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The major accounting scandals such as of Enron, WorldCom, and Xerox at the international level and also in many incorporated companies on a relatively smaller scale unearthed in Pakistan and throughout the world necessitated stringent rules to regulate the corporate sector for its sustained growth.

A number of countries the world over have, therefore, reviewed their prospective legislation concerned with auditing and accounting practices of their corporate and audit firms to prevent recurrences of corporate failures, including accounting scandals. Among these measures, the mandatory rotation of audit firms after a specific period of time has also been proposed by some countries as one of the important policy instruments to ensure the accuracy in auditing.

However, there are a number of key themes and arguments, both for and against, mandatory rotation. The following points are argued as most important factors that affect audit quality:

i) Long involvement of an auditor with any particular client can lead to formation of a close relationship between them. This is likely to adversely affect the objectivity and independence of auditors. It has been revealed that major accounting scandals (some of them referred to above) and also many on small scale in Pakistani scenario exposed the relationship that existed between companies and their auditors.

ii) It 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 fellow outgoing auditor.

iii) Moreover, the so called monopoly of large audit firms existing in many countries may be broken by healthy competition, inducing firms to improve their operational skills. It would help the small and medium-sized audit firms to grow to the benefit of all concerned.

On the other hand, it is generally recognised that there are (i) additional start-up costs affecting both the auditors and client, (ii) adverse effects on the quality of the audit due to a lack of familiarity in the first and early years of the audit, (iii) lack of incentives if the audit is about to change hands and (iv) the signals that may be given out currently when there is change in auditor.

To safeguard the corporate sector and investors against any such corporate failures and scandals, some countries such as Australia, Greece, India and Italy have mandatory rotation of audit firms. However, despite a number of advantages of mandatory rotation of audit firms pleaded by certain quarters, most of the countries still have the system of periodic rotation of audit partner. The main factors for non-implementation of the desired system were a strong opposition by a strong group of auditors’ community and indifference of the companies themselves towards its adoption.

The Security and Exchanges Commission of Pakistan (SECP) decided to adopt the principle of rotation of audit firm in its Code of Corporate Governance, notified as far back as in March 2002. However, the Institute of Chartered Accountants of Pakistan (ICAP) opposed its introduction on some grounds, which are summed up as under:

i) The objective of ensuring independence in audit has been addressed by limiting the auditors of listed companies to undertake only defined services in the list of companies drawn up by ICAP in consultation with SECP.

ii) The quality of audit of the listed companies was subject to Quality Control Regulations by ICAP, which was duly acknowledged by SECP.

iii) The ICAP has and the members adopted and strictly implemented the International Audit Standards and had adopted Code of Ethics of International Federation of Accountants, which specifically addressed the independence and familiarity issues.

iv) Section 252 of Companies Ordinance, 1984 clearly gives privilege to the shareholders to appoint auditors and does not envisage anywhere that these rights could be impeded in any manner. The rotation of auditors, therefore, lacks locus standi when viewed in the context of the provisions of law.

The SECP, however, offered ICAP that application of the requirement may be rationalised in any of the following manners:

Phased application to auditors of listed companies according to the size of companies.

Phased application to auditors of listed companies according to the length of their audit.

Deferred its application for one year.

The ICAP disagreed with the first two propositions. The available record showed that it was, accordingly, decided that the mandatory rotation of auditor should be enforced in respect of appointment of auditors after December 31, 2003. The decision was ratified by the ICAP in its council meeting held on April 26, 2002 but in December 2003, the ICAP again wrote to the Commission that the decision of rotation of auditors was neither in the interest of accountancy profession nor in the interest of corporate sector.

On the request of ICAP, a task force was constituted in consultation with ICAP, said to represent the members from all stakeholders to study the issue in the local as well as international scenario.

The composition of the task force, however, seemed to be highly lopsided as those having interest against the rotation of the audit firms predominantly represented it. The representatives of some of the most important stakeholders such as Ministry of Finance, Federal Bureau of Revenue, State Bank of Pakistan, Ministry of Investment and SECP were missing on the task force.

Five rounds of day-long sessions of the task force were held which dealt with the issue in depth but the ICAP, including those interested in status quo, opposed it except a member of auditors’ community and a few others kept themselves away either from the whole proceedings or with the ending sessions.

Keeping in view all these facts, the Chairman of the Task Force who was so strongly convinced with the advantages of rotation of audit firms on the basis of arguments advanced during the proceedings of the meetings, recommended the following against the views of the majority of the members attending the session:

Instead of rotation of lead partners in the firm, mandatory rotation of audit firm, every five years, for all listed companies should be allowed.

On rotation, the audit firm, which is replaced, shall not be permitted to compete for the same audit service for four years.

Appropriate provisions be incorporated to ensure that in the event of any attempt by the auditors to circumvent the spirit of law by indulging in malpractices, such as audit swap, reciprocal arrangement, shifting of audit to a dominant firm or to a firm of cross ownership or controlling interest or otherwise, shall in suspension or cancellation of practicing license.

SECP for adequate reasons and exceptional circumstances shall have power to exempt any company or class of companies from mandatory rotation of audit firm for which specific provisions should be clearly specified and added.

Report of the Task Force — a thorough work of five months was submitted in September 2004 but since then, the issue has been swept under the carpet. There is a need that the matter of great national interest, having implications for the economy, be reconsidered by a properly constituted working group having equal representation of audit community and corporate firms besides concerned government departments and former members of judiciary, to finalize the decision which was once a decided one.

Rotation of audit firms may also facilitate the FBR in scientific evaluation of tax obligations at least of the corporate sector. The work, which was carried out by the formerly constituted task force, is available with the SECP, which may serve as the Working Paper for the proposed group.

The writer is Senior Economic Advisor, Sustainable Development Policy Institute, Islamabad

This article was originally published at: The News

The opinions expressed in this article are the author's own and do not necessarily reflect the viewpoint or stance of SDPI.