INSTITUTE FOR CORPORATE ACHIEVERS(ICA): Rotation of Auditors

[2016] 132 CLA (Mag.) 61
T V Narayanaswamy^*

In this article, the author analyses sub-section (2) of section 139 of the Companies Act, 2013 read with rule 6 of the Companies (Audit and Auditors) Rules, 2014 dealing with rotation of auditors in listed companies and manner of rotation of auditors by companies on expiry of their terms.

Introduction

Sub-section (2) of section 139 of the Companies Act, 2013 (the Act) has introduced a novel concept for the rotation of auditors in listed companies and in such class or classes of companies as may be prescribed. In exercise of the powers conferred on the Central Government, the Central Government in the Ministry of Corporate Affairs has prescribed in rule 5 of the Companies (Audit and Auditors) Rules, 2014 (Audit Rules) that this concept of rotation of auditors would also apply to the following classes of companies excluding one person companies and small companies :
- All unlisted public companies having paid-up share capital of Rs.10 crore or more
- All private limited companies having paid-up share capital of Rs.20 crore or more
- All public and private limited companies having a paid-up share capital of less than the threshold limit set out above but having public borrowings from financial institutions, banks or public deposits of Rs. 50 crore or more.

It should be noted that the limit of Rs.50 crore on public borrowings would apply to the aggregate borrowing from financial institutions, banks and public deposits and not to borrowings of Rs.50 crore prescribed, individually from each of the categories listed.

Concept of rotation of auditors in listed companies

Sub-section (2) of section 139 of the Act reads as under :
1. No listed company or a company belonging to such class or classes of companies as may be prescribed, shall appoint or re-appoint –
  - an individual as auditor for more than one term of five consecutive years; and
  - an audit firm as auditor for more than two terms of five consecutive years:
  Provided that –
  1. an individual auditor who has completed his term under clause (a ) shall not be eligible for re-appointment as auditor in the same company for five years from the completion of his term;
  2. an audit firm which has completed its term under clause (b ), shall not be eligible for re-appointment as auditor in the same company for five years from the completion of such term:
  Provided further that as on the date of appointment no audit firm having a common partner or partners to the other audit firm, whose tenure has expired in a company immediately preceding the financial year, shall be appointed as auditor of the same company for a period of five years:
  
  Provided also that every company, existing on or before the commencement of this Act which is required to comply with provisions of this sub-section, shall comply with the requirements of this sub-section within three years from the date of commencement of this Act:
  
  Provided also that, nothing contained in this sub-section shall prejudice the right of the company to remove an auditor or the right of the auditor to resign from such office of the company.”

Sub-section (3) of section 139 confers an option on companies to prescribe a shorter period for rotation of auditors and to appoint more than one auditor for conduct of audit of accounts.

Sub-section (4) of section 139 confers on the Central Government to prescribe by rules the manner in which the companies shall rotate their auditors. It should be noted that under this sub-section (4) the Central Government has been conferred the power to prescribe the manner in which the companies shall rotate their auditors and not to give retrospective effect to the requirement of rotation of auditors spelt out in sub-section (2) of section 139.

Manner of rotation of auditors on expiry of their term

The Central Government in exercise of this power has prescribed the manner in which the companies should rotate the auditors through rule 6 of the Audit Rules, 2014 the extract of which is reproduced below :

Manner of rotation of auditors by the companies on expiry of their term. –

The Audit Committee shall recommend to the Board, the name of an individual auditor or of an audit firm who may replace the incumbent auditor on expiry of the term of such incumbent.

Where a company is required to constitute an Audit Committee, the Board shall consider the recommendation of such committee, and in other cases, the Board shall itself consider the matter of rotation of auditors and make its recommendation for appointment of the next auditor by the members in annual general meeting.

For the purpose of the rotation of auditors –

in case of an auditor (whether an individual or audit firm), the period for which the individual or the firm has held office as auditor prior to the commencement of the Act shall be taken into account for calculating the period of five consecutive years or ten consecutive years, as the case may be;

the incoming auditor or audit firm shall not be eligible if such auditor or audit firm is associated with the outgoing auditor or audit firm under the same network of audit firms.

