Pros and Cons of Mandatory Audit Firm Rotation - Case Study Example

Audit Contents Contents 2 Introduction 3 Discussion 3 Mandatory audit rotation in action 3 Proposed changes 4 Analysis of arguments supporting mandatory audit firm rotation 5 Factors leading to threat of auditor’s independence 6 Arguments against mandatory firm rotation 7 Conclusion 9 References 11 Introduction Audit is an important part of financial management in any domestic or international company. The relevance of audit in the modern business world is very high. It is the process of examining and evaluating the various objective evidences which have been reported by a company with an aim to establish the compliance and adherence of the business processes and reporting with the pre-defined international business and accounting standards. The audits of companies are carried out by both internal auditors and external auditors which consist of qualified people and established auditing professionals and companies. The internal and external auditing processes encompass the evaluation of the validity, compliance and effectiveness of the accounting processes and financial reporting of the client company. However, certain globally significant events like the financial crisis of 2008 and multiple corporate scams in recent years like the case of Enron have led to an identification of the inconsistencies and loopholes in the prevailing international auditing and reporting systems. This has led to many questions regarding the effectiveness of audit firms, the impact of the continuity of one audit firm on the quality and objectivity of audit reporting etc. As such, the European commission has presented Mandatory Audit Rotation (MAR) as a concept which has substantial weightage for consideration in the current business environment. Discussion Mandatory audit rotation in action Mandatory Audit Rotation (MAR) has become an important evolving concept in international audit practices. After the Great Financial Crisis (GFC) much focus was given on finding the true reasons which drove the crisis. One of the main reasons identified was the discrepancies in the audit practices of various companies (Khurana and Raman, 2008). The influence of the clients on the auditing companies was perceived as a significant driver of low quality and inconsistency in auditing. So, international standards and authorities guiding the auditing principles have made it mandatory to rotate the auditors of a company on a regular periodic basis. International boards like the International Accounting Standards Board (IASB) and international standards like the Generally Accepted Accounting Principles (GAAP) are used to guide the auditing processes through the use of standardised perspectives. The main aim of auditing activities is to ensure compliance and prevent frauds and corporate scams and make the business world a more transparent and ethical domain (Ruddock, Taylor and Taylor, 2006). Proposed changes Recently, significant changes have been proposed in the prevailing regulatory processes and framework used for audit activities in the international scenario. The European Commission has made it mandatory for the companies operating as public interest entities to implement audio firm rotation (Kim and Cheong, 2009). This means that it is obligatory for these companies to change their auditing firms within or on completion of a period of five years. This is done with the aim of improving the quality of audit, complying with the established international standards of audit as well as to reduce the chances of any threat of familiarity or influences on the audit firms by the client company (Carey and Simnett, 2006). Audit rotation has been considered to be important for improving the quality and transparency in audit practices because the process of audit is identified to have considerable and long term impact on the business processes as well as on the functioning of the company itself, the shareholders, partners, the public, customers and other stakeholders of the business (Zhang, 2003). It is identified that the audit companies can be influenced and controlled by the client company if the term of service remains same for a long time. This may have negative implications for the quality and independence of the auditors (Stanley and DeZoort, 2007). Therefore, mandatory audit firm rotation is identified to be a factor that can enhance the quality of an audit by ensuring auditor independence from the client company. The periodic changes in the audit firms of a company would ensure that a level of familiarity and control of the client company in the audit firm is not established (Neal and Carcello, 2000). This in turn would ensure that the audit firm performs in an ethical and unbiased manner and presents reports which are valid, verified, authentic and unbiased in nature. Analysis of arguments supporting mandatory audit firm rotation Mandatory audit firm rotation is expected to have positive impacts on the costs, quality and auditor independence. This can be considered to be highly beneficial because of the adherence to the international audit standards. Mandatory audit firm rotation is expected to improve the competitive landscape in the audit industry by ensuring more compliance to the audit standards and unbiased and independent performance of the respective audit firms (Walker, Lewis and Casterella, 2001). A long term relationship between the auditors and the client company would lead to the development of familiarity between the two parties. One of the side effects of the informal relations is that the audit firm may display an interest to satisfy the client companies and may become ready to distort information and present audit reports without considering the loopholes, discrepancies and issues in the financial reporting processes of the client company (Kim, Chung and Firth, 2003). This would reduce the quality of audit. Mandatory audit rotation is expected to remove these obstacles by ensuring the information represented in the audit reports is not distorted. Moreover, the new audit firm once appointed takes a fresh perspective and interest in the audit process. This would prevent the audit processes from becoming just a ritual and would ensure that all aspects relevant to the audit are considered sufficiently and that proper adherence to the international standards and procedures of audit is maintained. Mandatory audit rotation is also expected to reduce any kind of conflicts of interest arising among the client companies and the audit companies in the long term of their allied working (Nagy, 2005). Factors leading to threat of auditor’s independence There are many key factors that may lead to threat to auditor independence in the audit domain. These factors may be threat to self-review, threat of self-interest, threat of intimidation, threat of advocacy and threat of familiarity (Jameson, 2005). Self –review: The threat of self-review refers to the threat which arises when the audit companies have complete control on their work and their work is not reviewed by any external authority. This may lead to distortion of information and inaccurate validation and verification on the part of the audit companies. Self-interest: The threat of self-interest is caused when the audit firms may have direct or indirect financial or non-financial benefits from the relationships with the client companies. The threat of familiarity refers to the threat that may be caused when the relationships between the management of the client company and the audit firm becomes more informal