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Why is Audit Independence Important?

Why is audit independence important?

An audit is basically an examination of a set of records, both financial and non-financial, to ensure that they can be relied upon in terms of accuracy and completeness. An auditor is a qualified person who carries out the audit assignment and reports on the ‘true and fair view’ of the client entity’s financial statements so that the users of financial statements can rely on the reliability and credibility of the financial statements. There are many users of financial statements who do not have sufficient knowledge to understand what is contained in a company’s annual accounts. Thus, they rely on the auditor’s independent assessment and the auditor’s main objective is to express an audit opinion over financial statements (Corplaw Admin, 2014).  This opinion intends to enhance credibility of the financial statement. The opinion itself shall be credible and for that the auditor’s objectivity shall be beyond question.  This created requirements for auditor to be and appear to be independence of those influences that could override his professional judgement.

Being independent is about preserving “Independent of mind” which is about the capability to maintain profession objective while exercising professional judgement which is important to preserve quality of auditor’s judgement.

While appearing independent is about preserving “Independent of appearance” which is how public/users perceive auditor as being objective which is important to get users confidence over auditor’s judgement.

Audit independence is important so that auditor’s opinion can be impartial, unbiased, free from any undue influence or conflict of interest to override the professional judgement of the professional accounting (Rutgers Accounting Web, 2015).

It is critical for an auditor to be independent of the firms they audit due to many reasons. 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 public. Therefore, it is extremely important for external auditors to do their jobs professionally and independently so that these problems can be avoided (, 2012).

Changing landscape

There is and was always an expectation gap between auditors and user of the audit report regarding the perception of issue that affect independence and liabilities. The major issues that affect the audit independence are long relationship between client and audit, provider non-audit services to the client, employment of former auditors of client, job opportunities, related party etc. The user of the audit report mostly perceives these issues as reducing auditor’s independence (Hay, 2004).

The apparent conflict of interest for audit firms in the provision of non-audit services to clients has been an enduring concern to many regulators and commentators. During the 1990s, the financial importance of non-audit services to public accounting firms increased dramatically, and the growth of the consulting divisions or companies associated with the largest audit firms is seen as a significant possible impairment to the independence of audit partners (D A. Moore, 2004).

The independence of external auditors had been brought into question because of the potential influence the corporations had on its auditors. Most of the users of financial statements such as public, stakeholders and sometimes professionals also believe that it is auditor’s responsibility to give a warning if the company is in trouble. They believe that once the auditor signed the annual report of the company it means that the company has been investigated for fraud and wrongdoing and the financial statement are totally accurate and it reflects the true financial position of the company (Mills, 1990).

However, the auditor’s understanding about their responsibilities are different than the public beliefs. The principal responsibility of an auditor is to report on whether the accounts of the company are “true and fair” and present fairly the company’s financial position and the results of its operation as per the accountancy professions. The different perception of public and accountancy profession about the role and responsibilities of an external audit creates the expectation gap. These expectations include the external auditor to be suspicious, detect fraud, provide a certificate of good health for the audited company and independently exercise these responsibilities for the benefit of the public as well as the audited company and shareholders (Integrity, Objectivity and Independence, 1997).

These expectation gap is filling up by the courts or legislation through the cases in past century. The recent developments have imposed higher responsibilities on auditors and wider the applicable standard of care, wider the definition of negligence and duty of care to owed to third party or in another word, we can say that the auditor’s responsibility has been increased with time and cases which demand for higher independence level in auditing.

More than 100 years back in 1896, the landmark judgement was delivered in Kingston Cotton Mill case where Lord Justice Lopes describe an external auditor as “watchdogs” rather than “Bloodhounds” which establish the principle that auditors’ duties involve the exercising of reasonable professional care and skill. The extent of reasonable care and skill and caution is based on the circumstances of each cases (Academic Dictionaries and Encyclopedias, 2014). According to this case, auditor should probe it to the bottom if there is anything suspicious but in the absence of it, auditor need to be only reasonably cautious and careful. After this case, the extent to which auditor are expected to be suspicious and exercise their responsibilities has been debated in many cases.

