The Improvement of the European Auditing Industry - Essay Example

CRITICAL REVIEW OF EU MEMO ON THE IMPROVEMENT OF THE EUROPEAN AUDITING INDUSTRY INTRODUCTION There have been various propositions by the European Union to tighten the audit process and the audit rules. This is to ensure that the audit service and procedures in the Common Market becomes more productive and more robust to encourage investor confidence and enhance investment in the Eurozone. Cases like the Enron and Worldcom scandals dented the image of the United States as a safe haven for investments. The EU is therefore seeking to strengthen its systems to be able to deal with issues and problems of such nature in order to guarantee investor trust and confidence. This paper critiques and analyses the various propositions and proposals that have been put forward. Each of the proposals are critically examined and evaluated in relation to the changes that it seeks to bring and how it seeks to modify the audit environment. Realistic issues in the world of business are explored to provide an assessment and overview of whether the propositions are going to be practical or not. CONTEXTUAL FRAMEWORK OF PROPOSALS There is the need for audit work to be carried out primarily to ensure that organisations and their management play their stewardship role and avoid the agency problem (Millichamp, 2012). Thus, the essence of auditing is to provide an independent review of a firms financial statements to assure users of the accounts, primarily the shareholders that the accounts showed a true and fair view (Companies Act, 2006). External audits involve the shareholders hiring auditors to check the reports presented by the managers and directors. The ISA 100 states that the essence of the audit is “to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatements, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the account expresses a true and fair view or not”. After major scandals like the Enron and Worldcom cases, governments around the world have come to appreciate the need to tighten corporate laws to ensure that auditing and other checks are strictly adhered to. This is because Enron provided very promising accounts on a year-by-year basis ten years before their collapse. Each year, their accounts were audited and they got an unqualified audit report showing that their reporting standards and processes referred the true and fair view. However, when information about their trade malpractices and reporting malpractices came to bear, it became clear that their accounts were absolutely misleading. In line with this, the United States introduced very strict rules, in the form of the Sarbanes-Oxley Act to ensure that firms present accounts that are truthful and not misleading. In this case, the European Union has also sought to provide some kind of rules and regulations that are meant to strengthen auditing and enhance the framework of controls and checks in the corporate world. This has the ultimate end of strengthening investor confidence and make the Eurozone a competitive destination for investment, particularly in light of the threats posed by the United States as an investment destination. Amongst the proposition are: Mandatory rotation of auditors after 10 years Public interest entities can only extend the tenure of their auditors once Encourage joint audits Reduce familiarity and enhance professional self analysis Reduce conduct conflict of interest audits Eliminate the risks of self-review Clarification of societal role of auditors to increase audit quality, transparency and better accountability Maintain a single standard to enhance the single market vision of the EU CRITICAL EVALUATION OF PROPOSITION The main end that is sought by the proposal is to provide some degree of harmonisation and consolidation of auditing standards. Thus, all the nations in the EU will have to abide by these rules and standards in their auditing sector. To this end, the proposal seem to indicate that they are willing to work within the framework of the International Standards on Auditing (ISAs) and the global harmonisation of these standards. To this end, the authorities seek to get a way through which auditing standards application can be modified to become more relevant in the member states of the European Union. This will be backed by national law and given the power and authority to get the relevant parties to do what is required of them. Thus, upon final approval by the appropriate authorities, there will be international cooperation amongst the EU member states. This agreement will allow for international cooperation between supervisory authorities in the member states and they must find ways of implementing it. The central issues identified in the provisional agreement include the problems of familiarity and its consequent lack of professional scepticism and prevention of fresh perspectives. Also, the need to make auditing more scientific and the need to create a dynamic and competitive environment by guaranteeing that auditing is effective play central roles in the proposal. IMPROVING AUDIT QUALITY The main idea of the proposal is to ensure that audit is carried out in a way that delivers results that are expected by the relevant rules and authorities to enhance the right results. In this sense, it