Rotation of auditor: a law that will damage audit quality irreparably

If the intention of this law is to improve audit quality, it does the opposite, damages audit quality irreparably. This is a terrible law for several reasons:

•  It does not solve any problem. It’s a trivial solution to the big issue of audit quality. It imposes an unnecessary cost on Ghanaian companies, most of which are small private companies. There are no discernable benefits.
•  It does not consider the state of audit firms in Ghana. The industry is fragile. Improving the capacity of a firm to perform a quality audit requires significant investment. Many depend on their operating cash flow to fund the investment required to strengthen their capacity.
• Auditor rotation, as being implemented, will undermine the commercial viability of the local audit firms, and harm their capacity to invest in building stronger audit firms. 75% of the firms make less than GHC 500,000. That revenue base is too small to run operations and invest in significantly strengthening the firms.
• Improving audit quality costs money. Our goal should be to enable the 10% of the audit industry that can perform the more sophisticated audits to invest in strengthening their audit capacity. This law as being implemented does the opposite.
• Auditor rotation does not solve audit quality problems. We already have auditor rotation for banks, insurance companies, and pension funds. In countries that have powerful institutions and accounting bodies such as the UK, there have been audit failures in companies subject to rotation.

The lawmakers propose an ineffective solution to a wrongly diagnosed problem. As the cost of the cure far exceeds the benefit, we must reconsider this law.

The issue

Parliament approved the Companies Act, 2019 (Act 992) in 2019. It provides for auditor rotation in section 139 (11) which states that “an auditor shall hold office for a term of not more than six years and is eligible for appointment after a cooling-off period of six years.”

There was extensive consultation on the proposals leading to the new law, which did not include a requirement for auditor rotation. Parliament introduced the provision when considering the bill and passed it into law without assessing the cost and benefits of auditor rotation.

This law imposes a hefty cost on companies and the audit profession. It has no discernible benefits. This article discusses the stark implications of the law and offers some recommendations.

Implementation

The Registrar General has instructed that since the law came into effect on 2nd August 2019, companies should change auditors at the next annual general meeting, if the auditor’s tenure is over 6 years. In a letter to the CEO of the Institute of Chartered Accountant, she reasoned that:

•  “The provision of the law implies that the six-year term runs from the date of appointment of the auditor, and the beginning of the terms of the auditor’s appointment is set by his instrument of appointment”.
• “The obligation enacted by the law is that the auditor should not be in office for over 6 years and therefore if the auditor has served six years, the Act prohibits from further contract until after the cooling-off period”.

Impact on audit firms

The immediate impact of the Registrar’s approach to implementation is that long-established audit firms risk losing between 30% to 40% of their clients in 2021, with no certainty that they can replace the business lost immediately.

This will undermine the viability of the firms before the dust settles. As a Managing Partner of a firm, I cannot see how we can hold audit staff and make the investments needed to perform a quality audit when, at a fell swoop, you lose that amount of business.

This is a serious problem because it takes years to develop auditors. It takes even longer to develop auditors for complex industries like the banking and financial sector. Losing such staff will hurt the firms, especially the local firms, for a long time.

Building capacity to perform effective audits demands investment in training, methodology, IT, and a host of other things. These investments require capital. The firms, being small businesses, have limited access to external capital. The firms depend on funds generated from their operations.

If the intention is to improve audit quality, implementation of this law does the opposite—it undermines the viability of the firms, limits their capacity to invest in audit quality, and that will ultimately affect the quality of audit work.

What is the purpose of the law?

One can only guess, as there are no explanatory notes in the Memorandum to the Companies Bill 2019, on the rotation of Auditors. According to the Registrar General, “the decision was necessitated by the Banking and Financial Sector crisis during the period which prompted the need for Auditors to be rotated in order not to be complacent in their advisory role”.

Her comments raise several questions:

• Is the purpose to stop auditors from being complacent?
• Is there any evidence that the bank audit failures were because of auditor complacency
• Is there any evidence that there are widespread audit failures across many companies and industries, and that the failure is because of auditor complacency?
• Does auditor rotation stop audit failures?
• Is a retrospective application of the law legal?
• Considering that the impact, cost, and benefits of this provision was not assessed, is an immediate implementation wise?

The law assumes that the bank audit failure is because of auditor complacency. This presumption is false and unproven. The presumption of widespread audit failure across public and private companies is also false. There is no proof.

Auditor rotation is not a cure for auditor complacency or audit failures. Bank audits in Ghana are already subject to rotation, so if it is a cure, we should not have had bank audit failures. Publicly traded companies are subject to audit rotation in the EU, but that has not prevented the occurrence of audit failure involving the big four.

