Independence and Objectivity Retired Partners on Audit Committees

By Dan M. Guy and Stephen A. Zeff

In Brief

The Independence Imperative

Corporate audit committees, their membership, and their responsibilities have received increased attention since the collapse of Enron. Of paramount importance in the composition of an audit committee of a public company is the assurance that its members are competent to provide adequate oversight of the audit function and are independent of the company and its auditor. Although retired audit firm partners possess many attributes that would make them excellent audit committee members, it may be extremely difficult for them to fulfill public expectations of independence and objectivity.

Retired audit firm partners represent an attractive pool of potential members for public company boards of directors and their audit committees. Because of the stock exchanges’ new listing requirements, corporate boards are actively seeking retired partners as members. Before considering or making such appointments, however, the audit firm and the company must resolve a number of independence issues.

Exchange Requirements

In December 1999, The New York Stock Exchange (NYSE), National Association of Securities Dealers (NASD), and the American Stock Exchange (AMEX) adopted new listing requirements that all members of a company’s audit committee must be (or on their way to becoming) financially literate, unless the company qualified as a small-business filer. In addition, at least one member of the committee must possess accounting or financial expertise. Although the meaning of financial literacy is vague and varies among the exchanges, the intent is for all audit committee members to have a general understanding of financial statements, including GAAP and a general knowledge of auditing. Because retired partners of audit firms fulfill the financial literacy requirements and bring many other valuable attributes to boards, they are prime candidates for corporate boards and their audit committees.

An historical note. The authors’ research indicates that it was only in 1974 that Household Finance Corporation became the first U.S. public company to appoint a retired partner of an audit firm to its board. The appointment was very carefully and sensitively handled; the company asked Haskins & Sells, its external audit firm, if it would object to the new board member, Thomas D. Flynn, who was then retiring as a senior partner of Arthur Young & Company. Haskins & Sells interposed no objection, and the appointment went ahead. A more interesting question arises, however, when the newly appointed board member is a retired partner of the company’s current external audit firm.

Conflict of interests. The financial collapse of HIH Insurance Limited was widely reported in the Australian press in 2001. Among the many issues raised by the incident was that two nonexecutive (i.e., outside) board members were retired senior partners of HIH’s external audit firm. It also became known that both of these retired partners were members of the board’s audit committee, and that one chaired it. The Australian government appointed a Royal Commission to investigate and report, and among the issues that the Prime Minister directed the commission to consider was whether the decisions or actions of HIH and its personnel “involved undesirable corporate governance practices.”

The appointment of retired partners of a company’s external audit firm to its board of directors brings up a number of questions about the independence and objectivity of the audit firm. When a retired partner of the company’s external audit firm also sits on, or even chairs, the board’s audit committee, serious questions about the committee’s independence and objectivity may arise.

Appointing retired partners of a company’s external audit firm to the company’s board, and even to its audit committee, is not precluded by any rules and regulations in such countries as the United States, Canada, the United Kingdom, Australia, and New Zealand. In the United States, the practice would be allowed as long as there is no financial dependence, influence, or the appearance of continued association by the retired partners with their former audit firm. The practice of appointing retired partners of an audit firm to a client’s board of directors occurs in all five of the above countries, but the extent to which it occurs is not readily known.

SEC Requirements

If a retired partner of an audit firm becomes a member of the board of directors of one of the firm’s audit clients, he or she is thrust into an accounting or financial reporting oversight role, which triggers the application of the SEC’s rule 2-01(c)(2)(iii), “Employment at Audit Client of Former Employee of Accounting Firm.”
This rule covers all retired partners from the audit firm without regard to their line of service (audit, tax, or consulting). To maintain its independence, the audit firm must—

In addition, the SEC and the AICPA require the audit firm to adopt and administer safeguards in order to reduce the risk of impairing independence. The required safeguards specify actions that are necessary before and after the partner’s retirement. If the retired partner was associated with the audit engagement before retirement, the audit firm is required to have policies that obligate the partner to—

In addition, the audit firm must review the partner’s work to assess whether the retiring partner exercised appropriate professional skepticism on the audit engagement.

Without regard to whether the retired partner was associated with the audit engagement, the audit firm also must implement the following post-retirement safeguards:

Appearance of Independence

An interpretation of the AICPA’s Code of Professional Conduct goes further than the SEC’s rule and safeguards discussed above, by prohibiting certain practices that would cause a reasonable investor to conclude that the audit firm’s independence was impaired. A retired partner (without regard to line of service) who joins the board of directors of an audit client will impair the audit firm’s independence if the firm—

The prohibitions listed above are illustrative and do not represent all practices that would impair independence. The essence of the requirement is that the retired partner should not appear to participate in the activities of, or be associated with, the audit firm.