Pacific Acceptance (1970) had changed the standard of care and skill which was established since the Kingston Cotton Mill case of 1986. It was one of the landmark decision on auditor’s responsibilities by Justice Moffitt where an auditor was referred to as a “skilled inquirer” who prefer to know by direct investigation rather than rely on client management and staff (Kujinga, 2009). Justice Moffitt acknowledge that auditor is not an insurer and their duty is verification not detection of all errors that may occur in company’s financial statement (Tom Campbell, 2005). Nevertheless, the auditor should carry out his task with an inquiring mind, investigate any suspicious circumstances to their satisfaction and if necessary, warn management about it (Mills, 1990). So, in contrast to the approach taken in Kingston Cotton Mill case, In Pacific Acceptance case, judge held an auditor responsible for the losses occurring since they should reasonably have communicated their suspicions to management and was negligent in not reporting suspicions (Mills, 1990).

This approach was represented as law in WA Chip & Pulp (1988) case where Justice Wallace rejected the argument of the auditors that auditor’s duty does not include the detection of fraud and held that the auditor’s duty went beyond the need to examine the financial statements and whether the fraud was uncovered or even if there was a suspicion of it and promptly failure to report the directors or senior management about it constituted negligence. He also addresses this case as “case of the dog sniffing around and being required to follow up the scent and keep its eyes and nose open” (Law Teacher, 2013).

The term “reasonable care and skill” is consistently increasing with time and cases. The auditors are in dilemma regarding the term as the court may conclude the auditor’s judgement on the degree of inquiry to be made fell short of the “reasonable care and skill” expected at that time despite compliance with the usual auditing standards and practices (Mills, 1990).

The BGJ case is seen as like AWA because both cases related to losses caused by foreign exchange transactions. The major claim in BGJ was that the auditors had not alerted the directors to the foreign currency losses of $4 million. The findings were in favour of the auditors which was contrasted with the findings in the AWA case where the auditor was found negligent (Malane, 2005).

In BGJ Holdings case, the auditors raised the matter with other directors and senior executives by means of a letter of recommendation.  whereas in AWA case, the auditor warns the management about the serious internal control problem only after sometimes due to which the auditor was held negligent however the management of the AWA was held guilty of contributory negligence as they failed to take appropriate action to protect itself even after getting warning by auditors (Ferdinard A. GUL, 2014).

In the recent Feltex case (2010) where the auditor was found guilty of negligence and highlighted the point such as lack of communication between the audit firm and client and how the auditor was failed to explain the difference between review engagement and full audit.

The recent case of negligent by the auditor was Cattles vs PwC where PwC was fined of $2.3 million for negligence with the case settled in October for an undisclosed sum. It was two directors of Cattles who did not give the PwC the full picture when compiling the account and mis-leaded the investors about the quality of the firm’s loan books (Dakers, 2016).

HIH Royal Commission Report (2003) is considered the biggest corporate collapse in the history of Australia where Justice Owen made number of recommendations with regards to the auditor independence and their duty of care which consider as on the major reason for the collapse (Robyn Moroney, 2014). Arthur Anderson, the auditor of HIH Royal Commission Report was not independent as there were lots of threats involved in it. The HIH board of directors included three former partners of Anderson. Anderson was performing non-audit service as well to HIH. Anderson was auditing the company for long time. When company was reluctant to increase the audit fee, Anderson decided to reduce the amount of work performed for the company. Anderson paid the consultation fee to his former partner who was the chairman of HIH board. Theses all facts indicate the presence of familiarity threat to his independence due to his personal relation with HIH directors and self-interest threat due to his long audit relationship with company, fees generating through audit and non-audit services. There is a chance of intimidation threat due to the pressure from HIH for the reduced fees as well. This case also questions about the standards followed by the auditor (Allan, 2018).

