The Auditors Independence and the Mandatory Auditor Rotation - Essay Example

 Audit Introduction In April 2014 the European Parliament has voted for bringing mandatory auditor rotation into the EU region. This initiative implies that European-listed companies, financial institutions, and banks will have to hire new auditors every 10 to 24 years. Appointment of a new auditor every decade can be extended in cases when companies appoint another audit firm to do a joint-audit or initiate bidding process at the 10-years mark (Chasan 2014). While the rules of mandatory auditor rotation were also initiated in the U.S by the 2002 Sarbanes-Oxley Act, Europe’s restrictions would be tougher. Even though the U.S. companies will not have to adhere to the new EU rules, the subsidiaries of the U.S. banks operating in Europe will be affected (Chasan 2014). The aim of this research is to provide an overview of the auditor’s independence and the mandatory auditor rotation and to analyze whether compulsory auditor rotation will improve the overall auditor independence and audit quality. Auditors’ independence and factors that influence auditor independence Auditor’s independence is a critical issue that is broadly discussed in the business world, especially after the world-known scandal of Enron. Auditor’s independence implies performing of duties “free of subjective biases and professional impropriety” (Ponemon and Gabhart 1990, 228). Professional integrity, high moral caliber, and honesty are recognized to be integral characteristics of the auditor’s independence (Ponemon and Gabhart 1990). In attempts to identify the factors that influence on the auditor's independence, Beattie & Brandt (1999) have carried out a research analyzing the survey results of 244 audit partners and 153 U.K. listed company finance directors. The results of the survey have shown that the principal factors related to the economic dependence where the individual partner's income depended on the retention of a specific audit client (Beattie & Brandt 1999, 103). Based on these results, policymakers and their decision to introduce mandatory auditor rotation with a purpose to increase auditor's independence can be viewed as logical and rational. Mandatory auditor rotation The quality of the audit is one of the most important issues in the auditing industry. The audit process of a higher quality is the process when the auditor is able to detect and report on the existing misstatement reported by the client firm (Mohamed & Habib, 2012). Thus, high-quality audit implies independence of an auditor. One of the solutions to ensure the high quality audit is considered to be the mandatory auditor's rotation (Mohamed & Habib, 2012). Over the past 30 years periodically several concerned bodies perceive mandatory auditor rotation as a measure that will improve auditor independence. Under mandatory auditor rotation, it is understood that a business or a client firm should not retain the same auditor for more than a specified period of time (Comunale and Sexton, 2005). Based on this approach, auditors will less interested in seeking for a future economic gain from a particular client firm and this will minimize the risk of bias reports in management's favor (Comunale and Sexton, 2005). Another reason for changing the auditors is an opportunity of enhancing the quality of audit through adopting various audit testing methods and approaches which might be limited due to established relationships and familiarity with the client firm (Carey and Simnett, 2006). Recently, the American Accounting Association has published the results of the survey carried out by Daugherty et al (2013). Based on their study results "partner rotation has a direct and negative effect on client-specific knowledge, and the client-specific knowledge has a direct and positive effect on audit quality" (Daugherty et al 2013, 31). On the other hand, the model predicted a direct and positive effect of partner rotation on both auditor independence and quality of the audit. There are many other different views and opinions regarding the correlation between auditor's independence and auditor rotation reforms. While some experiments published in the accounting literature indicate on some potential benefits of this measure, other studies illustrate that there is no positive effect for auditor rotation and moreover, it may cause the adverse effect (Fiolleau et al. 2013). In addition to the theoretical views, there are some countries that have already undertaken some actions towards the shift to the mandatory audit rotation. Thus, for example, Singapore has adopted mandatory auditor rotation banks and Brazil has adopted it for financial institutions. Italy, Spain, Turkey, and Slovakia also have adopted the mandatory auditor rotation but have eliminated their requirements, except Italy (Comunale and Sexton, 2005). Ireland has taken the policy of mandatory auditor rotation into consideration but rejected it. In Korea, mandatory auditor rotation is required only for problematic firms (Jenkins and Vermeer, 2013). Experience of some of these countries is reviewed further in the research. Below is provided a brief overview of both pros and cons of the mandatory auditor rotation. Pros of Mandatory Auditor Rotation Mandatory Auditor Rotation is perceived by the Public Company Accounting Oversight Board as the measure that will enable to enhance independence, objectivity, and professional skepticism of auditors (PWC 2012). Michel Barnier, the European Internal Market, and Services Commissioner also believe that the "new measures will reduce risks of excessive familiarity between statutory auditors and their clients, encourage fresh thinking, and limit conflicts of interest” (Chasan 2014, n.p.). Mandatory rotation of audit firms would prevent auditors from undermining their independence in the result of becoming too aligned with the client firm's management (Jackson, Moldrich and Roebuck, 2008). The results of the above-mentioned study carried out by Daugherty et al (2012) also support the approach that mandatory auditor rotation helps to improve auditor independence. Moreover, compulsory auditor rotation may help to prevent large-scale corporate collapses similar to the collapse of Enron, Tyco, WorldCom, and to restore confidence in the regulatory system (Jackson, Moldrich and Roebuck, 2008). Mandatory audit rotation will imply search of new auditors, enabling thus audit-service providers compete with others and therefore improve quality of their services (Jackson, Moldrich, and Roebuck, 2008). By setting term limits for relationships between the audit firm and client firm, auditors become empowered to provide more transparent audit services as they do not need to protect long-term client relationships (Pinnel 2011). Cons of Mandatory Auditor Rotation While there are certain groups of stakeholders who believe that the EU will benefit from the introduction of mandatory auditor rotation, there are also views that it will not bring the desired outcomes. Thus, for