Threat To Auditor Independence

Accounting Essay
In almost all countries auditing, as a profession, is becoming very demanding. Auditor
independence has long been regarded as a cornerstone of the auditing profession (AICPA
1999; SEC 2000). The government of Mauritius often requests for a Report on
Observance of Standards and Codes, Accounting and Auditing Review (ROSC A&A)
which focuses on the institutional framework underpinning the accounting and auditing
practices in the country. It evaluates the statutory framework supporting the accountancy
profession; education and training of accountants; professional accountancy organizations
and ethics; accounting and auditing standards; and monitoring, enforcement, and
oversight of the profession. The link between auditor independence and audit risk is
closely linked. Audit independence as well as audit risk, both has a significant effect on
audit quality and audit credibility and the economy as a whole and is also related to
sustainable success. Safeguards are identified and classified by the Financial Reporting
Council, the Mauritius Institute of Professional Accountants and the National Committee
on Corporate Governance to strengthen auditor independence. Auditors play an important
role in the capital markets. Financial markets crisis since 2007 has unfolded many issues
regarding the supervision of financial institutions, financial reporting and auditing as of
core importance to many regulatory bodies in order to ensure proper-functioning
framework in the internal market, more specifically, this has brought issues of long-
standing debate (Brown, 2005; Young, 2005; Reinstein and McMillan, 2004; Dewing and
Russell, 2003) including: audit and accounting regulation; auditor independence; earning
management; and audit and audit firm quality controls. This issue results in a lack of
confidence on part of the public. Ethics have been observed to play a key part in the work
of auditors. The accountancy profession claims to be both moral and ethical (Francis,
1990).

1.2 Research problems

In Mauritius, scarce literature is available on the perception of the threats that impair
auditor independence and safeguarding it. People are taught the professional behavior;
integrity, objectivity and independence. But have regulatory framework and education
been able to instill complete independent (both in fact and in appearance) in the work of
auditor? The aim of this study is to provide data viewed from a local perspective by
taking into account the Mauritian’s framework, as well as institutions, which provides the
training to equip people with the required professional and ethical conducts required as
an auditor, so as to safeguard auditor independence. But in one way or the other auditor
independence is threatened. It is argued that poor outcomes arise where the safeguards
are insufficient defence against the threats thus increasing independence risk and also
incentives also influence an auditor. Stakeholders and regulators due to their concerns for
the audit quality have criticized the auditing profession. Auditors have the main aim to
assure the trust of the public. Concerns are shown towards both the competence
(discovering a problem or making a correct judgment) and the independence (disclosure
of the problem by the auditor) of the accounting firm (Duff, 2004). In addition the audit
process is seen to be unobservable to third parties, while audit risk is fundamental to the
audit process as auditors cannot and do not attempt to check all transactions. Another
problem is that the behavior of the auditor is not only determined by the professional
conducts, but also ethical cognition and moral of the auditor also influence the work of
the auditor. This research enables us to investigate the relationship between independence
and audit risk as well as ethical cognition and auditor independence and the role of the
regulatory framework in influencing individual auditors as well as safeguard the trust of
the public.

1.3 Objectives of the research

This assignment has two overall objective:
Part 1: This assignment examines whether an appropriate accounting framework and
ethical code of professional conduct effectively enhances auditor independence.

Part 2: The impact of both auditor independence and audit risk on the main elements
related to an audit work; audit quality, audit failure, earning management and the audit
process, to ensure confidence for the public interest.

Specific objectives:
-To highlight the importance of auditor independence and how it is fundamental to public
confidence in the audit process.

-To determine the factors associated with the decision-making process of an auditor;
ethical, moral and independence in judgment-base decisions.

-To determine the extent to which Mauritius framework protect auditors’ independence.

-To reflect how risk and independence are linked.

-To analyse the impacts that auditor independence and audit risk have on audit work and
hence public confidence.

