Auditor Independence Enron
A Comparative international study of Auditor Independence Regulation after Enron and its implications for the UK
Alexander and Fairbridge (1999) has defined audit as, "an examination of records or accounts to check their accuracy, an adjustments or correction of accounts or an examined or verified accounts (p. 195)." On the other hand, Porter, Simon and Hatherly (1996) used the word ‘true and fair’ view of financial statements in accordance with the relevant legislation.
In today’s competitive world external auditors have additional responsibility to provide value added services such as identifying business risk and providing guidance on internal control weaknesses (Cosserat, 2004). Therefore, it is fundamentally important for the external auditor to act with an independent mind and in good faith while conducting audit work.
The importance of auditor independence has been recognised in the UK over the last two centuries as compare to the other countries in the world (Vansco, Skousen & Santagato 1997). Over the last few decades different researchers have recognised the auditor independence also as an ethical issue. For example, Mednick (1990) stated that there should be more emphasis on developing professional ethics in order to overcome the problems related to auditor independence (Cited in Vansco et al, 1997).
Development of professional ethics is not only sufficient; the harsh criticism led the professional bodies to adopt procedures in order to enforce rules related to auditor independence (Vansco et al, 1997). As stated by Camus (n.d.), "A man without ethics is a wild beast loosed upon this world" (p, n.d.). Ethics are important because it helps an auditor to decide the concept of right and wrong and how to react in difficult situations. Therefore, codes of ethics are relatively important as rules in the accounting profession.
The 21st century corporate failures such as Enron, Parmalat and WorldCom again heated up the issues related to auditor independence and questioned their integrity, objectivity and independence (Yang et al, 2003). This led the Governments around the world to bring changes to auditor independence regulation and professional bodies to develop new code of ethics.
For example, Sarbanes Oxley act passed by the US Congress in order to improve quality of financial reports and retain investors’ confidence (Rezaee and Jain, 2002), and code of ethics issued by professional bodies such as ICAEW, ACCA and ICAS in the UK. Therefore, corporate failure is the common problem for countries around the world which are forcing regulators to make legislative changes.
The academic literature is full of researches conducted on issues related to auditor independence since the Enron failure. The aim of this dissertation is to explore any differences with relation to auditor independence regulation changes implemented by regulators worldwide. It also includes the critical analysis of selected auditing standards issued by different professional bodies.
Therefore, this research raises two questions, firstly, "up to what extent the objective of safeguarding auditor independence has been achieved by regulators and if not what can be done in near future" and, secondly, "what other reforms can be implemented in the UK by learning from the changes made in different countries worldwide". This research will focus on auditor independence regulation in four different continents since Enron failure. These are American, European, Asian and Australian perspective.Find out how our expert essay writers can help you with your work...
The reason for choosing Asian countries along with western countries is the globalisation and continues economic development of countries such as India and China. Due to international nature of the study the researcher will only analyse the key changes and reforms affecting independence. The researcher has decided not to include African and North American countries because of two reasons.
Firstly, unavailability of sufficient amount of research conducted and secondly nature of the study itself. This research is the mixture of both primary and secondary data. The reason for choosing these two approaches is discussed in detail in methodology chapter. Finally, the study conducted by Vansco et al (1997) ‘Auditor Independence: An international Perspective’ is used as a base for the dissertation.
In auditing profession "Auditor Independence" has traditionally no precise definition and academic literature also seems very unclear (Altman, 1984). Altman (1984) stated that both AICPA and SEC have neglected the necessary attempts to provide precise definition of auditor independence and end up with having lengthy rules.
Generally, independence issues are discussed by different parties such as investors, scholars and regulators. They all have different objectives and expectations which makes independence a debatable issue. Therefore, there is no common acceptable definition of auditor independence exists in the academic literature (Ketz, 2006).
Most definitions of auditor independence reflect the significance of integrity (willingness to express truthful opinion) and objectivity (ability to overcome biases) as the main feature of auditor independence (Dunmore and Falk, 2001). Independence "in fact" (or actual independence) and "in appearance" (or perceived independence) is two types of auditor independence.
