Factors Affecting Quality of External Audit - Dissertation Example

?Introduction Yearly external audit is a sta y requirement under which all limited companies are required to allow independent auditors to comment on the true and fair nature of the financial statements prepared by them. Independent auditors are not only required to perform the external audit thus checking whether the financial statements are prepared according to the established accounting standards and procedures but are also required to ensure that they are free from any material error and may not result into a wrong judgment by the investors. In the aftermath of the corporate scandals and current financial crisis, the overall importance of external audit and its scope has come under greater scrutiny. Increasingly, investors as well as regulators are demanding a better external audit function so that the overall interests of the stakeholders could be safeguarded. This therefore requires an improvement in the quality of the external audit and how it can be improved in order to ensure that the external audit could help to safeguard the interests of different stakeholders. This topic is important in the sense that it can help to identify, within specific context of UK, some of the factors which can contribute towards improving the quality of the audit. Investors and shareholders can be more assured about the overall credibility of the audit and what factors they can look into when assessing the overall quality of the audited financials. Researcher aims to explore the overall nature and the extent of factors affecting the quality of the external audit. On a broader level, this research study will explore different concepts related with the quality of the audit, identification of different methods which are used to improve the quality of external audit as well as the quality and nature of the impact of such factors on the overall quality of the external audit in UK. Literature Review The overall requirement for the services of the auditors and the firm is formed on the basis of the agent-principal relationship. Accordingly, under the agency relationship, a principal delegates some tasks and responsibilities to the agent under the understanding that these tasks will be performed by the agent on behalf of the principal. In modern concepts of the management and the owners, the managers are appointed as agents by the principals (shareholders) to manage the overall affairs of the firm. (Causholli & Knechel, 2009) As such when a conflict of interest arises between agent and the principal, agents may take actions which may not be entirely in the best interests of the principals. In order to narrow that gap, a financial reporting mechanism is prepared which is duly supported by the independent external auditors to ensure that the financial reporting made by the management is free from errors and frauds. The overall concept of audit quality therefore is linked with how well the function of external audit is successful in highlighting and detecting material errors in the financial statements while at the same time reduce the information asymmetry between the shareholders and management of the firm. Underlying the concept of external audit is also the reduction of the information asymmetry between the shareholders and the management of the firm. Preparation of financial statements is one of the key functions management has to perform in order to inform the shareholders and other stakeholders about the overall performance of the firm during given period of time. As such, it is through the financial statements that the management informs the shareholders regarding the overall quality and effectiveness of the management as the same has to translate into better financial position and profitability for the firm. Reducing the information asymmetry therefore can further improve the credibility of the financial statements but also provide a third party endorsement that the financial statements are prepared in true and fair nature. The concept of Audit quality and factors affecting it Audit quality is one of the much debated concepts given the overall concerns of the regulators and other stakeholders trusted with the responsibility of ensuring the credibility and existence of financial reporting mechanism. This has also became more critical owing to the corporate scandals witnessed in US which have exposed the vulnerabilities of existing financial reporting mechanism and its impact on the overall economic system of the country. It is generally agreed that the good quality audit means the external auditor fulfills all his professional responsibilities and all the activities of the external auditors are always under their professional and legal mandate. (DeAngelo, 1981). It therefore becomes critical that the overall quality of the audit depends upon the definition of the different roles and responsibilities which external auditors are required to undertake and perform. There are two important responsibilities of the external auditors which are considered as important for the purpose of assessing the quality of the audit. Firstly, ascertaining the financial condition and the earn quality of the firms and secondly detection of fraud and errors in the financial statements or overall reporting mechanism are considered as two important responsibilities of the external auditors. It is imperative to understand that the defining the different characteristics of the audit quality and identifying the parameters of the same is still considered as one of the significant challenge. Classical definition on the quality of the extern audit indicates that it is the market assessed joint probability that the external auditors will be successful in assessing the material breach in the financial reporting system of the firm and subsequently report the same to different stakeholders associated with the firm. More recent views on the assessment of the audit quality however, suggest that since audit quality cannot be measured when actual audit is performed therefore there are different proxies which can be used to assess the overall quality of the external audit. (Ayres, 1994) Various studies have considered different proxies such as size of the audit firm, earning management and the number of men hours spent on the conduct of the audit as some of the key parameters which can be utilized in order to ensure that the quality external audit is delivered. (Arrunada, 2000) One of the most important factors which outline the importance of audit quality is the quality of information presented in the financial statements. It is generally believed that when financial statements are audited by the quality auditors, they are less likely