External Auditors - Corporate Governance and Business Ethics

External auditors are also part of a firm’s corporate governance system. Auditors play an important role in ensuring that shareholders and other “outsiders” receive transparent information about firm activities. Improving how audits are conducted is one of the main goals of SOX (Coates 2007). To accomplish this, SOX attempts to reduce the potential for conflicts of interest between auditors and shareholders. As auditors work for shareholders, anything that makes them less likely to look out for shareholders’ interests can be viewed as an ethical problem. This part of the essay addresses mandatory partner rotation and the prohibition of non-audit services.

Mandatory Audit Partner Rotation

A SOCK requires lead and coordinating partners to rotate off engagements every five years. They may return to the engagement after a five-year “cooling off” period. The rationale for partner rotation is that partners may become too “cozy” with their clients or too trusting of their clients if they stay on an engagement too long, creating a potential conflict of interest between the partner and the shareholders of the client firm. If this occurs, then partners may not detect unethical behavior by clients or may actually participate in unethical behavior. However, since it typically takes time for a new partner to get “up to speed” with a new client, mandatory rotation may actually increase the likelihood of unethical behavior as the new partner may miss something that a more experienced partner would catch.

The evidence concerning audit partner tenure and financial reporting quality appears to be mixed. For example, Johnson, Khurana, and Reynolds (2002) find that financial reporting quality is higher when auditors have been on a client between four and eight years then when they have been on a client for only two to three years. In addition, they find no decrease in audit quality when auditor tenure stretches past eight years. However, Carey and Simnett (2006) report evidence that audit quality (measured as the likelihood of issuing a going concern opinion and just missing or beating earnings targets) decreases as audit partner tenure increases. Although not an exhaustive summary of empirical evidence, these two studies demonstrate that existing research concerning whether audit partner rotation reduces the potential for unethical behavior is mixed.

Researchers have also considered the relationship between audit partner rotation and perceived auditor independence. Perceived auditor independence is an important corporate governance issue as investors who perceive that an auditor’s independence has been impaired are less likely to trust that there is no conflict of interest between the auditor and investors. Again, the evidence is mixed. For example, Jennings, Pany, and Reckers (2006) show that perceived auditor independence is lower under mandatory partner rotation than under mandatory firm rotation. On the other hand, Kaplan and Mauldin (2008) find that audit firm rotation does not improve perceived auditor independence relative to audit partner rotation. When SOX was being debated, there was some consideration of requiring firms to change audit firms occasionally. Section 207 of SOX instructs the Comptroller General of the US to conduct a study of the potential impact of mandatory audit firm rotation. The main result of the study is that 79% of respondents believed this would increase the likelihood of unethical behavior as the new firm learned about a client’s business (GAO 2003). Not surprisingly, the GAO concluded that mandatory audit firm rotation was not necessary at the time.

Based on all of this evidence, it is not clear that audit partner rotation mandated by SOX is an effective way to improve auditing and financial reporting. In addition, consistent with the GAO report (2003), it does not a pear that audit firm rotation would lead to improved financial reporting.

Provision of Non-Audit Services

Academics and practitioners have been arguing for many years that auditors performing non-audit services for their audit clients unacceptably impair auditor independence (Prentice 2006). Opponents argue that auditors may have an incentive to “look the other way” on an audit matter in order to hold on to non-audit work (which is usually more profitable than audit work). Additionally, audit firms could offer to do an audit at a relatively low price (possibly even at a loss) as a way to obtain non-audit work. Even if auditor independence is not actually impaired, opponents argue that the appearance of non-independence could result in less faith in the audit process. However, it was not until it was learned that Enron paid Arthur Andersen more for non-audit services than for audit services that this issue became much more important to regulators. To address this, SOX prohibits auditors from performing most non-audit services for their audit clients.

Although the prohibition on non-audit services reduces the likelihood for conflicts of interest between a firm (through its auditor) and shareholders, it is not clear that this is necessarily good for shareholders. In a review of the extensive literature on non-audit services, Francis (2006) concludes that although there is no definitive evidence showing that non-audit services lead to audit failures, significant evidence indicates that investors perceive that non-audit services impair independence. Since appearances are important in capital markets, prohibiting non-audit services seems to have been an appropriate ethical response to various corporate scandals.

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