Institute of Internal Auditors (IIA) appreciates the opportunity to present its view on the independence and outsourcing of the internal auditing function. Basil Pumm and I plan to attend the open session of the AICPA Professional Ethic Executive Committee meeting at 9:30 AM on January 19, 1996, in Ft. Lauderdale. The information in this letter provides The IIAs general comments regarding those situations in which an external auditor also performs internal auditing for an organization. After the Public Oversight Board provided its views in a June 14, 1995 letter to you, The IIA considered it important to make its views known to the Securities and Exchange Commission (SEC). A copy of my letter to the Chief Accountant and an associated press release also are enclosed for you and your committee. I also understand that a replacement to Ethics Ruling 97-101 will be exposed for a period of 60 days; The IIA intends to comment on that exposure draft. During the Committee of Sponsoring Organizations (COSO) meeting on December 14, Mike Sutton of the SEC, in discussing the situation in which the external auditor has both the attest engagement and the internal auditing assignment, expressed three major concerns on the important issue of independence and the outsourcing of the internal auditing function:

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1. (310) Reliability and Integrity of Information Internal auditors should review the reliability and integrity of nancial and operating information and the means used to identify, measure, classify, and report such information. 2. (320) Compliance with Policies, Plans, Procedures, Laws, and Regulations Internal auditors should review the systems established to ensure compliance with those policies, plans, procedures, laws, and regulations which could have a signicant impact on operations and reports, and should determine whether the organization is in compliance. 3. (330) Safeguarding of Assets Internal auditors should review the means of safeguarding assets and, as appropriate, verify the existence of such assets. 4. (340) Economical and Efficient Use of Resources Internal auditors should appraise the economy and efficiency with which resources are employed. 5. (350) Accomplishment of Established Objectives and Goals for Operations or Programs Internal Auditors should review operations or programs to ascertain whether results are consistent with established objectives and goals and whether the operations or programs are being carried out as planned. Second, The IIA Standard 500, Management of the Internal Auditing Department, establishes the management of the internal auditing function to include broad responsibilities requiring a competent and professional director. 1. The formal charter of the internal auditing department is to be approved by senior management and accepted by the board of directors. The director of internal auditing is responsible for properly managing the internal auditing department. This includes having a statement of purpose, authority, and responsibility of the department; planning to carry out those responsibilities; providing written policies and procedures to guide the audit staff; selecting and developing the internal auditing department staff; coordinating internal and external auditing efforts; and establishing and maintaining a quality assurance program to evaluate the operations of the department. 2. The IIA position is that the independence issue cannot be resolved simply by the organization retaining a general auditor with employee status to be responsible for directing or liaisoning with the external auditor performing the outsourced internal auditing function. Even if the responsibilities for this position include preparation of a charter of policy, oversight, approval of audit plans, review of results, and communication with the board and/or audit committee, this general auditor must be more than a gurehead. Specically, the general auditor should be a dedicated, fully competent professional who has

complete authority and responsibility over the resources, techniques, and quality to assure that internal auditing is done in compliance with The IIAs Standards. As such, the general auditor must have sufficient authority and resources to plan, direct, and control all internal auditing activities. Finally, the Public Oversight Board (POB) Report Directors, Management, and Auditors Allies in Protecting Shareholders Interests, September 1995, states under the responsibilities of the independent auditor that The board of directors, as the representative of the shareholders, should be the client, not corporate management. Corporate boards and audit committees should make this clear to the auditors. The POB Report also states: 1. In United States v. Arthur Young & Co., the Supreme Court of the United States concluded that the independent public account owes ultimate allegiance to the corporations creditors and stockholders, as well as to the investing public. This, public watchdog function demands that the accountant maintain total independence from the client at all times and requires complete delity to the public trust. 2. Too close a relationship can discourage the auditor from speaking up if the auditor questions the accounting principles selected, the clarity of disclosures, or the estimates and judgments made by management. Thus, The IIA believes that any new interpretation should alleviate the concerns articulated by the POB. In summary, The IIA recommends the following: First, that the Ethics Executive Committee specically dene Extended Audit Services so as to identify those services that would impair the independence of the external auditor. Second, that language be included that would require a dedicated, competent professional appropriately resourced to be able to carry out the full authority and responsibility required to comply with The IIA Standards. Third, that the Ethics guidelines should focus on the need for total independence of the external auditor. Guidelines should encompass the breadth of internal auditor and management responsibilities, including planning, staffing, organizing, controlling, reporting, monitoring, follow up, etc. Further, the guidelines should include requirements to document fully the scope and conditions of the engagement, including an understanding of the extent of managements reliance upon the external auditor for an assessment of the system of internal control. Again, we thank you for this opportunity to share our views on this important issue. I look forward to meeting you on January 19th, and, if we can assist you in formulating guidelines from an

