Auditor rotation: Are we going round in circles?

Auditor rotation is the practice of mandatory changes in auditors to keep a fresh set of eyes on accounts and to prevent overfamiliarity that could lead to misstatements and misrepresentation in financial accounts.

As a practice, it goes in and out of fashion. Around the world, South Korea, Argentina, and Brazil have each implemented and discontinued the policy for certain sectors. EU-wide auditor rotation rules came into force on 17 June this year, based on an EU directive that was originally published in May 2014. These have already been introduced in the United Kingdom, but some member states (such as Spain and Italy) had previously implemented and discontinued the policy. Back in 2013, the U.S. House of Representatives voted overwhelmingly to prohibit the Public Company Accounting Oversight Board from requiring mandatory audit firm rotation. Then, in a single week in early October, the South African Independent Regulatory Board for Auditors announced that it would be introducing mandatory audit firm rotation and Singapore’s Monetary Authority announced it would be discontinuing mandatory auditor rotation.

Compliance Week spoke to Fayez Choudhury, the CEO of the International Federation of Accountants (IFAC), to understand why so many jurisdictions are going round in circles.

“As you know, there is quite a bit of discretion in the EU directive on auditor rotation for member states, and it seems that different jurisdictions are implementing the law in different ways, leading to a patchwork of regulation. But this makes it very difficult,” continued Choudhury, “especially for multinationals who would like to retain the same auditor across all the different jurisdictions in which their company operates.” This is certainly the case if one country requires an audit rotation every 10 years, one every 20 years, and one not at all.

But Choudhury also pointed to concerns that the way regulations were drafted and implemented was often antithetical to business. “We did a survey last year,” he said, “of business people in different sectors on the broader issue of regulation, and the responses we got were very striking–regulations were overly complex, they increased risk rather than reduced it, they were stunting growth, and there was regulation fragmentation.” To find a solution to this problem, IFAC convened a couple of roundtables to come up with some principles of smart regulation (see sidebar).

Ten Principles for High Quality Financial Regulation

Clear objectives in the public interest
Proportionate and balanced approach
Evidence-based assessment
Appropriate resourcing for regulators
Collaborative action
Consistent and coherent
Active oversight
Transparent and open consultation
Systematic review
Deliberate enforcement
Source: IFAC

“We ran two roundtables,” he explained, “in Hong Kong and London, with a diverse set of stakeholders, discussing regulation as a whole rather than just regulating auditors, and there was a general consensus that we needed to move from regulation to smart regulation.”

Choudhury noted the South African and Singapore announcements. The reasons for the MAS discontinuation of the policy, he understood, were research studies that did not show a link between audit firm rotation and an improvement in audit quality. “The MAS is a pretty robust authority, one of the most rigourous around, and it would not quote lightly if it did not believe that the studies were convincing.”

But Choudhury also felt that much more work into understanding the auditor client relationship was needed, across all jurisdictions. “We need more research into the feasibility and impact of auditor rotation. It shouldn’t be difficult to get. We have a lot of information on one side of the equation—problems with overfamiliarity—but it seems very little from the other side, the introduction of unintended consequences and risks. There are many different views on whether there are benefits to it [rotation] or not, but how significant is it in improving audit quality? One thing the Singapore situation shows, however, is that if it doesn’t seem to be working, authorities can reverse the legislation.”

Choudhury cited the Singapore development as one of the ways smart regulation could operate.  “Around the world, we need more governments like Singapore with the courage to review and analyze regulation that has been implemented. Informal conversations are a good place to start. Getting the regulated and the regulators together to concentrate on a clear objective that will be in the public interest, is crucial. It should not be about flexing muscles, but a collaborative dialogue leading to agreement or narrowing of grey areas, before final agreement with politicians involved.”

Choudhury also pointed to actions the industry was already taking to police itself. “Regulators also need to take into account that there is a great deal of self-regulation involved that would prevent overfamiliarity. Licensed accountants have to abide by very strong professional codes that may vary from country to country. There are both professional disciplines and detailed internal disciplines in firms, so auditors don’t become too familia—a sophisticated culture of ensuring independence. Of course, public authorities can and do overlay those industry codes.”

“Regulators also need to take into account that there is a great deal of self-regulation involved that would prevent overfamiliarity.”
Fayez Choudhury, CEO, International Federation of Accountants

One of the main arguments used by auditors in the United States to lobby against mandatory rotation—something the PCAOB had first formally considered in the United States in 2012—was that firms rotated partners with existing clients regularly, so overfamiliarity was not the issue. “There are already different partners involved in an audit, so the concept of partner rotation [rather than audit firm rotation] is not only a good idea, it is also already substantially in place. But impacts of this change have not been fully assessed before regulators are changing the rules yet again. The engagement partner and the review partner would rotate under normal circumstances. The institutional knowledge of the company being audited continues, and there is likely to be less risk of a new partner missing something. It mitigates the risk of someone coming in with no understanding of the company.”

Clearly there are strong feelings on both sides of the argument. In the United Kingdom, prior to the EU directive, audit firm rotation was on a comply or explain standing; while now it is mandatory. Some understanding of whether this has improved the quality of public company financial accounts would be a useful study for the regulatory body there, the Financial Reporting Council, to undertake.