- To determine the actions taken in Mauritius to ensure confidence in auditors’ work to

the public by manipulating audit quality, audit failure, earning management, the audit
process as a whole

Part 1
Auditor Independence
2.1 Definitions of an audit, auditor and auditor
independence
An audit is basically an examination of a set of records, both financial and non financial,
to ensure that they can be relied upon in terms of accuracy and completeness. An auditor
is a qualified person who carries out the audit assignment and reports on the ‘true and fair
view’ of the client entity’s financial statements so that the users of financial statements
can rely on the reliability and credibility of the financial statements. The objective of
auditing has been given by International Standards of Auditing (ISA) 200; Overall
Objectives of the Independent Auditor and the Conduct of an Audit in accordance with
International Standards on Auditing. ISA 200 deals with the independent auditor’s overall
responsibilities when conducting an audit of financial statements in accordance with
ISAs. Specifically, it sets out the overall objectives of the independent auditor, and
explains the nature and scope of an audit designed to enable the independent auditor to
meet those objectives.

The Mauritius Financial Reporting Act 2004 states: "independence" means independence
of mind and independence in appearance. Independence Standards Board (ISB) 2000
states that auditor independence is the ‘freedom from those pressures and other factors
that compromise, or can reasonably be expected to compromise, an auditors’ ability to
make unbiased audit decisions’. According to Okolie (2007), "audit independence
equates the term with an attitude and approach of objectivity (being unbiased, fair and
impartial) and integrity (being intellectually honest". Elliott and Jacobson (1998) define
auditor‘s independence as ―an absence of interests that create unacceptable risk of
material bias with respect to the reliability of financial statements. Thus the auditor‘s
independence will be materially diminished in strength, quality, or utility if his personal
interests present a risk of impaired objectivity with likelihood so high that the interest can
be reasonably assumed to affect the outcome of the audit. According to Mcgrath,Siegel,
Dunfee, Glazer and Jaenicke (2001) however, the definition of independence does not
require the auditor to be completely free of all the factors that affect the ability to make
unbiased audit decisions, but only free from those that rise to the level of compromising
that ability.

Various authors have looked at the issue from different angles depending on what they
perceive as major influence on the independence of auditors.

2.2 Independence of mind and independence in appearance

Independence "in fact" (or actual independence) and "in appearance" (or perceived
independence) is two types of auditor independence.

Mauritius Financial Reporting Act 2004 states:

independence of mind :
"independence of mind" means the state of mind that permits the provision of an opinion
without being affected by influences that compromise professional judgment, allowing an
individual to act with integrity, and exercise objectivity and professional skepticism;

independence in appearance :

"independence in appearance" means the avoidance of facts and circumstances that are so
significant that a reasonable and informed third party, having knowledge of all relevant
information, including any safeguards applied, will reasonably conclude that the
integrity, objectivity or professional skepticism of a firm or a member of the audit team
had been compromised

2.3 Importance of auditors’ independence

Independence is a key concept-a characteristic that is essential for ensuring the credibility
of audit work. If users of financial statements are to believe and rely on the auditor’s
opinion, it is essential that the auditor is, and is perceived to be, independent of the entity
and its management. This is reflected in the fundamental principle of auditing-
Objectivity and Independence- which states: "Auditors are objective. They express
opinions independently of the entity and its directors. (APB, 1996)

The importance of auditors’ independence – to both investors and the wider economy
was succinctly conveyed by Turner (2001), former Chief Accountant of the Securities
and Exchange Commission (SEC) in the USA, when he stated:

"The enduring confidence of the investing public in the integrity of our capital markets is
vital…. [The capital they invest] is providing the fuel for our economic engine, funding
for the growth of new businesses . . . and job opportunities for tens of millions of
workers. . . .[But] the willingness of investors to continue to invest … cannot be taken for
granted. . . . Public trust begins, and ends, with the integrity of the numbers the public
uses to form the basis for making their investment decisions. . . . It is the report of the
independent auditor that provides investors with the critical assurance that the numbers in
the financial statements have been subjected to an impartial, unbiased and rigorous
examination by a skilled professional. But in order for that report to have credibility with
investors, to add value to the process and investors, it must be issued by a person or firm
that the investor perceives is free of all conflict- conflicts that may or will in part weight
on or impair the auditor’s judgments about the accuracy of the numbers" (pp. 1-2)"

As expressed by Bartlett, (1993) audit independence refers to an unbiased mental attitude

in making decisions throughout the audit and financial reporting that without
independence, audit has no value (Power, 1997), as the result, auditor should maintain
independent and exists to professional ethics, but current audit environment changing
very rapidly, increased many force on the audit independence.

