Describe The Mandatory Rotation Of Audit Firm Accounting Essay

Introduction

From the 2008 financial crisis, the weakness of audit system has exposed in several aspect. European Parliament and public consider that the auditors fail to play during the financial crisis. The European Commission said that the auditors only consider majority of banks had exposed a great quantity of loss from 2007 to 2009 in both on and off balance sheet in the financial crisis, however, it is a hard work for the public and stakeholders to know how the auditors to give the clean auditing reports to their principal. In addition, the European Commission takes into account preventing the concentration in the audit industry, which including restricting the choices and competition. Further, they also consider the independence of the audit firm and the reduction of the expectation gap. All things the European Commission do is to increase the quality of audit, so they think that the current auditing system should be reform.

According to KPMG (2012), because of the failure of auditors in financial crisis, the lobby of small firms and the US has taken action on the independent issue. Meanwhile, in order to adapt to the environments, which contain changes to financial reporting and increasing the risk and going concern issue for the companies. The European Commission came up the proposals on 30th November 2011 to address the matters that appeal in the financial crisis and rebuild the confidence of the audit system. The proposals define the role of auditors and propose more restrict provisions for audit firms. It aim at strengthening the independence and professional skepticism of auditors, making the audit industry more diversification, enforcing the regulation, promote the cross-border stipulation of audit services and relieving the burden of the small and medium-size enterprise. To enhance the independence of audit firm and prevent the concentration of the audit industry is the main purpose of the proposals.

The Elliott and Jacobson (1998) suggested that ‘audit independence is an absence of interests that create an unacceptable risk of material bias with respect to the reliability of financial statements.’ The basic goal of audit is to assure the information which provide to shareholders are reliable. Further, as for audit independence, the direct role is to provide auditing serve and make the cost of capital market more efficiently. Consider about preventing the concentration, should make the audit industry more dynamic, such as decreasing the power of the Big Four audit firm (KPMG, Deloitte, Pricewaterhousecoopers and Ernst & Young). In addition, the dynamic of audit market give the opportunities for small and medium-size enterprise to benefit from the internal market.

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In order to strengthen the independence of audit and make the audit market more dynamic, the European Commission brought up the proposals to perfect the audit system, the key elements of the proposals is mandatory rotation of audit firms, mandatory tendering, non-audit services, and European supervision of the audit sector, Enabling auditors to exercise their profession across Europe, Cutting red tape for smaller auditors. This essay is aim at discussing the issue of mandatory rotation of audit firm, one of the key elements to enhance the independence of audit industry. The essay will divided into three parts, firstly, it will describe the mandatory rotation of audit firms; secondly, it will analyses the argument for and against this issue; finally, it will come to a conclusion.

Describe the mandatory rotation of audit firm

In order to strengthen the auditor independence, the European Commission is considering introducing mandatory external rotation. In the previous years, only internal rotation is required, which means only auditors should be rotated, because they think that auditors may make less suggestions because the routine activities of audit. However, the internal rotation cannot enhance the independence of the auditors, because the audit firm and audited entity build up partnership, no matter which auditors engage in the audit procedure, they have closely relationship, the independence of auditors cannot be enhanced. Therefore, current environment has suggest that the internal rotation is not sufficient, the external rotation should be taken in account to achieve the independence of audit.

The proposal required the audit firm should be rotated after at most six years (with some exception). In addition, it should be after at least four year before the same audit firm can be entrusted again by the client, this is stated as the cooling period. The cooling period ensure the mandatory rotation can be implemented effectively, because if there is not the cooling period, the client can entrust the same audit firm after a short time, so that the closely relationship cannot be avoidance. There is a exception that the period of rotation can be extend to nine years if joint audits are engaged. This means that if an audited entity entrust at least two audit firm, it can extent the period of rotation to nine years, because the joint audit can make each audit firm work harder to avoid another audit firm find out their failure, this can increase the quality of the audit, so called “four-eye principle”. Hence, the joint audit is encouraged.

According to Bocconi, which do a survey of the effect of mandatory rotation in Italy. The investigate shows that ’69 % of managers of listed companies approve of rotation. 14 % consider it negatively.’ The survey presents a positive result, because they consider that in previous years, auditors focus on routine activities rather than making improvement. The people including in the survey agree the mandatory rotation in Italy can strengthen the independence.