Explanation. I - For the purposes of these rules the term “same network” includes the firms operating or functioning, hitherto or in future, under the same brand name, trade name or common control.

Explanation. II - For the purpose of rotation of auditors,-

a break in the term for a continuous period of five years shall be considered as fulfilling the requirement of rotation;

if a partner, who is in charge of an audit firm and also certifies the financial statements of the company, retires from the said firm and joins another firm of chartered accountants, such other firm shall also be ineligible to be appointed for a period of five years.’

3.1 It may be observed from a close examination of sub-rule (3) of the aforesaid rule 6, highlighted for purposes of facility that for the purposes of rotation under sub-section (2) of section 139 the period for which the individual or firm has held office as auditor prior to the commencement of the Act shall be taken into account for calculating the period of five consecutive years or ten consecutive years, as the case may be. Section 139 was put into force from 1st April, 2014. A period of three years has been allowed to companies, within which, to comply with the requirements of the appointment of auditors and their rotation. The auditors invariably are appointed at annual general meetings of companies. In view of this an auditor appointed in the annual general meeting held after 1st April, 2016 and the rotation requirement would apply to such an auditor appointed in the annual general meeting held after 1st April, 2016. If this appointment is done in the annual general meeting held after 1st April, 2017 then it would be noticed that the compliance would be established after the expiry of three years from the date of commencement of the Act resulting in default in compliance with the requirements of the Act. Thus, an auditor appointed at the Annual General Meeting held after 1st April 2016 can continue to be in office up to the date of the annual general meeting held in the year 2021. In the case of an Audit firm, the firm could continue to be in office till the annual general meeting held in the year 2026.

3.2 But sub-rule (3) of rule 6 curtails this tenure of appointment depending upon the period the auditor or the firm, as the case be, were in office. This curtailment would amount to giving effect to the requirement of rotation of auditors a retrospective operation. It might be argued that wherever such retrospective operation is not to be given, the Legislature has expressly provided so as in the case of appointment of independent directors where by an Explanation appended to sub-section (11) of section 149 it has been clarified that ‘for the purposes of sub-sections (10) and (11), any tenure of an independent director on the date of commencement of the Act shall not be counted as a term under those sub-sections. To this the counter is expressed in the Latin maxim ‘nova constitution futuris forman imponere debet nonpraeteritis’ (a new law ought to regulate what is to follow, not the past). Further in a number of cases the Supreme Court has held that “it is a cardinal principle of construction that every statute is prima facie prospective unless it is expressly or by necessary implication made to have retrospective operation”.

3.3 Sub-section (2) of section 139 neither expressly nor by implication indicates that the requirements set out therein would have retrospective operation. It is only the rule highlighted above stipulates that this rotation will be retrospective in effect. A tail can never wag the head. A rule cannot override the provisions in the Act. Courts have held that rules should be consistent with the provisions of the Act and if a rule goes beyond what the Act contemplates, the rule must yield to the Act. The Companies Act, 2013 was put in the statute book in 2013 and bulk of its provisions including the one relating to rotation of auditors were put into effect from 1st April, 2014.

Conclusion

Third proviso to sub-section (2) of section 139 allows of companies to comply with its requirements for appointment of auditors within three years from the commencement of the Act, i.e., from 1st April, 2017. If this is the intention of the Legislature, it is not comprehendible as to how a portion of the requirement has to be given retrospective effect. It would have been ideal if an Explanation has been appended to sub-section (2) of section 139 similar to the Explanation to sub-section (11) of section 149. This lapse on the part of the draftsman cannot be construed that in regard to rotation of auditors, the Legislature had intended to give retrospective effect. In view of what has been stated, second proviso of sub-section (2) of section 139 should be given effect prospectively and not retrospectively. In this view of the matter the change in the office of an auditor or audit firm appointed in the annual general meeting held after 1st April, 2017 is mandatorily required to be made only in the annual general meeting held in the year 2022 or 2027, respectively, as the case may be, and not earlier. This, however, does not preclude an auditor or audit firm the right resigning before that period or a company removing an auditor or an audit firm before the expiry of the tenure of appointment.