The Impossibility of Auditor Independence - Example

Introduction This project is an analysis of the changes that have occurred in the external auditing with respect to changes in corporate governance practices in U.S. The external auditing provides the verification and assurance regarding the financial disclosures in the form of opinions. The public’s and investors’ confidence in the viability of the disclosures by the firm depends upon the accuracy and objectivity of audit report. There are audit standards issued by PCAOB that govern the audit profession. Following the accounting scandals and collapse of a number of large organizations such as Enron and WorldCom Sarbanes-Oxley Act was introduced in 2002 which was a major step in changing regulations in the audit and corporate governance practices. The Act responded to the drawbacks in audit practices by limiting the scope of external auditors and increasing the independence of the board of directors. The historical changes in the audit practices and corporate governance have been provided in this project. In the first section the external auditing practices in U.S. have been introduced along with the various standards that govern this profession. Then the problems have been identified related to external auditing that led to the necessity of regulatory changes in auditing practices by SEC. the SEC Act 1933, changes in 1934 and establishment of Sarbanes-Oxley Act 2002 are the highlight of the discussion. At the end of first section the importance and reasons for worldwide acceptance of U.S. auditing practices are provided. The second section introduces the corporate governance practices in U.S. and the characteristics of good corporate governance. The historical development of the corporate governance practices under the ambit of SEC, NYSE and NASDAQ are discussed with emphasis on the disclosure requirements and responsibilities of audit committee. The independence of the directors on the committee has been identified to be very important. However Macey has identified the trade-off between the proximity and objectivity to be the essence of the corporate governance oversight. Any close proximity of the board with the management affects its independence. The objectivity of the shareholders and board is affected by the outside forces such as analysts, credit rating agencies by widening the gap between the shareholders and the management. In the third section the recent changes in newly established Dodd Frank Act and the effectiveness of Sarbanes-Oxley Act have been discussed. External Auditing Audit of financial statements involves verification of a firm’s financial statements and an assurance in the form of an opinion that the statements have been prepared and presented in a fair manner and in all material respects provide a true and fair view of the organization’s business. External auditing involves developing opinions on the financial statements of the firm based on audit analysis. The value of the opinions is affirmed by public’s confidence in its accuracy and objectivity of the reports. The failure of external auditing results into failure of the financial system as a whole. A free market economy is founded on the sharing of reliable and accurate information among the stakeholders of an organization. Its strength also depends upon the transparency and neutrality of the disclosures (Rittenberg et al, 2009, p.6). The financial disclosures must reflect the current economic conditions of assets owned and liabilities owed. Audit standards are set to provide assurance to the public regarding the professionalism in audit process and that the financial statements are clearly presented. The scope of audit standards not only includes the audit process but also the quality of internal control. Recently the role of audit especially in US has expanded beyond the traditional audit practices of providing opinion on the fairness and truth of the financial disclosures. Assurance services provided by the auditors are business risk assessments, assessment of reliability of information, measurement of business performance, viability of e-commerce and other risks faced by the company (Gray & Manson, 2007, p.19). Following are the types of standards which affect the audit: 1. Auditing standards applicable to the auditors on providing opinion on major financial statements. Independent opinions reflect the quality of a firm’s internal control over preparation and disclosure of the financial statements. 2. Assurance Standards applicable to the auditors for providing opinion on financial information other than normal financial statements. 3. Attestation Standards applicable to assurance services. 4. Compilation and review standards are the financial reporting standards issued by AICPA which apply to nonpublic companies. US companies come under the ambit of SEC regulations and are audited as per the accounting standards established by PCAOB. The failures of Enron and WorldCom led the investors seek assurance that such corporate failures do not happen in companies in which they have invested. Therefore it becomes all the more important for external auditors to understand the governance of organizations and key information utilized by their boards to ensure proper management of the organization. After these financial failures the audit committees were criticized especially the external auditors and AICPA. Previously the public accounting firms were self-regulated. Under the AICPA’s peer review process a firm’s standards and practices were reviewed by a public accounting firm. The accounting firm knew that it could be assigned this same firm again in future so it would not take much trouble in being critical about the firm (Moeller, 2011, pp.2). The U.S. congress established SEC with an Act in 1933 which included the requirements to audit accounts by