September 2002

Defending the AICPA’s Independence Rules and Process

Nicholas J. Mastracchio Jr.’s article “Independence and the Users of Closely Held Companies’ Financial Statements” (June 2002) requires clarification regarding the newly revised AICPA independence rules, their interplay with SEC rules, and the process by which the AICPA’s recent rule revisions were made.

Mastracchio states that the rules do not distinguish between SEC clients and closely held companies. Your readers should recognize that the preface to the interpretations of Rule 101 of the AICPA Code of Professional Conduct, Independence, clearly states that a member providing attest services to clients subject to the SEC’s jurisdiction must observe the SEC’s rules in addition to the AICPA’s. The AICPA’s rules in no way disregard the fact that other regulators’ rules may apply, but rather highlight that possibility.

Mastracchio also points out that the AICPA justified changes to the rules by focusing on large firm issues, and he implies that small firm viewpoints were not considered. Neither conclusion is correct. Justification for the modernized rules resulted from a fully deliberative process involving the Professional Ethics Executive Committee (PEEC) and a special task force that met numerous times over the course of a year. During that process, state accountancy board and CPA society representatives (mostly from smaller firms) provided their input, and the committee specifically sought feedback from its small and medium-sized firm constituents such as the AICPA Private Companies Practice Section’s Technical Issues Committee. The small firm practitioners that were key players in this process included the task force chair, who worked for a mid-sized firm. More than 60% of the committee members are not affiliated with the larger accounting firms, and all—including the public (or non-CPA) members of the committee—firmly believed that independence rule modernization was long overdue. Therefore, small-firm viewpoints were considered quite carefully before the committee approved any changes to the rules.

Mastracchio also states that “the AICPA creates something called a ‘covered member.’” In fact, the AICPA did not create this notion. The covered member definition was patterned after and is essentially the same as the SEC’s “covered person” definition. As in the case of the new SEC definition, the concept applies solely to situations involving financial interests and family relationships; it has no bearing on other independence rules, such as those covering nonaudit (or consulting) services. That is, one cannot apply the rule such that one professional in the firm can provide prohibited services for a client while another professional in that firm performs the audit.

Mastracchio focuses on the AICPA’s liberalization of its rules, but he does not mention that the SEC similarly found cause to liberalize its rules in this area. Nor does he correctly state that in some cases the AICPA’s revisions made its new rules more restrictive than previously. Finally, Mastracchio incorrectly states that a covered member’s spouse and dependents are covered by the rule but not other relatives. In fact, under the new AICPA rules, similar to the SEC rules, other relatives (e.g., parents and siblings) are subject to certain restrictions involving financial interests in and employment with the client.

Mastracchio remarks that, “other areas of concern were in conflict with the AICPA’s new rules. … These included activities by individuals that probably would not be considered covered persons [sic] under the AICPA rule. Users of the closely held financial statements were more likely to have CPA firm offices in closer proximity to each other and inter-office work was more likely to affect firm income.” As previously mentioned, certain AICPA rule revisions actually resulted in more restrictive rules: one, where a professional (any professional employee, covered member or not) serves in a management role for a client (e.g., as a director), and another, where any professional employee (or their immediate family) owns more than 5% of a client’s outstanding equity securities. In other words, where significant relationships were deemed to exist, the committee extended those rules to the entire professional staff.

Your readers should also recognize that the GAO recently adopted new standards that go beyond those of the SEC or the AICPA in restricting the scope of the services that a CPA can provide to the thousands of entities that receive federal funding, the banks that issue federally guaranteed loans, and others doing business with the government. During the GAO’s standard-setting process, the AICPA scheduled meetings with the GAO to attempt to mitigate varying interpretations and any unintended adverse consequences that the standard might have, particularly on smaller entities subject to Yellow Book standards.

Finally, we are interested in learning more about the survey of financial statement users referred to by the author; for example, the organization conducting the survey, methodology, and other details. Given the attention that Congress, the GAO, and others have directed at the profession, such information would aid us in understanding users’ perceptions and in providing responses to those organizations.

