Auditor Independence - Case Study Example

Auditor independence Table of Contents Introduction 3 2) Definition of Independent Auditing 3 3) Perception of Auditor Independence before 2001 3.1) General Perception 3 3.2) Famous Accounting Scandals before 2001 4 4) The Enron Disaster 4 5) The Global Auditing Scenario 5.1) Scenario before 2001 4 5.2) Scenario after 2001 4 6) Ways by which Auditor Independence are Compromised 6.1) General 5 6.2) Non-Audit Fees 5 7) Regulations Presently in Place 7.1) Global Regulations 5 7.2) UK Regulations 7.2.1) Hewitt-Brown Reforms 6 7.2.2) UK Accounting Law Regulatory Bodies 7 7.2.3) Solutions from Auditing Firms 7 8) Recommendations 8.1) Steps to be taken by the UK Government 7 8.1.1) Non-Audit Services 8 8.1.2) Auditor Rotation 8 8.1.3) Incentives to Two-Tier Audit Firms 8 8.1.4) Emulation of Sections of Sarbanes-Oxley Act 8 8.2) Steps to be taken by Audit Clients 9 9) Conclusion 9 10) References 10 1) Introduction Shareholders expect accuracy and reliability in the publicised audited account reports of the organisations they invest in. Besides shareholders, other stakeholders like investors, bankers, bonding agencies and other creditors depend on audited financial reports to initiate or enhance business with those organisations. The need to assure all interested players about the accuracy and reliability of published financial reports represents the main reason accounts should be checked by an independent auditor. In the UK, while many regulations have been put in place to ensure and promote auditor independence, there is much more that can be done by the government as well as by audit clients. 2) Definition of Independent Auditing Power (1997, 4) defines independent auditing as the ‘independent examination of and expression of opinion on, the financial statements of an enterprise’. In another definition, an independent auditor is ‘a Certified Public Accountant who provides a company with an accountant’s opinion, but who is not otherwise affiliated with the company’ (Investorwords.com). 3) Perception of Auditor Independence before 2001 3.1) General Perception While agreeing auditor independence is important, former President of the Institute of Chartered Accountants in England & Wales {ICAEW} Peter Wyman opined it is not ‘all-important’ but superceded by the audit quality and the knowledge/experience of auditors (Wyman, 2004). This observation of an imminent personality like Wyman in 2004 reflects the general perception of auditor integrity that existed in the world in general and in the UK in particular before 2001. Lehman (2006, 33) found that the compliance aspect - assurance that auditors fulfill their fiduciary duty to investors was largely taken for granted. In April 1980, the ‘Accountants Magazine’ reported that UK auditors interpreted any focus on auditor independence as a threat to their non-audit services (Hopwood et al., 1994, 276). 3.2) Famous Accounting Scandals before 2001 Collegenews.org (2005) recalled US Rubber Importer Fred Stern & Co. went bankrupt in 1925 after providing fake information about assets worth £700,000 to get investment capital. BBc.co.uk (1991) cited the Bank of Credit and Commerce International {BCCI} scandal in 1991 involving a £5.6 billion deficit, making the Bank of England close all its UK branches over charges of fraud. Perry (2002) reported that when FTSE 100 Company Polly Peck International collapsed in 1990 with borrowings of £522 million, its auditor Stoy Hayward had to pay a fine of £75,000 plus £250,000 in costs. 4) The Enron Disaster No pre-2001 scandal was as massive as the Enron disaster that Pbs.org (2002) recalls involving filing for the biggest Chapter 11 bankruptcy in US history on December 4, 2001. Beams (2002) contends that it was due to rogue trading, deliberate concealment of debts and other financial irregularities done by Enron in connivance with auditor Arthur Andersen LLP. Kadlec (2002) adds other charges - creation of partnerships with shell companies to hide its own liabilities, deliberate destruction of evidence, obtaining special favours by political contributions, and Enron executives selling $ 1.1 billion in stock while motivating employees and other investors to buy stock. 5) The Global Auditing Scenario 5.1) Scenario before 2001 Europa.eu (2002) recalled that the global auditing world was ruled by 5 auditing firms {Big Five}: Price, Waterhouse, Coopers {PwC}, Klynveld, Peat, Marwick, Goerdeler {KPMG}, Ernst & Young {E&Y}, Deloitte & Touche {D&T}, and Arthur Andersen {AA}. Bbc.co.uk (2007) reported that the Big Five audited 80% of organisations in the UK FTSE 100, the US DOW, the Japanese Nikkei and the Chinese Hang-Seng, besides organisations in other global markets. 