MANDATORY AUDIT FIRM ROTATION A MISSED OPPORTUNITY FOR SA?

The collapse of many major corporates, such as Enron and WorldCom in the United States, has been attributed to poor audit quality and a perceived lack of auditor independence.

There are arguments both for and against mandatory auditor rotation. Proponents of auditor rotation argue primarily that rotation can remedy the potential reduction in auditor independence and the related declines in the quality of financial reporting resulting from lengthy auditor-client relationships (Gavious, 2007).

In addition to pressures to retain the client, an extended relationship may cause the auditor to become complacent.

This could lead to substandard audits and/or auditors tending to agree with client preferences, which results in poor earnings quality (Myers, Myers, & Omer, 2003).

Proponents also argue that rotation would bring a fresh look at the firm’s financial statements which might increase the likelihood that the auditor will be able to detect misstatements and/or challenge questionable accounting practices.

The South African Landscape

In recent years, South Africa has seen some major high-profile accounting scandals that have brought attention to issues of external auditor independence and effectiveness, as well as audit regulator integrity.

Some notable audit failures include South Africa-listed global retailer Steinhoff International Holdings NV inflating its profits and assets in 2016 by ZAR 250 billion, becoming the largest accounting scandal in the market to date.

There was also South Africa’s largest sugar producer, Tongaat Hulett Ltd, overstating its 2018 equity by ZAR 3.5-4.5 billion; and the South Africa-based Gupta family, whose leaked conversations with several key state officials in 2017 led to a judicial commission of inquiry into the allegations of state capture under Jacob Zuma’s presidency.

These events implicated some of the country’s big four audit firms, including Deloitte and KPMG, leading to an investigation by the Independent Regulatory Board for Auditors (IRBA), the country's audit regulator.

According to ISS data, as of 2021, 48.3% of South African listed companies had an audit tenure of 10 or more years, with the average audit tenure in South Africa being 17 years – mainly pulled up by some auditors with a tenure of over 50 years. The top ten companies with the highest audit tenure are shown in the table below. These represent almost half of the top 21 JSE-listed entities reported by IRBA in 2015 to have an audit tenure of over 50 years. The rest have already rotated their auditors since.

These failures highlight the > importance of the anticipated audit regulatory changes effective next year. In June 2017, the South African accounting watchdog, the Independent Regulatory Board for Auditors (IRBA), implemented a new mandatory audit firm rotation (MAFR) rule. The MAFR rule requires audit firm rotation every 10 years, effective for financial years commencing on or after 1 April 2023. Audit firms become eligible for reappointment after a cooling-off period of five years.

The Supreme Court of Appeal (SCA) has since set aside a rule by SA’s audit industry body requiring listed and public interest entities to rotate their auditors every 10 years.

The May 31 ruling by the SCA found that the Independent Regulatory Board for Auditors (IRBA) did not have the power to force audit firm rotation as per the Mandatory Audit Firm Rotation Rule (MAFR) it introduced in June 2017, which became effective three months ago.“In safeguarding an auditor’s independence, we still believe that MAFR is the appropriate mechanism that strengthens auditor independence. The court’s judgement against the IRBA in this matter was on a technical legal basis and did not bring into question the value and/or effectiveness of MAFR. Therefore, we stand by the principle of strengthening independence through regular rotation of firms,” IRBA CEO Imre Nagy was quoted as saying. IRBA has indicated that the setting aside of the MAFR by the SCA poses minimal risks to investors on a short-term basis as the majority of listed entities (91%) and public interest entities have already rotated audit firms, thereby minimising the risk of independence threats as a result of long tenure. The benefit of these rotations will be in effect for at least the next five to ten years.

“We will therefore work urgently with parliament and stakeholders to address the technical issue raised in the judgment,” IRBA said in a statement.

Nagy told Accounting Weekly that the IRBA will approach parliament to pass or amend legislation requiring MAFR. Despite

Opponents of auditor rotation (generally led by the accounting profession) argue that mandatory auditor rotation increases audit startup costs and increases audit failure risk. They argue that new auditors must rely more heavily on management estimates and representation in the initial years of an audit engagement (Myers et al., 2003).

As auditor tenure increases, the auditor learns more about the client and its business processes, allowing the auditor to reduce reliance on management estimation and representation, resulting in a more effective audit (Crabtree, 2004).

In other words, they believe that extended auditor-client relationships increase audit quality; the new auditor will not have the benefit of the client-specific knowledge of a previous auditor (GAO, 2003).

According to Lu & Sivaramakrishnan (2009), this poor knowledge of the new auditor hampers the effectiveness of the audit process and can result in a deadweight loss to society.

Management also tends to be opposed to mandatory auditor rotation, because they face the potentially disruptive, timeconsuming, and expensive process of selecting new auditors, and familiarising them with the organisations operations, procedures, systems and industry (AICPA, 1992).

Auditor rotation can take place at the firm or partner level. Mandatory audit firm rotation is still being debated in most places, but audit partner rotation has been adopted in certain countries. The professional requirements in the U.S. state that the partner in charge of an audit engagement should be replaced at least once every seven years.

The Sarbanes-Oxley Act of 2002 further requires audit partner rotation at Audit Tenure, Auditor Rotation, and Audit Quality: The Case of Indonesia Asian Journal of Business and Accounting, 5(1), 2012 at least once every five years.

In the UK, audit partner rotation has been a requirement for many years, and in January 2003, the maximum period for rotation of the lead partner was reduced from seven to five years. Requirements for audit partner rotation have also been adopted in the Netherlands and Germany. In Japan, beginning in April 2004, audit partners and reviewing partners were prohibited from being engaged in auditing the same listed company over a period of seven consecutive years (Chen, Lin, & Lin, 2008). Regardless of the debate surrounding audit firm rotation, this audit firm rotation rule was introduced in a few countries (Comunale & Sexton, 2005; Cameran, Di Vincenzo, & Merlotti, 2005).

Italy has adopted mandatory audit firm rotation, while Brazil has adopted mandatory audit firm rotation for banks and listed companies.

In conclusion, the quality of a financial statement's content will be enhanced if it is audited, and a qualified auditor expresses a judgement on its accuracy and fair presentation.

The audit’s quality will also be improved if the auditor is independent in mind and in appearance; that is if any breaches are discovered and reported by the auditor. A financial statement that is supported by an audit report is viewed as more qualitative than one that is not.

It will be viewed as such, however, if the financial statement offered an impartial, unbiased, true and fair assessment of the company's financial activity for each accounting period. To achieve this, the auditors’ independence must not have been compromised, and the expected audit quality must be improved by interest groups to the financial statements in general.