An Overview of Independence Rule Modernization

The American Institute of CPAs adopted significant revisions to the Code of Professional Conduct last August. The overriding goal of these revisions was modernization, harmonization with the other rulemaking bodies, such as the Securities and Exchange Commission, and simplification. Strides have been made toward these goals despite the complexities of today’s business environment.

Fundamental Concept

The new rules, to an extent, are based on an approach whereby the highest level of restrictions are limited to persons on the attest engagement team and those who can, through personal or professional interaction, generally influence the engagement team (and therefore the outcome of the engagement). This concept, originated by the Independence Standards Board, represents a dramatic departure from rules several decades old in which all partners in a firm were required to be independent of all the firm’s attest clients.

The SEC and the International Federation of Accountants have also endorsed the approach as appropriate for contemporary practice. These organizations cited extensive changes in business—such as client globalization, dual career families, varied and evolving CPA firm structures, ever-increasing technological advances and worker mobility—in supporting independence modernization.

The Move to Modernize

The American Institute of CPAs’ Professional Ethics Executive Committee has carefully studied this new approach for years, and in April 2001, having seen the final result of deliberations at the SEC, issued an exposure draft to modernize rule 101, Independence. The committee proposed replacing the existing interpretation of “member” (that is, one who is required to be independent of a particular attest client) with a more narrow definition—covered member. The committee proposed other modifications to the rules as well, including those applying to a covered member’s family, former associations with clients and a modified application of the rules for certain attestation engagements resulting in restricted-use reports. These rules introduced several new and revised definitions.

Members, firms, professional organizations, state CPA societies, state boards of accountancy and other legislative bodies commented on the proposal and in August 2001, with appropriate revisions based on feedback and further deliberation, the committee adopted final revisions. Highlights of the most significant rules follow.

Covered Member: An Important Term

Understanding the term covered member is critical because a covered member is held to the highest level of independence in terms of financial, business and other relationships with a specific client. This is true particularly if he or she is on the attest engagement team or is in a position to influence the client’s attest engagement.

Under the rules, a covered member is:

• An individual on the attest engagement team.
• An individual in a position to influence the attest engagement.
• A partner or manager who provides 10 or more hours of nonattest services to the attest client.
• A partner in the office in which the lead attest engagement partner primarily practices in connection with the attest engagement.
• The firm, including the firm’s employee benefit plans.
• An entity whose operating, financial or accounting policies can be controlled by any of the individuals or entities described above or by two or more such individuals or entities if they act together.

Any of the above persons (or entities) is considered a covered member subject to restrictions under rule 101with respect to a particular attest client.

A Covered Member’s Financial and Other Relationships

Accordingly, as a covered member, an individual is prohibited from having financial and other relationships as provided for in the rules. The following examples illustrate this point:

Example: JJ is a partner in a CPA firm and the firm performs an audit of ABC Co. JJ practices in the same office where the lead engagement partner for the ABC audit practices in connection with the engagement.

Outcome: As a partner in the office of the lead ABC audit partner, JJ is a covered member and is prohibited from having:

• Any direct financial interest (e.g.; ABC stock options) or material, indirect financial interest (e.g.; an interest in ABC held through a mutual fund).
• A material joint investment with ABC or certain persons associated with ABC, such as ABC’s officers.
• A loan with ABC or certain ABC associates, such as shareholders of ABC holding a 10 percent or greater ownership interest in the company (unless the loan is specifically allowed or grandfathered under special provisions in the code).

JJ is also subject to other restrictions. For example, JJ may not be employed by or otherwise associated with ABC and JJ’s family members will also be subject to various restrictions, as described in the following section.

A Covered Member’s Family: Also Subject to Rules

A covered member’s immediate family—his or her spouse (or spousal equivalent) and dependents—are generally subject to the same rules as the covered member since the interests of those persons are considered to be indistinguishable. There are, however, two exceptions to this rule. They are:

• Employment with the attest client is permitted if the family member is not in a “key position” (please refer to www.aicpa.org/members/div/ethics/edutools.htm for a list of selected definitions); generally, a key position allows one to influence the client’s financial statements.
• A financial interest may be held through an attest client’s employee benefit plan in certain instances, although this exception does not apply to the immediate family of persons on the engagement team or of individuals in a position to influence the engagement.

Consider these examples:

Example: BB is a partner in a CPA firm who supervises the engagement partner assigned to the audit of ABC Co.

Outcome: Since BB is a covered member (i.e., able to influence ABC’s audit), BB’s spouse must comply with all the same rules as BB. Since BB is able to influence the audit, BB’s spouse may not hold a key position with ABC nor may he or she have any direct or material indirect financial interests in ABC through his or her participation in ABC’s employee benefit plans.

