There are three main ways in which the auditor’s independence can manifest itself. Mautz, R.K.

& Sharaf, H.A. (1961) ‘The Philosophy of Auditing’, American Accounting Association. &
Dunn, J., 1996. Auditing Theory and Practice. 2nd ed. Prentice Hall.

 Programming independence
 Investigative independence
 Reporting independence

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

While programming independence protects auditors’ ability to select appropriate strategies,

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

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

[edit] Real independence and Perceived independence

There are two important aspects to independence which must be distinguished from each other:
independence in fact (real independence) and independence in appearance (perceived
independence). Together, both forms are essential to achieve the goals of independence. Real
independence refers to the actual independence of the auditor, also known as independence of
mind. More specifically, real independence concerns the state of mind an auditor is in, and how
the auditor acts in/deals with a specific situation. An auditor who is independent 'in fact' has the
ability to make independent decisions even if there is a perceived lack of independence present,[1]
or if the auditor is placed in a compromising position by company directors. Many difficulties lie
in determining whether an auditor is truly independent, since it is impossible to observe and
measure a person’s mental attitude and personal integrity. Similarly, an auditor’s objectivity
must be beyond question, but how can this be guaranteed and measured? This is why perceived
independence is of such importance.

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

[edit] Restrictions on independence

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

The problems regarding independence stem from two main sources the auditors’ relationship
with the company and the nature of the accountancy profession.

[edit] Relationship with the client

An auditor earns a living from the fee he is paid it is therefore automatic that he does not want to
do anything to jeopardize this income.[2] This reliance on clients’ fees may affect the
independence of an auditor. If the auditor feels this client income is more important than their
responsibilities to shareholders he may not perform the audit with the shareholder’s interests in
mind. The larger the fee income the more likely the auditor is to shirk his responsibilities and
perform the audit without independence. This could lead to the manipulation of figures and
exploitation of accounting standards. By performing the audit without independence the
shareholders’ may get misled, as the auditor is now reliant on the directors. To encourage
auditors to maintain their independence they must be protected from the director’s board. If they
were able to challenge statements and figures without the risk of losing their job they would be
more likely to work with complete independence. Ultimately, as long as the client determines
audit appointments and fees an auditor will never be able to have complete economic
independence.[3]

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

It is common for the audit firm of a company to provide extra services as well as performing the
audit. Helping a company reduce its tax charges or acting as a consultant for the implementation
of a new computer system, are common examples. Having this additional working relationship
with the client would result in questions being asked of the independence of the audit firm. If
non-audit fees are substantial in retaliation to audit fees suspicions will arise that auditing
standards may be compromised. The firm would no longer be unbiased, as it would want the
company to perform well so it can continue to earn the addition fee for their consultancy. This
would mean the audit firm would be dependent on the directors and they would no longer be
working with independence.

[edit] The structure of the accountancy profession

Price competition is a major factor in auditor independence.[4] Prior to the 1970’s audit firms
were not allowed to advertise their services and take part in bidding competitions for contracts.
Competition between the accountancy firms greatly increased when these restrictions were
abolished, putting pressure on the audit firms to reduce audit fees. Competitive bidding for
contracts has also encouraged the reduction of auditor engagement hours.[4] The pressure to
reduce costs may compromise the quality of an audit. If a firm feels threatened by competition
they may be tempted to further reduce costs to keep a client. This risks lowering the standard of
the audit performed and therefore mislead shareholders.

The increased competition between the larger firms means that company image is very
important.[2] No audit firm wants to have to explain to the press the loss of a big client. This gives
the directors of the large company a commanding position over its audit firm and they may look
to take advantage of it. The audit team would feel pressured to satisfy the needs of the directors
and in doing so would lose their independence.

[edit] Independence regulations in the United Kingdom

Within the United Kingdom there are various regulations in force regarding auditor
independence. The main enforcement of auditor independence is through the Companies Act
1985 and the Companies Act 1989 although the matter is also covered by the professional
accounting bodies’ rules of professional conduct and the Auditing Practices Board. It is also of
note that regulations (i.e. International Accounting Standards or International Financial
Reporting Standards) relating to the preparation of financial statements are also relevant.

The Companies Act 1985 dictates that it is the responsibility of shareholders (rather than
directors) to appoint the auditor at the annual general meeting (AGM) – section 384 of the act
refers. The theory behind this is that directors cannot intimidate auditors with the threat of
replacement or bribe them by offering reappointment. In practice the existing auditors of a
company are generally reappointed for another term at the AGM but the shareholders are free to
choose another auditor if they wish to. Directors can only appoint auditors in exceptional
circumstances (perhaps to fill a casual vacancy during the year). However, such appointments by
directors will expire at AGMs. The Companies Act 1985 (section 386) allows shareholders to
eliminate the need to reappoint an auditor each year. If they elect to do so then it is automatically
assumed that the existing auditor will be reappointed each year without the matter arising at the
AGM. In such circumstances it would take an extraordinary general meeting (EGM) in order to
remove the auditor.

The Companies Act 1989 (part II) goes further to protect the independence of the auditor in
various ways. One of the key ways is that auditors must belong to a recognised supervisory body
(RSB) before they can undertake such work. Within the United Kingdom ICAEW, ICAS, ICAI
and ACCA have been granted this status. Schedules 11 and 12 of the Companies Act 1989
specify the duties of the RSBs and the strict entry requirements for their members that they must
impose. It is intended to ensure that all auditors have the required knowledge and skills in order
to carry out their role to an acceptable standard.

Section 33 of the Companies Act 1989 allows for professional accountants who have gained their
qualification in another country to practice within the United Kingdom although it is necessary
for such persons to undertake extra education in British law and accounting practices. In the past
this would tend be exploited by members of the Commonwealth but due to there being an EU
directive on mutual recognition of professional qualifications it is now possible for professional
accountants within Europe to come and work in the United Kingdom. The safeguards put in
place by section 33 (that any foreign professional accountants must have an adequate knowledge
of British law and accounting practices) should protect the quality of audits.

The Companies Act 1989 also has provisions to prevent employees of firms from becoming
auditors of their own companies and subsequently either any subsidiary of their employers or
parent companies (section 27 refers). This is intended to prevent the appointment of an auditor
with vested interests in a company.

It is also a requirement that any person barred from acting as an auditor should refuse any such
offers of appointment and resign immediately if for whatever reason they become ineligible
during their appointment. If for whatever reason an ineligible person carries out an audit then the
Secretary of State (under section 29 of the Companies Act 1989) has the power to require a
company to appoint a second auditor and bear the brunt of the cost as a result. However,
companies are allowed to recover additional fees from the original ineligible auditor.

Further to regulations regarding the appointment of auditors the various Companies Acts also
contain rules regarding the rights of auditors. The most fundamental of these regulations is
section 389A of the Companies Act 1985. This section states that auditors have a right of access
at all times to accounting related information from companies and further have the right to
demand explanations from companies regarding any accounting related enquiry they may have.
Section 389A also covers other matters such as making it illegal for employees of a company to
make misleading, false or deceptive statements to auditors regarding any accounting related
queries they may have. Subsidiaries of British companies also must provide any accounting
related information to the auditor of the parent company should they request it although in
general it is usually the same auditor who undertakes the audit of both the parent company and
its subsidiaries. Section 389A finally goes on to state that companies must take all reasonable
steps to obtain accounting related information for auditors from any overseas subsidiaries it may
have. Auditors also have the right to communicate directly with shareholders as dictated in
section 390 in the Companies Act 1985.

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

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

[edit] Possible future developments

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