ANALYSIS OF HOW NON-AUDIT SERVICES PROVIDED TO AUDIT CLIENT HAS CHANGED SINCE ENRON IN THE UK.
The Enron scandal is, perhaps, the biggest scandal in the history of corporate scandals. This paper will examine the changes that emerged in the accounting and audit sectors due to the Enron Scandal. Enron was one of the big four companies, and energy company in the US. Its auditors were Arthur and Anderson. The company filed for bankruptcy in December 2001 following irregular accounting procedures which the firm implemented throughout the 1990s. For example, Enron was engaged in questionable accounting practices. Enron widely used off-balance sheet financing, and was ordered to restate its profits (1997 – 2001), and this lowered its book value by $1.25billion, (McCarthy et al, 2005). It also had a number of discrepancies as regards its share price, sales, earnings, cash flows and balance sheet disclosures. For example, in 2000 its revenues increased by 151% while cost of sales increased by 172% but the share price increased only by 100% (McCarthy et al, 2005). All these led to the fall of Enron and a re-birth of structural changes to the nature of audit and non- audit services which audit firms provide, the relationship between audit and non-audit fees and the scope of work available for auditors. This paper seeks to examine the effect of these structural reforms following the Enron case in the UK industry.
Aims and Objectives of the Study
Following a wave of accounting scandals at Enron, WorldCom, Tyco et al in the last few years, this study is aimed at looking at how effective the responses to these scandals have been in reducing the scandals in future. Amongst other objectives, the paper will be to investigate the ethical regulations passed after the Enron scandal, how the Sarbanese Oxley Act passed by congress on the 25th of July 2002 and put into law by President Bush has been effective in mitigating these standards at a UK-based energy corporation with listing in the U.S. other objectives include:
- Analyzing the impact of the Enron scandal by reviewing relevant literature on the field;
- Determine what has been done to minimise this risk (regulations, discussions, separation of powers etc);
- Examine the regulation if any that were introduced since the Enron Ethical Standards and
- To determine whether auditors should be restricted from any other services apart from non-audit services which they engage with.
Outline of the Study
The paper will continue thus: chapter 2 is a presentation of a theoretical framework and a literature review. Chapter 3 provides the research method that will be used to achieve the objectives of the study. In particular the chapter presents a discussion of the case study approach to research, its merits and demerits; chapter 4 provides a presentation of information about the case study BP. The chapter presents information on how the board of directors of BP is constituted, the independence of the board from executive management, as well as how BP complies with the requirements of applicable sections of the Sarbanes Oxley Act of 2002; Chapter 4 presents a summary of the key findings, analysis and discussion of the findings as well as conclusions that can be drawn from the findings. This chapter also presents possible areas for further research.
- Literature Review
2.1 Theoretical Framework
Auditing is “a systematic process for obtaining and assessing evidence regarding assertions of one kind or another in accordance with established criteria” (Lyke, 2002:24) This is so as to determine the degree of correspondence of the financial statements to accounting standards and to attest the truth and fairness of these financial statements. An audit is carried out by a qualified person known as an auditor whose responsibility is to carry out the auditing process and decide as to whether the financial statements are prepared according to the accounting standards, the Generally Accepted Auditing Standards, (GAAP), and to form an opinion as to the truth and fairness of these financial statements. Auditors are regulated by government bodies and other professional organizations such as the Securities and Exchange Commission, (SEC). According to the Companies Act of 1985, not all companies are required to be audited: small companies are generally exempt. The criteria below explain the requirements attained in order for a business to be liable for audit.
- i) Companies which have a turnover less than £5.6 million and a balance sheet total of less than £2.8 million may be exempt from statutory audit, (Smullen et al, 2008)
- ii) Companies with a turnover of £1 million and a balance sheet total of less than £1.4 million do not need an auditor report. (Smullen et al, 2008)
iii) Companies whose turnover is £1 million and balance sheet total is £5.6 million need an accountant’s audit exemption report. (Smullen et al, 2008)
In performing their duties an auditor is supposed to be independent and disinterested in judgement. An auditor’s main duty is to perform a range of duties know as audit services. Audit services can be defined as Non- audit services generally refer to all other services which an auditor provides beyond their related audit services such as tax advisory, management consultancy amongst others to its clients other than the traditional audit framework. There is no certain classification structure in which non-audit services are classified; as such most researchers have utilized diverse classification of non-audit services while trying to evaluate the concept of non-audit services. Non audit services have been defined from many angles by various boards and institutions. The Auditing Practices Boards (APB) Ethical Standards define non-audit services as: any engagements which an audit firm provides professional services to an audit client other than the audit of its financial statements and other duties such as the audit of the clients’ internal control in compliance with the procedural and reporting requirements of the regulatory bodies. (Auditing Practice Board, 2004).
