Auditing and assurance - Essay Example

……………………………………………………………………………xxxxx ………………………………………………………………………xxxx …………………………………………………………………………….xxxxx …………………………………………………………………………xxxx @2012 Auditing and Assurance Introduction The global financial crisis caused an economic meltdown. The response after the crisis was to find way of mitigating the crisis and prevent another one. Auditing was used as one of the vehicles in mitigating the effects of the current financial crisis (Se Hoon et.al 2008). Had auditing not been around, the financial crisis would have been even worse. Therefore, this report will discuss the background of the financial crisis and the proposals tabled by the commission. 1. Background of the financial crisis The financial crisis started in the year 2007 and spread with intense in 2008 despite of the central banks and regulators effort to calm it down (Merkel, 2012). In early 2009, the global economy was experiencing recession and the only way out was to focus was on preventing the downtown from prolonging to a great depression. The root causes of the financial crisis had to be looked into so as to take a cause of action (Se Hoon et.al 2008). Everyone one was responsible for the financial crisis from the government, auditors, credit agencies, banks and the public. But most of the causes originate from banks and financial institutions since they are responsible for regulating monetary policies and financial stability. Banks and other financial intermediaries play a critical role in the financial system thus it is vital to understand their role (Allison 2012). For instance, they respond to contagion meaning that one shock can affect a wide area. Therefore, if a shock is experienced by the banks, then the whole financial sector will experience the same impact. According to Allen (2001), a study conducted shows that when banks are have different network structures, they likely respond to contagion. Diamond (1996) points out those banks insure against liquidity shocks by having their interbank deposits exchanged. As a result, swapping of deposits exposes the banking system into contagion. This means that if the banks are secure from liquidity, then the financial sector is also safe. Therefore, we can say that banks responded to contagion during the financial crisis and as a result the global economy was affected (Se Hoon et.al 2008). Banks eliminate information problems between investors and borrowers by monitoring and ensure that depositors’ funds are in proper use. Secondly, they spur up economic growth. They also provide intertemporal smoothing of non-diversifiable risk at a given time as well as insuring depositors against consumption shocks. Moreover, the origin of the crisis is believed to be in U.K and in U.S. In the financial system, lenders of money include households and firms while borrowers include firms, governments and households. Lenders supply funds to borrowers in two ways. To begin with, lenders supply money through the financial markets. Secondly, through which lenders supply money is through financial intermediaries such as the banks, mutual funds, market funds, pension funds and insurance companies. The bank relaxed the lending policies by reducing the interest rates and as a result many borrowers were attracted. In U.S mortgage lending rates were relaxed and also in U.K by the Bank of England. The housing prices rose and then began to fall to unsustainable levels as a result of the abundant credit and as a result the housing bubble came into the scheme (Calvo 2009). The decline in the value of houses made borrowers to default their mortgage loan payment. The U.S public debt which forms 100% of its GDP was also another contributor of the financial crisis. Other countries such as Japan and china run surpluses. Investigations show that many banks had an off-balance sheet so as to engage in risky investments (Financial Crisis Inquiry Commission 2011). This act made them issue more loans and holding less capital to cushion them against loss. Contingent liabilities were created and this made the public to lose confidence in banks. Shadow banking system was in operation as risky financial activities such borrowing short and lending long migrated into unregulated institutions. Another cause of the financial crisis is the increased leniency in regulating commercial banks. As a result, more responsibility was put on auditors in detecting and preventing fraud. Regulators are supposed to prevent such incidence but this time the Audit profession was used as a scapegoat. Auditors contributed to the crisis by accepting director’s valuations instead of valuing the assets themselves (Jones 2011). As much as much blame is on auditors, the financial crises would have been worse. According to audit report on banks and financial intermediaries, there was insufficient information provided by the banks to the auditors (Financial Crisis Inquiry Commission 2011). As a result, there was no transparency in financial reporting. If sufficient information was provided, auditors would detect the liquidity risk and make it public. Banks did not communicate with auditors thus auditors used judgments and estimates in accordance with the international financial reporting standards (IFRS). According to the report, the responsibilities of Auditors are currently being limited. It is the responsibility of Directors to provide information to Auditors therefore auditors is not to blame. According to the audit report the presentation of risk information in the financial statements is not concise thus it becomes difficult for the users to grasp any risks (Se Hoon et.al 2008). 