That's not what I audited

Many of our recent financial crises have been blamed on auditing gone awry. But planned reforms to make auditing better through independence could have the reverse effect, if the Australian experience is anything to go by.

The audit profession has received consistently bad press in recent years. Audit independence, or rather the lack of it, has been blamed as a contributing factor in some of the major corporate collapses in the early 21st century, the global financial crisis and, more recently, the Greek debt crisis.

A central issue in audit independence is the possibility of compromised independence when the same accounting firm provides both audit and non-audit services to a client.

Late last year, in response to public concerns about audit independence in Europe, EU internal markets commissioner Michel Barnier, released a green paper on auditing. The green paper suggests that in the future audit firms will have to choose between providing audit and non-audit services to clients. That is, the green paper establishes the idea of "audit only” accounting firms.

His belief is that such regulations would ultimately improve audit quality by increasing auditor independence and breaking up comfortable relationships between auditors and clients. These proposed regulations are similar to those that the Australian audit industry has been operating under since the introduction of the Corporate Law Economic Reform Program Act (CLERP 9) in 2004.

The CLERP 9 audit independence provisions adopted a "one size fits all” approach. That is, irrespective of the type of client involved (such as a football club or an ASX100 company) the audit must be conducted to the same high standard. We believe Mr Barnier may not achieve his objectives with the proposed regulations in the green paper.

We base this belief on a recent study that we conducted with 17 audit firms in Australia – seven regional (that is, non-metropolitan) firms, six mid-tier firms, and all of the "Big Four” firms.

In that study, we conducted detailed interviews with partners of those firms regarding their perceptions of the "costs” of the independence requirements of CLERP 9. All the respondents were experienced auditors who were aware of the impact that CLERP 9 had on their firms. They talked about their own experiences of implementing and working with the legislative requirements.

Overall, we found that the total costs of conducting an audit had increased considerably, for several reasons. First, a much increased level of documentation was required during the audit. Auditors had to document far more fully in their working papers the bases on which all of their decisions and reliances were made. Indeed, this area was the one that was most heavily criticised by ASIC as a result of its first inspection program in late 2005.

Second, the cost of the introduction of the systems (both manual and computer-based) used to coordinate the separation of audit clients from non-clients across the firm both nationally, and internationally, was necessarily increased. Finally, enhancements were required to audit administration policy particularly in the area of providing clear and comprehensive guidelines on distinguishing audit and non-audit work across the firm. Furthermore, audit staff had to be trained in all aspects of the audit impacted by the new CLERP 9 independence regulations.

It is clear that these "costs” still persist and that they contribute significantly to the price charged for an audit in Australia, according to a BRW magazine article called "Path to Extinction” published in November.

In that BRW article, Lee White, chief executive of the Institute of Chartered Accountants in Australia, suggested the need for a more appropriate pricing of audit to take into account the increased costs flowing from the more heavily regulated nature of audit.

But the findings from our study point to several consequences if the proposals of Mr Barnier’s paper are enacted. Provisions requiring the separation of audit and non-audit services into different firms will lead to a more concentrated market for the supply of audit services. The "costs” of providing audit services will price smaller audit firms out of the market.

Very recent evidence implies that concentration of audit services within a group of audit firms within a country appears to be associated with lower earnings quality in clients. Thus, it appears also to be detrimental to audit quality in that country.

In addition, the recruitment and retention of auditors generally, and registered company auditors specifically, will decrease significantly because of the increased "costs” of being an auditor. We are seeing the impact of this consequence already in the registered company auditor area. Finally, overall audit quality will be reduced as auditors focus on documentation and compliance rather than the audit itself.

Mr Barnier and the EU should hasten slowly to introduce the proposals outlined in their green paper: rather than increasing audit independence and overall audit quality, they may well have the opposite effect.

Professor Peter Green is from the UQ Business School at the University of Queensland. Julie Walker is associate professor in accounting at the University of Queensland. This story first appeared on The Conversation. Reproduced with permission.

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