the corporations when they issued shares. The audit requirements were based on the provisions in UK Companies Act 1929. The requirements of audit in 1933 Act in U.S. were taken into 1934 Act for sale of existing shares. However this did not mention who will be responsible to hire and set compensation of auditors the responsibility of which eventually fell upon the management and directors whom the auditors were going to audit. This was the impairment of auditor independence which occurs when the auditor compromises his/her professional decisions under the pressure of employer. Such problem of auditor independence as many believe was a result of audit provisions in 1933 Act and 1934 Act (Baker & Anderson, 2010, p.86-87). To improve the effectiveness of corporate audit committee NYSE and NASDAQ established Blue Ribbon committee in 1999 whose recommendations were that the audit committee charters to require their meetings a minimum four times in a year. Regulators started addressing the problem of auditor independence more effectively after the Enron collapse and their response led to the formation of Sarbanes-Oxley Act 2002 in U.S. and proposals of EU for revised 8th Directive. The Sarbanes-Oxley Act addressed the problems in accounting standards setting, boards of directors, internal control by public company, corporate management, auditing and auditor’s independence, financial reporting and penalties for noncompliance. For auditor’s independence the Act requires the lead audit firm and reviewing partner to rotate off the audit in every five years. The CEO and equivalent positions of the audited firm should not be filled by its audit firm in the one year preceding the audit. The audit firm is prohibited to provide the non-audit services to the client firm such as bookkeeping, design and implementation of financial information systems, contribution-in-kind reports of fairness opinions, internal audit, investment advice, appraisal and valuation, legal and expert services not related to audit etc (Garner, McKee & McKee, 2008, p.62). Many countries follow U.S. audit practices for many reasons. Firstly U.S. is a role model for them in market-based economy. Secondly OECD’s corporate governance principles are based on these practices. Thirdly the rating agencies for corporate governance use metrics on OECD principles and so the regulators and other bodies for organizations in non-U.S. regions follow U.S. practices. Fourthly there are practical incentives from the size and influence of U.S. financial markets. Lastly the international aid and bilateral finance agencies such as IMF and World Bank encourage governance practices based on U.S. audit principles (Baker & Anderson, 2010, p.87). Corporate Governance Corporate governance entails the relationships between stakeholders internal as well as external with the objective of safeguarding the long-term success of the organization. The conflicts of interest between the management and providers of capital are addressed effectively here. Good governance is essential to the audit because companies with good corporate governance practices are less prone to audit risk. Such companies have a code of conduct reinforced by the top management, independent board members with sufficient resources and time to perform their work, consideration of good internal control over financial reporting, commitment to financial competence and low level of financial engineering (Rittenberg et al, 2009, p.47). Corporate governance has a deep impact on the success of business. A successful corporate has the following characteristics: 1. Effective board of directors where it is independent from the management and representative of the shareholders. 2. Competent CEO appointed by the board. 3. Valid business concept created by the management with the consent of the board and which requires the interests of management and board to be aligned with those of shareholders. 4. Effective system to ensure that the obligations of the organization to its stakeholders are met and comply with the existing rules and regulations. 5. Timely and full disclosure of business performance to the owners and investors community. The failure of the board to ensure sound governance in the organization results in the failure of the organization. After the SEC Act in 1933 and 1934 regarding the mandatory audit, AICPA formed Accounting Principles Board (later replace by FASB) where it became the authoritative source of accounting standards. SEC in 1940 recommended improved financial reporting by audit committees of outside directors. NYSE brought significant changes in 1956 onwards in the governance mechanisms of the organizations by mandating listed companies to have at least two outside directors on their boards. The directors need not be independent. The audit committee was required to be comprised of undefined independent directors. By 1999 the audit committees of the listed companies were required to be independent by NYSE and NASDAQ. The independence was defined on the basis of previous employment, business associations and family relationships. Later in 2003 the NYSE and NASDAQ proposal of majority of the members of the board to be independent was adopted by SEC and the scope of ‘Independence’ remained the same. The reporting frauds and scandals in 2001 led to the introduction of Sarbanes-Oxley Act in 2002 whose major objective was to improve the governance practices by U.S. firms. The major provisions of the Act regarding the corporate governance were: 1. Establishment of PCAOB: PCAOB is responsible for inspecting and disciplining the registered public accountancy firms (U.S. & non-U.S.) that offer external audit services. It also determines the standards for auditor and auditing. It replaces Auditing Standards Board of AICPA. 