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Will rotating audit firms harm the quality of auditing?
May, 21st 2014

Last month, auditing firm PricewaterhouseCoopers came out with a special audit of commodity exchange MCX that has restarted the whole debate about companies changing their auditors every few years. The report found several irregularities in the way MCX was operating since 2003, its year of inception. Indirectly, the scathing report has also raised question marks on the role of a company's statutory auditors.

The new Companies Act that came into force in April has made it mandatory (for companies) to rotate their audit firms every five years. The argument in favour of this rule maintains that a long period of working relationship between the auditor and the management significantly affects the former's independence. Others, however, believe that frequent rotation harms audit quality and makes it difficult for the auditor to spot frauds.

Suppose the management of a company is already engaged in some kind of fraud when it changes its auditor. The new auditor will find it very difficult to catch the fraud because by the time the new auditor learns the business, it will be too late. Ultimately, the watchdog will change but the thief remains.

It is widely known that India has a shortage of good auditing firms. According to some estimates, India has only 90,000 practicing chartered accountants. There are just 230-odd auditing firms which have 20 or more partners. There will be a complete chaos three years down the line when the cooling-off period (to rotate audit firms) expires.

Let us look at the global scenario. The largest economy in the world - the US - has concluded that audit firm rotation can be harmful and thus moved to the partner rotation system some years ago. Audit partner rotation happens every five years. But it seems even that is not working. A March 2014 research paper released by the American Accounting Association finds evidence of lower financial reporting quality following an audit partner change.

"We find lower financial reporting quality during the first two years with a new audit partner relative to the final two years with the outgoing partner. We find the lower financial reporting quality to be more prevalent for larger clients," the report points out.

Till early last year, some 30 countries, including Brazil, China, the Netherlands and Turkey, required some form of mandatory firm rotation. The practice of audit firm rotation has also received backlash in several countries. Countries such as Singapore, Canada, Latvia, Czech Republic and Slovak Republic have annulled rotation rules owing to diminishing audit quality and other reasons.

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