MY SUBMISSION TO PARLIAMENT - MAFR (PART 1)

1. Introduction
Nkonki supports the implementation of Mandatory Audit Firm Rotation (MAFR). Nkonki considers
the development of this requirement to be in the public interest as it aims to improve the
protection of the investing public from potential audit failures that might result in substantial
financial losses for investors. In addition Nkonki believe that MAFR will have a large impact in the
small to medium audit firm market which includes black audit firms.
Sello Hatang – CEO – Nelson Mandela Foundation – We have to take the growing discontent, in
especially black communities, about the slow pace of transformation more seriously. The
pedestrian pace of transformation is also evident in the business community, which goes largely
untouched.
2. The Value of an Audit Depends on Auditor Independence
The auditor occupies an inimitable place among white-collar professionals. Although selected and
compensated by his or her client, the auditor’s duties may extend beyond his or her client to
certain third parties and public investors. While attorneys and physicians act as advocates,
advisors, and confidants, an auditor must remain a disinterested and independent party and may
be engaged to protect and promote interests other than those of his or her client.
As recently as September 2016 a large network firm of auditors agreed to pay $9.3 million to settle
charges that two of the firm’s audit partners got too close to their clients on a personal level and
violated rules that ensure firms maintain their objectivity and impartiality during audits.
Relationships between auditors and their clients can create closeness with management that may
adversely affect the auditor’s independence and reduce the reliability and quality of the audit. It
is alleged that relationships that were “too close” have led to the external auditor’s inability to
scrutinize transactions and contributed to recent dramatic audit failures at several high-profile
companies (e.g. Enron, WorldCom, Xerox, etc.) The Wall Street Journal characterized one of these
arguably “too-close” relationships as follows: “Andersen auditors and consultants were given
permanent office space at Enron. They shared in office birthdays, frequented lunchtime parties
people just thought they were Enron employees” (Herrick and Barrionuevo, 2002).
Mautz and Sharaf (1961) state that the greatest threat to auditors’ independence is a “slow,
gradual, almost casual erosion of his honest disinterestedness. Palmrose (1989) determined that
audit hours decline as audit firm tenure increases.
3. Background
A system of mandatory audit firm rotation would require companies to rotate their independent
auditor periodically. Since the first statutory requirement for external audits of joint stock
companies was enacted in the 19th century, the nature of an audit has changed, almost beyond
recognition. At first, auditors checked accounting records in detail but did not verify the physical
assets of a business, nor did they review management decisions. Changes in the audit process from
a mechanical routine of checking the books of account, to a vital part of corporate governance,
have accelerated in recent years. At the same time a massive gap has developed between the
responsibilities that the auditing profession believe they have, and the expectations that
stakeholders in a company have of an audit. In its simplest terms, the purpose of an audit is to give
additional credibility to the accounts that directors give of their stewardship. Company law
requires directors to account to the shareholders in their company according to rules set out in
accounting standards. The auditor’s task is to audit those accounts and report to the shareholders
on whether they fairly present the company’s results, financial position and cash flows. The
credibility of auditors depends to a large extent on their independence from management and the
directors of the company on whose financial statements they issue their opinions. If auditors do
not remain independent, they might be less likely to report irregularities, or less likely to have the
financial statements prepared to their satisfaction, thereby impairing audit quality. This lessens
the credibility of the financial reporting process.
It has been argued that long-term auditor–client relationships can result in auditors becoming
complacent and lax in their assurance roles. Repeat audit engagements provide the auditor with
the opportunity to accumulate knowledge of the client’s financial reporting practices and internal
controls over financial reporting.
Though increased client-specific experience is crucial to audit quality standard setters have
struggled to determine when auditor familiarity with the client may threaten the external auditor’s
independence. In response to these concerns in the South Africa financial market, the Companies
Act 2008 section 92 requires engagement audit partners to rotate every five years to strengthen
external auditor independence.
The same individual (engagement partner) may not serve as the auditor or designated auditor of
a company for more than five consecutive financial years, while the IRBA Code of Professional
Conduct (referred to above) requires the audit partner to be rotated every seven years. However
it appears that this does not appear to be sufficient.
