Auditor independence-or rather the potential absence of same-is apparently still a cause of significant agita at the SEC's Office of Chief Accountant. In October last year, 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." That statement was prompted largely by the trend at that time toward the use of "new and innovative transactions" to access the public markets, such as SPACs, together with the potential effect on independence of increasingly complex tangles of business relationships among audit firms, audit clients and non-audit clients. (See this PubCo post.) But that caution seems not to have been enough to slay the dragon. In this June statement, Munter again addresses auditor independence. The SEC, he observes, "has long-recognized that audits by professional, objective, and skilled accountants that are independent of their audit clients contribute to both investor protection and investor confidence in the financial statements." This time, Munter focuses his statement on the critical importance of the general standard of auditor independence and recurring issues in recent auditor independence consultations. He also addresses the value of firms' treating accounting as a profession, one that fosters "a culture of ethical behavior in all their professional activities, but especially with respect to auditor independence." Munter appears to be especially concerned about the "decreased vigilance" and "ethical deterioration" that may arise out of "checklist compliance mentality," an unfortunate state of mind he highlights in several contexts. 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.
Auditor independence standards. In his most recent statement, Munter emphasizes the importance to investors of high-quality audits performed by accountants that are independent of their audit clients. The general independence standard of Rule 2-01(b), he observes, is at the heart of the auditor independence rule and employs a reasonable investor standard to assess whether the accountant is "capable of exercising objective and impartial judgment of all issues encompassed within the accountant's engagement." Under this standard, the SEC must take into account all relevant circumstances and relationships between the accountant and the audit client, beyond just reports filed with the SEC. The rule also provides a framework with four general guidelines for evaluating independence: auditor independence would be impaired if the circumstances or relationships "create a mutual or conflicting interest between the accountant and the audit client; place the accountant[s] in the position of auditing their own work; result in the accountant acting as management or an employee of the audit client; or place the accountant in a position of being an advocate for the audit client." Munter has previously cautioned 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."
Paragraph (c) of the rule provides a very long, but non-exclusive, list of examples reflecting the application of the general standard to particular circumstances where an accountant would not be considered independent. But, even in this context, Munter stresses, it is important not to lose sight of the general independence standard: independence can still be impaired even if a set of circumstances is not identified on the prohibited list of paragraph (c). Importantly, a determination of independence is not a "checklist compliance exercise under Rule 2-01(c)"; it also requires a more nuanced analysis under the general independence standard. According to Munter,
"accountants, audit firms, registrants, and their audit committees should never make the mistake of assuming that just because a particular circumstance is not expressly prohibited in, or captured by, Rule 2-01(c), their independence analysis is over. Instead, accountants, audit firms, registrants, and their audit committees must always assess and approach auditor independence for purposes of considering, beginning, or continuing an audit engagement under Rule 2-01(b). Stated differently, compliance with the prohibitions enumerated in Rule 2-01(c) is necessary but not sufficient. The general standard requires an evaluation of auditor independence, including an assessment of independence both in fact and appearance from the perspective of a reasonable investor."
Munter also includes a reminder that the general independence standard applies to all years included in a filing.
Consultations with OCA. Staff of the Office of Chief Accountant are available to help with assessments of auditor independence "for either an existing set of facts or a specific contemplated circumstance such as a future merger or acquisition involving known parties," including, on an informal basis, "potential circumstances that may result from a contemplated arrangement or transaction." However, consultations are not available for assessments based on "inchoate or unknown facts" or hypotheticals. Persons seeking guidance must be sure to "communicate all relevant circumstances of their specific question to OCA staff." Because applicable law or other circumstances may have changed, Munter "strongly discourage[s] accountants from placing undue reliance on any historical OCA staff positions, which are necessarily limited to the particular circumstances of the consultation."
Recurring issues. In the course of OCA staff consultations and external engagements with audit committees, auditors and companies, the staff have identified some recurring issues that Munter believes "reflect loosening attitudes toward the Commission's general standard of auditor independence." As noted above, one issue in particular is performing a "checklist compliance exercise" in disregard of the general standard. Munter cautions that this practice "is not conducive to compliance, and the Commission investigates and enforces against violations of its general standard of auditor independence."
Another area of increasing concern that also implicates the general independence standard involves non-audit services, particularly "non-audit services and business relationships between the accountant and affiliates and non-affiliates of the company being audited" the extent and magnitude of which "would make it difficult for a reasonable investor to conclude that the accountant could exercise objective and impartial judgment in its audit."
According to Bloomberg, at a PLI conference in October last year, Munter cautioned that "[o]ne merger or deal can turn accounting firm advisory clients into audit clients and run headlong into strict U.S. conflict-of-interest rules that require auditors to be independent in both fact and appearance." The recent increase in the number and complexity of audit firms' business relationships and service agreements has created "'increased risk to the auditor's ability to be able to serve existing clients with objectivity and impartiality.. We find in many circumstances that those previous relationships will impair the auditor's independence.'" At the same conference, the chief accountant for Enforcement echoed Munter's admonition, warning that "the SEC continues to prioritize conflict-of-interest cases and pursue violations when 'firms come to us with independence issues of their own making..I have less than zero sympathy for independence violations that resulted from firms having prioritized growing consulting practices, growing non-audit services, prioritizing those over the integrity of its independence to its issuer audit clients. This is too important an area.'"
Munter also highlights the risks inherent in recent moves toward alternative practice structures, which, he contends, could undermine auditor independence. Some of these structures may involve complex business arrangements and restructurings. Recent examples include investment by private equity in accounting firms, necessitating that the firm be split into two entities-an attest firm that will perform audit services and a separate firm that will provide consulting or other non-audit services. (The split is usually necessary because of rules about who can own an audit firm.) Munter here admonishes firms to "carefully consider the implications for auditor independence when considering alternative practice structures, as will the OCA."
Professional ethics. "Auditor independence" Munter cautions, "is grounded in an understanding of accounting as a profession rather than an industry, which is critical to serving the public interest. As a profession, accountants have a responsibility to the public interest and to act ethically and with integrity in every professional activity." Munter emphasizes the "paramount importance that public accounting firms foster a culture of ethical behavior with respect to all aspects of their professional responsibilities, including auditor independence..Any perceived erosion of auditor independence or the profession's ethics or integrity breaks down the critical gatekeeper role of public accountants and can, over time, lead to diminished investor confidence." That erosion may occur, he reminds us, even before a line is crossed that could lead to Enforcement action. Rather, it could occur as a result of "decreased vigilance when it comes to auditor independence-what we describe as a 'checklist compliance' mentality. This has, in turn, led to a deterioration in the ethical culture in some firms." Here he cites as examples, accounting firm cheating scandals and instances of "accounting firm leadership viewing accounting errors and restatements as 'business opportunities.'"
Audit firms, he cautions, should "take compliance with all aspects of the Commission's auditor independence rule very seriously," leading by example in "prioritiz[ing] auditor independence and a culture of ethical behavior in all professional activities, and where independence on an audit engagement is a close-to-the-line call, the firms must be willing to forego audit and review fees or potentially lucrative restructuring proposals to comply with their independence responsibilities. Further, firms should establish and maintain quality controls that adequately reckon with regulatory requirements and be vigilant about internal efforts to circumnavigate those requirements. Finally, firms should address auditor independence compliance with the seriousness and urgency it deserves." Making difficult ethical and other determinations, he concludes, "is precisely how public accountants fulfill their gatekeeping function to help protect investors."
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