The proposed mandatory audit firm rotation ruling 

This article was extracted from an article titled Will mandatory audit firm rotation reduce audit market concentration in South Africa? which appeared in the South African Journal of Business Management. The purpose of this shorter article is to provide an overview of the envisaged deconcentration of the audit market through the proposed mandatory audit firm rotation (MAFR) ruling in South Africa. 

MAFR is a contentious topic. The USA decided against its implementation while the EU implemented MAFR since 2016. Of the top 20 countries ranked by the World Economic Forum, only six EU countries and China apply MAFR. Now, South Africa will be implementing MAFR on 1 April 2023 in an effort to address auditor independence, transformation, and market concentration within the audit profession.

South Africa is a developing country with a dual economy. It shares characteristics with both developed and developing countries, which provided a unique opportunity to add to the debate on MAFR. The country was ranked number one in the world for high auditing and reporting standards by the World Economic Forum for seven consecutive years (2010 to 2016), but has subsequently dropped to number 30, mainly in response to the decline in investor confidence.

The Independent Regulatory Board for Auditors (IRBA) agreed that the MAFR implementation periods in other jurisdictions have mostly been too short to prove its effectiveness. IRBA also said that research alone does not inform regulation and that empirical evidence is not required when investor protection is compromised. That is why this study focused on evidence-based research on one aspect of MAFR in South Africa, namely audit market concentration as this would contribute to the development of policy in this regard. Insights obtained from this study can help regulators and other stakeholders decide whether additional measures are required to mitigate possible unintended consequences of MAFR prior to its implementation in 2023.

To better understand the auditing landscape in South Africa, let us first look at some aspects of auditing firms and their clients.

Audit firm tenure – does longer mean better?

Audit firm tenure is one of the key topics in debates about MAFR. Longer audit firm tenure can increase the likelihood of familiarity, even friendship and dependence on an audit client and therefore a likely lower-quality audit. At the same time, longer audit firm tenure can also represent greater knowledge of a company’s business and therefore a higher-quality audit. The fact that the market for auditing in many countries is concentrated in a small number of suppliers – the so-called Big 4 audit firms, namely PricewaterhouseCoopers (PwC), Deloitte, Ernst & Young (EY) and Klynveld, Peat, Marwick, Goerdeler (KPMG) – have added to the debate on MAFR. On the one hand, it is argued that audit quality could be low in oligopolistic markets (i.e., markets characterised by limited competition) because of clients’ lack of auditor choice and limited competition. On the other hand, it is argued that audit market concentration (i.e., the extent to which the market share is concentrated among a small number of firms) is a natural and permanent global phenomenon, driven by economies of scale, a global footprint and prior mergers of audit firms.

Jurisdictions introducing MAFR argue that it can strengthen independence and decrease audit market concentration, while non-adopters of MAFR stress the importance of the auditors’ learning curve and the effect thereof on audit quality and audit fees. Empirical evidence on whether MAFR is an effective measure is limited, mainly because it has been enforced in only a few countries. Most research on audit firm rotation is conducted in jurisdictions where voluntary rotation is applicable, which may affect the reported results, as voluntary rotation is often associated with troubled companies – i.e., companies that are susceptible to fraud, that are financially distressed or that disagree with their auditor’s opinion.

More about audit quality and auditor independence

Evidence of the impact of MAFR on audit quality and auditor independence is inconclusive. There is some evidence that audit firm rotation may have a positive impact on ‘independence in appearance’, but evidence of the positive impact of audit firm rotation on ‘independence in mind’ is lacking. Cross-country studies on audit firm tenure have, in general, concluded that long tenure does not negatively affect audit quality. The effect of audit firm tenure on audit quality varied based on audit firm size: shorter tenure was associated with lower audit quality, while Big 4 audit firms showed higher audit quality when compared to non-Big 4 audit firms.

More about audit market concentration and audit quality

Increased audit market concentration is a global phenomenon that has resulted from large audit firm consolidations in the late 1980s and 1990s as well as the collapse of Arthur Andersen in 2001 and the exit of many small audit firms from the audit market for listed clients (because of tightening of regulations pertaining to listed entities). The Big 4 audit market concentration mainly arose in response to market forces, specifically the demand from investors for high-quality audits and the ability to undertake complex audits across the world.

Regulators are concerned that the dominance of a few large audit firms might diminish competition in the audit market, cause cartel pricing and lower the quality of audits. Investors, too, have raised concerns, asking whether this level of concentration results in lower-quality audits and lower investment protection. They question whether financial markets could recover if one of the Big 4 audit firms failed or exited the market.

South African audit firm rotation regulations

In South Africa, it was promulgated in June 2017 that MAFR – with a maximum tenure of 10 years – will be applied to public interest entities for financial years commencing on or after 1 April 2023. 

In anticipation of MAFR, IRBA required that the audit firms of public interest entities disclose their tenure in the audit report of the entity as from 2015 onwards. In addition, as from 20 September 2017, the decision to rotate audit firms was more transparent, with all companies listed on the Johannesburg Stock Exchange (JSE) required to announce the termination or resignation of the auditor via the JSE’s Securities Exchange News Service (SENS).

