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Rotation Of Auditors: Cure Worse Than The Disease?

Published on Wed, Feb 13,2013 | 23:06, Updated at Wed, Feb 13 at 23:06Source : 

By: Sunil Kothari, Deloitte Haskins & Sells

The Companies Bill, 2012 (Bill) passed in the Lok Sabha on 18th December, 2012 is poised to replace the law governing companies in India which was prevalent for more than half a century. The Bill is set to address the contemporary need of corporate regulation in India proposing many radical changes in regulation and governance. One such area is the regulation of the audit profession and the independent auditors through, amongst other measures, the proposed ‘National Financial Regulation Authority’ to be constituted by the Central Government which would regulate matters relating to accounting and auditing policies and standards. The Bill also prescribes making rotation of auditors mandatory for the listed and certain prescribed class of companies after two consecutive terms of five years in case of a firm of auditors and single term of five years in case of an individual.  A transition period of three years is provided to the companies to comply with the mandatory requirement of auditor rotation.

The periodic rotation of a company's auditor is a matter which is being raised from time to time as a possible way of ensuring and enhancing auditor independence and audit quality. The matter of mandatory audit rotation has been widely discussed and debated across the globe and has also been implemented in a few countries, while in few other countries this was introduced and subsequently reversed as it did not really succeed in meeting the objectives of auditor independence effectively.

High quality auditing requires that the auditor is competent and objective. It is perceived that a long-term relationship between an auditor’s and their audit client could create a risk of excessive familiarity that might impair objectivity and independence. Thus some advocate that mandatory rotation of audit firms would not allow such long-term relationships to develop.

However, various studies carried out on this subject suggest that there are serious disadvantages in mandatory rotation of audit firms. The studies highlight how changing auditors can be a costly and sometime risky endeavor that should not be undertaken without careful and thorough consideration. A survey conducted by the General Accounting office in United States of America revealed 71% of the Tier One firms (the 97 public accounting firms that audit at least 10 public companies) and Fortune 1000 public companies expressed that changing firms increases the risk of failure in the early years of the audit. It also found that approximately 90% of Fortune 1000 public companies and audit committees did not support mandatory audit firm rotation. The October, 2004 Fédération des Experts Comptables Européens (FEE) study, titled “Mandatory Rotation of Audit Firms,” reviews reports by governments, regulatory bodies, and academics on mandatory auditor rotation, including analysis from Italy, Spain, the United Kingdom, and the United States, and concludes that mandatory audit rotation threatens audit quality. A study carried out by the Institute of Chartered Accountants of England and Wales summarizes various researches and publications supporting a correlation between audit failures (like fraud related cases etc.) and changes in independent auditors, this is due to the newly appointed auditor’s lack of client knowledge; such knowledge is critical to the early discovery and resolution of problems that may threaten a business.

Some arguments in support of mandatory auditor's rotation -:

Regular audits should not become a sort of long term annuity for the audit firm paid for by the company being audited, rather than being responsive to the investing public.

Since the tenure of the independent auditor would be limited, the auditor’s incentive for resisting pressure from management would be increased, and a new independent auditor would bring a fresh viewpoint (development of new perspectives and new insights).

The new auditor's ability to revisit established accounting positions.

A different audit firm's knowledge and ability to better meet the broad needs of the company.

The argument that mandatory rotation would lead to improved audits is countered by other arguments, including that with auditor change comes increased risk, (unnecessary) revisiting settled accounting positions by a new auditor who may not yet fully understand the company, additional time, effort, and cost of bringing in a new firm, and a possible erosion of confidence in the audit.

The relationship between a large, diverse organisation and its auditor’s is complex and is often developed over years. The in-depth understanding of a large company with diverse or global operations, is acquired not in a short period.

From the management's perspective based on thoughts put forth by the professionals of large global organisations, specialized industries, (like energy, oil, consumer product etc.) are complex and require expert auditors. "These complexities can require significant time to comprehend". Mandatory change in audit firms would result in disruption to business and loss of auditor knowledge. The institutional knowledge of the audit firm enables them to assess risk and design audit procedures. The requisite knowledge can't be effectively gained over a few years. It is built over much more time. Also a change in auditor if required should be at the choice of the stakeholders. A forced change takes away the right of choice and ability to effectively and efficiently plan the transition.

Some thoughts on the challenges that could arise from a mandatory rotation of auditors:

Significant time commitment from management and the board.

Effort required to educate the new auditor

Different interpretations of established accounting treatments

Distraction from key priorities

Time and effort required to develop efficiencies

Possible increase in  costs

The challenges mentioned above create threats to audit objectivity and quality. This is definitely not intended when it comes to assurance to the stakeholder including public at large. As an expert put it, to introspect, the cure could be worse than the disease, depending on the amount of time people would be required to rotate off.

The perceived audit quality benefits from firm rotation are achieved in many countries through alternative means, including rotation of the audit partner every five or seven years, appointment of independent review partners, internal quality control procedures and external oversight of the work of audit firms. These steps are sufficient to mitigate the risk of excessive familiarity and to assure auditors’ objectivity. Today, with the emphasis and increased scrutiny on corporate governance, it seems reasonable to assume that audit committees will play a greater role in critically monitoring auditor performance, not necessarily achieved by auditor rotations.



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