to contain any material errors or misstatements. It therefore outlines that the overall quality of the audit largely depends upon whether information presented in the financial statements is complete and free from any material misstatements and errors. (Deis & Giroux., 1992) The size of the firm is also considered as another important factor which affects the quality of the firm. Larger the size of the audit firm, better it is equipped to perform the audit with relatively higher quality. These studies also suggest that though the size of the firm is one of the key factors however, the overall quality and less information asymmetry play the key role in defining the overall quality of the external audit. (Davidson & Neu., 1993) It is also important to consider that the convergence of the reporting incentives of the managers as well as the auditors can actually dilute the overall quality of the audit. When the overall interests collude with each other, the overall quality of the audit may be compromised and the auditors despite their bigger size and effective manpower may fail to deliver the desired results and generate quality external audit which can safeguard the interest of all the stakeholders and reduce the information asymmetry between the stakeholders and the company. Another important factor affecting the overall quality of the audit includes the overall number of audit hours spent on the audit. It is suggested that the greater size of the firm coupled with higher number of hours spent on the performance of the audit function also counts as one of the key parameters of the audit quality. More men hours spent on the performance of audit therefore entails that the overall quality of the audit will be higher as compared to the audit where lesser men hours are spent. Earnings management is also considered as one of the factors affecting the audit quality considering the fact that both managers and the shareholders may have inherent conflict with each other. (Ayres, 1994). According to Agency Theory, if both the managers as well as the shareholders act as utility maximisers therefore there is bound to be a conflict between the interests of the two. It is therefore suggested that if the overall performance of the managers is directly linked with the financial performance of the firm, there is strong probability that the earnings of the firm may be manipulated in order to boost the chances for higher compensation for the managers. (Beatty, 1989) It is argued that the main function of the audit is to reduce the information asymmetry between the different players involved and to facilitate their relationship. This therefore gives rise to the concept of managing the contractual relationship between different parties including management as well as the shareholders. Audit therefore ensures that these contractual obligations are fulfilled according to the overall expectations of the different parties. As such the overall earnings management is inversely related with the audit quality i.e. higher audit quality is related with the low level of earnings management. Studies suggest that the clients of Big 6 firms show less discretionary accruals for earnings as compared to the clients of the non- Big 6 Audit firms. This suggests that the higher audit quality may result into lesser discretionary accruals for the income hence reduces the chances of manipulating the income of the firm. (Barefield & Comiskey., 1999) Regulations and Monitoring in Auditing in the UK It is critical to understand that the government of UK has the overall responsibility for the development and managing of the legislative framework required for the implementation of auditing standards within the country. The government actually intends to ensure that effective corporate governance, financial reporting and auditing mechanism should exist within the country so that the overall interests of all the stakeholders are saved. It is because of this reason that the government legislate in order to achieve these objectives. UK Government has recently introduced changes in the regulatory framework related with the audit and corporate governance. Companies Act 2006 as well as the Statutory Auditors and Third Country Auditors Regulations 2007 have been introduced in order to update the domestic regulatory framework in order to comply with the EU directives. (Financial Reporting Council, 2008) It is important to understand that the UK being part of the European Union has to comply with the directives and regulations made at the EU wide level. In order to achieve this, changes in the domestic legislative framework are made to ensure the compliance with these regulations and directives. The current legislative infrastructure for the auditing and its monitoring is also built around the legislative framework outlined by European Union. UK government therefore has the mandate of ensuring that required legislative framework is in place to ensure that the external audit is performed according to the laid down rules and procedures in the domestic and international laws and regulations. Financial Reporting Council Financial Reporting Council is one of the most important bodies in UK with the mandate of ensuring that confidence in financial reporting as well as corporate governance is maintained at the desirable level. It is a semi-government organization which is partly owned by the UK government whereas rest is guaranteed by the industry within the country. It is also because of this reason that the FRC, as it is usually called, is a company limited by guarantee. The overall supervisory oversight of maintaining public confidence in the quality of audit is ensured by the Professional Oversight Board (POB) with the broader mandate of overseeing the accountancy bodies responsible for supervising the overall working of the auditors. These accountancy bodies are also responsible for offering accounting and auditing qualifications in order to ensure the auditors meet certain level of educational and training requirements before they can actually embark on to practice the function of external audit. It also has an Audit Inspection Unit which monitors the quality of audit of the publically listed entities. Further AIU is also responsible for ensuring that the accountancy bodies remain independent and free from any influence on them. POB is also responsible for the oversight of the regulation making process of the accountancy bodies also. All the accountancy bodies within the country are required to give careful consideration to the recommendations of POB, implement the same or provide cogent reasons for not implementing the recommendations made by POB. Audit Inspection Unit Audit Inspection Unit or AIU is