Independent Auditing in the UK - Essay Example

What should the U.K do to enhance Auditor Independence Auditing plays a crucial role in business, government and our national economy (Boynton et al., 5). It is the “process of examining the assertion or representation of another party and providing assurance on the fairness and reliability of the information in accordance with given standards” (Giove, 1). Independent auditing is a process involving the “independent examination of, and expression of opinion on, the financial statements of an enterprise” (Power, 4). The 2001 Enron disaster in the U.S. was the result of rogue trading, deliberate concealment of debts off balance sheets and other financial irregularities carried out by Enron in connivance with its auditing firm, Arthur Andersen LLP (Beams, 2002). The Enron scandal was immediately followed by the Worldcom disaster: in June 2002, Worldcom disclosed that during 2000 and 2001, it had been guilty of capitalising (instead of rightfully showing as expenses), a staggering amount of $ 3.8 billion (Boynton et al., 3). These scandals were so massive that it shook public confidence to a degree rivaled only by the collapse of banks and utility organisations during the Great Depression in the United States. Just as it happened after the Great Depression, the after-effects of the Enron (and to a lesser degree, Worldcom) debacles marked a watershed not only in the U.S. but also in the whole world (Beams, 2002). Business standards are expected to be reliable. As the Financial Times (February 2002) put it: “Trustworthy business standards are among the most important social capital the developed world possesses” (Beams, 2002). It is the fundamental right of every shareholder to expect accuracy and reliability in the publicised financial reports of the companies they invest in; this crucial factor governs the shareholders’ relationship with the company, because such reports are the only sign of the company’s financial (especially its investment) health and progress, thus making it the foundation on which the shareholders take decisions about investment in the company (Hermes.co.uk). Shareholders as well as others (investors, bankers, bonding agencies and other creditors) depend on the company’s audited financial reports to make certain that they have access to accurate and reliable information when initiating or enhancing business with that company (Boynton et al., 5). The need to assure shareholders, investors and other interested players about the accuracy and reliability of the company’s published financial reports represents the main reason why companies have their accounts checked by an independent auditor. High profile fraud cases like those involving Enron and Worldcom not only drastically reduce the public’s high regard of the auditing profession in general, but also results in erosion of shareholder and other players’ confidence as they begin to doubt the authenticity of the reports published (Hermes.co.uk). Since 1998, the global auditing world has been ruled by 5 auditing firms (called the Big Five) that have the capability and international network to audit the largest public companies in the world. They are PriceWaterhouseCoopers (PwC), Klynveld, Peat, Marwick, Goerdeler (KPMG), Ernst & Young (E&Y), Deloitte & Touche (D&T), and Arthur Andersen (AA) {Europa.eu, 2002}. What was originally the Big Eight (1970s to 1989), that also included Arthur Young & Co., Coopers & Lybrand, Haskins & Sells and Touche Ross, was reduced to the Big Six (1989-1998) when Haskins & Sells merged with Touche Ross to form Deloitte & Touche. The last major merger involved Price Waterhouse and Coopers & Lybrand, who formed PriceWaterhouse Coopers, thereby trimming the Big Six to Big Five (1998-2002). Arthur Andersen was struck off the Big Five in the wake of the Enron scandal in 2002, and there are now only the Big Four audit firms (Wikipedia). U.K regulations require all public sector companies (irrespective of amount of turnover), and those private sector companies whose turnover exceeds £1 million, to prepare, audit and publish yearly financial reports (Porter et al., 2). Arthur Andersen’s U.K business was taken over by Deloitte & Touche in July 2002 (Europa.eu, 2002). The Big Four are almost evenly matched when compared on a global basis, but within the U.K, PwC holds the largest share. The FTSE 350 companies consider the Big Four, in view of their strong in-depth capacity and international network, most suited to provide a high quality audit that is considered a satisfactory trade-off between price and quality, which delivers 3 main features – the technical audit itself, value-added services, and safeguard against financial disasters and potential damage to business standing (Oxera.com, 2006). Public concern about the independent status of auditors is founded on their tendency to provide several non-audit services. Some of these services have no