James L. Curry
Chair, AICPA Professional Ethics Executive Committee
Lisa A. Snyder
Director, AICPA Professional Ethics Division

The Author Responds:

It is clearly a fact that the AICPA’s proposed new rules do not distinguish between SEC clients and closely held businesses. It is also a fact that the bankers’ survey responses indicate their willingness to allow small firms more liberal business service relationships with clients than the SEC rules, but more conservative financial relationships than envisioned for a covered member of an engagement team. These are the points that I was trying to make. The users of financial statements should be listened to, and for closely held companies these are typically financial institutions. I do not believe users of small business’ financial statements were given the same opportunity as users of publicly traded firms to express their opinions.

As for the other details in the letter, I have the following comments:

That the SEC has rules and the AICPA is aware of them and agrees that they must be followed is not the point. Nothing in the AICPA rules distinguishes between closely held companies and public companies, or those that serve each group’s accounting needs. The SEC, on the other hand, went to great lengths to point out that their rules do not apply to small CPA firms and their privately held clients.

The point of my article was that the users of the audits of closely held companies were not consulted about whether they agree with the new standards. I made no implication about my knowledge of whether the AICPA consulted small firms about the project. Having spoken to Dan Dustin, executive secretary of the New York State Board for Public Accountancy, and David Costello, president of the National Association of State Boards of Accountancy (NASBA), I know that neither of those organizations has taken a position on this issue. I do not know whether other state boards have taken positions, but that is not the point. When were the users consulted, as they were in the SEC hearings on publicly traded companies?

The explanation I hear is that this is a global economy and that an owner thousands of miles away would not compromise a job’s independence. (Possibly true, but how about an owner 15 miles away?) The users of closely held company audits do not seem to agree. In the AICPA’s February 2001 Journal of Accountancy, the article “The Engagement Team Approach to Independence” states: “Independence rules based on a firm-wide approach made sense when firms were smaller and less diversified, but now standard setters and regulators acknowledge that a fresh look at them is warranted because of recent changes in the business environment and in society.” It appears to me that the users of financial statements of small businesses that are not publicly owned are using audits done by smaller, less diversified CPA firms, and they seem to be saying that the old rules still make sense for them.

The fact that the SEC has a category of “covered person” is exactly the point. Perhaps the rules should be liberalized for the large firms. The SEC did not suggest liberalization for local firms, and indeed the survey responses suggest that they should not be liberalized in this manner either. Curry and Snyder’s comments are exactly what I am trying to point out: The AICPA rules are patterned after the SEC’s, which itself did not want its rules to cover all firms. When the SEC was dealing with independence, AICPA PCPS Executive Chairman Harold L. Monk Jr. testified before the SEC: “If the proposed rule is adopted, we would expect the other regulators—state boards of accountancy, U.S. Department of Labor, federal and state regulators, for example—will follow your lead. Hence, we must assume your rule becomes our rule. And that causes us great concern.” In summarizing his testimony, Monk also said: “But what I think concerns me, especially after the hearings and some of the comments that have come forward as a result of this process, was the comment from the NASBA representatives that said that after this process is finished that they would anticipate seeing similar rules adopted. Now, NASBA clearly has direct access to all of the state boards and if the state boards adopted this same rule, I could see significant harm being done to firms my size, not just from the standpoint of SEC clients, because most of them don’t have many SEC clients, but if the same rules applied to all of their audit clients, they would have to make a choice between types of work that they want to do.”

I do not disagree that some revisions may result in more restrictive rules. I think what the AICPA suggests makes sense for the larger firms but the survey shows there is some doubt whether it should apply to local firms in the same form. Perhaps some definition of office could be constructed that would be helpful.

Last, although it is true that the GAO has adopted new rules that go beyond the AICPA’s, that is not surprising, nor is it relevant to the issue. In fact I wonder if the GAO considered the impact on small agencies that can no longer have CPAs perform services that they did in the past.

I would be happy to discuss the methodology used in the survey. It was supported by the University at Albany and used Thompson’s national database of financial institutions to draw a statistically valid national sample. Mr. Curry and Ms. Snyder are welcome to contact me directly for more details.