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Mandatory rotation of audit firms need not enhance corporate governance
September, 15th 2010

Familiarity rarely breeds contempt between companies and their auditors. More often than not, it results in a level of comfort that weakens auditor independence and reduces audit quality. The price of that closeness is then borne by the non-promoter shareholders, investors, employees and other stakeholders in the company. Sometimes, it threatens the survival of the company. Such relationships are believed to be the cause for the multi-crore financial fraud at Satyam Computer Services as well as for the collapse of Lehman Brothers in recent years and for the demise of Enron and WorldCom in the early part of this decade.

The US administration responded to the many instances of corporate fraud with Sarbanes-Oxley Act of 2002, which, among other things, required mandatory rotation of the lead audit partner and the concurring partner every five years, and cooling off period of five years before that partner could audit the same company. Other partners of the audit team are to be rotated after seven years, with two-year time-out from that account. The Act did not seek mandatory rotation of the audit firm.

For that matter, very few countries such as Italy, Brazil and South Korea have stipulated mandatory rotation of the audit firm, most others have stipulated only rotation of audit partners.

Cross over to India. The fraud at Satyam, no doubt a bolt out of blue, appears to have had a deep impact on our lawmakers. So, the ministry of corporate affairs is now planning to make rotation of not just the audit partners but also of the firms mandatory. The proposal came up during the review of the Companies Bill of 2009 by the standing committee on finance, chaired by former finance minister Yashwant Sinha. The committee wanted such provisions in the Act to prevent recurrence of frauds perpetrated by promoters and managements in connivance with the auditors of the company. If the proposal does find its way into the Act, the companies will need to find themselves a new audit firm every five years.

Thats not all. Individual auditors cannot hope to continue their association with the client after they have completed 3-5 years of consecutive term by hopping to another firm. A time-out stipulation would make him ineligible for such reappointment for three years. For the audit firm, the cooling off period is proposed to be five years. Also, firms will need to rotate audit engagement partner after three years.

Such proposals to ensure auditor independence would without doubt sound good on paper and are well intentioned. But the feasibility of implementing such proposals is debatable, particularly when the audit business is highly fragmented and the firms are small. A majority of audit firms in the country are small setups with a handful of partners. Most of them would not have the capacity or the capability to audit accounts of large firms. Besides, most companies would prefer to work with established names in the business. So, more likely than not, mandatory rotation of firms would result in audit mandates circulating among the same set of firms. That will defeat the purpose of trying to break the cosy relationship between company managements and auditors.

The economic benefits of mandatory rotation of audit firms have yet to be established globally. Proponents of mandatory rotation feel that new auditors will bring in fresh points of view that the outgoing auditor may not have. Opponents, however, would disagree: they feel that an incoming auditor would take time to understand the business of the client, and during that period, the quality of audit may be impaired. And, it is not necessarily true that rotation would prevent auditors from getting very comfortable with the company or turning a blind eye to non-compliance with law.

India Inc has all along been opposed to the mandatory rotation of audit firms. Almost all the committees on corporate governance set up in the past few years have favoured rotation of audit partners rather than rotation of audit firms. The last one, a CII taskforce on corporate governance chaired by Naresh Chandra, too in its report of November 2009 recommended rotation of audit partners every six years, with a three-year cooling period before the partner could resume the audit assignment. The Naresh Chandra committee of 2002 and JJ Irani committee of 2003 too had favoured rotation of partners rather than firms.

The wisdom of the legislating mandatory rotation of audit firms, when mandatory rotation of audit partners is not yet required under law, needs to be questioned, even though it is well intentioned. It may make more sense to begin with mandatory audit partner rotation and then consider moving to firm rotation. Alongside, the government could also stipulate that joint audit by two firms to improve corporate governance.

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