2.2 EMPIRICAL LITERATURE REVIEW
There are a number of studies regarding the provision of non-audit services by auditors, the range of non-audit services they can provide, the fee they are entitled to receive for these services and how they manage to keep their independence when carrying out these services alongside their traditional audit services of the financial statements of their client. These were propagated as a result of the collapse of one of the big four companies; Enron in the year 2001. Despite the evidence provided against the provision of non-audit services, cases like the Enron debacle which happened in 2001 are still evident. For example, the global financial crisis serve as a test of the regulations and procedures put in place following the Enron debacle and other accounting scandals. The big question still remains as to whether auditors can remain independent while providing both audit and non-audit services. This section reviews theories which have been suggested by researchers since the collapse of Enron in 2001, how non-audit services have changed since then, how much non-audit fee measures up to audit fee and what regulations have been set up by the Board of Ethical Standard. Interesting studies emphasizing reforms to non-audit services after the Enron collapse can be examined thus.
There have been significant changes in internal auditing following the accounting scandals at Enron and WorldCom, (Carcello et al, 2005). In a study by Carcello et al using data from 271 mid-sized US publicly traded companies, they find that internal audit budgets, staffing levels, meetings with the audit committee and meeting lengths increased significantly during this time. Using regression analysis, Carcello et al. provide further evidence of: (1) larger budget increases among smaller firms; (2) larger budget and staff increases in companies with greater financial resources (i.e., stronger operating cash flows) or with greater liquidity risk (i.e., lower current ratios); and (3) industry differences in the change in internal auditing, (Carcello et al, 2005: p.117).
With respect to the relationship between the audit fee and non-audit services, valuable studies pertaining to non-audit services and its relationship with the audit fee has been studied by a number of researchers. Simunic (1984) states that the clientele demand of audit services affects the provision of non-audit services on audit fee. Similarly, Abdel-khalik ( 1990) suggested that the audit and non-audit fee are positively related. In addition, Barkess & Simnett (1994), and Firth (1997a) also indicate the significant correlation between audit fee and non-audit services fee.
Also, in response to this deluge of corporate scandals, the US congress in 2002 passed the Sarbanes Oxley (SOX) Act. It became law in 2002, (Carcello et al, 2005). The SOX has brought significant changes in several elements of corporate governance and financial reporting for public companies particularly by significantly improving internal controls of a company. (Carcello, 2005).
In addition, audit committees are now expected to be more independent and audit firms are expected to keep the provision of non-audit services to audit clients at a minimum level to ensure that they do not form strong bonds with the client that may have an impact on their independence, (Chadha et al, 2005; Grant et al, 2007). So now certain consulting services are now deemed illegal under the SOX rules, (Chadha et al, 2005; Grant et al, 2007).
The SOX also created the Public Company Accounting Oversight Board (PCAOB) to oversee the activities of accounting firms and accounting firms are required to be registered with this board, (Carcello e al, 2005; McCarthy et al 2005).
In addition to the rules, the U.S stock markets also responded to the corporate scandals by adopting additional set of rules for companies wishing to list their securities in the U.S. for example, in 2003 the New York Stock Exchange (NYSE) and the NASDAQ stock exchange issued a number of new regulations for companies that want to list in the exchange, (Chadha et al, 2005). The American Stock Exchange (AMEX) followed suit in December 2003 with similar rules, (Chadha et al, 2005).
Also, in response to the scandals, rules based accounting standards have been complemented with principles-based accounting standards. The FASB and the SEC in recognition of the fact that rules-based standards have a number of bright-lines decided to complement rules-based standards with principles based standards so as to reduce the loopholes that preparers of financial statements may use to manipulate investors, (Lee, 2003; Williams, 2005; Schipper, 2006). The financial accounting Standards Board has already developed a proposal for the principle-based approach to the US setting (Lee, 2003; Williams, 2005; Schipper, 2006).’
