Essay on "External Auditing"

Essay 8 pages (2414 words) Sources: 10

[EXCERPT] . . . .

External Auditing

The role of external auditing on corporate governance corporations has increased dramatically over the past ten years. At the outset of the 21st century, auditing was still a somewhat minor consideration, something that was required but did not add significant value to the firm. The role of the auditor in corporate governance was never direct, but rather the auditor served as a check in the system (Broadly, 2006). However, the wave of corporate scandals in the early part of this decade illustrated the importance of strict auditing principles. The Enron scandal perhaps highlighted the importance of the auditor's role best. While senior managers were engaging in illegal activities, auditor Arthur Andersen turned a blind eye, because the company stood to gain from lucrative consulting contracts. Enron's activities were revealed when it collapsed under the weight of its debt. This also revealed the lack of care in auditing on the part of Arthur Andersen. Ultimately, both companies were destroyed. Andersen had failed in its duty to protect shareholder wealth through vigorous auditing. What followed was a series of developments that has transformed the auditing function within today's corporations.

The Auditing Function at the Outset of the 21st Century

The field of external auditing looked much different ten years ago than it does today. The industry was dominated by a handful of international firms -- PriceWaterhouseCoopers, Ernst & Young, KPMG, Deloitte Touch and Arthur Andersen. The Securities Exchange Commission was in what would become the first phase of overhauling the accounting and auditing industry.

In 1998, three significant accounting failures -- Cendant, Sunbeam and Waste Management Corporation -- had focused regulators on the industry (Barr, 200). There was a perception among regulators and eventually among the general populace that auditors were not independent. The Big Five did not only conduct auditing work but they developed relationships with their clients. These relationships were based on the conduct of a number of types of work, including accounting, auditing and consulting. The auditing function, while necessary for the client, was not a lucrative part of the business. Auditing by that point had declined to just 33% of revenue for the Big Five, and consulting revenues were growing at double the rate of other revenues (Ibid.). At particular issue was the fact that auditors were expected to cross-sell other services to their clients, putting the objectivity of auditors into question.

For their part, the Big Five took offense to the characterization that they would not be independent in their auditing duties. They felt that their professional integrity was being challenged by such claims and that these claims were baseless. A report by the Public Oversight Board (POB) Panel on Audit Effectiveness found that consulting fees had increased dramatically to that point. However, the panel also found that 75% of Big Five audit clients received no consulting services, and only 4% of audit clients received consulting services worth more than the audit services they received (POB, 2002)

Between 1998 and 2000, this battle between regulators such as the SEC and the Big Five escalated. In January 2000 for example the SEC released a report outlining some 8000 violations at PriceWaterhouseCoopers in the previous 2 1/2 years (Ibid.). Industry response to the report was negative. It was argued that the regulatory environment was not sufficiently modern. The SEC even went as far to pressure some firms to change auditors (Barr, 2000).

The Public Oversight Board, established to provide oversight on the accounting profession, created the Panel of Audit Effectiveness at the behest of the SEC. When the final report was published, the panel had found that "the conduct of audits and the governance of the profession need substantial improvement" (POB, 2000). The result of this conflict between the Big Five and the SEC is that the entire nature of the industry had been put on the table. There was significant concern about the impact the regulators were going to have on the structure and nature of the industry.

Scandal

As the Securities Exchange Commission and Public Oversight Board were ratcheting up their scrutiny of the external auditing industry, a wave of high-profile accounting scandals hit. The most famous was the Enron scandal. One of the largest and most success firms in the United States, Enron admitted in late 2001 that its accounts for the past three years had essentially been works of fiction (Arnold, 2002). Arthur Andersen had signed off on all of Enron's finances, but also had a lucrative consulting relationship with the Houston-based energy trader.

The scandal had several outcomes. Enron collapsed and several of its employees were subject to arrest and imprisonment for their criminal activities. Arthur Andersen ultimately failed as a result. That company had previously been subject to a $7 million fine from the SEC for its work on Waste Management, and was also the auditor for Sunbeam. When the Enron scandal broke, Arthur Andersen lost clients rapidly.

Most importantly for the state of the external auditing industry was the impact that the scandal had on the regulatory environment. The SEC had been working for four years at that point to make changes to the auditing industry. The size and scope of the Enron scandal provided the SEC with the flash point it needed to have the industry overhauled.

The Enron collapse and other accounting scandals had resulted in a significant loss of confidence among investors in the Big Five and the integrity of the capital markets. Millions of people had lost money on Enron, spurring legislators to pass a set of sweeping changes under the Sarbanes-Oxley Act of 2002, also known as SOX.

Sarbanes-Oxley

The basic structure of Sarbanes-Oxley was influenced heavily by the final report of the POB's Panel on Audit Effectiveness (Sarbanes-Oxley Act, 2002; POB, 2000). For example, Title I of SOX created the Public Company Accounting Oversight Board (PCAOB), which was the strengthened POB envisioned in the report. The passage of Sarbanes-Oxley was the single most important event in the external auditing industry in the past ten years.

The creation of the PCAOB marked a major shift for the industry. Prior to that point, the auditing industry had been self-regulated, through the Auditing Standards Board (ASB). With the creation of PCAOB, responsibility for oversight of the auditing industry was shifted to this private sector watchdog. Despite the private sector nature of the PCAOB, its members are appointed by the Securities Exchange Commission. The SEC also has oversight off the PCAOB. This structure has been subject to legal challenge, as it has been argued that the PCAOB is, in effect, an arm of the government.

The PCAOB fills many roles in the auditing industry. It is responsible for the registration of the auditors. It also develops auditing standards, and oversees auditing firms' adherence to GAAS and GAAP. The PCAOB guides the industry through standards and rules. There are now six standards and a handful of rules (PCAOB, 2009). Firms in the auditing industry must follow these rules and standards, or risk censure from the PCAOB.

The direct influence of the accounting scandals can be felt in a pair of PCAOB roles. The first is that the PCAOB may compel members of audit firms to testify, and has the power to remove any person unwilling to testify from the audit industry. The second is that the PCAOB has the power to regulate the non-audit services provided by auditing firms. These rules exist specifically to address issues that arose as a result of the accounting scandals. To this point, the SEC had been publicly decrying the relationship between audit work and consulting work, and this was believed to be a consideration in the Enron scandal. Furthermore, the ability to bring members of the auditing profession to testify gives the PCAOB significantly stronger power with respect to maintaining discipline in the industry. This complements its abilities to inspect auditing firms and enter into proceedings in the event that it finds evidence of misconduct.

Post-SOX

The changes that came about as a result of Sarbanes-Oxley have dramatically changed the landscape of the external auditing industry. The industry remains an oligopoly (without Arthur Andersen now the Big Four). These firms conduct all the audits on the world's major multinationals (Ascher, 2008). They control 95% of the American auditing business. That said, many smaller firms have entered the market in recent years (Hodgson, 2007). Another outcome of the increased scrutiny has been a rapid escalation in costs, which in turn has driven auditing fees substantially higher (756% between 2001 and 2006). This was coupled with a decline in non-audit services provided by the Big Four, a direct result of SOX and the scrutiny of the PCAOB.

The PCAOB has continued to develop since its inception. The regulatory body has added standards and rules, and continued to refine earlier ones. The Auditing Standard Board has had its authority undercut. The American Institute of Certified Public Accountants (AICPA) was forced to relegate the ASB as relevant only to non-public companies in terms of audit standards and… READ MORE

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