The two most important regulators of
the word, namely, the European Commission (E.C.) in Europe and the PCAOB in the
U.S. have taken very different routes to enhance the audit quality of the
firms. In April 2014, EU amended the Statutory Audit Directive of 2006 to
introduce provisions relating to the Mandatory Firm Rotation (MFR) to extend
periodical changes to audit firms as well. However, the US decided to stick to
its rule of only Mandatory Audit Partner Rotation. Three years later, in April
2017, India, through Companies Act, 2013 mandated Audit Rotation in India too.
Mandatory Audit Rotation imposes
periodic breaks to audit engagements and is intended to avoid excessively long
relationship between the auditor and the client. This means that listed and
other public interest entities will have to bid goodbye to their long-standing
auditors, put out their audit tender periodically and completely change the
auditor after the prescribed period by the regulator. For audit companies, this
means that they will have to chase many more new clients than they normally do
and re-work on permissible activities that they can provide to their audit clients
to avoid a conflict-of-interest between their other services, like consulting,
and auditing.
This increased tendering environment
has put a limelight on data and analytics. Statutory audit is a homogenous service
defined strictly by a few hundred pages of legislation leaving very little room
for differentiation. Firms are offering innovative solutions, not only as a
differentiator of services being offered, but to address key business risks and
inadvertently improving audit quality. The Flip side to this is that the big
four, with their deep pockets, are developing new technologies at a
considerable cost, effectively creating a barrier to entry for the smaller
firms. It’ll be a while until the cost stabilize through innovation seep down. We
can safely assume that the big four will continue their dominance, well into the
new contract cycle in the coming decade.
The bottom line lies in the audit
quality. Auditing quality is widely discussed and debated topic across the
globe. It can be defined as the probability that an auditor will both
discover and report a breach in the client's accounting system. It can potentially bring
out the scam in public domain or sustain it for many years. The probability of finding fault in
accounting depends on the auditor’s intellectual
competence while that of
reporting, depends on auditor’s independence. Audit quality being very
subjective topic, can neither be quantified nor be accurately
measured, but only proxies are used for its assessment.
Many countries have undergone massive
transformations in its auditing practices laws. New Zealand, after Initially refraining
from making reforms to its auditing profession, eventually felt threatened that
the country might be excluded from international recognition of its auditors
and found it necessary to impose reforms.
Key Findings after Partner Rotation in US
There are some interesting results observed when the change in audit partner takes place. For larger firms, we see a positive psychological change in perception. By analyzing the Earnings Response Coefficient, we can conclude that investors perceive the rotation of lead audit partner as enhancing audit quality. While On the other hand, for smaller firms, it is observed that their predictive value of earning for future cash flows improved to as much as 85% during the post-rotation period.
Mandatory
Audit Firm Rotation- A Silver Bullet?
MAR is not a new phenomenon. It has
found acceptance in other countries such as Italy (auditor term limit of 9
years), Brazil (5 years), South Korea (6 years), and India (4 years for banks,
insurance companies, and public sector companies).
External or statutory audit firms
keep reiterating that their business is not investigation but assessing fraud
in financial statements. However, two of the biggest frauds committed in
Parmalat, Italy and PNB, India show that auditor could have detected malpractices
with just some due diligence in their regular work. These frauds were at
similar scale of Enron and often dubbed as ‘Italy’s Enron’ and ‘India’s Enron’
respectively. In fact, the Parmalat fraud took place after the implementation
of mandatory firm rotation.
Implementation
of MAR or MPR is yet to have its desired effect on fraud detection. However,
the question is, will MAR lead us to a serious problem that is beyond our
imagination today?
Additional Concerns
- Quality of CPAs (Certified Public Accountant Firm)
Major CPA (equivalent
to CAs of India) firms usually hire bright minds from reputed B Schools. Over
time, accounting as a career has started to lose its charm due to work pressure.
Major CPAs are abandoning professionalism to pursue consulting profits. This
implies neither proper compensation nor hope for advancement in the minds of aspiring
students. As a result, the quality of
graduates joining the firms may be questionable.
- Protecting each other’s interest
When
auditing firms closely compete for the same limited pool of profitable clients,
it is in their interest to protect the industry from probable disruption. This
behavior has a potential to lead us towards another major financial crisis.
- Consolidation
Below graph plots ordinary least squares (OLS) coefficient estimates (together with 95 percent confidence intervals) from regressions of Audit Fees and audit effort (measured as Audit Hours, Total Partner Hours, or Engagement Partner Hours) for client i in year t on five separate indicators marking the years 1 to 5 of the tenure cycle of the engagement partner. Year 3 serves as base period and lacks a coefficient estimate. The models include various audit and client-specific control variables plus fixed effects (see notes to Tables 4 and 5 for details). The sample comprises up to 17,903 client-year observations over the 2008-2014 period with PCAOB and control variable data.
- Sagar Gogate
Ankit Sharma
SDA Bocconi Asia Center
