Before and After Enron: CPAs' Views on Auditor Independence

CPA Journal, The, Nov 2004 by Lindberg, Deborah L, Beck, Frank D

Auditor independence is often referred to as the cornerstone of the auditing profession because it is the foundation for the public's trust in the attest function. Although many have stated that the collapse of Enron has negatively affected the perception of auditor independence, we do not need to rely on anecdotal evidence alone. In October 2001, approximately two months prior to Enron declaring bankruptcy, an extensive survey instrument on auditor independence had been sent to 1,500 CPAs. After Enron declared bankruptcy in December 2001, the survey was sent to another 1,500 CPAs drawn from the same database.

The results indicated that CPAs' perceptions of the effects of nonaudit services on auditor independence are more negative after the Enron bankruptcy. In addition, after Enron declared bankruptcy, CPAs held a more conservative view of whether a material transaction or event detrimentally affects auditor independence. Furthermore, the findings suggest that auditors perceive that nonaudit services and other issues that threaten auditor independence detrimentally affect the public's perception of independence to a greater extent than they adversely influence actual independence.

A Discussion of Auditor Independence

Auditor independence helps to ensure quality audits and contributes to financial statement users' reliance on the financial reporting process. Several major instances of misstated earnings prompted the SEC in 2000 to adopt rules prohibiting nonaudit services inconsistent with auditor independence.

Auditor independence has long been couched in terms of independence "in fact" and independence "in appearance." An auditor who is independent in fact has the ability to make independent audit decisions even if there is a perceived lack of independence or if the auditor is placed in a potentially compromising position. Nonetheless, even when the auditor is in fact independent, one or more factors may lead the public to believe the auditor does not appear independent. This may cause users of financial statements to believe they cannot rely on financial information.

Because auditor independence in fact is a mental state, investors and other users of financial statements cannot accurately assess actual auditor objectivity; they can only evaluate an auditor's appearance of objectivity. Thus, even when an auditor acts independently in fact and issues an unbiased audit opinion, investor confidence is eroded if investors and other users of the financial statement information do not perceive that the auditor was independent in appearance. Arthur Andersen, Enron's former auditor, was perceived as lacking independence, because the accounting firm earned more revenue from nonaudit services than from audit services. While independence in fact and in appearance are both required in order to achieve the goal of independence, the Enron debacle, and the negative publicity that the auditing profession received, may have altered the public's expectations.

Policy Issues

Economic bonding. In 2000, the SEC adopted amendments to its rules governing relationships between independent auditors and their SEC clients. These rules identified nine nonaudit services inconsistent with auditor independence (Exhibit 1). The rules regarding management functions and human resources were consolidated into a single rule, resulting in eight rules that were subsequently made into law by the Sarbanes-Oxley Act of 2002.

While the independence rules allow audit firms to offer consulting services such as information technology (IT) and internal auditing, those services are subject to certain restrictions. Among other things, the rules now require annual disclosure of audit firms' fees received for auditing, IT consulting, and all other services.

Many commentators have stated that the Enron bankruptcy has forever altered the public's view of auditor independence, because Enron's auditors had previously issued unqualified opinions on Enron's financial statements. Regulators and critics of the accounting profession view an audit firm's provision of consulting services to an audit client as a conflict of interest. There is also a stream of critical literature, dating from the early 1980s, which argues that the provision of most nonaudit services threatens auditor independence, because an economic bond, which the auditor does not want to lose, develops between the client and the accounting firm.

The authors expected that CPAs would perceive the provision of nonaudit (consulting) services to auditing clients as weakening auditor independence, more so after the bankruptcy of Enron than before.

Survey

In October 2001, before Enron declared bankruptcy, the authors had developed an extensive survey instrument on auditor independence and sent it to 1,500 CPAs. After Enron declared bankruptcy, the survey was sent to another 1,500 CPAs drawn from the same database, asking their views on auditor independence.

Survey participants were asked to provide their opinions about issues that may impair auditor independence. For one set of questions, survey participants were instructed to provide their opinions about specific nonaudit services on a scale from "definitely weakens independence in fact" (1) to "definitely strengthens independence in fact" (5). Respondents were also asked to provide their perceptions of how the same nonaudit services affected independence in appearance. In a similar vein, participants were asked to provide their perceptions, in several different formats, of how several other issues affect auditor independence (Exhibit 2).