* As printed in Audit Conduct News (Summer 2021). A fully formatted PDF appears below.
Subject to a one-year deferred effective date last year, in December 2018, the AICPA’s Professional Ethics Executive Committee (PEEC) issued a revised interpretation under the Independence Rule (ET sec. 1.200.001) of the AICPA Code of Professional Conduct (the “Code”) on Leases (ET section 1.260.040). The PEEC also revised Client Affiliates (ET section 1.224.010). Prior to these revisions, the Code referenced terms found in the then-existing Financial Accounting Standard Board (FASB) lease accounting standard, generally permitting, or prohibiting a covered member’s lease with an attest client based in part on whether the lease was classified as an operating or capital lease. The FASB’s overhaul of its lease accounting standard and removal of those classifications from the standard prompted PEEC to revise the independence rule for leases with attest clients, which became effective for fiscal years beginning after December 15, 2020.
This article highlights the changes to the interpretation and provides an illustration of its application.
Leases with Attest Clients
A lease arrangement between a covered member and an attest client can raise self-interest, familiarity, and undue influence threats to independence. The rule addresses three possible scenarios involving an attest client; either you (i) are executing a new lease, (ii) are renegotiating the terms of an existing lease, or (iii) have an existing lease.
These scenarios are described below:
Scenarios #1 and 2: New or Renegotiated Lease with Attest Client
The act of establishing a new lease or renegotiating an existing lease with an attest client during the period of professional engagement raises the likelihood that self-interest and/or intimidation threats to independence will exist. Therefore, the strictest provisions in the interpretation apply when the firm or certain covered members in the firm (identified in 1 – 3 below) enter into a new lease agreement or renegotiate the terms of an existing lease agreement with an attest client.
1. CPA firm (including the firm’s affiliated entities),
2. Persons on the client’s attest engagement team, and
3. Persons who can influence the client’s attest engagement (including, for example, those providing technical consultations or engagement quality reviews of the firm’s attest engagements).
The revised rule prohibits the above persons and entities from entering into a new lease or renegotiating the terms of an existing lease with an attest client during the period of professional engagement unless two (2) safeguards are met when these actions are undertaken. First, the lease is established on market terms and at arm’s length; and second, the lease is not material to any parties to the lease. Multiple leases with the attest client should be evaluated collectively.
If the lease is permissible, the lease terms should be kept current, with timely payments made in accordance with the lease terms.
Scenario #3: Existing Lease with Attest Client
An existing lease with an attest client is one that was executed or renegotiated with an attest client before: (i) the period of professional engagement, (ii) the covered member became subject to the rule, (iii) the attest client became a counterparty to the lease, or (iv) a permissible lease became impermissible during the period of the professional engagement because the lease became material to a party to the lease.
As before, this part of the interpretation applies to certain covered members, i.e., the firm, attest team members, and those able to influence the attest engagement. Several factors, discussed further below, come into play when one of these covered members has an existing lease, which may or may not give rise to a significant threat to independence. Thus, a covered member who has an existing lease with an attest client should evaluate threats to independence to determine whether they are significant. If threats are significant, the covered member should apply safeguards to reduce threats to an “acceptable level” and maintain its independence if the firm wishes to continue providing attest services to the client.
What does “acceptable level” mean when evaluating threats to independence?
An acceptable level means that in your professional judgment, a reasonable and informed third party who is aware of the relevant information would be expected to conclude that your independence is not impaired.
Here is an illustration:
You and your spouse lease a townhouse from CL Properties; when you signed the agreement, CL was not a client of your firm. A year later, CL engages your firm to perform its audit. You work for a small firm. Does your existing lease with CL create an independence issue? Can you participate in this audit?
The answer is: it depends.
First, you should evaluate the threats to independence and determine whether they are significant (which means threats are not at an acceptable level). Questions to consider are:
• What would your role on the engagement team be?
• What is your role in the firm?
• To what extent would your lease agreement be subject to attest procedures or financial statement disclosures?
• Is the lease material to you and your spouse, or to your client?
• What is the duration of the lease?
• Was the lease established on market terms in an arm’s length transaction?
Assume your lease was established on normal terms in an arm’s length transaction. The lease has a one-year term and you and your spouse are current on the lease payments. You are one of four audit managers in the firm, which is comprised of a single office. The lease is material to you and your spouse’s net worth; it is your primary residence. Given these facts, your firm concludes that threats to independence are significant and should not assign you to this engagement. If the lease were not material to you and your spouse, your firm might be willing to assign you to the engagement, but they may still have reservations depending on the other facts and circumstances. Assume instead that you are a quality control partner responsible for the firm’s internal inspection program and technical consultations. Though you will provide no services to CL, you are in a position to influence the attest engagement. Therefore, a similar evaluation of the threats to independence, based in part on the previously noted questions, is required.
Application to Client Affiliates
PEEC also amended the Client Affiliates interpretation (ET section 1.224.010.02(e)). The revised interpretation allows the firm, attest team members, and those able to influence the attest engagement to have a lease with certain affiliates of a financial statement attest client that do not meet the requirements of the leases interpretation. To apply this exception, the covered member must evaluate threats to independence using the Conceptual Framework for Independence and apply safeguards as needed to reduce threats to an acceptable level. Examples of affiliates this interpretation may be applied to include certain parent and sister entities of a financial statement attest client (e.g., audit client).
The revised Leases and Client Affiliates interpretations went into effect for fiscal years beginning after December 15, 2020.
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