April 2019 JD Supra
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Auditors are required to be “Independent” of their Audit Clients was published by JD Supra on 4/23/19.

The Sarbanes-Oxley Act of 2002 (SOX) mandates that audit committees be directly responsible for

the oversight of the engagement of the company’s independent auditor, and the Securities and Exchange Commission (SEC) rules are designed to ensure that auditors are independent of their audit clients. SOX was approved by Congress due to the scandals that rose from intentional manipulation of financial statements with the disclosure of financial misconduct by trusted executives of corporations or governments. Such misconduct involved complex methods for misusing or misdirecting funds, overstating revenues, understating expenses, overstating the value of corporate assets, or underreporting the existence of liabilities.  The scandals led to the misleading and deception of investors and shareholders.

There is a General Standard for Auditor Independence

The general standard of auditor independence is that an auditor’s independence is “impaired” if the auditor is not, or a reasonable investor with knowledge of all the facts and circumstances would conclude that the auditor is not, capable of exercising objective and impartial judgment on all issues encompassed within the audit engagement.

How to determine if an Auditor is Independent?

An audit committee needs to consider all of the relationships between the auditor and the company, the company’s management and its directors; not just those relationships related to reports filed with the SEC. The audit committee should consider whether a relationship with or service provided by an auditor:

  • creates a mutual or conflicting interest with their audit client;
  • places them in the position of auditing their own work;
  • results in their acting as management or an employee of the audit client; or
  • places them in a position of being an advocate for the audit client.

There are “Non-audit Services” that auditors are prohibited from performing with their audit clients:

  • Bookkeeping
  • Financial information systems design and implementation
  • Appraisal or valuation services, fairness opinions, or contribution-in-kind reports
  • Actuarial services
  • Internal audit outsourcing services
  • Management functions or human resources
  • Broker-dealer, investment adviser, or investment banking services
  • Legal services and expert services unrelated to the audit

Sox was established 17 years ago, and Accounting Firms are Still getting intro trouble

On February 13, 2019, the SEC announced that Deloitte Touche Tohmatsu LLC (Deloitte Japan) will pay $2 million to settle charges with “Violating Auditor Independence Rules” because Deloitte Japan issued audit reports for an audit client at a time when employees of Deloitte Japan maintained bank accounts with a client’s subsidiary. Under SEC rules, accountants aren’t considered independent if they maintain bank accounts with an audit client with balances greater than FDIC or similar depositary insurance limits.  According to the SEC’s order, the accounts had balances that exceeded depositary insurance limits in violation of the SEC audit independence rules.

The SEC is clear about “Prohibited Relationships” including “banking” relationships:

The SEC states that certain relationships between audit firms and the companies they audit are not permitted. These include:

  • Employment relationships. A one-year cooling off period is required before a company can hire certain individuals formerly employed by its auditor in a financial reporting oversight role. The audit committee should also consider whether the hiring of personnel that are or were formerly employed by the audit firm might affect the audit firm’s independence.
  • Contingent Fees. Audit committees should not approve engagements that remunerate an independent auditor on a contingent fee or a commission basis. Such remuneration is considered to impair the auditor’s independence.
  • Direct or material indirect business relationships. Audit firms may not have any direct or material indirect business relationships with the company, its officers, directors or significant shareholders. Thus, audit committees should consider whether the company has implemented processes that identify such prohibited relationships.
  • Certain Financial Relationships. Audit committees should be aware that certain financial relationships between the company and the independent auditor are prohibited. These include creditor/ debtor relationships, banking, broker-dealer, futures commission merchant accounts, insurance products and interests in investment companies.

Professional judgement is compromised when there is a Conflict of Interest

Conflicts of interest can arise at any time during a professional engagement.  According to the American Institute of Certified Public Accountants (AICPA), “A conflict of interest may occur if a member performs a professional service for a client or employer and the member or his or her firm has a relationship with another person, entity, product, or service that could, in the member’s professional judgment, be viewed by the client, employer, or other appropriate parties as impairing the member’s objectivity.  If the member believes that the professional service can be performed with objectivity, and the relationship is disclosed to and consent is obtained from such client, employer, or other appropriate parties, the rule shall not operate to prohibit the performance of the professional service”. This definition can be summed up by stating that a conflict of interest exists when the member believes that objectivity is impaired.

The AICPA recommends that CPAS:

  • Identify a conflict of interest.  A CPA ought to be able to identify potential circumstances that could generate a conflict before accepting a client relationship.
  • Evaluate a conflict of interest.  If a conflict is identified, the CPA needs to determine if the level of risk associated with the client relationship is an acceptable level.
  • Disclose a conflict of interest.  The conflict needs to be disclosed to all parties involved even if the risk(s) involved are at an acceptable level.  

To avoid stress related to a conflict of interest, a CPA ought to:

  • check for conflicts before every assignment
  • define what constitutes a conflict
  • if a potential conflict is identified, explain the process that will take place to determine if the engagement is acceptable
  • establish parameters to determine that no conflict exists
  • recognize when the risk level associated with the conflict is high and have an exit strategy to discontinue services in place.

Don’t be a victim of your own making

When engaging the services of a CPA, make sure that major business relationships (personal relationship, clients, lenders and vendors) are disclosed. Identifying potential conflicts of interest ahead of time and remaining objective in evaluating them is essential in the client and service provider relationship.   A CPA must have:

  • Integrity: Honesty is the best policy.  Providing a service and gaining trust is the goal.
  • Objectivity:  Remaining impartial is critical.  
  • Independence:  Professional judgement cannot be compromised and seeking the truth and facts is the main priority