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internal auditing perspective, please call me at extention 288. Regards, William G. Bishop III, CIA 2 Attachments: 1. IIA Press Release, 12/5/95 2. IIA Letter to Michael H. Sutton, 9/26/95 cc: William L. Taylor Anthony J. Ridley, CIA Arleen R. Thomas

Appendix 2: Bishops letter to Sutton


William G. Bishop III, CIA President The Institute of Internal Auditors 249 Maitland Avenua Altamonte Springs, Florida 32701-4201 (407) 830-7600 Ext. 288 FAX (407) 831-5171 September 26, 1995 Mr. Michael H. Sutton, CPA Chief Accountant Securities and Exchange Commission Washington, DC 20549 Dear Mike: The Institute of Internal Auditors (IIA) is an international organization comprised of more than 52,000 internal auditing professionals in over 100 countries. It is the only organization dedicated solely to the advancement of the individual internal auditor and the internal auditing profession. The IIA is the worlds leader in research and education for internal auditors and is the standards-setting body for the internal auditing profession. The IIA has become increasingly aware of arrangements through which an organizations internal auditing function is performed by its external auditors on a contract or extended audit services basis, hereby dened as outsourcing. Of particular importance is the situation in which the entire internal auditing function is performed by the same rm that does the external auditing. The source of this concern relates to the public interest which is currently protected by the independent external auditor. Shareholders and regulators of publicly held companies rely upon managements representations of nancial positions and results of operations and, to an increasing degree, upon assertions about the sufficiency of internal controls. This reliance is built upon the thesis that a professional external auditor completely independent of the organizations management has completed sufficient verication tests to attest to managements representations and assertions. The primary concern of The IIA is that modern internal auditing, as currently dened in profes-

sional literature and practiced in the majority of U.S. publicly held companies, is generally incompatible with the independence requirements of the eternal auditor. External auditors are precluded by tradition, regulation, and rulings from becoming part of the mangement functions of the organization for which they perform public accounting. However, the internal auditing function provides the major supporting assurance that allows management to make a public assertion as to the effectiveness of its organizations internal control structure. If a public accounting rm performs all the internal auditing activities an outsourced basis, it becomes, at the very least, an indirect advocate of managements assertion. The independence issue arises when the same rm that provides an independent opinion of an organizations nancial statements also performs an engagement to express an independent opinion on the fairness of managements assertion. This may result in reduced public condence in the integrity of the processes that provide vital information to the various users. Further, the control environment of the organization is adversely impacted by the disruption of the roles of internal and external auditors. Boards of directors, management, regulators, and the general public have come to rely on the checks and balances inherent in the relationship between internal and external auditors. Internal auditors routinely comment to audit committees on the sufficiency of the external auditor. Similarly, external auditors respond to audit committee inquiries about internal auditor performance. When external auditors and internal auditors are one, this check and balance is eliminated and the control environment is weakened. Finally, the current controversy regarding this topic is sufficient to warrant some consideration of public disclosure. Public statements by members of your staff and others have indicated that many share our concern about the independence of auditors and the impact on control within the organization. Their concern is of sufficient magnitude to warrant public disclosure in annual reports to shareholders whenever the traditional relationship between management and the external auditor has been disrupted. On behalf of The IIAs members, I submit this letter and the attached discussion paper regarding The IIAs perspective on the practice of outsourcing. Thank you for the opportunity to share our views on this important issue. If we can assist you in any way, please advise. We would also be pleased to meet with you and members of the SEC staff to discuss these matters further. Best Regards, William G. Bishop III, CIA cc: Roy T. Van Brunt Attachment: The IIA Outsourcing Internal Auditing Discussion Paper, w/3 enclosures

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