There was a similar case known as collapse of the merchant bank Rothwells Limited, where the point was emerging about the need for auditors to resist pressure from the client and maintain a healthy scepticism in dealing with them which require an evaluation of the auditor independence and conflicts of interest of people involved in it (Mills, 1990). In US v. Arthur Young (1984) case, the court demanded that the auditor maintain total independence from the client at all the times and must be responsible to the public trust.

Enron is the another classic case for the corporate collapse due to the lack of audit independence as one of the major reason along with the objectivity by the auditors, series of accounting fraud, failure of the board and poor corporate ethics (Tom Campbell, 2005). The activities such as unapproved employee bonuses paid to managers and executives, manipulation of the financial statement to present the favourable financial position, wrong accounting treatment despite of the auditor’s involvement were highlighted in the report. Arthur Anderson was the audit partner of Enron who was one of the largest audit firm at that time and was a part of “Big Five”. Arthur Anderson was dealing with high profile clients such as Enron, WorldCom and HIH insurance in Australia. The demise of Arthur Anderson is normally linked with Enron case as there were visible lack of audit independence. Arthur Anderson was playing the role of external auditor and at the same time consultant on accounting, internal auditor, tax advisor and reviewer of financial disclosure due to which they earned US$25 million as an audit fees and US$27 million as other service fees from Enron. This create the risk of self-review threat on the audit independence and self-interest threat as there was a fear of losing a large client which lead to failure to inform investors on Enron’s non-disclosures (Tom Campbell, 2005). The firm was convicted in March 2002 which resulted in its ability to audit companies being withdrawn and in June 2002, the “Big Five” became “Big Four” (Tom Campbell, 2005).

Auditor independence is mostly challenge by the close relationship between the auditor and a client company which provide the audit fees. Cases such as WA Chip & Pulp, Pacific Acceptance and Enron are some of the example where the auditing profession became too closely involved with the management of the company and ultimately losing their independence (Ferdinard A. GUL, 2014). The auditor should always maintain an appropriate level of independence from the client to balance the duty to provide quality audit report to the shareholders and public too.

Auditors responsibility has been widened with the time and now has been extended to the third party who are other than the investors, shareholders and stakeholders. The duty of care was not extended to other parties that are not known to auditors till the case of Candler v. Crane, Christmas & Co (1951).  This case made it more difficult for third parties to establish that an auditor owes them of duty of care (Robyn Moroney, 2014).

Unless the Candler case, Scott Group Ltd v. McFarlane (1978) case made the dramatic extension about the auditor’s duty of care toward the third parties. The decision of the New Zealand Court of Appeal in the Scott Group case agreed that the auditors had been negligent when they failed to detect a material error in the accounts of a company. Although the third party who made the decision to take over the business was unknown to the auditor, was owned a duty of care as the third party was relied on the publicly filed audited financial statement of a company (Arens, 2013).

Caparo Industries plc v. Dickman (1990) case made it more difficult for a third party to prove that the auditor owes the duty of care to them as the decision made on this case introduced the concept of reasonable proximity between auditor and third party. As per this case, the auditors only owe a duty of care to the shareholders as a group but not to individual shareholders who may use the financial report to make the decision that auditor may not foresee (Robyn Moroney, 2014).

Opposite to this case, In Columbia Coffee & Tea Pty Ltd v. Churchill (1992) where the Judge held the decision against using the audit firm’s manual to rule that the auditor owed duty of care to the third party. The firm’s manual contained an acknowledge that the third parties can rely on their report. This case again made it easier for the third parties to establish that an auditor owes them duty of care (Robyn Moroney, 2014) (Arens, 2013).