appears that the ultimate end of this proposal is to attain a high degree of certainty in applying auditing standards to cases and issues in the European Union. This is because the attempt to reduce the certainty gap comes with the need to create a framework of rules and regulations that brings a specific result. Thus, there is going to be a trend towards rigidity rather than flexibility in the application of auditing standards. Therefore the UK will have to adopt these standards if they sign up to the agreement that is coming up. However, there are some areas and aspects that have been challenged and questioned by the Financial Reporting Council (FRC). This is because they are against the principles of auditing in the United Kingdom and there is the need to avoid integrating them into the UKs legal system through various means of resistance. The main area and aspect of enhancing transparency proposed in the memo is the need to set strict transparency requirements for auditors. ISA 200 requires that auditors get all the cooperation necessary for carrying out audit work. This means that they must be given access to their clients premises and there must be no attempt to hide anything from an auditor. This seem to provide sufficient proximity and sufficient access to information from audit clients. In relation to the promotion of transparency, there might be the need for auditors to disclose more information to enable stakeholders get the right picture of affairs in the firm. To this end, there might be the need to expand the scope of audit reporting and provide more detailed information in their reports. In the past, many issues and matters were kept from the publics eyes. However, with the advent of these new rules and procedures, there is the need for improved and enhanced reporting systems and structures. Audit Supervision and Audit Committee The requirement of enhancing better accountability of auditors is central in ensuring the improvement of audit quality. This involves the increasing of communication and better cooperation with audit committees. Technically, the audit committee is a wing of the Board of Directors and hence, they represent the best needs and expectations of the shareholders. Many firms on the major European stock exchanges like the London Stock Exchange have no option but to set up an audit committee. However, the audit committees role is not clearly defined in the ISAs. The ISA 310 now replaced with ISA 315 and 330. These require the auditor to learn about the way the audit committee operates and how they affect the firm. In the memo, however, there is a proposition that auditors must be supervised by the audit committee to enhance accountability. This is quite problematic because it could potentially lead to some degree of overrides and disputes. This is because the audit committee is meant to be independent. At the same time, they have absolutely no role and no connection with external audits. If this is to cover internal audits only, that will be good. On the other hand if this is meant to cause external auditors to get any kind of contacts with external auditors and try to supervise them, then there is going to be major issues and problems. The best this can do is to enhance cooperation between audit committees and external auditors. The EU Directive 2006/43/EC article 41.2(c) states that the audit committee must review statutory audits of annual consolidated accounts (d) Review and monitor the independence of statutory audit or audit firm. These are central issues that can add up to the quality of audits. And they can be enhanced and instituted to ensure that audits are free of independence and other qualitative issues and matters. This is quite good and positive and must be enhanced and improved. IMPROVING ETHICS “Integrity is a prerequisite for all those who act in public interest. It is essentially that the auditors act, and are seen to act in the public interest, which requires a broad range of related qualities such as fairness, candour, courage, intellectual honesty and confidentiality” (APB, 2011). Integrity is a broad framework but it is about doing good things and being faithful to what is right. It is carried out in an atmosphere of objectivity which is a state of mind that excludes bias, prejudice and compromise (APB, 2011). Integrity also encompasses the framework of independence which is the freedom from all situations and relationships that make it problematic for people to make reasonable decisions (APB, 2011). Areas and aspects where this principle must be used include situations where auditor might come under undue influence by some powerful and influential members of an auditee company as the case was in the Enron saga. Independence & Rotation Independence has been a major issue in the perception of whether an audit is fair or not. Auditor independence is actually important because in cases like the Enron saga, auditors represented that they were independent. However, after the scandal, it became apparent that auditors had come under the influence of some influential individuals and officials in the company. In order to ensure independence of auditors, the proposal states that there will be the need for a mandatory 10-year audit rotation. And this 10-year rotation could be extended for public