example, PWC claim that the perceived benefits of a periodic fresh thinking mentioned by Barnier are overweighed by significant costs (Comunale and Sexton, 2005; PWC 2012). One of the most considerable costs is related to the loss at fixed intervals of the auditor’s cumulative knowledge of the company’s business, systems, processes, risks and people (PWC 2012; Nicolaescu 2014). The member of the Big Four believes that mandatory audit firm would not improve audit quality, and on the contrary will result in the adverse effect. Rotation of auditors will also result in increased time and distraction of management, as new auditors will require more time for understanding company's business practices, operations, and financial reporting processes (PWC 2012; Kroll 2012). Some other investigations also found that mandatory auditor rotation will have the negative impact on the audit procedures. The main reasons include the following: change in auditors is associated with the financial fraud; appropriate safeguards are already in place (including second partner review, rotation of engagement partners, peer reviews, requirement for audit committee to hire and monitor the auditor, etc); reduced audit quality as a result of loss of client-specific audit knowledge and experience (Comunale and Sexton 2005, 236; Daugherty 2013; Ionescu 2014). Lack of knowledge of the client’s operations often causes audit failures in the first years of auditor’s work with a new company (Jenkins and Vermeer, 2013; Pinnel 2011). Based on this approach, it is possible to conclude that as only one auditor will understand the industry and specific environment in which the company operates he will have to give place to a new auditor. Some experts strongly believe that mandatory auditor rotation neither brings automatically greater auditor independence nor automatically ensures high standards and quality of audit (Holding the Line on Auditor Rotation 2012; Kroll 2012). One more argument against mandatory audit rotation relates to the multinational corporations, which tend to use the Big Four who are well adjusted to the needs of global players (Holding the Line on Auditor Rotation 2012). In this case, the mandatory rotation is automatically reducing the number of alternatives for multinational companies, as audit firms not included in Big Four may lack sufficient capability in a particular industry or area (Holding the Line on Auditor Rotation 2012). Even though there is the significant amount of literature where mandatory rotation is both supported and rejected, there is a lack of empirical evidence based on the direct tests of the policy implementation. Dopuch et al (2001, 94) explain it by highlighting the difficulty of obtaining "empirical evidence on the costs and benefits of proposed regulation prior to its implementation". However, Ruiz-Barbadillo, Gómez-Aguilar, & Carrera have carried out own research, contributing thus to the literature review by empirical evidence from Spain examining the influence of mandatory rotation on the independence of auditor (Ruiz-Barbadillo, Gómez-Aguilar, & Carrera, 2009). Based on the research, authors have not found evidence supporting the idea that a mandatory rotation requirement is associated with a higher likelihood of issuing going-concern opinions (Ruiz-Barbadillo, Gómez-Aguilar, & Carrera, 2009, 113). Discussion Even though there was analyzed a significant amount of literature where mandatory rotation is both supported and rejected, there was discovered the shortage of empirical evidence based on the direct tests of the policy implementation. There is a need to carry out more evidence-based research to evaluate the correlation between the auditor's independence and mandatory auditor rotation. Based on the overall research results it is possible to assume that mandatory auditor rotation might have some impact on the auditor's independence due to minimization of the economic dependence of the auditor, however, there is not enough empirical evidence to support this view. Taking into consideration the number of arguments against the introduction of the mandatory audit rotation it is also possible to assume that it might have the adverse effect on the auditing industry, especially it relates to the Big Four group. The experience of the countries that have already practiced adoption of mandatory auditor rotation policy and have canceled it should be analyzed in more details in order to provide the deeper understanding of the pitfalls and disadvantages of this measure. Conclusion Recent news that European Parliament has voted for bringing mandatory auditor rotation into the EU region has once again reminded to the global society about the necessity to improve auditor’s independence and stressed the importance of this measure. The aim of this research was to provide an overview of the auditor's independence and the mandatory auditor rotation and to analyze whether compulsory auditor rotation will improve the overall auditor independence and audit quality. Under mandatory auditor rotation, it is understood that a business or a client firm should not retain the same auditor for more than a specified period of time. There are many different views and opinions regarding the correlation between auditor's independence and auditor rotation reforms. While some experiments published in the accounting literature indicate on some potential benefits of this measure, other studies illustrate that there is no positive effect for auditor rotation and moreover, it may cause the adverse effect. The research provided a brief overview of both pros and cons of the mandatory auditor rotation. The main pro was an opportunity to enhance independence, objectivity, and professional skepticism of auditors and to prevent auditors from undermining their independence in the result of becoming too aligned with the client firm's management. The number of arguments against the introduction of mandatory auditor rotation was much higher than the number of opponents' arguments. The majority of opponents believe that mandatory audit firm would not improve audit quality, but will result in increased time and distraction of management, as new auditors will require more time for understanding company’s business practices, operations, and financial reporting processes. Lack of knowledge of the client’s operations was viewed as the most critical and the most often mentioned argument. While there are proponents of mandatory audit rotation, stating that this measure will enable to improve auditors’ independence, the number of arguments put forward by the opponents of this idea is much greater. References: Beattie, V, & Brandt, R 1999, 'Perceptions of Auditor Independence: U.K. Evidence', Journal Of International Accounting, Auditing & Taxation, 8, 1, p. 67, Business Source Elite, EBSCOhost, viewed 11 July 2014. Carey, P. and Simnett, R. 2006. Audit partner tenure and audit quality. The Accounting Review, Vol. 81 No. 3, pp. 653-676. Chasan, E. 2014. 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