Moreover, the International Accounting Standards Boards as well as the Financial Accounting Standards Board have been working towards a common conceptual framework and have been issuing new accounting standards reducing the bright-lines in the old standards so as to ensure that financial statements present fairly. (Epstein et al, 2007).
Jain asserts that companies could distinguish themselves to investors as having higher quality financial statements if they announced higher limits of coverage and smaller premiums (Jain et al, 2006). Conversely, companies with little or no coverage as well as higher premiums would be considered by investors as companies with lower quality statements, (Jain et al, 2006). This would instil discipline on each company’s management in that they would be motivated to avoid this characterization, (Jain et al, 2006).
A few studies have been carried out on how effective SOX and other responses to the accounting scandals could be effective in mitigating Enron-like type of scandals. In particular, the only study that the researcher came across was the study by Jain et al.. The study provides evidence that there are wider spreads, lower depths and higher adverse selection of component spreads at the time of the reported financial scandals implying that liquidity measures deteriorated as a result, (Jain et al, 2006). They also provide evidence that liquidity measures witnessed an improvement following the implementation of the SOX Act in 2002, (Jain et al, 2006). Following from these findings Jain et al., conclude that the observed improvements in the market liquidity in the post-SOX period is positively correlated with the quality of financial results, as well as several variables such as firm size, market factors ( e.g. price volatility), volume, microeconomic events such as the NYSE Open Book, (Jain et al, 2006). In addition to the above findings, Jain et al. also observe that the improvement in liquidity measures were more pronounced for companies that were closer to compliance that for those that weren’t. From all this literature it can be observed that less attention on how the responses (in particular the SOX implementation) are effective in mitigating Enron-like accounting scandals in future. Much of the literature has been documenting the causes of, consequences of and responses to the scandal with little attention toward how effective these responses could be. Even the few (e.g., Jain et al., 2006) that were carried out were on companies that are based in the US with no attention to European-based companies that are listed in the US and therefore required to comply with SOX.
Another important response is the issuing of new accounting standards and compliance requirements by the International Accounting Standards Board and the Financial Accounting Standards Board and the move towards harmonization of International Accounting Standards (IAS)/International Financial Reporting Standards (IFRS) with U.S Generally Accepted Accounting Principles (GAAP) by the IASB and the FASB, (Sellani et al, 2005; Ding et al, 2005, Ausbaugh, 2001). The EU also responded by issuing regulation 1606/2002, which meant that all EU listed companies had to report accounting information as from 1st January 2005 in compliance with IAS/IFRS, (Haverals, 2007).
This study is aimed at breaching the literature gap by studying how auditing standards have since changed post Enron collapse in 2001. New audit regulations were provided for to govern audit practices. For example the SOX in particular have helped in mitigating financial statement fraud in a UK-based company that is required to comply with SOX. There has been increased debate on whether European-based companies too should comply with SOX. Studies regarding the auditor’s independence with regard to its fee from non- audit and audit services have been examined and have shown that the auditor is likely to rely on the non-audit service fees as such this will impair his independence in carrying out his audit services.
Presentation of Facts
In this section of the paper, corporate governance issues at BP in 2002 will be compared to those of 2006. In addition, disclosures relating to accounting standards in 2002 will be compared to those of 2006. The section will begin by providing an overview of BP Plc, its business divisions, employees and locations. The section will later discuss BP’s corporate governance structure in 2002 and 2006 as well as accounting standards in 2002 and 2006.
3.1 Overview of BP Plc
BP Plc was incorporated in England and Wales in 1909 as The British Petroleum Company p.l.c. It later became the BP Amoco PLC after a merger with Amoco Corporation. The company is known today as BP Plc. The company subsequently changed its name to BP P.l.c. BP Plc is a global group. Its activities and interests are carried out through subsidiaries and associates, in many different countries. The company thus has to comply with laws and regulations of many different jurisdictions. BP operates its business through three main business divisions including Exploration and production; Refining, Marketing and Gas; and Power and Renewables. As at 31st December 2006 the company had an approximate number of employees of 97,000.
