On June 8, 2022, Paul Munter, the SEC’s Acting Chief Accountant, issued a statement (the “statement”) emphasizing the importance of the auditor independence framework under Rule 2-01(b) of Regulation S-X (“Rule 2-01(b)” or the “general standard”). Mr. Munter noted that determinations of auditor independence “cannot be limited to a checklist compliance exercise under Rule 2-01(c) . . . the general standard of Rule 2-01(b) is at the heart of the Commission’s auditor independence rule, it always applies, and the Commission investigates and enforces against violations of the general standard.”
In addition, Mr. Munter’s statement highlights the importance of fostering an ethical culture in the accounting profession, noting its role in protecting investors and instilling investor confidence by facilitating the dissemination of transparent, reliable financial information. Mr. Munter also discusses recurring independence-related issues observed by the staff of the Office of the Chief Accountant (“OCA”) during recent consultations.
Mr. Munter’s statement comes at a time when there has been an increase in the number of investors voting against the ratification of auditors, perhaps signaling increasing investor discomfort regarding the independence of, and resulting quality of work being done by, audit firms, due to their long tenure. The statement reiterates Mr. Munter’s prior remarks concerning the importance of high-quality independent audits and effective audit committee oversight of financial reporting, serving as a reminder to all gatekeepers, including the management and audit committees of audit clients, to carefully evaluate auditor independence on an ongoing basis, including under Rule 2-01(b)’s general standard, and seek OCA consultation where appropriate.
Rule 2-01 of Regulation S-X
Rule 2-01(b) of Regulation S-X sets forth the SEC’s auditor independence standard (i.e., objectivity and impartiality, in both fact and appearance) as measured by the reasonable investor. In addition, the introductory language to Rule 2-01 provides four guiding principles for evaluating auditor independence. Namely, whether a relationship or the provision of a service:
- creates a mutual or conflicting interest between the accountant and the audit client;
- places the accountant in the position of auditing his or her own work;
- results in the accountant acting as management or an employee of the audit client; or
- places the accountant in a position of being an advocate for the audit client.
Unlike Rule 2-01(b), which is a facts and circumstances analysis, Rule 2-01(c) provides a non-exhaustive list of relationships and services that are plainly inconsistent with Rule 2-01(b)’s general standard. Such relationships and services include restrictions on financial, employment and business relationships between an auditor and audit client, as well as restrictions on an auditor providing certain non-audit services to an audit client.
OCA Auditor Independence Consultations
Through its consultation process, the OCA staff assists auditors, audit clients and their management and audit committees in interpreting and complying with the SEC’s auditor independence rules. Such consultation facilitates the proactive evaluation of auditor independence, potentially reducing the need for costly reaudits and a resulting decline in investor confidence.
Based on recent consultations, Mr. Munter notes that the OCA staff has seen situations that reflect “loosening attitudes” towards the SEC’s general standard of auditor independence. Specifically, the potential undermining of auditor independence due to:
- audit firms and audit clients treating auditor independence rules as a mere checklist of prohibitions, as described above;
- the extent and magnitude of the non-audit services and business relationships between audit firms and audit clients; and
- audit firms engaging in increasingly complex business arrangements and, in some cases, attempting to facilitate such arrangements through restructurings and the use of alternative practice structures.
Takeaways for Management and Audit Committees
While accounting firms engage in extensive independence analyses in accordance with SEC and Public Company Accounting Oversight Board (PCAOB) rules and auditors’ professional responsibilities, this responsibility is shared by audit clients, their management, and audit committees, which are charged with overseeing the responsibilities of independent auditors.
Companies and audit committees should take the statement as a reminder that while evaluating auditor independence according to Rule 2-01(c) is necessary, it is not sufficient; independence must also be evaluated based on the general objectivity and impartiality standard described in the four guiding principles articulated in Rule 2-01 and Rule 2-01(b)’s general standard.
Audit committees can take practical steps towards enhancing auditor independence by exercising vigilance in appointing, compensating and overseeing the work (and the scope of work) of independent auditors and, when appropriate, seeking consultation with the OCA.