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3 Takeaways from the SEC’s August 29 Statement on Auditor Independence
In late August, Paul Munter, the Acting Chief Accountant of the Securities and Exchange Commission’s (SEC’s) Office of the Chief Accountant (OCA), released a statement entitled, “Auditor Independence and Ethical Responsibilities: Critical Points to Consider When Contemplating an Audit Firm Restructuring” (statement). His fourth statement highlighting auditor independence in the past year, here are three (3) takeaways from Mr. Munter’s most recent statement:
#1. Complex business transactions between audit firms and entities outside the profession raise the risk of impaired independence.
The statement advises firms to consider the Rule 2-01 of Regulation S-X (Rule 2-01) definition of “accounting firm,” which includes associated entities, in the context of all entities involved in the transaction. Entities that fall within this definition will be subject to the SEC’s independence rules and other requirements. While “associated entity” is not defined in Rule 2-01, the SEC staff has considered the financial interest an entity has in the audit firm and ability of the entity to influence the firm’s operating or financial decisions to be critical factors.
Also, firms should consider whether persons involved in the transaction (e.g., investor in the audit firm or individual in the chain of command) meet the Rule 2-01 definition of “covered person.”
All persons and entities meeting the above definitions will need to monitor their interests and relationships to avoid independence violations.
#2. Private equity involvement raises additional challenges
As noted in Mr. Munter’s June 2022 statement, some audit firms have recently engaged in restructurings and the use of alternative practice structures (for example, private equity investment in a firm’s non-audit practice, which separates the firm’s audit and non-audit practices). Such arrangements have the potential to undermine auditor independence, the OCA warned. In this statement, he notes that the ever-changing nature of private equity (PE) makes it particularly challenging for firms to maintain independence of their audit clients. To counter this difficulty, an audit firm restructuring in this manner should have a robust system of controls to monitor their compliance with the rules.
Another concern raised was that PE investments often are short term in nature and hyper-focused on return on the PE firm’s investment; this may cause the public to perceive that the audit firm prioritizes profits over quality. Here, the statement cautions that audit firms must be willing to sacrifice revenue when needed to maintain independence. Failure to do so may result in investigations by the SEC and/or Public Company Accounting Oversight Board (PCAOB).
#3. Divesting a portion of an audit firm’s business: OCA staff expectations
In some cases, an audit firm may divest a part of its business such that the divested entity is no longer part of the firm. In this statement, Mr. Munter laid out the OCA staff’s expectations that, at a minimum, the firm and divested entity would: (1) adopt separate corporate governance, management, and financial structures; (2) terminate all interests between them; (3) have no revenue or profit sharing arrangements; (4) have no joint-marketing or advertising arrangements; (5) prohibit the divested entity and its affiliates from profiting from the firm’s name or logo; and (6) complete any transition-related shared services between the firm and the divested entity promptly.
In closing, the statement reminded audit firms of the requirement to be independent in fact and appearance and the need for a strong, ethical culture to make the right calls. As some firms consider possible restructurings, the OCA staff expect that those firms will keep their gatekeeper role front and center.
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