Independence and non-audit services.by Spindel, Fred S.
In rendering an audit report on the financial statements of a client an auditor's independence is generally considered at least of equal importance to the professional competence he or she brings to an engagement. While professional competence is largely acquired through the study of technical literature including the regulatory pronouncements that are applicable to the situation encountered, the information available that may permit an auditor to be unequivocally assured of independence is much more uncertain.
The basic guidelines established by the SEC as to the independence of the auditor reporting on financial statements included in SEC filings are contained in Rule 2-01 of Reg. S-X, Qualifications and Reports of Accountants. The rule in principle proscribes two very important aspects of an auditor's relationship to the client: 1) any direct or material indirect financial interest; and 2) any connection as a promoter, underwriter, voting trustee, director, officer or employee. The rule further points out that the proscription, or more specifically the independence requirements, apply not only to the auditor but also to the auditing firm and its "members" as defined in the rule. The rule does not deal with any other relationships between the auditor and the client that may impair independence.
The accounting profession under the AICPA Code of Professional Ethics has established categories of ethical standards by which the auditor must abide in order to avoid impairment of independence. These categories include rules of conduct, their interpretations as well as ethical rulings. While the ethical standards as established by the AICPA deal with a wide array of issues and subjects including non-audit services, the SEC over the years has considered them inadequate. For many years the SEC concluded that independence is best addressed on a case by case basis and has dealt with such issues as they arose in a specific situation. These cases became part of the SEC's Codified Financial Reporting Policies. In 1982 the SEC announced that it would also henceforth make publicly available its correspondence on the impact of independence which is now published by most professional services. All this information is unquestionably helpful in guiding the auditor when identical situations are encountered; however, the situations an auditor sometimes faces in practice may not be analogous to the subject matter discussed by the SEC. If the auditor's resource in such instance is the AICPA Code of Professional Ethics, it could be a dangerous step since, as indicated, the SEC staff may not limit its view of independence to the standards established by the Code.
The rendering of an audit opinion on the financial statements of a company has always been and will continue to be the principal function of a CPA firm. However, the complexity of the business environment has necessitated that the firms become competent in a wider array of peripheral activities in order to provide a full service to their clients. It is in this area that the determination whether independence may be affected has become more difficult. The determination of whether independence may be affected becomes less evident the less clear the analogy is to the published case, and the more confident the auditor is as to the propriety of the non-audit service rendered. While prior discussions of any situation with the SEC staff have generally been encouraged, as noted above, the need for such an inquiry may not always be evident.
While attempts have been made in the past to align the differences between the AICPA rules and the views on independence as expressed by the SEC staff and establish a uniform set of standards, such attempts have so far been unsuccessful. The alternative, therefore, continues to be an important but sensitive evaluation by the auditor as to whether the case in hand has been previously considered by the staff or whether the situation has some elements of uncertainty that shold be discussed with the chief accountant's office to avoid subsequent challenges. Unfortunately, if the auditor's independence is considered to have been impaired after the audit is completed, a costly new audit by another firm may become necessary.
In the April 1988 issue of this magazine a case was cited in this colum where the SEC staff responded to an accounting firm that had inquired whether its independence would be impaired if the accounting firm assisted their audit client in the preparation of financial projections. Since the submission of forward-looking information had frequently been encouraged by the SEC, the conclusion that assisting clients in the preparation of such data would impair an auditor's independence was of considerable concern to many practitioners. In reaching its conclusion on the cited case, the SEC analogized the work contemplated by the auditor to that of performing bookkeeping services for audit clients, a long-standing proscription. (In a subsequent public forum the SEC staff acknowledged that impairment of independence might be removed if the projection were no longer relied on.)
Early in 1988, an accounting firm's independence was challenged by the SEC in a filing after it was learned that the firm had rendered a "fairness opinion" for the audit client. As a result of this, the SEC staff concluded that the accounting firm's report on the financial statements was unacceptable. This challenge by the SEC unfortunately was costly since apparently it required a reaudit of the company's financial statements by another firm.
The following are excerpts from a letter by the Chief Accountant to that accounting firm, evidently following a meeting with representatives of the firm after the SEC's challenge of the firm's independence. While the views expressed in that letter give a general indication of the staff's position on certain non-audit services based on issues raised at that meeting, they are not necessarily conclusive since, as acknowledged by the chief accountant, "In all independence determinations, the particular facts and circumstances must be carefully considered."
"At our...meeting, you inquired about the possible impact on auditors' independence of a large number of non-audit services. However, as you recall, most of those issues were discussed briefly and in a very general and hypothetical manner and the staff repeatedly emphasized that additional information would be needed in order to reach definite conclusions on those issues. In all independence determinations, the particular facts and circumstances must be carefully considered. That, in part, is the reason that the staff usually will not respond to hypothetical independence questions. However, the following sets forth our general views on the subjects discussed.
