In an Aug. 29, 2022, Statement (the “Statement”), Paul Munter, Acting Chief Accountant of the U.S. Securities and Exchange Commission (“SEC”), gave very emphatic guidance to audit firms, warning that they must, always and in all contexts, maintain compliance with the SEC’s auditor independence rule set out in Rule 2-01 of Regulation S-X under the Securities Act of 1933, as amended. Regulation S-X prescribes the form and content of financial statements required to be maintained (and typically filed with the Commission and given to investors) by businesses subject to the SEC’s jurisdiction (public companies, broker/dealers, investment advisers, investment companies, etc.). It also prescribes what is required of an audit firm so it can provide audit services to those entities. One of the most important requirements is that audit firms be “independent” of the entity that is being audited and any “associated entity.”
This Statement is not the first time Munter has expressed concerns about auditor independence. As discussed at some length in my Aug. 1, 2022, Blog “Who Are You?: Auditor or Consultant, and Still Cheating on Exams,” Munter, participating in a PLI conference in October 2021, said (as reported by Bloomberg) that the determination of independence is not a “checklist compliance exercise,” and that the SEC Rule requires an assessment of “independence” both in fact and appearance, from the perspective of a reasonable investor. He added that the key question is whether the auditor “is capable of exercising … objective and impartial judgement of all issues encompassed within” the auditor’s engagement.
At that PLI conference, Munter gave particular attention to the potential conflicts posed by accounting firms providing non-audit services, and the resulting business relationships that can and do develop between the accounting firm and the audit client. He said somewhat harshly, “I have less than zero sympathies for independence violations that resulted from firms having prioritized growing consulting practices, growing non-audit services, prioritizing those over the integrity of its independence to its issuer audit clients. Auditor independence is grounded in an understanding of accounting as a profession rather than an industry.”
It seems clear that fundamental changes to that “profession” are the reasons for issuing the Statement. Much of the Statement concerns the structural and inter-entity relational impacts of the growing frequency of private equity and similar financial institutions investing in accounting firms, becoming partial or total owners. The resulting structure becomes even more complex if the accounting firm is only one of several “portfolio” companies. These investments reflect an assessment on the investing side that accounting firms generate substantial and predictable profits. The accounting firm will enjoy benefits from the injection of additional capital for use in acquiring advanced computer and other systems, as well as for possibly opening new offices and, in any event, enhanced distributions to the accountants, which may facilitate new hiring.
But what of the impact on “independence”? The SEC Rule defines “accounting [or audit] firm” to encompass:
The organization’s departments, divisions, parents, subsidiaries, and associated entities, including those located outside the United States…and the organization’s pension, investment, or similar plans.
This definitional reach sets out the ambit, in Munter’s words, of the “Commission’s auditor independence rule” and “determines which entities are subject to” it. The Statement goes on to note “[p]rivate equity structures can be complex and can include entities that have varying levels of influence over other entities – either within their investment portfolio or within the contemplated structure.” The audit firm must “carefully evaluate …[whether] each entity within such structure …to determine if the entity is an associated entity and therefore part of the accounting firm for purposes of” the independence rule. It is the view of the SEC staff (specifically the staff of the Office of the Chief Accountant [“OCA”]), as disclosed in the Statement, that in making that determination one must consider “i) the financial interest the entity has in the accounting firm; and ii) the ability the entity may have to influence the operating or financial decisions of the accounting firm.” The Statement then gives a hypothetical example:
A fund, organized as a limited partnership, owns an investment interest in an accounting firm.
The fund’s general partner owns a limited partnership interest in the fund and is responsible
for the investment decisions of the fund. An investment adviser controls the general partner.
The Statement asserts that the OCA staff would conclude all three entities, namely the
Fund, the general partner, and the investment adviser, have a financial interest in the accounting firm and have the ability (in the eyes of a reasonable investor) to influence the operations and decisions of the accounting firm, and so, each is an “associated entity.
The Statement goes on to note that individuals, not partners of the accounting firm, may also be investors in the firm and, hence be “covered persons” as defined in the SEC Rule, especially if such an individual could be seen either from formal position or functional relationships as being in the “chain of command” of the accounting firm. Those “covered persons,” along with any person or entity affiliated with the “covered person,” would be subject to the same inclusion in the definition of “accounting firm.”
To provide prophylactic guidance, the Statement says that in “the view of OCA staff it would be a high hurdle for the accounting firm to be in compliance with … [the SEC’s auditor independence rule] if it provides ANY audit, review, or attestation services … for ANY entity within the private equity structure.” [Emphasis in the original]. The Statement explains:
This is because the relationship [between or among the various persons and entities] would raise potential mutual or conflict of interest concerns in fact or appearance with respect to the nature of the financial relationship between the private equity structure as a whole and the accounting firm.
The Statement then directs that in the case of such an investment, “all parties to the transaction should understand the need for BOTH the accounting firm and any covered persons [or associated entities] … to implement monitoring processes and controls to comply with the SEC rule on the ‘independence’ of auditors.” The Statement cites a March 16, 2019, letter from the American Investment Council (to the SEC regarding the proposal of an SEC Rule amendment) that observed that private equity firms have “a continuously evolving universe of entities.” The Statement notes that this factual setting poses even greater risks for violations of the auditor independence rule, requiring “a suitably designed and implemented system of vigilant ongoing monitoring” of i) compliance with the SEC Rule; ii) audit quality; iii) the firm’s ethical culture; and iv) the firm’s gatekeeper responsibilities for investor protection. Further, it notes that such a system may no longer be effective, as the changes to the private equity firm require material revisions to maintain the requisite compliance. The Statement expresses particular concern about the impact on compliance due to the typical short-term, profit maximization focuses of the private equity firm, noting the accounting firm may well need “to forgo potential revenue so that…[it] can comply with…[its] professional responsibilities and independence requirements.”
Having focused on the potential corruptive effects of outside investment in accounting firms, the Statement returns to a related topic covered in Munter’s presentation at the conference, the growth of consulting services offered by accounting firms and the potential conflicts posed by both the inducement of greater financial returns from providing non-audit services and the relationship consequences on the accounting firm that has advised the client on business matters and then has to audit that same client’s financial statements. Specifically, the Statement addresses the divestiture by accounting firms of their consulting businesses. This topic is addressed in some detail in my August 1 Blog “Who Are You?” cited above, including the millions of dollars involved in some planned divestitures. Indeed, the Sept. 9, 2022, issue of The Wall Street Journal reports that the leadership of the accounting firm Ernst & Young has decided to begin the month-long process to obtain the vote of its approximately 13,000 partners on a proposal to split the firm into an audit firm and a consulting firm, with resulting seven-figure distributions to the Ernst & Young partners. The Statement lays out what it characterizes as minimum requirements for compliance expected by the OCA staff in such transactions: i) separate corporate governance, management, and financial structures for each resulting entity; ii) termination of all interests between the two entities; iii) prevention of any revenue or profit sharing; iv) no co-marketing or advertising; v) no use by the divested entity of the intellectual property (e.g., name, logo, etc.) of the accounting firm; and vi) prompt cessation of any transition-related shared services (e.g., computerized file maintenance, client history transfer, etc.). As noted in the cited excerpts from Munter’s October 2021 presentation, the OCA staff will have little sympathy for failures to meet these minimum expectations where the accounting firm’s independence is compromised as a result.
The Statement implicitly expresses serious concern that accounting, driven by ever-increasing opportunities for greater earnings, will sell its soul as a profession, becoming just an “industry” for a higher rate of return.
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