Objectivity and Impartiality Replaces the Strict Application of Independence Rules
In June 2021, the Securities and Exchange Commission (SEC) made amendments effective for certain rules regarding auditor independence requirements (known as Rule 2-01 of Regulation S-X). The intention behind these amendments is to modernize the SEC’s rules governing auditor independence and more effectively focus the analysis of independence on relationships or services that may threaten an auditor’s objectivity and impartiality as well as reduce the effect that the independence rules can have on a company’s ability to select an auditor.
In recognition of the critical importance of auditor independence to the reliability and credibility of our financial reporting system, the SEC’s auditor independence rules require auditors to be independent of their clients both “in fact and appearance.”
Overview of Rule Changes
The changes are intended to more effectively and efficiently identify transactions and relationships that could impair an auditor’s independence. The SEC believes the changes will reduce compliance costs for both audit clients and their auditors by updating unduly burdensome requirements for relationships and services that are less likely to threaten auditor objectivity and impartiality. They will also diminish the effects of technical violations of the Independence rules that have no bearing on objectivity and impartiality in meeting audit obligations. The technical complications addressed in the Rule are a symptom of a long-standing problem within the auditing firms – a lack of discipline and accountability surrounding independence conflicts.
The purpose of the changes to the rule is to “maintain the relevance” of the SEC’s auditor independence requirements, to “evaluate their effectiveness in light of current market conditions and industry practices,” and to “more effectively focus the independence analysis on those relationships or services that the Commission believes are most likely to threaten an auditor’s objectivity and impartiality.”
The implication is that the independence rules are outdated or focused on non-essential matters, and this is true in limited cases. However, entirely ignored in the proposal is extensive evidence that audit firms’ compliance with existing independence standards is inadequate, that lack of compliance undermines auditors’ ability or willingness to approach the audit with professional skepticism, and that more fundamental reform is needed to strengthen the rules and increase accountability for independence violations.
The General Standard
Although several substantive amendments were made to the auditor independence requirements, what is known as the “general standard” (i.e., Rule 2-01(b)) did not change because of these amendments. The introductory text to Rule 2-01 indicates, in evaluating the general standard, the SEC will consider whether a relationship or service:
- Creates a mutual or conflicting interest with the audit client;
- Places the auditor in the position of auditing their own work;
- Results in the auditor acting as management or an employee of the audit client; or,
- Places the auditor in a position of being an advocate for the audit client.
When applying these amended standards, companies must still keep in mind the general standard, which further indicates that “an accountant is not considered to be independent with respect to an audit client, if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not capable of exercising objective and impartial judgment on all issues encompassed within the accountant’s engagement.” Therefore, even in circumstances when a service or relationship is not explicitly prohibited by the independence rules under Rule 2-01, the general standard requires auditors, audit committee members and management to evaluate a service or relationship from the perspective of a reasonable investor and determine whether there is a real or perceived impact on the auditor’s objectivity and impartiality.
The capital markets depend on the steady flow of timely, comprehensive, and accurate information. Auditors have a central role to play in ensuring the accuracy of this information as part of their gatekeeper role. Like the SEC rules on which they are based, the modernized Independence rule would weaken auditor independence standards, further undermining investors’ faith in the reliability of financial disclosures and putting the integrity of our capital markets at risk.
As with listed companies, auditors have an obligation to ensure the investing public can rely on their work. Control systems over the qualification of auditors is key to that trust. With independence issues being resolved in secret, and technical transgressions being viewed as minor, the approach lacks the discipline and transparency necessary to engender investor trust.
As the SEC itself once emphasized, our markets depend on “the steady flow of timely, comprehensive, and accurate information,” which results in “a far more active, efficient, and transparent capital market that facilitates the capital formation so important to our nation’s economy.” Auditors have a central, and lucrative, role to play in ensuring the accuracy of the financial information that companies are required to report. But, with auditors paid and supervised by the companies they audit, investors can only trust in the reliability of those financial statements if the auditor maintains its independence, to the extent possible within this conflicted business model, and approaches the audit with an appropriate degree of professional skepticism. Oftentimes, auditors have failed to live up to this standard, and investors have paid the price.
Providing Non-Audit Services and Independence
Historically, and increasingly most recently, each of the Big Four firms have been found to have provided non-audit services to audit clients that violate the Independence standard set by the SEC and Public Accounting Oversight Board (PCAOB). Therefore, it would seem the answer is to strengthen the Independence requirement, not weaken it by relying mostly on objectivity and impartiality. For example, a firm might provide advice to an audit client on a merger and acquisition arrangement, which is prohibited under SOX, but make no decisions for management thereby being permitted under the modernized rules so long as the auditors could still be objective and impartial in carrying out their audit responsibilities AND the general standard is not violated.
The Sarbanes-Oxley Act (SOX) created an important requirement for management to ensure that an assessment of the company’s internal controls over financial reporting (ICFR) is made, with management rendering an opinion as to whether they are operating as intended and designed to ensure the financial statements do not contain any material misstatements or fraud.
Audit Quality Controls
There are no requirements for auditors and audit firms to assess their own audit quality controls and make an analysis like management must do under SOX regarding its ICFR. The SEC and PCAOB should require auditors and audit firms to assess their own quality controls because they are the first line of defense to ensure that those systems are operating as intended, designed to ensure audit independence, and establish mechanisms to control for relationships and services that might pose threats to an auditor's objectivity and impartiality."