The reason for such a provision is that long audit tenure by the firm as well as by members of the
engagement team may also create potential threats to independence. The IRBA have cited many
reasons for this.
The most significant being:
• Familiarity threat between CFOs and incumbent auditors.
• Familiarity threat between audit committee chairs and incumbent auditors.
• Long audit tenure of audit firms.
• Lack of auditor independence from the client firm is also a matter of concern. One
suggested avenue to address these concerns is to place term limits by enforcing mandatory
audit firm rotation (MAFR).
The measures introduced by the Companies Act, 2008 that are aimed at auditor independence
include the establishment of audit committees, the rotation of auditors; and the prohibition on
certain non-audit services by the auditor. Section 94 of the Companies Act, 2008 provides that at
each annual general meeting, a public company or state-owned company, or other company that
is required to have an audit committee must elect an audit committee comprising at least three
members, unless the company is a subsidiary of another company that has an audit committee;
and the audit committee of that other company will perform the functions required under this
section on behalf of that subsidiary company. The audit committee must, for the year it is
appointed, perform the following functions nominate for appointment a registered auditor who is
independent of the company; determine the auditor’s fees and terms of engagement; ensure that
auditor’s appointment complies with the Act and other legislation relating to the appointment of
auditors; determine the nature and extent of any non-audit services which may be provided by
the auditor to the company; pre-approve any proposed contract with the auditor regarding the
provision of non-audit services by the auditor; insert in the financial statements a report describing
how it carried out its functions and that it is satisfied that the auditor was independent of the
company; an deal with any complaints relating to the accounting practices and internal audit of
the company or to the content of its financial statements.
In order to give meaning to the auditor's role as an objective third-party assurance provider the
Companies Act, 2008 in terms of s 90 (2) creates a legislative regime for auditor’s independence.
The public policy imperative of such legislation must be viewed in the context of the independence
of the auditor of the information contained in the annual financial statements. An auditor's
independence from his or her clients is one of the hallmarks of the accounting profession.
Independence ensures that the auditor will be objective when obtaining, reviewing and reporting
client information. The intention s 90 (2) is to prevent the auditor undertaking activities considered
to be the responsibility of ‘management’. The difficulty in defending against a claim increases
dramatically if the auditor crosses the independence line from service provider to being perceived
as a member of client management.
Section 90 (2) states that to be appointed as an auditor of a company, a person or firm must be a
registered auditor; must not be a director or prescribed officer of the company; an employee or
consultant of the company who was or has been engaged for more than one year in the
maintenance of any of the company's financial records or the preparation of any of its financial
statements; a director, officer or employee of a person appointed as company secretary; a person
who, alone or with a partner or employees, habitually or regularly performs the duties of
accountant or bookkeeper, or performs related secretarial work, for the company; a person who,
at any time during the five financial years immediately preceding the date of appointment, was a
person contemplated in any of subparagraphs above; or a person related to a person
contemplated above; and must be acceptable to the company's audit committee as being
independent of the company, having regard to the matters enumerated in s 94 (8) in the case of a
company that has appointed an audit committee, whether as required by s 94, or voluntarily as
contemplated in s 34 (2).
In an increasingly global environment – from global capital markets, accounting and auditing
standards, and audit firms to global independence rules – South Africa cannot isolate itself from
the changes being proposed in other countries. South Africa needs to be responsive to change and
must ensure that South African independence rules continue to be of the highest quality so that
investors will continue to find South Africa attractive. Also, with many South African companies
now operating in an international environment, it is important that South Africa’s audit processes
and quality align with international rules and standards.
In the context of justifying the corporate law reform process that is currently taking place in South
Africa, the Department of Trade and Industry made the following comment:
‘We now live in a world of greater globalisation, increased electronic communication, greater
sensitivity to social and ethical concerns, fast changing markets, greater competition for capital,
goods and services. South Africa cannot afford to be left behind.’
A compelling reason to warrant mandatory auditor rotation in South Africa is to ensure that South
African law is aligned with international trends and to reflect and accommodate the changing
environment for business, both in South Africa and globally.