Impact Of Mandatory Rotation Of Audit Firms example essay topic

Abstract In light of a number of high-profile corporate failures during the first half of 2001, a number of studies have been performed to address the impact of mandatory rotation of audit firms to ensure the appropriate level of 'independence' of auditors. Majority of studies conclude that the detrimental effects of firm rotation on the quality of the audit work by far outweigh its positive effects as a safeguard against various independence and quality threats. Frequent changes of audit firms, whether resulting from mandatory rotation or otherwise, introduce threats to independence and operational difficulties that make audit failure more likely. Many studies have involved practitioners' opinions on this issue, which have been based on their experiences and is therefore necessarily more subjective than from impartial, third party studies. There are differing opinions, as some audit firms wish to preserve the client bases, while others welcome more market volatility. Mandatory firm rotation has been concluded as an unnecessary step at present, whose main impact will be the auditing profession and its ability to attract talent for the future.

At a time when the restoration of public trust in financial reporting is a key priority, such changes should be avoided. Background Following the failure of HIH Insurance and other listed Australian companies during the first half of 2001, concerns were raised about the adequacy of Australian rules governing audit independence. Auditor independence is fundamental to the credibility and reliability of auditors' reports. Independence is defined to require. ".. a freedom from bias, personal interest, prior commitment to an interest, or susceptibility to undue influence of pressure, any of which could lead to a belief that the audit opinion was determined other than by reference to the facts of the audit alone". With the increasing globalist ion of capital markets and the fact that that section 324 of the Corporations Act in relation to the independence of auditors had not changed in any form for at least 40 years, it was recognised that this area required attention and revision.

The existing regulation prior 2004 of the auditing profession was predominantly the responsibility of the professional accounting bodies. Whereby the legislative requirements were "minimal" and "piecemeal". International developments were in progress by International Federation of Accountants (IFAC) which aimed to update the ethical requirements of audit independence. European Commission released a consultative paper containing proposals designed to achieve greater uniformity throughout Europe & United States Securities and Exchange Commission's (SEC) had decided to remake its rules on audit independence to address issues associated with recent independence violations by auditors in the US. As a part of the growing recognition of the desirability of achieving global uniformity and harmonization in all areas of financial reporting and auditing, many studies and discussions including the Ramsay report were instigated since 2001. The CLERP (Audit Reform & Corporate Disclosure) Act 2004 implemented the CLERP 9 measures and the recommendations of the Ramsay Report on the independence of Australian company auditors and took into account the relevant recommendations of Report 391 of the Joint Parliamentary Committee of Public Accountants and Audit.

The CLERP 9 Act draws on the HIH Royal Commission (HI HRC), Cole Royal Commissions Report and the Ramsay Report in focusing on the importance of an independent audit on capital market efficiency. This is to be achieved through adding value to financial statements by improving reliability, which in turn should assist to lower the cost of capital by reducing information risk and enhancing value to capital market by strengthening the credibility of financial statements. The many arguments for and against Mandatory audit firm rotation was considered as part of this reform however, the Audit Review Working Party concluded that 'the anticipated cost, disruption and loss of experience to companies is considered unacceptably high, as is the unwarranted restriction on the freedom of companies to choose their own auditors' As an alternative, mandatory rotation of the audit partners was included in the CLERP Act 2004, whereby rotation is to occur after 5 consecutive years with a 2 year cooling off period before a person who has played a 'significant role' in the audit can be reassigned to that audited body. Arguments 'For' & 'Against' Mandatory rotation of Audit firms The arguments for and against mandatory rotation of audit firms fundamentally revolves around the issues of auditor independence, audit quality and increased audit costs. Compromising either auditor independence or audit quality will adversely effect the accuracy of audits performed and hence effect the shareholders' future. The significance of mandatory rotation of audit firms on an auditor's independence and quality of audit can be evaluated on a large number of factors, such as length of time an individual has served, the role of the individual, the size and structure of the firm, the nature of the engagement and whether the client is a public interest entity or not.

There are numerous threats to the independence of auditors which have been identified in the multiple studies and discussions both in Australia (such as the Ramsay report, CLERP 9 Paper) and internationally by IFAC, the European Commission and SEC. The key threats identified are over-familiarity, self-interest, advocacy and intimidation of auditors. Over-familiarity Mandatory firm rotation avoids over-familiarity between the auditor and client and removing the 'undesirable nexus between client and auditor'. As the auditor may be perceived as too trusting because of familiarity, thus resulting in insufficient professional scepticism or testing of representations made in the firm's disclosure statements. Self-Interest This issue of 'self-interest' by the auditor may potentially influence an audit judgement arising from the auditor benefiting from a financial interest or self-interest conflict such as a desire to retain the client.

