United States: SEC Acting Chief Accountant Urges Scrutiny Of Auditor Independence In Current Environment

This week, Acting Chief Accountant Paul Munter issued a statement regarding the importance of auditor independence-a concept that is "foundational to the credibility of the financial statements." The responsibility to monitor independence is a shared one: "[w]hile sourcing a high quality independent auditor is a key responsibility of the audit committee, compliance with auditor independence rules is a shared responsibility of the issuer, its audit committee, and the auditor." That has long been the case. But what is happening in the current setting to prompt this statement? It is the recent trend toward the use of "new and innovative transactions" to access the public markets, such as SPACs, together with the continued expansion by audit firms of business relationships with non-audit clients. That is, gatekeepers must be especially vigilant to prevent an audit firm from unwittingly losing its independence in the event of a transaction by an audit client with a non-audit client, a risk that is enhanced as audit firms engage in consulting relationships with more non-audit clients. This environment, Munter cautions, requires audit committees to be especially attentive in considering "the sufficiency of the auditor's and the issuer's monitoring processes, including those that address corporate changes or other events that potentially affect auditor independence." And it requires audit firms to consider "the impact of business relationships and non-audit services on existing and prospective audit relationships." It is important for companies to keep in mind that violations of the auditor independence rules can have serious consequences not only for the audit firm, but also for the audit client. For example, an independence violation may cause the auditor to withdraw the firm's audit report, requiring the audit client to have a re-audit by another audit firm. As a result, in most cases, inquiry into the topic of auditor independence should certainly be a recurring menu item on the audit committee's plate.

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According to Bloomberg, Munter emphasized this same theme at a PLI conference in October. As reported, Munter cautioned that "[o]ne merger or deal can turn accounting firm advisory clients into audit clients and run headlong into strict U.S. conflict-of-interest rules that require auditors to be independent in both fact and appearance." The recent increase in the number and complexity of audit firms' business relationships and service agreements has created "'increased risk to the auditor's ability to be able to serve existing clients with objectivity and impartiality.... We find in many circumstances that those previous relationships will impair the auditor's independence.'" At the same conference, the chief accountant for Enforcement echoed Munter's admonition, warning that "the SEC continues to prioritize conflict-of-interest cases and pursue violations when 'firms come to us with independence issues of their own making....I have less than zero sympathy for independence violations that resulted from firms having prioritized growing consulting practices, growing non-audit services, prioritizing those over the integrity of its independence to its issuer audit clients. This is too important an area.'"

"As we near the twentieth anniversary of SOX," Munter cautions,

Rule 2.01 sets forth restrictions on financial, employment and business relationships between an accountant and an audit client and restrictions on providing certain non-audit services to an audit client.  In considering this standard, the SEC looks to four "guiding principles" to assess whether a relationship or service:

• "Creates a mutual or conflicting interest between the accountant and the audit client;
• Places the accountant in the position of auditing his or her own work;
• Results in the accountant acting as management or an employee of the audit client; or
• Places the accountant in a position of being an advocate for the audit client." 

Munter cautions that it would require crossing a "high hurdle" to conclude that the accountant "could remain objective and impartial when an auditor has provided services in any of the periods included in the filing that is contrary to any one of these guiding principles."

Munter urges managements and audit committees to be proactive, as companies negotiate potential transactions with third parties, in keeping on top of any potential impact on auditor independence, including understanding the filings that could be required for these transactions, any relationships the auditors may have with counterparties and whether the prospective transaction and relationships could impair the "auditor's ability to continue to comply with the Commission's auditor independence rule applicable to such filings." That means that all gatekeepers-management, audit committees and independent auditors-should "consider the potential effects of the auditor's existing business and service relationships with other companies on the auditor's ability to remain independent of the issuer if a contemplated transaction is consummated." For example, Munter continues, gatekeepers will need to appreciate the scope of business relationships, "including non-audit service relationships, between the audit firm and other entities that will, or in the future could, require an audit, become the existing audit entity's affiliates, or result in other companies that have significant influence over the entity."

Audit firms, warns Munter, have an additional responsibility to "carefully consider the impact of business relationships and non-audit services on existing and prospective audit relationships," especially the potential effect of big, multi-year non-audit service contracts or business relationship arrangements with non-audit clients." For example, independence could be impaired if an existing audit client merges with, acquires or sells a significant equity position to the non-audit client and the audit firm engages in business or service arrangements that would then be considered prohibited. Munter recommends that, as part of their risk management processes, audit firms "should use a firm-wide perspective to understanding the potential future consequences of such arrangements on their ability to remain independent of their existing audit clients. Ultimately, because an audit client is required to retain an independent auditor, audit firms should always consider the potential impacts of all their business relationships on their audit clients."

Through their oversight function, audit committees play a critical role in enhancing auditor independence, observes Munter. The committee can provide a forum for auditors to discuss their concerns and facilitate communications among the board, management, internal auditors and independent auditors. In addition, when the audit committee fulfills its responsibilities to appoint and compensate the auditors and oversee their work, the committee can be instrumental in supporting the auditors' independence from management. The committee also has a key role in "setting the tone at the top for the quality of the issuer's financial reporting to investors. In selecting, retaining, and evaluating the independent auditor, the audit committee always should be focused, in the first instance, on audit quality."

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In 2019, the SEC announced settled charges against PwC and one of its audit partners for violations of the auditor independence rules. As described in the Order, the violations included performing prohibited non-audit services during an audit engagement, including exercising decision-making authority in the design and implementation of software relating to an audit client's financial reporting, and engaging in management functions for the audit client. PwC was also charged with "improper professional conduct" in connection with 19 engagements by failing to comply with PCAOB rules requiring an auditor to "describe in writing to the audit committee the scope of work, discuss with the audit committee the potential effects of the work on independence, and document the substance of the independence discussion." According to the Order, the failure to properly advise these audit committees prevented them from examining whether the non-audit services affected PwC's independence. Notably, because it issued an audit report stating that it was independent when it was not, PwC was also charged with having caused its audit client to violate the Exchange Act by filing with the SEC an annual report that contained materially false or misleading information and that failed to include financial statements audited by an independent public accountant, as required. The SEC concluded that these violations reflected "breakdowns in [PwC's] system of quality control to provide reasonable assurance that PwC maintained independence." In addition to requiring PwC to pay disgorgement and penalties, the SEC censured PwC. (See this PubCo post.)

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