Section 139(2) of the Companies Act, 2013 (the Act) has mandated all listed companies and certain categories of unlisted public companies and private companies to mandatorily rotate their auditors (whether such auditor is an individual or a firm) once their auditor has served office as an auditor for a period of 10 or more consecutive years (Rotation Period). In this regard, the third Proviso to Section 139(2) of the Act has provided a moratorium period, wherein companies incorporated prior to 1 April 2014, have been provided a time period of 3 years from such date to comply with the requirement to rotate their auditors. Therefore, beginning 1 April 2017, all companies who are required to rotate their auditors under the Act, will have to rotate their existing auditors (Current Firm), if the Current Firm has held office as such company’s auditor for a period of 10 years or more.

However, an area which is likely to cause some confusion to companies and audit firms alike in the near future, is whether the time in office served as an auditor of a company by multiple audit firms belonging to the same network, prior to the commencement of the Act, i.e., 1 April 2014, should be considered when calculating the 10 year period, i.e., the Rotation Period. There may be instances where a company may have appointed different audit firms belonging to the same network prior to 1 April 2014 and, in such cases, these companies may be faced with the question of whether the time served by the Current Firm alone should be considered or whether the time period served by multiple audit firms belonging to the same network as the company’s auditors should be considered.

This article attempts to provide a background of the relevant legal provisions and analyse the issue.

Concept of network of audit firms

In a nutshell, a network of audit firms is essentially a formal, cohesive, integrated and branded network of audit firms, consisting of a number of independent audit firms. The Revised Guidelines of Network, issued by the Institute of Chartered Accountants of India, has prescribed various factors to be considered when determining whether a larger structure of audit firms can be considered to form a ‘network’. Some of these factors include: (i) co-operation amongst audit firms; (ii) sharing of professional resources; (iii) common ownership / control / management; and (iv) common quality control processes.

Small or mid-sized audit firms typically tend to join or become part of a larger network in order to gain access to better control policies / procedures, follow common business strategies and gain various advantages such as superior professional resources, technology, valuable brand name, and the network arrangement may also include profit and cost sharing.

Requirements under the Act and the apparent dichotomy

Section 139(2) of the Act prohibits the following categories of companies from appointing / re-appointing an audit firm for more than 2 terms of 5 consecutive years, i.e. 10 consecutive years, after which such company would be required to mandatorily rotate its auditors in accordance with the Act:

  1. listed companies;
  2. unlisted public companies having a paid-up share capital of INR 10 crores or more;
  3. all private limited companies having a paid-up share capital of INR 20 crores or more; and
  4. all companies (private and public) which do not meet the thresholds mentioned in (ii) and (iii) above, but have public borrowings from banks / financial institutions or public deposits of more than INR 50 crores.

Therefore, on the face of it, Section 139 of the Act only appears to apply prospectively and does not appear to require the time period served by an individual audit firm or multiple audit firm prior to 1 April 2014 to be considered when calculating the Rotation Period.

However, Rule 6(3)(i) of the Companies (Audit and Auditors) Rules, 2014 (the Rules) states that, in case of “an auditor” (whether an individual or audit firm), the period for which “an audit firm” has held office as auditor of a company prior to the commencement of the Act should be considered when calculating the Rotation Period and determining the requirement to rotate auditors under the Act. Therefore, by virtue of Rule 6(3)(i) of the Rules (which deals with events which occurred prior to 1 April 2014), it appears that only the time served an individual audit firm is to be considered when calculating the Rotation Period.

Further, it is interesting to note that the concept of a “network of audit firms” (and therefore multiple audit firms) has only been used in Rule 6(3)(ii) of the Rules, which states that an “incoming audit firm” cannot be appointed if such incoming audit firm is associated with the outgoing audit firm under the “same network of audit firms”. Therefore, the usage of the term “incoming audit firm”, appears to have been used in the future tense, and appears to deal with the eligibility of an audit firm being appointed after the commencement of the Act (which can be undertaken after determining the requirement to rotate audit firms under the Act). Further, a network of audit firms has been defined to include audit firms operating or functioning under the same brand name, trade name or common control (at present or in the future).

