SEC loosens auditor independence rules

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The Securities and Exchange Commission voted Friday to adopt amendments to its longstanding auditor independence requirements, relaxing restrictions on relationships between auditors and their clients as part of a deregulatory push by the SEC in recent years.

The SEC said the amendments to Rule 2-01 of Regulation SX would “modernize the rules and more effectively focus the analysis on relationships and services that may pose threats to an auditor’s objectivity and impartiality.” In announcing the changes, it said the SEC staff has found over the years that certain relationships and services would trigger technical violations of the independence rules and require potentially time-consuming reviews by audit committees of “non-substantive matters” and take time and attention from auditors, audit clients and audit committees away from other investor protection efforts.

Last December, the SEC proposed changes to the independence rules (see story). The final amendments approved Friday would change the auditor independence requirements to evaluate specific relationships and services that might threaten the objectivity and impartiality of auditors.

“Today’s amendments reflect the Commission’s long-recognized view that an audit by an objective, impartial, and skilled professional contributes to both investor protection and investor confidence,” said SEC chairman Jay Clayton in a statement. “These modernized auditor independence requirements will increase investor protection by focusing audit clients, audit committees and auditors on areas that may threaten an auditor’s objectivity and impartiality. They also will improve competition and audit quality by increasing the number of qualified audit firms from which an issuer can choose.”

Jay Clayton, chairman of the Securities and Exchange Commission

The SEC outlined some examples of how the rules would change in certain circumstances, such as an audit partner who is paying off her student loans before starting her career at an audit firm. A different audit partner in the same city audits the lender that provided the other partner with her student loan. Under the earlier rules, the student loan of the audit partner who isn’t part of the audit would lead to an independence violation for the audit engagement of the lender. Under the amended rules, it wouldn’t result in an independence violation.

The changes are the most substantial changes in the auditor independence rules since 2003, although some changes were made last year in the definition of an “audit client” under the loan provisions of the rules to exclude some affiliated entities when deciding if a lender’s ownership interest in an audit client would impair an auditor's independence.

Two SEC commissioners, Allison Herren Lee and Caroline A. Crenshaw, criticized the move to relax the restrictions further in a joint statement Friday. “It is against this backdrop that the Commission relaxes auditor independence rules for the second time in as many years,” they wrote. “Among other changes, today’s rules replace 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. What’s more, under the final rules, there is no mechanism for ensuring that the SEC and the investing public have visibility into how effectively auditors are making these assessments. And, as has too often been the case in recent years, these changes are disfavored by investors— those who actually rely on auditor assurances.”

The final amendments will alter the definitions of “affiliate of the audit client” and “investment company complex” to address some affiliate relationships, including entities under common control. They will also amend the definition of “audit and professional engagement period” to shorten the look-back period from three years to one year for U.S. companies planning to go public in weighing their compliance with the independence requirements.

Other amendments will add some types of student loans and consumer loans to the categorical exclusions from independence-impairing lending relationships.

The updates will also replace a reference to “substantial stockholders” in the business relationships rule with the concept of beneficial owners with significant influence. They will also replace a transition provision with a new rule to provide a transition framework to deal with inadvertent independence violations that only come about as the result of a merger or acquisition.

Clayton defended the changes as modest and in the interest of the capital markets. “Our auditor independence rules are far-reaching and restrictive,” he said in a statement. “They should be, as even the appearance of inappropriate influence can undermine confidence. As markets evolve, however, far-reaching and restrictive rules can have unintended, negative consequences. In this case, the reach of our rules, particularly in the cases of a broad, diversified investment portfolio and certain consumer-finance transactions (such as student loans), is operating to limit auditor choice which, in turn, may adversely affect the important arms-length nature of the issuer-auditor relationship. Today’s modest and tailored amendments reduce or eliminate those adverse effects on auditor choice without detracting from the independence obligations of auditors and issuers. This type of retrospective review and tailored action is important to the continued effectiveness and efficiency of our rules.”

However, Lee and Crenshaw contend that the rule changes will compromise auditor independence and voted against them. “While it makes sense for us to assess how our rules are functioning from time to time and to recalibrate them as needed, we are concerned that the dial for auditor independence is turning in only one direction, and that is toward loosening standards and reducing transparency,” they wrote. “We cannot support introducing greater opportunity for error and uncertainty into auditor independence standards while decreasing visibility into how auditors are actually making these judgments. We respectfully dissent.”

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