The Engagement Team Approach to Independence

An updating of the rules offers greater flexibility for practitioners and their firms.
BY CATHERINE ALLEN AND BRIAN CASWELL

EXECUTIVE SUMMARY
  • IN LIGHT OF FAST-MOVING CHANGES in society and business, the profession has responded by shifting from “firm-based” independence rules toward an approach that is “engagement team based.”
  • THAT APPROACH IS INCLUDED in the SEC’s recently adopted rule 2-01 revisions. An exposure draft from the International Federation of Accountants that addresses this concept is pending, and the Independence Standards Board and the AICPA professional ethics executive committee have proposals in development.
  • THE ENGAGEMENT TEAM APPROACH to independence significantly narrows the pool of staff who must follow the rules. The underlying concept is that the greatest risk to independence lies in the actions and judgments of those closest to the attest engagement. Prohibitions also extend to those who are able to influence the attest engagement or the attest engagement team.
  • MODERNIZED RULES that are more intuitive and relevant will ultimately benefit not only the public but also attest clients and firms.
BRIAN CASWELL, CPA, managing partner of Caswell & Associates, CPAs, PC, Syracuse, New York, is a member of the AICPA professional ethics executive committee. His e-mail address is brian@caswellaccountants.com . CATHERINE ALLEN, CPA, is a technical manager in the AICPA professional ethics division. Her e-mail address is callen@aicpa.org .

ramatic transformations in society and business are driving changes to the accounting profession’s independence rules. A key development, which will affect all professionals affiliated with firms that provide attest services, is the profession’s movement from “firm-based” rules toward an “engagement team” approach. Independence standard-setters and regulators have embraced this approach because it permits much-needed modernization of the rules. For instance, the approach is included in the SEC’s recently adopted rule 2-01 revisions. (The revisions are effective February 5, 2001, with a three-month transition period (to May 7) granted to anyone who needs to change or dispose of various interests or relationships to comply.) An exposure draft from the International Federation of Accountants that also addresses this concept is pending, and the Independence Standards Board and the AICPA professional ethics executive committee have related proposals in development. (For more information, see the sidebar, “Independence and the Accounting Profession.”)

This article discusses the profession’s shift toward the engagement team approach and the environment that led to reassessment of the rules. It explains the concepts and rationale underlying the approach and addresses the impact the new rules will have on professionals and their firms.

OLD VS. NEW

The existing rules rely on a “firmwide” approach to interpreting independence, meaning that they apply to specific professionals throughout the firm. Those at the top level—firm owners—and those who participate in an engagement are held to the highest standard and those in lower positions to a less restrictive standard. Rule 101 of the AICPA Code of Professional Conduct defines the members of a firm who are subject to restrictions under the independence rules (for example, they cannot own stock in an attest client) to protect the firm’s independence. These include

All owners of the firm.

All managers in an office that provides significant attest services to a client or who participate in the attest engagement.

All professional staff who participate in the attest engagement.

The firm (entity)—in a legal sense—providing attest services.

All entities controlled by any of the above people or entities.

Basic Concept Behind the Engagement Team Approach. The modernized engagement team approach to independence significantly narrows the pool of people who must follow the rules. They include

Anyone who participates in the attest engagement.

Anyone who can influence the attest engagement or the attest engagement team.

The firm (entity) providing attest services.

All entities that are controlled by any of the above people or entities.

The concept underlying the engagement team approach is that the actions and judgments of those closest to the attest engagement, namely those who actually perform the services, pose the greatest risk to independence. Recognizing that the engagement team does not exist in a vacuum and is influenced by others within the firm, the rules also extend to those who could influence the attest engagement or the attest engagement team—for example, those firm members who set compensation for the attest engagement partners or who oversee the team’s activities. The focus in the engagement team approach places the spotlight on the engagement team rather than on the entire firm.

Independence and the
Accounting Profession

I ndependence has long been the bedrock of the accounting profession and is a critical prerequisite for attesting to the fair presentation of financial information. Users of that information (creditors, investors, audit committees and other interested parties) make business decisions with the expectation that the firm providing attest services did so without an unacceptable risk of outside influence or bias.

Due to its critical importance in protecting the public interest and its inherently subjective nature, independence has been interpreted by the accounting profession through various standard-setting and regulatory bodies, such as the AICPA, the SEC, the Independence Standards Board, the International Federation of Accountants and others. Independence interpretations range from the simplest of rules (such as the prohibition against owning stock in your client) to rules on employment by family members, alternative practice structures and indirect investments. Some carry the force of law (for example, the SEC rules—which apply to audits of public companies), and others are standards set by the profession through the public exposure process over time.

