In this first lesson,
we're gonna talk about independence and audit quality and in particular,
what trade-offs we make when we attempt to improve independence.
I want you to think about this in terms of an interaction
between how close the auditor is to the client,
and I'm not talking of course about geographic closeness,
instead I'm talking about social closeness.
Is the relationship beyond a mere professional acquaintance.
If you audit the same company for years on end,
you may become quite knowledgeable,
and even friends with, maybe close friends, with management
and does that cause problems or provide benefits overall?
So one thing you have to worry about,
is that this closeness to client management,
can increase the incentive related,
or unintentional sources of bias.
Again, when you have close friends,
you sometimes want their conclusions and their judgments to be good judgements.
After all, they're close to you.
And when this incentive related,
which could be conscious or in the presence of incentives,
or could also be subconscious bias,
or bias that's unrelated to financial incentives, maybe to
social closeness which often will be unintentional bias.
That's going to impair the auditor's objectivity in doing his or her job.
And the thing is, the insidious part of this is that the auditor
may be unaware of the extent to which
he or she is biased in making these professional judgements.
And when there's an impairment in the objectivity,
there is a decrease in audit quality.
And when there is a decrease in audit quality,
what is that going to do to the overall quality of the financial reporting by management?
Well it's going to decrease it.
On the other hand,
this closeness to the client,
will actually enable the auditor to know and
understand the client's business much better than he or she would have been able to do,
if watching the client only from afar.
If you think about the way you might respond if the IRS
sends you a love note in the mail and says that your tax return is going to be audited,
you don't immediately say, well
I'm just going to open every checking account I've
ever had and show them every asset that I ever had.
And part of the reason is that you actually worry about the competence,
sometimes, of an IRS auditor to come in and make a reasonable judgment.
You are somewhat careful about what you share to the government.
That is not the type of
relationship that you have many times in the financial statement audit,
where this governmental auditor comes in and sinking and maximize.
You know, sometimes, the return they get from the audit of
your tax return itself, rather than just getting it right.
If we really believe,
the only thing that every IRS agent had in his or her mind and heart,
was getting it right, well that would be just absolutely wonderful.
And maybe your view is that is exactly the way it
works and that would be excellent to be able to get
some empirical evidence along
those lines, and there may well be some out there and we can dig for that.
I do know more about the empirical evidence in the financial statement audit space.
When you get closer to a client,
management feels much more comfortable in sharing the assumptions that they're using to
underpin their financial statements much more comfortable telling
you some of the business risks that they see popping up on their radar,
and that will allow you to
judge the adequacy of management's responses to those business risks,
because remember, when business risks are not attended to in a wise way by management,
that presages is a precursor to enhanced heightened risk of material misstatement.
So, at the same time the auditor's drawing close to the client,
at the same time as you worry about an impairment in
their objectivity due to incentive related,
or subconscious bias, and of course the incentives can lead to, you know,
a strategic conscious bias, but also subconscious bias as well.
At the same time that's occurring,
you're getting, as a result of the auditor's closeness to the client,
enhanced knowledge of the client's business and industry,
which actually lets you improve the audit quality.
And when you improve the audit quality,
earnings quality will improve.
And I will later talk about markers of earnings quality
and markers of audit quality.
Right now, it's okay for these just to be, you know, sort of theoretical concepts in your mind.
So I guess one way to simply boil this down,
as you think about this framework that have provided to you in this lesson,
is sort of what would you prefer,
a crooked genius, or an honest idiot?
Now of course those are extremes
and you want an auditor would be neither of those.
But they do sort of prove the point of this framework.
There's a trade-off being made.