Auditor-Firm Conflicts of Interest

Auditor-Firm Conflict of Interests

The Auditor-Firm Conflict of Interests: Its Implications for Independence

Arieh Goldman and Benzion Barlev, 1974,The Accounting Review, 49 (4), 708-717.

The autonomy of auditors in the performance of their professional duties has always been considered a cornerstone of the profession. In this respect, auditing is similar to other professions.The purpose of this paper is to explain why the independence issue has become so central in auditing, to indicate possible methods of dealing with this problem, and to suggest a framework for their evaluation.

THE AUDITING ROLE

Auditing is defined as "an examination intended to serve as a basis for an expression of opinion regarding the fairness, consistency, and conformity with accepted accounting principles of statements prepared by a corporation or other entity for submission to the public or to other interested parties." The following discussion views auditing as a profession designed to supply auditing services to publicly owned companies.

Auditors submit opinions in the form of written reports. The report describes the nature and scope of the examination (audit) made and includes a statement (opinion) as to whether the financial statements fairly represent the financial position of the audited firm in accordance with accepted accounting principles. If the auditor feels unable to endorse a financial statement wholeheartedly, he must qualify his opinion, or state that he is unable to express an opinion, or express an adverse opinion.

The auditor's report is of interest to three groups: (1) the management of the audited firm; (2) the shareholders of this firm; and (3) "Third Parties" or outsiders, such as potential investors, creditors, and suppliers. Understanding the relationships between these groups and the auditor is basic to the problem of independence. Management occasionally may make some use of the auditor's evaluation of the quality of internal control or benefit from the uncovering of errors or frauds. It can, however, be safely assumed that management knows the firm's true financial position and is likely to detect irregularities without reference to the report. Management, therefore, is not very interested in the information contained in the report. But because the auditor's report serves as one of the shareholders' and third parties' main means of evaluating the firm's financial position and management's performance, management is highly concerned with the way the report reflects on the firm.

CONFLICTS OF INTEREST IN THE AUDITING ROLE

The auditor is potentially involved in three conflicts of interests. These represent different sources of pressures on the auditor to produce a report not according to professional standards and represent potential threats to his independence.

The Auditor-Firm Conflict of Interests

The auditor's report may contain facts and evaluations that may cause potential investors not to invest in the firm and creditors to decide against the granting of loans. The value of shareholders' stock may go down and management might come under criticism. In this respect management and shareholders have the same interest: both, though for different reasons, want the report to make a good impression on third parties. The "firm," i.e., management with the tacit agreement of shareholders, therefore, has much to gain by influencing the auditor's report in order to present more favorable results before third parties. The auditor, however, is expected to produce a report only on the basis of professional standards and, therefore, a potential conflict of interests is created between the auditor and the firm.

The Shareholders-Management Conflict of Interests

The auditor may be caught between shareholders and management. To the extent that shareholders rely on the auditor's report in their evaluation of management's performance, the accountant's fee and freedom of action may be dependent on the content of the report. Management is likely, therefore, to try and influence the auditor to produce a more favorable report in order to impress shareholders.

The Self-interest - Professional Standards Conflict

This conflict is common to all professional groups. An auditor may find himself in a situation where he can benefit from violating professional standards or lose by refusing to violate the standards. If, for example, he has direct or indirect financial holdings in the audited firm, he is in a position to increase their value by omitting relevant facts or misinterpreting certain activities. The auditor also may be tempted to agree to the wishes of management rather than risk being replaced by a more compliant accounting firm. These can be viewed as internal conflicts between the auditor's self-interest and his professional integrity.

The auditing literature devotes much of its attention to the self-interest conflict. The SEC and the AICPA do not consider an auditor "independent" if he has financial interest in an audited firm. Also, many appeals, designed to strengthen auditor's professional considerations, appear in the literature (e.g., be "honest," display "disinterestedness" and maintain a "right state of mind"). However, the potential loss of the audit fee may be a much greater cause for conflict between professional integrity and self-interest.

The primary task of accountants, which extends to all the others, is to prepare and examine financial records. They make sure that records are accurate and that taxes are paid properly and on time. Accountants and auditors perform overviews of the financial operations of a business in order to help it run efficiently. They also provide the same services to individuals, helping them create plans of action for improved financial well-being.

On the job, accountants:

• Examine statements to ensure accuracy
• Ensure that statements and records comply with laws and regulations
• Compute taxes owed, prepare tax returns, ensure prompt payment
• Inspect account books and accounting systems to keep up to date
• Organize and maintain financial records
• Improve businesses efficiency where money is concerned
• Make best-practices recommendations to management
• Suggest ways to reduce costs, enhance revenues and improve profits
• Provide auditing services for businesses and individuals

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External Auditing and Attestation

The primary function of public accountants and public accounting firms is to conduct external audits of balance sheets, income statements, quarterly reports, and earnings reports. Public accountants must evaluate their clients' financial statements based on GAAS (Generally Accepted Auditing Standards) and ensure that the statements have been prepared in accordance with GAAP (Generally Accepted Accounting Principles).

The use of the word "public" in the term public accounting highlights the importance of the services these professionals provide to the general populace when conducting external audits. Investors and consumers depend on the accuracy of accounting information when evaluating the financial status of companies, and when making decisions about what to do with their financial resources. The integrity of the financial system as a whole depends largely upon the ability of public accountants to perform external audits competently.

The external auditing services provided by public accounting firms are crucial to providing the investment community with an accurate picture of the financial viability of publicly traded companies.These companies issue quarterly and annual reports to inform the public of their financial status and prospects. Investors use the information contained in these reports to make decisions about which stocks to buy and sell.

When public accountants audit these reports, they check the actual data used to create the financial claims made by the companies so as to ensure their accuracy.When public accountants attest to the completeness and accuracy of a company's reports, they are performing what are known asattestation servicesby giving their word that the company's financial statements are true. Audit and attestation performed by a public accountant lends an element of trustworthiness to a company's financial reports.

1. To whom should the CPA be ultimately responsible? Why?
2. Based on the articles, what do you think are the most powerful reasons auditors struggle to be truly objective and independent?