Stubbornly high inflation. Warning signs that the economy and job growth are slowing. We are in uncertain economic times. In the US, we have a system of checks-and-balances that ensures trust and transparency in the capital markets that help make our economy resilient, even when the outlook is gloomy.
Public company auditors evaluate financial statements and play a key role as gatekeepers in this system that helps keep US capital markets humming. The audit profession has undergone a tremendous evolution in the last two decades, one that cannot be downplayed. This sea change embodies the profession’s relentless commitment to objectivity, accountability, and independence, especially in the wake of crisis.
The passage of the Sarbanes-Oxley Act of 2002 (SOX) implemented reforms that brought about undeniable improvements to financial reporting, the audit process, and audit quality. Since then, the auditing profession has also invested in innovative approaches and mechanisms to foster accountability and safeguard against potential conflicts, from the education of auditors to firms’ best practices and controls.
These investments help maintain independence in both fact and in appearance. According to Audit Analytics, approximately 90% of the fees paid to a public company auditor are for the audit. Of the remaining 10%, the majority is related to tax services. Approximately 2% of fees paid to the auditor are for other permissible services that go through a review and approval process by the audit committee as required by SOX to safeguard independence. d by SOX to safeguard independence.
Firms invest considerable time and resources internally as an investment to uphold the letter and spirit of auditor independence. For example, at one firm a team of 15 partners and more than 250 employees constantly monitors the firm’s independence and helps audit teams maintain independence for the firm – these teams perform tens of thousands of independence-related consultations over the course of a year to maintain independence.1 Firms see systems like this as important safeguards, not compliance burdens, necessary to maintain high audit quality.
Although there are detailed rules and extensive investments to comply, there are still criticisms of the current model of auditor independence. These criticisms fail to consider the vital components – both imposed by regulation and voluntarily enacted – that safeguard the independence of auditors.
In addition to the many safeguards that auditors must follow, the Sarbanes-Oxley Act had the wisdom to reinforce the role of public company boards of directors and their audit committee. SOX requires that the audit committee, not the CEO or CFO, maintain sole responsibility for the hiring, firing, compensation of, and oversight of the external auditor. Audit committee oversight is an important ingredient of auditor independence; external auditors are not reporting to the employees whose work they are reviewing but instead to a committee with fiduciary responsibilities to the company and its investors.
There are also significant market forces that further incentivize auditors to guard their independence. Overlooking such strong market-based incentives (e.g., reputation, litigation, regulatory) can lead to unsupported predictions in those public policy proposals that advocate for a change to the existing auditor engagement model in the U.S., where the company pays the fees—as negotiated and overseen by the audit committee of the company—of the auditor (referred to as the issuer pay model). Any analysis of a public policy proposal not taking into consideration the impact of these strong safeguards and market incentives is at least incomplete—and most likely misleading—in prediction.
SOX requires that the audit committee, not the CEO or CFO, maintain sole responsibility for the hiring, firing, compensation of, and oversight of the external auditor.
One of the more stringent proposals calls for a model like IRS audits of tax returns (i.e., a regulatory/ governmental agency). Under these proposals, audits would be performed by a government agency. What such a proposal fails to acknowledge is that pushing auditor independence requirements to this extreme would also lead to a decrease in expertise. A regulatory/governmental agency may not possess the resources needed to stay completely up to date with the newest technology and audit methodology or have access to specialists and could face challenges auditing components in non-US jurisdictions, at a minimum. Although this model may appear to strengthen auditor independence on paper, it poses a significant threat to the system in practice by hamstringing the expertise needed to perform a quality audit and obtain reasonable assurance on a company’s financial statements and ICFR.
Audited financial statements are the “oxygen” of the capital markets, and the auditors who perform them remain as important as ever. The audit profession will continue to adapt, evolve, and improve, ensuring accurate, trustworthy reporting, always with the public interest in mind.
- PwC FY22 Audit Quality Report, pages 9-10. https://www.pwc.com/us/en/services/trust-solutions/library/pdfs/pwc-2022-audit-quality-report.pdf
The Value of Auditor Independence
Independence underpins the very credibility of the audit and, ultimately, its value to capital markets. It is also one reason why audit quality in the US has never been higher. Learn more about how trust is built on auditor independence.