An audit partner who regularly takes a client to ball games and vacations together probably isn’t independent, though treating that client to one dinner per year probably won’t run afoul of Securities and Exchange Commission guidelines.
The SEC clarified its guidance on auditor independence rules this summer, reflecting current practices and regulatory changes since the last round of revisions in 2011. In addition, the guidance covers prohibited services such as accounting and financial statement preparation and auditor tenure for emerging growth companies.
The regulators “make it clear the nature and frequency of the gifts and entertainment will be considered when determining whether independence is impaired,” said Margaret Gembala Nelson, auditor liability counsel with Foley & Lardner LLP.
To hammer home the point, the SEC cited two of its own enforcement actions.
The 2016 cases involved close personal relationships between Ernst and Young LLP audit partners and audit clients.
One partner lavished trips, dinners, and tickets on the client and then billed the client for those expenses. The firm missed several red flags that would have alerted it to the budding personal relationship between auditor and client, according to the SEC’s settlement.
The second case involved a romantic relationship between a partner and the chief accounting officer of a client. Another partner working on the same audit knew of the relationship but didn’t alert the firm’s independence office, according to the SEC.
“If you read those cases, they are not gray. They are very extreme,” Nelson said.
An expensive ski trip might threaten independence, but a cocktail or dinner at a conference likely wouldn’t. Still, that leaves a gulf of uncertainty between those two extremes, said Mike Hermsen, a partner at Mayer Brown LLP who focuses on compliance and regulatory reporting.
Instead of painting a bright line, the updates serve as a reminder that accountants should tread carefully when it comes to giving and entertaining, Hermsen said.
Don’t plan on the SEC clearing up gray areas. The regulator expects accountants to apply professional judgment, based on their specific circumstances, to determine whether they are complying with the rules, said Cathy Allen, who advises accounting firms nationwide on auditor independence and ethics issues.
The SEC also provided updates to help auditors apply rules that bar them from offering their clients services like accounting and financial statement preparation.
For example, pitching non-audit services before an audit wraps up would violate the rules. The guidance also cautions corporate management and audit committees to be leery of such proposals.
“Proposing on prohibited non-audit services while the firm is still the auditor heightens the threat, both in fact and in appearance, of audit team members acquiescing to management in order to increase the firm’s chance of winning the prohibited non-audit services engagement,” the guidance states.
The SEC also clarified a narrow exception to the independence rules for private equity groups, which hold various funds that must be audited.
Firms may audit a fund and provide what would be an otherwise prohibited accounting or bookkeeping service to a portfolio company held within another fund at the same group without impairing independence, Nelson said.
Private equity funds have complex structures, she said. “There is an inter-relatedness that sometimes the independence rules, back when they were written, didn’t necessarily contemplate.”
Emerging Growth Companies
The rise of emerging growth companies has also spurred questions from accounting firms about when to begin counting a lead engagement partner’s tenure on an audit, said Hermsen.
Lead auditors are allowed to work on a client’s audit for five years before they must rotate to another assignment. However, emerging growth companies are exempt from certain SEC filing and financial reporting requirements.
“They made it clear that you worked on an audit that year for this client, and so therefore, that year counts even though it’s not part of the public file,” Hermsen said of the new guidance.
The Public Company Accounting Oversight Board now collects audit partner information and makes it available in a public, searchable database on its website. That new data makes it easier for regulators and investors to track audit partner rotation.
But it’s too soon to know how the PCAOB or the SEC might use that information, Hermsen said.