Would the independence of the CPA be considered to be impaired with respect to the client?

June 27, 2000

The Commission is considering a rulemaking proposal to modernize the rules for auditor independence primarily in three areas: (1) investments by auditors or their family members in audit clients; (2) employment relationships between auditors or their family members and audit clients; and (3) the scope of services provided by the audit firms to their audit clients.

• The proposals would significantly reduce the number of audit firm employees and their family members whose investments in audit clients would impair an auditor's independence.

• They would also identify certain non-audit services that, if provided to an audit client, would impair an auditor's independence. The proposals would not extend to services provided to non-audit clients.

• A limited exception would be provided to accounting firms for inadvertent independence violations if the firm has quality controls in place and the violation is corrected promptly.

• Companies would disclose in their annual proxy statements certain information about non-audit services provided by their auditors during the last fiscal year.

The release articulates four principles by which to measure an auditor's independence. An accountant is not independent when the accountant (1) has a mutual or conflicting interest with the audit client, (2) audits his or her own work, (3) functions as management or an employee of the audit client, or (4) acts as an advocate for the audit client. These principles are rooted in the bedrock philosophy of the profession that auditors must be independent in fact and in appearance.

The principles, as well as many of the proposed rules, reflect existing Commission interpretations and standards recognized by the industry and the Independence Standards Board.

Financial Relationships

The proposed rule would narrow significantly the circle of people whose investments trigger independence concerns. For example, many partners in firms that do not work on the audit of a client, as well as their spouses and families are restricted from investments in a firm's audit clients. However, the proposed rules limit such restrictions to principally those who work on the audit or can influence the audit. Under the proposed rules, an accountant is not independent under the following circumstances:

• Any direct investment in an audit client or its affiliates by the firm, "covered persons" (i.e., those involved in the audit or in a position to influence the audit, or their immediate family).
• Direct investments of more than 5 percent of the equity of an audit client or its affiliates held by firm partners, professional employees and certain of their family members, not included above.
• The firm, any covered person in the firm, or any immediate family members has any material indirect investment in an audit client, including, ownership of more than 5 percent of an entity that owns an interest in the audit client, or ownership of more than 5 percent of an entity of which the audit client owns an interest.

Certain other financial relationships with an audit client also would preclude an accountant from being independent. These relationships include:

• Having loans to or from an audit client except for certain consumer loans, such as mortgages or auto loans.
• Maintaining savings, checking, brokerage, or similar accounts in excess of insured amounts.
• Maintaining a credit card with a balance in excess of $10,000.
• Holding individual insurance policies, and for the firm, professional liability policies.
• Investing in an investment company that is in the same investment company complex as the audit client.

The proposed rule also prohibits investments by the audit client in the auditor. It also prohibits an audit client from acting as an underwriter, or engaging in related activities, for the auditor.

There are certain exceptions for financial interests that are acquired through gifts or inheritances that are disposed of in a timely manner.

Employment Relationships

As with financial relationships, the proposed rules would greatly reduce the pool of people within audit firms whose families would be affected by the employment restrictions necessary to maintain independence. The rules also identify the specific positions, namely those in which a person can influence the audit client's financial records, which would impair an auditor's independence if held by a "close family member" of the auditor.

An accountant will not be independent when certain employment relationships exist:

• A close family member of a covered person is employed by an audit client in an accounting or financial reporting oversight role.
• A former partner or professional employee is employed by an audit client in an accounting or financial reporting oversight role -- unless the former partner has severed his or her financial ties with the firm.
• A former employee of an audit client becomes a partner of the accounting firm and participates in the audit of the audit client.

Business Relationships

Consistent with existing rules, independence will be impaired if the accountant or any covered person has a direct or material indirect business relationship with the audit client, other than providing professional services or acting as a consumer in the ordinary course of business.