3.2 Corporate Governance of in BP Plc
After a careful review of BP’s 2002 annual report and account, no information can be found on its corporate governance. It appears the company never disclosed information on corporate governance during this time. Attempts to retrieve this information from other sources have yielded no results.
Board of Directors of BP Plc
The board of directors of BP consists of 9 non-executive directors. The company considers efficiency and effectiveness of the non-executive directors to be of paramount importance, (BP Plc, 1996-2008). The increase number of non-executive directors is justified on the grounds that a larger number is necessary to staff the different board committees such as the Audit Committee for example, (BP Plc, 1996-2008). To be eligible for membership of the non-executive Board of BP, members must be totally independent and thus free from any family or business relationship with management, because this may influence the exercise of the Board’s judgments and decisions, (BP Plc, 1996-2008). As per the Board, it is held that this condition is fulfilled, particularly with the non-executive board of 2006. To strengthen this rule, all non-executive board members have to be elected and endorsed at the AGMs, BP Plc, 1996-2008). Some of these non-executive board members make up the nomination committee, which is usually chaired by the chairman, (BP Plc, 1996-2008). The role of this committee is to scrutinize or screen potential members to join the board as older ones age out and retire, (BP Plc, 1996-2008). To an extent, the board also considers the nomination committee as an independent body, (BP Plc, 1996-2008).
The Audit Committee.
The audit committee combined code requires the board of directors to establish a formal and transparent arrangement with auditors (Smith, 2003). In addition, the board of directors is obliged to set up an audit committee (three members to be non-executive independent directors) ((BP Plc, 1996-2008). The audit committee (AC) is therefore delegated responsibility from the board.
The board of directors of the BP group has an audit committee, whose responsibility is to ensure that the financial reports and accounts as well as financial processes reflect a high degree of objectivity and integrity. The committee monitors the activities of the executive directors on the behalf of the board ensuring that the interest of shareholders is maintained, (BP Plc Annual Report and Accounts, 2006). The audit committee meets regularly and at the end of each meeting an agenda for the next meeting is set, (BP Plc Annual Report and Accounts, 2006). The agendas usually come from a number of sources: those that are required by law or regulation as well as items reflecting the board’s desire to review the group risk. During the meeting, a review of issues that relate to the group chief financial officer, the external auditors and the BP general auditors are reviewed. Information on issues that may be included in the agenda of a meeting usually come from the chief financial officer, the internal auditor and the external auditors, (BP Plc Annual Report and Accounts, 2006). The committee also reserves the right to meet with the external auditors in the absence of the executive directors. In addition, the committee is free to seek external advice from independent consultants if it deems necessary. For example, in 2006, the committee received external specialist legal and regulatory advice from Sullivan & Cromwell LLP. The audit committee also reviews all annual and quarterly financial results before their issue to shareholders, (BP Plc Annual Report and Accounts, 2006).
Internal controls and risk management
The audit committee is also responsible for overseeing the internal control activities of the company. For example, in 2006, the committee performed a review on risks, controls and assurance on all business divisions of BP. In addition, the audit committee reviewed the group’s long-term contractual agreements as well as the risk management approaches adopted for these agreements. In addition to its standing agenda items, the committee also discusses regulatory issues throughout the year. For example, the committee carries out a quarterly review of the group’s evaluation of its internal controls systems as required by section 404 of the Sarbanes Oxley Act of 2002.
External Auditors. Change in Audit and Non-Audit fees.
