“It’s Enron and Arthur Andersen all over again. In the end, the firm [KPMG] acquiesced to what were just flat‐out errors in the financial statements.” Former Securities and Exchange Commission Chief Accountant Lynn Turner.¹

“This is really the embryo of the credit crisis. … The theme of the report is how easily the loans were originated, how exceptions were made, how they used bad appraisals. There were no appropriate internal controls, and KPMG failed to look at these things skeptically.” Michael Missal, Court Examiner.²

In January 2007, “KPMG and New Century’s own accountants stunned the company’s board by revealing that the lender had incorrectly calculated the reserves for troubled home loans. That mistake was likely to cost New Century $300 million, wiping out profits from the second half of 2006.”³ A week later, New Century announced it would restate financials from the first three quarters of 2006. The market reaction to New Century’s announcement was swift, and its stock price dropped significantly at the news. Shares dropped further when the company announced on March 2, 2007, that it would not file its 2006 annual report on time. This declaration placed additional financial pressure on the beleaguered mortgage lender, and on March 8, New Century stated that it had stopped accepting new loan applications. A few days later, the New York Stock Exchange delisted New Century Financial Corporation, and on April 2, only two months after the restatement announcement, New Century filed for bankruptcy protection.⁴

The March 2008 report submitted by the court‐appointed bankruptcy examiner chronicles the catastrophic failure of the company, once the second largest distributor of subprime mortgages. New Century originated, retained, sold, and serviced home mortgage loans designed for subprime borrowers. In 1996, the company originated more than $350 million in loans, and by 2005, subprime loan originations and purchases had grown to an astounding $56 billion. New Century’s growth trajectory mirrored the growth of the subprime loan industry in the United States. Between 2001 and 2003, subprime loans accounted for only 8 percent of all residential mortgage originations, but by 2005, they had grown to 20 percent.

New Century retained KPMG as the company’s auditor from its inception in 1995 until April 2007 when KPMG resigned. KPMG had several different engagement partners, with varying degrees of experience in the mortgage industry, heading the New Century account over the years. The examiner’s report lists seven types of improper accounting practices not in conformity with GAAP. The practice that has garnered the most attention concerns the mistakes in calculating the repurchase reserve. New Century sold mortgages in loan pools to investors, primarily major financial intermediaries such as Goldman Sachs and JPMorgan Chase. New Century’s loan purchase agreement required them to repurchase the loans if (i) they suffered an early payment default, (ii) it was found that New Century had misrepresented their loans, or (iii) if there was borrower fraud.⁵ The problem, according to the examiner’s report, was that New Century calculated the repurchase reserve incorrectly. Essentially, New Century used historical data about the rate of repurchases, which was inaccurate, and based its model on the incorrect assumption that all repurchases would be made within 90 days.⁶

The error was exacerbated by New Century’s lack of reliable data on the numbers of repurchase claims it received, because repurchase claims were handled by different departments within the company. This led to a backlog of repurchase claims worth $188 million, which were unresolved in 2005. By 2006, the backlog had skyrocketed to $421 million as many borrowers became delinquent within only a few months of taking out a loan.⁷ New Century’s reserves were seriously inadequate, as it had only $13.9 million set aside for repayment, which would cover a mere 3.5 percent of the repurchase claims.

Did KPMG fail? According to one report:

New Century’s accounting methods let it prop up profits, charming investors and allowing the company to tap a rich vein of Wall Street cash that it used to underwrite more mortgages. Without the appearance of a strong bottom line, New Century’s financial lifeline could have been cut even earlier than it was.⁸

The examiner’s report did not find sufficient evidence to conclude that New Century had engaged in earnings management or manipulation, or that KPMG had engaged in intentional wrongdoing. The report did conclude, however, that KPMG failed to conduct its audits in accordance with professional standards:

Had KPMG conducted its audits and reviews prudently and in accordance with professional standards, the misstatements included in New Century’s financial statements would have been detected long before February 2007. The 2005 (KPMG) engagement team, in particular, was not staffed with auditors with sufficient experience in the client’s industry and/or relating to the particular tasks to which they were assigned. … The team also consisted of auditors who were relatively inexperienced in the mortgage banking industry. The engagement team’s lack of experience was compounded by the fact that New Century’s accounting function was weak and led by a domineering and difficult controller.⁹

Lawsuits filed against KPMG in the matter of New Century allege that the engagement team dismissed the claims made by experts from KPMG’s Structured Finance Group when they tried to call attention to the problems at New Century:

When a KPMG specialist continued to raise questions about an incorrect accounting practice on the eve of the Company’s 2005 Form 10‐K filing, the lead KPMG audit partner told him: “I am very disappointed we are still discussing this. As far as I am concerned we are done. The client thinks we are done. All we are going to do is piss everybody off.”¹⁰

Although KPMG may not have created New Century’s problems, many claim that it turned a blind eye to what could be considered reckless and irresponsible business practices. More egregiously, KPMG continued to do so even when its own experts challenged New Century’s accounting practices. The lawsuit alleges that KPMG’s failings were motivated by a desire to appease a demanding client and to maintain a profitable relationship.

