SPECIAL REPORT – AUDIT REFORM

How can auditor independence be enhanced and the audit market be deconcentrated and transformed? Victor Sekese elaborate.

The recent reported global and local corporate governance failures have put a spotlight on auditors and their role in the financial reporting process.
Furthermore, the revelations at the Zondo Commission have accentuated public debate on the role of auditors. This discourse is complicated by a general misunderstanding of the role of auditors − the so-called expectation gap.

The public expects auditors to identify and report fraud and malfeasance taking place at auditees. Auditors, on the other hand, claim that the current framework within which they operate is not designed to identify all fraud and wrongdoing. They also argue that other role players in the corporate governance ecosystem also need to take accountability in the event of corporate failure.

The auditors’ arguments have not succeeded in changing the public narrative and sentiment towards the audit profession. There is therefore a need for intervention to address this situation and most importantly to prevent future corporate governance and audit failures.

The question is, what needs to be done. In 2017, The Independent Regulatory Board for Auditors (IRBA), against fierce opposition from some stakeholders, introduced mandatory audit firm rotation (MAFR). With effect from 2023, all public interest entities (PIEs) must rotate their audit firms after every ten years, with a five-year cooling period before they can be considered for possible reappointment.

The MAFR policy was introduced because of a concern by IRBA that long-term audit tenure negatively impacts on auditor independence. Auditor independence and objectivity are pivotal in the auditing process and have a direct impact on audit quality. Auditors who are not independent may overlook irregularities and omissions in the financial reporting process, thereby compromising audit quality and devaluing financial statements. To enhance audit quality, auditor independence therefore needs to be maintained and improved.

The primary objective of MAFR is to improve audit quality through strengthening auditor independence by limiting auditor tenure to ten years.

According to IRBA, as of April 2020, 25% of the JSE-listed entities had rotated audit firms since the announcement of MAFR in 2017. Future studies will be required to test the efficacies of the MAFR policy.

The stated secondary objective of MAFR is to reduce audit market concentration and achieve racial transformation. IRBA, however, acknowledges that MAFR policy will not achieve the secondary objectives of reduction of audit market concentration and achievement of transformation on its own. Additional policy instruments are therefore necessary for the achievement of these objectives.

This formed the subject of my recently completed research paper in part fulfilment of the requirements of a public policy master’s programme. I share in this article some of the key findings of my research.

The objective of the research was to identify additional policy interventions necessary to address market concentration and transformation of the audit profession in South Africa.

It is common knowledge that the audit profession is dominated globally and locally by the Big 4 accounting firms. In many global jurisdictions, the audit market has arguably assumed an oligopolistic form. Regulators are therefore concerned about the negative effects of this market structure as espoused by economic theory. Also, they are particularly concerned about the systemic risks that the structure presents. They have thus been, for a long time, contemplating various policy instruments to change the market structure to be more inclusive and broader.

My study participants acknowledged that many factors are contributing to the concentrated audit market structure, which is not limited to the audit profession but extends to other industries as well. They nevertheless unanimously agreed that policy interventions are necessary to deconcentrate the audit market.

The European Commission (EC), in response to the concerns above, in 2010 released comprehensive proposals for reforming the European audit market in a green paper titled Audit policy: lessons from the crisis’. The objective of the green paper objective was to enhance the audit regulatory framework to improve audit quality.

Following the public consultation process on the green paper, final regulations were promulgated in 2014 through a European Parliament audit directive.

The EC 2010 green paper proposals were varied and included mandatory audit firm rotation, mandatory joint audits and the appointment of auditors by an independent body. The latter two were not carried through to the final regulations promulgated in 2014.

 

Appointment of auditors by an independent body

Several scholars argue that the current system of appointment of auditors is flawed. Auditors are expected to always act in the interest of the public. Audit firms are, however, private enterprises with a profit motive. Their commercial interests, scholars argue, are in conflict with public interest objectives.
Furthermore, they argue that the current process of appointment of auditors compromises auditor independence. Auditors are appointed by shareholders on the recommendation of the board, particularly the audit committee. However, in practice, executives and the board are very influential in auditor appointment and shareholders rarely vote against their recommendations. In essence, auditors are appointed and remunerated by executives and the board and yet they are accountable to a much wider group of stakeholders including shareholders, lenders, employees and government agencies. The current process thus contains an embedded conflict of interest for auditors.

Scholars therefore recommend a framework similar to one once considered by the EU 2010 green paper, namely appointment of auditors by an independent body. This, they argue, will address conflict of interest challenges and enhance auditor independence.

There is however limited global precedence of the application of the framework. Germany has partially applied the framework for cooperatives and savings banks.

This model is currently being considered in the UK and India. The UK Competition and Markets Authority (CMA) study recommended that the model be revisited in future should other interventions not achieve the objectives of changing the audit market structure.

The consultation paper issued by the government of India in 2020 is considering possible enhancements of audit independence and accountability and recommended the appointment of auditors by external authorities like the Comptroller and Auditor-General of India, a body equivalent to the Auditor-General of South Africa (AGSA).

 

Infrastructure and capability of the AGSA

The infrastructure and capability of the AGSA can be used to achieve the objectives of further enhancement of auditor independence, diversifying the audit market by expanding participation of non-Big 4 firms and transformation of the audit profession through supporting black-owned firms.

The AGSA is mandated through the Public Audit Act to audit the state, state organs and state-owned companies. The act also empowers the AGSA to use privately owned audit firms in the execution of its mandate. The AGSA has thus implemented a well-functioning system, the Contracts Work Committee, through which it allocates its work to private audit firms.

South African regulators can consider extending the mandate of the AGSA to cover non-state public interest entities, or they can assign the responsibility to appoint auditors of specified PIEs to the AGSA. The AGSA as a credible Chapter 9 institution will ensure that the objectives of public interest are maintained at all times. This will reduce the risks of future audit failures. Furthermore, the audit firm allocation framework will ensure an equitable share of audits that will encourage wider firms’ participation and transformation through the participation of black firms.

This proposition was not supported by my study participants, however. Various arguments were advanced against the proposition including that the framework is not aligned with free-market principles, challenges relating to accountability, possible bureaucratic inefficiencies, and risk of capture by audit firms.

I believe there is merit in further exploring this and other possible models that will be effective in changing the audit market structure and achieve BBBEE objectives of enabling the emergence of viable, sustainable black-owned audit firms. Experience has proved that the market cannot self -correct − regulatory intervention is necessary to rectify market structure deficiencies.

AUTHOR | Victor Sekese, Chief Executive of SNG Grant Thornton and board member of Grant Thornton International

 

Source: https://www.accountancysa.org.za/special-report-audit-reform/