Advocacy & Intimidation The independence of auditors can be strengthened through mandatory firm rotation, when the auditor becomes an advocate for or against a firm's position or opinion to the point that objectivity is, or is perceived to be, impaired. It also reduces the situations where auditors are subjected to increased intimidation of clients through actual or perceived threats by clients. Negative Economic Impact It can be argued that as a result of the rotation, especially for clients within specialised industries, the loss of cumulative knowledge and and the difficulty in maintaining industry specialization would increase. The lack of knowledge and understanding of the firm's operations, information systems and practices can incur additional risk and time in the initial year's of the new auditor's tenure. The Bocconi Report on Italy's experience of mandatory rotation found that there was a need for a "training period" of two to three years for new auditors of complex groups to fully understand the business.

Therefore the significant costs in terms of management time particularly in terms of working with the new auditors to familiaris e them with the company should not be underestimated, especially when these costs will be incurred "in each rotation" Bocconi quantified such costs as "15% greater for a new client in a familiar industry and 25% higher in a new client in a new industry" and reported a 40% increased in audit hours were invested to familiaris e with the fustiness, processes and people. To overcome this initial cost, additional procedures can be implemented to develop the new auditor's knowledge more quickly, however such additional costs and company management time make the potential benefits of mandatory audit firm rotation harder to predict and quantify, though GAO is "fairly certain that there will be additional costs". Despite the initial increased risk and time costs of implementing new auditing firms, the rotation of audit firms facilitates easier detection of material misstatements of financial statements through the "fresh look" approach. This approach will avoid any tendency of an auditor 'anticipating results' and as a result will be alert to subtle and often surreptitious, though important, anomalies. Impact on Market for Audit Services To negate the above mentioned costs, the mandatory rotation would increase competition and volatility in the audit market. Bocconi concluded that this had generally led to a reduction in audit fees.

Initially, this would imply that smaller audit firms would be encouraged to grow and challenge the leading larger audit firms, however studies indicate that mandatory external rotation of audit firms actually results in decreased competition in the audit market. The ICA A and CGAA raised this issue and advised that the rotation requirements would drive small to medium sized firms out of business. By reducing competition and force clients previously serviced by the smaller firms to obtain audit services from larger and possibly more expensive firms. Hence would result in a diminishing pool of available expertise in the future. This is also demonstrated in Bocconi's findings that the above considerations actually led to an increase in concentration of market share by the Big 5 audit firms. Arrundata, Paz-Ares and Bocconi recognised the risk of collusion among audit firms, together with the effect of short-term appointments on the willingness of firms to invest and compete because firms that would manage to excel under these conditions would find themselves " obliged to relinquish their achievements periodically".

The combination of increased risk of audit failure and demise of the economic climate for audit firms would not be in the best interests of a robust and sustainable auditing profession or of the business community as a whole. Quality Impact Despite the comparative analysis of the potential risks and perceived benefits of mandatory firm rotation, it has been the consensus in all countries (other than Italy), that "the anticipated cost, disruption and loss of experience to companies is considered unacceptably high, as is the unwarranted restriction on the freedom of companies to choose their own auditors" To date, Italy and (Spain, until recently) were the only countries that stipulates the requirement of an audit firm rotation where there is no strong evidence of a positive impact on audit quality. Further research in Italy concluded that rotation carries significant threats to audit quality from competitive pressures and that other approaches focusing on audit partner rotation, quality control in firms and effective regulatory oversight might be preferable. This highlights the complexity of this analysis, as the intention of the mandatory rotation to avoid personal relations between auditors and clients needs to be evaluated against the detrimental effects of an auditor's awareness of the client's business, risks and industry. Alternate Means Ultimately, the objective of the proposed mandatory firm rotation concept was to enhance auditor independence and audit quality, through greater transparency. It has been suggested to rotate the engagement of audit partners within the audit firm, to negate some of the risks and costs inherent in mandatory firm rotation, yet allows greater emphasis on independence and audit quality.

However, GAO and CGAA have also recommended empowering the audit committee of public interest entities to select, supervise and scrutinize the audit firm and their independence which would ensure active involvement and convergence of both auditors and clients intentions and objectives. Conclusion The proposal of mandatory firm rotation has serious disadvantages that outweigh its perceived benefits, including significant costs and new challenges to maintain a competitive and efficient market for audit services. The change of auditor enhances the independence and quality of auditors and their work, yet introduces a number of new threats to audit quality. Where the mandatory rotation is restricted to partners rather than firms, the audit committee can phase changes to ensure institutional knowledge is maintained, and the threat of quality is minimise d but the benefit of a periodic 'fresh look' at the client's accounting is realised. This is confirmed through the adoption of mandatory auditing partners in the CLERP Act 2004 rather than the rotation of audit firms.

Nonetheless, the audit partner rotation has been endorsed as best practice by the professional bodies in Australia and internationally and in principle, represents a better alternative to audit firm rotation as a means of safeguarding audit quality.

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