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The question whether there should be a system of rotation of statutory auditors introduced to avoid repetition of Satyam episode has been raised in some quarters. In the past, the Government had tried to introduce this system by proposing amendments in the Companies Act on two occasions. However, these amendments could not be implemented as the Parliamentary Committees which examined these proposal rejected them in view of the strong protests from our members and the Institute. Investigations about the role of auditors in the Satyam episode are in progress. The reasons for the audit failure are not ascertained and, therefore, it would be premature to make this episode as illustrative. No definite conclusions can be drawn at this stage and it cannot be said that such episode will not be repeated if we introduce the system of rotation of statutory auditors through any legislation. It is reported that no developed country in the world has introduced this system.

Concept of rotation of statutory auditors

The question of rotation of auditors has been considered in the past. In 1972, it was proposed to add clause (1B) in Section 224 of the Companies Act by the Companies (Amendment) Bill, 1972. This clause sought to introduce the concept of ‘rotation of auditors’. This was proposed with a view to bringing out disassociation of auditors from groups of companies, so that they may not have any temptation to shield shortcomings of the management from shareholders. It was also stated that this would achieve a more equitable distribution of audit work among younger members of the profession.

There was lot of resistance from members when this proposal was sought to be introduced by amendment of the Companies Act. It was felt that such a proposal would put out of gear complete machinery in respect of audit of corporate sector by members of the accounting profession. It was also felt that this provision would not achieve the proposed objective. As a compromise, it was decided to represent to the Government that if ceiling on audits per member/partner is fixed, it would achieve the objective of wider dispersal of audit.

The Joint Committee of Parliament appreciated the submissions made by the Institute. The Joint Committee took the view that a ceiling on audits would sufficiently serve to break the evil of continued association of auditors with groups of companies. It was decided to fix the ceiling at 20 as such groups generally consisted of more than 20 companies. It was also decided that out of these 20 companies, not more than ten companies should be having paid-up share capital of Rs.25 lacs or more. In the case of a firm of auditors the ceiling applied was on the basis of each partner in whole-time practice. On the above basis, the Companies (Amendment) Act, 1974, amended Section 224 of the Companies Act to provide for ceiling on company audits on the above basis.

Companies Bill, 1997

The above provision worked with satisfaction for more than 20 years. Even in the Companies Bill, 1993 the concept of ceiling on audits was accepted. However, the Companies Bill, 1997 once again proposed to provide rotation of auditors in clause 180 (2). Under this clause, it was proposed to increase the ceiling on audits to 25 companies and also provide for rotation of auditors in such a manner that no company would be able to appoint or reappoint an auditor for more than five consecutive years.

The Council of our Institute strongly opposed the concept of rotation of audit when the above Bill was under consideration. After an in-depth consideration of the matter at various forums in the profession all over the country, the Council came to the conclusion that the proposal relating to rotation of auditors was neither in the interest of the shareholders nor would it lead to better corporate governance and, therefore, it was not in the national interest. The Council, therefore, suggested dropping of the proposal on the following grounds.

“The legislation in almost all developed countries does not contain any provision regarding rotation of auditors. On the contrary, the concept is that the position of the auditors should be strengthened and the option of the management to change them should be limited to the very minimum. This seems to be the concept behind the spirit of various provisions of the Companies Act in India, which provide for certain special proceedings if an auditor is to be removed or he is not to be reappointed at a general meeting.

“The system of rotation can be evaded easily and will only result in practices like tie-up arrangements between auditing firms and splitting of existing firms. It would indeed be impossible to implement it in a manner that its perceived advantages are realised.

“Rotation does not improve the independence of auditors. This is because the management plays one auditor against the other. It considerably reduces the chance of a strict and upright auditor to be appointed after his term, since the management (having been exposed to different auditors) would tend to opt for the ones who are considered more convenient.

