Mandatory External Rotation of Accountant Offices - Essay Example

Mandatory External Rotation of Accountant Offices of Mandatory External Rotation of Accountant Offices 1.0 Introduction In the aftermath of When European financial crisis was over the European commission issued the Green paper as the aftermath of the crisis in order to analyze what happened and how to avoid the same kind of problems in future. The Green paper had to demonstrate that European leaders embarked on an audit policy aimed at developing a well ordered relationship between a client and its auditors. The European Commission was in favor of mandatory firm rotation and mandatory rotation of audit partners. The aim of these new audit policies was to resolve the financial crisis on a dynamic market, as well as to set out the objectives of auditing. In the U.S., the Securities and Exchange Commission is responsible for spelling out audit requirements. The SEC is more focused on internal audit as compared to external mandatory rotation of audit firms. Financial accounting reporting and auditing have been the key areas affected by the European crisis. In an attempt to resolve the predicament, both Europe and the U.S. have tried to come up with rotation. Rotation has been viewed as a solution to mitigate the threats associated with financial independence generated by developed nations (Mihaela et al., 2010). At a time when the world is facing a crisis new audit policy has to be a crucial factor in avoiding losses. Auditors usually find themselves in a fix due to the fact of being familiar with the management and being intimidated by their clients, which adversely leads to long-term client-audit relationship. Over the recent years, the subject of long-term audit and client relationship has raised eyebrows within public and social realms. Mandatory external rotation of accountants’ offices is believed to increase auditor independence and quality of audit and financial reporting (Velte & Stiglbauer, 2012). On the other hand, external auditing increases the cost of auditing in the first two years. This is because the risk of liability from auditors is significantly high in the first two years than within subsequent years. Due to the audit concentration of the four big companies, external mandatory rotation is almost not realized. The big four has a command on the number of companies they audit each year. In addition, the big four has vast experience in consultancy and have advisory services to attest to it. Therefore, this makes it hard for small and mid-sized accounting firms, which are looking forward to enter into a new market (Velte & Stiglbauer, 2012). In other cases, there have been arguments on the quality of auditing in regards to mandatory external rotation. Some circles believe that auditors conduct their reports poorly. This is because new auditors tend to ignore the going concern opinion (Velte & Stiglbauer, 2012). Rotation increases the rate of denying auditors approval due to fear of capital markets. Rotation has an impact on the capital markets and therefore management applies pressure on auditors. As a result, Companies make the auditors comply to avert the risk of losing their public image (Velte & Stiglbauer, 2012). In some cases however, the quality of audit can be explained by a lack of experience from the auditors. Such a situation cannot be resolved by mandatory external rotations. In this essay, the issue of implementing mandatory external rotation might be complex as was in Spains case (Aguilar et al., 2006)., The examples of Corporations will be cited in discussing the effectiveness of mandatory external rotation by using the empirical research method. 2.0 Theoretical Framework External mandatory rotation has been a subject of debate in the accounting profession and in the public eye. The Spanish case for instance shows that regulation in accounting and auditing is a more precarious process than suspected (Forgaty et al., p. 181). Spain is a good example of how mandatory rotation can be ineffective as it did not work and was abolished (Aguilar et al., 2006). In this essay I will use four criteria to explain the effects of using mandatory rotation. In the context of the first criteria the essay will address the question of independence. The essay will examine the pros and cons of having independent accounts in a mandatory rotation. Secondly, the essay will address the question of transparency and quality of audits. Do mandatory rotations work towards or against the quality of audits? Third, the essay will delve into the subject of implementing mandatory rotations. Here the essay will look into the cost and benefits of embracing the new accounting policy. Finally, the essay will address the relationship between the client and the accountant in mandatory external rotation. Carrera et al. (2009) points out that this topic has been heavily debated within the accounting and auditing profession but no definitive position has been arrived at regarding its appropriateness and benefit in the light of challenges that it may present. The Independence of external auditors’ implies that the auditing firm is independent from all the parties that have or might have an interest in the published results of a particular entity. Ideally, the support from the client company’s audit committee, the contractual reference to the accounting standards provides the necessary independence to the firm. Besides, the accounting professions’ code of ethics helps to provide guidance on audit firm’s independent. The Sarbanes-Oxley Act of 2002 allows external auditors to be independent. The primary purpose of an audit is to enhance the reliability and credibility of the published financial statements results (Chiu et al., 2004). It does this by providing reasonable assurance in