Affiliations between entities have steadily increased over the years. Due to factors such as mergers and acquisitions, the proliferation of private equity, and the manner in which companies sponsor employee benefit plans, even smaller companies can have numerous related entities or "affiliates." Independence rules apply when a CPA firm (firm) has an attest relationship with an entity (an attest client), but when do those rules apply to an attest client's affiliates? And which independence rules apply? This article seeks to answer these important questions.
"Affiliate" is defined in Definitions in the AICPA Code of Professional Conduct (the Code) (ET §0.400.02) and applies solely to a "financial statement attest client" (FSAC), which is also defined (ET §0.400.16). An FSAC exists when a firm performs any of the following attest services for an entity:
- Financial statements audit or review; or
- Financial statement compilation that does not disclose a lack of independence.
When a firm provides these types of attest services to a client, the client is an FSAC, and the Code requires the firm to identify all of the FSAC's affiliates.
The affiliates described in items a-l of the Affiliate definition (ET §0.400.02) are categorized and summarized below.
Entity is 'downstream' from FSAC
An FSAC controls the entity (item a) or has significant influence over an entity and the entity is material to the FSAC (item b).
Examples and illustrations key: Audit Client (AC); Affiliate (AF); Controlling Entity (CE).
- Your audit client (AC) has a controlled subsidiary (AF), or
- AC owns 30% of an entity's (AF's) common stock (i.e., has significant influence over AF), which is material to AC.
Entity is 'upstream' from FSAC
An entity controls an FSAC or has significant influence over an FSAC and the FSAC is material to the entity (items c and d, respectively).
- An entity (AF) controls your audit client (AC), or
- AF owns 40% of AC's common stock (i.e., has significant influence over AC), and the investment is material to AF.
Entity and FSAC are under common control
An entity controls an FSAC and another entity (sister entities) and each sister entity is material to the controlling entity (item e).
- Your audit client (AC) and an entity (AF) are each owned 100% by another controlling entity (CE). AC is material to CE; AF is material to CE.
Entity is associated with FSAC employee benefit plan
- A single employer sponsors an employee benefit plan FSAC (item g).
- A participating employer, union, or group of employers has significant influence over a multiemployer employee benefit plan FSAC and the plan is material to the employer, union, or group of employers (item h).
- A participating employer is the administrator of a multiple employer employee benefit plan FSAC (item i).
- An entity (AF) is the sole sponsor of a Sec. 401(k) plan that is your audit client (AC), or
- AF participates in a multiemployer employee benefit plan (AC) with two other entities (Y and Z); AF has significant influence over AC and the investment is material to AF, or
- AF administers a health and welfare plan (AC).
Employee benefit plan is associated with FSAC
- An FSAC (or entity the FSAC controls) sponsors a single or multiple employer employee benefit plan (item j).
- An FSAC (or entity the FSAC controls) has significant influence over a multiemployer employee benefit plan and the plan is material to the FSAC (item k).
- Your audit client (AC) is the sole sponsor of a Sec. 401(k) plan (AF), or
- AC has significant influence over a multiemployer health insurance plan (AF) that is material to AC.
Entity is trustee, investment adviser, or general partner
- A trustee that is not an investment company (fund) controls an FSAC (item f).
- A(n) investment adviser, general partner, or trustee has significant influence or control over an FSAC investment company (fund), and the fund is material to the investment adviser, general partner, or trustee (item l).
- A financial institution (AF) is the trustee for your trust account audit client (AC), which AF controls, or
- A general partner (AF) owns 40% of a private-equity fund (AC) that is material to AF.
HOW DO THE INDEPENDENCE RULES APPLY TO AFFILIATES?
Once you've identified the affiliates of an FSAC, the "Affiliates, Including State and Local Government Affiliates" subtopic (ET §1.224) of the "Independence Rule" dictates how the independence rules apply to those entities. If the FSAC is a state or local government entity, the "State and Local Government Client Affiliates" interpretation (ET §1.224.020) applies (but due to space constraints, will not be addressed in this article). The "Client Affiliates" interpretation (ET §1.224.010) applies to all other FSACs and is described next.
