Mandatory Audit Firm Rotation: a useful tool or an inappropriate measure?

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Business

Regulatory frameworks to enhance audit independence and foster confidence in the integrity of audit findings have always been of paramount importance. Without these imperative checks and balances, wide-ranging and potentially catastrophic implications for audit firms, their clients and stakeholders of both entities can ensue. This has been evidenced by the Enron scandal in 2001, which led to the dissolution of Arthur Andersen (at the time, one of the then Big Five audit firms), and the high-profile Steinhoff accounting scandal that once again threatened the reputation of a major audit firm. In light of this need for good governance in the audit industry, the Independent Regulatory Board for Auditors (the “IRBA”) has, since 2006,[1] been tasked with regulating the profession. However, on 31 May 2023, the Mandatory Audit Firm Rotation Rule (the “MAFR”), initially published in 2017, was struck down by the Supreme Court of Appeal (“SCA”) in the case of East Rand Member District of Chartered Accountants and Another v Independent Regulatory Board for Auditors (“East Rand”).[2]

The IRBA was established in terms of the Auditing Professions Act 26 of 2005 (the “Auditing Professions Act”).[3] The IRBA Code of Professional Conduct for Registered Auditors (the “Code”) sets forth five fundamental principles of ethics for registered auditors. These are integrity; objectivity; professional competence and due care; confidentiality; and professional behaviour.[4] The Code also delineates five broad categories of threats to compliance with the fundamental principles of the Code. These are self-interest, self-review, advocacy, familiarity and intimidation threats.[5] The MAFR, which was published on 5 June 2017 and came into effect on 1 April 2023, sought to prohibit the same audit firm from serving as the appointed auditor of a public interest entity for more than 10 consecutive years and only allowed reappointment after a minimum of five financial years.[6] This was done in an effort to enhance integrity and objectivity and mitigate against familiarity threats.

Before delving into why the MAFR was struck down, it is important to note that the Companies Act 71 of 2008 (the “Companies Act”) already had rules in place regarding rotation of auditors. Section 92(1) of the Companies Act prohibits the same individual from serving as the auditor of a company for more than five consecutive financial years. The differentiation is that, in terms of the Companies Act, individuals in a firm must be rotated. The goal of the MAFR, however, was that the audit firms themselves must be rotated.

When considering the appeal from the Pretoria High Court in the East Rand case, the SCA considered section 4 of the Auditing Professions Act. The section details the IRBA’s rule making powers, which are limited to specific functions. Section 4(1)(c) allows the IRBA to prescribe standards of professional competence, ethics and conduct of registered auditors. The SCA held that the MAFR did not fall into any of these categories. The SCA held further that the restrictions on companies and their audit committees are broad and curtail the ability of entities to select an audit firm of their choice.[7] The IBRA relied on section 10(1)(a) of the Auditing Professions Act when publishing the MAFR, in terms of which the IRBA is allowed to set rules on matters “required or permitted” by the Auditing Professions Act. Section 10(1)(b) empowers the IRBA to set rules that are aimed at “any matter for the better execution of this Act or a function or power provided for in this Act”. The SCA noted that section 10(1)(b) was not mentioned in the MAFR but was used subsequently by counsel for the IRBA to justify the publication. Considering the above, the SCA found the promulgation of the MAFR was ultra vires.

Although the MAFR has been set aside, since it was in operation for around two months before being struck down, most public interest entity auditors had already rotated their auditors.[8] Therefore, the intended effect of the Rule has already materialised, despite the SCA’s decision and the IRBA hopes this will augment measures to ensure auditor independence and improve audit quality for at least 5 years.[9] A voluntary rotation by 91% of listed companies has been observed,[10] which can be seen as an encouraging statistic. The CEO of IRBA, Imre Nagy, has highlighted the importance of mitigating risks, whether real or perceived.[11] No matter the veracity of claims of independence or lack thereof, even the possibility of a familiarity risk constitutes a need to be seen to take active steps to eliminate these risks.

It is important to note that mandatory audit firm rotation is not a new concept and was first introduced in 1988 in Spain.[12] Spain has since scrapped the rule, but EU countries and China apply mandatory audit firm rotation.[13] So, the rule is not untested. The EU has implemented mandatory audit firm rotation in terms of Directive 2014/56/EU and these rules have been in place ever since.

Given the technical point on which the judgment was made, we may well anticipate an application for leave to appeal to the Constitutional Court. Nevertheless, although the goals of the IRBA in attempting to bolster audit independence are laudable, the MAFR remains set aside, for the time being. Whether improved audit independence can be addressed in other ways remains to be seen, but, given that accounting scandals seem to be more common than they should, more stringent regulations should undoubtedly be affected.

This article is a general information sheet and should not be used or relied on as legal or other professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your adviser for specific and detailed advice. Errors and omissions excepted (E&OE).

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