Auditors serving smaller businesses know that those clients often need help navigating the highly technical and overwhelming body of accounting standards. They also know that their audits will likely be more efficient, and the financial statements will be of higher quality, if they can offer some timely assistance and advice, particularly as to the accounting most likely to withstand audit scrutiny. But in the world of SEC financial reporting, walking the fine line between providing valuable client service and maintaining auditor independence can be a delicate balance and a formidable challenge.
Underlying the positions historically taken by the SEC and its staff is Rule 2-01(c)(4)(i)(B) of its Regulation S-X, which prohibits an auditor of a client that is subject to the SEC independence rules from preparing, or substantially assisting in the preparation of, the audit client’s financial statements. Historically, the SEC has elaborated only slightly on this prohibition, saying that “an accounting firm cannot be deemed independent with regard to auditing financial statements of a client if it has participated closely, either manually or through its computer services, in … preparation of the financial statements” [SEC Codification of Financial Reporting Policies section 602.02.c(i), emphasis added].
The point at which accounting assistance or advice creates an independence problem is not clear-cut; rather, it is a matter of professional judgment. It depends on whether the assistance constitutes “close participation.” This author has identified limited additional published guidance available on the meaning of that expression in the context of auditor independence, as follows.
According to a 2006 speech by a high-ranking SEC staff member:
The basic consideration is whether, to a third party, the client appears to be (i) substantially dependent upon the accountant’s skill and judgment in its financial operations, or (ii) reliant only to the extent of the customary type of consultation or advice … The prohibitions on bookkeeping and management functions are not intended to discourage twoway communication between the audit firm and its audit client. (Michael W. Husich, Associate Chief Accountant, Office of the Chief Accountant, “Remarks Before the 2006 AICPA National Conference on Current SEC and PCAOB Developments,” http://bit.ly/2zpLdrd)
Probably the best available guidance as to the SEC staff’s general views, although unfortunately written specifically in the context of (but not limited to) Sarbanes-Oxley Act (SOX) reporting on internal control over financial reporting (ICFR) is this statement issued by the PCAOB staff:
The staff understands that management at times has hesitated to ask auditors technical accounting, auditing, and financial reporting questions [and] … that auditors also have a heightened concern that providing management with advice might impair the auditor’s independence.
The Commission’s auditor independence requirements with respect to services provided by auditors are largely predicated on four basic principles. [That is, 1) An auditor cannot function in the role of management, 2) an auditor cannot audit his or her own work, 3) an auditor cannot serve in an advocacy role for his or her client and 4) an auditor and audit client cannot have a relationship that creates a mutual or conflicting interest.] In addition to these four basic principles, the Commission’s rules also specifically identified nine categories of prohibited services. The auditor’s discussing and exchanging views with management does not in itself violate the independence principles, nor does it fall into one of those nine prohibited categories of services. The staff supports a strong audit profession where a hallmark of its professionalism is to exercise sound judgment in both the audit and in ongoing dialogue with management [emphasis added]. The staff recognizes that questions arise in certain circumstances as to the proper application of accounting standards. Investors benefit when auditors and management engage in dialogue, including regarding new accounting standards and the appropriate accounting treatment for complex or unusual transactions. The staff believes that as long as management, and not the auditor, makes the final determination as to the accounting used, including determination of estimates and assumptions, and the auditor does not design or implement accounting policies, such auditor involvement is appropriate and is not of itself indicative of a deficiency in the registrant’s internal control over financial reporting. [“Staff Statement on Management’s Report on Internal Control over Financial Reporting,” May 15, 2005]
The SEC press release that was accompanied by the foregoing PCAOB staff statement added that “as long as management determines the accounting to be used and does not rely on the auditor to design or implement the controls, we do not believe that the auditor’s providing advice or assistance, in itself, constitutes a violation of our independence rules. Both common sense and sound policy dictate that communications must be ongoing and open in order to create the best environment for producing high-quality financial reporting and auditing; communications must not be so restricted or formalized that their value is lost” (Release 2005-74, “Commission Statement on Implementation of Internal Control Reporting Requirements,” May 2005, http://bit.ly/2QUsWsT).