2. Background of the proposal After the financial crisis, measures which were to stabilize the financial system were taken. The role played by credit agencies, banks, hedge funds and the central banks had been questioned and analyzed in depth but little attention was directed to the role of audit in the financial crisis. It was evident that many banks had incurred huge losses from 2007 onwards as they were operating off balance sheet. It became difficult for the public to understand how auditors can give unqualified audit reports to their clients in the presence of financial weaknesses. The main justification by the auditors was that the current legislation allows clean reports in spite of the presence of any financials flaws in the audited entity. This reaction is what directed all attention to the scope of Audit. The commission now considered Audit as one of the key contributors to financial stability alongside corporate governance and supervision. Main argument being that assurance should detect any material misstatements and reduce risks that reduce the costs of failure on the shareholders and the wider society. Risks are usually ascertained at the financial statement level but further procedures are carried out at the assertion level (Brown 2010). The presence of financial problem is one of the key indicators of high risks in an entity of which auditors failed to bring during their audit process. On the other hand, Audit reduces costs of capital on audited companies by ensuring high degree of transparency of information with regard to the financial statements. Auditors analyze financial statements, therefore they can advice their clients whether to lend money or not. The investors use financial statements in decision making thus they have much confidence in audited reports. If the information is not accessible, transparent and cost effective then wrong decisions are most likely to be made. With all these problems the commission assumed the role of leadership and launched discussions with G20 and financial stability Board. The commission started was set up on 13th October 2010 and it started its work by consulting the public and it received a large number of responses which it processed. The first conference was the held 4the February 2011 with regard to Audit matters. It was not an easy task to obtain the opinions because everyone had a different opinion on joint audits and rotation of audit firm. The audit profession was much against these changes. However, more response lied on the need for clarity on the role of auditors and communication between the auditors and managers of entities being audited. An Impact Assessment Steering was set up in March 2011to gather all departments that were relevant to the commission. Several meeting were done and Impact Assessment Board (IAB) opinion changes were made in line with the recommendations of the impact assessment. These changes particularly showed major states experiences with joint audits and addition of mandatory and non-mandatory services. 2.1 Commissions interest in statutory Audit Statutory audit is regulated and can only be performed by statutory auditors or audit firms approved by authorizes at a national level. They are responsible to external quality assurance and act to the public’s interests. The commission is concerned with statutory audit after identifying a number of problems: a) Expectation gap on the role of Auditors As mentioned earlier, the financial crisis raised a lot of questions with regard to the quality of audits. Recent audit investigations indicate quality issues that are underlying in major audit firms. As a result, an expectation gap between the scope of audit and the audit report came into existence. Many investors could not understand why financial institutions failed a few months later after unqualified audit reports were released (Woolf and Hindson 2011). As a result, shareholders and the public raised questions with regard to the role of auditor. The EU rules do not require auditors to give an assurance on the future sustainability of the audited entity or explain the methodology used in carrying out audit work. Their main interest is on the opinion of the auditors on the financial statements and on the going concern of the entity. This creates an expectation gap among stakeholders as they get confused on the scope of the audit assessment. The legal requirements of the auditors mission, scope of audit and verification by auditors on the ability of the entity to continue as a going concern raises questions. When this gap exists; the stakeholders’ expectations are not met. A good audit opinion and report meets the needs of the user. Under the current mandates on statutory audits, auditors have less access to information about the company being audited as they do not provide sufficient facts for reporting purposes (Brown 2010). Therefore, auditors end up giving out clean audit reports. The communication between auditors and supervisors of the audited entities was poor and the opinion of the auditor on the financial reports was questionable. According to the green paper report, there has been strong support from stakeholders for financial institutions to improve their communication with external auditors. b) Insufficient existing measures to tackle risks of conflict of risks This leads to the independence of audit firms being compromised and impairment of professional skepticism. There are three impacts the independence of auditors. They include the provision of non-audit services, audited selecting and paying the auditor and familiarity to the threats. The provision of non-audit services while the audit process is still ongoing posses threat to the independence of auditors (Ernst & Young 2011). This is because auditors’ ability to question any assumptions made by the entity is compromised. Article 22 of the statutory Audit Directive points out that the presence of any third party during audit results to independence