Mandatory Audit Rotation and Auditor Independence - Essay Example

International Issues in Audit Contents Contents 2 Introduction 3 Discussion 4 Mandatory audit rotation and auditor independence 4 Different ideas related to mandatory audit rotation 8 Pros and cons of auditor rotation 10 Independence 10 Quality 11 Conclusion 11 References 13 Introduction Audit can be defined as a documented process carried out by qualified personnel and auditing companies in order to examine investigate and evaluate the objective evidences that are presented by the companies in order to establish their compliance and adequacy with the established accounting and business standards. The effectiveness, validity and compliance of the documents and implementation of the accounting processes are also checked through internal and external auditing. Auditing encompasses a number of activities like internal controls, project management, quality management, energy conservation, water management, accounting etc. Auditing follows a systematic approach and performs independent examination and evaluation of statements, reports, operations, records, data, financial and non-financial performances. Auditing processes are guided by internationally recognized audit standards and the Generally Accepted Accounting principles (GAAP). The purpose of the internal and external auditing processes are to validate and provide expert opinions about the adequacy of financial and operational controls, to evaluate the effectiveness of the risk management processes of the business as well as the corporate governance processes and the control systems used in the business. Auditing has been established as a critical part for the global business operations to validate and verify the activities carried out by different companies across the globe and to minimize frauds and scams by the businesses. But recently many corporate scams and the global economic crisis has raised critical issues related to the quality and scope of market concentration, auditor independence and external audit. One of the major issues considered presently by the European Commission is Mandatory Audit Firm rotation (MAFR). Discussion Mandatory audit rotation and auditor independence The European Commission has proposed certain changes in the present regulatory framework used to guide the auditing sector. The companies which belong to the Public interest category are proposed to use audit rotation for their firms on a mandatory basis. Audit rotation in both the internal and external audit activities has been a debatable topic in the recent years with different opinions being formed about mandatory audit rotation and their positive and negative impacts on the businesses as well as the auditing firms. According to Watts and Zimmerman (2003) the implementation of the mandatory audit rotation may have several implications on the functioning of the firms, the shareholders, the clients, the general public and other stakeholders (Watts and Zimmerman, 2003, pp.613-634). The European commission states that since the accountants are much influenced and controlled by the clients, therefore the independent functioning of the auditing firms may be lost if the same auditing firm continues to conduct audit of a particular business for a long time period. The mandatory audit rotation is considered as a solution to these problems of loss of independence and quality issues. Audit rotation can have multi sided effects on the quality of audits, costs of audit, competition and independence of the auditors (Arel, Brody and Pany, 2006, pp.1-27). Audit rotation is likely to remove the three major conditions that may affect quality, cost and independence of the auditors. These are the eagerness of the audit company to satisfy the client business, close relationship with the client management which might result in distortion of information and loss of attention of the auditors due to redundancy and staleness in the auditing process. Audit rotation is useful in removing conflicts of interests among the clients and the auditors when working for a long time with the same companies. Audit is mainly aimed at performing three functions including the underpinning of the market confidence to make the company function effectively in the modern corporate world, validating the financial statements, thus making them more credible and reliable for the shareholders and maintain proper external scrutiny and check on the transparency and integrity of the financial disclosures. Audit rotation helps in reducing the over dependency of the auditing firm on the previous years’ files of audit reports. This helps in bringing about a fresh perspective and the auditors give more attention to details due to the freshness and incentives associated. Without proper auditing, there may be divergences in the quality and integrity of the financial disclosures given by a company which would in turn increase the costs of capital, make the capital markets inefficient and decrease the standards of living in a country (Knechel and Vanstraelen, 2007, p.113). Addressing the emerging issues by the auditors is critical because these can have direct or indirect impacts on the audit process, financial reporting and control environment related to a particular business (Walker, Lewis and Casterella, 2001, pp.209-242). The understanding of an audit firm about how the company is responding to the challenges is important for the auditors, the company as well as its clients. Audit rotation is useful because it provides opportunities for a wider range of audit companies and gives scope for smaller audit companies to have access to work. As proposed by the IESBA in the IESBA code, independence encompasses the concepts of independence of mind and independence of appearance (Zhang, 2003, p.115). Independence of mind indicates the perceptions in the mind which facilitate the expression of a relevant conclusion which is independent of the influences related to professional judgement. This allows a person to incorporate integrity, professional scepticism and objectivity in their work. The independence related to appearance encompasses the avoidance of different circumstances and facts which are significant for the conclusions. This involves the consideration of specific circumstances and facts that indicate that the