“Rotation of auditors will inevitably result in higher cost since new auditors will have to spend extra time in familiarising themselves with the nuances of the activities of a company. As a matter of fact, research has shown that modern business operations are becoming so complex that an auditor takes at least two years to really understand the intricacies of the input-output relationships and the economic realities behind the financial transactions. It is well known that audit failures are more in the first or second year of an audit. In more advanced countries, certain audit firms have actually developed special expertise in specific industries. The quality of audit will therefore definitely suffer if there is rotation of auditors.

“The Council of the Institute is fully supportive of all initiatives meant to enhance the independence of the auditors. It genuinely believes that rotation of auditors will be a retrograde step unlike some of other initiatives in the Companies Bill, 1997, e.g. tightening up of provisions regarding disqualification of auditors and constitution of audit committees. The Council has in fact been constantly debating and enforcing a number of steps to improve the qualify of audit. A few initiatives being taken by the Council are (a) working out a system of peer reviews, (b) enforcing audit standards more stringently, and (c) ensuring that an auditor does not have interest in the organisation under audit.

The above Bill was referred to the Parliamentary Standing Committee for its consideration. In its report dated 27th July, 2000, the Committee has considered the suggestions received from the Institute and others and recommended that clause 180 (2) of the above Bill, relating to rotation of auditors, for giving stability to the appointment of auditors, be dropped.

That Committee, has, however, accepted the alternative suggestion made by the Institute that the system of appointment of joint auditors be introduced. The Committee has observed that with the acceptance of this suggestion, the effect will be that the Companies Act will be introducing, for the first time, the concept of joint auditors, which is prevailing in some of the advanced countries. This will ensure that the continuity in audit is not broken. It may be noted that the Companies Bill, 1997, ultimately lapsed and could not be passed.

Naresh Chandra Committee report

The Government of India appointed a Committee under the Chairmanship of Shri Naresh Chandra in August, 2002 to examine various issues relating to Corporate Governance. One of the terms of reference related to examination of measures required to ensure that managements and auditors actually present a true and fair statement of affairs of companies. The whole effort of the Government was to improve corporate functioning and to improve corporate financial reporting. The Committee submitted its report in November, 2002. Besides considering the corporate governance issues, the Committee also considered the issues relating to statutory auditor – company relationship, steps to be taken to preserve independence of auditors, rotation of auditors , measures to improve corporate financial reporting, composition of board of directors, role of independent directors, strengthening the statutory provisions governing Chartered Accountants and other related matters.

On the question of good corporate governance, the Committee observed that two corporate instruments that improve corporate governance are (i) financial and non-financial disclosures and (ii) independent oversight of management. It was observed that independent oversight of management comprises two aspects. The first relates to the role of independent statutory auditors and the second relates to the role of independent directors.

The Committee observed that shareholders appoint auditors who are required to report whether the audited financial statements present a ‘true and fair’ view of the financial health of the auditee. Therefore, the quality and independence of statutory auditors was fundamental to corporate oversight. While it was the job of the management to prepare the accounts, it was the responsibility of the statutory auditors to scrutinise the same and give an independent report on the same. Auditors have the skills to scrutinise complex accounts of today’s multi-divisional and multi-segmental corporations, but these skills will come to naught if the auditing firm did not have a strict arm’s length independent relationship with the management of the corporate body.

In order that auditors are able to preserve their independence, the Committee suggested that auditors should maintain arm’s length relationship with the management. The suggestions of the committee that the auditor should not (i) have financial interest in audit client, (ii) have business or personal relationship with the audit client, (iii) have undue dependence on the audit client, (iv) accept loans or guarantees from audit client, (v) have key management position within two years prior to his appointment and (vi) render certain non-audit services, were incorporated in the Companies Amendment Bill, 2003. Unfortunately, this Bill could not be passed by the Parliament.