The lawmakers have adopted a simplistic approach to audit quality and proposed an expensive cure. Many factors affect audit quality, so if we care about audit quality, we must first understand the problem. That is what the UK did - set up a review, the Brydon Review [i], to investigate the cause of the failures and propose a solution. I suggest this approach to the Government of Ghana.

This law fails all the criteria for good regulation. The law shows a lack of understanding of the factors that affect audit quality, the state of the accountancy profession in Ghana, the nature of Ghana companies, and the cost exceeds any benefit to society.

The state of accounting and auditing

The World Bank has done two studies on the state of accounting and audit in Ghana[ii], one in 2004 and the other in 2014. All the matters covered affect the quality of financial reporting and auditing. The review covered the following areas:

•  Standards.
• Education and training.
• The capacity of accounting and auditing professions.
• Technical capacity.
• Professional competence.
• Ensuring compliance - strengthen the capacity of the regulator.

There are weaknesses in all the areas reviewed. We have made some progress since 2010, but we still have a lot to do. Without comprehensively addressing the weaknesses in corporate reporting and audit, we will not get corporate reporting and auditing to consistently high standards.

Audit firms in Ghana

In 2020, ICAG approved 285 firms to carry out audits in Ghana. ICAG classifies firms into 5 categories based on their revenues. The revenue earned correlates to the capacity of the firm to perform complex audits. The bigger the firm, the more resources it can command to build capacity and infrastructure.

75% of the firms are in categories B to E and make a revenue of GHC 500,000 or less. Only 10% of the firms, categories A1 and A, make a revenue of over GHC 1M. Many of the firms in the industry are weak and do not have the capital to make the investments needed to build stronger firms.

Only 10% of the firms have some capacity to make the investments they need to improve their capacities and serve bigger clients. The big four, who dominate the A1 category, have the support of their big four parents. All the other firms must find financial and technical resources to build their firms.

The big four firms can withstand the immediate destabilizing effect of this law. All the other firms will struggle in the unstable market that this law creates.

The burden on Ghanaian companies

Most Ghanaian companies are private companies. Most are owner-managed, and the vast majority are small. They face many challenges, such as access to capital and finding appropriate personnel.

The relationship between small companies and their auditors differs from that of the big firms. The small companies depend on their auditors for more than an audit. They look to them for accounting help and advice on aspects of their businesses. These relations take a long time to build.

Their accounts are private–for the benefit of the shareholders. Apart from GRA, they are not obliged to share their accounts with anyone. The shareholders endure the consequence of their management decisions.

Why should private companies, whose accounts are private, be obliged to change auditors every six years? What is the benefit to them considering they depend on their auditor for more than an audit? Does the benefit exceed the cost?

These companies struggle to comply with regulations, and this law only adds to their burden. We should reduce the burden of regulation on companies, not add to it.

Audit firm role in training accountants

Most Ghanaian companies do not have organized training programs for their accountants. The audit firms play a disproportionate role in training accountants. The impact of this law has implications for the capacity to hire and develop accountants.

Audit rotation global practice

Auditor rotation is not new, but the practice across the world is to limit such rotation to public interest companies. Public interest companies are companies in which a lot more people than the shareholders have interests. Banks, insurance companies, pension funds and companies listed on a stock exchange are examples of such companies.

In Ghana, we have auditor rotation in the category of businesses classified as public interest entities - banks, finance companies, insurance companies, and pension funds.

I do not know of any country in the world where all companies must rotate auditors by law. Other countries limit auditor rotation to only public interest entities. Some jurisdictions even exempt small companies that meet a threshold from performing an audit. They exempt such companies because the cost of audit exceeds the benefits.

Recommendations

To limit the damage that this law will cause:

1. We should not apply the law retrospectively. The length of auditor tenure should count from 2019 when the law came into effect. That will reduce the disastrous impact that the law is having on audit firms.
2. We should limit auditor rotation to public interest entities, e.g. banks, insurance companies, pension funds, finance companies.
3. The government should conduct a study into audit quality. The World Bank has done two such studies on Ghana, and the recommendations could be a starting point.
4. We should weigh the cost and benefits of all proposals to address audit quality. If the cost far exceeds the benefits, we should repeal it.

George Katako

[i] Sir Donald Brydon CBE, Report of The Independent Review Into the Quality and Effectiveness of Audit, December 2019

[ii] World Bank, Republic of Ghana: Report on Observance of Standards and Codes – Accounting and Auditing (ROSC A&A) 2004, 2014