Not everyone, however, is convinced that KPMG should be held responsible for what is ultimately the failure of a risky and poorly conceived business strategy. David Aboody, an accounting professor at UCLA argued as follows:

I think it’s a stretch to blame everything on the accounting profession. … What does the SEC want? Does it want an auditor who tries to predict the future? Or does it want an auditor to record what is clearly going on at the time?¹¹

Professor Aboody raises an interesting question: What does the public expect of independent auditors in a situation like New Century? If a company is engaged in risky and unsound business practices, it seems that the public expects the audit report to reflect this. This leads to another question: If auditors cannot provide the investing public with this information, if they cannot or will not sound the alarm about companies operating like New Century, then is the independent auditor of any use to the average – or even the sophisticated – investor?

The case of KPMG and New Century is only one example of the serious ethical pressures in the accounting profession today – risks and dangers to the integrity of the accounting practice created by conflicts of interest and the necessity to survive in a competitive market. To maintain profitable relationships with valued clients, the auditor can feel intimidated into approving inappropriately aggressive accounting treatments that can lead to financial statements that misrepresent the firm’s economic substance.

It appears unlikely that an auditor will be able to maintain a client relationship if that client is given an unfavorable audit. The client might then shop for an audit firm that will provide a more lenient reading of the books. If the audit is inadequate, however, and people suffer from misinformation that the accountants should have uncovered, the accounting firm might be sued, because auditors are expected to look out for the public interest before looking out for the client’s interest. This responsibility reinforces the critical importance of the role the auditor plays in financial services.

As a result of the way financial markets and the economic system have developed, society has carved out a role for the independent auditor, which is absolutely essential for the effective functioning of the economic system. If accounting is the language of business, it is the auditor’s job to ensure that the language is used properly to communicate relevant information accurately, “to see whether the company’s estimates are based on formulas that seem reasonable in the light of whatever evidence is available and that formulas chosen are applied consistently from year to year.”¹² The lawsuits filed against KPMG in the matter of New Century Financial allege that the audit team failed to fulfill this obligation.

The Ethics of Public Accounting

Usually, when people talk about the ethics of public accounting, they are discussing the responsibilities of the independent auditor. Auditing the financial statements of publicly‐owned companies is not the only role of an accountant, but in the current economic system, it is certainly one of the most important.

John Bogle, founder of The Vanguard Group, articulates it skillfully:

The integrity of financial markets – markets that are active, liquid, and honest, with participants who are fully and fairly informed – is absolutely central to the sound functioning of any system of democratic capitalism worth its salt. It is only through such markets that literally trillions upon trillions of dollars – the well‐spring of today’s powerful American economy – could have been raised in the past decade that became capital for the plant and equipment of our Old Economy and the capital for the technology and innovation of our New Economy. Only the complete confidence of investors in the integrity of the financial information they received allowed these investment needs to be met at the lowest possible cost of capital.

Sound securities markets require sound financial information. It is as simple as that. Investors require – and have a right to require – complete information about each and every security, information that fairly and honestly represents every significant fact and figure that might be needed to evaluate the worth of a corporation. Not only is accuracy required but also, more than that, a broad sweep of information that provides every appropriate figure that a prudent, probing, sophisticated professional investor might require in the effort to decide whether a security should be purchased, held, or sold. Those are the watchwords of the financial system that has contributed so much to our nation’s growth, progress, and prosperity.

It is unarguable, I think, that the independent oversight of financial figures is central to that disclosure system. Indeed independence is at integrity’s very core. And, for more than a century, the responsibility for the independent oversight of corporate financial statements has fallen to America’s public accounting profession. It is the auditor’s stamp on a financial statement that gives it its validity, its respect, and its acceptability by investors. And only if the auditor’s work is comprehensive, skeptical, inquisitive, and rigorous, can we have confidence that financial statements speak the truth.¹³

As Bogle notes, a free market economy needs to base transactions and decisions on truthful and accurate information. In market transactions, a company’s financial status is vital information on which a decision to purchase is based. The role of the auditor is to attest to the accuracy of the company’s financial picture presented to whatever the user needs to make a decision on the basis of that picture.

This function and responsibility is not new. It has recently come to the public’s attention, however, with the eruption of the numerous accounting scandals that shocked investors, regulators, and politicians in 2002. Justice Warren E. Burger made this statement about the auditor’s function and responsibility in the 1984 landmark Arthur Young case:

Corporate financial statements are one of the primary sources of information available to guide the decisions of the investing public. In an effort to control the accuracy of the financial data available to investors in the securities markets, various provisions of the federal securities laws require publicly held companies to file their financial statements with the Securities and Exchange Commission. Commission regulations stipulate that these financial reports must be audited by an independent CPA in accordance with generally accepted auditing standards. By examining the corporation’s books and records, the independent auditor determines whether the financial reports of the corporation have been prepared in accordance with generally accepted accounting principles. The auditor then issues an opinion as to whether the financial statements, taken as a whole, fairly present the financial position and operations of the corporation for the relevant period. (Italics added.)¹⁴

Burger states the responsibility of the auditor clearly: to issue an opinion about whether the financial statement fairly presents the financial position of the corporation. Performance of this role, attesting that the corporation’s financial positions and operations are fairly presented, requires that an auditor have integrity and honesty. Further, to ensure that an accurate picture has been presented, it is essential that the auditor’s integrity and honesty is not jeopardized by the presence of undue influence. To bolster integrity and honesty, the auditor must have as much independence as possible. Those who need to make decisions about a company based on true and accurate information must be able to trust the accountant’s pictures if the market is to function efficiently. Trust is eroded if there is even an appearance of a conflict of interest.

