This week, Acting Chief Accountant Paul Munter issued a statement regarding the importance of auditor independence—a concept that is “foundational to the credibility of the financial statements.” The responsibility to monitor independence is a shared one: “[w]hile sourcing a high quality independent auditor is a key responsibility of the audit committee, compliance with auditor independence rules is a shared responsibility of the issuer, its audit committee, and the auditor.” That has long been the case. But what is happening in the current setting to prompt this statement? It is the recent trend toward the use of “new and innovative transactions” to access the public markets, such as SPACs, together with the continued expansion by audit firms of business relationships with non-audit clients. That is, gatekeepers must be especially vigilant to prevent an audit firm from unwittingly losing its independence in the event of a transaction by an audit client with a non-audit client, a risk that is enhanced as audit firms engage in consulting relationships with more non-audit clients. This environment, Munter cautions, requires audit committees to be especially attentive in considering “the sufficiency of the auditor’s and the issuer’s monitoring processes, including those that address corporate changes or other events that potentially affect auditor independence.” And it requires audit firms to consider “the impact of business relationships and non-audit services on existing and prospective audit relationships.” It is important for companies 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 the firm’s 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 certainly be a recurring menu item on the audit committee’s plate.
“As we near the twentieth anniversary of SOX,” Munter cautions,
“it is critical for all gatekeepers to continue to vigilantly maintain the independence of auditors, in both fact and appearance. In this regard, auditors and audit clients must carefully consider the scope of their audit and any permissible non-audit engagements that have been pre-approved by the audit committee to guard against impairments of independence. As part of this responsibility, all gatekeepers in the financial reporting ecosystem should be especially mindful of the nature and the scope of any other services provided by the independent auditor. For instance, an auditor that provides extensive non-audit services to an entity that has an active mergers and acquisitions business model must continually monitor the impacts of all such transactions, and potential transactions, on its audit engagements to ensure that the auditor remains, in fact and appearance, independent of all of its audit clients.”
Rule 2.01 sets forth restrictions on financial, employment and business relationships between an accountant and an audit client and restrictions on providing certain non-audit services to an audit client. In considering this standard, the SEC looks to four “guiding principles” to assess whether a relationship or service:
- “Creates a mutual or conflicting interest between the accountant and the audit client;
- Places the accountant in the position of auditing his or her own work;
- Results in the accountant acting as management or an employee of the audit client; or
- Places the accountant in a position of being an advocate for the audit client.”
Munter cautions that it would require crossing a “high hurdle” to conclude that the accountant ”could remain objective and impartial when an auditor has provided services in any of the periods included in the filing that is contrary to any one of these guiding principles.”
Munter urges managements and audit committees to be proactive, as companies negotiate potential transactions with third parties, in keeping on top of any potential impact on auditor independence, including understanding the filings that could be required for these transactions, any relationships the auditors may have with counterparties and whether the prospective transaction and relationships could impair the “auditor’s ability to continue to comply with the Commission’s auditor independence rule applicable to such filings.” That means that all gatekeepers—management, audit committees and independent auditors—should “consider the potential effects of the auditor’s existing business and service relationships with other companies on the auditor’s ability to remain independent of the issuer if a contemplated transaction is consummated.” For example, Munter continues, gatekeepers will need to appreciate the scope of business relationships, “including non-audit service relationships, between the audit firm and other entities that will, or in the future could, require an audit, become the existing audit entity’s affiliates, or result in other companies that have significant influence over the entity.”
Audit firms, warns Munter, have an additional responsibility to “carefully consider the impact of business relationships and non-audit services on existing and prospective audit relationships,” especially the potential effect of big, multi-year non-audit service contracts or business relationship arrangements with non-audit clients.” For example, independence could be impaired if an existing audit client merges with, acquires or sells a significant equity position to the non-audit client and the audit firm engages in business or service arrangements that would then be considered prohibited. Munter recommends that, as part of their risk management processes, audit firms “should use a firm-wide perspective to understanding the potential future consequences of such arrangements on their ability to remain independent of their existing audit clients. Ultimately, because an audit client is required to retain an independent auditor, audit firms should always consider the potential impacts of all their business relationships on their audit clients.”
Through their oversight function, audit committees play a critical role in enhancing auditor independence, observes Munter. The committee can provide a forum for auditors to discuss their concerns and facilitate communications among the board, management, internal auditors and independent auditors. In addition, when the audit committee fulfills its responsibilities to appoint and compensate the auditors and oversee their work, the committee can be instrumental in supporting the auditors’ independence from management. The committee also has a key role in “setting the tone at the top for the quality of the issuer’s financial reporting to investors. In selecting, retaining, and evaluating the independent auditor, the audit committee always should be focused, in the first instance, on audit quality.”
