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The Accounting Review • Issues in Accounting Education • Accounting Horizons Accounting and the Public Interest • Auditing: A Journal of Practice & Theory

Behavioral Research in Accounting • Current Issues in Auditing Journal of Emerging Technologies in Accounting • Journal of Information Systems

Journal of International Accounting Research Journal of Management Accounting Research • The ATA Journal of Legal Tax Research

The Journal of the American Taxation Association

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PRACTITIONER SUMMARY

A Current Evaluation of Independence as a Foundational Element of the Auditing Profession in the United States

J. Gregory Jenkins Auburn University

[email protected]

Jonathan D. Stanley Auburn University

[email protected]

September 7, 2018

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PRACTITIONER SUMMARY

A Current Evaluation of Independence as a Foundational Element of the Auditing Profession in the United States

SUMMARY: This paper summarizes “Auditor Independence in the United States: Cornerstone of the Profession or Thorn in Our Side?” (Church, Jenkins and Stanley 2018). Church et al. (2018) provides a current, systematic evaluation of independence as a foundational element of the audit profession in the United States (U.S.). Their paper maintains that while the concept of independence is theoretically appealing, it is fraught with practical problems surrounding its implementation, monitoring, and regulation. Church et al. (2018) analyzes the current oversight of auditor independence in the U.S. and the need for auditor independence from the perspective of various parties involved in the financial reporting process. In doing so, the paper discusses important implications and challenges that affect one or more of these parties. Finally, Church et al. (2018) evaluates alternatives to the current regulatory approach of prohibiting various auditor- client relationships to manage auditor independence. The paper concludes that increasing audit committees’ responsibilities for monitoring auditor independence, along with additional disclosure about threats and safeguards to auditor independence, is worthy of further discussion and debate as a path toward addressing the auditor independence conundrum. Keywords: auditor independence; independence in fact; independence in appearance

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PRACTITIONER SUMMARY

A Current Evaluation of Independence as a Foundational Element of the Auditing Profession in the United States

THE AUDITOR INDEPENDENCE CONUNDRUM

Independence is commonly accepted as foundational to auditing and has been the subject

of significant public discussion and debate for more than a century. While a great deal of

regulatory effort has been expended in addressing auditor independence, these efforts and the

resultant rules changes have often been met with criticism. A recently published paper by

Church, Jenkins and Stanley (2018) entitled “Auditor Independence in the United States:

Cornerstone of the Profession or Thorn in Our Side?” explores the concept of auditor

independence from various perspectives, describes the problems and challenges associated with

related regulations, and offers alternatives to the current regulatory approach. The purpose of this

practitioner summary is to provide an overview of Church et al. (2018) and to promote further

discussion within the profession about this important topic.

Auditor independence is comprised of independence in fact and independence in

appearance. Independence in fact is associated with an auditor’s mindset and “entails self-

reliance, such that professional judgment is not subordinated…” (Church et al. 2018, 145).

However, the auditor’s mindset is unobservable, which makes determining whether an auditor is

independent in fact nearly impossible (SEC 2001). On the other hand, independence in

appearance is focused on the nature of the auditor-client relationship, and is determined by

whether others perceive the auditor to be impartial and free of conflicts of interest (SEC 2001).

Church et al. (2018, 146) “contend that by prohibiting specific relationships, regulators exert

their influence and create an illusion that auditor independence can be monitored and enforced.”

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However, regulators cannot guarantee that an auditor is truly independent, much less prove the

assertion.

The current rules-based approach is beset by a number of conceptual and practical

problems and challenges. Although some of these are unsolvable (e.g., the auditor’s state of mind

is unobservable), other problems and challenges (e.g., balancing the profession’s commercial

interest with its responsibility for protecting the public interest) can be addressed, either in whole

or in part, through changes to current regulation. Church et al. (2018) conclude that eliminating

independence rules and interpretations can address many of the problems and challenges

surrounding the concept of auditor independence; however, such an overhaul is neither practical

nor workable absent other changes. They suggest that increasing audit committees’

responsibilities for independence and providing additional disclosure about threats and

safeguards surrounding auditor independence are alternatives worthy of further consideration and

debate. Although there may be other alternatives, the proposed changes are believed to offer a

reasonable means of addressing the independence conundrum within the current regulatory

environment.