The Committee considered the question of rotation of auditors and after detailed discussion with various bodies, came to the conclusion that there was no need to provide for rotation of auditors. It was stated that the Committee had not found sufficient international evidence favouring compulsory rotation of audit firms. Various independent accounting studies made available to the Committee indicated no discernible benefit from rotation. In fact, these studies universally indicated the opposite — that rotation tends to enhance the risk of audit failures in the last year of the tenure of the outgoing auditor and the first two years of the new auditor. Even in the USA the Sarbanes-Oxley Act, 2002 (SOX Act) does not provide for rotation of auditors.

Given the international practice, the Naresh Chandra Committee observed that there was no conclusive proof of the gains while there was sufficient evidence of the risks if the concept of rotation of auditors was accepted. However, the Committee was in favour of compulsory rotation of audit partners as provided in SOX Act in the USA.

According to the Committee, the partners and at least 50% of the engagement team (excluding the articled clerks and trainees) responsible for the audit of either listed companies or companies whose paid up capital and free reserves exceed Rs.10 Crores, or companies whose turnover exceeds Rs.50 crores, should be rotated every five years. Persons who are rotated in this manner can be allowed to return, if need be, after a break-up of three years.

Having emphasised the need for keeping arm’s length relationship with the management, the Committee considered the vexed question of who will audit the auditors ? It is true, the auditor performs a critical role in informing the shareholders of the true and fair picture of the state of financial and operational affairs of a company. However, the ability to play this role will depend on the auditor’s knowledge, skills, independence, professional skepticism and integrity. For this purpose, there is a great need to regulate auditors effectively to ensure that they properly discharge their fiduciary responsibilities.

In India the Institute of Chartered Accountants of India (ICAI) has been set up under the Chartered Accountants Act, 1949 to examine and regulate the profession of Chartered Accountancy. The ICAI has set up a system of Peer Review of audit firms. The Committee considered the Peer Review Statement issued by ICAI and observed that this system was indeed a good one. However, the Committee felt that it was time to think of a very indigenous and refined arrangement to ensure the quality of attestation services performed by Chartered Accountants in relation to the technical standards prescribed for them. Although the Committee was satisfied with the above peer review statement which was a self-contained document and which addressed most of the issues regarding ‘who audits the auditors’, the Committee recommended establishment of a ‘Quality Review Board’ as an independent body outside the Council of the Institute. It may be noted that under Sections 28 A to 28 D of the Chartered Accountants Act, as amended in 2006, a Quality Review Board consisting of 5 members nominated by the Government and 5 members nominated by the Council of ICAI has been appointed.

The Companies Bill, 2008

The Companies Bill, 2008, has been introduced in the Lok Sabha on 23.10.2008 to replace the existing Companies Act, 1956. There is no proposal about rotation of statutory auditors in the Bill. However, some of the provisions are proposed to ensure that the independence of statutory auditors is not impaired. In brief, these provisions are as under :

“Special Resolution will be required if an auditor other than retiring auditor is proposed to be appointed.

“An auditor who has direct financial interest in the company or who receives any loans or guarantee from the company or who has any business relationship (other than an auditor) with the company cannot be appointed as auditor.

“A person whose relative is in employment of the company as a director or Key managerial personnel cannot be appointed as auditor.

“If a firm is appointed as auditors, only the partner of the firm, as authorised by the firm, can sign the audit report on behalf of the firm.

“An auditor cannot accept any other assignment from the company like accounting, book keeping, internal audit, design and implementation of any financial information system, actuarial services, investment advisory services, investment banking services, financial services and management services.

“Audit report shall state whether the financial statements comply with the accounting standards and auditing standards. It may be noted that the National Advisory Committee appointed by the Government will now be required to advise the Government about Accounting Standards as well as Auditing Standards. In other words, the auditors will have to comply with Auditing Standards laid down by the Government on the advice of the National Advisory Committee.

“Auditor shall have a right to attend every Annual General Meeting and shall have a right to be heard at such meeting on any part of the business conducted at the meeting.

