Auditor Independence Threats and Malpractice Claims

Questions of independence can damage the defense of an audit claim. Some independence threats are more impactful than others. Learn how to address them.
By Sarah Beckett Ference, CPA
All CPAs are expected to perform their professional responsibilities with the highest sense of integrity. Indeed, integrity is one of the hallmarks of the profession. In accordance with the AICPA Code of Professional Conduct (the Code), integrity requires CPAs “to observe the principles of objectivity and independence and of due care” (see paragraph .05 of ET sec. 0.300.040, “Integrity”). The Code further states that CPAs in public practice “should be independent both in fact and appearance when providing auditing and other attestation services” (see paragraph .01 of ET sec. 0.300.050, “Objectivity and Independence”).

Acting with integrity and complying with independence requirements may sound simple and straightforward, and there are many bright line rules enumerated in the Code’s independence standards to address specific situations, but the Code does not, and cannot, address and provide an answer for every situation. Circumstances can and will arise that require the CPA to apply judgment in evaluating compliance with these provisions of the Code.
Complicating this assessment is that individuals may not always evaluate the same situation in the same way. Because a person’s professional judgment involves the application of their unique training, skill, and experience and can be influenced by their individual conscious or unconscious bias, different people may arrive at different conclusions. Moreover, in the event of a professional liability claim related to audit services, conclusions regarding an auditor’s independence are drawn after the fact and by unrelated third parties with the benefit of hindsight, rather than by the auditor.
Indeed, questions of independence are typically alleged as a secondary assertion in a malpractice claim in an attempt to strengthen a plaintiff ’s position against a CPA or compel settlement. Plaintiff counsel will seek to second-guess the firm’s independence, painting a picture that the auditor’s professional skepticism was tainted. Consequently, defense counsel may be reluctant to take a claim to trial, and the claim may be more difficult to defend, because juries tend to impute greater liability to the CPA firm if misconduct is alleged. For this reason, allegations of ethical violations are considered an early warning sign of a large professional liability claim. For more on this topic, read “Early Warning Signs of a Large Malpractice Claim,” (Professional Liability Spotlight, JofA, Sept. 2020).

Commonly asserted threats to independence

Auditors face constant threats to their independence, often without realizing that a threat exists. Three threats come up more often than others in the event of a claim: familiarity, self-interest, and self-review.
The Code’s independence standards describe this threat as a situation in which a member becomes “too sympathetic to the attest client’s interests or too accepting of the attest client’s work or product” due to a long or close relationship with the attest client.
This is perhaps the most common threat to independence standards raised by plaintiff attorneys against auditors, and it is easy to see why. Auditors must constantly balance the seemingly competing priorities of independence and client service. Their commitment to client service can become a double-edged sword in the event of a dispute when it is alleged that the auditor had too cozy a relationship with the client and, as a result, missed or dismissed an issue.
Common factors that can give rise to a familiarity threat include the length of the client relationship or tenure of engagement team members or the appearance of friendship between members of the engagement team and the client as evidenced through interactions and activities, such as electronic communications, social outings, and more.
The Code’s independence standards describe this as receiving a “benefit, financially or otherwise, from an interest in, or relationship with, an attest client or persons associated with the attest client.”
This threat may arise when total fees received from an attest client (both from attest and nonattest services) are significant to the firm as a whole, or the firm receives a large proportion of non-audit fees relative to the audit fee, or even if a significant portion of an auditor’s compensation is based on revenue generated from their audit clients. A plaintiff will assert that the auditor wasn’t sufficiently skeptical, and their judgment was tainted or compromised by the importance of the client relationship to the firm.
The Code’s independence standards describe this threat as a situation where “a member will not appropriately evaluate the results of a previous judgment made, or service performed or supervised by the member or an individual in the member’s firm and that the member will rely on that service in forming a judgment as part of an attest engagement.”
This threat may arise when the firm provides non-audit services and then audits the result of those services. For example, did the firm assist with the calculation of the income tax provision and disclosures? Does the firm help the client draft their footnotes? Although independence requirements call for the attest client management to designate someone with suitable skills, knowledge, and/or experience to oversee the nonattest service, the reality is that not all clients are sophisticated enough to have someone with the appropriate skills, knowledge, and experience, calling the effectiveness of this safeguard into question.

Risk management considerations 

To help address situations that may lead to a third party’s perception of impaired independence, consider the following:

  • Identify, evaluate, and address threats. ET sec. 1.210.010, “Conceptual Framework for Independence,” provides a methodology for identifying, evaluating, and addressing threats to independence resulting from a particular relationship or circumstance not otherwise explicitly addressed in the Code’s independence standards. The structured thought process provided by the conceptual framework helps CPAs reflect upon a set of facts and arrive at a reasoned conclusion and demonstrate that the firm understands the importance of independence and has taken steps to address any perceived issues. Evaluate threats and potential safeguards with an inquiring mind, considering the source, relevance, and adequacy of the information being used along with the nature, scope, and results of the professional service being provided. For more, read “A Framework for Maintaining Ethics Compliance,” (Professional Liability Spotlight, JofA, Nov. 2019). The AICPA provides a Conceptual Framework Toolkit for Independence to help members implement the conceptual framework approach.
  • Emphasize and reinforce the importance of independence with all levels of a client engagement team. Responsibility for complying with independence requirements rests with everybody.
  • Keep communications professional and engagement-related, especially written communications such as email. That’s because email is discoverable, permanent, and an easily searchable medium for plaintiff counsel to identify potential evidence against a CPA firm. Even seemingly benign comments may be interpreted out of context and viewed negatively. Don’t write something that you would be embarrassed to have read in court.
  • Consider rotating engagement team members, even if not required to do so.
  • Evaluate concentrations of revenue from individual clients and consider compensation models to ensure engagement team members are not influenced by financial incentives or gains, even subconsciously.
  • Rigorously evaluate a client’s skills, knowledge, and experience to oversee nonattest services during the acceptance process. AICPA Ethics Q&A Section 210, “Nonattest Services — General Requirements,” specifically paragraphs .02–.10, includes guidance to assist a practitioner in assessing a client’s skills, knowledge, and experience.
  • Be mindful of the impact of aggregation of threats to independence. Sometimes, it’s not the impact of one item that can damage the defense of claim, but rather the totality of them that can be troublesome. Remember to look at the big picture when performing independence evaluations.

A matter of ethics
The percentage of ethics violations investigated by the AICPA Professional Ethics Division and closed in 2021 that resulted in the expulsion, suspension, or admonishment of, or requirement of corrective action by, an AICPA member.
Source: Annual Report of AICPA Disciplinary Activity Jan. 1–Dec. 31, 2021 and 2020.

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