2. SEC oversees the working of PCAOB and authorizes the recognition of accounting standards issued by FASB. 3. Audit Independence 4. Auditor Rotation 5. Audit Committee: The audit committee members/directors must not receive payments other than for what they are supposed to do under the committee. They should not be affiliated to the company. 6. Statements of Responsibility: The acknowledgement regarding the underlying accounting assumptions and reported financial statements must be provided by the CEO and CFO. 7. Internal Control Responsibility: Senior management is responsible for internal control systems and must report its effectiveness in the annual reports for the shareholders and other stakeholders (Lee, 2007, p.35-37). The financial frauds at the turn of the century not only affected audit process and regulations but also the perception of the corporate governance. In the light of corporate failures Macey identifies a trade-off between proximity and objectivity while evaluating the monitoring of the corporate governance. Proximity captures the steady loss of independence of the board and shareholders that come into close proximity with the firm and adopts the perspective of management it supervises. Objectivity brings out the existing distance that prevails between the shareholders and the management due to existence of outside forces like credit agencies, investment banking analysts, institutions that act as a substitute for shareholders’ direct involvement. This leads to shareholders not being able to obtain reliable and timely information from the management. This affects corporate governance practices. U.S. system is at an advantageous position due to lack of proximity. However the distance between the investors and firm due to outside forces mentioned above imposes high level of objectivity which in turn increases the probability that the shareholders and board will favor underperforming managers (Macey, 2004, p.400-401). Recent Changes & Effectiveness of Sarbanes-Oxley Act The history of regulatory changes in external audit practices and corporate governance is mostly a series of responses to the failed markets and corporations resulting in SEC Act 1933, Sarbanes-Oxley Act 2002 and the most recent Dodd-Frank Act 2010. The Dodd-Frank Act is the response to the recent financial crisis preceded by the collapse of Bear Stearns and Lehman Brothers. The Act has exempted the smaller companies from the provisions of internal audit control in Sarbanes-Oxley Act and while maintaining the investors’ protection, the compliance burden for auditor attestation requirement for companies with public float from $75m to $250m (with respect to Section 404(b) of Sarbanes-Oxley Act) (SEC, 2011). Other provisions under the Dodd-Frank Act included the changes in executive compensation and responsibilities of compensation committee within an organization. After a careful evaluation of the historical changes in audit process the two major problems that were prevailing are auditor’s independence and unwillingness of auditor to critically evaluate the firm. The Sarbanes-Oxley Act has successfully tried to address the issue of auditor’s independence. However many argue that the independence of auditors cannot be achieved because the audit committee provides a frequent and intimate basis for bonding the external auditor with the board rather than the shareholders. Bazerman, Morgan and Loewenstein purport that it is not the morality of the external auditor that affects his/her independence rather the cognitive limitations in processing the information. This is bound to result in failure of external audit and therefore the auditor’s independence cannot be achieved (Bazerman, Morgan & Loewenstein, 1997, p.93-94). Contrary to this belief an investigative study of relationship between auditor independence, audit committee quality and internal control weakness disclosures after the enactment of Sarbanes-Oxley Act, it was found that there were significant relations between these three factors. The firms were more likely to be identified with internal control weakness in the case of independent auditor (Zhang, Zhou & Zhou, 2007, p.322). This shows that the enactment of Act has resulted into improvements in internal audit control in the organizations. Sarbanes-Oxley Act significantly changed the structure of U.S. public accounting. Firstly the self-regulation under AICPA ended with the creation of PCAOB. The auditing standards and inspections of CPA firms are being conducted by PCAOB. Any disciplinary action will be taken by this board only. The section 201 of the Act responds to the conflict of interests between external audit services and consulting. The independence of auditor was strengthened by section 203 mandating the audit partner rotation. The intention here was to keep the auditors from clients and prevent any unethical collusion between client firms and auditors. A study conducted by GAO (Government Accountability Office) in 2003 concluded that the mandatory firm rotation was not the only way of strengthening auditor’s independence and improve audit quality because this has resulted in additional costs and knowledge (GAO, 2003). Further section 206 prohibited the audit firm to employ any of their staff as controllers, CFO or finance manager. It was a common practice for auditors to accept employment with the audited firm leaving the existing public accounting profession. This practice was more prevalent at HealthSouth, collapsed due to unethical and fraudulent acts of inflating earnings by $2.7bn (CNN Money, 2005). The employment with the client firm in a managerial position has been prohibited for the lead partner, member of audit engagement team or concurring partner who has given more than 10 hours of audit service, review and/or attest service. The person can be employed after one year from the start of audit (Rockness & Rockness, 