However, Peter Wyman ("Is Auditor Independence Really the Solution?," April 2004)
makes an important contribution to this discussion, about being full independent by
emphasizing that auditor independence is an enabler of good auditing, and that to view it
as an end in itself could have severe adverse consequences. He states that attracting and
retaining high-quality people to the auditing profession is vital. Incompetent but totally
independent auditors are not a solution.

2.4 Threats to auditor independence

2.4.1 Threat to auditor independence
Threat to auditor independence is the risk that set limits on the auditor preventing him
from acting fully with professional behavior. Pany and Whittinton (1997), Gupta(1999),
ICAN (1999), ISB (2000), (Myring and Bloom, 2003), Aquaisua (2004) and Okolie
(2007) identify some of these threats which include undue dependence on a client;
overdue fees; actions or threatened litigations; family or other personal relationships;
beneficial interesting shares and other investments; beneficial interests in trusts, loans,
voting on audit appointments; acceptance of goods and services as gifts or hospitality;
and provision of other services to audit clients.

UK, European Commission, Australia, IFAC as well as Mauritius framework identify

five threats by the approach of "threats and safeguards" approach. According to this
threats and safeguards approach, the frameworks identify five basic categories of threats
to auditor independence:

self-interest threat: the threat to auditors’ independence resulting from a financial or other
self-interest conflict

self-review threat: the difficulty of maintaining objectivity in situations where a judgment

of a previous audit, or non-audit, assignment needs to be challenged or re-evaluated in
reaching audit conclusions

advocacy for client threat: the threat to auditors’ objectivity resulting from auditors
becoming advocates for (or against) their client’s position in any adversarial proceedings
or situations

intimidation by clients threat: the possibility that auditors may be intimidated by threat,
by a dominating personality, or by other pressures, by a director or manager of their
client or by some other party

trust or familiarity threats: this arises from auditors becoming over-influenced by the
personality and qualities of their clients’ directors and/or senior managers and
consequently too sympathetic to their interest. Alternatively, auditors may become too
trusting of management representations and, thus, insufficiently rigorous in their audit
testing.
The relative importance of each of these threats varies based on the details of the
individual audit firm-client relationship, but most of the threats exist in every auditor-
client arrangement.

2.4.1.1 Meaning of an urgency threat

This can arise when issues emerge at a late stage, either as a result of audit procedures or
from events within the company. Auditors find themselves under greater pressure when
issues come up at last minute and that there is no time to research matter properly.
(Fearnley, S.and Beattie, V.and Brandt, R.(2005) Auditor independence and audit risk: a
reconceptualisation.)

2.4.1.2 Meaning of loss of face threat

This is the threat arising from dismissal. The threat of dismissal is the fundamental self-
interest threat for an auditor as it leads to loss of face for the firm and very probably for
the partner as well. Here there is the risk of losing the client. (Fearnley, S.and Beattie,
V.and Brandt, R.(2005) Auditor independence and audit risk: a re-conceptualisation.)

2.4.1.3 Independence risk with judgment-base decisions

2.4.1.3.1 Definition of independence risk
According to Johnstone (2001) independence risk is defined as the risk that an auditor's
independence may be compromised or may be perceived to be compromised. Some
actual or perceived incentive to the auditor is necessary for independence risk to exist as
well as judgment-based decision situations are necessary for independence risk to
adversely affect actual or perceived audit quality.

2.4.1.3.2 Direct and indirect incentives decisions

2.4.1.3.2.1 Definition of direct incentives
Direct incentives involve actual or potential monetary benefit, for examples investments
in the client might cause an auditor's financial interests to align with the interests of
management, possibly to the detriment of the interests of other investors or creditors.
Client's fees to auditors that are contingent upon specific opinions can, if allowed to
occur, result in the auditor's financial interests becoming dependent upon whether audit
judgments coincide with management's preferences. Financial dependence introduces
incentives that threaten the auditor's ability to resist management pressure, out of concern
that a financial relationship will be terminated (Johnstone, K.M., M.H. Sutton and T.D.
Warfield. 2001. Antecedents and consequences of independence risk: framework for
analysis).
2.4.1.3.2.2 Definition of indirect incentives
Indirect incentives arise from other circumstances that could make it difficult for the
auditor to maintain objectivity. Theses occur when the auditor possesses a personal,
family, or professional relationship with the client. These incentives also arise when
auditors audit their own work, including financial statements they prepared, valuations
they recommended for financial statement items such as in-process research and
development, outsourced internal audit services they did, and management decisions they
advised on. Interpersonal relationships might cause the auditor to favor personal over
professional objectives and also might affect the auditor's ability to exercise an
appropriate level of professional skepticism (Johnstone, K.M., M.H. Sutton and T.D.
Warfield. 2001. Antecedents and consequences of independence risk: framework for
analysis).