entities upon the acceptance and usage of tenders. They also advocate for joint-audits which will ensure that no single firm gets too familiar with a given organisation, thereby leading to issues of audit quality. Jenkins and Vermeer (2013) identified that audit firm matters are heavily debated in academia and industry. This shows that there is a major doubt about the appropriateness of auditor rotation as a means and a tool for encouraging auditor independence. In the Sarbanes-Oxley Act, the American counterpart to this European audit enhancement process, they supported partner rotation as opposed to firm rotation (Jenkins and Vermeer, 2013). Many investors see audit rotation as a means of dealing with independence issues and problems (Myers et al, 2003). However, empirical studies showed that audit rotation is expensive in the long-run. This is because it undermines and decreases audit quality (Jenkins and Vermeer, 2013). The study also showed that auditor/audit firm rotation increases the likelihood of opinion shopping and this leads to a situation where a wide range of opinions can be applied to a firm that hardly changed its reporting standards. Therefore, the consistency of the audit process is affected adversely. The UKs FRC came up with numerous dilemmas when they tried to deal with the issue of rotation and the new proposition. The default position in the UK is a mandatory requirement for firms to put out for tender, their audit services once every five years (Gray, 2013). This means that a company must put out its audit service once every five years for new applications to be brought up. On the other hand, the EUs proposition in the memo in question indicates that a firm will have to rotate in a mandatory manner once every 10 years. In other words, once every ten years, there must be a mandatory change. This is in contrast with the UKs position whereby the current firm could also tender after 5 years. The EUs stance is that an audit firm that audited on a given project cannot join the tenders. Thus, the main idea behind the EUs position is to prevent one firm from being too dominant because there is a likelihood or at least a chance that a firm will retain its position under the UKs traditional approach. Another position taken by the EU is that the mandatory rotation program ensures that audit firms can get the chance to also practice. This is because the market is dominated by a few firms. And without a mandatory rotation process, these firms will continue to dominate the markets into the foreseeable future. The FRC came under fire and evaluated this position of mandatory auditor rotation. This is because many people in the UK like the competition agencies argued that the current UK position is much more competitive and enhances auditor transparency and efficiency better than the proposed EU system (Gray, 2013). This is because the UKs system ensured that auditors were working harder in a much more appropriate manner to retain their slot. This means that audit firm rotation might not be the best option. However, the use of joint audits are likely to promote and enhance audit quality. This is because it promotes some degree of cooperation and the need to impress on the firm level. Independence and Joint Audits Joint audits also seem to have their own issues. At least in theory, they seem to be very vital in promoting checks and balances and enhancing audits. However, in practice, there are major issues with them. These audits were common and popular in Scandinavian nations but businesses in those nations are moving from the joint audit system to single audit systems (Holm and Thingaard, 2014). Empirical findings indicate that there is a short-term reduction in fees for firms that switch to single audits. With the increase in auditor bargaining power, auditors are ready to offer discounts and they have an incentive to reduce their fees (Holm and Thingaard, 2014). This shows that joint audits can potentially increase the amounts of money a firm spends on its external audit engagements. Familiarity and Non-Audit Fees The APBs ethical standard requirement is that before an engagement, the audit engagement partner is to identify and assess the circumstances which could lead to adverse effects on auditor objectivity (APB, 2009). This means that there is the need for some degree of risk assessment and risk analysis in order to identify solutions to reduce threats to an acceptable level (APB, 2010). The EU proposal seeks to ban certain aspects of non-audit services provided by firms auditing a given company. This approach seem to provide some guarantees that there will be some degree of independence in the audit. However, some findings have shown that there is an adverse view of this. Gul et al (2007) identify that the risk of self-review is contingent upon the term of service. If the term of the audit is short, non-audit fees could affect the independence of the audit process. This is because the firm will want to charge high fees and conduct the audit and sometimes condone in earnings management (APB, 2010a). However, where there is a long-term relationship with the client, there is a general tendency towards improved independence and objectivity. Although this proposal seem to be put forward in good faith, it has major practical issues and