Apart from the proposed MAFR rule, the mandatory rotation of the engagement audit partner after five years remains in place. There is no strict requirement regarding the external auditor’s non-audit service delivery in South Africa, apart from the Companies Act requirement pertaining to the responsibility of the audit committee to assess the independence of the external auditor and approve the nature and extent of non-audit services delivered before recommending the appointment of the auditor to shareholders. Since the adoption of the new Companies Act in 2011, disclosure of audit fees in the annual report is no longer a requirement.

IRBA highlighted the following points to motivate the introduction of MAFR in South Africa:

• The long audit firm tenure of some JSE-listed companies: For example, 21 JSE-listed companies had audit tenures of over 50 years in 2016.
• The Big 4 audit firm dominance of the audit market: Big 4 audit firm clients represented more than 90% of the market capitalisation of JSE-listed companies that had South African engagement partners who signed off their audit reports. In addition, Big 4 audit firms collected 94% of total audit fees spent by JSE-listed companies in 2016.
• Recent business failures and poor performance on IRBA quality reviews.

After the promulgation of IRBA’s decision to implement MAFR in South Africa, the debate was fuelled by the auditing irregularity exposure of one of South Africa’s Big 4 audit firms, KPMG. This audit failure and possible elimination of a Big 4 audit firm raised the spectre of serious market disruption. Although there was a spike in reported audit firm rotations since 2017, most rotations were motivated as proactively adhering to the anticipated MAFR rule.

Research on audit firm rotations, audit firm tenure and audit market concentration in the South African market is scant, mainly because data on audit firm identity and tenure is not available in commercial financial databases. 

Will the implementation of MAFR increase or decrease audit market concentration?

The study on which this article is based looked at the actual audit firm landscape over a period that incorporates the pre-promulgation and post-promulgation of MAFR and covered all size categories of JSE-listed companies. The disclosure of audit firm tenure (as from 2016) is interpreted as a signal to stakeholders of the ‘independence in appearance’ of the audit firm to assess whether to replace the audit firm in anticipation of the MAFR regulation. 

The study hypothesised that South African audit market concentration will increase after the implementation of MAFR. With Big 4 audit firms showing the same dominance in the South African audit market as in developed countries, it is expected that the global evidence (on increased audit market concentration subsequent to MAFR) will be mirrored in South Africa. This expectation is also supported by evidence of South African audit market stakeholders’ perspectives.

A sample of 415 South African listed companies was studied for the period 2010 to 2018. Data was mainly captured from annual reports. Descriptive statistics and significance testing were performed on calculated concentration ratios and identified audit firm rotations. Some of the results are noted below:

• The number of JSE-listed companies (clients) varied between 272 and 325 companies per year during the period 2010 to 2018. Audit firm tenure from 2016 to 2018 was on average 17 years, with a median of 10 years in 2016 and 2018 and a median of 8 years in 2017. This means that at least half of the companies already had an audit tenure of 10 years in 2018 and needed to rotate their auditors before or on 1 April 2023. 
• Audit market concentration ratios (CRs) were determined per year for the Big 4 audit firms (CR4 = PwC, Deloitte, EY and KPMG), the five largest firms (CR5 = Big 4 and Grant Thornton), the six largest firms (CR6 = Big 4 + Grant Thornton and Mazars), and the seven largest firms (CR7 = Big 4 + Grant Thornton, Mazars and BDO).
• The CR4 figures are comparable to CRs reported for most developed countries. In 2018, approximately 68% of clients were audited by Big 4 audit firms, with clients’ assets and market capitalisation representing 95% and 96% of the total market, respectively.
• Referring to market concentration and the Big 4 audit firm group, PwC was the largest audit firm in South Africa. With a market share of 25% of audit clients and a share of 53% in the assets and market capitalisation of the market, PwC met the criteria of a monopoly position. Deloitte is the second-largest audit firm. 
• SENS announcements on audit firm rotations after 2018 indicate that a change in the South African Big 4 audit firm group occurred in 2019. Based on the number of clients, KPMG was replaced by EY as the third-largest audit firm, while BDO was ranked fourth and KPMG fifth in 2019. SENS announcements on audit firm rotations in 2019 and 2020 indicated that clients are starting to re-appoint KPMG as their auditor and that the company is recovering from its reputational tumble.
• The results on the concentration ratios of the South African audit market indicate a significant increase in Big 4 audit clients after 2015. Based on the premise that post-2015 audit firm rotations were motivated by the anticipated MAFR regime, the post-2015 trends in concentration ratios seem to support the expectation that MAFR may increase audit market concentration.
• A total of 141 audit firm rotations occurred from 2010 to 2018 and were carried out by 117 companies. The results of the post-2015 period show that audit committees and shareholders are reluctant to appoint non-Big 4 audit firms for large, listed companies. Surprisingly, the results also showed that Big 4 audit firms are the preferred choice of smaller companies. An increase in audit market concentration is therefore expected based on post-2015 audit firm rotation behaviour.
• Big 4 audit firms were predominantly the auditors of clients with long audit firm tenure. The decreasing trend in the number of Big 4 audit firm clients with long audit tenures, combined with the increasing trend in the number of Big 4 audit firm clients with short audit tenures, suggests that audit firm rotations after 2015 were predominantly switches to Big 4 (and not non-Big 4) audit firms.
• Based on the 2018 audit firm tenures, 206 audit firm replacements need to be carried out after this reporting period in anticipation of the 2023 MAFR rule of a maximum tenure of 10 years. Most of these post-2018 rotations will involve the replacement of a Big 4 audit firm.

