The Importance of External Auditor’s Independence

Table of Content

According to Gillespie, Lewis and Hamilton (2004:221) an audit is: “a scrutiny of the accounts by a qualified auditor who carries out checks on the figures so as to establish whether the accounts show a true and fair view of the results and the financial position of the entity. ” According to Wikipedia (2011a), auditor independence refers to “an attitude of mind characterized by integrity and an objective approach to the audit process”. Independent auditing has been an important part of the corporate monitoring system since the mid-1930s, when it became a legislation requirement after the Great Depression.

This was caused by reckless spending by corporations in the late 1920s (Kim, Nofsinger, Mohr, 2010a). However in recent times it has become even more important after a number of firms have become bankrupt due to fictitious accounting methods, the most infamous one being the Enron scandal of 2001. This has led to the new legislation that has emphasised the importance of external auditors to be independent from the corporations they audit. Although it is not a legal requirement for a public company to be audited internally, many corporations tend to have their own internal audits.

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These can be very beneficial to the corporation as they check for accuracy in “financial record keeping”, “implement improvements” and can be used to “detect fraud” at an early stage. Internal auditors can actually “enhance a corporation’s accounting and internal control efficiency” (Kim, Nofsinger, Mohr, 2010b). However arguments are still being poised as to whether this is a necessary exercise as internal auditors may not be entirely independent of their employer. However WorldCom showed the importance of internal auditors. The company’s chief financial officer and their controller (at that time) were said to have claimed $3. billion in regular expenses as capital investment (Tran, 2002). Their internal auditors are said to have been the first to spot these misallocated expenses. However it is a legal requirement for all public companies to be audited by an external auditor.

In the early days of financial auditing, many of the auditing firms offered both audit and consultation services to the same corporation. This was an attempt to solidify their relationships with the corporation’s management therefore maintaining them as clients. However this led to many auditors failing to be completely honest in their work in order o refrain from aggravating their relationships with the corporations they audited and consulted. Legislation had to be put in place that made sure that the auditing firms could only either offer auditing services or consultation services to a corporation (Kim, Nosfinger, Mohr, 2010c). This meant that external auditors could do their jobs without being biased, therefore making financial audit reports more reliable for investors, government bodies and the general public. The primary role of an external auditor is to present an independent and unbiased audit report of a firm’s financial position.

This is a critical report because the information obtained from it will give guidance and support to investors, government bodies and the general public as to whether the corporation is adhering to the correct financial and accounting practices (Wikipedia, 2011b). It is extremely important that external auditors be independent of the corporations that they audit. This means that there is no conflict of interest and no reason for auditors to not comply with the financial accounting standards. A lack of independence between auditors and the corporations led to one of the biggest scandals in financial history.

Enron Corporation was an energy company in the US who doctored their books to show large incorrect profits using “sophisticated and complicated methods to generate inflated reported earnings” (Kim, Nofsinger Mohr, 2010d:36). However in late 2001 the business filed for bankruptcy after its share price dramatically fell from $90 to $0. 26 within 2 years (Healy, Palepu, 2003). Their auditors, Arthur Andersen (formerly one of the ‘Big 5’ auditing firms) received blame for failing to recognise the fictitious accounting methods carried out by Enron.

The auditing firm then also became defunct after a jury ruled against them for obstructing justice; after they had shredded documents of their auditing of Enron (Thomas, 2002). This was evidence to the potential of failure in independence between the corporation and the auditor. Therefore the lack of auditor independence may impact adversely on an audit in many different ways. Other than the two examples previously mentioned above, there have been many other corporations that experienced adverse reactions due to bad accounting practices and the lack of auditor independence.

The independence of external auditors had been brought into question because of the potential influence the corporations had on its auditors. It used to be the duty of the corporation’s CFO to employ an external auditor. Therefore if the auditor’s report was not particularly favourable for the CFO, the CFO could decide to fire them and choose an auditor who would be willing to express a much more favourable view of the financial accounting of the corporation. This then led to the Sarbanes-Oxley Act of 2002 which gave the responsibility of choosing an auditor to an audit committee rather than the CFO (Locatelli, 2002).

However there are still many other corporations that have experienced problems as a result of the lack of auditor independence. Examples of these include Tyco (2002), Xerox (2000) and AOL (2002). However recent times, due to the economic downfall, have seen the fall of Lehman Brothers and the near fall of AIG. Lehman Brothers’ auditor, Ernst and Young, has been accused of “malpractice”, “negligence” and “failure to exercise professional care” after they apparently “failed to raise alarm on the bank’s accounting practices” (Watkins, 2010).