relation with the audit, but others (like tax accounting and merger-related work) are perceived as having a close relationship with auditing; and since it is the auditing firm’s own clients that are supplied with such non-auditing services, it causes suspicion among shareholders that the audit process may be endangered by fraud (Hermes.co.uk). Many empirical studies have explored whether the supply of audit as well as non-audit services compromises auditor independence (Krishnan et al., 2005). Shareholder and other players’ concerns are exacerbated by the fact that non-audit fees are much more than audit fees (Hermes.co.uk). Among the Big Four, PwC earns the highest audit fees in the U.K, followed by KPMG, D&Y and D&T (Europa.eu, 2002). The audit fee in itself is quite high – the Oxera 2006 study found that during the period 1995 to 2004, U.K audit fees increased by 11.7% per year, and the top 10 auditing firms in the U.K earn over £1.5 billion in audit fees every year (Oxera.com, 2006), but this impressively high figure pales into insignificance when compared to non-audit fees. The Brand Finance 2000 survey of FTSE 350 companies found that the audit fees paid to the Big Five was £300 million, whereas non-audit fees paid to them was £500 million (Hermes.co.uk). Another 2000 survey (Porter et al., 2), quoting relevant companies’ annual reports, published the following interesting table: Audit and Non-Audit Fees paid to the Auditors of 10 of the largest Companies listed on the London Stock exchange in 2000 Company Audit fees Non-Audit fees paid Auditor To the same auditor £million £million BP plc 20.0 36.4 E&Y Vodafone Group plc 1.0 16.0 D&T HSBC Holdings plc 18.4 10.7 KPMG Astra Zeneca plc 2.3 9.9 KPMG Royal Bank of Scotland plc 4.9 8.3 PwC Lloyds TSB plc 4.0 32.0 PwC Barclays Bank plc 4.6 27.0 PwC British Telecommunications 2.7 19.1 PwC Diageo plc 2.5 7.0 KPMG Cable & Wireless plc 2.5 14.5 KPMG As is evident from these figures, non-audit fees were nearly double the audit fees in case of Royal Bank of Scotland plc and BP plc, treble in case of Astra Zeneca plc, quintuple in case of Barclays Bank plc, 8 times in case of Lloyds TSB plc and British Telecommunications, and an astounding 16 times in case of Vodafone Group plc (Porter et al., 2). A third survey, conducted by the ‘Financial Director’ in 2002 that examined FTSE 100 companies found that while the average audit fee was £2.21 million, average non-audit fees done by their auditors was £6.5 million (Hermes.co.uk). These studies also noted cases where the non-audit fee was 10 to 12 times higher than the audit fee; in a few extreme cases, the non-audit fee was a whopping 47 to 78 times higher than the audit fee – both of course paid to the same auditor (Hermes.co.uk). In the face of such lopsided gyrations, it is no wonder that public suspicion about auditor integrity began rising with the publication of each company’s financial report. In the U.K, the Audit Commission and the National Audit Office (NAO) are operating. The Audit Commission, governed by the Audit Commission Act of 1998, lays down the qualifications of auditors suitable to audit the accounts of local public authorities and the National Health Service in England and Wales (Opsi.gov.uk, 2006). The function of the NAO, headed by the Comptroller and Auditor General, is to audit the accounts of central government and public entities and submit a report to the U.K Parliament regarding the financial saving, competence and result-oriented efforts of these bodies in their use of public money (Nao.org.uk). The U.K government would do well to make several (if not all) of the following recommendations mandatory in order to allay public suspicion about the auditing profession, and restore confidence in it, and by association, in the publicised financial reports of companies audited by them. Since it has been established that the issue of non-audit services lurks at the bottom of the auditor independence problem, there is an urgent need to make a crystal clear differentiation between audit and non-audit services. The U.K government should set up an Audit Committee similar to model created by the Canadian Institute of Chartered Accountants (CICA) which came into force from January 1, 2004. The Canadian Audit Committee has defined audit and non-audit services clearly and succinctly. Non-audit services have been classified into two groups based on the expense’s recurring or non-recurring nature; an upper limit of $ 50,000 is laid for non-recurring service fees. Specific non-audit services like expert services (including lawsuit support), legal services, management functions, corporate finance services, and Human Resources services have been expressly forbidden. Some non-audit services (related to bookkeeping and accounting, valuation, financial information systems design and execution, and internal audit) could be approved at the discretion of the Committee if it feels that the results