integrity, professional objectivity or scepticism of an employee of the firm or a member of the audit committee has been compromised (Ruiz-Barbadillo, Gomez-Aguilar and Carrera, 2009, pp.113-135). Independence of mind for then auditors helps to increase fidelity to public trust and a non-corrupt approach towards the auditing process. The independence of appearance in auditing encompasses objectivity and independence in practice where the audit company validates an audit report in its name. Both independence of mind and independence of appearance are critical in ensuring high quality and unbiased approach of the audit report. There may be a number of factors that create threats to the independence of the auditors (Velte and Stiglbauer, 2012, pp.90-99). These include Threat of self-interest: This threat may occur when the auditors are likely to benefit from their relationship with the firm. This may be a direct financial benefit or non-financial benefits. Threat of self-review: This threat occurs when the auditors are in full control of their work and themselves review and monitor their work like in book keeping services. Threat of advocacy: This threat occurs when the auditors can exercise control over promoting the views and opinions of the firm for which the audit is being done. This may include the legal services (Stanley and DeZoort, 2007, p.131). Threat of familiarity: This threat may occur when the close relationship between the auditing company and the management of the audited company develops when the same auditor audits the firm for a long time. In this case, a sympathetic bond is developed between the management and the auditor which may impact the auditing process because the auditors become too comfortable with the work and decision of the management. Threat of intimidation: This threat for the auditors is created when the auditors may face or perceive intimidation on their part due to the scepticism of the management of the company. This may include the case of the company employing an ex-audit team member. The main goal of audit rotation is to achieve the independence of auditors. If the auditors are changed in every five years, as planned in the mandatory audit firm rotation, it may make the auditors appear more independent from the influence of the managers (Cameran, Merlotti and Di Vincenzo, 2005, p.40). But it is difficult to ensure that the individual auditors would be completely unbiased and develop an opinion exclusively based on the evidences derived from the audit. This would create the chances of the auditor being much dependent on the management of the company for which the audit is being done. Mandatory audit rotation is likely to remove the threat of independence of appearance than removing the other related threats in audit. The auditing processes are guided by a number of rigorous standards that are used to create the independence of the auditing committee from the audited companies (Myers and Omer, 2003, pp.779-799). The mandatory rotation of the lead auditors in every five years is considered as a cost effective method of increasing the level of independence between the auditors and the client companies. Though the main objective of the establishment of a mandatory audit rotation system is to achieve auditor independence, yet independence of the audit processes may actually decrease in the face of audit rotation. In case the audit rotation process is implemented and a company is forced to change the audit committees in every five years, it is likely to use a number of auditing companies for other financial services related to the business. Therefore, the companies would be exposing their financial credentials and information to different audit firms. When the same auditing form comes for audit on a rotational basis, the independence level is much compromised due to the familiarity of the audit firms with the specific company. This would develop multiple relationships of a business with a number of audit firms. The high level of exposure of the business information may create increased chances of fraud activities and corporate scams related to the auditing processes (Carcello and Nagy, 2004, pp.55-69). Different ideas related to mandatory audit rotation According to Ruddock and Taylor (2006), the changes in the existing regulatory framework made by implementing the mandatory audit rotation processes may increase the inefficiency and the costs for both the firms and their auditors (Ruddock and Taylor, 2006, pp.701-746). They also argue that the mandatory audit rotation may have an adverse impact on the quality of the audit and audit rotation does not guarantee the independence of the auditor. In the case of the Enron scam, the accountants were held responsible for the scam. The accountants in Enron used complex structures and derivatives to hide large debts from the balance sheet of the company (Chan and Zhang, 2006, pp.49-82). But in the present regulations of the accounting and auditing domains, the auditing committees are held more responsible for wrongly validating the misrepresented financial statements for Enron. Many researchers have indicated that a rotational process of audit ma have prevented this type of corporate scam. According to Blouin, Grein and Rountree (2007), the arguments used for mandatory audit rotation are based on the following main points (Blouin, Gren and Rountree, 2007, pp.621-650): Auditor independence and objectivity: The rotation of auditors in every five years may increase the independence of the auditors by improving the perceptions of objectivity on the part of the auditors. This would help the development of fresh opinions by the new auditors for a specific company (Carey and Simnett, 2006, pp.653-676). Audit quality: The quality of the audit would be dependent on the rigor of the process. The audit rotation processes increase the investment of the audit companies and the cumulative knowledge building over years may become redundant when the auditors bare removed from auditing one company (Barton, 2002, pp.49-50). Many incidences of audit failure after the implementation of audit rotation indicate that the quality of audit work is adversely affected by the change in the auditors. Cost of audit: According to Brody and Moscove (2008), the auditing companies may face challenges when a mandatory