Auditor’s ability to make objective and unbiased audit decisions and his/her state of mind is defined as "actual independence". On the other hand "Perceived independence" refers to the public’s perception towards the audit profession (Dykxhoorn and Sinning, 1982 cited in Bakar, Rahman and Rashid, 2005).
2.2-Importance of auditor independence
Auditors are believed to work on behalf of company shareholders in order to ensure that financial statements are representing "true and fair" view (Cosseratt, 2004). This is to ensure that the capital invested by the shareholders is in the safe hands (i.e. not misused by the company directors or management).
There is sufficient amount of academic literature available which emphasises on the significance of auditor independence. For example, Bakar et al (2005) stated that auditor independence is fundamental to the public confidence in the auditing profession as well as in financial reporting. Similarly, Gul (1989) stated that perceived independence has generated a sufficient amount of debate and controversy and a source of much concern.You can get expert help with your essays right now. Find out more...
The 21st century corporate frauds such as Enron (discussed later) and other recent audit failures have highlighted the importance of auditor independence as a global issue (Yang et al, 2003). These failures also raised the questions about the quality of financial reporting (IAS, 2002). This has led audit profession to look more closely in this problem and develop certain policies and procedures, which in turn can minimise the potential for non independence. Due to globalisation and economic development most of the capital invested in companies is by the investors around the world. Therefore, the assurance provided by the auditors about the reliability and credibility of financial statements more useful to them for decision making (Bode, 2006).
2.3-Conflicts of interest
Donald et al (2002) have defined a conflict of interest as "a situation in which a person has a private or personal interest sufficient to appear to influence the objective exercise of his or her official duties as, say, a public official, an employee, or a professional (p.68)". Many users of the financial statements fears that financial information provided by the management is biased in nature.
This apprehension gives rise to conflict of interests among these users and management of the company (Cosserat, 2005). Therefore, the assurance from independent auditors ensures different users groups that information is neutral and not manipulated by the management.
Different researchers have identified different "Conflicts of Interest" and also provided the recommendations to tackle this problem. Goldman and Barlev (1974) identified three types of "Conflicts of Interest" that affects auditor independence. These "Conflicts of Interest" pressurises auditors not to produce audit report in accordance with developed professional standards and code of ethics. Under "Audit-firm conflict", management and shareholders both have similar interest, where both the parties want auditors not to disclose any facts and evaluations concerning their wishes.
Because they think that these facts can affect future investment as well as creditors’ decisions for loan grant. Under "Shareholders-Management conflict" management tries to put pressure on auditors to produce a more favourable report in order to impress shareholders. This is because shareholders normally evaluate management’s performance by looking at auditor’s report.
Finally, under "Self interest- Professional standard conflict" auditor may find himself in a situation, where they may get any financial benefit by violating the professional standards. This conflict of interest can also be seen in Enron’s case, where Arthur-Anderson (Enron’s auditor) was paid $52m for conducting audit and non-audit services, and with a fear of losing such a client Anderson represented the facts as Enron was wanted them to do(The Economist, 2002, Cited in Bakshi, (2004)).
O’Connor (2006) stated that several attempts or reforms to reduce conflict of interest and improve independence are still proven inconsistent. He recommended that control of audit must be in the hands of shareholders rather that audit committees. By implementing this action two benefits will be achieved, firstly, reduction in audit cost and secondly, reducing the chances of conflict of interest among different users.
Moore et al (2006) conducted research on US auditing system, in order to identify the causes or factors that give rise to conflicts of interest. They used two different theories, namely "moral seduction theory" and "issue cycle theory" were stating different predictions. The "moral seduction theory" predicts that the decision taken by the auditors are influenced by the social and economic pressures, and "issue cycle theory" predicts that special interest groups will undermine the audit industry reform efforts.Find out how our expert essay writers can help you with your work...
They concluded that the recent reform efforts to improve audit quality in US are insufficient because these efforts have failed to identify the underlying conflicts of interest. Conversely, Nelson (2005) stated that it is important to understand the affect of the reforms before implementing further changes.
