Auditor Independence: How the SEC Wants to Amend the Rules

The Securities and Exchange Commission (SEC) recently proposed changes to its auditor independence rules. The proposal targets situations in which auditors are borrowing funds or issuing debt to accumulate working capital. Here’s why auditor independence is important and how the SEC plans to alleviate some of the recordkeeping challenges associated with the existing rules.

Independence matters

Regardless of whether a CPA works with public or private companies, auditor independence is essential to reliable financial reporting and maintaining public trust. The SEC requires auditors to be independent of their public audit clients both “in fact and in appearance.”

Under the SEC’s rules, auditors generally lack independence “if a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant isn’t capable of exercising objective and impartial judgment on all issues” related to the work at hand.

SEC guidance provides a list of specifically prohibited nonaudit services and financial relationships. (See “Which nonaudit services and financial relationships are taboo?”) AICPA Interpretation No. 101-3, Performance of Nonattest Services, extends many of these restrictions to auditors of private companies.

The loan provision

Included in the list of prohibited financial relationships is a restriction on debtor-creditor relationships, also known as the “loan provision.” Under this restriction, generally an auditor isn’t independent when the audit firm (or any “covered person” in the firm or that person’s immediate family members) has any loan (including any margin loan) to or from:

• An audit client,  
• An audit client’s officers or directors, or
• Any record or beneficial owners of more than 10% of the audit client’s equity securities.

A “covered person” includes members of the audit engagement team and those in the chain of command, as well as any other partner, principal, shareholder or managerial employee of the audit firm who has provided 10 or more hours of nonaudit services to the audit client for the current accounting period or on a recurring basis. It also may include another partner, principal or shareholder from an office of the audit firm in which the lead audit partner primarily practices.

The broad definition of a covered person has caused auditors and various stakeholders of public companies — such as registered investment companies, pooled investment vehicles and registered investment advisors — to express concerns about the loan provision.

Proposed amendments

As a result, the SEC recently proposed amendments to help auditors and audit committees evaluate relationships where an audit firm borrows funds or issues bonds or other debt instruments to provide itself with working capital to fund operations. In some instances, a lender to an auditor or investor in one of the bonds might currently have an ownership stake in one of the audit firm’s clients.

The proposed changes update the analysis that auditors, clients and clients’ audit committees must use to determine if the auditor is independent. Specifically, the amendments would:

• Focus the analysis solely on beneficial ownership, rather than on both record and beneficial ownership,
• Replace the existing 10% bright-line shareholder ownership test with a “significant influence” test,
• Add a “known through reasonable inquiry” standard with respect to identifying beneficial owners of the audit client’s equity securities, and
• Amend the definition of “audit client” for a fund under audit to exclude from the provision any funds that otherwise would be considered “affiliates of the audit client.”

In a nutshell, the proposed amendments are designed to better focus the loan provision on those relationships that could impair (or appear to impair) an auditor’s ability to exercise objective and impartial judgment. Although threats to auditor independence can occur in any industry, they’re most prevalent in asset management.

“The proposal reflects an approach for strengthening our auditor independence framework. … We’re trying to right size so that audit committees can be much more accurate and audit firms can be much more accurate in identifying relationships that really are independence-impairing,” explained SEC Chief Accountant Wesley Bricker in a recent statement.

Stay tuned

The SEC’s existing rules on auditor independence impose a significant recordkeeping challenge. The SEC wants to refine the broad criteria for evaluating debtor-creditor relationships so that auditors and their clients face less of a challenge complying with the rules. We’re monitoring the status of this proposal, which will be subject to a 60-day comment period after it’s published in the Federal Register. In the meantime, feel free to contact us with questions about the auditor independence rules for public or private companies.

Sidebar: Which nonaudit services and financial relationships are taboo?

The Securities and Exchange Commission (SEC) specifically prohibits auditors from providing the following nonaudit services to an audit client or its affiliates:

• Bookkeeping,
• Financial information systems design and implementation,
• Appraisal or valuation services, fairness opinions or contribution-in-kind reports,
• Actuarial services,
• Internal audit outsourcing services,
• Management functions or human resources,
• Broker-dealer, investment advisor or investment banking services, and
• Legal services and expert services unrelated to the audit.

This list isn’t exhaustive. Audit committees should consider whether any service provided by the audit firm may impair the firm’s independence in fact or appearance. SEC independence rules also prohibit audit firms and auditors from engaging in the following financial relationships with their public audit clients:

Employment relationships. A public company must wait at least a year before it can hire certain individuals formerly employed by its audit firm in a financial reporting oversight role.

Contingent fees. Paying the audit firm a contingent fee or on a commission basis impairs independence in fact or appearance.

Direct or material indirect business relationships. Independence is compromised if the audit firm has a direct or material indirect business relationship with the public company or its officers, directors or significant shareholders.

Certain financial relationships. Prohibited financial relationships between a public company and its auditor include debtor-creditor relationships, banking, broker-dealer relationships, futures commission merchant accounts, insurance products and interests in investment companies.

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