The five threats to independence 

Independence has long been regarded as a cornerstone of the auditing profession. This is underscored today by the title of the auditor’s certificate. It is no longer simply called the auditor’s report; rather, we have included that very word “independent” in the title, making it the “independent auditor’s report,” emphasizing the importance of an auditor’s separation from management. But what is this independence thing all about? Why is it necessary?

One way to think about independence is to look at what I like to call the accountability triangle (see Figure 1 below).

Here we see the accountability relationship graphically. Notice that the heart of the triangle is something called “subject matter.” Think of the subject matter as a set of financial statements. At the top of the triangle are the users of these financial statements. Think of investors in a business, or maybe a banker who has loaned money to a not-for-profit organization.

In the government context, think of citizens providing funding to our government agencies, or legislators who have the important job of holding government to account. All these users need good financial information to do their job. In this context, we can think of financial statements that management – the “accountable party” – prepares for the users. One way the managers display they are the accountable party is by providing a financial statement each year to the users.

But since the managers are accountable to the users for how they ran operations, there is a bit of a problem here. Managers have an incentive – their own self-interest – to make those financial statements look as good as they can. Consider, for example, a manager who may receive a bonus based on reaching certain financial targets during the year. That manager would certainly feel some pressure to make those financial statements show that he or she had achieved that bonus target. In short, the user of the financial statements would have concerns about the quality of the information in financial statements mangers prepare.

That’s where the third corner of the triangle – the practitioner corner – comes in.  

The practitioner auditor’s role adds credibility to financial statements. In effect, if you think of an annual report, the triangle shows that the user is getting information from two sources. The financial statements are coming from management. But the user has reasons not to fully trust management. Therefore, a separate document, the independent auditor’s report, is coming from the practitioner to the user. Essentially, the auditor’s report gives the user assurance that the financial statements from the other side of the triangle are reliable. The user can trust them.

And independence is at the heart of trust. Think, for example, how a user would respond if the auditor just happened to be the husband of the manager who prepared the financial statements. The user might be concerned that perhaps this relationship between the auditor and the manager was a bit too cozy. In other words, the value of the audit report may not be worth the paper it was printed on.

This example of a husband auditing his wife’s work seems pretty clear cut. But what are some other factors that compromise an auditor’s independence? To answer that question, the accounting profession has documented five threats to independence. Before each audit, each member of the audit team should examine each of the five threats illustrated the table to ensure that they are indeed independent in both fact and appearance.

Table One

These five threats must be looked at carefully. If the auditor cannot avoid them, they should not pursue the engagement. They will not be independent – in fact or appearance, or both.