In Esanda Finance Corporation Ltd v. Peat Marwick Hungerfords (1994) case, Esanda sued the auditor claiming they relied on the financial report of Excel Finance Corporation which was negligently audited, in granting finance to the company but the judge made the decision in favour of the auditors which was against the finding in the Columbia Coffee and Tea case. In this case, the judge held that foreseeability alone is not sufficient enough to establish a duty of care, they need to prove the relationship of proximity as well (Arens, 2013) (Robyn Moroney, 2014). This judgement has provided some relief to the auditors as it made difficult for third party to establish that a duty of care is owed by the auditors.

These days third party can request for a privity letter from the auditor to establish proximity before using the audit report to make any decision as this letter will prove that a duty of care was owed to them (Robyn Moroney, 2014).

Auditor independence is mostly challenge by the close relationship between the auditor and a client company which provide the audit fees. Cases such as WA Chip & Pulp, Pacific Acceptance and Enron are some of the example where the auditing profession became too closely involved with the management of the company and ultimately losing their independence (Ferdinard A. GUL, 2014). The auditor should always maintain an appropriate level of independence from the client to balance the duty to provide quality audit report to the shareholders and public too.

Many companies have joined Enron and WorldCom in issuing earnings restatements because of inaccuracies in published financial reports. Adelphia, Bristol-Myers Squibb, FastTrack Savings & Loans, Rocky Mountain Electric, Mirant Energy, Global Crossing, Halliburton, Qwest, AOL Time Warner, Tyco, and Xerox are some of the firms that have come under scrutiny for potentially corrupt management and a clear lack of independent financial monitoring. At the root of both this mismanagement and the failure of monitoring systems lie conflicts of interest. For example, stock options give upper management incentives to boost short-term stock prices at the expense of a company’s long-term viability. And auditors charged with independently reviewing a firm’s financial reports have often been found to be complicit with firm management in this effort (Levitt & Dwyer, 2002). Accounting firms have incentives to avoid providing negative audit opinions to the managers who hire them and pay their auditing fees.


The importance of audit independence has been increased mainly due to the recent audit failures such as Enron, WorldCom, HIH Insurance, Feltex etc. The issue related with the audit independence was not the recent one but was existed when the public start noted that the fees for non-audit service were growing rapidly and auditor were more interested toward the non-audit service than the audit service. Many countries reacted after the failure of big companies where audit independence was in questioned. The corporate law reform in Australia, The Sarbanes-Oxley Act ion the US and CA ANZ was start reviewing their standards. CA ANZ suggested the government to improve the Corporate Reporting standard.

There are various regulations and guidelines as lay down by New Zealand to protect audit independence.

The Company Act 1993 dictates that the company must be appoint an auditor if the financial statements must be audited and it is the responsibility of the shareholders to appoint the qualified auditor at the annual general meeting which can be changed in next annual general meeting if the shareholders wished.  According to the section 207P of the act, the first casual auditor of the company may be appointed by the director of the company till the annual general meeting and then the shareholders decide whether to keep the same auditor or change it.  The authority to choose an auditor was in the hand of shareholders instead of the directors to avoid the scenario where directors can intimidate auditors or bribe them by assuring reappointment. But if the company is the public entity, the Auditor-General is its auditor in accordance with that Act (Companies Act 1993, 2018). The Company Act 1993 (section 207T) allows an auditor to be automatically reappointed at annual meeting of the company unless the auditor was the Auditor-General or unqualified auditor or existing auditor resigned or the company decided to change the auditor in the annual general meeting (Companies Act 1993, 2018). As per the Company Act 1993 (section 207Q) the authority to select the auditor goes to the hand of the Registrar if the annual general meeting of the company is not able to appoint or reappoint an auditor. The company must inform through writing to Registrar within 5 working days of the power becoming exercisable. If the company failed to comply with this section, it considers as an offence and is liable for penalty (Company Act 1993, 2018).

As per the principle 3 of FMA and Listing Rule 3.6.1 of NZX, each publicly owned company should establish an audit committee of the board with responsibilities to recommend the appointment of external auditors; oversee all aspects of the entity-audit firm relationship; and to promote integrity and transparency in financial reporting. The structure of the audit committee is particularly important, both in terms of independence and the skills required(Financial Markets Authority Corporate Governance in New Zealand, 2014).