of audit firm being compromised. In spite of all this, NAS for audit firms is growing globally relative to audit services which are no longer dominant in most audit firms. In UK, the investigations report done in 2011 confirmed that conflict of interests which compromised the independence of auditors was a problem. When it comes to remuneration of auditors, the responsibility lies within the management. In fact no consultation is made with the shareholders. The choice of the auditor is usually validated during the annual general meeting, and shareholders have little or no impact on the choice of the auditors. These two issues have raised a lot of questions regarding the effectiveness of audit committees. The audit committee is an agent of the investors and should act independently from the management. This problem was identified and green paper results indicate that stakeholders support the need to strengthen the performance of audit committee and also their competence and structure (Ernst & Young (2011). The other aspect is that of familiarity where the entity appoints and reappoints the same audit firm for decades. This poses a threat which is not addressed by the EU legislation. A new auditor less agrees with the decisions of the previous auditor. At study done at a global level indicate that 60% of all fortune 1000 listed public companies have had the same auditor for more than 10 years and 10% have had the same auditor for more than 50 years. According to the select committee for economic affairs (2012) researches also indicate that audited entities who have received qualified opinion or emphasis on matter are those who have had their auditors changed often (Brown 2010). c) Barriers to entry into the statutory market for PIEs The green paper response was that choice of auditors in the market is limited to the big four companies, that is Pricewater House coopers (PWC), Delloitte, KPMG and Ernest & young. The limited choice has put barriers on other firms from entering the audit market. These barriers also prevent the extent to which audit firms can be penalized. Research in 2009 showed that the big four had a market share of 71% globally. The medium and the smaller audit firms lag behind the big four by four times in terms of the market share. In UK the bif four have 99% of the market share for all FTSE 100 index companies. In Germany, they hold 90 percent of the 30 DAX listed companies while in Spain only 46 percent of the companies are audited by the big four (European Commission 2012). The reason for such a market concentration is the perception of the public in that the big four audit firms are too big to fail. When demand is high, prices also increase and this is the same case with the big four. They charge very high prices for their services. 2010 data from the UK market indicate that at average, the big fours profit margins were 50% higher than the other audit firms. d) Burdens resulting from fragmentation of the national regulation This results to additional costs to auditors and audit firms as they have to comply by going through an aptitude test. Article 14 of the statutory directive points out that the auditor have to go through an aptitude test from the companies in which audit process id to be carried out. This is an additional compliance cost for firms who wish to operate in more than one member state and may affect the size of the firm (Perry 2011). e) Problems associated with the supervision of compliance by auditors with their obligations The cause of this problem is caused by active involvement in public oversight by the representatives of the audit professions or other practicing auditors. Most of the public oversight authorities are not independent genuinely from the audit profession of member states. Some member states such as U.K, France, Greece, Austria, Spain, Italy and Sweden have inspection systems run and executed by staffs of the public oversight committees. This is a problem as the same persons involved in providing audit services are still members of the public oversight committees (European Commission 2012). Underfinanced and Weak national structures have led to ineffective supervision of the national and EU wide audit network firms. The reason why there is lack of effectiveness in the national regulators is because of political interference and involvement of members of the profession. This problem is vibrant in Netherlands, France and Bulgaria. The EU-wide cooperation mechanism does not have effective means to ensure that supervisory rules, powers and investigation systems and penalties are properly applied. Currently, cross-border management entities covering audit network operations in member states are not supervised (European Commission 2012). Empirical evidence received from EU member states supervisory bodies indicate that a number of the national banking supervisory authorities have the right to veto on the appointment of statutory auditors for financial institutions under the national law. The information on how this exercise is carried out is not made public and that is the reason why no auditor of failed financial institution has ever been sanctioned for unqualified report. 