Auditor Independence

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Auditor Independence
Curtis Gagné Michael McCue Terry Tang
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Agenda

• What is auditor independence?
• International View on auditor independence
• Auditor Independence Cases
• PwC
• Ernst Young
• KPMG
• Safeguards

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Opinions on Auditor Independence
In todays global markets, multiple stakeholders
investors, lenders, regulators, governments,
employees and customers- rely on assurance
provided by auditors on the reliability and
creditability of financial reporting. Auditors
play a vital role in enhancing the stability of
capital markets, promoting liquidity and lowering
the cost of capital. And for auditors to perform
this role, their objectivity and independence
must be without question. Robert E. Lord,
Chair of CICA
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Opinions on Auditor Independence

• Operating in our public capital markets is not,
  however, an unqualified right it carries
  responsibilities, and one of the most fundamental
  is to provide full, true and plain disclosure on
  a timely basis.
• David A Brown, Chair of OSC

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What is Auditor Independence?

• Auditor independence is the ability of the
  auditor to give an objective opinion on whether
  the financial statements of a public company
  follow GAAP based on their professional judgment.
• This means their opinion is free of any bias,
  influence, incentive or interest and truly
  reflects the state of the financial statements.

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Independence in Appearance

• Independence in appearance means that individuals
  outside the audit firm believe the audit report
  objectively states the financial position of the
  audit client. Independence in appearance give
  the audit report creditability.

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Independence in Appearance

• Independence in appearance can be maintained by
• (1) Auditors and firm appear to have no financial
  or personal ties to the audit client, such as
  stock ownership in the audit client.
• (2) Members of the audit team are not currently
  employed by audit client (a member of the board
  of directors) and have not recently been an
  employee of the audit client.

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Independence in Appearance

• (3)Members of the audit team follow the ethical
  and professional codes of conduct established by
  their Accounting association.
• (4) The auditing firm has a reputation of high
  ethical and professional conduct. (I.e. after
  the fall of Enron, Arthur Anderson would not have
  a reputation of high ethical standards.

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Independence In Reality

• Independence in reality is the degree to which
  the audit firm and members of the audit team are
  actually independent.
• How can an auditor remain independent?
• Have no financial or personal interest in client
• Maintain an independent frame of mind
• Complete auditor to the best of their ability,
  and gather sufficient evidence to support their
  opinion.
• Report instances of fraud or peculiarities and do
  try to cover up or take part in the situation.

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Who Benefits From Auditor Independence ?

• The Users of financial statements are the
  beneficiaries of auditor independence
• Investors Including individual investors, and
  institutional investors
• Creditors (bond holders and loan holders or
  potential creditors)
• Regulators and Security Commission
• Public in general

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Classification Of Accountants through time

• Throughout the twentieth century accountants have
  had three classifications of their roles, these
  are
• Professional Man
• Judicial Man
• Economic Man

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Professional Man

• Up until the 1960s there was no formal rule on
  auditor independence in the AICPA rules for CPAs
• The rational for this is accountants were ethical
  people from their life experiences and from their
  socialization.

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Professional Man (Cont)

• It was believed that if an accountant was in a
  position that would compromise their professional
  opinion (their independence) they would recognize
  this threat and handle it appropriately because
  they are ethical people.
• There were no need to have independence in
  appearance because public had trust that
  accountants and auditors were ethical and would
  act in an ethical manner, not primarily in their
  own self interest.

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Judicial Man

• Auditors were seen as the gatekeeper to the
  securities market as companies needed audited
  financial statement to get listed on public
  exchanges and to receive bank loans.
• The increasing responsibility of Auditors and the
  implication of their work requires independence,
  both in fact and in appearance.
• To foster independence both SEC and AICPA
  establish rules prohibiting ownership or
  interests in audit clients. Conflicting opinions
  resulted based on what was seen as being
  independent in appearance, many changes in what
  accountants could do and still remain
  independent.
• Division among CPAs with instituting
  independence rules, some felt these rules implied
  the profession was untrustworthy and were capable
  of professional judgment

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Economic Man

• This mindset of accountants started in the late
  1990s.
• Accountants today are pursuing many other areas
  within accounting other than just audit, examples
  being consultancy, taxation, bookkeeping. These
  services are more profitable than the audit
  function.
• Less emphasis is put on the appearance of
  independence and more on the independence in
  fact. This is because its easier to evaluate the
  work of the auditor than their appearance.
• Auditors are believed to follow independence and
  professional standards because the cost of not
  following them are too great (i.e. losing
  professional designation).
• This is just prior to the legislative reform of
  the Sarbanes Oxley Act (SOX).

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Philosophies Of Independence

• There are three philosophies regarding
  independence and they are
• Independence in Separation
• Avoiding Dependence
• Independence in interests

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Independence In Separation

• This philosophy states that for an auditor to
  have independence they cannot have any
  relationship with the client they are auditing.
• This philosophy is impossible to achieve because
  a relationship exists as soon as a client engages
  a firm to complete the audit. It is further
  unachievable in that the client pays the auditor
  for their work. The auditors duty of care is to
  the financial statement users, however they still
  have relationship with client.
• Absolute independence is almost impossible to
  achieve because even the slightest conflict of
  interest can exist (i.e. auditor may have some
  association with client, no matter how small
  violates absolute independence).