part of the Professional Oversight Board of the Financial Reporting Council. It is responsible to monitor the audits of the publically listed companies and as such is mandated with the role of ensuring that the quality of the external audit is maintained at the required level. AIU issues different reports after concluding its monitoring of the different sample audits conducted in order to check the compliance. In one of its reports, AIU mentioned that its key audit engagements suggest that the judgments exercised in financial reporting appear to be appropriate and sound. (AIU, 2005). AIU also suggested that almost all of the major firms in the country have repeatedly assured the Government and other stakeholders regarding their commitment to ensure audit quality in order to improve the confidence of the investors in the financial reporting process. AIU , in one of its recent reports, however, do mentioned that the auditors engaging into the alternation of the audit files when an inspection request is made by the AIU. (The Accountant, 2010). AIU has also highlighted some other operational issues which have been ignored by the audit firms hence compromising the overall quality of the audit. Issues such as obtaining confirmation from third parties, lack of confirmations for confirming the overall level of existence of assets and liabilities of the firm. Though these issues may look simpler in nature however, on a broader level they tend to create the level of audit quality deficiency thus putting the interests of the investors at stake. AIU has also highlighted some of the factors which can derive the audit quality. (AIU, 2005) These factors include: 1. Leadership 2. Human Resource 3. Ethical Policies of audit engagement 4. Engagement performance 5. Monitoring AIU’s main role therefore is to ensure that the overall audit quality is based upon these broader factors which encompass other important sub-factors also. Empirical research however, tend to present a different set of factors such as size of firm, men hours spent etc as critical for ensuring that the overall quality of external audit will be maintained. In its various reports, AIU emphasised that in order to ensure audit quality, it is important that the senior management of the firm must take an active part in making a public commitment of the firm in achieving the desired level of audit quality. AIU however, highlighted that the different firms measure the performance of their partners based on the achievement of commercial targets rather than on ensuring audit quality. These trends therefore indicate that the firms may find it difficult to balance their commercial objectives with audit quality. Effectiveness of the factors As discussed above that the convergence of the reporting incentives between the auditors and the management of the firm can actually undermine the overall effectiveness of other factors in ensuring the overall quality of the audit. This also means that auditor’s independence is one of the key criteria underlying the fact that quality audit can only be delivered when auditors are independent and have no other interests within the firm. It is argued that when managers attempt to overstate the income through the accruals, the overall conservative approach taken by the auditors can actually create a conflict between the auditors as well as the management of the firm. However, when the under-estimation of income becomes and incentive for the management, auditor’s conservatism colludes with such practices and hence auditors may not be able to ensure that the quality audit is delivered. (Francis & Krishnan., 1999) Other studies suggest that the factors such as size of the firm may not be a better proxy for the assessment of the audit quality. This is also may be a direct result of the perceptual differences between the market assessed audit quality and the actual audit quality and as such this may create a difference between the two. Though different studies have suggested that the size of the audit firm may be an effective proxy or factor in ensuring the audit quality however, it is not generally an effective measure. It is also important to understand that the different studies have highlighted the overall weaknesses of the different statistical techniques undertaken to measure the impact of different factors on the audit quality. It is argued that the larger forecast errors in the earnings forecasts and the actual earnings of the firms may suggest that the overall audit quality may be superior. However, this link is not statistically proven considering the fact that the audit as a profession has evolved over the period of time and the different and innovative techniques used by the management to under or over-estimate the earnings may go unnoticed by the auditors. The overall impact of these factors is also subject to the nature of the relationship between the audit firm and the company. If the firm is also engaged in providing different other services to the companies, their overall quality of audit may be circumvented. Case of Enron is often cited as a prime example wherein providing services other than audit resulted into the compromise of the audit quality hence the audit firm failed to notice material errors and misstatements reported in the financial statements of Enron over the period of time. It is suggested that the overall quality and impact of these factors however, is positive and result into better audit quality. Different studies have specifically suggested that the size of the audit firm do matter a lot in ensuring the overall quality of the external audit. Research Objectives and Questions This research study is aimed at understanding and exploring the issue of audit quality and how it is related with the UK. On the whole, this research study will be focused on achieving following research objectives: Analysis of concepts that related to the quality review, relevance and the factors affecting them As the literature review identified, the concept of quality review and audit is one of the key aspects of ensuring that the interests of all the stakeholders are protected. This research study will aim at developing a broader understanding of the relevance of the audit quality and the factors which may affect the overall audit quality. This research will also aim to explore the overall impact of these factors on the audit quality also. Considering the above research objectives, this research study also aim to seek answer for the questions such as: 1. What are the factors affecting the quality of the external audit. 2. Is the impact of these factors positive or negative? 