The Securities and Exchange Commission (Commission) recently adopted amendments to the auditor independence requirements of Rule 2-01 of Regulation S-X (Rule 2-01) to modernize certain aspects of its auditor independence framework (Amendments).1 The Amendments are intended to more effectively focus the independence analysis on relationships and services that may pose threats to an auditor’s objectivity and impartiality.
The Commission adopted the Amendments largely as proposed.2 The Amendments will be effective 180 days after publication in the Federal Register.
A summary of the Amendments appears below.
Definitions of “Affiliate of the Audit Client” and “Investment Company Complex.” Under the current auditor independence requirements of Rule 2-01, the term “audit client” is defined as “the entity whose financial statements or other information is being audited, reviewed, or attested” and “any affiliates of the audit client.” The requirement to identify and monitor for potential independence-impairing relationships and services applies to affiliates of the audit client, including sister entities,3 regardless of whether the sister entities are material to the controlling entity. This same requirement to identify and monitor for potential independence-impairing relationships and services applies to sister entities that are part of an investment company complex (ICC).
The Amendments modify the definitions of “affiliate of the audit client” and “investment company complex” to address certain affiliate relationships, including entities under common control. The Amendments incorporate a dual materiality threshold such that a sister entity will be included as an affiliate of the audit client only if the sister entity and the entity under audit are each material to the controlling entity (dual materiality threshold). If either the sister entity or the entity under audit is not material to the controlling entity, then the sister entity will not be deemed an affiliate of the audit client. The Amendments also add the concept of the “entity under audit” in the definition of “affiliate of the audit client” to avoid confusion and circularity in the analysis of how to identify affiliates of the issuer whose financial statements are being audited.
The Release provides a number of examples to illustrate the application of the materiality concept under the Amendments to particular fact patterns but notes that an assessment of materiality requires consideration of all relevant facts and circumstances, including quantitative and qualitative factors. The Release notes that the Amendments are not intended to change the application of the general independence standard in Rule 2-01(b).4 The Release reflects the Commission’s belief that any potential threat to independence arising when the entity under audit is not material to the controlling entity (under the dual materiality threshold) should be sufficiently mitigated by the continued protections afforded by the general independence standard. In this regard, when facts or circumstances indicate that services or relationships between the auditor and the non-affiliate sister entity to the entity under audit impair the auditor’s objectivity and impartiality, the general independence standard (requiring the consideration of all relevant facts and circumstances related to the auditor’s objectivity and impartiality) would be sufficient to prohibit providing the service or establishing the audit relationship.
The Amendments direct the auditor of an investment company or investment adviser to apply the ICC definition to identify affiliates and align the ICC definition with the affiliate of the audit client definition with respect to the dual materiality threshold.
The Amendments include certain sister investment companies within the ICC definition regardless of materiality. For example, when a sister investment company shares the same investment adviser as an investment company under audit, these entities are to be included as part of the ICC in evaluating the auditor’s independence. Similarly, if a sister investment adviser is included as part of the ICC under the dual materiality threshold, the investment companies advised by the sister investment adviser are to be included as part of the ICC in evaluating the auditor’s independence. In addition, the Amendments indicate that common control entities engaged in the business of providing administrative, custodial, underwriting, or transfer agent services should be part of the ICC when they provide services to investment companies or investment advisers in the ICC.
Lastly, the Amendments define ICC to include unregistered funds and include a “significant influence” provision in the ICC definition.5
Definition of “Audit and Professional Engagement Period.” The Amendments modify the definition of “audit and professional engagement period,” which is currently defined differently for domestic issuers and foreign private issuers with respect to situations in which a company first files, or is required to file, a registration statement or report with the Commission. The Amendments shorten the look-back period for assessing compliance with the independence requirements for domestic first-time filers to match the one-year look-back period for first-time filers that are foreign private issuers.
Loans or Debtor-Creditor Relationships. The existing “loan provision rule” provides that an accountant is not independent when the accounting firm, any covered person in the firm, or any immediate family member of such accountant has any loan to or from an audit client, or certain other entities or persons related to the audit client, but the loan provision rule excepts four types of loans from its scope, including certain mortgage and automobile loans and certain credit card debt. The Amendments add specified student loans and de minimis consumer loans (replacing the reference to credit cards) to the categorical exclusions from independence-impairing lending relationships. The Amendments also clarify that the mortgage loan exception may apply to multiple mortgage loans on a primary residence.
Business Relationships Rule. Currently, the “Business Relationships Rule” prohibits the audit firm or any covered person from having “any direct or material indirect business relationship with an audit client, or with persons associated with the audit client in a decision-making capacity, such as an audit client’s officers, directors, or substantial stockholders.” The Amendments replace the reference to “substantial stockholders” in the Business Relationships Rule with the concept of beneficial owners (known through reasonable inquiry) with significant influence over the entity under audit.
Inadvertent Violations Due to Mergers and Acquisitions. The Amendments provide relief to audit firms with respect to violations of independence standards that arise as a result of a corporate event, such as a merger or acquisition. The Amendments establish a transition framework for mergers and acquisitions (based on an effective system of quality controls) to address inadvertent violations related to such transactions, so the auditor and its audit client can transition out of prohibited services and relationships in an orderly manner.
The Amendments should permit auditors and their clients to focus their time and resources on those relationships and services that present the greatest risks to an auditor’s objectivity and impartiality. The Amendments should also reduce non-material rule violations and corresponding audit committee reviews of those matters. In addition, the Amendments have the potential to increase the number of auditors who could be considered independent and thus available to funds for audit services, under certain circumstances.