End of compulsory audit firm rotation rule ‘poses minimal threat in the short term’

The Independent Regulatory Board for Auditors (Irba) will continue to support the principle that companies should rotate their auditing firms regularly, to ensure that audits are independent.

Irba said this in response to the setting aside by the Supreme Court of Appeal (SCA) of Irba’s Mandatory Audit Firm Rotation Rule (MAFR), which compelled “public interest entities” to appoint a new audit firm every 10 years.

In terms of Irba’s Code of Professional Conduct, a public interest entity includes:

• A listed entity;
• An entity defined by regulation or legislation as a public interest entity; or
• An entity whose audit must, in terms of regulation or legislation, be conducted in compliance with the same independence requirements that apply to listed entities.

Irba, which was established in terms of the Auditing Profession Act, promulgated the MAFR on 5 June 2017, and the rule came into effect on 1 April 2023.

The MAFR stated that an audit firm, including a network firm, shall not serve as the appointed auditor of a public interest entity for more than 10 consecutive financial years. Thereafter, the audit firm would be legible for reappointment after at least five years.

“We still believe that MAFR is the appropriate mechanism that strengthens auditor independence. The court’s judgment against the Irba in this matter was on a technical legal basis and did not bring into question the value and/or effectiveness of MAFR. Therefore, we stand by the principle of strengthening independence through regular rotation of firms,” Irba chief executive Imre Nagy said in a statement on 1 June.

In Nagy’s view the court did not rule on whether the MAFR is or is not the right mechanism to increase independence, but the decision arose from a difference of opinion on whether the Auditing Profession Act allowed Irba to issue the rule.

“We will therefore work urgently with Parliament and stakeholders to address the technical issue raised in the judgment,” he said.

Although Irba respects the judgment, it would continue to pursue its mandate to protect investors and assist the government to grow the economy by restoring confidence in audits. As the audit regulator, it aims to create an enabling environment for registered auditors to produce high-quality audits that investors can trust when making investment decisions, Nagy said.

“Whether it is a real or perceived lack of independence, the shareholders and public will continue to question whether an audit firm is truly independent when reviewing financial statements in circumstances where they have audited the clients for longer than a decade.”

Nagy said the setting aside of the MAFR poses “minimal risks to investors” in the short term because most listed entities (91%) and public interest entities have already rotated audit firms. “The benefit of these rotations will be in effect for at least the next five to 10 years.”

Problems with long audit firm tenure

He said the SCA acknowledged the important role played by auditors and the problems associated with long audit firm tenure.

“Audit firms play a pivotal role in ensuring that representations made by companies in annual financial statements are reliable, accurate and portray a fair and balanced position of a company’s financial affairs. Investors and the public rely on the accuracy of those representations to make investment decisions,” Acting Judge Thina Siwendu said in the appeal court’s judgment.

“The industry has been marred both locally and globally by accounting scandals, with dire consequences for investors and the public. In part, the Irba attributes the genesis of the problem to the long tenure of audit firms, which have in some instances endured for 80 to 114 years. It claims that chief financial officers, who hold sway in the decision to appoint an audit firm, are drawn from a limited pool of auditors, often from the same auditing firms.

“According to the Irba, the acquaintance between audit committee chairs and incumbent auditors exacerbates the perception of a lack of independence and poses a threat to audit outcomes.

“It identified the need for measures to ‘strengthen auditor independence to enhance audit quality’, a trend adopted and followed by regulators in other international jurisdictions,” Acting Judge Siwendu said.

Objection from accountants’ association

One of the measures identified by Irba was the MAFR, which, in July 2016, Irba decided in principle to adopt. It initiated consultations with stakeholders on the introduction of the rule.

The East Rand Member District of Chartered Accountants objected to the introduction of the MAFR. According to the SCA, about 15% of the association’s members are registered auditors who practise in small to medium-sized firms.

In September 2017, the association, exercising its rights under the Promotion of Administrative Justice Act (Paja), requested reasons from Irba for its decision to introduce the MAFR. Irba provided its reasons in December 2017.

The association approached the High Court in Pretoria in May 2018, seeking an order to review and set aside the MAFR.

The High Court dismissed the application in a judgment handed down in December 2021. The court found that the review was brought outside the period prescribed in Paja, and it could not find sufficient grounds to condone the delay. The court found it was unnecessary to consider the merits of the review.

The SCA disagreed with the High Court’s criticism of the association, saying there had been no unreasonable delay in bringing in the review application.

Irba exceeded its powers

Turning to the merits, the SCA observed that Irba may not exercise a power not conferred by the Auditing Profession Act or act in a manner inconsistent with it.

Irba submitted that section 10(1)(a), read with section 4(1)(b), (c) and (e) of the Act, was the source of its power to promulgate the MAFR.

Section 10(1)(a) permits Irba to prescribe rules on matters “required or permitted” to be prescribed by the Act.

The matters that Irba is permitted to prescribe are stated in section 4, which deals with its general functions. The relevant provisions of section 4(1) state that Irba must, in addition to its other functions provided for in the Act:

(b) take steps it considers necessary to protect the public in their dealings with registered auditors;

(c) prescribe standards of professional competence, ethics and conduct of registered auditors;

(e) prescribe auditing standards.

The SCA said section 4 confines Irba’s rule-making power to “the prescription of standards” in respect of defined functional areas. The MAFR is not a standard of competence or a professional standard.

“The net effect of the MAFR, as counsel for the Irba conceded during the hearing, is that it imposes a broad restriction on companies, audit committees, and their current and future shareholders from appointing an audit firm of their choice. At the same time, it prohibits audit firms from accepting appointments even if selected by a company.”

Irba then tried to rely on section 10(1)(b), which states that the regulatory board must “take steps it considers necessary to protect the public in their dealings with registered auditors”.

But the SCA found that Irba made no reference to section 10(1)(b) when the MAFR was published.

The court found that the MAFR was unlawful and should be set aside.

The SCA awarded costs in favour of the appellants, the East Rand Member District of Chartered Accountants and its chairman, Jaroslav Cerny, but the costs order was subject to conditions (see below).

Judgment doesn’t apply to individual auditors

The setting aside of the MAFR does not affect the compulsory rotation of individual auditors, as provided for in the Companies Act.

Section 92 of the Companies Act, among other things, regulates individual audit tenure. It prohibits the same individual (not audit firm) from serving as the auditor of a company for more than five consecutive financial years. There is a cooling-off period of two years between appointment cycles.

Attorneys punished for ‘unnecessarily large’ court record

The judges were not happy with the size of the court record, saying it was “awash with reports and unnecessary material”.

The record consisted of 15 volumes, comprising 2 633 pages, whereas it should not have exceeded seven volumes.

“This court has expressed its displeasure in numerous matters at the disregard for the rules in the preparation of the record and the cost to the parties when that happens.”

It said both parties were responsible for the state of the record.

“Accordingly, the attorneys for both the appellants and the respondents shall only be entitled to recover from their clients no more than 50% of the costs associated with the preparation, perusal, and copying of the record in the appeal in this court.”