Recently, SEC Chief Accountant Sagar Teotia hinted at possible forthcoming changes to the auditor independence rules, remarking that, in connection with the recent changes related to lending relationships, the SEC “also received comments on other aspects of auditor independence rules. In conjunction with that feedback, the Chairman directed the staff to formulate recommendations to the Commission for possible additional changes to the auditor independence rules for potential rulemaking.” However, the nature of the potential changes remained something of a mystery. The proposal to amend the auditor independence rules has now been released. According to the press release issued today, the proposal is intended to modernize aspects of the independence rules to minimize the potential for “relationships and services that would not pose threats to an auditor’s objectivity and impartiality [to] trigger non-substantive rule breaches or potentially time consuming audit committee review of non-substantive matters.” It is important to keep in mind that violations of the auditor independence rules can have serious consequences not only for the audit firm, but also for the audit client. For example, an independence violation may cause the auditor to withdraw its audit report, requiring the audit client to have a re-audit by another audit firm. As a result, in most cases, inquiry into the topic of auditor independence should be a menu item on the audit committee’s plate. The comment period will be open for 60 days.
The comprehensive framework of rules governing auditor independence identifies principles and relationships that would cause an auditor not to be independent of its audit client. The framework was initially adopted in 2000 and amended in 2003, but, except for the recent change in connection with debtor-creditor relationships, has otherwise not been reexamined since then, notwithstanding changes in “market conditions and industry practices.” Under Rule 2-01(b), the SEC “will not recognize an accountant as independent, with respect to an audit client, if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not, capable of exercising objective and impartial judgment on all issues encompassed within the accountant’s engagement.” In addition, in determining whether an auditor is independent, the SEC “will consider all relevant circumstances, including all relationships between the accountant and the audit client.” Rule 2-01(c) provides a nonexclusive list of financial, employment, business and non-audit service relationships that the SEC views to be inconsistent with the independence standard in Rule 2-01(b).
The proposed changes reflect the impact of myriad staff consultations, as well as public feedback, and are designed to “more effectively focus the independence analysis on those relationships or services that are more likely to pose threats to an auditor’s objectivity and impartiality.” Some of these consultations have related to fact patterns that, while technically violating the rule, involve relationships “with, or services provided to, an entity that has little or no relationship with the entity under audit, and no relationship to the engagement team conducting the audit. In these scenarios…, the staff regularly observes that the audit firm is objective and impartial and, as a result, does not object to their continuing the audit relationship with the audit client.”
Examples provided of relationships that would technically violate the independence rule but that the staff has viewed to not impair independence or objectivity include:
- An audit partner has outstanding student loans that predate his joining the audit firm, and a different audit partner audits the large student loan company that provided the loans;
- A portfolio company of an investment fund is audited by an auditor that also has provided non-audit services to other otherwise unrelated immaterial portfolio companies of the same fund.
In the second example, under current rules, the other portfolio companies are entities under common control with the audit client, are considered affiliates and therefore fall within the definition of the “audit client.” As a result, in the scenario above, under current rules, the portfolio company would need to “(1) replace [the auditor] with another audit firm, (2) wait to register with the SEC for up to three years after termination of the services provided to [the other portfolio companies], or (3) make a determination, likely in consultation with Commission staff and/or the audit committee, that the rule violation did not impair the auditor’s objectivity and impartiality. Similarly, if the entities had been entities under common control as part of an investment company complex, they would be considered affiliates when the audit client is part of that complex. These relationships can require companies to “identify and monitor for potential independence-impairing relationships and services [applicable] to affiliated entities, including sister entities, regardless of whether the sister entities are material to the controlling entity.” In some situations, the existing audit firm cannot be replaced as a practical matter because all other qualified audit firms have themselves provided services or established other relationships with portfolio companies of [the investment fund] that triggered a breach of our independence rule.” Apparently, these types of scenario have arisen several times just in the past year alone.
More specifically, the proposal would effect the following changes:
- “Amend the definitions of affiliate of the audit client, in Rule 2-01(f)(4), and Investment Company Complex, in Rule 2-01(f)(14), to address certain affiliate relationships, including entities under common control.” The proposal would include materiality qualifiers in the provisions related to operating companies under common control and, under the ICC definition, to sister investment companies, advisers and sponsors. The proposal would also “distinguish how the definition applies when an accountant is auditing a portfolio company, an investment company, or an investment adviser or sponsor.” Note that the general standard in Rule 2-01(b) would continue to apply, with the result that the auditor could still identify “independence concerns in fact or in appearance, individually or in the aggregate, upon considering the nature, extent, relative importance and other aspects of the services or relationships between the auditor, the controlling entity, and such sister entities that are not material to the controlling entity.”
- “Amend the definition of the audit and professional engagement period, specifically Rule 2-01(f)(5)(iii), to shorten the look-back period, for domestic first time filers in assessing compliance with the independence requirements.” Under the proposal, the “audit and professional engagement period” would essentially be the same as applicable currently for foreign private issuers; it would “not include periods ended prior to the first day of the last fiscal year before the issuer first filed, or was required to file, a registration statement or report with the Commission, provided there has been full compliance with applicable independence standards in all prior periods covered by any registration statement or report filed with the Commission.”
- “Amend Rule 2-01(c)(1)(ii)(A)(1) and (E) to add certain student loans and de minimis consumer loans to the categorical exclusions from independence-impairing lending relationships.” Under the proposal, the student loan must have been incurred prior to the person’s becoming a “covered person.” The proposal would not cover student loans to the covered person’s immediate family. The proposal also clarifies that the exclusion could apply to multiple mortgage loans. The proposal would replace the current reference to “credit card loans” with de minimis “consumer loans.”
- “Amend Rule 2-01(c)(3) to replace the reference to ‘substantial stockholders’ in the business relationship rule with the concept of beneficial owners with significant influence.” Currently, Rule 2-01(c)(3) “prohibits, at any point during the audit and professional engagement period, the accounting firm or any covered person from having ‘any direct or material indirect business relationship with an audit client, or with persons associated with the audit client in a decision-making capacity, such as an audit client’s officers, directors, or substantial stockholders….’” The proposal would replace the reference to substantial stockholders with a significant influence analysis that looks at “beneficial owners (known through reasonable inquiry) of the audit client’s equity securities where such beneficial owner has significant influence over the audit client.” The release also provides guidance that narrows the focus of the analysis to “those business relationships with persons in a decision-making capacity as it relates to the entity under audit.” [Emphasis added.]
- “Replace the outdated transition and grandfathering provision in Rule 2-01(e) with a new Rule 2-01(e) to introduce a transition framework to address inadvertent independence violations that only arise as a result of merger and acquisition transactions.” The proposing release notes that auditor independence issues arising in connection with an M&A transaction can adversely affect the audit client, potentially resulting “in the termination of audit work midstream or termination of the non-audit service that is in progress in a manner that is costly to the audit client. Alternatively, it could result in a delay of a merger or acquisition while the auditor and its audit client attempt to resolve the potential independence matters to the possible detriment of the audit client and investors.” The proposal would provide for a transition framework that includes compliance with applicable independence standards from inception of the relationship, correction of the violation as promptly as possible (with corrective action expected no later than six months post-closing) and having in place a quality control system.
- Implement miscellaneous updates.