The oversight of the audit profession

Table of Contents

1. Executive Summary

2. Introduction

3. The Audit Oversight
3.1 Oversight system in the US
3.2 Oversight system in the UK
3.3 Oversight system in Germany
3.4 Comparison of the US, UK and German systems

4. Evaluation

5. Conclusion

6. Bibliography

1. Executive Summary

This paper provides an overview of the current regulatory frameworks for financial reporting and auditing in the UK, US and Germany. During the last years these frameworks were noticeably changed. These changes arose especially from political interest in accounting regulation following the Enron collapse. The main change in the US was the introduction of the Sarbanes-Oxley Act containing strict regulations for auditors, including their responsibilities and services. It also contains a list of prohibited audit activities, the so-called “non-audit” services. The main feature of the Act was the creation of an oversight board to regulate and control auditors of public companies. Thus the “Public Company Accounting Oversight Board” was established. The PCAOB is a private-sector non-profit overseer, supervised by the US Securities Exchange Commission (SEC) which regulates basically anything related to the securities market.

Following the collapse of Enron and the turbulence in the UK markets that followed, a review of financial regulation in the UK was ordered, covering for example auditor independence, corporate governance, financial reporting and auditing standards and accountability of audit firms. In order to restore credibility in UK accounting the Financial Reporting Council (FRC), an independent private sector body funded by the accountancy profession, was set up. The FRC has several subsidiary bodies, including the Professional Oversight Board (POB) providing independent oversight of the regulation of the auditing profession.

The German Auditor Oversight Commission (AOC) was established according to the Auditor Oversight Law. It is in charge of the public oversight of all activities of the German Chamber of Public Accountants (WPK) with respect to statutory auditors. The Commission has the ultimate responsibility in the areas of licensing, registration, disciplinary investigations and quality assurance, all with respect to members of WPK entitled to provide statutory audit services (WPK, n.d.).

It is argued that these new regulations impose another layer of bureaucracy with significant costs for very little apparent gain. But ethical issues surrounding the public’s perception of auditor performance need to be addressed, not just for the sake of the profession, but for the efficiency and effectiveness of capital markets in general (Malthus and Scoble, 2005).

2. Introduction

Over the years the accounting profession has been subject to various forms of oversight with varying degrees of success. Nevertheless, it used to be self-regulating. But a series of financial scandals involving once prominent companies such as Enron, WorldCom and Parmalat lead the authorities to consider whether the accounting profession's self-regulatory oversight system was appropriate to meet the necessary objectives. These corporate failures had shown that the self-regulatory system did not produce credible results and “had the potential to undermine investor confidence in the integrity of the securities markets” (The Treasury, 2006) . As a consequence a number of countries have reviewed their arrangements for independent oversight of the auditing profession. The United States, for example, has introduced tough external audit regulation under the Sarbanes-Oxley Act of 2002. Canada has also introduced a regulator with extensive powers, including a national inspections unit as independent monitor of major audits, while the British and Australian solutions are based mainly on oversight rather than on full regulatory control (Malthus and Scoble, 2005). However all these oversight bodies are needed to protect the public and the credibility of financial information.

The aim of this paper is to describe and analyse the developed oversight system of external auditors in countries such as the UK and Germany and compare it with the standards in the USA. It also considers the extent to which auditors are supervised in each of the mentioned countries.

First it is important to clarify why an oversight is necessary, thus the essay commences with a short introduction of recent events that finally led to a review of the oversight system. Following, the particular bodies in the countries stated above are mentioned, including the accordant regulatory systems and bodies. This part responds especially to the functions of the bodies, their responsibilities and the changes that were undergone since the establishment of the system. The fourth chapter reviews the system and deals with reflections and criticism from the public side. In the fifth and last chapter a short summary of the previous chapters is given.