A review of recent PCAOB inspection reports shows, for example, that staff members routinely find deficiencies related to auditor independence and professional skepticism, two cornerstones of an effective audit. In many cases, it was the absence of effective audit controls that enabled such violations to occur. As the Board indicated in its December 2018 Staff Inspection Brief, “These recurring deficiencies suggest that some firms and their personnel either do not sufficiently understand applicable independence requirements or do not have appropriate controls in place to prevent violations.” Currently, deficiencies in audit quality controls identified in PCAOB inspection reports are not identified in the PCAOB report so long as the deficiencies are corrected within one year.
Violations found at both the largest firms and at smaller firms have included:
- A failure to have adequate systems in place to provide investors with confidence that the audit firm was in fact complying with the independence rules. and
- The existence of evidence that auditors were misleading audit committees by failing to provide them with the information they need to make informed decisions.
The importance of having a strong system of audit quality controls was made clear on April 5, 2022, when the PCAOB disciplined Scott Marcello, KPMG’s former Vice Chair of Audit, for supervisory failures in connection with KPMG’s receipt and use of confidential PCAOB inspection information. I have blogged about this before.
Using a Materiality Standard to Judge Independence
One area of concern addressed in the new Independence rule is that problems can arise when otherwise permissible non-audit services are provided to a non-audit client that becomes an affiliate of an audit client. The independence rules then apply to both clients as if they were one entity. Some firms are now using a materiality criterion to determine whether these non-audit services provided to an affiliate entity, which would be prohibited if the parent had provided them, violate the independence requirement in audit engagements. Applying such a materiality standard can have the effect of dismissing otherwise improper relationships.
Using a materiality criterion to determine whether certain non-audit services should be allowed presents some difficult questions: 1) Is independence a standard best left to the individual judgment of the auditors, or is it based on SEC regulations and PCAOB standards? 2) Where do you draw the line in making materiality determinations? 3) By applying a materiality criterion to affiliate relationships, is the SEC opening the floodgates and creating an ethical slippery slope where other areas of the audit might be judged by a materiality criterion? For example, should a firm be allowed to accept contingent fees in non-audit engagements for audit clients? The current ethics rules say ‘no,’ because it might violate the General Standard. However, if the non-audit services were not material, would it then be acceptable to accept such forms of payment?
In a published paper I address the controversy in the United Kingdom (U.K.) about how best to restrict non-audit services for audit clients. The U.K. Competition and Markets Authority (CMA), a government department, issued a report on April 18, 2019, that recommended an operational split of audit and non-audit services. The large firms would be split into separate operating entities with respect to auditing and consultancy functions to reduce the influence of consulting practices upon auditing divisions. The split would help prevent potential conflicts of interest from impairing audit independence and increasing the public trust in the quality of financial statements. However, the CMA stopped short of recommending a full breakup based on firm services (Competition and Markets Authority, “Statutory audit services market study,” Final Report, April 18, 2019. Some in the U.K. accounting profession have warned that the split of non-audit and audit services into separate entities would challenge firms’ ability to adjust to changes in market conditions, perhaps because audit fees account for only 20% of the firms’ overall fee income, making it less likely that audit firm could operate profitably as a stand-alone entity.
The CMA has said that the proposed separation would have auditors “focus exclusively on audit to secure higher quality, and not also on selling consulting services.” They suggest that the separation would achieve this by:
- Creating a strong culture in the audit firm and eliminating tensions with the very different culture of advisory services
- Enhancing transparency
- Making audit truly independent by ending the subsidies from the rest of the firm
- “Demonstrating a culture of quality, independence, and objectivity” and eliminating “undue influence from the wider (nonaudit) business” (Callum MacRae, “FRC Calls for the Break-up of Audit and Non-Audit Services of the Big 4,”
On February 27, 2020, the Financial Reporting Council (FRC) sent a letter to the seven biggest U.K. audit firms—the Big Four as well as BDO, Grant Thornton, and Mazars—asking them to separate their audit practices and put in place independent boards to make changes to how they run their audit business to reduce conflicts of interest. The regulator is asking companies to take steps to separate their audit businesses in advance of expected legislation that could mandate these separations. The result of such a separation would be that audit units at these seven companies would have to be financially independent from other business units, thereby ending profit sharing between audit and other entities and establishing separate boards to strengthen governance (Nina Trentmann, “U.K. Regulator Asks Accounting Firms to Wall-Off Audit Practice, Install Separate Board.” The firms are expected to complete the transition by mid-2024.
- The SEC and PCAOB should require auditors and audit firms to assess their own quality controls and report on them to ensure that those systems are operating as intended, designed to ensure audit independence, and establish mechanisms to control for relationships and services that might pose threats to an auditor's objectivity and impartiality.
- The PCAOB should no longer allow audit firms to have one year to fix problems with their audit quality controls before these deficiencies are made public. Investors have a right to know about the deficiencies and make their own judgment on the quality of audit work in a timely manner.
- The SEC should provide guidance to auditors (and the public) about how the materiality standard should be applied through a “Question and Answer” document.
- The U.K. experience should be looked at by the SEC to assess whether a separation of audit and non-audit services operationally could work in the U.S.
It is troubling that the SEC may have given up in its efforts to make independence the cornerstone of audit engagements; instead, it may be over-relying on objectivity and impartiality under the guise of a materiality exception.
Blog posted by Dr. Steven Mintz, The Ethics Sage, on April 5, 2022. Steve is the author of an accounting ethics textbook, Ethical and Professional Obligations and Decision Making in Accounting: Text and Cases, 6th edition. You can sign up for his newsletter and learn more about his activities at: https://www.stevenmintzethics.com/. Follow him on Facebook at: https://www.facebook.com/StevenMintzEthics and on Twitter at: https://twitter.com/ethicssage.