United States: SEC's OCA Updates Auditor Independence FAQs

Last Updated: September 19 2019
Article by Cydney Posner

The SEC's Office of Chief Accountant has updated its FAQs regarding auditor independence. The new and revised questions relate to the general standard for independence, prohibited non-audit services, partner rotation, definitions and miscellaneous other independence issues. 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 another menu item on the audit committee's plate.

The issues addressed in the revised and new FAQs are summarized below:

A. General Standard of Independence [2-01(b)]

  • New Question 2—Unpaid Fees

Generally, to maintain auditor independence, the company should pay any unpaid professional fees owed to the audit firm prior to the commencement of the current audit engagement. However, usually, there would be no issue so long as "at the time the current audit engagement is commenced, a definite commitment is made by the client to pay the prior professional fees before the current year audit report is issued, or an arrangement is agreed upon for periodic payments to settle the delinquent fees and there is reasonable assurance that the current audit fee will be paid before the audit of the ensuing year begins." But if the fees are not paid "for an extended period of time and become material in relation to the fee expected to be charged for a current audit, there may be a question concerning the accountant's independence with regard to the current audit because the accountant may appear to have a direct interest in the results of operations of the client."

  • New Question 3—Gifts

Under the "general standard" of auditor independence of Rule 2-01(b), "[t]he Commission 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 determining whether an accountant is independent, the Commission will consider all relevant circumstances, including all relationships between the accountant and the audit client and not just those relating to reports filed with the Commission." As a result, giving or accepting gifts or entertainment to or from an audit client must be assessed in considering the independence of the auditor. The FAQ states that the "nature and frequency of the activities may reflect a close personal relationship that could be independence impairing," citing Release No. 78873 (Sept. 19, 2016), In the Matter of Ernst & Young LLP, Robert J. Brehl, CPA, Pamela J. Hartford, CPA, and Michael T. Kamienski, CPA (romantic relationship between audit partner on the engagement team and chief accounting officer of audit client) ; and Release No. 34-78872 (Sept. 19, 2016), In the Matter of Ernst & Young LLP and Gregory S. Bednar (close personal relationship between lead partner and CFO (and family) of audit client involving extensive socializing and >$100K in entertainment expenses, including multiple out-of-town social trips and sporting events; this example is a bit more woolly because, with some exceptions, the conduct at issue was problematic largely because of the scale of it. Unfortunately, however, there is no bright line drawn, and determining when the line is crossed may be a thorny question in some cases: is an occasional dinner acceptable? If so, what about multiple dinners? How many dinners is too many? Caution seems to be the prescription here. See this PubCo postand, for a discussion of the consequences to the audit clients, see this PubCo post.)

E. Non-audit Services [2-01(c)(4)]

  • Revised Question 1—Bookkeeping Services

Rule 2-01(c)(4)(i) (bookkeeping services) precludes an auditor from assisting an audit client in preparing its financial statements. In addition, "the Codification of Financial Reporting Policies provides that: 'It is the Commission's position that an accounting firm cannot be deemed independent with regard to auditing financial statements of a client if it has participated closely, either manually or through its computer services, in maintenance of basic accounting records and preparation of financial statements, or if the firm performs other accounting services through which it participates with management in operational decisions.' The staff would also consider participating closely with an audit client to include providing accounting and financial statement templates for the audit client's use in its financial reporting process."

  • Revised Question 4—Prohibited Services by Successor Auditor

Five of the prohibited services (bookkeeping, internal audit outsourcing, valuation services, actuarial services, financial information system design and implementation) are permitted if "it is reasonable to conclude that the results of these services will not be subject to audit procedures during an audit of the audit client’s financial statements." Where a successor auditor provided these types of services in connection with the financial statements of a prior period audited by a predecessor auditor, the successor auditor’s independence would not be impaired, in the current period, so long as "the services (i) relate solely to the prior period audited by the predecessor auditor and (ii) were performed before the successor auditor was engaged to audit the current audit period. However, it would be independence impairing if the successor auditor was engaged to help design a financial system in the prior period, which was not implemented until the current period."

  • New Question 5—"Not Subject to Audit" Exception

The accountant may be able to apply the "not subject to audit" exception to the prohibited services rule (recited above) if the prohibited services are provided to a separate entity, even if it is under common control with the audit client, if the entity has autonomous financial and business operations, and the audit firm audits a different entity. The example here is a private group: according to the FAQ, "the staff has not objected to the 'not subject to audit' exception as applied in a private equity group context under similar circumstances." However, the exception may not apply in "other contexts, such as a traditional corporate entity or an investment company complex, based on the facts and circumstances. For example, there could be intercompany transactions and overlaps of corporate governance, management, personnel, or systems" that could mean that the financial and business operations would not be autonomous.

  • New Question 11—Proposal For Non-Audit Services

Auditor independence could be impaired if an audit firm were to make a proposal to an audit client regarding prohibited non-audit services before the end of the audit and professional engagement period (even if the firm will not continue as the auditor afterwards). If the audit firm is still the auditor when the pitch is made, the threat is intensified, "both in fact and in appearance, of audit team members acquiescing to management in order to increase the firm's chance of winning the prohibited non-audit services engagement. Management and the audit committee should consider the facts and circumstances before pursuing any discussion with its auditor about proposing on any prohibited non-audit service while the auditor is performing audit procedures to issue its final audit report."

