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By Cathy Allen
Cathy Allen, CPA helps CPAs and others understand and apply auditor independence and professional ethics rules though consultation, training, litigation support and expert services. Ms. Allen was a Managing Director in PwC LLP and served as senior staff to the AICPA Professional Ethics Executive Committee (PEEC), where she was instrumental in developing standards and tools for the profession such as the AICPA Plain English Guide to Independence and the Conceptual Framework for Independence. She authors several AICPA courses and other publications, including the Institute’s Ethics and Professional Conduct: Updates and Professional Ethics: The AICPA’s Comprehensive Course, and has written on professional ethics for various publications. Ms. Allen is a CPA in New York, New Jersey and Maryland and serves on the New York State Board for Public Accountancy and the National Association of State Boards of Accountancy (NASBA) Board of Directors as Northeast Regional Director. She also chairs the NASBA’s Ethics Committee and contributes to AICPA PEEC task forces.
For the first time in many years, the Securities and Exchange Commission proposed revisions to independence Rule 2-01, Qualifications of Accountants, under Regulation S-X. The Release, Auditor Independence with Respect to Certain Loans or Debtor-Creditor Relationships, addresses an independence issue identified in a June 2016 “no-action” letter from the SEC Division of Investment Management to Fidelity Management & Research Co. (“FMR”) and its affiliates (“Fidelity Entities”).
In the no-action letter, the SEC responded to concerns FMR raised about loans from certain owners of Fidelity Entities’ equity securities to their auditors. The SEC agreed not to take enforcement action against Fidelity Entities for auditors’ noncompliance with the loan provision of Rule 2-01, which deems any loan between a(n) audit firm or covered person in the firm (and their immediate family) and any of the following parties or entities to impair independence:
In summary, the changes would significantly narrow the rule’s application from greater than 10 percent record and beneficial owners of the audit client’s equity securities to include only beneficial owners (known through reasonable inquiry) of an audit client’s equity securities, where the owner has significant influence over the client. The term, audit client, in Rule 2-01 includes affiliates of the audit client, which the SEC broadly defines to include (among others) entities that control, are controlled by or under common control with an audit client, and all entities in an investment company complex (ICC) with an audit client . An ICC can include numerous entities, such as registered investment companies or pooled investment vehicles the audit client manages, investment advisors that control, are controlled by, or under common control with the client and private fund companies.
As the independence challenges of applying the current rule in the investment company industry are particularly acute, the SEC also proposed that when applying the rule to a fund under audit, the term audit client would exclude any other fund that otherwise would be considered an affiliate of the audit client under Rule 2-01.
If adopted, the proposed changes would significantly shrink the pool of shareholders whose loans with an audit firm and its covered persons create independence issues under the current rule.
The SEC believes that in the current environment, the loan provision is not operating as intended by in most cases identifying lending relationships that do not appear to impact the auditor’s objectivity and impartiality. Highlights from the SEC’s rationale for the amendments follow:
Use of a bright-line test
Currently, the loan provision uses a 10 percent “bright-line test” as a proxy for identifying entities that have a “special and influential role” with the audit client, but the release acknowledges shortcomings and practical challenges in applying that bright-line test. Thus, the proposal advocates use of a broader and more qualitative assessment of whether the lender has significant influence over the audit client. Rule 2-01 already uses the term significant influence in other contexts, which is intended to sync with the Financial Accounting Standards Board (FASB) use of the term in ASC 323, Investments – Equity Method and Joint Ventures, and is generally familiar to auditors.
Owner of record and affiliates of the audit client
After extensive consultations with auditors, funds and operating companies, the SEC concluded that significant compliance challenges exist in applying the loan provision to shareholders who are solely owners of record, including that:
Exception to the affiliate rule
When an auditor applies the loan provision to an affiliate of the audit client, the impact can be extremely far-reaching, especially in the mutual fund industry where multiple auditors may be engaged to audit various entities within a single ICC . For example, a firm may audit one mutual fund that is affiliated with hundreds of funds in the same ICC . The result? The auditor of that one fund audit client must maintain independence with respect to every other fund (and other entities) in that ICC. The proposed exemption to the affiliate rule for fund audit clients would alleviate this issue.
Firm lending relationships
Auditors use loans for various purposes, including to fund current operations and investments in audit methodologies and technology. Since their loans are often syndicated, auditors tend to have many lenders, increasing the likelihood of impaired independence when lenders are record owners of more than 10 percent of an audit client (or affiliate’s) securities. It is costly for companies and auditors to monitor compliance with the current loan rule and those costs invariably are passed along to shareholders without a discernible corresponding benefit to shareholders.
The SEC will accept comments on its amended loan rule and other elements of Rule 2-01 until July 9, 2018. The proposal provides an excellent opportunity for stakeholders to comment not only on the proposed revision to the loan rule, but on other aspects of the SEC’s independence rules that may be improved upon by more accurately defining the types of relationships or interests that would impair an auditor’s independence in fact or appearance.
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