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

? Does the rotation of auditors improve the quality of auditing? Introduction The auditors play an important role in the decision making purposes. They have the responsibility of assessing the authenticity of the financial statements. The financial statements are used by the owners of the organizations for evaluating the management stewardship (Okpala, 2012). It is also used by the investors in their decision making process, related to purchase or sell of the securities. The auditors guide the investors and owners in their decision making process. The effective utilization of financial statements requires understanding of the functions of auditors as well. As the financial statements are the representation of management, it becomes very important to maintain the reliability and authenticity of these statements in order to avoid fraudulent activities in their preparation. The auditors have the responsibility of expressing their views related to the maintenance of fairness by the management. They are authorized with the responsibility of assessing the financial statements for testing the fairness and transparency of the information available in those statements. They collect evidences for assuring the fact that figures which are mentioned in the information does not involve material misstatement. The credibility of the financial statements is increased through the audit process conducted by the auditors. The report provided by the auditors has high influence on the decision making of bankers, creditors, investors or other stakeholders. Issues affecting the credibility of auditors and increasing the need of their rotation The present economy is struggling to recover from the turbulent period that is filled with various corporate scandals and also lacks investor confidence. Nowadays, greater emphasis is laid on the improvement of transparency, credibility, accountability and trust related to the information available in the financial statements. The structure in this auditing business appears to be problematic. Generally most of the organizations pay these auditors through one third party called ‘audit system’. But when the payments to these audit firms directly comes from their clients then they receive some incentives for not delivering any unfavourable news to them. The major question which arises is that whether these types of activities affect the real performance of the auditors. In reality, it actually affects the auditor’s performances and reduces the accuracy or authenticity of the information available in their reports (Cooper and Neu, 2006). The auditors change the figures in the financial statements for earning high incentives. This has turned out to be one of the most highlighted issues that require immediate attention. Real evidences of material misstatements increasing the need of rotation of the auditors 1. In 2003, HealthSouth Corporation was accused by SEC for violating the civil law (Turner and The Staff of Vault, 2005). According to SEC, the chairman of the company Mr. Richard M. Scrushy has inflated the actual earnings of the company by an amount of $1.4 billion by 1999. SEC states that this fraudulent activity has been done in order to satisfy Wall Street’s demands and expectations. HealthSouth Corporation has manipulated the actual figures in the financial statement for satisfying its stakeholders by hiding the real performance. Scrushy along with Don Siegleman (the previous Alabama Governor) have been accused for a series of activities, such as racketeering, bribery, laundering and various other illegal activities. There were other executives involved in the criminal activity of displaying fake company earnings in the financial statement in order to increase its reputation. SEC has reported after detailed analysis that the real earnings of HealthSouth Corporation fell short of Wall Street analyst’s expectations. Thus, the ultimate solution found by Scrushy and his team was fixing the difference amount by overstating the profit figure. Frieswick (2003) argued that there were limited paper works, which could be used to find out this fraudulent activity. The auditors of the company failed to trace such misstatement. Ernst & Young was the auditor of HealthSouth Corporation. It was unable to find out this systematic overstatement of an amount of almost $ 2.5 million of earnings of the organization. Moreover, HealthSouth Corporation was permitted to keep an overstated amount of $ 500 million accounts receivables, owed by the healthcare technology companies. The audit company was suspected to have various non audit dealings with HealthSouth Corporation. Within the time period of 2000 to 2010, Ernst & Young has conducted janitorial as well as physical appearance assessment of the company. Ernst & Young used ‘Fifty Point Checklist’ for this particular inspection procedure. The scores that were obtained was utilised by HealthSouth Corporation in its market campaigning. On the other hand, Ernst & Young received an amount of $ 2.6 million for this inspection as ‘audit associated fee’. This increased the suspicion related to the credibility of the audit company. 2. The corporate governance failures have worsened the financial situation of the organizations. The failure of Parmalat is one such example. The lack of proper corporate governance structure was one of the main reasons responsible for such failure (La Porta et al., 1997; Macey, 1998; Johnson et al., 2000). The role of the auditors have led Parmalat into the scandal (Heller, 2003; Consob, 2002; Mulligan and Munchau, 2003; Lyman, 2004). The company’s corporate governance structure was unable to maintain the Italian corporate governance structure (Melis, 1999; 2000). The internal control committee and external auditors are responsible to a great extent for putting the company in such worldwide controversy case (Melis, 2004). Bank of America stated that Parmalat did not possess 5 billion liquid assets that were reported in its financial statement as on September 2003. A notification was sent by the bank to Grant Thornton, the auditor of Parmalat, that there is no existence of such account as presented in the financial statement. Both Deloitte and Touche and Grant Thornton International failed in detecting the fraudulent activity. Perceived advantages due to the rotation of the audit companies The perceived advantages related to the mandatory rotation of the audit firms mostly centres around the improved audit quality. Proponents of this proposal claim that this term limit would help in reducing as well as eliminating the illegal dealings that might exist between these audit firms and their clients. This in turn would increase the independence and objectivity. There are situations when the auditors prefer maintaining good relationship with their clients, rather than performing best audit. However, the main concern of the auditors