Commercial Law- Mandatory Rotation of Audit Firms

This article discusses the mandatory rotation of audit firms in commercial law, its impact on audit quality, and the law in Australia. The law was made mandatory in Australia in 2003, and since then, it has been adopted in many parts of the world. The article also discusses the impact of mandatory rotation on audit quality and the benefits it offers. The article concludes that mandatory rotation has been successful in achieving its aim of providing independence to auditors and improving audit quality.

Commercial Law- Mandatory Rotation
of Audit Firms
1

Table of Contents
Introduction................................................................................................................................3
The Law.....................................................................................................................................3
The Impact.................................................................................................................................4
Conclusion..................................................................................................................................6
References..................................................................................................................................7
2

Introduction
Audit is one of the crucial parts of commerce and hence a lot of importance is given to the
appointment of Auditor. In order to ensure the independence of auditors, mandatory rotation
of audit firms is adopted in Australia. This model is being adopted in many different parts of
the world. The research studies suggest that this mandatory rotation also has the ability to
improve the quality of audits and because of this reason this approach is being adopted on
such a wide scale globally. Though, additional costs are attached to this practice, however the
advantages offered outweigh the drawbacks of the same.1
The Law
This law was voluntary in Australia before 2003, but after the implementation of the
“Professional Auditing Statement F1: Professional Independence” in the year May 2002 this
rule came into existence. This act was a revolutionary reform in the field of auditing. The
conduct of audit is mentioned in the Section 9 of the Corporations Act 2001 and according to
that, audit firm includes the lead auditor, the review auditor and a registered company that is
appointed as the auditor in an organization.2On the basis of this law, the rotation of audit
firms was made mandatory and also the period was set to resume these requirements. Lead
partner is required to rotate in after time period of 7 years with a cooling period of two years.
The second reform took place in the year 2006 and with this reform along with the lead
partner the audit review partners were also subject to rotation. And this policy was tightened
by fixing the rotation time period to five years.3This rule is mentioned in the Section 324DA
1Jackson, AB, Moldrich, M & Roebuck, P 2008, 'Mandatory audit firm rotation and audit quality',
Managerial Auditing Journal, vol 23, no. 5, pp. 420-437.
2CPA Australia 2013, Auditor independence, viewed 04 September 2018,
<https://www.cpaaustralia.com.au/professional-resources/audit-and-assurance/auditor-independence>.
3Ryken, K, Radich, R & Fargher, NL 2007, 'Audit partner rotation: Evidence of changes in audit
partner tenure as the result of mandatory regulation in Australia', Current Issues in Auditing, vol 1, no.
1, pp. A28–A35.
3

(1) and (2) of the Corporations Act. According to the APES 110 Code of ethics for
professional accountants, an auditor is prohibited from engaging in any audit 2 years or more
after the completion of his financial year that is five years of auditing.4According to Section
323D (3) financial year can be extended for 18 months only.5
The Impact
It has been found that the change of auditors is beneficial to the business. This is so because
the change influences the positive peer review and offers a fresh perspective to the auditing
work. Many researches have also been conducted that reveals that there is a relationship
between the mandatory rotation and the audit quality. The occurrence of audit adjustments is
practiced by the moving auditor as well as the new auditor in the beginning of his
tenure.6Monroe and Hossain (2013) undertook research in Australia in order to find out about
the result of mandatory rotation of audit firms and whether it is successful or not. The authors
found out that there was a positive association between the mandatory rotation and the quality
of the audits in Australia. The author mentioned that when the tenure of audit client
relationship is extended, the quality of audit is negatively impacted. The reason behind this is
that over certain period, the auditor focus shifts towards making money from the client and as
a result, economic dependency is generated.7Another reason is that the auditor over certain
period may develop learned confidence that he/she knows everything about client and may
4CPA Australia 2018, APES 110 Code of Ethics for Professional Accountants, viewed 04 September
2018, <https://www.cpaaustralia.com.au/professional-resources/accounting-professional-and-ethical-
standards/apes-110-code-of-ethics-for-professional-accountants>.
5CPA Australia 2013, Auditor independence, viewed 04 September 2018,
<https://www.cpaaustralia.com.au/professional-resources/audit-and-assurance/auditor-independence>.
6Lennox, CS, Wu, X & Zhang, T 2014, 'Does Mandatory Rotation of Audit Partners Improve Audit
Quality?', The accounting review, vol 89, no. 5, pp. 1775–1803.
7Monroe, G & Hossain, S 2013, 'Does audit quality improve after the implementation of mandatory
audit partner rotation', Accounting and Management Information Systems, vol 12, no. 2, pp. 263–279.
4

