The Lack of Competition in the Audit Marketplace - Assignment Example

Introduction The lack of competition in the audit marketplace and its effects on the independence enjoyed by auditors in providing a true and fair view on a client company's financial statements have been debatable issues ever since the incidence of Enron etc. Such incidences made it evident to the world that auditing profession is lacking its effectiveness in reporting problems with a client company's financial condition to the shareholders. The audit quality as well as the investor confidence was greatly affected when the audit firm Arthur Andersen seriously failed to truly represent the shareholders. One of the major causes behind the occurrence of that incidence was the uncompetitive nature of audit market where only four firms dominate the whole market and provide audit and non-audit professional services to their clients for several years. This paper provides an insightful study into the role played by lack of competition in the audit marketplace in affecting auditor independence and the ways through which it can affect the audit quality. It also sheds light on the solutions actually implemented to resolve this problem as well the ones that have been proposed and yet to be implemented. Lack of Competition in Audit Marketplace as a Threat to Auditor Independence Lack of competition in the audit marketplace is one of the most significant concerns among the regulators these days. Lack of competition in the audit marketplace refers to the fact that there are big four auditing firms predominantly involved in the provision of accounting services around the world encompassing approximately 78% of the total US publicly trading companies. There is a serious lack of accounting services firms in several markets and usually companies are left with no or few choices as to the selection of company auditor because of domination of these big four firms in their respective markets. For example, KMPG has a dominating position in providing auditing services to financial institutions whereas PricewaterhouseCoopers is dominant in the coal and petroleum industry (Bloom and Schirm, 2005). The events such as Enron and WorldCom led to the widespread notion of audit failure or audit incapacity to act as shareholders representatives and report any problems prevailing in the company. This lack of competition became a concern of crucial importance soon after the incidence of Enron and the termination of Arthur Andersen (Bloom and Schirm, 2005). There have been several causes behind the occurrence of such events that seriously shattered the image of auditing and accountancy service profession and directed the attention of regulators towards the notion of lack of competition in the audit marketplaces. Simunic and Stein (1995) elaborate that the market for professional accountancy services highly lacks competitiveness because of several rigid restrictions imposed by the government such as code of ethics, limit on fees and prohibition of advertisement etc. Such restrictions as well as the dominance of big four firms in the industry has been hampering the advent and success of new firms in the market leading to lack of competition. Apart from that, these firms are also involved in the provision of non-audit professional services to their client companies. Because of that fact that there happen to be a very few number of firms in the market, companies turn towards these four firms for both audit and non-audit professional services. Such involvement also contributes to concentration of a major part of these audit firms' income in the client company. This has been the major factor affecting the independence of auditors in providing an opinion on a client company's financial statements. Hence, lack of competition in the audit marketplace is considered to be acting as a threat to audit independence. Audit independence refers to the notion of complete freedom on the part of an auditor while presenting an audit opinion. Hemraj elaborate that "the function of 'public watchdog' demands that the auditor subordinates responsibility towards the client in order to maintain complete fidelity to the public trust." (2002, p. 88) An independent auditor remains completely unbiased and indifferent while providing his view on a client company's financial statements. Independence on the part of auditor is very crucial because he is the only person who acts as a representative of the shareholders and who posses a great capacity to influence shareholders' decisions. Audit independence only can lead to a true and fair view on the part of auditors. There have been several concerns regarding the prevailing threats to auditor independence. Auditor's independence can be affected by several factors including a lack of competition in the audit marketplace. This uncompetitive state of the audit market causes companies to choose the same firm for the provision of accountancy services every year creating income dependence on the part of auditing firms. Jeppesen also propound that "audit independence may in turn be threatened by the auditor intentionally favouring the auditee's interest." (1998, p. 529) For instance, if an audit firm remains associated with a client company providing it audit and non-audit services for several years, the client company may be induced to intimidate the auditor to suspend the auditing services in future. Auditor independence is apparently one of the most crucial aspects of the auditing profession. If the auditor is not independent in providing his or her opinion on the integrity of a company's financial statements, it can greatly affect audit quality. Tackett puts forward that "the appearance of auditor independence is obviously important because the true product of an audit is the increased credibility attached to the financial statements by the independent audit." (2004, p. 342) It suggests that audit quality or integrity of the opinion provided by the auditor, being the sole product of audit industry, depends a lot on the extent