would be conducting the audit process with increased efficacy. The audit failures have huge negative impact on the investors. This proposal would enhance the audit quality and result in increased confidence of the investors towards the audit process. The fraud detection would be easier with the change of the audit firms in frequent manner, as it would not be easier to dissuade the successor auditors in the short span of time. The clients would not get the opportunity to establish and maintain illegal dealings with auditors. Moreover, it would result in increased authenticity and fairness of the audit reports thereby increasing the confidence and faith of the investors, shareholders, owners and other stakeholders of the organizations. Perceived disadvantages due to the rotation of the audit companies There are several disadvantages associated with the mandatory rotation of the audit companies as well. The short term limit of the accounting firms would result in losing major clients as well as other important sources of revenue for them. The specialized nature of the industries makes it necessary for the organizations in those industries to engage the audit companies, which have expertise related to the appropriate industry levels. The audit term limits might restrict the companies in selecting the best suitable audit firms for the respective industries. The audit committees of the organizations have to relinquish their role associated with the selection of audit companies, which would result in weakening of the committee’s impact. In order to implement a quality audit process, it is very important for the auditors to understand the nature of the client’s business and financial transactions involved in it. This requires time as well resources for both the audit company and the client company. It takes more time for the auditors to understand their new clients thereby increasing the chances of audit failure within first few years of the audit process. The inclusion of term limit would result in increased costs associated with the attempt of the audit firms in increasing their efficiency. Recommended Alternatives Enhancement of the language in the audit report The audit report can be defined as primary communication in between the audit company and the investors. However, the audit report provides very limited insights into various significant aspects of audit process to the investors. Thus, the investors are unable to judge from the audit process what the important issues were during this audit and how they were resolved. Enhancement of the language in the audit report would help the investors in understanding the judgement level employed by the management and audit companies. This would develop a better understanding between the investors, the management and the audit companies. Effective Audit Committees and increased transparency in the auditor oversight The audit committees are important tools that reinforce the independence of the auditors. The audit committees should have authority of overseeing the entire audit procedure and appoint as well as remove the auditors. These committees need to be well resourced and the members of these committees need to be highly qualified and independent. The audit committees should conduct assessment of the objectivity and independence of the auditors in a periodic manner in order to ensure that the auditors are performing their functions in fair manner. The reports of these committees should be made available publicly in periodic manner, detailing their oversight related to the auditors and the audit process. Increased transparency associated with the audit committee’s oversight would provide the shareholders the basis for evaluating the decision, whether to retain or change the auditor. Mandatory rotation of the audit companies would not provide the shareholders with these additional insights related to the relationship existing between the audit committee and the external auditor. Conclusion There have been increasing corporate scandals in the recent days, which resulted in decrease of the investors’ confidence. It is due to this reason that greater emphasis is given on the credibility, accountability and transparency of the information available in the financial statements of the organizations. The mandatory rotation of the auditors have several perceived advantages, such as increased audit quality and efficiency of the audit process, elimination of illegal dealings between the audit firms and their clients. However, the short term limit of these auditors has some disadvantages as well. Increased costs, audit failure in the first few years etc, are some of the disadvantages. Enhancement of the language in the audit report, creation of effective audit committees and increased transparency in the auditor oversight are some of the alternatives, which would increase the credibility in the audit process without introducing the system of mandatory rotation of the audit firms. Reference List CONSOB, 2002. Relazione annuale 2001- Commissione Nazionale per le Societa e la Borsa. [online] Available at: < http://www.consob.it/main/consob/pubblicazioni/relazione_annuale/storico_relazioni.html> [Accessed 21 October 2013]. Cooper, D. J. and Neu, D. 2006. Auditor and audit independence in an age of financial scandals. Advances in Public Interest Accounting, 12(1), pp. 1-15. Frieswick, K., 2003. How audits must change. [online] Available at: [Accessed 21 October 2013]. Heller, R., 2003. Parmalat: A particularly Italian scandal. [online]. Forbes.com LLC™ Available at: [Accessed 21 October 2013]. Johnson, S., La Porta, R., Lopez-de-Sinales, F. and Shleifer, A., 2000. Tunnelling. American Economic Review Papers and Proceedings, 90(2), pp. 22–27. La Porta, R., Lopez-de-Sinales, F., Shleifer, A. and Vishny, R., 1997. Legal Determinants of External Finance. Journal of Finance, 52(3), pp. 1131–1150. Lyman, E., 2004. Parmalat’s problems: An Italian drama. The Washington Times, January. Macey, J., 1998. Italian corporate governance: One American’s perspective. Columbia Business Law Review, 1, pp. 121–144. Melis, A., 1999. Corporate Governance. Un’analisi empirica della realta Italiana in un’ottica europea.Torino: Giappichelli. Melis, A., 2000. Corporate governance in Italy. Corporate Governance – An International Review, 8(4), pp. 347–355. Melis, A., 2004. On the role of the board of statutory auditors in Italian listed companies. Corporate Governance – An International Review, 12(1), pp. 74–84. Mulligan, M. and Munchau, W., 2003. Comment: Parmalat affair has plenty of blame to go round. Financial Times, 29 December. Okpala, K. E., 2012. Adoption of IFRS and financial statements effects: the perceived implications on FDI and Nigeria economy. Australian Journal of Business and Management Research, 2(5), pp. 76-83. Turner, T. N. And The Staff of Vault, 2005. Vault guide to the top health care employers. New York: Vault Inc. Read More