Trust

We can understand why if we apply Immanuel Kant’s first categorical imperative, the universalizability principle: “Act so you can will the maxim of your action to be a universal law.” As we saw earlier (see Chapter 3 for a detailed discussion of Kant’s ethical theories), to universalize an action, we must consider what would occur if everyone acted the same way for the same reason. As we learned in Chapter 3, an individual generally gives a false picture to cause another party to act in a way other than the party would act if given full and truthful information. Suppose a CFO misrepresents his company’s profits to obtain a bank loan, thinking that no loan would be forthcoming if the bank had the true picture. What would happen if this behavior were universalized – that is, if all individuals misrepresented the financial health of their companies when it was to their advantage to lie?

Two things would happen. First, trust in business dealings that require information about financial status would be eroded. Chaos would ensue, because financial markets cannot operate without trust. Cooperation is vital, and trust is a precondition of cooperation. We engage in hundreds of transactions daily that demand trusting other people with our money and our lives. If misrepresentation became a universal practice, trust and, consequently, cooperation would be impossible.

Second, universalizing misrepresentation, besides leading to mistrust, chaos, and inefficiencies in the market, would make the act of misrepresentation impossible. Why? Because no one would trust another’s word, and misrepresentation can occur only if the person lied to trusts the person lying. Prudent people do not trust known liars. Thus, if everyone lied, no one would trust another, and it would be impossible to lie. Universalized lying, therefore, makes lying impossible. Do we trust the defendant in a murder case to tell the truth? Do we trust young children who are concerned about being punished to tell the truth? Of course not. Once we recognize that certain people are unreliable or untrustworthy, it becomes impossible for them to misrepresent things to us, because we don’t believe a word they’re saying. Hence the anomaly: If misrepresentation became universalized in certain situations, it would be impossible to misrepresent in those situations, because no one would trust what was being represented. This makes the universalizing of lying irrational or self‐contradictory.

The contradiction here, according to Kant, is a will contradiction, and the irrationality lies in simultaneously willing the possibility and the impossibility of misrepresentation, by willing out of existence the conditions (trust) necessary to perform the act. Face it, people who lie don’t want lying universalized. Liars are free riders. Liars want an unfair advantage. They don’t want others to lie – to act like the liars are acting. They want others to tell the truth and be trusting so that the liars can lie to those trusting people. Liars want the world to work one way for them and differently for all others. In short, liars want a double standard. They want to have their cake and eat it, too. Such a selfish, self‐serving attitude is the antithesis of ethical.

If misrepresentation of an organization’s financial situation were universal, auditing would become a useless function. Rick Telberg, in Accounting Today¹⁵, claims this may have already happened. “CPA firms long ago became more like insurance companies—complete with their focus on assurances and risk‐managed audits—than attesters,” he says. The attitude precludes telling the public what a company’s financial condition really is. Firms with this attitude just guarantee that the presentation won’t be subject to charges of illegal behavior. These firms serve the client and not the public.

This points to another important aspect of trust. Only a fool trusts someone who gives all the appearances of being a liar. Only a fool trusts people who put themselves in positions where it is likely that their integrity will be compromised. These are the reasons why individuals take precautions against getting involved with anyone who gives even the appearance of being caught in a conflict of interest. Because trust is essential, even the appearance of an accountant’s honesty and integrity is important. The auditor, therefore, must not only be trustworthy, but he or she must also appear trustworthy.

The Auditor’s Responsibility to the Public

The auditor’s duty to attest to the fairness of financial statements imbues the accountant with special responsibilities to the public. As we saw in Chapter 4, these responsibilities give the accountant a different relationship to the client than those relationships in other professions. Justice Burger refers to this relationship this in his classic statement of auditor responsibility:

The auditor does not have the same relationship to his client that a private attorney who has a role as … a confidential advisor and advocate, a loyal representative whose duty it is to present the client’s case in the most favorable possible light. An independent CPA performs a different role. By certifying the public reports that collectively depict a corporation’s financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporation’s 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 fidelity to the public trust. To insulate from disclosure a CPA’s interpretations of the client’s financial statements would be to ignore the significance of the accountant’s role as a disinterested analyst charged with public obligations. (Italics added.)¹⁶

Given the sometimes opposing interests between the public and clients, it is clear that auditors face conflicting loyalties. To whom are they primarily responsible – the public or the client who pays the bill? Accountants are professionals and thus should behave as professionals. Like most other professionals, they offer services to their clients. But the public accounting profession, because it includes operating as an independent auditor, has another function. The independent auditor acts not only as a recorder, but also as an evaluator of other accountants’ records. The auditor fulfills what Justice Burger calls “a public watchdog function.”

Over time, the evaluation of another accountant’s records has become a necessary component of capitalist societies, particularly the part of society that deals in money markets and offers publicly traded stocks and securities. In such a system, it is imperative for potential purchasers of financial products to have an accurate representation of the companies in which they wish to invest, to whom they are willing to loan money, or with whom they wish to merge. There must be a procedure to verify the truthfulness of a company’s financial status. The role of verifier falls to the public accountant – the auditor.¹⁷

In their article, “Regulating the Public Accounting Profession: An International Perspective,” Baker and Hayes reiterate the accountant’s distinctive role:

Other professionals, such as physicians and lawyers, are expected to perform their services at the maximum possible level of professional competence for the benefit of their clients. Public accountants may at times be expected by their clients to perform their professional services in a manner that differs from the interests of third parties who are the beneficiaries of the contractual arrangements between the public accountant and their clients. This unusual arrangement poses an ethical dilemma for public accountants.¹⁸

Although auditors’ clients are the ones who pay the fees for the auditor’s services, the auditor’s primary responsibility is to safeguard the interest of a third party – the public. Because the auditor is charged with public obligations, he or she should be a disinterested analyst. The auditor’s obligations are to certify that public reports depicting a corporation’s financial status fairly present the corporation’s financial position and operations. In short, the auditor’s fiduciary responsibility is to the public trust, and “independence” from the client is fundamental in order for that trust to be honored.