matters that might not be very positive. For a country like the UK, the Audit Practice Board has numerous processes and procedures that provide the impetus for firms to review and analyse their risks. Since the rule on auditor independence is more about the auditor “appearing” to be independent, these new proposals seem to be one that will support audit practice in the Union. However, the UKs framework and the APBs rules seek to get auditors to analyse their self-interest threats, self-review threats, management threats, advocacy threats and familiarity threats before an audit commences (APB, 2011). This is to be done by an engagement partner so there is some kind of independence and objectivity in such a review. As such, a firm can be allowed to go about the audit without the government or state having to set up extreme and excessive rules and regulations that ban some other services a firm renders to a company. In most small companies, they cannot afford to get many auditors to help. And the UKs caliberation processes are ideal and can enhance the audit services. Dominant Audit Client The quest to set a 70% cap on fees generated from non-audit service is very reasonable. This is because it somehow limits the reliance on a firm. Also, the cap that is set on the reliance on a single firm is very credible. This is because when an audit firm is heavily reliant on a given company, it will automatically want to “soften its lines” in issues of relevance. This means that they are likely to be less critical and they may fail to provide reasonable audit reports that can cover the appropriate scope of audit reporting. Enhancing Competition Another aspect of the memo that makes it positive and progressive for the audit landscape is the fact that it helps firms to become capable of competing in the markets. The EUs central objective is to create a Common Market and also enhance competition. Thus, the move towards eliminating clauses that support “Big Four” firms only must be changed. This is because without that, the audit terrain will be dominated by a few firms and this will prevent efficiency. This is a positive aspect of this memo. CONCLUSION The European Unions attempt to modify the audit industry of member states including the UK and other nations is turning out to be problematic. This is because some areas and aspects that they seek to improve already have ethics and rules that are successfully working in the industry. In areas like auditor rotation and the ban on self-review by audit firms, the memo seem to contain some over-idealised views that are not practical. This is because the audit industry has some variables that allow such trends and processes to thrive. And this will mean that most of the rules and regulations of the EU are not necessary in this area. However, in areas like enhancing competition and preventing firms from being over-reliant on some clients, the EUs proposal is valid and will change and enhance the audit industry in the union. As stated in the proposal, there will be a series of meetings and discussions before the proposal is finally adopted and upgraded into a directive for member states. Thus, there is the need for the existing proposal to be reviewed and analysed for better results. References The Audit Practice Board (2009) Long Association with Audit Engagement London: APB The Audit Practice Board (2010) Audit Evidence London: APB The Audit Practice Board (2010) External Confirmations London: APB The Audit Practice Board (2010) Fees, Remuneration and Evaluation Policy: Litigation, Gifts, and Hospitality London: APB The Audit Practice Board (2010) Non Audit Service Provided to Audited Entity London: APB. The Audit Practice Board (2010) The Auditors Response to Assessed Risks London: APB The Audit Practice Board (2011) Integrity, Objectivity and Independence London: APB. The Audit Practice Board (2012) Understanding the Entity and its Environment London: APB Companies Act (2006) Chapter 2: Appointment of Auditors London: TSO Companies Act (2006) Chapter 3: Functions of the Auditor London: TSO Companies Act (2006) Chapter 4: Removal, Resignation etc of Auditors London: TSO Gray, J. (2013) “UKs FRC Rejects Calls for Compulsory Audit Rotation” Corporate Governance Report [Online] Available at: http://www.corporategovernancereport.com/auditing-policies/uks-frc-rejects-calls-for-compulsory-audit-rotation/ Retrieved: March 7, 2014. Gul, F. A., Jaggi, B. L. and Krishnan, G. V. (2007) “Auditor Independence: Evidence on the Joint Effects of Auditing, Turnover and Non-Audit Fees” Auditing: A Journal of Practice and Theory 26(2) pp117 – 142 Holm, C. and Thinggaard, F. (2014) "Leaving a joint audit system: conditional fee reductions", Managerial Auditing Journal Vol. 29 Iss: 2, pp.131 – 152 International Standard of Auditing (2010) Overall Objectives of the Independent Auditor and the Conduct of Audit London: FRC Jenkins, D. S. and Vermeer, T. E. (2013) “Audit Firm Rotation and Audit Quality: Evidence from Academic Research” Accounting Research Journal 26(1) pp75 – 84 Millichamp, A, (2012) Auditing Wadsworth: Cengage. Myers, J. N., Myers, L. A. and Omer, T. C. (2003) “Exploring the Term of the Auditor-Client Relationship and the Quality of Earning: A Case forMandatory Rotation?” The Accounting Review 78(3) pp779 – 799 Read More