Ernst and Young were accused of knowing, supporting and advising Lehman on its “Repo 105” transactions which led to the ultimate collapse of the bank. These transactions were labelled as sales in order to make the bank look less risky than it actually was (Newquist, 2010). This just goes on to show the consequences of collaboration between external auditors and the firms they audit. In conclusion, we have established that it is critical for external auditors to be independent of the firms they audit. There are some key reasons for this. Firstly, it is a legal obligation for an external auditor to be independent.

Failure to oblige could lead to massive fines, expensive court cases, jail time and ultimately the collapse of the auditing firm (like in the case of Arthur Andersen). Secondly, if external auditors are not independent of the firms they audit and overlook bad accounting practices; there is a relatively high chance that these corporations will become bankrupt when their “bubbles burst”. This would lead to large numbers of people being unemployed which is a negative thing as it could cause a recession or even a depression if too many firms in a critical industry become exposed as frauds.

Finally, the lack of external auditors’ independence has an overall effect on many other parties other than the ones directly involved. Investors could lose money which would affect pension funds, the economy could therefore suffer leading to a financial crisis (especially if huge corporations collapse) and this would lead to a reduction in the welfare of the general public. This was the case with Lehman Brothers, although one could argue that the falling house prices were also a contributing factor to this outcome.

Therefore it is extremely important for external auditors to do their jobs professionally and independently so that these problems can be avoided. After all, that is the main purpose of their job, to carry “out checks on the figures so as to establish whether the accounts show a true and fair view of the results and the financial position of the entity” (Gillespie, Lewis, Hamilton, 2004:221); if external auditors do this independently, then disasters such as before can be avoided.

Reference List

Gillespie, I. , Lewis, R. and Hamilton, K. (2004) Principles of Financial Accounting, 3rd Edition, Harlow: Pearson Education Limited. Healy, P. M. , Palepu, K. G. (2003) “The Fall of Enron”, Journal of Economic Perspectives, Vol. 17, No. 2, pp. 3-26. Kim, K. A. , Nofsinger, J. R. , and Mohr, D. J. (2010a) Corporate Governance, 3rd Edition, NJ: Prentice Hall Kim, K. A. , Nofsinger, J. R. , and Mohr, D. J. (2010b) Corporate Governance, 3rd Edition, NJ: Prentice Hall Kim, K. A. , Nofsinger, J. R. , and Mohr, D. J. (2010c) Corporate Governance, 3rd Edition, NJ: Prentice Hall Kim, K. A. , Nofsinger, J. R. , and Mohr, D. J. (2010d) Corporate Governance, 3rd Edition, NJ: Prentice Hall Locatelli, M. (2002) “Good internal controls and auditor independence”.

All Business Inc. 1/10/2002. http://www. allbusiness. com/professional-scientific/accounting-tax/951680-1. html [Accessed 7/2/2011] Newquist, C. (2010) “Cuomo Checks Ernst & Young Off the Hit List” Sift Media. 21/12/2010. http://goingconcern. com/2010/12/cuomo-checks-ernst-young-off-the-hit-list [Accessed 7/2/2011] Thomas, C. B. (2002) “Called to Account”. Time Inc. 18/6/2002. http://www. time. com/time/business/article/0,8599,263006,00. html [Accessed 7/2/2011] Tran, M. (2002) “WorldCom accounting scandal” Guardian News and Media Limited. 9/7/2002. http://www. guardian. co. k/business/2002/aug/09/corporatefraud. worldcom2 [Accessed 7/2/2011] Watkins, S. (2010) “Will Lehman Brothers and Repo 105 allegations bring down Ernst & Young? ” Associated Newspapers Ltd. 13/03/2010. http://www. dailymail. co. uk/money/article-1257724/Will-Lehman-Brothers-Repo-105-allegations-bring-Ernst–Young. html Wikipedia (2011a) “Auditor Independence”. http://en. wikipedia. org/wiki/Auditor_independence [Accessed 7/2/2011] Wikipedia (2011b) “External Auditor”. http://en. wikipedia. org/wiki/External_auditor [Accessed 7/2/2011] Word count (excluding title page and reference list) – 1,297

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