Suppose you audit a company that leases apartments and office space to individuals and companies. Should you be allowed to lease your apartment from your client? Should your firm be allowed to lease office space from the client?
Recently, the AICPA revised its interpretation “Leases” (ET §1.260.040) in the Code of Professional Conduct (the Code). The interpretation prescribes when a lease with an attest client impairs, or may impair, independence.
The interpretation represents a significant change from the existing rule, which permits operating leases under certain conditions but prohibits capital leases as those terms are (were) defined in GAAP. Changes to GAAP drove the AICPA to reconsider the leases standard.
This article walks through the requirements of the revised leases interpretation.
Leases and independence
Lease arrangements with attest clients can raise self-interest, familiarity, and undue influence threats to independence:
- Self-interest threat is the threat that a member could benefit, financially or otherwise, from an interest in, or relationship with, an attest client.
- Familiarity threat is the threat that, because of a long or close relationship with an attest client, a member will become too sympathetic to the attest client’s interests or too accepting of the attest client’s work or product.
- Undue influence threat is the threat that a member will subordinate his or her judgment to that of an individual associated with an attest client or any relevant third party due to that individual’s reputation or expertise, aggressive or dominant personality, or attempts to coerce or exercise excessive influence over the member.
Many independence rules apply to “covered members” — the persons or entities required to be independent of a firm’s attest clients. The strictest requirements apply to a subset of covered members, the: (1) accounting firm; (2) persons on the attest engagement team; and (3) persons able to influence the attest engagement (“certain covered members”).
Split into two sections, the new leases rule takes two approaches:
- New or renegotiated leases require certain covered members to apply explicit safeguards to avoid an independence impairment.
- Existing leases require certain covered members to evaluate whether threats to independence, using the “Conceptual Framework for Independence” (ET § 1.210.010), are significant, and if so, apply safeguards to eliminate threats or reduce them to an acceptable level.
New or renegotiated leases
The most stringent rule applies when certain covered members enter into a new lease or renegotiate an existing lease during the period of professional engagement, that is, with a current attest client.
An example: Diane is the audit manager for her firm’s engagement with Tealgrass Properties and is professionally obligated to be independent of Tealgrass. Under the revised rule, she should not obtain a new lease or renegotiate the terms of her existing lease with Tealgrass unless the lease is:
- On market terms and established at arm’s length, and
- Not material to any of the parties of the lease (if there are multiple leases, consider materiality in the aggregate).
The lease would not impair independence if the above safeguards are met. However, Diane must also comply with all the lease terms (for example, by making timely lease payments according to the agreement) throughout the period of the professional engagement, or independence will be impaired.
Existing leases are those that certain covered members entered into or renegotiated before they had a professional obligation to be independent of the other party to the lease. For example, this may occur prior to:
- The period of professional engagement;
- Becoming a covered member; or
- The lessor becoming an attest client or an affiliate of a financial statement attest client.
Assume a different set of facts: Diane signed a condominium lease with Tealgrass in 2017 before Tealgrass was an attest client of her firm. In 2018, Tealgrass engages her firm to perform annual audits and the firm wants to assign Diane to the engagement. The firm should evaluate the threats to independence using the conceptual framework; if threat(s) are significant, safeguards should eliminate the threat(s) or reduce them to an acceptable level.
In connection with “independence,” an acceptable level is a level at which a reasonable and informed third party who is aware of the relevant information would be expected to conclude that a “member’s independence” is not “impaired.” When used in connection with any rule but the “Independence Rule” (ET §1.200.001), an acceptable level is a level at which a reasonable and informed third party who is aware of the relevant information would be expected to conclude that a “member’s” compliance with the rules is not compromised.
Which threats are significant?
It takes professional judgment to evaluate threats and determine whether they are significant. Diane and her firm can consider various factors such as:
- Her role on the attest engagement team and in the firm.
- The number of leases Diane has with Tealgrass.
- The (combined) materiality of the lease(s) to either Diane or Tealgrass.
- The likelihood of the lease(s) being subject to audit or other attest procedures.
- The duration of the lease(s).
- The extent to which Diane’s lease(s) would be included in the client’s financial statement disclosures.