Board Members’ Independence

Under the NYSE, NASD, AMEX, and SEC requirements, the external auditor is required, at least annually, to disclose in writing to the company’s audit committee all relationships between the auditor and the company that may reasonably bear on independence. In addition, the SEC requires the audit committee to state in its annual report to shareholders whether the committee received the external auditor’s disclosures about independence and whether the committee discussed independence issues with the external auditor.

When a retired partner joins a client’s board of directors, the external auditor will have to disclose and discuss the issue with the audit committee. During this discussion, the audit committee should address the preretirement and the postretirement safeguards with the external auditor and inquire about any relationship between the retired partner and the company that would cause an impairment of independence, including the appearance of independence. It would be good practice for the audit committee to require management or the board to advise it of any plans that the company has to appoint any retiring partner to the board of directors. In this communication, the audit committee should also discuss the actions that the company plans to take to ensure the audit firm’s independence.

Audit Committee Independence

If a retired partner becomes a member of the audit committee of a client of the partner’s former audit firm, the effects on audit committee independence should be considered. If the audit firm and the retired partner follow all SEC and AICPA requirements, the audit firm may be independent, but the retired partner may not be suitable for service on the audit committee. The audit committee, among other things, is responsible for overseeing all aspects of the independence of the external auditor, including the performance of nonaudit services by the external auditor. In turn, the board of directors is the guardian of the audit committee’s independence. Independence is the hallmark of the audit committee, without which it cannot oversee the quality of the audit, evaluate the performance of the external auditor, and, if needed, replace the external auditor.

The independence requirements adopted by the NYSE, NASD, and AMEX in 1999 identify directors that should not ordinarily be appointed to an audit committee because of independence impairments. These requirements generally address independence from the company’s perspective, prohibiting current employees, certain former employees, immediate family members of current and former employees, consultants, and others having business relationships with the company from audit committee membership because they are not independent.

When they established their new independence requirements for audit committee members, the stock exchanges explicitly addressed the case of an existing partner in an audit firm who has a business relationship with the company. The requirements did not deal with retired partners from audit firms. Nor did the Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, which laid the foundation for the stock exchange requirements, discuss the possible appointment of retired audit firm partners to an audit committee. In fact, the authors are unaware of any published writings that address the appointment of retired audit firm partners to an audit committee. Although a retired audit firm partner who joins the audit committee of a current client of the firm would not usually run afoul of the explicit NYSE, NASD, or AMEX independence rules, the analysis and discussion should go beyond those requirements.

Mental objectivity, and furthermore the appearance of objectivity, is the essence of an audit committee member’s independence. Before appointing a director to its audit committee, the board of directors should consider whether a reasonable investor, having knowledge of all of the relationships that the director has had with the company, would consider the individual objective and independent. In today’s environment, where financial analysts and the press are inclined to be severe judges, a board should be exceedingly reluctant to appoint a retired partner of its external audit firm to its audit committee.

In order to justify appointment to the audit committee, a retired partner of the company’s audit firm must assure the board that he or she convincingly possesses the attributes of independence and would be seen by a reasonable investor as independent. In cases where the board desires to appoint such a retired partner to the audit committee, a cooling-off period may be beneficial. According to current requirements for service on a company’s audit committee, a former employee of the company or an affiliate is not independent until separated from the company for at least three years. This could be a useful rule of thumb. In the authors’ view, an even longer cooling-off period might be warranted, assuming that, after the cooling-off period, the retired partner would possess the requisite mental objectivity to oversee the external audit firm’s performance as well as the strength of character to replace that firm if necessary.

The authors believe that analysts, stakeholders, the press, juries and jurists, and the public would not be persuaded that a retired partner of an audit firm could perform effectively as a member of the audit committee of a client of the partner’s former firm. An analogous circumstance occurs when jurists recuse themselves from a case that relates to parties with whom they were associated before ascending to the bench. Because the audit committee performs a quasi-judicial function, the same standards should apply with equal force to retired partners of audit firms being appointed to the audit committee of the firm’s client. There is an ample pool of retired partners from other audit firms to consider without having to entertain an appointment to an audit committee that may taint the committee’s independence.

©2002 CPA Journal. Legal Notices