Under the principle 7 of FMA act and NZX Corporate Governance Code 2017, The board should establish a framework that ensure that there is no relationship between the auditor and the entity or any other related person who can influence the auditor’s independence by obtaining confirmation through the external auditor in writing (Financial Markets Authority Corporate Governance in New Zealand, 2014).

Section 32 of Audit Regulation Act 2011 has set up the minimum requirement and standards for licensing that a person need to be issued with a licence by an accredited body or the FMA. This set up the strict entry requirements for the auditor which is intended to ensure that all auditors have the required qualification, knowledge and skills to carry their duty and role to an acceptable standard (Auditor Regulation Act 2011, 2017).

Section 12 of Auditor Regulation Act 2011 allow professional auditor who gain their qualification and experience overseas if the person meets the minimum standards required by FMA can be the member of one of the recognised body (Auditor Regulation Act 2011, 2017). The auditor who is the member of the licensed body must require completing the competence programmes to maintain their ongoing competence under the section 18 of Auditor Regulation Act 2011. The main purpose behind providing licence and proper ongoing competence programmes to the overseas qualified and experience auditor is to protect the quality of audits which support the independence. New Zealand Institute of Chartered Accountants has been granted accreditation under the section 50 of Auditor Regulation Act 2011 (Auditor Regulation Act 2011, 2017) but FMA must monitor the audit regulatory systems of each accredited body to the extent that it is adequate and effective and if the body are failed to comply with it, they may considered as committed an offence and is liable for fine not exceeding NZ$100,000.00 (Auditor Regulation Act 2011, 2017).

The section 207U of the Company Act 1993 further protect the independence of the auditor by rule for replacing the qualified auditor. Under this section, the company can only replace the auditor by providing 20 working days written notice to the auditor or by giving reasonable opportunity to make representations to the shareholders on the appointment of another person either in writing or by the auditor or the auditor’s representative speaking at a shareholders’ meeting. The auditor is entitled to be paid by the company reasonable fees and expenses for making the representation to shareholders (Companies Act 1993, 2018).

The Company Act 1993 (section 207) clearly stated that the auditor must report to the shareholders of the company instead of any managers or directors on the financial statements audited by them and the report must be comply with the requirements of all applicable auditing and assurance standards (Companies Act 1993, 2018). As per the section 207W of the Company Act 1993 and principle 7.2 of NZX Corporate Governance Code, the board of directors must involve the auditor in the meeting of the shareholders and the auditors are free to communicate the concern of the auditor as auditor (NZX Corporate Governance Code 2017, 2017) (Companies Act 1993, 2018). This section protects the right of the auditor to reveal any information to the public or shareholders that they believe should be disclosed. If the directors of the company have been misleading the auditor by providing manipulated accounting information, then they may try to prevent auditor from reporting this. So, if the directors are failed to involve the auditor in the shareholders meeting, they may liable on conviction to the penalty (Company Act 1993, 2018).

The auditors’ fees and expenses must be fixed for the period it is appointed or till the next annual general meeting by the source they were appointed such as shareholders through meeting or directors if it is casual auditor or Registrar/ Audit-General as per the section 207S of the Company Act 1993. The section of the act prevents the situation where the company bargain about the fees in the middle of the accounting period which help to maintain the independence of the auditors (Company Act 1993, 2018). As per FMA Act, the company should report all the fees paid to the auditor for audit and non-audit services to the shareholders and stakeholders through the annual report along with the details of it and the reason on how it does not affect the objectivity and independence of the auditors (Financial Markets Authority Corporate Governance in New Zealand, 2014). This act really helps the users of report to understand and to get satisfied on auditor’s objectivity and effectiveness and this report also need to include the identification of threat, the mitigation factors and the safeguard used for it.