written form from an independent audit that the published financial statement results present a “true and fair view” according to the accounting standards. The primary purpose of external audit will not be achieved if the users of the audit report believe that the company may have influenced the auditor involved either directly or indirectly. (Johnson et al., 2002) points out that the credibility and reliability of an audit report relies mostly on the technical competence of the auditor and the independence of the said auditor. Indeed, the independence of an auditor is the cornerstone of accounting and auditing profession as it is based on public trust. The recent financial crisis and high profile accounting scandals that took place in the past decade had deteriorated the image of the profession thereby calling for increased auditor’s independence. Two definitions of independence have emerged over the years. There has been real and perceived independence. Two types of independence dictate that the auditor should act independently and at least appear as independent as can be. Auditors usually have two main roles to play in the financial markets. The first one includes the role of information and, secondly, there is the insurance role. Auditors usually help in giving verification of the various financial statements that are generated by the managers, as well as help in preventing the chances of occurrence of any conflict between managers and the stakeholders whose overall effect is to uphold the value of the company. Managers tend to leave out the auditors without informing the stakeholders. The main problem that is likely to arise from this scenario is that the independence of the auditors is endangered. In other words, managers will avoid hiring qualified auditors who would give an honest opinion (Jackson et al., 2008). Audit firm rotation is a hot debate today but various countries have gone ahead and adopted the mandatory audit rotation. In the United States of America, for example, the requirements for the audit rotation is that the engagement of the auditors in a particular company should be changed once in every seven years while in the United Kingdom the audit period was reduced from seven years to five years in 2003. In South Korea, the mandatory rotation was introduced and it targets all the firms that are registered in the Korean Stock Exchange or the Korean Securities Dealers Automated Quotations with the exceptions of the foreign investment companies that are subsidiaries to the various foreign parent companies (Myers et al., 2003). 2.1 Evaluation of the Criteria This section will seek to evaluate how the mandatory rotation of the accountant offices will help in ensuring accurate reporting. The evaluation will embark on the effectiveness of mandatory rotation in external accounts office in enhancing accurate financial reporting. The shortcomings of the mandatory rotation will then be discussed. Mandatory external rotation can be helpful because of the following reasons: firstly, the auditor may fail to identify some new changes in the client’s statements. The auditor may be anticipating the result of the previous financial statement instead of looking at the statements presented. This may make the auditor overlook some changes on their financial statements. Mandatory assigning external auditors to different companies can avoid such a situation. The proponents of mandatory rotation of the accountant offices argues that this rotation will help in ensuring the auditors are not influenced by the managers in undertaking their audit activities which result in the production of incorrect reporting. They also argue that mandatory rotation will enable the accountant offices to be trusted while improving the overall image of the auditors (Chi et al., 2009). In other words, compulsory rotation increases the independence of the auditor. Unlike before, an independent auditor is more likely to identify errors and oversights. Auditors are torn between identifying errors and facing the management. In most cases, new auditors are likely to unravel new issues and challenges in the company because they are acting independently. (Ghosh & Moon, 2005) points out that the opponents of mandatory rotation are against the introduction of this mandatory rotation as they argue that the whole process is very expensive to the companies as there will be costs in the hiring of new auditors after every few years at the end of the audit term or tenure. The time that is required by the auditor to understand the management system of an institution may take long thus making the auditor to depend on the management for the assessment. However, the quality of the audit is enhanced because the relationship between the auditor and management is reduced. Consequently, new auditors tend to be alert and scrupulous because they are not working to impress the management. 3.0 Arguments 3.1 Effectiveness of Mandatory Rotation To some extent, the mandatory external rotation of accountant offices has been effective in the financial reporting of various companies but there have been some shortcomings in the adoption of this strategy. This section, will, therefore, examine the extent of the effectiveness of this strategy in financial reporting. Financial reporting has helped in preventing the client-auditor long term relationships that occur when the auditor performs audit exercises in a firm for a very long time as this relationships are likely to impair the independence and the objectivity of the auditor thus the results of the audit will not be of good quality. Mandatory rotation has helped in bringing in new auditors who brings in a new look in to the firm’s system, thus, uncovering the mistakes that were done by the previous auditors (Rapoport, 2011). Mandatory rotation