Regardless of the complexity of the issue being addressed, the main objective in interpreting independence for the profession has been, and continues to be—to assure to the degree possible—that persons rendering attest services have the proper mind set. No less important is the appearance of independence to a reasonable person who knows all the relevant facts and circumstances and is able to conclude whether professionals rendering attest services can exercise objective and impartial judgment.

A TIME FOR CHANGE

Independence rules based on the firmwide approach made sense when firms were smaller and less diversified, but now standard setters and regulators acknowledge that a fresh look at them is warranted because of recent changes in the business environment and in society:

Dual income families now have become the norm.

Incidences of spouses employed in high-level management positions with clients, which were once rare, have increased significantly.

There has been increased use of stock options as a form of employee compensation.

Globalization of client entities due to mergers and acquisitions between U.S. and international companies has ballooned.

Professionals are increasingly mobile because of a proliferation of telecommunications and more flexible work arrangements.

Further, the way accounting firms are structured and do business has changed as a result of globalization, restructurings, affiliations with both non-CPA firms and CPA firms, and planned public offerings.

Prior to the recent revisions, the SEC rules had remained largely unchanged since their introduction in the 1930s. Other rules—those of the AICPA and some state boards and state CPA societies—have gone through various modifications over the last several decades. The profession’s standard setters recognize that the existing rules do not accurately reflect developments in society and business. They know that more is needed.

SAFEGUARDING INDEPENDENCE
UNDER THE NEW APPROACH

Independence prohibitions are based on the premise that a firm’s independence is threatened when a member of the firm has certain relationships with an attest client (for example, a member’s spouse is employed by a client or the member has a loan with a client). The engagement team approach recognizes that, in certain cases, some threats to independence may be reduced to an acceptably low level if practitioners simply apply proper rules and use accompanying independence safeguards.

For example, a tax manager’s spouse owns a small amount of stock in the firm’s audit clients. The firm performs all audits from a single office location. Under the engagement team approach, the firm would prohibit the tax manager from providing any services to the client and would forbid his or her involvement with the audit engagement team. Combined with some of the safeguards discussed below, these steps would sufficiently mitigate the threat that the tax manager would unduly influence the audit engagement team or the engagement itself. However, under existing AICPA independence rules, there are only three options:

The spouse must immediately sell the investment in the client.

The tax manager must resign from the firm.

The firm must terminate its relationship with the client.

Using the engagement team approach, the firm may perform the audit provided it effectively segregates the tax manager from the audit engagement and the engagement team, thus avoiding any possibility of influence. If the firm is unable to effectively separate the manager from the engagement, it would have to consider the choices required under firmwide rules.

It is important to note that under certain conditions, threats to independence cannot be sufficiently mitigated using engagement-team-based rules and safeguards. An example of a situation that could not be addressed using the rules and safeguards is when a person on the attest engagement team has a financial interest in the client. (On the other hand, an unrelated tax manager can have a financial interest in the client as long as he or she is completely uninvolved with the client and the engagement team.)

INDEPENDENCE SAFEGUARDS

Over the last several years, the accounting profession has steadily developed more and better safeguards to protect and maintain firms’ independence. They include

Having the firm’s leadership set the proper “tone at the top” by stressing the importance of independence for all professional staff.

Communicating with the client’s audit committee or with the board of directors on matters that may affect the firm’s independence.

Participating in AICPA/state CPA society peer review programs.

Implementing quality control standards, which include independence policies that are actively communicated to partners and professional staff, including regular training and education.

Internal monitoring and compliance to ensure that the firm and its personnel comply with independence policies.

Requiring professional staff to communicate to firm senior management any independence and objectivity issues that concern them.

Where appropriate, involving an independent partner, who did not take part in the attest engagement, to review the work.

Enrolling in the AICPA SEC practice section, which requires firms to adhere to strict requirements regarding independence, including (in part) monitoring professionals’ investment portfolios, affirming independence periodically in writing and maintaining specific policies and educating professionals on independence.

Where appropriate, rotating the firm’s engagement partner.

Being aware of the threats to the firm’s reputation that would result from litigation or disciplinary or regulatory actions.

WHAT THIS NEW APPROACH MEANS TO FIRMS

The exhibit on below shows how three practices—(A) a small firm, (B) a midsize regional firm and (C) an international firm—apply current AICPA rules and their obligations under the new approach.

Note that existing rules stress the individual’s position within the firm and, in the case of the small firm (practice A), require that all owners and managers avoid interests and relationships that would impair independence with respect to all the attest clients, regardless of whether they can affect those engagements. In contrast, the engagement-team-based rules require only those who can actually affect the attest engagement (or the attest engagement team) to adhere to the rules with respect to a particular client. Hence, the proposed rules put the focus on each engagement as opposed to using a “blanket” or firmwide approach to independence.