Paragraph 290.223 of the Code recommends that, in cases involving overdue fees, a professional accountant who is not a member of the audit team should review the audit work, and requires the audit firm to determine whether the overdue fees might be regarded as equivalent to a loan to the client and whether, because of the significance of the overdue fees, it is appropriate for the firm to be reappointed or continue the audit engagement (Professional and Ethical Standard 1, 2016).

Under the recommendation 3.2 of NZX Corporate Governance, no employee of the company can attend the committee meeting without the invitation from the audit committee which protect the independence of the audit committee from any undue influence (NZX Corporate Governance Code 2017, 2017).

As per the FMA Act, it is the audit committee’s responsibility to deal with the complaint against the auditor or the relationship between the auditor and the management which may affect the objectivity, independence and quality of audit work. They are the first reporting point for the whistle-blower (Financial Markets Authority Corporate Governance in New Zealand, 2014). Also, according to the Company Act 1993 and section 290 of the Code of Ethics, an auditor cannot have any employment relationship with the client company or related company such as director, employee, liquidator or receiver. The code also prohibits equity investment in client’s company (Professional and Ethical Standard 1, 2016). An n auditor must ensure that his judgement is not impaired by reason of any relationship with or interest in the company (Company Act 1993, 2018). If an auditor has any financial interest or employment with a client company, the auditor’s ability to make independent evaluations of the fair presentation of financial statements could easily be affected (Arens, 2013).

Financial interests are considered in s. 290 of the Code. Under this section, Equity investment (including options) in clients is specifically prohibited. This section also prohibits an auditor from being an employee, director or officer of a client company. If an auditor has any financial interest or employment with a client company, the auditor’s ability to make independent evaluations of the fair presentation of financial statements could easily be affected (Arens, 2013).

New Zealand has basically followed the IFAC rules as the basis of their requirements. The Code of Ethics for Professional Accountants is in line with the conceptual approach to auditor independence. There are occasions where independence of the auditors may be threatened or appear to be threated so the frameworks identify five threats to independence.

There are infinite of ethical issue that can be faced by professional auditor and thus it is impossible for the code to cover all these situations. Therefore, the code is primarily principle base rather than the rules base in New Zealand. The code is the blended of principles and rule with the heavily reliable on principles (KnowdegEquity – Support for CPA, 2015).

New Zealand has basically followed the IFAC rules as the basis of their requirements. The Code of Ethics for Professional Accountants is in line with the conceptual approach to auditor independence (Ainul Islam, 2005) .

The code of ethics has three parts where part A also establishes the fundamental principles of professional ethics for members and provides a conceptual framework for applying those principles. Parts B and C illustrate how the conceptual framework is to be applied to identify and address threats in specific situations (Arens, 2013).

The ethical principles for the auditors included in part A are integrity, objectivity, Professional competence and due care, confidentiality and Professional behaviour (Arens, 2013).

Conceptual framework approach describes the audit team or review team to achieving mind maintaining independence which comprise of independence of Mind and independence of appearance. The conceptual framework approach comprises of three steps which includes identify the threats to independence, evaluates the significance of the threats and implement safeguards to eliminate or reduce the threats to an acceptable level (Professional and Ethical Standard 1, 2016).

There are occasions where independence of the auditors may be threatened or appear to be threated so the frameworks identify five threats to independence. These threats are: self-interest threat, self-review threat, advocacy threat, familiarity threat and intimidation threat (Malane, 2005).

The code of Ethics classified safeguards in two categories i.e. institutional safeguards and safeguards specific to the work environment. Institutional safeguards are broad such as education and training that can be recognized the person as the professional accountants (Ainul Islam, 2005).

Basing any fees on the outcome of an audit engagement (contingent fees) is prohibited by the subs. 290.219–222 of the Code (Professional and Ethical Standard 1, 2016).

The ‘familiarity threat’ caused by using the same senior personnel on an audit has long been recognised by the professional bodies as a potential problem. Paragraph 290.152 of the Code of Ethics, Principle 7 of NZX Corporate Governance Code, and FMA Act, lead auditor and review partner be rotated every seven year and in case of NZX listed company, it is 5 years (Financial Markets Authority Corporate Governance in New Zealand, 2014) (NZX Corporate Governance Code 2017, 2017). This principle helps the company to balance between the efficiency, cost and independence related with the auditing.

Preparing accounting records and financial statements for audit clients poses a substantial self-review threat. The Code of Ethics permits a public accounting firm to do both bookkeeping and auditing for a client provided it is not a listed entity (or a ‘public interest entity’) and provided any self-review threat is reduced to an acceptable level (section 290.171) (Professional and Ethical Standard 1, 2016).

Section 290.172 of Code of Ethics, generally prohibits the provision of accounting and bookkeeping services to audit clients that are public interest entities. Despite this general prohibition, section 290.173 states that provision of accounting and bookkeeping services of a routine or mechanical nature to divisions or related entity audit clients that are public interest entities would not be impairing independence if the personnel providing the services are not members of the audit team and either:

(a) the divisions or related entities for which the service is provided are collectively immaterial to the financial statements on which the firm will express an opinion; or

(b) the services relate to matters that are collectively immaterial to the financial statements of the division or related entity (Professional and Ethical Standard 1, 2016).

It is suggested that an auditor can demonstrate that undue economic dependence doesn’t place independence at risk by ensuring that the fees from one audit client or group of audit clients don’t exceed an appropriate limit. Individual circumstances make it difficult to set a general limit, but a review and safeguards are needed when the total fees from an audit client exceed 15% of the gross fees of the firm (section 290.222 of the Code) (Professional and Ethical Standard 1, 2016). As per this FMA Act, the accounting firm should not take any work for a client that can compromise or seen to be compromise the quality, independence and the objectivity of the audit process (Financial Markets Authority Corporate Governance in New Zealand, 2014).

Code of Ethics for Assurance Practitioners (PES 1) also contains many requirements about the independence. Code of Ethics requires the auditor preforming audit must maintain independence of mind and appearance both. Auditors need to carefully and continually review the risk related with the financial engagement with client such as audit or non-audit fees and manage risk to their objectivity. It was the auditor to avoid the case where there is financial involvement of family members or involvement of personal relationship etc. It also required the auditors to neither accept or offer the gifts and hospitality which can have a believed to influence their professional judgement. Code of Ethics also include the threat and safeguard mode that have discussed below. These threats can either eliminate or reduced to the acceptable level using the safeguards (Professional and Ethical Standard 1, 2016).


Most threats arise from one of the following sources:

  • Self-interest—when the financial interests of the auditor or relative are involved.
  • Self-review—when an auditor evaluates a situation that is a consequence of a previous judgment or advice by the auditor or the auditor’s firm.
  • Advocacy—when the auditor promotes a position or opinion to the point where subsequent objectivity may be compromised.
  • Familiarity—when an auditor becomes too sympathetic to the interests of another party because of a close relationship.
  • Intimidation—when an auditor’s actions may be compromised by actual or perceived threats.


The Code identifies two broad categories of safeguards that reduce threats to an acceptable level. These are safeguards attributable to:

(a) Safeguards created by the assurance practitioner’s profession, legislation or regulation; and

(b) Safeguards within the firm’s own systems and procedures.


The auditors are professionals who receive a fee from client for his service so the threats to independence of judgement is unavoidable (Siegel, 2002). So, the issue of auditor’s independence has always been an important public concern and a matter of many debates, especially because of the fiduciary role played by the auditors in modern society.

Safeguarding independence is a key component requirement of the regulatory framework which supports capital markets. This independence can be maintained through external constraints (i.e., legislation and regulation) or through the profession itself, which will maintain independence to preserve its market value (Kinney 1999).

Safeguards are actions or other measures that may eliminate threats or reduce them to an acceptable level. They fall into two broad categories:

(a) Safeguards created by the assurance practitioner’s profession, legislation or regulation; and

(b) Safeguards within the firm’s own systems and procedures.

Safeguards created by the assurance practitioner’s profession, legislation or regulation include (Professional and Ethical Standard 1, 2016):

  • Policies and procedures to implement and monitor the quality of employee performance and quality control of engagements.

Every audit firm is supposed to have a policies and procedures in place which gives the staffs an indication as what they should do when they face with the challenges from independence or ethical issue and these policies and procedures should be very descriptive as to what should be done by the firm.

  • Training of staff in these policies and procedures and appropriate disciplinary procedures.

If the firm find a member or staff breach the policies and procedures, the firm should first find out if the staff breach the policies and procedure because they did not know about the policies and procedures. Sometimes the problem is not about the member being unethical, but it was about the situation where members were not informed or properly trained about the policies and procedures. So, the member must get the proper training about the policies and procedure and the disciplinary procedures within it so that if somebody breaches it then they will be discipline accordingly.

  • Using different partners and teams for the provision of non-audit services to assurance clients.

When the other services are provided by the audit firm to the client which create the self-interest threat and it will be major self-review threat and to safeguard it, we can create an invisible wall which means that the different team are created for audit service and for non-audit service.

  • Review of the file by a partner not involved in the audit engagement.

The partner who are not involved in the audit engagement can always review to check that the independence is not compromised and to conduct another review to find out that the quality of the audit is up to the required standard. These reviews must be carried out before the auditor signed the audit report.

  • Discussing ethical issues with those charged with governance and audit committees if one exists.

All threats to independence are brought to the attention of those charged with governance and if required with the audit committee as well.

  • Consultation with another professional accountant.

This include cost, but it can be very useful, if the audit firm is the sole practitioner. If there are any threats to independence, talking to another professional accountant like CA or CPA or institute may help to find some guidance to deal with it.

  • Leadership that stresses the importance of ethical behaviour

If the leader or senior partner of the firm follow the ethics or act in ethical way, it will encourage other staffs to follow the same path and be ethical as well.

  • Audit rotation

This is quite popular one when we look for the safeguards for threats to independence specially when familiarity threats come up. When the auditor audits the same client for long period, it automatically creates a familiarity threats. So if the period of audit to the client is just few years, the risk is quite low so as a safeguards, audit firm can simply let the another partner to review the audit but if the audit period is longer such as 10 years, then the risk is significantly high so audit rotation (rotation of audit partner or even audit manager in some cases) would be better as the safeguard.

In practice, audit rotation is not popular because of the high recurring costs of audits and loss of trust and experience built up. The familiarity threat cause due to long term relationship between auditor and client is a kind of double edge sword as it is also beneficial to the auditor as they are familiar with the business of the client, familiar with their system, know their customers, suppliers therefore, it will be easy for an auditor to identify the risk related with the business. But from ethical point of view, familiarity is a huge problem as the more auditor became familiar with the director, it will be more difficult for him to argue that he is independent.

Auditor professionals will always argue against the audit rotation. This audit rotation is the rotation of the audit firm and from the client point of view when you rotate the audit firm, it involves huge cost implication to the client.

  • Resignation from engagement can be extreme safeguard but in come circumstances the only option available

The ultimate safeguard is resignation. So, if there are major threats to independence that cannot be overcome with any other safeguards then the only thing that will be available would be resignation of the auditor (CPA Ireland, 2017)

Safeguards created by the firm’s own systems and procedures (Professional and Ethical Standard 1, 2016):

  • The client requires persons other than management to ratify or approve the appointment of a firm to perform an engagement.
  • The client has competent employees with experience and seniority to make managerial decisions.
  • The client has implemented internal procedures that ensure objective choices in commissioning non-assurance engagements.
  • The client has a corporate governance structure that provides appropriate oversight and communications regarding the firm’s services.

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