THE OVERSIGHT OF AUDITOR INDEPENDENCE

Today, numerous regulatory and professional bodies prescribe independence rules.1 The

primary responsibility for setting independence rules and monitoring compliance in the U.S. is

shared by the AICPA, SEC, and PCAOB (refer to the top portion of Figure 1). Although each of

these bodies arguably aims to strengthen auditor objectivity and credibility, such a fragmented

regulatory environment increases the compliance burden for members of the profession and leads

1 For example, state boards and societies of accountancy, the American Institute of Certified Public Accountants (AICPA), Securities and Exchange Commission (SEC), Public Company Accounting Oversight Board (PCAOB), U.S. Government Accountability Office (GAO), U.S. Department of Labor, International Auditing and Assurance Standards Board, and International Ethics Standards Board of Accountants currently prescribe independence rules and standards.

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to conflicting requirements. Even the largest accounting firms face difficulty complying (Church

et al. 2018). Moreover, independence rules are not static, but change to reflect shifting business,

economic, and political conditions such that members of the profession must remain ever-

vigilant for possible violations (O’Connor 2004). Nonetheless, many of the independence rules,

and the concepts embedded in them, were written when the physical distances between clients

and their auditors were meaningful, data and information took time to access and process, and

the ownership structures of business entities were simpler.

Figure 1 from Church et al. (2018) summarizes the current role of auditor independence for

the primary parties involved in the financial reporting process and the relationships among the

parties. It is included herein as a framework for organizing the discussion.2 Key observations about

the different oversight bodies’ roles in regulating auditor independence are summarized in the top

portion of Figure 2 (from Church et al. 2018).

[Insert Figure 1 about here.]

[Insert Figure 2 about here.]

The AICPA and Auditor Independence

The AICPA is the primary professional organization representing the accounting profession

in the U.S. It performs many roles for the profession, including oversight of auditor independence.

The AICPA has a vested interest in endorsing the virtues of independence as it promotes auditors’

moral character and the profession as serving the public interest (Church et al. 2018). The

profession’s assertions of independence can be legitimized by showing auditors’ compliance with

the AICPA’s many related rules and interpretations (Preston, Cooper, Scarborough, and Chilton

1995). Ultimately, independence helps the profession maintain its monopoly on public-company

2 The figures used in this paper appear in Church et al. (2018).

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audits and to continue to serve as an independent monitor of and a gatekeeper to the securities

markets (Sikka and Wilmont 1995; Sikka 2009; Watts and Zimmerman 1983).

There are a number of problems and challenges related to the AICPA’s oversight of auditor

independence. In addition to providing self-oversight, the AICPA serves as an advocate for the

profession which results in the AICPA having a bifurcated allegiance to its members and financial

statement users. Compared to members of the profession, financial statement users and

government regulators are less cognizant of the costs and practicalities of establishing

independence (Kinney 2005; Palmrose 2010). Furthermore, the AICPA’s rules-based approach to

operationalizing independence is fundamentally flawed. It does not establish independence in an

operational manner; rather, the AICPA prohibits certain auditor-client relationships and auditor-

provided nonaudit services that, by definition, impair independence. As a consequence of this

approach, independence can never be affirmed, only negated (Church et al. 2018). In addition,

compared to government regulators, the AICPA has been less willing to prohibit nonaudit services

and less progressive in calling for actions to bolster independence, both of which are moves that

would further limit the profession’s profit potential. Church et al. (2018, 150) emphasize that “the

schism between the profession’s commercial interests and its duty to protect the public’s interest

comes to the forefront in considering self-oversight versus government oversight.”

The SEC, PCAOB and Auditor Independence

The SEC and PCAOB are broadly responsible for protecting investors and ensuring

accurate information flows associated with U.S. public companies. They establish and monitor

auditor independence as a means to facilitate the functioning of U.S. securities markets. As such,

the responsibilities of these oversight bodies transcend the narrower objectives of the AICPA. As

government regulators, both bodies are particularly leery of the colossal economic losses that can

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result from large-scale financial reporting failures such as the one that accompanied the collapse of

Enron. As a result, they may over-prescribe auditor independence rules to help bolster financial

reporting quality and public trust in the financial markets (Kinney 2005). Church et al. (2018)

emphasize that a significant difference between government oversight and self-oversight of auditor

independence is that government regulators focus less on the expected costs and more on the

expected benefits of tightening independence rules as compared to the AICPA.

There are a number of problems and challenges related to the oversight of auditor

independence by the SEC and PCAOB. Similar to the AICPA, government regulators have

pursued a rules-based approach. Proscribing certain auditor-client relationships does not ensure

that auditors are independent in fact and may actually reduce audit effectiveness and efficiency

under certain conditions (e.g., Knechel 2016). Likewise, violations of independence rules do not

necessarily imply reduced audit quality (Gramling, Jenkins, and Taylor 2010). Church et al. (2018)

also observe that government regulators are incentivized to frame auditor independence as a

“problem” that needs to be addressed and to keep something as fundamental as auditor

independence at the forefront of public discourse. By doing so, government regulators legitimize

their existence, demonstrate their value in the marketplace, appease constituents, and secure

resources.