3. Commissions proposals We have looked into the problems identified by the commission, their effects and causes. If no changes in statutory audit policies are made, existing obligations falling under statutory audit directive and other legal related acts will still be used. Therefore, the problems will not be addressed and the expectation gap on the role of auditors and value of audit will become wider. More risk will be experienced on the going concern of entities to be audited. Also, between auditors and supervisors will cause more financial instability. The provisions of no-audit services (NAS) by audit firms will continue to pose a threat to the independence of statutory audit providers. At the same time, the audit committee will not be in a position to monitor independently operations of entity due to interference by the management. The threat of familiarity will not be addressed through rotation of auditors. Also market entry barriers caused by the big four will continue to exist and may lead to status quo. All said, the situation will not improve across the EU and in other countries. Solution will not be self-regulation and lack of harmonized International Auditing standards will continue to generate compliance cost burden for audit firms. Considering the quality of audit findings, the national supervisors at the European level are not independent enough from the profession to address the it is questionable effectiveness (Brown 2010). However, individuals recommendations made during inspection by the commission can be used as supplements but cannot replace the legal framework for statutory audit. Also, the aspect of maintaining different approaches on audit regulation among member states would not eliminate the problems discussed earlier. It is critical that the independence of auditors and the market structure dealt with especially in Europe. The commissions solutions addresses not only problem at the member state level but at the global level. According to the EC select committee for economic affairs (2012) the proposals by the commission are discussed below: i. Clarification and definition of the role of statutory auditors general At the European Union level, there was no definition to the scope of Audit. Therefore, the commission proposed that more clarity should be made on the scope of Audit ant the EU level. Requirements were to be established based on the important tasks carried out during Audit work (Ernst & Young `2011). For example, requirements on the organization of audit file appointment of audit staff, responsibility of auditors as a group, record keeping, prevention of fraud and the internal quality control. Also the expectation gap was to be addressed by redefinition of the scope of statutory audit. The context of going concern of entities being audited would also lie in the hands of auditors by using information provided for by the company. To improve on the quality of information provided by the auditors, the commission proposed that audit reports should be made long and detailed so that users and audited entities could understand better. Usually, an audit report is short and has a standard language. The communication between the auditor and the audit committee was to be increased through regular dialogue. Regular dialogue does to not amount to breach of confidentiality on auditors according law. It was also required that the dialogue should at all times take place effectively in all circumstances. ii. Reinforcement of independence and professional skepticism for statutory auditors and audit firms in provision of audit services to PIEs Provision of non- audit services (NAS) to entities being audited was to be prohibited (Ernst & Young, `2011). Generally, these services were not prohibited but since it was discovered that they compromise auditors independence they have to be removed. NAS will only be provided to entities that are not being audited. Also only approved statutory audit firms will be allowed to offer audit services and connect with the firms providing NAS to the entity being audited. With regard to selection and appointment of auditors, strict rules were to be imposed on audit committees. It is proposed that the appointment of auditors shall be discussed in the presence of shareholders during the annual general meeting. Also at least two members of the audit committee shall independent and one member to have audit knowledge. Finally, appointment of the statutory auditor shall be done by an independent third party. The threat of familiarity was addressed by making rotation of statutory audit firms mandatory. The proposal on rotation of audit firms shows that audit firms are to step down after engaging for a certain number of years and would be allowed to engage again with the same entity after cooling-off period. Also the role of audit committee was too strengthened with regard to overseeing the work of the auditors. iii. Improvement of market conditions for Audit of PIEs with a view of increasing audit quality Research shows that most companies do not have time to organize tenders thus end up paying premiums to the big four for statutory audits. Therefore, the commission proposed that regular tendering was to be mandatory to all companies which are to be audited. Therefore, they are to organize invitations for audit firms who will participate in the tendering procedure regardless of whether they fall within or out of the big four (Great Britain: Parliament 2012). To avoid market dominance by the big four, contractual clauses limiting the choice of audit firms was to be prohibited. Also, transparency on the quality of audit and audit firm firms to be increased by having the audit firms financial statements disclosed. In addition, they will also report information regarding fees to supervisors. It was proposed that a certification on audit quality was to be established through a pan-European system. The system certifies that the firm is in a position of carrying out statutory audits of high quality (Ernst & Young `2011). Policy options on ways to increase the choice of auditors for PIEs was solved through joint audits and pure audit firms. PIE audits were to be done by audit firms authorized to perform audit services. In the case of joint audits, the audit obligation is to be done by more than one firm but at least one must not be from the big four. The scope of both firms should be defined but