Compulsory Rotation of auditors

Concept of mandatory audit firm rotation

Mandatory audit firm rotation is defined in the Sarbanes-Oxley (SOX) Act as the imposition of a limit on the period of years during which an accounting firm may be the auditor.

Rationale of mandatory rotation of auditors - To enhance audit quality

The idea behind mandatory rotation of auditors is to enhance audit quality. Quality of an audit is a function of (1) the competence of the audit firm (i.e., the auditor’s ability to detect material omissions or mis-statements in the client’s financial statements), and (2) the level of actual threats to auditor independence (i.e., the probability the auditor will reveal material errors). The US Supreme Court has emphasized the importance of the connection between investor confidence and the appearance of independence of auditor “….Public faith in the reliability of a corporation’s financial statements depends upon the public perception of the outside auditor as an independent professional. If investors were to view the auditor as an advocate for the corporate client, the value of the audit function itself might well be lost.” [United States v. Arthur Young & Co. 465 U.S. 805, 819 n.15 (1984)].

Companies to which provisions for compulsory rotation of auditor’s apply [Section 139(2)]

Provisions for compulsory rotation of auditors in section 139(2) shall apply to :

• listed companies
• a company belonging to such class or classes of companies as may be prescribed

Rule 5 of the Companies (Audit and Auditors) Rules, 2014 provides that for the purposes of sub-section (2) of section 139, the class of companies shall mean the following classes of companies excluding one person companies and small companies:—

(a)all unlisted public companies having paid up share capital  of rupees ten crore or more;

(b)all private limited companies having paid up share capital  of rupees twenty crore or more;

(c)all companies having paid up share capital of below threshold limit mentioned in (a) and (b) above, but having public borrowings from financial institutions, banks or public deposits of rupees fifty crores or more

The provisions of section 139(5)/139(7) dealing with Government Companies and companies owned or controlled directly or indirectly by Government override only section 139(1) but not section 139(2). Therefore, provisions of section 139(2) shall also apply to Government companies and companies owned or controlled directly or indirectly by Government if such companies are listed companies or fall in prescribed class or classes of companies i.e. covered by Rule 5 above.

Provisions as to compulsory rotation of auditors

The following provisions may be noted:

No listed company or a company belonging to such class or classes of companies as may be prescribed, shall appoint or re-appoint—

(a) an individual as auditor for more than one term of 5 consecutive years; and

(b) an audit firm (including LLP) as auditor for more than two terms of 5 consecutive years.

Cooling off period

The cooling off period is the minimum gap between expiry of maximum tenure and appointing the auditor again which is stipulated by law. The provisions in this regard are as under:

• An individual auditor who has completed his term as per (a) above shall not be eligible for re-appointment as auditor in the same company for 5 years from the completion of his term; 
• An audit firm (including LLP) which has completed its term under (b) above, shall not be eligible for re-appointment as auditor in the same company for 5 years from the completion of such term.

Provisions cannot be circumvented by appointing partner of audit firm whose tenure is over - On the date of appointment no audit firm having a common partner or partners to the other audit firm, whose tenure has expired in a company immediately preceding the financial year, shall be appointed as auditor of the same company for a period of 5 years. The words ‘same company’ in section 139(2) of the 2013 Act are significant. It appears that there is no bar on appointing the rotated auditor (auditor/audit firm who has completed term) as auditor of holding company/subsidiary/co-subsidiary/associate of the company in question during the cooling-off period.

Every company, existing on or before the commencement of this Act which is required to comply with provisions of this sub-section, shall comply with the requirements of this sub-section within three yearsfrom the date of commencement of this Act.

The above provisions shall not prejudice the right of the company to remove an auditor or the right of the auditor to resign from such office of the company. [Section 139(2)]

The Central Government may, by rules, prescribe the manner in which the companies shall rotate their auditors. [Section 139(4)]

Manner in which the companies to rotate their auditors on the expiry of term

Rule 6 of the Companies (Audit and Auditors) Rules, 2014 provides as under :

• The Audit Committee shall recommend to the Board, the name of an individual auditor or of an audit firm who may replace the incumbent auditor on expiry of the term of such incumbent. 
• Where a company is required to constitute an Audit Committee, the Board shall consider the recommendation of such committee, and in other cases, the Board shall itself consider the matter of rotation of auditors and make its recommendation for appointment of the next auditor by the members in annual general meeting. 
• For the purpose of the rotation of auditors—(i) in case of an auditor (whether an individual or audit firm), the period for which the individual or the firm has held office as  auditor prior to the commencement of the Act shall be taken into account for calculating the period of five consecutive years or ten consecutive years, as the case may be;(ii)the incoming auditor or audit firm shall not be eligible if such auditor or audit firm is associated with the outgoing auditor or audit firm under the same network of audit firms. 
• The term “same network” includes the firms operating or functioning, hitherto or in future, under the same brand name, trade name or common control. 
• For the purpose of rotation of auditors,—(a) a break in the term for a continuous period of five years shall be considered as fulfilling the requirement of rotation;(b) if a partner, who is in charge of an audit firm and also certifies the financial statements of the company, retires from the said firm and joins another firm of chartered accountants, such other firm shall also be ineligible to be appointed for a period of five years.

Illustration explaining rotation in case of individual auditor

Number of consecutive years for which an audit firm has been functioning as auditor in the same company [in the first AGM held after the commencement of provisions of section 139(2)]	Maximum number of  consecutive years for which the firm may be appointed in the same company (including transitional period)	Aggregate period which the firm would complete in the same company in view of columns I and II
I	II	III
5 years	3 years	8 years or more
4 years	3 years	7 years
3 years	3 years	6 years
2 years	3 years	5 years
1 year	4 years	5 years

Note: 1. Individual auditor shall include other individuals or firms whose name or trade mark or brand is used by such individual, if any.

2. Consecutive years shall mean all the preceding financial years for which the individual auditor has been the auditor until there has been a break by five years or more.

Illustration explaining rotation in case of audit firm

Illustration 2:—

Number of consecutive years for which an audit firm has been functioning as auditor in the same company [in the first AGM held after the commencement of provisions of section 139(2)]	Maximum number of  consecutive years for which the firm may be appointed in the same company (including transitional period)	Aggregate period which the firm would complete in the same company in view of columns I and II
I	II	III
10 years (or more than 10 years)	3 years	13 years or more
9 years	3 years	12 years
8 years	3 years	11 years
7 years	3 years	10 years
6 years	4 years	10 years
5 years	5 years	10 years
4 years	6 years	10 years
3 years	7 years	10 years
2 years	8 years	10 years
1 year	9 years	10 years

Note : 1. Audit Firm shall include other firms whose name or trade mark or brand is used by the firm or any of its partners.

2. Consecutive years shall mean all the preceding financial years for which the firm has been the auditor until there has been a break by five years or more.

Rotation of auditors to be factored in while appointing joint auditors

Rule 6(4) of the Companies (Audit and Auditors) Rules, 2014 provides that  where a company has appointed two or more individuals or firms or a combination thereof as joint auditors, the company may follow the rotation of auditors in such a manner that both or all of the joint auditors, as the case may be, do not complete their term in the same year.

Enabling provision for rotation of audit partners

Rotation of auditor/audit firm is not to be confused with rotation of audit partner/team. The former is mandatory. The latter is optional. Moreover, rotation of auditor applies to auditor irrespective of whether auditor is individual/audit firm. Rotation of audit partner applies only when auditor is audit firm.

Subject to the provisions of this Act, members of a company may resolve to provide that in the audit firm appointed by it, the auditing partner and his team shall be rotated at such intervals as may be resolved by members [section 139(3)(a)]