implies that the period, which the auditors practice in a certain company, is usually limited, and this has enabled the auditors not to succumb to the managers pressures, which would otherwise result in the adjustment of the results to suit the manager’s interests. Mandatory rotation has helped in the improvement of the audit results of a company because the auditor becomes more cautious in performing his or her audits. These auditors are aware that other auditors will come to the company after their tenure is complete and review their work. Mandatory rotation has improved on the competition on the audit market because there are many auditors in the market that are ready to do auditing for a company thus the quality of the audit is enhanced. With the mandatory rotation there are more innovation that are likely to be undertaken in selecting as well as applying the audit methods (Ruiz-Barbadillo, Gómez-Aguilar & Carrera, 2009). By way of example, Spain implementation was more politicized than the actual process of accounting itself (Forgarty et al., p. 180) The reason why mandatory rotation in Spain proved to be ineffective was because people were afraid of its high level of transparency and hence the abolishment. 3.2 Shortcomings of Mandatory Rotation Ghosh and Moon (2005) point out that mandatory rotation has not been effective in financial reporting because mandatory rotation only serves to increase the risk of failure in the audit process. This is because in the initial duration of the audit process, the auditor depends on the management for representation but as the years progresses the auditor will learn more about the organization and its processes thus allowing the auditor to adapt and reduce the reliance on the management, which result to independence of the auditor. In addition, the previous auditors of a company will lack the knowledge transfer of the client to the successors, which is destroyed by rotation. Management usually faces a great difficulty in hiring new and qualified auditors to undertake the audits for their companies. Moreover, this proposal has the problem of considerable loss of audit quality because of the issues that may arise from the new audit firm’s understanding of the business. The fact that appropriate knowledge regarding the client may be lost as the company is switching to new auditors may be detrimental to a company. Because of this, auditors would lose client specific expertise and knowledge thereby compromising the quality of audit in the end. The best international practices requires that the audit firms should request to regularly verify the client’s continuous acceptance while taking into account the independence rules requirement. 4.0 Conclusion The adoption of the mandatory external rotation has its pros and cons. Some of the cons include increased independence of the auditor that allows them to report financial and audit reports correctly. Therefore, this improves the quality of audit reports disseminated by companies. On the hand, mandatory external rotations can have additional costs to the company. The AICPA article revealed that auditors’ risk of liability is significantly high on the first two years as compared to subsequent years. In addition, companies may lose an experienced auditor who understood the structure of the company well. A new auditor may make erroneous reporting which may adversely affect the companys image. Overall, experimental studies show that auditors collaborate with the management in concealing errors from the public (Velte & Stiglbauer, 2012). Therefore, the mandatory external rotation would put an end to such practices. References Aguilar, N., Carrera, N., Barbadillo, E., & Humphrey, C. (2006) Mandatory audit firm rotation in Spain: A policy that was never applied. University of Cadiz, Madrid. Carrera, N., Ruiz-Barbadillo, E. & Gómez-Aguilar, N. (2009). Does mandatory audit firm rotation enhance auditor independence? Auditing, Vol. 28, p. 113-135. Chiu, S., Klum, J., & Norbert, P. (2004). Mandatory rotation and auditor independence. Taiwan Accounting Review, Vol. 5, p. 71-104. Fogarty, T.J., Zucca, L.J., Meonske, N., & Kirch, D.P. (1997). Proactive practice review: a critical case study of accounting regulation that never was. Critical Perspectives on Accounting, Vol. 8(3), 167-187. Ghosh, A. & Moon D. (2005). Auditor tenure and perceptions of audit quality. The Accounting Review, Vol. 80, p. 462-479. Jackson, A., Brown, K., & Ogden, T. (2008). Mandatory audit firm rotation and audit quality. Managerial Auditing Journal, Vol. 23, p. 420-437. Johnson, V. Fahs, J., & Lutz, W. (2002). Audit firm tenure and the quality of financial reports. Contemporary Accounting Research, Vol. 19, p. 637-660. Mihaela, M., Aurelia, S., & Eugeniu, T. (2010). Audition rotation - a comparative and comperative analysis. Burcharest. Myers, J., Krumbel, A., & Onyieji, T. (2003). Exploring the term of the auditor-client relationship and the quality of earnings: A case of mandatory rotation? The Accounting Review, Vol. 78, p. 779-799. Rapoport, M. (2011). Board weighs mandatory rotation of auditors. Wall Street Journal (Online), pp.123-45 n/a-n/a. Retrieved from http://search.proquest.com/docview/869748956?accountid=45049 Ruiz-Barbadillo, E., Gómez-Aguilar, N., & Carrera, N. (2009). Does mandatory audit firm rotation enhance auditor independence? Evidence from Spain. Auditing, 28(1), 113-135. Retrieved from http://search.proquest.com/docview/216739496?accountid=45049 U.S. Securities Exchange Committee. (2000). Final rule: Revision of the commission’s auditor independence requirements. Washington: U.S. Government. Velte, P., & Stiglbauer, M. (2012). Impact of auditor and audit firm rotation on accounting and audit quality: A critical analysis of the EC regulation draft. Helsinki. Read More