In view of Section 139(2) and Rule 6(3) of the Rules, one may conclude that when calculating the Rotation Period, a company will only have to calculate the time period served by its Current Firm prior to 1 April 2014 up to 31 March 2016, and even if such company had appointed other audit firms belonging to the same network as its Current Firm (Previous Firm), the time served by the Previous Firm need not be taken into consideration.

However, surprisingly, Note 1 to the Illustration under Rule 6(3), which illustrates the maximum time period that an audit firm holding office as on the first annual general meeting of the company after 1 April 2014 can continue being the said company’s auditor; defines an “audit firm” to include other firms whose name, trade mark or brand is used by the said firm or any of its partners. Therefore, by virtue of Note 1 to Illustration II under Rule 6(3), the time served by multiple audit firms as a company’s auditor prior to 1 April 2014, may have to be considered when calculating the Rotation Period (which is not contemplated under Rule 6(3)(i)).

Prima facie, while neither the Act nor Rule 6(3)(i) of the Audit Rules require the time period served by multiple audit firms prior to 1 April 2014 to be considered when calculating the Rotation Period, Note 1 to the Illustration to Rule 6(3), which has been provided to illustrate the manner in which the Rule should operate, appears to expand the scope of the Rule itself, and requires the time served by multiple audit firms to be considered.

Analyses

At the outset, there appears to be a clear distinction between the number of audit firms referred to in Rule 6(3)(i) of the Rules, which applies to events which occurred prior to 1 April 2014, and Rule 6(3)(ii) which deals with the eligibility of an audit firm to be appointed as an auditor of a company after the commencement of the Act.

While Rule 6(3)(i) specifically states that the time period served by an audit firm prior to the commencement of the Act should be considered when calculating the Rotation Period; only Rule 6(3)(ii) introduces the concept of a network of audit firms, i.e. multiple audit firms. In view of the above, it can reasonably be concluded that even if a company had appointed multiple audit firms belonging to the same network prior to 1 April 2014 as its auditor, it is only the time period served by the Current Firm which is to be taken into consideration when calculating the 10 consecutive years (for purposes of determining the requirement to rotate an audit firm).

Strictly speaking, illustrations

In view of the apparent contradiction between Rule 6(3)(i) of the Rules and Note 1 to Illustration 1 under Rule 6(3), it is likely that companies would be faced with the question of whether the aggregate time period served by multiple audit firms belonging to the same network, and who have served as their auditors prior to 1 April 2014, should be considered when calculating the Rotation Period.

Until such time the Ministry of Corporate Affairs issues a clarification on the manner in which Rule 6(3) ought to be interpreted in cases involving multiple audit firms prior to 1 April 2014, the aforesaid contradiction between the Rules and the Illustration to the Rule is likely to be a cause for concern for large networks of audit firms which have served as auditors of companies for long periods of time prior to 1 April 2014.

In view of the aforesaid contradiction, one may consider either of the following approaches when dealing with such a situation:

  1. calculate the time period served by multiple audit firms prior to 1 April 2014 when calculating the Rotation Period only if the following conditions are satisfied: (a) the Current Firm is using or has used the name, trade mark or brand of the Previous Firm of the company; or (b) any of the partners of the Current Firm are using or have used the name, trademark or brand of the Previous Firm when they were partners of the Previous Firm; or
  2. take a stance that Note 1 to Illustration II to Rule 6 essentially expands the scope of Rule 6(3)(i) of the Rules, which is not legally permissible, and therefore, only consider the time served by the Current Firm prior to 1 April 2014, when determining the Rotation Period; and ignore the time period served by other audit firms prior to 1 April 2014 (that belong to the same network as the Current Firm).

The aforesaid issue is likely to gain increasing importance in the next couple of years, as we approach 1 April 2017, when companies will have to start determining the requirement to rotate their auditors. It is hoped that the MCA would issue clarifications / amendments to clarify the said issue in the interim.