Securities Regulation Daily SEC adopts amendments to auditor independence requirements
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Friday, October 16, 2020

SEC adopts amendments to auditor independence requirements

By John Filar Atwood

Commission said the amendments are based on years of observations of situations in which certain relationships and services triggered technical independence rule violations without necessarily impairing an auditor’s objectivity.

In an effort to focus auditor independence rules on relationships and services that are more likely to jeopardize the objectivity and impartiality of auditors, the Commission has adopted final amendments to certain auditor independence requirements in Rule 2-01 of Regulation S-X. The Commission proposed the changes in December 2019, and after reviewing the many comments received from public stakeholders decided to adopt the changes largely as proposed.

As with many recent rulemakings, the SEC adopted the measure in a 3-2 vote with Commissioners Allison Herren Lee and Caroline Crenshaw dissenting. In support, Chairman Jay Clayton said the amendments will improve competition and audit quality by increasing the number of qualified audit firms from which an issuer can choose. Lee and Crenshaw believe, among other things, that the Commission has replaced a clear standard with one that provides auditors greater discretion when assessing their own independence and presents greater risk of mistaken or inconsistent application of that standard.

Specific amendments. Among other things, the new rules amend the definitions of "affiliate of the audit client," in Rule 2-01(f)(4), and "investment company complex," in Rule 2-01(f)(14), to address certain affiliate relationships, including entities under common control. They also amend the definition of "audit and professional engagement period," specifically Rule 2-01(f)(5)(iii), to shorten the look-back period, for domestic first time filers in assessing compliance with the independence requirements.

The new rules include an amendment to Rule 2-01(c)(1)(ii)(A)(1) and (E) to add certain student loans and de minimis consumer loans to the categorical exclusions from independence-impairing lending relationships. They also amend Rule 2-01(c)(3) to replace the reference to "substantial stockholders" in the business relationships rule with the concept of beneficial owners with significant influence.

In addition to certain other miscellaneous updates, the new rules replace the transition provision in Rule 2-01(e) with a new Rule 2-01(e) to introduce a transition framework to address inadvertent independence violations that only arise as a result of a merger or acquisition transactions.

Timing. The Commission said in a news release that the amendments will be effective 180 days after publication in the Federal Register. The SEC will allow voluntary early compliance after the amendments are published in the Federal Register in advance of the effective date as long as the final amendments are applied in their entirety from the date of early compliance.

The Commission will not permit auditors to apply the final amendments retroactively to relationships and services in existence prior to the effective date or the early compliance date if selected by an audit firm.

Rationale. In the final rule release, the SEC said that the amendments maintain the principle that auditors must be independent in fact and in appearance. However, the changes improve the relevance of the auditor independence standards in light of existing market conditions by more effectively focusing the independence analysis on those relationships or services that are more likely to threaten an auditor’s objectivity and impartiality.

The Commission stated that the final amendments are based on recurring fact patterns observed over years of consultations in which certain relationships and services triggered technical independence rule violations without necessarily impairing an auditor’s objectivity and impartiality. According to the SEC, the relationships either triggered non-substantive rule breaches or required potentially time-consuming audit committee review of non-substantive matters, thereby diverting time, attention, and other resources of audit clients, auditors, and audit committees from other investor protection efforts.

Clayton noted that the auditor independence rules are appropriately far-reaching and restrictive, but that sometimes far-reaching rules can have unintended, negative consequences. He said that the current auditor independence rules, particularly in cases of a broad, diversified investment portfolio and certain consumer-finance transactions such as student loans, limits auditor choice and may adversely affect the arms-length nature of the issuer-auditor relationship.

Dissent. Lee and Crenshaw also emphasized the critical importance of the auditor independence rules, and questioned why the Commission has chosen to relax them for the second time in two years. They cited last year’s move to narrow the definition of "audit client" to exclude certain affiliated entities under the loan provision of the rules. In their view those amendments also replaced a bright line test with a more discretionary "significant influence" test for determining when a lender’s ownership interest in an audit client impairs independence.

Lee and Crenshaw expressed particular concern that the final rules provide no mechanism for ensuring that the SEC and investors have visibility into how effectively auditors are making their independence assessments. The Commission is relying on auditors to subjectively determine when their own independence is impaired without providing specific guidance on materiality, they said.

They concluded that the new rules introduce greater opportunity for error and uncertainty into auditor independence standards, while decreasing visibility into how auditors are making those judgments.

MainStory: TopStory AccountingAuditing

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