SEC Acting Chief Accountant Cautions Against “Checklist Compliance” Approach to Auditor Independence

SEC Acting Chief Accountant Cautions Against “Checklist Compliance” Approach to Auditor Independence

Blog Focus on Audit Committees, Accounting and the Law

SEC Acting Chief Accountant Paul Munter re-emphasized the SEC’s focus on auditor independence in his June 8 statement on “The Critical Importance of the General Standard of Auditor Independence and an Ethical Culture for the Accounting Profession.”  This latest statement follows a pair of statements issued in October 2021 and December 2021, both of which similarly highlighted auditor independence.  This time, however, the statement goes further in describing both the application of the general independence standard and common recurring issues from auditor independence consultations with the Office of the Chief Accountant (“OCA”). (See our prior post)

Similar to prior statements, the June 8 comments stress that high-quality audits are critical to investors and that independent audits are a key element of investor protection and a foundation of investor confidence in company financial statements.  Mr. Munter’s latest statement, however, more directly focuses on the “general standard” of auditor independence set out in Regulation S-X 2-01(b) and states “compliance with the prohibitions enumerated in Rule 2-01(c) is necessary but not sufficient.”  As a reminder, the general standard in Regulation S-X 2-01(b) provides:

The Commission will not recognize an accountant as independent, with respect to an audit client, if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not, capable of exercising objective and impartial judgment on all issues encompassed within the accountant's engagement. In determining whether an accountant is independent, the Commission will consider all relevant circumstances, including all relationships between the accountant and the audit client, and not just those relating to reports filed with the Commission.

In applying this standard, consideration is given to the following four guiding principles set out in the introductory text of Regulation S-X 2-01 as to whether all the relevant circumstances:

  • Create a mutual or conflicting interest between the accountant and the audit client;
  • Place the accountant in the position of auditing its own work;
  • Result in the accountant acting as management or an employee of the audit client; or
  • Place the accountant in a position of being an advocate for the audit client.

Mr. Munter made clear “the general standard of Rule 2-01(b) is the heart of the Commission’s auditor independence rule, it always applies, and the Commission investigates and enforces against violations of the general standard.”  To that end, he reminds audit committees, registrants, and audit firms that auditor independence determinations require more than a “checklist compliance” exercise, including (i) a wholistic evaluation of auditor independence, including an assessment of independence both in fact and appearance from the perspective of a reasonable investor and (ii) an understanding of the applicability of the general standard to all relevant reporting periods. He cautions that “accountants, audit firms, registrants, and their audit committees should never make the mistake of assuming that just because a particular circumstance is not expressly prohibited in, or captured by, Rule 2-01(c), their independence analysis is over.”  Of course, this raises the question as to the subjectivity that may be associated with independence determinations going forward and the degree of reliance that may be placed on the S-X 2-01(c) prohibitions framework in reaching conclusions regarding situations that are not squarely prohibited by the rules.

Perhaps prompting the issuance of this latest statement, Mr. Munter notes that the OCA has recently observed “loosening attitudes toward the Commission’s general standard of auditor independence in a few notable areas,” including:

  1. When the auditor independence rules are treated as a mere checklist of prohibitions under Rule 2-01(c) of Regulation S-X, thereby ignoring the general standard;
  2. When the extent and magnitude of non-audit services and business relationships between the accountant and affiliates and non-affiliates of the company being audited would make it difficult for a reasonable investor to conclude that the accountant could exercise objective and impartial judgment in its audit; and
  3. With the creation of increasingly complex business arrangements and, in some cases, attempts to facilitate these arrangements through restructurings and the use of alternative practice structures by accounting firms.

Turning to OCA’s approach to auditor independence consultations, Mr. Munter emphasizes that the effectiveness of the consultation process requires that any party seeking guidance must communicate all relevant facts and circumstances surrounding their question.  He also explains that, while OCA may refer to prior consultations, it also always considers “(i) how recently such prior consultations occurred, (ii) risks presented to investors, and (iii) the impact of any rulemaking, judicial precedent, or legislation subsequent to any prior consultations.”  Accordingly, OCA “strongly discourage[s] accountants from placing undue reliance on any historical OCA staff positions,” even in instances that may appear similar.

Mr. Munter’s statement primarily concludes with remarks directed to accounting firms, imploring that they “lead by example” and “prioritize auditor independence and a culture of ethical behavior in all professional activities.”  These remarks highlight the essential gatekeeping role served by public accounting firms.  Of course, as alluded to elsewhere in the statement and discussed in prior statements, compliance with auditor independence rules is a shared responsibility among companies, their audit committees, and their auditors.  To that end, audit committees of companies across all spectrums, from pre-IPO companies to established public companies, would be well advised to keep these latest remarks in mind when engaging with auditors on matters of auditor independence.

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