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Mandatory auditor rotation can improve reporting standards

Globally we have witnessed quite a few large accounting frauds, Enron, WorldCom, and
Satyam closer to us. These have resulted in shareholder value erosion and loss of
investors’ confidence. Pursuant to this many steps were taken to avert such situations.
Mandatory rotation of auditors was one such measure used to end the cosy relationship a
company shares with its auditors. In India, the Companies Act, 2013 – which came into
effect on 1 April 2014 – makes it mandatory for companies to rotate their auditors every
few years. So, is this measure enough to curtail frauds? And does effective corporate
governance means good corporate performance?

I belong to Italy, one of the countries where rotation of auditors after a fixed tenure is a
mandatory. Associated with SDA Bocconi since 2008 as full time faculty, my research
interests include links between corporate governance and firm performance, earnings
management, and auditing & related issues.

Before beginning my career in the academia, I have worked as consultant in auditing
firms, I believe mandatory auditor rotation is effective, but it is not the only solution to
prevent accounting frauds. According to me, regulatory framework has to be in sync with
the time and help regulators identify frauds and take preventive steps.

Though auditing industry is resistant to changes, three trends are quite evident.

• First, IT tools are being widely used in the auditing processes.

• Second, firms are focusing on specialization in terms of practices (experts in
accounting standards) or sector-wise.

• Third, they are increasing the number of offices in multiple locations to be closer
to the clients.

The approach of regulators, not just in the accounting industry but in general, is more
often reactive rather than being proactive. Changes take place in the regulatory
framework more as a response to an event. In respect to accounting, it can be said that
standards have not kept pace with the evolution in the economy.

If, we look at it in isolation, the changes in accounting standards between 2008 and today
seem extensive. The key question though is, are these enough? To site an example,
globally, in spite of all the modifications and improved standards, there are still several
financial instruments in accompany which are not properly managed by accounting
standards. The economy obviously is evolving much faster than the norms laid down by the

Regulators appeared to me are quite often detached from the market, this could be a key
reason why accounting standards have failed to keep pace with the trends in the real

Having said that, there are countries where the entire accounting world has transformed
after 2008. For example, all countries in Europe have shifted from local GAAP (Generally
Accepted Accounting Principles) to IFR (International Financial Reporting) standards.
Considering the approach to accounting in IFR is distinct from the traditional cost-based
GAAP standards, shift to IFR is quite radical and implies large changes in culture,
organization and financial market functioning. This is something new, and is being adopted
by many organizations across the globe. Even India is moving towards IFR standards.

The 2002 fraud was related to one company and its implication was restricted to a few
companies. Hence, it was easy to identify the problem and fix it. The 2008 financial crisis
impacted banks, financial institutions (FIs), Companies amongst others which in turn had
an impact on the GDPs of large economies. Hence, it is taking a longer time to understand
and find solutions to these problems because we are not in a position to fathom the extent
of involvement of these organizations in the crisis and its implication on the global

Now, the sparkling market has indeed helped auditing firms to improve their financial
performances as it has opened up new areas of opportunities, which was not earlier
available to them. Enactment of Sarbanes-Oxley Act of 2002 (SOX Act) in the US, rise in
adoption of IFR standards, etc are few of the factors driving growth of the auditing firms.
The SOX Act – enacted as a reaction to a number of major corporate and accounting
frauds, including Enron and WorldCom – has raised the accounting standards for all US
public company boards, management and public accounting firms. Basically, the Act forced
the companies to audit their financial statements with external auditors, thus offering
additional source of revenues for the auditing firm.

For companies who want to globalize and attract overseas investors, it is important
(though not mandatory) for them to either adopt the two commonly used accounting
standards (i.e, IFR or US GAAP) or get listed on the renowned stock exchanges such as New
York, London, etc. With the number of companies adopting IFR increasing, more
opportunities have emerged for auditing firms as they are much better prepared for the
new assignments.

On one hand, the auditing firms are improving their revenues by offering multiple services
in a complex working environment. On the other hand, in a sparkling marketing
environment, their activities have become riskier.

Good governance is a tool that can help performance get better. But, there is no proof
that good governance automatically results in good performance. Historically, there has
been companies known for their corporate governance, but could not last long as their
performance was abysmal. It can be said that companies with good performances over a
long period of time, normally also have high standards for corporate governance. However,
good corporate governance alone cannot lead to increase in profitability and sales.
Corporate governance can provide basic ground work (or guidelines) for creating good
companies to perform over a longer period of time.

Good performance, especially in uncertain conditions, comes with good ideas and
innovations, and corporate governance should facilitate these ideas to generate better
performance for the company in an ethically acceptable manner. An auditor’s role is to
protect shareholder’s value by doing his/her job impartially, irrespective of who is paying.
At present, the company hires an external auditor to check its financial statement, which
some view as a conflict of interest for the auditor.

There are some countries that have adopted the rules such as compulsory rotation of
auditor (or auditing firm) after fixed period of time, having two auditors from different
firms, etc. however; even these systems have loop-holes.

There are two ways to ensure true independence.

• First, auditing firms can be made public institutions so that they are independent
of market, organizations, government, etc.
• Second, an independent body (may be the financial market regulator) can be
entrusted upon to appoint an external auditor for the company.

Mandatory auditor rotation can improve financial reporting standards by reducing the
chances of accounting scams. It is difficult for companies to perpetuate frauds as they
have to face a new auditor after a fixed period. But this in itself is not enough, for things
to work, it is important to frame rules that are very clear (with no scope of ambiguity) and
build in strong penalties for unethical behavior. In addition to mandatory auditor rotation,
there should also be systems in place to help government, regulators, auditors, and FIs etc
to detect and punish behaviors that deviate from the standards of ethical financial

Mandatory rotation represents a good opportunity for auditing firms who are not leading
the market. For leaders, having a large market share in the auditing industry, it will be
challenging as they can retain their clients only for a fixed period. So, the competition will
hot up among the auditing firms due to the changes in auditing norms. On the other hand,
as a result, compliance cost for auditing firms will go up. Auditing firms invest heavily
(time and money) in the first couple of years to understand an organization and the
complexity of its business, before they start garnering higher margins.

While new Act will offer opportunities for new auditors, it will also have an effect on the
profitability of the auditing firms.

On the other hand, there has been a decrease in large-scaled accounting frauds in the last
few decades; primarily due to stringent regulations. However, the nature of frauds has
been changing. Organizations are adopting new means for unethical reporting or
perpetuating small frauds (which are too small to be detected by the regulator or the
auditors) they are carrying these out from multiple locations. Such kind of new frauds and
their size are often difficult to detect.

There are a lot of disparities in the remunerations terms of employees and that of the top
management. Low rate of employment and slow growth rate are leading to unrest in some
parts of the world. Corporates are aware of it, but have hardly taken any steps to solve
these issues as they believe these are irrelevant for them. The modern economy should
ideally find a way to reduce wage differences between blue-collared workers and top
management as it can lead to a friction resulting in a large conflict in the long run.

When the difference in compensations for the employees and top management becomes
too large, it is not good for the organization, in particular, and the economy, in general.
Sharing a part of the fortune with the employees when the organizations’ performance is
good and making them part of the decision-making processes can go a long way in
reducing these disparities.

Prof. Antonio Marra

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