A handful of high-profile legal flaps in recent weeks should serve as a wake-up call to public companies that they need to make their own determinations about whether their audit is being delivered by a truly independent auditor.
Auditor independence rules are the responsibility of auditors to follow, but companies have perhaps the greater burden and will be left to clean up the mess if an audit is blown by a discovery of possible bias. “Maybe a lot of companies overlook this, but it is the company’s responsibility to have audited financial statements by an independent auditor,” says Kelly Bossard, managing director at FTI Consulting. “If something goes awry, it is the company, not the auditor, that is left in the lurch.”
The world will never know if that line of thinking might have spared the widespread misery of meltdown at Taylor Bean & Whitaker Mortgage, where multiyear, multibillion-dollar fraud allegations led to the lender’s collapse and a cascade of litigation, most notably the recent settlement in a $5.5 billion lawsuit against PwC.
Lynn Turner, former chief accountant at the Securities and Exchange Commission who testified at the trial before it was interrupted with an out-of-court agreement, says auditor independence was at least a factor. The court had already ruled, in fact, that for one particular year, the audit firm was not independent because of an indemnification clause in the engagement contract, he says.
Taylor Bean hired a senior manager from PwC’s audit team in a financial oversight role, a clear indicator that the audit firm should not be seen as independent going forward, says Turner. The audit firm reasoned that the hiring merited an exception under independence rules because it constituted an emergency or unusual situation. Where else would the company find a highly qualified person in Montgomery, Ala.?
Turner testified that the exception should not apply. Soon after, the case settled. “It shows how important independence is,” he says. “If there had been a change in auditors as required, that fresh set of eyes might have challenged something.”
Jurors related to the notion that a fresh perspective on the audit might have led to far earlier detection of the six-year-long fraud scheme, says Turner. “I could tell the jury got what it meant that the auditor needed to be independent,” he says. “I think it was resonating.” PwC had no comment on the case.
“There are all kinds of things that can affect independence. Audit committees have to police it.”
Nancy Reimer, Partner, LeClairRyan
Investment managers, too, are feeling the pain of auditor independence requirements as auditors in that space scramble to comply with an apparently long-overlooked technical violation of a loan rule. The SEC issued a no-action letter to Fidelity Management and Research this summer saying it will not recommend enforcement action for failures to meet independence requirements due those specific violations, but the position expires in 18 months.
Dan Goelzer, a partner with law firm Baker & McKenzie and a former member of the Public Company Accounting Oversight Board, says it’s not clear why the SEC put an 18-month timeline on its no-action letter. “Maybe it’s designed to let auditors change their lending relationships or for the funds to change auditors,” he says. “For people in the investment management world, this was a big independence crisis until the SEC solved it with a no-action letter.”
The SEC beefed up its independence requirements even before the Sarbanes-Oxley Act gave audit committees explicit marching orders to oversee auditors. The PCAOB also has independence rules requiring auditors to discuss them with the audit committee annually along with numerous other audit issues. Experts say it would be wise to dig into the independence discussion with plenty of questions to assure auditors are turning over every stone in search of possible impairments.
Audit committees should take seriously the internal measures companies take to identify potential conflicts, especially questionnaires about business relationships that might overlap with the audit firm, says Goelzer. “There are a handful of cases where the SEC has taken action against audit committee members or directors if he or she was the cause of an independence violation,” he says. That happened most recently in 2015 when the SEC took action against Deloitte and a trustee on three funds it audited.
AUDITOR NO NOs
Below is a list of non-audit services and relationships that are not permitted.
Specific Prohibited Non-audit Services
The auditor is prohibited from providing the following non-audit services to an audit client including its affiliates:
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
In addition to the specific prohibited services, audit committees should consider whether any service provided by the audit firm may impair the firm's independence in fact or appearance.
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.
Nancy Reimer, a partner at law firm LeClairRyan, says fall is a great time for audit committees to double check independence provisions before auditors get elbow-deep into their field work. “There are all kinds of things that can affect independence,” she says. “Audit committees have to police it.”
Companies looking to get their arms around assuring their auditors are independent should view it as a compliance matter, says Mike Scudder, a partner at law firm Skadden, Arps, Slate, Meagher & Flom. “Dedicate resources that are commensurate with the risk you are trying to mitigate and control,” he says.
Where independence issues arise in public company audits, says Scudder, it often occurs because an affiliate of the audit firm performs a prohibited service under SEC rules, perhaps overseas, for a subsidiary or a division of the public company. Under SEC rules, that constitutes a conflict of interest that impairs independence.
“You need systems, controls, and processes in place as a company to ensure you are not blind to that happening or learning about it after the fact,” Scudder says. “You need to set up measures where you are going to identify those services that are contemplated to be provided that may impair independence. It gets down to a very detailed level.”
When it comes to violations involving foreign affiliates and subsidiaries, companies are perhaps even better positioned to identify conflicts than auditors, says Bossard. “It’s the accounts payable systems that are cutting checks to a Big 4 firm in the United States that’s doing the audit and then to an affiliate in another country doing consulting work,” he says.
Auditors spend plenty of time with management, so it’s only natural that they will form a close relationship, says Tom Ray, an accounting faculty member at Baruch College and former chief auditor at the PCAOB. That makes it imperative for audit committee chairs to proactively form close relationships with senior members of the engagement team to keep tabs on possible impairments to independence, he says. “It takes time and effort, but you have to create an environment where the auditor is comfortable speaking with and working with the audit committee,” he says.
Where there may be uncertainties, companies would be wise to escalate the discussion to the SEC’s chief accountant, says Bossard. Auditor independence determinations are steeped in fact and circumstance, he says. “There’s a lot of gray area.”