to which an auditor is independent concerning the provision of his report. The incidences such as Enron etc make evident that a lack of independence on the part of auditor seriously affects the quality of audit report causing great loss not only to the shareholders but also the auditing profession as whole. The events of Enron and WorldCom encompassing the involvement of Arthur Andersen, one of the giant big five accountancy firms, caused a great dismay to the world of audit regulation. Concerns were raised throughout the world on the effectiveness of auditing profession in reporting the problems concerning a company's financial condition. This led the regulators in the United States as well as the United Kingdom to bring about reforms in the regulatory practices and requirements of the auditing profession. The event of Enron was immediately followed development of Sarbanes Oxley Act in the United States. Under the Sarbanes Oxley Act, the auditing firms as well as the client companies are required to comply with certain rules in performing the auditing services. One of such restriction is that the selection or hiring of auditing firm was no longer to be performed by the client company's management, rather an audit committee was to be created for this purpose. Tackett mentions that under SOX "the independent auditor is hired by, and serves at the pleasure of, the audit committee rather than the management" (2004, p. 347) Thus it endeavours to minimise the extent to which an audit firm would be threatened by the client company as to the provision of an unfair opinion. This act tends to remove the probability that the auditors would be intimidated by the client company regarding their suspension etc. Despite the effectiveness of the Sarbanes Oxley Act in minimising pressures on the auditors, one can argue the role it can play in maximising auditor independence. The selection of auditors, as a matter of fact, would not still be a true representation of shareholders' needs because of the fact that the audit committee could also tend to serve the interests of management rather than shareholders. Mayhew and Pike suggest that " the board of directors' audit committee may also have incentives to please management, especially given the large number of corporations in which the CEO is also the chairman of the board." (2004, p. 820) This happens to be one of the greatest concerns regarding the selection of auditors as well as the effectiveness of Sarbanes Oxley Act in minimising the chances of intentional wrongdoings on the part of the auditing firms, as in the case of Enron. Hence, a solution proposed to this threat is the selection of auditors on the part of shareholders or selecting an audit committee that truly represents the shareholders. Another solutions proposed to the threats posed by lack of competition in the audit marketplace to the auditor independence is rotation of auditors. This proposal propounds that the auditors should be rotated every three years as well as a limit on the auditor income received from one client (Hemraj, 2002). The rotation of auditor bears the capacity to minimise the chances of intimidation on the part of management regarding the suspension of auditing services from a particular firm. This can also be effective in reducing the tendency on the part of auditors to serve the interests of management rather than shareholders. However, the greatest problem in this regard is the lack of competition in the audit marketplace as the auditor rotation will not yield results because of dominance of four firms in the audit industry. For instance, KPMG completely dominates the financial services industry and thus there will not remain any option with the client company other than to select the same auditors time and again. Conclusion This paper discusses the impact of low competition in the audit marketplace on the extent of independence enjoyed by an auditor while providing a true and fair opinion. Lack of competition seriously affects auditor independence as well as the audit quality, as evident in the case of Enron. This is because there remains no choice to the client companies for the selection of new auditors. Thus it creates dependence on the part of auditors as a greater part of their incomes get concentrated with those companies obtaining accountancy services for several years. This might lead the management of a client company to intimidate the auditors and pressurise them to provide an unfair view on the financial statements. The event of Enron provoked concerns regarding the audit effectiveness and quality leading the regulators to take immediate steps to overcome the issue. The development of Sarbanes Oxley Act in the United States and Companies Act in the United Kingdom depict the reaction of regulators to the incident. The selection of auditor as well as integrity on the part of audit committee, a requirement under the Sarbanes Oxley Act, also remains to be significant issue. The auditor rotation proposal also might lead to effective results because of a lack of accountancy firms in the market. Reference List Bloom, R. and Schirm, D.C. (2005) Consolidation and Competition in Public Accounting: An Analysis of the GAO Report, The CPA Journal, retrieved from the World Wide Web 27 April 2007 from http://www.nysscpa.org/cpajournal/2005/605/infocus/p22.htm Hemraj, M. B (2002). The Utility Of Independence in Preventing Audit Failure. Jeppesen, K.K. (1998) Reinventing Auditing, Redefining Consulting and Independence. The European Accounting Review, 7(3), pp. 517-539 Journal of Money Laundering Control, Summer, 6(1), pp. 88-93 Mayhew, B.W. and Pike, J.E (2004). Does Investor Selection of Auditors Enhance Auditor Independence The Accounting Review; July, 79(3), pp. 797-822 Simunic, D.A. and Stein, M.T. (1995). The Auditing Marketplace Exploring the Economics of Auditing Services in the Real World, January/February, CA Magazine Tackett, J. (2004). Sarbanes-Oxley and Audit Failure: A Critical Examination. Managerial Auditing Journal, 19(3), pp. 340-350 Read More