of such services will not be ruled by audit procedures. The Canadian Audit Committee requires all listed companies to submit half-yearly reports to it in order to obtain its approval, only after which work by an external auditor is allowed to commence (CPP Investment Board, 2004). The U.S Securities and Exchange Commission (SEC) also recognised the importance of this factor, and since 2001, required all listed companies to publish details of fees paid to auditors; the vitality of this issue blossomed in the aftermath of the Enron and Worldcom scandals, prompting the SEC to refine its regulations in 2003, requiring listed companies to give a very detailed breakdown of all (audit and non-audit fees) paid to its auditors (Mishra et al., 2005), and for the companies’ guidance, the SEC also defined the many types of non-audit services that can be provided by an auditor to the same client (Krishnan et al., 2005). If the U.K adopts this recommendation, auditors will be stopped from providing non-audit services that could compromise their independence. The second recommendation is (based on the clear distinction between auditing and non-auditing services discussed in the first recommendation) to make it mandatory for auditing firms operating within the U.K to split their businesses into two – one firm dealing only with auditing, and the other handling non-audit services. Two of the Big Four already took steps in this direction – E&Y sold its non-audit consultancy service to France’s Cap Gemini, and KPMG created a new firm called KPMG Consulting to handle its non-audit services (Hermes. co.uk). By adopting this suggestion, like in case of the first recommendation, auditors will no longer be able to provide such non-audit services that could endanger their independence. The third recommendation is to break the monopoly enjoyed by the Big Four. The U.K audit market is greatly and tenaciously concentrated with the Big Four – a fact exacerbated over the last decade by the merger that formed PwC (1998), and the drop-out of AA from the Big Five (2002). The Big Four moved quickly to consolidate themselves by merging AA’s U.K operations with D&T, and merging AA’s France and German operations with E&Y in those countries. The U.K government should make second-tier audit firms stronger by providing friendly term finance with long payback option to solve their two main drawbacks – developing in-depth resources and hiring highly qualified staff (including at least one auditor with FTSE 100 experience), and developing a large and composite international network. These developmental strategies will bring mid-tier auditing firms credible reputation and make them gain favour with FTSE 100 and FTSE 250 companies – two sectors which are almost totally served by the Big Four (the Big Four in fact serve 99 of FTSE 100 and 242 of FTSE 250 companies, while the remaining sector that comprises lower listed companies are served by both the Big Four as well as mid-tier firms). If this encouragement to mid-tier firms had happened earlier, maybe AA’s U.K operations could have been merged with less known U.K audit firms like BDO or Grant Thornton. In this connection, it is significant to note that Oxera’s 2006 survey of U.K companies noted that all those interviewed considered the Big Four competition unhealthy as far as competition and price are concerned, and Oxera’s in-depth analysis of these interviews found that these companies are unhappily bound by such constraints (Oxera.com, 2006). Adopting this recommendation is sending a strong message to the Big Four firms that they cannot continue their monopoly rule; they will have to carefully desiccate their activities to ensure that they do not compromise their independence, because if they do not, there are other mid-tier firms strong enough to take over. The fourth recommendation follows the one above, namely, companies should be encouraged to break away from the Big Four by making it mandatory for each company to rotate its auditors after a fixed period (say 5 years), that too by the tendering process (Hermes.co.uk). The Oxera 2006 survey found that the rate of changes from one auditor to another in the U.K is very low – less than 3% per year for FTSE 350 companies, and about 4% a year for all listed companies; more than 70% of the FTSE 100 companies have not held a competitive tender during the last 15 years (Oxera.com, 2006). This regulation will provide greater opportunity for lower-tier audit firms to increase their range of customers. Also, the fact that the fresh eyes of a new auditor will be reviewing their work will make the existing auditors more conscientious and painstaking in their efforts. While constant tendering will definitely add financial burdens on companies, this would be more than offset by the perceived advantages, the most important being a significant reliability enhancement of the company’s financial information in the eyes of its