Does the Rotation of Auditors Improve the Quality of Auditing - Essay Example

?Does The Rotation Of Auditors Improve The Quality Of Auditing? As the economy of the United Kingdom struggles to recover from the recent financial crisis marked by mortgage defaults, high rates of unemployment, corporate scandals and overall lack of investor confidence, there has been a growing debate on the need to improve transparency, accountability, trust and credibility. Whitehouse suggested that this is only achievable through quality audit (par. 3). However, according to the U.K. Competition Commission, most audit firms and public companies in the country are too interdependent, thus compromising the objectivity and skepticism that is intended to safeguard interests of shareholders. In the provisional report released by the panel, it was proposed that, for there to be audit quality, audit firms must be rotated periodically (Whitehouse par. 4). This proposal by the U.K. Competition Commission is in line with the United States Public Company Accounting Oversight Board’s (PCAOB) concept, which proposed compulsory rotation of audit firms. According to PCAOB, the proposed regulation would set a threshold on the number of years that a registered public audit firm could act as the auditor of a public company, noted Bhika and Francis (par. 2). This proposal came about out of the increasing need to improve audit quality in both the U.K. and the U.S. Audit quality, according to Arter (3) is a process involving a systematic examination of internal and external auditor’s quality system. Audit quality is seen as an important part of quality management system in an organization. Quality audit ensures that audit companies perform their duties objectively, and independently. Therefore, the U.K. Competition Commission and PCAOB believe that rotation of auditors of public companies will help increase competition among audit firms, which will also increase the quality of audit. This will be of great benefit to the shareholders since it will help safeguard shareholders interests by increasing the managers’ accountability. A report released by the U.K. Competition Commission showed that about 31% of top 100 public companies in the U.K. and 20% of the top 250 had been sharing the same audit firm for more than two decades. This raises concern since it does not promote the spirit of competition, thus resulting in lower quality, higher prices and less innovation. In addition, this results in failure of audit firms to protect the interest of shareholders (Whitehouse par. 5). The U.K Commission is also concerned that the audit market, subjugated by the Big 4, is constrained by factors that prevent companies from changing auditors. In addition, these factors allow auditors to focus more on satisfying the needs of managements than those of shareholders. A study also established that most companies find it difficult in comparing alternative audit firms with their existing auditors, as they prefer continuity. As a result, they incur significant costs in hiring and terminating the services of auditors. Therefore, the reluctance of these companies to change auditors limit reduces their bargaining power. All these problems, according to the U.K. Commission can only be addressed effectively through mandatory rotation of auditors (Whitehouse par. 6). Audit rotation, according to PWC (par. 2), pertains to setting a limit that ensures that a particular auditor does not overstay as an auditor for a particular client for too long. Instead, the auditors are required to move to terminate their services with the firms they have been working for after the expiry of the set time limit to find other clients. Perceived advantages One of the perceived advantages of audit firm rotation is that it increases audit quality (Bhika and Francis par. 6). Those in support of proposed rotation of audit firms in the country claim that the establishing term limit for audit firms will help in eliminating some of the “chumminess” that might exist between companies and audit firms, thus promoting increased skepticism, independence and objectivity. According to Bhika and Francis, establishing mandatory audit rotation in the country will make auditors focus on what they need to do in order to get audit done (par. 6). He pointed out that situations sometimes arise when auditors become more interested in establishing relationships with their clients, as opposed to performing the work for which they have been appointed to do. In this regard, he noted that when an auditor knows that his relationship with the company for which he or she is acting as an auditor is about to end, the auditor’s main concern is to perform the audit efficiently and effectively instead of getting hired next time. Audit rotation also provides many benefits to the investors of a company. Bhika and Francis noted that the U.K. investors have been the most affected by audit failures (par. 7). Some of the failures have resulted from skepticism. In this regard, it is widely believed that the proposal to introduce mandatory audit rotation will help in enhancing audit quality and independence. This will help increase investor confidence in the country’s audit process and the audit profession. Audit rotation is also seen as one of the strategies of improving audit detection in a company (Ball et al. 2). Even though auditors are not expressly mandated to detect frauds in a company, the fact that a new auditor takes over might result in the questioning of some of the long-standing practices, which might help in detecting frauds. Most fraudsters prefer taking advantage of lack of audit rotation to build and maintain trusted relationships with auditors, according to Brian Fox of Capital Confirmation, reveals Bhika and Francis (par. 8). The existence of such relationships gives fraudsters the opportunity to defraud the company without detection, a situation that only hurts the shareholders of a company. Fox argued that fraudsters seek trust of auditors in order to get their report unqualified by auditors. However, this will not be possible a mandatory rotation of audit firms is established in the country. Ball et al. attribute this to the fact that fraudsters will develop the fear of being caught by the new audit firms that would takeover (3). However, so far, there is no academic research evidence for the advantages of audit firm