2005, p.46-47). These prohibitions have had significant impact on internal audit professionals. The internal auditors’ relationship with the audit committee has been strengthened as the audit committee seeks assistance from internal auditors for services that external auditors cannot provide. Studies to understand the impact of Sarbanes-Oxley Act on the responsibilities of audit committees within organizations have indicated as the proportion of independent board members have increased the overstatement of earnings is less frequent, lower is the earnings management, external audit fee increases, financial restatement occurs less frequently and the probability of financial fraud decreases. It was also found that audit committees that have financial expertise and that are independent are less likely to face the internal control problems. Another study examined the impact of Sarbanes-Oxley on audit committee and its disclosures from a sample of 100 firms and found that most audit committees disclose only limited information in their reports and consider it only a regulatory requirement (HassabElnaby, 2007). However it is quite possible that the information must have been disclosed in other sections of annual reports such as proxy statements and charters. A survey conducted in 2005 of the impact of Sarbanes-Oxley on nonprofit and private companies showed that the 87% of the respondents attributed the corporate governance reforms for the impact on their organizations. This proportion was 77% in 2004. 78% of the private companies self-imposed corporate governance reforms in 2005 (2004: 605). The practices that are adopted by the private organizations are inclusion of financial statement certification by CEO/CFO, adoption of corporate ethical code, independent directors’ appointment, board’s approval to non-audit services and establishment of whistleblower procedure. These adopted governance practices are considered relatively inexpensive. However the results internal financial controls under Section 404 of the Act were expensive and time-consuming and so the results do not include survey in aspects (Broude & Prebil, 2005, p.2). The requirements under Section 404 (b) have been relaxed for certain small firms under Dodd Frank reforms. A 2001 survey after the recommendations of Blue Ribbon committee in 1999 showed that the audit committees used to meet less than the recommended number of times. A similar annual survey of S&P500 companies by Spencer Stuart Board Index showed the increase in the meetings to an average of five times. Another survey in 2005 by Pearl Meyer and Partners showed an average of nine meetings of audit committees. GAO apart from studying the audit firm rotation and its possible consequence also published its report on the competitiveness of the audit market which stated that there was no impaired competition for the public accounting and audit firms although the conditions for tier-II firms joining the Big Four were not favorable. However many organizations switched to tier-II firms for two reasons. First the Big Four had dropped many clients due to lack of manpower to conduct more time consuming audit required by Sarbanes-Oxley Act. Second these organizations believed they would be esteemed clients of tier-II firms. The audit process to evaluate internal controls is also changed by requirements under Sarbanes-Oxley that the management and external auditors should attest the effective controls on financial reporting. The most important changes brought by the Act were enhanced corporate disclosures. Other significant changes included increased power of shareholders, increased accountability of the senior management, prohibited company loans to executives, effective auditing of the auditors by PCAOB, increase in audit fees, increase in compensation of accountants and auditors, enhanced record keeping etc (Koehn & DelVecchio, 2006). Conclusion This project involves a critical analysis of the changes occurred in the external audit profession due to changes in the corporate governance practices in U.S. The major event that has shaped the audit and corporate governance practices in U.S. were the corporate frauds in early 2000s. As a result of these frauds the Sarbanes-Oxley Act was established in 2002. The provisions under this Act for the auditors and corporate governance have significantly altered the external audit industry and perception of the corporate governance. The major problems identified with the auditors and corporate governance was the auditor’s independence and lack of transparency and accountability. These two weaknesses in the regulations as most believe led to the corporate frauds such as Enron and WorldCom. The restrictions on the external auditors for providing non-audit services enhanced the responsibility of the organizations’ boards and audit committees. Other changes include establishment of PCAOB with oversight by SEC, auditor rotation every five years, statements of responsibility by CEO and/or CFO, internal control responsibility, directors’ independence in audit committee etc. The effects of this Act’s enactment has been the increased audit costs, effective auditing of the auditors by PCAOB, improved corporate disclosures, increased involvement of audit committee, increased accountability of the senior management, prohibited company loans to executives, increase in compensation of accountants and auditors, enhanced record keeping etc. Certainly despite many criticisms such as auditor’s independence, rising costs and time-consuming audit process the benefits certainly outweigh the perceived drawbacks of Sarbanes-Oxley Act. The resultant changes in U.S. over the years have worked in favor of the investors who rely on boards of the organizations and regulators for the protection of their interests. 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