The results on the concentration ratios (CRs) of the South African audit market point towards possible audit quality and financial market stability concerns. The negative association between concentration within the Big 4 audit firm group and audit quality may be a reality (i.e. with respect to PwC) that needs to be addressed in the South African audit market, and investors’ concerns over whether financial markets can recover from the failure, or exit, of a Big 4 audit firm may not be unfounded (i.e. KPMG).The sheer number of audit firm rotations to be carried out between 2019 and the MAFR implementation date raises some questions: Do the Big 4 audit firms (and the South African audit market) have the capacity to accommodate these rotations? How will the multiple new audit engagements impact audit quality? 

With many Big 4 audit firms already providing additional non-audit services to companies required to rotate, the options for new Big 4 audit firm appointments may be limited. The large market share of PwC may affect its ability to accommodate audit switches, while the reputational risk attached to dealing with KPMG may negatively affect its appointment as a replacement auditor. It might also be difficult for the South African audit market to absorb the cost associated with the scale of audit rotations to be carried out. This is why an impairment in audit quality may be expected once MAFR comes into effect.

How should we to interpret this?

With information on South African audit firm tenure only recently becoming available, this study looked at the possible effect of MAFR on one of the objectives of MAFR, namely the deconcentration of the audit profession. Data on audit firm identity and audit firm tenure of companies listed on the JSE is not available in commercial financial databases. Hence, this study was the first to apply empirical evidence to provide insights into audit market concentration, audit firm tenure and audit rotation in South Africa.

This study found that concentration ratios (CRs) in South Africa mirror global empirical evidence of most developed economies with respect to the dominance of the Big 4 audit firms. Within the Big 4 audit firm group, one audit firm, PwC, was found to have a monopoly in the audit market, while a change in the Big 4 constituents after 2018 was observed, with one Big 4 audit firm, KPMG, dropping to fifth place.

On the premise that the required disclosure of audit firm tenure (effective from December 2015) has motivated audit firm rotations in anticipation of MAFR, empirical evidence from the post-2015 period indicated a significant increase in the number of Big 4 audit clients. Also, audit firm rotations were predominantly awarded to Big 4 audit firms and most of the audit firm replacements to be carried out after 2018 are with respect to Big 4 audit firms. Indications are, therefore, that MAFR may further increase Big 4 audit firm concentration in South Africa.

A cause for concern is the finding that a significant number of audit firm rotations need to be carried out prior to the implementation of MAFR in 2023. Based on the Big 4 dominance and sheer scale of audit firm rotations to be affected, this study identified an impairment of audit quality and an increase in costs as possible unintended consequences of MAFR in the South African audit market. A monopoly within the local audit market, the risk of an audit failure of one of the Big 4 audit firms, and the struggling local economy add to the complexity and associated risks of MAFR in this country.

This study concluded that South African MAFR rules might not attain the envisaged deconcentration objective. Regulators are therefore urged to reconsider the implementation of MAFR or to implement additional measures to mitigate the unintended consequences of MAFR prior to its implementation in 2023.

As an alternative to MAFR, the study recommended that current South African auditor independence measures are strengthened and formalised. For example, strengthen the role of the audit committee and improve audit peer review processes. It is also recommended that the transformation and audit market concentration concerns could be addressed by considering the total audit market (and not focusing only on JSE-listed companies) to provide opportunities to small and medium-sized audit firms and to promote the consolidation of smaller audit firms into larger mid-tier audit firms. However, if IRBA decides to proceed with the implementation of MAFR in 2023, it is advised that a staggered approach is implemented.

In essence, the South African audit market concentration mirrored empirical evidence from most developed countries – with Big 4 audit firms dominating the audit market while a monopoly within the Big 4 audit firm grouping was also evident. Based on observed audit firm concentration and audit firm rotation behaviour, it is anticipated that MAFR might further increase audit market concentration. A concerning result was the sheer scale of audit firm rotations to be carried out in anticipation of MAFR in 2023.

• Find the original article here: Wesson, N. (2021). Will mandatory audit firm rotation reduce audit market concentration in South Africa? South African Journal of Business Management. 52(1):a2426. https://sajbm.org/index.php/sajbm/article/view/2426/1882