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The two sides of rotation

S. Sivakumar

S. Sivakumar on the benefits of auditor rotation

AUDITOR rotation is the hottest topic doing the rounds in the accounting and auditing arena. The spate of corporate (read accounting) scandals in the US has exposed the rather cosy relationship that exists between companies and their auditors, and audit firms' independence has been called into question. The recently passed Sarbanes-Oxley Act of 2002, has introduced several measures aimed at enhancing auditors' independence of listed companies in the US.

Unlike in the US, in India, the demarcation between the ownership and management in listed companies is rather thin. Despite having public and institutional shareholders, including foreign investors, promoters of most listed companies in India also act as the `management', and it is not uncommon to see the original promoter of a listed company, having a single digit shareholding in the company, donning the cap of a `chairman and managing director'. The result has been a complete overlap between ownership and management in most companies.

The so-called responsibility of the auditor to report to the `shareholders' has become rather blurred and has ended up in his being responsible to the company's management, clearly undermining the interests of the non-promoter shareholders at large.

Moreover, the concept of independent audit committees, as exists in the US, is unknown in India. This is despite listed and large public companies being required to have audit committees. Audit committees in India are seen as a virtual extension of the companies' managements.

There is, therefore, a pressing need to ensure auditors' independence in order that the interests of shareholders are protected.

Worldwide, several countries are moving forward, slowing but surely, in the area of auditor rotation. Can India be left behind? Of course, the concept of mandatory rotation of auditors is not new to India; it has been in vogue for quite some time in public sector companies, including banks. The auditor concept seems to have worked quite well even in the case public sector monoliths in sectors as diverse as oil, refineries and heavy engineering. Why cannot the concept of auditor rotation be extended to the other listed companies as well? What could be the arguments against auditor rotation in India?

First, auditor rotation is likely to affect audit quality. Mandatory rotation, it is argued, would affect audit quality, as auditors would take significant time to work up to full effectiveness and would lost interest as the rotation date approached. Auditor rotation would undermine the ability of auditors to develop cumulative knowledge of a company's business, its risks and its external and internal environment in an era of constantly changing global business environment. One way to get over this genuine problem would be to keep a longer rotation period of, say, five to seven years, rather than the three years which is in vogue in the public sector. Having a longer rotation period would also enable the auditor to develop a much better knowledge and understanding of the company, enhancing the quality of the audit.

Second, there are not enough large audit firms in India to take care of the audit requirements of large companies, making auditor rotation impracticable at the ground level. While auditor rotation would help promote healthy competition amongst audit firms and also help smaller and medium firms grow, there is no denying the fact in the short run, absence of many large audit firms would act as a deterrent. One way to overcome this problem would be to provide that outgoing auditors may be considered for re-appointment after a reasonable gap of, say, every 15 years.

And third, auditor rotation would significantly increase audit costs, as each time a company changed its auditors, it would have to go through a time-consuming and expensive selection process and also would have to invest in executive time and resources in the process of helping the new auditor acquaint himself with the company's systems and procedures. This cost could go up significantly in the case of a multi-location company. The increased costs associated with auditor rotation should be a lesser evil as compared to the larger evil of the undesirable cosiness that develops between companies and long-standing auditors.

On the other hand, the benefits of auditor rotation could be manifold and significant. First, mandatory auditor rotation could help break the above-said undeniable cosiness. Viewed in the context of a more or less passive role played by a listed company's non-promoter shareholders, including the financial institutions, it is absolutely necessary that audited accounts are more revealing and are more dependable and mandatory auditor rotation could help achieving this. Second, auditor rotation could actually help increase the efficiency levels of audit firms, given the fact that a fellow succeeding auditor is more likely to discover the inefficiencies and major failings of a fellow outgoing auditor. Third, mandatory auditor rotation would help in the more even development of the auditing profession in India, helping the smaller and medium sized audit firms to grow, to the benefit of all concerned. And lastly, mandatory auditor rotation would serve to enhance the interest of listed companies' stakeholders, including lenders such as banks and financial institutions. All of the corporate lending that happens today in India is based on audited accounts of companies and a concept such as private investigations by lenders, which is prevalent in the West, is virtually unknown in India. It is generally seen that a company's auditors, having taken a particular stand on a contentious issue related to, say, valuation of its inventories in an earlier year, are reluctant to change their view or opinion in subsequent years despite the emergence of new circumstances which would justify change of their stand. The Indian situation is much less stringent and demanding than, say, in the US, and a concept like mandatory auditor rotation could go a long way in making up for other deficiencies.

There is no need to go for it in one go. We can perhaps make auditor rotation mandatory for the larger listed companies, with a paid-up capital of over, say, Rs 5 crore and see how it works. Perhaps, at a later stage, the concept can be extended to the smaller companies.

The ICAI is debating the concept mandatory auditor rotation, which it had reportedly rejected in its earlier sittings.

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