During its limited life, the Independence Standards Board (ISB) issued an interpretation in 1999 that set forth clear boundaries, based on a similar rationale, on the nature and extent of auditor assistance permissible without impairing independence, although it was applicable solely to the narrow circumstances specified therein [ISB interpretation 99-1, Impact on Auditor Independence of Assisting Clients in the Implementation of FAS 133 (Derivatives)]. Such allowable assistance was broadly described by the ISB as “providing advice, and expressing views” regarding how the difficult new accounting standard should be applied in the specific client’s situation. Detailed examples were provided, but performing services such as preparing accounting entries, computing values, being responsible for key assumptions or inputs, or others that would be subjected to auditing would not be permitted (presumably because they would likely be deemed “close participation”).
The SEC’s Division of Corporate Finance, Office of the Chief Accountant, has also expressed the view that assisting an issuer client (or providing software that would do so) in the preparation of its income tax accrual (as opposed to proposing adjustments as a result of auditing management’s accrual) would impair an auditor’s independence (Application of the Commission’s Rules on Auditor Independence Frequently Asked Questions, “Prohibited and Non-Audit Services,” Questions 5 and 6, Aug. 13, 2003).
Audit Adjustments, Assistance with Note Disclosures, and ICFR Recommendations
The PCAOB’s independence standards clearly set forth that under certain qualifying conditions, proposing audit adjustments (without regard to their number, nature, or significance) for review and acceptance by management does not impair audit independence (PCAOB Interim Ethics section ET 101.05.101-3). The foregoing notwithstanding, it is a widely held (though unwritten) view that independence may be threatened, if not impaired, when audit adjustments are too numerous and significant. Such a condition also has potentially significant implications regarding reportable ICFR deficiencies, the most serious of which may call into question the auditability of the reporting entity’s financial statements.
The PCAOB asserts that the term “mis-statements” should be understood to include “omission and presentation of inaccurate or incomplete disclosures” [Auditing Standard (AS) 1301.18-19; 2810.2, footnote 13]. This supports the view that additions or editorial corrections to note disclosures are, in fact, audit adjustments “other than those that are clearly trivial,” and similarly must be communicated to audit committees as such (AS 1301.19).
Although the PCAOB auditing standards contain no obligation for auditors to provide management or the audit committee with recommendations for any remedial action to be taken in response to observed deficiencies in ICFR, there is no prohibition either, and it is common practice to make such recommendations for evaluation and consideration by those with the authority to take such action. In doing so, however, this author cautions auditors not to be so detailed and specific as to cross the line and effectively engage in ICFR system design, which is a management function.
Specifically, questions have been raised in recent years as to the extent to which an auditor can assist an issuer client with the drafting or editing of note disclosures without being viewed as auditing his own work or “closely participating” by performing a management function. Since an auditor’s opinion is not piecemeal with regard to note disclosures, but rather applies to the financial statements (including the accompanying notes) taken as a whole, this author believes that assessing the effect of such drafting is rightfully a matter of degree—and also a matter of professional judgment.
Word Processing and Assembly of Financial Statements
In recent years, SEC staff members have informally expressed the view that Rule 2-01(c)(4)(i)(B) effectively precludes auditors from providing audit clients with typing, word processing services, or financial statement templates that are not publicly available. This author has learned that at least one large CPA firm has been advised privately that the staff believes auditors should not be involved in any aspect of word processing or assembling financial statements. Accordingly, providing SEC issuer clients with marked text of their draft financial statements and notes in a format that facilitates alteration of the client-prepared original draft financial statements by client personnel, without retyping the editorial changes after management has evaluated and accepted them, is risky and inadvisable.
Three factors cited by SEC staff member Michael Husich in his 2006 speech cited above should be considered by issuers and auditors in deciding whether performing certain services threatens or impairs independence: Is the level of management’s knowledge and expertise commensurate with the complexity of the business and the relevant accounting standards and sufficient to maintain materially accurate books and records, without delegating to the auditor? Is the auditor’s role in the financial reporting process appropriately limited to providing management with technical guidance, research materials, advice, comments, or editorial suggestions regarding presentation of the notes or basic financial statements, as opposed to drafting or rewriting the notes or proposing excessive adjustments such that a reasonable investor would likely be concerned? Has management performed the work necessary to enable it to take full responsibility for the judgments applied in preparing the financial statements, rather than placing undue reliance on the auditor’s judgment?