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Mandatory rotation: what is the price for audit firms?

Incumbents see pros and cons to regulatory suggestions.

In August the Independent Regulatory Board for Auditors (IRBA) announced its plans to pursue a change in the Companies Act in favour of mandatory audit firm rotation (MAFR) for the audits of public interest entities.

In certain circumstances, says the CEO of the IRBA, Bernard Agulhas, a better option may be to implement mandatory audit tendering or joint audits, rather than across-the-board firm rotation.

The regulator will consult further with the industry and hopes to issue a final rule in November.

This announcement has been met with mixed feelings, with many stakeholders, most notably the big-four audit firm audit partners, expressing unhappiness with the regulator’s intentions.

According to Agulhas, the main reasons a Board must consider further measures to strengthen auditor independence through MAFR are the following:

  • It will strengthen auditor independence and so protect the public and investors, which is part of the regulator’s strategy;
  • It will address market concentration of audit services and create a more competitive environment, which will positively influence audit quality; and
  • It will promote transformation by creating more opportunities for small and mid-tier audit firms to enter certain markets, provided they are competent to audit in those markets.

Of course these three objectives set out above do make the South African debate around MAFR somewhat different to the international debate.

“Our latest inspection findings include independence issues as one of the top five findings amongst the audits of financial statements. This is consistent with global inspections results. In a South African context, the IRBA Board has also recognised the challenges with lack of economic transformation, and domination by certain firms within the profession. Out of the 353 audit partners who sign off on the financial statements of all JSE listed companies, only nine are Black African and over 90% are audited by a few firms. We will only see true empowerment when opportunities are provided equally amongst everyone,” says Agulhas.

 Is change necessary?

It is agreed that the external audit function is an activity of public protection and provides credibility to the financial statements and assurance to investors. However, does the status quo need to change? Is there a problem with auditor independence in reality and what are the implications on the audit firms and companies of forcing rotation via legislation?

According to interviews with many senior audit partners, from wide variety of large and mid-size audit firms, such a rule, however, will come at a high cost. According to the partners interviewed, changing the auditor results in, among other things, organisational disruptions, start-up costs, increased need to compete for expensive tenders, loss of client-specific knowledge and the ability of the audit client to negotiate on audit fees. Of most concern, MAFR could also negatively impact the quality of the service delivered.

Ultimately, according to nearly all of the audit partners interviewed, they believe that on a cost-benefit analysis, MAFR is too costly and runs the likely risk of actually decreasing audit quality, counter to the regulator’s intention. Most of the audit partners simply did not believe that auditor independence was a concern in reality, but rather that, due to the public’s misunderstanding of the nature and the limitations of the audit process, an unrealistic expectation was imposed on audit practitioners. This unrealistic expectation has resulted in a perception problem with auditor independence – rather than an actual problem.

In the opinion of these partners, the current professional and legal frameworks are more than sufficient to regulate the audit committees and the audit firms, to ensure adequate independence is maintained during the tenure which the auditor remains appointed, even if this is many years. Among other regulations, one of the more significant is the Companies Act requirement for the audit partner to rotate off the client after a period of five years, with a two year cooling off period before being allowed to be reconsidered as engagement partner.

Many of the audit partners also expressed concern over the IRBA’s intention to pursue three objectives with MAFR. Internationally the MAFR debate centres on the all-important objective of auditor independence which promotes quality audits. Yet in South Africa MAFR is seen as a means of improving transformation and competition in the audit industry. There is mixed opinion among audit partners as to whether MAFR can deliver on transformation without compromising audit quality, and many point to the commendable advances that their firms are making in transformation as evidenced by their improving BEE scorecards and number of black staff at all level of management.

Musical chairs

A strong argument posed by many of the audit partners, from both big four and non big four firms, is the question of whether large listed and public interest company audit committees will indeed consider the non- big four firms (so called mid-tier firms) for appointment as auditors? Can it reasonably be expected that an audit committee will consider a mid-tier audit firm, who possibly does not have the resources, international presence or the experience, to audit a large complex multinational company? Because if not, then the result will actually be a decrease in competition as the outgoing big four firm will not be allowed to tender for reappointment, leaving just the other three big firms as the responsible choice.

