Following the recent collapse of the United Kingdom’s second largest construction firm, due in part to overvaluation of contracts by its long-time auditors, the debate over auditor tenure has been re-energized.  Concerns about the terms or length of auditor engagements are nothing new and recent scandals provide good reason for Canadian companies to reconsider their audit governance practices.

In 2016, the European Union implemented mandatory rotations of audit firms for public companies, which was similarly considered, though rejected, in the United States. While Canada has not implemented mandatory auditor rotation, the annual appointment of auditors is an area in which shareholders have considerable power and responsibility, particularly following transactions that substantially change the nature and structure of a company.

Each year, business corporations legislation requires shareholders to approve the appointment of its auditors. Often these decisions are made by the board of directors and simply recommended for approval by shareholders as a formality.  The norm of shareholder passivity in this area highlights an opportunity to help mitigate some of the risks that frequently follow M&A transactions or long periods of status quo.

Traditionalists have long argued that audit quality increases with the length of tenure of a company’s auditors. However, a 2018 study suggests that misstatements are discovered faster after the appointment of a new auditor, and most significantly, in the new auditor’s first ten years with the company.[1]  The study found that longer auditor tenure also resulted in misstatements of greater magnitude. Supporters of short auditor tenure point to the importance of auditor independence, suggesting that as the relationship between an auditor and a company grows, the auditor’s impartiality is compromised.

On the other hand, critics of regular auditor rotation argue that companies benefit from long term relationships with their auditors, stating that longstanding relations allow auditors to develop and specialize their knowledge of the companies they work for and fine tune their skills to meet their needs. Critics also argue that the initial learning curve for auditors with a new company can be steep and costly.[2]  Interestingly, their claims appear to be supported by investor sentiment, as the results of a 2005 Accounting Review study revealed that investors perceived companies with longer auditor tenure more favourably.[3]

While the debate over auditor tenure rages on, shareholders should take notice that auditor appointment is an area over which they exercise important oversight, and arguably, have a responsibility to do so. Though auditor appointments rarely receive much attention, it may be time for shareholders to take on a more active role or risk subjecting their company to bigger problems down the road.

[1] See: Zvi Singer & Jing Zhang, “Auditor Tenure and the Timeliness of Misstatement Discovery” (March 2018) 93:2 The Accounting Review 315-338 at 335.

[2] See: Van E Johnson, Inder K Khurana & J Kenneth Reynolds, “Audit-Firm Tenure and the Quality of Financial Reports” (2002) 19:4 Contemporary Accounting Research 637-660 at 641-642.

[3] See: Aloke Ghosh & Doocheol Moon, “Auditor Tenure and Perceptions of Audit Quality” (2005) 80:2 The Accounting Review 585-612 at 609.

The authors would like to thank Devon Lenz, summer student, for her assistance in preparing this legal update.

Stay informed on M&A developments and subscribe to our blog today.