What are Threats to Auditor Independence?
In the auditing profession, there are five major threats that may compromise an auditor’s independence. Before an audit engagement, it is crucial that each member of the audit team review the five threats to independence. If an auditor is exposed to a certain threat, he or she should either develop safeguards to reduce the threat to an acceptable level or resign from the audit engagement.
What is Auditor Independence?
Auditors are expected to provide an unbiased and professional opinion on the work that they audit. An auditor who lacks independence virtually renders their accompanying auditor report useless to those who rely on them.
For example, consider yourself a potential investor in ABC Company. If you know that the auditor for ABC Company keeps a close, personal relationship with the CEO of the company, how much would you trust that the audited work is a fair representation of the company’s financial standing? How can you be certain that the auditor and CEO did not collude to issue a favorable audit report?
The fact is that auditors who lack independence compromise the integrity of financial markets and the reliability of information. Investors would not be willing to extend capital to companies, knowing that the audited information was performed by an auditor who is not independent. Furthermore, banks would not be willing to issue a loan for fear that the auditor might’ve provided a biased audit report.
Five Threats to Auditor Independence
The following are the five things that can potentially compromise the independence of auditors:
1. Self-Interest Threat
A self-interest threat exists if the auditor holds a direct or indirect financial interest in the company or depends on the client for a major fee that is outstanding.
The audit team is preparing to conduct its 2020 audit for ABC Company. However, the audit team has not received its audit fees from ABC Company for its 2019 audit.
The audit team might be tempted to issue a favorable report so that the company is able to secure a loan to settle the fees outstanding for their 2019 audit.
2. Self-Review Threat
A self-review threat exists if the auditor is auditing his own work or work that is done by others in the same firm.
The auditor prepares the financial statements for ABC Company while also serving as the auditor for ABC Company.
By having the auditor review his or her own work, the auditor cannot be expected to form an unbiased opinion on the financial statements.
3. Advocacy Threat
An advocacy threat exists if the auditor is involved in promoting the client, to the point where their objectivity is potentially compromised.
The auditor is assisting in selling ABC Company while also serving as the auditor for the company.
The auditor may issue a favorable report to increase the sale price of ABC Company.
4. Familiarity Threat
A familiarity threat exists if the auditor is too personally close to or familiar with employees, officers, or directors of the client company.
ABC Company has been audited by the same auditor for over 10 years and the auditor regularly plays golf with the CEO and CFO of ABC Company.
The auditor may have become too familiar with the client and, thus, lack objectivity in their work.
5. Intimidation Threat
An intimidation threat exists if the auditor is intimidated by management or its directors to the point that they are deterred from acting objectively.
ABC Company is unhappy with the conclusion of the audit report and threatens to switch auditors next year. ABC Company is the biggest client of the auditor.
The auditor’s independence may be compromised, as ABC Company is their biggest client and they, quite naturally, do not want to lose such a client. Therefore, the auditor may issue a report that appeases ABC Company.
We hope you’ve enjoyed reading CFI’s guide to threats to auditor independence. CFI is the official provider of the Financial Modeling and Valuation Analyst (FMVA)® certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional CFI resources listed below: