Auditor Independence An International Perspective PDF

Managerial Auditing Journal
Auditor independence: an international perspective

Rocco R. Vanasco
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Rocco R. Vanasco, (1996),"Auditor independence: an international perspective", Managerial Auditing J ournal, Vol. 11 Iss 9
pp. 4 - 48
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Managerial Auditing J ournal
11/ 9 [1996] 448
MCB University Press
[I SSN 0268-6902]
Audi t or i ndependence: an i nt ernat i onal perspect i ve
Rocco R. Vanasco
Director, Centre for Internal Auditing Studies, National-Louis University, Chicago,
Illinois, USA
Examines the role of profes-
sional associations, govern-
mental agencies, and interna-
tional accounting and audit-
ing bodies in promulgating
standards to foster auditor
independence domestically
and abroad. Focuses speci-
cally on the role played by the
American Institute of Certi-
ed Public Accountants, the
Institute of Internal Auditors
(IIA), the Securities and
Exchange Commission and
the US Government Account-
ing Office. Also looks at other
professional associations in
banking, industry, and manu-
facturing sectors dealing with
sensitive issues of auditors'
involvement in such matters
as management advisory
services, operating responsi-
bilities, outsourcing, opinion
shopping, auditor rotation,
and other conicts of interest
which may impair auditor
independence.
Int roduct i on
No person i s an i sland unto hi mself and that
i ndependence i s always a relative ter m.
That i s greater or less, but never absolute[1].
The Ameri can I nsti tute of Certi ed Publi c
Accountants (AI CPA), The I nsti tute of I nter-
nal Audi tors (I I A), the Ameri can Accounti ng
Associ ati on (AAA), the Securi ti es and
Exchange Commi ssi on (SEC) and several
professi onal associ ati ons nati onally and
abroad have emphasi zed that audi tor i nde-
pendence i s both an ethi cal and a
professi onal i ssue cruci al to audi tors. I nde-
pendence has been vi ewed as a deeply felt
professi onal credo. I t i s beli eved that part of
the soluti on i n solvi ng ethi cal di lemmas
regardi ng potenti al and perceived threats to
audi tor i ndependence i s to place more
emphasi s on professi onal ethi cs[2]. The
Ethi cs Commi ttee of the I nter nati onal Feder-
ati on of Accountants (I FAC) has also empha-
si zed the concept of i ndependence as an ethi -
cal i ssue i n i ts gui deli nes on audi tor i ndepen-
dence.
Several authors have come wi th phi losophi -
cal, soci ologi cal, behavi oral, and legal deni -
ti ons of i ndependence and what leads to i ts
i mpai r ment. Eli jah Watts Sells[3] emphasi zed
the i mportance of the audi tors i ndependence
vis--vis the audi tee: The posi ti on of the
publi c accountant wi th respect to corpora-
ti ons and thei r management i s always an
i ndependent one. Unli ke attor neys, accoun-
tants are not expected to make out a case. The
character of the servi ce they render i s i mper-
sonal. Early i n 1928, an edi tori al i n the J our-
nal of Accountancyhi ghli ghted the exi stence
of a coni ct of i nterest when an audi tor i s a
stockholder, offi cer, or di rector of the organi -
zati on. I t stated: The accountant should be
utterly divorced from nanci al or other par-
ti ci pati on i n the success or fai lure of an
undertaki ng under audi t that no one could
ever poi nt an accusi ng nger, however
unjustly, and allege the possi bi li ty of bi as[4].
Mautz and Sharaf[5], i n thei r Philosophy of
Auditing, advocated recogni ti on of three
di mensi ons of audi tor i ndependence whi ch
can mi ni mi ze or eli mi nate potenti al threats
to the audi tors objectivi ty:
1 Programming independencei ncludes:
freedom from manageri al i nterference
wi th the audi t programme;
freedom from any i nterference wi th
audi t procedures; and
freedom from any requi rement for the
revi ew of the audi t work other than that
whi ch nor mally accompani es the audi t
process.
2 I nvestigative independenceencompasses:
free access to all records, procedures,
and personnel relevant to the audi t;
active co-operati on from management
personnel duri ng the audi t exami nati on;
freedom from any management attempt
to speci fy activi ti es to be exami ned or to
establi sh the acceptabi li ty of evi denti al
matter; and
freedom from personal i nterests on the
part of the audi tor leadi ng to exclusi ons
from or li mi tati ons on the audi t exami -
nati on.
3 Reporting independencei ncludes:
freedom from any feeli ng of obli gati on to
modi fy the i mpact or si gni cance of
reported facts;
freedom from pressure to exclude si gni -
cant matters from i nter nal audi t reports;
avoi dance of i ntenti onal or uni nten-
ti onal use of ambi guous language i n the
statement of facts, opi ni ons, and recom-
mendati ons and i n thei r i nterpretati ons;
and
freedom from any attempt to overrule
the audi tors judgement as to ei ther facts
or opi ni ons i n the i nter nal audi t report.
Carey and Doherty[6] came up wi th three
meani ngs of audi tor i ndependence:
Fi rst, i n the sense of not bei ng subordi nate,
i t means honesty, i ntegri ty, objectivi ty and
responsi bi li ty. Second, i n the narrow sense
i n whi ch i t i s used i n connecti on wi th audi t-
i ng and expressi on of opi ni ons on nanci al
statements, i ndependence means avoi dance
of any relati onshi p whi ch would be li kely,
even subconsci ously, to i mpai r the CPAs
objectivi ty as audi tor. Thi rd, i t means avoi d-
ance of relati onshi ps whi ch to a reasonable
observer would suggest a coni ct of i nterest.
Mi chael Barrett[7] i ndi cated that the audi t
professi ons ethi cal noti on of apparent i nde-
pendence can be dened i n a soci ologi cal role
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Rocco R. Vanasco
Auditor independence:
an international perspective
11/ 9 [1996] 448
construct, whereas i ts concepti on of real
i ndependence can be dened as a personali ty
construct. Professi onal audi t i ndependence,
accordi ng to Barrett, has two constructs:
1 I nterpersonal independencedescri bes func-
ti onal si tuati ons whi ch promote or dys-
functi onal si tuati ons whi ch i mpai r the
professi ons audi tor i mage as perceived by
reasonable observers, and
2 I ntrapersonal independencei s the second
order factor contai ni ng three operati onal
content vari ables. I t i s assumed that audi -
tors who are eld analyti cal rather than
global eld types, who evi dence a low
soci al approval need rather than bei ng
approval motivated, and who prefer to
descri be themselves i n ter ms of i ndepen-
dent rather than i nter medi ate or depen-
dent personali ty typologi es tend to pos-
sess a hi gh degree of i ntrapersonal i nde-
pendence as characteri zed by thei r behav-
i or i n test and non-test si tuati ons.
Shockley[8] exami ned the effects of competi -
ti on i n the audi t professi on, management
advi sory servi ces (MAS), and si ze of the audi t
r m i n thi rd-party percepti ons of the exter-
nal audi tor i ndependence. Hi s results show
that all the vari ables si gni cantly affected
thi rd-party percepti ons of audi tor i ndepen-
dence. Knapp[9] also exami ned the effects of a
number of vari ables that could affect thi rd-
party percepti ons of the audi tors abi li ty to
resi st management pressure i n an audi t con-
i ct si tuati on. Hi s results i ndi cate that the
nature of the coni ct, the nanci al condi ti on
of the cli ent, and competi ti on, affected the
percepti ons of the audi tors abi li ty to resi st
management pressure.
Lawrence Sawyer[10] speaks of two ki nds of
i ndependence for i nter nal audi tors:
1 Practitioner independence: when the i nter-
nal audi tor, by reason of a suffi ci ently hi gh
reporti ng status i n the organi zati on, can
mai ntai n an objective atti tude i n for mi ng
opi ni ons and prepari ng reports.
2 Professional independence: the i mage that
i nter nal audi tors bri ng to mi nds of people,
a feeli ng of trust that evi dence has been
gathered wi thout bi as, and opi ni ons have
been expressed freely.
Pasewark and Wi lkerson[11] suggested that
audi tors exami ne the followi ng factors when
consi deri ng i ndependence:
whether the audi tor and the cli ent have
certai n nanci al relati onshi ps, and
whether the audi tor can be consi dered part
of the management or an employee under
management control.
They menti on ve sources of power that have
the potenti al to i nuence the audi tors i nde-
pendence:
1 authori tative power;
2 experti se power;
3 control over rewards;
4 coercive power; and
5 personal power.
When evaluati ng a speci c cli ent or potenti al
cli ent, the audi tor should consi der the
cli ents potenti al to i nuence audi tor i nde-
pendence. As an ai d i n perfor mi ng such an
evaluati on, they recommended the followi ng:
Consi der the cli ent i n ter ms of the ve
sources of power.
Assess the probabi li ty that the cli ent mi ght
exerci se the power possessed.
Consi der how the probabi li ty of the use of
the power mi ght i nuence audi tor i ndepen-
dence.
Accept or reject the engagement on the
basi s of the evaluati on.
Bartlett[12] suggests that the extensive body
of li terature and research concer ni ng audi tor
i ndependence has centred mai nly on alleged
threats to perceived i ndependence or threats
to actual i ndependence. Whenever the i nde-
pendence concept i n accounti ng i s
questi oned, there i s a tendency to be defen-
sive by ci ti ng a ki nd of semi -spi ri tual i ncan-
tati on such as:
No i nstance can be found i n whi ch an audi -
tors i ndependence i s lacki ng.
Surveys i ndi cate that the CPA professi on i s
held i n the hi ghest regard by those who
know what CPAs do.
I f more constrai nts are placed on the profes-
si ons activi ti es, i t wi ll not be able to serve
cli ents properly, leadi ng to si gni cant costs
to the publi c.
I ndependence i s a mental state for profes-
si onal accountants and not subject to
empi ri cal observati on or quanti cati on.
Bartlett beli eves that these semi -spi ri tual
i ncantati ons serve as a poor justi cati on for
the actual exi stence of i ndependence. I f the
mi ssi on of the professi on i s publi c welfare,
and i f the members of the professi on are con-
vi nced that i ndependence actually exi sts,
then i t i s ti me to revi se and restate a concept
of i ndependence that can be observed.
The audi ti ng professi on has come under
constant scruti ny regardi ng the audi tors
perceived i ndependence. Forbes[13] publi shed
an edi tori al questi oni ng audi tor i ndepen-
dence by rai si ng the followi ng: Si nce audi -
tors are selected and pai d by management,
are they truly i ndependent? and the Wall
Street J ournal[14] publi shed another edi tori al
i n whi ch a shareholder cri ti ci zed a $1.6
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11/ 9 [1996] 448
mi lli on loan by the bank to the companys
audi tors on the ground that such loan consti -
tuted a coni ct of i nterest and jeopardi zed the
audi tors i ndependence. The harsh cri ti ci sm
by the publi c and private sectors on audi tors
apparent and perceived i ndependence has led
the AI CPA, the I I A, the SEC and i nter nati onal
accounti ng bodi es to for mulate rules regard-
i ng i ndependence and adopt procedures to
enforce them.
Par t I Prof essi onal assocat i ons,
government , and management
The rol e of t he AICPA
Because i t i s an atti tude or state of mi nd,
i ndependence i s di ffi cult to assess objec-
tively; only an audi tors acti ons can be used
by observers to evaluate i ndependence[15].
CPAs perfor m the attest functi on on commu-
ni cati on of economi c data by one party to
another. The attest functi on adds credi bi li ty
to the communi cati on only i f CPAs are i nde-
pendent and competent. The AI CPA has dealt
wi th the deli cate i ssue of audi tor i ndepen-
dence on several occasi ons. The followi ng
chronology detai ls the evoluti on of thi s con-
cept of CPA i ndependence and affi r ms the
hi gh pri ori ty given i t by the AI CPA. I ndepen-
dence has become the cor nerstone of the
audi ti ng professi on.
The AI CPAs predecessor, the Ameri can
Associ ati on of Publi c Accountants (AAPA),
establi shed i n 1887, di d not recogni ze i nde-
pendence i n i ts consti tuti on and by-laws. I n
1907, i ts bye-laws were amended expressi ng
the desi rabi li ty of avoi di ng i ncompati ble
functi ons. I n 1916, the AAPA was renamed as
the Ameri can I nsti tute of Accountants (AI A).
Both the AAPA and AI A di d not appear to be
actively concer ned wi th audi tor i ndepen-
dence unti l 1930. I n 1931, the AI A recogni zed
the i mportance of the audi tors i ndependence
when CPAs assumed the dual roles of both
di rector and audi tor for a company. To pre-
vent such i ncompati ble functi ons, the AI A
i ntroduced the followi ng:
RESOLVED, that the mai ntenance of a dual
relationship, as di rector or offi cer of a corpo-
rati on, whi le acti ng as audi tor of that corpo-
rati on i s agai nst the best i nterests of the
publi c and the professi on and tends to
destroy that i ndependence of acti on consi d-
ered essenti al i n the relati onshi p between
cli ent and audi tor[16].
The AI As Counci l also recogni zed that a
coni ct of i nterest may ari se when CPAs
certi fy nanci al statements of compani es i n
whi ch they have a substanti al i nterest. To
prevent such si tuati ons, the followi ng was
adopted at the 1934 AI A annual meeti ng:
RESOLVED, that no member or associ ate
shall certi fy the nanci al statements of any
enterpri se nanced i n whole or i n part by
publi c di stri buti on of securi ti es i f he i s
hi mself the actual or beneci al owner of a
substantial nancial interest i n the enter-
pri se or i f he i s commi tted to acqui re such
an i nterest[17].
I n 1940, the nanci al i ndependence rule
became part of the Code of Professional Ethics.
The AI A adopted the followi ng rule on audi -
tor i ndependence:
A member or associ ate shall not express hi s
opi ni on on nanci al statements of any
enterpri se nanced i n whole or i n part by
publi c di stri buti on of securi ti es, i f he hi m-
self i s the actual or beneci al owner of a
substantial nancial interest i n the enter-
pri se or i f he i s commi tted to acqui re such
an i nterest; nor shall a member or an associ -
ate express hi s opi ni on on nanci al state-
ments whi ch are used as a basi s of credi t, i f
he i s hi mself the actual or beneci al owner
of a substanti al i nterest i n the enterpri se or
i f he i s commi tted to acqui re such i nterest,
unless he di scloses hi s nanci al i nterest i n
hi s report[18].
I n 1942, the AI A ampli ed thi s rule and
ali gned i tself wi th the 1937 SEC posi ti on
taken i n the ASR # 2. The AI A added the fol-
lowi ng clause speci fyi ng that the audi tors
i ndependence i s i mpai red:
i f he (audi tor) owns or i s commi tted to
acqui re a nanci al i nterest i n the enterpri se
whi ch i s substantial ei ther i n relati on to i ts
capi tal or to hi s own personal fortune[19].
I n 1947, the AI As Commi ttee on Audi ti ng
Procedures publi shed a speci al report ti tled
Tentative Statement of Auditing Standards.
Their Generally Accepted Signicance and
Scopei n whi ch i ndependence i n fact i s
descri bed as:
I ndependence i n the last analysi s bespeaks
an honest di si nterest on the part of the
audi tor i n the formulati on and expressi on of
hi s opi ni on, whi ch means unbiased judg-
ment and objective consideration of factsas
deter mi nants of that opi ni on. I t i mpli es not
the atti tude of a prosecutor, but the judi ci al
i mparti ali ty that recogni zes an obli gati on
on hi s part for fai r presentati on of facts
whi ch he owes not only to the management
and the owners of a busi ness but also to the
credi tors of a busi ness, and to those who
may otherwi se have a ri ght to rely upon the
audi tors report as i n the case of prospective
owners or credi tors[20].
The 1948 Statement on Auditing Procedures
(SAP) No.23descri bes the ten generally-
accepted audi ti ng standards (GAAS). The
second general standard requi red that i n all
matters relati ng to the assi gnment, an
i ndependence i n mental atti tude i s to be
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mai ntai ned by the audi tor[15]. I n 1950, the
AI CPA publi shed Audits by Certied Public
Accountants: Their Nature and Signicance
emphasi zi ng that I ndependence, both hi stor-
i cally and phi losophi cally, i s the foundati on
of the publi c accountant[21].
I n J anuary 1962, the AI CPA adopted the
followi ng rule on i ndependence as part of the
Code of Professional Ethics:
Article 1: Relations with Clients and the
Public:
1.01 Nei ther a member or associ ate, nor a
r m of whi ch he i s a partner, shall express
an opi ni on on nanci al statements of any
enterpri se unless he and hi s r m are i n fact
i ndependent wi th respect to such enter-
pri se.
I ndependence i s not suscepti ble to preci se
deni ti on, but i s an expressi on of the profes-
si onal i ntegri ty of the i ndivi dual. A member
or associ ate, before expressi ng hi s opi ni on
on nanci al statements, has the responsi bi l-
i ty of assessi ng hi s relati onshi ps wi th an
enterpri se to deter mi ne whether, i n the
ci rcumstances, he mi ght expect hi s opi ni on
to be consi dered i ndependent, objective and
unbi ased by one who had knowledge of all
the facts.
A member or associ ate wi ll not be consi d-
ered i ndependent, for example, wi th respect
to any enterpri se i f he, or one of hi s part-
ners, (a) duri ng the peri od of hi s profes-
si onal engagement or at the ti me of express-
i ng hi s opi ni on, had, or was commi tted to
acqui re, any di rect nanci al i nterest or
materi al nanci al i nterest i n the enterpri se,
or (b) duri ng the peri od of hi s professi onal
engagement, at the ti me of expressi ng hi s
opi ni on or duri ng the peri od covered by the
nanci al statements, was connected wi th
the enterpri se as a promoter, underwri ter,
voti ng trustee, di rector, offi cer, or key
employee.
I n March 1962, the AI CPA moved to prohi bi t
the di rect nanci al i nterest or materi al
i ndi rect nanci al i nterest i n an enterpri se
under audi t by a member[22]. I n 1972, the
AI CPA, i n i ts Restatement of the Code of Pro-
fessional Ethics, stated that i ndependence
has always been a concept fundamental to the
accounti ng professi on, the cornerstone of i ts
phi losophi cal structure and adopted new
rules of conduct regardi ng audi tor i ndepen-
dence[23].
I n November 1972, the AI CPA Commi ttee on
Audi ti ng Procedures i ssued Statement on
Auditing Standards (SAS) No. 1whi ch empha-
si zes audi tor i ndependence both i n fact and
appearance and states:
To be i ndependent the audi tor must be i ntel-
lectually honest; to be recogni zed as i nde-
pendent, he must be free from any obli ga-
ti on to or i nterest i n the cli ent, i ts manage-
ment, or i ts owners[24].
I n the 1980s, several cri ti cs of the professi on
charged that the AI CPA Code of Professional
Ethicsdi d not serve the publi c i nterest. I n
response to these charges the AI CPA for med
the Anderson Commi ttee i n 1983 to revi ew
the Code. Thi s resulted i n 1988 i n the estab-
li shment of a new Code of Professional Con-
duct. The followi ng i ssues were revi ewed:
li mi ted li abi li ty;
cli ent condenti ali ty and whi stleblowi ng;
and
audi tor i ndependence.
Colli ns and Schultz[25] argue that a number
of i ssues sti ll remai n unresolved or
confounded by the new Code and that, i n each
area, the AI CPA promoted a posi ti on that i s
potenti ally har mful to the publi c good.
SAS #58, Reports on Audited Financial
Statementsattempted to close the expecta-
ti ons gap by revi si ng the audi tors standard
report whi ch expli ci tly labels the report as
the I ndependent Audi tors Report to
emphasi ze the audi tors i ndependence. The
expectati ons gap refers to the si gni cant
di fference that exi sted between the level of
condence perceived by nanci al statements
users and the level of condence provi ded by
the audi tor[26].
SAS# 65, Considering the I nternal Audit
Function in an I ndependent Audit of Financial
Statementsstates that when exter nal audi tors
use i nter nal audi t i nfor mati on to reduce
thei r own work, they are obli gated to i nvesti -
gate the i nter nal audi tors i ndependence by
lear ni ng about thei r organi zati onal status
and li nes of communi cati on i n the company.
SAS #65was based on the theory that i nde-
pendence i s enhanced when i nter nal audi tors
report to the hi ghest level of management
and the audi t commi ttee.
Research results i ndi cate that the Bi g Ei ght
audi tors, non-Bi g Ei ght CPAs, bank loan
offi cers, and certi ed nanci al analysts di f-
fered si gni cantly i n the extent of thei r sup-
port for the poli ci es di scussed i n the Cohen
Commi ssi on Report as a means to enhance
audi tor i ndependence[27]. On many occa-
si ons audi tor i ndependence has been ques-
ti oned by the SEC and the medi a whi ch led
the AI CPA to conduct semi nars and publi sh
i ts vi ews on audi tor i ndependence.
I n March 1993, the AI CPA Publi c Oversi ght
Board (POB) publi shed a report, I n the Public
I nterest: I ssues Confronting the Accounting
Profession, expressi ng concer n about the
i ndependence and objectivi ty of the account-
i ng professi on. The POB appoi nted an advi -
sory panel to look i nto thi s matter. The advi -
sory panel, after i ntervi ewi ng 77 professi onal
accountants, busi ness executives, attor neys,
academi cs, and others, concluded there are
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i mportant steps that should be taken to better
assure the i ntegri ty and objectivi ty of audi -
tors judgement[28].
I n J une 1993, the AI CPAs board of di rectors
i ssued a statement enti tled, Meeting the
Financial Reporting Needs of the Future: a
Commitment from the Public Accounting Pro-
fession[29]. The AI CPA endorsed all the rec-
ommendati ons of the Publi c Oversi ght Board
and proposed several accounti ng refor ms i n
order to:
i mprove fraud detecti on;
strengthen audi tor i ndependence;
enhance the usefulness of nanci al reports;
and
di scourage unwarranted li ti gati ons
through congressi onal tort refor m[30].
I n 1993, the AI CPA i ssued Ethics Ruling 97
stati ng that exter nal audi tors:
cannot perfor m management functi ons or
make management deci si ons;
cannot be part of the cli ents approval
process; or
cannot be part of the i nter nal control sys-
tem wi thout i mpai ri ng thei r
i ndependence[31].
I n 1994, the AI CPAs Professi onal Ethi cs Divi -
si on publi shed a proposed i nterpretati on of
the professi ons Code of Professional Conduct
to sharpen the di sti ncti on between cli ent
advocacy and cli ent servi ce. Fi r ms and i ndi -
vi dual CPAs should exerci se professi onal
i ndependence before commi tti ng to cli ent
posi ti ons on accounti ng or nanci al report-
i ng i ssues. The AI CPA Statement on Auditing
Standardsand the Code of Professional Ethics
both emphasi ze i ndependence as a precondi -
ti on i n expressi ng an opi ni on on nanci al
statements. The General Standards of SI AS
No. 1state that I n all matters relati ng to the
assi gnment, an i ndependence i n mental atti -
tude i s to be mai ntai ned by the audi tor or
audi tors.
Rule 101 of the Code deals wi th audi tor
i ndependence and states that: A member i n
publi c practi ce shall be i ndependent i n the
perfor mance of professi onal servi ce as
requi red by the standards promulgated by
bodi es desi gnated by Counci l. I nterpretation
of Rule 101provi des examples of si tuati ons
that would i mpai r an audi tors i ndependence:
I ndependence shall be consi dered to be
i mpai red i f, for example, a member had any
of the followi ng transacti ons, i nterests, or
relati onshi ps:
A Duri ng the peri od of a professi onal
engagement or at the ti me of expressi ng
an opi ni on, a member or a members
r m:
had or was commi tted to acqui re any
di rect or materi al i ndi rect nanci al
i nterest i n the enterpri se;
was a trustee or executor or admi ni stra-
tor of any estate i f such trust or estate
had or was commi tted to acqui re any
di rect or materi al i ndi rect nanci al
i nterest i n the enterpri se;
had any joi nt, closely held busi ness
i nvestment wi th the enterpri se or wi th
any offi cer, di rector, or pri nci pal stock-
holders thereof that was materi al i n
relati on to the members net worth or to
the net worth of the members r m; and
had any loan to or from the enterpri se or
any offi cer, di rector, or pri nci pal stock-
holder of the enterpri se. Thi s proscri p-
ti on does not apply to the followi ng loans
from a nanci al i nsti tuti on when made
under that i nsti tuti ons nor mal lendi ng
procedures, ter ms, and requi rements:
Loans obtai ned by a member or a
members r ms that are not materi al
i n relati on to the net worth of such
borrower;
Home mortgages; and
Other secured loans, except loans
guaranteed by a member or by a mem-
bers r m whi ch are otherwi se
secured.
B Duri ng the peri od covered by the nan-
ci al statements, duri ng the peri od of the
professi onal engagement, or at the ti me
of expressi ng an opi ni on, a member or a
members r m:
was connected wi th the enterpri se as a
promoter, underwri ter, or voti ng trustee,
a di rector or offi cer or i n any capaci ty
equivalent to that of a member of man-
agement or of an employee; or
was a trustee for any pensi on or prot-
shari ng trust of the enterpri se.
The AI CPA Code of Professional Ethicsstates
that a CPA shall not express an opi ni on on
nanci al statements of an enterpri se unless
he and hi s r m are i ndependent wi th respect
to such enterpri se. An opi ni on on the fai r-
ness of presentati on of nanci al statements
should be i ssued only i f he or she i s i ndepen-
dent of the cli ent both i n fact and appearance.
I n other words, i ndependence must be per-
ceived by thi rd parti es.
I n February 1994, the POB and the SEC
Practi ce Secti on (SECPS) appoi nted a three-
member advi sory panel on audi tor i ndepen-
dence. The panels charge was to deter mi ne
whether the SECPS, the accounti ng profes-
si on or the SEC should take steps to better
assure the i ndependence of audi tors and the
i ntegri ty and objectivi ty of thei r judgements
on the appropri ate appli cati on of generally-
accepted accounti ng pri nci ples to nanci al
statements.
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One month later, on 16 March, 1994, the POB
announced the for mati on of a speci al panel
to i nqui re i nto matters relati ng to audi tor
objectivi ty and i ndependence. Thi s was i n
response to the cri ti ci sm made by Walter P.
Schuetze, chi ef accountant of the SEC[32].
The panel recommended appropri ate steps to
bolster the professi onali sm of the i ndepen-
dent audi tor, and to assess the worki ng rela-
ti onshi ps among the professi on, the SEC, and
the FASB[33]. On 13 September, 1994, the
POBs advi sory panel on audi tor i ndepen-
dence i ssued i ts report enti tled Strengthening
the Professionalism of the I ndependent
Auditor[34]. The panel made the followi ng
recommendati ons:
The i ndependence of boards of di rectors
must be enhanced to protect the i nterests of
corporate i nvestors.
The audi tor must consi der the board of
di rectors to be i ts audi t cli ent.
There should be more ti mely, more
frequent, more open, and more candi d com-
muni cati on between the audi tor and the
board.
These recommendati ons were ai med at
i mprovi ng audi tor i ndependence and
strengtheni ng corporate gover nance. The
advi sory panel also publi shed i ts suggesti ons
and recommendati ons on such matters as:
the need for addi ti onal rules on audi tor
i ndependence;
the role of audi ti ng i n publi c accounti ng
r ms;
strengtheni ng the relati onshi p between the
board of di rectors and the i ndependent
audi tor; and
the relati onshi p among audi tors, standard
setters, and the SEC[34].
I n the report, the panel urged the accounti ng
professi on to look to the board of di rectors as
the audi t cli ent, not management. I t called for
a di rect i nterface between the board and the
audi tor at least annually, and an expanded
i nterface wi th the audi t commi ttee[35].
Donald J . Ki rk, chai r of the advi sory panel
on audi tor i ndependence, stressed that the
audi tors role i s not a seller of other servi ces,
by putti ng to work the ski lls and judgements
gai ned i n deali ng wi th control systems and
complex accounti ng i ssues to promote added
value. Audi tor i ndependence i s enhanced
when the audi ti ng professi onal steps i nto the
role of commenti ng on the quali ty of report-
i ng practi ces[36].
The rol e of t he Inst i t ut e of Int ernal
Audi t ors
The professi onal i nter nal audi tor must have
i ndependence to full a professi onal obli ga-
ti on, to render a free, unbi ased, unrestri cted
opi ni on and to report matters as they are
rather than as some executives would li ke to
see them[10].
The I nsti tute of I nter nal Audi tors (I I A) was
founded i n 1941. On 15 J uly, 1947, The I I A
i ssued i ts rst Statement of Responsibilities of
the I nternal Auditor[37] whi ch dened i nter-
nal audi ti ng as an i ndependent apprai sal
activi ty wi thi n the organi zati on for the
revi ew of the accounti ng, nanci al, and other
operati ons as a basi s for protective and con-
structive servi ce to management. I t deals
pri mari ly wi th accounti ng and nanci al
matters but i t may also properly deal wi th
matters of an operati onal nature.
Er nest Meyers[38] reported that early i n the
1950s the i nter nal audi tors role of i nuence
and i ndependence was li mi ted because of
four majors factors:
1 I nter nal audi tors di d not have access
throughout the corporati on and could not
questi on hi gher management deci si ons.
2 The majori ty of i nter nal audi t
departments lacked trai ned professi onal
accountants.
3 Most i nter nal audi t departments were
allowed to concer n themselves only wi th
matters of accounti ng and nanci al
nature.
4 The majori ty of i nter nal audi t
departments reported to lower-level man-
agement.
Gupta[39] observed that management soon
started to reali ze that the reason why thei r
i nter nal audi t staff were not able to make
larger contri buti ons to the enti ty was due to
thei r lack of stature i n the organi zati on. By
allowi ng i nter nal audi tors to report to the
hi ghest echelon of the organi zati on, manage-
ment enhanced i nter nal audi tors i ndepen-
dence as well as thei r stature. Sawyer[40]
beli eves that the enhanced i nter nal audi tor
i ndependence i s not only attri buted to the
managements recogni ti on of the major con-
tri buti ons i nter nal audi tors bri ng to the orga-
ni zati on, but also to the I I As posture i n
expandi ng consi derably the role of the i nter-
nal audi tor by:
departi ng from the tradi ti onal i mage of an
i nter nal audi tor as an accounti ng clerk;
extendi ng the role of the i nter nal audi tor to
operati onal activi ti es; and
havi ng the i nter nal audi tor report to the
hi ghest echelon of management to enhance
audi tor i ndependence.
To professi onali ze the di sci pli ne of i nter nal
audi ti ng and recogni ze i ts expanded i ndepen-
dence, the I I A amended and rened the State-
ment of Responsibilities of I nternal Auditorsi n
1957[41]. The new deni ti on of i nter nal
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Rocco R. Vanasco
11/ 9 [1996] 448
audi ti ng elevates i nter nal audi tors to a part-
nershi p wi th management. I nter nal audi ti ng
i s dened as an i ndependent apprai sal activ-
i ty wi thi n an organi zati on for the revi ew of
nanci al accounti ng and other operati ons as
a basi s for servi ce to management. I t i s a
manageri al control, whi ch functi ons by mea-
suri ng and evaluati ng the effectiveness of
other controls. The Statement was further
rened i n 1971, 1974, and 1981 to reect
si gni cant changes i n the i nter nal audi ti ng
professi on.
I n the 1970s, the board of di rectors of major
corporati ons and professi onal associ ati ons
such as the AI CPA, the Ameri can Accounti ng
Associ ati on (AAA), the Fi nanci al Executives
I nsti tute (FEI ), the Nati onal Associ ati on of
Accountants (NAA), and the I nter nati onal
Federati on of Accountants (I FAC) recogni zed
the changi ng role of i nter nal audi tors, the
relevance of the i nter nal audi ti ng functi on,
and the professi onali sm of i nter nal audi tors.
I nter nal audi tors were reporti ng to the audi t
commi ttee and i ndependent audi tors were co-
ordi nati ng thei r audi t efforts wi th i nter nal
audi tors[42]. I n 1978, the I I A i ssued the Stan-
dards for the Professional Practice of I nternal
Auditing(SPPI A)[43] thus broadeni ng i ts
scope and reaffi r mi ng i nter nal audi tor i nde-
pendence as the most i mportant aspect of the
i nter nal audi ti ng professi on.
Bradford Cadmus[44] eloquently stressed
that i ndependence i s essenti al to the effective-
ness of an i nter nal audi ti ng programme. The
reason why i ndependence i s so i mportant i s
that i t per mi ts i nter nal audi tors to render
i mparti al and unbi ased judgements. I ndepen-
dence for i nter nal audi tors di ffers from that
for exter nal audi tors. I nter nal audi tors, as
employees of the enti ty, do not have the
nanci al i ndependence of an exter nal audi -
tor[45].
The SPPI A[43] requi res that i nter nal audi -
tors be i ndependent of the activi ti es they
audi t. Two i mportant factors contri bute to
i ndependence:
1 The organi zati onal status (110.01) of the
i nter nal audi ti ng department should be
suffi ci ent to per mi t the accompli shment of
i ts audi t responsi bi li ti es. I nter nal audi tors
should have the support of top manage-
ment and the board of di rectors so that
they can gai n the co-operati on of audi tees
and perfor m thei r work free from i nterfer-
ence. I nter nal audi tors should not report
to divi si onal management, li ne managers,
or other persons wi th a stake on the out-
come of thei r ndi ngs. I ndependence i s
thus enhanced when audi tors do not audi t
thei r bosses. I ndependence i s enhanced
when the di rector of the i nter nal audi ti ng
department i s responsi ble to an i ndivi dual
i n the organi zati on wi th suffi ci ent author-
i ty to promote i ndependence and to ensure
broad audi t coverage, adequate consi dera-
ti on of audi t reports, and appropri ate
acti on on audi t recommendati ons.
2 Objectivi ty i s an i ndependent mental atti -
tude whi ch i nter nal audi tors should mai n-
tai n on perfor mi ng audi ts (120.01). Objec-
tivi ty requi res i nter nal audi tors to per-
for m audi t i n such a manner that they
have an honest beli ef i n thei r work product
and that no si gni cant quali ty compro-
mi ses are made (120.02). Thus i nter nal
audi tors should be excluded from li ne
operati ons and i nvolvement i n the
deci si on-maki ng process. Objectivi ty i s
questi oned when i nter nal audi tors report
to divi si onal management, li ne managers,
or other persons wi th a stake i n the out-
come of thei r ndi ngs.
The SPPI A underscores the i mportance of
i ndependence by stati ng: I ndependence
per mi ts i nter nal audi tors to perfor m thei r
work freely and objectively. Wi thout i ndepen-
dence, the desi red results of i nter nal audi ti ng
cannot be reali zed. The SPPI A also
descri bes several means of meeti ng i ts stan-
dards. The gui deli nes for the i ndependence
standards are:
The di rector of the i nter nal audi ti ng
department should be responsi ble to an
i ndivi dual i n the organi zati on wi th suffi -
ci ent authori ty to promote i ndependence
and to ensure broad audi t coverage, ade-
quate consi derati on of audi t reports, and
appropri ate acti on on audi t recommenda-
ti ons.
The board of di rectors should concur i n
the appoi ntment or removal of the di rector
of the i nter nal audi ti ng department.
The purpose, authori ty, and responsi bi li ty
of the i nter nal audi ti ng department
should be dened i n a for mal wri tten docu-
ment (charter). The di rector should seek
approval of the charter by management as
well as acceptance by the board.
The charter should:
establi sh the departments posi ti on wi thi n
the organi zati on;
authori ze access to records, personnel, and
physi cal properti es relevant to the perfor-
mance of audi ts; and
dene the scope of i nter nal audi ti ng activi -
ti es [43].
I ndependence i s so relevant to i nternal audi -
tors that the I I A i ssued ei ght i nterpretati ons
i n i ts Professi onal Standards Bulleti ns
(PSBs). PSB 85-6, I ndependence of I nternal
Auditors vs External Auditors[46] notes that
the greatest si ngle i ssue concer ni ng the
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i ndependence of i nter nal audi tors i s that they
are i nsi de looki ng i n. All audi tors, when i n
compli ance wi th thei r standards, are equally
i ndependent; therefore, all i nter nal and exter-
nal audi ti ng organi zati ons strive to maxi mi ze
managements knowledge and understandi ng
of, and agreement wi th, standards gover ni ng
thei r efforts. I n thi s way, practi cal i ndepen-
dence i s enhanced. PBS 85-6 emphasi zes that
as long as the i nter nal audi tors subscri be and
adhere to the standards and do not have
responsi bi li ty or accountabi li ty for opera-
ti ons subject to revi ew, they may be as i nde-
pendent as any other enti ty provi di ng
apprai sal servi ces to an organi zati on.
PSB 88-4, Steps to Foster I ndependence,
stresses that the organi zati onal
i ndependence of the i nter nal audi t depart-
ment has the greatest i mpact on both actual
and perceived i ndependence. To foster i nde-
pendence PSB 88-4 suggests that the followi ng
addi ti onal cri teri a be consi dered by the di rec-
tor of the i nter nal audi t department:
an audi t charter, outli ni ng the
departments responsi bi li ti es si gned by
the audi t commi ttee whi ch precludes out-
si de i nterferences or repri sals;
peri odi c meeti ngs between the audi t di rec-
tor and the audi t commi ttee wi th i mmedi -
ate access i n ti me of speci al need;
balanced audi t scope and plan approved by
the audi t commi ttee;
adequate budgetary resources;
strong staff quali cati ons, experi ence, and
conti nui ng educati onal requi rements;
rotati on of staff members assi gned to
audi ts; and
the level and organi zati onal posi ti on of
management responsi ble for the perfor-
mance apprai sal and compensati on of the
di rector.
The evoluti on of i nter nal audi ti ng i n the last
50 years has been i n tandem wi th the
expanded concept of i nter nal audi tor i nde-
pendence. The new role assumed by i nter nal
audi tors requi res an unrestri cted i ndepen-
dence i n order to perfor m a vari ety of duti es
wi thi n the organi zati on they serve. The i nter-
face wi th the audi t commi ttee and other con-
sti tuenci es conr m that audi tor i ndepen-
dence i s paramount i n the i nter nal audi ti ng
professi on.
The rol e of t he SEC
I f i nvestors were to vi ew the audi tor as an
advocate for the corporate cli ent, the value
of the audi t mi ght well be lost[47].
The Securi ti es and Exchange Commi ssi on
(SEC) has tri ed to dene i ndependence i n a
seri es of rules and regulati ons whi ch has
played a promi nent role i n fosteri ng audi tor
i ndependence. Over the years the SEC has
i ssued several pronouncements related to
audi tor i ndependence. I t was the SECs i nsi s-
tence on stri ct observance of speci c rules
deni ng i ndependence that led to the i nde-
pendence clause i n the AI CPA Code of Profes-
sional Ethics.
On 6 J uly, 1933, the SEC adopted the follow-
i ng resoluti on:
The Commi ssi on wi ll not recogni ze any
such certi ed accountant or publi c accoun-
tant as i ndependent i f such accountant i s
not i n fact i ndependent. Unless the Commi s-
si on otherwi se di rects, such accountant wi ll
not be consi dered i ndependent wi th respect
to any person i n whom he has any i nterest,
di rectly or i ndi rectly, or wi th whom he i s
connected as an offi cer, agent, employee,
promoter, underwri ter, trustee, partner,
di rector, or person performi ng si mi lar func-
ti ons[48].
The Securi ti es Exchange Act 1934, Secti on
78(1), requi res SEC-regi stered compani es to
i nclude audi ted nanci al statements i n thei r
annual reports to shareholders and to pro-
vi de other nanci al i nfor mati on i n an annual
li ng to the SEC. I n 1936, the SEC amended
thi s rule wi th respect to i ndependence and
adopted the AI CPAs posi ti on prohi bi ti ng any
substanti al i nterest[49]. On 6 May, 1937, the
SEC i ssued Accounting Series Release(ASR)
#2[50] and took the posi ti on that an audi tors
si gni cant i nvestment i n the company
audi ted would i mpai r i ndependence:
The Commi ssi on has taken the posi ti on that
an accountant cannot be deemed to be i nde-
pendent i f he i s, or has been duri ng the
peri od under revi ew, an offi cer or di rector of
the regi strant or i f he holds an i nterest i n
the regi strant that i s si gni cant wi th
respect to i ts total capi tal or hi s own per-
sonal fortune.
I n 1937, the Commi ssi on refused to hold an
audi tor as i ndependent because of hi s sub-
stanti al i nvestment i n the company:
I n a recent case i nvolvi ng a r m of publi c
accountants, one member of whi ch owned
stock i n a corporati on contemplati ng regi s-
trati on, the Commi ssi on refused that the
r m could be consi dered i ndependent for
the purpose of certi fyi ng the nanci al state-
ments of such corporati on and based i ts
refusal upon the fact that the value of such
holdi ng was substanti al and consti tuted
more than 1 percent of the partners per-
sonal fortune.
I n 1939, I n the Matter of I nterstate Hosier, I nc.,
4 SEC 706, 717, the SEC found that a staff
member of a CPA r m had been mai ntai ni ng
cli ent accounti ng records. Further, the nan-
ci al statements had been falsi ed by the staff
member. Clearly, thi s dual role of the i nter nal
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accountant and i ndependent audi tor resulted
i n defeati ng the purpose of the audi t[51].
On 14 March, 1941, the SEC i ssued ASR
#22[52] prohi bi ti ng any i mmuni ty from li abi l-
i ty provi ded to the audi tor by the audi ted
company. Wi lli am W. Wernts, SEC chi ef
accountant, commented thus:
When an accountant and hi s cli ent, di rectly
or through an affi li ate, have entered i nto an
agreement of i ndemni ty whi ch seeks to
assure to the accountant i mmuni ty from
li abi li ty for hi s own negli gent acts, whether
of omi ssi on or commi ssi on, i t i s my opi ni on
that one of the major sti muli to objective
and unbi ased consi derati on of the problems
encountered i n a parti cular engagement i s
removed or greatly weakened. Such condi -
ti on must frequently i nduce a departure
from the standards of objectivi ty and i mpar-
ti ali ty whi ch the concept of i ndependence
i mpli es.
On 7 November, 1942, the SEC i ssued ASR
#37[53] and poi nted out that i n deter mi ni ng
audi tor i ndependence due consi derati on i s
given, not only to the relati onshi ps but also to
the practi ces i nvolved i n renderi ng such
servi ces to the corporati on by the i ndepen-
dent audi tor. On 25 J anuary, 1944, the SEC
i ssued ASR #47[54] and provi ded some sce-
nari os whi ch i mpai r i ndependence:
Both an accountant and a busi ness asso-
ci ate made loans to the regi strant. Fur-
ther, a son of the accountant was an offi -
cer of the regi strant.
The accountant advanced funds to the
regi strant for nanci ng a new depart-
ment.
The regi strant was unable to pay the
accountants fee and the regi strant
pledged shares of i ts own stock to assure
that such fee would be pai d. I n addi ti on,
i t had given the accountant an opti on to
purchase the pledged securi ty at market
pri ce at the opti on date.
The accountant was the treasurer and a
shareholder of a company whi ch sold
some of the regi strants products.
The son of a partner was servi ng as assi s-
tant treasurer and chi ef accountant of a
regi strant. The son resi ded wi th hi s
father.
The accountant audi ted cash reports
prepared by the cli ents staff, entered
them i n a summary record, posted such
data to the general ledger, and made
adjusti ng entri es each month.
I n 1950 the SEC revi sed i ts rule on i ndepen-
dence by deleti ng the word substanti al
from the clause substanti al i nterest thus
reaffi r mi ng i ts ori gi nal posi ti on taken i n 1933
i n whi ch there was a prohi bi ti on agai nst the
accountant havi ng anydi rect nanci al i nter-
est i n hi s cli ent. On 11 December, 1958, the
SEC i ssued ASR #81[55] and hi ghli ghted 34
cases i n whi ch i ndependent audi tors were not
i ndependent. I n 1962, the SEC deci ded that a
CPA rm was not i ndependent because one of
i ts partners also acted as the cli ents legal
counsel[56]. On 21 May, 1963, the SEC i ssued
ASR #97[57] and di scussed the si tuati on
about a CPA who lacked i ndependence si nce
he was one of the three stockholders and was
an offi cer of the company.
On 26 J une, 1972, the SEC i ssued Regulation
S-X. On the i ssue of audi tor i ndependence,
Rule 2-01 of S-X states:
The Commi ssi on wi ll not recogni ze any
certi ed publi c accountant or publi c
accountant as i ndependent who i s not i n fact
i ndependent. For example, an accountant
wi ll be consi dered not i ndependent wi th
respect to any person or any of i ts parents,
i ts subsi di ari es, or other affi li ates (1) i n
whi ch, duri ng the peri od of the professi onal
engagement to exami ne the nanci al state-
ments bei ng reported on or at the date of hi s
report, he or hi s r m or a member thereof
had or was commi tted to acqui re, any di rect
nanci al i nterest or any materi al i ndi rect
nanci al i nterest, or (2) wi th whi ch, duri ng
the peri od of hi s professi onal engagement to
exami ne the nanci al statements, he or hi s
r m or a member thereof was connected as
a promoter, underwri ter, voti ng trustee,
di rector, offi cer, or employee, except that a
r m wi ll not be deemed i ndependent i n
regard to a parti cular person of a former
offi cer or employee i f such person i s
employed by the r m and such i ndivi dual
has completely di sassoci ated hi mself from
the person and i ts affi li ates, and does not
parti ci pate i n audi ti ng nanci al statements
of the person or i ts affi li ates coveri ng any
peri od of hi s employment by the person. For
the purposes of Rule 2-01 the ter m mem-
ber means all partners i n the r m and all
professi onal employees parti ci pati ng i n the
audi t or located i n an offi ce of the r m par-
ti ci pati ng i n a si gni cant porti on of the
audi t.
The SEC has moreover emphasi zed an i mpor-
tant facet of factual i ndependence stati ng:
Perhaps the most cri ti cal test of actuali ty on
an accountants i ndependence i s the
strength of hi s i nsi stence upon full di sclo-
sure of transacti ons between the company
and members of i ts management as i ndivi d-
uals; accessi on to the wi shes of management
i n such cases most i nevi tably rai ses a seri -
ous questi on of whether the accountant i s,
i n fact, i ndependent.
On 5 J uly, 1972, the SEC i ssued ASR #126[58]
and provi ded some gui deli nes for accoun-
tants i n deter mi ni ng the exi stence or lack of
i ndependence. I t stated: The concept of i nde-
pendence, as i t relates to the accountant, i s
fundamental to thi s purpose because i t
i mpli es an objective analysi s of the si tuati on
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by a di si nterested thi rd party. ASR #126
provi des samples of si tuati ons i n whi ch the
audi tors i ndependence could be i mpai red. As
to bookkeepi ng and EDP servi ces, the ASR
stated: Systems desi gn i s a proper functi on
of the quali ed publi c accountant. Computer
programmi ng i s an aspect of systems desi gn
and does not consti tute a bookkeepi ng ser-
vi ce. However, where source data i s provi ded
by the cli ent and the accountants work i s
li mi ted to processi ng and producti on of li st-
i ngs and reports, i ndependence wi ll be
adversely affected i f the li sti ngs and reports
become part of the basi c accounti ng records
on whi ch, at least i n part, the accountant
would base hi s opi ni on[58]. The release also
li sts the followi ng as an example of a si tua-
ti on that i mpai rs audi tor i ndependence:
A cli ent prepared and forwarded to the CPA
tapes to be read on an opti cal scanner. The
CPA merely sent those tapes to a servi ce
bureau and forwarded pri nt-outs of the
nanci al statements and general ledgers
back to the cli ent. Due to the appearance
that the servi ce bureau was acti ng as the
CPAs agent, i ndependence i s i mpai red. I f
i nstead, the cli ent dealt di rectly wi th the
servi ce bureau, no such i mpai r ment would
result.
I n contrast the AI CPA sees no i mpai r ment of
i ndependence i n offeri ng bookkeepi ng or
data processi ng servi ces. Attempts to ali gn
the di fferences between the SECs vi ews and
the AI CPAs rules i n thi s area have been
unsuccessful. The SEC has developed a num-
ber of i ndependence rules, i ncludi ng the
preclusi on agai nst the audi tors owni ng stock
i n a cli ent.
On 23 May, 1973, the SEC i ssued ASR #144
and deter mi ned that the i ndependence of a
large r m has been i mpai red because part-
ners and employees of the branch offi ce
received payments from the general partners
of the cli ent company i n the gui se of prots
from parti ci pati on i n the purchase and sale of
hot i ssues. I n December of 1977, the SEC
i ssued ASR # 234and set forth the gui deli nes
for resolvi ng i ndependence questi ons. The
SEC had taken a more restri ctive vi ew of
i ndependence unti l the J uly 1972 change i n
S-X reporting guidelines for public companies.
I n J anuary 1994, Walter P. Schuetze, chi ef
accountant of the Securi ti es and Exchange
Commi ssi on, made a presentati on ti tled A
mountai n or a molehi ll? at the AI CPAs
Nati onal Conference. He questi oned the i nde-
pendence and objectivi ty of exter nal audi tors
who are not standi ng up to thei r cli ents i n
nanci al accounti ng and reporti ng i ssues
when thei r cli ents take a posi ti on that i s, at
best, not supported i n the accounti ng
li terature or, at worst, di rectly contrary to
exi sti ng accounti ng pronouncements[32].
I n March 1994, the Offi ce of the Chi ef
Accountant (OCA) of the Securi ti es and
Exchange Commi ssi on publi shed a
comprehensive Staff Report on Auditor I nde-
pendence. The report concludes: The OCA
beli eves that the combi nati on of the extensive
systems of i ndependence requi rements
i ssued by the Commi ssi on and the AI CPA,
coupled wi th the Commi ssi ons active
enforcement program, provi des to i nvestors
reasonable safeguards agai nst loss to the
audi ts by accountants that lack i ndependence
from thei r audi t cli ents[59].
Further di fferences between the SEC and
AI CPA on audi tor i ndependence are i ncluded
i n the secti on of cases deali ng wi th outsourc-
i ng, MAS, and other audi ti ng i ssues.
The rol e of t he US General Account i ng
Of fi ce
There i s a global tendency for the gover n-
ment audi t functi on to transcend the tradi -
ti onal parameters of nanci al attestati on
and legi slative compli ance i n order to
espouse broader noti ons relati ng to audi tor
i ndependence, audi ti ng accountabi li ty, and
audi t mandate[60].
Si nce i ts i ncepti on i n 1921, the US General
Accounti ng Offi ce (GAO), an i ndependent
audi ti ng agency of the federal gover nment,
has been charged to perfor m comprehensive
audi ti ng of the federal government agenci es.
I n the 1930s and 1940s, the federal government
mandated that accounti ng be used not merely
as a bookkeepi ng functi on but also as an
i nstrument of management control. Audi ts
were conducted to assess whether gover n-
mental agenci es properly spent and
controlled thei r appropri ati on and compli ed
wi th appropri ate laws and regulati ons. I n the
1950s, the US Congress began requesti ng
i nfor mati on on the effi ci ency of perfor mance
by management at the vari ous federal agen-
ci es. The purpose was to deter mi ne whether
management was usi ng personnel, property,
funds and other resources i n an economi cal
and effi ci ent manner. I n the 1960s and the
early 1970s, the GAO expanded i ts scope and
began evaluati ng the effectiveness of a total
program. Such evaluati ons needed i ndepen-
dent nonadvocate audi tors.
I n 1972, the GAO i ssued Standards for
Audits of Governmental Organizations, Pro-
grams, Activities, and Functionswhi ch set
forth audi t standards for audi tors i n all levels
of gover nment. Such comprehensive gover n-
ment audi ti ng i ncludes three categori es:
1 Fi nanci al and compli ance audi ti ng to
assess whether the enti ty has compli ed
wi th laws and regulati ons of the legi slative
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body and whether nanci al statements
fai rly present the nanci al posi ti on and
the results of operati ons i n accordance
wi th the generally accepted accounti ng
pri nci ples (GAAP);
2 Economy and effi ci ency audi ti ng to assess
whether the enti ty i s managi ng and uti li z-
i ng the resources economi cally and effi -
ci ently and to deter mi ne the causes of
i neffi ci enci es; and
3 Program results audi ti ng to assess
whether the desi red results or benets
establi shed i n the legi slati ng body have
been achi eved and whether the agency has
consi dered alter natives that mi ght yi eld
desi red results at a lower cost[61].
The 1972 GAO standards were revi sed i n 1988,
and agai n i n 1994. There have been substan-
tive changes over the years regardi ng i nde-
pendence.
Studi es conducted by the GAO i ndi cate
substanti al deci enci es i n the quali ty of
audi ts i n the publi c sector. The GAO has
urged some 100,000 publi c enti ti es receivi ng
federal assi stance to organi ze and use audi t
commi ttees to enhance audi tor i ndependence
and to move forward i n pursui t of quali ty
audi ts[62].
The role of the gover nment audi tor and the
related i ndependence i ssue have evolved i n
the last 50 years owi ng to the GAOs changi ng
mi ssi on. The General Standards of the GAO
Standards for Audits[61] requi re that gover n-
ment audi tors be i ndependent:
I n all matters relati ng to audi t work, the
audi t organi zati on and the i ndivi dual audi -
tors, whether gover nment or publi c, should
be free from personal and exter nal i mpai r-
ments to i ndependence, should be organi za-
ti onally i ndependent, and should mai ntai n
an i ndependent atti tude and appearance.
The i nterpretati on of thi s standard i s that
gover nment audi tors shall be certai n thei r
atti tudes and beli efs allow them to be com-
pletely objective and there i s nothi ng that
would lead others to doubt thei r i ndepen-
dence[63].
Gover nment audi tors, li ke exter nal and
i nter nal audi tors, hold i ndependence as a
goal. Audi tors of gover nmental uni ts are
presumed i ndependent when they are:
free from sources of personal i mpai r ment;
free from sources of exter nal i mpai r ment;
organi zati onally i ndependent;
i ndependent under the AI CPA Code of Pro-
fessional Conduct;
elected or appoi nted reporti ng to a legi sla-
tive body of gover nment; or
audi ti ng i n a level or branch of government
rather than the one to whi ch they are nor-
mally assi gned[64].
I nter nal audi ti ng i n the federal government
i s done by the Offi ces of the I nspectors Gen-
eral[65], whi ch were establi shed by the
I nspectors General Act 1978. Anthony
Carrollo, I nspector General of the Envi ron-
mental Protecti on Agency (EPA), brought to
our attenti on that the i ndependence of gov-
er nment audi tors i s more i n li ne wi th the
publi cs percepti on of what audi tor i ndepen-
dence i s or should be, rather than the actual
i ndependence of CPAs or CI As (Memo
addressed to R. Vanasco, 11 March, 1996).
The AI CPA has acknowledged that state
gover nmental audi tors, although gover nment
employees, were suffi ci ently i ndependent
to express audi t opi ni ons that were accept-
able by the federal gover nment i n meeti ng
mandatory audi t requi rements for the pur-
pose of quali fyi ng for revenue shari ng funds.
From ti me to ti me, the GAOs i ndependence
has been questi oned. An edi tori al wrote:
GAO has been functi oni ng lately not as Con-
gresss watchdog but as i ts lapdog[64].
Several countri es are establi shi ng govern-
mental audi ti ng offi ces si mi lar to the US
Gover nment Accounti ng Offi ce and are i ssu-
i ng audi ti ng standards to safeguard thei r
state audi tors i ndependence. I n 1988, Egypt
establi shed the Central Audi ti ng Organi za-
ti on (CAO) as an i ndependent body that helps
parli ament to oversee publi c funds. CAO laws
requi re that state audi tors mai ntai n an i nde-
pendent perspective. To protect thei r i nde-
pendence, CAO laws have i ncorporated the
followi ng safeguards:
seni or audi tors have i mmuni ty privi lege,
and
they can be reli eved from thei r posi ti ons by
a presi denti al decree requi ri ng the
approval of the majori ty of members of the
Peoples Assembly[66].
I n J anuary 1995, the Estoni an parli ament
establi shed the State Audi t Offi ce (SAO). The
legi slati on authori zes the SAO to order i nde-
pendent audi ts to be perfor med by authori zed
i ndependent state audi tors. The law
addresses state audi tors i ndependence by
allowi ng them unli mi ted access to documents
and les[64].
The rol e of t he audi t commi t t ee
Regular communi cati on wi th the board
assures independenceand provi des a means
for the board and the di rector to keep each
other i nfor med on matters of mutual
i nterest[43].
The New York Stock Exchange (NYSE), the
SEC, and the AI CPA have led a concerted
effort to persuade corporati ons to establi sh
audi t commi ttees compri si ng i ndependent
members of the board of di rectors to enhance
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audi t i ndependence. The argument i s that
outsi de di rectors can preserve a hi gher
degree of i ndependence from management
i nuence. To emphasi ze i ndependence from
management, many corporati ons follow the
practi ce of havi ng i nter nal audi tors report to
the audi t commi ttee. I n addi ti on, the exter nal
audi tors are appoi nted by the commi ttee and
elected by the stockholders[68].
More than 80 per cent of publi cly-traded
compani es i n the USA now mai ntai n audi t
commi ttees. The Treadway Commi ssi on
stressed thei r i mportance, and many r ms
are worki ng to revi se and expand thei r audi t
commi ttee charters. Fraudulent nanci al
reporti ng i s more li kely i f i ssues related to
accountant i ndependence and preservati on of
i nter nal audi tor i ndependence have been
omi tted from the charter[69]. I ndependence,
however, i s enhanced when the board concurs
i n the appoi ntment or removal of the di rector
of the i nter nal audi ti ng department[43, 100.3].
I n 1987, Knapp exami ned several factors
affecti ng audi t commi ttees percepti on on
audi tor i ndependence. Hi s results show that
audi t commi ttee members background (cor-
porate managers or non-audi t managers),
audi t r m si ze class (Bi g Ei ght and non-Bi g
Ei ght), objectivi ty of professi onal standards,
and the nanci al condi ti on of the audi tee
si gni cantly affected the extent to whi ch
commi ttee members were wi lli ng to support
exter nal audi tors[70].
I nter nal audi t i ndependence and objectiv-
i ty depend greatly on the i nter nal audi tors
reporti ng relati onshi p wi th the organi zati on.
A survey of chi ef i nter nal audi tors shows
that a strong majori ty of i nter nal audi tors
i ndi cate that vesti ng the hi ri ng-ri ng author-
i ty wi th the audi t commi ttee would enhance
i nter nal audi tor i ndependence, i mprove
oversi ght by the audi t commi ttee, and
i mprove the abi li ty of the i nter nal audi tor to
get acti on on audi t ndi ngs [71].
I n 1993, a comprehensive study, I mproving
Audit Committee Performance: What Works
Best, prepared by Pri ce Waterhouse for the
I I A, stressed that the credi bi li ty of nanci al
reporti ng has been i ncreasi ngly questi oned
and urged all parti es i nvolved i n the nanci al
reporti ng by provi di ng, on behalf of the board
of di rectors, oversi ght of the nanci al report-
i ng process as well as i nter nal controls[72].
I n 1994, the AI CPA advi sory panel on audi -
tor i ndependence recommended that i nstead
of legi slati ng audi t commi ttees functi ons, the
panel should place responsi bi li ty on the i nde-
pendent audi tor to be more forthcomi ng i n
communi cati ng wi th the audi t commi ttee
and the board of di rectors. Stronger, more
accountable boards wi ll strengthen the pro-
fessi onali sm of the audi tor, enhance the value
of the audi t, and serve the i nvesti ng publi c
[73]. Some practi ces that lead to
i ndependence i nclude:
the frequency of audi t commi ttee meeti ngs
wi th the i nter nal audi t executives;
the length of the audi t commi ttee member
ter ms of offi ce; and
the apprai sal of i nternal audi t executive
perfor mance by the audi t commi ttee.
Although these si tuati ons may consti tute an
i deal si tuati on, i t must, however, stri ke a
balance between total i ndependence from
management and the ri sk of ali enati ng man-
agement and i solati ng the i nter nal audi ti ng
department[74].
The i nterchange between audi t commi ttees
and i nter nal audi tors i s more frequent i n the
USA, the UK and Canada than i n J apan. A
recent survey shows that US rms audi t
commi ttees meet wi th i nter nal audi tors four
or more ti mes a year, whereas J apanese audi t
commi ttees meet wi th audi tors twi ce a
year[75]. The Canadi an I nsti tute of Chartered
Accountants study group on audi t commi t-
tees reported that corporate audi t commi t-
tees enhance audi tors perceived i ndepen-
dence, maki ng i t easi er for them to be objec-
tive and not be subject to undue i nuence by
management.
A recent survey conducted by Arthur
Andersen LLP shows that about 56 per cent of
compani es around the world have no audi t
commi ttees. The analysi s reveals large di s-
pari ti es between tradi ti ons i n Canada, the
USA and the UK and those i n other countri es.
Many audi t commi ttees around the world
have no resemblance to Ameri can, Canadi an,
or Bri ti sh audi t commi ttees[76].
The rol e of management
True audi t i ndependence i s sti ll elusive. Too
often we have to temper our opi ni ons
because of poli ti cal i ssues[77].
Management can do much to establi sh an
atti tude of i ndependence by allowi ng audi tors
ample freedom i n selecti ng the operati ons for
study and by i nfor mi ng those responsi ble for
the operati ons under study that the i nvesti ga-
ti on i s fully sancti oned. One of the dangers
for the i nter nal audi ti ng functi on i s the loss
of top management support. Should manage-
ment or the board unduly i nterfere wi th the
audi tor or fai l to support the audi t functi on,
there i s a danger that the audi tors wi ll lose
the necessary i ndependence to perfor m thei r
duti es[63].
The i nter nal and exter nal audi tors must
remai n i ndependent of operati ons and the
deci si on-maki ng process of the organi zati on,
and should remai n i ndependent of undue
i nuence by management. Audi t objectivi ty
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could be jeopardi zed by any perceived or real
i nti mi dati on by management personnel who
mi ght be affected by audi t ndi ngs[78].
A research project sponsored by the I owa
Chapter of the I nsti tute of I nter nal Audi tors
shows that although i ndependence i s a neces-
si ty for the i nter nal audi tor, absolute i nde-
pendence may not be achi evable. The respon-
dents apparent concer ns i n thi s area may
reect some di scomfort wi th the poli ti cal
aspect of the i nter nal audi tors posi ti on and
the ethi cal di lemmas that result[77].
Chadwi ck[74] reported that at an I I A con-
ference, 12 chi ef i nter nal audi t executives of
major publi cly-held compani es were asked
the followi ng three questi ons:
1 What i f the chi ef executive offi cer (CEO)
asked you not to audi t certai n manufactur-
i ng operati ons even though the audi t
engagement had already been speci ed i n
the plan approved by the audi t commi ttee?
2 What i f the CEO asked you not to di scuss
wi th the audi t commi ttee a hi ghly embar-
rassi ng nanci al exposure related to haz-
ardous waste dumpi ng i denti ed duri ng
an audi t of a subsi di ary? and
3 What i f your vi ce presi dent of sales
restri cted audi tor access to hi s or her
travel and expense reports? What would
you do?
None dared to report the above si tuati ons to
the audi t commi ttee because they would be
red and would probably never nd another
job as seni or i nter nal audi t offi ci al. Thi s
si tuati on led Chadwi ck to suggest eli mi nat-
i ng the joi nt reporti ng relati onshi p of i nter-
nal audi t departments to both seni or manage-
ment and audi t commi ttees. To prevent man-
agement i nuence and create a truly i nde-
pendent relati onshi p, the di rector of i nter nal
audi ti ng should report solely to the audi t
commi ttee[74]. J ohn J . Mi ckevi ce, di rector of
i nter nal audi t of the Ameri can Bar Associ a-
ti on and for mer presi dent of the I I A Chi cago
Chapter, commented on Chadwi cks ndi ngs:
Chadwi cks comments are of great i nterest.
Thi s does not bode well for the i nter nal
audi t professi on. I di d not reali ze the chi ef
executives are so weak-wi lled!! No wonder
many of thei r peers have been outsourced!
What i s the relati onshi p of these chi efs to
thei r Audi t Commi ttee? I f the chi efs feel i t i s
unwi se to tactfully report these i mpai r-
ments on thei r scope, how can an effective
relati onshi p be establi shed wi th thei r
respective Audi t Commi ttee? Thi s i s a si g-
ni cant area of i nter nal audi tor i ndepen-
dence. I f the chi efs are too afrai d to address
these i tems, what i s thei r long-ter m value to
thei r organi zati on? (Memo addressed to R.
Vanasco, 15 March, 1996).
Whi tti ngton et al.[79] shows that there i s
every reason to beli eve that audi tors do not
carry out thei r work wi th complete i ndepen-
dence from management. Thi s ari ses from
the anecdotal evi dence of di rectors putti ng
pressure on audi t partners, and audi t part-
ners applyi ng pressure to techni cal partners,
to secure thei r approval for schemes that take
creative accounti ng to, and someti mes
beyond, the li mi ts per mi tted by accounti ng
standards. Some degree of audi tor li abi li ty i s
essenti al i n the absence of complete audi tor
i ndependence.
Hossei ni and Rezaee[80] elaborate on the
partnershi p concept, the shi fti ng from the
tradi ti onal role of the i nter nal audi ti ng as
one of poli ci ng the vari ous uni ts to the orga-
ni zati on to the collaborative approach by
provi di ng a broad range of assi stance to man-
agement, i ncludi ng proactive deci si on-mak-
i ng and problem-solvi ng functi ons. The key
argument agai nst the partnershi p concept i s
that i t may i mpai r i nter nal audi tors i ndepen-
dence i f not properly i mplemented. Thi s sort
of parti ci pative audi ti ng was previ ously
di scussed by Sawyer[10]. Thi s approach to
audi ti ng bri ngs the audi tee i nto the audi t
process as part of a co-operative venture.
He war ns, however, that parti ci pative audi ts
must be dealt wi th very carefully si nce they
may i mpi nge upon audi tor i ndependence.
Par t II The i ndust ry sect or
The banki ng sect or
I ndependence i s perhaps the si ngle most
i mportant attri bute that the CPA bri ngs to
the cli ent-CPA relati onshi p. I ndependence
and the appearance of i ndependence must
be preserved at all costs[81].
Thi rd parti es often rely on the work of i nter-
nal audi tors, so thei r professi onal objectivi ty
i s an i mportant i ssue. A study was under-
taken to deter mi ne whether a r ms manage-
ment can i nuence the professi onal objectiv-
i ty of the r ms i nter nal audi tors. A sample of
58 i nter nal audi tors from three banks parti ci -
pated i n a deci si on-maki ng exerci se i nvolvi ng
i nter nal control systems. The results i ndi cate
that management di d have the abi li ty to i nu-
ence the i nter nal control system evaluati ons
reached by i nter nal audi tors. I I A member-
shi p i s an i mportant deter mi nant of i nter nal
audi torss professi onal objectivi ty[82].
I n Swi tzerland, all compani es or branches
i n the banki ng sector are subject to the sup-
plementary audi ti ng requi rements of the
Swi ss banki ng law whi ch entai ls a detai led
audi t by a rm of speci ali zed i ndependent
bank audi tors recogni zed by the Swi ss Fed-
eral Banki ng Commi ssi on[83].
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The heal t hcare sect or
Professi onal competence i s largely acqui red
through the study of techni cal li terature,
but the i nformati on avai lable that may
per mi t an audi tor to be unequivocally
assured of i ndependence i s much more
uncertai n[84].
Kri shnamoorthy and Sprui ll[85] conducted a
study on the materi al departments of vari ous
hospi tals and concluded that operati onal
audi ts are parti cularly beneci al to the hospi -
tal materi al department because thi s depart-
ment represents one of the major cost centres
i n the hospi tal. Such audi ts have the potenti al
to i ncrease effi ci ency and lead to si gni cant
cost savi ngs. I t can be done by an i nter nal
audi tor or by exter nal consultants. Audi tor
i ndependence i s an i mportant consi derati on
i n ei ther event. The i nter nal audi tors i nde-
pendence can be ensured i f the audi tor has no
di rect connecti on to the materi al or any user
department. Dame[86] beli eves that opera-
ti onal audi ts of materi al transportati on activ-
i ti es can help to reduce frei ght costs by i denti -
fyi ng i neffi ci enci es or i neffective practi ces.
Any i mprovements of transportati on opera-
ti ons can result i n a reducti on of the cost to
purchase materi al and substanti al savi ngs for
the organi zati on.
The muni ci pal sect or
Audi tors must appear i ndependent to audi -
tee managers i f they are to be effective and
effi ci ent[87].
A study was undertaken to exami ne muni ci -
pal i nter nal audi tors and the envi ronment i n
whi ch they functi on. The results of the study
i ndi cate that i nter nal audi tors are i ndepen-
dent to perfor m the task to the best of thei r
abi li ty. A potenti al weakness to thi s conclu-
si on was that most of the respondents di d not
follow the gui deli nes of the I nsti tute of I nter-
nal Audi tors. They were i n vi olati on of the
SPPI A (110.01):
the di rector of the i nter nal audi t depart-
ment should be responsi ble to an i ndivi dual
i n the organi zati on wi th suffi ci ent authori ty
to promote i ndependence and to ensure
board audi t coverage, adequate consi dera-
ti on of audi t reports, and appropri ate acti on
on audi t recommendati ons.
Fai lure to meet thi s gui deli ne i mpai rs audi -
tor i ndependence and poses potenti al coni ct
i n that the i nter nal audi tor reports to those
who made the appoi ntment[88].
The audi t commi ttee i s beli eved to be the
most logi cal avenue for local gover nments to
enhance audi tor i ndependence and sati sfy
the growi ng demands for servi ces wi th li m-
i ted resources. A survey of muni ci pal offi cers
of 164 ci ti es revealed that the audi t commi ttee
activi ti es ranked hi ghest by admi ni strators
i nvolved: (a) faci li tati ng the audi t and (b)
helpi ng to mai ntai n audi tor i ndependence.
The need for a commi ttee to act i n a watchdog
capaci ty i s not necessary i n a muni ci pal set-
ti ng; rather, the drivi ng i ssue seems to be that
of achi evi ng effi ci ency and effectiveness i n
ci ty gover nment[89].
The i nsurance sect or
Although i ndependence i s a necessi ty for
the i nter nal audi tor, absolute i ndependence
may not be achi evable[77].
Audi tor i ndependence i s called for when a
speci al i ndustry sector undergoes cri si s i n
credi bi li ty. The number of i nsolvenci es i n the
i nsurance sector has ri sen to a level that
demands seri ous analysi s. Given the tremen-
dous i nvestment i n i nsurance company li abi l-
i ti es by employee benet plans, i ndependent
credi t evaluati on sources and audi tor i nde-
pendence need to be re-evaluated[88].
Par t II t he i nt ernat i onal arena
The statement that professi onal accountants
i n practi ce should be "i ndependent i n fact
and appearance wi ll be a puzzle i n a collec-
tive culture i n whi ch relati onshi ps and
group membershi p are the cor nerstone of
the organi zati on of soci ety[90].
The I nsti tute of I nter nal Audi tors, i n the
i ntroducti on to the SPPI A, states:
throughout the world i nter nal audi ti ng i s
perfor med i n diverse envi ronments and
wi thi n organi zati ons whi ch vary i n pur-
pose, si ze, and structures. I n addi ti on, the
laws and customs wi thi n vari ous countri es
di ffer from one to another. These di fferences
may affect the practi ce of i nter nal audi ti ng
i n each envi ronment. The i mplementati on
of these Standards, therefore, wi ll be gov-
er ned by the envi ronment i n whi ch the
i nternal audi t department carri es i ts
assi gned responsi bi li ti es.
Thus, cultural di fferences may li mi t the effec-
tiveness of audi tor i ndependence. They are
i mportant to our understandi ng of di ffer-
ences i n the percepti on of audi tor i ndepen-
dence and thei r values because they i denti fy
generally-held beli efs and nor ms of appropri -
ate behavi or i n a country [91]. The concept of
i ndependence i n Chi na and J apan i s ti ed up
to thei r collectivi st culture. I ndivi duali sm i s
consi dered selsh and therefore evi l. The
i ndivi duals self-i nterest i s best guaranteed
by mai ntai ni ng the group wellbei ng. I n ori en-
tal cultures, i ndivi duals are driven not by
thei r personal needs, but rather the need not
to lose face. One loses face by fai li ng to
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Rocco R. Vanasco
11/ 9 [1996] 448
meet the soci al requi rements deemed appro-
pri ate to the soci al posi ti on one occupi es[92].
Stamp and Mooni tz[93] have i denti ed
professi onal i ndependence as one of two key
areas of di ffi culty encountered i n the
i nter nati onal audi ti ng eld. I t i s thei r con-
tenti on that the i mplementati on of profes-
si onal i ndependence i n the multi nati onal
context i s di ffi cult to i mplement. They
beli eve that the steps taken are li kely to be
those that wi ll preserve the outward for m of
i ndependence, objectivi ty and i ntegri ty wi th-
out necessari ly preservi ng i ts essence. To
assess audi tor i ndependence worldwi de, a
representative group of i nter nati onal
accounti ng associ ati ons and several coun-
tri es i n the vari ous conti nents have been
taken as a sample to deter mi ne whether or
not:
gover nments and/ or professi onal associ a-
ti ons requi re that nanci al statements be
audi ted;
statutes descri be factors that i mpai r audi -
tor i ndependence; and
professi onal associ ati ons or soci eti es of
accountants have promulgated audi ti ng
standards that dene the concepts of
i ntegri ty, objectivi ty, and i ndependence.
The gover nment often takes the lead i n devel-
opi ng audi ti ng standards i n countri es that do
not have a well-developed audi ti ng profes-
si on, as well as i n some i ndustri al countri es
that are very legali sti c and prescri ptive.
Int ernat i onal Federat i on of Account ant s
Audi tor i ndependence i n developi ng coun-
tri es i s i mportant si nce the audi tor by pro-
vi di ng credi bi li ty to nanci al statements
faci li tates the allocati on of scarce capi tal
resources i n nanci al and capi tal markets.
Audi tor i ndependence i s also necessary for
for mulati ng i nternati onal har moni zati on of
audi ti ng standards[94].
Founded i n 1977, the I nter nati onal Federati on
of Accountants (I FAC) i s a federati on of
nati onal professi onal accounti ng bodi es. I ts
objective i s the development and enhance-
ment of a co-ordi nated world-wi de accoun-
tancy and audi ti ng professi on and the har mo-
ni zati on of accounti ng pri nci ples and audi t-
i ng standards[95]. I n 1977, I FAC i ssued the
I nternational Audit Guidelines(I AG)[96]. One
of the gui deli nes denes i ndependence as the
abi li ty of the accountants to be and appear to
be free of any i nterest that mi ght be regarded
as bei ng i ncompati ble wi th i ntegri ty and
objectivi ty.
I n 1994, I FACs I nter nati onal Audi ti ng Prac-
ti ce Commi ttee (I APC) i ssued I nternational
Auditing Standard (I AS) No. 10 enti tled Using
the Work of an I nternal Auditor whi ch gives
gui dance to the exter nal audi tors when the
i nter nal audi ti ng functi on i s consi dered i n
deter mi ni ng the nature, ti mi ng, and extent of
the audi t procedures i n nanci al audi ted
statements[97].
The rol e of t he European Uni on (EU)
Above all, we clearly uphold our i ndepen-
dence and objectivi t[98].
The EU Fourth Di rective requi res compani es,
whose annual accounts are requi red to be
audi ted, to appoi nt an audi tor to exami ne the
accounts and express an opi ni on about
whether they present a true and fai r
vi ew[99]. The Ei ghth Di rective, adopted i n
1989 and i mplemented on J anuary 1, 1990,
deals wi th the quali cati ons of statutory
audi tors, reci proci ty, and i ndependence[100].
I ndependence i s one of the areas of strong
di sagreement i n the draft of the Di rective.
Some countri es felt that statutory audi tors
should do nothi ng but audi t nanci al state-
ments, whereas other countri es felt that tax
and advi sory servi ces could be perfor med by
audi ti ng r ms wi thout i mpai ri ng i ndepen-
dence. Si nce no agreement was reached on
i ndependence, the Ei ghth Di rective deci ded
to allow the i ndivi dual member countri es to
deter mi ne the condi ti on for i ndependence.
The Commi ssi on may i ntroduce a speci c
directive on the independence of auditors[101].
Many problems i denti ed i n the current
debate about possi ble EU legi slati on on audi -
tor i ndependence could be remedi ed i f the
professi on were given at least some self-regu-
latory responsi bi li ti es. A si ngle I nsti tute of
Accountants i n Europe i s not the answer.
Rather, the soluti on li es somewhere between
a si ngle i nsti tute and the present
si tuati on[102].
The rol e of t he IASC
Audi tors i ndependence and objectivi ty may
be compromi sed i n a collective culture
where audi tors have extended fami ly
ti es[103].
The role of the I nter nati onal Accounti ng
Standard Commi ttee (I ASC), whi ch was
founded i n 1973, was to contri bute toward the
development and adopti on of accounti ng
pri nci ples and audi ti ng standards that were
relevant and comparable i nter nati onally. The
I ASC developed standards that allowed a
substanti al degree of choi ce, presenti ng two
or more alter native accounti ng approaches
wi th respect to a transacti on[104]. By the end
of 1999, the I ASC and the I nter nati onal Orga-
ni zati on of Securi ti es Commi ssi ons (I OSCO)
plan to have i n place a core set of i nter na-
ti onal accounti ng and audi ti ng standards
that wi ll reduce reli ance on nati onal stan-
dards[105].
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Asi an count ri es
The Chinese perspective
I f culture i nuences a soci etys nor ms and
values, i f i t affects the behavi or of group
i nteracti ons, then audi t i ndependence i n
Chi na should have a consi derably di fferent
mi en from that found i n the West[106].
I n Chi na, i ssues of nati onal i mportance
i nclude promoti ng i ndependent nanci al
audi ts of state enterpri ses. The nati onal regu-
latory authori ty for Chi nas CPA professi on i s
the Mi ni stry of Fi nance. The Chi nese I nsti -
tute of Certi ed Publi c Accountants (CI CPA),
whi ch was establi shed i n late 1988, i s the
organi zati on that actually regulates the pro-
fessi on. Chi na does not have a private profes-
si onal standard board to set nati onal audi t
regulati ons. Regulati ons are set by the gov-
er nment and contai ned i n the Audi t Regula-
ti ons of the Peoples Republi c of Chi na 1989.
The new audi t regulati ons ai m at i mprovi ng
and strengtheni ng the i ndependence of audi -
tors[107]. Audi ts are requi red under the
i ncome tax laws and audi ted nanci al state-
ments are therefore prepared for tax report-
i ng purposes. The audi t requi rements for
forei gn i nvestment enterpri ses are contai ned
i n the Accounti ng Regulati ons of the Peoples
Republi c of Chi na for Enterpri ses wi th For-
ei gn I nvestments promulgated i n J uly
1992[108].
Arti cle 3 of the Audi t Regulati ons of the
Peoples Republi c of Chi na states: The audi t-
i ng organi zati ons execute thei r audi ti ng
work i ndependent of any i nterference from
other gover nment admi ni strative organi za-
ti ons, other soci al groups or i ndivi duals[109].
The audi t bureaux are per mi tted by the new
regulati ons to establi sh an i nter nal audi t
department to perfor m i nter nal audi ts.
The Hong Kong perspective
The advocacy of weak and unsupported
cli ent accounti ng posi ti ons speak loudly
about i ndependence i n fact. I t i s hoped that
through self-restrai nt i ndependence i ssues
wi ll be reexami ned[110].
I n Hong Kong, compani es are i ncorporated
under the Compani es Ordi nance and are
requi red to appoi nt an audi tor to audi t thei r
nanci al statements. The Hong Kong Soci ety
of Accountants has set forth gui dance on
professi onal ethi cs and i ndependence that
are si mi lar to those of the USA. The code of
ethi cs war ns audi tors to exerci se due care,
objectivi ty, and i ntegri ty. They must avoi d
si tuati ons that may i mpai r thei r i ndepen-
dence[111]. Managi ng di rectors share a con-
sensus percepti on of the audi t functi on as an
i ndependent apprai sal of the companys
i nter nal control system. More than 50 per
cent of top management beli eve that
i ndependence of the i nter nal audi tors i s
enhanced when they report to an audi t com-
mi ttee[112].
The J apanese perspective
The hi story of some busi ness fai lures i n
J apan i llustrates the lack of t of the Anglo-
Ameri can focus on i ndependence wi thi n the
J apanese collective culture[113].
The construct of audi tor i ndependence i s
central to the Anglo-Ameri can audi ti ng tradi -
ti on. The noti on of an i ndependent functi on
runs counter to the J apanese beli ef i n the
centrali ty of the group and i ts resulti ng
desi re for privacy[113]. CPAs and audi t corpo-
rati ons are requi red to be i ndependent of
thei r cli ents under both the CPA law and the
securi ti es and exchange law. CPAs or audi t
corporati ons may not render conti nuous tax
servi ces for a fee to audi t cli ents. Tax retur n
preparati on servi ces are i nstead provi ded by
certi ed tax advi sers (CTAs). The by-laws of
the J apanese I nsti tute of Certi ed Publi c
Accountants (J I CPA) i nclude rules of profes-
si onal ethi cs and i ndependence. Audi t stan-
dards are provi ded under the Auditing Stan-
dards, Audit Procedures Rules and Audit
Reporting Rulesi ssued by the Enterpri se
Accounti ng Deli berati on Counci l of the Mi n-
i stry of Fi nance[114]. The J apanese busi ness
law requi res the presence of a statutory audi -
tor to look after stockholder i nterests, the
relati onshi p between the statutory audi tor
and the corporati on i s typi cally of i ndepen-
dence between management and audi tor. I n
reali ty the nanci al and mental i ndepen-
dence necessary for the objective
perfor mance of the statutory audi tors revi ew
and supervi sory duti es remai n absent[115].
Owi ng to the collective nature of J apanese
culture, audi tors have li ttle success i n obtai n-
i ng the speci c documents necessary to i nde-
pendently assess the nanci al posi ti on of the
enti ty audi ted. I nter nal audi tors wi thi n the
J apanese rms appear much less i ndepen-
dent. They report to hi gh-level management
and do not have an audi ence wi th the board of
di rectors[72].
The Malaysian pespective
Si nce ones usefulness as an audi tor i s
i mpai red by any feeli ng on the part of thi rd
parti es that he i s li kely to lack i ndepen-
dence, he has the responsi bi li ty of not only
mai ntai ni ng i ndependence i n fact but also
of avoi di ng any appearance of lacki ng i nde-
pendence[116].
I n Malaysi a, the accounts of all compani es
i ncorporated under the Compani es Act 1965
must be audi ted by an i ndependent audi tor.
I n order to quali fy as audi tor, a person must
be approved by the Mi ni stry of Fi nance. The
Compani es Act requi res audi tors to report to
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the Regi strar of Compani es any breach or
nonobservance of any of the provi si ons of the
Compani es Act[117].
The Singapore perspective
Clearly, i f the i nter nal audi tors are goi ng to
fulll the role of provi di ng reassurances to
boards of di rectors on the relevance and
reli abi li ty of a companys i nter nal control
system, i t i s i mportant that the i nter nal
audi tors are as i ndependent as possi ble
from the executive management[118].
Singapore requires that all registered compa-
nies under the Companies Act have their nan-
cial statements audited. The Singapore Audit-
ing Guideline (SAG) #4, Basic Principles Gov-
erning an Audit, requires auditors to be inde-
pendent, honest, and sincere. They must not
allow prejudice or bias to override their objec-
tivity. Independence is impaired when:
members of the audi tors i mmedi ate fami ly
hold a si gni cant beneci al i nterest i n the
company audi ted;
the audi tor was an offi cer or employee of
the company audi ted; and
the audi tor has di rect or i ndi rect i nterest i n
the company audi ted[117].
European count ri es
The Danish perspective
Growi ng reli ance on nonaudi t servi ces has
the potenti al to compromi se the objectivi ty
or i ndependence of the audi tor by diverti ng
some leadershi p away from the publi c
responsi bi li ty associ ated wi th the i ndepen-
dent audi t functi on[34].
All li mi ted li abi li ty compani es are requi red
to be audi ted i n Denmark by certi ed audi -
tors li censed by the Mi ni stry of I ndustry. To
the Danes, the followi ng consti tutes an
i mpai rment to i ndependence:
CPAs are not allowed to render an opi ni on
on the nanci al statements of a company
that has any ki nd of economi c i nuence i n
the for m i n whi ch the audi tor i s an
employer.
Audi tors are not allowed to receive loans or
guarantees from a company that they audi t.
The followi ng persons are precluded from
acti ng as audi tors:
members of the board of di rectors of a com-
pany;
persons who are employed by the company;
and
persons who are related by marri age, adop-
ti on, or fami ly relati on to the di rectors or
management of the company.
However, renderi ng consulti ng servi ce does
not prohi bi t an i ndivi dual from acti ng as an
i ndependent audi tor[120].
The Dutch perspective
The concept of i ndependence i s at the center
of the audi t functi on. The accounti ng
professi on has long recogni zed the need for
audi tor i ndependence i n both fact and
appearance[121].
The nanci al statements of Dutch compani es
are audi ted to meet statutory and stock
exchange requi rements. I n 1984, the Dutch
adopted the EU Fourth Di rective whi ch
requi res that the annual accounts be audi ted.
The Dutch audi t phi losophy and practi ce i s
si mi lar to the US practi ce. The Code of Ethi cs
has a legi slative status and gives gui dance to
i ts members on matters deali ng wi th audi tor
i ndependence, due care, and professi onal
conduct. The requi rement of objectivi ty and
i ndependence i s detai led i n Arti cle 20 of the
Code. Audi tors engaged i n practi ce may not
perfor m a servi ce for a person, corporati on,
or i nsti tuti on i f they have a vested i nterest
that may affect thei r objectivi ty[122].
The French perspective
I nter nal audi t departments cannot be i nde-
pendent of seni or management because they
depend on them for the same operati onal
needs as any other department i n the orga-
ni zati on[71].
The accounti ng professi on i n France i s
divi ded i nto two mai n bodi es. The Ordre des
Experts Comptables et des Contable Agres
i ncludes all quali ed i ndependent accoun-
tants. The I nsti tute of Statutory Audi tors
(Compagnie Nationale des Commissaires aux
Comptes) i s the professi onal body of offi ci al
statutory audi tors. Statutory audi tors are
required to be i ndependent of thei r cli ents.
Any remunerati on from the cli ent company
other than that for the audi t i s prohi bi ted.
The audi ti ng standards are si mi lar to those of
the USA[123]. I n J anuary 1996, the Federati on
of European Accounti ng Experts released
The Role, Position and Liability of the Statu-
tory Auditor in the European Union whi ch
prohi bi ts the si multaneous provi si on of all
non-audi t servi ces by statutory audi tors.
The Spanish perspective
To opti mi ze the i mage of i ndependence i n
practi ce, an audi tor must remai n free of any
obli gati on or i nterest that would damage
i ndependence i n appearance[124].
I n 1988, the Spani sh gover nment approved a
law requi ri ng annual nanci al statements for
all enti ti es except small compani es. A stock
exchange regulati on provi des that compani es
quoted on the stock exchange must appoi nt
i ndependent audi tors. The I nstituto de Con-
tabilidad y Auditoria de Cuentospubli shed
the audi ti ng standards i n i ts Gazette. The
audi ti ng standards are si mi lar to those of the
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USA and i nclude gui deli nes on audi tors
i ndependence, i ntegri ty, and objectivi ty[125].
The Swedish perspective
The i nternal audi tor i s provi ded wi th the
i ndependence and objectivi ty to look at the
vari ous operati onal activi ti es i n the li ght of
total company welfare, and wi thout the bi as
of speci c i nterests[1].
I n Sweden, the I nsti tute of Authori zed Publi c
Accountants has developed rules of profes-
si onal ethi cs si mi lar to those of the US certi -
ed publi c accountants that i nclude gui de-
li nes on audi tor i ndependence, condenti al-
i ty, and professi onal conduct. The Compani es
Act prohi bi ts the engagement of an audi tor
who i s not personally, professi onally, and
nanci ally i ndependent from the company.
Both the Compani es Act and the I nsti tute of
Authori zed Publi c Accountants consi der
i ndependence i n fact and appearance to be a
requi rement for any audi t engagements[126].
Recently, a Swedi sh law has requi red that
i nter nal audi ti ng of publi c authori ti es be
perfor med i n accordance wi th the I I A Code of
Professional Ethicsand the generally
accepted i nter nal audi ti ng pri nci ples as out-
li ned i n the I I A Standards for the Professional
Practice of I nternal Auditing(SPPI A). Thi s
i ni ti ative proposed by the Swedi sh Nati onal
Audi t Bureau wi ll not only enhance i nter nal
audi tor i ndependence but wi ll also recogni ze
i nter nal audi ti ng as an i nter nati onal profes-
si on. Previ ously, the Swedi sh i nter nal audi t-
i ng had taken three for ms:
1 The i nter nal audi t department served
mai nly as a support uni t for exter nal audi -
tors perfor mi ng nanci al audi t.
2 The i nter nal audi t department perfor med
operati onal audi t and had no responsi bi l-
i ty for nanci al audi ts.
3 There was no i nter nal audi t servi ce at
all[127].
I nter nal audi tors are requi red to provi de
audi t coverage and report the ndi ngs to
management.
The Swiss perspective
The concept of i ndependence i s not
absolute; no audi tors can clai m complete
i ndependence of a cli ent. Rather, i ndepen-
dence i s relative a matter of degree[128].
I n Swi tzerland, corporati ons are requi red to
have one or more audi tors who must be i nde-
pendent of the board of di rectors and share-
holders. They must also be i ndependent of
compani es belongi ng to the same group of
compani es. I ndependent audi tors report on
compli ance wi th legal requi rements and
provi de support to busi ness management on
nanci al matters. The Swi ss I nsti tute of
Certi ed Accounts and Tax Consultants
i ssued ethi cal rules deali ng wi th audi tors
i ndependence and objectivi ty[83].
Angl o-Saxon count ri es
The Australian perspective
Wi thout i ndependence, the value of any
audi tors work to the cli ent or to the i nvest-
i ng publi c i s questi onable. And nei ther
i nternal or exter nal audi tors can clai m to be
i ndependent unless they have the abi li ty to
deter mi ne and control the scope of thei r
audi t tests[129].
Under Australi an corporate law, the audi tor
of a company i s requi red to report to the
shareholders on every balance sheet and
prot and loss account (i ncome statement)
submi tted to shareholders of the company.
The audi tor has the ri ght to access at all
ti mes the accounti ng and other records of the
company and the ri ght to obtai n from offi cers
of the company such i nfor mati on and expla-
nati ons as are requi red for the audi t. Aus-
trali an audi ti ng standards (AUS) are compa-
rable wi th those appli cable i n the USA[130].
AUS #1requi res that audi tors be i ndepen-
dent, honest, and si ncere. They shall mai n-
tai n an i mparti al atti tude and be free of any
i nterest that mi ght be regarded as bei ng
i ncompati ble wi th thei r i ntegri ty and objec-
tivi ty. Audi tors are prohi bi ted from:
bei ng beneci ary owners of shares i n an
audi t cli ent;
acti ng as trustees of a trust or as di rectors
of a corporate trustee company;
accepti ng, maki ng, or guaranteei ng loans
from or to an audi t cli ent;
accepti ng from audi t cli ents goods or ser-
vi ces on ter ms more favorable than those
generally avai lable to others;
accepti ng or retai ni ng a di rectorshi p of a
company that exerts si gni cant i nuence
overanother company that i s an audi t
cli ent;
acti ng i n an executive deci si on-maki ng role
when provi di ng management consulti ng
servi ces to an audi t cli ent;
parti ci pati ng i n the preparati on of the book
of account of a publi c company bei ng
audi ted[131].
The Canadian perspective
I ndependence i s the keystone of the audi t
professi on; wi thout i ndependence, the users
of nanci al statements would not be able to
rely on the audi tors report[132].
I n Canada, an audi tor must be i ndependent,
must be li censed by the provi nce i n whi ch he
practi ces, and must comply wi th the rules of
ethi cs of the organi zati on to whi ch he
belongs. The audi tor has a statute-protected
ri ght of access to all books, records, i nfor ma-
ti on, and explanati ons that he requests[133].
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11/ 9 [1996] 448
The Canadi an Busi ness Corporati on Act
requi res an audi tor to be i ndependent. How-
ever, the Act per mi ts an i nterested person to
apply to the court for an order exempti ng the
audi tor from the requi rement to be i ndepen-
dent. The Act sti ll requi res the audi t to be
conducted wi th generally accepted audi ti ng
standards and the nanci al statements to be
prepared i n accordance wi th generally
accepted accounti ng pri nci ples[134].
The New Zealand perspective
The I nter nal Audi ti ng Standards Board of
the I nsti tute of I nsti tute of I nter nal Audi tors
has been di li gent i n i ts efforts to ensure
i nternati onali zati on of the I I A
Standards[135].
Compani es i ncorporated under the New
Zealand Compani es Act 1955 are requi red to
have thei r nanci al statements audi ted. All
forei gn-owned subsi di ary compani es must
also be audi ted by a New Zealand chartered
accountant. The Code of Ethicsof the New
Zealand Soci ety of Accountants i s si mi lar i n
many respects to those of the USA, Australi a,
Canada, and the UK[136]. The Offi ce of the
Audi tor Generals Guidelines on I ntegrity,
Objectivity, and I ndependencepreclude statu-
tory audi tors who certi fy nanci al
statements of a company from servi ng as
i nter nal audi tors of the company.
The UK perspective
Arguments about what i s needed to safe-
guard the audi tor i ndependence are peren-
ni al. Whatever rules are i ntroduced, the
debate on i ndependence wi ll no doubt be as
lively as i t has been thi s ti me around[137].
The Bri ti sh have emphasi zed audi tor i nde-
pendence for almost two centuri es. The provi -
si on agai nst audi tors servi ng as offi cers or
employees of thei r audi tees has been a land-
mark of the Bri ti sh system. A concer n for the
audi tors i ndependence i n the UK appeared i n
the Compani es Clauses Act 1845, secti on 102,
whi ch prohi bi ted audi tors from servi ng as
offi cers of the company:
Where no other quali cati on shall be pre-
scri bed by the speci al Act, every Audi tor
shall have at least one share i n the undertak-
i ng; and he shall not hold any offi ce i n the
company, nor be i n any other manner i nter-
ested i n i ts concer n, except as a
shareholder[138].
The requi rement of shareholdi ng, however,
has not been retai ned i n the UK as an audi tor
quali cati on as evi denced by the Compani es
Act 1862, whi ch per mi tted but di d not requi re
shareholdi ng[138]. The Compani es Act 1948,
Secti on 161, provi ded that no person who i s
an offi cer or servant of the company i s
quali ed for appoi ntment as audi tor of such
company.
The standards of i ndependence i n the UK
are si mi lar to those i n the USA, although one
major di fference i s that, i n the UK,
i ndependent audi tors are allowed to perfor m
certai n bookkeepi ng functi ons for private
compani es. The Compani es Act 1985 requi res
compani es to i ssue audi ted nanci al state-
ments. Audi tors have the ri ght of access to
books, records, and other perti nent i nfor ma-
ti on as needed to carry out thei r statutory
duti es. The rst statement on ethi cal matters
requi res a member i n publi c practi ce to be
and to be seen to be i ndependent[139]. The
UK amended the Compani es Act 1985 to
i mplement the European Uni ons Ei ghth
Di rective. I t lays down mi ni mum approval
requi rements for company audi tors, i nclud-
i ng thei r educati on and trai ni ng. I t obli ges
member states to ensure that company audi ts
are perfor med wi th i ntegri ty and that there
are appropri ate safeguards to protect audi tor
i ndependence[140].
For over 100 years, the accountancy profes-
si on i n the UK has bui lt i ts reputati on on the
foundati on of objectivi ty, i ntegri ty, and com-
petence whi ch i nclude all that i s requi red for
audi tor i ndependence. Darbyshi re[141] con-
tends that i nvesti gati ons i nto corporate
crashes that have occurred over the past two
decades show that, i n the relatively few cases
where the audi tors role has been challenged,
i n vi rtually no case has lack of i ndependence
been demonstrated or even alleged. I t has
been suggested that, after a number of years,
audi tors become too cosy wi th thei r cli ents.
Although the evi dence presented i s li mi ted, i t
shows that audi t fai lure i s three ti mes as
li kely to occur i n the rst two years after a
change i n audi tor than i n subsequent years.
He beli eves that there i s substanti al evi dence
that audi tors should be separate from thei r
cli ents management, although the US and
Canadi an commi ssi ons have concluded that
there i s no reason to suppose that audi tor
i ndependence i s affected by the provi si on of
non-audi t servi ces.
A questi onnai re survey has revealed a
wealth of detai l as to how audi tors and some
of the mai n parti ci pants i n the UK company
nanci al report process di ffer i n thei r vi ews
regardi ng the nature of audi ti ng and the work
that audi tors do. The survey conr ms the
extent of the audi tors responsi bi li ti es to
thi rd parti es, the nature of balance sheet
valuati on, the strength of, and conti nui ng
threats to, audi tor i ndependence. The results
of the factor analysi s of activi ty constructs
provi de evi dence of the prevalence of i nde-
pendence-related attri butes i n assessments of
the contri buti on and quali ty of audi ti ng[142].
Owen Green[143] has called for a greater
audi tor i ndependence and an i n-depth revi ew
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Rocco R. Vanasco
11/ 9 [1996] 448
of the audi ti ng professi on i n the UK. He
argues that such a system would restore the
audi tor as watchdog and release nonexecu-
tive di rectors to a more constructive role.
Afri can count ri es
The Africa perspective
As the eyes and ears of the audi t commi ttee,
i t i s essenti al that i nter nal audi tors be truly
i ndependent[71].
Audi ti ng has always been seen as an ali en
phenomenon i n most parts of the Thi rd
World, especi ally i n Afri ca. Thi s i s because of
Afri cas hi story, culture, and collective way of
li fe . The Charter, as dened by the I nsti tute
of I nter nal Audi tors, does not really seem to
give that unrestri cted scope to Thi rd World
audi tors. I f audi ti ng i s a reecti on of culture,
applyi ng the I I A standards of i ndependence
and objectivi ty poses a seri ous di lemma to
Thi rd World audi tors[103].
The Nigerian perspective
I n the Thi rd World countri es, an objective
audi tor i s not always accepted by manage-
ment as loyal. The audi tor i s made to feel
helpless and totally dependent on manage-
ment[100].
Ahmed Opetubo[144], i n hi s Masters thesi s
on Percepti ons of Ni geri an audi tor i ndepen-
dence, showed that publi c accountants and
users of certi ed statements di sagree about
the role that the audi tors i ndependence plays
i n the audi t envi ronment. Thi s di screpancy
reects the cultural and poli ti cal bi as i n
Ni geri an soci ety.
Sout h Ameri can count ri es
The Argentine perspective
Rules on i ndependence are stated, usually i n
general ter ms, but are appropri ately devel-
oped and dened by the techni cal i nsti tu-
ti ons[145].
I n Argenti na, annual nanci al statements of
all compani es must be audi ted by an i ndepen-
dent publi c accountant. The audi tors report,
i ssued after an exami nati on made i n accor-
dance wi th dened audi ti ng standards, must
be led wi th regulatory authori ti es. Audi ti ng
standards are si mi lar to those of the USA and
are embodi ed i n Technical Pronouncement
No. 7of the Argenti ne Federati on of Profes-
si onal Counci ls of Economi c Sci ences. Audi t-
i ng standards i nclude gui deli nes deali ng
wi th audi tor i ndependence, i ntegri ty, and
objectivi ty[145].
The Mi ddl e East
The Israeli perspective
Professi onal competence i s largely acqui red
through the study of techni cal li terature,
but the i nformati on avai lable that may
per mi t an audi tor to be unequivocally
assured of i ndependence i s much more
uncertai n[84].
The I sraeli legi slature, the Knesset, passed
the I nter nal Audi ti ng Act 1992 on 16 March,
1992. The new law makes the State of I srael
one of the few to award such expli ci t statu-
tory status and gover nmental recogni ti on to
the i nter nal audi t functi on and the role of the
i nter nal audi tor. I t requi res publi c i nsti tu-
ti ons to establi sh the i nter nal audi ti ng func-
ti on i n thei r organi zati on. The legi slati on has
safeguards for audi tor i ndependence.
The I sraeli Securi ti es and Exchange Com-
mi ssi on Act 1968 and gui deli nes publi shed on
24 J uly, 1989, by the I sraeli I nsti tute of Certi -
ed Publi c Accountants preclude statutory
audi tors who certi fy nanci al statements of a
company from servi ng as i nter nal audi tors.
The Russian Federation perspective
As long as i nter nal audi ti ng staffs are
hi ghly ski lled, effi ci ent and responsive to
management, organi zati ons are best served
by keepi ng the i nter nal audi t functi on i nter-
nal[146].
Audi ti ng i n the Russi an Federati on i s i n i ts
i nfancy. I n December 1993, the Presi denti al
Commi ssi on on Audi ti ng Activi ty started to
i ssue li cences to audi ti ng r ms to carry out
audi ti ng activi ti es. The Commi ssi on plans to
co-ordi nate audi ti ng practi ces and i ssues
gui deli nes deali ng wi th audi tors objectivi ty,
i ntegri ty, and i ndependence[147].
Par t IV Cases i mpai ri ng audi t or
i ndependence
Although i ndependence i s a necessi ty for
i nternal audi tors, the respondents i n thi s
area reect some di scomfort wi th the poli ti -
cal aspect of the i nter nal audi tors posi ti on
and the ethi cal di lemmas that result[74].
Several si tuati ons may i mpai r the audi tors
i ndependence, such as conti ngent fee
arrangements, gi fts, audi tors overfami li ari ty
wi th personnel or operati ons, management
advi sory servi ces (MAS), outsourci ng, opi n-
i on shoppi ng, reporti ng relati onshi ps, and
others. The li ne of what consti tutes i mpai r-
ment to the audi tors i ndependence may be
debatable and subject to cultural, economi c,
envi ronmental, legal, and poli ti cal bi ases.
Even i n the USA, we wi tness that despi te the
many si mi lari ti es between the SEC rules on
i ndependence i n Rule 2-01(b) of Regulation
S-X and the AI CPA I nterpretation of Rule 101
of the Rules of Conduct, there are substantive
di fferences i n the way the two regulatory
bodi es i nterpret coni ct of i nterests, fami ly
relati ons, nanci al i nterests, for mer
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partners, outsourci ng, MAS, and other mat-
ters related to audi tor i ndependence. Thus
divergent vi ews may ari se from the AI CPAs
advocacy posture i n the expandi ng role of the
exter nal audi t work and i n the SECs posi ti on
i n protecti ng i nvestors, credi tors, and the
publi c.
Coni ct of i nt erest
I ndependence means that an audi tor should
be objective and unbi ased. An audi tor does
not subordi nate hi s judgement to pressures
from others and avoi ds relati ons that would
appear to others to create a coni ct of i nter-
est[148].
The SEC considers independence impaired in
most cases when a spouse, dependent person
or someone else in the members household
has a direct or material indirect nancial
interest, or when non-dependent close rela-
tives have material direct nancial interests in
or management relationship with an audit
client. The AICPA, however, makes allowance
for the audit sensitivity of a relatives
employment, letting independence be consid-
ered intact if the position is not sensitive.
Overall, the AICPA position appears to be very
exible and permits assessment of the circum-
stances in each case[64)] The SEC considers
the rms independence impaired if:
a for mer partner becomes a member of the
board of di rectors of the audi tee wi thi n two
years after hi s resi gnati on or reti rement;
a for mer partner who was promi nent i n hi s
r m becomes a di rector of a cli ent of the
accounti ng rm wi thi n ve years; and
a for mer partner becomes an executive of a
cli ent of the accounti ng rm wi thout a total
separati on, i ncludi ng settlement of reti re-
ment benets from the r ms.
Although the AI CPA rules are si mi lar, they
do not contai n the speci c ti me li mi ts[63].
The perfor mance of duti es that coni ct
wi th the i nter nal audi t role consti tutes a
potenti al i mpai r ment to i nter nal audi t objec-
tivi ty. The underlyi ng phi losophy of a poli cy
deali ng wi th coni ct of i nterest i s to ensure
all concer ned employees avoi d si tuati ons
whi ch mi ght be i nterpreted as a coni ct
between thei r personal i nterests and those of
the organi zati on (PSB 84-7). The I I A Stan-
dards for the Professional Practice of I nternal
Auditingsuggest that i nter nal audi tors
should report to the di rector of i nter nal
audi ti ng any si tuati on i n whi ch a coni ct or
bi as i s present or may be reasonably i nferred.
I n such ci rcumstances, the di rector should
reassi gn the i nter nal audi tors (120.02.2). Arti -
cle I V of the I I A Code of Professional Ethics
addresses i ndependence by prohi bi ti ng i nter-
nal audi tors from enteri ng i nto activi ti es
whi ch may be i n coni ct wi th the i nterest of
thei r organi zati on or whi ch would prejudi ce
thei r abi li ty to carry out objectively thei r
duti es and responsi bi li ti es. Vi olati on of the
I I A Code of Professional Ethics i s subject to
forfei ture of membershi p i n the i nsti tute and
the certi ed i nter nal audi tor desi gnati on.
Fi fty-four audi t partners parti ci pated i n a
study by completi ng hypotheti cal audi t cases
desi gned to allow varyi ng ranges of accept-
able accounti ng alter natives. Thi s i nvesti ga-
ti on revealed that the degree to whi ch r ms
emphasi zed local offi ce perfor mance i n deter-
mi ni ng i ndivi dual partner compensati on was
a di scri mi nati ng feature of compensati on
schemes. Thi s represents an audi t-cli ent
coni ct i n audi t judgements[149].
I n the UK, the Guidance for I nternal Audi-
torsstates that the i nter nal audi tor, notwi th-
standi ng hi s employment, should be free from
any coni ct of i nterest ari si ng ei ther from
perfor mance or personal relati onshi ps or
from pecuni ary or other i nterests i n an orga-
ni zati on or activi ty whi ch i s subject to
audi t[150]. The 1991 Ethics, I nterpretations
and Rulingsof the J oi nt Ethi cs Commi ttee of
the I nsti tutes of Chartered Accountants i n
England and Wales (I CAEW), Scotland (I CAS)
and Norther n I reland (I CANI )[151] give exam-
ples of cases i n whi ch i ndependence may be
deemed to be i mpai red. For i nstance, i nde-
pendence would be consi dered to be i mpai red
wi th respect to a cli ent for whom the member
or the cli ent has guaranteed a loan for the
other party. I f the guarantee exi sts duri ng the
peri od of the professi onal engagement or at
least at the ti me of expressi ng an opi ni on,
i ndependence would be consi dered i mpai red.
Another case of i mpai red i ndependence
ari ses when an i ndivi dual parti ci pati ng i n an
engagement, who i s offered employment by,
or seeks employment wi th, that cli ent duri ng
the conduct of the engagement must consi der
whether or not hi s or her abi li ty to act wi th
i ntegri ty and objectivi ty has been i mpai red.
When the engagement requi res
i ndependence, the i ndivi dual must remove
hi mself or herself from the engagement unti l
the employment offer i s rejected or employ-
ment i s no longer sought, i n order to prevent
any appearance that i ntegri ty and objectivi ty
have been i mpai red[152].
Cont i ngent fees
Conti ngent fee agreements may tempt a
practi ti oner to i ssue the wrong opi ni on[148].
Conti ngent fee i s a fee establi shed for the
perfor mance of any servi ce pursuant to an
arrangement i n whi ch no fee wi ll be charged
unless a speci ed ndi ng or result i s
attai ned, or i n whi ch the amount of the fee i s
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otherwi se dependent upon the ndi ng or
result of such servi ce. Rule 302 of the AI CPA
Code of Professional Conduct prohi bi ts
conti ngent fees i n attest engagements where
users of nanci al i nfor mati on may be relyi ng
on the CPAs work. Acceptance of conti ngent
fee arrangements i s consi dered an i mpai r-
ment of i ndependence. There are, however,
excepti ons i n tax matters as descri bed i n Rule
302-1. As of J anuary 1990, state laws and
board of accountancy rules i n 48 states pro-
hi bi t conti ngent fees. Some professi onal li a-
bi li ti es i nsurance poli ci es exclude conti n-
gency-fee arrangements from thei r malprac-
ti ce[153].
Report-conti ngent audi t contracts may
appear i nherently undesi rable because they
seem to compromi se audi tor i ndependence.
An analysi s conducted shows that a si ngle
audi tor wi th a si ngle cli ent may seek to
employ a conti ngent contract, even though
audi tors collectively would prefer to ban
conti ngent fees. I n addi ti on, i t i s possi ble to
i denti fy certai n condi ti ons under whi ch
expandi ng audi tors contracti ng opportuni -
ti es may reduce competi ti on[154].
Di scl ai mer of opi ni on
The i ndependent publi c accountant must be
wi thout bi as wi th respect to the cli ent; oth-
erwi se, he would lack that i mparti ali ty
necessary for the dependabi li ty of hi s nd-
i ngs[155].
Another reason for a departure from the
standard report i s when the audi tor i s not
i ndependent. SAS No. 26states:
When an accountant i s not i ndependent, any
procedures he mi ght perform would not be
i n accordance wi th generally accepted
audi ti ng standards, and he would be pre-
cluded from expressi ng an opi ni on on such
statements. Accordi ngly, he should di sclai m
an opi ni on wi th respect to the nanci al
statements and should state speci cally that
he i s not i ndependent[155].
I n hi s di sclai mer, the audi tor:
should not menti on any reasons for not
bei ng i ndependent because the reader
mi ght erroneously i nterpret them as uni m-
portant;
should make no menti on of any audi t proce-
dures appli ed because readers mi ght erro-
neously conclude that they were suffi ci ent;
and
should label each page of the nanci al state-
ment as bei ng unaudi ted.
The di sclai mer of opi ni on should read as
follows:
We are not i ndependent wi th respect to XYZ
company, and the accompanyi ng balance
sheet as of December 31, 199X and the
related statements of i ncome, retai ned
earni ngs, and cash ows for the year then
ended were not audi ted by us and accord-
i ngly, we do not express an opi ni on on them.
I n J apan, i f the audi tors di sclai m an opi ni on,
the fact and reasons thereof, i ncludi ng nonap-
pli cati on of i mportant audi t procedures, must
be i ndi cated[114].
Di scl osure of sensi t i ve i nformat i on
Although the appearance of i ndependence
does not guarantee i ndependence i n fact,
such appearance i s essenti al i n mai ntai ni ng
publi c condence[63].
Rule 301 of the AI CPA Code of Professional
Conduct denes condenti al i nfor mati on that
i nfor mati on whi ch should not be di sclosed to
outsi de parti es unless demanded by a court
or an admi ni strative body havi ng subpoena
power. The Code speci cally provi des that the
condenti al relati onshi p must not i nfri nge
upon audi tor i ndependence and obli gati on to
fully and fai rly report on audi ted nanci al
statements. I n the US v. Arthur & Young, the
US Supreme Court stated:
The i ndependent publi c accountant per-
for mi ng the audi t functi on owes ulti mate
allegi ance to the corporati ons credi tors and
stockholders, as well as to the i nvesti ng
publi c... I f the audi tor were convi nced that
the scope of the audi t had been li mi ted by
managements reluctance to di sclose mat-
ters relati ng to tax accruals, the audi tor
would be unable to i ssue an unquali ed
opi ni on on the corporati ons nanci al state-
ment.
I nfor mati on i s not consi dered condenti al i f
di sclosure of i t i s necessary to make nanci al
statement not mi sleadi ng. Di sclosure of sen-
si tive i nfor mati on may i mpai r objectivi ty
and i nter nal audi tor i ndependence. An exper-
i ment was conducted to deter mi ne the predi c-
ti on-task judgement of 54 i nter nal audi tors
from the publi c and private sector. The
results of thi s experi ment suggest that i nter-
nal audi tors beli eve that di sclosure of sensi -
tive i nfor mati on such as fraud i s unli kely,
especi ally when di sclosure would result i n
job ter mi nati on. Di sclosure i s i nuenced by
the channel the i nter nal audi tor uses to com-
muni cate i nfor mati on and i s not affected by
the posi ti on of the i nter nal audi ti ng depart-
ment wi thi n the organi zati on[156].
Gi ft s
I ndependence i s a cor nerstone of the
accounti ng professi on, but i t i s di ffi cult to
prove and easy to challenge[2].
Gi fts and di scounts received by the audi tors
consti tute the most frequent coni ct of i nter-
est concer ni ng audi tor i ndependence. The
I I As professi onal standards state that
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Rocco R. Vanasco
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i nter nal audi tors should be objective i n per-
for mi ng an audi t. Accepti ng a fee or gi ft may
i mply that the audi tors objectivi ty has been
i mpai red. The I I A Code of Professional Ethics
also prohi bi ts i nter nal audi tors from accept-
i ng a fee or gi ft from an employee, a cli ent, a
customer, or a busi ness associ ate of thei r
employer wi thout the knowledge of seni or
management. No consi derati on should be
given to the audi t status as justi cati on for
receivi ng fees or gi fts. I n J apan, small gi ft
exchanges should be vi ewed as a part of the
cultural eti quette rather than as a compro-
mi si ng of audi t i ntegri ty[115].
Incent i ve pl ans
As long as the audi ti ng department i s a part
of the enterpri se and receives i ts li fe support
from the enterpri se, i t must reli nqui sh some
i ndependence[10].
The I I As Professi onal Standards Bulleti n
PSB 83-26 di scusses the i mpact of
bonus/ i ncentive plans on the i nter nal audi -
tors i ndependence. PSB 83-20states that
bonus/ i ncentive compensati on programmes,
whi ch are an i ntegral part of the organi za-
ti ons compensati on programme and admi n-
i stered by the board or i ts salary admi ni stra-
ti on commi ttee, would not i mpai r audi t objec-
tivi ty. However, i f such programmes are based
on operati ng results, i t may i mpai r audi t
objectivi ty. PSB 87-8poi nts to the possi bi li ty
that an audi t manager may fai l to report the
results of the audi t work completely or
release the results of the audi t work wi th
ti mi ng favourable to the bonus/ i ncentive
compensati on[157]. The PSB war ns that extra
care needs to be taken i n desi gni ng a
bonus/ i ncentive plan for audi tors due to the
uni que reporti ng responsi bi li ti es they have
i n the organi zati on. Numerous busi nesses
are, however, i ncludi ng audi tors i n i ncen-
tive/ results shari ng types of programmes.
These can have posi tive i mpacts i n that they
sharpen the i denti cati on of audi tors wi th
i mprovi ng operati ng results.
There i s also a concer n that the audi tors
expected economi c benet from keepi ng a
cli ent (the value of i ncumbency) may affect
audi tor i ndependence towards that cli ent.
Magee and Tseng[158] demonstrated that,
when all audi tors agree as to whether a
reporti ng deci si on i s consi stent wi th gener-
ally accepted accounti ng pri nci ples (GAAP),
a posi tive value of i ncumbency should not
lead to a compromi se of i ndependence when
audi tors di sagree about the proper treatment
of an i tem. These conclusi ons are based on
the assumpti on that an enforceable ban on
conti ngent contracts exi sts between audi tor
and cli ent.
Trompeter[149] exami ned the i mpact of
audi t partner compensati on schemes and
generally accepted accounti ng pri nci ples
(GAAP) on audi t judgements i nvolvi ng
audi tor-cli ent coni ct. These factors are
i mportant because of thei r potenti al i mpact
on audi tor i ndependence and objectivi ty.
Fi fty-four audi t partners parti ci pated i n a
study by completi ng hypotheti cal audi t cases
desi gned to allow varyi ng ranges of accept-
able accounti ng alter natives. Thi s i nvesti ga-
ti on revealed that deter mi ni ng i ndivi dual
partner compensati on was a di scri mi nati ng
feature of compensati on schemes and had a
potenti al i mpact on audi tor i ndependence.
Management advi sory servi ces and
co-cont ract i ng
CPAs shall be aware of others vi ews of thei r
role and shall not per mi t themselves to be
put i n a posi ti on that would endanger thei r
objectivi ty and i ndependence[159, No. 3].
Management advi sory servi ces (MAS) consi st
of advi ce and assi stance to a cli ent to i mprove
capabi li ti es and resources and achi eve stated
objectives. The accountant may conduct stud-
i es and counsel management i n such matters
as busi ness organi zati on, planni ng, controls,
systems operati ons, personnel and
nances[159, No. 1]. Management engage-
ments requi re an i nvesti gati on and analysi s
of the cli ents operati ons to deter mi ne the
enterpri ses objectives, the nature of the prob-
lem, and feasi ble soluti ons. They also i nclude
the evaluati on of alter native soluti ons, for-
mulati on and recommended acti on, and sug-
gesti ons for and assi stance i n the i mplemen-
tati on process. MAS could also requi re the
revi ew of the nanci al statements for a cli ent.
All these professi onal servi ces may pose a
threat to the audi tors i ndependence. Audi -
tors must, therefore, exerci se due care to
preserve thei r status of i ndependence.
I n 1966, the AI CPA appoi nted an ad hoc
commi ttee i nvesti gati ng the propri ety of
CPAs renderi ng management servi ces. The
Commi ttee report di d not nd i nstances i n
which independence had been impaired. Some
researches have, however, shown that manage-
ment advi sory servi ces can actually enhance
an audi t rms i ndependence[160,161]. I n the
1970s and early 1980s, the i ssue on non-audi t
servi ces was once agai n debated. Some cri ti cs
argued that i ndependence i s i mproved when
a r m reali zes si gni cant non-audi t fees from
an audi t cli ent.
I n 1972, the SEC i ssued ASR # 126 Financial
Reporting[57], whi ch states that audi tors are
not consi dered i ndependent and cannot full
the role of outsi der cri ti c for cli ents for whom
they also perfor m bookkeepi ng and wri te-up
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servi ces. The SEC dened i ndependence as
an objective analysi s of a si tuati on by a di si n-
terested thi rd party and stated:
I t i s the Commi ssi ons posi ti on that an
accounti ng r m cannot be deemed i ndepen-
dent wi th regard to audi ti ng nanci al state-
ments of a cli ent i f i t has parti ci pated
closely, ei ther manually or through i ts com-
puter servi ces, i n the mai ntenance of the
basi c accounti ng records and preparati on of
the nanci al statements, or i f the r m per-
for ms other accounti ng servi ces through
whi ch i t parti ci pates wi th management i n
operati onal deci si ons.
The basi c consi derati on i s whether, to a thi rd
party, the cli ent appears to be totally depen-
dent on the accountants ski ll and judgement
i n i ts nanci al operati ons or to be reli ant
only to the extent of the customary type of
consultati on or advi ce. I n 1977, the Metcalf
Subcommi ttee clai med that non-audi t ser-
vi ces i mpai r i ndependence. I n 1978, the
Cohen Commi ssi on on Audi tors Responsi bi l-
i ti es consi dered management advi sory ser-
vi ces for audi t cli ents and concluded that
there i s li ttle questi on that the provi si on of
some other servi ces to audi t cli ents poses an
obvi ous potenti al threat to the audi tors i nde-
pendence.
I n 1977, the AI CPA i ssued Rule of Conduct
102, MAS Engagement to Evaluate Service
Bureaus. CPAs, who are asked to evaluate
servi ce bureaux for processi ng the cli ents
accounti ng records, should not accept the
engagement i f they have a nanci al i nterest
i n one of the servi ce bureaux under consi der-
ati on. The cli ents nanci al i nterests can
constrai n the r ms abi li ty to perfor m cer-
tai n MAS engagements[162].
I n 1978, the SEC responded to the nonaudi t
servi ces i ssues wi th Accounting Release
Series (ARS) #250, whi ch requi red di sclosure
i n For m 10-K of the nature of all non-audi t
servi ces and the percentage of audi t fees. I n
1981, the SEC resci nded ARS # 250, and as a
result, publi c di sclosure of non-audi t servi ces
i s no longer mandatory. Some research i n the
1980s suggests that both sophi sti cated nan-
ci al i nfor mati on users, such as nanci al
analysts, and educated but i nexperi enced
readers, have relatively hi gh condence i n
audi tor i ndependence, even i n cases i nvolv-
i ng non-audi t servi ces[163].
I n J une of 1979, the SEC i ssued ASR # 264
i mplyi ng that engagi ng an audi tor for man-
agement advi sory servi ces mi ght i mpai r
i ndependence. AI CPA rules do not emphasi ze
thi s poi nt. J ack Robertson[64] feels that the
SEC vi ew casts a cloud of suspi ci on over the
practi ce of negoti ati ng wi th the cli ent the
nature and amount of nanci al statement
adjustments proposed by the audi tors.
I n 1979, at the request of the AI CPAs Execu-
tive Commi ttee of the SEC Practi ce Secti on,
the Publi c Oversi ght Board (POB) exami ned
the questi on of management servi ces and
audi tor i ndependence. The POB report con-
cluded that mandatory li mi tati ons on scope
of servi ces should be predi cated only i n the
deter mi nati on that certai n servi ces, or the
role of the r m perfor mi ng certai n servi ces,
wi ll i mpai r a members i ndependence i n
renderi ng an opi ni on on the fai r ness of a
cli ents nanci al statements or present a
strong li keli hood of doi ng so[164].
I n 1986, the POB of the AI CPA
commi ssi oned Audi ts & Survey I nc. to con-
duct a survey on the publi c percepti on of
management advi sory servi ces on audi tor
i ndependence. The ndi ngs i ndi cate that the
followi ng MAS engagements could i mpai r
i ndependence:
Negoti ati ng mergers, acqui si ti ons and
divesti tures;
Perfor mi ng actuari al servi ces that di rectly
affect amounts i nvolved on the balance
sheet;
I mplementi ng a strategi c plan;
Valui ng assets i n busi ness combi nati on;
Executive search for seni or management;
Renegoti ati ons or redeter mi ni ng pri ce
under a procurement contract;
Developi ng a strategi c plan; and
Developi ng an executive compensati on
plan[165].
I n J anuary 1991, the Bi g Si x accounti ng r ms
publi shed a report ti tled The Public Account-
ing Profession: Meeting the Needs of a Chang-
ing Worldsuggesti ng a new framework for
deni ng i ndependence. I t stated: Busi ness
relati onshi ps between publi c accountants
and audi t cli ents do not i mpai r i ndependence
so long as they result from the ordi nary
course of busi ness and are not materi al to
ei ther party. The proposed framework,
whi ch was rejected by the Securi ti es and
Exchange Commi ssi on, downplayed concer ns
about the appearance of coni cts of i nterest
wi th audi t cli ents.
I n 1993, the AI CPA, i n order to assi st CPAs
i n i denti fyi ng what functi ons make up con-
sulti ng servi ces, i ssued the rst Statement on
Standards for Consulting Services (SSCS),
Denition and Standards. The new statement
di scusses audi tor i ndependence and the per-
for mi ng of consulti ng servi ces for attest
cli ents. The SSCS states that the AI CPAs
i ndependence standards relate exclusively to
perfor mance of attestati on servi ces and that
consulti ng for an attest cli ent does not, i n and
of i tself, i mpai r i ndependence[81].
I n March 1994, the Securi ti es and Exchange
Commi ssi on i ssued i ts Staff Report on Auditor
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I ndependenceand di scussed whether or not
the perfor mance of management advi sory
servi ces by audi tors has an i mpact on audi tor
i ndependence. The SEC stated that the lack
of an apparent, dramati c i ncrease i n MAS
provi ded to SEC audi t cli ents suggests that a
fundamental change i n the Commi ssi ons
regulati on i s not necessary at thi s ti me[59].
As the si ze and the complexi ty of the cli ent
i nfor mati on systems needs have ri sen, CPA
r ms have found i t necessary to co-contract
wi th non-CPA r ms as a means of effi ci ently
provi di ng servi ces to cli ents. The SEC has
taken the posi ti on that co-contracti ng wi th
audi t cli ents i s unacceptable because i t
i mpai rs audi tor i ndependence. The Bi g Si x
CPA r ms have proposed certai n safeguards
i n an effort to sati sfy the SECs concer ns but
the SEC has not yet developed workable stan-
dards on co-contracti ng wi th audi t
cli ents[166].
I n provi di ng management advi sory ser-
vi ces i ncludi ng trai ni ng programmes, super-
vi si on, revi ew of engagements and co-con-
tracti ng, those i n charge should emphasi ze
the si gni cance of i ndependence i n mental
atti tude[63]. The hi story of provi di ng MAS to
audi t cli ents has been a thor ny i ssue i n the
audi ti ng professi on. I n provi di ng MAS
engagements, CPAs must be i ndependent i n
fact; i ndependence i n appearance i s encour-
aged[45]. CPAs must be careful that the com-
bi nati on of accounti ng, tax, and management
servi ces does not create coni ct of i nterest or
the appearance of such.
I n summary, research on management
advi sory servi ces i mpacti ng on audi tor i nde-
pendence shows contrasti ng vi ews. Some
clai m that MAS can actually enhance audi t
r ms i ndependence. Others beli eve that
MAS threatens audi tor i ndependence. CPAs
who provi de them may:
become the cli ents advocate;
develop a stake i n thei r cli ents success;
make deci si ons that they are later requi red
to audi t; and
become too close to management[45].
I n the USA there i s no prohi bi ti on agai nst
audi tors perfor mi ng management advi sory
servi ces for thei r cli ents as long as they do
not get i nvolved i n maki ng management
deci si ons. I n Ger many, audi tors do a lot of tax
and management-consulti ng work wi th thei r
cli ent compani es whereas i n The Netherlands
audi tors do not perfor m any tax servi ces,
management servi ces work, or any other
for m of consulti ng activi ty for thei r audi t
cli ents. I n the UK, i ndependent audi tors are
allowed to perfor m certai n bookkeepi ng func-
ti ons for private compani es.
I n Australi a, non-audi t servi ce has become
a very i mportant i f not the most i mportant
source of revenue for accounti ng r ms. A
questi onnai re regardi ng atti tudes toward
accounti ng i ndependence was mai led to Aus-
trali an CPAs. The respondents di d not thi nk
that accounti ng r ms renderi ng non-audi t
servi ces to thei r cli ents were at a greater ri sk
of losi ng thei r i ndependence than accounti ng
r ms not renderi ng such servi ces[167].
Wi nes[168] i nvesti gated the questi on of
whether there i s the potenti al for an appear-
ance of audi tor i ndependence i mpai r ment
when hi gher levels of non-audi t servi ces are
provi ded to audi t cli ents. Thi s questi on was
i nvesti gated by analysi ng the audi t reports
for a sample of publi cly li sted compani es over
the peri od 1980 to 1989. The ndi ngs suggest
that audi tors are less li kely to quali fy a given
companys nanci al statements when hi gher
levels of non-audi t servi ces fees are derived.
Barkess and Si mnett[169] also conducted a
research study to:
i denti fy the extent and level of other ser-
vi ces provi ded by i ncumbent audi tors i n
the Australi an busi ness envi ronment;
exami ne pri ci ng i ssues and audi t fees; and
address the questi on of i ndependence by:
i denti fyi ng whether the i nci dence of
audi t quali cati on i s related to the level
of other servi ces purchases; and
i nvesti gati ng whether there i s a relati on-
shi p between audi t tenure and the level
of servi ces, si ze, and audi t quali cati ons.
The study provi des evi dence that an i ncreas-
i ng number of cli ents are purchasi ng other
servi ces from thei r audi tors.
Operat i ng responsi bi l i t i es
Si nce complete objectivi ty i s essenti al to the
audi t functi on, i nter nal audi tors should not
develop and i nstall procedures, prepare
records, or engage i n any other activi ty
whi ch they nor mally would be expected to
revi ew and apprai se[44].
The Standards for the Professional Practice of
I nternal Auditing (SPPI A) speci cally pro-
hi bi t i nter nal audi tors from assumi ng operat-
i ng responsi bi li ti es si nce i t would i mpai r
objectivi ty. But i f on occasi on management
di rects i nter nal audi tors to perfor m non-
audi t work, i t shall be understood that they
are not functi oni ng as i nter nal audi tors.
Moreover, objectivi ty i s presumed to be
i mpai red when i nter nal audi tors audi t any
activi ty for whi ch they had authori ty or
responsi bi li ty. Thi s i mpai r ment should be
consi dered when reporti ng audi t results
(120.02.4).
The Standards also state that: Desi gni ng,
i nstalli ng, and operati ng systems are not
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audi t functi ons. Perfor mi ng such activi ti es i s
presumed to i mpai r audi t objectivi ty(120.03).
A study was conducted to deter mi ne whether
i nter nal audi tor i nvolvement i n systems
desi gn affects deci si ons about subsequent
audi t work. The parti ci pants i n the study
consi sted of 51 i nter nal audi tors who worked
for 21 di fferent organi zati ons located i n a
large US ci ty. The results of the study i ndi cate
that the i nter nal audi tors mai ntai ned thei r
objectivi ty despi te previ ous i nvolvement i n
the desi gn of a parti cular system. These nd-
i ngs support the vi ew that i nter nal audi tors
are true to the i deals of objectivi ty[166].
PSB 81-1, I ndependence Bank Reconcilia-
tions, cauti ons that the di rector of i nter nal
audi ti ng should avoi d prepari ng bank recon-
ci li ati ons as an operati ng responsi bi li ty. I f
management requi res the i nter nal audi ti ng
department to perfor m bank reconci li ati ons,
the di rector of i nter nal audi ti ng should
i nfor m management and the companys pub-
li c accountant that thi s activi ty i s not an
i nter nal audi t activi ty; and therefore, audi t-
related conclusi ons should not be drawn. PSB
81-3, I ndependence Operating Responsibili-
ties, suggests that the assi gnment of person-
nel to audi t the activi ti es for whi ch they pre-
vi ously had authori ty or responsi bi li ty
should be delayed unti l thei r successors have
had the ti me and opportuni ty to i nuence the
system of control for the activi ty. Even though
objectivi ty could be preserved by carefully
scheduli ng steps i n the audi t programme,
PSB 81-3suggests that the di rector of i nter nal
audi ti ng must consi der whether those mem-
bers of the organi zati on who read the report
wi ll accept the results i f the audi tor previ -
ously had operati ng responsi bi li ty or author-
i ty wi thi n the audi t area.
When a CPA r m i s asked to help an audi t
cli ent to i mplement an i nfor mati on and con-
trol system, the r m must be careful to avoi d
di rect supervi si on of operati ons or undue
i nvolvement i n management functi on. Under
Rule of Conduct 101, the CPA r ms i ndepen-
dence would not be i mpai red i f:
management made all of the deci si ons
related to both hi ri ng and system i mple-
mentati on; and
supervi sory activi ti es were restri cted to
i ni ti al i nstructi on and trai ni ng[171].
I n the UK, the Ethics, I nterpretations and
Rulingsof the joi nt I nsti tutes of Chartered
Accountants state that an i ndependent audi -
tor should not parti ci pate i n the preparati on
of the accounti ng records of publi c company
audi t cli ents except i n excepti onal ci rcum-
stances[135].
Out sourci ng
Because exter nal audi tors must be i ndepen-
dent, i n fact and i n appearance, of the com-
pany bei ng audi ted, exter nal audi tors
attempti ng to attend to both responsi bi li ti es
of the exter nal audi tor and the responsi bi li -
ti es performed by the i nter nal audi tor func-
ti on must exerci se great care[110].
The i ndependence i ssue ari ses when the
same r m that provi des an i ndependent
opi ni on of an organi zati ons nanci al state-
ment also performs an i nter nal audi ti ng
engagement upon whi ch management bases
i ts opi ni on[172].
Reasons for outsourcing
The recent phenomenon of outsourci ng i s
vi ewed by the I nsti tute of I nter nal Audi tors,
the Securi ti es and Exchange Commi ssi on
and i nter nal audi tors as a potenti al threat to
audi tor i ndependence. Courtemanche[173]
beli eves that the major reason for outsourc-
i ng the i nter nal audi t functi on i s that CPA
r ms can provi de better servi ces wi th better
quali ed staff, lower overall costs, conti nui ty
of i nter nal audi t operati ons, and better plan-
ni ng. To prevent outsourci ng, he beli eves that
i nter nal audi tors must provi de added value
to thei r organi zati ons si nce outsi de r ms
clai m that they have:
more quali ed staff;
better planni ng;
greater emphasi s on i nter nal control;
di scount pri ci ng and lower overall costs;
and
conti nui ty of operati ons.
Peter Block[174], i n hi s book Stewardship,
mai ntai ns that consi stency and control have
been the way we rati onali ze the need for
poli ci ng and audi ti ng and admoni shes that
when given a choi ce, and i t i s comi ng, the
li ne organi zati on wi ll not conti nue to buy
poli ci ng, i nspecti on, and care-taki ng ser-
vi ces. I nstead, they wi ll ask: What value
have you added to the process of deliveri ng
our product or servi ce to our customers?
Blocks i dea i s that staff functi ons, i ncludi ng
i nter nal audi ti ng, need to begi n bui ldi ng
competency i n the organi zati on they serve.
He stated: I nstead or mai ntai ni ng consi s-
tency and control, thei r contri buti on i s that
of bui ldi ng capabi li ty. Audi ti ngs deeper pur-
pose i s to support stewardshi p responsi bi li -
ti es at every level[175].
Gary Ster n[176] suggests 15 ways of addi ng
value to the company; these i nclude audi tors:
becomi ng catalysts of change;
shari ng technology; and
concentrati ng on busi ness ri sks.
Lampe[177], J ames[178], and others share the
same vi ew that audi t departments that fai l to
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Rocco R. Vanasco
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bri ng added value to the company may run
the ri sk of bei ng outsourced. The outsourci ng
of the i nter nal audi t functi ons proves, accord-
i ng to Tongren[179], that i nter nal audi tors
are not i ndependent of those who control
thei r resources. I nter nal audi tors cannot
perfor m objective audi ts of the overall i nter-
nal control system when they are an i ntegral
part of i t. He questi ons the basi c doctri ne of
i nter nal audi t as of an i ndependent apprai sal
functi on that ai ms to assi st members of the
organi zati on i n the effective di scharge of
thei r responsi bi li ti es and suggests to replace
the concept of i ndependent i nter nal audi -
tor wi th the synergy of the work group, the
judgemental apprai sal of an outsi der i nter-
nal audi tor wi th team self-reali zati on.
Ri chard Anderson[129] beli eves that i f audi -
tors are not successful i n enhanci ng servi ces
and perceived value to cli ents and sharehold-
ers, future examples of entrenched,
i nwardly focused, and defunct organi zati ons
may i nclude us.
Downsi zi ng, ri ghtsi zi ng, re-engi neeri ng,
and outsourci ng are not li mi ted to the i nter-
nal audi ti ng departments. The trend suggests
that compani es are movi ng away from a hi er-
archi cal organi zati on structure to a hori zon-
tal or at organi zati on structure to i ncrease
communi cati on among vari ous departments
and gai n a better control of thei r organi za-
ti on. But the outsourci ng of the i nter nal audi t
functi on may pose more problems than com-
pani es had bargai ned for.
Management may unconsci ously outsource
i nternal audi ti ng departments, not because of
i ts lack of added value to the organi zati on, but
rather for other suspi ci ous motives such as:
meeti ng stockholders expected hi gher
retur ns; and
eli mi nati ng those basi c controls whi ch may
i mpai r management fraud.
Outsourci ng i s often undertaken by compa-
ni es wi thout understandi ng the full spectrum
of the advantages and di sadvantages i n eli mi -
nati ng the i nter nal audi ti ng functi on. The
Treadway Commi ssi on and a recent study on
audi t commi ttees sponsored by the I nsti tute
of I nter nal Audi tors suggest that audi tors
must be proactive i n advi si ng both manage-
ment and audi t commi ttees on i nter nal audi t-
i ng matters. A well-i nfor med audi t commi ttee
can be a strong ally i n preventi ng outsourc-
i ng[68].
A survey of 72 Bi g Si x audi t partners
reveals that outsourci ng i s a real threat to
audi tor i ndependence. The partners who
have been i nvolved i n outsourci ng reported
that 86 per cent of thei r engagements were
wi th current cli ents[178]. Outsourci ng eli mi -
nates the common checks and balances that
exi st between i nter nal and exter nal audi tors
si nce the Bi g Si x r ms would have a monop-
oly on an organi zati ons operati onal audi t
processes[180]. Thi s li mi tati on would exi st
when the same r m was perfor mi ng both
functi ons.
The SEC position on outsourcing
The 1984 SECs i nterpretative deci si on on
Rule 2-01(b) of Regulation S-X vi ews outsourc-
i ng an i mpai r ment to audi tor i ndependence:
I t also appears that the I nter nal Audi t Type
Duti es... would i mpai r the appearance of
the Fi r ms i ndependence. The i nter nal
audi tor relati onshi p seems to be one whi ch
would be close i n nature to that of an
employee. An audi tor may assi st a cli ent i n
the establi shment of a system of i nter nal
control whi ch wi ll be admi ni stered by the
cli ents personnel. An i nter nal audi t func-
ti on generally would be part of the system of
i nternal controls admi ni stered by employ-
ees of the cli ent.
On 4 November, 1994, duri ng the AI CPAs
Ni neteenth Annual Conference on Banki ng,
Walter D. Schuetze, the past chi ef accountant
of the US Securi ti es and Exchange Commi s-
si on, questi oned the i ndependence of out-
sourci ng practi ces whereby exter nal audi tors
perfor m both the exter nal and i nter nal audi t
functi ons. He stated:
I understand that there are many di fferent
alternatives avai lable to a company that
wi shes to outsource i ts i nter nal audi t func-
ti on. One alter native bei ng consi dered by
some i s for a company to completely replace
i ts i nter nal audi t functi on wi th an
expanded exter nal audi t functi on. As a
result, the exter nal audi tor would perform
both the exter nal audi t functi ons and the
functi ons previ ously performed by the i nter-
nal audi t department. That i s, the exter nal
audi tor would be responsi ble for:
perfor mi ng audi t procedures and i ssui ng
an opi ni on on whether the nanci al
statements were prepared i n confor mi ty
wi th GAAP,
i ssui ng another opi ni on on manage-
ments asserti ons regardi ng the effective-
ness of the companys i nter nal controls,
and
desi gni ng and executi ng audi t proce-
dures that tradi ti onally were performed
by the i nter nal audi tors.
Because exter nal audi tors must be i ndepen-
dent, both i n fact and i n appearance, of the
company bei ng audi ted, exter nal audi tors
attempti ng to attend to both the responsi bi li -
ti es of the exter nal audi tors and the responsi -
bi li ti es tradi ti onally perfor med by the i nter-
nal audi t functi on must exerci se great
care[181].
At the 1995 AI CPAs Nati onal Conference on
Banki ng, Mi chael H. Sutton, SEC chi ef
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Rocco R. Vanasco
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accountant, expressed hi s frustrati on over
the lack of clear, ethi cal gui dance i n the area
of audi tor i ndependence[182]. The SEC offi -
ci al called for clari cati on as to whether or
not an i ndependent audi tor who accepts out-
sourced i nter nal audi t functi ons from a cli ent
has assumed management or employee
responsi bi li ti es:
I m getti ng i mpati ent wi th the AI CPA; I m
getti ng i mpati ent wi th the process of clari fy-
i ng the standards. I want to emphasi ze that
i t i s not the staff s goal to preclude audi tors
from provi di ng i nter nal audi t outsourci ng.
Rather, i f audi tors provi de those servi ces to
the audi t cli ents, we beli eve that the i mpact
of those arrangements on audi tors i ndepen-
dence should be carefully consi dered i n
each si tuati on[183].
At the 14 December, 1995 meeti ng of the Com-
mi ttee of Sponsori ng Organi zati ons (COSO)
of the Treadway Commi ssi on, Sutton di s-
cussed the si tuati on i n whi ch the exter nal
audi tor has both the attest functi on and the
i nter nal audi ti ng engagement. He expressed
the SECs concer n regardi ng the exter nal
audi tors i ndependence i n provi di ng
extended audi t servi ces. He emphasi zed the
followi ng poi nts:
There should be a responsi ble and compe-
tent manager for i nter nal audi ti ng wi thi n
the company wi th a clear separati on of
management and exter nal audi tor func-
ti ons.
The gui deli nes coveri ng extended audi t
servi ces should clearly deli neate ongoi ng
moni tori ng activi ti es so as to i denti fy
those that could i mpai r the i ndependence of
exter nal audi tors.
I n attestati on si tuati ons such as FDI CI A,
the exter nal audi tors should obtai n assur-
ances from management that i t di d not rely
heavi ly on the exter nal audi tor to for m the
basi s for managements asserti on on the
effectiveness of i nter nal controls.
There should be a clear separati on of man-
agements and audi tors responsi bi li ti es
and that thei r i ndivi dual roles should be
clari ed (Bi shops letter to Fi nkston,
Appendi x 1).
Spectacular busi ness fai lures have been
attri buted to the absence of a sound i nter nal
control system. The SEC enforced the Forei gn
Corrupt Practi ces Act and requi red that all
compani es devi se an i nter nal control system
to prevent unethi cal and i llegal acti ons per-
petrated by management. Si mply, outsourc-
i ng means weakeni ng the apparatus of the
i nter nal control system for whi ch the SEC
had worked assi duously for many years. I t
also runs counter to the Treadway Commi s-
si ons recommendati on that active
parti ci pati on of the i nter nal audi t functi on i n
all facets of the company i s vi tal to prevent
the i ssuance of fraudulent nanci al state-
ments.
The AICPA position on outsourcing
I n 1993, the AI CPA, aware of the potenti al
i mpact of outsourci ng on the exter nal
audi tors i ndependence, i ssuedEthics Ruling
97, Performance of Certain Extended Audit
Services[31], whi ch states that the exter nal
audi tor:
cannot perfor m management functi ons or
make management deci si ons;
cannot be part of the cli ents approval
process; and
cannot be part of the i nter nal control sys-
tem wi thout i mpai ri ng thei r i ndependence.
I n i ts response to the proposed i nterpretati on
of the AI CPA Ethics Ruling 97, the AI CPAs
Publi c Oversi ght Board (POB) declared i ts
support of the perfor mance of extended
audi t servi ces by the exter nal audi tor as long
as the audi tor does not assume managements
operati onal or deci si on-maki ng responsi bi li -
ti es. However, the SEC staff advi sed audi tors
that i t would questi on i ndependence, consi s-
tent wi th Ethics Ruling 97, when exter nal
audi tors perfor m procedures that are man-
agement functi ons. Practi ti oners are, there-
fore, advi sed to give careful consi derati on to
the i mpli cati ons that attend such outsourci ng
arrangements and the resulti ng effect on the
accountants i ndependence[182].
J erry Sullivan, executive di rector of the
Publi c Oversi ght Board, observed that the
POBs posi ti on i s based on the premi ss that
the moni tori ng of the i nter nal control system
over and above that requi red by the generally
accepted audi t standards, when perfor med by
the exter nal audi tor, i s not part of the i nter-
nal control structure as dened by the COSO
Report. I n hi s letter to the AI CPAs di rector of
professi onal ethi cs, Sullivan stated:
COSO recogni zes and states that parti es
exter nal to the organi zati on, such as regula-
tors, the i ndependent audi tor, customers,
and others transacti ng busi ness wi th the
enterpri se, are not part of the enti tys i nter-
nal control system but do assi st manage-
ment i n fullli ng i ts responsi bi li ty to moni -
tor i nter nal control. Thus, moni tori ng activ-
i ti es conducted by the i ndependent audi tor
to replace the i nter nal audi t functi on are
not i nter nal to the organi zati on and are not
part of the moni tori ng component of the
i nternal control structure[184].
Sullivans i nterpretati on refers to the follow-
i ng passage of the COSO Report:
Everyone i n the organi zati on has some
responsi bi li ty for i nter nal control. Manage-
ment, however, i s responsi ble for an enti tys
i nternal control system. The chi ef executive
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Rocco R. Vanasco
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offi cer i s ulti mately responsi ble and should
assume ownershi p of the control system.
Fi nanci al and accounti ng offi cers are cen-
tral i n the way management exerci ses con-
trol, though all management play i mportant
roles and are accountable for controlli ng
thei r uni ts activi ti es. Si mi larly, i nter nal
audi tors contri bute to the ongoi ng effective-
ness of the i nter nal control system, but they
do not have pri mary responsi bi li ty for estab-
li shi ng and mai ntai ni ng i t. The board of
di rectors and i ts audi t commi ttee provi de
i mportant oversi ght to the i nter nal control
system. A number of exter nal parti es, such
as exter nal audi tors, often contri bute to the
achi evement of the enti tys objectives and
provi de i nformati on useful i n effecti ng
i nternal control. However, they are not
responsi ble for the effectiveness of, nor are
they a part of, the enti tys i nter nal control
system.
But the COSO reports i ndi cates that:
I nter nal control i s effected by people wi thi n
the enti ty.
I nter nal audi ti ng i s part of the enti tys
i nter nal control system a Management
responsi bi li ty.
Exter nal audi tors are not part of the i nter-
nal control system.
At the sessi on on Outsourci ng the audi t
functi on sponsored by the I I A, some panel-
li sts expressed thei r concerns about CPA
r ms perfor mi ng the i nter nal audi t functi on
for thei r cli ents. Ri chard Anderson, nati onal
di rector of i nter nal audi t servi ces for Er nst &
Young, expressed concer n for i ndependence
and urged that care be taken i n such si tua-
ti ons. He stated:
Such an engagement has to be very carefully
structured to protect our i ndependence and
the i ndependence of the company. We have
very speci c poli ci es how those types of
engagements have to be structured[185].
On 5 Apri l, 1995, key representatives of the
AI CPAs Publi c Oversi ght Commi ttee (POB),
vi si ted I I A headquarters seeki ng i nput on the
i ssue of audi tor i ndependence. POB executive
di rector J erry D. Sullivan and representative
Donald J . Ki rk di scussed wi th I I A representa-
tives the i ndependence of exter nal audi tors
who perfor m both the i nter nal and exter nal
audi ti ng functi ons for the same organi zati on.
The I I A presented the argument that an
exter nal audi tors i ndependence i s i mpai red
when perfor mi ng both nanci al and i nter nal
audi ti ng for an organi zati on[35].
I n J une 1995, A.A. Sommer J r, chai r man of
the POB, wrote a letter to the AI CPA Ethi cs
Divi si on stati ng that the POB i s supportive of
the perfor mance of the extended audi t ser-
vi ces by the exter nal audi tor as long as the
audi tor does not assume managements
operati onal or deci si on-maki ng responsi bi li -
ti es. He further stated: We have heard i nfor-
mally from representatives of the I nsti tute of
I nter nal Audi tors and certai n regulators a
contrary vi ew, i .e., that such extended moni -
tori ng i s part of the i nter nal control structure
as dened i n the COSO Report, and therefore,
the perfor mance of the servi ce by the
exter nal audi tors mi ght i mpai r i ndependence
under certai n ci rcumstance. He urged that
the Ethics Ruling 97deali ng wi th thi s i ssue be
re-exami ned[186].
I n September 1995, the Publi c Oversi ght
Board (POB) report enti tled Directors, Man-
agement, and Auditors Allies in Protecting
Shareholders I nterestsstated that under the
responsi bi li ti es of the i ndependent audi tor:
The board of di rectors, as the representative
of the shareholders, should be the cli ent, not
corporate management. Corporate boards
and audi t commi ttees should make thi s
clear to the audi tors[187].
At the 19 J anuary, 1996 meeti ng of the AI CPA
Professi onal Ethi cs Executive Commi ttee
held i n Fort Lauderdale, Flori da, there was
recogni ti on that i ndependence could become
an i ssue when the attest functi on audi tor and
i nter nal audi tor are the same. The Commi t-
tee commented that servi ces can be divi ded
i nto components: management of the i nter nal
audi ti ng functi on; and perfor mance of
extended audi t procedure. The vi ew of the
Commi ttee i s that perfor mance of procedures
can be perfor med by the exter nal audi tor
wi thout i mpai r ment of i ndependence. The
I I A recogni zed that extended audi t servi ces
can effectively supplement an organi zati ons
i nter nal audi ti ng functi on, although The I I A
beli eves that total management of the i nter-
nal audi ti ng functi on must consi st of organi -
zati on employees[188].
On 28 February, 1996, the Professi onal
Ethi cs Executive Commi ttee i ssued an Expo-
sure Draft of proposed i nterpretati on 101-13
Extended Audi t Servi ces and related rul-
i ngs under Rule 101, I ndependence, whi ch
was mai led for a si x-day comment peri od to
10,000 AI CPA members. Wi lli am J . I nlanfeldt,
presi dent of the I nsti tute of Management
Accountants (I MA), i n response to the Expo-
sure Draft, wrote:
Generally, the I MA Ethi cs Commi ttee does
not support the AI CPAs proposed i nterpre-
tati ons and ruli ngs as outli ned i n the Expo-
sure Draft, and the commi ttee urges the
AI CPA not to proceed based upon the pro-
posed provi si ons. The pri nci pal reason for
the commi ttees posi ti on i s that the perfor-
mance of the extended audi t servi ces such
as i nter nal audi ti ng by the same for m whi ch
conducts the exter nal audi t would, at a
mi ni mum, i mpai r the appearance of i nde-
pendence under any ci rcumstances.
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I nlanfeldt felt that:
the exposure drafts attempt to dene ci r-
cumstances that would mai ntai n i ndepen-
dence for the exter nal audi tor to perform
such servi ces wi ll create a seri ous publi c
percepti on problem i f the ruli ngs and i nter-
pretati ons are i mplemented. I t would appear
to us that the soluti on to thi s problem i s
strai ghtforward. Any publi c accounti ng
r m can perfor m the i nter nal audi t func-
ti on for any cli ent for whi ch i t does not
perfor m the attest functi on[189].
By advocati ng outsourci ng, di rectly or i ndi -
rectly, the AI CPA has aroused the I MAs and
the I I A s suspi ci on, and justi ably so, that the
concept of i ndependence of CPAs does not
reect the ethi cal posture on i ndependence
espoused by i ts predecessor the Ameri can
I nsti tute of Accountants whi ch stated that:
I ndependence i n the last analysi s bespeaks
an honest di si nterest on the part of the audi -
tor. Some i nter nal audi tors may i nterpret
that the AI CPA i s renegi ng on i ts ori gi nal
posture on audi tor i ndependence.
The IIA position on outsourcing
The I I A posi ti on, i n i ts whi te paper enti tled
Perspective on Outsourcing I nternal Auditing:
a Professional Brieng for Chief Audit Execu-
tives[146], i s that a competent i nter nal audi t
department that i s properly organi zed wi th
trai ned staff can perfor m the i nter nal audi t
functi on more effi ci ently and effectively than
a contracted servi ce si nce i nter nal audi tors
are better acquai nted wi th the organi zati on,
poli ci es, procedures, operati ng practi ces, and
personnel. The I I A recommends that i nter-
nal audi tors:
evaluate thei r mi ssi on and strategi es on an
ongoi ng basi s, and they should ensure that
management i s aware of the uni que and
cri ti cal contri buti ons of the i nter nal audi t-
i ng department;
prepare and i mplement a vi si on statement
whi ch i s based on and li nked to the overall
organi zati onal vi si on and i s i mplemented
through a strategi c plan. An i nter nal audi t-
i ng department wi th vi si on i s:
proactive,
i nnovative,
focused,
i ntegrated, and
motivated.
Other key i ndi cators for strong audi ti ng
departments i nclude:
a clear i mage of who are the most i mpor-
tant i nter nal audi ti ng customers;
an enhanced planni ng process;
an enhanced methodology that provi des
selective ri sk coverage and i ncreased man-
agement i nvolvement i n the audi t process;
a deni ti on of the role and servi ces that the
i nter nal audi ti ng functi on must provi de;
strong communi cati on ski lls;
enhanced organi zati onal and staff develop-
ment[190].
The I I A has di scouraged outsourci ng and
provi ded useful advi ce to help members to
develop a posi tive professi onal strategy wi th
regard to outsourci ng. The I I As posi ti on on
outsourci ng i s based on the followi ng rati o-
nale:
When the i nter nal audi tor and the exter nal
audi tor are one and the same, i t wi ll jeopar-
di ze the exter nal audi tors i ndependence.
An organi zati on cannot delegate i ts total
responsi bi li ty for moni tori ng the effective-
ness and effi ci ency of i ts i nter nal control
structure to an exter nal party, especi ally to
i ts exter nal audi tors.
One-ti me extended servi ces or activi ti es can,
however, be perfor med under the supervi si on
of the i nter nal audi ti ng di rector, such as:
revi ewi ng controls i n new appli cati ons
development;
provi di ng audi tors to support audi t tests i n
remote areas;
provi di ng language ski lls on i nter nati onal
audi ts;
analysi ng controls of re-engi neered
processes; and
i nvesti gati ng frauds.
The I I As posture on outsourci ng i s a grave
concer n for the audi ti ng professi on. The I I A
beli eves that outsourci ng:
vi olates the I I As Standards for the Profes-
sional Practice of I nternal Auditing(SPPI A)
whi ch states: The i nter nal audi ti ng
department i s an i ntegral part of the orga-
ni zati on and functi ons under the poli ci es
establi shed by seni or management and the
board;
does not comply wi th the Commi ttee of
Sponsori ng Organi zati ons (COSO) Gui de-
li nes on i nter nal control whi ch state that:
i nter nal control be effected by people
wi thi n the enti ty;
i nter nal audi ti ng i s part of the enti tys
control system a management respon-
si bi li ty;
exter nal audi tors are not part of the
i nter nal control system.
The pamphlet has had a great i mpact i n di s-
suadi ng some corporati ons from outsourci ng
i nter nal audi t departments[191]. The stature,
the maturi ty, and the professi onali sm of the
audi ti ng professi on, as evi denced i n the last
20 years, supports the I I A posi ti on on out-
sourci ng.
On 26 September, 1995, Wi lli am G. Bi shop
I I I , presi dent of the I nsti tute of I nter nal
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Rocco R. Vanasco
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Audi tors, i n hi s letter addressed to Mi chael
H. Sutton, the SECs chi ef accountant, rei ter-
ated the I I As long-standi ng posi ti on on out-
sourci ng whi ch consi ders outsourci ng of
materi al segments of i nter nal audi ti ng work
to an exter nal audi tor to be i nappropri ate
and a threat to i ndependence. Bi shop makes a
forci ble argument on the i ncompati bi li ty of
the so-called extended servi ces on the part
of the exter nal audi tors (Appendi x 2).
On 5 December, 1995, I I A presi dent Bi shop,
i n a press release ti tled Accountants May
I mpair I ndependence by Accepting I nternal
Audits, ter med the move by publi c accoun-
tants i nto total outsourci ng i nter nal audi t-
i ng functi ons a threat to the objectivi ty and
i ndependence of the audi ti ng process[192].
Bi shop beli eves that the control envi ronment
of the organi zati on i s adversely i mpacted by
the di srupti on of the roles of i nter nal and
exter nal audi ti ng.
On 15 J anuary, 1996, I I A presi dent Bi shop
sent a letter to Herbert Fi nkston, di rector of
the AI CPA Professi onal Ethi cs Divi si on, i n
whi ch he wrote that the development and
i nterpretati ons on the i ndependence of the
exter nal audi tors when perfor mi ng the i nter-
nal audi ti ng functi on for a cli ent, should give
consi derati on to the I I A Standardsand other
pronouncements whi ch provi de a basi c struc-
ture to frame the three factors i mpacti ng the
i ndependence of the exter nal audi tor:
1 the scope of i nter nal audi ti ng;
2 the structuri ng of i nter nal audi ti ng as part
of management; and
3 the demand for total i ndependence of the
exter nal audi tor.
Bi shop made the followi ng three recommen-
dati ons:
that the Ethi cs Executive Commi ttee speci f-
i cally dene extended audi t servi ces so as
to i denti fy those servi ces that would i mpai r
the i ndependence of the exter nal audi tor;
that language be i ncluded that would
requi re a dedi cated, competent professi onal
appropri ately resourced to be able to carry
out the full authori ty and responsi bi li ty
requi red to comply wi th the I I A Standards;
that the Code of Professional Ethicsgui de-
li nes should focus on the need for total
i ndependence of the exter nal audi tor.
Gui deli nes should encompass the breadth
of i nter nal audi tor and management
responsi bi li ti es, i ncludi ng planni ng,
staffi ng, organi zi ng, controlli ng, reporti ng,
follow-up, etc. Further, the gui deli nes
should i nclude requi rements to document
fully the scope and condi ti ons of the
engagement, i ncludi ng an understandi ng of
the extent of managements reli ance upon
the exter nal audi tor for an assessment of
the system of i nter nal control (Appendi x 1).
Bi shop beli eves that the extended audi t
servi ces provi ded by the exter nal audi tor
are not clearly dened, and i t i s unclear
whether these servi ces encompass the full
range of i nter nal audi ti ng activi ti es.
On 31 J anuary, 1996, I I A presi dent Bi shop
met wi th representatives of the Bi g Si x
accounti ng rms to di scuss the outsourci ng
of the i nter nal audi ti ng functi on. The I I A
arti culated i ts vi ew on outsourci ng i nto ei ght
statements:
1 I nter nal audi ti ng must be perfor med i n
accordance wi th the I I As Standards.
2 The i nter nal audi ti ng functi on i s best
perfor med by a fully resourced and profes-
si onally competent staff that i s i ntegrated
to the management of an organi zati on.
3 I ndependence i s an i ssue when total i nter-
nal audi t functi on i s perfor med by the
organi zati ons exter nal audi tor.
4 Some si tuati ons warrant outsourci ng to
achi eve organi zati onal goals and objec-
tives more economi cally.
5 Outsourci ng could be a remedy to substan-
dard i nter nal audi ti ng activi ti es.
6 Outsourci ng can be preferable to havi ng
no i nter nal audi ti ng.
7 The I I As role i n gui di ng i nter nal audi tors
to i mprove the quali ty of the i nter nal
audi ti ng servi ces.
8 The I I A posture to co-operate wi th publi c
accounti ng rms i n all aspects of the pro-
fessi on[193].
On 26 Apri l, 1996, the I nsti tute of I nter nal
Audi tors made i ts offi ci al response to the
AI CPA Professi onal Ethi cs Divi si on regard-
i ng the Exposure Draft, Omnibus Proposal of
Professional Ethics Division I nterpretations
and Rulings, dated 28 February, 1996. I n i ts
response, the I I A recommended that the
Exposure Draft:
i nclude greater deni ti on of the manage-
ment responsi bi li ti es that the exter nal
audi tor cannot assume wi thout i mpai r-
ment of i ndependence;
more clearly dene the types of extended
audi t servi ces (i nter nal audi ti ng) whi ch, i f
perfor med, would i mpai r the exter nal audi -
tors i ndependence;
deli neate ongoi ng moni tori ng activi ti es
and i denti fy those that i mpai r the exter nal
audi tors i ndependence.
The I I A also made the followi ng suggesti ons:
Wi th respect to the responsi bi li ti es of the
cli ent for managi ng the i nter nal audi ti ng
functi on, the I I A recommends that the nal
i nterpretati ons and ruli ngs i nclude a refer-
ence to the I I As Standards, and/ or i ncorpo-
rate expli ci t statements i ndivi dually
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11/ 9 [1996] 448
descri bi ng those di rector of i nter nal
audi t responsi bi li ti es prescri bed i n the
I I As Standards.
The Exposure Draft should ampli fy the
management functi ons of the i nter nal
audi ti ng department that must remai n
wi thi n the company to protect the i ndepen-
dence of the exter nal audi tor from i mpai r-
ment and should requi re the company to
retai n a quali ed di rector of i nter nal audi t
capable of perfor mi ng those management
functi ons.
Management should not rely to a materi al
degree on the work of the exter nal audi tor
when perfor mi ng thei r assessment of the
system of i nter nal control. I n executi ng
thei r responsi bi li ti es to the cli ents share-
holders, the exter nal audi tor should test
managements representati ons wi thout
bei ng i nvolved i n supplyi ng i nfor mati on
used to for mulate the assessment.
The Exposure Draft should deli neate the
types of extended audi t servi ces and speci fy
those that i mpai r i ndependence. The ruli ng
should preclude perfor mance of
operati onal audi ts duri ng whi ch the mem-
ber evaluates busi ness activi ti es and
processes to the poi nt of for mulati ng rec-
ommendati ons for procedures whi ch are
managements responsi bi li ty[189].
The I I A beli eves that the adopti on of the
Exposure Draft, i n i ts present for m, would
result i n i ndependence standards i n the US
bei ng less stri ngent than i n other countri es.
Cases of outsourcing
The followi ng cases show that outsourci ng of
the i nter nal audi ti ng functi on can be detri -
mental to compani es:
An outsi de audi tor, who was doi ng the
Landmark Bancorps i nter nal audi t work,
fai led to detect a $2.1 mi lli on fraud. The
bank offi cer was steali ng from unused
credi t li nes of si x customers and usi ng an
outsi de address to receive the customers
bi lli ng statement. Landmark di sconti nued
the outsourci ng and hi red i ts own i nter nal
audi tors[194].
I n 1993, most of the i nter nal audi t depart-
ment of Morri son Knudsen Corporati on i n
Boi se, I daho, was lai d off and Deloi tte &
Touche was charged wi th perfor mi ng Mor-
ri sons exter nal and i nter nal audi t. A Mor-
ri sons spokesman defended Deloi ttes
double duty argui ng that there was no
coni ct of i nterest because the accounti ng
r m has a Chi nese wall and so, i n
essence, i t does two audi ts. I n early 1995, the
board ousted Wi lli am Agee as chi ef execu-
tive offi cer because the constructi on com-
pany reported huge losses[194,195].
Some corporati ons have adopted the si ngle
i ntegrated approach. I n 1993, Chi cagos Conti -
nental Bank outsourced the bulk of i ts i nter-
nal audi ti ng functi on by expandi ng i ts rela-
ti onshi p wi th Pri ce Waterhouse, i ts exter nal
audi tor si nce 1985. Under thi s unusual
arrangement, i nter nal and exter nal audi ti ng
work have been i ntegrated[196]. The Conti -
nental Bank researched the possi bi li ty of
outsourci ng the i nter nal functi on completely
but rejected i t. I nstead the Conti nental Bank
adopted a si ngle i ntegrated audi t programme
whi ch combi nes the previ ously separate
i nter nal and exter nal audi t programs i nto a
si ngle whole under the joi nt management of
Conti nentals Audi t Department and Pri ce
Waterhouse[125].
Some compani es and banki ng i nsti tuti ons
have rejected outsourci ng:
I n New York, the audi t commi ttee of a large
multi nati onal bank rejected the i dea of
outsourci ng the i nter nal audi t functi on
after a presentati on on the topi c by the
general audi tor. The presentati on, whi ch
reli ed heavi ly on the materi al from the I I As
pamphlet on outsourci ng, poi nted out the
advantages of a professi onal i nter nal func-
ti on and outli ned the SECs posi ti on on
outsourci ng[197].
On 9 February, 1995, the Norwegi an Bank-
i ng, I nsurance, and Securi ti es Commi ssi on
sent a ci rcular to the boards of di rectors of
all commerci al and savi ngs banks, and
i nsurance compani es stati ng that i nter nal
audi t work cannot be perfor med by the
nanci al i nsti tuti ons exter nal
audi tors[198].
The US Gover nments FDI C I mprovement
Act 1991, the Offi ce of the Comptroller of the
Currency, the Federal Reserve Board, and
the Offi ce of Thri ft Supervi si ons Draft,
I nteragency Policy Statement on Audit Out-
sourcing, have rai sed the exter nal audi tors
i ndependence i ssues and questi oned the
practi ce of outsourci ng[198].
Some compani es may prefer outsourci ng the
audi ti ng functi on. The cost savi ngs provi ded
by outsourci ng may be worth the ri sk. I n
1993, McDer mott I nter nati onal, the bi g
mari ne-constructi on company based i n New
Orleans, gave Er nst & Young, i ts exter nal
audi tor, the i nter nal audi ti ng job. The move
was made to save several mi lli on dollars
annually[194].
Reactions to outsourcing
The speci c functi ons attri buted to the i nter-
nal audi tors and exter nal audi tors are vi ewed
by professi onal and governmental bodi es as
separate and i ndependent i n the checks and
balances of the i nter nal control systems. The
necessi ty of the i nter nal audi t functi on i n the
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corporate and gover nmental setti ngs has
been recogni zed worldwi de. The Research
Commi ttee of the I nsti tute of Chartered
Accountants of Scotland (I CAS) i n a di scus-
si on document enti tled Audi ti ng i nto the
twenty-rst century emphasi zes such a
need:
To provi de a board of di rectors wi th reassur-
ance that i ts management i nfor mati on
systems and i nter nal control systems are
suffi ci ently reli able and relevant, we beli eve
each company should establi sh and mai n-
tai n a strong i nter nal audi t functi on under
the di recti on of a Chi ef I nter nal Audi tor. As
the i nter nal audi tors wi ll be carryi ng out
thei r work on a conti nuous basi s they
should have a sound understandi ng of the
range of activi ti es i n whi ch a company i s
i nvolved. The Chi ef I nter nal Audi tor should
be i n a strong posi ti on to provi de a board of
di rectors wi th reassurances regardi ng the
reli abi li ty and relevance of the systems
bei ng operated wi thi n that company.
The I CAS Research Commi ttee also recog-
ni zed that the need for constant moni tori ng of
the system of i nter nal control i s a role for the
i nter nal audi tors rather than the exter nal
audi tors. McI nnes and Stevenson[118] beli eve
that the present work of the exter nal audi -
tors does not provi de boards of di rectors wi th
the reassurance on i nter nal controls.
Pri or to the POBs statement on outsourc-
i ng, the I I A presented i ts vi ew that, because
of the audi tors dual role i n the control
process, the perfor mance of i nter nal audi ts
by the exter nal audi tor may jeopardi ze the
audi tor i ndependence and thereby contri bute
to the organi zati onal ri sk. Car man Young,
the audi tor for the Bank of Canada and I I A
past chai r man, voi ced the I I As concer n when
the same exter nal audi tor responsi ble for
attesti ng to the fai r ness of an organi zati onals
nanci al statement perfor ms the i nter nal
audi t[186].
Accordi ng to the I nsti tute of I nter nal Audi -
tors survey on outsourci ng, several coun-
tri es and organi zati ons preclude statutory
audi tors who certi fy nanci al statements of a
company from servi ng as the i nter nal audi -
tors:
The European Confederati on of I nsti tutes
of I nter nal Audi ti ng stated i n thei r 1995
Position Paper that the knowledge and
understandi ng of i nter nal audi ti ng can best
be achi eved by entrusti ng i nter nal audi ti ng
to personnel employed wi thi n the enter-
pri se.
The Federati on of European Accounti ng
Experts, i n thei r The Role, Position and
Liability of the Statutory Auditor in the
European Union (J anuary 1996), stated that
two countri es, France and I taly, prohi bi t the
si multaneous provi si on of all non-audi t
servi ces by the statutory audi tor.
The I tali an agency whi ch oversees the pub-
li c compani es quoted i n the stock exchange
has released regulati ons whi ch forbi d com-
pani es from hi ri ng management consulti ng
r ms whi ch are di rectly or i ndi rectly asso-
ci ated wi th the rms who certi fy thei r
nanci al statements.
The I ndi an Compani es Act 1956 precludes
statutory audi tors, who certi fy nanci al
statements, from servi ng as i nter nal audi -
tors of the company[189].
Opi ni on shoppi ng and l owbal l i ng
The value of the accountants attestati on i s
due to thei r neutrali ty and judi ci al i mpar-
ti ali ty[63].
The SEC has dened opi ni on shoppi ng as the
practi ce of seeki ng an audi tor wi lli ng to sup-
port a proposed accounti ng treatment
desi gned to help a company to achi eve i ts
reporti ng objectives even though doi ng so
mi ght frustrate reli able reporti ng. Audi tor
i ndependence, the credi bi li ty, role, and status
of the accounti ng professi on, and the reli abi l-
i ty of nanci al statements can be substan-
ti ally affected by opi ni on shoppi ng[199].
I n 1977, the Commi ssi on on Audi tors
Responsi bi li ti es, known as the Cohen
Commi ssi on, ci ted possi ble excessive com-
peti ti on for opi ni on shoppi ng. Such a prac-
ti ce affects the quali ty of servi ces[200]. To
enhance audi tor i ndependence and deter
opi ni on shoppi ng, the SEC requi res that
regi strant compani es provi de an explanati on
as to why the audi tor was red. ASR # 165
expli ci tly states that whenever the compani es
di smi ss the audi tor they must give the follow-
i ng i nfor mati on i n li ng For m 8-K on
whether:
there were any di sagreements wi th the
for mer accountant on any matter of
accounti ng pri nci ples or practi ce, nanci al
statement di sclosure or audi ti ng scope or
practi ce, whi ch di sagreements i f not
resolved to the sati sfacti on of the for mer
accountants would have caused hi m to make
reference i n connecti on wi th hi s report on
the subject matter of the di sagreement[201].
For m 8-K requi res the followi ng di sclosures:
Were for mer accountants di smi ssed or di d
they resi gn?
Di d the board of di rectors or audi t commi t-
tee di scuss di sagreements wi th for mer
accountants? and
Di d regi strant company li mi t di scussi on
between new and for mer accountants?[202].
A study found that after the change of audi tor,
the companys reported ear ni ngs and audi -
tors opi ni ons were more favourable[203]. I n
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the UK, the need to take i nto account the
publi cs percepti on of audi tors and thei r
i ndependence led the J oi nt Ethi cs Commi ttee
of the I nsti tutes of Chartered Accountants i n
England and Wales (I CAEW), Scotland (I CAS)
and Norther n I reland (I CANI ) to li mi t the
ci rcumstances i n whi ch audi t r ms may give
second opi ni ons, and to ban speci ali st valua-
ti ons. I t was felt that the danger i n provi di ng
a second opi ni on i s that the r m mi ght not be
aware of parti cular ci rcumstances[204].
Regulatory bodi es have also expressed
concer n about the common practi ce of pri c-
i ng i ni ti al audi t si gni cantly below cost (low-
balli ng). They fear that lowballi ng could
weaken audi tor i ndependence and reduce
audi t quali ty[205]. The SEC also cri ti ci zed the
practi ce of lower i ni ti al fees, suggesti ng that
i t could affect the audi tor i ndependence i n a
manner analogous to uncollected fees[206].
Qual i t y cont rol
The evaluators must be i ndependent of the
organi zati on and wi thout a real or apparent
coni ct of i nterest[10].
Competence alone i s not suffi ci ent; audi tors
must also be free of cli ent i nuence i n per-
for mi ng the audi t and i n reporti ng the nd-
i ngs. To emphasi ze i ndependence from thei r
cli ents, members of professi onal associ ati ons
embraced self-regulati on to emphasi ze thei r
i ndependence toward thei r cli ents. They
wanted to assure the publi c, i nvestors, and
credi tors that thei r servi ces were not only of
hi gh quali ty but were also done wi th i mpar-
ti ali ty. As a consequence, the AI CPA, the I I A,
the SEC, the GAO and other professi onal
bodi es developed poli ci es to ensure quali ty
control among them by subjecti ng themselves
to self-regulati on and i ndependent revi ews
and apprai sal of perfor mance.
I n 1976, the US General Accounti ng Offi ce
(GAO) i ssued Audit Standards Supplement
No. 9, Self-Evaluation Guide for Governmental
Audit Organizations[207]. I n 1977, the Comp-
troller General of the USA i ssued a Comptrol-
lers Handbook for National Bank Examiners
contai ni ng i nstructi ons for the revi ew of a
banks i nter nal audi t functi on[208]. I n 1977,
the AI CPA i ssued i ts Statement of Quality
Control Statement No. 1, System of Quality
Control for CPA Firmswhi ch mandates CPA
r ms to have a system of quali ty control. The
rst element of quali ty control i s i ndepen-
dence and pertai ns to the perfor mance of
attest servi ces only. I t states:
All professi onals should be i ndependent of
cli ents when perfor mi ng attest servi ces. An
i nvesti gati on i s made to deter mi ne the
r ms i ndependence before accepti ng a new
audi t cli ent[209].
I n 1978, the AI CPA establi shed a Quali ty
Revi ew Divi si on for CPA r ms and i ssued a
Peer Review Manual to emphasi ze CPA r ms
i ndependence and i ntegri ty i n thei r
work[210]. Poli ci es and procedures should be
establi shed to provi de the r m wi th reason-
able assurance that r ms at all
organi zati onal levels mai ntai n i ndependence
to the extent requi red by the:
rules of conduct;
regulati ons;
i nterpretati ons;
ruli ngs of the AI CPA, state CPA soci ety,
state board of accountancy; and, i f appli ca-
ble,
accounti ng seri es releases of the Securi ti es
and Exchange Commi ssi on[124].
I n 1984, the I nsti tute of I nter nal Audi tors
followed other professi onal organi zati ons as
a means of objectively revi ewi ng i nter nal
audi ti ng functi ons and i ssued a Quality
Assurance Manual for I nternal Auditing[211].
Later, the I I A amended the SPPI A and i ssued
SI AS No. 4, Quality Assurance[212].
I n 1987, the sui t over the fraud of E.S.L.
Gover nment Securi ti es I nc. not only received
the professi ons attenti on as a threat to the
enti re professi ons reputati on, but also
encouraged i mproved emphasi s on quali ty
control, audi tors i ndependence, the
mai ntenance of an ethi cal envi ronment
wi thi n CPA r ms and clearer communi ca-
ti on. I ntegri ty i s foremost i n tandem wi th
techni cal effectiveness[45].
Rot at i on of audi t ors
The lack of audi tor rotati on could conceiv-
ably compromi se i ndependence i n some
organi zati ons[213].
The SEC prohi bi ts anyone who perfor ms
wri te-up servi ces for a company from also
servi ng as an audi tor for that company. To
prevent close relati onshi ps between the cli ent
and the audi tor that mi ght i mpai r the appear-
ance of i ndependence, accounti ng r ms that
belong to the SEC Practi ce of the AI CPA are
requi red to rotate every ve years the partner
i n charge of a cli ent.
I n March 1992, the SEC Practi ce Secti on of
the AI CPA i ssued a report enti tled Statement
of Position Regarding Mandatory Rotation of
Audit Firms of Publicly Held Companiesmak-
i ng a case i n opposi ti on to mandatory rota-
ti on[214].
To enhance audi tor i ndependence, di rec-
tors of i nter nal audi t departments rotate
thei r audi t staff especi ally i n small r ms. I n a
survey of i nter nal audi t di rectors of small
groups (staff si zes two to ei ght), i t was felt
that moni tori ng i ndependence and handli ng
peer revi ew can present thor ny problems for
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small audi t staff. Di rectors must be sensi tive
to si tuati ons that mi ght i mpai r
i ndependence, and they should i ntervene
personally as needed. Di rectors feel that si m-
ply bei ng aware of the potenti al problem and
keepi ng close watch mi ti gates the i ndepen-
dence i ssue[213].
The I I As PSB 82-5, I ndependence Objectiv-
ity, cauti ons that audi ti ng the same area
several ti mes mi ght result i n personal rela-
ti ons wi th the audi tee that could i mpai r
objectivi ty. I nter nal audi tors may not con-
ti nue to use professi onal scepti ci sm i n
revi ewi ng areas wi th whi ch they are fami li ar.
Accordi ngly, i t i s a prudent poli cy to rotate
audi tors peri odi cally from assi gnment to
assi gnment. PSB 82-5also recommends that
an i nter nal audi t departments professi onal
development program for staff should i nclude
proper job rotati on that wi ll allow profes-
si onal growth and wi ll assure that audi ts are
perfor med objectively.
I n 1992, the Chartered Accountants J oi nt
Ethi cs Commi ttee i n the UK proposed the
rotati on of audi t partners, not only because i t
would help avoi d si tuati ons that could lead
outsi ders to questi on the audi tors objectivi ty,
but also because i t would give the cli ent the
benet of a fresh and objective scruti ny of the
nanci al statements[204].
Concl usi on
We must be fully aware of the truth that
complete i ndependence can never be
achi eved. Thi s i s true because there are
always condi ti ons that to some extent li mi t
i ndependence[1].
Audi tor i ndependence i s consi dered the hall-
mark of the audi ti ng and accounti ng profes-
si on. I ndependence i s vi ewed as the most
essenti al element of the audi ted nanci al
statements i n safeguardi ng the i nterests of
several parti es management, i nvestors,
credi tors, and the government. Professi onal
associ ati ons such as the Ameri can I nsti tute
of Certi ed Publi c Accountants, the I nsti tute
of I nter nal Audi tors, the Canadi an I nsti tute
of Chartered Accountants (CI CA), the Cad-
bury Commi ttee i n the UK, and many others
have recogni zed the i mportance of audi tor
i ndependence as both a professi onal and
ethi cal matter and codi ed i t i n thei r profes-
si onal codes of ethi cs. The US Securi ti es and
Exchange Commi ssi on, the US General
Accounti ng Offi ce, forei gn gover nments, and
stock markets have played an i mportant role
i n requi ri ng that nanci al statements be
audi ted by i ndependent accountants.
The SEC, si nce i ts i ncepti on, has played an
active role i n enhanci ng audi tor
i ndependence, i ssued several accounti ng
seri es releases, and provi ded several exam-
ples of si tuati ons that could i mpai r audi tor
i ndependence. Unfortunately, many countri es
do not have a gover nmental body li ke the US
Securi ti es and Exchange Commi ssi on to
enforce audi tor i ndependence i n audi ted
nanci al statements.
The survey of the countri es exami ned
shows that they have taken steps to enhance
audi tor i ndependence by:
establi shi ng codes of ethi cs;
promulgati ng professi onal audi ti ng stan-
dards; and
detai li ng si tuati ons that may consti tute
i mpai rment of audi tor i ndependence.
The UK recogni zed the relevance of audi tor
i ndependence as early as 1845. Most countri es
have followed the UK footsteps i n requi ri ng
that nanci al statements be audi ted by i nde-
pendent audi tors. Most countri es vi ew audi -
tor i ndependence not just as a legal tenet but
also an ethi cal matter to reckon wi th. Most
codes of ethi cs prohi bi t coni cts of i nterest
by not:
allowi ng the audi tor to serve as di rector or
employee of the company audi ted;
acti ng as a corporate trustee of the com-
pany audi ted;
accepti ng, maki ng, or guaranteei ng loans
from or to an audi t cli ent;
havi ng a di rect or i ndi rect materi al i nterest
i n the company audi ted;
assumi ng operati ng responsi bi li ti es;
havi ng fami ly relati onshi p wi th the audi t
cli ent;and
bei ng i n si tuati ons i n whi ch audi tor i nde-
pendence i s presumed to be i mpai red.
I n several countri es, the i mplementati on of
audi tor i ndependence and the compli ance
wi th professi onal audi t standards are carri ed
out by thei r gover nments and, i n many occa-
si ons, sancti oned by professi onal associ a-
ti ons. I ndependent audi tors may be censured
and even expelled from thei r respective pro-
fessi onal associ ati ons i f they are found i n
vi olati on of thei r codes of ethi cs.
The survey also shows that cross-cultural
di fferences may li mi t the effectiveness of
audi tor i ndependence even wi thi n a rela-
tively homogeneous professi on such as audi t-
i ng. Fi rst, they create a lack of consensus
wi thi n a professi on as to what consti tutes
audi tor i ndependence; and, second, they
cause a diversi ty of i nterpretati ons. The
statement that audi tors should be i ndepen-
dent i n fact and appearance wi ll be a puzzle
i n a collective culture i n whi ch relati onshi ps
and group membershi ps are the cor nerstones
of soci ety[92]. J ensen and Yi u[106] i ndi cated
that the Wester n concept of audi tor
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i ndependence runs counter to the cultural
values of the Asi an communal soci ety. Even
Confuci uss admoni shments di scourage audi -
tor i ndependence si nce The man who i s
lear ned and di scer ni ng ri sks hi s li fe, for he
exposes others faults (Lau Tses Admon-
ishment to Confucius). Chi na, J apan,
Malaysi a, and Si ngapore may adopt i nter na-
ti onal audi ti ng Standards for thei r multi na-
ti onal corporati ons, sti ll thei r cultural values
are i nconsi stent wi th the i ndependent rela-
ti onshi ps of the Asi an soci ety, thei r beli ef i n
the centrali ty of the group, and i ts resulti ng
desi re for privacy[113].
Si nce the admi ssi on of the UK i nto what
was then the European Common Market,
later became the EEC and i s now the Euro-
pean Uni on, and the enactment of the Eighth
Directive on Company Law on audi tors quali -
cati ons, the European countri es are fami l-
i ari zi ng themselves wi th the Ameri can con-
cept of audi tor i ndependence. Some cri ti cs
beli eve, however, that cultural di fferences
among European countri es make the concept
of audi tor i ndependence i nto a sort of wi ndow
dressi ng. Thi s may be the reason that led the
I nter nati onal Audi t Commi ttee of the I nter-
nati onal Federati on of Accounti ng (I FAC) to
let the local gover nments deal wi th matters of
audi tor i ndependence and other related mat-
ters.
Audi ti ng i n Afri ca, i n Russi a, and i n some
Mi ddle Easter n countri es i s sti ll i n i ts
i nfancy. I t i s premature to predi ct how audi t
i ndependence wi ll evolve. Audi t i ndepen-
dence i n the Anglo-Saxon countri es (Aus-
trali a, Canada, UK, USA, and New Zealand)
has reached a hi gh level of sophi sti cati on
owi ng to the i nuence of powerful accounti ng
and audi ti ng bodi es.
The I nsti tute of I nter nal Audi tors has
played a major role i n fosteri ng the i nter nal
audi tor i ndependence and placed i t at the top
of i ts agenda. To di spel the noti on that i nter-
nal audi tors, as part of management, may be
vi ewed as less i ndependent than thei r coun-
terpart the exter nal audi tors, the SPPI A
requi red that i nter nal audi tors report to the
hi ghest echelon of the management hi erarchy
and that an audi t commi ttee be made of exter-
nal di rectors. The I nsti tute of I nter nal Audi -
tors, as an i nter nati onal audi ti ng associ ati on,
wi ll face some di lemmas i n the area of audi -
tor i ndependence on whether the SPPI A
ought to be modi ed to meet the cultural
values of i ts diverse i nter nati onal member-
shi p, or let the local i nsti tutes develop thei r
own standards i n consonance to thei r cul-
tural values.
The US Securi ti es and Exchange Commi s-
si on has recogni zed the uni que role of i nter-
nal audi tors and has requi red that
corporati ons devi se an i nter nal control sys-
tem and establi sh an i nter nal audi t functi on
to moni tor the i nter nal control system i n
compli ance wi th the Forei gn Corrupt Prac-
ti ces Act. I nter nal audi tor i ndependence i s a
well-accepted noti on worldwi de that even the
AI CPA has recently created a new i nter nal
audi ti ng post of the di rector of i nter nal audi t
and quali ty control. Accordi ng to AI CPA
presi dent, Barry Melancon, the creati on of
the post i ndi cates that i nter nal audi ti ng i s
somethi ng that goes beyond the nanci als, i t
i ncludes your organi zati ons processes and
abi li ty to meet i ts goals[181].
Certi ed publi c accountants (CPAs) are not
li mi ti ng themselves to the tradi ti onal attest
functi on of nanci al statements but have
expanded thei r servi ces by provi di ng compa-
ni es wi th management advi sory servi ces
(MAS) and absorbi ng the functi ons of the
i nter nal audi tors. Thi s has caused a seri ous
concer n on the part of the I nsti tute of I nter-
nal Audi tors and the Securi ti es and Exchange
Commi ssi on.
Hi stori cally the AI CPA and the SEC have
been at the crossroads on matters of audi tor
i ndependence, coni ct of i nterest, i nati on
accounti ng, the Forei gn Corrupt Practi ces
Act and now outsourci ng. Unfortunately,
attempts to ali gn the di fferences between the
SECs vi ews and the AI CPAs rules i n the
areas of audi tor i ndependence have been
unsuccessful. The latest surveys and research
studi es conducted i n Australi a show an
i nverse correlati on between the expansi on of
servi ces provi ded by the CPA r ms and the
number of quali cati ons i ssued. The larger
the servi ces provi ded the fewer the audi t
quali cati ons. Thi s conr ms the SECs long
standi ng posi ti on that extended servi ces to
compani es bei ng audi ted may i mpai r audi t
i ndependence.
The I nsti tute of I nter nal Audi tors has arti c-
ulated i ts vi ews about the new wave of out-
sourci ng that i s endangeri ng the i nter nal
audi ti ng professi on and casti ng a doubt on
CPA r ms that are assumi ng the dual role of
exter nal and i nter nal audi tors. The reason-
i ng that the i nter nal audi t functi on and the
attestati on functi on of nanci al statements
are done by two di fferent and separate
departments wi thi n the same CPA rm does
not seem a convi nci ng argument that audi tor
i ndependence wi ll be preserved. I n the past,
the SEC brought examples i n whi ch the CPA
r m played the dual role by helpi ng the com-
pany i n prepari ng the nanci al statement
and, at the same ti me, audi ti ng them. There
are no assurances that thi s wi ll not happen
agai n thus creati ng a new wave of scandals.
The legi slati on on audi tor i ndependence i s
very clear i n demandi ng from exter nal
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audi tors complete i ndependence from the
company audi ted. I n the United Statesv.
Arthur Young & Co., the Supreme Court of
the USA upheld that the i ndependent publi c
accountant owes ulti mate allegi ance to the
corporati ons credi tors and stockholders, as
well as to the i nvesti ng publi c. The publi c
watchdog functi on demands that the accoun-
tant mai ntai n total i ndependence from the
cli ent at all ti mes and requi res complete
deli ty to the publi c trust. Thi s i s also the
vi ew upheld by the Securi ti es and Exchange
Commi ssi on. Thi s rei nforces the concer n of
the I nsti tute of I nter nal Audi tors regardi ng
the new wave of i nter nal audi t servi ces pro-
vi ded by exter nal audi tors whi ch creates an
i mbalance i n the i nter nal control process.
Si nce the CPA r ms are assumi ng the dual
role of the i nter nal audi tor and the exter nal
audi tor, there i s no need, therefore, for the
exter nal audi tor to i nvesti gate the i nter nal
audi tor i ndependence i n accordance to SAS #
65, Considering the I nternal Audit Function. I t
i s dubi ous when a secti on of the CPA r m
that i s charged wi th the attestati on of the
nanci al statements has to assess the i nde-
pendence of another secti on of the same rm
charged wi th the i nter nal audi ti ng functi on.
Some cri ti cs have argued, and forci bly so,
that when checks and balances between
exter nal audi tors and i nter nal audi tors are
broken, who i s goi ng to safeguard the organi -
zati on agai nst the i ssuance of potenti al
fraudulent nanci al statements? But the
AI CPA i s sti ll argui ng that CPA r ms may
provi de i nter nal audi ti ng servi ces and are
operati ng wi thi n the COSO framework.
Outsourci ng the i nter nal audi t
departments translates i nto bi lli on dollars of
added revenues for the expandi ng CPA r ms
that are fast i ncorporati ng i nter nal audi ti ng
i n thei r practi ce. There i s a potenti al ri sk that
the slowi ng down of the i nter nal audi ti ng
functi on perfor med tradi ti onally by the i nter-
nal audi tors may further i ncrease the li keli -
hood of management fraud, the proli ferati on
of fraudulent nanci al statements whi ch may
result i n the collapse of corporati ons i n the
long run. Hi stori cally, the US government has
been slow i n preventi ng busi ness fai lures and
has i ntervened only after congressi onal com-
mi ttees have been for med to i nvesti gate thei r
causes and recommended courses of acti ons
to remedy the di sastrous si tuati ons.
The I I A wants outsourci ng stopped enti rely
and war ned the SEC that the extended audi t
servi ces or double duty trend can lead to
major problems. These extended servi ces
provi ded by exter nal audi tors are i nconsi s-
tent wi th the checks and balances bui lt i nto
the i nter nal control system, are i n vi olati on
of the Forei gn Corrupt Practi ces Act whi ch
requi res the establi shment of an i nter nal
control system to be moni tored i nter nally,
and threaten the very exi stence of the I nsti -
tute of I nter nal Audi tors, an i nter nati onal
associ ati on that provi des counseli ng world-
wi de on i nter nal controls. The I I A vi ews
i nter nal audi ti ng as a key management func-
ti on that coni cts wi th the publi c accoun-
tants responsi bi li ti es to be i ndependent of
management (Appendi x 1).
The mai n body of li terature and research
concer ni ng audi tor i ndependence shows
contrasti ng vi ews. I t has centred mai nly on
alleged threats to perceived and actual i nde-
pendence. Schlei fer and Shockley[27] i nvesti -
gated the di fferences i n the way i n whi ch
audi tors and nanci al statement users react
to poli ci es desi gned to enhance audi tor i nde-
pendence. They used multi di mensi onal scal-
i ng techni ques to measure the si mi lari ti es
and di ssi mi lari ti es of four separate groups:
1 Bi g Ei ght CPA r ms;
2 non-Bi g Ei ght CPA r ms;
3 bank loan offi cers; and
4 certi ed nanci al analysts.
The results i ndi cate that the four groups
di ffered si gni cantly i n the extent of thei r
support for the 14 poli ci es di scussed i n the
Cohen Commi ssi on Report as a means to
enhance audi tor i ndependence. The only
percepti on gap on audi tor i ndependence that
could potenti ally affect the accounti ng and
audi ti ng professi on i s the one regardi ng the
audi tors restri cti ons i n provi di ng servi ces
such as MAS and outsourci ng.
I nter nati onally, there i s no consensus on
other audi ti ng servi ces provi ded by the exter-
nal audi tors. Thi s has led the I nter nati onal
Audi ti ng Standard Commi ttee of the I nter na-
ti onal Federati on of Accountants (I FAC) to
defer thi s matter to the local gover nments.
Despi te the controversy about CPAs provi d-
i ng other accounti ng and audi ti ng servi ces, i t
must, however, be acknowledged that audi tor
i ndependence i s unparalleled i n the USA.
Thi s i s mostly due to the relentless efforts of
the US Securi ti es and Exchange Commi ssi on,
the I nsti tute of Certi ed Publi c Accountants,
and the I nsti tute of I nter nal Audi tors.
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Auditing, J ohn Wi ley & Sons, New York, NY,
1982.
2 Medni ck, R., I ndependence: lets get back to
basi cs, J ournal of Accountancy, Vol. 169,
J anuary 1990, pp. 86-93.
3 Watts Sells, E., Corporate management
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tive commi ttee, I I A Today, March/ Apri l
1996, p. 5.
189 I I A, I MA Ni xes AI CPA exposure draft, I I A
Today, May/ J une 1996, p. 5.
190 I I A, To remai n i nter nal you must remai n
i ntegral, I I A pamphlet suggests how, I I A
Today, March/ Apri l 1996, p. 4.
191 I I A, Outsourci ng loses ground i n banki ng
i ndustry, I nternal Auditor, Apri l 1995, p. 8.
192 Bi shop, W.G. I I I , Accountants may i mpai r
i ndependence by accepti ng i nter nal audi ts,
I I A News, 5 December 1995.
193 I I A, I I A hosts meeti ng wi th Bi g Si x, I I A
Today, March/ Apri l 1996, p. 2.
194 Berton, L., Who i s goi ng to audi t the audi -
tors?, The Wall Street J ournal, 5 March,
1996, p. B1.
195 Chapman, C., Fi nanci al turmoi l does not
di ssuade company from outsourci ng, I nter-
nal Auditor, 1995, p. 9.
196 Verschoor, C.C., Conti nental bank
outsources I A, I nternal Auditor, J une 1993,
p. 10.
197 Chapman, C., Outsourci ng loses ground on
banki ng i ndustry, I nternal Auditor, 1995,
p. 8.
198 I I A, Perspective on Outsourcing I nternal
Auditing: A Professional Brieng for Chief
Executi ves, The I nsti tute of I nter nal Audi -
199 Hendri ckson, H. and Espahbodi , R., Second
opi ni on, opi ni on shoppi ng and i ndepen-
dence, CPA J ournal, Vol. 61, March 1991,
pp. 26-9.
200 Cohen Commi ssi on on Audi tors Responsi bi l-
i ti es, Report of Tentati ve Conclusions, AI CPA,
New York, NY, 1977.
Accounting Series Release, #165, 12(b) of For m
8-K, 1987.
202 Smi th, D.B., An i nvesti gati on of securi ti es
and exchange commi ssi on regulati on of
audi tor change di sclosure: the case of
accounti ng seri es release No. 165, J ournal of
Accounting Research, Spri ng 1988, pp. 134-45.
203 Mangold, N.R., The Effect of Auditor Changes
on Earnings, Auditors Opinions, and Stock
Prices, Worki ng Paper, Cali for ni a State Uni -
versi ty, Hayward, CA, 1988.
204 Accountancy, Ethi cs rules to be ti ghtened,
Accountancy, Vol. 110, J uly 1992, p. 13.
205 Kanodi a, C. and Mukheri ji , A., Audi t pri c-
i ng, lowballi ng and audi t turnover: a
dynami c analysi s, Accounting Review, Vol.
69, Oct 1994, pp. 593-615.
206 AI CPA, The Commission on Auditors Respon-
sibilities: Report, Conclusions, and Recom-
mendations, AI CPA, New York, NY, 1978.
207 General Accounti ng Offi ce (GAO), Audit
Standards Supplement No. 9, Self-Evaluation
Guide for Governmental Audit Organizations,
Comptroller General of the Uni ted States,
Washi ngton, DC, 1976.
208 Comptroller of the Currency, Comptrollers
Handbook for National Bank Examiners,
Offi ce of the Comptroller of the Currency,
Washi ngton, DC, 1977.
209 AI CPA, Statement of Quality Control No.1
System of Quality Control for CPA Firms,
AI CPA, New York, NY, 1977.
210 AI CPA, Peer Review Manual, AI CPA, New
York, NY, 1978.
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[ 46 ]
Rocco R. Vanasco
11/ 9 [1996] 448
211 I I A, Quality Assurance Manual for I nternal
Auditing a Self-Assessment Handbook, The
I nsti tute of I nternal Audi tors, Altamonte
Spri ng, FL, 1984.
212 I I A, SI AS No. 4 Quali ty Assurance, The
I nternal Auditor, December 1986.
213 Cuzzetto, C.E., Lean, mean, audi ti ng
machi nes, The I nternal Auditor, Vol. 51,
December 1994, pp. 26-30.
214 AI CPA, Statement of Position Regarding
Mandatory Rotation of Audit Firms of Pub-
licly Held Companies, AI CPAs SEC Practi ce
Secti on, New York, NY, 1992.
Appendix 1: Bishops letter to Finkston
Wi lli am G. Bi shop I I I , CI A
Presi dent
The I nsti tute of I nter nal Audi tors
249 Mai tland Avenua
Altamonte Spri ngs, Flori da 32701-4201
(407) 830-7600 Ext. 288
FAX (407) 831-5171
J anuary 15, 1996
Herbert A. Fi nkston
Di rector, Professi onal Ethi cs Divi si on
AI CPA, Harborsi de Fi nanci al Center
201 Plaza Three
J ersey Ci ty, NJ 07122-3881
Dear Mr. Fi nkston:
The I nsti tute of I nter nal Audi tors (I I A) appreci -
ates the opportuni ty to present i ts vi ew on the
i ndependence and outsourci ng of the i nter nal
audi ti ng functi on. Basi l Pumm and I plan to
attend the open sessi on of the AI CPA Professi onal
Ethi c Executive Commi ttee meeti ng at 9:30 AM on
J anuary 19, 1996, i n Ft. Lauderdale.
The i nfor mati on i n thi s letter provi des The I I As
general comments regardi ng those si tuati ons i n
whi ch an exter nal audi tor also perfor ms i nter nal
audi ti ng for an organi zati on. After the Publi c
Oversi ght Board provi ded i ts vi ews i n a J une 14,
1995 letter to you, The I I A consi dered i t i mportant
to make i ts vi ews known to the Securi ti es and
Exchange Commi ssi on (SEC). A copy of my letter
to the Chi ef Accountant and an associ ated press
release also are enclosed for you and your com-
mi ttee. I also understand that a replacement to
Ethi cs Ruli ng 97-101 wi ll be exposed for a peri od of
60 days; The I I A i ntends to comment on that expo-
sure draft.
Duri ng the Commi ttee of Sponsori ng Organi za-
ti ons (COSO) meeti ng on December 14, Mi ke
Sutton of the SEC, i n di scussi ng the si tuati on i n
whi ch the exter nal audi tor has both the attest
engagement and the i nter nal audi ti ng assi gn-
ment, expressed three major concer ns on the
i mportant i ssue of i ndependence and the out-
sourci ng of the i nter nal audi ti ng functi on:
1. There should be a responsi ble and competent
manager for i nter nal audi ti ng wi thi n the com-
pany, wi th a clear separati on of management and
exter nal audi tor functi ons.
2. The gui deli nes coveri ng Extended Audi t
Servi ces should clearly deli neate ongoi ng moni -
tori ng activi ti es so as to i denti fy those that could
i mpai r the i ndependence of exter nal audi tors.
3. I n attestati on si tuati ons such as FDI CI A, the
exter nal audi tors should obtai n assurances from
management that i t di d not rely heavi ly on the
exter nal audi tor to for m the basi s for manage-
ments asserti on on the effectiveness of i nternal
controls.
The I I A has si mi lar concer ns as SEC offi ci als
have expressed. The I I A i s opposed to the total
outsourci ng of the i nter nal audi ti ng functi on to a
companys publi c accountant because i t i mpai rs
the exter nal audi tors i ndependence. I nter nal
audi ti ng i s a key management functi on that con-
i cts wi th the publi c accountants responsi bi li ti es
to be i ndependent of management.
Also, The I I A beli eves that total management of
the i nter nal audi ti ng functi on must consi st of
company employees. Thi s would allow the com-
pany to meet The I I A Standards for the Profes-
sional Practice of I nternal Auditing (Standards)
and sti ll outsource parts of the i nter nal audi ti ng
work. The I I A, however, objects to the appoi nt-
ment of a gurehead member of management i n
an attempt to shi eld the publi c accountants from a
management role.
Fi nally, The I I A acknowledges that the i nter nal
audi ti ng functi on could be outsourced to thi rd
party provi ders other than the companys publi c
accountants i f The I I A Standardswere followed.
We commend the Ethi cs Executive Commi ttee for
the di ffi cult work bei ng perfor med to develop
i nterpretati ons on the i ndependence of the exter-
nal audi tor when perfor mi ng the i nternal audi t-
i ng functi on for a cli ent. The I I A beli eves that
consi derati on of perti nent I I A Standardsand
other pronouncements provi des a basi c structure
to frame the three factors i mpacti ng the i ndepen-
dence of the exter nal audi tor: (1) the scope of
i nternal audi ti ng; (2) the structuri ng of i nter nal
audi ti ng as a part of management; and (3) the
demand for total i ndependence of the exter nal
audi tor.
Fi rst, Extended Audi t Servi ces are not clearly
dened, and i t i s unclear whether these servi ces
encompass the full range of i nter nal audi ti ng
activi ti es. The I I A Standard 300, Scope of Work,
states that The scope of i nter nal audi ti ng should
encompass the exami nati on and evaluati on of the
adequacy and effectiveness of the organi zati ons
system of i nternal control and the quali ty of
perfor mance i n carryi ng out assi gned responsi -
bi li ti es. Thi s would i nclude:
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[ 47 ]
Rocco R. Vanasco
11/ 9 [1996] 448
1. (310) Reli abi li ty and I ntegri ty of I nfor mati on
I nter nal audi tors should revi ew the reli abi li ty
and i ntegri ty of nanci al and operati ng i nfor ma-
ti on and the means used to i denti fy, measure,
classi fy, and report such i nfor mati on.
2. (320) Compli ance wi th Poli ci es, Plans, Proce-
dures, Laws, and Regulati ons I nternal audi tors
should revi ew the systems establi shed to ensure
compli ance wi th those poli ci es, plans, procedures,
laws, and regulati ons whi ch could have a si gni -
cant i mpact on operati ons and reports, and
should determi ne whether the organi zati on i s i n
compli ance.
3. (330) Safeguardi ng of Assets I nternal audi -
tors should revi ew the means of safeguardi ng
assets and, as appropri ate, veri fy the exi stence of
such assets.
4. (340) Economi cal and Effi ci ent Use of
Resources I nter nal audi tors should apprai se
the economy and effi ci ency wi th whi ch resources
are employed.
5. (350) Accompli shment of Establi shed Objec-
tives and Goals for Operati ons or Programs
I nter nal Audi tors should revi ew operati ons or
programs to ascertai n whether results are consi s-
tent wi th establi shed objectives and goals and
whether the operati ons or programs are bei ng
carri ed out as planned.
Second, The I I A Standard 500, Management of the
I nternal Audi ti ng Department, establi shes the
management of the i nternal audi ti ng functi on to
i nclude broad responsi bi li ti es requi ri ng a compe-
tent and professi onal di rector.
1. The formal charter of the i nternal audi ti ng
department i s to be approved by seni or manage-
ment and accepted by the board of di rectors. The
di rector of i nternal audi ti ng i s responsi ble for
properly managi ng the i nternal audi ti ng depart-
ment. Thi s i ncludes havi ng a statement of pur-
pose, authori ty, and responsi bi li ty of the depart-
ment; planni ng to carry out those responsi bi li ti es;
provi di ng wri tten poli ci es and procedures to gui de
the audi t staff; selecti ng and developi ng the i nter-
nal audi ti ng department staff; coordi nati ng i nter-
nal and external audi ti ng efforts; and establi shi ng
and mai ntai ni ng a quali ty assurance program to
evaluate the operati ons of the department.
2. The I I A posi ti on i s that the i ndependence
i ssue cannot be resolved si mply by the organi za-
ti on retai ni ng a general audi tor wi th employee
status to be responsi ble for di recti ng or li ai soni ng
wi th the exter nal audi tor perfor mi ng the out-
sourced i nternal audi ti ng functi on. Even i f the
responsi bi li ti es for thi s posi ti on i nclude prepara-
ti on of a charter of poli cy, oversi ght, approval of
audi t plans, revi ew of results, and communi cati on
wi th the board and/ or audi t commi ttee, thi s
general audi tor must be more than a gure-
head. Speci cally, the general audi tor should be
a dedi cated, fully competent professi onal who has
complete authori ty and responsi bi li ty over the
resources, techni ques, and quali ty to assure that
i nternal audi ti ng i s done i n compli ance wi th The
I I As Standards. As such, the general audi tor must
have suffi ci ent authori ty and resources to plan,
di rect, and control all i nternal audi ti ng activi ti es.
Fi nally, the Publi c Oversi ght Board (POB) Report
Di rectors, Management, and Audi tors Alli es i n
Protecti ng Shareholders I nterests, September
1995, states under the responsi bi li ti es of the i nde-
pendent audi tor that The board of di rectors, as
the representative of the shareholders, should be
the cli ent, not corporate management. Corporate
boards and audi t commi ttees should make thi s
clear to the audi tors. The POB Report also states:
1. I n Uni ted States v. Arthur Young & Co., the
Supreme Court of the Uni ted States concluded
that the i ndependent publi c account owes ulti -
mate allegi ance to the corporati ons credi tors and
stockholders, as well as to the i nvesti ng publi c.
Thi s, publi c watchdog functi on demands that the
accountant mai ntai n total i ndependence from the
cli ent at all ti mes and requi res complete deli ty to
the publi c trust.
2. Too close a relati onshi p can di scourage the
audi tor from speaki ng up i f the audi tor questi ons
the accounti ng pri nci ples selected, the clari ty of
di sclosures, or the esti mates and judgments made
by management.
Thus, The I I A beli eves that any new i nterpreta-
ti on should allevi ate the concer ns arti culated by
the POB.
I n summary, The I I A recommends the followi ng:
Fi rst, that the Ethi cs Executive Commi ttee
speci cally dene Extended Audi t Servi ces so
as to i denti fy those servi ces that would i mpai r the
i ndependence of the exter nal audi tor.
Second, that language be i ncluded that would
requi re a dedi cated, competent professi onal
appropri ately resourced to be able to carry out the
full authori ty and responsi bi li ty requi red to
comply wi th The I I A Standards.
Thi rd, that the Ethi cs gui deli nes should focus
on the need for total i ndependence of the exter nal
audi tor. Gui deli nes should encompass the breadth
of i nter nal audi tor and management responsi bi li -
ti es, i ncludi ng planni ng, staffi ng, organi zi ng,
controlli ng, reporti ng, moni tori ng, follow up, etc.
Further, the gui deli nes should i nclude requi re-
ments to document fully the scope and condi ti ons
of the engagement, i ncludi ng an understandi ng of
the extent of managements reli ance upon the
exter nal audi tor for an assessment of the system
of i nter nal control.
Agai n, we thank you for thi s opportuni ty to share
our vi ews on thi s i mportant i ssue. I look forward
to meeti ng you on J anuary 19th, and, i f we can
assi st you i n for mulati ng gui deli nes from an
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[ 48 ]
Rocco R. Vanasco
11/ 9 [1996] 448
i nternal audi ti ng perspective, please call me at
extenti on 288.
Regards,
2 Attachments:
1. I I A Press Release, 12/ 5/ 95
2. I I A Letter to Mi chael H. Sutton, 9/ 26/ 95
cc: Wi lli am L. Taylor
Anthony J . Ri dley, CI A
Arleen R. Thomas
Appendix 2: Bishops letter to Sutton
Presi dent
The I nsti tute of I nter nal Audi tors
249 Mai tland Avenua
Altamonte Spri ngs, Flori da 32701-4201
(407) 830-7600 Ext. 288
FAX (407) 831-5171
September 26, 1995
Mr. Mi chael H. Sutton, CPA
Chi ef Accountant
Securi ti es and Exchange Commi ssi on
Washi ngton, DC 20549
Dear Mi ke:
The I nsti tute of I nter nal Audi tors (I I A) i s an
i nternati onal organi zati on compri sed of more
than 52,000 i nter nal audi ti ng professi onals i n over
100 countri es. I t i s the only organi zati on dedi -
cated solely to the advancement of the i ndivi dual
i nternal audi tor and the i nter nal audi ti ng profes-
si on. The I I A i s the worlds leader i n research and
educati on for i nter nal audi tors and i s the stan-
dards-setti ng body for the i nternal audi ti ng pro-
fessi on.
The I I A has become i ncreasi ngly aware of
arrangements through whi ch an organi zati ons
i nternal audi ti ng functi on i s perfor med by i ts
exter nal audi tors on a contract or extended
audi t servi ces basi s, hereby dened as out-
sourci ng. Of parti cular i mportance i s the si tua-
ti on i n whi ch the enti re i nter nal audi ti ng func-
ti on i s perfor med by the same r m that does the
exter nal audi ti ng. The source of thi s concer n
relates to the publi c i nterest whi ch i s currently
protected by the i ndependent exter nal audi tor.
Shareholders and regulators of publi cly held
compani es rely upon managements representa-
ti ons of nanci al posi ti ons and results of
operati ons and, to an i ncreasi ng degree, upon
asserti ons about the suffi ci ency of i nter nal con-
trols. Thi s reli ance i s bui lt upon the thesi s that a
professi onal external audi tor completely i ndepen-
dent of the organi zati ons management has com-
pleted suffi ci ent veri cati on tests to attest to
managements representati ons and asserti ons.
The pri mary concern of The I I A i s that modern
i nternal audi ti ng, as currently dened i n profes-
si onal li terature and practi ced i n the majori ty of
U.S. publi cly held compani es, i s generally i ncom-
pati ble wi th the i ndependence requi rements of
the eter nal audi tor. Exter nal audi tors are pre-
cluded by tradi ti on, regulati on, and ruli ngs from
becomi ng part of the mangement functi ons of the
organi zati on for whi ch they perfor m publi c
accounti ng. However, the i nter nal audi ti ng func-
ti on provi des the major supporti ng assurance
that allows management to make a publi c asser-
ti on as to the effectiveness of i ts organi zati ons
i nternal control structure. I f a publi c accounti ng
rm perfor ms all the i nter nal audi ti ng activi ti es
an outsourced basi s, i t becomes, at the very least,
an i ndi rect advocate of managements asserti on.
The i ndependence i ssue ari ses when the same
rm that provi des an i ndependent opi ni on of an
organi zati ons nanci al statements also perfor ms
an engagement to express an i ndependent opi n-
i on on the fai r ness of managements asserti on.
Thi s may result i n reduced publi c condence i n
the i ntegri ty of the processes that provi de vi tal
i nfor mati on to the vari ous users.
Further, the control envi ronment of the organi -
zati on i s adversely i mpacted by the di srupti on of
the roles of i nter nal and exter nal audi tors.
Boards of di rectors, management, regulators, and
the general publi c have come to rely on the checks
and balances i nherent i n the relati onshi p
between i nter nal and exter nal audi tors. I nter nal
audi tors routi nely comment to audi t commi ttees
on the suffi ci ency of the exter nal audi tor. Si mi -
larly, exter nal audi tors respond to audi t commi t-
tee i nqui ri es about i nternal audi tor perfor mance.
When exter nal audi tors and i nter nal audi tors are
one, thi s check and balance i s eli mi nated and the
control envi ronment i s weakened.
Fi nally, the current controversy regardi ng thi s
topi c i s suffi ci ent to warrant some consi derati on
of publi c di sclosure. Publi c statements by mem-
bers of your staff and others have i ndi cated that
many share our concer n about the i ndependence
of audi tors and the i mpact on control wi thi n the
organi zati on. Thei r concern i s of suffi ci ent mag-
ni tude to warrant publi c di sclosure i n annual
reports to shareholders whenever the tradi ti onal
relati onshi p between management and the exter-
nal audi tor has been di srupted.
On behalf of The I I As members, I submi t thi s
letter and the attached di scussi on paper regard-
i ng The I I As perspective on the practi ce of out-
sourci ng. Thank you for the opportuni ty to share
our vi ews on thi s i mportant i ssue. I f we can assi st
you i n any way, please advi se. We would also be
pleased to meet wi th you and members of the SEC
staff to di scuss these matters further.
Best Regards,
cc: Roy T. Van Brunt
Attachment: The I I A Outsourci ng I nternal Audi t-
i ng Di scussi on Paper, w/ 3 enclosures
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2. Marshall A. Geiger, K. Raghunandan. 2002. Auditor Tenure and Audit Reporting Failures. AUDITING: A Journal of Practice
& Theory 21:1, 67-78. [CrossRef]
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