As Justice Burger notes, the auditor’s role requires “transcending any employment relationship with the client.” Thus, dilemmas arising from conflicts of responsibility occur. We’ll now examine the auditor’s specific responsibilities.

The Auditor’s Basic Responsibilities

We have seen that the auditor’s first responsibility is to certify or attest to the truth of financial statements. But an auditor also has other responsibilities. A document known as the Cohen Report contains a comprehensive statement of an independent auditor’s responsibilities. They are the same today as when the report was issued. We turn now to that report.

In 1974, the AICPA’s Commission on Auditor’s Responsibilities (the Cohen Commission) was established to develop conclusions and recommendations regarding the appropriate responsibilities of independent auditors. Another of the commission’s tasks was to evaluate the public’s expectations and needs and the realistic capabilities of the accountant. If disparities existed, the commission was to determine how to resolve them.

As we might expect, the report defined the independent auditor’s main role as an intermediary between the client’s financial statements and the users of those statements, to whom the auditor is accountable. Hence, the Cohen Commission made it clear that the auditor’s primary responsibility is to the public, not to the client.

The commission also examined what auditors, given the restraints of time and business pressures can reasonably be expected to accomplish. The report pointed out some areas that are not the responsibility of the independent auditor.

For example, some people erroneously assume that auditors are responsible for the actual preparation of the financial statements. Others wrongly believe that an audit report indicates that the business being audited is sound. Auditors, however, are not responsible for attesting to the soundness of the business. Recall that Professor Aboody made this point in reference to the KPMG/New Century Financial case earlier in this chapter. In most cases, management accountants prepare the financial statements, and it is management – not the auditor – who is responsible for them. (We will examine the management accountant’s role in Chapter 8.)

Auditors are responsible for forming an opinion on whether the financial statements are presented in accord with appropriately utilized accounting principles. The traditional attest statement affirms that the financial statements were “presented fairly in accordance with generally accepted accounting principles.” This is a controversial subject in the accounting ethics literature. In the 1960s, a committee of the AICPA raised the following questions about the fairness claim:

In the standard report of the auditor, he generally says that financial statements “present fairly” in conformity with generally accepted accounting principles – and so on. What does the auditor mean by the quoted words? Is he saying: (1) that the statements are fair and in accordance with GAAP; or (2) that they are fair because they are in accordance with GAAP; or (3) that they are fair only to the extent that GAAP are fair; or (4) that whatever GAAP may be, the presentation of them is fair?¹⁹

The Cohen Report recognizes that “fair” is an ambiguous word; hence, it is imprudent to hold auditors accountable for the fairness of the financial statements, if that means the accuracy of material facts. Rather, the responsibility of the auditors is to determine whether the judgments of managers in the selection and application of accounting principles was appropriate in the particular circumstance. Note that this differs from Justice Burger’s opinion that the auditor attests to the “fairness” of the picture.

The Cohen Report would likely find Burger’s viewpoint too rigid for three reasons: (i) In some situations, there may be no detailed principles that are applicable, (ii) in others, alternative accounting principles may be applicable, and (iii) at times, the cumulative effects of the use of a principle must be evaluated. The report calls for more guidance for auditors in these three areas. Still, the idea prevails that “fairly” presented means that the report being audited will give a reasonable person an accurate picture of an entity’s financial status. GAAP principles, however, can be used by artful dodgers to hide the real health or sickness of a company. Indeed, one accountant has suggested that accounting is an art, and a truly proficient artist can, by the skillful use of GAAP, make the same company look to be a dizzying success or a miserable failure. We will consider the “fairness” debate in Chapter 10 of this book. For now, let’s return to the Cohen Report and its enumeration of auditors’ responsibilities.

Independence

Thus far, we have discussed the responsibilities of the auditor. To meet those responsibilities, it is imperative that the auditor maintain independence. Let’s look at Justice Burger’s statement again:

… The independent public accountant performing this special function owes ultimate allegiance to the corporation’s 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 fidelity to the public trust. …²⁴

“Total independence” is the term that Burger uses. Obviously, an external auditor should be independent from the client. But must independence be total, as Justice Burger says? If so, what does total independence require? What does “complete fidelity to the public trust” require? We need to examine whether total independence is a possibility or even a necessity. How much independence should an auditor maintain, and how should the auditor determine that?