WHO NEEDS AUDITOR INDEPENDENCE?

External users and information producers benefit from auditor independence (refer to the

bottom and middle portions of Figure 1). Key observations about the different parties’ needs for

auditor independence are summarized in the bottom and middle portions of Figure 2.

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External Users’ Needs for Auditor Independence

Within the framework of Church et al. (2018), information users are parties external to

the reporting entity, and represent third-party beneficiaries who rely on auditor independence to

uphold financial reporting quality. Information users are concerned with auditor reliability as a

way to strengthen financial reporting quality. Auditor independence is a component of auditor

reliability, but it is not the only component (e.g., Taylor, DeZoort, Munn and Thomas 2003).

Users are mindful of the quality of an auditor’s work and are concerned with matters such as

independence, integrity, expertise, firm resources, and other factors that impact audit quality.

The extent to which users are concerned about independence, however, is unresolved. Likewise,

the role of independence in appearance is unsettled, with empirical evidence being mixed.

Information Producers’ Needs for Auditor Independence

Information producers such as company management and the audit committee are

internal to the reporting entity and have direct access to internal information. For information

producers, auditor independence promotes the credibility and quality of audited financial

statements. In addition, auditor independence is necessary to comply with regulatory

requirements and to fulfill fiduciary responsibilities. Independence rules provide a means to

ensure that such obligations are satisfied. Independence rules are also intended to foster unbiased

and impartial behavior on the auditor’s part, promoting financial reporting quality.

However, independence rules create a number of problems and challenges for

information producers. For example, the rules can lead to suboptimal contracting. The client may

be forced to hire a second-best nonaudit service provider, voiding knowledge spillovers and

potentially increasing cost (e.g., Gaynor, McDaniel and Neal 2006; Schneider, Church and Ely

2006; Knechel 2016). Furthermore, while compliance with independence rules suggests

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independence in appearance, compliance does not ensure independence in fact. Notably, auditor-

client interactions occur on an ongoing basis, which leads to social bonding and potentially

undercuts independence. Relatedly, information producers’ need for independence, as compared

to other auditor attributes, is unclear. In spite of the significant problems and challenges, the

infrequent occurrence of outright audit failures suggests that independence in fact is functioning

and effective (e.g., Francis 2004).

ALTERNATIVE APPROACHES TO THE AUDITOR INDEPENDENCE CONUNDRUM

Figure 3 recaps the fundamental problems and challenges that undermine auditor

independence, impacting oversight bodies, information producers, and information users. This

figure includes nine issues that affect one or more of these parties, and classifies each as being in

a conceptual and/or practical domain. Alternatives to the current regulatory approach that

address some of these problems and challenges are described below. The three alternatives

discussed are: eliminating independence rules and interpretations, increasing audit committees’

responsibilities for independence, and providing additional disclosures surrounding auditor

independence.

[Insert Figure 3 about here.]

Eliminating Independence Rules and Interpretations

Some prior work argues that auditor independence, as currently operationalized by

regulators, is impossible to achieve (e.g., Bazerman et al. 1997; Bazerman et al. 2002). A potential

remedy is deregulation. Specifically, regulators could eliminate the countless rules and

interpretations and revert to the profession’s earlier approach and maintain the concept of

independence as an overarching principle that guides auditor behavior. This remedy addresses

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several of the problems and challenges shown in Figure 3.3 Research shows that market forces

shape auditor behavior and reward high levels of audit quality. However, such market forces may

be inadequate at protecting users of audited financial statements. In the past, deregulation of the

audit profession, such as allowing the provision of currently prohibited nonaudit services, has been

blamed for weakening auditor independence and degrading audit quality (e.g., Kinney 2005;

Salterio 2008). Furthermore, even in today’s environment with a multitude of independence rules

in place, concerns remain that auditors’ commercial interests too often take precedence over

auditors’ responsibility to protect the public interest. Church et al. (2018) conclude that eliminating

independence rules and interpretations is neither practical nor workable, absent other changes.

