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Auditors Welcome Proposed Changes to SEC Independence Rules

Chris Gaetano
Published Date:
Feb 27, 2020


The Securities and Exchange Commission (SEC) has proposed loosening the rules around auditor independence, saying that the market and economy have changed significantly since the current regulations were set in 2003. 

A major part of this proposal, which was released to the public late last year, involves changing who does and does not count as an audit client. Under current regulations, the audit client is not only the entity that the CPA firm audits, but also any affiliates of that client. Such affiliates are defined as entities that have “control over the audit client, or over which the audit client has control, or which [are] under common control with the audit client, including the audit client’s parents and subsidiaries.” 

But the SEC proposal said that including affiliates in this way does not account for a number of situations it has observed in which a prohibited service or relationship with such an entity did not result in a corresponding threat to an auditor’s objectivity and impartiality, and that, further, portfolio companies found it challenging to monitor all their relationships in order to remain in compliance. 

With this in mind, the SEC has proposed adding to the rules governing which affiliate entities will fall under the audit client umbrella the phrase, “unless the entity is not material to the controlling entity.” The commission has also proposed a similar amendment when it comes to affiliated investment companies. In both cases, the SEC said, this amendment does not change the application of the general standard, and so even if the affiliate no longer counts as an audit client, the auditors could still identify independence concerns regarding that entity.

Catherine R. Allen, the founder and managing member of Audit Conduct LLC and the chair of the National Association of State Boards of Accountancy’s Ethics Committee, said that this change would relieve auditors of issues “that have dogged the profession for 20 years now,” namely situations in which a client has sister entities, including in an investment company complex such as a mutual fund. Allen said that, as the market has changed, “it’s become nearly impossible for firms to manage these two components of the rules” due, in particular, to the rising influence of private equity, which has complicated the picture of who controls what. 

Vanessa C. Teitelbaum, technical director of professional practice at the Center for Audit Quality and another proponent of the change, said that the past few years have seen private equity firms with large, complex organizational structures. As a result, she said, “What ends up happening is you are auditing Entity A; you are not auditing Entity B, but they become your affiliate because they are under common control,” despite the two entities not having any material relationship with each other besides that.

“It’s not the same as a subsidiary—it’s apples and oranges,” she added. 

By adding a materiality component to the affiliate rules, Allen said that audit independence can be preserved while, at the same time, dispensing with situations that don’t matter. 

“If there are sister companies through the audit client, unrelated to the client but for the fact they share a common parent, if that sister company is immaterial to the parent company, then the auditor, in theory, could potentially have interests or relationships with that sister entity and still be independent,” she said. 

Douglas R. Carmichael, an accounting professor at Baruch College who served as chief auditor of the Public Company Accounting Oversight Board in 2003, was, overall, supportive of the proposal, but he was a little hesitant when it came to the case of certain hedge funds and affiliated investment companies. Imagine, he said, that “you’ve got controlling person A, and he’s got Fund B and C. You’re auditing Fund B and you have a big investment in Fund C. So this rule would say, ‘Hey, that investment of fund C doesn’t jeopardize your independence of Fund B.’ But let’s say Fund C has restrictions on when you can pull your money out. You could call up the controlling guy, ‘Hey, I’m your auditor for Fund B and I want to get out of Fund C; won’t you let me do that?” 

“So I think it’s more complex than that. Just ‘not material to the controlling entity’ doesn’t do the job,” he said. 

But Allen noted that, even with this change, the SEC’s general rule on independence would still be in effect, and so facts and circumstances can still mean that even if a sister company isn’t technically an affiliate, it would still represent a threat to independence. Teitelbaum added that even outside the SEC’s own general rule, firms also have an interest in maintaining independence and quality control, and will occasionally find such facts and circumstances themselves. 

Allen added that, in terms of implementation, it might be challenging for firms to get the materiality information from the sister entities of their audit clients. Unless the auditors are doing the work at the parent level, they may have trouble conducting the materiality analysis, which, Allen said, “would be a shame because I think that’s the right answer, to filter out immaterial sister entities, but I’m not sure firms will always be able to obtain that information. And if they can’t, what choice do they have but to include them, and then we end up with the status quo.” 

 Jonathan Zuckerman, a partner at PKF O’Connor Davies, LLP, and the chair of the Society’s Auditing Standards  Committee, said that this change will likely “have a noticeable impact on the number of possible additional clients a firm can take on,” as there will be less of a chance of an independence violation. He said, however, that many of these same firms might actually lose, as the pool of potential clients for other firms would expand too. Beyond the number of clients, Zuckerman also pointed out that the change could affect what firms do for clients as well. 

“The change to amend the definition of an affiliate of an audit client would result in larger international firm networks being able to perform more nonattest work for attest clients, potentially reducing the number of firms that may be engaged by an SEC registrant,” he said. 

Other provisions

The SEC proposal would also loosen rules around the types of relationships that count as independence threats. Student loans would be added to the current list of debt relationships—which include auto loans, loans fully collateralized by an insurance policy, loans fully collateralized by cash deposits, mortgage loans collateralized by the borrower’s primary residence, and credit card debt under $10,000—that do not represent an independence threat. It would also change the focus on the types of business relationships representing a threat from “substantial stockholders,” which currently has no regulatory definition, to “beneficial owners,” which does. In addition, the types of prohibited business relationships would be focused on those that involve persons in a decision-making capacity, as it relates to the entity under audit, meaning that the independence analysis would focus on whether the beneficial owner has significant influence over the entity under audit. 

The new regulations would also amend what counts as an audit engagement period. Currently, Rule 2-01(b) outlines certain circumstances that, if they occur during the “audit and professional engagement period,” are inconsistent with the general standard of independence. However, the SEC said, domestic and foreign filers have different lengths for what counts within this period. For foreign filers, it’s just the past year. For domestic filers, it’s the “period covered by any financial statements being audited or reviewed” or the “period of the engagement to audit or review the ... financial statements or to prepare a report filed with the Commission.” Because the SEC believes that the difference creates an unfair barrier for domestic filers, the proposal would simply give everyone, foreign and domestic, the same one-year audit engagement period currently used by first-time filers. 

The regulations would also create a transition period for firms that acquired accidental independence violations via merger and acquisition activity; the violation, in the proposed framework, would need to be corrected as promptly as possible, and the entity would need a quality control system and be otherwise in compliance with independence rules. 

Carmichael said that the SEC’s proposal, overall, is the product of years of auditors asking the SEC about circumstances that, technically, count as violations but are eventually found to not actually threaten auditor independence. The proposed regulations essentially codify the many piecemeal exceptions that staff had allowed. 

At the Accountants Club of America’s (ACA) “Annual Issues Breakfast” on Feb. 4, AICPA President and CEO Barry C. 
commented on the SEC’s proposed changes, saying, “Rules written decades earlier need to change with the environment.”

Jan C. Herringer, a retired BDO USA, LLP audit partner and NYSSCPA past president, had a similar assessment, saying that the proposal is an acknowledgement of the rapid change the market has been undergoing, and that the changes would allow auditors to focus on important matters without threatening their independence. 

“The business environment is much more dynamic and complex than it was even five years ago,” Herringer said. “For example, business transactions and acquisitions occur more often and at a much quicker pace than historically, which has implications not only for how corporations conduct business but also for matters relating to auditor independence and, consequently, for audit quality. I believe the SEC’s release is appropriately looking to obtain feedback on how to modernize the auditor independence requirements to reflect the current market landscape, while maintaining the integrity of auditor independence and audit quality.” 

Comments on the proposal are due by March 16.

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