3. What is the overall importance of each factor from the view point of the parties to the review process? On a broader scale, this research study will therefore aim to seek the answers of above questions and will explore their relevance and applicability with reference special reference to the UK. Since audit as a function is also a regulated function in UK, this report will therefore explore the role of different parties and how different factors identified in this report may have a relevance to different parties to the overall audit review process conducted in UK based firms. Research Design & Methodology Methodology is often considered as the use of some statistical methods in order to investigate the research questions. It also help the researchers to understand and explore as to what is actually achievable with the help of statistical methods and what is not achievable considering the overall inherent limitations of the different statistical methods. In order to perform this research, the researcher will use a mix of different desktop research methods. Desktop research will be used in order to review and explore the existing literature on the topic and to unearth different research themes on which earlier authors have already touched upon. Desktop research will also be used with an aim of explore the current research and statistical methods used by the previous authors. This will help the researcher to understand the traditional weaknesses of different research methods while applying them to the current research. In order to conduct this research, researcher also aims to apply different tools and methods including literature review, review of the business and industry literature, personal interviews, as well as some field research in order to ensure that different factors are comprehensively covered and adequately addressed during the research. Researcher also expects to get an insight from the research Supervisor in order to properly identify the factors and explore their relevance and importance for the proper conduct of the research. Overall Approach to Research Before conducting the research, it is also important to define the overall approach to the research to be undertaken. This research study will be a combination of both the qualitative as well as quantitative methods in order to explore different aspects of the research. Qualitative research is always related with the in-depth observation and analysis of the data whereas quantitative research is associated with the collection of data and performing different statistical methods to actually identify and extract meaningful results from the research. Quantitative research also give empirical credibility to the research conducted. The overall approach to the research will be qualitative in nature wherein the researcher will exclusively focus on evaluating the qualitative data and understanding its impact on the overall research questions under study. Secondary Research Researcher aims to study different literature review, text books, previous studies, industry journals as well as important websites to collect the data and perform the requisite background research on the topic. Researcher is aware of the fact that secondary research may not itself provide the necessary guidance as well as provide definite conclusions to the research however; it can help to set the overall direction of the research. Secondary Research is based upon review of existing research done on the subject and the researcher has to rely on different research themes and issues identified in the previous research. This may however, limit some of the independence of the researcher in order to some of the critical insights which primary research could have provided. Data Collection In order to collect the data and compare the impact of the factors on the audit quality, researcher aim to collect data through the different methods such as review of literature, business magazines, AIU reports, Websites etc 1. First identify the factors which may have a direct impact on the overall quality of audit. 2. Secondly identified as to whether firms under the study have been linked with any particular accounting scandal or not 3. Identify the overall trust of the shareholders in the earnings management of the firm. Review of the above material will provide the researcher with ample data to further analyse and collect important data from the secondary sources. Further, review of literature will offer further opportunity to understand and explore existing themes in the current literature. It is important to understand that researcher will only rely on the authentic and credible sources of literature in order to ensure that the data is collected from plausible sources with important research implications. Data Analysis Since this research will be based on secondary data therefore data analysis will be based upon the review of the existing literature. The overall aim is to identify as to whether existing research have successfully highlighted the factors identified and their impact on the audit quality. Bibliography AIU. (2005, June). 2004/5 AUDIT QUALITY INSPECTIONS. Retrieved May 29, 2011, from Audit Inspection Unit: http://www.iasplus.com/uk/0506ukaudit.pdf Arrunada, B. (2000). Audit Quality: Attributes, Private Safeguards and the Role of. The European Accounting Review , 9 (2), 205-224. Ayres, F. L. (1994). Perceptions of Earnings Quality: What Managers Need to. Management Accounting , 75 (9), 27-29. Barefield, R. M., & Comiskey., E. I. (1999). The Accuracy of Analysts’ Forecast of. Journal of Business Research , 3 (3), 241-252. Beatty, R. P. (1989). Auditor Reputation and the Pricing of Initial Public Offerings. The Accounting Review. , 64 (4), 693-709. Causholli, M., & Knechel, W. (2009). Is the Audit a Credence Service? Flordia: University of Flordia. Davidson, R. A., & Neu., D. (1993). A Note on Association Between Audit Firm. Contemporary Accounting Research , 9 (2), 479-488. DeAngelo, L. (1981). Auditor size and audit quality. Journal of Accounting and Economics , 183-199. Deis, D. R., & Giroux., G. A. (1992). Determinants of Audit Quality in the Public. The Accounting Review. , 67, 462-479. Financial Reporting Council. (2008). The Audit Quality Framework. Retrieved May 24, 2011, from Financial Reporting Council: http://www.frc.org.uk/documents/pagemanager/frc/promoting_audit_quality_responses/audit%20quality%20framework%20for%20web.pdf Francis, J. R., & Krishnan., J. (1999). Accounting Accruals and Auditor Reporting. Contemporary Accounting Research , 18 (2), 17-34. The Accountant. (2010, July 21). Audit Inspection Unit issues 2010 annual report. Retrieved May 29, 2011, from The Accountant: http://www.vrl-financial-news.com/accounting/the-accountant/issues/ta-2010/ta-6080/audit-inspection-unit-issues-2.aspx Read More