5.2) Scenario after the Enron disaster Bbc.co.uk (2007) noted that after intense scrutiny by US Congress, SEC and ICA, Arthur Andersen LLP went down in disgrace. Europa.eu (2002) recalled its UK business being taken over by D&T in July 2002. Oxera.com (2006) confirms there are presently the Big Four audit firms that are almost evenly matched globally, but PwC holds the largest share within the UK. 6) Ways by which Auditor Independence are Compromised 6.1) General Hermes.co.uk contends that public concern about auditor independence stems from auditors’ tendency to diversify to other non-audit services such as legal consulting, IT consultancy, corporate finance and management consulting. Duska et al. (2003, 106) adds another - internal audit services {as performed by AA for Enron}. 6.2) Non-Audit fees Hermes.co.uk also cites stakeholders’ concern about auditor independence because non-audit fees are higher than audit fees. A 2002 ‘Financial Director’ magazine survey of FTSE 100 companies found the average audit and non-audit fee was £2.21 million and £6.5 million respectively. Another 2000 survey by ‘Brand Finance’ involving FTSE 350 companies found that audit and non-audit fees paid to the Big Five were £300 million and £500 million respectively. The studies also contain cases where the non-audit fee was 10 to 12 times higher than the audit fee. In case of Enron, Miller et al. (2002, 23) contend that ‘Andersen collected audit and non-audit fees of more than $ 50 million in one year, while claiming they were “independent” of Enron.’ 7) Regulations Presently in Place 7.1) Global regulations Government authorities around the world moved quickly to place additional restraining regulations after 2001. Kersnar (2008) adds that following the passing of the Sarbanes-Oxley Act by the US in 2002, EU countries formed independent auditor oversight bodies under their already existing Eighth Company Law Directive to enhance standards and be internationally competitive with ‘very good’ {meaning the UK and US} countries. 7.2) UK Regulations Porter et al. (2003, 2) reports that UK regulations require all public sector companies {irrespective of amount of turnover} as well as those private sector companies whose turnover exceeds £1 million, to prepare, audit and publish yearly financial reports. 7.2.1) Hewitt-Brown Reforms The UK passed its own equivalent to the US and EU regulations on January 29, 2003 in the form of the Hewitt-Brown reforms. Hewitt (2003) clarifies that the rules are contained in 4 sets of reforms. The first set, requires organisations to ensure that the guiding audit partner is replaced within five years; partners or employees of audit firms should be forbidden employment in listed companies within 2 years of resigning or termination from the audit firm; and, the audit firms should publish detailed annual reports. The second set, directs the Financial Services Authority to assist the Financial Reporting Review Panel on enforcement issues, and requires the existing range of FRC functions should be expanded to include the functions of the Accountancy Foundation. The third set requires the jobs of chairman and chief executive should be distinct and separate; at least 50% of the board members, nomination committee and remuneration committee members should be independent; the practice of appointing directors through private connections should cease and be replaced by impartial appointments procedures; the corporation’s audit committee members should be totally independent; and the practice of allowing auditors to supply non-audit services to their audit clients should be stopped. The last set of reforms requires professional institutions to transfer standard-setting duties to the Auditing Practices Board; a new Professional Oversight Board should replace the Ethics Standard Board; the FRC should create a new Independent Inspection Section within itself to take over {from professional institutions} the task of monitoring audits of listed companies, pension funds and prominent charitable organisations; and a new Investigation & Discipline Board should be formed to act as an independent medium of expression to judge important public interest cases about enforcement of rules of behaviour. 7.2.2) UK Accounting Law Regulatory Bodies Icaewfirms.co.uk (2007) confirms that in the UK, the ICAEW is not only the country’s most important accountancy institution with a membership of over 126,000 entities, but also the biggest in Europe. Wyman (2004) adds that the ICAEW works to make certain that not only the topmost-caliber persons are enrolled into accounting jobs, but also that they get the best possible training to turn them into excellent auditors. Kersnar (2008) states that from late 2008, the Financial Reporting Council {FRC} will issue independent reports on every large auditor it inspects {a change from its past general, consolidated report}, and will also prepare reports after reviewing more than 100 audits it prepares annually, to be dispatched to auditors to enable them discuss the same with clients’ top management. 