shareholders, investors and other interested players (Hermes.co.uk). This recommendation, if adopted, will, like the third recommendation, make the Big Four sit up and note that the monopoly they took for granted will not continue. As a result, a strong spirit of competition will be thrown in, whereby the Big Four will rush to examine their activities minutely to ensure that these activities reflect auditor independence as strongly as possible. The fifth recommendation is to make it obligatory for U.K companies to set up their own audit committee. This committee should be given wide-ranging powers. Its prime task would be to focus on non-audit contracts with the company’s auditor, evaluate those documents thoroughly, and ensure that such contracts are the result of a fair competitive evaluation, vetoing any suspect contract (Hermes.co.uk). The committee should play a major role in selecting the company’s auditor, and must be given the power to threaten to switch auditors if satisfactory terms are not agreed upon (Oxera.com, 2006). Companies should be warned that its executive directors should not also be members of the audit committee, because when audit committee members are non-executive and independent, it makes it easier for the committee to establish direct rapport with auditors based on mutual trust, with the joint aim to expose and discuss about any perceived danger to an accurate, reliable, and independent audit (Hermes.co.uk). This recommendation will enable companies to get into the act themselves to ensure that their auditors’ function relate only to their designated auditing role; it will also forestall company executives from conniving with auditors to take over non-audit services that could compromise auditor independence. The sixth recommendation is to make companies assume corporate responsibility for financial reports. The U.K would do well to emulate this clause that is contained in Section 302 of the U.S. Sarbanes-Oxley Act of 2002. This regulation requires a company to declare that duly authorised company officials have critically examined the publicised financial reports before eventually signing them, that too within the previous 90 days of publication. Such a declaration also is accompanied by a confirmation that the reports contain true and accurate details, without any false, misleading or omitted information. This regulation is accompanied by a warning to companies not to circumvent these requirements by merging or relocating their activities outside of the U.K (Soxlaw.com, 2006). By adopting this recommendation, the company executives are drawn directly into the scenario, lending authority and reliability to their financial reports in the eyes of the public as they guarantee that their auditor’s independence has not been so compromised that it affects the reliability of their company’s accounting information. The seventh recommendation relates to management assessment of internal controls, another clause (contained in Section 404) worth borrowing from the U.S. Sarbanes-Oxley Act of 2002. This regulation requires companies to disclose details of the range and sufficiency of their individual controls framework and system of financial reporting. (Soxlaw.com, 2006) In addition to the company’s own disclosure, its auditing firm should also confirm that the information provided by the company is true, and that it has assessed the information and found it effective as far as the company’s internal controls and financial reporting are concerned (Boynton et al., 5). By adopting this step, like the seventh recommendation, the accuracy and reliability of the financial reports are strengthened in the eyes of the public who view it against the background of the explained strong internal control systems of the company plus the auditor confirmation as well; the public is assured that auditor independence is not, and cannot, be compromised under such system. The eighth recommendation is about real time issuer disclosures. Once more going to the U.S. Sarbanes-Oxley Act of 2002 (Section 409), these rules require companies to urgently inform the public about any alteration in their financial condition or activities in a very clear and easy-to-understand way (Soxlaw.com, 2006). This aspect of the company’s structure is of vital interest to shareholders, investors and other players, forming the very foundation on which their relationship with the company is based or enhanced. By adopting this recommendation, the public is assured that, unlike the Enron debacle where evidence was blatantly altered, companies are now guaranteeing that such discrepancies are not present, and will not occur. The ninth recommendation is about corporate and criminal fraud accountability. Also worth copying from the U.S. Sarbanes-Oxley Act, this clause, contained in its Section 802, stipulates criminal penalties on companies for altering documents, using the methods of destruction, concealment, mutilation, and/or