Integrity vs. Money: The Importance of Auditor Independence

Auditing public and nonpublic companies present a myriad of challenges not commonly known to the public. Missing from nonpublic company audits are the oversight regulations of the SEC and the requirement for an audit committee. However, both public and nonpublic company audits test auditor independence and integrity, since management controls the payment of fees. To date, the accounting profession and government has failed to safeguard the independence of the auditor by providing for fee payment through independent third parties.

Small and medium-sized auditing firms performing nonpublic company audits usually deal directly with the client, the very same client that pays the engagement fee. This relationship on face value puts the auditor’s integrity in question. After all, self-interest dictates that we grow our firm and establish a profitable practice through serving and establishing long-term relationships with our clients. What happens to our independence when the client takes us hostage through non-payment of fees?

The Financial Consequences Report Modifications

Subsequent discovery of facts can lead to the issuance of an adverse opinion, or worse, withdrawal from the engagement. Fulfilling our obligation to the public may result in non-payment of fees, lawsuits and loss of the client. Of course, we are better off without this type of client, but is there a better way?

When I started my auditing career in the 1970’s one of my first employers was a national “Big 8” (now “Big 4”) auditing firm with offices based in South Florida. At the time, South Florida had the reputation of being the fraud capital of the world.

One of my first jobs involved auditing a public company that operated a franchise business. During the audit, we discovered fraudulent sales invoices – a covert effort by the client to overstate sales and earnings, and thus, increase the stock price. The audit firm acted credibly by hiring outside legal counsel and bringing in additional talent from the New York office to limit negative exposure to the firm. In the end, the client became insolvent and the CPA firm ended up with a large unpaid bill.

The Local Firm Experience can be More Severe

Many years later, I faced a similar experience as managing partner in a small local practice of fifteen professionals. The additional costs of hiring lawyers and another prominent CPA firm to “double check” my conclusions became prohibitive and overwhelming. SEC involvement added further complications.  Conclusion – the resources that small and medium-sized firms possess to properly deal with situations of this type are significantly limited when compared to a larger firm. Auditor independence came at a high price.

A substantial up front retainer might have mitigated this result, followed with frequent progress billing – but the extensive additional work would still have resulted in a substantial loss to the firm. It was years later I realized a better solution.

Regardless of the controls put in place, auditor independence is challenged when there is temptation to compromise principles for money.  Auditors should be business professionals with integrity, but not angels. In our case, the public interest was served at great expense to our firm.  Might this have been avoided if the entire audit fee, plus a contingency fund was placed in escrow? Preferably with an independent third-party before the work began.

Auditor Independence is Worth Safeguarding

Shouldn’t the honesty, integrity, independence and talent required of the auditor be worth protecting?  It seems outrageous that auditing firms, through the competitive process, submit low bids for work that should cost as least as much as high quality tax work, and then wait for collection of these fees. How can this practice protect the auditor’s independence and be in the best interests of the public good?

Competent auditors pressured with the possibly of non-collection of fees should not be pressured to compromise integrity.  The exposure the auditor faces by encountering or failing to find fraud, or other defalcations is sufficient pressure. Under this stressful conditions, there should be no additional concerns about collection issues.

Advance Progress Billing at a Minimum

At the very least, small firms auditing non-public companies must establish in the engagement letter the requirement for progress billing. The time and billing software should provide a means to paragraph bill progress fees and expenses without sacrificing the ability to document detail time spent in the event of a budget dispute. This, in fact, is one reason our firm created our own billing system and much later, ImagineTime software.

The invoice system should be flexible enough to separate agreed upon fees that do not require supporting detail from additional costs that may result from extra work outside the scope of the normal engagement. Extra work can optionally display as an additional paragraph or detail time slips, whichever is more appropriate. The final bill should recapitulate the total engagement cost and subtract previous progress billings. It should also show services outside the engagement scope and any unpaid outstanding balances – see the example that follows. In the event of disputes, support total engagement costs with a comprehensive detailed work in progress report.

Client Background Checks May not be Enough

Another way to limit exposure is to vet your client by performing a detailed background check. Nevertheless, even the most credible client on the surface can obscure a can of worms. During the 1980’s as our local firm established its’ reputation in the community. As a result, a very prominent local charity selected us as their auditors. My worst nightmare ensued by catching our audit client in an indefensible misuse of restricted funds. As fate would have it, a director misused funds for personal gain. To make matters worse, the board member involved was a prominent attorney.

Our client discharged us with a significant fee loss and referred to me as an ‘auditor in a white coat’. In hindsight, we should have insisted on substantial advance funds at engagement inception. This simple step would have limited our losses.  Consequently, the engagement letter should safeguard auditor independence. Provisions should include fee disputes and advance fee payments.

In our case, the situation reached a crisis when the successor firm consulted with us before beginning their engagement. However, we were unable to fully recover the additional time spent on the engagement. It is my hope that you can learn from our experiences.

Value yourself and insist on fair treatment. Level the playing field with a comprehensive engagement letter that covers fees and disputes. If possible, before field work begins make arrangements to have the fee placed in escrow with a third party.

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