Note too that engagement-team-based rules would eliminate a firm’s need to determine which offices provided significant attest services (often a complex, judgmental determination) to particular clients for purposes of identifying and monitoring managers’ relationships with attest clients. For midsize to large firms, such identification and monitoring could involve hundreds or thousands of individuals. These determinations have been further complicated by greater flexibility in the workplace and a steady move toward industry and line-of-service-based office structures, which have significantly changed the way professionals work and interact.

BENEFITS OF THE ENGAGEMENT TEAM APPROACH

The engagement-team-based approach offers advantages for all constituencies:

The public. Financial statement users (such as creditors, analysts, investors, audit committees and boards of directors) will benefit from independence rules that are easier to apply because they are more logical and intuitive. Audit committees and boards of directors in particular will be better able to make informed decisions about the independence of their companies’ auditors.

The client. Clients will realize the same benefits as the public, and straightforward independence rules should reduce disruptions due to inadvertent violations. Such violations, which often are the result of a professional’s confusion about the rules, could also surface after the completion of an attest engagement. Any move, therefore, to simplify the rules could also help to prevent situations in which a firm has to consider withdrawing its previously issued report. The lower likelihood of these events, which come at great cost to both attest firms and their clients, should decrease costs for attest services.

The attest firm. When the public and the client benefit, so do attest firms. Simplification may also reduce costs of identifying staff independence issues and monitoring compliance with the rules, which, in turn, could translate to lower costs for clients and the public for attest engagements. In addition, less burdensome rules should help accounting firms attract and retain professionals, a serious problem that has left many firms struggling to compete for the best available talent.

CHANGES OVERDUE

Independence is the cornerstone of the accounting profession and a critical and unique precondition for providing attest services. The profession recognizes that changes to the independence rules are necessary and overdue, given the seismic shifts in society and business that have altered the environment in which attest firms operate.

The SEC issued its omnibus revision to its independence rules, which incorporate the engagement team approach. The AICPA, IFAC and the ISB have similarly endorsed this approach in their latest deliberations and rule proposals. After much debate and thoughtful discussion, the profession’s standard setters and regulators have determined that the engagement team approach will both modernize and enhance the current rules. The resulting rules will be more intuitive and relevant, which will ultimately benefit attest clients, firms and the public.

The Rules: Old vs. New
Firm A: Local
4 partners (2 audit, 2 tax)

3 managers (1 audit, 2 tax)

6 staff (3 audit, 3 tax)

Single office firm

26 attest clients

EXISTING AICPA RULES—Who must comply?

  • All partners (4) must be independent of all 26 attest clients.
  • All managers (3) must be independent of all 26 attest clients.
  • Audit staff and any tax staff providing attest-related services to a client must remain independent with respect to that client.
  • The firm (entity) providing attest services.
  • Any entity controlled by any of the above people or entities.
Firm B: Regional
50 partners (22 audit, 18 tax, 10 consulting)

41 managers (20 audit, 14 tax, 7 consulting)

85 staff (35 audit, 30 tax, 20 consulting)

Six offices

200 attest clients

EXISTING AICPA RULES—Who must comply?

  • All partners (50) must be independent of all 200 attest clients.
  • Managers must be independent of all attest clients that receive a significant amount of attest services from personnel based in the same office and with respect to any attest clients to which they provide attest services.
  • Audit, tax and consulting staff providing attest or attest-related services to a client must remain independent with respect to that client.
  • The firm (entity) providing attest services.
  • Any entity controlled by any of the above people or entities.
Firm C: International
2,300 partners (900 audit, 800 tax, 600 consulting)

3,800 managers (1,500 audit, 1,300 tax, 1,000 consulting)

6,400 staff (2,100 audit, 2,200 tax, 2,100 consulting)

80 offices (worldwide)

4,500 attest clients

EXISTING AICPA RULES—Who must comply?

  • All partners (2,300) must be independent of all 4,500 attest clients.
  • Managers must be independent of all attest clients that receive a significant amount of attest services from personnel based in the same office and with respect to any attest clients to which they provide attest services.
  • Audit, tax and consulting staff providing attest or attest-related services to a client must remain independent with respect to that client.
  • The firm (entity) providing attest services.
  • Any entity controlled by any of the above persons or entities.

For All Firms

ENGAGEMENT-TEAM-BASED RULES—Who must comply?

  • A partner or professional employee who participates in an attest engagement for a client.
  • A partner or professional employee who can influence the attest engagement or the attest engagement team for a client.
  • The firm (entity) providing attest services.
  • Any entity controlled by any of the above persons or entities.
These Web sites contain information on the status of engagement-team independence rules and proposals:

AICPA: www.aicpa.org/members/div/ethics/ethicdiv.htm

IFAC: www.ifac.org/Members/Source_Files/Exposure_Drafts/EXD-Eth-Final_Independence.pdf

ISB: www.cpaindependence.org

SEC: www.sec.gov/rules/final/33-7919.htm.

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