not test the financial reports with due care.8Also, a long relationship between the two may
turn into personal relations, which may hamper the independence of the auditors.9
According to the research conducted by Ottaway (2011), it can be said that the law pertaining
to mandatory rotation of audit firm’s is working well in Australia but, there are still scope for
improvements that can be adopted by the Australian government and other law institutions.
The author has said that this system of Australian Law has provided independence to the
auditors of Australia and also the quality of audit has been improved because of the features
like fresh look and the watchdog offered by this system. But, the author has also mentioned
the shortfalls in this law and how this law is not competent enough. It has been mentioned
that the negative impact of this system can be directly seen on the market competition, as
there scarcity of audit firms in the market. Specialization is ignored and also the effectiveness
of the committees is negatively impacted. The author has also mentioned other models that
can be adopted by the Australian Law like the Lottery Model, The Insurance Model or the Re-
Tendering Regime adopted by UK.10 Though, many other authors do not support this
statement and argue that a clear change or improvement can be seen in the quality of the audit
in Australia after the implementation of this reform.
Conclusion
It can be concluded that the main aim of the mandatory rotation of audit firm which is to
provide independence to the auditors of Australia and also to improve the quality of audit has
been successfully achieved. Many researchers have proved this statement as mentioned above
that, the direct impact of this law was seen on the quality improvement of audits in the
8GAO 2003, Required Study on the Potential Effects of Mandatory Audit Firm Rotation, viewed 04
September 2018, <https://www.gao.gov/new.items/d04216.pdf>.
9Arel, B, Brody, RG & Pany, K 2005, 'Audit firm rotation and audit quality', The CPA Journal, vol
75, no. 1, pp. 36-39.
10Ottaway, J 2011, Improving auditor independnece in Australia: Is 'mandatory audit firm rotation'
the best option?, viewed September 2018,
<https://law.unimelb.edu.au/__data/assets/pdf_file/0004/1709509/27-OTTAWAYJoanne-
MandatoryAuditFirmRotationPaper2.pdf>.
5

country. Apart from this, because of the continuous rotation the independency of the auditors
has been maintained in the market. Though, this system was criticised by few authors by
comparing this system with other common law in different countries. But, it can be said that
this law is best suitable for the Australian market though there is always some scope left for
further improvements. Apart from this, the fact cannot be denied that the mandatory rotation
of audit firms has done wonders in the Australian market. A negative relationship is drawn
between the quality of the audit when there is long tenure between the audit partner and the
client. Hence, to avoid this, mandatory rotation is the best available option.
6

References
Arel, B, Brody, RG & Pany, K 2005, 'Audit firm rotation and audit quality', The CPA
Journal, vol 75, no. 1, pp. 36-39.
CPA Australia 2013, Auditor independence, viewed 04 September 2018,
<https://www.cpaaustralia.com.au/professional-resources/audit-and-assurance/auditor-
independence>.
CPA Australia 2018, APES 110 Code of Ethics for Professional Accountants, viewed 04
September 2018, <https://www.cpaaustralia.com.au/professional-resources/accounting-
professional-and-ethical-standards/apes-110-code-of-ethics-for-professional-accountants>.
GAO 2003, Required Study on the Potential Effects of Mandatory Audit Firm Rotation,
viewed 04 September 2018, <https://www.gao.gov/new.items/d04216.pdf>.
Jackson, AB, Moldrich, M & Roebuck, P 2008, 'Mandatory audit firm rotation and audit
quality', Managerial Auditing Journal, vol 23, no. 5, pp. 420-437.
Lennox, CS, Wu, X & Zhang, T 2014, 'Does Mandatory Rotation of Audit Partners Improve
Audit Quality?', The accounting review, vol 89, no. 5, pp. 1775–1803.
Monroe, G & Hossain, S 2013, 'Does audit quality improve after the implementation of
mandatory audit partner rotation', Accounting and Management Information Systems, vol 12,
no. 2, pp. 263–279.
Ottaway, J 2011, Improving auditor independnece in Australia: Is 'mandatory audit firm
rotation' the best option?, viewed September 2018,
<https://law.unimelb.edu.au/__data/assets/pdf_file/0004/1709509/27-OTTAWAYJoanne-
MandatoryAuditFirmRotationPaper2.pdf>.
Ryken, K, Radich, R & Fargher, NL 2007, 'Audit partner rotation: Evidence of changes in
audit partner tenure as the result of mandatory regulation in Australia', Current Issues in
Auditing, vol 1, no. 1, pp. A28–A35.
7