Increasing Audit Committees’ Responsibilities

SOX significantly enhanced the oversight responsibilities and resources of public company

audit committees. One practical alternative to the current regulatory regime is to build upon this

strengthened oversight arrangement and allow the audit committee greater responsibility and

flexibility for managing auditor independence. For example, the audit committee could be

empowered to approve currently prohibited nonaudit services if, in the audit committee’s

judgment, the services did not inappropriately jeopardize the auditor’s independence and offered

economic benefits to the company’s shareholders. While some observers may view this alternative

as naïve, there is evidence that some audit committees would likely be in favor of this option (see

Gramling et al. 2010). This remedy does address several of the practical concerns presented in

Figure 3; however, the approach hinges critically on the diligence of the audit committee (DeZoort,

3 For example, this approach avoids the need to define independence negatively, which in turn avoids the infinite regress of rulemaking, the flaws that plague rulemaking, and the need to closely monitor compliance. The approach also eliminates the potential negative side effects of prohibiting various auditor-client relationships.

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Hermanson, Archambeault, and Reed 2002).4 Evidence suggests that audit committees are, on

average, more diligent today than they were before the implementation of regulatory reforms

mandated by SOX (Cohen et al. 2010); however, concerns persist that some audit committees fail

to fulfill their oversight responsibilities (e.g., Beasley et al. 2009). To address these concerns,

Church et al. (2018) highlight two additional changes to the current oversight arrangement that can

help further improve the audit committee’s effectiveness: (1) greater involvement from the internal

audit function in monitoring the independence of the external auditor and (2) greater disclosure of

audit committee activities related to auditor oversight. Involvement from the internal audit function

may take a variety of forms such as a request for internal auditors to examine and report on

interactions among management and other company personnel with members of the audit team

that might bear on the auditor’s independence. With regards to the second change, we note that

there is a growing number of audit committees that voluntarily disclose information about their

oversight of the external auditor (EY 2018). This trend is encouraging.

Providing Additional Independence Disclosures

Public disclosure is a viable mechanism for informing information users about auditor

independence. In addition, the accountability and public scrutiny that is associated with public

disclosure can deter independence impairments by encouraging information producers to more

carefully evaluate auditor independence (SEC 2001). Church et al. (2018) suggest that, going

forward, additional disclosure that elaborates on auditor independence threats and safeguards is a

feasible means for addressing many of the practical problems and challenges listed in Figure 3.

This approach aligns well with recent and contemplated changes by regulators and current trends

4 This alternative could allow an audit committee to choose a level of independence that is appropriate for the company and balance independence for expertise and other factors as appropriate (Knechel 2016). In doing so, the audit committee can assess whether matters such as social bonding between management and the auditor is a concern. The arrangement also avoids the negative side effects of independence rules identified in the literature (e.g., suboptimal contracting and nullifying knowledge spillovers).

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in voluntary disclosure noted above. Although, Church et al. (2018) explain that there is a risk that

increased disclosure does not achieve the desired outcome. Prior work calls attention to the idea

that individuals often fail to adequately discount advice from biased experts such as auditors, even

when conflicts of interest are disclosed (Cain, Loewenstein, and Moore 2005). Under certain

conditions, disclosure can actually increase bias (e.g., by reducing feelings of guilt) and reduce

responsibility for adverse outcomes (e.g., via the caveat emptor or “let the buyer beware”

principle). Some find that disclosure also can induce gamesmanship that could reduce overall audit

quality (Dranove and Jin 2010). Despite these drawbacks, Church et al. (2018) asserts that

additional disclosure can offer potential advantages over further rules and interpretations. Potential

drawbacks to the disclosure approach to managing independence should, to some extent, be offset

by complementary assurance mechanisms that have been put in place since the passage of SOX.

The public disclosure of other audit quality indicators being considered by the PCAOB (2015) also

would reduce the likelihood of “gaming” the system and reducing overall audit quality by focusing

excessively on independence at the expense of other important audit and auditor attributes.

CONCLUDING REMARKS

Church et al. (2018) provides a robust discussion of the challenges and complexities

associated with auditor independence. They suggest that the current trajectory of ever-expanding

rule-setting is not sustainable for the profession. Instead of continuing under the current

regulatory regime, Church et al. (2018) offer two possible alternatives. First, they suggest

leveraging the increased resources and authority of audit committees under SOX to allow the

audit committee greater responsibility and flexibility for managing auditor independence. Second,

they suggest that additional disclosures about threats and safeguards to auditor independence

may be informative for interested parties. The combination of these two approaches is worthy of

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further consideration for addressing a number of the problems and challenges associated with the

current regulatory regime.

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FIGURE 1 Primary Parties Affected by Auditor Independence

GOVERNMENT OVERSIGHT SELF-OVERSIGHT

SEC

Independence promotes reliable and credible financial information and facilitates the functioning of U.S. securities markets.

