Auditor independence and regulation

Essay 2006 19 Pages

Business economics - Revision, Auditing


Table of Contents



1. Introduction

2. Auditor independence
2.1 Arguments against auditor independence
2.2 Arguments for auditor independence

3. Auditor Regulation
3.1 Pre-1980s period
3.2 Post-1980s period
3.3 View into the future

4. Conclusion



Abbildung in dieser Leseprobe nicht enthalten


This essay is concerned with the pros and cons of auditor independence and describes the way to the current audit regulation.

The editor specifies five major threats which could jeopardise auditor independence. If auditors have any financial or personal interests in their clients then the self-interest threat, the self-review threat, the advocacy threat, the familiarity threat and finally the intimidation threat may occur. The intimidation threat is stressed as the most important one: as auditors highly rely on companies’ directors. They have the power to interfere with auditors’ work and can cease all lucrative non-audit service contracts if auditors do not agree with their view. Moreover, auditors’ remuneration is determined and auditors are appointed by them in reality.

Furthermore, it is emphasised that especially in recent times some safeguards have been implemented by the profession, regulation, within the assurance clients and within auditing firms to eliminate the above-mentioned threats. Within the assurance client introduced independent audit committees are widespread. Further, auditing firms have implemented their own more narrowly prescribed ethical standards. Beyond this, it is highlighted that legislation is of paramount importance. The Companies Act 1985, 1989, 2004 and above all the ISA were enacted to enhance auditor independence.

The third section commences by describing the past of audit regulation. It is explained that in response to the growing public criticism in the 1960s and 1970s the professional accountancy bodies began slowly to introduce auditing standards, ethical codes, disciplinary, licensing and monitoring arrangements. Further, in the aftermath of the demise of many large companies in the 1980s, the government started to implement a new regulatory framework to reduce auditors’ failures. However, in this context it is also argued that profession have been self-regulated up to now as they create all new legislation in their bodies. The Companies Act 1989 and the implemented ISA in 2004 are results of the entry into the EU, as the UK must adopt EU legislation.

It is estimated that in the near future the professions’ self-regulation may be abolished. Moreover, stricter rules regarding audit liabilities and regulation to promote competition in the audit business are assumed.

This essay concludes by stating that the current situation may upset all stakeholders as unbiased auditors are not guaranteed by the self-regulated profession. The fact that audit is a business may contradict it, too. Nevertheless, it is mentioned that auditors, who act dependently are a tiny minority in reality.

(Words: 400)

1. Introduction

This essay critically analyses the reality of auditor independence in respect of the source of assurance for company financial statements and explores the issues surrounding audit regulation. The essay commences by presenting the importance of auditor independence and outlines the occupation of auditors. The second section identifies matters by which auditor independence may be affected. It then points out some implemented safeguards helping to foster auditor independence. After outlining the pros and cons in terms of auditor independence, the focus switches to audit regulation. The third section begins by presenting past regulation of auditing profession. Following, the focus is channelled to present regulation and afterwards to possible future changes. This essay concludes with an ultimate statement about the current situation in the UK in regard with audit independence.

In recent years auditor independence has been in the public focus after some well-known firms (Enron; WorldCom [BBC News 2005]) went into bankruptcy despite getting an unqualified audit opinion just a few months previously. The question arises as to how could this happen, when auditors do their job and act independently. Independence in mind and appearance is a very vital criteria concerning auditing legitimacy. That importance is stressed by Taylor and Glezen by suggesting that “Of all the standards in the Code of Professional Conduct, perhaps no other is more important than independence, which is often defined as the ability to act with integrity and objectivity.” (1994, p. 82)

Auditors are the only external professionals who are duly authorised to control companies’ accounts regularly. They provide stakeholders with reliable and credible information regarding companies’ financial statements. That establishes the basis for shareholders’ financial decisions. However, what legitimacy has the work of auditors, when they are biased?

2. Auditor independence

In the following section some light will be cast on the pros and cons of auditor independence. Within the confines of this section, it is clearly not possible to analyse all the existing arguments in depth. Consequently only few examples will be given to each criterion.

2.1 Arguments against auditor independence

In the past the collapse of some huge firms and the failure of auditors to detect misstatements concerning this matter proved that sometimes auditors were biased. Elizabeth MacDonald suggests that “There's a fair amount of evidence … that auditors are not as independent as they should be.” (KeepMedia 2001)

In practice there are many circumstances that pose a threat to auditors’ independence.

In this way Porter, Simon and Hartherly argue that the profession’s Guide to Professional Ethics Statement (GPES, released in the US) identified five major threats to auditors’ independence:

- The self-interest threat
- The self-review threat
- The advocacy threat
- The familiarity or trust threat
- The intimidation threat (Porter, Simon and Hartherly, 2003, p. 73)[1].

The self-interest threat appears when auditors have financial investments, for example shareholdings or loans in their clients. By giving a qualified audit opinion all these investments would be in danger, for instance clients’ share prices would immediately drop dramatically. Auditors are aware of this disastrous effect on their investments. Hence, in this case they would tend to secure their investments by ignoring any misstatements. On the other hand, they may get free goods or services delivered by their clients. Then again, they would be tempted to turn a blind eye on irregularities, due to fear that their gifts will dry up abruptly.

Auditors would be confronted with the self-review threat, either if they have to reassess a former decision for a new engagement or if they audit their previous employer. This situation could arise when they were in charge, for example when preparing accounting records. By reviewing their old decisions they would tend to reaffirm them, because that is in the nature of mankind not to admit any mistakes. Thus, by reviewing own decisions taken in the past, auditor independence could be jeopardized.

In practice, it is common that one audit team controls the same client for a long period of time. In so doing a certain relationship between the auditors and the client’s management may be created. Under these circumstances the advocacy threat occurs. As a result of their good relationship, auditors may become more and more in favour of their client’s position, even in doubtful accounting matters.

The familiarity or trust threat arises from the possibility that either auditors’ relatives or close friends work for the audited company in question. Then again, auditors would dislike taking any decisions that may endanger the workplace of their relatives or close friends, respectively.

The last major threat and maybe of paramount importance comprises the intimidation threat.

Companies’ directors have the power to put pressure on auditors. For example, in theory, the shareholders are entitled to appoint auditors at the general meeting of the company. However, in reality, shareholders often give their legal right to vote to the company’s directors. Additionally, the company’s directors determine the auditors’ remuneration as well. By considering these facts, it should be clear that auditors may be dependent on the company’s management to a high degree (ACCA 2001).


[1] See also Hayes, R., Dassen, R., Schilder, A. and Wallage, P. (2005) Principles of Auditing, 6th Ed., Prentice Hall Europe, page 87; Cosserat, G. (2004) Modern auditing, 2nd Ed., John Wiley & Sons LTD, page 76; and the European Commission in their Commission Recommendation (eur-lex.europe 2002); In contrast to these, John Dunn divides auditors’ independent in Programming independence, Investigative independence and Reporting independence (1996, p. 20).


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Title: Auditor independence and regulation