Institutional EYE IiAS Comment | 11 April 2014

Auditor Rotation: No value for vintage

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Related research Auditor rotation: Formality or fiduciary duty?

IiAS’ analysis of the top 200 listed companies reveals that more than 60% of these companies will need to change their auditors over the next three years to comply with the recently notified section 139 of the Companies Act 2013. While the Act provides a 3-year window to comply with the provisions, companies must be forward-looking and start complying immediately. Globally, auditor rotation continues to be a subject of much debate, as regulators and policy makers around the world examine lessons from the financial crisis in order to improve and strengthen the quality of financial reporting. But while critics continue to oppose the move, a broader consensus seems to be emerging on the importance of auditor rotation in ensuring audit independence and objectivity. Capping the overall tenure forces auditors to pay closer attention to details and be more sceptical in their audit approach. This is why earlier this month, the European Parliament introduced regulations which make auditor rotation mandatory after 10 years in all member states (Press Release). Back home in India, the Companies Act 2013 makes it mandatory for audit firms to be changed after every 10 years. The relevant sections were notified recently by the Ministry of Corporate Affairs (MCA) and are applicable from 1 April 2014 on a retrospective basis (refer box 1 below). India is now one of the few markets where even unlisted and private companies (above a certain threshold) need to rotate their auditors. This is welcome as it strengthens the entire financial reporting framework. A select list of countries, with their stance on auditor rotation, has been provided in Annexure A.

Box 1: Regulation Snapshot: Section 139 of Companies Act Approval Process: Section 139 of the Companies Act 2013 states that every company shall appoint an auditor for an initial term of five years. The appointment must be ratified by shareholders at every annual general meeting of the company by passing an ordinary resolution. Auditor Rotation: The Act requires mandatory rotation of individual auditors in every 5 years and of the audit firm in every 10 years (after two terms of 5 years each) in listed companies, with audit partner rotation being left to shareholders. A cooling-off period of five years after the stipulated threshold is required to be considered eligible for re-appointment. Eligibility: For the purpose of rotation, the incoming auditor or audit firm shall not be eligible if they are part of the same audit network (which includes the firms operating or functioning, hitherto or in future, under the same brand name, trade name or common control) as the outgoing auditor or audit firm. Further, if a partner, who is in charge of an audit firm and certifies the financial statements of the company, retires from the said firm and joins another firm of chartered accountants, such other firm shall also be ineligible to be appointed for a period of five years. Applicability: In the rules notified recently by the Ministry of Corporate Affairs (MCA), it has been clarified that section 139 will be applicable on a retrospective basis - which means the existing term of the current auditors will be taken into account for computing the overall tenure. Commencement: Companies will have to comply with the requirements within three years from the date of commencement of the Act.

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Chart 1: Companies by auditor tenure

IiAS’ analysis shows that more than half of the 2211 companies have auditors whose tenure has exceeded 10 years2. Another 24 companies have auditors who have been auditing the accounts for at least 7 years. Given that the Act provides a 3-year window to comply with the provisions, these 137 companies will need to replace their existing auditors by 2017-18.

84 113

Interestingly, some of the large business groups in India like Reliance, Tatas, Mahindra, Infosys, L&T and a few MNCs like Maruti, Colgate, P&G have vintage auditors and will soon need to start initiating the transition.

24

0 to 6 years

7 to 9 years

>=10 years

Table 1: Auditor tenure: Select companies Company

Auditor/Audit Network

Hindalco Industries Singhi and Co. Reliance Industries Chaturvedi and Shah, Rajendra and Co., Deloitte 1 Larsen & Toubro Sharp and Tannan Jaiprakash Associates M.P. Singh & Associates Mahindra and Mahindra Deloitte / A F Ferguson & Co Procter & Gamble Deloitte Tata Power Deloitte / A F Ferguson & Co Maruti Suzuki PWC Hero MotoCorp Deloitte / A F Ferguson & Co Jindal Steel SS Kothari Mehta and Co Tata Steel Deloitte / A F Ferguson & Co Infosys BSR and Co. Colgate PWC 1. Deloitte has been an auditor since 2005

Tenure as on 31Mar-2013 (years) >50 >35 >30 >25 >23 >20 >16 >16 >16 >16 >16 >15 >10

In India, the auditing industry is fragmented and comprises a large number of small to medium sized audit firms. However at the top end, the industry is still characterized as an oligopoly primarily due to the dominance of the ‘Big 4’ - i) Deloitte, ii) PriceWaterhouse Coopers (PWC), iii) Ernst & Young (E&Y) and iv) KPMG. In India, these firms operate through their respective audit networks which comprise of local partner firms as listed below: Table 2: Audit Networks Deloitte

PwC

Ernst & Young (E&Y)

       

    

    

Deloitte Haskins & Sells, P C Hansotia, C C Chokshi & Co, SB Billimoria, M.Pal & Co., Fraser & Ross Touche Ross & Co, A.F Ferguson

Price Waterhouse, Price Waterhouse & Co., Lovelock & Lewes, RSM & Co, Dalal & Shah

SR Batliboi & Co, SR Batliboi & Associates, SV Ghatalia & Associates, P D Desai & Co, SRBC & Co LLP

KPMG

 

BSR & Co BSR & Associates

Source: Market information 1 2

Unique list of companies that comprise the S&P BSE 200 and CNX200 indices For companies with more than one auditor, the tenure of the auditor with the longest association has been considered

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No value for vintage In 2012-13, 57% of the S&P BSE 200 and CNX 200 companies were audited by the Big 4. Of these, Deloitte has the largest presence, followed by E&Y.