7.2.3) Solutions from Auditing Firms Hermes.co.uk lauded auditing firms for forwarding two solutions. The first was to split its business into two – one firm dealing only with auditing, and the other handling non-audit services. Two of the Big Four took steps in this direction: KPMG created a new firm called KPMG Consulting, and E&Y sold its non-audit consultancy service to Cap Gemini of France. The second solution {as implemented by D&T} was for the firm to retain a small part of the non-audit service capacity in-house so as to help audit clients who want their auditors to continue providing non-audit services, because such services {especially tax consultancy} would be very costly if provided by another source. 8) Recommendations 8.1) Steps to be taken by the UK Government It is recommended that the UK government adopt the following measures. 8.1.1) Non-Audit Services Pointing to the urgent need to differentiate between audit and non-audit services, Hermes.co.uk urges the UK government to taking a cue from KPMG and E&Y by making it mandatory for all auditing firms to split their businesses into two {one handling auditing and the other handling non-audit services). CPP Investment Board (2004) recommends setting up an Audit Committee similar to the Canadian Institute of Chartered Accountants {CICA} model whereby non-audit services are classified as recurring or non-recurring with a maximum upper limit of $ 50,000 set for the latter; also, specific non-audit services {such as lawsuit support, management, finance and human resources} are forbidden. 8.1.2) Auditor Rotation Hermes.co.uk recommends that the Government makes it mandatory for auditor rotation after say 5 years, by floating tenders. Oxera.com (2006) agrees, because a study revealed that over 70% of FTSE 100 organisations did not hold a competitive tender since 15 years. 8.1.3) Incentives to Two-Tier Audit Firms Stating that the Big Four audited 239 of the FTSE 250 organisations in August 2007, Kersnar (2008) recommends that the government try to break their monopoly. Oxera.com (2006) agrees, recommending strengthening two-tier audit firms like BDO and Grant Thornton by providing friendly term finance to develop in-depth resources and composite international networks. 8.1.4) Emulation of Choice Sections of Sarbanes-Oxley Act Soxlaw.com (2006) recommends that the government emulate several sections of the US Sarbanes-Oxley Act. Section 302 makes organisations assume corporate responsibility for financial reports while auditors confirm truth and accuracy. Section 404 requires disclosure of details of individual controls framework and system of financial reporting, also duly confirmed by auditors. Section 409 requires urgent public information about any alteration in financial condition or activities. Section 802 stipulates criminal penalties of fines and/or imprisonment up on company as well as auditing firm officials. 8.2) Steps to be taken by Audit Clients Hermes.co.uk recommends formation of audit committees with powers to focus on non-audit contracts including the authority to veto any suspect contract. Oxera.com (2006) adds that such committees should prominently participate in auditor selection. Hermes.co.uk next recommends that executive directors do not function as audit committee members, and that audit clients adopt accounting reports that show non-audit fees in full detail, totally different from audit fees 9) Conclusion Although there were famous financial disasters after Enron like Worldcom in 2002 and Lehman Brothers in September 2008, none have surpassed its magnitude. In case of another loss of a Big Four firm caused by professional misconduct, the effects of a four-to-three scenario would, among other effects, erode investor confidence to an unprecedented low, one from which it would take years to recover. Coming to the UK, by adopting the recommendations mentioned earlier, the government will definitely enhance the prevailing public image of auditing firms, and strengthen the esteem of publicised financial reports of UK companies – thereby avoiding the humiliation of shamefully acknowledging, as Beams (2002) recalls US Federal Reserve Chief Paul Volcker admitting after the Enron disaster: “Accounting and Auditing in this country is in a state of crisis.” 10) References ANON. 2007. About the Institute: The Institute of Chartered Accountants in England & Wales (ICAEW). [Online]. Available: http://www.icaewfirms.co.uk/section.asp?catid=24 [16 September 2008] ANON. 2005. 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