Introduction
The beginning of independence
The role of the auditor
The Sarbanes-Oxley Act of 2002
Canadian actions
Independence and audit failures
Independence, Part 1: The Need
for Independence
By STEPHEN SPECTOR, MA (Econ), FCGA
This article is the first in a three-part series by Mr. Spector on the subject of Independence to be carried on PD Net.
Introduction
The financial failures in the United States have been cited as examples of the failure of the profession AND governance bodies to abide by appropriate ethical standards. The Enron collapse focused on the relationship between the services provided by Arthur Andersen as Enron’s auditor and the services it provided as Enron’s consultants. Was the collapse of Enron caused by systemic flaws in that the same firm provided both audit and consultancy services?
There is no direct evidence that the consulting/auditing relationship was a factor in the alleged audit failure. However, it was argued that the circumstances at Enron inevitably led to a conflict of interest as it was impossible for a firm (Arthur Andersen) to recommend a course of action (consultancy) on the one hand and then criticize that action (the audit) on the other. Such actions belie the transparency and independence supposedly brought to the table by the auditors. The U.S. reaction to the perceived conflict of interest was a move in July 2002 to proscribe such relationships and to preclude the auditor from providing advisory services to the same client.
In this, the first part of a three-part series, we will look at the role of the external auditor and why independence is such a critical notion in providing assurance that the financial statement really represent what they purport to represent. In Part 2, we will look at actions taken by CGA-Canada to ensure that practitioners are independent as the profession takes steps to restore confidence in the veracity of financial statements. Finally, Part 3 will delve into the impact of the CGA-Canada Independence Standard on practitioners and discuss how you can make sure that you comply with the requirements.
The beginning of independence
In 1897, the United Kingdom courts formally established the doctrine of limited liability. One consequence of this action was the need for independent verification of the reports submitted by the company to investors and creditors — there needed to be assurance that the accounts rendered by the venture were “truthful.” That assurance was to be provided by the auditor. Over time, the auditor became seen as someone whose role was to provide confirmation of the veracity of the company accounts. Modern economic theory views this as an agency issue, where the role of the auditor is to reduce information asymmetry.
response will be something along the lines of “equivalent to going to a physician and receiving a clean bill of health.” The problem of course, is that an audit does nothing of the sort. Nevertheless, the majority of unsophisticated investors and creditors think it does. The profession’s attempts to eliminate the expectations gap by informing stakeholders as to what it is realistic to expect, and by raising auditor performance by improved practices, higher standards, and strengthened regulation, do not appear to have reduced the gap significantly. Enron’s demise (and the many other corporate failures) called into question two assumptions relating to the auditor:
• Is the auditor independent and impartial? Real or perceived threats to this independence include the process by which the auditor is appointed, auditors who provide consulting services to their clients, increasing competition and pressures on fees, and client opinion shopping.
• Who should prepare the financial statements and what should be the role and responsibilities of the auditor?
The role of the auditor
More than 20 years ago, Rodney J. Anderson suggested that “the role of auditing is to add credibility to financial statements and thus to enhance the effectiveness of accounting communication needed by our economic system.” The increased complexity of twenty-first century financial information adds another dimension to the decision as to whether something is relevant. In the presence of information asymmetry, an audit reduces information risk in instances where the consequence of error in financial information is significant.
When information asymmetry occurs, at least some relevant information is known to some, but not all, parties involved. Information asymmetry causes markets to become inefficient, since not all the market participants have access to the information they need for their decision-making processes.
Agency theory argues that, under conditions of incomplete information and uncertainty, which characterize most business settings, two agency problems arise: adverse selection and moral hazard. While moral hazard relates to shirking, it can be ignored here. What matters is adverse selection. Adverse selection is the condition under which the principal cannot ascertain if the agent accurately represents his ability to do the work for which he is being paid, or even if that work has been performed.
Therefore, the owners employ the auditor to check up on their agent. In the context of the audit, the “principal” is the owners of the firm; management is their “agent.” Management possesses information asymmetry in their favor, since the owners cannot check up on
everything they do. The auditor is expected to report to the principal (the owners) whether the agent (management) has performed in accordance with the expectations of the owners. In other words, auditors are seen as fulfilling the monitoring function necessary to ensure that management does not take (too much) advantage of information asymmetry.
Over the years, a body of jurisprudence has grown regarding the role of the auditor. In the U.S., one landmark case is that of US v. Simon. In rejecting the auditors’ claim that criminal charges were foreclosed because the financial statements literally complied with GAAP, the court held that, if literal compliance with GAAP creates a fraudulent or materially misleading impression in the minds of shareholders, the accountants could, and would, be held criminally liable.
Generally, the investing public seems to assume that the auditor functions to provide confidence that a company’s financial reports are both reliable and truthfully prepared. The problem with this contention is that it ignores a number of issues. Nobody can guarantee that deliberate efforts by management to mislead owners and regulators will not occur. Nobody can guarantee that auditors will always be able to detect situations where management collude to mislead the auditors. Nobody can guarantee that auditors can or will always be able to detect fraud. Notwithstanding, the auditor must bring an attitude of professional scepticism to the audit. The auditor cannot claim that, as Enron, WorldCom, Adelphia, and others
demonstrated, there will always be “bad people doing bad things.” The auditor must bear some responsibility for the results of the audit.
The Sarbanes-Oxley Act of 2002
Against the backdrop of corporate failures in the United States, the U.S. Congress acted swiftly to pass the Sarbanes-Oxley Act (SOX). Arguing that it was necessary to build and restore confidence in public financial reporting, SOX limited the non-audit services auditors could provide an audit client. The Act also created the Public Company Accounting Oversight Board (PCAOB) to register public accounting firms, establish auditing standards, inspect registered firms, and investigate and discipline public accounting firms.
