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US Securities and Exchange Commission

SEC Relaxes Auditor Independence Rules

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

By Soyoung Ho

SEC Commissioners Allison Herren Lee and Caroline Crenshaw said in a joint statement that they voted against adopting a rule intended to give auditors more discretion when determining whether they are independent of their public company audit clients.

They were referring to the SEC’s 3 to 2 decision to simplify compliance with certain aspects of the commission’s auditor independence Rule 2-01 of Regulation S-X, which was initially adopted in 2000 and revised in 2003.

“While it makes sense for us to assess how our rules are functioning from time to time and to recalibrate them as needed, we are concerned that the dial for auditor independence is turning in only one direction, and that is towards loosening standards and reducing transparency,” the two Democrats on the commission said in the statement. “We cannot support introducing greater opportunity for error and uncertainty into auditor independence standards while decreasing visibility into how auditors are actually making these judgments.”

The five commissioners voted in seriatim, which means they submitted their votes individually without holding a public meeting. Historically, the agency has often used the seriatim process on noncontroversial votes, but it rarely has done so with an important issue. The SEC under Chairman Jay Clayton has bucked the trend throughout his tenure.

The final rule is in Release No. 33-10876Qualifications of Accountants, on October 16, 2020. It becomes effective 180 days after publication in the Federal Register. Auditors may apply the rules early but only after the release is published in the Federal Register, which normally takes a few weeks after a rule is posted on the SEC’s website.

The market regulator said that the rule is borne out of decades of staff experience in consulting with auditors about independence matters. The rule is intended to put the focus and analysis of relationships that may pose threats to an auditor’s impartiality.

“The final amendments reflect updates based on recurring fact patterns that the Commission staff has observed over years of consultations in which certain relationships and services triggered technical independence rule violations without necessarily impairing an auditor’s objectivity and impartiality,” the SEC said.

The commission said auditors and audit committees will not have spend time analyzing non-substantive rule breaches.

“Today’s amendments reflect the Commission’s long-recognized view that an audit by an objective, impartial, and skilled professional contributes to both investor protection and investor confidence,” Clayton said in a statement. “These modernized auditor independence requirements will increase investor protection by focusing audit clients, audit committees, and auditors on areas that may threaten an auditor’s objectivity and impartiality. They also will improve competition and audit quality by increasing the number of qualified audit firms from which an issuer can choose.”

The commission provided some examples, including student loans, that will no longer trigger independence rule violations.

In the student loan scenario, an accounting firm has an audit partner in Atlanta who continues to pay student loans taken to attend college. A different audit partner in Atlanta audits the lender that provided the student loan. Previously, the SEC said the rule would have triggered an independence violation.

Among other things, the final rule amends the following definitions:

  • “affiliate of the audit client” and “investment company complex” to address certain affiliate relationships, including entities under common control
  • “audit and professional engagement period” to shorten the look-back period, for domestic first-time filers in assessing compliance with the independence requirements

The rule adds certain student loans and de minimis consumer loans to the categorical exclusions from independence-impairing lending relationships.

Release No. 33-10876 replaces the reference to “substantial stockholders” in the business relationships rule with the concept of beneficial owners with significant influence.

In addition, the release replaces the outdated transition provision in Rule 2-01(e) with a new Rule 2-01(e) to introduce a transition framework to address inadvertent independence violations that only arise as a result of a merger or acquisition transactions.

Lee and Crenshaw’s Dissent

The two dissenting commissioners pointed out the important role that auditors play in promoting the integrity of financial reporting. However, they also noted that auditors play their role in an imperfect issuer-pays model world. This means that auditors are being paid by the clients they audit.

Such conflict of interests, they said, would be significant even if their only source of income were from audits. But they noted that Big Four firms have been making a lot more money on tax, consulting, and other non-audit services.

“Auditor independence rules provide the central method for addressing and mitigating this conflict of interest,” Lee and Crenshaw stated. “By reducing the potential for external influence, they promote two separate but related goals: fostering high quality audits and promoting investor confidence in audits…. It is against this backdrop that the Commission relaxes auditor independence rules for the second time in as many years.”

The agency’s effort in part comes as auditors and companies have asked for further changes while the commission staff was working on the so-called “loan rule.”

The SEC in May 2018 issued a proposal in Release No. 33-10491Auditor Independence With Respect to Certain Loans or Debtor-Creditor Relationships, and in June 2019 finalized it in Release No. 33-10648Auditor Independence With Respect to Certain Loans or Debtor-Creditor Relationships. (See Auditor Independence Rule on Lending Relationships is Revised in the June 20, 2019, edition of Accounting & Compliance Alert.)

In their view, the latest rule in Release No. 33-10876 is a slippery slope towards partiality.

“Among other changes, today’s rules replace a clear standard with one that provides auditors greater discretion when assessing their own independence and presents greater risk of mistaken or inconsistent application of that standard,” they said. “What’s more, under the final rules, there is no mechanism for ensuring that the SEC and the investing public have visibility into how effectively auditors are making these assessments. And, as has too often been the case in recent years, these changes are disfavored by investors – those who actually rely on auditor assurances.”

The final rule is based on a proposal issued in December 2019 in Release No. 33-10738Amendments to Rule 2-01, Qualifications of Accountants.

Chairman Clayton has prioritized cutting back requirements over the objections of investor protection advocates in the three and half years he has led the agency.

 

This article originally appeared in the October 20, 2020 edition of Accounting & Compliance Alert, available on Checkpoint.

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