Office of the Chief Accountant:
Regarding Auditor Independence
Letter to Arthur Andersen & Co., 1989
May 12, 2017
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
February 14, 1989
Mr. Duane R. Kullberg
Arthur Andersen & Co.
69 West Washington Street
Chicago. Illinois 60602
Dear Mr. Kullberg:
This letter responds to the petition, "In the Matter of Clarification or Modification of Section 602.02.g of the Codification of Financial Reporting Policies", filed March 29, 1988 by Arthur Andersen & Co., Peat Marwick Main & Co., and Price Waterhouse, and supplemented by Arthur Andersen & Co. on October 7, 1988. That petition requested the Commission to modify Section 602.02.g of the Codification of Financial Reporting Policies ("Section 602.02.g") to incorporate a materiality standard to be used in evaluating the independence of an accountant with respect to an audit client with whom the accountant has entered into a prime or subcontractor arrangement (or any other similar cooperative service arrangement). The Commission has carefully considered the petition, as supplemented, and has determined, for the reasons explained more fully below, to deny your request to modify Section 602.02.g.
The petition expressly states that the petitioners "ask only that Section 602.02.g be modified to permit the application of a materiality standard in determining whether specific prime or subcontractor arrangements with audit clients are to be prohibited." Petition at 16.1 Pursuant to the petition's suggested standard, an auditor's independence would be deemed to be impaired only where the prime/subcontractor relationship was found to be material to either the auditor or the audit client.
The petition advances a number of arguments in support of the proposed modification. It argues that the staff's present interpretation of Section 602.02.g, which contains no materiality standard for direct business relationships, is anticompetitive in that it deprives the accountant of an opportunity to compete by providing services in combination with its audit clients; is injurious to the public interest in that the public is deprived of the efficient delivery of the prime/subcontractor's technical non-attest services; and does not further any "countervailing public benefit" because no studies or evidence show that independence is diminished by the prime/subcontractor relationship. The petition also contends that the staff's present interpretation leads to irrational and arbitrary results because, while an accountant may provide non-attest services for an audit client's own use, the provision of such services is forbidden if the client intends to combine the services with its own and sell the entire package to a third party.
Finally, in support of the contention that Section 602.02.g should not be construed to encompass all prime/subcontractor relationships, the petition asserts that Section 602.02.g is intended to apply primarily to co-investments between accountants and their audit clients, and that the prime/subcontractor relationship satisfies the exception to the general prohibition set forth in Section 602.02.g, since such relationships "are in fact "in the normal course of business" for professional service firms". Petition at 14.
The federal securities laws require, or authorize the Commission to require, registrants to file with the Commission financial statements that have been certified by an independent public or certified accountant.2 The Commission has the authority to define accounting terms such as "independent."3 Rule 2-01 of Regulation S-X, 17 C.F.R. 210.2-01 ("Qualifications of Accountants"), states that under certain conditions the Commission may recognize that an accountant is not independent. Rule 2-01 does not contain particular objective standards for determining whether an accountant is independent because such a determination must be made in view of all pertinent facts and circumstances of a particular case.
In Section 600 of the Codification of Financial Reporting Policies ("Codification"), the Commission has included discussions on the topic of independence and examples of situations in which an accountant's independence may or may not be deemed impaired. More specifically, Section 602.02.g of the Codification4 contains the Commission's views regarding the effect of business relationships between an auditor and its audit client (or persons associated with the client in a decision-making capacity) on the auditor's independence with respect to the audit of that client. That section indicates that a direct [or] material indirect business relationship, other than as a consumer in the normal course of business" with the client "will adversely affect the accountant's independence with respect to that client." The staff has interpreted Section 602.02.g to preclude an auditor and its client from entering into a prime/subcontractor relationship for the purpose of jointly providing services to a third party without reference to the materiality of the relationship to either party. It is this interpretation that is challenged in the petition.
In analyzing an auditor's independence, it is important to keep in mind that the concept requires both the appearance of independence and independence in fact on the part of the auditor. As the Commission stated in Section 602.01 of the Codification:
The Commission views both the fact and appearance of independence as essential in order that the public may justifiably view the audit process as a wholly unbiased review of management's presentation of the corporate financial picture.
The need for auditors not only to be independent in fact, but also to maintain the public appearance of independence, has also been recognized by the United States Supreme Court,5 Congress,6 and the National Commission on Fraudulent Financial Reporting.7
The Commission has recognized that certain situations, including those in which accountants and their audit clients have joined together in a profit-seeking venture, create a unity of interest between the accountant and client. In such cases, both the revenue accruing to each party in the prime/subcontractor relationship and the existence of the relationship itself create a situation in which to some degree the auditor's interest is wedded to that of its client. That interdependence impairs the auditor's independence, irrespective of whether the audit was in fact performed in an objective, critical fashion. Where such a unity of interests exists, there is an appearance that the auditor has lost the objectivity and skepticism necessary to take a critical second look at management's representations in the financial statements. The consequence is a loss of confidence in the integrity of the financial statements. Application of the type of materiality standard proposed in the petition would fail to protect adequately against the loss of independence and the appearance of auditor partiality that result from this type of relationship.
