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Auditing Theory

Notes Auditor independence can be defined as a reference to the independence of internal or external
auditors from parties that might have a financial interest in the business being audited.

3.2 Independence Needs

1. Independence of mind: The state of mind that permits the provision of an opinion without
being affected by influences that compromise professional judgment, allowing an individual
to act with integrity, and exercise objectivity and professional skepticism.

2. Independence in appearance: The avoidance of facts and circumstances that are so significant
that a reasonable and informed third party, having knowledge of all relevant information,
including safeguards applied, would reasonably conclude a firms, or a member of the
assurance team’s, integrity, objectivity or professional skepticism had been compromised.
The use of the word “independence” on its own may create misunderstandings. Standing alone,
the word may lead observers to suppose that a person exercising professional judgment ought
to be free from all economic, financial and other relationships. This is impossible, as every
member of society has relationships with others. Therefore, the significance of economic, financial
and other relationships should also be evaluated in the light of what a reasonable and informed
third party having knowledge of all relevant information would reasonably conclude to be
unacceptable.

3.2.1 Appearance of Independence does affect Perceived Information
Risk

Elliott and Jacobson assert that “appearance of independence does not, at least in any way that
has been identified, affect ... information risk.” This assertion is very important to the concepts
of independence that they propose because they acknowledge that “the information risk perceived
by investors and creditors is reflected in the cost of capital to the corporation,” and they propose
that “the purpose of audit independence is to improve the cost-effectiveness of the capital
markets.” The link between audit independence and the effectiveness of the capital markets is at
the heart of their analysis.
The relationship between the appearance of independence and the effectiveness of capital markets
is not at all difficult to identify. In very simple terms, if investors and creditors believe that
auditors are advocates for their clients and lacking in objectivity and integrity, then the
information risk perceived by investors and creditors will increase and negatively impact the
cost of capital. The cost of capital will increase for corporations generally and for new and
relatively unknown companies especially. This would undermine the effectiveness of capital
markets and, at the least, seriously diminish the value of the audit function.

3.2.2 Appearance of Independence is an Appropriate Subject of
Regulation

Elliott and Jacobson suggest that the appearance of independence, apart from the fact of
independence, is not a separate, self-sufficient cause for regulation. They argued in an earlier
article (The CPA Journal, April 1998) that investors do not suffer damages from a specific
engagement when there is an appearance of lacking independence. Investors in this circumstance
simply do not rely upon the auditor. If the auditor is not independent in both appearance and
fact, then lack of reliance is the proper response. If the auditor is actually independent in fact, but
not appearance, then the auditor suffers, but the investor does not. Thus, regulation of the
appearance of independence is not justifiable, they argue, because only the person pursuing the
activity is harmed.

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