rotation. Perceived disadvantages As with any concept, compulsory rotation of audit firms is associated with certain disadvantages that need to be taken into consideration before implementing the proposal. Firstly, audit firms are concerned that setting term limits for which audit firms can audit the accounts of a given firm is likely to result in the loss of sources of revenue and major clients for audit firms (Ball et al. 3). At the same time, the specialized nature of certain companies often require such companies to hire only the audit firms which has personnel with desired level of expertise. As such, setting term limits for audit firms is seen to cause inconvenience since it precludes companies from choosing audit firms. This denies the audit committee the powers to vet and hire audit firms, thus diluting the impact of the committee in the governance of a company. Performing audit quality is key to audit work. However, this is only achievable if audit firms understand well their client business. Understanding a client business requires both, the audit firm and the client to devote much time are resources. In addition, hiring a new audit firm is likely to increase the risk of audit failure since the new audit firm will take too much time trying to understand its new client’s business. Therefore, there will be high risk of audit failure within the first few years of audit. According to Bhika and Francis, mandatory audit rotation increases the cost of audit (par. 10). He uses the learning curve to describe the scenario. In this regard, Plichta argues at new auditors tend to spend a lot of time soon after appointment trying to familiarize with their clients business. The time commitment spent in familiarizing with the client has to be paid by either the company or the auditors. This is a cost, which auditors claim can be avoided by allowing audit firms to audit the accounts of a given company for as long as it takes without rotation. The rotation of audit firms is also considered disadvantageous in the sense that it involves transactions that results in additional costs to both the client and the audit firm. For example, audit rotation results in increased need of communication between the predecessor and the successor, which results in additional costs. This cost is avoidable in the absence of mandatory audit firm rotation (Bhika and Francis par. 12) Critics of audit firm rotation argue that audit firm rotation will make financial reporting less reliable. This is attributed to the fact that new audit firms may not have a better understanding of the new client, thereby resulting in unreliable financial reporting and audit report. Other disadvantages associated with audit firm rotation include the fact that it impairs audit quality by promoting ‘beauty contest” among audit committee members. It also discourages buildup of audit experts (PWC par. 4). So far, there is satisfactory evidence in the field of academic research that indicates that the rotation of audit firms impairs audit quality. The PCAOB concept paper indicated that new auditors are most vulnerable to failure to detect fraud in a new engagement (Bhika and Francis par. 13). Another study conducted by the PWC showed that the quality of audit numbers is linked to the increase in audit tenure (par.6). Further, a study conducted by United States General Accounting Office on mandatory audit firm rotation found that the policy increased the initial cost of audit by more than 20% (9). To make matters worse, this cost did not include the cost incurred by the management and the audit committee in tendering the process. These compelling evidences shows that proposed mandatory audit firm rotation could greatly undermine the expertise’s accretion and impair audit quality. How to achieve audit rotation Audit firm rotation can be achieved by formulating a regulation that set limits on the number of consecutive years that any registered audit firm in the country is allowed to serve as the audit of any public company in the country. Setting such, a policy will ensure that all registered audit firms and companies know the number of consecutive years for which an audit firm is allowed by law to serve as an auditor for a company. However, in the event that an audit firm that disregard such a policy will have to be taken to a disciplinary committee. The same applies to companies that knowingly disregard this law, once formulated, and implanted (United States, General Accounting Office 11). Conclusion Even though audit firm rotation is capable of the quality of auditing, the policy may cause a lot of harm to many companies. According to the findings, as much as the audit rotation is capable of improving the quality of audit through increased objectivity, it undermines auditor independence, which is key to achieving audit quality. Therefore, the proposal by the U.K. Competition Commission to introduce a mandatory audit firm rotation needs to be reconsidered and its benefits weighed against the demerits. This might explain why the U.S. House of Representative unanimously rejected the PCAOB proposal for mandatory audit firm rotation in the U.S. Works Cited Arter, Dennis R. Quality Audits for Improved Performance. London, UK: ASQ Quality Press. 2003. Print. Ball, Tracey C., Jonathan Glover, Karim Jamal, Rozina Kassam, Ken Kouri, Brad Paterson D., Suresh Radhakrishnan and Shyam Sunder. Audit Firm Rotation: A Joint Academic and Practitioner Perspective 6 (9), 2012 1-4. Print. Bhika, Rajendra, and Andrea Francis. “Will Rotating Accounting Firms Enhance Audit Quality?” 7 May 2012, Web. http://www.corporatesecretary.com/articles/regulation-and-legal/12224/will-rotating-accounting-firms-enhance-audit-quality/. PWC. “Auditing Firm Rotation, Financial Reporting and Independence.” Web. 9 October 2013, http://www.pwc.com/gx/en/audit-services/publications/regulatory-debate/mandatory-firm-rotation.jhtml. United States, General Accounting Office. Mandatory Audit Firm Rotation Study: Study Questionnaires, Responses, and Summary of Respondents' Comments: Report to the Senate Committee on Banking, Housing, and Urban Affairs and the House Committee on Financial Services. GAO, 2004. Print. Whitehouse, Tammy. “U.K. Panel Suggests Rotation to Improve Audit Quality.” 22 Feb. 2013. Web. http://www.complianceweek.com/uk-panel-suggests-rotation-to-improve-audit-quality/article/281597/ Read More