Financial Statements’ auditors and independence, part 2: mandatory rotation

Francisco de Marcos. Professor. Instituto de Empresa

1 January 2005

The second part of Francisco Marcos’ look at auditors and the companies they audit. Part one appeared in Focus 22 (Nov. 2004).

Modern-day legal provisions assign an essential function to financial statements’ auditors to “guarantee” reliability and the exactness of the financial information firms provide to financial markets. Every country has a detailed catalogue of auditor’s obligations and duties to ensure their independence from the company being audited.

Recent years have seen several financial scandals in large companies, on both the domestic and international stage, as a result of financial statements fraud and manipulation by managers and directors. This misconduct went unnoticed by the financial statements’ auditors. It has created a situation where the modifications proposed for avoiding and preventing fraud of this kind include various reforms of the laws governing financial statements’ auditors.

Mandatory rotation

The proposed measures for preventing the absence of auditor independence include making it mandatory for companies to change auditors after a certain number of years. This provision is in force in Italy and was so in Spain between 1989 and 1995, although its reduced implementation prevented it from having any real or practical application.

The original version set forth in Spain’s Limited Companies Act of 1989 prevented the renewal of auditors nine years after their initial appointment. The imposition of a time limit beyond which a company’s auditor had to be changed sought to avoid connivance between the auditor and the company’s directors, and aimed at making it impossible for undeserved favourable opinions or reports on the company’s accounts to surface. The provision was criticized and repealed by the Limited Companies Act of 1995.

The remedy seemed excessive. Such a drastic formula overlooked the fact that, as professionals, auditors are already subject to a series of legal and ethical obligations which, under normal circumstances, are sufficient to avoid excessive dependence of auditors on their clients.

Furthermore, together with a possible disciplinary fine, or fines imposed by the legal system, the reputation of independence is any auditor’s main presentation card for use on the market. A damaged reputation, owing to lack of independence, would deprive the auditor of his or her main asset, and perhaps livelihood.

This legal intervention seriously distorts the incentives of both auditor and the firm under scrutiny, especially when the date of expiry of contracts nears. It likewise does away with any encouragement for performing a quality audit. In any case, this solution is not considered worthy of any great merit.

The most extreme reaction has been to introduce the obligatory rotation of the partner responsible for reviewing a client's financial statements within the audit firm. This has been true in Spain since 2002 for listed companies or companies with a turnover higher than €30 million.

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