There has been substantial debate, both for and against, regarding auditor rotation following the announcement by the Independent Regulatory Board of Auditors (IRBA) that it plans to introduce mandatory auditor firm rotation.1
Bernard Agulhas, IRBA’s CEO, states that the objective of mandatory audit firm rotation is to strengthen the independence of audit firms from their clients and to boost empowerment.
Audit partner rotation is entrenched in South African law through Section 92 of the Companies Act 71 of 2008 (the Act)2, also with the objective of achieving auditor independence from companies. Section 92 of the Act enables an auditor or designated auditor of a company to serve as a company’s auditor for five consecutive financial years. If an individual has served as the auditor or designated auditor of a company for two or more consecutive financial years, and then ceases to be the auditor or designated auditor, the individual may not be appointed again as the auditor or designated auditor of that company until after the expiry of at least two further financial years. This seems to be uncontroversial and accordingly, there seems no reason to conclude that it has not achieved its objective of enhancing the independence and integrity of financial statements and has not resulted in significant negative consequences.
The question then arises as to whether these legal safeguards in place are sufficient to ensure auditor independence and, if not, will audit firm rotation achieve the stated objective.
Section 90 of the Act details strict independence requirements for the appointment of an auditor. Apart from the mandatory audit partner rotation, Section 94 of the Companies Act requires that public companies, state owned companies or other companies that are required by their Memorandum of Incorporation to have an audit committee, to appoint the members thereof at each annual general meeting. Each member of the audit committee is required to be independent. Furthermore, the assurance model, as encapsulated in Principle 15 in King IV3 adds an additional element to ensure the integrity of the financial statements. Principle 15 states that “The governing body should ensure that assurance services and functions enable an effective control environment, and that these support the integrity of information for internal decision-making and of the organisation’s external reports”.
In addition, Section 94(7)(d) of the Act requires the audit committee to determine the nature and extent of the any non-audit services that the auditor may provide to a company. Section 94(7)(e) goes further and requires that any non-audit services to the company must be pre-approved by the audit committee. If all these safeguards of independence are not working, then it seems to the writer that the remedy does not lie in more legislation but rather to look at the culture and ethics of the company. If the ethical culture of the company does not promote the independence sought by the Act and King IV, then the remedy is to address the ethical culture, not introduce more legislation.
Behaviour cannot be legislated and the programme to create and entrench an ethical culture in a company involves, inter alia, several elements such as developing a Code of Ethics, ongoing ethical training and workshops to understand the ethical issues that the company faces, appointing a director responsible for managing and overseeing the ethical culture of the company, including ethical leadership in the key performance objectives of executives and reporting on the outcome to stakeholders.
Principle 7 of King IV states that “The governing body should comprise the appropriate balance of knowledge, skills, experience diversity and independence for it to discharge its governance role and responsibilities objectively and effectively”. This is a more qualitative approach to ensuring independence on the board, which differs from King III which recommended that boards should compromise a majority of non-executive directors, of which the majority should be independent.
If the objective of Principle 7 of King IV is to strengthen the board and the objective of audit firm rotation is to strengthen the independence of the auditors in relation to the company that they audit, surely the approach should be the same? The writer is of the view that if the board, with the assistance of a nomination committee, if appropriate, has the latitude to decide if directors, whether they are non-executive or executive, are acting with an independent mind in regard to fulfilling their fiduciary duties and other responsibilities to a company, then surely it is sufficient for the audit committee, which presumably has been through a rigorous nomination committee process, to apply its mind as to whether the audit firm is acting with sufficient independence in fulfilling its duties and responsibilities to the company.
This article first appeared in Directorship magazine, the official publication of the Institute of Directors Southern Africa, published by Future Publishing.