He stated that the recent reforms are based on the probability that the clients pressurises auditors and creates misstatement in the financial statement, and are also based on the probability of audit detects the statement and auditors resist pressure from their client. Therefore, identification and finding simple solutions for factors giving rise to conflicts of interest is more important rather than making new rules that complicating the whole system.
2.4 -Arguments against independence
Different authors have identified the different threats to auditor independence; however there are commonly five threats to auditor independence are identified. These are self-interest, self-review, advocacy, familiarity and intimidation threat (Cosserat, 2004). Alleyne et al (2006) stated that auditors are watch dogs for public and it is their responsibility to evaluate the materiality and probability of each threat. "Having mutual interest" and "acting in the capacity of the management" are two familiar concepts included in the prior mentioned threats. Therefore, auditors must not favour their clients’ interest and must not act as a managerial decision makers.
Hussey (1999) stated that growing importance to non-audit fees and increasing competition among auditors are main factors affecting independence. He has also mentioned ‘Familiarity threat’ i.e. development of informal relationships between company directors and auditors. He concluded that ‘Familiarity threat’ is present in both public and private companies. Therefore, it is worthwhile to concentrate on selection and appointment process and auditors’ term of office to ensure that threat is kept at minimum level.
Recent professional and regulatory initiatives have been implemented restricting non-audit services in US and elsewhere with a claim that these services affect independence "in fact" as well as "in appearance" (Ruddock et al, 2004). In academic literature, researchers have also concluded that how non-audit services impair audit independence. For example, Ruddock et al (2004) conducted research on non-audit services and earning conservatism in order to see how much they impair auditor independence.
They concluded that independence "in fact" is less likely to improve with recent legislature intervention restricting non-audit services; however it is more likely that independence "in appearance" may be improved. Similarly, Hay et al (2006) conducted research on 200 New Zealand companies in order to see the level of non-audit services affecting independence.
They also found that level of non-audit fees might give indication of lack of independence "in appearance" but independence "in fact" is not affected by the level of non-audit fees. Therefore, there is sufficient evidence available in academic literature which states that independence "in appearance" is affected by the level of non-audit fees rather than independence "in fact".
Another factor which affects the auditor independence is the Size of the audit firm. As stated by Nicholas and Smith (1983) that the larger the size of the audit firm, the greater the auditor’s independence. The reason behind this factor is that the large audits firms are capable of resist more pressure from client as compare to small audit firm (cited in Bakar et al,2005).
On the other hand Goldman and Barglev (1974) states that competition among large size audit firms can challenge this assumption audit firm’s ability to resist pressure from clients. This point can be seen in Arthur Anderson and Enron case (cited in Bakar et al,2005).You can get expert help with your essays right now. Find out more...
Hemraj (2002) stated that it is the auditor’s responsibility to ensure that to recognise the real and apparent threat in order to retain independence. Some of the threats he identified were being indebted, receiving recurring fee, accepting directorship or owning shares, accepting goods and services from client Company.
The academic literature is full of researches conducted on identification of potential threats affecting independence. However, it is also full of researches conducted on explaining different ways of safeguarding auditor independence. As stated by Moizer (1997) that there are some existing and suggestive ways also persist in order to improve auditor independence. The following section highlights some of the ways recommended by different researchers to improve independence.
2.5-Argument for independence
There are certain statutory provisions exist in order to safeguard the auditor independence such as the Company Act 1985 in the UK (Dunn, 1996). However, over the years different recommendations have been re-issued such as audit-rotation’, ‘peer-review’, ‘prohibition of other services’, ‘audit committees’ and ‘Company law reform’ (Byrne, 2001). There is a common perception that mandatory audit rotation is helpful in improving independence.
For example, Bakshi (2004) stated that the most obvious advantage is that auditors would be less vulnerable to management’s pressure because they would know that they will be replaced after certain time period. As a result, this will improve independence along with reduction auditor-management conflict of interest.
