Mandatory Rotation of Auditors

Abstract

In light of a number of high-profile corporate failures during the first half of 2001, a number of studies have been performed to address the impact of mandatory rotation of audit firms to ensure the appropriate level of 'independence' of auditors. Majority of studies conclude that the detrimental effects of firm rotation on the quality of the audit work by far outweigh its positive effects as a safeguard against various independence and quality threats.

Frequent changes of audit firms, whether resulting from mandatory rotation or otherwise, introduce threats to independence and operational difficulties that make audit failure more likely. Many studies have involved practitioners' opinions on this issue, which have been based on their experiences and is therefore necessarily more subjective than from impartial, third party studies. There are differing opinions, as some audit firms wish to preserve the client bases, while others welcome more market volatility. Mandatory firm rotation has been concluded as an unnecessary step at present, whose main impact will be the auditing profession and its ability to attract talent for the future. At a time when the restoration of public trust in financial reporting is a key priority, such changes should be avoided.

Background

Following the failure of HIH Insurance and other listed Australian companies during the first half of 2001, concerns were raised about the adequacy of Australian rules governing audit independence. Auditor independence is fundamental to the credibility and reliability of auditors' reports. Independence is defined to require "... a freedom from bias, personal interest, prior commitment to an interest, or susceptibility to undue influence of pressure, any of which could lead to a belief that the audit opinion was determined other than by reference to the facts of the audit alone."

With the increasing globalistion of capital markets and the fact that that section 324 of the Corporations Act in relation to the independence of auditors had not changed in any substantiative form for at least 40 years, it was recognised that this area required attention and revision. The existing regulation prior 2004 of the auditing profession was predominantly the responsibility of the professional accounting bodies. Whereby the legislative requirements were "minimal" and "piecemeal."

International developments were in progress by International Federation of Accountants (IFAC) which aimed to update the ethical requirements of audit independence. European Commission released a consultative paper containing proposals designed to achieve greater uniformity throughout Europe & United States Securities and Exchange Commission's (SEC) had decided to remake its rules on audit independence to address issues associated with recent independence violations by auditors in the US.

As a part of the growing recognition of the desirability of achieving global uniformity and harmonisation in all areas of financial reporting and auditing, many studies and discussions including the Ramsay report were instigated since 2001 . The CLERP (Audit Reform & Corporate Disclosure) Act 2004 implemented the CLERP 9 measures and the recommendations of the Ramsay Report on the independence of Australian company auditors and took into account the relevant recommendations of Report 391 of the Joint Parliamentary Committee of Public Accountants and Audit.

The CLERP 9 Act draws on the HIH Royal Commission (HIHRC) , Cole Royal Commissions Report and the Ramsay Report in focusing on the importance of an independent audit on capital market efficiency. This is to be achieved through adding value to financial statements by improving reliability, which in turn should assist to lower the cost of capital by reducing information risk and enhancing value to capital market by strengthening the credibility of financial statements.

The many arguments for and against Mandatory audit firm rotation was considered as part of this reform however, the Audit Review Working Party concluded that 'the anticipated cost, disruption and loss of experience to companies is considered unacceptably high, as is the unwarranted restriction on the freedom of companies to choose their own auditors' As an alternative, mandatory rotation of the audit partners was included in the CLERP Act 2004 , whereby rotation is to occur after 5 consecutive years with a 2 year cooling off period before a person who has played a 'significant role' in the audit can be reassigned to that audited body.

Arguments 'For' & 'Against' Mandatory rotation of Audit firms

The arguments for and against mandatory rotation of audit firms fundamentally revolves around the issues of auditor independence, audit quality and increased audit costs. Compromising either auditor independence or audit quality will adversely effect the accuracy of audits performed and hence effect the shareholders' future.

The significance of mandatory rotation of audit firms on an auditor's independence and quality of audit can be evaluated on a large number of factors, such as length of time an individual has served, the role of the individual, the size and structure of the firm, the nature of the engagement and whether the client is a public interest entity or not.

There are numerous threats to the independence of auditors which have been identified in the multiple studies and discussions both in Australia (such as the Ramsay report, CLERP 9 Paper) and internationally by IFAC, the European Commission and SEC. The key threats identified are over-familiarity, self-interest, advocacy and intimidation of auditors.

Over-familiarity

Mandatory firm rotation avoids over-familiarity between the auditor and client and removing the 'undesirable nexus between client and auditor'. As the auditor may be perceived as too trusting because of familiarity, thus resulting in insufficient professional scepticism or testing of representations made in the firm's disclosure statements.

Self-Interest

This issue of 'self-interest' by the auditor may potentially influence an audit judgement arising from the auditor benefiting from a financial interest or self-interest conflict such as a desire to retain the client.

Advocacy & Intimidation

The independence of auditors can be strengthened through mandatory firm rotation, when the auditor becomes an