The lead partner of the audit firm Ernst and Young attends all audit committee meetings pursuant to the request of the committee chairman. Other audit partners may be invited to attend committee meetings if those meetings are related to their expertise areas. The audit committee is also required to perform an evaluation of the external auditors to determine level of objectivity, independence and integrity. In line with the independence objective, provision of non-audit services have been limited to tax and audit-related work that fall within specific categories, (BP Plc Annual Report and Accounts, 2006). Non-audit work must be pre-approved and a quarterly monitoring of all non-audit services is performed is carried out. The proportion of non-audit and audit fees which BP pays to its external auditors has changed since the Enron scandal in 2001. According to Investor Responsibility Research Center (IRRC), scandals such as that at Enron have had some impact on how much companies paid auditors in 2001/2002. Audit and non-audit fees in 2001 before the scandal showed that out of the $83 million BP paid to Ernst and Young $59 million of these was for non-audit services. The balance of $24 million accounted for audit services. Published results from the company four years after reflected a decline in audit fees which BP paid to Ernst and Young. Ernst and Young received total fees of $73million in 2006 and only 16% of this amount; approximately under $12 million was for non-audit services, (BP Plc Annual Report and Accounts, 2006). This can be explained: audit staff are also rotated regularly to ensure that objectivity and independence. For example, a new lead audit partner is appointed after every five years and a rotation of other staff is done after every seven years. In addition to the independence objective, senior staff from Ernst and Young connected to the BP audit must not be employed at BP, (BP Plc Annual Report and Accounts, 2006).
Relationship with the Internal Audit Function.
The role of the internal audit function at BP is to provide advice to the audit committee on risk identification and control. The general auditor participates in discussions with the committee in matters relating to the framework of internal controls. For example, the audit committee approved the internal audit department’s work that was to be undertaken in 2006. Two written reports of the committee’s findings were made by the internal audit department to the audit committee in 2006. Private meetings were also organized between the head of the internal audit (the BP general auditor), in the absence of executive directors, (BP Plc Annual Report and Accounts, 2006). The audit committee also evaluates the performance of the internal audit function. In addition to evaluating the performance of the internal audit, the committee also evaluates its own performance. The audit committee met a total of twelve times during the year 2006, (BP Plc Annual Report and Accounts 2006).
In addition to the above, BP has been in active compliance with the SEC rules relating to the provisions of the SOX.
Appendix B below presents the certification of the CEO pursuant to section 906 of SOX relating to BP Plc’s form 20-F filing with the Securities and Exchange Commission (SEC).
BP has also complies with section 404 of the SOX – Management Assessment of Internal Controls, and also evaluates the internal control as well as preparing a report on the assessment management’s assessment of the company (Moeller, 2004).
3.3 Accounting Standards in 2002 and 2006
3.3.1 Accounting standards in 2002.
As at 2002, being a UK-based company, BP was required to prepare financial statements in compliance with the UK Generally Accepted Accounting Principles (GAAP) as well as in compliance with the 1985 Companies Act. Its 2002 Accounts were therefore prepared following UK GAAP. In addition, being listed in the U.S BP was also required to file Form-20F with the US Securities and Exchange Commission which requires a reconciliation of UK GAAP with US GAAP.
3.3.2 Accounting Standards in 2006
Following EU regulation 1606/2002 of 19th July, 2002, BP adopted International Accounting Standards. This implies that it was a first time user of International Accounting Standards as per IFRS1 First Time Adopters of International Financial Reporting Standards. (Epstein and Jermacowicz, 2007). IFRS 1 requires retrospective restatement of prior period financial statements, not prepared in accordance with IAS. BP therefore restated its 2004 financial statements to comply with IFRS 1 as well as ease compliance with EU Regulation 1606/2002.
The Annual Reports and Accounts of BP for the year ending 31st December 2005 therefore included BP’s first consolidated financial statements that were prepared in compliance with International Financial Reporting Standards, (BP Plc Annual Report and Accounts 2006). Some of the main changes that may be expected to affect BP as a result of this change is the fact that under UK GAAP research and development costs were to be capitalized while under UK GAAP they were being expensed. IAS 38 Intangible assets however requires the separation of research and development costs into research and development (Carkey and Hadden, 2006). Research costs are expected to be expensed while development costs are expected to be capitalized.
From the foregoing, BP is therefore expected to have more assets in its balance sheet following the adoption of IFRS as opposed to when it was using only UK GAAP. Expensing research and development cost often leads to understatement of earnings in the income statement as well as assets in the balance sheet, (Penman, 2003). This in turn makes it difficult for the value of a company to be reflected from the balance sheet.
Summary and Analysis of Key Findings, Conclusions and
4.1 Summary of Key Findings
The key findings in this study can be summarized as follows:
That the cause of the accounting scandals were as a result of bad management and weak internal controls; pressure on management to produce high earnings and good performance; investors’ irrational exuberance; continuous dependence of auditors on CEOs and CFOs for auditing contracts; failure on the part of accounting standard setters; failure of accounting education to train future accounting students as well as other business students on ethical issues related to accounting; equity-based compensation plans; and ignorance of applicable laws and regulations on the part of auditors.