the audit responsibility is on the joint firms. It was also proposed that market share ceiling to be established particularly for the large audit firms. As a result, no audit firm is to have 20 percent of the market share with regard to audit of PIEs (Great Britain: Parliament 2012). iv. Avoidance of unnecessary compliance costs for audit providers and audited SMEs in the context of cross-border There will be mutual recognition of audit firms in member states, thus audit firms will not have to incur extra costs by doing an aptitude test. Clarified International Auditing standard were proposed to be introduced with national adds-on policies to streamline audit standards, independence, practice and internal control of audit firms (Great Britain: Parliament 2012). It was also proposed that limited reviews to be introduced instead of statutory audits as they are less costly. The only limit with limited reviews is that the level of assurance that they provide is lower compared to that of statutory audits. In addition, audit standards for SMES to be simplified and made proportionate to the size and complexity of the business. v. Improvement on the effectiveness, independence, EU-consistency on regulation and supervision of auditors It was proposed that an independent EU oversight authority be established (Great Britain: Parliament 2012). The responsibility of this authority will be to supervise national audit firms auditing PIEs across the border. In addition, the national audit supervisory authorities were to be strengthened in terms of powers and independence to the national levels (Ernst & Young`2011).. The audit firm structures were improved by having an independent legal status and European Union wide structure. The commission shall act as a watchdog as they would decide their own work. 4. Evaluation of the proposals Proposal one policy to change the scope of audit will solve the gap on the role of auditors. With more clarity and disclosure of information on work carried out will lead to the expectations gap being closed. However, the future viability of the firm audited will not be assured though this excluded the going concern of the entity. According to the green paper report, this option received majority votes from the respondents. Also, representatives of the audit profession supported this option (Great Britain: Parliament 2012). Rotation of auditors will eliminate the threat of familiarity and this will lead to better opinions on financial reports. On the contrary, this policy was voted against in the green paper by both the stakeholders and the audit profession. Also, making audit reports for SMEs lengthy and more detailed will enhance more understanding to. This is because most audit work is done without their knowledge. Increased communication between auditors and supervisors will lead to increased quality in assurance and financial reporting. This policy was largely voted for by respondents of the green paper. Conclusion In my opinion, all the proposed policies are for the interest of the stakeholders and improve the quality of the audit profession. Implementation of these policies will change the audit profession and also prevent future financial crises. References 1. Adrian Blundell-Wignall,Atkinson Paul & Lee, Se Hoon, 2008. The current Financial Crisis:Causes and Policy Issues. http://www.oecd.org/finance/financialmarkets/41942872.pdf 2. Albert D. Halm-addo, 2010.The 2008 Financial Crisis: The Death of an Ideology. Dorrance publishing  3. Allen, F. and Gale, D., 2001. Comparing Financial Systems, MIT Press. Ch.1, 2, 3 & 15. 4. Allison, John, 2012. The real causes of financial crisis. http://www.cato.org/pubs/catosletter/catosletterv10n1.pdf 5. Diamond, D., 1996. Financial Intermediation as delegated monitoring: A simple example. Federal Reserve Bank of Richmond Economic Quarterly, 51-66. 6. Ernst & Young, 2011. European commission legislative proposals on Audit policy. http://www.ey.com/Publication/vwLUAssets/European_Commission_legislative_proposals_on_audit_policy/$FILE/EC legislative 7. European Commission, Green Paper on Audit Policy: Lessons from the Crisis, 2011. http://ec.europa.eu/internal_market/auditing/docs/reform/COM_2011_779_en.pdf 8. Financial Crisis Inquiry Commission (U.S.), National Commission on the Causes of the Financial and Economic Crisis, 2011. The Financial Crisis Inquiry Report: Final Report of the National Commission. Government print house 9. Great Britain: Parliament: House of Lords: Select Committee on Economic Affairs, 2012.Auditors: market concentration and their role, second report of session 2010. The stationery office (TSO) 10. Guillermo Calvo, 2009. Reserve Accumulation and Easy Money Caused the Subprime Crisis. 11. Howard Davies, 2010. The Financial Crisis. Polity. 12. http://wallstreetpit.com/11562-reserve-accumulation-and-easy-money-caused-the-subprime-crisis/ 13. Jones, Adam, 2011. “Auditors Criticized for Role in Financial Crisis’’ 14. Mark J. Perry, 2011. Reckless Government Policies, Not Private Greed Caused the Housing Bubble and Financial Crisis. http://wallstreetpit.com/85403-reckless-government-policies-not-private-greed-caused-the-housing-bubble-and-financial-crisis 15. Merkel, David, 2012. What Caused the Financial Crisis of 2008? http://wallstreetpit.com/95607-what-caused-the-financial-crisis-of-2008/ 16. Morgenson, Gretchen (June 25, 2010), "Strong Enough for Tough Stains?", New York times, http://www.nytimes.com/2010/06/27/business/27gret.html, retrieved 2010-06-25  17. Orice Williams Brown, 2010. Financial Markets Regulation: Financial Crisis Highlights Need to Improve. Diane publishing company 18. PWC. Audit, the Big Four, and European Commission proposals. http://www.pwc.com/gx/en/audit-services/publications/regulatory-debate/benefits-of-scale.jhtml Read More