Example: GG is a tax partner who provides only nonattest services to ABC (totaling about 25 hours per year) and is not otherwise able to influence the ABC audit engagement.

Outcome: Since GG is a covered member (i.e., provides a certain level of nonattest services to ABC), GG’s spouse must follow the same independence rules as GG. However, under the exceptions above, GG’s spouse may be employed by ABC and have financial interests through an ABC benefit plan provided he or she is not in a key position with ABC and the plan is offered equitably to all similar ABC employees.

A covered member’s other close relatives (see Selected Definitions) may also impair independence under the new rules. Here, the rules differentiate among covered members, with relatives of persons not on the engagement team being subject to a less restrictive standard than those participating on the engagement team. For example:

Example: CC is the concurring review partner for ABC Co.’s audit engagement. CC’s (nondependent) mother owns shares in ABC that are material to her net worth and of which CC has knowledge.

Outcome: Independence would be considered impaired because CC is on ABC’s attest engagement team (see Selected Definitions) and has knowledge of his close relative’s material investment in ABC.

Example: DD is the managing partner of a CPA firm (i.e., in a position to influence the attest engagement) that performs a review engagement for ABC Co. DD’s brother is a six percent shareholder of ABC and the investment is material to his net worth.

Outcome: Independence would not be considered impaired because even though the brother’s six percent investment is material, it would presumably not allow him to exercise significant influence over ABC.

Rules that Apply to All Partners and Professional Employees of the Firm

Due to their magnitude, certain financial and other relationships pose a far greater threat to independence than others, necessitating a broader application than that described thus far in terms of covered members and their families. Accordingly, the rules prohibit all partners and professional employees(regardless of their location in the firm or function relating to the client(from having:

• Financial interests in an attest client that constitute more than five percent of that client’s outstanding equity securities (or other ownership interests, such as a partnership interest).
• Employment or certain other business associations (for example, serving as director, officer or in another management capacity for an attest client).

Example: VV is a tax manager in a CPA firm that provides annual review services to ABC Co. ABC offers VV a seat on its board of directors. VV provides no services to ABC and is not in a position to influence the engagement.

Outcome: Since prohibitions on certain business associations such as board memberships apply to all firm personnel, VV’s service on ABC’s board would impair independence.

Example: FF is a staff person in a CPA firm’s Houston office who owns 10 percent of ABC Co.’s outstanding common stock. The CPA firm’s Dallas office performs an audit of ABC. FF provides no services to ABC and is not able to influence the engagement.

Outcome: Since prohibitions on financial interests of more than five percent of an attest client’s equity securities (or other ownership interests) apply to all of the firm’s professional personnel, FF’s financial interest would impair independence.

Special Provisions

Because new and substantially different rules and terms are being introduced, the committee has included certain transition and grandfathering allowances to facilitate application and compliance with them.

Transitioning

• The new rules are effective six months after the last day of the month in which they appear in the Journal of Accountancy. The committee believes that this period will provide the membership sufficient time to learn and begin applying the new rules. Earlier application is encouraged.
• Because rules pertaining to employment and business associations of certain (non-partner) professional employees have been tightened, a six-month transition period allows individuals ample time to sever those relationships and maintain independence.

Grandfathering

In certain limited instances, persons whose relatives were previously not prohibited from being employed by attest clients will become subject to proscriptions. The grandfathering provisions permit family members to continue in those positions without impairing independence if certain criteria are met.

Educational Tools

To help the profession and other interested parties learn the new rules in the most efficient manner possible, the committee will make the following educational tools available via the Institute’s website at www.aicpa.org/members/div/ethics/edutools.htm. Tools will include a white paper on the rationale behind the adopted rules, a Plain English Guide to Independence, with an update on the new rules, and informal Q&As to help with application issues.

The site will also contain the complete wording of the rules along with selected definitions.

The expected Journal of Accountancy publication date for the new rules is November 2001. The committee also expects to have both its white paper and the Plain English Guide available online at that time. Informal Q&As will be developed on an as-needed basis once the rules have been formally released.

As many state boards of accountancy will consider these rules for possible incorporation into their own codes of conduct, the committee will continue to offer its assistance, in the hopes of further increasing coordination among the profession’s independence standard-setting bodies.

Caution Regarding Other Independence Requirements

As noted, state accountancy boards (and some CPA societies) will be reviewing the new AICPA rules to determine whether to synchronize their rules to those of the Institute. Accordingly, members are encouraged to contact their state representatives to ensure compliance with those rules before implementing the new AICPA rules. In addition, there may be other independence requirements (such as those of the SEC and other government regulators) that apply.