European Commissions Proposal to Introduce Audit Independence Reform - Essay Example

Finance and Accounting Table of Contents Review of the European Commission’s Proposal to introduce audit independence reform 2 Compulsory Audit Rotation 3 Limiting the fees charged by audit firms for non-services 5 References 7 Review of the European Commission’s Proposal to introduce audit independence reform Conformity with the audit standards is a requirement that every corporate business organization is supposed to follow. The audit report is an independent report issued by external auditors subsequent to getting hold of and evaluating complete information concerning declarations and statements on the subject of financial activities and proceedings. Following the evaluation, the auditors determine the level of conformation between those declarations and the required auditing standards, and communicating their opinion through the audit report. The quality and authenticity of audit report and compliance to the prescribed practices of audit standards has always been a subject of discussion in the corporate environment. Adherence to audit standards practice is necessary as it helps a corporate organization to lessen risks as well as optimize its business performance at the same time (Gray & Manson, 2007). Currently, the competitive business environment that prevail worldwide, calls for a rigid regulatory setting and compliance to audit standards norms, for businesses and the financial system to sustain in the long run. However, the European Commission considers the global economic depression during 2007-2009 had pointed out significant drawbacks in the audit system followed in the Europe. The Commission believes so because many financial organizations were found to have been given clean reports by their auditors, in spite of the fact that those institutions had grave financial health issues. As a result the European commission had proposed a number of reforms to improve the independence of the auditing profession (Murtagh, 2012). This paper would focus on and review two such proposed reforms, namely, compulsory audit rotation and limiting the fees charged by audit firms for their non-auditing services. Compulsory Audit Rotation To alleviate the danger of any impending conflict of interest owing to an acquaintance risk, the European Commission in its report has proposed that all publicly listed companies will have to obligatorily alter their auditor after each six years in case they had employed one auditor to execute the audit process, and after each nine years when two auditors were employed to perform the audit (Berger, 2012). This proposed reform is said to have a number of advantages in context of dealing with issues like conflict of interest and in so doing enhancing the quality of audit. The major advantage expected from this reform is the reinforcement of professional skepticism. In cases where the auditors have a long standing association with the company, it is likely that there would be dilution of professional skepticism. In view of the close relationship with their clients, auditors might develop a tendency to overlook areas of concern owing to their depending association with the management, which might hamper the actual independence of the auditors. Various researches have opined that the major rationale for the detrimental audit quality comprise of the personal long term association amid the company’s management and the auditor, the amalgamation of consulting as well as auditing services, in addition to the auditor’s objective of preserving the assignment (Myers, Myers & Omer, 2003; Mansi, Maxwell & Miller, 2004). The mandatory rotation of audit would elevate the fear of public exposure in case of any discrepancy and hence the quality of audit would consequently improve. Another potential advantage of the obligatory audit rotation is that the clashing dissimilarities of judgment amid management and the auditor are not hazardous to the auditor if a rotation is planned in the coming future anyway. Reviews have confirmed the widespread expectation that consequent to this new reform of compulsory rotation, there would be more stringent and more persistent auditing (Knechel & Vanstraelen, 2007; Velte & Stiglbauer, 2012). This is in view of the fact that the auditors would aspire to lessen the threat of having their successor criticize about their low quality performance upon assessment of preceding periods’ audits (Velte & Stiglbauer, 2012). However, this proposed compulsory rotation had certain disadvantages as well, increased cost being one of them. The Government of UK had stated that, “Mandatory rotation would add additional costs to these tendering costs. We have estimated that if implemented in the UK, mandatory rotation every five years would add at least £55m per annum of costs to UK companies, without any guarantee that the audit would be awarded outside of the 'Big 4' audit providers” (CBI, 2012). Furthermore, the audit market in Europe for publicly listed organizations is mainly under the control of the ‘Big