2.4.1.3.2.3 Independence risk as a function of incentives

in judgment-based decisions
Incentives and motivation play a vital part in auditor judgments. Experimental research
has documented that auditor judgments can be impacted by incentives which, in turn, can
negatively or positively influence the quality of the audit process. Judgment-based
decisions are those in which there is uncertainty regarding the appropriate decision or
valuation judgment that an auditor should make. For example, settings in which there
might be a high degree of judgment include deciding on the appropriateness of a client’s
revenue recognition policy or judging the adequacy of a client’s allowance for doubtful
accounts. Where little or no judgment is required in certain circumstances is unlikely that
incentives to compromise independence will result in reduced audit quality. The quality
of auditor judgments has been found to be adversely impacted by the perceived risk of
client loss (e.g., Farmer et al. 1987; Blay 2005); fee pressure (e.g., Houston 1999;
Gramling 1999), client retention incentives (e.g., Lord 1992; Trompeter 1994; Chang and
Hwang 2003), economic benefits contingent on specific actions (e.g., Schatzberg and
Sevcik 1994; Beeler and Hunton 2002), and other client-related and engagement
pressures (e.g., Hackenbrack and Nelson 1996; Haynes et al. 1998; Jenkins and Haynes
2003; Kadous et al. 2003; Blay 2005). However, there are several countervailing
incentives in place, such as concerns for regulatory enforcement, potential litigation
costs, and potential reputation losses, promoting high audit quality (e.g., Nelson 2009). In
general, it is believed that incentives lead to preferences for a desired outcome which
unintentionally influence one’s decisions, in a self-serving manner (e.g., Kunda 1990;
Russo et al. 2000).

However, the quality of an auditor’s judgment is also influenced by pressures emanating

from the firm itself. These pressures can arise from immediate supervisors on the audit
team or the overall evaluation process used by the firm. For example, audit managers
held accountable to a partner who aggressively tries to grow the firm’s business are more
likely to support bidding on a client who engages in aggressive accounting practices
(Cohen and Trompeter 1998). Likewise, audit managers who perceive audit partners to
value efficiency as compared to effectiveness may rely on questionable work by an
internal auditor to a greater extent (Gramling 1999) and engage in less skeptical
behaviors during audit testing (Brown et al. 1999). Finally, research also finds auditors’
perceived goals of the audit (Sweeney and McGarry 2011) and perceptions of how the
audit firm values them (Herrbach 2001) influences auditors’ judgments.

2.5 Safeguard to auditor independence

The issue of auditor’s independence has always been an important public concern and a
matter of many debates, especially because of the fiduciary role played by the auditors in
modern society. "At the heart of the audit profession is a belief about human nature.
Human being will speak the truth unless there is sufficient to be gained by being
dishonest’. Many would disagree and argue that it is a partial view of human nature.
However, if all the auditors were truly independent the subject would not find such a
prominent place in the code of conduct of every professional institute of the world. The
very fact that it attracts so much attention would indicate that auditors, independence is
difficult to maintain.

Safeguarding independence is a key component requirement of the regulatory framework

which supports capital markets. This independence can be maintained through external
constraints (i.e., legislation and regulation) or through the profession itself, which will
maintain independence to preserve its market value (Kinney 1999). According to the UK,
European Commission, Australia, IFAC as well as Mauritius framework there are four
safeguards against these threats are identified (Vivien Beattie and Stella Fearnley,
September 2002, "Auditor Independence and Non-Audit Services):

regulatory safeguards and sanctions either emanating from legal or professional

requirements e.g. auditing standards, prohibitions, disclosure requirements, ethical
guidelines, oversight and enforcement, etc;

safeguards within the firm which can be firm-wide or engagement specific, e.g. quality
control and documentation, identification of threats, availability of consultation
procedures, internal reviews by independent partners, division of responsibilities,
training, staff development, ethical standards, etc.

governance procedures in the company, particularly the audit committee;

where the safeguards are not considered sufficient the auditor can refuse to act.

