SEC AUDITOR INDEPENDENCE REQUIREMENTS

On November 15, 2000 the SEC adopted the first changes in its independence rules since 1983. The following discussion addresses the underlying drivers that caused the SEC to amend its independence rules, the scope of audits that are affected by the new rules, and an explanation of the new rules as they relate to family relationships, employment relationships, non-audit services, quality controls, and disclosure rules.

Drivers of change for new independence rules

The accounting industry is in the midst of a dramatic transformation. Accounting firms are increasingly global and they offer a wide range of multi-disciplinary services. As a result of these trends, many CPA firms have partners and other family members that have not influence on the audit that need to be concerned about independence issues. Further, the growth of non-audit services raise questions about the ability of CPA firms to remain independent while providing other services that may represent a revenue stream that is larger than that provided by the independent audit. Each of these issues are explored further below.

Family Relationships

The SEC’s previous independence rules on financial and employment relationships of auditors were developed during an era when accounting firms were small, less diversified, and there were few dual career families. As accounting firms have expanded internationally, most SEC registrants now have their financial statements audited by firms that have officers and professionals all over the globe. Most of the professionals in those offices have no connection to, or influence over, the registrant’s audit.

The size of auditing firms, the increase in the number of professionals employed by these firms, and the increase in dual career families has greatly increased the number of employees who potentially would have independence problems. For example, the spouse of an accounting firm partner could not hold certain positions at an audit client or stock in the audit client, even though an employee stock compensation or 401K plan and the partner had not connection to the audit. The new SEC rules allow accounting firm employees to maximize the opportunities available to them , while promoting the public interest and protecting investor confidence.

Non-audit Services

In 1993 four of the Big Six accounting firms earned more than 50% of their revenues from accounting and auditing fees. According to Figure 1-6 the most that any of the Big Five firms earns from accounting and auditing fees is 35% of total firm revenues. According to the SEC, in 1999 4.6% of Big Five SEC audit clients paid consulting fees in excess of audit fees. The SEC is concerned that the more the auditor has at stake in its dealings with the audit client, the greater the cost to the auditor should he or she displease the client, particularly when the non-audit service relationship has the potential to generate significant revenues on top of the audit relationship. Further, certain types of non-audit services, when provided by the auditor, create inherent conflicts that in incompatible with objectivity.

The accounting profession, however, disagreed about whether non-audit services impaired or facilitated the performance of the audit and the financial reporting process, and served the public interest. On one hand, many auditor’s believe that if they understand the factors that influence and improve the entity’s performance, that they also focus the audit on the most critical audit issues. On the other hand, the SEC wanted to ensure that auditors approach each audit with an appropriate level of professional skepticism, and that auditor’s would be willing to take positions that might be against the interests of management or against the interests of the accounting firm. The issues that might impair an auditor’s objectivity are subtle, and the SEC final rules represent steps to minimize the possibility that external factors will influence the auditor’s judgment.

Scope of rules

The final rules apply only to public companies and other entities registered with the SEC or otherwise required to file audited financial statements with the SEC. The AICPA and the accounting profession were concerned that State Boards of Accountancy might adopt similar rules, particularly as they relate to non-audit services offered by CPAs. The accounting profession was also concerned that the GAO might adopt similar rules for governmental audits (see Chapter 23), which might restrict the services offered to small governmental entities. However, at present, these rules apply only to companies that file financial statements with the SEC.

Financial Relationships

The new SEC rule addresses the direct or material indirect investments that impair independence. It also addresses a variety of other financial relationships that impair independence, such as loan relationships, credit cards, and other similar financial relationships. Investments in audit clients and other financial relationships are discussed below.

Investments in Audit Clients

The goal of the new rule regarding investments in clients is to allow worldwide partners or employees of an accounting firm that have no influence on the audit to be able to invest directly in an audit client without violating the independence rules. Under the new rule the following individuals in an accounting firm would be prohibited from investing directly in an audit client through stocks, bonds, notes, options or other securities, in order for the firm to remain independent.

< The accounting firm including its pension, retirement, investment or similar plans.

< Any covered persons in the firm which means the following partners, principals, shareholders, and employees of an accounting firm:

< The audit engagement team.

< The chain of command including all persons who (1) supervise or have direct management responsibility for the audit, including all successively senior levels through the accounting firm's chief executive; (2) evaluate the performance or recommend the compensation of the audit engagement partner; or (3) provide quality control or other oversight of the audit.

< Any other partner, principal, shareholder, or managerial employee of the accounting firm who has provided ten or more hours of non-audit services to the client for the period.

< The immediate family members (a person’s spouse, spousal equivalent and dependents) of a covered person.

A direct investment also includes investing through an intermediary unless it is a diversified management investment company as defined by Section 5(b) (1) of the Invest Company Act of 1940.

The scope of the independence rule increases to any partner, shareholder, or professional employee of the accounting firm, or immediate family member, or any group of the above persons that has beneficial ownership of more than 5% of an audit client’s equity securities or controls an audit client.

Independence would also be violated if the accounting firm, any covered person in the firm, or his or her immediate family member serves as voting trustee of a trust, or executor of an estate, containing the securities of an audit client, along with the authority to make investment decisions for the trust or estate.

Independence problems also surface through material indirect investment. Hence, if an accounting firm, a covered person, or his or her immediate family members owned more than 5% of a diversified management investment company that invests in and audit client, the firm would no longer be independent with respect to the audit client.

Other Financial Relationships

The SEC has also established rules related to a variety of financial relationships that relate to the accounting firm, covered persons, and his or her immediate family members. Such financial relationships with an audit client includes:

< Lending and debtor – creditor relationships.

