Audit Conduct

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SEC Proposing Numerous Changes to Independence Rules

On December 30, 2019, the US Securities and Exchange Commission (SEC) issued Release No. 33-10738; 34-87864; FR-86; IA-5422; IC-33737; File No. S7-26-19, Amendments to Rule 2-01, Qualifications of Accountants (the Release). As stated in the Release, the primary reason for, and objective of, the proposed amendments is to update certain provisions within the Commission’s auditor independence rules to more effectively focus the analysis on those relationships or services that are more likely to pose threats to an auditor’s objectivity and impartiality.

In summary, the proposed amendments would:

1. Amend the definition of "affiliate of the audit client" (affiliate) as follows:

  • For an operating entity under common control with the audit client (sister entity), add a materiality qualifier (i.e., sister entity is an affiliate only if it’s material to the controlling entity).
  • For an "investment company complex" (ICC) where entities (e.g., a fund or portfolio company) are under common control with the audit client, add a materiality qualifier (similar to operating entities).
  • For an ICC, focus the definition on the entity’s relationship with the entity under audit.
  • Clarify how the proposed definition would apply to the audit of a portfolio company versus an investment company or investment adviser or sponsor.

2. Shorten the "look-back period" for auditors of domestic first-time filers by requiring firms to be independent under SEC rules for the most recently completed fiscal year included in the first filing if the firm complied with the applicable independence standards, e.g. AICPA, for all prior periods included in the filing. (This is the current requirement for auditors of foreign private issuers that are first time filers, however, auditors of domestic filers are subject to SEC independence rules for all periods in the initial filing.)

3. Amend the loan provision as follows:

  • Include student loans related to a covered person’s educational expenses obtained before the individual became a covered person (similar to the exception provided for mortgage loans) as an additional exemption to the loan rules.  
  • Clarify the exemption provided for certain mortgage loans.
  • Broaden the exemption for credit card borrowings to include consumer loans such as retail installment loans, cell phone installment plans and similar finance arrangements.

4. Amend the business relationships rule as follows:

  • Replace the reference to “substantial stockholders” with the concept of beneficial owners with significant influence (similar to 2019 changes to the loan provision).
  • Clarify that the independence analysis should focus on whether the beneficial owner has significant influence over the entity under audit.  

5. Adopt a transition framework that addresses inadvertent violation of the independence rules resulting from a corporate event (e.g., merger or acquisition) to allow the auditor and its client to terminate prohibited services and relationships in an orderly manner. The  framework would require auditors to: 

Comply with the applicable independence standards related to the services or relationships throughout the period in which the applicable independence standards apply;

Correct the independence violations arising from the merger or acquisition as promptly as possible (generally expected before the closing date of the transaction, but if this cannot be done in an orderly manner without significantly disrupting the client, as promptly as possible, no later than six months after the effective date of the transaction);

Have in place a quality control system as described in Rule 2-01(d)(3) procedures and controls that:

  • monitor the audit client’s merger and acquisition activity to provide timely notice of a merger or acquisition; and
  • allow for prompt identification of potential violations after initial notification of a potential merger or acquisition that may trigger independence violations, but before the transaction has occurred

6. Make certain other updates to conform other rules to these proposed revisions.

The SEC based the proposed changes on years of experience consulting with firms applying the independence rules and feedback the SEC requested and received when they amended the loan provision in 2018-19.

The Release was published in the Federal Register on January 15 and will be open for comment until March 16, 2020 (60 days).