A number of proposals have been put forward to safeguard auditors’ independence and
empower them to withstand pressures to compromise. Some of the suggested safeguards
have already been implemented in many countries including Mauritius, such as restriction
on other services, rotation of auditors and user education.
According to Myring and Bloom (2003), these safeguards are the controls, which
mitigate against the effects of threats, and provide greater incentives to the auditors to
make appropriate independent decisions.

2.5.1 Establishing real auditor independence

Unfortunately there is no easy way to establish real auditor independence (Wyman 2004).
But a more drastic step would be to require rotation of audit firms at regular intervals (say
every five years). Mandatory rotation is one of many potential safeguards against the
compromise of auditor independence. It is relatively attractive as a mechanism as it is a
very visible indication of independence. Its popularity as a 'solution' has risen in recent
years due in part to its perceived value in addressing audit market concentration. Gupta
(1999) and Okolie (2007) also agree that one of the most effective safeguards is the
rotation of auditors. However, that mandatory rotation is primarily a safeguard of the
appearance of independence.

The existence of these frameworks does not mean that these above safeguards are always
effectively applied. It must be noted that even thought we make a distinction between the
two types of auditor independence (in fact and in appearance), when considering the
threats and safeguards to auditor independence these two components are not considered
separately.

2.6 Ethical cognition and auditor independence

2.6.1 Definition of ethical cognition
Experimental studies have found that the individual auditor’s level of ethical cognition
has a significant impact on audit decisions. Based on individual’s ethical development
which influences judgment and work, Kohlberg (1958) defined ethical development as
the ‘Cognitive Moral Development’ (CMD) of the individual, governing the thought and
knowledge processes involved in deciding about what is right or wrong. Kohlberg’s
CMD implies that higher levels of ethical development should result in more ethical
behavior. Kohlberg’s CMD model distinguishes three part of an individual’s ethical
development to examine an auditor’s implicit reasoning in the resolution of an
independence conflict, which he described as

– the pre-conventional level: an individual’s ethical decisions are shaped by external

authorities, self interest, and the rewards and punishment associated with various choice
outcomes. This stage reflects the lowest level of cognitive moral or ethical development

– conventional level: an individual’s ethical decision is shaped by considerations of the

law and social norms.
– post-conventional level: an individual’s ethical decision-making is influenced by
universal principles of fairness, conscience and justice. This stage reflect the highest
order of ethical development.

James Rest (1982) built on Kohlberg’s work by developing a four-component model of

the ethical decision-making process which describes the cognitive processes individuals
(as cited in Bebeau 2002). Bebeau (2002) has summarized Rest’s (1982) the four-
component model as starting with ethical sensitivity: the individual must be able to
identify a moral dilemma through to his/her intention and finally courage to behave
ethically, moving to an ethical judgment whereby the individual forms a judgment on the
ideal solution to the moral dilemma, moving to the ethical intention which is the
individual’s intention to comply or not comply with the ideal solution is formed and
finally ethical behavior. Here the individual develops the courage to follow through with
his/her moral action.

Ethical decisions are affected by the decision maker’s level of moral development,
awareness of relevant professional standards, and contextuality, defined as the interaction
between issue characteristics and person characteristics (Wright, Cullinan, & Bline,
1997). Kohlberg (1969) believed that ethical decision making is largely a function of
one’s level of moral development, and he formulated a six-stage model of moral
development that was further classified into three levels: pre-conventional, conventional,
and post-conventional.

2.6.2 Auditors’ moral in the cognitive process

underlying ethical reasoning:
2.6.2.1 Independence judgments are significantly
influenced by factors relating to penalty and less
sensitive to affiliation factors
Auditors’ moral is considered to have a vital role in the cognitive process underlying
ethical reasoning and judgment formation. Moizer (1997) identifies two types of ethical
reasoning:

consequentialism, whereby actions are judged in terms of their consequences (to self or
others); and

deontology, whereby some actions are deemed morally obligatory regardless of their
actions.