One mid-tier firm managing partner referred MAFR as a “kind of the chicken and the egg situation”. The mid-tier firms will be expected to gear up their resources and experience before being appointed as auditors, yet the audit fee revenue, which is needed to fund the investment in staff and other resources, is only paid once appointed. Consider any one of the mid-tier firms – is it reasonable to expect one of them to audit one of the top 20 JSE listed companies if appointed tomorrow? If not, then many of the partners argue that a decline in the quality of the audit is inevitable. It is argued that a lack of staff and experience of the industry and the client will surely impact the quality of the audit work performed and the findings raised.

A senior partner from one of the black-owned audit firms (who are expected to gain the most from MAFR) expressed the concern that MAFR may simply become a “game of musical chairs” among the big four, thereby reducing market competition, as well as promoting low-balling of fees to secure the appointments.

However, not all audit partners are against MAFR. Black-owned audit firm Nkonki welcomed the announcement. According to Nkonki’s managing partner Mitesh Patel, “A lot of second-tier firms have the capability to audit JSE-listed companies but are not getting the opportunities due to longstanding relationships held by the big four”.

No consensus globally

These mixed opinions, and the possibility of significant negative consequences and financial costs to the audit profession, is the reason why the rule has not been applied consistently around the world. As an example, the two most important regulators in the world, namely the European Commission in Europe and the regulator in the United States, have taken very different routes to achieve auditor independence. The EU, after having implemented partner (not firm) rotation in 2006, decided in 2014 to adopt MAFR at 10- to 24-year intervals, depending on certain criteria. The US implemented partner mandatory rotation back in 1978, but decided, after long discussions, which also involved academics and public hearings, not to introduce the rule at the audit firm level, at least for now. The US regulations are very similar to the South African five year audit partner rotation.

All the partners interviewed agreed that the best means of improving auditor independence is actually to improve the quality of corporate governance in the audit clients, rather than through MAFR. Improving the quality of the non-executives on the audit committees was believed to be a means of having a greater impact on auditor independence and audit quality.

As it currently stands in legislation, the audit committee must formally assess the independence of the auditors and retain the right to place the audit for tender and replace the auditors. If corporate governance practices and principles are maintained and even further strengthened, should we be following Europe with MAFR, or should we rather stick with partner rotation like the US?

Michael Harber (CA) is a lecturer in the College of Accounting, University of Cape Town

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^not well written. the only case highlighted on the article is of the opposing party…terrible really. the small guys always have to prove themselves, whilst the big guys are being protected by such articles 🙁

Great read.

A big part of the article is focused on the audit partner, who naturally will defend themselves. I am curious as to what board members, executives, investors and even some notable members of the public think about this, because the objective of IRBA seems to be in a good place on paper. A little more balance would great. (Perhaps some of these people can comment here?)

I also am not worried about the global trend- South Africa is a global leader on many measures of financial reporting so it may just be our duty to set the trend.

100% correct Illphil……………..massive waste of money to keep a [protected ] “industry” alive.

Solution is to make all non-guvmunt business excempt from mandatory audit. Those businesses that need external audit (and there will be many) will use external audit as the market locally and internationally may dictate.

There also needs to be a cap on fees when/if there is a statutory requirement to have an external audit. This will bring about a huge reduction in what currently looks like a rapacious fee environment. It is simply unethical to force the private sector to have an external audit then promote a free for all in charging fees. SAICA cannot any longer be allowed to have their cake and eat it.

As for audit quality……………….can it get worse?

“South Africa is a global leader on many measures of financial reporting”

Name 1.

Auditors add no real value to the bottom line – this is my view based on 15 years as major shareholder in mid-size financial services business.
They charge without mercy and you need to disclose everything (no problem) but yet use the “audit” as a on the job learning opportunity for their new trainee accountants.
We used the top audit firm and during that time a massive fraud was perpetrated by an associate company located in another city. Despite visiting the associate company three times in four years they did not pick this up. The fraud was eventually discovered when a non-accountant employee followed his instinct and investigated.
I invite the business owners to read the disclaimer on Audit engagement letters and audit reports and financial reports – they are not liable for anything!!
AIG failed a few years ago – despite clean audit reports and AAA+ credit rating.
In SA, auditors have become another regulatory function to assist government which the business owners need to pay for.

Must agree with you. After installing a new computer system, which had bugs (don’t they all) the auditors failed to see what was obvious. I had to prompt them to look at the security of passwords on the system. I rather regret having told them their job, because from then on they made our lives a misery by insisting on special software being run at every audit to check. Because of that they took their eyes of the real ball and missed some rather more serious matters.

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