This perception has been criticised by many researchers over different periods. For example:
Church and Yhang (2006) compared the benefits of a system which require audit rotation to one that does not. They concluded that overall benefit is very sensitive to the cost associated with biased report, start up cost, rotation period and time span. On the other hand it can only be achieved if start-up and biased report cost is high, the rotation period is long. Jackson et al (2008) also stated that mandatory audit firm rotation will not improve audit quality.
This is because cost on both auditor and the client, rotation cost, cost related to early stages of auditor client relationship. They also concluded that rather than mandatory audit firm rotation other initiatives are more likely to have greater impact. In 2003, a survey was carried out by Accountancy age where all major auditing firms in the UK were against the idea of audit rotation (Accountancy age, 2003). However, currently in the UK, under APB’s Ethical Standard ES (3), no one should serve as engagement partner on the audit of a listed company for more than five years.
One further suggestion is ‘peer review’ where audit work done by one audit firm is reviewed by another audit firm in order to ensure the audit quality (Moizer, 1997). Russell and Armitage, (2006) stated that this is the profession’s responsibility to make peer review disciplinary rather than educational and corrective. The standard should also contain the penalties in order to provide benefits to the entire profession.
Regulators and stakeholders worldwide have recognised the non-audit services as potential threat to auditor independence (Sori & Karbdhari, 2005). Researchers have also proved that non-audit services (see; Ruddock et al, 2004 & Hay et al, 2006) impair independence in appearance. Therefore, regulators in USA (under SOX) and elsewhere have put restriction on auditors to carry out non-audit services. Bakshi (2004) claimed that this prohibition on services will not only safeguard independence but it will also reduce the problems associated with conflicts of interest.Find out how our expert essay writers can help you with your work...
Bakshi (2004) stated that in some cases such as banks and other non-profit organisations, appointment of auditors is decided by the independent authorities. Similar procedures can also be adopted for the companies listed on the stock market. Auditing and accounting standards are also useful for auditor independence when prescribed procedure is followed under similar circumstances.
Another recommended method to safeguard independence is the formation of audit committees by the regulators worldwide. Sufficient amount of research has also been conducted in order to see affect of audit committee on auditor independence. For example, Sori et al (2007) revealed that the activities such as audit committee meetings, report in annual report and determining audit have great amount of affect on auditor independence.
Similarly, in another paper on Malaysian capital market, Sori and Karbhari (2006) concluded that presence of active audit committee is successful in maintaining or improving independence. This gives a clear cut indication that stakeholders have faith in the audit committees which as a result enhance communication between management and auditors. The following section discusses why and how the recent corporate failures make the auditor independence issue more debatable in current corporate world scenario.
2.6-Recent corporate failures affecting auditor independence
Certain corporate failures and scandals such as Energy giant Enron, WorldCom and Parmalat further heated up the issue related to auditor independence. Enron was the American energy giant formed in mid 1980s and was the seventh largest in the USA in terms of revenue (Elliott & Elliott, 2007). Enron’s disastrous diversification strategy was failed to generate revenue or recover the money invested in projects such as water, telecommunication and energy.
Therefore, in order to generate billions of dollars, Enron employed series of schemes to manipulate the financial statements (Kroger, 2004). During that period questions were also raised on the integrity and independence of Enron’s audit firm Arthur-Anderson. In a speech Anderson’s CEO said that "faith in our firm and in the integrity of the capital market has been shaken" (page, n.d.). He admitted that his firm was involved in the honest errors (i.e. known errors) in the financial statements (Hermes, n.d.).
Enron exploited the loophole in the US GAAP i.e. revenue recognition under Statement of Financial accounting Concept (SFAC) 5. This concept states that revenue should not be recognised until it is earned or realised. By virtue of this loophole Enron reported $23.4m of profit in a deal with Quaker Oats and including revenue of $110m in financial statements even before the trading began (Greer and Tonge, 2006).
Bazerman et al (2002) stated that biasness is normally present where relationships with the client have been formed and scope of decision making exist (Cited in Greer and Tonge, 2006). In this case auditors will make judgement with the approval of client, hence affecting their integrity and independence (i.e. Arthur-Anderson).