The "Client Affiliates" interpretation notes that interests in and relationships with affiliates of an FSAC may create threats to independence. So, the general rule is that the same independence rules that apply to an FSAC apply to the FSAC's affiliates. That said, the rule provides several exceptions, which are summarized below. Most of the exceptions do not apply to FSAC affiliates that are included in the FSAC's consolidated financial statements (that is, they exclude items a and b in the Affiliate definition; the "downstream" affiliates). Exceptions applicable only to items c—l in the Affiliate definition are indicated for each item below:
Nonattest service performed for (item c-l) affiliate of FSAC
A firm may be permitted to provide otherwise prohibited nonattest services to an item c-l affiliate of an FSAC if two conditions are met: (1) it is reasonable to conclude that the services do not create a self-review threat with respect to the FSAC because the results of the nonattest services will not be subject to financial statement attest procedures; and (2) for any other threats that are not at an acceptable level, the firm applies safeguards to eliminate or reduce the threats to an acceptable level (ET §1.224.010.02(b)).
Illustration: Your firm provides temporary CFO services to an affiliate (AF) that is a sister company of your audit client (AC). AF and AC are completely separate companies that are separately managed and share no systems or other resources. Based on these facts, your firm concludes that performing these otherwise prohibited services to AF would not create self-review, management participation, or other threats to independence (either in fact or appearance) when performing the audit of AC.
Subsequent employment of former firm employee in key position at (item c-l) affiliate of FSAC
A firm would not be required to apply the safeguards described in the "Subsequent Employment or Association With an Attest Client" interpretation (ET §1.279.020) if a former employee of the firm takes a key position with an item c-l affiliate of an FSAC that would not be considered a key position with the FSAC.
Illustration: You leave your firm to become the CFO of a sister entity (AF) that is structurally and operationally separate from your firm's audit client (AC). Clearly, the CFO role is a key position (see the sidebar, "Definition of 'Key Position' "). However, due to the separation of AC and AF, your firm concludes that your serving as the CFO of AF will not be considered a key position at AC and, therefore, not impact your firm's independence with respect to AC.
Employment of covered member's family in key position at (item c-l) affiliate of FSAC
A covered member's immediate family or close relative may be employed in a key position at an item c-l affiliate of an FSAC during the period of the professional engagement or period covered by the financial statements if the family member is not in a key position with respect to the FSAC (ET §1.224.010.02(d)).
Illustration: You are the engagement partner for three employee benefits plans (AC1, AC2, and AC3 — the plans). A participating employer in the plans (AF) offers the controller position to your spouse, so the question is whether this position at AF would equate to a key position at the plans. Questions to ask are, "Would your spouse be responsible for preparing the plans' financial statements or for significant accounting functions underlying those statements?" and "Would your spouse be able to exercise influence over the plans' financial statements?" If the answer to either of these questions is "yes," independence would be impaired (that is, the exception cannot be applied).
Lease arrangement with (item c-l) affiliate of FSAC
The firm, an attest engagement team member, or person able to influence the attest engagement may have a lease arrangement with an item c-l affiliate of an FSAC that does not meet the requirements of the "Leases" interpretation (ET §1.260.040) if the firm evaluates threats using the "Conceptual Framework for Independence" interpretation (ET §1.210.010) (Conceptual Framework) and concludes that threats are at an acceptable level.
Illustration: Your firm would like to lease office space from an audit client's (AC's) parent company (AF). The arrangement does not meet the requirements of the "Leases" interpretation because the lease expense would be material to the firm. The firm concludes that threats to its independence are significant (not at an acceptable level) but believes that a second review of the audit by an independent professional unaffiliated with the engagement would sufficiently reduce the threat to an acceptable level. The firm will also have a discussion with AC's and AF's governance bodies to determine whether the lease arrangement raises any concerns regarding the firm's independence and discuss the safeguard (i.e., second review of the audit engagement by an outside professional) the firm proposes to apply.
Staff augmentation arrangement with (item c-l) affiliate of FSAC
A firm may enter into an otherwise impermissible staff augmentation (loaned staff) arrangement with an item c-l affiliate of an FSAC affiliate if the firm evaluates threats using the Conceptual Framework and concludes that threats are at an acceptable level (ET §1.224.010.02(f)).
