The Self-Interest Threat

Most auditors, except perhaps legislative auditors like the GAO, are not perfectly independent.

A truly independent auditor can tell the truth and suffer no consequences.

CPAs in public practice aren’t independent because they are hired by the auditee and could get fired for telling the truth.

Internal auditors work inside the organization they audit and could also suffer a consequence – like a reduced budget or prohibition on hiring more auditors – if they tell the truth.

Most auditors must temper what they say in order to keep their jobs and, of course, this is not ideal.

The GAO – who is truly independent because they get funding from and report directly to the US Congress (and not the federal agencies they audit) – calls this compromise a ‘self-interest threat.’

The definition of a self-interest threat plus examples

Here’s how the GAO defines a self-interest threat in the Yellow Book:

3.30 a. Self-interest threat: The threat that a financial or other interest will inappropriately influence an auditor’s judgment or behavior.

Here are examples of this threat:

3.38 Examples of circumstances that create self-interest threats for an auditor follow:

1. An audit organization having undue dependence on income from a particular audited entity.
2. A member of the audit team entering into employment negotiations with an audited entity.
3. An audit organization discovering a significant error when evaluating the results of a previous professional service provided by the audit organization.
4. A member of the audit team having a direct financial interest in the audited entity. However, this would not preclude auditors from auditing pension plans that they participate in if (1) the auditors have no control over the investment strategy, benefits, or other management issues associated with the pension plan and (2) the auditors belong to such pension plan as part of their employment with the audit organization or prior employment with the audited entity, provided that the plan is normally offered to all employees in equivalent employment positions.

So what’s an auditor to do about it?

Well, for a CPA firm, I think it’s important to have a healthy number of clients so that you won’t have to close your doors if you lose one of them.

Ever since I was laid off from my first job after college, I’ve been wary of allowing any one client to control my economic fate. If one of my clients looms too large and makes up too much of a percentage of my revenue, I reduce my involvement with that client.

For internal auditors, nothing can really be done. The GAO requires internal auditors add a clause to their audit reports making the users of the report aware they are not absolutely independent.

9.04 Audit organizations that meet the independence requirements for internal audit organizations, but not those for external audit organizations, should include in the GAGAS compliance statement, where applicable, a statement that they are independent per the GAGAS requirements for internal auditors

Why doesn’t the GAO require a similar paragraph for CPAs in public practice? Maybe because it’s possible they could be paid and hired by someone who is not the auditee.

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