falsification with the willful aim of blocking, hindering or making wrong use of power to sway legal investigations. These penalties take the form of fines and/or imprisonment of responsible officials for up to 20 years. The second part of this regulation stipulates a fine and/or imprisonment (up to 10 years) of the auditing firm accountants who willfully contravene the rules of audit or review of documents covering a financial period of 5 years (Soxlaw.com, 2006). Adopting this step will further strengthen the eight recommendation as auditors and company executives will be wary of committing any wrongdoing that could bring them harsh penalties; in addition, the public will be heartened to note these safeguards, and this will strengthen the accuracy and reliability aspect of the publicised companies’ financial reports. The tenth and last recommendation is to make it mandatory for companies to adopt an accounting report format that shows non-audit fees in full detail, as completely different from audit fees (Hermes.co.uk). The U.S. Sarbanes-Oxley Act 2002 also makes such information from U.S companies mandatory – as per its Section 401 under the title ‘Enhanced Financial Disclosures in Periodic Reports’ (Soxlaw.com, 2006). A good example is the 31.12.2000 report of U.K based Halifax Group Plc. Relevant parts of it are provided below (Hermes.co.uk). By adopting this recommendation, companies and auditors put forward all the non-audit services clearly and transparently, implicitly declaring that the auditors are doing just what they have been contracted to do, viz., independent audit services only, and are not unduly compromising their independence by doing non-audit services for the same company. Details of expense Year 2000 Year 1999 £million £million Remuneration of auditors & their associates (including VAT) 2.0 1.7 Non-audit services 4.0 1.4 Non-audit services comprise the following: Regulatory reporting 1.9 0.6 Tax services 0.8 0.5 Consultancy 1.0 0.2 Other 0.3 0.1 Total non-audit services 4.0 1.4 Non-audit fees of £ 0.4 m have also been incurred by the Group I the year ended 31 December 2000 relating to acquisition (1999: £ 0.1 m). The Company’s audit fee, which is included in the figure for audit services to the Group, amounted to £ 29,375 (1999: £ 34,000). A competitive tendering process is prescribed for the appointment of consultants where the expected fee exceeds £ 50,000 (excluding VAT). If the tendering process results in the external auditors being the recommended supplier, the decision has to be approved by the Group Finance Director. The Group Finance Director also has the authority to appoint the external auditors in cases where an urgent appointment is necessary, or for certain specific areas of work where he considers that the auditors’ experience of the Group’s activities is required. Fees payable to the external auditors are reported regularly to the Audit Committee, which monitors the auditor’s independence on behalf of the Board. In conclusion, these ten recommendations should be implemented by the U.K at once, and accompanying the regulations should be a statement that is perhaps the most important of all the information contained in the U.S. Sarbanes-Oxley Act of 2002: “Do NOT put off until tomorrow what can be done today!” (Soxlaw.com, 2006). By adopting these ten recommendations, the U.K government would be doing much towards preventing the public seeing a repeat of chilling accusations leveled against auditors and companies such as ‘hallmarks’ of the Enron scandal highlighted by the February 2002 report of “Financial Times” – ‘individual greed’ on an unprecedented level, a ‘shocking willingness’ to ignore suspicious practices by organisations, a ‘shameful determination’ to hide proof, and the ‘enthusiasm of politicians’ to accept bribes from an organisation that was eventually exposed as a ‘sham’ (Beams, 2002). By incorporating the ten recommendations, the U.K government will definitely enhance the prevailing public image of auditing firms, and strengthen the esteem of publicised financial reports of U.K companies – surely making the country immune against having to shamefully acknowledge, as the then Head of U.S Federal Reserve Paul Volcker admitted in the wake of the Enron disaster: “Accounting and Auditing in this country is in a state of crisis” (Beams, 2002). References used: “Audit & Non-Audit Services Approval Policy.” CPP Investment Board. 2004. 3 Jan. 2007. “Audit Commission Act 1998.” Office of Public Sector Information. 2006. 4 Jan. 2007. “Auditor Independence.” Hermes.co.uk. 2006. 3 Jan. 2007. Beams, Nick. “Enron Fallout is Spreading.” World Socialist Web Site. 2002. 3 Jan. 2007. “Big Four Auditors.” Wikipedia.org. 2006. 3 Jan. 2007. 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Power, Michael. “The Audit Society: rituals of verification.” UK: Oxford, 1997. “The Sarbanes-Oxley Act.” Soxlaw.com. 2006. 3 Jan. 2007. Read More