Non-Audit Services

The proposed rules identify particular non-audit services that are inconsistent with independence under the four basic principles articulated in the rule. Certain services, such as advising on internal accounting controls and risk management, do not impair an auditor's independence. The proposal covers certain aspects of the following types of services, several of which are already precluded under SEC, AICPA, and SECPS membership rules:

• Bookkeeping or other services related to the audit client's accounting records or financial statements.  When an accounting firm provides bookkeeping services for an audit client, the auditor auditing the client's financial information may be auditing his or her accounting firm's work.
• Financial information systems design and implementation.  Designing and implementing a hardware or software system used to generate information that is significant to the audit client's financial statements may create a mutual interest between the client and the accountant in the success of that system, supplant a fundamental business function, or result in the accountant auditing his or her own work.
• Appraisal or valuation services, fairness opinions, or contribution-in-kind reports where there is a reasonable likelihood that the accountant will audit the results.  Valuing assets and liabilities or opining on the adequacy of consideration in a transaction may create a situation where the auditor reviews his or her own work, including key assumptions or variables that underlie an entry in the financial statements.
• Actuarial services.  Providing any advisory services involving the determination of policy reserves and related accounts, unless the audit client uses its own actuaries or third party actuaries to provide management with the primary actuarial capabilities, may affect amounts reflected in an audit client's financial statements and may result in an accountant auditing his or her own work.
• Internal audit outsourcing.  Companies sometimes "outsource" internal audit functions by contracting with an outside source to perform all or part of their audits of internal controls. Since the external auditor generally will rely, at least to some extent, on the internal control system when conducting the audit of the financial statements, the auditor would be relying on a system he or she helped to establish and maintain. There also may well be a mutuality of interest where management and external auditor may become partners in creating an internal control system and share the risk of loss if that system proves to be deficient. This proposal does not include nonrecurring evaluations of discrete items or programs that are not in substance the outsourcing of the internal audit function. It also does not include operational internal audits unrelated to the internal accounting controls, financial systems, or financial statements.
• Management functions.  When the accountant acts, temporarily or permanently, as a director, officer, or employee of an audit client, or an affiliate of the audit client, or performs any decision making, supervisory, or ongoing monitoring functions, the accountant becomes part of the very entity he or she is auditing.
• Human resources.  Recruiting, advising clients about organizational structure, developing employee evaluation program, or conducting testing of employees may create a mutuality of interest with the audit client in the success of the employees the auditor selected, tested or evaluated.
• Broker-dealer, investment adviser, or investment banking services.  Serving as a broker-dealer, promoter, underwriter, investment adviser, or analyst of an audit client's securities will create a mutuality of interest with the audit client in enhancing the value of the securities portfolio. In addition, providing advice and recommendation in this realm often places the auditor in the position of promoting the client's securities.
• Legal services.  A lawyer's core professional obligation is to advance clients' interests. This fundamental obligation is incompatible with the independence required of an auditor.
• Expert services.  An accountant who renders or supports expert opinions in legal, administrative, or regulatory filings or proceedings creates, at the very least, the appearance that the accountant acts as an advocate.

Contingent Fee Arrangements

The proposed rule reiterates that an accountant cannot provide any service to an audit client that involves a contingent fee. Contingent fees result in the auditor having a mutual interest with the audit client in the outcome of the work performed.

Quality Controls

The rule proposal provides a limited exception from independence violations to the accounting firm, if certain factors are present:

• The individual did not know, and was reasonable in not knowing, the circumstances giving rise to his or her violation.
• The violation was corrected promptly once the violation became apparent.
• The firm has quality controls in place that provide reasonable assurance that the firm and its employees maintain their independence. For the largest public accounting firms, the basic controls must include, among others, written independence policies and procedures, automated systems to identify financial relationships that may impair independence, training, internal inspection and testing, and a disciplinary mechanism for enforcement.

Proxy Disclosure Requirement

The proposal would require registrants to disclose in their annual proxy statements information relating to services and fees provided by the auditor. Under the proposal, registrants would be required to disclose each professional service provided by the registrant's principal independent public accountant, if the fees exceed $50,000 or 10 percent of the audit fee, whichever is less. The disclosure would also indicate whether a company's audit committee or board of directors considered the effect that the provision of each disclosed service could have on the auditor's independence.

Lastly, if over fifty percent, the registrant would be required to disclose the percentage hours worked on the audit engagement by persons other than the accountant's full time employees. This requirement responds to recent moves by some accounting firms to sell their practices to financial services companies. The partners or employees often become employees of the financial services firm. The remaining accounting firm becomes in essence a "shell" that then leases assets, namely professional auditors, back from those companies to complete audit engagements. The professionals who had previously worked in the firm's audit practice become full-or part-time employees of the financial services company, but work on audit engagements for their former accounting firm, and receive compensation from the financial services firm, and in some situations, from the accounting firm.

Alternatives

The Commission solicits comments on each of the rule proposals. In addition, the Commission solicits comments on a range of alternative approaches regarding non-audit services.

Public Hearings