The AICPA Code of Professional Conduct recognizes two kinds of independence: independence in fact and independence in appearance. Independence in fact is applicable to all accountants. If the accountant’s function is to render accurate financial pictures, conflicts of interest that cause incorrect pictures do a disservice to whoever is entitled to and in need of the accurate picture. Whether independence in appearance must apply to all accountants or only to independent auditors is an open question. Some contend that independence in appearance is applicable only to independent auditors.²⁵

The Independence Standards Board (ISB) published “A Statement of Independence Concepts: A Conceptual Framework for Auditor Independence,” one of the most thorough documents on independence ever prepared. The ISB was established in 1997 by Securities and Exchange Commission Chairman Arthur Levitt in concert with the AICPA. “The ISB was given the responsibility of establishing independence standards applicable to the audits of public entities, in order to serve the public interest and to protect and promote investors’ confidence in the securities markets.”²⁶ It acknowledged that “[t]he various securities laws enacted by Congress and administered by the SEC recognize that the integrity and credibility of the financial reporting process for public companies depends, in large part, on auditors remaining independent from their audit clients.”²⁷

The ISB originated from discussions between the AIPCA, other representatives of the accounting profession, and the SEC. However, as a result of the pressure that large accounting firms were exerting on the AICPA – for which independence might mean surrendering their lucrative consulting contracts with firms they audited – the ISB was dissolved in August 2001. Nevertheless, its findings are among the best resources for ethical responsibilities.

Shortly after the dissolution of the ISB, the fallout from the Enron/Andersen debacle occurred, and in the winter of 2002, the Big Five (now the Big Four since Andersen’s fall) began separating their auditing and consulting functions. This separation was ultimately mandated, as we have discussed, by provisions of the Sarbanes–Oxley Act. Recent history has taught us that this independence is necessary.

John Bogle explains why eloquently:

Our government, our regulators, our corporations, and our accountants have … properly placed the auditor’s independence from his client at the keystone of our financial reporting system. And auditor independence has come to mean an absence of any and all relationships that could seriously jeopardize – either in fact or in appearance – the validity of the audit, and, therefore, of the client’s financial statements. The auditor, in short, is the guardian of financial integrity. On the need to maintain, above all, this principle of independence, I hear not a single voice of dissent – not from the corporations, not from the profession, not from the regulators, not from the bar, not from the brokers and bankers – the financial market intermediaries – and not from the institutional investors who, as trustees, hold and manage the securities portfolios of their clients.²⁸

What did the proposed conceptual framework of the now‐defunct ISB say about independence? The ISB board defined auditor independence as “freedom from those pressures and other factors that compromise, or can reasonably be expected to compromise, an auditor’s ability to make unbiased audit decisions.”²⁹ This, of course, does not mean freedom from all pressures, only those that are “so significant that they rise to a level where they compromise, or can reasonably be expected to compromise, the auditor’s ability to make audit decisions without bias.”³⁰ “Reasonably be expected” means based on rational beliefs of well‐informed investors and other users of financial information.

For example, if I stand to gain from a company to which I give a favorable attestation because I am a shareholder, a reasonable person would be somewhat skeptical of my ability to be unbiased in that case. Similarly, if the company is planning to hire my accounting firm for extensive consulting work when it gets a loan from the bank, which is contingent on a favorable audit, a prudent person would doubt that I could perform an impartial audit. The doubt would arise, not because I am inherently a dishonorable person, but because human beings, in general, can be unduly influenced by such pressures.

What sorts of pressures are there? To begin, there are pressures that can stem from relationships such as family, friends, acquaintances, and business associates. Standards‐setting bodies issue rules to limit certain activities and relationships that they believe represent “potential sources of bias for auditors generally.”³¹ Although some auditors may be able to remain unbiased in such situations, the rules apply to them as well, because “it is reasonable to expect audit decisions to be biased in those circumstances.”³² Accordingly, noncompliance with those rules might not preclude a particular auditor from being objective, but it would preclude the auditor from claiming to be “independent” at least in appearance, if not in reality.

Still, not every situation can be identified or covered by a rule. The absence of a rule dealing with a certain relationship, therefore, does not mean that the relationship does not jeopardize the auditor’s independence if the audit decision could reasonably be expected to be compromised as a result. “Compliance with the rules is a necessary, but not a sufficient, condition for independence.”³³

The goal of independence, the report says, is “to support user reliance on the financial reporting process and to enhance management efficiency.”³⁴ Hence, independence is an instrumental good, while the goal is management efficiency.

The ISB delineated four basic principles and four concepts to use as guidelines to determine what interferes with or aids independence. The four concepts are:

• threats;
• safeguards;
• independence risk;
• significance of threats/effectiveness of safeguards.

Threats to auditor independence are defined as “sources of potential bias that may compromise, or may reasonably be expected to compromise, an auditor’s ability to make unbiased audit decisions.”³⁵ There are five types of threats to independence:

• self‐interest threats;
• self‐review threats;
• advocacy threats;
• familiarity threats;
• intimidation threats.

In an article titled “Auditing and Ethical Sensitivity,”³⁶ Gordon Cohn discusses several other factors that jeopardize auditor independence. First, he considers the effect of family and financial relations on independence. Obviously, if the auditor is a relative of a client or maintains financial interests with a client, this could create a conflict of interest that affects the auditor’s independence. Hence, the AICPA’s rule of independence prevents being an auditor where such relationships exist. Even if the auditor could overcome the conflict of interest and his or her evaluation and attestations were impeccably honest, the public would be suspicious of the auditor’s findings. As we have discussed before, it is important to avoid even the appearance of a conflict.

But there other possible conflicts of interest that challenge the auditor. The problems with an auditor’s independence, according to Cohn, came from two places: The first is the actual or apparent lack of independence, and the second is the inefficient functioning of accounting firms.