Illustration: The sole sponsor (AF) of an employee benefit plan audit client (AC) suffers significant data loss from a cyberattack and asks the audit firm to lend staff to assist it in reassembling certain information, including participant records and other plan-related information. The firm evaluates the situation using the Conceptual Framework and concludes that it should not enter into the arrangement because the nature of the work would create significant self-review and management participation threats to independence that safeguards could not reduce to an acceptable level.
Loan to or from certain individuals associated with an affiliate of FSAC
A covered member may have a loan with an individual who is an officer, director, or 10% or more owner of an affiliate of an FSAC during the period of the professional engagement unless the covered member knows (or should know) of the person's association with the affiliate, in which case the firm should evaluate threats to independence using the Conceptual Framework. (See the note below.)
Nonclient or nonattest client acquires FSAC
A firm's interest in or relationship with a nonclient (or nonattest client) that acquires or merges with an FSAC may impair its independence due to the creation of an affiliate relationship with the FSAC. This exception states that independence would not be impaired if: (1) the firm's attest engagement covers only periods prior to the transaction and (2) the firm will cease providing financial statement attest services to the acquirer (affiliate). (The firm should also consider potential conflicts of interest.)
Note: As part of an SEC Rule 2-01 convergence project, the AICPA's Professional Ethics Executive Committee (PEEC) recently adopted changes to the "Client Affiliates" (and other) interpretations, which will be effective on Dec. 31, 2022, with early implementation permitted. These changes are not reflected in the preceding paragraph.
IDENTIFYING AND MONITORING AFFILIATES
Identifying affiliates of an FSAC can be challenging, particularly in the private-equity (PE) environment, which impacts more accounting firms than ever before. For example, an FSAC's sister portfolio company may have little interest in sharing nonpublic information with your firm (i.e., whether the sister company is material to the controlling PE fund).
Due to these challenges, the Code requires firms to employ "best efforts" to obtain the information needed to identify client affiliates (ET §1.224.010.03).
If, after expending best efforts, a firm cannot obtain the information to determine which entities are affiliates of an FSAC, the firm should take the following steps to avoid an independence impairment:
- Discuss the matter, including the possible impact on independence, with the FSAC's governance body.
- Document the results of the discussion and efforts taken to obtain the information.
- Obtain written assurance from the FSAC that it cannot provide the information.
Once the firm identifies an FSAC's affiliates, the audit team should monitor the information carefully to avoid independence impairments.
Implementing a variety of policies and procedures — including periodic testing of their effectiveness — to identify and monitor affiliates of FSACs can help ensure firms' ongoing compliance with the independence rules. For example, a firm can:
- Explain to the FSAC that accurate, timely information is needed to maintain independence;
- Obtain the FSAC's cooperation to provide the data and communicate changes on a timely basis (e.g., planned acquisition or merger);
- Include provisions in the firm's engagement letters requiring the FSAC's cooperation;
- Implement policies and procedures that prompt the audit team to seek affiliate-related information from the FSAC periodically and consistently;
- Periodically test the effectiveness of the firm's policies and procedures to identify and monitor FSAC affiliates; or
- Employ online tools or services that monitor activities that impact companies' structure and holdings.
Definition of 'key position'
A "key position" is a position in which an individual has:
- Primary responsibility for significant accounting functions that support material components of the financial statements;
- Primary responsibility for the preparation of the financial statements; or
- The ability to exercise influence over the contents of the financial statements, including when the individual is a member of the board of directors or similar governing body, CEO, president, CFO, COO, general counsel, chief accounting officer, controller, director of internal audit, director of financial reporting, treasurer, or any equivalent position.
For purposes of attest engagements not involving financial statements, a key position is one in which an individual is primarily responsible for, or able to influence, the subject matter of the attest engagement.
About the author
Cathy Allen, CPA, is the managing member of Audit Conduct LLC (auditconduct.com), which provides customized self-study courses on auditor independence and professional ethics for CPA firms and other organizations. She has been a member of the AICPA Professional Ethics Executive Committee (PEEC) since May 2020. All views expressed in this article are her own and do not represent official positions of either PEEC or the AICPA. To comment on this article or to suggest an idea for another article, contact Courtney Vien at Courtney.Vien@aicpa-cima.com.
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"Ethics Quiz: Affiliates, Confidentiality, and More," JofA, May 1, 2019
Frequently Asked Questions: General Ethics