Compulsory Audit Firm Rotation - Essay Example

Compulsory Audit Firm Rotation Since 2006, the mandated audit firm rotation was adopted by the Korean Financial Supervisory Services (FSS). This seven-year audit firm rotation was aimed at reducing auditors’ incentives to develop long-term relationships with their clients, which may induce preference of conservative accounting choices. The decision as to whether audit rotation should be made compulsory has become a ground for discussion in the U.S. and the world in general for over half a decade (Chi et al 2009). While the proponents of mandatory audit firm rotation boast of the new auditor’s bringing a fresh perspective and greater skeptism that would be lacking in the long-standing auditor-client relationship, the opponents maintain that because the auditor’s lack of familiarity with the industry and client, audit quality would suffer under such a regime (AICPA 1992). In late 2001, the Enron debacle followed by its high-profile collapse now focuses attention on the profession’s effectiveness in protecting the interests of the public. Thus, Sarbanes-Oxley Act 2002 mandated the General Accounting Office (GAO) to conduct a research on the potential effects of mandatory audit rotation as required by law. The study concluded that mandatory audit rotation would not necessarily strengthen auditor independence (G.A.O. 2003). The arguments for and against mandatory audit firm rotation contend whether the auditing firm’s long-term client-customer relationship and the profitable desire to maintain the client adversely affects the public accounting firm’s independence during the auditing of a company’s financial statements. Furthermore, reservations about the likely effects of the audit firm rotation include the fear of losing company-specific information gathered by an audit firm over years of experience as an auditor, and whether the intended benefits are likely to outweigh the costs. Additionally, the implementation of the Sarbanes-Oxley Act (as applied in the United States) has raised question as to its effectiveness of reforming the intended benefits of mandatory audit firm rotation. Furthermore, research studies and other publications specifically show that the advantages and disadvantages of mandatory audit firm rotation touch on auditor independence, audit quality, and increased costs. Interference with auditor independence or audit quality can result in failure and adversely affect the parties relying on the fair representation of the financial statements in conformity with established accounting standards. Proponents of audit firm rotation according to Putty and Cuganesan (1996), contend that the auditor’s comfort level with management developed over time and pressures faced by the incumbent auditor to retain the audit client can adversely affect the auditor’s actions. Thus the auditor will not appropriately deal with financial reporting issues that materially affect the company’s financial statements. On the contrary, the opposing counterparts foresee production of financial statements that contravene existing accounting standards due to the limited knowledge of the company’s operations by the new auditor, as well as information systems that support the financial statements, and financial reporting practices, none of which can be achieved within the limited time. Because more time will be required in achieving the above audit prerequisites, the risk of the auditor not being able to detect financial reporting issues could eventually affect the company’s financial reporting during new auditor’s initial years of the tenure. Similarly, there is fear that the mandatory audit would heighten the costs incurred by the private companies and public accounting firms. Precisely, the added costs of mandatory audit firm rotation and the increased risk of an audit firm failure outweigh the value of the periodic “fresh look” by a new public accounting firm (Johanson et al 2002). However, the value of the “fresh look” to cushion creditors and creditors who depend on financial statements according to the supporters of audit firm rotation are considered more beneficial than the added costs of the mandatory firm rotation. Additionally, certain competition-related issues affect auditor independence and mandatory rotation. Proponents of mandatory audit firm rotation often considered it as an appropriate means of enhancing audit quality and independence. As a matter of fact, mandatory rotation may provide increased opportunities for some public accounting firms to compete in providing quality audit services to public companies. Majority of audit firms faced with mandatory rotation predict an opportunity for them to compete for public company audits. However, others felt that mandatory rotation would close out a number of firms capable of competing for audits of public companies. Certain pressures however, are faced by firms dealing with financial reporting issues. Proponents of mandatory audit firm rotation attest to the fact that when public company management is opposed to the auditor’s position on required accounting standards, the pressures to retain the client can adversely affect the auditor’s decision to appropriately deal with financial reporting issues. Instead, the auditor would be motivated to take appropriate action by the limited tenure of record and related revenues available for the auditor through the mandatory audit firm rotation (Carcello & Nagy 2004). Accounting firms and public companies based on their experiences when asked whether the auditor’s length of tenure was factor in the auditor’s dealing with financial reporting issues and whether audit firm rotation affected the pressures the firms face, responded with majority not believing that the risk of an audit failure increased due to the auditor’s long-term relationship with the auditors’ desire to retain their client companies and the accounting firm’s management in a long audit tenure. Mandatory audit firm rotation has been established to have an effect on man-hours. This often evident during the first year of a new appointment, whereby additional man-hours will be required, coupled with the deployment of more qualified resources than those initially employed during the auditing of financial statements (Deis and Giroux 1996). The newly appointed auditor will have to work longer hours because the start-up costs such as