Concerning lack of independence, it is important to recognize that auditing firms have a strong stake in client retention and financial solvency, as was apparent in the New Century/KPMG case, among others. A claim can be made, therefore, that an “accountant’s dependence on compensation from and gratitude to the client limits independence.”³⁷

Having other financial relationships with the client firm also puts a strain on the auditor’s independence. The practice of opinion shopping indicates how far we are from actual independence. Opinion shopping – the act of searching for an auditor who will give a positive attestation, even if it is unwarranted – is simply bad. Any accountant or accounting firm that succumbs to that practice should immediately be ethically suspect.

On the other hand, defenders of the claim that auditors can remain independent, even when they are performing consulting or other services for a company, maintain that “the synergy between two functions assists the accounting firm to produce improved services in both areas.”³⁸ Indeed, after 15 years of research, studies³⁹ found not one instance in which the values of the accounting firm’s auditing department were compromised by performing management advisory services. Those findings have been challenged,⁴⁰ however, on the grounds that the AICPA’s definition of independence is ambiguous, and that some cases in which an accounting firm’s integrity was compromised are settled out of court and therefore not identified. The recent accounting scandals, as well as the Big Four’s decision to limit their consulting roles for firms they are auditing, seem to weaken that argument.⁴¹

The second threat to auditor independence – inefficient functioning of accounting firms – raises this question: How much time and effort can and should be spent to determine the accuracy of presented data? Being skeptical takes time. Consider a teacher who suspects plagiarism. Think of how much time it takes to trace the possible sources of the plagiarized material. The same is true for the accounting firm that suspects discrepancies in a company’s finances. If these discrepancies are overlooked, is it because of shortcomings in the accounting firm’s structure or constraints of time and money?

Independence Risk

After examining the threats to independence, the ISB report outlines “controls that mitigate or eliminate threats to auditor’s independence.”⁴² These include “prohibitions, restrictions, disclosures, policies, procedures, practices, standards, rules, institutional arrangements, and environmental conditions.”⁴³

Another important concept is independence risk, which the report defines as:

… the risk that threats to auditor independence, to the extent that they are not mitigated by safeguards, compromise, or can reasonably be expected to compromise, an auditor’s ability to make unbiased audit decisions. Simply, risk to independence increases with the presence of threats and decreases with the presence of safeguards.⁴⁴

The report also examines the significance of threats and the effectiveness of safeguards, noting, “The significance of a threat to auditor independence is the extent to which the threat increases independence risk.”⁴⁵

Because there will always be some bias and interest, and because no independence is absolute or total, it is necessary to assess the different levels of risk. For example, with the development of mutual fund investing, it is possible that an accountant’s family members may hold stocks in companies the accountant is auditing. Or, given the number of sudden mergers (such as Pricewaterhouse Coopers), there may be stock holdings in companies audited by a firm with which the accountant’s own has recently merged. There must be ways to judge the seriousness and significance of such threats.

Recognizing that total independence is impossible, the report gives auditors a framework in which to evaluate whether the amount of independence they have will protect them from the risks that would jeopardize their judgment or audit. There are four basic activities, called principles, used to determine auditor independence. The first principle reads as follows:

Principle 1. Assessing the level of independence risk. Independence decision makers should assess the level of independence risk by considering the types and significance of threats to auditor independence and the types and effectiveness of safeguards.⁴⁶

To help with this assessment, the report suggests that auditors examine five levels of independence risk:

• No independence risk (Compromised objectivity is virtually impossible.)
• Remote independence risk (Compromised objectivity is very unlikely.)
• Some independence risk (Compromised objectivity is possible.)
• High independence risk (Compromised objectivity is probable.)
• Maximum independence risk (Compromised objectivity is virtually certain.)

Although it is not feasible to measure any of these levels precisely, it is possible to associate a specific threat with one of the risk segments or to place it at one end of the continuum.

The remaining principles are as follows:

Principle 2. Determining the acceptability of the level of independence risk. After assessing the level of risk the auditor needs to determine whether the level of independence is at an acceptable position on the independence risk continuum.

Principle 3. Considering benefits and costs. Independence decision makers should ensure that the benefits resulting from reducing independence risk by imposing additional safeguards exceed the costs of those safeguards.

Principle 4. Considering interested parties’ views in addressing auditor independence issues. Independence decision makers should consider the views of investors, other users and others with an interest in the integrity of financial reporting when addressing issues related to auditor independence and should resolve those issues based on the decision makers’ judgment about how best to meet the goal of auditor independence.⁴⁷

The SEC released a “Revision of the Commission’s Auditor Independence Requirements,” effective February 5, 2001, which prohibits certain nonaudit services that impair auditors’ independence. The release, which met with resistance from the accounting profession, was deemed necessary by Levitt of the SEC and those sympathetic with his position.

