This article explores the theory of independence, and discusses why it’s vital in many contexts relating to corporate governance and professional behaviour
The concept of independence occurs at several points in the Paper P1 Study Guide. It is listed as one of the key underpinnings of corporate governance in Section A1d, it is a crucial quality possessed by both internal and external auditors (Sections B2b and B2c), and it is included in Section E5c as an ethical quality.
In corporate governance, independence is therefore important in a number of contexts. It is vital that external auditors are independent of their clients, that internal auditors are independent of the colleagues they are auditing, and that non-executive directors have a degree of independence from their executive colleagues on a board. But what do we mean by ‘independence’ as a concept?
Independence is a quality that can be possessed by individuals and is an essential component of professionalism and professional behaviour. It refers to the avoidance of being unduly influenced by a vested interest and to being free from any constraints that would prevent a correct course of action being taken. It is an ability to ‘stand apart’ from inappropriate influences and to be free of managerial capture, to be able to make the correct and uncontaminated decision on a given issue.
If, for example, an auditor is a longstanding friend of a client, the auditor may not be sufficiently independent of the client. Given that it is an auditor’s job to act on behalf of shareholders and not the client, the friendship with the client may compromise the auditor’s ability to effectively represent the interests of the shareholders. The auditor may not be as thorough as he ought to be, or he may be influenced to give the benefit of a doubt to the client when he should not be doing so.
The same could apply to non-executive directors (NEDs). In some countries, NEDs are referred to as independent directors to emphasise this very point. NEDs are appointed by shareholders in order to represent their interests on company boards. The primary fiduciary duty that NEDs owe is, therefore, to the company’s shareholders. This means that they mustn’t allow themselves to be captured or unduly influenced by the vested interests of other members of the company such as executive directors, trade unions or middle management.
Degrees of independence
A common problem in many organisational situations is ensuring independence where it could represent an ethical threat if absent. In real-life situations, friendships and networks build up over many years in which relationships exist at a number of different levels of intensity. Audit engagement partners can get to know clients very well over many years, for example, and serving together on boards can cement friendships between NEDs and executive members of a board.
Clearly then, there are varying degrees of independence. I find the use of continua helpful when describing a variable such as this. A continuum is a theoretical construct describing two extremes and a range of possible states between the two extremes. In the case of the continuum in Figure 1, the left‑hand extreme describes the ‘total independence’ extreme. At this point, the parties in the relationship have no connection with each other, may not know the identity of each other and, therefore, have no reason at all to act other than with total dispassionate independence. On the other extreme on the right-hand side – the ‘zero independence’ end – the two parties are so intimate with each other they are incapable of making a decision without considering the effect of that decision on the other party.