audit rotation process is followed (Brody and Moscove, 2008, pp.32-35). This is because the audit industry is a highly concentrated industry with a number of audio companies competing strongly with each other, The cost of audits are high, especially in case of the first audit for a business. A new auditor needs to spend more money, time and resources for auditing a company. Other factors of consideration: According to the work of Khurana and Raman (2008), the auditing process of specialized industries is complex and a new auditor may take a lot of time to establish proper control over the auditing system (Khurana and Raman, 2008, pp.115-140). This may lead to loopholes for scams and frauds to occur and may also result in the creation of bad quality audit. Another factor for practical consideration is that the freedom of the individual companies in choosing their auditors is constrained which may lead to conflicts between the management and the auditors instead of creating a cooperative relation between them. There does not exist any concrete evidence that mandatory audit form rotation would guarantee the independence of auditors or reduce the over familiarity of the auditing committees with the management, According to Neal and Carcello (2000), the effect of audit rotation on audit quality is also debatable with some people believing the this process helps to improve the quality of the audits while others indicating that it is costly and may lead to limitations and disruptions in choices and reduce the knowledge level of an auditor with respect to a specific firm (Neal and Carcello, 2000, pp.453-467). Pros and cons of auditor rotation Auditor rotation is considered to be a debatable topic in the accounting domain. Many countries have adopted the audit rotation process in the past with some countries being able to implement it successfully while others making it obsolete after some time due to the non-effectiveness of the process in meeting its exact objectives. Independence The mandatory audit rotation may reduce the risks related to familiarity, self-interest and intimidation. These risks are directly connected with the independence of the auditors. Auditor independence is the willingness exhibited by the auditor in reporting any irregularities that are detected in the auditing process with respect to the financial and non-financial aspects of the business (Arrunada and Paz-Ares, 1999, pp.31-34). The objectivity of the auditors may increase when functioning on a rotational basis. The level of collusion with the management is likely to decrease in a rotational format which will foster independent decision making of the auditors. On the other hand, these requirements of policies may be deemed as unnecessary because the auditors themselves are likely to have interest in remaining independent from the sway of the management. The auditors would automatically prefer to report the irregularities and maintain integrity to improve their reputation in the industry (Azizkhani, Monroe and Shailer, 2010, pp.743-756). Audit rotation may hinder the cooperative relationship between the auditors and the management. When the auditing committees are changed, the new auditors have to start from scratch for the audit process because the impacts of long term relationships between the auditors and the management do not exist. This also means that the audit firms will have to spend more time when it has to audit a new company. The rotational process of auditors may increase the independence of the auditing firms but would also bring subsequent challenges like exposure to low quality audits and instability in the audit patterns. Quality The main factors influencing the quality of audit are the experience and knowledge of the auditors, the economic incentives and the structure of the audit market. The appointment of the new auditors may bring new opinions and perspectives for the audit as well as help to create an unbiased audit report (Al-Ajmi, 2009, pp.64-74). The mandatory audit rotation is considered to be beneficial for the audit quality because the degree of familiarity and scepticism is reduced which would improve the quality of the audit. On the other hand, the rotational audit may affect the fees and profits of the auditors which may make the auditors inclined to produce low quality audit reports. Conclusion The mandatory audit rotation is supported by the authorities but is seen as disadvantageous by the auditing firms. There may be more effective methods of ensuring auditor independence and a high quality of audit. These may be smooth communication and coordination among the regulators, audit committees and companies, more powerful national and international regulators and consistent inspection methods for audit quality. Also, ensuring increased transparency levels between the auditors and the audit committees as well as between the firms and the stakeholders is critical in making the audit processes successful. Though the main goal of audit rotation is to reinforce quality and independence in the auditing activities and thus decrease the chances of corporate frauds and scams, yet many countries which have adopted the audit rotation policies have been known to experience corporate. Italy is the only state in the EU which follows the audit rotation process. Despite that, one of the biggest corporate financial scams in the European Union occurred in the state. Thus, European Union should consider evaluating the past experiences of countries which have implemented audit rotation processes like Canada, Spain and Italy. Also, the distinction between independence in fact and independence in appearance for the workings of the auditors should be considered with respect to the implementation of the mandatory audit rotation firms (MAFR). References Al-Ajmi, J. 2009. Audit firm, corporate governance, and audit quality. Advances in Accounting. Vol. 25(1), pp. 64-74. Arel, B., Brody, R. G. & Pany, K. 2006. Findings on the effects of audit firm rotation on the audit process under varying strengths of corporate governance. Advances in Accounting. Vol. 22(1), pp. 1-27. Arrunada, B. & Paz-Ares, C. 1999. Mandatory rotation of company auditors: a critical examination. International Review of Law and Economics. Vol. 17(1), pp. 31-34. 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