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Avoiding Dependence

• This philosophy recognizes that there is
  dependence in an auditor-client relationship
  (i.e. auditor dependent on client for payment,
  client dependent on auditor for their audit
  report).
• It is easier for the auditor to measure their
  independence in fact rather than the public
  measure the auditors independence. Auditor must
  then make sure that the amount of dependence they
  have with client is not to high in that it would
  impair their professional judgment

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Independence In Interests

• This philosophy assumes that professional
  judgment of the auditor will result in
  independence. The short turn gain in unethical
  practices is smaller than the long run
  consequences of engaging in unethical conduct and
  giving the profession and firm a bad reputation,
  assuming this conduct is detected.
• Through independence and ethical conduct the
  auditor will retain clients and gain new clients,
  with the over benefit of this larger than a short
  run benefit of engaging unethically.

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International Viewsof Auditor Independence
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United States

• SOX

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Japan

• Japanese Institute of Certified Public
  Accountants has publicly voiced concern over
  Sarbanes-Oxley Act.
• Specifically concerned with the regulation of
  foreign public accounting firms
• HUH?

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European Union / UK?
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Auditor Independence Cases
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Case of Auditor IndependencePwC

• In the first quarter of 1999, PwC approved
  capitalization of non-audit consulting fees.
• Fees related to failed order-management system
  under development by PwC.
• Instead of writing off costs, Avon capitalized
  60 of 42 million.
• 60 consisted mainly of non-audit consulting fees.

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Case of Auditor IndependencePwC

• SEC Consequences
• An independent reviewing partner must
• Review audits of listed companies that have
  capitalized non-audit fees
• Perform verification audits of auditors
  performance on risky engagements
• Provide annual training for ALL employees

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Case of Auditor IndependenceErnst Young

• Ernst Young and Peoplesoft have marketing
  arrangement while Ernst Young are the auditors
  of Peoplesoft.
• Ernst and Young pays royalties of 15-30 to
  Peoplesoft for software that EY sells to its
  clients.
• This arrangement poses the question of does EY
  have financial interest in an audit client? The
  consultancy segment of EY has business
  arrangement with Peoplesoft. This clearly
  violates appearance of independence between audit
  firm and client, but is independence in fact
  violated also?

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Case of Auditor IndependenceErnst Young

• SEC accuses EY of violating independence
  standards by having business relationship with
  its audit client. SEC rules allow relationship
  between auditor and clients only as a consumer
  in normal course of business
• EY claims that its arrangement with Peoplesoft
  was within its regular business activities, SEC
  believes the opposite.
• SEC maintains that quality of work never suffered
  from arrangement, but arrangement is in total
  violation of Auditor Independence rules.

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Case of Auditor IndependenceErnst Young

• Ernst Young was fined 1.7 million for its
  activities, which breaks down to its audit
  revenue of 970,698 during 1993-2000 from
  Peoplesoft audit and interest of 729,302. EY
  made over 500 Million in consulting from
  Peoplesoft
• Ernst Young not allowed to take any new
  corporate audit clients for 6 months in USA,
  however Ernst and Young interprets this as
  allowing them to take on Private Corporation
  clients and internal audit engagements. EY also
  allowed to continue serving its current clients.

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Case of Auditor IndependenceKPMG

• SEC censured KPMG LLP for engaging in improper
  professional conduct because it purported to
  serve as an independent accounting firm for an
  audit client at the same time that it had made
  substantial financial investments in the client.
• KPMG consented to the SECs order with admitting
  or denying the SECs findings.

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Case of Auditor IndependenceKPMG

• The SEC found, from May through December 2000,
  KPMG held a substantial investment in the
  Short-Term Investments Trust (STIT), a money
  market fund within the AIM family of funds.
• KPMG opened the money market account with an
  initial deposit of 25 million on May 5, 2000,
  and at one point the account balance constituted
  approx. 15 of the funds net assets.
• The SEC further found that KPMG repeatedly
  confirmed its putative independence from the AIM
  funds it audited, including STIT, during the
  period in which KMPG invested in STIT.

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Case of Auditor IndependenceKPMG

• KPMG resulted in violation of the auditor
  independence requirement imposed by the SECs
  rule and by Generally Accepted Auditing Standards
  (GAAS)
• SEC ordered KPMG to undertake certain remedies
  designed to prevent and defect future
  independence violation caused by financial
  relationships with, and investments in, the
  firms audit clients.

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Safeguards
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Safeguards

• Restricted auditor activities and relationships
• Permits the activity or relationship, but
  restricts its extent

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Safeguards (cont)

• Requires policies and procedures to address the
  threat
• Requires the auditor to disclose information
  about it to the auditees management, audit
  committee, board or others

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Wrap Up!

• Auditor Independence Explained
• International Views on Independence
• 3 Cases Auditor Independence Cases
• PwC
• Ernst Young
• KPMG
• Safeguards

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References

• Slide 3,4
• CICA, Guidance for Audit Committees ,Discussing
  Auditor Independence Matters With Your
  Auditor, pg 2
• Slide 5,6,9
• Arens, Alvin A., Loebbecke, James K, Lemon, W.,
  Morley, Splettstoesser, Ingrid B., Auditing And
  Other Assurance Services Canadian Ninth Edition,
• Toronto, Pearson Education Canada. 2003 . Pp
  68-71.
• Slides 12-18
• Reiter, Sara Ann, et Paul F. Williamson. The
  Philosophy and Rhetoric of Auditor Independence
  Concepts Business Ethics Quarterly. Volume 14
  Issue 3
• ISSN 1502-105X. Pp 357-370
• Slides 19-21
• Taub, Stephen, Auditor Draws Six-Month
  New-Client Ban.CFO.com. April 20,2004. Online
  http//www.cfo.com/article.cfm/3013309?frelated.
  Retrieved February 18, 2005
• Sachdev, Ameet. SEC Judge Bars Accounting Giant
  Ernst Young from New Business for 6 Months
  Chicago Tribune Business News. April 17,2004.
  Chicago Chicago Tribune.