Audit expert urges 10-year audit firm rotation

A governance, audit, and probity consultant Jason Masters – who serves on audit and risk committees in the NSW public sector – has lodged a submission to Treasury’s options paper on the regulation of accounting, auditing, and consulting firms in Australia.

In his submission, Masters has recommended that reporting entities should rotate to a different audit firm every 10 years, with a five-year cooling-off period before reappointment, applied to public interest entities and enacted through the Corporations Act.

He also suggested a mandatory public tender at the five-year mid-point, with the incumbent permitted to bid and win.

“This produces two market tests per decade rather than the one contemplated by Treasury’s option 6B,” Masters said in his submission.

Option 6B in Treasury’s paper recommends mandatory periodic tendering for audit services, where existing and new reporting entities would be required to publicly tender for audit services every 10 years. New reporting entities would first be required to do so upon becoming a reporting entity.

In addition, Masters proposed a prohibition on the audit firm providing non-audit services to the audit client.

“Every non-audit engagement a firm holds removes that firm from the field of bidders for the audit,” he said.

“Removing the conflict expands the field, addressing a concentration in a way that rotation alone does not.”

Masters also supported Treasury’s option of mandating the frequency of audit reviews, increasing the level of surveillance, and publishing the findings. Treasury said this would mandate a minimum level of surveillance activity by ASIC.

He called for legislated restoration of firm-level publication of audit inspection findings, naming each firm and attributing results to it.

“ASIC published this data for three years and withdrew it,” Masters said.

“An audit committee selecting an auditor now has no comparative measure of audit quality, and a tender becomes a presentation contest. The United States, the United Kingdom, and now Canada all name firms. Australia should legislate the requirement rather than leave publication to regulatory discretion.”

Citing European and EU regulation, Masters also said there should be tender rules that prevent selection criteria acting as a proxy for firm size, alongside disclosure of the number of firms invited to tender and submitting a proposal.

Masters said there should be a staggered transition announced at least five years ahead.

Commenting on what audit firm rotation would potentially deliver for entities, Masters cited studies that examined the relationship between audit firm tenure and the speed with which accounting mistakes and misstatements are found and corrected.

He said longer firm tenure resulted in slower discovery and larger misstatements.

Another study showed that the predicted probability of a later re-audit by an incoming audit firm rose from 13.5 per cent to 27.2 per cent.

“I have seen this three times. On each occasion, an organisation changed its external auditor, and the incoming firm identified material misstatements that required restatement of prior-year accounts,” Masters said.

“One matter required notification to ASIC. Three cases prove nothing on their own. They stop being anecdotes when set against research finding the same pattern at scale. The incentive structure explains the pattern. A new firm gains commercially by finding what the previous firm missed, and carries a reputational exposure if it signs off on an error carried forward.”

On top of this, Masters provided several recommendations on steps audit committees could take to ensure robust auditing.

First, he said they should ask the auditor to demonstrate compliance with the five-year partner rotation rule in writing.

“The obligation sits with the auditor. The exposure sits with your board,” he warned.

Second, he recommended asking the audit firm for its most recent ASIC inspection outcome, noting that since ASIC no longer publishes firm-level findings, the firm is now the only source.

“A firm declining to provide them has told you something,” he remarked.

Furthermore, he said committees should disclose audit firm tenure and the date of the last tender in the annual report, ahead of any requirement to do so.

“Count your bidders at the next tender. Where fewer than three capable firms submit a proposal, record why, and record how many were excluded by non-audit engagements your own organisation awarded,” he said.

Finally, he asked for the application of the existing guidance on periodic comprehensive review of the external auditor, which recommends a full review every five years.

Masters noted that Australia allows an audit firm to hold an appointment for long periods (citing one case where the relationship had run for 58 years. However, the signing partner is required to change every five years, with ASIC finding that this rule is not always reliably observed.

“The asymmetry has no principled basis, because the economic relationship threatening independence sits with the firm and not the individual,” he said.

“Ten years is defensible. Twenty years is a gesture.”