Auditor Independence -
The Framework

Date: June 24, 2015

Publication: Business Law Update Summer 2015

This article is the first of a three-part series intended to help companies understand the basics of auditor independence. This installment provides an overview of the auditor independence standards and the standard setters. Read the second and third article in the series: "Auditor Independence – The Role of the Audit Committee" and “Auditor Independence – SEC Enforcement Actions Against Audit Committees.”

In the late '90s/early 2000s, a tightening of auditor independence standards caused many accounting firms to limit or eliminate their non-audit consulting practices. Recently, those firms have jumped back on the consulting bandwagon, a trend that has not gone unnoticed by the regulators.

It is the position of the Office of the Chief Accountant of the Securities and Exchange Commission (SEC) that:

“[p]ublic companies have a responsibility to ensure that the auditors of their financial statements are independent, as do the auditors themselves… Ensuring auditor independence is as important as ensuring that revenues and expenses are properly reported and classified. If the auditor's independence is impaired then the company has not satisfied the requirement to file financial statements audited by an independent accountant.”

Accordingly, and in view of the uptick in non-audit services offered by audit firms, companies need to understand the basics of auditor independence so as to avoid the situation where their independent auditor is no longer deemed independent or worse, the SEC comes calling. This first article of a three-part series provides an overview of the auditor independence standards and the standard setters. The next installment will outline the role of the audit committee in maintaining auditor independence, and the final piece will review relevant SEC enforcement actions.

The federal securities laws and the SEC rules promulgated thereunder require that financial information filed with the SEC be certified or audited by "independent" public accountants. According to the SEC, that independence requirement serves two public policy goals. First, it seeks to minimize the influence of external forces that could impact the auditor’s judgment, thereby fostering high quality audits. Second, an independent audit promotes investor confidence in the integrity of the reported financial information.

Until 1997, the SEC was the sole independence standard setter. Discussions between the SEC, the American Institute of Certified Public Accountants (AICPA) and the major accounting firms in 1997 led to the formation of the Independence Standards Board (ISB). The ISB set the auditor independence standards but the SEC also retained its authority. During its existence, the ISB issued three standards. The first requires annual independence discussions with the audit committee, including disclosure of all relationships between the auditor and the company that might bear on independence and confirmation of the auditor’s independence. The second relates to mutual funds and requires that an auditor be independent of the sister funds and all related non-fund entities in addition to the audited fund. The third standard set forth certain procedures to be put in place when an employee of an audit firm becomes employed by an audit client. To the extent not replaced by subsequent rulemaking, these standards remain in effect.

For a variety of reasons, including a general disagreement over the extent to which “independence in appearance” versus “independence in fact” should factor into the independence rules, the SEC promulgated its own independence rules in 2000 (which resulted in the ISB disbanding shortly thereafter) and again in 2003 in response to the Sarbanes-Oxley Act of 2002 (SOX). Those rules:

  1. prohibit relationships between certain members of the audit firm and the client;
  2. prohibit various non-audit services;
  3. address personnel issues, including audit partner rotation, employment of audit firm staff and certain compensation arrangements;
  4. require discussions with the audit committee; and
  5. mandate disclosure of the audit and non-audit services provided by the auditor and the associated fees.

The auditor must be independent both in fact and in appearance, such that an auditor is not independent if a reasonable investor would conclude that the auditor is not capable of exercising objective and impartial judgment. In making independence determinations, the SEC looks first to whether a relationship or the provision of a service:

  1. creates a mutual or conflicting interest between the accountant and the audit client;
  2. places the accountant in the position of auditing his or her own work;
  3. results in the accountant acting as management or an employee of the audit client; or
  4. places the accountant in a position of being an advocate for the audit client.

Following the creation of the Public Company Accounting Oversight Board (PCAOB) by SOX, the PCAOB adopted as its interim standards the AICPA’s Code of Professional Conduct and the ISB’s standards. Since that time the PCAOB has developed additional standards relating to contingent fees, tax transactions and audit committee communications, and has issued guidance applicable to certain rules. Because the PCAOB rules do not supersede those of the SEC, a public company auditor must follow the more restrictive rule.

Finally, the AICPA has its own set of comprehensive independence standards applicable to all of its public members and has recently developed a conceptual framework for its public members to follow when no direct authority exists. That framework requires that the auditor identify threats to compliance with the independence rules, such as family relationships, familiarity and self-interest; evaluate those threats; and apply various safeguards.

As the preceding discussion demonstrates, the auditor independence framework is intricate and the rules are complex. Companies and their audit committees, therefore, need to have a basic understanding of the standards but should be cognizant of the complexity and should not hesitate to bring in outside advisors to untangle the independence web when necessary.

If you have questions, please contact Tammy Bieber.

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