G. Partner Rotation [2-01(c)(6)]

  • Revised Question 4—Partner Switching Firms

Where a lead audit partner for an audit client changes audit firms and the audit client follows the partner and engages the new audit firm, the lead partner's prior service as lead partner for the audit client with his prior audit firm must be taken into account in determining when the partner must rotate off the engagement for the audit client. That is because the requirement for the lead partner to rotate off the engagement after five years is, in part, "directed towards the need to have a fresh look with respect to the audit client." Since the lead partner had a continuing relationship with the audit client, the prior service would count in the determination of the partner rotation requirement.

  • Revised Question 7—Specialty Partner Services

After a lead or concurring partner rotates off an audit engagement, a "time out" of at least five years is required. If, after rotating off, thepartner provides services to the audit client in a specialty partner capacity (i.e., providing tax services or national office/technical services), any time providing services to, or continuing the direct service relationship with, the audit client would not be considered as time off from audit engagement.

  • Revised Question 10—Transition to New Lead Partner

Where the lead partner is at the end of the permitted five years, but to complete the current audit, the partner's work would extend into the new period, the partner would be permitted to finish that current audit, even though work would extend beyond the end of the five-year period, without impairing the firm’s independence. However, the partner must not be involved in any work that may be performed with respect to the first quarter of the subsequent reporting period. Because "some of this work may be performed simultaneously with the year-end audit, auditors will need to carefully monitor the transition for compliance with the rotation requirements. Limited discussions solely between the audit engagement team and a rotated-off partner generally would be considered as time off the audit engagement. Such discussions should be limited to historical accounting and auditing issues. This question also applies to concurring and other audit partners discussed in Rule 2-01(c)(6)."

  • New Question 11—Quarterly Review Services

The partner rotation rules provide that an accountant is not independent of an audit client if an audit partner serves as a lead audit or concurring partner for more than five consecutive years or an audit partner provides one or more services defined in Rule 2-01(f)(7)(ii)(C) and (D) (e.g., audit, review or attest services) for more than seven consecutive years. After serving the maximum period permitted, independence would be impaired if the partner continued to serve on the engagement by performing, for example, quarterly review services in one or more of the quarters in the subsequent audit period.

  • New Question 12—Small Audit Firm Exception

Rule 2-01(c)(6)(ii) has an exception to Rule 2-01(c)(6)(i) mandatory rotation when the audit firm has fewer than five "issuer" audit clients and fewer than ten partners, provided the PCAOB conducts a review at least once every three years of each of these engagements. In applying this provision, a "partner" includes each individual who is a proprietor, partner, principal or shareholder of the accounting firm and other positions with equivalent responsibility.

  • New Question 13—Reverse Merger

The lead audit (or concurring) partner for a non-operating shell company that conducts a reverse merger with a private operating company may generally serve as the lead (or concurring) audit partner for the audit of the new surviving public operating company for the first five years after the transaction, so long as the surviving public operating company establishes new governance, management, operations and accounting policies and procedures. However, the partner could not serve in that capacity if the new operating company carried over the former non-operating shell that company's board of directors, management or accounting policies and procedures, because those elements would have been previously subject to audit by the lead (or concurring) audit partner.

  • New Question 14— IPO

A private company submits a confidential draft registration statement and then is required, during the comment process, to add a more recent audited year in the registration statement filing (dropping the earliest year included in the submitted draft). If the lead (or concurring) audit partner has served in that capacity for all years of the audited financial statements, then, all of the years included in the confidential draft submission and effective registration statement would count towards the partner rotation requirement, including for foreign private issuers. Further, the audit firm must also be independent in accordance with all other SEC and PCAOB rules for all years included in the confidential draft submission and effective registration statement, except for foreign private issuers. (For foreign private issuers, Rule 2-01(f)(5)(iii) provides that "for audits of the financial statements of foreign private issuers, the 'audit and professional engagement period' does not include periods ended prior to the first day of the last fiscal year before the foreign private issuer first filed, or was required to file, a registration statement or report with the Commission, provided there has been full compliance with home country independence standards in all prior periods covered by any registration statement or report filed with the Commission.")

K. Definitions [2-01(f)]

  • Revised Question 2—Consolidated Group

ASC 810 provides guidance for the preparation of consolidated financial statements, which include the financial statements of a parent and all its subsidiaries as a single reporting entity. Auditors of the consolidated financial statements must be independent of all of the entities that are included within the meaning of "audit client" and "affiliate of the audit client," and all of the entities in the consolidated group would be considered to be within the definition of those terms.

O. Other Independence

  • New Question 2—Reg D

Financial statements required to be provided to investors in offerings under Rule 506(b) generally must comply with Article 8 of Reg S-X and, although Reg D does not require these financial statements to be filed with the SEC, the auditors must still comply with the independence rules in Rule 2-01.

  • New Question 3—Equity Investee

Under Rule 3-09 of Reg S-X, separately audited financial statements of an equity investee must be included in the filing in some cases; these financial statements must be audited by an accountant that is independent under SEC rules, even though the accountant may be permitted to perform the audit under standards other than the PCAOB's standards.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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