Banking & finance

Compulsory audit firm rotation the ‘wrong solution’

  • 16 March 2005

World business today said that compulsory rotation of audit firms is the "wrong solution" for correcting real or perceived weaknesses in auditor independence.

A number of recent, high-profile corporate failures have raised concerns about the accuracy and reliability of company financial statements. Although the prime responsibility for preparing financial statements rests with company management, as overseen by the Board of Directors, criticism has also been levelled at the quality of external audits and the independence of auditors.

Some observers and regulators have suggested that auditor independence could be strengthened by a system of compulsory r otation of audit firms after a specified period of time. But in a new policy statement, experts from ICC’s Commission on Financial Services and Insurance have warned that compulsory audit firm rotation would have adverse effects on companies, investors and audit firms alike.

Victor Chu, Chairman of First Eastern Investment Group, a highly successful China based investment firm, and Chair of the ICC Commission on Financial Services and Insurance said: “Compulsory audit firm rotation is more likely to restrict rather than to enhance the freedom of boards, shareholders and audit committees of companies across the world.

“Such a requirement would increase audit costs and create significant practical problems. With each rotation, a whole new tendering process must be carried out and a new audit team must be brought up to speed on the client’s operations and reporting issues, involving significant management time,” he added.

The new ICC paper outlines business concerns about compulsory rotation from a global cross-sectoral point of view including users, providers and intermediaries of financial services. One of its main objections is that the quality of auditing would be at risk.

William G. Parrett, CEO of Deloitte Touche Tohmatsu, one of the world’s leading professional services firms, said: “Audit effectiveness depends upon the audit firm’s accumulated knowledge of, and long-term experience with, the client’s operations, transactions and complex reporting issues. Compulsory rotation undermines this and could adversely affect the quality of audits.”

Compulsory audit firm rotation has been adopted or is under consideration by a number of national governments, even though there is little if any evidence to demonstrate its effectiveness. It has been suggested that such a system would enhance the market for audit services by opening up opportunities for new providers of audit services, but according to ICC experts that is not the case.

“Compulsory rotation does not appear to have these claimed benefits; in fact, recent studies suggest that it increases concentration among the largest firms,” said ICC Secretary General Maria Livanos Cattaui.

“Market forces frequently help promote auditor independence. Companies are able to re-tender their audits and engage new firms if they so desire. If the audit market for listed companies is concentrated or limited, it may be difficult to identify an audit firm that is willing, able and qualified to accept the engagement. Such regulations could give rise to a whole host of problems,” she added.

Another point put forward by ICC is that compulsory rotation acts as a disincentive to the auditor to make investments that enhance quality. Knowing that the client relationship will be of fixed, usually rather short, duration, increasing resources and attention will be focused on new client development. No matter how much is invested in improving engagement quality, the rewards are lost with the next rotation.

The ICC document proposes a number of other policy recommendations that would strengthen auditor independence without the adverse effects of compulsory rotation, including:

* The appointment of auditors based on a qualified evaluation of their performance by experienced and competent board members (including audit committee members or members of other appropriate bodies).

* Strong professional rules on auditor independence, especially with regard to financial, business or familial relationships with clients, backed by monitoring and enforcement systems.

* Restrictions on certain types of non-audit services that can be provided to audit clients also help safeguard independence. (Examples of those that may create conflicts are bookkeeping services, management functions, or internal audit outsourcing.)

* Effective audit committees of the board, with independent, financially-astute members.

* Periodic rotation of the engagement partner and/or senior members of the engagement team to address the threat of over-familiarity with the client, without causing the loss of accumulated knowledge and experience.