August 2002

Who Needs Independence Rules?

In his article “Independence and the Users of Closely Held Companies’ Financial Statements” (CPA Journal, June 2002), Nicholas J. Mastracchio Jr. makes a case for why auditor independence rules should be different for auditors of private companies, as compared to auditors of public companies. But I am afraid the case he makes is not compelling.

If the users of the financial statements “do not rely upon the outside accountant to inform them of company performance,” then they don’t need audited financial statements. Similarly, “the bank or other lender [that] has had a long-term relationship with the company, knows the officers of the company, and lives in the same community as the owners” may not need an audit. We should not change the independence rules simply because some people don’t need the auditor to be independent.

But more important, the article deals with only one aspect of independence—its appearance. Independence rules are in place, in the first instance, to assure users of financial statements and others that the auditor is objective. The Independence Standards Board (ISB), in its staff report on a conceptual framework for independence, defined independence to include independence of mind: “freedom from the effects of threats to auditor independence that would be sufficient to compromise an auditor’s objectivity.” It is the responsibility of the accounting profession, or another independence standards-setter, to determine whether a relationship or activity is likely to compromise an auditor’s objectivity, and, if it is, either to prohibit it or to mandate safeguards that effectively mitigate the threat. Only after reaching a conclusion that independence of mind is unlikely to be compromised should the profession then go on to determine whether the relationship or activity should be restricted anyway because of a concern “that [it] would lead well-informed investors and other users [of the audited financial statements] reasonably to conclude that there is an unacceptably high risk that an auditor lacks independence of mind,” which is the second part of the ISB’s definition.

There may well be reasons why the auditor independence rules for private companies should be different from those for public companies. But any attempt to define those circumstances should start from the perspective of what is right to protect the public interest, because that is what is in the profession’s long-term interest.

I should point out that while the ISB has closed, its website, www.cpaindependence.org, is still active. Interested parties can find the staff report on the conceptual framework under publications, general information.

Arthur Siegel, CPA
Former executive director,
Independence Standards Board (ISB)


The Author Responds

I agree with Art Siegel that, “There may well be reasons why the auditor independence rules for private companies should be different from those for public companies. But any attempt to define those circumstances should start from the perspective of what is right to protect the public interest, because that is what is in the profession’s long-term interest.”

However, I do not agree with the false premise that those users of closely held companies, namely financial institutions, do not need audited statements if they know the companies. Those whose practices encompass closely held companies know that this is exactly the case most of the time.

As to the point that if you know about the company’s performance you do not need the audit, that is incorrect. Empirical studies have shown that a part of the support for historical-based financial statements is not that the balance sheet is the appropriate measure of assets but that it is a starting point for the users to develop an understanding of the company’s financial position. I would not assume that because the user would develop information outside the statements an audit is not necessary.

However, I believe the major point is missed. The ISB report states: “Independence decision makers should consider the views of investors, other users, and others with an interest in the integrity of financial reporting when considering the level of independence risk, when assessing its acceptability, and when considering the costs and benefits of applying safeguards.” I would say that, rather than debating what activities provide a hindrance to the users due to a degradation of independence or discussing what helps the auditor do their job, ask the public. The survey that my article refers to does that and indicates that there is a difference.

Finally, the article not only develops the thought that the independence rules should be different, it shows there are areas where the “public” needs more protection than is provided in new rules on independence developed with only the largest firms in mind. The users of audits of closely held companies seem to question the engagement team concept. One wonders how much the small firms were considered when this and other concepts were developed.

Nicholas J. Mastracchio, Jr., PhD, CPA
Associate Professor
University at Albany


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