Chart 2: No. of audits by the Big 4

Chart 3: No of companies audited in FY12-13 51 37

94

25 127

Big 4

5.5

Big 4

Deloitte

Others

Chart 4: Median auditor tenure (years) Others

14

10

E&Y

PwC

KPMG

The dominance of the Big 4 may be a result of their stature in the global auditing industry and the consequent level of comfort they provide to shareholders, particularly institutional investors and FIIs. Another reason might be that as the business has grown in complexity and scale, it has outgrown the capabilities of smaller audit firms. However, this translates into prolonged associations with the companies in which they are appointed as the statutory auditor. Our analysis shows that median tenure of the Big 4 audit firms tends to be much higher than the industry (refer chart 4).

Note: As discussed earlier, the Companies Act 2013 does not permit the rotation of audit firms within the same network. Hence, the data used in this report are based on the tenure of the ‘audit network’ and not of the individual audit firm. As a result, the longer tenure for the Big 4 firms (chart 4) might also be because they have a larger network and there is rotation of firms within the same network. For public sector banks (PSB), the rules are more stringent than those specified in the Companies Act and are based on the Reserve Bank of India (RBI) guidelines on appointment of statutory auditors. As per these guidelines, all PSBs have to rotate their central auditors and branch auditors every 3 years and 4 years respectively (see box 2 below). Box 2: Regulation Snapshot: RBI Guidelines for Appointment of Statutory Auditors in Public Sector Bank Statutory Central Auditor (SCA) SCAs appointed will have a tenure of three years, after which they will be rested for a period of two years. The appointment of SCAs will be made on an annual basis, subject to their fulfilling the eligibility norms prescribed by RBI from time to time and also subject to their suitability. Statutory Branch Auditor (SBA) SBAs will have a maximum tenure of four years. The appointment of SBAs will be made on an annual basis, subject to their fulfilling the eligibility norms prescribed by RBI from time to time and also subject to their suitability.

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No value for vintage In private sector banks, the auditors are appointed in consultation with RBI. As a result, the auditor tenure is lower in banks than other companies (refer chart below).

Chart 5: Classification of companies

Chart 6: Median Auditor Tenure (years) 13 11

28 19 25 3

149

Banks

MNC

PSU (excl banks)

Chart 7: Median No of auditors

Others

1

PSU

3

Chart 8: Investors supporting auditor rotation 5%

4%

4

Do not approve

MNC

PSU (excl banks)

Other Listed Companies

The appointment of auditors in public sector units (PSUs) directly vests with the Comptroller and Auditor-General of India (CAG). As part of their supervisory role in ensuring high audit quality, the CAG frequently rotates these auditors. Consequently, like banks, auditor tenure for PSUs is substantially lower. The CAG also tends to appoint multiple joint auditors for the same company. This is reflected in the higher number of auditors (median) for PSUs as compared to other companies. By way of example, State Bank of India has 14 auditors, NTPC has 6 auditors and ONGC has 4 auditors. But while banks and PSUs appoint auditors in line with the provisions of the new Act, the median tenure of auditors in non-PSU-non-bank firms is in the range of 11-13 years (see chart 6 above). Recently, companies like Eicher Motors, Amtek Auto, ACC and GlaxoSmithKline Pharma have reappointed auditors, whose network tenure has already exceeded 10 years. This seems to indicate that companies are taking refuge in the three-year transition window provided by the Act, rather than being proactive in strengthening their audit framework. This will not go down well with investors. In a recent investor survey conducted by IiAS, over 91% of the respondents supported the auditor rotation requirement of the Companies Act – which clearly highlights their concern on the cosy nexus between managements and vintage auditors.

91%

Approve

Banks

Other Listed Companies

3

No opinion

IiAS expects listed companies, especially those in the S&P BSE 200 and CNX 200, to take the lead and start complying with the spirit of the regulations i.e. change auditors who have audited their books for 10 years, when they come up for re-appointment. This will enhance the integrity of the audit process and go a long way in improving investor perception about the accuracy and quality of financial reporting.

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Annexure A: Select countries stance on auditor rotation Country

Requirements on audit firm rotation

Requirements on audit partner rotation

Australia

No

Yes, since 2001

Brazil

For non-bank listed companies: 5 years

No

China

For state-owned entities and financial institutions: 5 years

Yes

Germany [1]

No

Yes, 7 years

India[2]

For listed, public and private companies: 10 years

For listed, public and private companies: 5 years

Indonesia Italy [1]

For public and private companies: 6 years For listed companies and public interest entities: 9 years

No No

Japan

No

No

Malaysia

No

No

Portugal

For listed companies: 8-9 year rotation recommended on a ‘comply or explain’ basis

For public interest entities: 7 years

Singapore

Suspended in 2008

For listed companies: 5 years

South Africa

No

No

Sri Lanka

No

For listed companies: 5 years

UK

No

For listed companies: 5 years

USA

No

No

Source: The Institute of Chartered Accountants of Scotland (ICAS) Research [1] Germany and Italy are European member states. The auditor rotation requirements for these countries might change in the wake of the new norms introduced recently by the European Parliament. [2] Auditor rotation norms in India are applicable for all unlisted public companies having paid up share capital of at least Rs.100 mn, all private limited companies having paid up share capital of at least Rs.200 mn and all companies having public borrowings from financial institutions, banks or public deposits of at least Rs.500 mn.

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