PCAOB

Independence supports the efforts of the SEC to bolster users’ confidence in

audited financial statements.

AICPA

Independence upholds the public

interest and promotes members’

vested interests.

Company Management

Independence reduces agency

costs and signals financial reporting

quality.

External Auditor

Independence underscores

moral duty and reinforces objectivity.

Audit Committee

Independence is necessary to fulfill

regulatory requirements and fiduciary

responsibilities.

Investors, Creditors, Other Outside Users

Third-party beneficiaries of auditor independence, serving to strengthen financial reporting credibility and reliability.

Over sight Bodi

es

Infor mati on

Prod ucers

Infor mati on

Users

(continued on next page)

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FIGURE 1 (continued) ________________________

The figure depicts the relationships among the different parties that are affected by auditor independence. The text within the boxes characterizes the role of independence for each party. The arrows indicate the interconnectedness among the parties. The differing shades of gray represent different parties’ knowledge into the makeup of audited financial statements. Information producers, oversight bodies, and information users are shown in decreasingly translucent shadings (i.e., darkening shades of gray), respectively, to emphasize the decreasing degree of insight that the parties have into information producers’ inner workings and behavior. The differing degrees of insight, in turn, impact the function of auditor independence for each party.

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FIGURE 2 Key Observations about the Primary Parties Affected by Auditor Independence

SEC and PCAOB

Establish and monitor independence rules applicable to issuers’ filings.

Independence needs to be closely monitored.

Emphasize independence in appearance.

AICPA

Rules and standards reinforce auditor independence.

Bifurcated allegiance to auditors and users of audited financial statements.

External Auditor

Independence rules are designed to ensure that the auditor is unbiased and impartial.

Independence rules potentially void knowledge spillovers.

Company Management and Audit Committee

Adherence to independence rules provides a practical means to ensure that duties and obligations are fulfilled.

Independence rules can lead to suboptimal contracting.

Over sight Bodi

es

Infor mati on

Prod ucers

Infor mati on

Users

Independence in fact is a state of mind and, as such, unobservable.

Independence is defined negatively, by what it is not.

Independence rules fail to account for every possible relationship or business activity.

Independence in appearance is an imperfect surrogate for independence in fact.

Compliance with independence rules does not ensure independence in fact.

A low audit failure rate suggests that independence in fact is functioning and effective.

Operational independence is tenuous because of ongoing interactions and social bonding.

The importance of independence relative to other auditor attributes is unclear.

Investors, Creditors, Other Outside Users

Users are concerned about auditor reliability, not independence per se.

Users are attuned to auditor performance, which encompasses independence and other factors that impact audit quality.

The importance of independence is unclear.

GOVERNMENT OVERSIGHT SELF-OVERSIGHT

,,

(continued on next page)

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FIGURE 2 (continued) ________________________

The figure summarizes key observations about the primary parties affected by auditor independence which are more fully discussed in the third and fourth sections of the paper. Overlapping boxes are applicable to more than one party. The differing shades of gray are indicative of the degrees of insight that the parties have into information producers’ inner workings and behavior. Darkening shades of gray reflect decreasing degrees of insight.

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FIGURE 3 Auditor Independence Problems and Challenges

________________________

The figure identifies nine fundamental problems and challenges that undermine auditor independence, impacting oversight bodies, information producers, and information users. Each problem and challenge is classified as being in a conceptual and/or practical domain. The problems and challenges that fall solely within the conceptual domain are akin to thought exercises that are unsolvable: independence is unobservable (a state of mind) and defined negatively (it cannot be affirmed or proven). The problems and challenges that fall solely within the practical domain involve business interests and the realities of auditor-client interactions: auditors’ business interests get in the way of objectivity (commercial versus public interest), the side effects of disallowing certain auditor-client relationships (suboptimal contracting and nullifying knowledge spillovers), and social bonding (links between auditor and client personnel). The problems and challenges that span the two domains are centered on implementing and ensuring auditor independence: the infinite regress of rulemaking, an emphasis on independence (relative to other auditor attributes), rules being flawed (adherence to rules does not ensure independence), and a need for close monitoring (strict concerns over compliance).

Unobservable nature of independence in fact

Independence is defined

negatively, by what it is not

Balancing of commercial versus public interest

Social bonding influence

on independence Side effects of

independence rules

Rulemaking is prone to infinite regress

Importance of independence is

unclear Flawed rules yield imperfect

measures of independence Independence needs to be

closely monitored

Conceptual Domain Practical Domain

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