That the scandals resulted in a reduction of big five accounting firms from five to four; significant decrease in stock prices; corporate bankruptcies; financial statement restatements; and huge financial losses on the part of investors, creditors, and employees.
That a number of stakeholders including regulatory bodies, Accounting Bodies and Governments responded to the scandals by passing new laws and regulations for example the passage of the SOX Act and the subsequent creation of the PCAOB; issuance of new accounting standards; switch from a completely rules-based accounting standards system to a mixed accounting systems made up of a blend of rules-based standards and principles-based standards;
-That BP Plc adopted international accounting standards in its 2005 financial statements retrospectively restating its financial statements in 2004 prepared in accordance with UK GAAP to reflect IFRS standards.
-That BP Plc complies with all applicable sections of the SOX.
4.2 Analysis of Findings.
The first finding relating to causes of the accounting standards indicate that if bad management, weak internal controls, dependence of auditors on CEOs and CFOs for auditing contracts equity-based compensation, etc, could be reduced, then such scandals can be avoided in future. In addition, if auditors could be more aware of applicable laws and regulations, then they would easily identify non-compliance or illegal acts on the part of the management and thus point this out as early as possible. Also if students could be trained properly on ethical issues, then they would act with more integrity, independence and scepticism when carrying out professional engagements in the future careers as accountants or auditors.
As concerns the consequences, it is obvious that these consequences would occur. It is evident that when a company is not performing well or if it is suffering from poor management, then it must be subjected to the discipline of corporate bankruptcies, takeovers, financial losses and a fall in stock prices.
4.3 Conclusions and Recommendations.
Based on the findings above, one can conclude that the accounting scandals brought about significant changes in the accounting profession across the globe as well as changes in laws and regulations relating to the practice of accounting. One can also conclude that BP Plc complies with all the new applicable laws and regulations. This can be reflected in its adoption of IAS/IFRS in 2005 as well as its constant filings with the SEC in relation to relevant sections of the SOX Act. BP has also changed it corporate governance structure to be in compliance with the provisions of SOX. Non- For example, the non-executive directors are completely independent of the management and external auditors are not allowed to perform non-audit services above a certain limit as was the case with Anderson and Enron. In addition, non-executive directors are not allowed to provide consultancy, management advisory, or any other related services for a fee as this is expected to impair their independence as non-executive directors as well as reduce their ability to serve as watchdogs of the executive directors. The SOX Act as well as the adoption of IAS/IFRS has therefore improved internal control, management as well as Financial reporting at BP Plc and have therefore reduced the likelihood that such scandals can occur at BP Plc in future. For example, the Board of Directors of BP ensures that audit engagement teams are completely independent of the company. In addition, non-audit services are placed at a minimum and the head of the audit team as well as team members are rotated from time to time to ensure that they do not form strong bonds with the company, which may in turn impair their independence when expressing an opinion on the financial statements. All these are in compliance with SOX, which in turn go a long way to improve financial reporting producing financial results that are free from material misstatements that can collectively or individually affect users’ decisions on the financial results.
Despite the success of SOX and accounting standards to eliminate accounting fraud, full elimination of accounting scandals can only be achieved only to the extent that auditors, accountants, CEOs, CFOs, internal auditors, board of directors, internal auditors and employees are willing to act with integrity, professional skepticism, objectivity and independence. Minimum ethical requirements should be placed on accountants, CFOs, CEOs and other employees directly concerned with financial statement preparation. This paper also recommends that other companies in Europe should adopt the provisions of the SOX irrespective of whether they are listed in the US or not. The European Union should require EU listed companies to comply with SOX. This will go a long way to improve financial reporting in Europe as well as increase investors’ confidence in financial results.
4.4 Areas for Further Research
In the course of the study, Renon (2002) proposed financial statement insurance as a safeguard to financial statement fraud. A study investigating the feasibility of financial statement insurance is therefore desirable. In addition, this study focused only on one single company, another study investigating a handful of European companies is also necessary to better understand how SOX and other regulations have helped to mitigate financial statement fraud.
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