In support of the application of a materiality standard, the petition asserts that the present interpretation by the staff is anticompetitive, injurious to the public interest, and unsupported by data reflecting a countervailing public benefit. The Commission disagrees with each of these assertions.
The petition argues that the staff interpretation is anticompetitive in that it denies the accountant an opportunity to compete by providing services in combination with its audit clients. The accountant is precluded only from entering into a direct business relationship with an existing audit client. The accountant is thus free to enter into the relationship with any party unless the direct business relationship is in effect during the period covered by financial statements upon which the accountant expresses an opinion for that party, or during the period when the accountant is conducting an audit of that party. In addition, the Commission would not raise an independence question if the party receiving the combined services contracted separately with the auditor and the audit client for their respective portions of the service engagement, thereby separating the accountant's liability and contractual obligations from those of its audit client (unless the arrangement is considered to be a material indirect business relationship). Moreover, any anticompetitive effect that arguably results from the staff's present interpretation of Section 602.02.g must be weighed against the public benefit derived from the heightened perception of auditor independence.8
The petition also asserts that the staff interpretation is injurious to the public interest because the public is deprived of the efficient delivery of the prime/subcontractor's technical non-attest services. The public interest with which the Commission is concerned, however, is the assurance of the integrity of financial statements filed with it. As discussed above, it is this objective which requires independence and the appearance of independence on the part of the auditors of those financial statements. Moreover, certain alternatives, as discussed above, are available to accountants in providing non-attest services, making it possible for the public to receive such services.
The petition goes on to assert that there is no "evidence of any countervailing public benefit" in that no studies or evidence show that independence is diminished by the prime/subcontractor relationship. Petition at 15. However, all direct business relationships between an auditor and its client, other than as those in which the auditor acts as a consumer in the normal course of business, raise independence concerns, and nothing in the Commission's experience indicates that there is some factor in the prime/subcontractor relationship that obviates this concern. As noted above, the public does benefit from the current staff interpretation through increased confidence in the independence of auditors.
The petition contends that the staff's present interpretation leads to irrational and arbitrary results because an accountant may provide non-attest services for the client's own use, but may not provide those services as a subcontractor to the same client, who would combine the services with its own and sell the entire package to a third party. The providing of services directly to a client for the client's own use ordinarily would not present the unified interest between the auditor and client that is present in the prime/subcontractor relationship. In providing non-attest services to a client, the auditor's revenues are in no way dependent upon the efforts of the client.
Conversely, in the prime/subcontractor relationship, the auditor and client are coventurers whose revenues are interdependent. As noted above, the impaired auditor independence and perception of impaired independence that result cannot be corrected through the application of the type of materiality standard suggested by the petition.
The Commission believes that it should also address the concerns expressed in the petition as to the applicability of Section 602.02.g to the prime/subcontractor relationship, although the petition notes that the petitioners are not asking that Section 602.02.g be modified to render it "totally inapplicable" to the prime/subcontractor arrangements described in the petition. The petition contends that Section 602.02.g is not intended to be applied to the prime/subcontractor relationship. In support of this proposition, the petition notes that the prime/subcontractor relationship is not mentioned in the section and posits that the section is intended to apply primarily to co-investments between the auditor and its client.
It is the Commission's view that Section 602.02.g is applicable to the prime/subcontractor relationship. The list of prohibited business relationships in Section 602.02.g is intended to be illustrative only, and does not purport to be an exhaustive list of relationships that will be deemed to impair independence.9 Thus, the fact that the prime/subcontractor relationship is not expressly set forth in that list is not dispositive as to the section's application. Furthermore, the Commission notes that Section 602.02.g is not intended to be limited to co-investments between accountants and their clients.10 Joint business ventures and limited partnership agreements, as those terms are generally understood, do not refer only to capital investment relationships.
Rather, those terms include contractual agreements to perform interdependent services for the profit of the parties to the agreements. The prime/subcontractor relationship described in the petition consists of such a contract between the auditor and its client for the joint provision of services to a third party. Moreover, the relationship carries with it the characteristics that Section 602.02.g deems to impair independence, i.e., "a mutuality or identity of interest with the client [that] would cause the accountant to lose the appearance of objectivity and impartiality in the performance of his audit because the advancement of his interest would, to some extent, be dependent upon the client." Thus, Section 602.02.g is applicable to the prime/subcontractor arrangements described in the petition.