"Forecasts, projections, and feasibility studies. The staff's position in regard to forward-looking information is, in general, analogous to the Commissions' proscription on the provision of bookkeeping services to audit clients. Participation in the preparation of prospective information has been strictly interpreted by the staff to include all phases of the project bearing directly on quantification of the data. Generally, the staff has not objected to auditor assistance in identifying relevant matters to be considered in the development of the information. However, the auditor should not be associated with the assumptions made, the gathering of information, or with the processing of the data, whether mechanical or electronic. The auditors' software should not be used in the preparation process.
"Assuming that a transaction or event occurred which resulted in the impairment of the accountant's independence, the period during which the accountant's independence would be considered by the staff to be impaired would range between one year and the period covered by the prospective financial information, depending on the relevant facts and circumstance. Considerations bearing on the impairment period would include: 1) the period during which the feasibility study or prospective financial information would be subject to reliance by investors, creditors, or management; 2) whether investment or lending decisions were made in reliance on the information; and 3) the occurrence of subsequent events that would tend to invalidate the basic assumptions used in preparing the information.
"Since the attestation function is fundamental to the auditor's role, the staff does not object to situations in which an auditor examines and reports on forward-looking information.
"Valuation and appraisal services. The staff believes that auditor involvement in determining, or rendering an opinion on the fairness of, a purchase or sale price of an asset or business, or an exchange ratio in a business combination, would be expected to create the appearance that a mutuality of interest exists between the auditor and its client. This appearance stems from what logically could be viewed as a business relationship outside the normal auditor/client involvement. Therefore, the accountant's independence usually would be presumed to be impaired.
"Mergers and acquisitions services. The staff believes that in some cases the services provided by the public accountant may be of such a nature as to impair the appearance of independence of an auditor. Although limited activities on the part of an auditor by way of general exploratory work and limited fact finding would usually not be expected to impair an auditor's independence, the staff is concerned about the accountant entering into preliminary or other negotiations on behalf of the audit client. The staff believes that the independence of an auditor would be impaired with respect to subsequent audits of a client if the accountant renders advice as to whether, or at what price a transaction should be entered into. The issuance of a formal report would not be determinative in concluding whether an accountant's independence would be deemed to be impaired. Again, the particular facts and circumstances in these situations are key to an independence determination.
"Special services associated with taxes. Although the staff has not had an occasion to address the issue, we understand that auditors of non-public companies sometimes are engaged to assist in the valuation of closely-held corporations for estate tax purposes prior to a public offering. Absent some other use of the valuation, the staff would not ordinarily view this service as impairing the auditor's independence.
"The staff generally has not raised a question regarding auditor performance of depreciation and investment tax credit studies in connection with the acquisition of an asset or business by an audit client. The staff's understanding is that such services simply involve assisting management in determining the appropriate allocation of a management determined purchase price and/or in interpreting income tax law and regulations. However, in all of these situations, the particular facts and circumstances must be considered.
"Electronic data processing--applications programming. The staff has not had an occasion to address this question in an actual situation. In general, however, the staff believes that the auditor's independence may be impaired depending on the degree of the auditor's involvement and the impact of that involvement on the record-keeping process of the client, and other relevant facts and circumstances. It should be noted that the interpretations on bookkeeping services proscribe an auditor from participating in activities used to derive the amounts that become part of the basic accounting records (see, Sec. 602.02.c of the Codification of Financial Reporting Policies). The staff would need to know the facts and circumstances in the particular situation in order to conclude on the question of the auditor's independence.
"Executive Recruitment. In general, the staff believes that the guidance of the SEC Practice Section of the AICPA Division for Firms is appropriate in this regard, and you should refer to those requirements. See, for example, Scope of Services by CPA Firms, Public Oversight Board, American Institute of Certified Public Accountants, New York, New York (1979)."
As can be seen, the letter deals with a variety of non-audit services. It is published in this column since it may be helpful to some practitioners and SEC registrants to understand the SEC staff's general views on these very important subjects. At the same time it must be recognized that the views expressed, as acknowledged in the letter, are not all inclusive and could be modified depending on the particular facts and circumstances encountered.
It is hoped that continuing efforts by the accounting profession and the SEC staff will eventually result in the alignment of the SEC's views on independence and the AICPA Code of Professional Ethics, and some day provide one set of independence standards a CPA practicing before the SEC will need to abide by. This uniform view of independence would minimize the need of the SEC staff to deal with issues on a case by case basis and also avoid situations such as that which gave rise to this letter.
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