Discussion of the mandatory rotation

The argument for the mandatory rotation of audit firm

Firstly, the mandatory rotation of audit firm can reduce the risk of “familiarity threat”. If there is not mandatory rotation, the audit firm may have closely relationship with the audited entity, which would lead to several problems. For instance, the proposal (2011) of the European commission suggests that the audit firm tend to know well about the management of the audited entity, so that they may think the audit work as a routine work, which just repeating the work annually, and they pay less attention to make an improvement and find out the mistake the audited entity made. In addition, the auditor may be less suspicious of the audited entity, instead, they may decrease the difficulties so as to maintain the good relationship with the partner. The long period of engagement will cause routine, which may affect the competence and the quality of audit, hence, the mandatory rotation is necessary for reducing the “familiarity threat”.

Secondly, according to Hoyle (1978), short term engagement will encourage the auditors to do better. If the audit firm fails to make the improvement in their auditing period, however, the next audit firm detects the unreported information, the reputation of the previous audit firm may be affected, so that the auditor will minimize the errors for managing the reputation. Further, the mandatory rotation can avoid the mistake or unreported information continue, because the next audit firm will scrutinize the document provide by the former audit form. Also, the long term engagement of the same auditor may cause the auditor trust the previous auditing procedure, so the rotation can reduce the risk of the auditor regards the engagement as the repetition of the last year’s work. Therefore, the mandatory can improve the quality of audit.

Thirdly, the rotation provide the small and medium-size entities good opportunity to enter the competition in the segment of market. Although, the Bocconi study (2002) showed that the mandatory rotation did not provide the small and medium-size entity opportunity to compete in the audit market, they cannot compete against the large audit firm for the public-interest entities. However, take the mandatory tendering into account, the situation can be changed, the rules allow the small and medium-size entity to bid in the tendering, so that the rotation and joint audit enlarge the choice of audit firm for the audited enterprise. Therefore, combined with the mandatory tendering, the mandatory rotation can encourage the competition of the audit firm and provide more opportunity for small and medium-size entity to enter the audit market.

Last but not least, the rotation can reduce the risk of fraud, which the audited entity collude with the audit firm. If both of the audited entity and audit firm fraud the public, when rotation implement, the fraud will be exposed by the coming new audit firm. The scandal of Enron can give a good example of this, if the rotation enact, the deceptive accounting may be found early or the audit firm will not collude with Enron in order to prevent the impairment of the reputation. So the mandatory rotation can reduce the risk of fraud.

The argument against the mandatory rotation of audit firm

According to the Bocconi study (2002), the opinion the audit firms and managers argue is that the cost of auditing fees as well as man-hours will increase under the mandatory rotation. It takes time for the incoming audit firm to read the sufficient document to know the audited entity’s business. If the incoming audit firm do not know the audited entity enough, the quality of audit will decrease. Further, because there are many kinds of industry, it is difficult to maintain the industry specialization and may cause lack of choice of audited entity.

According to Chi et al. (2004), they do not agree the mandatory rotation, they hold the opinion that the rotation may have negative impact on the quality of audit. They show the explanation that in the last year of audit before the rotation, the auditors may abandon their independence because they do not need to worry about the loss of quasi rents for they will not be re-elected. These can lead to the decrease of the last period’s auditing quality. Bigus and Zimmermann (2007) said that because of the rotation, the quasi rent had been decreased, which implies the rotation may not increase the independence of audit firm. Consequently, the mandatory rotation cannot increase the quality and independence of audit firm as expect.

Conclusion

When come up the new proposals, there will have different voice because of the different role they play. As for the rule of the mandatory rotation of audit firm, according to the European Commission, the Big Four hold the opposed attitude, they insist there is studies that have certify the mandatory rotation affect the quality of audit firm; the Mid Tier Firms and small and medium-size entities also do not stand by the rule, they consider the increase cost and harm to the quality of audit firm; the investors had divergent opinion; some of public authorities did not favor of the mandatory rotation, while others think the rule will be beneficial, one of the idea regards to the issue they came up it to allow the committee to decide whether the rotation of a firm should be needed.

To sum up, the new rule of the mandatory rotation of audit firm may be beneficial, but only under certain situation. For example, the cost of fees and man-hours can be low to change audit firm; the negative impact of last period of audit before rotation can be avoid. So that, the proposal can be beneficial if more detail and rules can be add in to make the mandatory rotation more perfection.