Auditor terms extended

In a timely move, the Auditing Practices Board (APB) has finalised changes to its ethical standards regarding audit partner rotation. Effective 15 December 2009, the amendments will allow companies to extend their audit partner’s term for a further two years (from five years to seven) provided they can justify the reasoning behind it.

Companies will be required to publish those reasons in its annual report.

Within that, the terms are that the audit committee can only make the decision to extend the term if it believes it will “add to audit quality”. A company’s audit committee and its audit firm may consider that such ‘flexibility’ to increase the term safeguards the quality of the audit, for example, where either “substantial change has recently been made, or will soon be made to the nature or structure of the audited entity’s business”, or “there are unexpected changes in the senior management of the audited entity”.

A company can also exceed the five-year limit if it has become listed during the auditor’s five-year term and wants to continue to use its existing auditor up to a further two years.
Previously, the audit partner could only opt to stay it believed the client had “exceptional circumstances”.

Mandatory rotation
The auditing profession adopted the five-year rule of mandatory rotation following the collapse of Enron and the wave of accounting scandals that followed it. At the time, it was felt audit partners with long-standing client relationships might not recognise when a company’s accounting is going off-track, or find it difficult to challenge management decisions. Institutional investors are still not keen to change that policy, though they have seemingly relaxed their position. Companies, however, appear to back the notion of allowing greater flexibility.

In June this year, the Institute of Chartered Accountants in England and Wales (ICAEW) surveyed 121 FTSE-350 audit committee chairmen and found that nearly 55% would prefer a seven-year rotation period, while another 24% would like five, but with the option to extend to seven. Only 21% of those surveyed said they would opt for the status quo.

Commenting on the amendments, APB chairman Richard Fleck says he took into account concerns from investors who argued that any time extension should occur in limited circumstances, and whether audit committees signed off on the decision.

“While there was broad support for this approach, it was clear from the response from investors that they believed any extension from five to seven years should occur only if the audit committee was satisfied, in limited circumstances, that the extension is necessary to safeguard audit quality,” says Fleck.

“While judgement will be needed in determining whether an extension is, in fact, necessary to safeguard audit quality, the APB decided that it should emphasise… that the extension should only be granted if, in addition, there would be clear disclosure in annual reports of the audit committee’s decision and the reasons for it,” he added.

“The FRC’s Audit Inspection Unit will review the reasoning recorded by audit firms where the partner rotation period has been extended and the associated disclosures that are provided to shareholders.”

Ethical standards
The APB undertook a review of its ethical standards in 2007 and while it found that they were working in practice and appeared to meet the needs of stakeholders, the board recognised the issue of audit partner rotation needed further consideration. In March this year, it issued a consultation paper on the issue.

The major issue identified in the APB’s initial review of the standards was that there were different views as to whether the rotation periods for partners involved in listed company audits struck the right balance between auditor objectivity on the one hand and relevant knowledge and experience on the other. Most respondents continued to argue for a seven-year rotation period for all listed companies. However, investor bodies such as the Association of British Insurers, Hermes and the National Association of Pension Funds continued to take the view that the rotation period should remain at five years.

As a result, the APB’s technical director Jon Grant says the standard-setter reached a compromise that should appease all parties: companies can extend the audit partner’s term by up to two years to a total of seven years, providing that they gain audit committee approval and disclose the reasons behind such a decision as quickly as possible to shareholders.

Disclosure guidance
Grant says the APB will explore with the Financial Reporting Council (FRC) whether disclosure can also be encouraged through amendments to the Guidance on Audit Committees, which may be updated following the finalisation of the Combined Code on Corporate Governance in 2010. In the meantime, the FRC’s Audit Inspection Unit will review the reasoning recorded by audit firms where audit committees decide to extend the partner rotation period and the associated disclosures that are made in relation to the circumstances.