Auditor independence in the public sector, revisited.

• Author: Blann, Stephen W.

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The external audit lends credibility to the financial reporting process of state and local governments, and an essential element of that process is the independence of the external auditors from the governments they are auditing. Otherwise, those who use governmental financial statements cannot rely on the integrity and objectivity of the auditors' report.

The concept of auditor independence is governed by a number of professional standards setters, including the American Institute of Certified Public Accountants (AICPA) through its generally accepted auditing standards (GAAS). In addition, state and local governments, along with many not-for-profit entities they contract with, are frequently subject to government auditing standards, which are issued by the Government Accountability Office (GAO). Government Auditing Standards, also referred to as generally accepted government auditing standards (GAGAS), or the "Yellow Book," builds on the foundation of GAAS laid down by the AICPA and adds additional ethical principles and independence standards for performing financial audits, beyond those provided by the AICPA.

In December 2011, the GAO released an updated version of the Yellow Book that is effective for financial audits of periods ending on or after December 15, 2012. Among the more significant changes in the 2011 revision of Government Auditing Standards was the introduction of a new conceptual framework for auditor independence, which completely replaced the former "overarching principles" and "supplemental safeguards" of the previous Yellow Book. While similar in spirit to earlier guidance, this new framework represents a significant shift from a more rules-based approach to auditor independence to a more principles-based approach. (The GAO had previously issued a 70-page Q&A guide on auditor independence, in addition to the guidance actually contained in the Yellow Book.)

BASIC PRINCIPLES

The GAO's basic rule for auditor independence is fairly simple: "In all matters relating to the audit work, the audit organization and the individual auditor, whether government or public, must be independent." (1) The GAO goes on to indicate that the concept of independence comprises two elements: independence of mind, and independence in appearance.

Independence of mind is the mental state that allows an auditor to perform his or her duties with integrity and objectivity, without being influenced by factors that could compromise his or her professional judgment. This concept is sometimes referred as "independence in fact," but there is an important distinction here--the GAO isn't concerned about whether the auditor is "factually" independent of his or her client, but rather whether the auditor is actually able to undertake the audit with the appropriate mental attitude.

Independence in appearance speaks to the concept of public perception and is defined as "the absence of circumstances" that would cause a third party to conclude that an auditor's integrity, objectivity, or professional judgment had been compromised. Given that one of the primary objectives of an audit is to allow users of financial statements to be confident of their reliability, it would be counterproductive to argue that an auditor should be permitted to conduct an audit when the users of the financial statements might reasonably question his or her independence. Of course, if not appropriately limited, this rule could easily be abused. Accordingly, the standard refers to a "reasonable and informed third party, having knowledge of the relevant information." (2)

These basic principles are equally applicable to each audit engagement, audit organization, and the individual auditors participating in an audit.

GAGAS CONCEPTUAL FRAMEWORK

The new conceptual framework laid out in the Yellow Book is essentially a risk-based approach to independence.

First, the auditor...