Because that position seems prophetic in the light of subsequent events, it is worth reviewing Bogle’s defense of the SEC’s recommendations. According to Bogle, the independence requirements that the SEC recommended ban “only those services which involve either a mutual or conflicting interest with the client; the auditing of one’s own work; functioning as management or an employee of the client; or acting as the client’s advocate.”⁴⁸ Bogle rightly asserts that “it is unimaginable … that any reasonable person could disagree in the abstract that such roles would threaten – or, at the very least, be perceived to threaten – the auditor’s independence”:⁴⁹

It must also be clear that, whether or not the auditor has the backbone to maintain its independence under these circumstances, many management and consulting arrangements could easily be perceived as representing a new element in the relationship between auditor and corporation – a business relationship with a customer rather than a professional relationship with a client. Surely this issue goes to the very core of the central issue of philosophy that I expressed earlier: The movement of auditing from profession to business, with all the potential conflicts of interest that entails. So I come down with a firm endorsement of the substance of the proposed SEC rule, which would in effect bar such relationships.⁵⁰

Nevertheless, Bogle recognizes that there is some merit to objections raised to the commission’s recommendations:

Of course, I have read extensive material from the opponents of that rule making the opposite case. Some arguments seem entirely worthy of consideration, especially those relating to technical – but nonetheless real – issues that engender unnecessary constraints on an auditor’s entering into any strategic alliances or joint ventures, or that relate to the complexity in clearly defining “material direct investment” or “affiliate of the audit client” and so on. Personally, I would hope and expect that this bevy of issues will be resolved by the profession and the Commission meeting and reasoning together.⁵¹

Still, there are objections Bogle sees as invalid and without merit. Again, in the light of subsequent events, Bogle’s insights are remarkably astute:

But other opposition seemed to me to be rather knee‐jerk and strident (rather like those debates I mentioned at the outset). No, I for one don’t believe the SEC proposals represent “an unwarranted and intrusive regulation” of the accounting profession. And, no, I for one do not believe that the new rules “strait‐jacket” the profession. And, yes, I do believe that the growing multiplicity of inter‐relationships between auditor and client is a serious threat to the concept of independence, the rock foundation of sound financial statements and fair financial markets alike. In this context, I was stunned to see this recent statement from one of the senior officers of the investment company industry group for one of the Big Five firms. “Fund companies have increasingly looked to … big accounting firms to help them with operational, regulatory, strategic and international decisions.” If that isn’t functioning as management, I’m not sure what would be.⁵²

But even considering recent accounting scandals, is it completely clear that the mere appearance of independence is necessary? After all, couldn’t we argue that although there may seem to be a conflict, the accountant may have already resolved or avoided it? It is not the existence of a conflict of interest that is the issue; it is whether or not the accountant can set it aside and do the right thing.

Lynn Turner, former chief accountant at the SEC, presented an extensive argument for the importance of appearing independent:

The SEC requires the filing of audited financial statements to obviate the fear of loss from reliance on inaccurate information, thereby encouraging public investment in the Nation’s industries. It is therefore not enough that financial statements be accurate; the public must also perceive them as being accurate. Public faith in the reliability of a corporation’s financial statements depends on the public perception of the outside auditor as an independent professional. … If investors were to view the auditor as an advocate for the corporate client, the value of the audit function itself might well be lost.⁵³

The accounting profession has long embraced the need for the appearance of independence. Statement on Auditing Standards No. 1 reads as follows:

Public confidence would be impaired by evidence that independence was actually lacking, and it might also be impaired by the existence of circumstances which reasonable people might believe likely to influence independence. … Independent auditors should not only be independent in fact, they should avoid situations that may lead outsiders to doubt their independence.⁵⁴

Witnesses at the Commission’s hearings on the auditor independence rule strongly endorsed the need for auditors to maintain the appearance of independence from audit clients. Paul Volcker, former chairman of the Federal Reserve Board, in response to a question about investors’ perceptions of a conflict of interest when auditors provide nonaudit services, said, “The perception is there because there is a real conflict of interest. You cannot avoid all conflicts of interest, but this is a clear, evident, growing conflict of interest. …”⁵⁵

In addition, John Whitehead, former Co‐Chairman of Goldman Sachs and a member of numerous audit committees testified as follows:

Financial statements are at the very heart of our capital markets. They’re the basis for analyzing investments. Investors have every right to be able to depend absolutely on the integrity of the financial statements that are available to them, and if that integrity in any way falls under suspicion, then the capital markets will surely suffer if investors feel they cannot rely absolutely on the integrity of those financial statements.⁵⁶

In 1988, three major accounting firms had petitioned the SEC to modify the independence rules and allow expanded business relationships with their audit clients; by 1989 all of the Big Eight had applied for a modification. But in the wake of Enron/Andersen, the Sarbanes–Oxley Act tightened the independence rules.

On January 28, 2003, in response to the Act, the SEC adopted amendments to strengthen requirements on requiring auditor independence. Rule 2‐01 lays out four principles, which:

… focus on whether the auditor‐client relationship or the provision of service (a) creates a mutual or conflicting interest between the accountant and the audit client; (b) places the accountant in the position of auditing his or her own work; (c) results in the accountant acting as management or employee of the audit client; or (d) places the accountant in a position of being an advocate for the audit client.⁵⁷

Finally, rule 2–10 prohibits certain specific relationships, including financial relationships, employment relationships, business relationships, relationships in which the audit firm performs nonaudit services to the client. Rule 2‐10 also includes requirements regarding partner rotation and audit committee administration of the engagement.

The reasons to avoid even the appearance of a conflict of interest, which might affect auditor independence, are obvious. To make their best judgments, people need faith in the representations upon which they base those judgments. Representations made by accountants who have – even appear to have – conflicting interests do not inspire such faith.

People’s thoughts govern their responses. If I think someone is angry, my response will be different from my response if I think the person is in pain. Similarly, if I trust someone, I will respond differently than if I suspect that individual. Thus, the appearance of dependence will have a major impact on the estimation of a financial entity’s worth.