3. The Audit Oversight

3.1 Oversight system in the US

The Enron bankruptcy, “which was the largest bankruptcy in history and resulted in substantial financial losses to investors and pensioners, has dramatically heightened the public attention given to those concerns, posing a critical threat to investor confidence in financial information generally” (SEC, 2002). Serious questions were raised about the credibility and reputation both of company directors and the accounting profession. In particular, the role of the external auditor and the relationship auditors have with their clients were called into question in a fundamental way (Malthus and Scoble, 2005).

“In the US these issues and others associated with the systematic failure are being addressed through the provisions of the Sarbanes-Oxley Act (SOX)^[1], which was passed in July 2002 to restore confidence in the US market”(Fearnley and Beattie, 2004). The law primarily regulates rules for the improvement of the Corporate Governance (guidelines for good and responsible management), which makes it compulsory for the management of capital market-oriented enterprises to ensure the completeness and correctness of the data given in the annual accounts. Thus the CEOs of American Public Companies have to provide a signature stating that their accounting is correct and that they are aware of the fact that they are committing a criminal offence, if this is not the case.

SOX applies to all enterprises that are registered at the US Securities Exchange Commission (SEC). Therefore it is also relevant for enterprises outside the USA, if

- their securities (too) are noted at a US stock exchange or

- they are significant subsidiaries of a society floated at American stock exchanges.

Malthus and Scoble (2005) refer to another key feature of the Act concerning the prohibition of nine types of non-audit services to audit clients by audit firms. A brief description of these non-audit services interdicted by the Act, as defined by the United States Securities Exchange Commission (2003), is:

1. Bookkeeping or other services related to the accounting records or financial statements of the audit client;
2. Financial information systems design and implementation;
3. Appraisal or valuation services, fairness opinions, or contribution-in-kind reports;
4. Actuarial services;
5. Internal audit outsourcing services;
6. Management functions or human resources;
7. Broker or dealer, investment adviser, or investment banking services;
8. Legal services;
9. Expert services unrelated to the audit.

The main feature of the Sarbanes-Oxley Act was the creation of the “Public Company Accounting Oversight Board”, also known as the PCAOB, as a private-sector nonprofit overseer. According to the Act the PCAOB’s primary responsibilities fall into four broad areas:

- registration of accounting firms that audit public companies trading in U.S. securities markets;
- inspections of registered public accounting firms;
- establishment of auditing and related attestation, quality control, ethics, and independence standards for registered public accounting firms, and
- investigation and discipline of registered public accounting firms and their associated persons for violations of specified laws or professional standards (The Treasury, 2006).

Or to put it another way, the goal of the PCAOB is the oversight of the auditors of public companies “in order to protect the interests of investors and further the public interest in the preparation of informative, fair, and independent audit reports” (PCAOB, n.d.). The Act requires that two of the five Board members be or have been certified public accountants. The members have to serve fulltime, and are prohibited from receiving payments (other than retirement payments) from public accounting firms (Malthus and Scoble, 2005). The salaries of the members equal those of the Chair and members of the Financial Accounting Standards Board.

Although the PCAOB is a private sector entity, the Act gives the Securities and Exchange Commission (SEC) oversight authority over it. The SEC is a United States government agency with the responsibility to oversee private regulatory organizations in the securities, accounting, and auditing fields, and to coordinate U.S. securities regulation with federal, state, and foreign authorities. In Woodard’s (n.d.) words, it regulates basically anything related to the securities markets. This includes individuals, investment advisors, mutual funds, broker-dealers, and public companies. Common enforcement actions include: insider trading, accounting fraud, and providing false information about securities and the companies that issue them. The Commission also appoints members of the PCAOB. In addition to this it must approve the Board’s budget and rules, including auditing standards, and may review appeals of adverse Board inspection reports and disciplinary actions against registered firms (PCAOB-Annual Report, 2005).

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^[1] Named after its authors, the democratic senator Paul S. Sarbanes and the republican delegate Michael Oxley.