On one hand, threats to the appearance of independence would likely be more significant if Diane were the company’s audit partner as opposed to an intern on the job. However, as an intern, there’s a greater chance that the lease could be material to her net worth. Perhaps other covered members in the firm have leases with the client that should be considered. If Tealgrass has a large portfolio of leases, Diane’s (or others’) leases may have little to no bearing on the client’s financial statement disclosures, and the odds that her (or others’) leases would be selected for audit are rather minuscule. If leasing is only a small part of the client’s business, though, threats would be potentially greater.
Let’s assume Diane practices in an accounting firm with four partners, six managers, and several professional staff. The lease is not material to her net worth. Nevertheless, the firm concludes that the self-interest threat to independence (or at least the appearance of self-interest) is significant. The next question is: Can safeguards eliminate or reduce the threat to an acceptable level?
Safeguards are actions or other measures that may eliminate a threat or reduce a threat to an acceptable level. Safeguards the firm could consider include:
- Discussing the matter with the client’s audit committee or other governance body.
- Engaging a professional (from outside the firm or someone from within the firm who is not otherwise associated with the engagement) to review the work done for the client or otherwise advise the engagement team.
- Excluding Diane from the attest engagement team.
The partners would like to exclude Diane from the engagement, which would eliminate the threat; however, the firm is short-staffed and needs her services on this engagement. They decide that an independent partner in the firm will perform a second review of her work, which they believe will reduce threats to an acceptable level.
They will also discuss the matter with the client’s board to gauge their comfort level with the situation. If they proceed, the audit partner will also document the firm’s review of the matter and how it concluded that independence was not impaired. As before, Diane must remain in full compliance with all lease terms throughout the professional engagement period.
Fast-forward one year: Due to unforeseen changes in her finances, Diane’s lease has become material to her net worth. The firm should reevaluate threats to independence, particularly whether they still believe the second review of her work will continue to reduce threats to an acceptable level.
Lease with an audit client affiliate
So far, this article has addressed how the Code applies when you have a lease with your audit client, but could your independence be affected if you have a lease with an affiliate of your financial statement attest client? The answer is: possibly.
A financial statement attest client is an entity whose “financial statements” are audited, reviewed, or compiled when the “member’s” compilation report does not disclose a lack of “independence.” This term is used in the “Client Affiliates” interpretation (ET §1.224.010) of the “Independence Rule” (ET §1.200.001) and in the definition of an “affiliate” (ET §0.400.02).
ET Section 0.400.02, Affiliate, defines several relationships with a financial statement attest client that, unless exempted, may impact independence. In revising the leases standard, the AICPA also revised ET Section 1.224.010, Client Affiliates, by adding an exemption for leases held with certain types of affiliates.
First, the exemption does not apply to:
- Entities your client controls, and
- Entities in which the client has a material equity method investment.
For those affiliates to which the exemption does not apply, you should comply with the same rules that apply to a lease with your attest client. For all other affiliates, you should apply the Code’s conceptual framework for independence.
Here’s a quick example: Sophia is scheduled to audit ABC Company but has a lease with one of ABC’s subsidiaries. Sophia must apply the same safeguards as if her lease was with her audit client, ABC. The answer would be the same if her lease was with an ABC 30%-owned company that is also material to ABC.
If, however, her lease is with ABC’s parent company or her audit client is ABC’s employee benefit plan and her lease is with ABC (the sponsor of the benefit plan/client), she should evaluate threats to her independence using the conceptual framework and determine whether safeguards are needed.
A final item to note is that the “Leases” interpretation excludes automobile leases, which continue to be addressed in paragraph .04 of the “Loans and Leases With Lending Institutions” interpretation (ET §1.260.020).
Significant revision takes effect soon
The revised leases interpretation goes into effect for fiscal years beginning after Dec. 15, 2019, which gives firms time to amend their policies and procedures and address any existing leases held by certain covered members. Early implementation is allowed.
This is a significant revision to the independence rules. For example, the existing rules allow operating leases if they are obtained at arm’s length and kept current. Applying the new rule to a new, renegotiated, or existing lease could lead to a very different answer, so it’s important to be aware of the change.
— Catherine R. Allen, CPA, (firstname.lastname@example.org) specializes in ethics and independence through her consulting firm at Audit Conduct LLC in New York. To comment on this article or to suggest an idea for another article, contact Ken Tysiac, the JofA’s editorial director, at Kenneth.Tysiac@aicpa-cima.com or 919-402-2112.