due to the same audit company working with the client company for a long period of time. This kind of relationship may result in the work of the audit company being influenced by the client company in an unethical manner. The threat of advocacy occurs when the audit company starts to promote the opinions and views of the client company (Barth, 2008). This may lead to unbiased opinion formation and unethical audit practices. Threat of intimidation: The threat of intimidation is caused in case the auditors are influenced by the scepticism of the key personnel in the client company and the audit performances of the audit firms are considerably affected by this perceived intimidation. The mandatory audit rotation is expected to reduce these risks of intimidation, familiarity, over dependence, advocacy and self-interest on the part of the audit firms (Velte and Stiglbauer, 2012). Advocacy: A decrease in these threats would mean the creation of more independence of the auditors in terms of their working and representation of views in the audit process. This would increase the chances of the audit quality being high and the minimization of the influences of the client company on the audit process. Arguments against mandatory firm rotation The main objective of mandatory audit firm rotation is to enhance the independence of the auditors and subsequently improve the quality and consistency of the audit reports. In mandatory audit firm rotation, the audit firm for a client company is changed every five years. This makes the audit companies more independent in nature because long term relationships and familiarity are not established due to which the control of the client company on the audit firm is minimized (Magee and Tseng, 1999). However, it would still be difficult to ensure that the individual personnel of the audit firm who interact with the client company would remain unbiased in the audit process and would not develop a view on the basis of the evidences obtained from the audit process (Chi, Huang and Liao, 2009). Therefore, mandatory audit firm rotation is likely to minimize the threat to the independence of the auditors. The mandatory rotation of the audit firms can be considered to be an appropriate and cost effective method for enhancing the auditor independence level. The mandatory audit firm rotation is likely to enhance the precision related to the objectivity of the audit firms (Carey and Simnett, 2006). The change of audit firms for a company in every five years will foster the development of new viewpoints and opinions for the auditing processes and would add value and new dimensions to the audit activities for a particular company. The audit quality is much dependant on the intricacies of the audit process. The mandatory audit rotation may result in adding new dimensions of opinion and validation to the audit process. The main elements which may impact the audit quality are the economic incentives, the interests of the audit companies, the experience of the auditors, the knowledge and expertise of the audit firms and the prevailing systems and structures in the industry. The mandatory audit firm rotation will improve the quality of audit because it would ensure the addition of new perspectives and interests due to changing audit firms and it would also help in creating unbiased audit processes by freeing the audit firms from familiarity, influence and scepticism of the client companies. While the main goal of mandatory audit rotation system to is to improve audit quality and auditor independence in a cost effective manner, this system may actually decrease the independence level of the auditors from the client companies (Choi, Kim, Liu and Simunic, 2008). The rotation of the audit firms in every five years would mean that the client company will employ new auditors every five years which would subsequently result in the financial information of the company being accessed by a number of audit companies. This may increase the vulnerability and exposure level of the critical financial information for the business. The high level of exposure of financial information to multiple audit companies may result in an increase in the chances of corporate scams and fraud activities. Other factors may influence auditor independence The adoption of mandatory audit firm rotation may decrease the cost effectiveness and efficiency of both the audit firms and the client companies (Kothari, Leone and Wasley, 2005). It may also lead to the redundancy of the knowledge development that has been done by a particular audit firm over years of working for a client company. This may increase the chances of incidence of failure of the audit process or negative impact on the audit quality after the establishment of audit rotation (Watts and Zimmerman, 2003). The mandatory audit rotation system would also create constraints in the choice of audit firms by a company. This may lead to the development of conflicts among the client companies and the audit firms and act as a hindrance in the way of establishment of a mutually beneficial and cooperative relation between the two (Carcello and Nagy, 2004). According to some scholars, this audit rotation system may not have far reached positive impact on auditor independence and instead may lead to unsatisfied auditors and low quality audit reports and processes due to less fees for the audit companies caused by the cost effective systems of the client companies (Ruiz-Barbadillo, Gomez-Aguilar and Carrera, 2009). Conclusion Mandatory audit firm rotation is considered to be advantageous from the perspectives of the international policy makers in auditing. On the other hand, the auditing companies are not supportive of the idea and are mostly averse to the new concept. While the authorities like International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) indicate that the mandatory audit firm rotation would ensure more stringency and transparency in the international auditing processes, the audit firms are of the view that this concept would do more harm than good in the audit performances. According to the individual audit firms, there are many other alternative methods of ensuring independence of auditors. These alternatives are more stringent international audit regulations, smooth coordination and communication among the client companies and their auditing firms, established control, review and inspection methods in auditing processes etc. These are deemed to be more effective ways of establishing auditor independence by the auditing firms. Also, the assurance of continuous communication and transparency between the client company and the auditing firms as well as the client company and its stakeholders is an effective way of ensuring success and effectiveness of the audit process. The main objective of mandatory audit rotation is to enhance auditor independence and audit quality and to ensure that the chances of corporate scams and frauds are minimized. However, in practical scenarios it has been observed that many countries like Canada and Italy which have taken up the mandatory audit rotation practices have experienced considerable level of corporate scams. Thus, there remains much scope of debate on whether the mandatory audit rotation process is adequate by itself for ensuing auditor independence and audit quality. References Barth, M. 2008. Global Financial Reporting: Implications. The Accounting Review. Vol.83 (5). Carcello, J. V. & Nagy, A. L. 2004. Audit firm tenure and fraudulent financial reporting. 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