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Auditor's rotation may ensure Independence
October, 04th 2010

Legally, the auditor provides a reasonable assurance to shareholders, who appoint it, that financial statements provide true and fair view of the financial position and performance during the year. Although the auditor reports to shareholders, it is accountable to all stakeholders of the entity because they rely on the audit report. The auditor is privy to all records and documents and has the competence to form judgement on the true and fairness of financial statements.

The judgement can be relied on only if the auditor holds its independence. Therefore, auditors independence is an issue that bothers all stakeholders. The Companies Act includes provisions to protect the independence of auditors by providing for rights of auditors and the process of appointment and removal of auditors.

Independence is a state of mind. Therefore, the mental makeup of an individual determines how stro-ngly he/she holds his/her indepe-ndence. However, as an audit firm grows, independence of the firm is driven by the quality of internal governance. It is the responsibility of senior partners and the governing board to set the tone at the top. Audit failures have brought out internal governance problems in big audit firms. This has raised concerns on independence of auditors.

The Standing Committee on Finance has expressed strong concern about the independence of auditors. In response to the same, it is proposed to include two new requirements in the new Companies Act to protect auditors independence. One relates to the rotation of auditors and audit partners and the second relates to the prohibition on the auditor to provide other services to the client.

If the proposal is accepted no company shall appoint or re-appoint an auditor for more than five consecutive years. An audit firm which has completed a consecutive tenure of five years shall be eligible for re-appointment as auditor in the same company after a gap of five years, the cooling off period.

The auditing partner of the firm should be rotated by the audit firm on completion of three consecutive years. In this case, the cooling off period is three years.

Proponents of the policy of rotation of the auditor argue that the auditor, by the very nature of the task, work closely with the executive management. Therefore, when an auditor serves its client for a long period, it develops some kind of proximity with the executive management, which exposes the auditor to the risk of subtle pressure on its independence. In most situations, auditors find it difficult to handle such subtle pressures.

Therefore, rotation of auditor protects the independence of the auditor. With the same logic, the rotation of the lead partner improves independence. On the other hand, those who do not favour the rotation of auditor argue that rotation may not achieve the desired objective because large companies have limited choice in selecting the auditor. This might lead to formation of cartel among large audit firms.

Another argument that is put forward is that the rotation policy will discourage small- and medium-size audit firms to invest in technology and training because of the uncertainly of securing another client of the same size operating in the same industry because only a few large players operate in a particular industry. Arguments from both the sides have strength. Therefore, the issue of rotation of auditor is yet unsettled.

It appears that the government has made up his mind to incorporate the provision of rotation in the Companies Act. Therefore, rotation of the auditor and the auditor will be the legal requirement in the near future. The auditing profession should take the challenge.

The onus will be on the auditing profession and leading audit firms to ensure that cartel is not formed and all the audit firms demonstrate high standard of ethical behaviour. Small and medium-size firms, which aspire to grow and succeed in a competitive environment, should explore the possibility of merger with other firms of the same size or with large firms.

Only large audit firms will be able to secure audit of listed companies. However, there will be large number of small entities, which will require individualised service. Small audit firms, which do not have high aspiration for growth, will serve those entities. There is no reason to worry too much about the new provisions.

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