Similar scandal also occurred in EU i.e. Parmalat in Italy where $4.7bn hole was found in their annual accounts. Many were held responsible for this including auditors such as Grant Thornton International and Deloitte. It was argued that Deloitte was failed to determine that 38% of Parmalat’s assets were held in a fictitious account (Greer and Tonge, 2006).
Because of these scandals many changes have been implemented by the regulatory bodies around the world mainly in the UK and USA. The following section will provide the auditing regulation in the UK and USA with relation to auditor independence. However, the detailed reforms in both countries will be discussed in next chapters.You can get expert help with your essays right now. Find out more...
2.7-Regulatory authorities in UK and USA
In the UK, audit profession regulation includes provisions to govern auditor independence. These provisions are contained in Company act 1985, Auditing standards and Guidelines in order to strengthen the appearance of independence (Dunn 1996). Under the Companies Act 1985 auditor have the right to access companies books of accounts during the course of audit (Vanasco et al, 1997). Furthermore over the years amendments have also been made in Company Act 2006 with relation to auditor’s rights and responsibilities (Morse, 2007).
Auditing Practices board (APB) has issued certain Ethical Standards which deals with the matters related to auditor independence. These Ethical Standards are compiled with the EU’s European Commission Recommendation (Morse, 2007). These Ethical Standards are not part of the regulation but these are necessary for the auditors when doing the audit work and are based on the integrity, objectivity and independence of the auditors (ICAEW, 2008).
On the other hand US have rule-based approach towards auditor independence. There are three main regulatory bodies in US are ‘The American Institute of Certified Public Accountants’ (AICPA), ‘The Public Company accounting Oversight Board’ (PCAOB) and ‘The US Securities and Exchange Commission,(SEC).
The AICPA is responsible for issuing codes of professional conduct and Ethics ruling on independence (ICAEW, 2008). The SEC rules have replaced the old functions of ISB and created new rules on auditor independence.
The Sarbanes Oxley Act 2002 created the PCAOB which is responsible to oversee auditors action to protect the interest of investors and public (ICAEW, 2008). Vasacco (1997) stated that USA and UK independence standards are the same; however one major difference related to independence is that in the UK auditors are allowed to perform certain book-keeping functions. The following section gives the overview changes made in both countries after Enron failure. However, these changes are discussed in detail in the upcoming chapters.
2.8-Post-Enron reform in the UK
Following the Enron collapse the Co-operative Group of Audit and accounting (CGAA) was set up by UK Government in 2002. During that period auditor independence framework’s adequacy was the key concern for the CGAA. Fearnley and Beattie (2004) stated that the APB’s responsibilities were extended with relation to auditor independence i.e. they are now responsible for setting up auditor independence standards.
Furthermore, in order to manage the relationship between company and the auditors, audit committees need to play a leading role. Fearnley and Hines (2003) stated that the main change with relation to audit rotation was also implemented. These were the key partner should rotate every seven years and engagement partners should rotate every five years. UK is already ahead in matters related to auditor independence as compare to other European Countries.
This can be seen in the EU Eighth Directive principle, under which audit firm or statutory auditors must not make any decisions on behalf of their client and must be independent. Whereas UK has already established principles and rules, and ethics in order to tackle this issues (Downes, 2006).
2.9-Post-Enron reform in the US
Similarly in the US Sarbanes Oxley Act (SOX) was passed by the US Congress with an aim to regulate the governance of firms. Cohen et al (2007) stated that the prime reason of SOX was to reinstate investors’ confidence in capital markets after the Enron collapse. In SOX sections 201-209 deals with the issues related to auditor independence (Moeller, 2005). Along with the intended benefits, however, SOX is criticised by many authors.
For example, Ribstein (2005) stated that future corporate scandals may not be prevented by implementing SOX (cited in Cohen et al 2007). In their research on economic consequences of SOX, Cohen et al (2007) found that after SOX value of the option grant is decreased as compare to the increased salary and bonus compensation. This shows that firms are shifted to bonus awards policies resulting in lesser incentive compensation for CEO’s.