The Sarbanes-Oxley Act stipulated that it shall be “unlawful” for a registered public
accounting firm to provide a non-audit service to an issuer contemporaneously with the audit including:
• bookkeeping or other services related to the accounting records or financial statement of the audit client;
• financial information systems design and implementation;
• appraisal or valuation services, fairness opinions, or contribution-in-kind reports;
• actuarial services;
• internal audit outsourcing services;
• management functions or human resources;
• broker or dealer, investment advisor, or investment banking;
• legal services and expert services unrelated to audit; and
• any other service that the (Public Company Accounting Oversight) Board determines, by regulation is impermissible.
SOX also imposed other strictures:
• the lead audit or co-ordinating partner and the reviewing partner must rotate off the audit every five years;
• ex-auditors must wait one year before working for clients; and
• it became illegal for companies to extend loans to directors or executive officers.
Canadian actions
In July 2002, the Canadian Institute of Chartered Accountants (CICA), the Canadian Securities Administrators (CSA), and the Office of the Superintendent of Financial Institutions (OSFI) banded together to create a body similar to the U.S.’s PCAOB. The Canadian Public Accountability Board (CPAB) was created to oversee those professionals performing audits of public companies.
In addition, Canadian auditor independence standards were to match the world standards then-recently established by the International Federation of Accountants (IFAC).
In late 2002, the CICA issued an Exposure Draft addressing changes proposed to the Institute’s Code of Conduct. The changes were designed to converge CICA independence standards with those of IFAC. The trouble was, the CICA chose to merge the IFAC principles-based framework with SEC SOX-derived prohibitions in the name of providing rigour for the audit of listed entities. This “one size fits all” betrayed a “big firm” focus as they imposed considerable hardship on those practitioners who provide assurance services to the majority of entities in Canada.
Moreover, a rules-based approach to independence must be “all or nothing.” Incomplete rules and related interpretations lead to loophole hunting, often facilitating unethical behaviour and frustrating the disciplinary system. Lastly, rules tend to instil a “comply with the rule” mindset rather than a “meet the spirit” perspective. Despite opposition, the provincial and territorial Institutes adopted the changes effective January 01, 2004.
On March 30, 2004, Canadian securities regulators (for the most part) approved NI 52-110:
Audit committee composition and responsibilities. This rule applied to all reporting issuers
other than investment funds, issuers of asset-backed securities, certain non-Canadian issuers, and certain subsidiaries of reporting issuers. This policy statement gave to audit committees responsibilities previously considered the purview of the Executive Committee and/or the Board of Directors.
Among other things, the audit committee will now have to directly oversee the work of the external auditors, including resolution of disagreements between management and the auditors and pre-approve non-audit services to be provided by the external auditors. Effectively, NI 52-110 required the auditor to be independent of the client, just as SOX required in the U.S.
Independence and audit failures
Did the lack of independence at Enron lead to an audit failure? A better question might be “what do we mean by ‘audit failure’?” Recall that the auditor expresses an opinion based on his testing. Audit failure refers to the circumstances wherein the auditor renders an
unqualified opinion when the reality demanded otherwise. In statistical sampling, we talk about a Type II error: accepting the null hypothesis when it is false.
The explosive growth in derivative instruments and the sophisticated and complex
environment in which these instruments trade has had a significant impact on the ability of the auditor to keep pace with the efforts of management to “push the envelope.” It is not unusual for management to be more familiar with a particular instrument than the auditors reviewing their actions. If the auditor is not familiar with the entity’s investments, it can lead to inappropriate decisions. This is particularly problematic when the audit team is pressed for time or budget or the relationship is such that there is a willingness to rely on management explanations.
It is not clear how Enron management was able to develop the complex web of Special Purpose entities that they did without the auditors becoming suspicious. The actions taken by the firm to transform itself from an oil and gas company to an energy trader did not occur overnight. It took at least five years to complete the switch. In Canada, the circumstances relating to the demise of Livent Inc., the flashy producer of such big-budget musical
extravaganzas as Ragtime, are similar. Management hid critical information from the auditors, as well as engaging in fraudulent activities. The question as to why these actions were not discovered earlier remains unanswered.
The actions of regulators and the accounting profession have been to proscribe activities that used to be permissible. Whether this is the right action has yet to be proven. In Part 2 of this series, we will cover the introduction of the CGA-Canada Independence Standard as a means to restore confidence and to require that the auditor is independent of the assurance client.
Coming next month, the second article in this three-part series: Independence, Part 2: CEPROC and Independence
Stephen Spector, MA (Econ), FCGA, is currently teaching Financial and Managerial Accounting at Simon Fraser University. From 1982 to 2002, Stephen worked at
CGA-Canada, where he concluded his employment as Manager of Standards and Research, Professional Affairs. Over the years, he has held a number of volunteer positions with the Certified General Accountants Association of British Columbia, including member of the By-Laws Committee and Ethics Committee. He is currently on CGA-BC’s board of governors and is Chair of the Ethics Committee. Stephen has served on the International Accounting Standards Committee’s Canadian Advisory Group, and he was also one of Canada’s technical advisors to the IFAC Ethics Committee from 1999 to 2003. He is a member of the Canadian Academic Accounting Association, where he served as an executive member from 1992 to 1997. In 1997, CGA-BC presented Stephen with the Harold Clarke Award of Merit for recognition of his outstanding service to the By-Laws Committee for 1990-1996. In 1999 he received the Fellow Certified General Accountant (FCGA) award for distinguished service to the Canadian accounting profession.