Finally, the petitioners assert that the prime/subcontractor relationship is in the normal course of business for the auditor and the client and is thus exempt from Section 602.02.g's determination of impaired independence. The Commission notes, however, that Section 602.02.g deals with business relationships "other than as a consumer in the normal course of business [emphasis added]." While the prime/subcontractor provision of services might be in the normal course of the auditor's and client's businesses, neither party is acting in the capacity of a consumer, and the exemption thus does not apply.
In summary, the closeness and unity of interest inherent in joint business ventures (including the prime/subcontractor relationships specifically addressed in the petition) between an auditor and its audit client, rather than just the amount of revenues derived from such a relationship, creates a mutuality of interest between auditor and client and may cause financial statement users to question the auditor's objectivity. For this reason, as well as those discussed above, it would be inappropriate to apply a materiality standard of the type requested in the petition to those types of relationships.
While the Commission has declined to modify Section 602.02.g as requested in the petition, the Commission invites the petitioners to explore with the staff alternatives with respect to prime/subcontractor and similar arrangements, provided that appropriate procedural safeguards and limiting principles could be developed to obviate the independence problems that arise from this type of relationship. In this connection, the Commission's staff will continue to discuss the issue with representatives of the petitioners, the Professional Ethics Division of the American Institute of Certified Public Accountants "AICPA"), and the SEC Practice Section of the AICPA Division for CPA Firms.
Alternative proposals, accompanied by evidence supporting the view that a change in the Commission's independence requirements in this area of accountant/client relationships would not undermine the fundamental concepts of auditor independence, will be carefully considered.
For the Commission,
Jonathan G. Katz
1While the focus of the petition is modification of Section 602.02.g to incorporate a materiality standard, the petition also raises an issue as to whether the staff's current interpretation of that section incorrectly construes Section 602.02.g as applicable to a prime/subcontractor arrangement. Nevertheless, the petition states that "[p]etitioners do not here ask that Section 602.02.g be modified to render it totally inapplicable to prime or subcontractor arrangements" [emphasis in original]. Petition at 16. For the reasons described below, the Commission disagrees with the petitioners' interpretation as to the applicability of Section 602.02.g to prime/subcontractor relationships.
2 Items 25 and 26 of Schedule A of the Securities Act, 15U.S.C. 77aa, and 17(e) of the Exchange Act, 15 V.S.C. 78q(e)expressly require that the financial statements be certifiedby an independent public or certified accountant. Sections12(b)(1)(J) and (K) and 13(a)(2) of the Exchange Act, 15U.S.C. 781 and 78m, authorize the Commission to require thefiling of financial statements that have been audited byindependent accountants.
3Section l9(a) of the Securities Act, 15 U.S.C. 77s(a); Section 3(b) of the Exchange Act, 15 U.S.C. 78c(b).
4Section 602.02.g provides in part:Direct and material indirect business relationships, other than as a consumer in the normal course of business, with a client or with persons associated with the client in a decision-making capacity, such as officers, directors or substantial stockholders, will adversely affect the accountant's independence with respect to that client. Such a mutuality or identity of interests with the client would cause the accountant to lose the appearance of objectivity and impartiality in the performance of his audit because the advancement of his interest would, to some extent, be dependent upon the client. In addition to the relationships specifically prohibited by Rule 2-Ol(b), joint business ventures, limited partnership agreements, investments in supplier or customer companies, leasing interests, (except for immaterial landlord-tenant relationships) and sales by the accountant of items other than professional services are examples of other connections which are also included within this classification.
5United States v. Arthur Younq & Comnany, 465 U.S. 805, 819 n.l5 (1984).
6 See, e.q., Subcommittee on Oversight and Investigations of the House Committee on Interstate and Foreign Commerce, Federal Regulations and Regulatory Reform, 94th Cong., 2d Sess. 35 (1976).
7 Report of the National Commission on Fraudulent Financial IReporting 43, 44 (1987).
8 The requested modification might itself be anticompetitive. The materiality standard proposed in the petition is based on a comparison of the total fees derived from the prime or subcontractor relationship to the total annual revenues of the auditor and the audit client. While the proposed materiality standard might well be meaningless to the large accounting firms (an example in the petition indicates that a relationship from which fees representing 2 per cent of the accounting firm's total revenues would be acceptable; applying that percentage to the 1987 revenues reported in the press for the petitioners would allow the acceptance of fees of $30 million, S29 million, and $17 million respectively), it would effectively preclude smaller firms from competing in concert with their audit clients for all but the smallest projects.
9No set of rules or compilation of representative situations can embrace all the circumstances which could affect [a determination of independence]. But what they can do, and what they are intended to do, is act as a general notification which simultaneously educates practitioners and places on them the responsibility for recognizing these general areas of potential loss of independence.
10 A separate section of the Codification, Section 602.02.b.iii, specifically addresses the subject of common investments.