Independence Test Applies For Former Auditors Essay

Question:

Explain how the independence test applies for former auditors and accountants joining company boards?

Answer:

Introduction

The core objectives of an audit relates to the enhancement of the validity of any financial statement; the improvement in the functioning of the capital market, along with enabling the users in making sound decisions; and helping in reducing the cost of capital. It is considered as crucial that the financial statements are audited properly, so as to ensure that the functioning of the capital market is done efficiently, as well as, a presence of effective corporate governance is maintained. Usually, independence refers to the mental state of lack of any bias, as well as, objectivity[1]. In the following parts, a discussion has been made regarding the former auditors and accountants, who join the board of the company, as well as, the independence test which is applicable on them.

The Corporations Act, 2001[2] (CA), under Part 2M.4, in Subdivision 3, contains the provisions regarding the independence of the auditors. Section 324CD[3] defines the situations where a conflict of inertest arises. As per this section, such a situation arises when an auditor is unable to exercise impartial, as well as, objective judgment. This section further states that, any prudent individual would conclude that an auditor is unable to exercise such judgment, with the full knowledge of the applicable circumstances and facts. This is known as a subjective test, which is the test for independence of an auditor.

This independence test is focused on the appearance. So, the manner in which a reasonable, prudent person would logically infer the available information, which is available with the auditors, and the manner in which this can be exercised impartially, is the independence test. The objectivity has to be applied both in the appearance, as well as, the mind, at continuing levels, and the significant task is to look at the circumstances which are faced by the auditors, as well as, the relationship with the clients of the auditors. This results in the enhancement of the confidence in the investors, along with the creditors regarding the financial statements.

The independence of the former auditors, as well as, the accountants is crucial to the companies, in which such person was the auditor or the accountant[4]. The issue arises when such auditors join the board of their client’s companies. This has been identified as a cause of concern, by various stakeholders, as it violates the independence of such auditors or the accounts, gravely. A threat is established to the independence of the audit firm, on occurrence of such a violation[5]. The issue is not when such former auditor joins the client’s board, but is occurred when such partner exercises its influence over the auditing firm, which affects the soundness of the financial setup in the company, as well as the audit firm.

There are cases when the auditors hand in their papers, of resignation, just so that they can join the board of the company. And in such cases, these individuals fail to exercise due diligence before leaving the audit process. These individuals have the full knowledge regarding the approaches which are used by the auditing board, along with their testing strategies. So, upon joining the board of the client company, these former auditors would be aware about the ruse which can be used to manipulate the audit board’s approaches, as well as, their testing strategies, along with the used procedures[6]. Further, such auditors have strong relationship with the members of the audit firm, in which they were the auditors. So, even this relationship can be manipulated to gain advantage for the company, in which the former auditor becomes the member of the board. Intimidation threats and familiarity are created in such cases.

To safeguard against these issues, the CA states various requirements which have to be complied. The general requirement to avoid such situation where a conflict of interest may arise is covered under section 324CB[7], as well as, section 324CD. The specific requirements which restrict the relationships of any of the former partner, on whom the independence test is applicable, and who becomes any officer in the client company of the audit firm, are covered under the section 324CF[8], as well as, section 324CE[9].

Further, a specific cooling off period of 12 months is stated in Para 290.139 to 290.141, which are applicable on the key audit partners, along with the managing or senior partners of the firm, where the client company is a public interest entity[10]. Also, Section 324CK[11] of CA provides five year cooling off period, before which any former member of the audit firm is prohibited from becoming a director or an officer of a client of such an audit firm, in cases where already one of the former partners of the audit firm is the officer in the client company. And, Section 324CI[12] of CA, provides a two year cooling off period, for any of the former audit partner to become an officer in the client company of the audit firm.

The independence test is stated in Section 324CF(7)[13] of CA. As per this section, an individual passes on the independence test when such individual, in relation to any firm, does not, in any way, influences the financial policies or the operations of the accounting, along with the audit practice of the firm; refrains from participation in the activities of the accounting, along with the audit practice of the firm; holds no rights against the members of the firm or the firm itself in the above quoted matters related to the termination or value of the former audit firm; and there is no sort of financial understanding with the firm regarding the above quoted matters, apart from the understandings related to the regular payment of predetermined and fixed amount or regular payment of an amount where the amount is fixed and which is not depended upon earnings, revenues or profits.

This independence test is designed to keep a check on the former, who continue to have attachments with the firm, and to ensure that such individual does not take active participation in financial or serving capacity of an audit client[14].

From the above analysis, the applicability of the independence test on the former auditors, as well as, the accountants, who join the board of the company, have been clarified. And also, the justification for such independence test has been elaborated.

Bibliography

Books/Journals

Latimer, P, Australian Business Law (2014, 33rd ed., Sydney: CCH Australia Ltd)

Lipton, P, Herzberg, A, & Welsh, M, Understanding Company Law (2013, 17th ed., Australia: Thomson Law Book Co)

Naiker, V, Sharma, D,S, & Sharma, V,D, ‘Do Former Audit Firm Partners on Audit Committees Procure Greater Nonaudit Services from the Auditor?’ (2013) 88(1) The Accounting Review 297-326.

Legislations

Corporations Act, 2001 (Cth)

Others

CPA Australia Ltd, Independence guide, (2013) 36 <

Independence Standards Board, Independence Standard No. 3, (2000), <

The Treasury, Australian Auditor Independence Requirements, (2006), <

The Treasury, Australian Government, Strengthening the financial reporting framework, (2016), <

U.S. Securities and Exchange Commission, Final Rule: Revision of the Commission's Auditor Independence Requirements, (2001) <

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