EXECUTIVE SUMMARY
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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.”
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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.
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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.
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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.
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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
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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.
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