Arguments against the value of audits

Category: Accounting

The accounting profession has confronted doubt on value of their financial reporting because of the reveal of financial scandals (Enron, WorldCom) in recent years. Most economists and investors blame auditor's inability to produce independent and reliable financial information and detect management fraud. For example, Cousins et al. (1998) criticized UK auditors for earning millions of pounds due to statutory monopoly advantage but not detecting and informing shareholders and investors about potential financial problems, which had subsequently led to collapses of BCCI, Queens Moat Houses etc. and enormous losses of jobs, bank deposits. This essay shed light on literatures related to the value of audits by reviewing arguments that for and against the value of audits, and draws attention on the independence of auditors and explored the impact of the provision of audit and non-audit services on auditor independence. Additionally, the value of audits is comprehensively explained from different perspectives of parties including users of financial reporting, the client and auditors themselves.

Arguments against the value of audits

The collapse of Lehman Brothers in 2008 files the biggest bankruptcy in USA's history, its auditor, Ernst & Young, has been criticized by aiding the company manipulating balance sheet and concealing numerous losses along with Lehman Brother's former CEO, former CFO and former Executive Vice President, hence results in misleading information for investors. Anton Valukas, the court-appointed examiner, indicated that Ernst & Young was negligent and its audits did not meet US accounting rules (AccountancyAge, 2008).

Audits are not valuable because there is general confusion over the role of auditors lasts for many years and can be explained explicitly by the term of expectation gap. Expectation gap exits when the audit profession and users of shareholders hold different perceptions about the performance. Generally, when a company has severe financial problems, auditors are expected by the public to be responsible for the financial crisis. Baron et al (1977) found that auditors and users of financial information hold dramatically different expectation on the role and responsibilities for detecting fraud and disclosing information about illegal behavior. Users expected auditors to be more accountable for these duties than auditors perceived themselves to be. The head of Deloitte, William Parrett (FT.com, 2005), expressed difficulties in detecting and preventing company fraud when it was collusive and involved with senior management. Auditors are perceived by the public to be policemen of the company, which has exceeded the ability that auditors could do in reality (Koh and Woo, 1998).

After reviewing the expectation gap between auditors and the public, then shall we remind the original and initiative role of auditors. In a principal-agent relationship, shareholders delegate some decision making authority to directors to act in the best interest of shareholders, however, conflicts of interest arising from the agency relationship as information asymmetries and director's opportunistic behaviors, directors may provide biased information to shareholders and benefit themselves in the expense of shareholders. Therefore, the role of auditors is to check financial information provided by directors on the basis of truth and fairness and to provide an independent view to shareholders. During the process of auditing, auditors act as agents of shareholders, complex issues and problems then have emerged. Auditors may have their own interest and thus cannot perform their job on a true and reliable basis which will lead to additional costs to shareholders (ICAEW, 2005).

Auditors are expected to act in the best interest of external stakeholders rather than the client who hire and pay for auditing service. Some journalists and economists suggested that the audit process is not valuable because auditor's independence is significantly affected by the pressure imposed by the client. Bazerman et al (1997) explicitly indicated that it is psychologically impossible for auditors to maintain independence and objectivity due to limitations from the process of auditing. The director's power to hire and fire auditors and auditors' self-serving interest result in the misrepresentation deliberately or unconsciously. Auditors need to maintain a close relationship with clients not only for generating appropriate information to complete work smoothly, but also for prospective streams of economic benefits. Myers et al (2005) found that the longer the auditor-client relationships are, the more likely the clients to pronounce income-increasing misstatement and core earnings misstatement. Beeler and Hunton (2002) conducted a study of 73 audit partners of the Big-Five CPA firms to indicate the influence of two forms of contingent economic rents (low-balling and potential non audit revenue). The result showed that in the presence of contingent economic rents, the independence of auditors was impaired subconsciously, auditors are more likely to assess the company that will continue as a going concern and gather supportive evidence in order to retain this client in fiercely competitive market. The more the auditor economically dependent on the client, the more likely it will surrender to client's pressure. Nie (2007) conducted an investigation with data generated from 2002 to 2005 and he detected that non-Big four audit firms relied heavily on clients than Big four and more likely to knuckle under client's pressure, which may lead to lower audit quality. From auditor's perspective, they confront high pressure from the client and difficult to resist. Nichols and Price (1976) depicted a difficult situation where divergence occurred between auditor and the audit firm on the attest function, the audit firm attempted to influence auditor's opinion through threat of termination of engagement. Compromise under client's pressure will lead to breach of general accepted accounting standards and legal ethics, failure to do so will provoke losses of potential revenue and then the job.