Mautz and Sharaf (1961, pp. 204-231) and Berryman (1974, p. 1) say that since
independent auditors occupy a position of trust between the management of the reporting
entity and users of its financial statements, they must be perceived to be operating
independently on the basis of sound auditing standards and strong ethical principles.
Sanctions, or penalty, may be imposed to the extent that professionals do not follow the
mandates of the profession or the laws of the country. The effectiveness of penalties
depends on both the individual and the situation. An individual’s attitude toward
sanctions, which varies across individuals, may affect judgments when sanctions are
present. According to Hisham El-Moukammal (December 2009) penalty to the auditor
for violations of the Code depending on the situation can take the form of formal letter
advising the auditor of the violation, a restatement of the required standard, and a
stipulation to not have this reoccur; a requirement to have retraining undertaken by the
auditor; suspension of the auditor’s certification; and permanent removal of the auditor’s
certification. A research conducted by Haim Falk, Bernadette Lynn, Stuart mestelman
and Mohamed Shehata (1999)(Auditor independence, self-interested behavior and ethics)
indicates that independence judgments are significantly influenced by factors relating to
penalty. The results show that:

1. As the probability of losing a client by disagreeing with the client’s decision increases,
the frequency of independence violations increases. This result is independent of whether
the independent auditors’ behavior is monitored.

2. Monitoring and penalizing independent auditors behavior reduce the frequency of

independence violations when the probability of losing a client is small, but the frequency
of violations is not reduced when the probability of the loss of a client is high.

3. On average, subjects with low moral development scores violate independence more
frequently than those who have higher scores.

These results suggest that while external review and potential penalties (litigation costs,
loss of reputation, directness or license suspension) may reduce violations of auditor
independence somewhat, the positive reinforcement of the attribute may come from
increasing independent auditors’ awareness of the ethical dimensions of their decisions.

Codes of ethics are normally designed to motivate members of professional organisations

to operate in an ethical manner. Prior studies suggest, however, that the underlying
psychology that governs professional behavior is more complicated than simply hoping
that professionals adhere to the organization’s code of conduct. The existence of a
penalty is more likely to affect the decision to increase the likelihood to behave ethically
than unethically (whether the choice is ‘ideal’ or ‘actual’). According to the Australasian
Accounting Business & Finance Journal, Loh & Wong: Matching the ‘Knowing What to
do’ and the ‘Doing What you Know’ in Ethical Decision Making (October 2009), a study
was carried out and this indicates that the existence of a penalty for unethical behavior
does seem to increase the likelihood for ethical behavior, with the numbers showing more
percentage of accountant moving from an unethical choice to the ethical choice in their
actual course of action.

According to Terri L. Herron and David L. Gilbertson (June 2003: Ethical Principles vs.
Ethical Rules), one’s level of moral development is measured by the Defining Issues Test
(DIT) with the P score measuring one’s propensity to reason at the post-conventional
stage. Accountants’ Moral Reasoning Though research into accountants’ moral
development is still growing (Gaa, 1992). Research addressing accountants’ ethical
judgments consistently finds that accountants reason at conventional levels, focusing
heavily on maintaining norms and following rules. Sweeney & Roberts (1997) found that
auditors at lower levels of moral development were more likely to comply absolutely
with independence standards, while auditors at higher levels of moral development were
less likely to resolve an independence dilemma by referring solely to technical standards.
Ponemon & Gabhart (1990) found that the independence judgments of auditors with low
DIT P scores were significantly influenced by penalty factors, such as the threat of legal
liability, whereas auditors with high P scores ranked this as the least important
consideration. Other authors Sweeney and Roberts’ (1997) research show the same result
as Ponemon and Gabhart. The higher the moral development of a person the less likely
their judgments will be affected by potential sanctions. This suggests that an auditor at
pre-conventional and conventional level will display a lower propensity of not complying
with standards when it is likely that violation will be detected and the sanctions will be
imposed. That is the individual places self-interest well above the common interests of
society and is sensitive to penalty attributes. While auditor at post-conventional level
judgment will not be affected by nature or severity of sanction. Auditors with a higher
level of moral reasoning are more likely to reveal audit finding which management does
not wish to be revealed regardless of reprisal. (Arnold and Ponemon, 1991).