Tackett et al (2004) conducted research on SOX’s ability to reduce the chances of audit failure in public listed companies. They concluded that provisions such as increased criminal penalties and restriction on audit-client consultation are helpful to reduce the chances of audit failure. On the other hand provisions such as mandatory use of audit committees and creation of PCAOB are less likely to reduce the chances of audit failure.
This is because of any hidden biasness and operational shortcomings entail in these provisions. Many believe that the impact of SOX can also be seen in other countries too. For example, Herz and Gurr (2006) found that this US legislation is affecting financial reporting in South East Asian countries. They concluded that SOX in these countries appears to be a mechanism. This is resulting in worldwide reform movements towards increased corporate responsibility and improved financial reporting.
For the purpose of this dissertation the researcher has used both primary and secondary data related to auditor independence regulation. The primary research is based on statements issued by the professional bodies in different countries and secondary research is the critical literature review of published academic literature related to auditor independence. Therefore, the primary research has enabled the researcher to compare and identify differences among statements issued by professional bodies.
This is highly unlikely that statements issued by the professional bodies can be analysed by using secondary data because information related to auditing standards can only be obtained from the professional body’s websites. On the other hand secondary data is also important for this study in order to compare the findings and results with the published literature. This has enabled the researcher to give suggestions and concluding comments for the research. The following paragraph explains the several reasons that why the researcher preferred not to use the other alternative approaches.
The approaches such as conducting Interviews, Questionnaire and Surveys could have been used for this dissertation. However, the researcher has given the priority to critical analysis of data published related to auditor independence over the approaches mentioned above. There are several factors which affected the researcher’s choice for conducting research. These factors include the nature of the study to be conducted and disadvantages of approaches mentioned above. The disadvantages related to these alternative approaches are discussed in the following paragraph.Find out how our expert essay writers can help you with your work...
The accuracy of interviews depends upon the adaptability of the interviewer otherwise accuracy of interviews can easily be questioned. Bell (2005) stated that conducting interviews are very subjective in nature; therefore there will always be a danger of biasness remains. Whether interview involves only small number of people but is very time consuming. This can be justified by the amount of time spend by the researcher for each interview.
Questionnaires are generally known as simple and quick method for distributing information. However, questionnaires occur after the event so this is more likely that participants may forget issues related to research. Questionnaires can create large amount of data for the researcher which can take longer period to analyse. Surveys can be applied to nearly all types or researches such as market, political and social research (McCormack, Hill & Hill, 1997). However, it has disadvantages such as participants may be unable to answer questions due to unclear questions. Furthermore, the respondents may provide the required feedback because of politeness of the researcher (McCormack et al, 1997).
This dissertation involves the international study of auditor independence regulation in four different continents i.e. America, Europe, Australia and Asia. Furthermore, it is difficult for the researcher to visit every single country and incur travel expenses. Therefore, the constraint such as time and money and amount of information required, these modes of research appears more suitable.
As a result, by considering all these factors researcher has decided to critically analyse the literature electronically available. The study conducted by Vanasco et al (1997) is used as a starting point for the dissertation. The main focus is on the research conducted by the academics and statements issued by the professional bodies worldwide. The following paragraph discusses that how the primary and secondary data is be gathered for this dissertation.
The primary data is obtained from different professional bodies’ websites. The main source of primary data is the statements issued by these bodies after Enron failure. The secondary research includes the use of books, articles and mainly academic journals. The books are used from the university library in order to understand the basic concept of proposed research.
Articles are also used from the professional bodies’ magazines such as ACCA’s student manual. Finally, journals are also included in the dissertation which is obtained from MyAthens website database resources. The databases used for this dissertation are Emerald, Ingenta connect, EBSCO, Proquest and SSRN. The table below shows different stages includes which will be followed to complete final dissertation.
The Statements issued by the different professional bodies are collected at the end of June until the mid of July. The second step will be analysing the collected information (Primary research) and compare this information with the previous research conducted. Then the researcher will critically analyse the both primary and secondary data in order to identify the appropriate steps to enhance independence in UK. After completing the conclusion and reviewing the draft dissertation the final copy will be submitted on 6th of October 2008.
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