We covered auditor independence in a recent post and decided to take a closer look at what has changed among the rules in the US.
In June 2019, the SEC adopted amendments to its auditor independence rules – which took effect on October 3, 2019 – relating to the analysis that must be conducted to determine whether an auditor is independent when the auditor has a lending relationship with certain shareholders of an audit client.
The previous bright-line 10% test was believed to be both over- and under- inclusive as a method of identifying debtor-creditor relationships that impair the auditor’s objectivity and impartiality.
When the SEC was operating under the longstanding, stricter version of the loan rule, auditing a single fund in a fund complex (say one of five hundred funds) meant that the auditor had to ensure they did not have a lending relationship with any significant shareholder (10%) – either record or beneficial – of any mutual fund in that fund complex. The revised rule means firms are no longer required to do this, but they still need to track beneficial owners of funds in order to perform the significant influence test.
Audit Analytics collects shareholder information to assist audit firms with tracking this data. We reviewed our Open-End Fund Ownership data for 4,337 funds belonging to 495 investment companies and, using the previous threshold, found that the average number of record or beneficial shareholders exceeding 10% weighted ownership of the fund is 1.97. The largest number of record or beneficial shareholders exceeding 10% weighted ownership observed for a single fund is 7.
These numbers add up quickly, considering that the entire investment company and fund complex has to be reviewed. One investment company – iShares Trust – disclosed 657 record and beneficial shareholders exceeding the 10% threshold across 381 funds.
With that said, the SEC replaced that threshold in the Loan Provision with a “significant influence test.” What does that mean? As defined in the final rule, “in part, that an accountant would not be independent when the accounting firm, any covered person in the firm, or any of his or her immediate family members has any loan (including any margin loan) to or from an audit client, or an audit client’s officers, directors, or beneficial owners (known through reasonable inquiry) of the audit client’s equity securities where such beneficial owner has significant influence over the audit client.”
The final rule also says, “although not specifically defined, the term ‘significant influence’ appears in other parts of Rule 2-01 of Regulation S-X, and the Proposing Release noted that use of the term ‘significant influence’ in the proposed amendment was intended to refer to the principles in the Financial Accounting Standards Board’s (FASB’s) ASC Topic 323, Investments – Equity Method and Joint Ventures.”
However, in December 2019, the SEC proposed further amendments to modernize auditor independence rules.
“The proposed amendments would update select aspects of the nearly two-decade-old auditor independence rule set to more effectively structure the independence rules and analysis so that relationships and services that would not pose threats to an auditor’s objectivity and impartiality do not trigger non-substantive rule breaches or potentially time consuming audit committee review of non-substantive matters.”
The SEC notes there have been significant changes in the capital markets and those who participate in them since the initial adoption of the auditor independence framework in 2000. The proposed amendments focus on fact patterns presented to the SEC that involve a relationship with, or services provided to, an entity that has little or no relationship with the entity under audit, and no relationship to the engagement team conducting the audit.
To help better understand, the SEC provided a couple of examples that help illustrate some of the concerns with the current rules that the proposals would address. The first is listed below:
Audit Firm has an audit partner based in Atlanta who continues to pay his student loans taken to attend college before starting his career at Audit Firm. A different audit partner in Atlanta audits the lender that provided the student loan, a large student loan company that originates thousands of student loans. Under the current rules, the student loan of the audit partner who is not part of the audit would still lead to an independence violation for the audit engagement of the lender.
If adopted, the proposed amendments would:
- Amend the definitions or affiliate of the audit client to address certain affiliate relationships including entities under common control;
- Amend the definition of the audit and professional engagement period to shorten the look-back period, for domestic first-time filers in assessing compliance with the independence requirements;
- Amend Rule 2-01(c)(ii)(A)(1) and € to add certain student loans and de minimis consumer loans to the categorical exclusions from independence- impairing lending relationships;
- Amend Rule 2-01(c)(3) to replace the reference to “substantial stockholders” in the business relationship rule with the concept of beneficial owners with significant influence;
- Replace the outdated transition and grandfathering provision in Rule 2-01(e) with a new Rule 2-01(e) to introduce a transition framework to address inadvertent independence violations that only arise as a result of merger and acquisition transactions; and
- Make certain miscellaneous updates.
The revised rules affect domestic and foreign registrants and issuers, investment advisers, broker-dealers, and any other entity whose auditor must comply with rule 2-01 of Regulation S-X.
The analysis in this post was provided by the Independence data solutions powered by Audit Analytics.
Audit Analytics tracks shareholders and control persons of SEC registered companies and mutual funds to support Independence teams for many leading firms.
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