Four’ Auditing companies. This high concentration of the audit market is likely to be another major shortcoming of mandatory audit rotation. These companies have the maximum experience and all the necessary resources to conduct high quality audits and hence new entries to this audit market find is extremely difficult to sustain them. Thus, as a result of obligatory rotation corporations might face the issue of lack of choice and the rotation might mean amongst the Big Four companies (Velte, P., & Stiglbauer, M., 2012). Limiting the fees charged by audit firms for non-services An important proposed reform by the European Commission is in context of the ‘related financial audit services’ that are rendered by the auditing companies. According to the proposed reformed, the auditors would be allowed to provide such services to the ‘Public Interest Enterprises (PIEs), for whom they perform the auditing. However, the fees to be charged for such services would be restricted to 10% of the overall fees charged by the auditing firm from the enterprise for the statutory audit service (Deloitte, 2012). The European Commission had even specified the services that can be considered under the proposed ‘related financial audit services’ category. According to a KPMG Report (2012), the limit of fee that an audit firm can earn from a particular PIE, as has been proposed by the new regulation of the European Commission, is likely not to cause any potential issue for majority of the audit companies. This is in consideration of the fact that the present ‘Ethical Standards’ that have to be adhered to by these companies are much lower than that proposed by the European Commission. Nevertheless, the restriction on fees that the Commission had recommended on revenues earned from the ‘related financial audit services’ would be a fresh obligation that the audit companies have to adhere to. As a result of this new proposed reform, the auditing firms might have to limit the scope of an audit company to carry out such services (KPMG, 2012). It is widely agreed upon fact that the audit firms should only provide such services to their clients that do not put their independence at risk. Thus, this reform is considered to be an attempt to limit not only the extent of service provided to one client but also the type of service offered to them. Nevertheless, it has also been widely opined that there is no potential threat to independence of audit owing to the carrying out of non-audit services for the same organization (AFM, 2012). Thus, conclusively, it can be stated that the reforms proposed by the European Commission have their advantages as well as disadvantages. However, the enhancement of audit quality and their independence would require more that the introduction of such reforms. References AFM, 2012. Analysis of the proposals from the European Commission for the reform of the audit market [Online] Available at: http://www.afm.nl/~/media/Files/rapport/2012/analysis-proposals-ec.ashx [Accessed on November 7, 2012]. Berger, N., 2012. Public Company Accounting Oversight Board Public Meeting on Auditor Independence and Audit Firm Rotation [Pdf] Available at: http://pcaobus.org/Rules/Rulemaking/Docket037/ps_Berger.pdf [Accessed on November 7, 2012]. CBI, 2012. Reform of the audit market CBI position paper [Pdf] Available at: http://www.cbi.org.uk/media/1299735/cbi_position_paper_-_reform_of_the_audit_market__january_2012.pdf [Accessed on November 7, 2012]. Deloitte, 2012. Deloitte Audit Reform Briefing: Unprecedented reform proposed for the EU audit market [Pdf] Available at: http://www.deloitte.com/assets/Dcom-Global/Local%20Assets/Documents/Audit/dttl_DeloitteAuditReform_final.PDF [Accessed on November 7, 2012]. Gray, I. & Manson, S., 2007. The Audit Process: Principles, Practice and Cases. UK: Cengage Learning. Knechel, W.R. and Vanstraelen, A. 2007, The relationship between auditor tenure and audit quality implied by going concern opinions, Auditing, Vol. 26, pp. 113-131. KPMG. 2012. EC Audit Reform [Pdf] Available at: http://www.kpmg.com/Global/en/services/Audit/EU-Audit-Reform/Documents/aci-ec-audit-reform.pdf [Accessed on November 7, 2012]. Mansi, S.A., Maxwell, W.F. and Miller, D.P. 2004, Does auditor quality and tenure matter to investors?, Journal of Accounting Research, Vol. 42, pp. 755-793. Murtagh, B., 2012. The Auditing profession - independence, quality and reforming the regulations as proposed by the European Commission [Pdf] Available at: http://www.icac.org.jm/pdf/Presentations_2012/The%20Auditing%20Profession%20-%20Independence,%20Quality%20&%20Reforming%20the%20regulations%20as%20proposed%20by%20the%20European%20Commission%20by%20Brenda%20Murtagh.pdf [Accessed on November 7, 2012]. Myers, J.N., Myers, L.A. and Omer, T.C. 2003, Exploring the term of the auditor-client relationship and the quality of earnings, The Accounting Review, Vol. 78, pp. 779-799. 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. International conference “Improving financial institutions: the proper balance between regulation and governance” Read More