Mandatory audit firm rotation is being evaluated worldwide, and here in India the Companies Bill 2011 has proposed it. The move has sparked widespread discussion among capital market participants and other stakeholders. The most important consideration would be whether mandatory audit firm rotation can achieve its central objective — increasing auditor independence and audit quality.
Quality of an audit
The auditor’s cumulative knowledge of the company’s business, people, processes, controls and risks plays a significant role in audit quality, which would be lost with the shorter terms mandated. Research shows that faulty audit work often surfaces in the first years after a new auditor takes over, when there is less experience of working with the company.
Audit Committee effectiveness
Audit committees and the investors they represent may find that their freedom to decide which audit firm best suits the needs of their company and stakeholders is taken away by the introduction of mandatory audit firm rotation.
Cost and Complexity of audits
Changing auditors on an arbitrary schedule, regardless of the company’s circumstances, will be disruptive both for the company and the auditor. For instance, companies will be forced to spend extra time and effort to manage the rotation process and bring the new auditor up to speed. This could be a daunting task if the company is experiencing difficult circumstances, or going through significant corporate developments.
market forces and consensus
Mandatory audit firm rotation reduces competition in the audit market because the current audit could not be eligible, even if there is no alternative. Most countries do not have mandatory rotation for audit firms. Some have considered but rejected it, while others have adopted it and later reversed their decision.
The US, Australia, the UK and 54 other countries do not mandate rotation of audit firms. India, China, Brazil, Pakistan and 13 other countries have made this necessary for some entities. In India, mandatory rotation of audit firms is necessary for banks and insurance companies. In Cambodia, Indonesia, Italy, Qatar and six other countries, audit rotation is mandatory for all entities. Canada, Greece, Spain and seven other countries introduced the system and later rejected or suspended it.
A majority of audit committees have said they do not believe mandatory rotation is an effective way to achieve the stated goal. This leads to the question of suitable alternatives. There are detailed rules in place already to safeguard independence in India, implemented by the Institute of Chartered Accountants of India, which have been effective. In addition, these steps can help improve the perception of audit quality and independence:
Better co-ordination and communication between the regulators, auditors and audit committees — to build a mutual, consistent and efficient approach.
Increased standards of inspection for audit firms.
Transparency on the general conduct of the audit (process/methodology, scope and materiality, accounting estimates and judgments made by management, and fraud and other risks).
Transparency on how the audit committee evaluates the performance of the auditor, the criteria and timetable used for assessing the audit, the basis for recommending appointment/reappointment of the auditor, the choice of non-audit services provided by the auditor and his/her fee, and how the auditor complies with rules and laws on independence.
Stronger governance by audit committees to assess auditors’ independence and objectivity, evaluating changes in accounting standards, sharing overall results of auditor’s inspections with the company, and having minimum mandatory competency requirements for audit committee members and so on.
Restrictions on non-audit services that present an insurmountable threat to independence and pre-approval by the audit committee for all non-audit services
Harinderjit Singh, Partner, Price Waterhouse