Is rotating auditors a good idea?

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The fall of Lehman Brothers has reignited the debate on the rotation of auditors.
The fall of Lehman Brothers has reignited the debate on the rotation of auditors.

Mandating rotation will open up more opportunities for mid-size audit firms.

There is an old saying that equates the medical, legal and accounting professions, by holding that one should never lie to one’s doctor, lawyer and auditor. In reality though, these professions are as different as chalk and cheese.

Ever since Enron filed for Chapter 11 bankruptcy in 2001, the auditing profession has come under serious scrutiny by regulators. It can be said that Enron-type disasters have not occurred in the medical and legal field, even though there have been isolated examples of wrong medication taking away life or suppressed evidence winning cases.

In the case of auditors, their failure to predict the downfall of Lehman Brothers, despite the latter’s highly leveraged balance sheet, has also reignited another debate. That has to do with rotation of auditors, among other new measures for regulating the profession.

The strongest measures here were proposed in late 2010 by the European Union Internal Market Commissioner, Michel Barnier. The 27 member-nation bloc’s top financial regulator not only proposed that big audit firms split up their audit and consulting divisions, but also sought frequent rotation of auditors and mandatory joint audits for some companies.

Following hectic lobbying, though, most of these proposals have since been dropped and auditors are now to be rotated once in 25 years. This is a complete mockery of the original proposal, as rotating audit firms in a quarter of a century is as good as not rotating them! In today’s age of mergers and acquisitions, besides private equity, not many companies arguably would last 25 years in their original shape.

One hopes that the Companies Bill now before Parliament in India — which provides for rotation of auditors every five years — will not end up aping the EU provisions!

The case against

Inevitably, the arguments on rotation of audit firms go both ways. The argument that rotation of audit firms would promote independence may not really fly, as it is always possible for the auditor to get cozy with the management within days of being appointed.

Alternatively, he can remain aloof forever, as independence is more a state of mind than something that can be enforced by regulation.

Various studies carried out on the subject, in fact, suggest serious disadvantages with mandatory rotation of audit firms. They highlight how changing auditors can be a costly and sometime risky endeavour that should not be undertaken without careful and thorough consideration.

One survey, conducted by the General Accounting office in the US, showed 71 per cent of the 97 tier-one public accounting firms (which audit at least 10 public companies) and Fortune-1000 companies as expressing that changing firms increases the risk of failure in the early years of the audit. It also revealed that approximately 90 per cent of the Fortune-1000 public companies and audit committees did not support mandatory audit firm rotation.

Likewise, a 2004 Fédération des Experts Comptables Européens (FEE) study, titled “Mandatory Rotation of Audit Firms,” reviewed reports by governments, regulatory bodies, and academics, besides including analysis from Italy, Spain, the UK and the US. It concluded that mandatory audit rotation threatens audit quality.

A study carried out by the Institute of Chartered Accountants of England and Wales, too, summarised various researches and publications, which supported a correlation between audit failures (such as fraud-related cases) and changes in independent auditors.

This, in turn, was primarily attributed to the newly appointed auditor’s lack of client knowledge, which is critical to the early discovery and resolution of problems that may threaten a business. It was also felt that rotation of auditors could threaten audit objectivity and quality, as there could be an investment in time and money that may not necessarily yield satisfactory results.

The case for

The arguments for rotation, however, are that the new auditors could bring in a fresh perspective to the business. The audit quality would also improve, as the new firm would not be saddled with any past baggage while going about its job.

Mandating audit firm and partner rotation for large companies would probably be worth a try. This, for one, would provide a good opportunity for mid-size firms to conduct the audit of large entities — an opportunity they would not like to bungle by compromising on audit quality. It would also ensure that the audit of large companies is spread out across audit firms and not top-heavy, thereby levelling the playing field.

The above method is being followed in the audit of banks and government companies. There could be some audit blemishes by these small firms; but then rules are normally made for the masses that follow them and not the minority who skip them.

Adequate penal provisions in the Companies Bill and other regulations would ensure that audit firms and their partners would be careful enough not to get onto the wrong side of the law.

(The author is Director, Finance, Ellucian.)

(This article was published on May 9, 2013)
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