< Savings and checking accounts.

< Broker-dealer accounts.

< Futures commission merchant accounts.

< Credit cards.

< Insurance products.

< Investment companies.

For example, a covered person or his or her immediate family member may not have a saving or checking account with an audit client with a balance that exceed the amount insured by the FDIC or similar insurer. In another example, the accounting firm, covered persons, and his or her immediate family members cannot have a broker-dealer account with an audit client if the account includes any asset other than cash or securities that are covered by the Securities Investor Protection Act of 1970. The full list of all rules is too numerous to cover here, but students should be aware of the general categories outlined above.

Exceptions

The new SEC rules provide three exceptions that address common situations that might cause an audit firm, covered person, or immediate family member not to be independent. The first exception relates to inheritance and gifts. Independence rules are not violated if any person acquires an unsolicited financial interest, such as through an unsolicited gift or inheritance, that would cause an accountant to be not independent and the financial interest is disposed of as soon as practicable. In any case the financial interest must be disposed of within 30 days after the person has knowledge of, and the right to dispose of, the financial interest.

The second exception relates to new audit engagements. Independence would not be violated if a accounting firm, covered person, or his or her immediate family member has a financial interest in a new audit client and

< The accountant did not audit the client’s financial statements for the immediate preceding fiscal year, and

< The accountant is independent before the earlier of

< Signing an initial engagement letter, or

< Commencing audit, review, or attest procedures.

The final exception relates to employee compensation and benefit plans. Immediate family members of covered persons are allowed to participate in employee compensation and benefit plans provided that the financial interest, other than unexercised employee stock options, are disposed of as soon as practicable, but no later than 30 days after the person has the right to dispose of the financial interest.

Employment Relationships

The SEC adopted new rules on employment relationships in light of the increased mobility of professional employees, the recent globalization of accounting firms, and similar changes in society at large. The rules greatly reduce the pool of people within audit firms whose families are affected by the independence requirements. The following paragraphs address the four categories of employment relationships that affect independence.

Employment of Accountant by Audit Client

An accountant cannot be employed by his or her audit client and be independent. Hence, an accountant is not independent if at any time during the audit and the professional engagement period, a current partner, principal, shareholder, or professional employee of the accounting firm is employed by the audit client. These individuals also cannot serve as a member of the board of directors, or similar management or governing body of the audit client.

Employment of Certain Relatives by Audit Client

A covered person’s spouse, spousal equivalent, dependent, parent, non-dependent children, and siblings cannot perform and accounting role or an financial oversight role with an audit client. And a ccounting role or financial reporting oversight role means a role in which a person is in a position to or does:

< exercise more than minimal influence over the contents of the accounting records or anyone who prepares them; or

< exercise influence over the contents of the financial statements or anyone who prepares them, such as when the person is a member of the board of directors or similar management or governing body, chief executive officer, president, chief financial officer, chief operating officer, general counsel, chief accounting officer, controller, director of internal audit, director of financial reporting, treasurer, vice president of marketing, or any equivalent position.

Note that the scope of family relations is more extensive than that associated to the financial interest rules. This is because employment is more transparent that a relatives investments.

Employment at Audit Client of Former Accounting Firm Employee

Independence issues are raised when an individual with an accounting firm assumes a position with and audit client and also remains linked to the accounting firm. Hence, if a former partner, shareholder, principal or professional employee of an accounting firm are employed in an accounting or financial reporting oversight role at an audit client, the following conditions must be met in order for the audit firm to remain independent.

< The individual must not influence the accounting firms operations or financial policies.

< The individual must not have a capital balance at the accounting firm.

< The individual must not have a financial arrangement with the accounting firm, other than one providing for a regular payment of a fixed dollar amount (which is not dependent on revenues, profits, or earnings of the accounting firm).

For example, an audit firm would not be independent if a former partner could took a position working for a client in an accounting or financial reporting oversight role, if the former partner’s retirement payments were dependent upon the firms revenues or earnings.

Employment at the A udit Firm of a Former Employee of the A u dit Client

The SEC’s independence rules address the revolving door issue both with audit firm employees going to the audit client and with audit client employees taking positions at the audit firm. An independent audit firm who hires individuals who were formerly officers, directors, or employees of an audit client as a partner, principle, shareholder, or professional employee must ensure that the individual does not participate in, or is in a position to influence, the audit of the financial statements of the audit client covering any period during which he or she was employed by or associated with the audit client. For example, if a former controller is hired by the audit firm, the individual can neither participate in the audit of his or her former employer nor be in a position to influence the audit, such as a position in the chain of command relating to the audit.

Business relationships

An accounting firm is not independent if at any time during the audit and professional engagement period, the accounting firm or any covered person in the firm has any direct or material indirect business relationship with an audit client. Hence, a covered person or the accounting firm could not enter into a joint venture with an audit client. This rule extends to business relationships with persons in a decision-making capacity at an audit client, such as a director, officer, or substantial shareholder. The rule on business relationships does not address professional services with are addressed below under the discussion of non-audit services.

Non-audit Services

The provision of non-audit services to SEC clients has changed dramatically in the last decade and is a major focus of attention of the new SEC rules. The new SEC rules identify nine non-audit services that are deemed to be inconsistent with auditor independence. Seven of the nine services are already restricted by the SEC, AICPA or SECPS and the rules closely track the language found in existing prohibitions. Hence, an accounting firm is not independent if, at any point during the audit and professional engagement period, the accounting provides the following non-audit services to an audit client.