The demise of Enron and Anderson has called in question the auditor independence is impaired through the provision of non-audit services to audit clients and motivated the emergence of Sarbanes-Oxley Act of 2002 which imposed restrictions on provision of several types of non-audit services. According to a research by an independent finance advisory firm, there were 26 of the FTSE companies who had expenses on non-audit services far more than audit services in 2009. The huge non-audit service revenue had led to greater concerns about audit quality. However, a spokesman of PwC announced that PwC will fully comply with regulation and standards, hence no room for the compromise of auditor independence. Hopefully, the increasing transparency and exposure of information will ensure audit quality (Guardian, 2009).

The provision of non-audit services benefits bilateral parties, the clients and the audit firms. Teng (n.d.) revealed two reasons why incumbent auditors are likely to be appointed by the client to provide consulting services, one is their technical expertise in this field and their familiarity with the client, and another is their additional knowledge obtained from other similar clients. Coulton, Ruddock and Taylor (2007) indicated that non-audit fees may have a higher profit margin thus incumbent auditors may use audits as a platform to sell non-audit services, however, they also emphasized that their conclusion is only confined to non-Big 6 audit firms. Larker and Richardson (2004) found a positive relation between non-audit fees and discretionary accruals, thus greater non-audit fees gained from the client may lead to the compromise of auditors. Nevertheless, their conclusion has limitations and cannot comprehensively represent all audit firms because their samples were based on small firms with weak corporate governance mechanism.

Arguments for the value of audits

If audits have such limitations and incurred plenty of problems to the world, then do we really need audits? Gómez-Guillamón (2003) stated the usefulness of audits because audit's opinion audit report about the company will significantly influence investment and lending decisions for banks and individuals. DeAngelo (1981) suggested that, ceteris paribus, audit independence and audit quality are related to the size of audit firms. Since larger accounting firms have a greater number of clients, each client holds a relatively small faction of total audit fees and little influence over the auditing of financial reporting when compared to small accounting firms, hence the less propensity to behave opportunistically and higher expected audit quality. Reynolds and Francis (2001) further extended DeAngelo's assumptions by investigating auditor independence in the context of Big Five accounting firms, they found that Big Five auditors are less likely to be influenced by economic benefits from larger clients to produce favorable reports, conversely, they report more conservatively for larger clients in the face to avoid litigation risk imposed by larger clients. Hope and Langli (2010) revealed auditor's objectivity in relation to audit fees. Auditors will not be allured by the significant amount of audit fees from client to compromise independence and objectivity, moreover, auditors will take prospective audit failures and reputation loss into account. Cahan et al (2008) raised objections against previous research findings by their experiment, and they did not find evidence that showed fast growth of non-audit fees or the length of the auditors' non-audit services with the client will impair auditors' independence. Chan (2009) found no significant relation between audit fees, non audit fees and total fees and auditor's propensity to express a going concern opinion in 2001 (pre-SOX). However, according to his investigation he found a positive relation between audit fees in proportion of total fees and a going concern opinion in 2003 (post-SOX). Nevertheless, non-audit fees are still irrelevant to the compromise of auditor's independence in 2003 (post-SOX). Basioudis, Papakonstantinou and Geiger (2008) and further explained the positive relation between audit fees and non audit fees and going concern opinions. Before auditors provide going concern opinions they will do numerous testing and documentation which involve expatiatory discussion with clients, hence the substantive work results increases in the costs of auditing. Robinson (2008) added that the provision of tax services is likely to enhance audit quality because it will induce auditors to scrutiny transactions more closely in order to maximize tax refunds from losses carry forwards.

Since the collapse of Anderson, UK auditor independence regime has been reinforced by adding restrictions on the provision of non-audit services. As the result, non-audit fees as a percentage of total audit fees has shrunk significantly from 300 percent in 2000 to 70 percent in 2009. In regard to Professor Fearnley's study, auditors are unwilling to provide suggestion on the client's operation which has incurred extra costs and inconvenience of appointing other audit firms to the client (FT.com, 2010). On the other hand, the rising concerns of auditor independence, have incurred enormous losses for audit firms as well, have urged large corporations such as Unilever to re-exam its current non-audit services provided by PwC, which has forced PwC to spin off its consulting services since 2002 (BBC, 2002)

Conclusion

There is enormous evidence showed the significance of auditing and auditors, even after latest shocking financial scandals. Self-interested behavior that may impel auditors act in an illegal manner, especially in small audit firms with weak corporate governance mechanism where clients play an important role and yield greater influence over auditing process. However, disregard of the role and value of auditors may be too pessimistic, as legislation and corporate governance will be enhanced in the foreseeable future. Therefore, I think audits do have value in the contemporary era.