Professional Skepticism

Independence is crucial because it is the auditor’s responsibility to maintain professional skepticism. During workshops with accountants, we often ask them how it is possible to be objective about a friend’s income statements. Does it cloud their judgment? In establishing standards for auditors early in its existence, the Public Company Accounting Oversight Board (PCAOB) incorporated the AICPA’s Auditing Standard No. 82, which called for due professional care. There are two key statements:

Due professional care is to be exercised in the planning and performance of the audit and the preparation of the report.⁵⁸

Due professional care imposes a responsibility upon each professional within an independent auditor’s organization to observe the standards of field work and reporting.⁵⁹

In addition to possessing the requisite skills, the AICPA standards stipulate that the auditor must maintain professional skepticism, arguably one of the auditor’s most important responsibilities:

Due professional care requires the auditor to exercise professional skepticism. Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. The auditor uses the knowledge, skill, and ability called for by the profession of public accounting to diligently perform, in good faith and with integrity, the gathering and objective evaluation of evidence.⁶⁰

Auditing Standard No. 82, approved by PCAOB as AU 230.07 provides further clarification of auditors’ obligations. An auditor may not detect a material irregularity, for example, because generally accepted auditing standards do not require the authentication of documents, or there may be collusion and concealment. The auditor is not an insurer; nor does the auditor’s report constitute a guarantee. The auditor, therefore, needs only to give reasonable assurance – that is, maintain a proper degree of professional skepticism.

To be appropriately skeptical, the auditor must consider factors that influence audit risk, especially the internal control structure. “The auditor’s understanding of the internal control structure should either heighten or mitigate the auditor’s concern about the risk of material misstatements.”⁶¹ The auditor should ask the following questions: Are there significant difficult‐to‐audit transactions? Are there substantial and unusual related‐party transactions not in the ordinary course of business? Is there a sizable number of known and likely misstatements detected in the audit of prior period’s financials from the previous auditor?

The auditor should review information about risk factors and the internal control structure by considering these issues:

• Are there circumstances that may indicate a management predisposition to distort financial statements?
• Are there indications that management has failed to establish policies and procedures to assure reliable accounting estimates by utilizing unqualified, careless, or inexperienced personnel?
• Are there symptoms of a lack of control, such as recurrent crises conditions, disorganized work areas, excessive back orders, shortages, delays or lack of documentation for major transactions?
• Are there signs of insufficient control over computer processing?
• Are there inadequate policies and procedures for security of data or assets?

The auditor needs to determine the effects of any of these issues on the overall audit strategy. High risk ordinarily demands more experienced personnel and more extensive supervision. “Higher risk will also ordinarily cause the auditor to exercise a heightened degree of professional skepticism in conducting the audit.”⁶²

The following paragraph summarizes the responsibility of maintaining professional skepticism:

An audit of financial statements in accordance with generally accepted auditing standards should be planned and performed with an attitude of professional skepticism. The auditor neither assumes that management is dishonest nor assumes unquestioned honesty. In exercising professional skepticism, the auditor should not be satisfied with less than persuasive evidence because of a belief that management is honest.⁶³

Reasonable Assurance

The final section of the standard on due care deals with reasonable assurance. It includes the following stipulations:

The exercise of due professional care allows the auditor to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud, or whether any material weaknesses exist as of the date of management’s assessment. Absolute assurance is not attainable because of the nature of audit evidence and the characteristics of fraud. Although not absolute assurance, reasonable assurance is a high level of assurance. Therefore, an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States) may not detect a material weakness in internal control over financial reporting or a material misstatement to the financial statements.⁶⁴

The independent auditor’s objective is to obtain sufficient competent evidential matter to provide him or her with a reasonable basis for forming an opinion. The nature of most evidence derives, in part, from the concept of selective testing of the data being audited, which involves judgment regarding both the areas to be tested and the nature, timing, and extent of the tests to be performed. In addition, judgment is required in interpreting the results of audit testing and evaluating audit evidence. Even with good faith and integrity, mistakes and errors in judgment can be made.⁶⁵

Furthermore, accounting presentations contain accounting estimates, the measurement of which is inherently uncertain and depends on the outcome of future events. The auditor exercises professional judgment in evaluating the reasonableness of accounting estimates based on information that could reasonably be expected to be available prior to the completion of field work. As a result of these factors, in the great majority of cases, the auditor has to rely on evidence that is persuasive rather than convincing.⁶⁶

Hence, we conclude that a prerequisite for an effective auditor is to maintain both the fact of independence and the appearance of independence. This allows the auditor to practice due care, which requires an attitude of professional skepticism. As a professional, the auditor has a duty to the public that he or she freely embraced in becoming a public accountant. Ethics demands nothing more than fulfilling that duty.

This concludes our discussion of the function and responsibilities of the auditor. We turn in Chapter 8 to an examination of the role and responsibilities of the management accountant.

Discussion Questions

1. What pressure does an auditor face that can challenge their and their firm’s integrity in the course of conducting an audit? How should the auditor handle such pressure?
2. What is the purpose of the audit function and what is required in order for accountants to successfully complete this task?
3. Who is the auditor ultimately responsible to and how does this impact the auditor/client relationship?
4. Discuss the auditor’s basic responsibilities and potential problems that can arise when carrying out these responsibilities.
5. Discuss the various threats to independence and how a firm should mitigate the risk involved with the threats.