What is the Familiarity Threat in Accounting?
To understand the familiarity threat, we need to understand the role of an auditor. An auditor is hired to go over a company's financial records to make sure that the financial statements are genuine and that the company complies with tax laws. The primary role is to make sure that businesses do not perform fraud. Auditors are also vital in identifying errors. Their findings and observations are often used to improve organizational operations and increase efficiency.
Before taking on an audit assignment, auditors need to ensure that they are independent and objective towards the company they are going to audit. This means that if any threats emerge towards independence and neutrality, auditors need to manage these threats.The five major categories of threats are self-interest, advocacy, intimidation, self-review, and familiarity. All these threats have their specific sources, intensity, and impact on the job assignment. This means that the threats need to be assessed for the level of influence that they have on the auditor's job performance and outcome. If the impact of a threat is high, the best option for an auditor is to cancel the specific job engagement. This article will cover the most frequently occurring aspects of the familiarity threat
The Familiarity Threat
As the name implies, the familiarity threat occurs when the auditor is familiar with their client to the extent that the auditor cannot remain neutral and independent during the course of their audit.
A high level of familiarity causes auditors to lose their objectivity towards the client and be unable to assess their performance neutrally. There are different sources of the familiarity threat. It could be that the auditor is personally familiar with the client’s management personnel. Closeness with staff affect an auditor’s opinions and rationality.
How The Familiarity Threat Emerges
The most common source of familiarity is through prior relationships or common backgrounds with the client management or their staff. While this relationship could be during college, school, or shared social circles, familiarity also develops between an auditor and their assignment in a client/auditor role.
An ongoing client-auditor relationship with a specific client can lead to an increase in familiarity. It is necessary to state that being familiar through repeated job associations does not necessarily impact financial statements.
There could be familiarity between an auditor and a client’s management before the start of their professional relationship. For instance, an auditor may have a close family member working with their client. At times, an employee with a client may be familiar through a previous job assignment or common college or university links.
How The Familiarity Threat Affects Auditor Performance
Suppose that an auditor is a member of an audit team for a long-term client. The auditor doesn't reveal to their superior or HR that they have a relative in the client’s staff. This staff member works in accounting and is directly responsible for preparing financial statements. This means that some in a client’s accounting team can influence the review (audit) of the financial statements.
While the audit is active, the auditor finds some gross and significant mistakes in the client’s financial statements. On deeper analysis, the auditor finds out that their relative is a party causing these issues. When these errors are discussed, the relative mentions that they will be fired if the auditor releases this information.
The auditor can avail either of two choices in situations with such glaringly apparent errors. The auditor can disclose the information to their auditing firm and maintain objectivity. In such a scenario, the firm will release a modified audit report and issue a qualified opinion. Their relative loses their job.
In the other choice, the auditor withholds information about the errors and helps their relative keep their job. However, the auditor will face professional and potentially legal action for it. In addition, if the client is a repeat client in our scenario the following year, the errors would snowball, and the entire situation could worsen.
The example shows that the familiarity threat is tangible when auditors let their relationship (or familiarity) with anyone in the client impact their thought process as an auditor. The familiarity threat is high if you cannot remain objective and neutral.
Familiarity threats can also emerge from other threats like self-interest. For instance, the familiarity threat may be rising due to advocacy from the client. Whatever the reason or cause of the threat, all members of an audit team must be trained and able to identify threats and deal with them appropriately.
Dealing with the Familiarity Threat
Like any other threat to an auditors’ neutrality and objectivity, the familiarity threat is also preventable. Auditors can usually apply a few standard safety measures against these threats to escape the most negative impacts on their duties. The most practiced is that the auditing firm removes the team member affected by the threat from the auditing team to remove the familiarity threat. The auditing team remains neutral, and the affected member gets routed to another group where they can do their job effectively.
A standard practice all auditing engagement teams should practice is the regular and random shuffling of audit personnel. This should be done for all team members, regardless of their seniority. This is a fundamental element of avoiding most audit threats but is particularly effective for familiarity threats.
It should also be a critical point that team leaders and supervisors are open to listening to such issues from their younger and more inexperienced members so that they are comfortable approaching to raise any issues.
Auditing firms should make it a point to place a staff experienced in dealing with such sensitive issues and handling projects with probable threats. Conducting periodic quality control reviews is also an essential tool for assessing and avoiding threats to auditors’ independence.
Any threats to an auditor’s independence are increased when the auditor allows any familiarity with the client or their staff affects their decision-making process. The threat can be due to shared experiences or a direct relationship with someone in the client’s personnel team.
The familiarity threat can be easily avoided by moving the affected auditor from the team. Senior staff in the audit deployment team should maintain an open-door policy and a no-blame policy to encourage team members to be proactive and willing to raise issues and identify threats.