Regulators in both the U.S. and the U.K. have recently debated changes to rules regarding auditor independence, with one big difference. In the U.S., the Securities and Exchange Commission (SEC) has proposed further loosening of auditor independence rules, while in the U.K., the Financial Reporting Council (FRC) has issued revised auditing standards aimed at strengthening auditor independence.
In this post, we review the anticipated changes proposed by the SEC and revised standards implemented by the FRC, and discuss the background of auditor independence regulations contributing to the contrasting courses of action.
SEC – Proposed changes to auditor independence would loosen regulations
Auditor independence has been an increasing area of focus for the SEC. In June 2019, the SEC adopted amendments – which took effect on October 3, 2019 – to its auditor independence rules 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.
Prior to the amendments, Rule 2-01(c)(1)(ii)(A), more commonly referred to as the “Loan Provision”, prohibited a firm from auditing a fund while also borrowing money from a lender that owns a stake of 10% or more in the same fund.
The amendment replaced the previous 10% threshold with a different form of appraisal referred to as a “significant influence test” after the rule seemed to capture relationships that did not pose threats to an auditor’s objectivity and impartiality. In addition, other changes to the Loan Provision include:
- a focus on the analysis on beneficial ownership rather than on both record and beneficial ownership;
- add a known through reasonable inquiry standard with respect to identifying beneficial owners of the audit client’s equity securities; and
- exclude from the definition of audit client, for a fund under audit, any other funds that otherwise would be considered affiliates of the audit client under the rules for certain lending relationships
According to a Wall Street Journal article, SEC Chairman Jay Clayton announced on December 9th that changes to auditor independence rules were a priority in the next year.
Not long after, on December 30, the SEC issued a press release proposing to modernize its auditor independence rules. The proposed changes would update certain aspects of the nearly 20-year-old auditor independence framework, aiming 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 proposed amendments are based on years of Commission staff experience in applying our auditor independence rule set and respond to recent and longer term feedback received from a wide range of market participants. The proposal is consistent with the Commission’s long-recognized view that an audit by an objective, impartial, and skilled professional enhances both investor protection and market integrity, and, in turn, facilitates capital formation.”-Jay Clayton, SEC Chairman
Clayton went on to say, “in practice, the proposed amendments also would increase the number of qualified audit firms an issuer could choose from and permit audit committees and Commission staff to better focus on relationships that could impair an auditor’s objectivity and impartiality.”
The recent attention that auditor independence has received is not limited to the proposed rule changes. Issues and violations involving audit firms – including auditor independence, audit deficiencies, improper professional conduct and audit partner rotation – have been of particular interest lately.
The SEC provides a list of certain enforcement actions related to financial reporting concerning administrative proceedings and civil lawsuits. These Accounting and Auditing Enforcement Releases (AAERs) are reviewed by Audit Analytics and key data points are extracted. In 2019, 7 AAERs related to auditor independence, compared to 3 AAERs in 2018; of all the AAERs since 2000, there have been 97 related to auditor independence.
However, the SEC isn’t the only regulator keeping tabs on auditor independence; the Public Company Accounting Oversight Board (PCAOB) announced that it will be a key focus for inspections in 2020, as auditor independence remains as one of the most common areas of deficiencies.
Although the loosening of auditor independence rules may provide companies with more options when choosing an audit firm, it’ll be interesting to see if it affects competition. As it stands right now, looking at the audit market concentration in 2019, the Big Four audited almost 50% of all public companies; these four firms dominated 89.5% of large accelerated filers.
FRC – Revised Ethical Standard 2019 strengthens auditor independence
In December 2019, the FRC – the audit regulator in the U.K. – issued revisions to its Ethical Standard regarding auditing standards and rules. According to the FRC, the revisions are intended to strengthen auditor independence and improve overall audit quality.
The more stringent standards prohibit auditors from providing recruitment and renumeration services, as well as barring auditor involvement in management decision making.
An additional component of the revised provisions addresses the ability of an auditor to provide non-audit services to a client that is a public interest entity (PIE), such as a credit institution or insurance undertaking. Auditors for PIEs are now only able to provide non-audit services if they are closely linked to the audit, or if the services are required by law or regulation. However, providing non-audit services is subject to approval by the audit client’s audit committee, providing another layer to ensure that the non-audit services do not interfere with independence.
The changes to the permitted non-audit services for PIEs aim to reduce the risk of a possible conflict of interest and refocus the audit relationship on a high-quality audit, as opposed to commercial interests of the audit firm. Currently, the restriction of non-audit services is only applicable to PIEs, but the FRC has considered expanding the requirement to more companies.
This change to allowable non-audit services is particularly significant, considering the FRC has found a 9% increase in audit fees among current FTSE 350 companies since 2014, noting in the Developments in Audit 2019 survey that non-audit fees are the main source of income for audit firms.
The changes to the auditing standards have occurred amidst general concerns regarding the audit market and audit quality in the U.K, particularly in light of the recent collapses of several major companies, including Carillion and Thomas Cook.
As a part of the Developments in Audit 2019 survey, the FRC reported that audit quality is not reaching the high standards expected. In 2018/2019, only 75% of FTSE 350 audits were classified as “satisfactory” or “good”, missing the 90% target.
Additional concerns over audit quality relate to a heavy concentration of audit firms, especially among the FTSE 350 where the Big Four account for over 96% of audit clients. Although, the competition problems are not limited to large companies in the FTSE 350.
An Audit Analytics analysis of Transparency Reports for PIEs in the U.K. found that a very small number of firms control the majority of the market. In 2017, 90% of the PIE market in the U.K. (over 2,000 PIE entities) was audited by just 7 firms, with around 79% audited by the Big Four, while the remaining 10% of the PIE market was shared among 29 audit firms.
Recently, in April 2019, the Competition and Market’s Authority (CMA) – the competition regulator in the U.K. – recommended splitting the audit and non-audit practices of the Big Four firms. The recommendation was made to avoid a firm’s audit work being subsidized by their other businesses as a result of profit sharing between audit and non-audit practices, and to “ensure maximum focus on audit quality”.
Other recent changes to audits include the reform of the EU Statutory Audit Market, which instituted mandatory auditor rotation for PIEs in the EU. This change was made to address concerns that lengthy auditor tenure may undermine a statutory auditor’s independence and have a negative impact on professional skepticism.
The U.K. audit industry is undergoing a transformational shift in response to the call for change, including the introduction of a newly formed statutory body, the Audit, Reporting and Governance Authority (ARGA), which will absorb the FRC. ARGA will continue to work with international standards boards to improve audit quality globally and it will be interesting to see if there is a noticeable increase in audit quality as a result of the multitude of changes.
Audit Analytics maintains an Independence data solution that tracks beneficial owners of mutual funds.
For more information on this data solution, or any of our US or European databases, please contact us.