The mandatory rotation of audit firms continues to be proposed as a way to promote the independence of the audit process. However, South Africa’s governance savvy has ensured we already have a workable solution that has proved to be effective, writes Parmi Natesan
The mandatory rotation of auditors is one of those issues that seem to flare up and then die down – but never completely, despite opposition from the profession and business.
The European Parliament approved a directive in 2014 to force companies listed in Europe to appoint a new auditor every ten years1 and in the United States the Public Company Accountancy Oversight Board published a concept paper on the issue. The latter provoked a bipartisan bill in the House of Representatives amending Sarbanes-Oxley to prohibit the board from requiring public companies to use specific auditors or to rotate auditors. Other industry bodies, such as the American Institute of Certified Public Accountants, are also opposed to the principle.2
While there’s clearly no unanimity on this topic, it’s clear that the global mood is generally skewed towards government intervention legislating towards mandatory audit firm rotation. Here in South Africa, at any rate, we already have a tried-and-tested approach to promoting the independence of auditors, and we should avoid this type of legislation and its unintended consequences.
One of these would be the loss of industry and company knowledge built up by a long-term auditor. Taking on new auditors requires huge input by the company’s management, a hidden cost for shareholders.
Long-time auditors are also, theoretically at least, best placed to pick up subtle changes year-on-year that could indicate problems – though it could be argued that they might also sink into complacency. However, research3 has shown that most fraudulent financial reporting and audit failures occur in the first three years of an auditor’s tenure, which would indicate the value of experience.
BOARD AND SHAREHOLDER OVERSIGHT IS CRITICAL
There are other factors in the South African business environment that would strongly tend to counteract possible complacency, or a lack of an independent mind and professional skepticism. These include the fact that both King III and the Companies Act require an independent audit committee which is explicitly required to recommend auditors based on their independence, and to monitor and report on that independence each year (Principle 3.9 of King III and sections 94(7)(a) and (f) of the Companies Act). The Act also provides guidelines audit committees should use to assess an auditor’s independence (in section 94(8)).
In other words, board oversight is being used as a way to temper any tendency for an over-cosy relationship between auditor and management. As important, though, is the fact that shareholders have to approve the appointment of auditors annually, thus giving those with most to lose the means (and the responsibility) for making the right choice. In an age of growing shareholder activism, this places the power where it belongs and will be exercised.
I also think it’s worth noting that by making auditor rotation a statutory requirement, we would be promoting a tick-box mentality. While mandatory rotation of auditors would definitely give the appearance of greater independence and thus better financial control, it might really be no more than that.
A surer defence is to continue strengthening the capacity of audit committees to discharge their existing responsibility to ensure that auditors do their work properly – and to support a culture of shareholder involvement. Another important safeguard is the fact that the codes of professional conduct for SAICA and the IRBA contain measures promoting independence, including partner rotation at the audit firm (similarly there are the Companies Act and King III requirements for audit partner rotation).
One might even consider ways of encouraging the wider group of stakeholders to scrutinise auditor independence. Employees, for example, would be in a good position to ring alarm bells about irregularities during an audit, and the whistleblower mechanisms could be used to channel this information to the audit committee.
I believe we have good measures in place for ensuring auditor independence. These measures are not isolated, but part of a governance system that has received global recognition and on which we should build. In fact, introducing a new statute requiring mandatory audit firm rotation could do more harm than good. In particular, it would tend to work against our attempts to make strong governance intrinsic to the way companies work, and not something that is imposed from outside.
1 European Parliament backs commission proposals on new rules to improve the quality of statutory audit, European Commission press release, 3 April 2014, available at http://europa.eu/rapid/press-release_STATEMENT-14-104_en.htm. See also Analysis: mandatory rotation of audit firms, Accountancy SA, 2 October 2014, available at https://www.accountancysa.org.za/analysismandatory-rotation-of-audit-firms/. It’s worth noting that these directives simply specify the desired goal and leave it up to member countries to work out their own solutions to achieving it.
2 Ken Tysiac, Bill prohibiting mandatory audit firm rotation passes US house, Journal of Accountancy, 8 July 2013, available at http://journalofaccountancy.com/news/2013/jul/20138294.html.
3 Research paper on audit firm tenure and fraudulent financial reporting, available at http://corpgovcenter.utk.edu/research/audfirmtenurecar2004.pdf.
Author: Parmi Natesan CA(SA) is Executive: Centre for Corporate Governance at the Institute of Directors in Southern Africa