“If the auditor makes default in complying with the provisions relating to reporting on the financial statements, provisions prohibiting rendering of other services, and allowing any person other than an authorised person to sign audit report, he shall be liable to pay fine of Rs.25,000 which may extend to Rs.5 lacs. If it is found that the auditor has knowingly or willfully contravened any of the above provisions, he shall be punishable with impairment for a term up to one year or with fine of Rs.1 lac which may extend to Rs.25 lacs or with both. It is also provided that in such cases, the auditor will have to refund the fees and also pay for damages to the company or to any other persons for loss arising out of incorrect or misleading statements of particulars made in the audit report.”

From the above provisions proposed in the Companies Bill, 2008, it will be noticed that these provisions are more stringent and are being introduced with a view to achieve the goal to improve/ strengthen the independence of statutory auditors and quality of audit. It must be recognised that the Government is keen to ensure that the independence of statutory auditors is not affected by any weakness in the corporate governance.

To sum up

Our Institute is a regulatory body and its function is to regulate training of articled trainees, conduct examinations, regulate and develop the profession. All our members are taught the importance of independence, integrity, objectivity, confidentiality, technical standards, professional behaviour and technical competence. Therefore, there is a strong presumption that our members are independent and will not succumb to any pressure. One of the reasons advanced in favour of rotation of statutory auditors is that statutory auditors will tend to lose their independence if they are associated with a particular company in that capacity for a long duration. There is no reason to doubt the competence of the Council of ICAI to ensure the virtues of independence, integrity, objectivity, etc. in the members of our profession. If a person qualifies our examination after completing the practical training without imbibing the above virtues, the Council should consider some other measures to improve the quality of education and training. If a member is independent by virtue of his training and qualification in the first three or five years of audit assignment of a company, he will always remain independent irrespective of his continued association with that company. If he has not imbibed the virtues of independence, integrity, etc. during his education and training period, he cannot remain independent even in the first year of his audit assignment even if rotation of statutory auditors is made mandatory.

Another probable argument by those who favour rotation of statutory auditors is that the younger members will get audits of large companies. This argument is also not valid, because the Institute’s representation before the Parliamentary Committee which was considering this amendment proposed in the Companies Bill, 1997, clearly states “the system of rotation can be evaded easily and will only result in practices like tie-up arrangements between auditing firms and splitting of existing firms”. The Institute has also observed in the above representation that “rotation does not improve the independence of auditors”. As stated above, several reasons are given by the Institute and it is possible that our members may adopt unethical means to secure assignments if compulsory rotation is introduced.

Our Institute has grown from strength to strength over 60 years. The reforms introduced in the field of education, training, CPE Programmes, Quality Review process, etc. have moulded our members to withstand pressures from outside. Therefore, the thinking that independence of members will be affected while discharging the attest function because of a long association with a particular client is not all justified.

From the above discussion it becomes evident that rotation of statutory auditors is not an answer to ensure independence of auditors and quality of audits. The steps taken to strengthen the education and training, ceiling on number of audits per partner, CPE Programmes, Peer Review, etc. are adequate at present. Further, the system of putting additional responsibilities on audit committee and independent directors will go a long way in ensuring independence of auditors and improving corporate governance. As suggested by various committees as well as the Council of the Institute, the system of joint auditors, rotation of partners and audit team of the audit firm can definitely improve the present position. It is also possible to introduce a system by which each audit firm should declare, while accepting the audit, as to under which partner the audit assignment is accepted. An audit firm cannot accept more than the specified number of audits per partner as permitted by the Companies Act. The audit firm should ensure that the audit report is signed only by that partner under whom the audit is accepted. In exceptional cases the audit firm can be allowed to make a change and assign the audit to another partner, subject to the specified number, after making disclosure for the same. In this manner it can be ensured that the system of appointing ‘Signing Partners’, which is in vogue in certain audit firms, at present, will be abolished. This system will ensure that each practising member of the Institute undertakes audit assignment of such number of audits, per partner, as permitted by the provisions of the Companies Act. This will improve the quality of audit.

Author:-P. N. Shah, Chartered Accountant

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April 2024