assessing the strength of internal controls are high. Total ban on audit companies (firms of accountants) carrying out non-audit services Fundamentally, based on the decisions by the Coordinating Group, a number of arguments have been put forward against total ban of audit/accounting firms providing non-audit services as well as audit services to their clients. Greater concerns arose due to growth in non-audit fees, during provision of non-audit services, and from possible regulation solutions. Thus, auditor independence may be impaired as a result of growth in non-audit fees propagated by provision of non-audit services by accounting firms in addition to the audit services. According to the figures, in addition to non-audit fees exceeding audit fees, the change was found to occur at an increasing rate. The study by the “Financial Director” magazine showed that in 2000/01 non-audit fees paid by FTSE 100 companies to the Big Five was £m 216.4 having increased by 19.4 percent over the 1999/00 period and £m 675.0 having increased by 37.0 percent over the 1999/00 period simultaneously for audit and non-audit fees. Figures for the non-audit fees earned by the firms from FTSE 100 clients remained at an all time high. Similarly, the ACCA established that amounts paid to auditors for non-audit services have significantly increased, with the conclusion that larger UK companies have been in front in the increased use of auditors for non-audit services (Carcello & Nagy 2004). Some of the activities offered by the accounting firms include audit and accounting, management consulting, tax and legal service, and corporate finance and business recovery. Others included forensic accounting, actuarial services, transaction services, and outsourcing. During the provision of non-audit services, the arguments include recruitment and retention, ‘cross-fertilisation’ between audit and non-audit services, and independent provision of non-audit services. First, due to recruitment and retention, non-audit services are likely to make important contribution to the profitability and success of the accounting firm which encourages an influx of high quality personnel. According to Thonton (2002) “audit firms will be unable to recruit quality personnel if they are precluded from offering their personnel a route into a wider business career“. Therefore, there would not be a substantial reason why accounting firms cannot provide audit and non-audit services in order to encourage high quality personnel. On the contrary, though, if there is a potential threat to independence, the audit firms should not be provided to the same clients at the same time. ‘Cross-fertilisation’ between audit and non-audit services is the second factor against the total ban on accounting firms providing non-audit services. In this case simultaneous provision of audit and non-audit services by an accounting firm to the audit client can prove advantageous to both the auditor and the provider of non-audit services, thus providing a better service to the audit client twofold. One, the diverse services provided by the accounting increases the auditor’s knowledge of the business and enhances his ability to identify and respond to risk. And two, the auditor’s knowledge of the audit client enables the accounting firms to provide enhanced non-audit services to the client (Bamber & Bamber 2009). The third argument against the total ban on accounting firms providing non-audit services is independent provision of non-audit services. In this case, independent third parties may adopt approaches, such as aggressive taxation or accounting policies, which are not mandated to report them as the auditor. Lastly, possible regulation solutions discredit the possibility of provision of non-audit services to undermine independence despite the above benefits to the auditor and the audit client. In their analysis however, they argue that the quality of the audit, on its own, is more important to the workings of capital markets compared to the joint provision of audit and non-audit services, though the benefits of joint provision should be demonstrated (Thonton 2002). Conclusion In conclusion, previous research and reports on analysis of the companies listed in the London Stock exchange indicated that costs of mandatory audit firm rotation outweighed the benefits. The Coordinating Group were right to reject these proposals because while the arguments against mandatory audit firm rotation outweighed arguments for; and the arguments against a total ban on audit companies carrying out non-audit services outweighed the arguments for. For instance, through audit quality was threatened by mandatory rotation, audit independence was equally important, and thus a balance has to be struck. There is also need for a fresh perspective and greater skeptism from the new auditor, that would have been lacking in the long-standing auditor-client relationship. Reference list American Institute of Certified Public Accountants (AICPA) 1992, Statement of position regarding mandatory rotation of audit firms of publicly held companies. New York, AICPA.  Bamber, EM, & Bamber, LS 2009, ‘Discussion of "Mandatory Audit Partner Rotation, Audit Quality, and Market Perception: Evidence from Taiwan"’, Contemporary Accounting Research, vol. 26, pp. 393–402. Carcello, J, & Nagy, A 2004, ‘Audit firm tenure and fraudulent financial reporting’, Auditing: A Journal of Practices & Theory, vol. 23, no. 2, pp. 55-69. Chi, W, Huang, H, Liao, Y & Xie, H 2009, ‘Mandatory Audit Partner Rotation, Audit Quality, and Market Perception: Evidence from Taiwan’, Contemporary Accounting Research, vol. 26, pp. 359-391. Deis, D.R. Jr, & Giroux, G 1996, ‘The Effect of Auditor Changes on Audit fees, Audit Hours, and Audit Quality’, Journal of Accounting and Public Policy, vol. 15, pp. 55–76. G.A.O. 2003, Public accounting firms required study on the potential effects of mandatory audit firm rotation, DIANE Publishing, PA, U.S.A. Johanson, V, Khurana, I & Reynolds, K 2002, ‘Audit-firm tenure and the quality of financial reports’, Contemporary Accounting Research, vol. 19, no. 4, pp. 637-660. Putty, R & Cuganesan, S 1996, ‘Auditor rotation: Framing the debate’, Australian Accountant, vol. 66, no. 4, pp. 40-41. Sarbanes-Oaxley Act, 2002, USA Thonton, G 2002, ‘The Financial Regulation of Public Listed Companies: Sixth Report of Session 2001-02’, vol. 1. Read More